Dear Reader,

It was a difficult week on the markets as share prices collapsed hitting retail investors the hardest.

The main driver of the latest slump was none other than the voracious Asian giant: China.

The world’s second largest economy began feeling the pressure of its overheating economy as it continued to search, more frantically, for ways to slow its rapid growth.

Our own economy felt the tremors of its heavy footsteps, as the commodity scoffing titan considered further raising interest rates (or once again tweaking its banks reserve ratios), a move that would slow down its, so far, insatiable demand for our commodities.

The fear of a Chinese contraction has caused the rand to weaken against the worlds developed currencies as money began to flow out of emerging markets like South Africa. And with 40% of the Johannesburg Stock Exchange in natural resources, if the world’s number one commodity-o-holic begins to stumble, it’s definitely a cause for your concern.

But as MoneyWeek business editor, John Stepek, points out in today’s article. There are still ways for South African investors to benefit as China tries to engineer a “soft landing”.

Read on to find out how you can protect your portfolio from Chinese contractionary policy in 2011...
 
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From John Stepek, in London (www.moneyweek.com)

The market is all about expectations. Investors and traders place their bets based on what they expect to happen in the future.

People generally expect Goldman Sachs - the uber-investment bank - to beat earnings forecasts. Last week they didn't. As a result, both bank shares and the wider markets took a bit of a tumble.

People also generally expect that China is going to be able to hit the "Goldilocks" spot. That's where it slows its economy down to the point where growth is neither too hot, nor too cold, but just right.

So the latest news out of the world's second-biggest economy is unlikely to cheer up the markets any...

China's economic growth is nothing for markets to be happy about

China's economy grew by 9.8% in the fourth quarter of 2010. That was above the 9.4% that economists polled by Bloomberg had expected. And in fact, it was faster than the 9.6% rise recorded in the third quarter.

The good news was that consumer price inflation slipped back to 4.6% in December, from 5.1% the month before. But that was already expected, and was down to inflation being higher in December last year than in November (so you're comparing against a higher base level).

Obviously this is the kind of growth that your average Western economy can only dream of. But as far as the markets are concerned, it's nothing to be happy about. Why? Because what investors want to see is clear evidence that China can 'engineer a soft landing', as central bank followers like to put it.

With growth continuing to beat expectations though, it seems the Chinese economy has no intention of making any kind of landing. It's not even losing altitude. And inflation is likely to pick up again in the next few months. As Liu Li-Gang of Australia and New Zealand Banking Group told Bloomberg, "if the economy keeps growing at the current pace, inflation will remain alarming".

Now the big worry is that China will tighten "too much". The country's central bankers, desperate to contain inflation, will overshoot the Goldilocks zone and crash the economy.

It's a dilemma. China's policy of keeping the yuan pegged to the dollar is inflationary, because it imports US monetary policy, which is of course extremely loose. At the same time, the country is trying to make banks cut back on the amount they lend, and interest rates have been raised.

High inflation is a worry because a rising cost of living causes social unrest. But then, slow the economy too much, and you'll get rising unemployment, which is also pretty disruptive.

Economies don't always act as expected

You start to get an idea of just how idealistic this notion is that a central bank can 'engineer a soft landing' simply by fiddling with a few economic knobs and levers. Trying to change course on an economy isn't like pressing the brake or accelerator pedals on a car. It's just not that responsive. And it doesn't always do exactly what you want it to do either.

The other problem is that, unlike markets themselves, monetary policy doesn't tend to be forward-looking. When the economy is on the up, central bankers don't want to "damage the recovery" by raising rates. So they leave it too late. By the time they tighten up, the economy is already too far gone into over-exuberance mode. Often the only thing that stops it is when it runs into a brick wall.

I'm not saying that China is going to have a catastrophic meltdown. I don't know exactly how a slowdown will pan out, or how long it will take to unravel. And China's stock market, for example, is hardly acting as a bubble asset should - the Shanghai Composite Index is down by 15% or so in the past year.

Where the 'China' effect has been felt mainly is in commodity markets. And that's perhaps one reason why a slump in China doesn't have to be a complete disaster. As my colleague Merryn has already noted, it would certainly give "all equity markets a very nasty short-term shock". The FTSE 100 is full of resource-related stocks, none of which would be great places to be if commodity prices fall back. And investors seem to have pegged much of their hopes for global growth on the Asia story in general.

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Lower raw material prices could be good for your portfolio

It may seem surprising but I don't think you should be completely avoiding emerging markets. It doesn't all hinge on never-ending Chinese growth, and in the long run, these regions will continue to develop and become richer.

The popularity of the general emerging story has certainly resulted in lots of the most attractive, best-known emerging market stocks becoming fully priced. However, delving into rather less well-explored areas of the emerging market can still offer you plenty of undervalued opportunity.

Until next time,

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