USFunds.com • August 28, 2015
Table of Contents
Index Summary • Domestic Equity Market • Economy and Bond Market • Gold Market
Energy and Natural Resources Market • Emerging Europe • China Region • Leaders and Laggards • Fund Performance Link
China’s Economy Is Undergoing a Huge Transformation That
No One’s Talking About
By Frank Holmes
CEO and Chief Investment Officer
U.S. 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 transformation right now. This might please proponents of the
green movement, but it’s ultimately harmful to the health of the manufacturing sector.
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
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, like
Beijing’s skies. Take a look at the following two charts, courtesy of BCA Research:
click to enlarge
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.
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?
Overseas travel, cinema box office revenue and
ecommerce in China 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
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 this 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
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.
click to enlarge
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 Austrailia.
click to enlarge
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
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 this 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 this week, 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.
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 from 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