China is still on course for a hard landing: here’s what to do

It’s been clear for a while now that China is slowing down quite sharply.

China’s manufacturing sector barely grew last month. The results from the latest manufacturing survey were also worse than analysts had expected.

The authorities are clearly getting worried. They have cut interest rates and are encouraging the banks to start lending more once again. So far, the only impact seems to be in the Chinese property market, which is the one area the government really doesn’t want to reflate.

But while the economic data is looking fragile, for the really grim news you have to look at Chinese companies.

The outlook for Chinese companies isn’t pretty

As the FT reported earlier this week, numbers out from Chinese companies so far this year “have not been pretty”.

The giant state-owned enterprises have posted their worst figures since the grim days of 2008. First-half profits were down 11.6% on the year. The main casualties so far have been commodity-related companies. Steelmakers have seen profits dive by 96% – it’s been described as a “disaster zone” by the China Securities Journal.

But the big hope for China – its consumer sector – is also suffering. As the FT notes, everything from electronics retailers to airlines to sportswear companies are running into trouble.

There are two key issues, according to Société Générale economist Wei Yao. The first is that, because of the economic slowdown, inventories have been building up. That’s bad news for profits: it means companies have to cut prices to shift stock. It also makes life harder for product producers, because companies won’t order as much stock in future.

The second problem is tax. While profit growth has been slowing, tax bills are higher than they were in the first quarter. This squeeze on private companies is “pushing China into a state of profitless growth”, argues Yao.

The authorities are trying to turn things around. Indeed, many analysts are placing their bets on a second-half recovery. Ambrose Evans-Pritchard, writing in The Telegraph, suggests that China has plans to “ditche its reform strategy and prepare a vast stimulus package as the country’s soft landing turns uncomfortably hard”.

It’s certainly possible. We always say that politicians take the path of least resistance. And while the central government might be talking a big game, the regional governments are keen to boost their growth again.

But any big stimulus measures will just boost inflation and increase the bad debt load across the Chinese economy. That would set up China for an even harder landing in the future. And if there’s conflict between the central government and regional ones over this, I’m not convinced that a lending boost would have the same impact as it did in 2008.

That’s why we’re staying bearish on China.

What this means for your portfolio

We’ve been suggesting that you avoid industrial metals miners and ‘base’ commodities in general. The good times also seem to be ending for luxury goods companies. And we’re certainly not ready to buy Chinese equities yet. (For more on how China’s woes might affect the US, you should read our interview with financial historian Russell Napier. (If you’re not already a subscriber, get your first three copies free here.)

As for how to profit from China’s decline, the most obvious play to us is a speculative one – to go short the Australian dollar.

As we’ve explained before, the Australian economy is highly geared towards China’s success. Australia sells commodities, China buys them. If China’s demand for commodities falls – which it has – then Australia’s economy loses one of its key drivers.

Throw in a bursting house price bubble, and you have a recipe for falling interest rates and a weakening currency.

The Australian dollar has taken a few knocks in recent months, but it has rebounded somewhat from recent lows. It fell below parity with the US dollar at one point, but is now well above it again.

This resilience is partly due to hopes for more monetary easing from central banks in general. But it’s also got quite a lot to do with the Swiss central bank.

The Swiss are artificially suppressing the Swiss franc against the euro. They don’t want their currency to be forced higher by people fleeing the carnage in Europe. That means they have been forced to buy euros. They don’t want to end up sitting on loads of euros in their reserves, so they have to swap them for something else. That ‘something else’ includes currencies such as the Swedish krona, the Canadian dollar, and the Aussie dollar.

This can’t last forever. Either the Swiss will be overwhelmed and have to break the peg, or Mario Draghi will actually do something effective this week and the flight from the eurozone will ease off.

You could short the Aussie using a spread bet. As we always point out, spread betting is highly risky, and you can easily lose a lot more than your initial stake. If you want to learn more about how to do it, you should sign up for our free email, MoneyWeek Trader, which has various tips and tactics for successful spread betting.

A less risky option – although it’s still high risk – is to use an exchange-traded product such as the ETFS Short AUD Long USD (LSE: SAUP). This London-listed financial instrument is designed to rise when the Aussie dollar falls against the US dollar, and vice versa.

Just remember to monitor this position closely – it’s not a buy and hold investment. There’s also an added layer of currency risk. The underlying product is denominated in US dollars, so if you are buying in sterling, you’ll find that the US dollar / sterling exchange rate has an impact too.

Follow John on Twitter || Google+ John Stepek

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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