Amid the eurozone panic, a greater threat is lurking

As the eurozone crisis snowballs again, stock markets and other assets have taken a hammering. But there's another, greater threat looming on the horizon - China's slowing economy. John Stepek explains what it means for you.

If you followed the old stock market adage this year, and sold in May and went away, you probably feel rather relieved.

May was an awful month for stock markets, and most other risk-on' assets. Crude oil saw its worst monthly drop since 2008. The FTSE 100 fell by nearly 8%.

The main reason for the big drop this month is pretty clear the eurozone crisis has managed to snowball yet again.

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The bad news is that this time round, any sort of temporary eurozone resolution will be overshadowed by another looming nasty China's slowing economy

China is going to disappoint the bulls

Growth in China's manufacturing sector is slowing rapidly, according to official data. In May, the purchasing managers' index hit a five-month low, worse than analysts had expected. A separate survey sponsored by HSBC which pays more attention to smaller companies than the official measure - suggests it is already shrinking.

The response from the China bulls is that China will launch another stimulus of some sort to save its economy. The idea is that China's leaders have so much power at their fingertips, that they can effectively make the economy do whatever they want it to.

Here's a quote from Zhang Liqun, an economist with a Chinese government think tank. "Pre-emptive, targeted fine-tuning of macroeconomic policy has already started, especially with a series of measures to stabilise investment. As that impact is felt, the economy will stabilise," he tells the FT.

As we've noted before, this is just the same sort of reassuring waffle that we heard before the subprime crash. It's not a million miles away from the sort of statements about Greece that we got used to seeing from eurozone officials in recent years either.

Why are intelligent investors willing to believe that China's officials can succeed where others have failed?

Investment stories die hard

As with most things, it's all about the money. Fund managers have stories to sell. You should buy stocks. You should buy my fund.' It's hard to make a pitch for stocks if there isn't a cheerful story around to back up your bullish argument. So you've got to find one.

"Yes, Europe is self-destructing. Yes, US growth is fragile, and stocks aren't massively cheap. But don't worry, because we've got China and Asia and all the other emerging markets. Their consumers will pick up the slack from the rest of the world. Western companies will have vast new markets to profit from. So all will be well."

It's a compelling story. But it's just not that simple. As Matthew O'Brien points out in The Atlantic, government officials have admitted that banks might miss their lending target for 2012. How can this be? After all, "China still has a state capitalist model. The government sets targets for loans, and the banks have until now hit them."

The problem is "a simple lack of demand." This in turn, is a side-effect of falling house prices. As O'Brien puts it, "popping a housing bubble which is what China is trying to do is usually an economic death sentence." The problem is that when prices fall, borrowers end up underwater' (in other words, the collateral is no longer worth as much as the loan secured against it).

"Underwater borrowers don't want to borrow more until their balance sheets are right-side up, even at zero rates. That's what happened to Japan in the 1990s. It's what happened to [the US] in 2008."

Some people argue that the property bubble will only affect wealthier Chinese people. Or that the Chinese don't over-stretch themselves in the same way that Western homebuyers do.

Even if this were true - anecdotal evidence suggests that in fact Chinese people borrow plenty of money to buy property, just not through official channels - it misses the point.

The key thing driving Chinese economic growth for years has been fixed asset investment building stuff, in other words. As Patrick Chovanec points out on his blog, fixed asset investment accounts for over half of China's GDP growth. And property investment accounts for a substantial chunk of this.

If property investment continues at the same pace as last year - in other words, if developers build as much property as they did in 2011 - "it could shave as much as 2.6 percentage points off real GDP growth."

Of course, given that developers have already built too many properties, and demand is dropping off, chances are they'll build less. And that could have a huge impact on Chinese growth. A drop of 10% in property investment "could bring GDP growth down to 5.3%."

That kind of figure would really spook markets.

So what should you do?

The pattern in recent years has been that Europe has a crisis, it does something to temporarily relieve it, and markets bounce back.

The eurozone crisis is rapidly reaching another of those something must be done' points. European officials would clearly rather wait until after the Greek elections this month, crossing their fingers that a pro-austerity party will get in. But there's no guarantee they won't be forced to act before then.

Trouble is, any relief rally will rapidly collide with evidence that China is on the slide. So I'm not convinced that any risk-on' rally will have much staying power.

The only solution is to stay defensive for now (blue chips, gold and cash), and look to buy what's cheap. From my point of view, Italy is starting to look interesting. The country is probably the most durable of the peripheral' countries, and yet its stocks are suffering at least as badly as the rest. We'll be taking a closer look at whether there are any bargains out there in the coming weeks.

Meanwhile, if you're looking for specific stock ideas, at the latest MoneyWeek roundtable, our panel of investment managers debated the outlook for both China and Europe. They came up with their favourite picks for riding out the chaos, including a precious metals miner and a surprising UK consumer stock. If you're a subscriber you can read the piece here: Nine investments our experts would buy into now. If not, subscribe to MoneyWeek magazine.

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

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John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.