Journal#3: A Tale of Two Economies (Part One: China)

July 2023

Happy summer.  I hope you're having a fantastic summer so far. Mine started off with an amazing golf trip to Niseko with my buddies. Niseko is famous for its skiing, but let me tell you, the golf there is absolutely fantastic too. If you're into golf, I highly recommend considering a Niseko golf trip.

Journal #3: A Tale of Two Economies. China was anticipated to recover but has not, while the US was predicted to weaken but has thus far defied those expectations. I will focus on China in this journal and leave the US for the next one.

China Recovery: The Original Recovery Thesis

The original idea was that once China reopened after the Covid lockdown, there would be a surge in spending fueled by the excess savings, similar to what we saw in the US in 2021. While this idea wasn't completely off the mark, the reality is that the recovery hasn't fully reached all sectors of the economy just yet.

For example, on one hand, travel activities during the May Day holidays and June's Dragon Boat Festival have bounced back and even surpassed pre-Covid levels, which is great news. On the other hand, the real estate market is still struggling. Despite mortgage rates dropping significantly (check out the chart below), real estate sales remain sluggish, and that's a sector that desperately needs a boost. 

Source: BCA Research

Consumer Confidence Recovery

Rebuilding consumer confidence takes time, especially after a major event like a pandemic lock-down. As shown in the chart below from Alpine Macro, both the US and India took their fair share of time before consumer confidence fully rebounded (the chart adjusted the reopening dates of the US and India by 23 months to match China's reopening date).

Source: Alpine Macro

Given the recovery seems to lose steam in Q2 and there is a potential risk of deflation in China, with both the CPI and PPI experiencing sharp declines recently, it becomes crucial for the CPC government to implement additional fiscal stimulus and pro-growth policies that rebuild consumer confidence, encouraging spending, particularly in big-ticket items like housing.

China Housing: Not Japan in the late 80s nor the US in 2008

China housing is a very complex subject that deserves a separate journal entry.  However, in a nutshell, the current housing crisis in China is distinct from the one Japan experienced in the late 80s or the US faced in 2008, in my view. The dynamics at play are different. While I do believe a recovery will eventually happen, similar to what we saw in the US after the 2008 crisis, it will take time.

My conclusion is largely based on the following: 1) there's a significant amount of untapped savings in China that hasn't been spent yet (check out the chart below). Moreover, the financial health of households is relatively robust, with China's household debt-to-GDP ratio lower than that of the US (source: https://stats.bis.org/statx/srs/table/f3.1). 2) China still maintains capital controls, limiting investment options primarily to domestic real estate, bonds, and stocks and real estate remains by far the most popular and familiar choice among these three options. 3) the working population is still relative stable until the end of the decade. As incomes and savings continue to rise, there will eventually be a rebound in housing demand.

Source: Federal Reserve

Again, patience is key, and the speed of recovery largely hinges on the government's response. To put things into perspective, let's consider the US experience. Despite the US recession officially ending in 2009 with quantitative easing, it wasn't until 2011 that the US housing market began a sustainable recovery trend, as illustrated by the chart below showing US existing home sales.

Source: Bloomberg

The Ultimate Macro Bet of China

Whether it's China's consumer confidence or its housing sector, my view is that these are cyclical issues that will ultimately work themselves out, as long as China maintains its unique political and economic system that has driven its success over the past four decades. This unique system, started by Deng, allows private enterprises to flourish while the CPC retains overall control of policies and national interests, free from any influence of private enterprises.

While the China system certainly has its flaws, its greatest advantage lies in the creation of an exceptionally effective government. Take, for instance, China's impressive achievement of building a state-of-the-art bullet train network spanning the entire country in just 12 years, while Californians are still waiting for a mile of track laid for the LA-SF bullet train rail, in which the project was announced in the SAME YEAR (2008) when China began constructing its bullet rail system.  Another example is the over 2 million EV charging stations available throughout China today, compared to the 150,000+ in the US (which might explain why Elon keeps visiting China). 

China Bullet Train Network

However, the policies of recent years like the tech and tutoring company crackdown and the pursuit of common prosperity, questions arise regarding whether private enterprises can continue to thrive under Xi’s kingdom. This is the ultimate macro bet of China. 

If Xi allows private enterprises to flourish and enables shareholders to reap the rewards, companies like Tencent and Alibaba, at their current valuations, could be the investment bargains of this decade, especially when compared to their US counterparts (see chart below). On the flip side, if Xi continues to have polices that kill entrepreneurism, no fiscal and monetary stimulus can offset the damage caused by these policies.  If this is the case, the US does not need to worry too much about China as #2 challenging its position as #1, as China's dream will crumble, leaving the US in its #1 place in the world for decades to come.

Unfortunately, the answer to this trillion-dollar question is known by only one person in the world, that’s Xi. But with Premier Li Qiang's recent meeting with tech firms, where he indicated that tech firms are basically back in the game, and tutoring companies in China are finding a new second life (evident from EDU stock price, less so in TAL), I am willing to remain patient with my China investment.

At the end of the day, Xi's China dream still revolves around achieving a GDP per capita level, similar to that of developed nations. This objective does not conflict with investors who want a consumption-driven China, transitioning away from the manufacturing-focused China of the past.

Returning to the theme of "a tale of two economies," between an economy where people have money but are reluctant to spend it and an economy where people are depleting their covid excess savings and accumulating credit card debt to a record level, the latter worries me more than the former.  So, stay tuned for part 2 of the Tale of Two Economies: the US. Thank you for reading, and I hope you enjoy the rest of your summer!