China’s economic transformation – NOT an economic collapse

China’s Economy Is Undergoing a Huge Transformation That No One’s Talking About

By Frank Holmes, CEO and Chief Investment Officer, US Global Investors

The photo you see below was snapped recently in Beijing. It might not be that special to some readers, but in my 25 years of visiting the Chinese capital, I’ve never seen a blue sky because it’s always been blotted out by yellow smog. Beijing is clearly undergoing a massive transformation right now. This might please proponents of the green movement, but it’s ultimately harmful to the health of China’s manufacturing sector.

Blue skies ahead? A cyclist pedals through Tiananmen Squar in Beijing

On the other hand, blue skies could be ahead for China’s service industries.

Misconception and exaggeration are circling China’s economy right now like a flock of hungry buzzards. If you listen only to the popular media, you might believe that the Asian giant is teetering on the brink of economic disaster, with the Shanghai Composite Index’s recent correction and devaluation of the renminbi held up as “proof.”

Don’t get me wrong. These events are indeed significant and have real consequences. They also make for some great, sensational headlines, as I discussed earlier this month.

But what gets hardly any coverage is that China’s economy is not weakening so much as it’s changing, much like Beijing’s skies. Take a look at the following two charts, courtesy of BCA Research:

China's Economy is Shifting Away from Manufacturing More Towards Services
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You can see that the world’s second-largest economy has begun to shift away from manufacturing and more toward consumption and the service industries. While the country’s purchasing managers’ index (PMI) reading has been in contraction mode since March of this year, the service industries—which include financial services, insurance, entertainment, tourism and more—are ever-expanding. The problem is that the transformation has not been fast enough to offset the massive size of the manufacturing sector.

the Czech Republic's PMI came in at an impressive 57.50 in July up from 56.90 in June

Just as a refresher, the PMI is forward-looking and resets every 30 days. It helps investors manage expectations. Consider this: The best-performing country in our Emerging Europe Fund (EUROX) is the Czech Republic—which also happens to have one of the highest PMI readings. Coincidence?

In China, overseas travel, cinema box office revenue and ecommerce are all seeing “explosive growth,” according to BCA. The country’s once-struggling real estate market is also robust. The government just relaxed rules to permit more foreigners to purchase mainland property.

But you’d be hard-pressed to come across any of this constructive news because it’s not particularly good for ratings.

A recent Economist article makes this point very clear:

The property market matters far more for China’s economy than equities do. Housing and land account for the vast majority of collateral in the financial system and play a much bigger role in spurring on growth. Yet the barrage of bearish headlines about share prices has obscured news of a property rebound. House prices have perked up nationwide for three straight months. Two months after the stock market first crashed, this upturn continues.

“Commodity Imports Have Actually Been Quite Strong”

Again, China’s transformation from a manufacturing-based economy to one that focuses on consumption has real consequences, one of the most significant being the softening of global commodity prices. As I told Daniela Cambone on last week’s Gold Game Film, gold’s Love Trade has become not a No Trade, but a Slow Trade. We’ve seen demand cool along with a decline in GDP per capita, the PMI readings and China’s M2 money supply growth.

Below you can see the relationship between China’s M2 money supply growth and metal prices. Since its peak in late 2009, money supply growth has been dropping year-over-year, driving down metal prices.

China's falling money supply since 2009 peak has driven down metal prices
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Money supply growth tends to be a “first mover.” When it has contracted, the PMI has usually followed. Recently, this has hurt economies that depend on China as a net buyer of raw materials, including Brazil, which supplies the Asian country with iron ore, soybeans and many other commodities, and Australia.

Australian Dollar and Brazilian Real Retreat with Drop in China's Money Supply
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When M2 money supply growth and the PMIs are rising, commodity prices can also rise. But that’s not what’s happening. It’s important to recognize that when new orders for finished products fall, there’s less consumption of energy to manufacture and ship. Again, this might make the greenies happy, but it’s ultimately bad for manufacturing.

I’ve said several times before that China is the 800-pound commodities gorilla, and it continues to be so. The country currently consumes about a quarter of the total global output of gold. For nickel, copper, zinc, tin and steel, it’s around half of world consumption. For aluminum, it’s more than half.

These are huge figures. But investors should know that Chinese imports of these important metals and materials still remain strong. Tom Pugh, a commodities economist at Capital Economics, told the Wall Street Journal last week that the market has it wrong about China, that the drop in demand has been overstated:

If you look at Chinese commodity imports over the last few months, they’ve actually been quite strong. A lot of it is just that people thought China would continue to grow at 10 percent a year, ad infinitum, and now people are just realizing that’s not going to happen.

Reuters took a similar stance, reporting that “there were at least 21 commodities that showed increases in imports greater than 20 percent in July this year, compared to the same month in 2014.” Weakening demand has been caused by a number of reasons, including “structural oversupply” and “the impact of the recent volatility in equity markets.”

But it’s important to keep things in perspective. Compared to past major market crashes, China’s recent correction doesn’t appear that bad.

China's Crash is Big, But Not the Biggest

Any bad news in this case can be seen as good news. I think that in the next three months we might see further monetary stimulus, following the currency debasement nearly three weeks ago. We might also see the implementation of new reforms in order to address the colossal infrastructure programs China has announced in the last couple of years, the most monumental being the “One Road, One Belt” initiative.

Dividend-Paying Stocks Helped Stanch the Losses

As investors and money managers, it’s crucial that we be cognizant of the changes China is undergoing. With volatility high in the Chinese markets right now, we’ve raised the cash level in our China Region Fund (USCOX), and after the dust settles somewhat and the right opportunities arise, we’ll be prepared to deploy the cash. We’re also diversified outside of China.

We managed to slow the losses during the Shanghai correction by being invested in high-quality, dividend-paying stocks.

According to daily data collected since December 2004, the median trailing price-to-earnings (P/E) ratio for the Shanghai Composite Index constituents currently sits at 48.6 times earnings. If it reverts to the mean, risk is 32 percent to the downside for the index. Currently, the P/E ratio of our China Region Fund constituents sits around 16 times. This suggests that USCOX has less downside risk and is cheaper than the Shanghai Composite.

Median Trailing Price-to-Earnings Ratio for Shanghai Composite Index Constituents
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We seek to take advantage of the trend toward consumption by increasing our exposure to the growing service industries—technology, Internet and ecommerce companies (Tencent is one of our top 10 holdings); financial services (AIA and Ping An Insurance); and enviornmental services (wastewater treatment services provider CT Environmental).

Golden State Warriors guard Klay Thompson unveiling the KT Fire ANTA EARLIER THIS YEAR

Rising sports participation among white collar workers in China is very visibile these days. Xian Liang, portfolio manager of USCOX, says that his friends back in Shanghai share with him, via WeChat, how they track their daily runs using mapping apps on their phones.

With that said, an attractive company is Anta Sports, an emerging, innovative sportswear franchise. Fans of the Golden State Warriors might recall that guard Klay Thompson endorsed its products earlier this year.

We believe the China region remains one of the most compelling growth stories in the world and continues to provide exciting investment opportunities.

Chinese gold demand 456 tonnes at 9 weeks.  On track for another strong year.

Chinese gold demand as represented by SGE withdrawals is just 2 tonnes higher than at the end of the same week last year suggesting another 2,000 tonne plus year.  How will this impact China and the world gold market..

Lawrie Williams

With Shanghai Gold Exchange (SGE) withdrawals for the week ended March 6th at 45 tonnes – up 7 tonnes from the 5 days straddling the Chinese New Year holiday – withdrawals for the year to date are almost exactly on a par with 2014, when Chinese demand, as represented by SGE withdrawals, was the second highest on record at a little over 2,100 tonnes for the full year.  Thus year to date withdrawal figures are 456 tonnes as opposed to 454 tonnes a year ago.  The figures to date suggest that Q1 SGE withdrawals will come to around 580 tonnes – possibly higher if the lower gold prices currently prevailing serve to stimulate Chinese demand as low prices have often done in the past.

As can be seen from the chart below from Nick Laird’s group of websites, Chinese demand tends to start the year strong ahead and around the Lunar New Year holiday, then fade away in the middle of the year and then build up again sharply in the final 4 months.   nickl

Chart courtesy of and

The latest SGE figures show that Chinese demand for gold – in comfortably the world’s largest current gold consumption market – remains alive and strong and is continuing to lead the flow of physical gold from West to East which seems to be continuing unabated.

Physical gold demand, as represented by official imports, in the other truly major gold consumer, India, appears to have faded in the weeks leading up to that country’s budget at the end of February when it was widely believed that import duties on gold and silver would be relaxed.  In the event this did not happen, so some element of pent up demand held over from the weeks ahead of the budget date seems likely to materialise – as may a return to an increase in volumes of smuggled gold.

Thus physical gold demand looks to remain strong but, as expected, not quite at the levels seen leading up to the Chinese New Year.  Going forward demand levels will be followed with great interest.  Even though 45 tonnes is well below the levels seen immediately prior to the New Year holiday, if maintained over the full year would amount to 2,300 tonnes plus.  As the Chinese middle classes expand the gold-owning section of society is expanding also.  While there may be blips up and down along the way we can probably expect Chinese demand to remain at around at least 2,000 tonnes a year going forward with an overall upwards trend.  If we have indeed reached peak new mined gold production at a little over 3,000 tonnes, with declining output likely ahead, then the market is going to be stretched as more and more of the global gold stock moves east.

And even a significant rise in the gold price is unlikely to alter this trend.  It will take several years to re-establish and build major new mining projects.  What a gold price rise may do is actually drive production downwards as miners may then find it profitable to mine ever lower grades, while the lower gold prices have done the opposite forcing many miners to mine higher grades and thus push up production when logic might suggest output should fall.

A single country consuming two-thirds of the world’s new mined gold supply, which is what is happening at the moment, creates a huge market imbalance that just cannot continue indefinitely without impacting the gold price.  If the three big Chinese banks which qualify do indeed become significant players in the new LBMA Gold Price mechanism which comes into effect on Friday, then it is possible that things will indeed change as far as pricing is concerned.  (However, as pointed out in an article on Mineweb today it is not yet certain that these Chinese banks will indeed be among the initial direct participants in the new benchmarking system: See Fixing the Gold Fix – with or without the Chinese banks?)

While some maintain China also has an interest in keeping the gold price down to enable it to build its own reserves at the lowest possible cost, it also has the task of avoiding a hard landing as its economy is being restructured.  This could be seen as helping that huge number of its citizens who have been persuaded to buy gold to feel wealthier (the spending community) and could go some way towards maintaining the necessary positive perception on its economy among its ever growing middle class citizenry which it needs to keep on side.