China's Outlook, in Microcosm

 | Oct 03, 2011 | 12:30 PM EDT  | Comments
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RealMoney subscribers, let's give a head-nod hello to Wenzhou, a coastal city in China and suddenly an area where businessmen are fleeing a physical beat-down from bruising loan sharks.

In the third week of September, China was barely capturing the attention of investors who were fixated on every word by third-tier European Union officials or an old dude on television pounding the table on equities for the long-term. (It was fine to lose 40% in Morgan Stanley in the third quarter -- the firm will be around for a while, and the stock will recover, right?)

Then whack, concerns regarding the severity of China's ongoing economic moderation hit the markets like a ton of bricks. Macro data on China, if they are to be believed (it's a Communist country, people, even though it "feels" capitalistic when reading 10-Ks), have promoted the view that the economy is headed for a soft landing.

Think rationally for a moment. How does China avoid a hard landing after a series of rate hikes, a property boom, a luxury-goods consumption boom and shady loan-givers trying to collect on principal and interest payments of 25% or higher (the benchmark rate in China is 6.56%)? Welcome to market psychology 101, where the herd mentality prevails until a new thundering herd arrives on the scene.

Why care about a mountainous, isolated region in China that's known for the production of cigarette lighters? The answer is simple to the trained market eye: Losses are rising for small and medium-sized businesses and for the city's manufacturing base -- operations supported by loans that made no economic sense -- for reasons that are representative of China as a whole. I am no Steven Roach in terms of loving China data, but common sense would suggest that if little Wenzhou has hit the economic skids, what is stopping the rest of China going from sweet economic growth story to sour?

Wenzhou talking points:

  • Over 3 million urban citizens.
  • 240,000 individually owned commercial and industrial units.
  • 130,000 private enterprises.
  • First to launch "market economy."
  • Often called the most active and developed private economic area in China.

When the headlines say that China's slowdown is rocking markets, it's more likely that the not-so-happy developments in a small port city are being enlarged to account for widespread global economic destruction.

I don't believe the market is acting irrationally. If we have learned anything from our own debt-induced bubble bust, it's that corporate over-leverage is a ticking time bomb. Considering that so many companies in their longer-term planning meetings consider China to be an unstoppable growth market, and considering that China is the largest holder of our Treasury bills, anything that goes against the status quo will ignite a new risk factor for the markets to take into account ... usually by selling risk assets.

Monday bonus round:

  • The Dow shed 12% in the third quarter, the worst performance since the first quarter of 2009. In my opinion, this weighed heavily on consumer confidence and specifically on future spending intentions. Most retail stocks I track are headed for their late August lows.
  • Initial reads on the employment picture for September are mixed. ADP estimates 48,000 in private payrolls, down from 91,000 in August, while non-farm is expected to bounce to 61,000 from zero in August.
  • Government was the only sector to log a gain in personal income in August. No comment.
  • I would hold off on jumping into Costco (COST) pre-earnings on Wednesday. Valuation is richer than the norm, I don't believe a dividend raise will do the trick catalyst-wise, and a membership fee increase may still be on tap for calendar 2012. Additionally, the company has already announced a massive share-repurchase program. In Wall Street jargon, the risk/reward is unfavorable.

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