DO CHINESE-MADE CARS COME WITH CRASH HELMETS?

During Winter 07/08 when the first spasms of a credit-driven recession was affecting the U.S., emerging market bulls suggested the rest of the world, especially China, would maintain high single digit GDP growth and continue climbing inexorably toward its destiny besides the U.S. as a superpower; maybe even usurp the leader completely faster than could be possibly imagined a year earlier.  Meanwhile, the flaws of Communist-styled capitalism went unquestioned and the gold rush mentality persisted.  Unfortunately, the effectiveness of directing capital by top-down command is like gauging the value of a car strictly based on its top speed.  Steering, brakes, and air bags are almost superfluous while speeding on the Autobahn, but what happens when you encounter a steep, downhill, tortuous mountain pass without those features?  Disaster.

The collapse of the commodity markets from the West’s POV, particularly crude oil falling from $147/bl to under $40, has been considered a welcome relief for consumers, but I’m afraid this is a pyrrhic victory.  It only seems to confirm that the official explanation for China’s industrial slowdown preceding the Summer Olympics in order to alleviate air pollution is utter B.S. as the “on” switch has apparently broke.

While GDP was marching along at a low double digit clip China’s central government had only limited success controlling the local provincial power brokers from moderating its small-scale industrial ambitions, let alone heed environmental/pollution controls.  The only measure that can possibly rationalize this wasteful overcapacity is an extended period of economic retribution.  Purchase of materials need to be curbed at least until material stockpiles are consumed even if everybody suffers.  Taking this bitter medicine appears may be a wise choice in the LT, but also reveals the extent that China’s growth was as primed by easy global financing dynamics as anybody else.

In November the IMF already lowered its 2009 GDP forecast to 8.5%, but this would appear to discount a best case scenario where the government perfectly manages the overcapacity and based on the assumption that the government's GDP statistics are robust; what if the results are less-than-perfect?  As it is, many China observers suggest that an 8% GDP growth rate is the minimum needed to sustain civil stability as the mass migration from rural to urban centers continues en masse.  If China’s GDP were to cross the proverbial Rubicon the negative consequences could factor geometrically and an actual GDP rate of 0-5%(!) comes into play.  Unfortunately, I think this “very very bad” scenario can’t just be easily dismissed.

The big question then becomes: Will China cease buying U.S. Treasuries as a way to recycle its export profits?  China already announced in November a $586B stimulus plan (~16% of GDP) to be spent over 2 years, and subsequent plans to restock base metals inventories.  Unlike Obama who has the benefit of taking advantage of playing with the world’s reserve currency, China's spending is more or less a zero-sum game in a dead credit environment.  During the Asian IMF crisis the above was a fruitful choice so I’m inclined to believe it bears repeating, but it’s hardly a no-brainer in a much more tightly integrated global economy.  After all, they can’t possibly depend on a immature domestic consumer market with its savers mentality (no social safety nets) to spend its way out of a slowdown since a sell-off in U.S.Treasuries hurts the purchasing power of its best customer.

The Bottom Line: I don’t see a Goldilocks scenario.  To date, the Treasury market has defied all expectations as a safe-haven asset class, but when a crowded trade reverses the consequences may be severe, including the US government’s inability to continue finance bailout funds at extraordinarily cheap cost.  If the collective global stimuli plans are successful, going long commodities (TCK), seaborne transportation (NM), construction-related equipment (TEX) and consulting (ACM) could rally for the next three-six months, but if we fail to see confirmation (e.g. dry bulk shipping chartering activity - Baltic Dry Index - is a good proxy) or a sustained recovery in commodity prices soon, one should be prepared to not move cash to the sidelines, but reverse the trade.  In the meantime staying long with limited gross exposure is the aggressive tactic.

Note: Representative small cap equities in ( ).

Disclosure: No positions.