China’s New Burden

Australia never suffered a recession during the global economic debacle of 2007-09. Meanwhile, Canada’s pullback during that dark time was one of the mildest on record, despite the sharp contraction of its largest trading partner, the US.

Both countries owed their resiliency to one thing: a rapidly growing trade relationship with China. The Middle Kingdom’s infrastructure buildout kept demand for their natural resources strong, even as demand plummeted from traditional markets in the US and Europe.

China’s continuing growth in the years following the 2008 crash is also a major reason US growth has restarted, even as Europe slips deeper into its austerity crisis. And the helpful push could get stronger in 2013, thanks to growing evidence China’s cooling off period of the past year is now over.

Chinese industrial production rose by 10.1 percent in November, even as the country’s retail sales rose 14.9 percent. With the country’s inflation rising at a moderate annualized rate of 3 percent, there’s every indication the newly installed Communist Party leadership will do everything in its considerable power to keep growth humming along.

The reliability of Chinese economic statistics has, of course, always been somewhat suspect. That’s partly due to the reach of the government and its motives, but also the sheer magnitude of the task of managing data for an economy of more than a billion people.

Iron ore prices don’t lie, however. And since going below $90 a ton at the end of August, the price of this critical element of steel making has surged to its highest price in four months. China is by far the world’s largest user of the resource and therefore the chief driver of global prices that some expect will average as much as $160 a ton next year, despite ramped up production.

Moreover, Australia’s Bureau of Resources and Energy Economics is forecasting an average iron ore price of just $106 a ton for 2013. That’s above the estimate of $101 a ton it issued in September, but still well below the $125 price reported recently at the Chinese port of Tianjin. That suggests producers’ economics are based on lower prices than they can currently sell for, which all else equal means less production and consequently higher prices.

All this is bullish news for the world’s iron ore miners, which have seen profits and stock prices all over the map this year. But it’s also very positive for any company doing business in China, by far the world’s largest consumer of the metal. The country accounted for nearly 90 percent of global demand growth for iron ore from 2000-2010 and now consumes 70 percent of global imports and more than half total annual world production.

Greater use of iron ore means accelerating steel production, which translates into stronger economic growth for China. We may have seen the last of double-digit annual growth for the world’s second-largest economy, but these sanguine developments should boost the country’s third-quarter gross domestic product (GDP) growth to 7.4 percent. That’s a powerful tailwind for a global economy in dire need of one.

In the October 12 issue of this publication, I pointed out a coming “data deluge” from the Chinese economy would have a major impact on markets already in a risk reduction mode. What we saw then was good enough to somewhat stem the fear level, but insufficient to overcome growing worries about the US elections and a possible plunge off the “fiscal cliff.”

Now with just a couple weeks to go in 2012, prospects for a settlement of the US budget crisis—or even for an extension of the US debt ceiling—are still up in the air. And while it’s still likely Washington will reach a compromise to avoid all those tax increases and government spending cuts, it’s also probable that we will experience at least some degree of austerity in 2013 that will adversely affect US economic growth.

The question is how far China’s apparent upturn can offset any slowdown in US growth, which some fear could deepen into a full-fledged recession. The answer is critical for every investment market, particularly with Europe unlikely to provide any lift next year.

Certainly, the better China can shoulder this burden, the better for natural resource markets and the stocks of companies that produce them. The reduced share of the US in global steel markets means a fall off in activity probably won’t impact iron ore miners so much.

Oil prices are a different story, particularly as North American output ramps up. Even in a worst case, oil is unlikely to see anything of the magnitude of recent years’ downturn in natural gas prices. That’s because unlike North American gas, oil can be exported. But a demand slide here would certainly affect the global supply balance, and is the main reason the fuel’s price remains stuck in the $85 to $90 a barrel range.

China to the Rescue?

If China is unable to play “economic hero,” the damage will be all the worse to global commodity prices as well as to most stock markets. In fact, there’s even the possibility that a slide in the US could stall China’s economic momentum, given the deepening trade and financial relationship.

The best case is the US makes a deal that establishes fiscal and tax stability without overly slowing the economy—and that China’s return to faster growth picks up the global slack. In that outcome, we could see a scenario unfold like 1993, with US corporations at last putting their record cash levels to work to spur growth.

The worst case is no deal and a US recession China is unable to offset. And the most likely outcome would be a slow down in the US resulting from steep cuts in government spending and tax increases, followed by recovery later in 2013.

We won’t know which to expect until well into next year. But there is some good news. As I’ve pointed out here before, this is a crisis that’s been long expected by investors, businesses, consumers and the government itself.

That means there’s just not enough leverage to make possible a reprise of 2008. And while stocks are likely to respond negatively to a real fiscal cliff, stock prices already reflect at least somewhat the possibility of failure to avert sudden austerity measures from Washington.

This doesn’t mean it won’t be painful if these spending cuts and tax increases aren’t softened. But it does mean that companies with reliable revenue and strong balance sheets will be able to weather the storm, maintain long-term growth plans and keep paying dividends. When the crisis passes, their stocks will recover.

We’ll do better sooner if Washington reaches a deal. But even if negotiations on Capitol Hill don’t turn as well as we hope, our focus on quality will keep us alive to fight another day. That’s the clearest investment plan in sight, at a time when the view from 30,000 feet is so obscured by clouds.

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