In this post, I want to discuss a particular dynamic that repeats over every ~40 years since WWI. In my belief, China is the best example of this forthcoming shift. Russell Clark has been talking about this dynamic, and I evaluated the historical data to have a better understanding. Geopolitics is not my prime interest, but I have come to a realization that it’s quite useful in today’s world when creating investment frameworks. As the famous quote of Mark Twain says, “History Doesn’t Repeat Itself, but It Often Rhymes”, I believe having some understanding about history and geopolitics can provide a significant edge when allocating money into capital markets. In addition, I would discuss my personal views on the next phase of the Chinese market and my perspective on investing in China which I will discuss towards the end of this post.
Capital Over Labour vs Labour Over Capital
Before diving into the boring history part, I want to explain Russell’s view first. Russell argues that; every ~40 years markets shift from inflation to deflation and vice-versa. However, this shift is driven by policy changes that are established to overcome issues in the existing regime (Inflation/deflation or disinflation). For example, today’s deflation regime is a consequence of the deflationary framework set up by policymakers during the 1980s to fight inflation which was created after WWII through the 1970s. Post-WWII inflation was a consequence of the inflationary framework formulated during the late 1940s and 1950s to combat deflation caused by the two World wars and the Great Depression. During deflationary periods, the focus is more on capital than on the Labour market. However, the focus shifts to labour during the inflationary periods. He then shows that identifying these policy shifts is the key to understand whether we are in a regime shift from capital to labour or labour to capital. He believes current Chinese policymakers are leading the way by shifting from Capital to pro-labour.
A little bit from the History
During WWI (1914-1918), the US industrial system played a huge role in providing goods and services to the rest of the world. Basically, they became the manufacturer of the world. This was a good time for US GDP as they were neutral during the first world war. Nevertheless, at the end of WWI demand for American goods & services disappeared as the rest of the world entered a post-war recovery era by cutting down their expenses. In order to sustain its growth, US monetary conditions eased off by cutting down interest rates and reducing taxes, and their focus shifted towards domestic consumption. In addition, the 1920s was one of the best decades for technological innovation. This period–the Roaring Twenties– were characterized by cheaper credit for consumers, more goods and services for US citizens, rapid technological innovation, and financial asset purchases. Bringing up the fact that good times will not last forever; massive consumer debts eventually started to default and triggered a series of cascading events in the financial markets which made the stock market crash. Consequently, the US entered a depression era.
Depression eventually ended as the US entered WWII with massive fiscal spending which again helped to increase industrial production. WWII came to an end in 1945. From the 1945-1955 period, GDP growth was not consistent due to the lack of organic growth in the economy. This was mainly due to the insufficient Labour force participation in the economy. Men who came from war did not have enough jobs. Moreover, the government was trying to cut down the spending which caused the economy to contract. This resulted in regular periods of mini-depression which occurred almost twice during the period from 1945 to 1955. However, there was a small period of inflation after WWII. Basically, at the onset of WWII, CPI increased as deficit spending increased; then during the war price controls came to stabilize inflation. After the war, as price controls lifted off, pent-up demand caused inflation to spike up temporarily. This dynamic played throughout history up until 1950. After the 1950 CPI basket started to dominate with durable goods than food which was dominant during WWI & WWII era. There is a wonderful article –One hundred years of price change: the Consumer Price Index and the American inflation experience– that explains CPI inflation throughout history, which I think is worth reading.
In summary, the period from 1915 to 1955 was an era of capital over labour. Continous monetary intervention by reducing interest rates and loose fiscal policy was helpful in managing deflationary forces temporarily, but it was a hard era for policymakers to achieve sticky meaningful inflation. Furthermore, the growth mainly came from industrial production during WWI and WWII rather than consumer wage increase and labour force participation.
This was the post-BrettonWoods era where global growth began to revolve around the US, and the rest of the world started to use the USD and US machinery to develop their economies which resulted in constant growth of GDP in the US from 1955 all the way to 1970. This coincides with the Vietnam war and Appolo program which allowed fiscal authorities to increase spending. In addition, favoring demographics where baby boomers entered into the workforce and started their careers and family was instrumental in creating sticky growth throughout decades from 1955. This was the period of Labour over capital. Synchronized growth in the US economy reduced the wealth gap across the society, which was characterized by the rising middle class. Moreover, oil was the key driver of the economy and industrial production. Nevertheless, as the US entered the second half of the 1960s, the GDP growth was not sustainable with respect to inflation, and demand for commodities was high to support the Vietnam War and consumer needs hence the US unemployment rate was low as ~3.5%. As stagflation fear started to grow in the late 1960s, corporations started to cut down the workforce and the US entered into a recession in 1970. Inflation was high during the recession and the government reacted to the situation with wage-price control from 1971-1973, which was one of the important periods in history to counter the inflation. To make things worst, the 1973 embargo oil crisis caused more inflationary damages to the US economy. As a response to the rapid inflation, President Nixon abandoned the gold standard to fight inflation as many foreign entities wanted to redeem gold for dollars. By 1978, Inflation hit 9% and unemployment was 6%. Next, even in the middle of a recession, Paul Volker came and raised interest rates to 20%. One might think, this is crazy, but this is what inflation does to the economy. The policy maker’s biggest worry during that era was inflation and they did whatever they could do to battle the existing problem −inflation−at the time.
From 1980 to 1990 was the period of rising Fed fund rates. The minimum Fed fund rate recorded in the decade was 6% and these were efforts to fight sticky inflation in an environment of low GDP growth. In 1990, Fed’s prolonged restrictions and collapse in the oil prices due to the Iraq invasion triggered another recession. Fed had to cut down interest rates from 7% in 1990 to 4% by 1991. Since then, the US inflation has gradually reduced over 3 decades. So the question is, what caused inflation to go down after the 1990s. This is when things get a bit interesting. Throughout history from 1960 to 1990, inflation was able to explain by the Philips curve (there are other factors as well)— The unemployment rate is inversely correlated to inflation. However, it started to break after the 1990s as the inflation started to positively correlate to the unemployment rate during the 1990s to 2000 and there was no correlation after 2000. Following are some of the key reasons that caused the Phillips curve relationship to break:
1) Immigration⇒ rapid immigration into the US caused an oversupply of labour force making wages to go down
2) Aging population⇒ less labour force participation as baby boomers approach retirement
3) Technological development ⇒ increased the pool of available labour force beyond the conventional measures which increased the productivity
4) Trade and globalization ⇒ moving manufacturing out of the US made, the output of the goods and services increase, prices drop-down, and increase the trade deficit.
5) Privatization of the economy ⇒ more human resources were allocated to private enterprise than government jobs (e.g. military)
From 2000 to 2010 was the lost decade of the US. During this period, the US had to go through two of the biggest financial crisis, and federal debt started to outpace its revenue after 2001 primarily due to the fiscal expansion to support the war against terror. A weaker dollar and Chinese demand-led commodity cycle caused a capital flight from the US to the emerging markets. However, in 2008 global financial crisis changed the entire course of the world’s economy. By end of 2010, every major economy in the world started to experience the pain of disinflation severely. Rates went to zero in the US and negative in Japan and Europe. There onwards began the never-ending MMT policies- QE (overcapacity of capital), low-interest rates, bifurcation of corporate profits (growth over value), ever-increasing wealth gap, corporate & federal debt, and rest is history. Today lack of organic growth and capital overcapacity is not only an US issue, but the entire world is going through this prolonged disinflation. Every attempt for monetary expansion during this period promoted capital over labor, which does not stimulate organic growth, but leads to constant misallocation of capital into financial markets.
Passing the baton from monetary to fiscal seems like an early indication of attempting to use a different technique to address the same issue, but its effectiveness is still a big question. In addition, the trade dispute between the US & China, de-globalization, Biden’s tax plans, and ESG mandates are other signals of an effort to move away from pro-capital to pro-labour regime. My perspective is that China is leading the way by taking drastic measures to get rid of this capital over labour cycle.
Rise of Tech in China
China has onshore and offshore funding markets. Onshore securities are traded in Mainland China on SSE and SZSE which is a much bigger market than the offshore market. These securities are available only for locals and qualified institutional investors, whereas offshore markets are available for foreign investors which are traded on Hong Kong exchange and the US exchanges. Macro factors that drive these markets are vastly different. The on-shore market is driven by the Chinese monetary policy, interest rates, currency volatility (for foreign institutional investors), credit spreads, etc., while offshore markets are more impacted by USD rates, foreign fund flows, and the global risk sentiment.
In a nutshell, If you look into the outperformance of Chinese financial markets in the past decade, the companies that mananged to access offshore funding raised a significant amount of capital in a strong USD enviroment. Those Chinese companies happened to be tech companies, and they were direct beneficiaries of a deep pool of liquidity from offshore markets which coincided with a low-growth environment. The sychronized global disinflation and easy money pouring into financial markets caused many tech companies in the world to get more USD fundings. We have seen one Chinese IPO after another in the US market seeking for funding. Companies like Alibaba and Tencent became market behemoths by 2020.
What is beyond China Crackdown
If you look closely at what China is trying to achieve, it is self-sustainability and a less USD-dependent economy. In addition, they have long term vision on how to get there, and they do whatever it takes to get there regardless of consequesnces. This was not a new mandate, but trade dispute has accelerated China’s economic proceedings. Without further details, I want to point you to a post by JPMorgan –What Are China’s Growth Drivers in 2021? This post highlights some of the key points with regards to China’s innovation ambitions, consumption upgrade policy, digital economy, and green initiative which matches with my thesis. I will add one more point to this, i.e. a less USD-dependent economy by promoting CBDC. So it’s pretty clear to me that, this crackdown is a part of the agenda to improve domestic competitiveness and reduce wealth concentration. All of these can be achieved by moving away from Capital to Labour . However, having a plan is one thing, but there are some macro headwinds that they still need to overcome.
Let us quickly look into a few macro uncertainties.
China currency issues
First, China has two currency systems; within China, they run a Yuan economy where CCP has full control over the money supply within China, and they run a dollar economy with the rest of the world. That is the reason why there are strict regulations for locals to get yuan in and out of the system because they want to control the yuan exchange rate. Yuan economy is very loose due to excessive money supply to stimulat the domestic economy. They kept the yuan cheap to make exports more attractive in the last decade. Eventhough China is the second largest economy of the world, only 1% of the cross boarder settlements are done in Yuan. Nevertheless, they are still short of resources which they have to buy using the USD. On top of that, they were increasing their dollar reserves to keep the global trade going. In order for labour market to prosper and stimulate the domestic economy, Yuan has to remain stronger. However, it has to be done by sacrificing some of the export benefits. With the current amount of debt load and resource requirement for economic growth, they still need to rely on USD. There is a currency challenge against their objectives. So Yuan is a key indiacator to watch out as we move forward.
Secondly, You cannot talk about economy in China without Hong Kong, because its a big piece of the puzzle in developing the Chinese economy. Let me back up a bit and give you a background, which will help you to understand some of the issues that Hong Kong is facing even to the present day. Back in British collonial days, HKD is a free floating currency, and in 1980s, Deng Xiaopeng had discussions with Margrett Thatcher on handing over Hong Kong to China from the British, which caused Hong Kong dollar to devalue by ~25% as capital flee out of Hong Kong. The issue was stablized by pegging the Hong Kong dollar to USD by the British in 1983. Then in 1984, the Sino-British joint declaration was signed which says that Hong Kong would retain its autonomy and rights for 50 years after the handover. Skipping into the 1990s; Hong Kong was handed over to China in 1997 with the agreement of China to be in charge of administrative and military matters.
Pegging a currency to another currency means you are accepting the monetary policy and yield curves of the anchored currency. As long as there is synchronicity in the outputs, the peg remains stable. For the past 40 years US economy is the dominant economy. When US economy went up, so did the Hong Kong economy. Prior to 2009, large part of Hong Kong’s exports were goods than services which was mainly due to its largest port in the region at that time. It was functionally relevent for China, and Hong Kong contributed 30% of the China’s GDP in 1990s. As China GDP started to grow from the late 1990s to 2010 with their growing exports (by keeping yuan low), they started to build southern ports (China’s worlds top 10 ports ownership in the world jumped from 9% in 2001 to 60% in 2015). Therefore, Hong Kong’s contribution to China’s GDP is less than 3% at present. Because of this dynamic, Hong Kong had to reinvent economic priorities. Now Hong Kong is a massive goods importer. 80% of service exports are depending on the demand from China. This is a massive decouple from the US economy. Thus, pegging the HKD to USD is a big bad idea for Hong Kong.
On China’s Side, Hong Kong is not important in terms of output, but economically it very important to work with rest of the world. As US rates went to zero so did the rates in Hong Kong, as it was massively stimulative for Hong Kong economy. Consequently, Hong Kong property prices skyrocketed in the last 10 years and the excess capcity went into the Chinese Stock market (China tech was direct beneficiary of stimulus) and Chinese property developers. This peg is a challenge for China as well. Pouring money into the system will increase wealth gap on one hand, while depending on USD to work with foriegn economies, as the USD is still the global reserve currency. Movement to CBDC, banning crypotocurrencies, emphasis of establishing the silk road economy, providing Yuan loans to emerging economies like Africa, Pakistan and Sri Lanka is an effort to establish Yuan within countries that they can control Yuan flows. I believe that HKD-USD peg will be challeged in the next decade. It is just a matter of time. Market remifications are yet unknown if the peg has to be broken.
Slowing Industrial Production
Since 2009, industrial production is in a downtrend.
Excessive Corporate Debt
If you look at % debt to GDP, in the US it’s the federal debt that contributed to overall debt to the GDP. However, in China, it’s the corporate debt that dominates. An increase of interest rates can cause difficulties for corporations to pay their debts. However, tech companies like BABA and Tencent are in great shape in terms of their balance sheets.
It is clear that China wants more wealth redistribution in the coming decade. But social engineering might take longer than one might think, especially when you are dealing with the largest population on the planet. Moreover, in order to move away from Capital to Labour, technology innovation should not destroy jobs and wages. Let’s look at demographics, unemployment rate, and income disparity in the country.
Implications for Investors
In an era of Capital overcapacity, It’s the liquidity that drives markets, not earnings. Following are some of the questions that I have when thinking about investing in China:
- Can they perform in the absence of less foreign liquidity? and Does my risk rewards the same as before?
- Can domestic consumption give this boost to tech companies to get back into its all-time highs? What is the catalyst?
- What are the tech companies that are least affected by the crackdown? Not all tech companies are the same.
- Am I being compensated for buying the dip? Because many growth companies do not pay dividends. In my personal opinion, mean reversion & buy the dip is a great strategy for companies that pay good dividends. But if it does not pay a dividend, trend following is a good strategy.
- What is the realistic time frame? let’s say if I buy the dip when I am going to throw the towel if it did not work as I expected. Opportunity is a cost.
- If you really want to buy the big tech names, I would recommend you to watch this video by The Fifth Person –China Tech Crash – Is It Time To Buy? I have a different opinion from them, but I can undestand their perspective.
In the past decade, everyone was focusing on mega-cap tech. But, I was surprised to see how MSCI China -A value outperformed growth up until 2018. There are more opportunities beyond tech in China.
Many of us are familiar with China & US tech divergence. As a trader, one would have made decent risk-adjusted returns over the past few months, if they have long US tech/short China tech, which is directionally neutral trade. Even if you were not into shorting, buying slightly OTM put spread on China Tech and long QQQ would have provided a capital-efficient opportunity.
The point I’m trying to make is; there are many ways to express your views about China either as a long-term investor or a trader. But the key here is to look at the situation objectively rather than just buying the dip just because the price dropped more than 40%. Some say be greedy when others are fearful. The question that always runs in my head is where is the catalyst? It is clear this is not a market-driven dip rather a policy issue. It is important, because how the recovery manifest itself will be vastly different from a policy issue in contrast to a market issue.
I do believe that there is a movement from Capital back to Labour, which is subtle, slow, and not easy to recognize if the time frame of your focus is short-term. If you expand the time frame and look into history, it is obvious that labour markets are the key to create meaningful inflation (it’s not purely money supply) because consumption matters a lot to the real economy than money supply. I think, China is a leading the way to show the world how its being done.
In terms of investing, I have three theses for the next decade to put my money into work: Blockchain innovation, Investing in Green energy, and Investing in NextGen. Health Care ( Biotech, genomics, and mental well-being). Along these themes, I believe health care & green energy in China may provide some good opportunities as the focus shifts towards labor. As a macro trend follower, the trend is my friend. So, I don’t have a strong macro conviction about China at this point eventhough some of the sectors are not affected by the crackdown. This is mainly because I do see better risk-reward else where right now. But, China is on my watch list. There are a lot of doubts and uncertainties among retail investors on, ‘should I invest or not invest in China right now?’. I had a deep thought about it too because things look very cheap on the surface. But, I would need some price confirmation to see the trend has already reversed before I dive in. Macro and policy uncertainties and timeframe uncertainty are real. In addition, even If i want to go long, I would prefer sector-focused ETFs as I do not have strong views on many of the domestic companies. So, i will let others do the heavy lifting for me. I would leave you with one of my favorite quotes, which helps me to remind myself constantly to look at things objectively.
“Markets can remain irrational longer than you can remain solvent” – John Keynes
Disclaimer – ” I am not a financial advisor and this article is a construct of my personal views on various markets and the economy. Therefore, information shared in this article should not be used as investment advice by the reader”