The Outlook For China & A Potential Contrarian Play to Profit

The biggest risk for China is it goes through a credit crisis before it gets rich. China has advanced assemblies, but the technology is not homegrown and most of the companies do not seek to do business abroad.

GDP per capita has risen from around $310 in 1989 to $12,720 at the end of 2022. That averages out at a compound annual growth rate of 16.74% for 24 years. That kind of growth is nothing short of stunning. If anyone has ever wondered why regular citizens have been prepared to endure communist rule, all you have to do is point out how living standards have improved over the last 30 years.

China is doing many of the same things Japan did as it matured.

China’s investments in securing supplies of basic resources are probably larger than Japan’s efforts in the 70s and 80s. China has also adeptly bought positions at key moments, like during the global financial crisis when bargain prices were available.

The Belt & Road Initiative was also key to ensuring access to resources and export routes for Chinese products. It also serves the dual purpose of tying countries to China’s sphere of influence through onerous debt terms. That is not something Japan was accused of and has ensured its commodity trading companies are still trusted all over the world.

Chinese companies are investing heavily in technology. China now has the fifth most robot-dense economy in the world ­– measured as robots per 10,000 workers. China also championed the evolution of a domestic tech sector by copycatting successful companies from the US. China is now investing heavily in chip manufacturing to break the US stranglehold on the global supply chain.

Over-investment doesn’t pay

Here is where the story for China gets messy. It realised, more than a decade ago, that the export and infrastructure/property economic model was no longer providing the same value as in its early stages.

When Xi Jinping came to power, China tried to improve growth by increasing debt and leverage within the system. Total debt in the non-financial sector went from $17.6 trillion in 2013 to $52.1 trillion in the last decade.

If that increase in debt had been invested in productive assets to drive innovation it may have allowed China to continue its leap into prosperity. Instead, most of the capital went back into property, endless train lines to nowhere, other infrastructure and paying for years of Covid lockdowns.

The price of property in China’s tier-1 cities is now over 30 times the domestic income level. That implies the average person would need to save their entire annual wage for 30 years to buy a property.

That might even be reasonable if your income was rising sharply every year. However, if incomes stagnate or fall, the sustainability of high property prices is very difficult. The potential for a property crash or at least a significant bear market is nontrivial.

The backward trend of personal freedoms in China and the increasingly overbearing state infrastructure are impediments to continued growth. Free enterprise and creativity require people to get together and test their ideas through argument and experimentation. The best ideas are then tested in the market. When the government takes over and tells you what the national priority is, it is a matter of luck whether the government is correct.

Declining birth rates can be considered a symptom of personal rebellion at the high cost of living and the expense of raising a child. Several couples I spoke to the last time I visited Beijing said they could not imagine bringing a child into the world. They wilfully ignore the government’s exhortations to have children even if they are compliant in every other area of Chinese life.

After the boom comes the…

The challenge at present is the government is no longer willing to sustain the credit growth that fuelled the debt build-up. That has resulted in several property developers going bust over the last couple of years and the trend is still underway.

China Evergrande’s bankruptcy was a major international news story in 2021. Since then, conditions have gone from bad to worse in the property sector. At present, default probability in China’s corporate bond market is rising.

As Nick Hubble alludes to above, I too am reminded of the US housing market ahead of the global financial crisis. Housing prices peaked in 2006, two Bear Stearns hedge funds went bust in 2007, and all hell broke loose when Lehman Brothers failed in 2008.

China is in a tough position. The debt issue needs to be addressed at some stage. If it does it now, it will cause a great deal of stress. If China waits and instead provides a fresh round of stimulus, the problem will be worse in future, but the status quo will be sustained for now.

Let’s put some numbers on the problem

The decline of property developers is only a piece of the puzzle. Local government financing vehicles (LGFV) are a $9 trillion problem on top of that, $486 billion in LGFV bonds need to be refinanced in 2024 alone.

China does not have a property tax system. That means local governments depend on alternative methods to raise funds. Land sales and business ventures are the most popular. During the pandemic, the decline of demand coupled with the cost of lockdowns forced provincial governments to take on significant additional debt through the LGFV system.

It’s important to highlight that none of these off-balance-sheet structures have yet defaulted on their debt. There have been some close calls, with payments arriving late, but no defaults. The Chinese government announced on 21 August it is ramping up support for the sector.

There is a significant risk that regional governments will have to significantly cut back on spending to become eligible for government funds. That could lead to mass layoffs among government employees and a cessation of infrastructure and property investment by local governments.

That points to the risk of deflation in China. If it is on the cusp of a recession that is going to have major knock-on effects for the commodity and tourist markets.

So why doesn’t China just bailout the entire LGFV sector and kick the property bubble question down the road even further?

No pain, no gain

I believe China is willing to take the pain now rather than stepping in and bailing everyone out because of great power competition. China’s Communist Party wants to be the global hegemon. The debt issue is a major impediment to achieving that goal.

China is not the only country with a debt issue. The US in particular has deficits running at wartime levels and no party is running on a sound budget platform. The state pension scheme (social security) is expected to run out of money in 2033.

China’s logic is simple. If it is willing to go through a debt restructuring now, it will be coming out of the other end of that process when the US has to make major decisions about how to restructure its benefits system. That will put China in a strong competitive position to dominate global markets and potentially to impose the renminbi as the global reserve currency.

Taiwan is a political, spiritual, and economic prize from China’s perspective. There is no way China will tolerate independence. However, an invasion would result in instant decoupling from the Western world.

In fact, the biggest risk is the US would choose to exfiltrate the majority of engineers and their families. It would then be free to bomb Taiwan’s factories into dust. That would deprive China of the biggest prize of all, which is Taiwan’s world-leading chip manufacturing capacity. Taiwan Semiconductor is already attempting to move 500 engineers to work at its new factory in Arizona, for example.

If I am correct that China is willing to go through restructuring now to achieve that long-term goal, we should expect the economy to enter a recession, property prices to drop, commodity prices to go through a painful bear market. Commodity producers would have a difficult time.

Restructuring is hard to do

The counterargument to China embracing restructuring is Japan never succeeded in doing that. It came close a few times, but always ended up printing more money eventually. Japan’s stock market crashed, but the malaise lasted for decades.

The actions of the Chinese government over the last couple of weeks suggest it is beginning to cave to demands for fresh liquidity. The CSI 300 Index, which is the mainland benchmark index, jumped 5.5% on 28 August following announcements of fresh support over the weekend. It then gave up the whole advance because traders quickly did the math and concluded the stimulus is not enough to move the needle.

If China does decide to kick the can down the road, the future debt problem will be worse, but it would provide a significant boost to global liquidity in the near term. That could provide the fuel for an additional leg higher for global stock markets. It could further inflate the frothy valuations currently evident among the mega-caps on Wall Street.

Oversold

I believe China is at serious risk of a recession. I also believe the Chinese government will do whatever it can to placate its citizens. It is well aware Chinese dynasties tend to be toppled by peasant revolts. After all, that is how they came to power.

With assistance measures ramping up, the potential for volatility is significant. To me the greatest risk in the short term is that Chinese stocks will rally first and decline again later as the inability to reflate the bubble becomes obvious.

Chinese stocks in Hong Kong have collapsed in advance of weak economic news. When a larger stimulus is announced, Chinese stocks should bounce. The risks are that the trade tensions with the US will intensify and foreign markets will shut down for Chinese companies, the is also the potential that the assistance measures being provided remain woefully inadequate. If the central government does not intervene more forcibly, markets could take an additional leg lower.

I recommend buying the JPMorgan China Growth & Income Investment Trust. It is currently trading at a discount to its net present value of -7.5%. The price has declined over the last eight months to test the 2022 low and is beginning to steady.

If China pulls the trigger on short-term stimulus, there is clear potential for the short, sharp rebound. That’s the kind of tactical opportunity I am looking for in the portfolio.

I am not a long-term investor in China. I expect trouble in future, but I don’t expect China to invade Taiwan at least until NATOs arsenal has been fully expended in fighting Russia in Ukraine.

There is also an election in Taiwan in January 2024. I do not expect China to invade before that is concluded.

China is a trader’s market and this is a good time to buy. This will not be a long-term hold. I expect to be out of the position within 6 months.

The Contrarian Play on China: JPMorgan China Growth & Income Investment Trust
Ticker: JCGI LN