VITALIY KATSENELSON, CEO and CIO of Investment Management Associates, on why what happens in China, may not stay in China.
To understand what will happen in China and its impact on the global economy, we simply need to invert what happened over the last two decades.
Housing Bubble
China has had the largest housing bubble in human (and possibly galactic) history, for a decade and a half. It has lasted much longer than any reasonable analyst, including yours truly, expected it could last. One thing about bubbles is that the longer you sustain them the bigger they get and the harder they implode.
The China housing bubble is now bursting, putting immense strain on internal demand from consumers and its economy. The banking system and Chinese consumers will bear the brunt of this situation, but we’ll probably feel it across the world.
It would obviously be wrong to say that all economic growth in China came from the building of ghost towns; China has tremendously improved its infrastructure and a large chunk of global manufacturing has moved there. However, capital investment as a percentage of GDP was above 40% for decades, double the level of the US. It is likely that capital investment will revert towards the US level, which in turn will reduce demand for industrial commodities (think iron and copper).
Commodities are priced on incremental (marginal) demand; the last few percentage points of demand above the inelastic (short-term) supply are the ones that set prices. Secondary effects of a decline in the demand and prices of industrial commodities will be felt in countries like Australia and Brazil that benefited from China’s ascent.
There are some factors that may offset the decline in Chinese appetite for industrial commodities. Selective deglobalization is forcing companies to bring factories out of China to more friendly countries, resulting in more construction and thus more demand for industrial commodities in those regions.
The US has passed the Inflation Reduction Act, which should result in more spending on industrial goods.
Lastly, India, the most populous country in the world, has one of the world's worst infrastructures, and it will be receiving upgrades.
Social Instability
One bright spot in the Chinese economy was its tech sector (Alibaba, Tencent, and others), but Xi viewed it as a threat to the power of the Communist Party. Xi cracked down on these companies, reducing their competitiveness. Also, sanctions from the US have further damaged these businesses.
The slowing (possibly shrinking) economy, an ocean of bad debt, enormous losses of life savings on investments in ghost towns, and a broken banking system all substantially increase the risk of social instability in China.
China is becoming a more dangerous place to conduct business, as we are starting to see headlines about China not allowing capital and foreign employees to leave the country. Foreign investment into China likely peaked before the pandemic. In the past, companies emphasized their investments in China (think Starbucks, car companies); these investments will start looking like liabilities.
China, not the overheating of its iPhone 15, is the biggest risk to Apple, not just from consumption but also from the production perspective. Tim Cook has to move production out of China without China noticing it – the most difficult magic trick ever performed.
Demographics
China has troubling demographics. The one-child policy, which was revoked in 2015, created a drastic imbalance between males and females and caused the rapid aging of China’s workforce, thus limiting its economic growth.
Geopolitics
We are no longer in the foothills of a Cold War with China; we are in that war.
The Chinese navy may not have the same quality as the US’s, but it has definitely begun to dominate the US Navy in terms of quantity. The US has little commercial shipbuilding capacity, and we will likely need a bigger navy to counter the threat from China.
Compared to the Soviet Union during the Cold War, China has a much bigger economy that is very good at building things. This is why we are doubling down on our defense stocks, especially the shipbuilders.
A Chinese invasion of Taiwan is probably one of the most important geopolitical risks. There are two lines of thinking here: A weaker Chinese economy may diminish China's ability and willingness to start a war that would further isolate it from the West. However, it is the wounded animal that is dangerous, not the fat and happy one.
