A slump in China is inevitable - here's how to protect yourself

Investors across the world think that China is walking a tightrope.

They hold their breath, watching as the canny Chinese government treads a slim line between the dangers of inflation and the perils of slower growth.

Every time the Chinese acrobat wobbles such as yesterday, when inflation came in a bit higher than expected the markets wobble too. But so far, investors remain hopeful.

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Trouble is, they're wrong. China isn't walking a tightrope, any more than Ben Bernanke was walking a tightrope back in 2005. It didn't matter what the Federal Reserve did back then. The property bubble had already inflated. The bad investments had already been made. It was only a matter of time before they blew up.

And the same goes for China now. The ultimate destination is some sort of economic slump. That might not be disastrous for China. But it could well be disastrous for anyone hoping it will lead the world out of the 'Great Recession'...

The Chinese government is behaving like any other

Chinese inflation data came in a little stronger than expected yesterday. The consumer price index (CPI) was up 2.7% year-on-year in February. That's a lot lower than British CPI inflation (currently 3.5%), but it was quite a jump from the 1.5% seen in January. And it was the highest level seen in 16 months.

Analysts were divided as they often are on China. Some argued that it was all down to the timing of the Chinese New Year (when people spend more). It was also blamed on last year's inflation figures being so weak.

But at the same time, property price inflation continued to surge, along with retail sales and the money supply. Bank lending slowed from January, but that's no surprise nearly a fifth of the 7.5 trillion renminbi that the government wants banks to lend in total this year was dished out in January. And food prices, which are a particular worry in terms of social unrest, jumped by 6.2% during the month.

I suspect the Chinese are like any other government. For now, inflation still seems a more remote problem than the growth slump that they managed to pull out of in 2008. So for now, they'd probably rather take their chances with inflation than risk slowing growth in any substantive way.

And as Mark Williams at Capital Economics argues, that's probably because the threat of a slump is more realistic. Much of the growth in retail sales is "due to strong sales of goods benefiting from temporary government subsidies, tax breaks and trade-in schemes. Without this support, household spending growth would be much slower, and global optimism about the outlook for China's economic rebalancing would probably be weaker."

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So it's odds-on that China will keep any tightening measures as minimal, fairly symbolic ones. But it might not be that simple. There's another big issue the value of the yuan, or renminbi. This is currently pegged to the dollar and has been since mid-2008 (for more on this, see Simon Wilson's piece from this week's issue of MoneyWeek magazine: Will China float its currency?).

Could America and China soon come to blows?

America likes to use the artificially weak yuan as a stick to beat China with. It takes some of the political pressure regarding US unemployment off Barack Obama if he can blame the Chinese for stealing American jobs. But unfortunately, it's more than just a talking point.

The concern, says Reuters, is that Obama's administration may decide to label China a "currency manipulator" in a Treasury Department report due on 15 April. That in turn could see "scattered trade spats between the two giants escalate into a full-fledged dispute, with Washington even considering across-the-board tariffs against Chinese products."

"The chances of a collision have never been higher," Stephen Green at Standard Chartered tells Reuters.

But as ever with protectionism, imposing tariffs would likely be counter-productive. A stronger yuan would hurt exports. This in turn would "lead to a double dip in the Chinese economy, which in turn will hamper the global economic recovery," said Li Jianwei, a member of Chinese government think tank, Development Research Centre.

And it's worth remembering that the dollar has been strengthening in recent months. So that means that the yuan has also already been rising against pretty much every other major currency on the planet. So the Chinese may well be reluctant to let it rise against the dollar as well.

Between what to do with interest rates and inflation, and what to do about its currency, what hope does China have? It's going to put a foot wrong at some point. And even if it doesn't, the US may decide to give it a shove.

Politics is playing a bigger and bigger role in the markets

What does all this mean for investors? Well, it's a very good example of how the investment landscape is increasingly being shaped by politics rather than anything that you might describe as "rational" profit-seeking behaviour.

And China is by no means the only place where danger lurks. As Gillian Tett notes in this morning's FT in a piece on the US home loan market: "The global financial machine has been so distorted by government aid that it is frustratingly hard for anyone to be entirely sure how the cogs are working."

Government stimulus has caused such a rebound in risk assets that everyone now takes the situation for granted even although it may well be the only thing that's keeping the markets going. Behavioural economist James Montier of GMO, marvels at how little we've learned. "Was it all just a bad dream?" he asks.

He points out that in terms of sentiment, "measures such as the Advisors Intelligence Index show a record low level of bears." At times like this, says Montier, the best stocks to be in are "high quality" companies. When investors are feeling bullish as they are now they pile into "volatile, unprofitable firms (i.e. junk)". So smart contrarian investors should go for the "mature, low volatility, profitable firms (i.e. quality)" that have been left behind.

We've been tipping several of these sorts of stocks in recent Money Mornings (Three high-yielding European stocks to buy). And I'd suggest you read Montier's piece in full few other analysts have such a solid grasp on what's wrong with the financial system, nor such a decent track record on calling turning points. You'll have to register free at GMO's site, but it's worth the five minutes that takes.

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