LEVATUS Investment | What the Heck Is Going on In China?
While experts continue to exhaustively debate and analyze the policies and actions of China, clarity at times can feel elusive. A dose of investment experience and history shed some light.
Keith Savard and Susan Dahl, LEVATUS Chief Research Officer and Chief Investment Officer, share their answers to some great client questions about China. While experts continue to exhaustively debate and analyze the policies and actions of China, clarity at times can feel elusive. We use internal and external work and our own many years of experience to offer straightforward answers that reflects our analysis and interpretation of events.
What do you make of the potential default of Evergrande?
The Chinese government has the financial ability, and seems to have the willingness, to support stabilization measures in order to avoid a messy default. An orderly restructuring would be sufficient to stabilize markets.
Evergrande is not intertwined enough within the global economy to create the global systemic risks that other large defaults have created in the past.
Evergrande is an example of the problems created by excessive debt. There is excessive debt many places in the world today and this is the more significant long term risk.
Direct U.S. exposure to Evergrande is de minimis.
The market is particularly spooked by this event at least in part because is it caused by excess debt. Excess debt is a function of the historically unprecedented levels of central bank liquidity injected into the global economy over the past decade. It is present in many, many pockets of the world. As central banks begin to go down the path of withdrawing this liquidity, situations like Evergrande remind markets of the pain the deleveraging process will inflict.
What is the condition of the Chinese economy?
Like nearly all the world’s major economies, China’s economy has suffered at the hands of the pandemic although its growth rate continues to exceed most industrial countries.
China’s business community has complained that liquidity conditions are too tight, but the monetary authorities are trying hard to balance the need to maintain economic growth with efforts to slow debt accumulation that has reached worrisome levels. The WSJ highlights how tricky this transition will be.
The potential for debt instability as a result of this intentional tightening of liquidity is exemplified by the real estate firm Evergrande, which is one of the largest in China with outstanding debt of more than $300 billion.
The Chinese technology sector continues to be a formidable global powerhouse, with both innovation and leading-edge applications. While the recent regulatory crackdown has sent chills through the market, it is clear the Chinese government values the potential of its technology sector as both a global competitor and domestic engine of growth.
The Chinese authorities seem prepared to help Evergrande work toward a debt restructuring, including working to assist retail clients to complete purchases of new homes. Should the situation unravel, disruption of the broader economy seems likely as liquidity and access to capital will tighten substantially and access to credit will become very difficult. The property market is a significant part of the Chinese economy and working through the deleveraging process will not be quick.
Are China and the US heading toward a ‘war’?
War of words, yes.
Economic competition, yes.
Bid for technological supremacy, yes.
Battlefield, no.
The first three areas are interrelated and constitute the main playing field for super-power relations at the moment. The military aspect is part of statecraft posturing and is often seen as a barometer for the level of tensions in relations. While war is seen as the final tool of diplomacy, its exercise has shown throughout history to be extremely costly and increasingly with few clear winners.
Why is the Chinese government and communist party trying to exercise more control over private companies?
To address legitimate anti-competitive practices.
To rein in individuals the communist party leadership views as potential alternative power centers stemming from their corporate platforms.
To curb activities believed to be detrimental to society.
To control data and how it is used, particularly potential access points available to foreign entities which could compromise national security.
To reaffirm the communist ideology.
The actions of Chinese authorities are portrayed domestically not so much as an exercise of control over private companies, but as a demonstration and reminder that the communist party is the preeminent authority in assuring the welfare of the people. However, the ultimate aim of preserving the unquestioned authority of the communist party is seen in its increasing supervision of private companies through the party’s participation in firms’ senior management decision making.
Is China likely to try to exert direct control over Taiwan?
From a domestic perspective, the Chinese leadership is satisfied that it has de facto sovereignty over Taiwan as the United Nations has recognized Taiwan as part of China since 1971.
The issue of direct control has become a hot button issue since the escalation of tensions between China and the United States.
Continued escalation of global tensions increases the likelihood of a Chinese move toward direct control.
Based on pure economic interests, China is unlikely to try and exert direct control over Taiwan for the next few years. China is heavily dependent on Taiwan for important strategic goods, like semi-conductors, and is not likely to jeopardize access to these goods in the near term. However, possible aggressive action by the United States and its allies in terms of providing military equipment that could be perceived as a threat to China’s mainland, might trigger a kinetic response from the People’s Liberation Army.
What are the biggest risks from possible prolonged tensions between China and the United States?
The possibility for serious mistakes, misjudgments and misinterpretation almost inextricably rises in the face of prolonged tensions between countries with immense power, particularly military power.
A less efficient and bifurcated trade system, technical standards system and financial system could be born, spurred on by existing efforts toward de-globalization.
Ongoing supply chain problems and commensurate inflationary pressures as facilities are moved closer to home.
In a front-line military situation training often dictates a quick response, making the repercussion of a misstep severe. Buildup of forces and rising tensions create more opportunities for mistakes. As the United States and China both have formidable military forces, escalation triggered by an accident has the potential for far reaching consequences.
Is the relationship between China and the United States likely to be repaired in the near term?
From the U.S. side the answer is no - China bashing is one of the few issues that Democrats and Republicans can agree on with an element of one upmanship in play.
After the unceremonious withdrawal from Afghanistan, the United States is looking to sure up its image of strength and China can serve that purpose as America seeks cooperation with Asian allies who are troubled by China’s aggressive behavior.
From the Chinese side the answer is no - The country’s leadership feels that it is the proper time for China to take its rightful place front and center in world affairs and offer its vision for global progress.
President Xi sees confrontation with the United States as a way to stoke nationalism and support for the communist party as it guides the population to a quasi-form of equalitarian socialism.
In the longer term, a rapprochement between the United States and China is likely to require two key ingredients in the form of enlightened practical leadership and a sufficient catalyst to trigger a dialogue. Enlightened practical leadership seems to be in short supply these days, but a new generation is emerging who might feel less encumbered by actions of past leaders. The catalyst for dialogue could come from issues already present like climate change or healthcare. The key will be to be demonstrate that self-interests are aligned.
Do you think President Xi is more interested in spreading Marxism, Leninism and Maoism or being the leader of a global economic superpower?
China is an economic superpower by most measures. However, President Xi has complained publicly for many years that China does not receive the global respect it deserves. A recent CNBC Op-ed highlights some of his ambitions.
The trend toward de-globalization have put significant strains on China’s international ambitions.
With increasing signs of economic stress, related in part to the pandemic and high levels of domestic debt, President Xi is increasingly relying on ideological euphemisms like common prosperity to stir nationalism and support for his recent policy actions.
President Xi must be careful in his attempt to neutralize growing tech titan power centers in China through the guise of more social equality that relies in part on seismic regulatory change as this creates disruption in important sectors of the economy. While the general population currently supports President Xi’s efforts to improve living conditions for the poor and middle class, this could abruptly change if the economy were to stagnate and put pressure on the standard of living.
What could all this mean for global financial markets?
Financial markets have always been spooked by uncertainty and the ongoing ratcheting up of tensions between China and the United States is certainly contributing to investor nervousness.
The increased risk premium on Chinese assets is unlikely to narrow before market participants are offered a clearer understanding of when the Chinese authorities plan to throttle back their regulatory campaign. That said, existing discounts on Chinese assets are extreme, with significant risk already priced in.
If the Chinese economy does slow as a result of tightening liquidity, whether due to Evergrande or policy measures, commodity prices are likely to experience significant pressure.
Supply chain pressures could create margin pressures that impact earnings. Given current valuations this would be a headwind, especially for companies with high input volume.
Global liquidity is the main support for markets at the moment and that remain intact for now, despite early discussions of ‘tapering’. Uncertainty in China may prolong this.
The combination of domestic business tensions in China and geopolitical tensions with the United States could certainly spill over to U.S. equity markets. So too could the rising cost of supply chain disruption spill over into margin pressure and earnings slowdown.
With that said, the continued liquidity being provided by central banks and corporate buy backs provide a backstop to financial markets. Business investment is seen as critical to further expansion in economic activity beyond the post COVID bounce. Confidence that continues to support this investment is essential.
Bottom Line
China is intentionally enacting policy aimed at deleveraging its economy and deflating asset bubbles. Evergrande is a casualty of this policy.
In the near term the Chinese economy is likely to slow because of these policies. Companies that depend on China for growth, especially commodity exporters, will suffer. Companies with high commodity input costs are likely to benefit. Highly leveraged Chinese companies will continue to be at risk.
In the long term a more stable Chinese economy is a positive. We believe China wants to continue to be a part of the global economic community and will not move so far as to jeopardize that unless pushed into a corner.
Rising geopolitical risks are unlikely to abate and we expect equity multiples to increasingly reflect the associated uncertainty. Multiples in China have begun to reflect this, other markets have not. The risk of military ‘mistakes’ that turn into something more is not insignificant.