Economic Shock and Awe: Next Downleg A’Comin?   

• In our January 19, 2009 market letter (Et Tu China?), we said that China today was like the U.S. was in the 1920s and Japan was in the (pre-oil shock), i.e., the most exposed to a serious downturn. We see China’s economy reacting more like Japan’s in the 1970s, i.e., going down hard but emerging a stronger economy, albeit with a lower sustainable growth rate.
• Some global strategists have begun to pick up on this theme suggesting that a 2009 implosion in China’s economic miracle could get ugly and cause not only social chaos in China but also a major, destabilizing devaluation of the Yuan. Perhaps this is what the new US treasury secretary Tim Geithner was alluding to when he warned China not to manipulate its currency.
• The case for an implosion in China’s growth is that; a) OECD leading indicators and China’s GDP growth have been tracking fairly closely. The OECD leading indicator has plunged from around 103 to just above 88 in late 2008, b) YoY growth in electric power output in China, which also correlates to GDP, has plunged from 15% to minus growth of several percent, c) exports from Taiwan, South Korea and Japan to China are plummeting.
• In this regard, all “official” estimates of China GDP growth in 2009 are too high, while China accounted for some 20% of growth in 2008. If China growth implodes, the US and Japan could slip into depression and a deflationary quagmire, with the predictable negative results for stock prices.
• So far, global markets have tested late 2008 lows and held. This includes the DJI, S&P 500, NASDAQ, Nikkei 225, FTSE 100 and China indices. What did not hold was financials and energy.
• The passage of the Obama Administration’s $825 stimulus package and a promised “comprehensive” bank package will be where the rubber hits the road. By most accounts, the US banking sector is effectively insolvent, as was Japan’s in the 1990s. Investors have already tried to discount this as much as possible in bank stock prices. If the bank package does begin to directly address toxic assets, we could see at least an interim rally in the financials that could be a significant “dead cat” bounce.

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