At an investment conference in Kuala Lumpur recently, I caught up with an old friend and Gavekal client. Over coffee between sessions, we talked about one of the most visible changes of the last few years in Asia: the Chinese cars that have so quickly appeared on roads across the continent. This led us to the comments made in September by Ford chief executive officer Jim Farley. Freshly returned from a visit to China, Farley told The Wall Street Journal that the growth of the Chinese auto sector poses an existential threat to his company, and that “executing to a Chinese standard is now going to be the most important priority.”
By any measure, this is an earth-shattering statement.
Making cars is complicated. Not as complicated as making airliners or nuclear power plants. But making cars is still the hallmark of an advanced industrial economy. So, the idea that China is suddenly setting the standards that others must now strive to meet is a sea-change compared with the world we lived in just five years ago.
This led my friend to question how Farley and other auto industry CEOs could have fallen quite so deeply asleep at the wheel. How could China so rapidly leapfrog established industries around the world without all those very well paid Western CEOs realizing what was happening until two minutes ago?
There are many possible answers to this question. They range from the obvious through the historical and cultural to the tin-foil hat variety. And they are well worth reviewing in an attempt both to understand where China is today, and to highlight the blind spots some investors still suffer from when looking at the world’s second largest economy and their implications for markets.
The obvious explanation: Covid, Ukraine, DEI and ESG
Gavekal’s head office is in Hong Kong. But we also have an office in Beijing, with a great team of analysts who publish excellent work (at least, I like to think so). I do not want to sound as if I am bragging (even though I am), but for years our Beijing office would host at least one visitor from abroad every day. I wouldn’t claim that Gavekal was a mandatory stop for every portfolio manager and CEO visiting Beijing. That would make me sound like a conceited jerk. But for many of Gavekal’s clients and their friends, it really was true (that we were a mandatory stop, not that I am a conceited jerk).
Then Covid hit. For three years, no visitor crossed our threshold. By the time the Chinese government finally lifted its Covid restrictions, Russia had launched its “special military operation” in Ukraine. This meant that for most Westerners, China had become uninvestible. The visitors stayed away. The end of Covid restrictions barely made a mark on our Beijing conference room’s planning schedule.
This brings me to the simplest, most obvious, and likeliest explanation why most CEOs and investors missed how China leapfrogged the West in industry after industry over the last five years: during that time, no one from the West bothered to visit China. Consequently—and perhaps more by accident than design—China followed Deng Xiaoping’s advice to “secure our position; cope with affairs calmly; hide our capacities and bide our time; keep a low profile and never claim leadership.”
To be fair, it wasn’t just that visiting China was difficult—even impossible—for much of the last five years; foreign CEOs had a lot on their plates. Covid restrictions forced company managements to come up with new ways to work on the fly. There were also massive supply chain disruptions to contend with. And some of these were greatly compounded by the Russia-Ukraine conflict.
Consider a car company CEO: after spending a few quarters figuring out how to rearrange factory work to comply with social distancing, he or she suddenly had to worry about the supply of platinum coming out of Russia, or of neon coming out of Ukraine. This might help to explain how car company CEOs missed how rapidly Chinese autos were gaining in their rearview mirrors.
And of course at the same time, many CEOs were trying to keep up with ever-multiplying diversity, equity and inclusion standards and environmental, social and governance requirements.
Diversity is a strength. But unfortunately, it could be that all the focus on diversity has not strengthened Western industries quite enough to cope with the oncoming Chinese onslaught. Hence Western policymakers’ enthusiasm for executing a 180˚ U-turn, and instead of promoting free trade and the beauty of Western liberalism, suddenly imposing tariffs and building walls.
Or to put it less kindly, while Western CEOs focused on virtue-signaling, Chinese companies forged ahead, producing better products for less money— which is what capitalism should be about. Today, we are seeing the results.
The cultural and political prejudice explanation
A second possible reason the West failed to spot how it was being leapfrogged by Chinese industry could simply be good old-fashioned ingrained cultural prejudice. It may be unkind to highlight it, but history has shown that Western leaders repeatedly underestimate their Asian competitors.
- Russian Tsar Nicholas II infamously thought his army and navy would quickly defeat the Japanese, only for his army to suffer successive defeats and for his navy to be destroyed at Tsushima in 1905.
- Winston Churchill and the British military’s chiefs of staff never thought the Japanese army capable of advancing so swiftly down the Malay peninsula and positioned Singapore’s big guns facing the wrong way.
- Douglas MacArthur and the US general staff underestimated their opponents’ resolve in the Korean war.
- The French establishment did the same in Indochina.
- Lyndon Baines Johnson and Robert McNamara did the same in Vietnam.
- US automakers initially laughed off Japanese competitors.
The “West” underestimating the “East” is a fairly strong constant of history (for more on this, I cannot recommend highly enough the 1963 book East And West by Cyril Northcote Parkinson). This time around, the underestimation may have been compounded by China’s official name—the People’s Republic of China—and the country’s political structure as a communist one-party state. To any self-respecting Western capitalist, the word “communist” implies inefficiencies, poor products, and technological backwardness.
This belief was amply demonstrated by the fall of the Berlin Wall and the collapse of the Soviet Union. By now, the PRC has survived longer than the USSR’s 74 years. Nevertheless, most Westerners still believe that at some point in the not-so-distant future, the Chinese Communist Party will lose its grip on power, just like the Communist Party of the Soviet Union. How could it be otherwise? It’s all in the name. Communism is bound to fail.
This assumes, of course, that China really is communist; a notion that could be debated. It also ignores the old adage that “the tragedy of Asia is that Japan is a profoundly socialist country on which capitalism was imposed, while China is a profoundly capitalist country on which socialism was imposed. But each will naturally drift back to its natural state.”
Recent anchoring and the Japan explanation
Another explanation for the Western blind spot on China’s industrial progress might well be the last three “lost decades” of Japanese growth. This shows up in investor’s responses to the China’s stimulus. Conversations about China’s growth predicament typically start with the assumption that without massive fiscal stimulus, China will be unable to get out of its current economic rut. This is because China resembles Japan 20 or 30 years ago, with (i) terrible demographics and (ii) widespread large losses across the real estate sector.
However, this is probably where the similarities end. Unlike Japan in the 1990s, China has not seen its banking system go bust and lose its ability to fund new projects. On the contrary, the surge in loans to industry over the past few years lies at the heart of China’s booming industrial productivity.
This is another key difference between China today and Japan in the 1990s. China today is not only more efficient and more productive than a decade ago, it is probably more efficient and more productive than most other major industrial economies. And it boasts a very attractive cost structure. Until a few years ago, you would need to check your bank balance before going out for dinner in Tokyo. Today, you can stay in the Four Seasons in Beijing or Shanghai for less than US$250 a night. Perhaps the best illustration of how Japan’s past is a very poor guide to China’s present is the difference in their trade balances; a reflection of how different their competitiveness has been.
This is not to understate the magnitude of the Chinese property bust. The rollover in real estate has been a massive drag on growth and on animal spirits over the past five years. But on this front, there is another key difference between China and Japan: in China, the contraction of real estate was the policy. It was not the unfortunate consequence of policies gone-wrong. Reallocating capital away from real estate and towards industry was a stated goal of the government. This is clear from the chart on bank lending.
The pain of the property bust is also clear in the consumer confidence data. As discussed in past reports, the rollover in real estate has hit millennials living in first and second-tier cities disproportionately hard (see Stimulus And Confidence In China or Chinese Stocks Are For Living In). This hit to confidence might help partially explain the Western blind spot on China’s recent industrial progress.
The ‘it depends who you talk to’ explanation
The table below illustrates how two groups in China feel particularly unhappy.
- Older folks living in the countryside—the “left behind” in China’s mad rush towards modernity.
- Millennials living in first and second tier cities—the “bag-holders” in China’s real estate consolidation.
Importantly, millennials in first tier cities also happen to be the group that most Westerners who have contacts in China typically talk to. This is the group that speaks English (older folks were seldom taught English at school) and that grew up using social media. It is the group that was spared the hardships of the cultural revolution, and did not experience the trauma of 1989, and which therefore tends to be more vocal.
This group has had little positive to report over the past five years. Their time has been tough. First, their balance sheets were hammered by falling real estate prices. Second their income prospects have been capped by the rapidly rising numbers of Gen-Z graduates churned out by China’s universities. In short, being a millennial in a first tier city has not been a fun experience in recent years.
Meanwhile, people living in third and fourth tier cities talk about the better-paying jobs in the growing factories, the improved municipal and regional infrastructure and the high-speed trains that link their towns to China’s mega-cities. To put it more succinctly, there have been two main stories in China over the past five years. The first was a real estate bust, which was felt disproportionately in the rich cities of China’s coast. The second was an impressive industrial boom, which had a greater impact on the cities of the interior with cheaper labor which were suddenly linked to the coast by new highways, railways and airports.
Over the past five years, consumers of Western media have heard a lot about the first trend; very little about the second.
The ‘maybe the media covered the wrong trend’ explanation
Over the past few years, I have argued at length that the relentlessly negative coverage of China by the Western media was doing its readers a disservice. This is not to say that China does not have serious problems to confront and major challenges to overcome. But by disproportionately focusing on these, Western media helped their readers to develop a massive blind spot when it came to China’s global economic and geopolitical impact.
Instead of collapsing into economic irrelevance, currency devaluation and a “shadow banking” meltdown (remember that one?), China has continued to make progress along the path it set for itself over a decade ago: tying ever more emerging markets into China’s economic orbit, settling more of its trade in its own domestic currency, bypassing Swift, fostering energy independence, and moving up the export value chain.
All these trends were both predictable and predicted. So how did the Western media manage almost entirely to ignore them? Why were there so few stories about how China now installs almost twice the number of industrial robots as the rest of the world combined? Or on China’s new status as the global leader in the nuclear industry? Or on how China graduates more engineers each year than the entire OECD?
The simplest explanation is that the media is in the “bad news” game. The old adage “if it bleeds, it leads” still holds good in most editorial conferences. So, in a click-obsessed world, stories about ghost cities and impending economic doom are bound to get more traction than features about educational progress, revolutionary drones or factory automation.
A second possible explanation is linked to our own equity-market-obsessed culture. It is hard to go anywhere in the US—airport lounge, hotel lobby, sports bar—without a screen in the background playing either CNBC or Bloomberg TV with the day’s stock quotes filing by. In Europe, stock prices aren’t quite so “in your face,” although you can still feel their presence. And in an equity-market-obsessed culture, the performance of the stock market index is quickly equated with the performance of the economy at large.
Of course, in most emerging markets, the relationship between economic progress and equity prices is tenuous at best. China is a great example. China’s economic progress over the past five, 10 and 20 years is undeniable, with collapsing infant mortality, increasing life expectancy, soaring educational attainment, the build-out of new infrastructure and enormous productivity gains across a broad swath of industries. But broad equity market returns as measured by key indexes have been pedestrian at best.
For an equity-obsessed culture, it is tempting to look at China’s disappointing stocks market performance and conclude that if stocks are not doing well, then something must be wrong with the underlying economy. But just because it’s tempting doesn’t mean it is right.
The tin-foil hat explanation: the user is the product
It is one of my deeply held beliefs that media organizations continue to charge viewers and readers for access, whether through streaming service subscription fees or just the few dollars needed to buy a newspaper or magazine, in order to give the impression to the end user that he or she is still the client. However, the true clients are the health care industry (one of the largest advertisers in the US), the luxury goods industry (another giant advertiser), the automobile industry (same again) and—perhaps most worrying—governments everywhere.
In some countries, such as France, governments have always doled out generous subsidies to the press. In other countries less so—at least in the past. But in many countries, Covid changed the relationship between governments and media. Governments took out full-page advertisements to remind people to wash their hands, keep their distance from each other, and to participate in an enormous health experiment. And, call it a miracle, but for their part the media almost entirely failed to question the unprecedented way governments trampled all over age-old civil rights and personal liberties.
Unfortunately, history shows that once latched on, it is difficult for anyone to ween themself off the government’s generous breast. This is where the happy—for the media—news of HR 1157 comes in. On September 9, the US House of Representatives approved a bill entitled “Countering the PRC Malign Influence Fund Authorization Act” by 351 votes to 36.
If passed by the Senate, this bill will authorize the US government to spend US$325mn a year every year for the next five years to “support... independent media to raise awareness of and increase transparency regarding the negative impact of activities related to the Belt and Road Initiative, associated initiatives, other economic initiatives with strategic or political purposes, and coercive economic practices.”
So yes, at a time of record debt and swelling budget deficits, the US government proposes to spend US$325mn a year paying “independent” media (the irony!) to push stories about the negative impact that China may be having around the world.
As Charlie Munger liked to say “show me the incentives, and I will tell you the outcome.”
If the US government is openly declaring that it will pay for negative stories on China in “independent” media, and allocating millions of US dollars to this purpose, should we be surprised if negative stories about China are precisely what the media delivers?
So, now more than ever before, when assessing stories in the media it is helpful to ask the question: just who here is the client, and who is the product?
Three Chinas
Putting all this together, there seem to be at least three separate visions of China.
The first is the China you read about in much of the Western media: a place of despond and despair. It is permanently on the cusp of social disorder and revolution, or it would be, were it not an Orwellian nightmare of state surveillance, supervision and repression that strangles creativity and stifles progress. This is the place that Westerners who have never visited China typically imagine, because it is the place portrayed by the media.
And not just by the media. This is also the China portrayed by large parts of the financial industry. Every 10 days or so, I get forwarded another report forecasting the imminent collapse of the Chinese economy. More often than not these are written by Western portfolio managers who typically don’t speak Chinese, know very few people who live in China, and in some cases have never even visited what is very clearly the most productive economy in the world today. This has happened so often, I have made a meme about it.
This is the vision of China that allowed CEOs of Western industrial companies to spend their time worrying about DEI initiatives while Chinese companies were racing ahead of them.
The second is the vision of China you get from talking to Chinese millennials in tier-one cities. This version of China recalls the “lost decades” of Japanese deflationary depression.
Clearly, for investors there are important differences between China today and Japan of the 1990s and 2000s. First, in 1990, Japan was 45% of the MSCI World index even though Japan accounted for only around 17% of global GDP. Today, Chinese equities make up less than 3% of the MSCI World, even as China is around 18% of world GDP. So, it seems unlikely that foreign investors will spend the coming years running down their exposure to China; few have much exposure to China in their portfolios to begin with.
Second, China’s dominance in a number of important industrial segments is growing by leaps and bounds. This is a reflection of the rapidly changing geopolitical landscape. In 2018, Donald Trump’s decision to ban the sale of high-end semiconductors to China acted as a galvanic shock on the Chinese leadership. If semiconductors could be banned today, tomorrow it might be chemical products or special steels. Protecting China’s supply chains from possible Western sanctions became a priority to which almost everything else (aside from the currency and the bond markets) was a distant second.
This brings me to the third vision of China: that it is only just beginning to leapfrog the West in a whole range of industries. This vision is starting to show up itself in the perception of Western brands in China, and their sales. For example, Apple’s iPhones no longer figure in the five best-selling smartphone models in China. And Audi’s new electric cars made and sold in China will no longer carry the company’s iconic four-circle logo; the branding is now perceived to be more of a hindrance than a benefit.
To put it another way, following years of investment in transport infrastructure, education, industrial robots, the electricity grid and other areas, the Chinese economy today is a coiled spring. So far, the productivity gains engendered by these investments have manifested themselves in record trade surpluses and capital flight—into Sydney and Vancouver real estate, and Singapore and Hong Kong private banking.
This has mostly been because money earners’ confidence in their government has been low. From bursting the real estate bubble, through cracking down on big tech and private education, to the long Covid lockdowns, in recent years the Chinese government has done little to foster trust among China’s wealthy. It’s small surprise, then, that many rich Chinese have lost faith in their government’s ability to deliver a stable and predictable business environment.
This brings me to the recent stimulus announcements and the all-important question whether the measures rolled out will prove sufficient to revitalize domestic confidence in a meaningful way. Will it even be possible to lift confidence as long as the Damocles’ sword of a wider trade conflict with the US and yet more sanctions looms over the head of Chinese businesses?
From this perspective, perhaps the most bullish development for China would be for the new US administration (regardless who sits behind the Resolute desk) to come in and look to repair the damage done to relations by the 2018 semiconductor sanctions and the 2021 Anchorage meeting (see Punitive Tariffs Or Towards A New Plaza Accord?). At the risk of mixing metaphors, this could be the match that lights the fuse that ignites a real fireworks show.
In the meantime, the dynamics in China can perhaps best be summarized by the following decision tree.
Investment conclusions
The narrative around China is shifting—regardless of the US$325mn that the US Congress is looking to spend each year to fund negative stories about China in the “independent” media.
Just a few weeks ago, China was still said to be uninvestible. This view had led many people, including prominent Western CEOs, to conclude that China no longer mattered. This was a logical leap encouraged by Western media organizations, whose coverage of China has been relentlessly negative. It was a leap that turned out to be a massive mistake.
When it comes to China’s relevance to investors, there are four ways of looking at things.
- China can be uninvestible and unimportant. This is the pool that most investors have been swimming in for the last few years. But this is akin to saying that China is like Africa. It simply doesn’t pass the smell test. Instead of sliding into irrelevance, China’s impact on the global economy only continues to grow.
- China can be uninvestible but important. This is essentially what Jim Farley, fresh back from his China trip, told The Wall Street Journal.
- China can be investible but unimportant. This is the space Japan inhabited for a couple of decades, and into which Europe seems to be gently sliding. However, the idea that China today is where Japan has been for the last three decades is grossly misplaced on many fronts, including the competitiveness of its economy, its overall cost structure, and its weight in global indexes.
- China can be investible and important. This is what David Tepper of Appaloosa Management argued on CNBC following the announcement of China’s stimulus (see Changing Narratives Around The World). For now, this is still a minority view, at least among Western investors. Not that Western investors matter all that much. What truly matters is whether Chinese investors themselves start rallying to this view. If they do, the unfolding bull markets in Chinese equities and the renminbi could really have legs.