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How to handle a China slowdown

Reports earlier this week that BHP Billiton Limited (ASX: BHP) was reviewing its capital expenditure plans gave some investors an uncomfortable few days. The reason? BHP was reportedly reassessing its opinion of when China’s demand for iron ore might peak before it confirmed or revised its plans to spend some US$20 billion on its Pilbara mine and associated infrastructure.

The boom may yet go on, but if it ends, investors need to be prepared.

From the sheep’s back to the minerals underfoot

Much of the recent growth of the Australian economy has been underwritten by the success of our mining industry. While the rest of the world struggles with low growth, large government deficits and high unemployment, the Australian economy has continued the dream run it has enjoyed since the early 1990s. Some of that can be sheeted home to our avoidance of US-style housing defaults, but a large lick of that success has come from China’s demand for our resources.

BHP’s current review poses an important question for investors – what if China’s growth slows? A similar, yet less visible question could have the same impact – what if mineral prices (iron ore in particular) drop due to a large increase in supply? While mining is often seen as a volume business, those who can remember back before the current run up in the gold price will recall a time when gold mines were mothballed for long periods because the precious metal couldn’t be extracted at a profitable cost.

Mining profits – not volumes – are what count

Either of those two outcomes – lower volumes or lower prices, or a combination of the two – would put pressure on our miners. In either situation, we’d see lower mining profits and a reduction in the growth of mining jobs, or even a loss of jobs in the mining and related industries.

In such a circumstance, what’s an investor to do? The first point is that forewarned is forearmed. There’s no point trying to fix a leaking roof when it’s raining – far better to do the preventative maintenance in better times.

Some investors are happy with a relatively binary outcome – if the boom continues, their portfolios will do well, but if the boom ends, the portfolio will be much, much poorer for the experience. I struggle to understand that mentality. The single worst outcome for an investor is to have to go back to – or even near – square one.

Instead, by all means expect the best, but prepare for the worst. Below are some possible outcomes of a slowing China or a drop in resource prices – and some investment options that present themselves as a result.

A slowing economy

If the mining boom does falter, it’s probable that unemployment would rise and consumer spending would falter. In those circumstances, you don’t want to be unduly exposed to those businesses that make money from either the discretionary consumer dollar or rising demand. That means being wary of fashion businesses and banks. The latter group grow through increasing home prices and growing consumer credit. In a downturn, both of those areas are likely to struggle.

Instead, defensive industries such as consumer staples businesses, insurance companies and utilities provide safe, if sometimes unspectacular options.

A falling dollar

I’m yet to find someone who can accurately – and consistently – predict the Australian dollar. However, it’s almost universally accepted that the robust Australian economy – and our exposure to China – are behind the recent strength of our currency.

If the boom – and as a result, our economy – falter, the dollar would come under pressure (it has already fallen overnight). While that will make our imports more expensive, it will be good news for both our exporters and also companies which earn a reasonable proportion of their profits overseas. Companies such as Westfield Group (ASX: WDC), Cochlear Limited (ASX: COH), CSL Limited (ASX: CSL) and QBE Insurance Group Limited (ASX: QBE) are likely to benefit in such a situation, as overseas earnings are translated into Australian dollars at a higher rate.

Buy growth

The options above are somewhat defensive in nature, but it’s still possible to make money if you choose well.

A slowing economy is supposed to be bad news. And if you’re a nationally dominant, mature business, it is. Myer (ASX: MYR) is one half of a struggling department store duopoly. The big four banks control over 90% of our retail banking industry. As the economy goes, so go these businesses.

However, small companies or companies in growing industries (and which will grow even in a slowing macroeconomic environment) can still deliver returns for investors. Apple (Nasdaq: AAPL), while now the largest company in the world, grew like topsy throughout the worst American and global downturn since the Great Depression.

Foolish take-away

There will always be a market for innovation, and doubly so when these companies are both creating a larger market and taking market share from their competitors. That was Apple’s experience and we think there are opportunities in Australia in areas such as technology, telecommunications and services. Examples include Corporate Travel Management (ASX: CTD) and 1300 Smiles Limited (ASX: ONT), and there are others.

In investing, as in sport, sometimes attack is the best form of defence.

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Scott Phillips is a Motley Fool investment analyst. Scott owns shares in Westfield Group and QBE. You can follow him on Twitter @TMFGilla. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691)

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