Money Morning Mid-Year Forecast: Why China's Economy Will Exceed Expectations in the Second Half of 2010

[Editor's Note: This is the latest installment in Money Morning's ongoing Midyear Economic Forecast series, which has covered such topics as oil, gold, and the U.S. dollar.]

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The rapid growth China's economy experienced in the first half of the year was a blessing and a curse. It helped propel the world out of a disastrous recession, but it forced policymakers into action to prevent overheating – which scared off many investors.

Money Morning Mid-Year Forecast
But the fact is that while most of the world was struggling to keep the engine of economic recovery from sputtering to a halt, China spent the first half of 2010 with its foot on the brake. And now that the Red Dragon has reigned in growth, the second half of 2010 will likely look very different from the first.

Money Morning Chief Investment Strategist Keith Fitz-Gerald says nearly everyone felt the first quarter's 11.9% growth in Chinese gross domestic product (GDP) was "too hot." But the 10.3% growth China saw in the second quarter will likely be topped in the second half.

The reasons for that are simple:

"From an investment perspective, the single biggest concern right now is how hard and for how long the Chinese government will keep tapping on the brakes," says Fitz-Gerald. "I personally don't think it's going to be too much longer – an easing sometime in the third quarter now seems realistic."


The Red Dragon's Real Estate "Problem"

China's government is making progress in reducing the explosive rate of construction growth and property speculation, especially in the housing sector.

After real estate investment accounted for 12.8% of China's GDP in 2009 – and 22.1% of all fixed-asset investment – Beijing decided to clamp down this spring, implementing new restrictions affecting loans, land sales and permits for new construction, as well as proposing a plan to gradually introduce property taxes.

As a result, nationwide property sales in June declined for the second straight month in volume terms, with the floor area of buildings sold down 3.1% from a year earlier, following a 3.4% drop in May, according to China's statistics bureau.

That should ease concerns among global investors about the impact of overbuilding – an issue Fitz-Gerald contends was overblown to begin with.

"China has historically built well in advance of what it's going to need, and most of the reports of empty buildings standing around have been confined to three areas – Beijing, Shanghai and Hong Kong – where future growth is expected to be most dramatic," he said.

Those areas are also where the recent restrictions have had the largest impact, with both Beijing and Shanghai reporting sharp declines in sales.

Analysts also frequently overlook one other critical point regarding China's real estate situation, according to Fitz-Gerald.

"Chinese law requires that, once you buy a piece of property, you must build on it within 18 to 24 months. They don't allow 'land banking' like we have here in the United States," he says. "As a result, developers who want to lock up land will buy it, throw up a garbage building and let it sit empty so as to avoid being taxed at higher occupancy rates until they're ready to build what they actually want. Empty buildings there don't necessarily equate to a lack of demand."

What's more is that the real estate restrictions are likely to be short-lived. The Ministry of Housing and Urban-Rural Development in May signed an agreement with local and provincial governments to fund construction of 5.8 million new affordable housing units and renovate another 1.2 million homes.

Also helping support the construction industry is a new government program to rebuild the earthquake-ravaged provinces of Sichuan, Gansu and Shaanxi. On May 14, the Ministry of Finance allocated more than $3.6 billion (24.8 billion yuan) for nearly 4,000 projects aimed at restoring municipal infrastructure and public services.

Additional money was allocated to ensure the funding of about $30 billion (200 billion yuan) worth of municipal bond requests filed with the National Development and Reform Commission (NDRC) since Jan. 1 – funding that had been delayed in the bid to slow economic growth. But now that a visible slowdown has been achieved, the funds are being released.

"The government doesn't want to see a bunch of unfinished projects," said Gao Huiqing, a member of the State Information Center Expert Committee. The municipal projects are thus being funded again, but "at a controlled pace."

Underestimating Exports

Real estate and construction aren't the only sectors that will surprise analysts in the second half of the year, either. China's export sector, still the backbone of the country's economy, remains strong.

Despite concerns that Europe's sovereign debt woes and America's wavering recovery would trigger the second trough of a double-dip global recession, dimming China's foreign business prospects, exports have continued to grow. China's total imports were up 34.1% from a year earlier in June, while exports climbed by 43.9%, taking the country's trade surplus to a record high $20 billion.

The rising demand also has many companies in China operating at full capacity, meaning they're now under renewed pressure to grow. For example, Caterpillar (NYSE: CAT), the world's leading supplier of construction and mining machinery, says it is operating at 100% in all its Chinese facilities.

Rather than being encouraged by the export numbers, some analysts expressed concern they might rekindle inflationary fires, but China's consumer price index actually fell to 2.9% in June from 3.1% in May.

"The thing with inflation is that you have to keep it in perspective," said Fitz-Gerald. "China's economy is growing at an annual rate of around 10%, so inflation of 3% is no big deal – unlike here (in the United States), where we're growing at just 2% or so a year and non-government sources estimate real inflation is running around 9%."

Of course, the fact that analysts have continually underestimated the Red Dragon's stability has left investors with a tremendous opportunity.

Stocks Set to Surge

Indeed, Chinese stocks are poised for a big rebound in the third quarter. The Shanghai Composite Index has dropped 17% in the past three months, and the CSI 300 has lost more than 25% of its value.

But consider this: From 2004 through 2009, the CSI 300 had five major declines. If you exclude the global collapse in 2008, the other four "internal corrections" have averaged 27.5% over an average time period of 88 days. The current pullback has already exceeded the 88-day mark, and the loss is close to the past average.

Given those numbers, Fitz-Gerald recommends that you "double your exposure to China for the second half of the year" – but with a couple of caveats.

"Chinese stocks are definitely going to be fairly volatile in the coming months," he warns, "if only because the markets are still relatively immature and the government is going to keep a very careful watch on them to keep growth in check. However, there will be plenty of bullish pressure on prices because the money that's been targeting real estate speculation – now blocked by the government restrictions – will be channeled into stocks."

The market also could get a boost from an easing of the European debt situation and a rebound in the value of the euro, which has fallen precipitously.

However, Fitz-Gerald cautions against placing too much emphasis on China's import-export numbers, which he says will likely remain "tepid" simply because trade balances have become more of a political than an economic issue.

"The more the West pressures Beijing to increase imports and cut exports," he says, "the more China is going to resist."

Investing in China

If you want to trade a potential second-half upturn in Chinese fortunes there are a variety of options.

Some Chinese stocks that trade on U.S. exchanges are worth a look given the potential resurgence in construction and newly authorized spending on public services.

  • Anhui Conch Cement (OTC: AHCHY), recent price: $15.15 – This stock is very thinly traded here in the United States, but it's a good candidate for two reasons. It is China's largest cement producer, having dominated the coastal building markets for years. And its share price has been halved in the recent correction. Fundamental info is scant on most U.S. market websites and, once again, it's very thinly traded, so buy only with limit orders.
  • Yingli Green Energy Holding Co. Ltd. (NYSE: YGE), recent price $11.75 – Recommended a number of times in past Money Morning and Money Map Report issues, Yingli is China's only fully "green" energy company, engaged in the design, manufacturing and installation of photovoltaic (PV) products for solar power and telecommunications systems. The stock has been range-bound for the last few months, but renewed municipal infrastructure spending could spike demand – and turn last year's loss into a healthy 2010 profit.
  • Another potential winner in the second half, if oil prices climb as expected, is China Petroleum & Chemical Corp. (NYSE: SNP), recent price $77.18. Also known as Sinopac, the company engages in the exploration, development and production of crude oil and natural gas; refining, transportation, storage and marketing of petroleum products; and the production and sale of chemicals, including basic organic chemicals, monomers and polymers for synthetic fiber, synthetic resin, synthetic rubber and chemical fertilizers. It also owns and operates oil depots and service stations. The stock's current price/earnings (P/E) ratio is just 7.39, and it pays a dividend of $1.80 a share.

For those who prefer the balance and stability offered by exchange-traded funds (ETFs) to direct stock investments, a couple of potential choices are:

  • Morgan Stanley China A Shares Fund (NYSE: CAF), recent price: $26.75 – This closed-end fund, which has recently been trading at a slight discount to net asset value (NAV), is the only fund focusing on Chinese A shares that's currently open to U.S. investors. It's also one of the best ways to diversify across a major slice of the Chinese economy, with a recent portfolio allocation of 28% in consumer goods and services, 26% in financials and 18% in basic materials. It also holds shares in companies that make auto components and beverages, among other products, and has numerous stocks in the metals and mining sectors. CAF pulled back 37% from a 52-week high of $37.44 in the recent correction, but bottomed at $23.51 in late May and has eased steadily higher since.
  • iShares FTSE Xinhua 25 index (NYSE: FXI), recent price: $38.95 – This exchange-traded fund (ETF) seeks to mirror the price and yield performance of the underlying index, which tracks 25 of China's largest and most liquid companies. At least 90% of the fund's $8.1 billion in assets is invested in either the actual Chinese shares or depositary receipts representing those securities. The recent P/E of the shares is 14 and the fund has a dividend yield of 1.4%.

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  1. Geoff Jakeman | July 20, 2010

    Please sign me up to MMN

  2. Bill | July 20, 2010

    Good points.

  3. Parry Tan | July 25, 2010

    would like to receive the articles

    thanks!
    Parry

  4. BenjaminB | August 9, 2010

    The Chinese economy depends very on exports.Export is urgent because the domestic market is not able to absorb the enornous quantity of goods ,the purchasing power is not strong enough.Export still "should close the circle ".Huge export is supported by under-valuated yuan which makes possible the goods are competitive.

  5. robert tang | August 25, 2010

    the two autonomous regions XINJIANG & TIBET will attract vast amount of investment in the next 10 to 15 years. all the eastern, north east and some central provinces plus beijing, tianjin and shenzhen are tasked to help various prefectures and cities in XINJIANG & TIBET. those listed companies dealing with energy and infrastratures will have growth potentual. china going western regions are accelerating and more investment and manpower will move in fast. greetings from robert

  6. bob mccready | August 27, 2010

    Money Morning–Please do not send me any more emails…Thank you.

  7. victor manuel rocha fitas da graca | September 16, 2010

    i whant now how much i heve in all banks wold (mundo),my contact is 00244912103045

  8. vicktor | October 4, 2010

    The world changes, what America gave to the world, China will never make up or give as much!!

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