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This Week Ahead episode discusses the current state of the Chinese economy and its potential trajectory in the future, with experts Leland Miller, Mary Kissel, and Samuel Rines. In this episode, the panel discusses China’s gradual reopening, China’s place in the world, and the Chinese Communist Party’s economy.
Leland Miller, who leads China Beige Book, talks about China’s Great(ish) Re-opening. He notes that the reopening has been a gradual process and not as quick as some had claimed it would be. He raises the question of when we will see China really break out, whether it will be after the Lunar New Year/Spring Festival or later. He also discussed what activity we should be watching to know that China is really back to normal, such as investment, hiring, etc. He concludes by commenting on what a “normal” Chinese economy will look like in 2024 and beyond.
Mary Kissel, from Stephens, leads a discussion on China’s place in the world. She notes that with confirmation that China’s population has already peaked, there seems to be a subtle reassessment of the “China opportunity.” She points out that there is a very different view of China from the European perspective vs the US perspective. Europe seems to be growing closer to China while the US seems to be pulling back. She also shares how US-China relations will change as China normalizes and whether US companies are really moving out of China. She also discusses the push-and-pull factors that influence these decisions and if US companies will be complacent and stop moving to manufacture elsewhere after the slower opening in China.
Samuel Rines, from Corbu, leads a discussion on The Party’s economy. He notes that under Xi’s leadership, we’ve seen the Chinese Communist Party return to a more involved role across Chinese society. He shares if the government will be more assertive toward businesses – both domestic and foreign businesses – in a post-Covid world and if that could impact how foreign investors view investments in China. He also mentions recent central government intervention in several sectors, most notably tech and real estate, and asks how involved the government will be in the repair of the real estate sector and protecting the tech sector. He also shares that if given renewed government involvement as well as factors like population and economic slowdown, we expect these sectors to return to rapid growth anytime soon.
Finally, the panel members share what they are thinking about China that they’re not sure most people see.
Key themes:
1. China’s Great(ish) Re-opening
2. China’s place in the world
3. The Party’s economy
This is the 50th episode of The Week Ahead, where experts talk about the week that just happened and what will most likely happen in the coming week.
Follow The Week Ahead panel on Twitter:
Tony: https://twitter.com/TonyNashNerd
Leland: https://twitter.com/ChinaBeigeBook
Mary: https://twitter.com/marykissel
Sam: https://twitter.com/SamuelRines
Listen on Spotify here:
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Transcript
Tony
Hi, and welcome to the week ahead. I’m Tony Nash, and today we’re joined for a special discussion on China. We’re joined by Leland Miller of China Beige Book. We’re also joined by Mary Kissel of Stevens and Sam Rines of Corbu. Guys, thank you so much for taking the time to talk about this. I think it’s a really critical time to understand what’s happening with China, and it’s just a really timely discussion. So I really, sincerely appreciate the time you’ve taken for this discussion.
Tony
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Tony
Thanks very much. We’ve got a few key themes that we’re going to talk through today. The first is China’s kind of great-ish opening. Everything in modern Chinese history is the great whatever. So this is kind of the great-ish reopening. We also want to talk about China’s place in the world. And so I think that’s a really important thing to understand. There’s a lot of discussion about the rising CNY and other things. And so we really want to understand China’s place in the world. And finally, a discussion about the economy, kind of the party’s economy versus the entrepreneur’s economy. And so I’ve heard some comments recently, actually, from an interview Leland did about kind of, is this the party’s economy? Is this not the party’s economy? So let’s kind of jump right into it.
Tony
Leland, I really want to understand the reopening in China. Post COVID, we had these protests. It’s been well covered. We had this really quick change from the central government in terms of when they’re going to open. And it seems like it’s been not as quickly as was claimed initially. And I think markets had this expectation that things were going to open on a dime.
Tony
And some of that’s happened, some of that hasn’t. So can you tell us what is your data seeing? Are we seeing a slow, delayed opening? And when do you see kind of the full reopening of China?
Leland
Sure. Well, look, reopening was always a bad term to use because markets equated a COVID Zero reversal, COVID Zero pullback with the reopening. So the second that Xi Jinping did this mystery call to just reverse himself the next day, they said, okay, China’s reopening, that was never going to happen. Obviously, if you’re opening the floodgates on COVID, then you’re going to have a COVID tidal wave wash over the country. So it never made any sense that there was going to be an immediate reopening. We like to use the word reactivation of the economy. There was always going to be a number of months in which things were just going to be bad, as people were either getting COVID, or they were hiding from COVID or they were dying from COVID. The reality was December was terrible. I mean, we don’t have to rehash the old economic data from last year, because we really are in a paradigm changing time right now. But 2022 was atrocious. The fourth quarter was in contraction. December was in contraction. It was just absolutely terrible time. January, this is where people, I think, are jumping the gun on the entire reopening question.
Leland
People are obsessed with subway indicators. So everywhere you turn there’s like somebody quoting a Beijing subway has more people this week than it did last week. Same with Shanghai, a couple of other tier one cities. That’s great. Look, it’s great that the low point has been pushed past in some of these bigger cities, but China is big, China is real big, and China is real rural, and a lot of the major economic engines of China are in smaller cities, manufacturing commodities, et cetera. So you’ve got a long time, or a longer time than most people think, where COVID just has to wash over the entire country. We don’t know what’s going to happen with Lunar New Year. I mean, you have the potential for it. This is the all time, world record super spreader event that anyone’s going to be ever see. And so what is going to happen? They’ve taken care of it in the big cities relatively well. Although people are dying and they’re not admitting to it. Many, many tens and tens and tens of thousands of people are dying and they’re not a day and they’re not admitting it. But when you get into the rural areas, you have massive hospital under capacity.
Leland
You don’t have ICU beds, you don’t have doctors, you don’t have nurses. They’ve run out of cold medicine, they’ve run out of other types of medicine. So what are they going to do? We don’t know. The assumption is that we’re not going to have a real good idea of what’s happening, but we do know it’s going to suppress any type of commercial activity, economic activity, for a little while. So I think the way we look at it is an optimistic take on this would be maybe by the end of February you start to have economic activity starting to come back. Not that you’re not going to see little jumps in travel here and there. People are running around. Obviously travel is going to do better. But in terms of the economy getting back open, maybe you start seeing that in March more broadly. It may be April, it may be later, but let’s just assume March 1 is a very optimistic way of looking at it. It still means that the first quarter is going to be bad. You’ve got January and February are going to be bad. Nothing is happening. We don’t have our January data out yet, but I can tell you what’s happening and that is very little other than people getting sick.
Leland
So you’ve got bad data. Q1 will look bad. The recovery story starts in Q2. And then there’s a question of how intense will this be? Will Chinese consumers… The story I hear ad nauseam from just about every one of my hedge fund clients is Chinese consumers are chomping at the bit to go spend, spend, spend, spend. I mean, that’s never been true of Chinese consumers, but let’s assume that they’ve been pent up, they want to spend. So that’s unclear. There’ll be some pent up spending. I think the big issue here is firm behavior. So in 2022, China Beige Book, probably the single most important conclusion takeaway we had from all our data was that firms told us, and thousands and thousands and thousands of firms told us that until COVID Zero was pulled back, they weren’t going to invest, they weren’t going to borrow, and they weren’t going to hire. They just weren’t going to do it. And that’s why you never saw any bounce backs after the lockdowns were eased along the way. Now COVID Zero is pulled back, COVID itself, the initial wave at least, will be passed as soon firms will start reinvesting.
Leland
So you will get a cyclical bounce back from that coming in the next couple of months. That’ll be great. Then maybe you have consumers spending on top of it to some degree, at least in the early going. The question is then do you have stimulus on top of that? Probably so in the early going. How moderate, modest? Mild? We’ll see. But look, you have the potential because this is the base of comparison, 2022 has been so bad, you have the potential for this beautiful cyclical bounce back for a time. But I think that the last point I would make here is 2023 has the potential to be a giant head fake because you’re going to see this cyclical bounce back. You’ve got all these things lining up. Maybe they stimulate and get the bigger numbers. Maybe they, they hold off and, and get just pretty good numbers. But this is in the larger context of a major structural slowdown. And so you’re going to see the numbers come up and then you’re going to see the numbers go back down and whether that’s the end of the year. We have an internal discussion about this.
Leland
Our chief economist Derek Scissors and I have different opinions on this, but he thinks it’ll go longer, a little longer than I do. But let’s say it’s two, three, four quarters of elevated growth and then you’re pushed back down again at the end so 2023 has a potential to be this nice year, particularly in the middle. People are going to start talking about the old China’s back, the old growth models back, the old stimulus playbook’s back. I don’t think any of that’s true, but you will see better times, better numbers, certainly in the middle and towards the end of the year. And then the question will be, where are we going from here? And I think it’s pretty clear we’re going to continue on the structural slowdown. But then that’s when the big questions about stimulus and whether they want to do any types of uturns, that’s when these got kickbacked in and become really interesting.
Tony
Okay, just to clarify a couple of things. First, you guys get new data every day, right? This isn’t a monthly or quarterly thing. You’re always getting renewed data on the Chinese economy, is that right?
Leland
Yeah. Back in the old days, we started over a decade ago. We were doing a quarterly survey because people said, you can’t get in for you. You’re not even going to be able to do a quarterly survey. It was smaller. Now we are not just releasing data quarterly and releasing a monthly. We have data populating our analytics platform on a daily basis in real time as the surveys are being conducted. So it’s daily to the extent that during survey periods, we’re populating the platform daily. So we don’t release the information daily because you got to be careful in what conclusions you’re making before you get your full set of data. So we release it monthly, but we populate the platform on a daily basis.
Tony
Right. I just asked that question because you’re not talking anecdotally, you’re talking about real data when you make the assertions that you’re making. Right.
Leland
Always perfect. Usually good.
Tony
Mary, what are your thoughts on this in terms of what you’re seeing right now and what you see in terms of the ramp up? What are the things that you’re really watching to know that a ramp up is happening?
Mary
Well, first of all, it’s great to be on with you guys again, and great to be on with you guys who I’ve known for a really long time. So thanks for inviting me. I agree with what Leland said. I think we should put it also in a broader context. You know, the idea that China is going to snap back to the kind of the Gogo days of the 2000s also has to be seen in light of the regime and its its view of economic growth. They don’t think about economic growth in the way that we do. The economy serves the party. Everything serves the party. And Xi Jinping was brought in to crack down on the excesses of corruption in the elite circles. He has done that. He moved on to cut off the heads of a lot of the corporate leaders and to rein in some of the more successful enterprises in the country. That’s not going to change. So in order to go back to the Gogo days, it’s not just about reopening or stimulus, it’s what is the extent to which businesses will be allowed to invest and take risks? And Leland raises a great question here about their willingness to do that.
Mary
How has behavior changed over this crisis? We don’t we don’t know yet. There’s another macro factor here, of course, which is demand for the goods that are being produced in China. We’re in an unusual situation where you have kind of the three pillars of the global economy, the United States, Europe and China really not positioned or implementing policy for growth, sustainable growth. And so that’s a factor as well. I think it’s interesting to see, and very predictable, by the way, to see Xi Jinping and his cadres kind of fan out and try to lure in particularly the Europeans and the labor government in Australia to renew their relationship with the regime. The Australians just in these last days came out and said that they had gotten close to some sort of trade they thought with China. Remember that Xi Jinping punished that country for some very principled stance that they took on COVID. I would expect that to continue, and I’m sure that the Germans and the French and the Australians and others will rush back in. But as Leland said, they may do well in the near term, but it could be a real suckers game in the long term. So I would absolutely caution against that.
Tony
Sounds like a really delicate year for China. Again, I think the prevailing sentiment is there’s all this pent up spending waiting to go, and it sounds like that’s not really what you’re seeing. And what about the lead times for some of these manufacturing firms to get back up? Is that a month or two months? So if we say March 1, hypothetically, is the date that things start, if all these factories started on March 1, would it be say, six to eight weeks before things are really moving? Or is it quicker than that?
Mary
Is that from you, for Leland?
Tony
Anybody? You guys all know what you’re talking about.
Leland
I could start then Mary can correct me. I think there’s a very fast turnaround in terms of how fast they can get up. The question is, what are they turning around into? The global economic situation is not terribly good going into next year. And the Chinese manufacturing sector has been going like gangbusters for years because it was producing for the world as the world was stimulating and the world was otherwise shut down for COVID. So the manufacturing numbers we’ve seen for years, up until relatively recently in 2022, were just unbelievable. So the idea that manufacturing can get back up pretty quickly, I think that’s fair. But the idea that there’s going to be a manufacturing sector and demand that will export market that will be there for this manufacturing sector the way we’ve seen the last couple of years, I don’t think that will happen. So manufacturing is unlikely to be this big driver over the next year or so and beyond. It was for a couple of years. It’s not anymore. The big idea here now is, oh, well, look, they’re going to rebuild property. They’re going to fuel a push a bunch of credit back into property, and there’ll be growth there.
Leland
I think that’s totally oversold. They’re going to do that a little bit, but they’re not going back to the old days. And then the question is this Chinese consumer. The Chinese consumer. I mean, how many times in the last decade have I had an interview about the Chinese consumer where people are like, we’re on the cusp. They’re going to take it away.
Leland
So, look, it’s a long, long myth that a lot of people on Wall Street pushed as a marketing ploy in order to get money sucked into China. So it’s never been true. It’s not going to be true. You could see a few months, maybe even a few quarters of retail sales bouncing because maybe there is pent up spending, maybe there is stuff to do. Services certainly bounce back when you’re talking about travel and other things. But look, do you have a robust enough domestic economy to sort of push this through? Well, you got enough to to give China some decent growth numbers for 2023. But this idea that Chinese, the Chinese economy resuscitated is going to be a global growth engine, I mean, that’s total nonsense.
Mary
We should also just talk about what was that growth engine to begin with. It was exploitation of labor. It was mercantilist policies. Yeah. It was ripping off all of the great innovation produced in the United States and to some degree also in Europe. That was the model. And I think you had a lot of credulous reporting in the west touting this kind of new version of capitalism that actually wasn’t capitalist really at all. It didn’t rest on property rights or the rule of law or fair competition or any of those things, right? It was a model to entice the capital in, to steal the innovation and to try to produce it themselves. And so it’s going to be really interesting to see, like, let’s take one sector, the tech sector. How are Chinese semiconductor companies really going to do without having American engineers over there and the export of our chips and all of our innovation, right? They’re going to hurt. They’re going to hurt bad. And you’re going to see that across several industries. I think this also really exposes the myth of Chinese competence. I mean, this is something I should say CCP competence.
Mary
There are many very innovative Chinese people in the United States and elsewhere and in the mainland who just, unfortunately, are stuck in the middle of this horrible system. But I’ve been talking to clients about this for years now, this idea that there’s some kind of far sided newfangled way to manage an economy. And, wow, look at the results. Well, gee, look at the results. Now we’re reopening and we’re figuring out that, hey, they’ve spent almost three years now doing absolutely nothing to prepare for the reopening, to figure out how to import drugs or develop their own that could deal with the symptoms of COVID So now they’re importing paxovid and they’re selling it at high markups to the rich people in Beijing who can afford it. And everybody else, good luck to you. I think that the scales have fallen from the eyes of a lot of investors and importantly, a lot of operators, American or otherwise, who really woke up during COVID and are waking up now in this reopening, looking at the supply chain disruptions, really for the first time asking, honestly, how much money can we really make here? Is it worth the risk?
Mary
What is my risk profile and what’s the trajectory of that risk profile? And they’re coming to the conclusion that actually it’s not what it was cracked up to be. And ultimately, I think that’s a good thing because I think that pulls capital to other parts of the world that, frankly, are friendlier to us and also far more predictable in the business environment.
Tony
Okay, that’s a great point. Sam, you talked to a lot of US investors, of course, and is what Mary is saying. Are you seeing that as well, where us investors are seeing through kind of the myth of CCP competence? Like, Mary, I’ve been talking about it for years. I know Leland has as well. And do you see us? Investors catching on to that, or is this something that I just kind of wish would happen?
Sam
Oh, no, they’re 100% catching on to it. Businesses are catching on to it, et cetera. Right. Because now it’s more of a risk to have that long supply chain and to have that supply chain based at least partially or mostly in China. Right. That is a significant risk not only to call it for headlines or headline risk, but also to actual revenues and earnings. Right. You miss out on actual sales. You miss out on margin expansion. That’s really becoming something that people are really paying attention to, that investing in people, plant and equipment is something you have to do closer to home. It’s not something that you can do with unfriendly neighbors. Yellen called it French shoring. I call it reregionalization. I prefer mine over hers. But I do think that there’s a lot to be said for that. There was an interesting quote from the United Airline CEO that said, “listen, we’re overstaffing by five to 10% because it costs a lot less to overstaff than it does to miss out on those revenues.” And I think a lot of manufacturers, a lot of US based companies are figuring out that it’s a lot cheaper in the long run to invest in Mexico or the US. Or maybe in parts of Eastern Europe for your plant and equipment than it is to lose out for years with a very volatile system in China.
Tony
Yeah. I’ve said this several times on the show. Pre global financial crisis, there was this China plus one, china plus two, China plus three strategy that a lot of Japanese companies were trying to look at. And the financial crisis went through, and everyone kind of shrugged their shoulders and said, look, it’s just cheaper to keep everything in China, so let’s not proceed with that. My concern is that these Western companies who have invested so much in China over the years, as China reopens, they’re just going to forget about kind of 2020 through 2022 and go, “oh, what the heck? We’ve already got that fixed investment there. Let’s just keep things as they are because the status quo is easier. We’ve got a new CEO.” They don’t want to figure it or whatever. Right. So is that likely to happen? Do you think American firms. And Sam, if you can start on this, do you think American firms are likely to just leave their capital in place and not diversify? Or what’s going to happen there over the next, say, two to three years?
Sam
Well, I would say that maybe they would want to. Maybe that would be something corporate America would do. Because corporate America tends to be rather short sighted in some instances. But you’re having it mandated. The chips act is probably call it the first shot over the bow, so to speak. Diversify your supply chains and put them in the US. Or put them in a friendly country. That’s the first stage, right? That’s the first kind of we’re going to force you to do it, period. And not necessarily force, but we’re going to highly encourage you to do it and we’re going to encourage you to do it over a fairly short time frame. So it’s not simply what corporate America would prefer to do. It’s what corporate America is somewhat being told to do. And I think that you’re going to continue to see that type of legislation, that type of tax incentive, continue to be put out there for various industries, particularly of relevance to defense and staying ahead in technology generally. Those areas are going to become much more difficult to outsource to save a couple of dollars on the bottom line.
Tony
Yes. Leland, what are you seeing on the ground? Or what are you hearing on the ground?
Leland
In terms of companies moving in terms.
Tony
Of companies moving remaining commitment to diversifying their supply chains, is that just a narrative that we’ve heard, or are people actually moving in that direction?
Leland
No. I think it’s finally happening.
Tony
Okay.
Leland
For years. There were all these reasons to be doing this contingency planning and no one did it. So you had geopolitical tensions. Companies refused to change their ways. You had the trade war, companies still refused to trade their way. You had COVID, people still refused to trade their way. It was really COVID Zero. That sort of broke the camel’s back on this. And so the combination of all these things, the fact that Expats didn’t want to be there, the fact that supply chains were just clearly breaking down, and the discussion points in the corporate boardroom changed from saying, look, we need to maximize profits, we need to maximize earnings per share. This is about efficiency. The conversation pivoted to this is about security. This is about making sure that we are not cut off, that we are not in a really bad position, and the politics are backing that up. So I think you have had a move from corporates more and more to take this seriously. Everybody has a plan B or plan C now. Some can move their supply chains easily. Some, like Apple, are going to be just toiling for years trying to get this right.
Leland
So it’s different depending on the size of the company and the industry. But I think this is a major issue. What I think is going to happen as well is that a lot of companies are saying we need to pull out supply chains. That is, previously Chinese production is producing for the west. So they’ll still funnel money in investment into Chinese production, but it’ll be for the Chinese domestic market. And then the rest of this will be supply chains pulled out for production demand ex China. So what you’re actually seeing or will see in the coming years is a bifurcation of production, supply chains, et cetera, going forward. So I think that’ll be inflationary. That will be costly. Corporates have resisted it for a while, but the risks of something bad happening, either geopolitically or through COVID or through something else, have just grown so significant that shareholders are finally demanding that companies do something about it. So companies finally are.
Tony
Yeah, sorry, Mary. I suspect that seeing companies pull out of Russia really abruptly, although it was a relatively much smaller opportunity for most, I think that may have emboldened people to be more assertive on China over the last, say, nine months. Mary, are you seeing that? And our investors from the investment community, do you believe that people will have a tolerance for that?
Mary
Yeah, I was actually just going to raise Russia. Totally anticipated.
Tony
Sorry, I’m sorry.
Mary
Take my thunder. Yeah. Actually there was a very interesting no doubt this morning from Euro Intelligence, which is a great little newsletter, I really recommend it of a St. Gallen study, and I’m not going to repeat it because it’s a subscriber only newsletter, but essentially the argument was, hey, we looked at how big was the actual pull out from Russia? And it’s not as big as you would imagine, but I do think that it jolted investors and sometimes it takes moments like that for investors in particular to realize, wait a second, my world could change on a dime. Have I really thought and planned for all of these scenarios? And I think that, yes, indeed, it was a very major event and a real wake up call, not just for investors, but also, as I said, for operators. There’s one other theme that I’d like to mention here, and I may have said before on this show, Tony, but that’s the concept of strategic narcissism. This idea that it’s all about what are us investors doing and what’s our next move? Well, China itself is planning, and not just planning, but activating the dual circulation strategy of Xi Jinping.
Mary
And what’s the goal of that? It’s to disentangle them from us. It’s to pull us in, get our capital, get our intellectual property and our expertise, train up their people and then kick us out. And that is a stated policy. You don’t need a security clearance to know about this. And I think we just didn’t pay attention, but I think investors are paying attention now. And so, again, it will be fascinating to see who the Patsies are, primarily from Europe, who go right back in and fall right back into this trap and give them all this valuable expertise.
Tony
I think we saw that in December when screwed. Yeah, I think we saw that in December when a bunch of German executives went there and just did everything.
Mary
I mean, Macron is going over. And we should talk, too, about Washington stance because let’s be honest, this is a very complex, difficult relationship to manage. I have an enormous amount of sympathy for the Biden team in what they’re confronting here from China because I’ve worked in that job and it’s hard. But I think it is also notable that you’ve had now a Republican and a Democrat administration in the United States, really recognize that this is not the partner we thought it was. And that’s where the Chips Act comes from. And they have expanded much of what we started in the Trump administration, to their great credit. Whether it’s expanding the relationship with our allies or taking some more of these steps to protect our strategic industries, I would not expect that to change. But it’s important to remember that as we take these measures, you also have to look at what is the regime saying about its goals and plans. Right. That in there. I think the direction is just very clear. They want to disentangle from us, create their own economic sphere through their Belt and Road to have their own market, and they want to pull allies of ours and partners like Saudi Arabia, like Turkey, like Brazil and others away from us and into their sphere. That’s the investment world that we’re confronting. It’s a brand new era.
Tony
Right, so Mary, you jumped into kind of China’s place in the world, and this was one of our key topics. We’re going to talk about. For people who are watching, who don’t understand. You advised Mike Pompeo as Secretary of State on many of these key issues. So what the person sitting in that seat today and going forward, how has that changed from, say, ten years ago? What are you watching today from, say, ten years ago? I remember when the Trump administration came in, there were all these cries of kind of free trade. Like, you can’t do these things because of kind of free trade, which is kind of a 1980s era, really sweet dream when that equates all to, say, zero tariffs without incorporating things like non tariff barriers and subsidies and other things. So do you believe that State and treasury and other organizations are now smarter about things like non tariff barriers and subsidies? Because certainly the WTO isn’t. Okay, so I believe the US. Administration. I’m hoping the US administration more constantly is paying attention to those things.
Mary
Well, I wouldn’t count on Treasury to get realistic about anything. It’s usually headed by a guy from Goldman who just wants to go in and do as much business in Beijing as possible on whatever terms, and then come back to the United States and talk about how great China is. Right? He’s kind of the useful spokesperson for the regime. And we’ve seen that repeat over and over, Trump administration. Hey, I too was one of those people, I’ll admit it, who said, “I don’t like the tariffs. It raises the cost to US consumers. That’s bad, bad. We can’t do that.” And then I got into the administration as the Secretary’s senior advisor, kind of his right hand person, strategist, whatever you want to call it. And what I realized was just how little leverage we actually had over the regime, how bad the behavior was, and how unfair, fundamentally unfair the relationship was across a number of areas. And so you can set ideology and demoralizing about it, set that all aside. It is very simple, I think, for US businesses and investors to understand, hey, we really just want a level playing field. If that’s the approach you’re going to take.
Mary
Right? Americans intuitively understand the concept of fairness and fair competition. We were never going to go from China as a friend to China as an enemy. Right? There was going to be an awakening and a process there. And so that started under the Trump administration, and it has continued under Biden. And so we call them a competitor. Well, that’s not actually accurate because if you’re competing, you’re agreeing on the rules of the game and the rules of investing in your respective rights as you trade or invest or whatever they don’t, period. And so that’s a problem for us. So eventually, I predict someday we will get to that point where we really level with the business community, with the American people, and the rest of the world. We say, no, they’re actually an enemy. Europe is moving in that direction. Remember, in March 2019, the EU called China, quote, economic. They said “competitor,” but they also called it a “systemic rival.” Okay, that’s a little bit different. So they’re starting to move there too. But, you know, we’ll have fits and starts. We didn’t figure out our strategy to confront the Soviets for decades. It took us a very, very long time, and we had great and robust debate about it.
Mary
I think the same thing is going to happen here. But like the Soviet era, I think the trajectory of it is clear. We’re recognizing what it is. Investors are recalibrating just how much they want to risk there. And operators, as Leland said, we’re looking at the feasibility of diversification because I don’t think anybody in their right mind believes that we’re going back to the good old days of the 2000s.
Tony
Okay, that’s great. And I guess, Leland, the question that comes to me after everything that Mary said is if we are truly competitors, and if those in some magical hypothetical world where all the rules are agreed, can Chinese companies generally and I know that’s a big generalization, but can they generally compete with, say, German and American companies? Do they have the ability outside of, say, cost, to compete in global markets?
Leland
Some can, but Beijing won’t let them. I mean, look, if you’re looking at Alibaba and Tencent, these are not Chinese data companies. These are global data behemoths. Tech behemoths. Extremely impressive. I mean, some of the stuff they were doing, we’re blowing our tech companies away. So can these companies compete globally? Sure. Is Beijing clipping their wings right now? Yes. So the question is, will Beijing let them compete? But there’s another part of this. If you’re seeing a movement towards the state sort of gobbling up just about everything. They’re gobbling up debts on one side, they’re gobbling up companies on the other side. You’re seeing golden shares being taken and all these big tech companies and other companies, too. And so what’s going to happen to these companies? Well, you’ve got them answering first and foremost to the state. Has it always been true? Sure. But it’s very different when you’re answering ultimately to the state or whether you’ve got party hacks yelling in your ear on a day to day basis about the direction of strategy. So to the extent that they keep doing this, and it looks like they’re doubling down and tripling down on this as we speak right now, then this is dramatically going to affect their ability to compete with Western firms on a global stage.
Leland
So this is a favor that the party is doing for the west in terms of clipping the wings of these Chinese companies. They would be able to compete. Many of them would be able to compete, but they’re not going to be allowed to.
Tony
Great. Okay. It’s a really valuable perspective. Sam from the perspective of, say, Western portfolio manager. If you’re evaluating Chinese companies or Chinese sectors, what are the special risks that you have to pay attention to, and how does that factor into your, say, valuation or other calculations?
Sam
That’s a broad question.
Tony
Yes.
Sam
If you’re an EM manager that’s tied to an EM benchmark, that’s going to be a big China allocation. If you decide that you want to be underway China, you’re going to be way outside your bench. And you’re potentially going to be in some trouble if they begin to rally. If you’re not tied to a benchmark, it’s a lot easier to look at the Chinese investment landscape and say, what are the risks here? And one is that you’re going to have significant government intervention without warning. That I would say is the number one risk. Number two would be what is the real ownership structure here of the securities I’m buying? Most investors would not be able to purchase the actual shares in the company. And number three is, what are the chances that I get Russia on this at some point? Whether it’s China decides to sell defense equipment to Russia, and all of a sudden, you have some pretty significant, instantaneous reactions from the US. And all of a sudden you’re donuted on all of your investments. And that’s an existential risk as a money manager. If that’s a three to 5% risk, that’s one thing. It begins to escalate to a 10-20 percent risk. That’s another thing. And while it’s a significant tail, it’s not a 0% risk. So I think those are the top three things that I’d be paying attention to on that front.
Sam
And the other one is how exactly do you define a state-owned company in a world where most at least have some sort of stake from a government entity? And I think that’s the other one. To Leland’s point that when your governance begins to break down, that’s the number one flashpoint. And there was a very large hedge fund that announced late last year that they were no longer going to do Chinese tech equity investments on public markets. That was pretty shocking. They were one of the larger investors in those securities. And they just said, no, not anymore. We’re not going to do any incrementals there. So I think there’s a number of call it cross currents to really getting behind investing in China. There’s a lot of derivative ways to do it that are a lot less risky. If you want to play the second or third quarter rebound, you don’t have to buy a Chinese equity to do it.
Sam
You can buy Australian Equities. You can buy mining equities. You can buy commodities. You can even buy European manufacturers. If you have really bad manufacturing numbers in the US. And you’re up on the margin, and all of a sudden, you begin to have a flood of orders on Capex from China that are pent up. That’s a significant tailwind to companies that have a lot less governance risk. And a lot less currency risk. I think if you’re looking to call it play a China reopening or play the Chinese economy, you don’t have to take the risk of buying the equities that are Chinese labeled.
Tony
That’s a great point, and I love the way you kind of triangulated that. So that’s excellent. It’s also a good kind of move into our last segment on kind of the party’s economy, and we’ve covered this in a lot of different ways up until now. But I think what I’ve been most surprised by over the last several months is the assertiveness of the Chinese government, not just with Chinese companies, but also with Chinese tech companies, which has really been the last couple of years more intensely, but also foreign companies. So it’s almost as if there’s a view that anybody doing business within the borders of China is, by extension, almost a party extension. Is that fair to say? And there are two big automakers, one German, one American, who sell more cars in China than they do in their home markets. Right? And so does it come to a point where firms like that start being seen as extensions of the party? So, Mary, why don’t you start us off? And then, Leland, if you can help us think through that.
Mary
Well, just definitionally. The PRC is a party state. The party runs everything. You can’t differentiate between selling a Mars bar in China and selling them military equipment that could help them build hypersonic missiles. It all is for the party before anything else. That’s the most important thing to understand. And I think if we had won a second term in office, that’s something that we would have socialized more broadly, because that’s, of course, what investors that’s how they’re going to try to split the baby, right? They’ll say, well, hey, look, we’re not investing in hickvision in the surveillance state that was put to such use now after the protest and in places like Xinjiang. But, hey, it’s okay. We can make T shirts and jeans in China, and that’s all fine. We’re not really helping the regime. Well, yeah, you kind of are. So you can’t separate doing business in China from the party. And the party itself never viewed the opening up to the rest of the world as embrace of our system. They viewed it, as Aaron Friedberg put in his book, getting China Wrong. They viewed it as a bird in a cage. It was something that had to be harnessed but always controlled.
Mary
And what we’re seeing now is the actual face of party control. And that’s not going to change because it’s not due to a single man or a single leader. It’s due to a system in which we’re doing business. It’s unfortunate but true. Now, we’re not going to decouple from China. That is a fantasy. There’s too much invested capital there. It’s going to happen in stages, or as has been mentioned earlier, it’s going to happen due to a shock like Russia when we’ll just all be forced to pull out. But will US automakers leave China tomorrow? No. But if you have a Russia situation, they may be like situation where China invades Taiwan or does something else extremely provocative. They may be forced to.
Tony
Right. Thank you. Leland, what are your thoughts on that?
Leland
Yeah, I agree completely with Mary. I think that this highlights the next big US political issue because if you look at what the Select House Committee on China, which is just getting put together by the Republicans at the Bipartisan committee, it’s going to focus on China. It may be the only part of Congress that actually works. It may not work, but if anything works in the next two years, it probably will be the Select House Committee on China. The big issue that I think that they’re looking to tangle to address is investment flows into China. And there’s two elements to that. The first is that we’ve spent a long time not being able to identify what’s going where or even how much of it. So there’s recent studies, the recent tracking shows that the amount of portfolio investment that’s going into China, the investment flow, it’s just many, many times what we thought it was before because it’s going through separate jurisdictions and it’s sort of making its way back to China. There hasn’t really been transparency on where all this money is going. So essentially you’ve got a huge investment flows that are going from Americans, American firms, American households going into China.
Leland
And to do what? Some of this may be buying something that’s relatively benign. Some of it may be going into parts that did fuel missile that could be shot at US troops down the line. There’s no transparency on it. So the first order of business will be to get clarity on what the situation looks like. Where is this money going? How much money is it? And then there’s a question like what do you do about it? So the question is, Mary brought up a point there’s no black and white line between here’s civilian and here’s military. But because she also brought up the point we’re not going to completely decouple, it means we’re going to be drawing these artificial lines based on what’s reasonable, what’s practical from a national security perspective in the coming years, those lines will move over time, as she said. But we’re going to have to draw, at least draw them, because we’re not drawing them very well right now. And that means figuring out, okay, well, this money is going towards the party and helping them do X, Y and Z. And we don’t like that. This money is going towards inputs into the tech sector which are helping build up their military.
Leland
We don’t like that. So we’re going to see more and more focus on making sure that investment flows are not going to things that Americans, by and large are very uncomfortable. One, they don’t know, but if they did know, they’d be very uncomfortable to money going that way. So this is sort of the next step in the entire decoupling drama. All of this is going in one direction, but it’s slow because it’s cumbersome and there aren’t bright lines. Not all of it’s obvious, and a lot of it has to do with Chinese behavior. If the Chinese are acting up around Taiwan, that’s a different set of circumstances than if for some reason we need Chinese assistance or support for something else that’s going on around the globe. So we’re going in one direction. This is going to be the big issue in the next couple of years. But it’s a slow plotting movement. That’s correct.
Sam
And to Leland’s point, from an investment perspective, it’s worth remembering. There’s a nontrivial amount of SP 500 sales and the growth over the last decade, two decades that have come from China, mainland China, right. If you look at Apple, if you look at Starbucks, Yum Brands, they split out GM.
Leland
Every chipmaker.
Mary
Every chipmaker.
Sam
Caterpillar, John Deere. There’s a significant amount of what I would call, “earnings risk” to an escalation of this type of rhetoric that shouldn’t really be ignored. There’s a tremendous amount of revenues and earnings that emanate from the mainland, at least in one way or another. Two very large, very high weights in the SP and other indices that maybe should get a little more attention as we move forward. Because if you begin to have call it tip for Tat type rhetoric it’s pretty easy to say, well, maybe Nike shoes can’t be sold now because we don’t like where they’re made or Starbucks is being investigated for the water quality. Right. There’s a lot of ways that you can have some pretty interesting movements here that kind of fly under the radar a little bit, but should not be ignored.
Tony
Very interesting. The American regulatory state applies to Chinese investment. That’s interesting. Guys, let’s wrap it up. One last thing. What are you thinking about China that you’re not sure that other people see? What do you think about that you wish other people saw, even if you already mentioned it? What’s the main thing that you’d like to underscore, that people need to see about the Chinese economy, US-China relation, anything we’ve talked about? What is that main thing? Ladies first, Mary. I hope I can still say that.
Mary
Yeah, of course. I love that. I think it’s the realization that the longer you’re there as an operator or manufacturer or an investor, the more you will be forced to do things that you would never do in any other jurisdiction to make certain choices of including a party member on your corporate board or requests for bribes, or tolerating a kind of risk to your staff or to your reputation that you would never tolerate if you were doing business in, say, you know, Australia or Colombia or somewhere somewhere else in the world. And so I think that China exception is going to go away. And I don’t see why we aren’t talking more about just how great the Gulf was between what we tolerated in China and what we tolerated in every other jurisdiction in the world. And increasingly, I think we’re going to talk about that, recognize it and act upon it.
Tony
All right, Sam, what are you saying?
Sam
I would go back to what Leland said about the head fake. I think that’s one of the most important things for investors to think about going forward, because it’s going to look like a wave in a lot of ways when you begin to have ordering of manufacturing goods and services out of the west again. And it’s going to look like a wave, and it’s going to look like we’re all getting back to normal, and then it’s not. Right? If Covid was an earthquake, this is an aftershock, and it should be treated as such. Yes, it can probably be treated and there will probably be some great returns, but that shouldn’t be extrapolated forward. That is one of the real critical dangers here, that investors get trapped and thinking we’re back to some sort of normality and we’re after normal. So let’s not forget that.
Tony
Yeah. One of the things that the Chinese Information Ministry is fantastic about is creating an air of inevitability around China. Right. It’s inevitable that they are the predominant economy. It’s inevitable that you have to put your manufacturing there. So I think what you’re saying is really important, Sam, like, don’t be misled by the head fake and make sure you separate the PR from the reality of the cycle.
Sam
Trade it, don’t invest.
Tony
That’s a great point. And Leland, what’s your last point? I think it’s really important for us to close out with you. Yeah.
Leland
I strongly second both what Mary and Sam just said. But I would add one piece of advice, and that is, when evaluating China, react to what not to what they say, but to what they do. I cannot tell you how many supposedly sophisticated investors react to Bloomberg headlines as if they are a reflection of actual policy. We make fun of this on our Twitter feed. We talk about stimulus 500 times a month. There’s something in which the Chinese announce some form of stimulus, ramping, rail stimulus, some sort of stimulus, this stimulus. And we saw during 2022, people react to that. It just wasn’t happening, you know, so so don’t react to these. With this, you know, shift to consumption. Yeah. Investments falling, but consumption, they’re doing nothing to structurally incentivize a shift to consumption. If they do, we’ll identify it, we’ll talk about it. It will be very interesting. But just because it’s in a headline, and just because someone like Leo Hood, Li Ka Chiang, someone comes out and makes a speech about how China is going to do this, it doesn’t mean it’s actually happening. You got to actually look at what’s happening on the ground, because 90% of the time, they just like to say stuff.
Tony
Yeah, that’s perfect. Guys, thank you so much. This has been incredibly valuable, and I know that everyone who watches it is going to get a huge amount of it. So thanks for your time. We hope to see you again and really appreciate all of the value and stuff you’ve shared with us today. So thank you very much. Have a great weekend.
Mary
Great, Steve.
Sam
Thanks. Take care.