Top 2015 Investment Stories and 2016 Expectations 5: China

We saved the most momentous for last. Nothing caused more angst in 2015 than China...namely whether or not China is heading for a "hard landing". A hard landing implies the economy will slow down more than expected. The implications of a Chinese hard landing are significant because:

  1. China is the largest "growth engine" in the world. No one really knows what China's GDP is but official records should have it somewhere around $11T. If China can grow at 6% that is an increase to global GDP of around $700B annually. The US is growing around 2% a year on a $18T economy or $360B or so. 
  2. Many commodities and therefore many countries, depend on Chinese demand. In some cases, especially around infrastructure commodities, China has been 30%-40% of world demand. That demand cannot be replaced anytime soon by anyone else.
  3. The developed world has deflationary problems. As China lets the yuan depreciate it effectively exporting deflation to the developed world. Deflation is a big problem for developed countries with large amount of debt and China is a massive exporter to these countries.
  4. Most importantly, no one is really prepared for a significant slow-down and the psychological impacts would be tremendous.

The last point has been made recently by both Paul Krugman and Howard Marks. Mr. Marks (one of the best distressed investors of all time) quotes Mr. Krugman in his latest letter. We are going to include his entire analysis because there is no way we could say it better than him:

I would say that, of all the things on the list, the possibility of a hard landing in China is of the greatest significance when you combine magnitude, potential ramifications and the probability of it occurring. So it’s important to look objectively at what it means for the U.S.

First, let’s remember that China doesn’t play a pivotal role in the U.S. economy (other than as a provider of finished goods). It is estimated to account for only 1% of the combined profits of the S&P 500 companies. Exports account for about 13% of U.S. GDP, and in the first eleven months of 2015 less than 8% of our exported goods went to China ($106 billion of goods, versus an annual GDP approaching $18 trillion – again, well below 1%).

Going on from there, I want to share Paul Krugman’s analysis from The New York Times of January 8. (I generally don’t agree with Krugman’s politics, but I don’t think they’re relevant here.):

Yes, China is a big economy, accounting in particular for about a quarter of world manufacturing, so what happens there has implications for all of us. And China buys more than $2 trillion worth of goods and services from the rest of the world each year. But it’s a big world, with a total gross domestic product excluding China of more than $60 trillion. Even a drastic fall in Chinese imports would be only a modest hit to world spending.

What about financial linkages? One reason America’s subprime crisis turned global in 2008 was that foreigners in general, and European banks in particular, turned out to be badly exposed to losses on U.S. securities. But China has capital controls – that is, it isn’t very open to foreign investors – so there’s very little direct spillover from plunging stocks or even domestic debt defaults.

All of this says that while China itself is in big trouble, the consequences for the rest of us should be manageable. But I have to admit that I’m not as relaxed about this as the above analysis says I should be. If you like, I lack the courage of my complacency. Why?

Part of the answer is that business cycles across nations often seem to be more synchronized than they “should” be. For example, Europe and the United States export to each other only a small fraction of what they produce, yet they often have recessions and recoveries at the same time. Financial linkages may be part of the story, but one also suspects that there is psychological contagion: Good or bad news in one major economy affects animal spirits in others.

So I worry that China may export its woes in ways back-of-the-envelope calculations miss . . .

I want to highlight Krugman’s reference to “psychological contagion.” It’s interesting in this regard that, last week, the world’s stock markets saw the following declines: S&P 500 – 6.0%, FTSE 100 – 5.3%, DAX – 8.3% and Nikkei – 7.0%. I consider it highly unlikely that such uniform declines were the result of independent, objective analysis of the impact of events on each economy and company. Rather, I think they show the extent to which markets are linked by their investors’ shared psychology.
— Howard Marks,

In other words, a Chinese hard landing wold be made worse because of fear. The economy and the markets are reflexive, meaning the participants actions affect them. If people get fearful they sell stocks and the market goes down. The market going down affects the economy. It is all interconnected. 

So why not run for the hills? To an extent we have through our increased holdings of cash. But at the same time, it is important to remember that we are all scarred by the Great Recession and that is the heuristic that we go to time and time again. Is this the next big one? Is the world going to fall apart?

We can have a recession or a Chinese hard landing without the entire world economy imploding. That does not mean stocks won't do badly, but it does mean a sound defensive portfolio with cash should perform okay. Going fully to cash may mean you miss the next big downturn but it does not mean you will be able to get back in at the right moment.  Timing the market is generally a fools game. As usual Mr. Marks puts it better than we could on our own:

So what about the likelihood of another 2008-style crash? The bottom line for me is that a rerun of the Global Financial Crisis isn’t in the cards:

We haven’t had a boom (either in the economy or in the stock market), so I don’t think we’re fated to have a bust. Because most businesses have been particularly loath to expand their facilities, I don’t think they’ll be slammed if revenues flatten or turn down.
The leverage in the private sector has been reduced. This is particularly true of the banks, where leverage has gone from the region of 30+ times equity before the crisis to very low double digits today. And, of course, banks are now barred from investing adventurously for their own account.
Finally, the main villain in the crisis was sub-prime mortgage backed securities. The raw material – the underlying mortgages – was unsound and often fraudulent. The structured mortgage vehicles were highly levered and absurdly highly rated. And the risky tranches ended up in banks’ portfolios, causing them to require rescues. Importantly, this time around I see no analog to sub-prime mortgages and MBS in terms of their combination of fragility and magnitude.

I don’t mean to suggest there aren’t a lot of things to worry about: swollen central bank balance sheets; complete ignorance as to how they will be unwound and how interest rates will be moved higher; the seeming inability to generate economic growth and inflation; and the many other macro negatives listed earlier. A hard landing and substantial devaluation in China, the world’s second largest economy, certainly could have far-reaching effects.

It’s important that investors (as well as economists) avoid using words like “always,” “never,” “will,” “won’t,” “has to” and “can’t,” and I try to do just that. But it’s my view that the GFC and its preconditions were highly unusual, and I don’t think we’re heading for an encore. Remember, however, that I’m not a seer, and Oaktree and I never bet heavily on opinions regarding the future – mine or anyone else’s.
— Howard Marks,