China the next shoe? or the final capitulation?

China, with its enormous reserves, had long been regarded by many investors as the last bulwark against the financial conflagration sweeping the globe. Now comes this story indicating that China itself could be a source of deflation:

After a recent visit to China, Nobuyuki Saji, chief economist and equity strategist for Japanese investment bank Mitsubishi UFJ Securities, issued a report warning that China could be on the verge of pushing the world into a deflationary spiral. The problem? Swelling industrial overcapacity, which threatens to undermine prices both for China's exported goods and its imports of raw materials.

He estimated that China's production is running as much as 50 per cent below capacity, as many industries that have been expanding rapidly are now being hit by slowing demand both domestically and abroad. Based on his estimates, China alone represents 7 per cent of the global supply/demand gap.

Excess Chinese capacity would crater capital investment
News of the Chinese economy slowdown is not new. What is new is the amount of excess manufacturing capacity in the country. (Remember those stories of all that dark fiber networks after the NASDAQ crash of 2000?)

I had called for a rally into year-end and then another leg down in the stock market. This Chinese overcapacity story, if it becomes widespread, could be the catalyst for the next downleg. It would serve to take US and European stocks down further. It would also be extremely negative for commodities of all types, as the hopes of commodity demand from future Chinese infrastructure investment would evaporate.


China slowdown: The final capitulation?
One ray of hope, however, comes from the analysis from Marty Chenard of stocktiming.com. He recently wrote a piece indicating that the Chinese stock markets may be in the process of forming a bottom. He highlights the point and figure chart of Shanghai Composite as an example. The Shanghai market recently broke out of a downtrend, indicating that it is in a bottoming process.

Point & Figure Chart: Shanghai Composite Index

If we were to juxtapose the analysis about China’s overcapacity to this technical formation, it suggests that the news is already discounted in the market. After all, when the story makes it to the pages of a Canadian newspaper, how late are we in the trade? (My Asian based readers are invited to comment).

Perhaps the final down-leg in the US equity market will occur when the China overcapacity story becomes widespread and hits the pages of US newspapers. That would serve to prompt the final capitulation that washes out the last weak and desperate holders of equities to sell out and form the basis for a new bull market.


Addendum: Stocktiming.com has kindly supplied me with a link so that the Shanghai analysis doesn't expire. The link in this post has been changed accordingly.