How investable is China? (Revisited)

About a year ago, when China emerged out of its zero-COVID lockdowns, I rhetorically asked, “How investable is China?”. I concluded, “Long-term investors in China are likely to face subpar returns coupled with high volatility”.

Now that China’s troubles have returned, it’s time to revisit the China investability question. The accompanying chart shows that China’s debt has exploded over the past decades, driven by a regime of growth-at-any-cost malinvestment. Similar credit cycles in other economies have resolved in financial crises. Will China be any different and how should investors react?
 

 

 

China’s malaise explained

To the outside casual observer, the most immediate and visible part of China’s problem is cratering stock prices. But her difficulties didn’t just appear overnight. It was the product of decades of misallocation of capital in two sectors. The first was infrastructure, which was initially productive but eventually became overbuilt. The second was the export sector, whose competitiveness was subsidized by the household sector of the economy.
 

 

The credit-driven infrastructure building initiative set off a stampede of residential construction and a property bubble. Eventually, infrastructure became overbuilt and the property bubble collapsed. China Evergrande, which was once the world’s largest property developer, is now bankrupt and undergoing liquidation. A more serious threat to social stability appeared when over-levered developers were unable to complete and deliver apartments that were bought and paid for by individuals.
 

 

The collapse in property can be resolved with a deflationary spiral, not only for consumer prices, but in producer inputs as well. Bloomberg reported that pork prices are falling ahead of the Lunar New Year. As Chinese consumption of pork tends to spike during such festivals, weakness in pork demand and prices is an informal signal of a consumer slump.
 

 

The one bright spot in the economy is exports. China’s manufacturing trade surplus has been strengthening since the onset of COVID-19, but the strength in manufacturing is supported by the export of deflationary pressures to China’s trading partners.
 

 

An SCMP article reported that wage growth has been weak. “Average monthly salaries in 38 major Chinese cities dropped by 1.3 per cent in the fourth quarter of 2023”. With the combination of weak wage growth, which reduced household income, and the weakness in the property sector, which hit household balance sheets, is it any wonder why consumer spending is so weak?

China watcher Michael Pettis has argued that the weakness in the household sector and the economy’s inability to rebalance to consumer-driven growth is attributable to the low share of the value-added in manufacturing exports. In effect, the household sector is subsidizing the manufacturing export sector, which is generating a substantial trade surplus to support the economy. Pettis concluded, “In every case an economy that must raise the wage share of GDP to rebalance domestic demand [it] cannot do so without a short-term manufacturing contraction, made worse by the fact that in the manufacturing share of the economy is disproportionately high.”
 

 

The policy response

In response to the latest stock market rout, Beijing has implemented a series of measures aimed at stabilizing stock prices, including banning short selling, the deployment of SOE’s offshore USD reserves to buy stocks, and the termination of the securities regulator.

From an economic viewpoint, China’s industrial policy for boosting growth seems to be to doubling down on export-led imbalances by investing in targeted industries in manufacturing.

However, industrial policy has its limits. A WSJ article reported that China is targeting green industries, such as EVs, batteries and renewable energy equipment. A (gated) Drum Tower podcast from the Economist discussed how China is targeting start-ups in specific industries to become the new unicorns and the fickleness of Beijing’s industrial policy. The unicorns of 2017 were in e-commerce, consumer-oriented internet, fintech and education tech – all of which are now out of favour. Today, money is pouring into AI, semiconductors, advanced robotics, health tech and green technology, but with a difference from 2017. Today’s investments tend to be more SOE directed, and the investment decision focuses on industrial policy objectives first and the technology second.

The flood of industrial policy-directed investment will undoubtedly lead to malinvestment, though there will be some successes and breakthroughs. Yanmei Xie of Gavkal, writing in the Financial Times, documented the pros and cons of this approach:

China’s well-rehearsed industrial policy can be staggeringly wasteful but still produce stunning results. This same pattern of fattening up companies with subsidies and protection and then cutting support and introducing market discipline to weed out the weak has already produced domestic and export juggernauts in steel, shipbuilding and solar panels.

It is precisely this kind of industrial policy that dooms China to an ever-slowing economic growth path. The malinvestment in targeted industries represents a form of subsidy for those sectors and a transfer of resources from the household and services sectors to manufacturing. Forget any hope of rebalancing growth to more household spending.
 

 

The market’s response

By now, it should be increasingly evident that the Chinese economy is becoming more state directed and subject to the uncertainty of regulatory policy. I believe Chinese stocks are at best trading vehicles and not investment vehicles. Nevertheless, investors can participate in Chinese growth by investing in the stock markets of China’s Asian trading partners, which are all in flat or falling relative downtrends.
 

 

Investors can also find some clues to the state of China’s cycle by analyzing sector relative returns. China has been a voracious consumer of global commodities and commodity prices can give some clues to her economic strength. Commodity prices have been flat to down over the past few months. More importantly, the cyclically sensitive copper/gold and base metals/gold ratios have been trading sideways. These chart patterns could be constructively interpreted as stabilization and not the sign of a growth deceleration.
 

 

However, the relative performance of Chinese material stocks to global materials is more concerning. Chinese materials have been extremely weak against their global counterparts (top panel) and they have also been weak against the Chinese market. This is a signal of more cyclical weakness in infrastructure spending.
 

 

Even though the macro backdrop for China is weak and investors should wait for signs of a turn before committing funds to Asian equities, I offer the following two tactical trading signals for the Chinese stock market.

Jason Goepfert suggested that traders buy Chinese stocks when Beijing replaces the main regulator, which is a sign of market panic. He found that such a “strategy” gained an average of 10% over two months with a single loss.
 

 

Jeffrey Hirsch offered the seasonal observation that Chinese and Hong Kong stocks perform well around the time of the Lunar New Year.
 

 

In conclusion, I reiterate my view that long-term investors in China are likely to face subpar returns coupled with high volatility, with the added view that the Chinese equity market can be a useful trading vehicle. China hasn’t addressed even trying to reverse the imbalances from long-standing past economic policies. However, investors can gain exposure to Chinese growth through the equity markets of China’s major Asian trading partners. Real-time market signals indicate further weakness in China, which investors should avoid. In the short run, the Chinese stock market looks washed out and traders may be able to profit from a tactical rebound over the next month or two.