Third Quarter 2015 – Quarterly Commentary


q315 China vs US GDP

Napoleon Bonaparte correctly observed some two centuries ago that; “China is a sleeping dragon”. He continued: “Let her sleep, for when she wakes, she will shake the world”.

It seems everyone is talking about China these days, and not without reason. In fact, not without plenty of reasons. For those of us over 40 years of age who can remember, and for all of us who can read, China has indeed awoken in our world with a fire-breathing roar. It seems the French emperor was prescient in his description of the “Middle Kingdom”.

Mao Zedong (or, Mao Tse Tung) who ruled China with the same absolute grasp of power as Joseph Stalin ruled the Soviet Union, died in 1976. This historic event was followed by two years of internal battles for supreme power within the Communist Party. In 1978 Deng Xiaoping emerged victorious over the “Gang of Four” (which included Mao’s widow) and set about charting a new course for China. Realizing how desperately backwards China was relative to the modern world in almost every respect, he set about reforming the landscape with his “Four Modernization’s” programme. These were: agriculture, industry, defence & science, and technology. With these “modernizations” set in motion, China would at last join the modern world. What no one foresaw at that time, was just how quickly the Middle Kingdom would shake from its centuries-long slumber and roar into the twenty-first century.

According to the International Monetary Fund (IMF) 2014 rankings, China’s GDP ($17,617.3 trillion) is now second only to that of the European Union ($18,526.5 trillion) and ahead of that of the USA ($17,418.9 trillion). This is a long way and, if the historians among our readers will forgive the intended pun, a “long march” from the $205 bn China’s GDP was in the first year of Chairman Deng’s reforms. Impressive would be an understatement. And now that China has, as Archie Bunker (of “All in the Family” fame) would put it; ‘the second grossest national product in da woild’, it’s understandable that what goes on in the Middle Kingdom will affect people everywhere in the world. And we do mean everywhere! From Australia to the UK, from Brazil to the USA and from central Africa to Siberia, everyone feels the effects (good, bad or, indifferent) from China’s growth pattern. One key reason for this is that China has become a big trading economy and indeed, its membership in the WTO (World Trade Association) since 2001 reflects this.

So here we are in 2015, some thirty-five years after reforms began, and what’s not to like about China’s emergence on the world’s economic stage? It’s lifted (literally) hundreds of millions of people out of dire poverty and into a new, burgeoning middle class in the Middle Kingdom. It has vastly expanded world trade and trade makes the world not just more interconnected but richer.

Headlong economic growth inevitably brings with it distortions, no matter which economy grows at a heady pace. Think here of the US economy in 2007 with the burgeoning housing market propelling forward everyone’s net worth. This was fuelled by ever-cheaper money from the Federal Reserve and lax lending oversight which created an opportunity for Wall Street to “package up” these housing loans to yield-hungry investors. Nothing could go wrong, could it? It was as safe as ‘money-in-the-bank’ wasn’t it? History (now) tells us otherwise.

China has built up a most impressive “producer” economy not dis-similar to what Japan did after the Second World War. Initially, this is based on “cheap” or, low value added goods and a weak currency so as to build national wealth through exports. In fact China’s done so well at this that a) it now runs the world’s largest trade surplus, and b) has eclipsed Japan at its zenith, in 1989. Latterly, China has focused on moving up the food chain by producing more expensive, sophisticated and advanced goods both for export and domestic consumption. The term used is to “balance” its economy more between production and consumption. Part of the problem with global trade patterns is that China, as the world’s largest producer of goods for both domestic construction and consumption as well as export oriented production, sucked in vast quantities of imports of a) raw materials from the likes of Australia, Canada, Brazil, Africa and yes, Siberia and, b) big volumes of imports of goods from Germany (high-end tools and machinery, luxury automobiles) France (Louis Vuitton, Chanel and other fashions) and from the USA (technology, software et al). On the export side of the equation, I think all we need to observe is that Walmart sources 80% of all its merchandise from China and it is the largest retailer (by far) in the world. Everyone wants to sell to China…and China wants to sell to everyone else. We have become rather economically interdependent. As the US Defense Secretary Charles “Engine Charlie” Wilson put it in 1953: “What was good for the country was good for General Motors and vice versa”. It seems in 2015 that; what’s good for China, is good for the world economy.

We’re all in this together                                                          

Here’s our premise and source of concern. We believe that China has succeeded all too well in building up its producer capability. Its supply lines to feed this capability are long, deep and clearly global. We have a surfeit of goods flooding the global marketplace. China has to keep their production lines running because, simply put, with hundreds of millions of people on the move from “rural” to “urban” in China, to coin an old western phrase, “they have to create jobs for the boys” [and girls]. This has a deflationary effect on prices worldwide and when the Chinese pace of growth slows down, it causes prices for the raw materials in imports to come under serious stress. Why else would copper, zinc, and aluminium today be close to historical lows? At the end of the day, this could lead not to value creation but to value destruction and that, if it occurs, is dangerous.

What goes up…

 q315 Shanghai composite

Source: Shanghai Stock Exchange

For fairly obvious reasons, the Chinese equity market, as measured by the Shanghai Composite “B” Index has reflected the steamy growth in the economy over these past several decades and like equity markets here and worldwide, reacts to economic stimulus from governments. The index “took off” in a frenzy of speculation in 2012 culminating with a peak in 2015 from which it has now declined some 40% in the last five months. While it’s true that the Shanghai equity market may not ‘reflect’ the Chinese economy as well as the S&P 5OO index does in the US, it surely must be some gauge of (local) investor sentiment or, faith in the economy in which they reside. Further, in order to keep the pace of growth going, the Chinese authorities have resorted to some time-tested tricks namely; the accumulation of vast quantities of debt. It doesn’t seem to get much press but, the Chinese governments (at all levels) have accumulated debt to the tune of now over 280% of GDP according to McKinsey & Company, a consulting firm. This is a big number by any standard of measurement and may be unsustainable in the face of declining growth rates and the world’s largest pool of foreign exchange reserves.

q315 China social financing

In their best-selling book “This Time It Is Different”, on the financial crisis of 2008, authors Ken Rogoff and Carmen Reinhart, professors of economics at Harvard University, make this key observation: every financial crisis stems from the same simple problem: too much debt. Professor Rogoff goes on to observe that China was said to be impervious to a severe downturn. “It’s very vulnerable…there is a lot of debt”. Ominously, Henry (Hank) Paulson, the former head of Goldman Sachs and former treasury Secretary of the US says “It’s not a question of if, but when, China’s financial system will face a reckoning and have to contend with a wave of credit losses and debt restructurings”.

In the end

In the end, like any and every other country, China will do everything in its power to have its own people and the world, keep the faith that it can manage its economic and debt challenges. It has to because: “financial meltdown leads to social meltdown which leads to political meltdown” according to Professor Rogan and it’s a safe bet that the current leadership in Beijing does not want any of that to occur. However, sometimes, events do spin out of control and the concern has to be that what happened in 1929 – 1930 which brought about a world-wide depression could occur again but this time, it might start in China.

In the interim, those countries as noted above, which are major players in China’s supply line including Canada, will have to diversify their export dependency away from that Asian Tiger. In this sense of the word though, Canada is fortunate that unlike Australia or, Brazil, we are more closely tied to the one economic engine that seems to be functioning reasonably well these days, the good ‘ole US of A. That said, an economic tsunami emanating from China could cause serious economic repercussions across the globe and we, as investors, need to be cognizant of this potential risk.