The market took great comfort in the 4Q GDP number (+8.9%) published an efficient 17 days after the end of the quarter (perhaps the BEA could pick up a few pointers). With a small improvement over the consensus of 8.7%, concerns of a weak Chinese economy have been banished from the 24 hour news cycle for the time being.

Source: Bloomberg

However, investors should probably look elsewhere for comfort.

Although China’s multi-decade economic rise is beyond dispute, China’s GDP pronouncements are more about Beijing’s economic policy thinking than a hard accounting of the sum total of goods and services produced in the PRC over a particular quarter. In my association with the Chinese markets, they have been playing this game since at least 1992 when the B share markets opened to foreign investors in Shanghai and Shenzhen.

For the next few announcements, a number too close to 8% would be signal leadership concern for a stalling economy and that a massive state intervention (a credit loosening) is imminent. A number which leans closer to double digits would signal concerns of domestic economic overheating and would foreshadow a credit tightening cycle to tame inflationary pressures. The thresholds change slightly from year to year but the game does not. China is signalling a “wait and see” stance for the time being. For Chinese provinces and municipalities which rely heavily on a bubbly property market to keep their finances in order, that message is not the one they are waiting for. Domestic demand in China is still driven primarily by investment rather than private consumption. And especially since the Global Financial Crisis, much of that investment has been skewed towards the property sector.

In the meantime, one of the “canaries in the mine” has definitely slipped off its perch. The Baltic Dry Index has halved since mid-December. Despite the name, the BDI covers shipping routes across the globe and the primary cargoes are coal, iron ore and grain. The index is subject to impressive swings because the supply of ships is fairly inelastic while demand for cargo is highly elastic That said, a 50% drop attributed to weaker Chinese demand for iron ore shipments, is not something one should ignore.

Source: Bloomberg

Australia’s “Two Speed” Economy

If China is in fact cooling its demand for iron ore in response to a general domestic slowdown, one should look at the short side of the Australian ETF, EWA. The Australian market is heavily weighted towards resources and financials and any trouble with Australia’s largest export market should show up in the market soon.

This week, there will be no newsletter as we are on the road in Australia.

What does Australia and year three of the US Presidential cycle have to do with each other? Usually, there would not be much of a connection.

But this year, there is a connection.

To over simplify, we are in year three of the cycle, the time when an incumbent President has to make sure the economy is as stimulated as possible so that the voters will give him another four years in the White House. As a result, it is often a good year to invest in risk assets like equities.

In this cycle, growth is coming from government spending and monetary expansion. And, while the Republicans may still get to repeat their temporary government shutdown routine (maybe they can avoid the political backlash this time), the expansionary policies at the FED are harder to stop.

That means we will continue to see inflationary money creation in the world’s reserve currency. And, since the money cannot all be put to work in the US economy, it will continue to fuel asset and commodity price growth around the globe.

How does that money get around the globe and into local economies? Primarily through Central Banks’ efforts to keep currencies from moving up against the US dollar, the FED’s accommodative policy is being exported to countries (like China) where inflationary expectations have already taken hold.

Australia is one of the places where these pressures will become most evident. As a major producer of agricultural and industrial commodities, it is a secondary beneficiary of the FED’s inflation creating policies. Not only has China’s boom created strong demand for iron ore, coal and other resources, it has also sent a wave of investment capital towards the continent sized country. This has ignited a surge in M&A activity as well as frothy real estate markets. The Reserve Bank of Australia has moved short rates about as high as politically possible (mortgages are mostly floating rate) so the next thing to go is the currency which has just crossed the 1.05 mark (FXA). If the Aussie dollar continues towards 1.10 and 1.20 as local investors expect, that’s a strong signal that one’s investments need to be well placed for an inflationary environment.

This week, for example, the base metal ETF (DBB) nudged the S&P 500 ETF (SPY) out of the top 3 in the Seeking Alpha ETF Portfolio. The main aim of the Fund King System is to track major investment flows to keep one’s money deployed in the most promising corners of one’s investment universe. Right now, it looks like major investors are positioning even more towards the inflation trade,

My buy order for EWJ was ignored on Tuesday morning. It wasn’t a large order. I was just putting it in to see if I could pick up the ETF on the cheap.

Unfortunately, I got a bit too clever on the limit (previous close less 10%) so I did not get filled. By 10am, I was pretty sure that I had missed the boat.

Why is that important?

Because the market meltdown in Japan and subsequent bounce are not being driven by rational calculations of the damage to the economy…it is just guesswork at this point. Nor is it a rational response to the nuclear power plant disaster. Our only comparable nuclear power accident scenarios happened decades ago.

It was the dramatic movement of money.

Smart Money Investors panicked and stabbed the sell button as soon as they saw their competitors doing the same. No one was waiting to see if mutual funds were going to be redeemed on the back of the shocking pictures and videos that blanketed the airwaves and bandwidth.

But, foreign investors only own about 25% of the Japanese equity market. There was only so much they could do. And once the selling pressure eased off…investors jumped in and bid the market up (both in Tokyo on Wednesday and EWJ not long after the opening bell on Tuesday).

The lesson in all this is that the weight of money can have dramatic effects on the value of assets. Japan’s “big picture” has not changed since last week. This week it is still the world’s #3 economy with an aging population, strong export sector, shocking level of government debt and extremely low interest rates. In the short term, it has sustained a mighty blow from Mother Nature but it has the institutions and experience to deal with the disaster. Fundamentally nothing much has changed. Emotionally, there have been several very big shifts.

What does the Fund King System have to say about it?

The System was not built for “Black Swan” events like this. What it can tell you is that Asia leading up to this event had some pretty crummy numbers behind it. Japan was the strongest of a weak bunch but the whole region is under a dark cloud of uncertainty over China’s short term economic outlook.

The first shocks have hit the market and there will undoubtedly be more aftershocks. One of the longer lasting aftershocks will be in the energy sector. As governments around the world (like Germany) take a close look at their nuclear power programs, the demand for oil is likely to rise. With the popular uprisings in Northern Africa and the Middle East threatening to disrupt the supply side, oil prices are likely to remain firm for the foreseeable future.

An informal study picked up in this Wall Street Journal blog shows that a number of basic items in East China (Hangzhou, Zhejiang Province) are actually more expensive than the same items found in Boston. The study compares basic things like eggs, milk, beef, gasoline and apartments and finds that those aspiring to join the Chinese middle class are going to pay heavily for the privilege.

When I was an expatriate in Shanghai in the 90′s, the cost of living for my family was 50% higher than that of Hong Kong but that was largely due to government imposed restrictions. Private housing was a brand new concept, expats were restricted to certain government controlled areas that charged outrageous rents and private car car ownership was almost unheard of (bicycles and buses were the main form of transportation around town). Beef and milk were frivolous luxuries and priced accordingly. A comparison of this sort 10-12 years ago would have been an apples-to-oranges type of undertaking.

But in the major cities of Eastern China (Zhejiang Province, Jiangsu Province and Shanghai municipality), owning a 100m (3600 sq ft) apartment, driving a nice car and buying more than rice and veggies for dinner have become the signposts of entry into the middle class for the young urban professional couple and their one child. The fact that these prices are both on the rise and that they constitute a much higher proportion of disposable income than in Boston is a serious political issue for China.

But Chinese officialdom is no better off than the hamster on its exercise wheel. Slowing the economy to control inflation imported from the US FED’s extremely accomodative policy (through a nearly fixed exchange rate) runs the risk of stalling the economy and sending tens of millions of urban workers to the unemployment lines. Keeping the hamster wheel going at present speed threatens a return to double digit inflation off a not so low base (as demonstrated in this article) which will eventually price China out of its traditional export based markets.

The markets are flopping around aimlessly. Investors are confused. The media is having more and more trouble trying to whip up enthusiasm or maintaining credibility: the latest doozy to float through the market was the Hindenburg Omen (a technical formation which predicts equity crashes 25% of the time).

What is going on? Why are the markets so directionless? Are we staring into the abyss of deflation plus the second part of a double dip recession or will we have to dust off the 1970’s era Misery Index to describe the upcoming years of stagflation? With warning signs of both inflation and deflation in the economy, there is little wonder that professional and individual investors alike are confused by the signals.

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