China!
There is no more bi-partisan issue in the US. There may be no more important story in 2025
China has been the story of the 21st century. From the entry in the WTO, to the massive commodity run-up into the Financial Crisis, to the Beijing Olympics to the stories of adding a city the size of Houston every year, China has been in the middle of the news stories.
Turning negative
Most of those stories were positive, with the China miracle driving growth and demand in some areas of the world, and the same miracle driving prices lower and enabling companies that sold inexpensive goods (read Amazon and WalMart) to generally create a massive disruption in retail. This disinflation was a major trend and led to a bull market in both stocks and bonds over the course of the last 20 years.
With inflation no longer a worry, the market only focused on growth. This led to a negative correlation between stocks and bonds, growth stumbles meant rate cuts so stock selloffs were offset by bond rallies, and upside surprises on growth meant stock rallies and bonds giving back their gains.
The China story turned negative in 2018 when Trump imposed tariffs on China and began a trade war. The negative story accelerated around the Covid crisis, whether fairly or unfairly. Since then, it has become the only bi-partisan topic in Washington D.C., with both parties negative about China, while perhaps taking different approaches to implement ideas.
As is typical with Trump, he didn’t identify a new issue, he just put a megaphone on an issue that he thought would garner him votes. As early as 2009, there were already concerns about Chinese industrial espionage and stealing US technology. The FBI investigated this. You can read a report here from the Center for Strategic and International Studies which highlights the issues go back to 2000: https://www.csis.org/programs/strategic-technologies-program/survey-chinese-espionage-united-states-2000
The trade deficit became the easiest target because this was a number one could point to, not because ‘fixing’ the deficit was possible or even desirable. However, it led to tariffs and increased negative rhetoric. More on that below. Whether it was by design or not, the trade deficit with China did peak in 2018 when the negativity began. While it is still quite large, it has been trending lower ever since.
Self-inflicted wounds
China’s problems weren’t only because of the US, however. China has many self-inflicted wounds. In an anti-corruption campaign aimed at delivering ‘common prosperity’ the Chinese Communist party cracked down on the tigers and flies. The tigers were high-ranking officials, and the flies were low-level bureaucrats. This was an opportunity for Xi to consolidate power and ultimately become essentially the emperor for life.
It wasn’t just a government crackdown. Industries were targeted and the heads of the major companies were also targeted. Finance, technology, healthcare, education companies were cracked down on. Famously, Jack Ma, the billionaire head of Ali Baba, was targeted and went quiet for an extended period of time. Perhaps this was ‘re-education’ or perhaps he was just laying low. Either way, his high-flying stock crashed in 2021 and has yet to recover.
In late 2021, I said Evergrande was China’s Lehman moment. I recall being derided at that time that this wasn’t nearly big enough. However, Evergrande was the largest property developer in the largest sector of the second largest economy. Chinese consumers lacking a social safety net like the Social Security the US enjoys, had plowed all of their retirement savings into the property market. A collapse in the property sector was not only going to impact commodity prices, but it was also going to leave a massive dent in the consumer psyche.
The crackdown and collapse of major companies has had a very negative impact on the economy. It has not only in the major companies. Everywhere, the economic slump is very real, and we see that in the unemployment levels, especially among the young workers. One can imagine the government officials are well aware of this, since social stability is a key focus of the government.
Per NBC: “The jobless rate for people in China ages 16 to 24, and not in school, rose to 18.8% last month, data from the National Bureau of Statistics showed Friday. That’s up from 17.1% in July, and 13.2% in June. China’s urban unemployment rate across all age categories rose 5.3% in August, compared to a 5.2% rise in July.
“It’s increasingly hard for young people to find high paying jobs as before, because in the past three years, the high value-added city services sectors which used to absorb many fresh graduates were in sharp contraction, in particular real estate, finance and IT,” said Dan Wang, chief economist at HSBC”
I see this first-hand as a number of my graduate students come from China. 5 years ago, when I started, the students would come, get their education, and go back to China for a good job. Increasingly, more students want to stay in the US, and a big driver for that is the lack of prospects back home. This has a negative impact on their mindset, but it also has a very negative mindset on their families who have spent a considerable sum to get their children the best education they can.
With consumers and companies alike reeling and probably scared of their own shadows, it is probably not surprising that the growth in the economy collapsed. What used to be a routine double-digit grower, the Chinese economy has been low single digits since. Only now is the government trying to turn around this aircraft carrier.
China stimulus
I started to write on LinkedIn about China this week on the back of the stimulus announcements that came out before the Golden Week holidays at the end of September:
Chart of the Day - velocity problems
In my portfolio management class, as we prepare to build economic models, we discuss a number of ways one can try to think about forecasting the economy, using various models of economic growth & inflation
One of those models is the tried & true quantity theory of money which dates back centuries. It is quite simple in its construct that money supply * velocity = output * prices
For the longest time, people assume velocity is roughly constant & therefore if you can observe changes in money supply growth, you can have a sense for the nominal growth in the economy, & therefore in stocks
However, velocity is not always constant. We saw this in the US post the financial crisis as many people worried the large money growth might lead to very high inflation. But velocity collapsed since there was no propensity to spend money by consumers or corporates. Thus, no inflation
Velocity can be observed but usually only with a long lag. For forecasting purposes, we can look at proxy measures of velocity such as mortgage applications, capex intentions & Senior Loan Officer surveys
I used to look at the differential between two countries money supply growth as a way to discern if one country would outperform another. For instance, I would look at Chinese vs. US M2 growth to see if FXI might o/p SPY. That is in the chart today
You can see it worked very well from 2004-2019, but then had its struggles around Covid as many data sets do. I think most importantly, in the last 2 yrs, it has completely stopped working
Chinese M2 growth has been much higher than the US, yet the Chinese stock market has continued to lag. I think this might have to do with a collapsing velocity in China. I fear that consumers & companies might not be willing to spend or to invest for the future given the uncertainty
What might be driving this? We see the unemployment rate for people aged 16-24 is 20%. I sense this among the students I have from China as their job prospects have them very worried even though they are all very talented people. One can imagine their families feel the same
You can imagine companies feel the same way. China is export-led after all, and exports continue to fall. Data came out last night showing exports grew at 2.4% yoy vs. 6% expected. Even the 6% is down sharply over the last few years
The govt is trying to step in & ignite the economy, but as we saw post the GFC in the US, this could lead to pushing on a string. Stimulus measures work only to the extent people see those & take action. When velocity is near 0 there is no propensity to use this stimulus
The 2 ways one can see to break this cycle is either: 1. ratchet up the stimulus to levels that far overwhelm any concern - the US Covid response 2. Time heals all wounds - persistent stimulus finally changes behavior - the US GFC response
Right now, in China it is both too early & not big enough
Podcasts
I broached the subject at the start of my Macro Matters podcast this past week:https://cfasocietychicago.libsyn.com/macro-matters-china
My co-host Tony Zhang is an expert on Chinese policy as he has written several papers on the topic. I am always curious to see his perspective because I think it is both balanced geographically, he grew up in China but has naturalized into the US, and also intellectually, as both an academic and market practitioner. Have a listen to Tony’s thoughts. I would suggest they lean a little more on the bullish side.
I also listened to the Bloomberg Odd Lots podcast on my drive to Champaign this week. It featured a bull and a bear on the recent Chinese news. You can find it here: https://www.bloomberg.com/news/articles/2024-10-17/richard-koo-and-zichen-wang-on-what-really-happened-with-the-chinese-stimulus?srnd=oddlots
I thought I would explore the idea of a balance sheet recession in my LinkedIn post on Friday:
Chart of the Day - balance sheet recession
I listened to a good Odd Lots podcast yesterday that had 2 guests talking about the current Chinese economic situation. It had on Richard Koo who was more bearish & Zichen Wang who was more bullish. It is worth a listen
I do think China will be the story of 2025. How it plays out is going to impact many markets around the world, so I was keen to hear both sides of the debate. I came away thinking Koo's story was more compelling, though I think both had good points
Koo is famous for his idea of a balance sheet recession. As an economist at the Nomura Research Institute, he coined this phrase to describe what Japan went thru in the 90s after once being the largest market in the world
His ideas again took prominence around the Great Financial Crisis as we tried to sort thru how central banks & govts should respond & help recover. You see, if a country is going thru a balance sheet recession, monetary stimulus will not be enough to help
I touched on this idea in my post on velocity on Monday of this week. If people aren't willing to spend or invest the money, it has no impact on the economy
We saw this in US in 2009. The Fed added a lot of reserves to banks (QE) but the banks took the money to repair the hole in their balance sheets. The money never made it to the economy. No credit was created. Obama chided the banks & we had a 'jobless recovery'
It wasn't until we had more fiscal stimulus that finally the economy recovered. When consumers & companies are repairing their own balance sheets, the govt needs to step in as buyer of last resort otherwise the central bank efforts fall flat
In Japan, it took decades to figure this out. This is why you see the peak in Nikkei in 90 & then it crashes & flat lines. The US also peaked but as it figured this out, the market was able to recover
In China, the steps we have seen are all monetary; however, consumers & companies will just use that to repair their balance sheet. We need to see fiscal response too. If we do, & if it is large enough, China may follow the US GFC example. Otherwise, China may follow the Japan example
Right now, I haven't seen enough of the right stuff to want to buy into the China recovery. I see all of the signs of a balance sheet recession. I see the falling demographics (ala Japan) as well. I think there are more risks to the Japan narrative taking over
Spoiler alert: Koo did say that Chinese policy makers have reached out to him to discuss. Perhaps they do realize what is happening & will take the necessary steps
By the way, that fiscal step is NOT to export your way out of this. Japan wanted to do that in 1990. This is why Reagan put tariffs on Japanese products
China has shown it wants to export out of it. This is why both parties in the US want to put tariffs on China & have. It needs a policy that will stoke domestic consumption. Then it’s time to get interested
Tariffs
Since the podcast brought up the tariffs, and I mentioned it in my Linked In, I thought I would dig in a little further on what that has actually looked like the last 5 years.
I asked ChatGPT to summarize how the tariffs used by Trump and Biden on China are the same and how they are different. The reality is Trump imposed tariffs back in 2018 and Biden has not only kept them but expanded them. However, the perception is that Trump is much harsher on both tariffs & China. Even Zichen Wang suggests this on the Odd Lots. I don’t know if ChatGPT is objective (I doubt it can be when pulling from all biased sources likely) but I thought this might be one way to try to analyze the topic:
The tariffs imposed by both the Trump and Biden administrations on China have similarities in their strategic goals but differ in their implementation, rationale, and broader economic approach. Here's a breakdown of how they are the same and how they differ:
Similarities:
Strategic Goals: Both administrations aim to address what they perceive as unfair trade practices by China, particularly:
Intellectual property theft: Both Trump and Biden have cited concerns over Chinese practices related to intellectual property, forced technology transfer, and unfair subsidies.
Trade Deficit: Trump and Biden both wanted to reduce the U.S. trade deficit with China by encouraging more domestic manufacturing and reducing reliance on Chinese imports.
Use of Tariffs:
Both administrations have used tariffs as a central tool in their economic policies to push China to the negotiating table. These tariffs cover a broad range of Chinese goods, including industrial machinery, electronics, and consumer goods.
Pressure on China:
Both have maintained pressure on China to address structural issues in the economy, such as state-owned enterprises and market access for U.S. firms, often using tariffs as leverage.
Differences:
Scope and Justification:
Trump Administration: The tariffs imposed by Trump (starting in 2018) were part of a broader trade war aimed at reducing the U.S. trade deficit with China. Trump often justified tariffs based on national security concerns and economic imbalances. The tariffs were aggressive and applied to hundreds of billions of dollars' worth of Chinese goods.
Biden Administration: While Biden has kept many of the Trump-era tariffs, his administration has been more focused on targeting specific issues like supply chain security, technology competition, and human rights abuses (e.g., forced labor in Xinjiang). Biden’s tariffs have often been linked to strategic concerns about competing with China in industries like semiconductors and green technology, rather than focusing purely on the trade deficit.
Tariff Adjustments and Strategy:
Trump: Trump's tariffs were broader and more confrontational, with less emphasis on negotiation or international cooperation. He used unilateral tariffs as a bargaining chip in trade negotiations, and his administration was willing to escalate the trade war if China didn’t meet U.S. demands.
Biden: While keeping most of Trump’s tariffs, Biden has shown a more multilateral approach by working with allies (like the EU and Japan) to confront China. He has also been open to targeted reductions or adjustments to tariffs in certain areas, especially to reduce inflationary pressures on American consumers and supply chains.
Economic and Diplomatic Approach:
Trump: His approach to tariffs was part of his broader "America First" policy. Trump used tariffs as a key economic and diplomatic weapon, applying them not just to China but also to allies (like the EU and Canada), with a focus on bilateral deals.
Biden: Biden's tariffs on China have been framed within a larger policy of strategic competition rather than outright confrontation. He has sought to rebuild international alliances and push for a coordinated response to Chinese trade practices. Biden has also introduced initiatives like the CHIPS and Science Act to strengthen U.S. manufacturing in critical sectors like semiconductors, thereby reducing reliance on Chinese technology.
Human Rights Considerations:
Biden: The Biden administration has placed more emphasis on human rights in its justification for tariffs, particularly regarding forced labor in Xinjiang. This has led to specific sanctions and tariffs on goods produced with forced labor, adding a new dimension to the trade policy that was less emphasized under Trump.
My read: both parties are going to use tariffs on China in some regard. China runs too big of a trade surplus with the US right now to hope to be able to export their way out of trouble. Perhaps the Democrats are more tactful and demurer in their approach to targeting China, while the Republicans are blusterier and forward. Either way, when your largest potential customer is not looking to buy more of your goods, it presents a difficult situation and one where you really need to consider a plan b.
Technically speaking
Ultimately, we can’t ignore the 40%+ spike over a week in the major index of the 2nd largest economy in the world. I personally can’t recall such a move in a major index. You can see from the daily chart below, this put the relative strength index (RSI) above a 90. I don’t know if I have seen that either. Whether I think China is a buy or not, one thing is clear: it isn’t a buy right now. The index is working off the overbought level, but the MACD is turning lower, and I would guess there is more of a correction that will still come in the days ahead, perhaps as the market is disappointed by the lack of news flow.
Stepping back and looking at the weekly chart, however, it starts to look more like a bullish picture. The index has started to breakout from a long-term bearish market. With the right news in the coming months, this becomes a more interesting long purely from a technical standpoint.
Stakeholder vs. Shareholder
As an investor, I constantly struggle with how shareholders are perceived by Chinese companies. Do you think Chinese companies are being run to maximize shareholder value? Or do you think Chinese companies, particularly after the government crackdown that went industry by industry and retained billionaires for months on end, perhaps focus on other ‘stakeholders’? Do you think the companies do what the government wants, focusing on maximizing employment and making prices as low as possible even at the expense of margins to benefit consumption? How does this help the shareholder? In many ways, I think investing in Chinese stocks may be the least efficient way to gain access to the Chinese recovery because of this.
I know many US companies have moved toward a more stakeholder friendly model. That is not what is happening in China though. In China, as Jack Ma found out, a company needs to run itself for the betterment of society and for the furthering of government goals. Profitability is an accident if it does happen. This always makes me think that China is more of a trade than an investment. I am happy to be proven wrong on this if others have a different idea.
Other markets
As I said before, the best way to play the China story may be in other markets. In the graph below, you can see that the underperformance of China vs. the US stock market has also coincided with the lagging of the industrial metals (like copper and aluminum) vs. gold. If we do start to see the Chinese economy pick up, will these industrial metals come to life?
One argument given is that the next iteration of a China bull market will not look like the last. It won’t be as intensely focused on property, infrastructure and the like. While I appreciate this view, I also would point to a couple of things said earlier. First, as Richard Koo said on that podcast, the easiest and perhaps highest social return the government could do fiscally is to finish the ‘shovel ready’ projects in the property sector. This is a high multiplier sector so it would employee plenty of people. The projects are drawn and maybe even much of the material sourced. It could be an efficient way to put stimulus to work. Second, Chinese consumers have a large amount of their life’s savings tied up in property. Thus, it would go a long way toward improving consumer sentiment.
As a result, I still lean toward finding ideas that are potentially tied to this sector of the economy as the way to play any China story. That is, if the government finally figures out it is in a balance sheet recession.
Stay Vigilant
