News from China has elevated volatility in financial markets, including its intention to secure winter fuel supplies at all costs. Kim Parlee speaks with Marko Papic, Partner & Chief Strategist at Clocktower Group, and author of “Geopolitical Alpha”, about China headwinds & tailwinds.
Marko, always great to have you with us. I want to start, if we could, I'll just jump right in because there's a lot to tall about, if we start with Evergrande, I know some people, I'll say, outside of China, have been drawing parallels to Lehman, and saying this feels like a Lehman moment. I know you've done some work saying that there could be a difference between what we're hearing from outside of China and what we're hearing inside of China. What's your take on what's going on?
- Yeah, I think the Lehman moment analogy is probably overused. There aren't really links between Evergrande and the Chinese financial system. The real link is between Evergrande and its suppliers, contractors. Evergrande owes something like $40 billion for the rest of this year to its suppliers. And that's a hit not to the financial system, but to the real economy in China.
Chinese policymakers are very much aware of this. And they've already handled similar situations, such as the restructuring of the HNA Group, where basically equity holders and private shareholders were taken to the woodshed when it came to that case. But HNA Group was then split up, and various other entities bought parts of the business in order to maintain those relationships with suppliers and contractors.
- Hmm. So do you then foresee that-- and thank you for the correction on the name, Evergrande-- do you foresee that happening again, that this will get something that will get handled in a way that is manageable? I would put it that way.
- So I think yes. I think that's not the issue. But it doesn't mean that there are no risks at all to the Chinese economy or to the wider global economy. The real risk is that real estate prices start to depreciate as individual investors in real estate, which is basically Chinese savers, you know, mom and pops who've bought second and third condos so they can pay for health care or their kids' education, the real issue would be if they started to sell the inventory and that created some sort of a cratering.
For China to arrest that risk, it needs to do more than just handle Evergrande. What they have to do is they have to go in, they have to loosen some of the mortgage rules, some of the macroprudential regulation that they're very proud of that you could argue has precipitated this crisis. They would also have to probably cut interest rates, and they would have to fiscally stimulate much more aggressively at some point over the next quarter or two. And we're still waiting for all of those policy moves. So the risk isn't gone. I just think that the Lehman analogy is probably wrong.
- So take me through this. I mean, walk me through where this could go, from your perspective, is they loosen up policies, whether it's regulatory reset for mortgages, they loosen the monetary spigots, there's some fiscal stuff going in there. Does that not only make the situation a bit better, but does it create a lift for more that could happen? Or is that a too optimistic take on things?
- You know, I think the Chinese policymakers are kind of between a rock and a hard place. And I know that's an overused analogy in this situation, but I think it's appropriate. They both don't want real estate prices to rise too much because they feel it contributes to demographic problems, young couples not wanting to have more than one kid because it's just difficult and expensive to do so in some of these tier one cities on the coast. So they wants to maintain an unofficial real estate price appreciation of about 1% annually.
At the same time, they are now faced with this risk where real estate prices start to depreciate. Now, that's a risk to the wider middle class of China that's basically invested 20 years' worth of Chinese growth into real estate. Why? Well, because for most of those 20 years, China's capital markets, like equities and bonds, simply were not sophisticated enough to articulate all the growth and savings into some sort of savings for the middle class. And so that's why this is a very dangerous situation that I just don't see how it gets resolved by China, other than pushing the can down the road and basically continuing the leverage in the system. China just simply has to do that.
Is that going to be super bullish for global growth? Not necessarily. I don't see China doing what it did in 2009 or 2010 or after other crises, like in 2018, when it stimulated with gusto. I think you're going to see pretty tepid stimulus, but enough to maintain global growth and ensure that we don't get a complete collapse, not because China cares about you and me or the Canadian dollar or Canadian markets or anything like that. I think China cares about domestic political security. And if real estate prices fall in China, no one will be celebrating.
- So I guess along that same theme, when we think about domestic security and keeping people content, people happy, keeping their savings protected, it sounds like what is a big part of this, we also saw there was a big crackdown on the tech side of things, in other industries. They stopped the Ant IPO and then a couple of others. Are those regulatory headwinds going to intensify? I mean, how does that play into the mix of what you're talking about?
- You know, China, I think, is coming to terms with a pretty pessimistic reality, which is that I think Chinese policymakers are abandoning the enthusiasm with which they tried to escape the middle income trap. Now, a little bit of a backward background I think is needed here. The middle income trap is sort of the dreaded trap in which many emerging markets fall and never get out of. Think Brazil or Latin American economies. It's at 30% to 50% of US GDP per capita. You basically have this pretty considerable rise in wealth, and then the country fails to break out of that and become, well, South Korea or Taiwan, in terms of its wealth.
And China has been really focused on supply side reforms, on things that we would define as capitalism or laissez-faire reforms to boost productivity and ensure that it escapes the middle income trap. I think the focus on income inequality is a sign that policymakers in China are coming to terms that, at least for the next decade, in large part due to the leverage of their households and corporates, that they're going to have to live with this middle income trap. And so they're focusing on common prosperity, as they call it, on shifting away from income inequality and fighting it. One of the ways that they intend to do that-- I mean, there's many ways, but one of them is to move away from tech-induced economic development.
In other words, to minimize the role of the TMT sector, which they believe doesn't help income inequality, it creates these winner-take-all companies, lots of temporary jobs, wealth accrues to the shareholders, and pivot more to a German economic development model, which focuses on maintaining manufacturing as a large proportion of the economy.
And so that's the pivot that's happening. I do think regulatory headwinds, as you say, will continue for the tech sector, but you will have regulatory tailwinds for China's energy, China's materials, China's industrials, China's clean tech sector, in particular. Also, semiconductors. So they're focusing and putting emphasis on hard tech over what they call soft tech, which is basically the TMT side.
- You were just talking about some of the, I'd say, regulatory headwinds and tailwinds that will be in place in China, headwinds perhaps for the soft tech, as you call it, tailwinds for the hard tech. Tell me just how does that play out in terms of the markets? Because I want to talk a bit about reflation trade we're hearing about. And when you talk about tailwinds for hard tech, I immediately go into there's a reflation trade attached to that.
- That's such a great point, Kim. I mean, I didn't mean it that way, but you're right. There's this atoms versus bits competition out there. And bits or bytes, however you want to talk about them, they've been winning for the past decade, right? If you invested in nothing but tech companies and forgot everything else, you did really well. This cycle is really going to be about atoms.
Now, China is explicitly doing this for kind of domestic regulatory and income inequality reasons. Competition with the US, I think, plays into it, as well. But I think, broadly speaking, the reflation trade, the macro reflation trade broadly defined, globally defined should be good for industrials, for energy, for material stocks.
And that reflation trade, globally speaking, has been on pause since March, for a number of different reasons, whether it's Delta, whether it's idiosyncratic reasons that caused the 10-year yield to go down. Global growth started surprising to the downside. China concerns, as well. There was a number of different reasons. Oh yeah, policy in the US, fiscal policy in the US started disappointing investors.
The point is that a slew of reasons has, for the past six months, put that reflation trade on pause. And of course, if you have a disinflationary trade, kind of low-growth, deflationary environment, then you want to be invested in what worked the last cycle, which is pretty much just banks. We've seen over the last couple of days very exciting moves in the markets, with the 10-year really selling off. And that has hurt tech stocks, in particular, in the US, which gives hope again that we will have in the fourth quarter of this year what we had in the first quarter, which is the outperformance of reflation trade plays, such as cyclicals, such as value, energy, financials, materials, industrials.
- Interesting. In your September report, you do highlight the three things that need to-- I mean, this rhymes, I think, with what you were just talking about, that China has to step off the brake, US fiscal issues must be resolved, the money has to get flowing, and Delta must dissipate. Do those three things seem as though they are moving in the right direction, from a reflation trade standpoint?
- Well, it's interesting because I talked about that basically two weeks ago-- no, four weeks ago I wrote that piece you referenced, and reflation trade seems to have restarted without all three being finished, to be quite honest. Maybe it was just the dissipation of Delta variant as the catalyst. Maybe investors are overly sanguine about China, although I don't think the market is wrong. I think Chinese policymakers will move. And maybe policy in the US is just not that relevant, in terms of fiscal policy.
Whatever the case is, the bond market seems to be reacting as if we are already on that reflation trade for the rest of the quarter. You know, I'm not going to disagree with the bond market. I think that's folly. I think that certainly things are ready again for the outperformance of cyclicals and value over growth.
- What do equity investors do with all this information? And I want to throw in, as well, too, because I know we've got a couple of minutes left, about your thoughts on ESG and how this plays into it, because I think we're seeing some interesting reflation trades in energy. You mentioned some things are taking off. Part of that could be supply bottlenecks, lack of capex into old-school energy complexes. There's just a lot of movement in the markets right now. So for the people who are watching who are going, great, this is all interesting, what do I do? What are your thoughts?
- I think, for the next couple of weeks, there's definitely reasons to be cautious. The overall S&P 500 could experience a correction between 10%, 15%. Why? Well, because enthusiasm, optimism about growth is not your friend if you're in the US equity market. Why not? Well, because the US equity market is tooled, it's tuned to a disinflationary secular stagnation macro context. What that means is that American equities outperform when growth is kind of tepid, there's no inflation, you know, and like everyone's kind of just miffed. That's when tech stocks do really, really well.
But when the 10-year sells off, the yield goes higher, what that's telling you is that actually there is enthusiasm about global growth, and inflation is likely to surprise to the upside. In that scenario, you don't necessarily want to be in those US tech stocks. You want to be in other things, such as energy stocks, financials, emerging markets.
The point about energy is a really important one. Why are oil prices going up? Why is natural gas going up? Well, there's a number of different reasons, but one of them is that we just don't have enough capex going into fossil fuel production. And that's because, whether you're an investor or a bank or whether you're an energy company, right now, policymakers are telling you move away from fossil fuels and go into clean tech.
And that's going to, over the long term, I think be one of the most interesting investment thesis, clean tech and green energy. The problem is that, in the near term, it almost ensures that oil prices and natural gas prices go higher because we're not investing enough to dig up fossil fuel out of the ground to satisfy the still robust demand that there exists for fossil fuels. And so that means that prices have to go much higher to incentivize some capex.
We have to watch, of course, with the October OPEC+ meeting. They could change this situation pretty dramatically if they were to increase production. But that will almost make the situation worse, in the long term, because that will only further disincentivize, for example, US shale to come back to the market. So it's a very complicated situation that I don't see how oil prices don't go higher over the next six months, which is good for Canada.
- Yeah. It's a fascinating discussion, Marko, and I love the nuance that you bring to it. It's always a pleasure. Thanks so much for joining us.
- Thank you, Kim. Real pleasure.