China’s Stimulus Package And The US Financial Markets

Along with the rest of the world, the Chinese economy has slowed significantly, from close to 12% growth in the second quarter to just 9% in the third, and clearly heading lower.  As people continue to pour into the cities from the countryside, China needs to keep its job growth engine going.

Many in the U.S. overestimate how much of China’s economic success is due to exporting to the U.S., but it is not a negligible factor either.  The E.U. recently surpassed the U.S. as China’s biggest trading partner, but that is cold comfort given that Europe is slowing as fast or faster than the U.S.

China has responded with a massive $586 billion stimulus package, aiming to jump-start the economy through investments in housing, infrastructure (especially rails) and health care.  Relative to the size of their economy, that is equivalent to a $2.25 Trillion stimulus package in the U.S (16% of GDP).

Now, if you add up all the special Fed lending facilities, the TARP, Fannie Mae (FNM)/Freddie Mac (FRE)/AIG (AIG) bailouts, plus our stimulus checks this summer etc., you also get to about $2.25 Trillion.  I wonder which country will have more to show for it after all is said and done.

From a U.S. perspective, this has both good and bad effects.  The Chinese stimulus should also stimulate the rest of the world and it would be nice to have a few trading partners who are not broke.  We might even manage to sell the Chinese things like pollution control equipment as part of their stimulus package.

The bad side is, however, likely to be more significant.  The U.S. is desperately dependent on China to buy our T-notes. If they are spending that sort of money to stimulate their economy, they are not likely to have much left over to continue to buy U.S. paper. The other major buyer of T-notes in recent years have been the oil states of the Persian Gulf, but with oil prices down sharply, the demand from that source is likely to fall just as sharply.

With the U.S. budget deficit likely to breech the $1 Trillion mark for the first time ever in fiscal year 2009 (ends Sept 30), the market is going to be flooded with new paper at a time when there are few obvious buyers.  That $1 Trillion figure does not count any stimulus measures that the Obama team might want (or need) to take.

For the short term, inflation is not the problem.  The deleveraging process still has a lot of room to run, and deleveraging is almost synonymous with deflation.  That, plus a flight to safety, has caused a very big rally in Treasury issues, particularly at the short end of the curve.

It looks tempting for the government to fund itself by issuing lots of short term T-bills at rates that are below 0.50%.  That would be a huge mistake — the equivalent of taking out a huge ARM with a teaser rate.  We need to be funding out farther on the curve.  I suspect the Chinese stimulus plan will result in much higher rates for medium to long term T-notes and bonds.  This will force interest rates up for everything else.

My basic advice stays intact: stay away, far away, from the financial sector. Regional banks like Zions Bancorporation (ZION), KeyCorp (KEY) are vulnerable, as are insurance companies like Hartford Financial Services (HIG) and Prudential Financial, Inc. (PRU).

Avoid most retailers — Circuit City (CC) is NOT the last major retail chain to go under — and Consumer Discretionary stocks.  Certainly investing in General Motors (GM) and Ford Motor Company (F) is something that should only be done by those who enjoy the roulette wheels of Vegas — and bet on individual numbers instead of red or black.  Avoid their suppliers, as well, like TRW Automotive Holdings Corp. (TRW) and Lear Corp. (LEA).

Hide in big, well-capitalized consumer staple names like Kimberly Clark Corp. (KMB) or big drug companies like Pfizer Inc. (PFE).  For those with a longer horizon, when the world economy does revive, I think oil prices will go higher than ever.  Exxon Mobil Corporation (XOM) and Chevron Corporation (CVX) are sitting on a ton of cash.  While earnings next year will probably be below 2008 levels, their dividends are safe.

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