Jim Jubak

Jubak's Journal8/19/2008 12:01 AM ET

The key to our wild market: Asia

As developing giants like China and India grapple with high inflation and slowing growth, the world feels their effects. Now is the time to hedge with commodities.

By Jim Jubak

One day I'm ready to pull the trigger and load up on rallying financial stocks such as Citigroup (C, news, msgs), American Express (AXP, news, msgs) and Bank of America (BAC, news, msgs). The next day I'm happy I didn't, as news from JPMorgan Chase (JPM, news, msgs) and Goldman Sachs (GS, news, msgs) takes the sector back down.

Just when I'm ready to dump my energy and commodity stocks, the sector rallies, and stocks like fertilizer maker Potash of Saskatchewan (POT, news, msgs) climb $7.48 a share, or 4.7%, in a single day.

It's enough to make your head spin.

To make sense of this market, you've got to go back to economic fundamentals and to where so many fundamental stories start these days: Asia. Do that and you'll understand several things:

  • Why the prices of oil and other commodities have been falling over the past month.

  • Why the drop doesn't signal the end of the commodity bull market of the past few years.

  • Why growth in Asia, especially in China, is likely to accelerate in the beginning of 2009.

  • Why inflation is a bigger danger today than at the beginning of 2008.

  • Why owning commodities as a hedge against inflation is more important than ever.

At the core of the current wave of volatility are investor worries that growth is slowing in the Asian economies, which have been driving the global economy forward since the U.S. economy dropped into low gear in the fourth quarter of 2007.

Investors have been expecting that Asia's export-driven economies would follow suit. Lower growth in importing economies must lead to a slowdown in exports from Asia, right?

Recent figures suggest the slowdown has finally arrived. Growth in China slowed to an annual rate of 10.1% in the second quarter of 2008 from 11.9% in 2007. Economists are predicting growth will slow even more in the rest of 2008 and in 2009. Goldman Sachs is projecting 10.1% for all of 2008 and 9.5% for 2009. The Economist magazine is somewhat more pessimistic, projecting 9.8% growth in 2008 and a drop to 9% in 2009.

The pattern is similar in other Asian economies, big and small. India, where gross domestic product grew 9.1% in the fiscal year that ended in March, will see growth of 7.1% this fiscal year, according to Morgan Stanley. The government of Vietnam has cut its target growth rate for 2008 to 7.5% from a prior goal of 8.5% to 9%. Indonesia recently cut its target rate to 6.4% to 6.7% from an earlier 6.8%.

But it's not just growth levels

All the economies of the developed world, including the United States, would kill for growth rates like those, but it's not the absolute level that matters. A drop from a 9.1% growth rate to a still high 7.1% is enough at the margin to cut demand for the commodities that fuel these economies. And that explains the price drop in commodities from oil to fertilizer to copper.

For example, copper, which was trading near historical highs July 6, dropped in price by almost 18% by Aug. 11. With expectations high that demand and price for these commodities would fall even further, commodity stocks have sold off, too.

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Chinese flag © Jeremy Woodhouse/Photodisc/Getty Images
Buy China, not Chinese
Robert Hsu of Absolute Return Capital Advisors thinks that despite China's big pullback, there are still some good Chinese stocks, but he says investors should buy only in New York and Hong Kong.
The slowdown in economic growth in Asia also pushed down the price of commodities and commodity stocks for another reason: Money flowed out of commodity stocks and into financial stocks, consumer stocks and retail stocks during these weeks on the theory that the slowdown in Asia was just beginning while the slowdown in the United States was far enough advanced that the U.S. economy would come out of its slump as the Asian economies were just starting their slowdown.

Earnings growth would pick up at U.S. companies while earnings were still falling for Asian companies, according to the theory. Shares of Bank of America picked up 56% between July 6 and Aug. 11, for example.

But while the slowdown in growth in Asia is pretty much what Wall Street has been expecting ever since the U.S. economy started to slump, the slowdown doesn't seem to be happening because growth in the U.S. economy has slumped. Instead, soaring inflation in Asia seems to be at the root of the slowdown, and the damage to Asia's economies is largely self-inflicted.

China, India wrestle with inflation

China, for example, has been waging a battle against inflation since 2007. The People's Bank of China raised interest rates five times in 2007 to a one-year lending rate of 7.29%, the highest official rate since 1998. The central bank has also raised reserve requirements, the amount of capital that a bank is required to keep in reserve and can't lend, to 14.5% of deposits. The 1% increase in reserve requirements announced Dec. 8 was the biggest jump in four years.

Those moves didn't work to slow inflation until mid-2008. Inflation climbed to an 11-year high of 8.7% in February before dropping to 7.7% in May and then to 6.3% in July. Of course, fighting inflation also slowed the economy. Growth slowed to 10.1% in the second quarter of 2008.

Continued: India

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