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China’s Economy Nears an Inflection Point – And It’s Not a Good One

Oh, China.

The Middle Kingdom’s stocks had a hell of a run leading up to the U.S. financial crisis. It was easy to get swept up in the vision of “a billion new consumers” fueling an endless bull-run.

Of course, the stocks crashed and have languished for five years now.

Perhaps Chinese investors forgot about impermanence, a central tenet of Buddhism – a religion with which 18% of Chinese self-identify.

The basic philosophy is that “nothing lasts forever.” And that’s doubly true of both stock gains and economic growth.

I’ve dogged on China since we started Wall Street Daily (see here, here and here) because of fraud, political instability and a false economy fueled by stimulus spending.

Even though Chinese stocks have seen a bit of a boost in recent months, they still lag behind the United States. On a risk-adjusted basis, U.S. small caps have provided a return 21-times greater than Chinese stocks over the last year.

Should you still wish to argue, though, that an economy growing more than 8% per year can’t continue to deliver lackluster stock returns, consider this: China is approaching an unfortunate inflection point.

What Does the Inflection Point Mean for China?

First, China will need to need to drastically reorient its market manipulations. That’ll lead to slower growth and lackluster stocks.

Just look at how China’s economy is working right now: The biggest game in town is still massive, government-directed infrastructure projects – primarily to expand and connect China’s massive cities through transportation systems.

As The Economist reports, “It’s like trying to tie the Philadelphia and New York metro areas together – if there were a couple more Philly-sized metros in between the two. The merger is being accomplished via a wave of infrastructure investment, including utility and telecommunications projects but consisting largely of massive spending on transport. China is undertaking similar strategies all around the country, and some clusters may come to hold nearly 100 million people.”

Now, I’m all for government investing that generates economic growth.

But China’s approach isn’t to foster organic growth by smart spending. Its goal is to manufacture growth by having the government pay for all of it.

Unfortunately, this stimulus approach is reaching its end game.

Growth, especially through stimulus, carries the risk of inflation.

According to Premier Wen Jiabao, “China is still under considerable inflationary pressure this year, and maintaining basic stability of overall prices has always been an important macro-control target.” In the same speech, Wen announced that the 2013 inflation target was cut to 3.5% – from 4% – the year before.

But in February, China’s CPI rose to 3.2%. In other words, to maintain price levels and – more importantly for a central bank – credibility, China’s going to need to slow the stimulus spigot in the very near term as inflation hits the ceiling.

To top it off, China’s manufacturing numbers have disappointed, with PMI hitting some of the lowest levels since 2009. Manufacturing growth overall grew at an annual rate of 9.9% so far this year, while expectations were for 10.6% growth.

I’m not going to say this is stag-flation.  It is, however, inflation paired with slowing growth… a terrible combination for investors.

I’ve been a China bear (a Panda Bear?) for years now. And I have a healthy respect for impermanence when it comes to investment outlooks. But this market call feels like it will last for a long time.

Ahead of the tape,

Matthew Weinschenk

Matthew Weinschenk