The bear case for China by Pivot Capital

In a recent blog entry, Yves Smith of Naked Capitalism referenced a very good report by Pivot Capital, outlining the bearish case for China. In China’s Investment Boom: the Great Leap into the Unknown (dated August 21, 2009), Pivot Capital goes over why they believe China's boom, largely led by investment, is bound to slow down or, in the worst case, blow up. It's a very good report and I recommend the report to anyone interested in China or macro issues.

Here is an overview of the report:

In this report we describe the background to and the extent of the capital spending bubble in China and identify factors that will precipitate its deflation. We focus on Chinese capital spending firstly because it is the single most important driver of current Chinese and global growth expectations and, secondly and more importantly, investment-driven growth cycles tend to overshoot and end in a destructive way.

We conclude that the capital spending boom in China will not be sustained at current rates and that the chances of a hard landing are increasing. Given China’s importance to the thesis that emerging markets will lead the world economy out of its slump, we believe the coming slowdown in China has the potential to be a similar watershed event for world markets as the reversal of the US subprime and housing boom. The ramifications will be far-reaching across most asset classes, and will present major opportunities to exploit. There are three key reasons why we take this view:

China’s expansion cycle surpassing historical precedents:

Policy actions not sustainable into 2010...

Overcapacity and falling marginal returns on investment...

Whenever I encounter a new source, I usually check their history. No one is perfect and everyone gets things wrong but a strong track record on core issues sort of indicates skill. Since I am attracted contrarian views, one of the worst mistakes I could make is to blindly follow so-called "contrarians," perma-bears, perma-bulls, or a related "ideologies." There are many who appear right simply because they are permanently bearish on central banks; or permanently bearish on US$; or permanently bearish on technology stocks; or premanently bullish on gold; and so on. Needless to say, these guys are next to useless for investment purposes. It makes for fun entertaining reading but it's difficult to invest off them.

One of the reasons I like Hugh Hendry is because he was somewhat prescient with the credit bust call all the back in 2003 in a Barron's article. I took a quick look at Pivot Capital, and they seem to have had the right reasoning back in 2006 (refer to the reports at the very bottom of this page.) Note that this was before Bear Stearns and before it was obviously that a crisis was unfolding. So it's worth paying attention to these guys.

The Pivot Capital report elaborates on reasons I have remained bearish on China, and very cautious on commodities. The conclusions are in-line with my thinking. In particular, there appears to be very large overcapacity in manufacturing and a potential real estate bubble. Furthermore, the report describes what I have mentioned in the recent past about China's employment issues. Namely, China has to switch to a service-oriented economy or else they are going to have serious unemployment problems (and, consequently, political problems.)

The report concludes by saying:

Although we see a high probability for a slowdown in 2010, the main issue facing investors is when markets will start discounting that slowdown. In this sense we are back to a situation similar to 2006-2007 as the sub-prime and credit booms were approaching their end. In view of the governments’ clear commitment to safeguard the recovery there is certainly a risk of multiple false breakdowns before a top has been reached. Nevertheless, the markets should experience a major growth scare sometime in H1 2010 at the latest.

Anything that is cyclical and dependent on Chinese investment demand would obviously be the most vulnerable to a Chinese growth disappointment. That would include industrial commodities as well as equities and credit of industrial and consumer cyclicals. There would also be a general rotation into more defensive areas taking place across most asset classes. The biggest uncertainty relates to what China means for the debate on deflation versus inflation. In principle, a Chinese slowdown should initially be deflationary, especially given the overcapacity currently building up in various Chinese industries. This should be negative for credit in general and also for most equities. However, depending on how aggressive the policy response will be in China and elsewhere, investors may very well start focussing on the inflationary risks again.

This is a very weak close. The report builds a case for deflation and then closes by saying inflation may be likely depending on government policies. Obviously such views cannot be acted upon. If we get deflation, stocks (in general) will get killed; but if we get inflation, they will rise (even if they don't post good real returns, they will likely post positive nominal returns.)


  1. Have you seen this Al Jazeera video:

  2. Although the focus is often on China and, yes, they have a demanding presence... but come on.  Sure, keep an eye on China...but keep an eye out for the rest of the world.  Last I heard, India is not a small, diminishing marketplace.

  3. Sivaram VelauthapillaiDecember 10, 2009 at 7:20 PM

    Indians are going to hate me for saying this but India is not significant on the world stage for various reasons. I'm not from India BTW. Here are some key reasons:

    People like to lump China and India together but India is very far back. It is far poorer, has a less developed economy, and so on. Its economy is very small compared to the whole world, whereas China's is actually sizeable.

    Secondly, India is largely a closed economy (this is good and bad.) It is still socialist and there is very little flow of anything--capital, goods, technology, processes, etc--into or out of it. This is noticeable by looking at the poor quality of average goods (not necessarily those targetted at the upper-middle-class). I remember reading once how printed brochures or posters are of terrible quality in India. This is such a subtle issue but it points to the closed-nature of their economy.

    India is probably a better place for investors if capital controls are removed for foreigners. The reason is because their legal system is decent (corruption still a huge problem) and the economy actually has pockets of private businesses and entrepreneurial spirit. China, in contrast, everything appears to be directed by the government. However, India is still very far back. Investing in it is like investing in late-1800's USA, whereas China is more like 1920's USA. Pick your "poison" ;) ...

    To sum up, there are only 4 economies that kind of matter right now: USA, Japan, Europe, and China. Others like Brazil, India, etc, are growing but unlikely to have a big global impact for a long time.

  4. The thing that makes me uncomfortable with these bearish predictions is that they are by nature speculative.

    For instance, I expect China's economy to be 2 or 3 times its current size in 20 years.  Making money on the bull side is easy:  you just wait.

    Making money on the bear side is harder:  you have to get the timing right.  Even if you anticipate a crash, if you are off by 5 years, you may still make little or no money.

    Essentially, time is working for the bulls, but against the bears.

    Disclosure:  Long the global economy :P

  5. Did the bear or bull eat Santa this year?   ;)


Post a Comment

Popular Posts

Thoughts on the stock market - March 2020

Warren Buffett's Evolution and his Three Investment Styles

"The Markets They Are A-Changin'"