Global Considerations: Is China Investable?
Recently Jason Trennert, the leader of the investment firm Strategas, asked the question, “Is China really investable?” The answer to this question is meaningful with serious tail-risks and rewards. The political and economic changes in China have driven global economic growth. But the internal communist party (read: President Xi) mandates are becoming more “Maoist” in nature, as the country moves further away from market-friendly policies and toward communist rule. This shift in the world’s second largest economy is meaningful globally and to U.S. economic growth.
With that in mind, it makes sense to ask the question, “Is China investable”? I’m not speaking about trading activities here. I am speaking specifically about the long-term validity of placing serious investment capital directly in Chinese markets. The purpose of my piece today is to help you think of this question in light of its importance to global economic activity, and ultimately to your own activity and capital allocation.
First as background, we need to understand how important the emergence of China’s domestic economy has been on global economic activity.
The chart above from the International Monetary Fund vividly shows historical Gross Domestic Product growth rates of China as compared to the rest of the world. The chart conveniently starts in 1980, a couple of years following the implementation of then-President Deng Xiaoping’s economic reform, which opened China to allowing more market- based economic systems to exist within their country, and away from strict “Maoist” communist party mandates. Prior to Deng’s policy changes, China, like so many emerging economies, was so poor they couldn’t afford to feed their own population.
We know the rest of the story – that due to these changes (and others), China, along with the world’s emerging economies, has been arguably the main beneficiaries of the massive trend of globalization, where trade barriers were removed. China prospered and became the world’s second largest economy. They did so through domestic investment in their productive capacity, financed by a very strong positive trade balance and currency manipulation. As global trade activity blossomed during the 1990s and 2000s, global, deep poverty, as measured by the World Bank, declined from 35% to less than 10% from 1990 until 2017. Global prosperity blossomed, and the extreme poor of the world benefited. I fear growing nationalization will negatively alter these positive global trends.
China’s enhanced role in the global economy benefited not just themselves, but much of the rest of the world. Taking a page out of David Ricardo’s notebook, China’s enhanced role as the world’s factory floor showed the benefit of comparative advantage. In the chart below, note the relationship displayed between the U.S. trade balance and the smoothed, multiyear trend of U.S. consumer price inflation. There is no mystery as to one main cause of global disinflation over the last 20+ years – that being the efficiency of the Chinese industrial engine and their capability of manufacturing goods cheaply and efficiently.
But much of this is changing. China’s policies, through the leadership of President Xi, has become much more internally focused and nationalistic. The Chinese communist leadership has become less tolerant of threats to social cohesion (read; command and control) than had been the case in the past. Xi and the communist party have become increasingly aggressive in threatening the workings of their country’s market-driven/communist state. The latest example is China’s government mandate to control behavior. For example, minors may only play video games a certain number of hours per week. Video-game usage will be centrally monitored by the government.
Policies, of course, are much deeper than video game viewing. In a quest of dictatorial control, President Xi is now in power for life. The last time that happened in China was when Mao was President/Chairman. Communist party leaders are now required to take a loyalty oath to Xi personally. History shows us this type of personal loyalty oath also occurred in Nazi Germany during World War II.
Xi’s aggression extends beyond the internal workings of the communist party. He has openly stated his intentions to directly challenge the independence of Taiwan. He has also tightened his grip on freedoms enjoyed by Hong Kong, Tibet and the people of the Xinjiang Province.
China’s leaders, through Xi’s dictate, are exercising a political crackdown on their own publicly traded, technology-leading companies. A price decline of about 20% has recently occurred in China’s stock market (as measured by the Shanghai Shenzhen Index). The deterioration in China’s technology leaders’ stock prices isn’t anything new, as the valuations of Chinese tech companies have been deteriorating since 2015 compared to those in the U.S., according to Jason Trennert.
Global investors have been expressing concerns in China’s investment environment for more than five years, particularly in relation to the U.S. stock market as the Shanghi index has traded sideways since 2015 while the S&P 500 index has doubled.
Back on the Homefront
Many have turned a blind eye toward the significant changes that have taken place in China. But some in the U.S. and certain areas of Europe have not done so. Nationalistic trends mentioned above are also present in areas outside of China.
Others are starting to conclude that the leadership in China is changing the rules of the trade and economic game. According to Larry Summers, the former President of Harvard University and Secretary of the Treasury under Barack Obama:
“To the extent to which China has lied at the heart of globalization and outsourcing for the last two decades, the pandemic, it would appear, has irreparably damaged China’s brand and the ability of developed economies to import disinflation.”
Many people have concluded that yes, indeed, the pandemic, which negatively affected the entire world, was wrought on the world by communist-led China. Investors are starting to wake up to the fact that President Xi is determined to achieve dictatorial power of the world’s second largest economy. What does this mean?
During the pandemic’s ravages in 2020, I wrote that experiences like 9/11, the Great Recession and COVID-19 normally bring deep changes in economic order. I noted potential changes that may take place in the future wrought by the pandemic experience, with the world’s trust in China being one possible change. That change is occurring to the negative. This all leads me to conclude that the world’s trust in China’s leadership to do what is “right” for those outside the communist (read – Xi’s) command is waning.
With a lack of trust of China’s leadership, investors need to consider the sanctity of ownership rights. The concept that ownership rights in China only mean what the communist leadership want them to mean. If this is the case, thoughtful investors need to consider whether China is truly “investable.”
George Soros wrote an editorial in The Wall Street Journal recently in which he states:
“I consider Mr. Xi the most dangerous enemy of open societies in the world. The Chinese people as a whole are among his victims, but domestic political opponents and religious and ethnic minorities suffer from his persecution much more. I find it particularly disturbing that so many Chinese people seem to find his social-credit surveillance system not only tolerable but attractive.”
In my 40+ years’ experience in the investment management business, I have managed global stock portfolios, and mutual funds. I developed several standards when placing capital in one market or another. One such standard was the country in question needed to be governed by laws, and not by men. Property rights needed to be guarded by the courts, preferably by standards grounded in British Common Law. Another standard was the ability to move capital from a country easily and not just into a market. It is usually easy to buy an asset in today’s world, but may not be as easy to sell. This is a problem. Today, China certainly fails on the governed standard. Is it a matter of time before they fail on both?
This is leads me to the conclusion that China, while a big growth story, may be becoming uninvestable for serious, long-term capital allocation. Following is a quote from Jason Trennert’s recent work.
“China appears to have eschewed any pretensions of continuing to suffer through its “century of humiliation,” COVID or no COVID. Instead, its rhetoric has become increasingly more nationalistic and bellicose and its actions decidedly more Maoist, rewriting inconvenient truths about its history. Marking the centenary of the Chinese Communist party in July, President Xi appeared to declare victory on creating a “moderately prosperous society” that was now ready to embark on the second centenary goal of ‘building China into a great modern socialist country in all respects.’ Xi has removed presidential term limits and created a vast surveillance state Amnesty International calls a “dystopian hellscape of extrajudicial incarceration.”
So, what may all this mean? It is unmistakable that the world’s economic order is changing. China, being a driver of disinflationary pressures, is driving this change. The people of the world’s emerging economies have been direct beneficiaries of the opening of global markets as the global “deep poverty” rate has collapsed. I fear that benefit is changing.
Over the next number of years, the changes occurring in China may lead to the following global economic and capital market shifts:
- Global deflationary trends may change over time, as the seemingly unstoppable downward pressure on global inflation may be ending. There doesn’t appear to be any country that can pick up the deflationary baton from China and lead the world to another round of deflation.
- Supply based bottlenecks will probably continue, leading to many companies altering their “just-in-time” inventory practices, which may lead to shorter, more volatile business cycles.
- The benefits of Ricardo’s comparative advantage1 will be challenged, as many companies will need to diversify their supply bases. This is currently occurring in the semiconductor manufacturing industry, which could further weaken the decades-long disinflation story.
- Military stresses may occur as China continues to flex their nationalistic muscles. What would the world’s response be to an outright Chinese invasion of Taiwan?
- Western dominance (democracy) may be challenged as Xi continues to strengthen his hold on his people, in a way that hasn’t occurred since the power-struggle days of the U.S. and the USSR.
- Cyber-espionage will continue to be a major issue, helping to drive many corporate decisions. The world of innovation is still dominated by private market organizations and not governments. For China to thrive, they need to “import” innovation from the western world.
- There will be ramifications as Xi’s dominance intensifies and the world sees his intent and the damage it will likely do to global market-driven societies.
1Among the notable ideas that David Ricardo introduced in Principles of Political Economy and Taxation was the theory of comparative advantage, which argued that countries can benefit from international trade by specializing in the production of goods for which they have a relatively lower opportunity cost in production even if they do not have an absolute advantage in the production of any particular good.
The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation.
The Shanghai Shenzhen CSI 300 is a capitalization-weighted stock market index designed to replicate the performance of the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange. It has two sub-indexes: the CSI 100 Index and the CSI 200 Index.
Individuals cannot invest directly in an index.
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