By Edward Lim
Continuing from the theme of music from the last Navigator, Folly of the Crowds, one of Radiohead’s most successful commercial hits was “High and Dry”. The song talks about the brevity of fame, the boorishness it cultivates, and eventually, the fleeting accolades that turn into disdain. While the song about China is still being written, there are some parallels of what has happened to China in the last 30 years of miraculous boom but with this success, it has also created large-scale excess across multiple sectors and bred a certain provincialism, both internally and in its interactions with neighboring nations. Reflecting on the song years later, when the lead vocalist remarked in an interview that it was “not a bad song, it was a really bad song.” The developments in the economic and political spheres in China in the last five years are increasingly looking like “a really bad song”. We see striking similarities between China’s future growth potential and Japan’s “lost decades” that began in the 1990s.
Japan, a decade before 1990, was a beacon of innovation and entrepreneurship with iconic products like the Sony Walkman and supercar Honda NXS. Even the famed Rockefeller Centre in New York was owned by Mitsubishi and Columbia Pictures was owned by Sony. Japan’s GDP grew by a compounded 1.83x from 1980-1990, faster than the US 1.08x. It accounted for 16% of the global GDP and was the second-largest economy after the US. However, in the subsequent decades, it saw a marked decline in economic growth slowing from 2.4% in 1991-1995 to stalling for much of the last 15 years. It lost its global stature with it share of the global pie falling to 4% and is a distant third from the US and China in terms of the size of their economies. China is also exhibiting the same growth trends slowing since its blistering pace as the economic liberalization goes into full swing from 2000 onwards embracing the Deng Xiaoping edict “to get rich is glorious”. However, in the last three years, growth has since slowed with its GDP growing below 5% pa. Based on a recent study by ADB, the institution forecasts China’s long-term growth prospect will slow even further to 3% pa and below into 2035.
China exhibiting same kind of growth trajectory as Japan back when it peaks in 1990
Source: IMF, CEIC, BOJ, ADB, Goldman Sachs
Demographics play a pivotal role in shaping a nation’s future growth prospects. In Japan, the population growth rate has slowed dramatically during this period. Before 1990, Japan’s working-age population was growing at an average rate of 1 to 2% pa, but by the turn of the decade, Japan’s working population growth rate had turned negative to -1% pa. China will experience the same dynamic as Japan but with a critical difference its population is aging faster than Japan. Japan’s population dividend peaked in 1983. Over t11 years from 1983- 1994, its share of the population above 65 grew from 10% in 1983 to 14%. China’s population dividend peaked in 2015, but it will reach the same ratio of 14% as Japan in a matter of 7 years. Thereafter, China’s total population started to decline while Japan population only declined in 2008, a good two decades from the time its population peak. The reason for China’s accelerating aging population is its One-Child policy implemented in 1980 which is also aggravated by its low population replacement rate (6th lowest in the world, 3 notches better than Singapore which is ranked the 3rd lowest). Compounding the possibility of China entering its own “lost decades” is that it will become old before it becomes rich. China’s GDP per capita of$12,800 in 2022 2.0x smaller than Japan’s GDP per capita back in 1994.
China is ageing fast and the working population will decrease faster than Japan post-bust
However, an aging demographics and an economy transitioning from an agrarian to an industrialized nation do not mean that the country will slip into an anemic growth cycle that lasts decades. There are several important accompanying requisites for that to happen. First, there must be an explosion of the country’s indebtedness that curtails future growth potential. In Japan, the government debt to GDP increased from less than 50% in 1990 to 130% by 2000 and has now reached 218%. During that period, Japan also saw an increase in both corporate and household debt with corporate debt increasing from less than 100% in 1980 to 150% by 1995 and its household debt rising from less than 50% in 1980 to 70% by 2000. Japan became a very indebted country on all fronts. The official figure of China’s debt to GDP obfuscates the fact that other borrowing entities like the local government and its financing vehicles are excluded. If we were to include them, China’s debt to GDP would have grown from less than 50% to 95% by end of 2022.
Like in Japan, China’s increase in debt extends beyond the government entities. We have also witnessed the proliferation of corporate and household debt. Post-GFC, China’s corporate debt-GDP increased substantially, and much of that debt binge went first into basic materials industries like steel and cement and flowed into the real estate market more recently. While the corporate debt-GDP has fallen lately as part of the central government’s deleveraging efforts, it still stands higher than peak level of Japan at 150%. But is the pace of that debt accumulation that should elicit references of excesses and state-sponsored not-for-profit oriented ventures. Their household debt has also more than doubled in the last five years and there are no prizes to guess where the borrowings were used for
And if we combine the above analysis consisting of both private and public debt, China’s debt trajectory pre-post its real estate bubble looks frighteningly similar to Japan’s.
Some of my astute readers will point out that China’s real estate bubble is not the same as Japan’s as the former is residential real estate while the latter is commercial real estate. I would argue that debt is debt and excess is excess. Property developer debt and housing debt are 48% of its GDP. 75% of the property developer debt is held by the banks and all mortgages are originated by them too. The largest asset class for the Chinese is in property and at 59% of their total household assets it is far larger than Japan’s 36% and the US 27%. In other words, the average Chinese household is very susceptible to a real estate downturn in the residential market with much of their wealth in this asset class and much of its debt is related to housing. Just as it was for Japan with much of their corporate debt is linked to real estate and highly intertwined with its banking system. The longer this real estate crisis persists, the larger and longer-lasting damage it will exact on its economy. We recorded a podcast clamouring for a bazooka approach to this problem but so far, it has not been forthcoming. Have a listen on Spotify by clicking this link China Real Estate.
Another important prerequisite of China following Japan’s lost decades is the behaviour change of borrowers or as famously coined by Nomura’s chief economist Richard Koo, “a balance sheet recession” in which despite central bank ardent effort to reduce borrowing costs, borrowers are reticent to borrow and prefer to pay down debt, invest and consume lesser. We are already seeing early signs of this in China. The mortgage rate is at its lowest in more than a decade and yet home sales have slumped and even more intriguing, borrowers have been paying down their outstanding loans.
Since the start of the year, PBOC has utilized its entire suite of policy tools including cutting the Reserve Requirement Ratio twice freeing up RMB500bn yuan, reducing its 7-day repo once, easing several lending programs, enacting several housing-related relaxation measures, and using moral suasion to encourage the banks to lend. Yet, the Total Social Funding (the best indicator to gauge financing activities in China) have grown 9% only and the growth in the overall stock of loan have not changed throughout the year.
China also grapples with unique challenges that Japan did not face, such as strained relations with US and its allies. Their fractious relationship with the US and Euro has curbed its advancement in technology and diverted resources towards military deterrence than on much needed healthcare and social programs. It has also redrawn China’s global market opportunities along the lines of political ideologies.
However, it is essential to note that China has advantages and differences over Japan. There is still plenty of room on the monetary front as real rates are still positive and China does not have an inflation problem; arguably is in a deflationary quagmire that necessitates lower rates. It still has relatively healthier fiscal and current account balances to implement more monetary stimulus. There is still plenty of room to increase its capital stock to improve productivity even as its labour pool shrinks. Lastly, given that the central government is the major shareholder of many of the largest banks in the country, it has plenty of levers to pull including “persuading” the banks to lend more (is the only country that I know of which requires the banks to set yearly loan quota which are monitored for adherence or adjustments), and granting greater forbearance to the zombie companies.
We have seen numerous commentators from both the buy and sell side capitulating from their view that US will enter a recession on the back of stronger-than-expected economic momentum in the last three quarters. As we have outlined in numerous publications, we have a systematic approach in ascertaining recession that uses a combination of economic nowcast and forecast models and indicators, market-driven signals, and bottom-up high-frequency anecdotal evidence. Updating all these factors, our case for a US recession remains unchanged even if it is pushed out for another 1 -2 quarters. As we have shared in the last Navigator, as long as the recession is shallow, the probability of SPX returning positive returns is high with 6 of out 8 such occasions returning an average of 9% returns. Based on the latest consensus forecast and NDR economic timing model, our base case remains a mild recession hence that forms our positive view of owning US Treasuries and still cautious view on equities.
Equities: Underweight but opportunities are appearing. In the last quarter, we have seen some improvement in the broadening of the S&P rally as well as the stabilization of earnings estimates for 2023 and 2024. Consensus is projecting EPS to grow 1% for 2023 and 11% for 2024 (last quarter’s consensus EPS growth forecast for 2023 and 2024 were -1% and +9%). Valuation remains our bugbear though September correction have improved with 12mths forward PE at 18x compared to the average of 16.5x since 2008. Investment community positioning is also no longer stretched. Our portfolio positioning has not changed much with the ongoing neutralization of our underweight in the US by adding single stock ideas in semiconductor and software, continue to be overweight in Japan and have added a new activist manager there, but remains underweight in Europe (the prospect of a longer recession) and Emerging Markets (China weighs heavy on our mind).
Fixed Income overweight in US Treasuries and Investment Grade. Yields have increased from the previous quarter and the asymmetry of returns has become more lucrative to own more. Moving away from our previous analysis where we know Treasury yields always fall if a recession occurs, we look at data to gauge what would likely happen if there were no recession but with a Fed ending its hiking cycle. Out of the 5 non-recessionary periods that followed a Fed tightening cycle since 1966, only on one occasion (1966) did yield rise within 4 months after the Fed stopped tightening. For the remaining 5 occasions, yields fell 200 to 300bps from the time the Fed stopped hiking till a good 9 months later therefore supporting our view to own Treasuries. However, in a non-recessionary outcome, the shape of the yield curve is less obvious. Most of the time, it flattens but there have been two occasions it bear steepens. This may dull the bull steepening construct we have in our portfolio but with 2-year Treasury yield at 5.10%, it does offer an attractive absolute yield.
There has never been a better time than now to own investment-grade debt. Yield is now above 6% and there has only been 7% percentile of the time in the last 14 years that it has been higher. Such a level of yield only occurs in a severe recession but that is not our central thesis. Credit spreads have compressed in synchrony of stronger than expected growth momentum but if our base case gravitates towards a mild recession, we should not be expecting too large widening of credit spreads. At current yields, favourable bond price convexity comes into play.
Alternatives: We have just launched a standalone multi-manager and multi-strategy hedge fund mandate. This is a cumulation of 8 years of due diligence and investing in them leveraging my more than 15 years of experience managing Asia long/short equities strategy. The multi-manager approach reduces manager concentration risk while the multi-strategy approach enhances return given the idiosyncratic characteristics of each strategy. The strategy has provided return of 9% pa since 2018, outperforming MSCI World Equities and the Global Hedge Fund indices significantly in terms of risk-adjusted returns. Correlation and beta read of the mandate with the broader market indices are low providing an uncorrelated return profile. We view this as a core hedge fund holding in our asset allocation mandates. Please speak to your wealth manager if you like to find out more about this opportunity.
FX: Likely range-bounded for the rest of the year as most developed central banks are at the end of their hiking cycle and will hold rates for a while longer. Key risks to watch are BOJ impending QT (which we believe will commence by early 1H24) and PBOC currency maneuvers.
Commodities: We took profit on our contrarian call of oil we had since Jan 23 as outlined in the 2023 strategy: The indomitable human spirit . The investment case for a bullish view for oil in the short-term remains with a resilient demand and OPEC compliance. But positioning has swiftly shifted from a very bearish view when shorts in oil contracts were at their all-time high back in June (higher than during covid and 2014-2015 oil collapse) to bullish now. When it comes to commodities, we should also look for extreme positioning and take a contrarian view when that happens. Sold all our oil futures and moved them to oil companies ETF because positioning in this 2nd derivatives remains dour.
Cash: Unchanged keeping some cash 10% to look for opportunities to bring our equities to overweight should the macro read necessitates that.
Dunning Krueger Effect. Bet you know someone at both ends. Click here if you think you already know what that is.
Edward Lim, CFA
Chief Investment Officer
edwardlim@covenant-capital.com
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