Are You Ready for a China Implosion?

For years, as developed economies around the world have stagnated, investors have turned to emerging markets in general and China in particular for their better growth prospects. With huge populations and improving standards of living, companies around the world have seen China and its emerging-market peers as rich sources of new business that could make or break their success for years or even decades to come.

Yet many of those investors have counted on the sustainability of emerging-market growth rates over long periods of time. As that theory starts to run into the harsh reality of a global slowdown to which even China has proven susceptible, investors around the world need to examine their investing strategies closely to determine just how exposed they are to possible Chinese economic troubles down the road.

Soft, hard, or crash landing?
Few topics inspire greater disagreement than the state of China's economy. Because its economy is more opaque than those of the U.S. and certain other large countries, China invites widely differing views even among experts.

What we already know is that Chinese GDP growth is likely to drop this year to about 8%. Although that hardly seems like cause for concern, we also know that China's central bank has cut interest rates twice in the past month, strongly suggesting either that it knows further drops in growth are coming or that it fears that the slowdown the nation has already seen could have more extensive impacts in the future.

What's open to debate, though, is just how bad things could get. As an article in Barron's last weekend discussed at length, some believe that the Chinese government's actions can succeed in providing a so-called soft landing for the slowdown, sustaining at least some economic growth going forward. But more pessimistic analysts point to the Chinese dependence on its banking system as well as a serious real-estate bubble, raising ugly parallels to the conditions that produced the worst recession in the U.S. since the Great Depression.

Protecting yourself
Already, Chinese investments have taken pretty big hits. Even Internet giant Baidu (Nasdaq: BIDU  ) , which has long boasted lightning-fast growth rates, sits almost 30% below its levels from a year ago and has lost almost a quarter of its share price just since April amid concerns about its future. Unlike the U.S. market, Chinese stocks generally have gone nowhere in 2012, with the Shanghai Composite within a few percent of a three-year low.

In addition, other investments linked to China have also suffered. One obvious candidate is Vale (NYSE: VALE  ) , which for years prospered by meeting immense Chinese demand for raw materials but which now faces the scary prospect of a slowdown that could wipe out much of its business. Similarly, in the U.S., natural-resource linked companies Freeport-McMoRan Copper & Gold (NYSE: FCX  ) and Cliffs Natural Resources (NYSE: CLF  ) have seen big drops in their shares as the prices for their products have fallen.

What investors have underestimated, however, is the extent to which other sectors rely on Chinese growth. Consider:

  • Fertilizer stocks CF Industries and Terra Nitrogen (NYSE: TNH  ) have seen impressive performance due to low input costs and favorable environments for farm commodities. But a drop in Chinese growth could reverse the middle-class trend there, sending food prices plunging and farm-related stocks down sharply.
  • The rise in wealth of China has directly benefited the U.S. housing market, as foreign real-estate purchasers make up an increasingly important part of overall demand. If China implodes, then that demand could quickly go away, leaving the real estate market here in even worse shape.
  • Casino stocks once known for their Las Vegas riches now depend on Macau for their profits. A Chinese hard landing could hurt the entire East Asian region, in turn leaving gaming customers with less to gamble. Even though most casino stocks are well off their highs, they're still arguably not pricing in the risk of a full economic collapse.

Stay on guard
Given the huge role that China now plays in the global economy, there's only so much that stock investors can do to protect themselves without fleeing the market entirely in favor of Treasuries and stable-value assets. What's most important, though, is simply to keep a close watch on the situation in China, always understanding that what you're seeing may just be the tip of a much larger hidden iceberg.

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Fool contributor Dan Caplinger tries to be prepared. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of CF Industries, Baidu, and Freeport-McMoRan Copper & Gold. Motley Fool newsletter services have recommended buying shares of Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy explodes with information.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 06, 2012, at 4:48 PM, ETFsRule wrote:

    China raised their interest rate 5 times from 2010-2011, when many countries were slashing their rates to almost zero.

    This led to a predictable slowdown for China's economy in 2012, along with a dramatic reduction in their inflation rate.

    Now, they are starting to cut their rates. My prediction is not a "hard landing" or a "soft landing", but rather a return to ~9-10% gdp growth in 2013.

  • Report this Comment On July 06, 2012, at 4:48 PM, ETFsRule wrote:

    .

  • Report this Comment On July 07, 2012, at 9:17 AM, hongchang wrote:

    no one in the western world got it right 10 years ago when China's economy was booming and no one will get it right this time either. They simply don't understand how things work in there, period. No hard landing, just slow down.

  • Report this Comment On August 14, 2012, at 10:55 PM, MHedgeFundTrader wrote:

    My grandfather was an immigrant from Sicily who joined the army during WWI to attain US citizenship, lost an eye when he was mustard gassed on the Western Front, and settled down in the Bay Ridge section of Brooklyn after the war.

    He bought a three bedroom brick home on 76th street for $3,000, eventually raising four kids. Back then, there was a dairy farm across the street, and horse drawn wagons delivered ice blocks door to door. During the roaring twenties an assortment of relatives chided him for avoiding the stock boom where easy fortunes were made trading on margin. When the 1929 crash came, all of them lost their homes. Grandpa finished off the basement, creating space for two entire families to move in. He never bought a stock in his entire life.

    Because dad contracted malaria with the Marines on Guadalcanal during WWII, the old man moved the family to Los Angeles in 1947 for the dry, sunny weather. Unfortunately, the train stopped long enough in Las Vegas for a flim flam man to sell him five acres of land for $500. Ten years later my dad drove out to check out the investment. It was a tumbleweed blown, jack rabbit and rattlesnake ridden piece of land so far out of town that it was worthless. You couldn’t see downtown, even if you stood on the rusted out model “T” that occupied the land. After that, the parcel became the family joke, and grandpa was ridiculed as the world’s worst investor.

    Grandpa died of emphysema in 1977 at the age of 78. Chateau Thierry and Belleau Wood finally caught up with him. What German shrapnel and gas failed to accomplish, 60 years of smoking two packs a day of Marlboro’s did. His estate executor put the long despised plot in Sin City up for sale. Although the final price was never disclosed, it was thought to be well into eight figures. In the intervening 30 years the city of Las Vegas had marched steadily Southward towards Los Angeles, eventually encompassing it, sending its value through the roof. The deal triggered a big fight among the heirs, those claiming he was the stupidest demanding the greatest share of the proceeds, the bad blood generated continuing to this day. It turns out the world’s worst investor was really the best, we just didn’t know it.

    What was the address of this fabled piece of real estate? Why, it is 3325 Las Vegas Blvd. South, the site today of the Venetian and Palazzo Hotels, home to the Dal Toro restaurant, the venue for the Mad Hedge Fund Trader’s last Las Vegas strategy luncheon. I’m sure grandpa is laughing in his grave.

    The Mad Hedge Fund Trader

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