China has been and remains the strongest leg of the economic recovery.  While most other countries remain entangled in a weak recovery or no recovery at all, China’s economy appears to have surged back to its pre-crisis growth rates.  But as the old saying goes, if it seems too good to be true it probably is.

At the beginning of the year we described China as one of our “5 biggest risks” of 2010.  Last week we mentioned (see here) the risks in the Chinese economy appear to be mounting as property prices surge and inflation begins to rear its ugly head.  Well, it looks as though we’re not the only ones who are concerned about the sustainability of the Chinese economic recovery.  According to Westpac Bank in Australia the leading economic indicators in China are beginning to roll over:

“Back on the 11th Feb we noted ‘Chinese data set to slow, but not abruptly’. Four weeks later, we wonder whether a more apt title might have been ‘Chinese data set to slow, abruptly’. Obviously, the Chinese LEI and CEI are only available with a significant lag while our Chinese pulse is available real time, so one can debate how synchronous the charts are. However, at face value there seems to be a reasonable relationship between LEI/CEI and the pulse. That is when the LEI crosses over the CEI, we tend to see major shifts in Chinese data momentum. And we certainly have seen a sharp shift in data momentum. Back in November/December, our Chinese data pulse was running super white hot at 94%. Last week, our Chinese pulse hit 39% – the lowest since March 13 2009.”

And this isn’t just a China problem.  It appears to be an emerging market problem:

“Our Asian pulse is at its lowest since June of last year. Our emerging market pulse is at its lowest since July 2009. Our BRIC pulse is at its lowest since mid June 2009 and our global pulse sits at its lowest level since May of 2009. Bottom line, we are seeing a more broad based waning in data momentum.”

Obviously, Westpac is approaching this drastic change with caution:

“Early signs of softening in data momentum suggests we should be much more cautious about corrections in those markets that benefited late last, and early this year.”

But Westpac isn’t the only bank in Asia that is turning more cautious.  Guotai Junan securities, China’s second largest brokerage firm says the Shanghai Index could fall nearly 20% further as tightening fears increase in the coming months:

“China’s benchmark stock index may fall a further 17 percent to 2,500 in the first half as the government steps up measures to cool growth, according to Guotai Junan Securities Co., the nation’s second-largest brokerage.The Shanghai Composite Index, which has declined 9.1 percent this year, may extend losses on prospects for monetary tightening after consumer prices and fixed-asset investment climbed more than estimated, said Zhang Kun, a strategist at the Shanghai-based brokerage, in a telephone interview today.

“There’s more and more pressure on the government to do more to rein in growth,” said Zhang. “The market may bottom out in July or August and then start to rebound when the tightening is expected to ease.”

Despite being the strongest leg of the economic recovery, Chinese investors have turned remarkably cautious in recent months.  The Shanghai Index peaked in July of 2009 and has traded down ever since.  The index has declined 9.5% this year while U.S. investors have continued to run head first into stocks.  Interestingly though, the leading indicators in the U.S. are telling a similar story.  Friday’s reading from the ECRI continues to show a weakening recovery. Their leading indicator’s growth rate fell to a 31 week low.

While China’s economy begins to show some warning signs, U.S. investors have signaled the all clear and are having a virtual free-for-all on the riskiest of risk assets.  Curiously,   the Chinese appear to be approaching the economic environment with substantially more prudence than their U.S. counterparts (much like their spending habits) despite continuing signs of private sector balance sheet weakness in the United States (you’d think it was the other way around!).  China has proven to be a fairly consistent leading indicator over the last 18 months when it comes to the equity markets.  U.S. investors could be wise to take note.

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