Don't be alarmed by the headlines announcing that Chinese growth has hit a 14-year low: the 7.7% increase in GDP for 2013 means a much bigger increase than the marginally higher proportionate growth of 7.8% in 2012, because the increase was off a larger base. Chinese growth is slowing slowly, with growth of 7.4% forecast for 2014.
Nonetheless, investors would be remiss to ignore the warning of legendary investor and speculator George Soros. It wasn't very long ago that he correctly predicted the imminent fall of the Australian dollar against the greenback. In an article for Project Syndicate, Soros recently stated that: "The major uncertainty facing the world today is not the euro but the future direction of China. The growth model responsible for its rapid rise has run out of steam."
"In July 2013," he explains: "The leadership ordered the steel industry to restart the furnaces and the People's Bank of China to ease credit. The economy turned around on a dime." However: "There is an unresolved self-contradiction in China's current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years."
Steven Barnett, the division chief in the Asia and Pacific Department of the International Monetary Fund has opined that the Chinese economy, "is becoming more vulnerable on several fronts: surging credit, strains on local government finances and weakening balance sheets in parts of the corporate sector." Furthermore, China's ghost cities and malls are hard evidence that a lot of the steel demand is confected, not real.
To me, this puts a question mark over iron ore producers, though I note that top-notch fund manager Cadence Capital has "meaningful positions" in both Arrium Ltd (ASX: ARI) and BlueScope Steel Limited (ASX: BSL). I can certainly see the attraction of investing in Arrium at current prices, because it is trading at a P/E of less than 3.5 and at around 4 times cashflow.
On the other hand, if Soros is right, and trouble is brewing in the Chinese economy, it seems reasonably likely that the iron ore price could be heading a lot lower in the next few years. On top of that, a considerable amount of iron ore capacity is slated to come online in 2014. New capacity will come from Jimblebar, owned by BHP Billiton Limited (ASX: BHP), Pilbara 290, owned by Rio Tinto Limited (ASX: RIO) and from the expansion at the Kings Mine, owned by Fortescue Metals Group Limited (ASX: FMG).
There are decent reasons to invest in BHP, which has a diverse portfolio of operating mines and an enormous cash hoard. To my mind, Arrium is trading at an attractive valuation, but I'm not willing to risk such exposure to the iron ore price. Soros' warnings about China are reason enough for me to pursue a share portfolio that does not rely on consistent demand for iron ore. If iron ore prices do take a dive in the next couple of years, it will be too late for investors in Fortescue, Arrium and Rio Tinto, especially if the Australian dollar remains around current levels.
Foolish takeaway
Those with doubts about China will be cautious about investing in iron ore producers. They may miss out on profits, but they will avoid significant capital loss if economic reform in China does reduce demand for the commodity. I don't want that kind of risk in my portfolio. I'm not overly worried about a crisis occurring in China, but I consider healthcare stocks and telecommunications stocks to be highly desirable alternatives to investment in iron ore companies.
