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The key to beating the Canadian stock market over the next couple of years will be accurately estimating how fast China will grow.
That's tougher than it sounds, because while recent data from Beijing suggest a strengthening economy, the country faces a growing risk of financial crisis that could bring the country's manic expansion to a screeching halt.
Thankfully, a few indicators can help investors keep tabs on the Asian giant. You should keep a close eye on these gauges, because any move, up or down, in Chinese activity is going to be reflected in a change in global demand for raw materials. And that, in turn, will affect the profits and stock prices of the materials companies that make up nearly half the value of the Toronto Stock Exchange.
Before we get to those indicators, it's important to understand why it's so difficult to call the direction of the Chinese economy.
In Canada and other Western countries, household consumption drives growth – demand comes first. But in China, supply comes first.
The government can more or less create growth as a matter of policy, by easing credit conditions (as it did in 2009), ordering banks to lend, or allowing the further growth of dubious "wealth management products" that pay savers high rates of interest while providing the financial backing for questionable business projects.
Of course, all of this economic stimulus works only up to the point where the credit bubble collapses. Market history teaches us that trying to forecast the exact timing of the collapse is a mug's game. But it is clear that China's credit growth is becoming a serious problem.
Charlene Chu, senior director in the financial institutions group at Fitch Ratings in Beijing, was described as the "rock star" of Chinese debt analysis by The Wall Street Journal. In a June 26 interview with Bloomberg, Ms. Chu noted that, "A lot of people are aware that we've had a large expansion of credit in China but they are not aware of the magnitude."
Assuming they maintain their current pace of lending, Chinese banks will have expanded their balance sheets by $14-trillion (U.S.) in the five years to the end of 2013, an amount equivalent to the entire U.S. commercial banking system. "You do not see credit expansions of this magnitude going smoothly over the long term," Ms. Chu said, and pointed to China's recent liquidity crunch as a sign of increasing financial stress.
This all sounds ominous indeed, but recent Chinese economic data have defied the naysayers and come in stronger than expected.
There are a number of indicators, most of which are available from the exceedingly helpful Tradingeconomics.com site, that can help Canadian investors navigate the mixed signals.
The usual suspects – gross domestic product, manufacturing PMI (purchasing managers index), and industrial production – provide monthly insights into the health of the overall Chinese economy.
Money supply growth (also available at Tradingeconomics.com) is less widely followed by investors, but has provided vital guidance for Canadians paying attention. Year-over-year expansion in the money supply (also known as M2) not only measures loan growth, but has also provided an effective leading indicator for Canadian mining stocks.
The Shanghai interbank offered rate (SHIBOR) – a measure of how much Chinese banks charge to lend money to one another – is likely to provide early warning signs when credit stress in China intensifies. If, as Ms. Chu predicts, loan defaults threaten the balance sheet health of major financial institutions, the SHIBOR rate will rise to reflect the risk.
As long as SHIBOR remains stable, investors can be reasonably confident that credit growth, construction and resource demand will remain in place, supporting Canadian equity values.
But when money supply growth flags, or the SHIBOR rate spikes higher, a quick trigger finger over the sell button may be required.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.
Scott Barlow