Goldilocks And Three China Bears

Never before has heat caused so much suffering. It’s everywhere; hot fuel and food pricing, record-breaking heatwaves, oven-ready Brexit, raging wildfires and war. Grim stuff but it could be worse. Liz Truss could be UK Prime Minister….oh……….ahhh they wouldn’t, would they? The Tory party is possibly beyond saving but it’s a resilient world out there with more serious challenges than “woke wars’, and a history of defying our worst fears.

Top of most consumer and financial markets’ lists of concerns is inflation. Furthermore, the knock-on threat of recession is in every portfolio manager, business or consumer survey but let’s cool the doom jets a bit. If we think about interest rates and inflation as dampening “taxes” on economic activity, we need things to cool down but not too much. A “goldilocks” scenario is what Wall Street-types love – not too hot, not too cold – and we’re wondering could China take some heat off the table? Let’s look at three developments in China which are negative/bearish but could ultimately help the wider world…

China Real Estate: The Chinese property market is valued at circa $62 trillion. Yep, that’s about three times the GDP of the USA. However, activity is more important than valuation and the construction/property sector accounts for 25% of annual Chinese GDP. Well, it did. The debt problems of developers like Evergrande have been known for a few years but there’s now a trifecta of pain hitting the sector and causing stress in the banking system:

  1. House prices in China have fallen for 10 consecutive months
  2. Mortgages held by buyers who purchased homes ahead of construction are currently boycotting payments on more than 300 yet-to-be-completed projects(per Bloomberg).
  3. Suppliers to the property sector, spooked by the mortgage boycotts, are in-turn now refusing to pay back loans to their banks until troubled developers pay them. No surprise then that the Chinese bank sector in just the past week has fallen by 8%.

China Economy: China has been on a construction spree for decades. Since 2019 alone a cool $3 trillion of housing stock has been built. Imagine, this is the equivalent of building Great Britain’s entire economy(GDP) in just a couple of years. That huge level of activity has turbo-charged economic expansion and a Chinese Communist Party(CCP) commitment to a minimum 6% GDP growth each year. Until now. Goldman Sachs thinks Chinese GDP growth could be half the norm at just over 3%. That will unnerve the Beijing authorities already dealing with a novel form of civil unrest through mortgage boycotts. Note also, 70% of household wealth is tied up in property so the CCP know the acute political risks of a property crash.

China Demand: A reduction in Chinese economic activity led by construction is going to change the global “inflation” narrative significantly. Iron ore prices are already down 50% from their highs last year, and copper has entered its own bear market with a 30% decline. This should not surprise given recent reports(from Gavekal Research) that the pipeline of floor space under construction in China is down 40% year-on-year. Of course, reduced activity in the Chinese economy is affecting trade figures too. It is striking to see in an inflationary world that Chinese imports were effectively flat compared to a year ago in May. Exports, on the other hand, accelerated to an 18% growth rate. Clearly, domestic demand in China is cooling due to its domestic property stresses.

These three Chinese bear stories above might appear as yet more macroeconomic woes to add to the risk bonfire but there is potential upside to this development. Size matters. In purchasing power terms China is probably the largest economy in the world. That means EVERY central banker has China on his/her risk watch list. The $20 billion of Chinese bond defaults year-to- date is already double last year’s toll and there will be many more. We already know from the 2008 credit crisis and Covid-19 that central banks will act super-fast if financial contagion is a risk. And, let’s just say an estimated $10 trillion of Chinese property debt will have systemic significance in the global financial ecosystem. So, here’s a few things which could happen if this China story develops through the summer….

  • Interest Rates: Instead of global interest rates rising, central banks, like the Fed and ECB, might have to reverse course (ECB hike of 50bps this week is its first in 11 years) and cut rates. Do not underestimate the positive impact of the cost of money falling on business investment and financial activity.
  • Inflation: If the world’s largest purchaser of goods, China, reduces activity this could have a double-whammy impact. Not only would prices of goods and services stop rising but it is quite likely the Chinese will pressure Russia to end its Ukrainian war. China will need its European customers to trade its way out of a slump and Europe won’t be able to do much buying if it’s dealing with crippling energy costs caused by war and Russia.
  • Incendiary Diplomacy : US House Speaker, Nancy Pelosi, is due to visit Taiwan. Beijing is extremely unhappy at this provocation and all geopolitical risk lists suggest an invasion of Taiwan by China in the next few years is very possible. In fact, this month both heads of the FBI and MI5 in an unprecedented joint appearance in London stated that China was the “biggest long-term threat to our economic and national security”. However, in a scenario of a weaker China battling a property crash and its debt-swamped aftermath it is highly unlikely China will willingly inflict more economic pain on its restless citizens.

The above combination of reliefs via falling interest rates, lower inflation and reduced geopolitical risk, including a possible end of hostilities in Ukraine, could be an unexpected global windfall. Of course, those that have profited from a China growing at gangbusters pace for years will be impacted. So, we should think about the following:

Luxury Leaders: China and its newly minted millionaires have had a voracious appetite for luxury goods. We’re not just thinking Gucci or Louis Vuitton will be impacted by a more cautious Chinese consumer. High-end tech hardware leaders like Tesla and Apple are going to feel a cooling effect too. Indeed, Henley & Partners consultancy are forecasting that 10,000 citizens will leave mainland China this year and take $65 billion of spending money with them.

Germany: In a way, Germany was the canary in the China coal mine. Technically, Germany was already in recession before the Russian invasion of Ukraine. Think back to the earlier data on flatlining China imports and then know that Germany is hugely dependent on its $100 billion of annual exports to the Middle Kingdom. Yes, idiotic Russian gas dependency is killing investor confidence in Germany Inc but China is impacting corporate confidence too. Stunningly, the German stock market (DAX) has no company in the Global Top 100 and the combined market capitalisation of all its companies is approximately equal to that of Apple.

FTSE 100: In Liz we Truss “to hit the ground”. Good grief, if choosing an inert gas as Prime Minister (think her nickname is ‘Radon’) would be bad enough then think again. The UK stock market leaders in the FTSE 100 index are massive plays on China – see HSBC and all the mining giants like BHP and Rio Tinto. A faltering FTSE to add to a brewing Great British Peso crisis will add to Boris Johnson’s legacy as Global Britain’s second worst PM in history and the hubris of his exit interview in Westminster as “mission largely accomplished”

As always, there will be winners and losers. Apart from the weather, many things are already cooling and mainstream financial media(and central bankers?) are possibly guilty of looking in the rear-view mirror. Watch China carefully and hold the counter-intuitive thought that a distracted Beijing might actually be a global good thing. Stay cool.

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