Bloomberg announced over the weekend that China’s manufacturing grew at the fastest pace in a year. We follow the government’s Purchasing Managers’ Index (PMI) closely, as we believe it is a better indicator of China’s domestic demand than the HSBC PMI. Whereas HSBC PMI surveys 400 small and mid-sized companies, which are typically export-oriented, the government’s PMI surveys 820 mostly large, state-owned enterprises across 20 industries.
Though manufacturing activity exceeded analysts’ estimates, some China bears focused on the fact that the March 2012 number is lower than the average during the third month from 2005 through 2011. What’s important for investors to consider is that the trend is your friend: It is the fourth month in a row where the PMI landed above the three-month PMI, and shows the economy is on the right path.

Below are three additional constructive trends we see in China.

1. China Returns Poised to Revert to the Mean

Over the past few years, Chinese stocks have lagged compared to their emerging market peers. However, the Periodic Table of Emerging Markets perfectly illustrates how last year’s loser can be this year’s winner. Historically, every emerging country has experienced wide price fluctuations from year to year. Over time, though, each country tends to revert to the mean.

In the visual below, we highlighted China’s performance pattern over the past 10 years. Chinese stocks landed in the top half four out of 10 years—2002, 2003, 2006 and 2007. In 2003, China climbed an astounding 163 percent; in 2007, it was the top emerging market again, returning nearly 60 percent.
Since then, the country has fallen to the bottom half of the chart. If you apply the principle of mean reversion, history appears to favor China landing in the top half during this Year of the Dragon.

See the original Periodic Table of Emerging Markets here.

2. Liquidity Cycle Could Benefit Stocks

Yet China leaders won’t leave its success to pure luck. If the Dragon doesn’t breathe fire into markets, it may be a shot of liquidity injected by policy easing that could drive stock prices higher. Macroeconomic theory states that when a country’s money supply exceeds economic growth, the excess liquidity tends to drive up asset prices, including stocks.

BCA Research documented this trend in China over the past eight years. The research firm compared the difference between the change in money supply growth and nominal GDP growth and Chinese stock prices. In both instances when the change in excess liquidity fell to a low, so did stocks. Conversely, the rise of money supply growth compared to GDP growth “coincided with major rallies” for China’s stock market, according to BCA.

Today, it appears that the change in excess liquidity is just beginning to bounce off another low, as are stocks, indicating another potential inflection point.

3. Incentive to Maintain Growth

BCA hedges China’s possible stock advancement in the short-term if signs of economic improvement continue because they “reduce the odds of aggressive policy easing.” A few weeks ago, I discussed how investors seemed to overlook China’s focused macro policy strategy, with its actions deliberate and purposeful. This year, the government has extra incentive to sustain meaningful growth as it transitions to a new leadership by the end of the year. As President Hu Jintao and Premier Wen Jiabao depart, Xi Jinping and Li Keqiang are expected to take over.

Looking at historical GDP growth per year since 1978, Deutsche Bank finds there’s precedence for this idea. During the fifth year of the leadership transition cycle, “high or stable” GDP growth was maintained, with the exception being the Asian Financial Crisis in 1997.

These trends will be covered in my upcoming webcast on China with CLSA’s Andy Rothman. Join us as we discuss what investors should expect from China in terms of long-term GDP growth, fixed asset investment, exports and the housing market.

When I was in Singapore at the Asia Mining Congress last week, I was fortunate to be among a group of sharp and intelligent experts across the financial and mining industries. A China bull presenting an excellent case for the country was Jing Ulrich, JP Morgan’s managing director and chairman of China equities and commodities group. She’s the Oprah Winfrey of the investment world, as for the past three years, Forbes Magazine has ranked her among the 50 Most Powerful Women in Business.

Ulrich expressed similar views toward China and its political will in a recent “Hands-On China Report” following her attendance at the China Development Forum in Beijing. She said that the government ministers emphasized their commitment to rebalancing the economy toward consumption. While “fundamentals are currently sound, the nation must modify its ‘imbalanced, uncoordinated and unsustainable’ course of development,” says Ulrich. What investors should remember is that the government had the financial resources to effect this change and considered it important to maintain sustainable growth.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. The Purchasing Manager’s Index is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. The Hang Seng China Enterprises Index is a capitalization-weighted index comprised of state-owned Chinese companies (H-Shares) listed on the Hong Kong Stock Exchange and included in HSMLCI index (Hang Seng Mainland Composite Index).

To paraphrase the great Steve Martin, today’s investors are very passionate people and passionate people tend to overreact at times. An overreaction is exactly what’s happened in gold and global markets in recent weeks. While market bulls have been sniffing out data points to support their case, market bears have continued to take a glass-half-empty approach.

Gold and China are two areas that have been caught in the bear trap this week, but we believe the gold and China bulls still have room to run.

Short-Term Challenges for Gold
Rising bond yields, a stronger U.S. dollar and an improving U.S. economy have squelched expectations for a third round of quantitative easing (QE3) and consequently, spelled trouble for gold. Since late February, gold has declined more than 7 percent.

As confidence improves, UBS says the yellow metal is losing the dual role of safe haven and risk asset: “Gold is moving off center stage, while growth assets are moving to the fore.” Earlier this month, we saw the largest weekly contraction in long gold positions on the Comex since 2004.

As I wrote in my blog this week, the selloff has pushed the price of bullion below its 200-day moving average for only the 30th time over the past 10 years. Over this time period, gold has declined on average 2.1 percent over the 10 days following the cross-below date. This means we’re likely only one-third into the correction in terms of price and duration.

All is not lost for gold. In his latest Gold Monitor, Dundee Wealth Economics Chief Economist Martin Murenbeeld lists 10 positive factors for gold, one of which is monetary reflation. We are currently experiencing one of the greatest global liquidity booms the world has ever seen. Over the past seven months, there have been 122 stimulative policy initiatives from central banks around the world, according to ISI Group.

You can see from Canaccord’s chart below that injecting liquidity into the global monetary system has been a steroid for stronger gold prices over the past decade. The global monetary base has ballooned three times larger, with gold increasing nearly six-fold.

While we are seeing strong signs of improvement in the global economy, it’s important to remember that the recovery has been built upon a mountain of printed money that cannot be hastily unwound. Dr. Murenbeeld explains, “Money doesn’t grow on trees; it will have to be borrowed by some government and/or it will have to be printed by some central bank.”

This is why we believe the bull market for gold remains intact.

Overreaction on China
Indication of a Chinese economic slowdown and negative comments from BHP Billiton regarding its outlook for Chinese demand caused anxiety for investors this week.

The March HSBC Flash Manufacturing Purchasing Managers’ Index (PMI) fell 3 points from the previous month due to weakening domestic and external demand.

However, Macquarie says, “It’s not that bad out there.” The firm’s research shows that relatively strong demand from China during the first two months of the year has had a positive impact on global commodity prices. Macquarie says, “While there is undoubtedly a slowdown taking place in Chinese economic growth as a result of domestic policy tightening and weaker export growth, the impact on commodities demand has been negligible.”

As for the BHP comments, Barclays says that they were misconstrued, stating the “BHP executive was by no means bearish on near-term Chinese demand prospects and comments referring to a softening in Chinese steel demand were largely focused on the scenario post 2025 … the notion that iron ore and steel demand growth is unlikely to grow at a double-digit pace forever is not a surprise to the market.”

Bright spots in China’s economy aren’t hard to find. Barclays reports that the backlog of manufacturing orders saw its largest month-over-month increase since 2005 from January to February of this year. Supported by an all-time high in gasoline demand, Chinese oil demand reached a record high in February. Gasoline demand was resilient despite Beijing hiking prices by 4 percent in February due to higher oil prices. The Chinese government followed that up with an additional 7 percent hike earlier this month. Auto sales increased nearly 24 percent year-over-year (13 percent sequentially) in February, the largest increase since November 2010, according to UBS.

As CLSA’s Andy Rothman and I will discuss in our April 5 “Hard or Soft Landing in China?” webcast, higher fuel prices will only modestly impact Chinese consumers because few come in direct contact with unsubsidized gasoline. Andy estimates that fuel accounts for only 2 percent of China’s Consumer Price Index (CPI) basket, compared to 5.4 percent in the U.S.

We’re also seeing positive developments in an area where Chinese consumers are vulnerable—housing prices. According to CLSA and China’s National Bureau of Statistics, home prices fell in 27 cities on a year-over-year basis during February, three times the volume in December. In addition, none of the 70 cities tracked reported more than a 5 percent increase in new home prices. A gradual reduction in home prices is exactly what the country needs to prevent a major housing crash, but don’t expect the Chinese government to let the bottom fall out.

Remember, the minimum cash down payment for a Chinese home buyer with a mortgage is 30 percent. Investors are required to put 60 percent down in cash. Currently, about one-third of home buyers are paying all cash, according to CLSA. Andy says the government is poised to relax the country’s strict housing policy measures as soon as this summer if the decline accelerates.

We’ll be discussing these developments and more during our April 5 “Hard or Soft Landing in China?” webcast with Andy. Sign up today.

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. The Consumer Price Index (CPI) is one of the most widely recognized price measures for tracking the price of a market basket of goods and services purchased by individuals. The weights of components are based on consumer spending patterns. The Purchasing Manager’s Index is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

Lost in the scuffle between Google and the Chinese government is how fast China’s Internet use is growing.

The total number of Internet users in China grew by 86 million in 2009 to reach 384 million by year-end.  That’s well more than the entire population of the U.S. and Canada combined, and a 29 percent increase year-over-year.

Of that number, 90 percent had broadband connections, according to the China Internet Network Information Center (CNNIC).

Nearly 30 percent of Chinese are now Web users, and this sets the stage for explosive growth in the years ahead.

Once Internet penetration in the U.S. reached 20 percent, it took just six years to get to 60 percent. Japan needed only three years to go from 20 percent to 40 percent, and Brazil went from 20 percent penetration in 2005 to more than 35 percent by 2007.

While the highest penetration rates surround China’s largest cities, the mobile Internet is bringing the Web to rural and lower-income users. Mobile internet has lowered the cost of entry for consumers—smart phones are cheaper then desktops.

A surprising result from CNNIC: more than 45 percent of mobile Internet usage is from people with monthly income of 100 yuan ($14.65) or less.

A recent survey reported by McKinsey & Co. shows that people in China’s 60 largest cities spend around 70 percent of their leisure time on the Internet. Most of this usage is for games, entertainment and shopping.

On the commerce side, two of the biggest growth areas were online banking and e-commerce. Users who book travel online jumped 78 percent last year. McKinsey says a significant number of consumers ages 18 to 44 won’t purchase a product or service without first researching it on the Web.

As the Internet continues to expand its reach into the lives of Chinese people, keep an eye on how users leverage the technology to improve their living standards.

The following securities mentioned in this post were held by one or more of U.S. Global Investors family of funds as of 12-31-09: Google Inc.