Don’t buy China – it’s just too expensive

US interest rates won’t be rising for a while. That was the message from Federal Reserve chairman Ben Bernanke when he testified in front of the government yesterday.

Bernanke’s main point is that the economy is in too crummy a state to support higher rates. It’s hardly cause for cheer. Yet the hope that cheap money will continue to flow was enough to bring the bulls back to Wall Street, despite a slide in new home sales.

Yet we wouldn’t bet on the rally being sustained for long. Investors’ appetite for risky assets across the world has clearly fallen in the past few months. And with more nasty surprises likely to come, that trend will only continue…

US markets are now outperforming the rest of the world

Despite the hesitant recovery from January’s stock market slide, risk appetite has clearly shifted in the last few months. Emerging markets – which were the quickest to rebound after the crash – are no longer leading global markets higher.

John Authers notes in the Financial Times this morning that the Shanghai Composite index is below its 200-day moving average (this is just the average closing price over the past 200 days). “This is usually a sign that its direction is firmly downwards.” The other Bric countries (Brazil, Russia and India) are all below their 100-day moving averages.

In other words, investors have stopped chasing emerging markets for now. Instead, “hopes seem to centre on the US.” The US market is now “significantly outperforming the rest of the world.”

The main reason for this outperformance is the strong dollar. Trouble is, this isn’t good news. Why not? Because the dollar’s not strong because of any vote of confidence in the US economy. It’s because everywhere else is in such a bad state.

What the strong dollar really represents is a shift away from risky assets. As investors became bolder following the crisis, they borrowed cheap money in dollars to invest in higher-yielding assets elsewhere. This is known as the dollar ‘carry trade’ – the yen is also a popular currency for such trades.

It’s a great trade when the dollar is falling and everything else is going up. But it’s been described as “picking up nickels in front of a steamroller”. Because if you get caught on the wrong side of it, you’ll get wiped out. If the dollar starts rising, then the income on your overseas investment won’t be enough to pay back your dollar borrowings. And once currency trends turn, they turn fast.

Investors are getting the jitters about China

The upheaval in Greece is of course making investors nervous. With the country riven by mass strike action, and Greek politicians now throwing the Second World War in Germany’s face, the odds of a bail-out are surely declining.

But it’s not just Greece. China is giving investors the jitters with every suggestion of tighter monetary policy. The most recent sign is that the state-owned banks are in a rush to raise money to prop up their balance sheets after the government-driven lending boom of the past year. “This week alone,” says the FT, “Chinese lenders have announced plans to raise up to £7.2bn through equity and bond sales.” Another £14bn-odd is “in the pipeline.”

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However, the general consensus remains that China is the future. Most investors seem to be betting that China can ‘walk the tightrope’ of monetary policy (i.e. keeping inflation under control without crushing growth), despite the fact that no one else seems to be capable of doing it.

And as you’ve no doubt noticed, superstar fund manager Anthony Bolton is about to launch an investment trust investing in the country. But I’m not sure that’s a good sign. Bolton’s past performance rightfully commands respect. But this launch will likely represent a huge influx of private investor money into the Chinese market. And like it or not, history shows that when retail investors are piling into an asset en masse, it’s usually on the turn. All the highest-profile tech fund launches came when the tech bubble was topping out. Same with the more recent commercial property bubble.

China may be the next decade’s biggest disappointment

Chris Rice of Cazenove Capital puts it bluntly. He told Citywire recently that for investors, China will be the biggest disappointment of the next decade. His point – which seems reasonable to me – is that even if all the expectations for China come true, investors are paying too much for exposure to the story. After all, the internet has revolutionised business, much in the way that tech bubble investors envisioned. “The problem was that the amount equity markets paid for the potential profits was too high.”

China sceptics are in the minority for now. Most of the fund managers at our latest Roundtable discussion (in this week’s issue of MoneyWeek magazine – out tomorrow. subscribe to MoneyWeek magazine if you’re not already a subscriber.) were cautiously upbeat on the country. But a few anecdotes were telling. One of our experts mentioned visiting an upmarket penthouse flat in Shanghai that cost more per square foot than a house in Chelsea.

To be fair, she believes there’s a bubble in property in the major cities. But for me, the story was uncomfortably reminiscent of the old story that the land around the Imperial Palace in Tokyo was at one point worth more than the entire state of California. It just doesn’t stand up – particularly when you consider that a house in Chelsea is hardly trading at bargain levels right now itself.

Of course, being wary of a bubble and knowing when it will burst are two different things. In the meantime, my colleague Merryn Somerset Webb suggests a much safer, cheaper way to get exposure to the China story on our blog.

Our recommended article for today

Grow your profits on a farm

Farmland may be the best low-risk investment over the next decade, beating bonds, cash and property, says Jonathan Compton. Here, he explains how to take advantage by investing in farms or farming-related businesses.

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