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The art market is warning of a slump in China

China is now the main driver of growth in many sectors of the global economy, including the art market. Demand has driven auction prices ever higher. But now one indicator is warning of a slump ahead. John Stepek investigates.

Europe hogged the headlines yesterday.

You can see why. Italy got a bad review from a credit ratings agency, Spain's government was trounced in local elections, and Greece's woes just keep rumbling on. It's a messy business.

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But in the background there's another concern perhaps even greater than the fears over the sovereign debt crisis.

Because evidence is now mounting that the saviour of the global economy China is slowing. That could be very bad news for stocks in general, and for one sector in particular.

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China's economy is slowing down

The Chinese stock market the Shanghai Composite Index has been in the doldrums for a while. It peaked in November last year. Yesterday it tumbled nearly 3% after a survey showed that the Chinese manufacturing sector's growth rate had fallen to its lowest level in ten months.

It's not the only indicator forecasting a slowdown. A poll of German private sector activity also showed that growth is easing. As an export-led economy, an Germany is a play on global growth. And for now global growth is driven by China.

Goldman Sachs and several other investment banks are trimming their growth forecasts for China. Goldman now reckons China's economy will grow by 9.4% in 2011. That's hardly recession territory, but it's down from an initial target of 10%.

Goldman also believes China won't tighten monetary policy much more. Even although inflation will remain high during the year, the government won't want to derail economic growth entirely.

In March, China's Premier Wen Jiabao said that tackling inflation was his top priority. But last month, reports Bloomberg, he noted that the government "must gauge the 'lagging effects' of tightening monetary policy to avoid future harm to the economy".

In other words, the bets are that the government can hit the 'Goldilocks' spot. The economy won't grow too fast, or too slow, but 'just right'.

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Hmm. Sound familiar? What China's experiencing right now is the same problem that every other central bank has faced through history. How do a bunch of men (and the occasional woman) sitting in a room somewhere in a nation's capital city decide what the correct 'risk-free' rate is for an entire economy?

Chinese central bankers aren't miracle workers

If that doesn't strike you as daft already, then let me put it another way. If the British government turned around tomorrow and set a minimum price for apples across the UK, what are the chances that they'd set the 'right' price?

It's a ridiculous question. The whole notion that there's a 'right' price for apples at all, let alone that the government could figure it out, is absurd.

So why is it any less absurd to imagine that the government (or a central bank) can set the 'right' price for money?

My colleague Merryn Somerset Webb recently discussed this problem with Jim Rogers, and we have more on the debate in the current issue of MoneyWeek: Do we need a central bank? (If you're not already a subscriber, get your first three copies free here.) If you're at all interested in how the monetary system works, and ideas on how it could work better, then have a read and have your say on Merryn's blog.

For now, I'm just trying to make the point that a central bank's task is a fool's errand. For a start, most central bankers refuse to do the job properly. In the West, and the US in particular, none were willing to raise interest rates and slow their economies down when they really should have.

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But even if you find a central banker who is willing to be the party pooper, then figuring out just how tight to set policy particularly when most economists reckon that changes to interest rates really only take effect 12 months after the change is almost impossible.

What's my point? You'd have to be incredibly lucky as a central banker to set policy just right. The 'Goldilocks' economy is well named, because it's a fairy tale. It's far more likely that either China will experience a sharp slowdown, or worse still, a hefty dose of inflation that forces a major crackdown on lending.

What does this mean for investors?

A slowdown in China would have a number of effects. We've discussed the impact on commodities. And it's another reason why we'd stick to our mix of defensives, cash (in inflation-protected accounts - see: How adventurous investors can beat inflation) and gold.

But there's another specific sector to be wary of luxury. Luxury goods have done extremely well in recent years as China's booming economy has driven up demand for status symbols for the newly wealthy. Fancy shoe designer Jimmy Choo has just been bought by European luxury group Labelux for £500m. And a number of labels are lining up to list in Hong Kong, the destination of choice for luxury IPOs.

But the sector could be heading for a fall. As Lex notes in the Financial Times, Chinese retail sales have slowed this year. And so, according to Credit Suisse, have sales of fine wine, "cognac shipments, Swiss watch exports and international air travel".

This might not matter if luxury goods companies were cheap. But they're not. The sector "still trades at a higher valuation premium than the long-term historical average".

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And there's another indicator that suggests this demand is rolling over. The Atlantic last month noted that in the past four years, China has gone from being the world's fourth-biggest auction market for art, to being the biggest. But according to Vikram Mansharamani, who has just published a book on bubbles, Boombustology, soaring prices for art are "scarily accurate bubble predictors".

When a country's citizens are paying record prices for art, it's a "symptom of overconfidence and hubris". It's like the skyscraper indicator you can tell an economy is heading for trouble when it starts building ever-taller buildings.

There's nothing surprising about this - when people or companies are coughing up hefty amounts of cash for status symbols and trophy assets, it's a clear sign that things are overheating.

But it does mean there's a nice simple leading indicator to watch the share price of auction house giant Sotheby's. As you can see from the chart below, Sotheby's is a pretty impressive 'crash' indicator. It peaked in 1999, ahead of the tech implosion. It peaked again ahead of the 2008 credit crunch.

11-05-24-mm01

Players in the art market have tried to brush this off arguing that Sotheby's rival Christie's is still seeing record sales, and that the Chinese art market is somehow 'unsophisticated' and unrepresentative of the global art market.

But that rather proves the point they're not buying these artworks because they like them, they're buying them so they can boast about what they spent on them. The fall in the Sotheby's share price suggests that the market reckons this isn't going to last. I'd say it's worth paying attention to that view.

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Our recommended article for today

For a better return on your cash, head east

At the moment, virtually every market in the world carries a dangerous level of risk. Other than gold, the alternative is cash. But hold sterling, and its value will very quickly be eroded. But there is one attractive alternative, says Merryn Somerset Webb - Asian currencies.

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