Why China is Still the World's Best Long-Term Profit Play

By Jason Simpkins
Associate Editor

While a recent crop of economic data suggests that China is not fully insulated from the economic turmoil that has overtaken the United States and Europe, some of that data is suspect. The upshot: The world's fastest-growing economy is still much better off than its Western counterparts and probably remains the best long-term option for globetrotting investors.

China's benchmark Shanghai Composite Index has plummeted nearly 70% in the past year. A big reason for the decline was concern among investors that economic chaos in the United States and Europe would deplete China's breadwinning export market. But, so far, those fears have proven to be largely unfounded.

China's exports grew 22% in the first eight months of the year, despite sluggishness in the global economy and turmoil in the world's financial markets.

Even more impressive: China's retail sales grew at the fastest pace in at least nine years last month, soaring 23.2% to $128 billion. Retail sales climbed 22% in the first eight months of the year, a hefty jump from the 16.8% pace for all of 2007.

So even if exports do diminish, there is a mounting body of evidence that suggests China's domestic demand will be enough to offset global weakness.

"Our outlook for consumption growth remains broadly positive," said Jing Ulrich, JPMorgan Chase & Co.'s (JPM) chairwoman of China equities, in a research note.  "As China's government attempts to move from export-dependent growth, we expect that additional resources will be pledged to support domestic consumption."

This is also true of China's industrial sector, which many critics contend is showing signs of weakness. China's industrial output expanded 12.8% in August after growing 14.7% in July, according to the National Bureau of Statistics. But there is a strong possibility that output will ramp back up over the next several months, as factories that were closed for the Olympics come back on line and Beijing sets out to rebuild areas of the country devastated by an earthquake earlier this year.

The government closed down a multitude of factories in and around Beijing to keep pollution from blemishing the Summer Olympic Games. Factories closed in Beijing and the surrounding areas account for 26% of China's economy, according to Goldman Sachs Group Inc. (GS).

"We expect industrial activity to pick up with the reopening of factories in Beijing and surrounding areas," said Ulrich.

Merrill Lynch & Co. Inc. (MER) estimates the factory shutdowns, combined with weaker demand for steel and cement, knocked 2.5 percentage points off headline growth.

"We expect a post-Olympic rebound in industrial production growth on both pent-up demand and the post-quake reconstruction," said Merrill economist Ting Lu. The tab for rebuilding large portions of the Sichuan region after May's devastating earthquake is expected to run about $78 billion.

With such robust growth in so many key sectors, a 70% decline in stock prices is almost baffling, unless you consider the troubles that have beset U.S. and European financial companies, as well as the gradual extinction of Wall Street's once-proud investment banks.

According to Jonathan Wu, head of distribution at Premium China Funds Management, cash-strapped U.S. and European banks have spent the past year liquidating their Chinese assets in a desperate bid to shore up their balance sheets.

"It's just sheer panic. U.S. and European banks are suffering to keep themselves afloat [amid the sub-prime crisis]," Wu told IFA. "What we have seen is that they are selling holdings in Chinese companies because Chinese stocks have been most profitable [for investors]."

It remains unclear when China's stock indices will bounce back, but Wu says investors won't be waiting for a U.S. recovery to pump cash into Chinese equities - especially at their current deeply discounted levels. Price/Earnings (P/E) ratios for Chinese stocks have plunged from about 40 last year to 14 in September.

"[Investors] may lose another 10%, they may lose another 15%," Wu told IFA, "But on a long-term trend, because of the fact that we are just buying these value stocks that have such good fundamentals behind them, once there is that confidence restored in the market, stocks will fly."

China Still Head of Strong Emerging Market Class

There's little doubt that China's economy will expand at a slower rate going forward, but it's becoming more evident  that the country's vulnerability to the turmoil plaguing the West has been greatly exaggerated. China is still expected to lead emerging markets in a period of strong growth throughout 2009, even as the United States and Europe continue to struggle.

"The negative impact coming from the global slowdown will continue to affect Asian economies, but the extent of the impact will be small and felt more next year," Haruhiko Kuroda, President of the Asian Development Bank (ADB), told the Financial Times. "But even then, the impact, or downward adjustment, will not be as great as some of us had feared [because] real demand is strong, including domestic demand [and] investment as well as the consumption are strong."

China's economic growth will remain unchanged at 10% this year, the ADB said last week.  Growth is then expected to slow 9.5% in 2009, which would still handily trump whatever growth developed economies manage to muster up.

A survey released yesterday (Tuesday) found that the overwhelming majority of executives operating within emerging markets are optimistic about their growth prospects over the next two years, Reuters reported.

About 87% of executives operating within emerging markets are optimistic about company revenues over the next two years, and just 3% are pessimistic. Roughly 80% are optimistic about profitability, according to an Economist Intelligence Unit poll of 1,300 executives in emerging markets at companies with annual revenue of at least $100 million.

"I am, despite the enormity of the financial crisis, more optimistic about the state of the world economy," Jim O'Neill, head of global economic research at Goldman Sachs Group Inc. (GS), told an emerging markets conference in London.

Because the U.S. economy no longer dominates the way it once did, O'Neal sees a bigger opportunity for the so-called  "BRIC" countries (Brazil, Russia, India, and China).

"It may be that the BRIC consumer is indirectly squeezing out the U.S. consumer," he said.

China is the most influential of all these markets because it is roughly the same size as the combined markets of Russia, India, and Brazil.

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