China is a No Touch!
An economic model failing in the wide open. Broken demographically, fiscally and structurally, this will likely underperform on the global stage for decades.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
One important investment theme this year and in fact the last couple of years has been the downfall of China as an asset class. Both the Hang Seng and the Shanghai Composite (SSE) are now back to GFC levels. Needless to say, the S&P is up 300% since then.
Year to date, this underperformance has accelerated. As of this writing, the Hang Seng is down 6% and the SSE is down 3%, while the S&P is up 6%.
Naturally, this attracts many speculators interested in buying the dip. After all, isn’t the country still delivering on the promise of ending a century of US hegemony by becoming the next global superpower?
I don’t dispute that such a severe and accelerating underperformance raises the odds of a near-term bounce. But I wouldn’t hold my breath. Chinese risk assets are a no touch from my perspective. I prefer to stay away from them as far as possible.
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From a macro perspective, China has been a tremendous growth story over the past decades. Between 1980 and today, they have 10xed their share of global GDP from 2% to 20%. It has created an aura of infallibility surrounding the Chinese Communist Party (CCP), which is believed to play 4D chess with the rest of the world. People suspect they are always a step ahead in executing on their master plan navigating China towards becoming the new global superpower.
It was easy to to conclude that their model is unsustainable based on reasoning alone. Their centrally planned investment binge can impossibly compete with Western style free market capitalism. But recently, this reasoning has been supported by evidence that ‘peak China’ is in and it’s now downhill from here. It will likely take many years and even decades to play out. China is about to head into the same lost decades that Japan is just now emerging from. Its economy is suffering from a toxic cocktail of demographic, fiscal and structural problems.
It is well known that China’s population is shrinking as the effects from their one child policy are kicking in. The trend is even worse for productive ages which will contract at a rate of about 1% (!) annually by the end of this decade. This limits their potential real economic growth because headcount is obviously one of its two determining factors (productivity gains being the other one).
But there is more to the demographic story for asset prices specifically. There is a natural equilibrium between the demographic trends of a country and the valuation of its assets. Middle aged people cause buying pressure. Retirees cause selling pressure. Historically, this has explained bubbles in the US and in Japan extremely well. And it looks very gloomy for China. From a demographic investment perspective, a bottom may not come before the mid 2030s.
Very few countries are as investment driven economies as China. Investment is not bad per se. If it’s used productively, it can fuel economic growth. But for that to work, the society needs to be built on liberal principles which spark entrepreneurial spirits. China has gone the other way. Over decades, they have centrally directed capital into bad investments, namely those with poor return on investment. The bill is paid by domestic savers. Due to tough capital controls, they have no other choice but to participate.
There is an important Achilles heel in China’s economic model. To run their factories, they need to import large quantities of energy from abroad to convert these into products and services for export purposes. This makes them an easy pray for energy rich countries and puts them into a weak position. This becomes particularly apparent in trade conflicts as evidenced in the last trade war with the US from 2018 to 2020 when the Chinese stock market trailed the American one by about 30% cumulatively. If Donald Trump wins the election, this could capture investor attention once again and serve as an additional downward catalyst.
Given all these issues, the bulls that are left are betting on a relaunch of large scale stimulus programs to get the country out of the mud. Such a bet seems obvious considering that many domestic problems are in fact self-inflicted due to regulatory crackdowns on important industries. However, it’s in my opinion unlikely the CCP will deliver on those. It would contradict their actions taken in the past years to reign in the economic excesses before the consequences get even worse. And even if they did so, it would likely come at the expense of a sharp devaluation of their currency. They can manipulate asset prices in local currency. But a sustained outperformance denominated in US Dollars seems highly unlikely. China is a classic value trap.
The Chinese Economic Model
After the disastrous consequences of the Cultural Revolution, China started implementing economic reforms in the late 1970s under Deng Xiaoping. These reforms were primarily targeted at opening the economy to international trade and foreign investments.
All of this was hugely successful and helped raising China’s share in global GDP from 2% to 20%. However, while I don’t want to discount the achievements of the leaders in charge, it is important to point out that they had important tailwinds facilitating the success of their policies.
In 1980, China was home to 22% of the global population. It’s still 18% today. This shows how utterly mismanaged it was at the beginning of the reforms. In financial analyst lingo: the comps were very easy and the fruits were hanging low.
If you open up a country home to 1bn people who are extremely poor and who are under the grip of a strong centralist authority, it’s actually quite easy to produce marvelous economic results. China simply exported what it had a great abundance of: cheap labor. Hundreds of millions of Chinese people effectively became slaves of the West. They chose to do so because the alternative was even worse. Their enormous sacrifices built the economic powerhouse that China is today.
It was not just about the sheer size of the workforce ready to be exploited by foreign investors. It was also about the underlying trends thereof. The productive age population (defined as ages between 20 and 65) entered into a strong growth spurt in the early 1980s, just in time for the reforms. For a short period of time, it grew at almost 4% annually, an incredible pace in the otherwise slow-moving world of demographics. Growth rates came down over the coming decades, but they remained elevated and - even more importantly - they remained above the growth of the entire population.
This lifted up the productive ratio in China, i.e. the share of the productive aged population. It peaked in the mid 2010s, which coincided with the first cracks in the Chinese economic model.
This economic model is predicated on investment and exports. China’s share of investment in GDP is hovering above 40%, up from below 30% before the reforms started. For comparison, the USA are pretty stable at just above 20%.
And in terms of net exports, China has maintained a structural net export position of around 2-4% over the past decades, while the US are at around 4% net imports.
Now, you might want to ask: Isn’t this good? Investments are the foundation for future growth and a trade surplus builds domestic savings which should strengthen the currency and build wealth for the population. I have issues in general with such assertations, but detailing those here would completely blow up this article. So I want to only comment on China’s situation in particular.
Investment can be a pillar for sustained economic growth if it is under the direction of free market forces. That is the only way to guarantee sufficient RoIs. In China, investment decisions are being directed by politicians. These lead to gross misallocations as evidenced in their giant real estate bubble.
This was probably not always the case. Under Deng Xiaoping, there was such a big investment backlog that you could probably achieve a positive RoI with pretty much any investment project. Every new road connected a new cohort of thousands of workers to the global economy. They could not do wrong, even with a centralist planning approach. But there was probably a tipping point when the model rolled over. I believe there is good reason to believe that China has continued with their investment binge beyond what was healthy for them. The media is full with apartment towers and shopping malls that are empty.
The brunt of this is born by domestic savers who are obviously financing all of this. It’s also the reason why the CCP makes it extraordinarily difficult for them to invest abroad. There are very few investment vehicles available to bypass capital controls and invest in overseas equities. Some of these are trading at a huge premium to their NAVs, a manifestation of the panic of the local population to get their funds abroad.
It’s a huge red flag for anyone interested to invest in this country. It’s frankly a bit amusing to me how some Westerners are trying to go the other way chasing exposure to Chinese assets, some of which happens via odd offshore structures. I view this as the equivalent of trying to jump over the Berlin wall from West to East. Who in their right mind would do that???
China’s population has started falling in 2022. Per the UN, this trend will accelerate over the next two decades to about 0.3% annually. It’s productive age population (defined as ages 20 to 65) is expected to contract even faster, at a rate close to 1% annually by the end of this decade. In contrast to that, the US population keeps growing, both its total and its productive ages.
By the middle of this century, China is expected to lose about 100m people to about 1.3bn, while the US is expected to grow by 40m people to 375m. This is based on the UN’s medium variant scenario. In reality, the gap could close faster considering the huge immigration wave the US is currently facing. I do not have the impression they the capability and willingness to put limits on that anytime soon. (I am not opining on this politically, I merely acknowledge the additional aggregate economic power that comes with every new head in a country.)
It’s needless to say that this is a growth burden for China. After all, there are only two ways to grow economic output: more heads or more productivity.
But I am not telling you anything new. You are certainly familiar with the Chinese demographic story. Much has been written about the detrimental impacts of the one child policy and the administration’s inability to overcome the spirits they have summoned.
But I do think I have something differentiated to add to this topic beyond stating the obvious. In spite of being a well known issue, I continue to believe that the impacts on asset prices continue to be underappreciated.
Humans drive financial markets through buying and selling, not institutions. And they do it when they either have the money or they need it. And that is first and foremost a function of their age.
In the article below, I illustrated the profound implications of US demographics on the P/E ratio of the S&P.
In that article, I defined people aged 40-49 as High Accumulators (HA), i.e. demographic buyers of risk assets. And I defined 60-69 as the age group of High Withdrawers (HW), i.e. demographic sellers of risk assets. The ratio between them explains about 80% of the movements in the cyclically adjusted price to earnings (CAPE) ratio of the S&P between 1955 and 2010. No other age group ratio matches this level of correlation.
Afterwards, this correlation fell apart. The distinction of this regime shift is absolutely astonishing. I had to check the data several times to ensure it was not an error of mine.
We can only speculate about the reasons, but I suspect two reasons:
There was a distinct change in US economic policy after the GFC. QE was a paradigm shift. The Fed jumped in as buyers of risk assets to replace the retiring boomers. Check out the details about that in the article above.
2010 was also the starting point to the domestic oil boom which improved the competitiveness of the US economy significantly and altered global capital flows.
The 2010s were also a distinct period as they came with the rise of Big Tech to world domination. It’s probably fair to say that their ascent is without precedent historically, especially at such a rapid pace.
In a later article about the 1920s/30s, I found that demographics also likely contributed to the poor performance in the 1930s as the negative slope of HA/HW ratio steepened.
Subsequent market tops (normalized for monetary debasement) always came with a cyclical peak in the HA/HW ratio.
This subject is not limited to the US. In the article below about Japan, I highlighted that their huge 1980s asset bubble and the bust thereafter coincided with a huge demographic wave. By the time, I wrote this piece on Japan, I had started to use the difference rather than the ratio between the buyers and the sellers which seemed to be more appropriate to me. It allows to quantify the buying pressure in relationship to market value or GDP for example.
The bottom line is this: An economy typically has an equilibrium between the valuation of asset prices and its demographic structure and trajectory. If there is a change to the latter (i.e. a turning point or an inflection point), it can disrupt asset prices.
Plotting the same metric for China looks like this:
By and large, the demographic peak in 2014 coincides with SSE’s bubble in the mid 2010s that I inserted in the intro of this article. This metric has entered into a downtrend since which is not expected to end anytime soon.
We could also define the groups a bit more broadly by including ages 30-54 in the buyers and 60-74 for the sellers. This metric shows an acceleration of the negative slope that is happening right now. A bottom is not expected until the mid 2030s.
In my recent article about the US oil production boom, I highlighted the importance of a healthy domestic energy sector as the foundation for prosperity.
Energy security increases the competitiveness of domestic industries. It shields the economy from geopolitical tensions. It attracts foreign investment *and* it strengthens the trade balance. It strengthens the local currency, which reduces inflation and gives policymakers flexibility with crises.
Of course, there are downside risks as well. Large reserves of natural resources incentivize corruption which can force a countries to its knees. There are numerous examples of failed states that should be among the richest on earth considering their resources. Think about Nigeria or Venezuela for example. But if managed well, these natural resources can make economies very successful. Think about Norway or many countries in the Middle East.
Over the past two decades, the US has closed their primary energy deficit from 30 quadrillion BTU to zero. This is the equivalent of 14 million barrel per day (mbd)!
Not all of this is crude oil, of course. But just for reference, global crude oil consumption is about 100 mbd. This production expansion is huge.
In contrast to that, China imports about 20,000 PJ of energy every year, which is up from almost nothing 25 years ago. This is the equivalent of 9 mbd.
As you can see, those numbers match each other surprisingly well. From an energy perspective you could even argue that the economic boom in China over the past 2-3 decades has been 'funded' by the US. Their growing appetite for energy from abroad has been satisfied by an increase in US energy output.
Hence, the economic relationship between both countries is not just about exchanging dollars for junk. It's also about exchanging energy for junk. China has used the energy produced in the US to massively build manufacturing infrastructure and housing, much of which are stranded assets due to demographic reasons and failed central planning. They have created some impressive tech giants and they are aggressively investing into electrification, which makes their prospects less hopeless than Europe's, but it is by far not enough to set them up for success in my view.
The bullish counterargument to this line of thinking usually looks like this:
But China’s manufacturing prowess is an illusion. They depend on the energy from abroad to run their factories. This puts them into a very weak position should a conflict arise. It’s very easy for other countries (especially the US) to extort them. The 21st century will see many examples where energy rich countries exploit energy poor countries. Germany is in a similar situation by the way.
When you think about the economic relations between energy rich and energy poor countries, think of it like a tax or a tribute that the latter will have to pay to the former. This limits their ability to accumulate wealth.
Potential Trade conflict
On February 4, 2024, Trump appeared in an interview on Fox’s “Sunday Morning Futures” where he floated the idea of going hard after China again with tariffs. The public opinion on this seems to be clear: He would be hurting the US at least as much as he would be hurting China.
I believe it is difficult for any country to emerge as an absolute winner from a trade conflict. After all, international trade generates synergies for everyone. But in relative terms, it is very clear to me that the US is in a much stronger position.
Take the last China-US trade war for example. It started in Jan'18 with Trump’s first tariffs. It ended when both admins entered into a trade deal in Jan'20. During that time, the S&P outperformed the SSE by about 30%. For the reasons outlined above, China needs the US more than vice versa.
Is a Trump win priced into Chinese equities? I don’t know. But I don’t like the odds. I believe China would not even an attractive investment under Biden.
What’s then left for bulls? When I parse their comments on social media, it seems to me that it all boils down to a valuation call. They post for example stuff like this:
Is China not to cheap to ignore? Haven’t investors capitulated enough? My response to this is a resounding no for several reasons.
The comparison between P/B of the NASDAQ and P/E of the Hang Seng is obviously nonsense. Nobody would value the former based on P/B because this index is dominated by companies that operate with self-created intangible assets that are not capitalized without M&A. Their book value is a number without economic relevance.
What I am outlining here is a generational bust of an economic model that has been in place for about 40 years. It’s highly unlikely that the excesses in this model can be wiped out in just a few years. Japan took 20 years to recover from its bubble.
Could China reverse course on some of their self-inflicted issues, like the regulatory smackdowns in financial services and the tech sector? Sure. And would that not pump asset prices? Sure. But it seems implausible that this could happen sustainably and denominated in USD.
I believe FX risk is utterly neglected by China bulls. How excited can you be about 7x earnings for an asset with CNY cash flow exposure when you have no idea what the cash flow will be worth in 5 or 10 years? The value of a currency is backed by the economic strength of its issuer, which weakening right now.
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