Play the China slowdown with an ETF

China's economy has gone from red-hot to showing clear signs of deflation. The broad inflation index in China is near zero, and still dropping. Local manufacturers are sitting on record stockpiles of unsold goods, while surveys of manufacturing activity point to declines in production in months to come. The prices of key commodities iron ore and coal have fallen by half or more in the last year. Chinese traders are reportedly walking away from purchase orders made earlier, worsening the price drops.

Meanwhile, mining companies have been investing heavily in new production facilities, positioning themselves, at just the wrong moment, for the good times to continue. Assets of the top 40 global miners grew by 13% last year and firms have budgeted for another double-digit increase in capacity in 2012.

Much of the last decade's mining sector boom has been China-related. So it looks increasingly likely that we are now close to a classic top in the business cycle for resources companies, where production plans continue to expand even as demand peaks and begins to drop away. But what's the best way for an investor to profit?

One way of playing the China slowdown is via a short position in the Aussie dollar, which is already reacting to poor regional growth statistics. Another is to short global mining stocks, which have been among the biggest beneficiaries of the last decade's China boom.

Shorting individual stocks is risky. However, there is an alternative, offered by an exchange-traded fund (ETF). The db x-trackers STOXX Europe 600 Basic Resources Short Daily ETF (LSE: XBRS) is designed to benefit from falls in the prices of mining stocks. The fund aims to track the inverse performance, compounded daily, of a basket of basic resources stocks (if that basket of stocks fall in price, the ETF's price will rise and vice versa). The index includes heavyweights such as BHP Billiton (24%), Rio Tinto (14%) and Anglo American (13%) among others.

Remember that the return on an inverse ETF will diverge over time from minus one times the underlying index's return, due to daily compounding. The more volatile the underlying index, the greater the divergence. So any position in XBRS should be tactical, not long term. But if you want to play China's slowdown easily and cheaply (the ETF charges 0.5% in annual fees), this is a good way to do it.

Paul Amery edits www.indexuniverse.eu, the top source of news and analyses on Europe's ETF and index-fund market.