Having recently been on the road meeting with clients, I thought it might be interesting to take a look at the questions I’m most frequently asked.
Q: Given China’s excess manufacturing capacity in automobiles, solar panels, telecom switches and home appliances, should we expect the global economy to face another big deflationary hit in the coming years?
Answer: The first way to look at this problem is that China has been the world’s major deflationary force for the past three decades. The question arises whether the deflationary impact is increasing from here. The second view is that the Western world’s relationship with China has changed dramatically in recent years, making it less open to Chinese imports or Chinese control of supply chains.
Typically, more protectionism means higher rather than lower prices. Third, China’s move up the value chain may prove less deflationary than many investors expect, as China’s recent trade growth has been largely driven by emerging economies. For example, over the past six years, China’s exports to the US have remained broadly flat, while exports to Southeast Asia have nearly doubled, as shown in the chart below.
This observation brings me back to the chart below showing growing auto exports to China, which I may have overestimated last year. China came out of nowhere to become the world’s largest car exporter, producing and selling cars cheaper than anyone else. But these cars are not sold on the streets of New York, London or Toronto, but rather on the streets of Jakarta, Santiago and Jeddah.
Will China devalue the yuan?
The arguments for devaluation are that the yen is now insanely undervalued, and that the clear goal of Chinese policy in recent years has been to move from a real estate-led growth model to an industrial-led one. Meanwhile, industry-led growth is quite a challenge when one of the world’s largest and more efficient industrial powers maintains an exchange rate that is undervalued by almost 40% at purchasing power parity.
Against this lies China’s efforts over the past decade to reduce its dependence on the dollar, which has forced China to offer investors higher yields on yuan bonds than those offered by Treasuries.
The problem for China today is that while five years ago its bond yields were more than double the levels that prevailed on Treasuries, today the opposite is true. This yield differential raises the question of how Chinese government bonds can continue to outperform Treasuries. There seem to be three possible answers to this question:
Option 1: Given the difference in yields, the CGB’s period of superiority is coming to an end and China’s dedollarization efforts will fail. Too bad for Xi Jinping’s grand geopolitical plans and his hopes of “making China great again.” This is the scenario most investors I’ve spoken with in recent weeks see.
Option 2: As long as US bond yields continue to rise, China can largely ignore the value of the yuan. If the Chinese currency remains broadly stable, this should be enough to guarantee the central currencies’ continued outperformance relative to Treasuries. This is the scenario that is currently unfolding.
Option 3: Given the low yield, it will be difficult for CGB to generate much capital return from here. Thus, if Chinese policymakers want to further internationalize the yuan and persuade foreign central banks to hold more reserves in the currency, they will have to force an appreciation of the exchange rate. It shouldn’t be too difficult.
Is the artificial intelligence craze over?
It was interesting to see Meta announce plans to spend tens of billions of dollars to build a more advanced artificial intelligence platform, but the share price fell on the news. Meanwhile, Alphabet announced share repurchases and dividends, sending shares to a new all-time high. At the very least, it “feels” like the tech industry is experiencing a shift in the zeitgeist.
Another interesting development is that stock market performance has expanded in recent months, with small caps, Chinese stocks and financials no longer dogs with fleas. However, in the fast-growing technological world, productivity has become more concentrated. The Magnificent Seven stocks became a Five (as Apple and Tesla dropped out) and then a Three, which eventually centered around Nvidia, which itself appears to be struggling to reach new highs. So yes, there is a sense that the AI craze has stalled.
Are we ready for more “China is not investable” rhetoric?
Overall, the news about China over the past couple of weeks has been as bleak as I remember. The first, of course, was the TikTok ban. Then news leaked to the American media that the Biden administration was considering financial sanctions against China’s major banks, including the Bank of China. Then Janet Yellen’s trip, in which the Treasury Secretary criticized China for building “overcapacity”, and then Antony Blinken’s trip, in which the US Secretary of State complained about the same thing, as well as China’s sales of key industrial goods to Russia (Blinken’s trip did not even cover red carpet upon arrival in Shanghai).
This was followed by the arrest of four alleged Chinese spies in Germany and two more in the UK, an early morning raid on Nuctech premises in Warsaw and Rotterdam and a European Union notice to China that it plans to add more Chinese firms to its blacklist for violating sanctions. against Russia.
So yes, if you look closely at the news, it seems that the gap between China and the Western world continues to grow. In fact, in the last few weeks there has been a feeling that not only is China on one side and the US on the other, but suddenly the EU is also starting to aggressively turn away from China.
Perhaps this latest development is not surprising. After all, as China increasingly moves from being a target market for big EU companies to being a high-end competitor (be it cars, machine tools, chemicals or specialty steel), Europe is probably right to feel more skittish.
But here’s where it gets interesting: Back in January, when China and Hong Kong stocks were falling, the news we’ve seen lately would have likely sent Chinese stocks down -10% to -20%. However, since the Financial Times published much discussed column Stephen Roach, it seems that no amount of bad geopolitical news can derail the rise in Hong Kong and Chinese stocks.
The market even ignores macroeconomic events such as a strong dollar, rising yields on long-term Treasury bonds and a falling yen. In the past, such factors would have been enough to push ailing Chinese stock markets further. But nothing more.
Now it seems that the Chinese market, which has always fallen, even in the face of good news, is set to rise, even in the face of bad news. The shift likely reflects the fact that most foreign investors who were contemplating selling their holdings in China due to geopolitical concerns or fears that Xi Jinping would take over all private sector assets have done so. We may hear another chorus of “China is not investable” in the Western media, but market behavior suggests that may not matter this time.
Is gold, like other precious metals, currently in a structural bull market? And if so, how might this end?
I think so. I have always argued that gold is a low beta way to play emerging markets, with an additional geopolitical cushion in case the world falls apart. Today, most people look at the rise of gold as the fulfillment of this requirement. After all, we live in a world with hot wars on the European continent and the Middle East, blocked sea lanes and great power rivalry.
However, gold really started to rise after the Bank of Japan signaled it would remain on the yield curve and after the People’s Bank of China threatened to devalue the yuan if the yen continued to fall.
Consequently, a threat to the gold bull market could come from Japanese or Chinese private savers stopping buying gold – or even starting to sell it. This is unlikely to happen until we see monetary policy tightening in either country. At the same time, gold’s upside potential could be significant if Westerners start buying precious metals in earnest instead of Bitcoin and tech stocks.
So far there is little sign of this, as evidenced by leading gold exchange-traded funds that have recently seen net outflows. This would seem to mean that there is still room to run.
Conclusion
These are just some of the most common questions I received during my last trip. Unsurprisingly, there were also deep concerns about geopolitical events, the sell-off in Treasuries and whether rising yields would start to disrupt the landscape (in addition to the yen and overvalued tech stocks), data center energy needs, the exploding double-digit deficit in the US, and US commercial real estate. . Questions like these probably deserve their own article.
Louis Gave – Founding Partner and CEO Gavekal. This article was originally published by Gavekal and republished with permission.
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