What's With China?

Back in the Fall of 2008, I initiated a large position in T. Rowe Price's New Asia Fund which ultimately accounted for 25% of my equity portfolio (with the remaining 75% in T. Rowe Price's Standard and Poor's Equity Index 500 Fund).  My total equity position then was double what I considered to be my personal core equity exposure given my age and investment in East Hampton real estate, whose value correlates highly with how Wall Street fares.  The reason I had such an outsized exposure to equities was that the Standard and Poor's 500 Index ("the 500 Index") was significantly undervalued then due to the "great recession's" having wreaked havoc on earnings.  I am a contrarian by nature -- prefer to invest when there is a maximum of fear and disinvest when there is a maximum of greed.

At that time China's economy was growing at a double digit rate, due primarily to its relative low wage rate and its rapid population migration from rural to urban areas.  Its products cost far less to manufacture than here, and thus China's export growth was explosive.  Our economy, on the other hand, was mired in recession.  In fact, many developing countries in Asia (ex Japan) were similarly growing far faster than the world's developed countries.  Given the disproportionate growth rates of the region's economies relative to ours, and the relative cheapness of its stock markets, I wanted to have exposure there despite the political risks, currency risks, and the fact that China's was not a free enterprise economy but rather a centralized one managed by the Communist Party.  Most economists warned that the China model wouldn't work.  Despite these misgivings, I felt that investing in the New Asia Fund was a good risk/reward pairing, like an attractive  "high risk/high return" growth stock.

Prior to this week, my position in the New Asia Fund had been cut back by 60%, yet it still accounted for 25% of my total equity portfolio.  The cutbacks were the result of the fund's initial dramatic out-performance relative to that of the 500 Index which led to a rebalancing of the overall portfolio; and the reduction of the overall equity portfolio to its core level because equities in general went from undervalued to overvalued as central bankers throughout the world flooded economies with money, the so-called "quantitative easings".  (The 500 Index is now roughly 25% overvalued.)

The comparative labor cost advantage that was responsible for China's export explosion has narrowed somewhat.   Several U.S.-based companies have decided to build plants here rather than in China due to this narrowing and the potential for lower fuel costs here as our natural gas becomes a larger contributor to domestic fuel supplies during the next decade.  China's growth has slowed from double digits to 7-9%, still high relative to ours, but the gap has narrowed.

As China's comparative labor cost advantage closes, its growth must become more dependent on internal consumption than on exports.  China's recent prosperity has created a vast middle class whose rising income should potentially stimulate consumption.  The key to the New Asia Fund's future performance will be how easily China's transition from an export-driven economy to a consumption-driven economy will unfold. (While only 30% of the fund's portfolio is directly invested in China's equities, the fund's investments in other Asian countries are significantly affected by exports to China; so as China goes, so goes the New Asia Fund.)

The risk of a speed bump in this transition has grown.  Two weeks ago "Sixty Minutes" exposed what the skeptical economists have been warning about all along. (They may not have been wrong, merely early!)  China's centralized managers have been encouraging construction of whole cities to accommodate continued population migration from rural areas.  This construction has provided work for fifty million people.  (With China's population of 1.4 billion that isn't such a large number but still significant.)  Many of these newly constructed cities remain empty.  What happens when such construction slows down and construction workers must find employment elsewhere or return to the rural areas?  Civil unrest may ensue.

Furthermore, the savings of many wealthy Chinese have been invested in second and third homes because prices of such real estate have been growing rapidly. Sound familiar?  China may be experiencing now what the U.S. economy dealt with in 2005-2007--a real estate bubble.  If so, eventual bursting of that bubble would probably have a similar negative impact on China's consumption as it did on ours.

For  months now,  the New Asia Fund has underperformed the 500 Index.   So far this year, it is up 1% versus 9% for the 500 Index.   Being a risk-averse individual, believing that there are times when "discretion is the better part of valor," I have reduced my New Asia Fund position from 25% to roughly 15% of my total equity portfolio.  Thus, from its original peak, that exposure has been cut by 75%.