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China's sherbet lemon economy keeps investors guessing

The debate about whether China faces a hard or soft landing is little more than semantics to shareholders of the world’s miners, who have seen their stocks lose three-quarters of their value since 2011.

It is screamingly obvious, the bears say, that China is having a hard landing. Look at the Brazilian real against the dollar (down 60 per cent since 2011), industrial metals (down more than half even after a bounce on Tuesday) or European shares exposed to China (underperforming the wider market by 15 percentage points this year).

China bulls are undeterred. They point to the services sector, which has boomed even as industry has all but stagnated. Over the past year, almost all economic expansion has come from services, supported by agriculture.

The purchasing managers' indices suggest Chinese manufacturing is shrinking. While services companies are expanding more slowly, they are still expanding. The data may be doubtful, and China still faces very significant debt problems. But China seems to be shifting as planned from manufacturing and infrastructure towards domestic services and consumption.

In August, Short View suggested this is the “sherbet lemon” economic landing: hard on the outside, soft on the inside. Both bulls and bears can be right, as the domestic economy keeps growing but its imports fall.

Investors who think the sherbet lemon still has fizz can bet on the hard landing for China’s suppliers getting worse. It takes some gumption to wager on prices falling further after such significant drops. On the other hand, if iron ore prices returned to their pre-China boom levels of 2002, then even after adjusting for inflation they would have to lose another two-thirds of their value.

This is too bearish. China’s economy is far bigger and will not stop using steel altogether. But it highlights that even after a massive fall, metals prices have given back only about half the gains they made from 2002 to 2011.

The alternative is to bet on the Chinese consumer. Others have already noticed and consumer-related stocks are expensive already. Chinese airlines are an exception, but heavy dollar debts leave them exposed to any further renminbi devaluation. They are cheap for a reason.

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