China Economy: Why China Likes Small Cap Stocks

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The newswires are buzzing about China's growth curve once again. This time there's intense debate about the meaning of the latest manufacturing data. Is it up? Or is it down?

The answer is a bit of both and figuring out why is important.

First the news. A government-backed Purchasing Manager's Index (PMI) declined to 55.8 last month from 56.6 in December, a slight loss indeed. But that figure is at odds with HSBC's China PMI survey, which actually showed a rise in January, to 57.4 from 56.1. What should we make of this difference?

First of all disregard news outlets that say the government PMI decline signals a drop in China's growth trend. Any reading above 50 on the PMI indicates ongoing growth in the manufacturing sector. Period. The PMI has been signaling growth since last year.

The HSBC purchasing manager's index is slightly different from the Chinese government reading in one important way. The government PMI looks at large and state-owned companies, while HSBC's sample of more than 400 companies is weighted more toward smaller businesses and export-related companies.

That means the declining government PMI shows that large cap state firms are somewhat weaker than small cap companies. HSBC finds small caps are growing more quickly.

The HSBC rating also indicates strength in export-related industries. The giant Japanese brokerage backs this up in an analysis given to Bloomberg. Nomura forecasts the Chinese economy will gain momentum this quarter as exports surge 30 percent! Nomura predicts that China's economy will grow at a blistering 12 percent this year. Pessimists see this as bad news.

Some news reports argue that strong growth will force the Chinese government to clamp down on lending to prevent asset bubbles from developing. That, they claim, would be bad for business and bad for the markets.

But we and many other China watchers see interest rate hikes as an inevitable trend in the coming year. The effects of this and other clampdowns on industrial growth are already assumed, and "baked-in" to stock prices.

What counts is the growth. Smaller cap companies and exporters are on a trajectory for double-digit growth in 2010. There will always be pessimists and critics of the China growth story. But what counts is not temporary lending halts or fractional increases in interest rates. It is the big picture.

The big picture still indicates that China will continue to grow faster than any other major economy.