«China Has to Convince Financial Markets that It Is not Suicidal»
Marko Papic, Partner and Chief Strategist at Clocktower Group, talks about the solution to China’s economic weakness, the Fed leadership’s concerns, and his arguments why the commodity supercycle is far from over.
The weakness of China's economy is surprising many investors, as is the robust state of the US economy. Contrary to many predictions, 2023 has so far been dominated by the shares of the «Magnificent Seven»: Microsoft, Alphabet, Nvidia and other large US corporations from the tech sector.
Marko Papic, chief strategist at research boutique Clocktower Group, says these developments are partly a head fake. The big issue for the coming years remains the foreseeable boom in capital investments (capex), driven by the reengineering of supply chains and production capacities as well as the transition to new energy sources.
In an in-depth interview with The Market NZZ, which has been edited for length and clarity, Papic shares his thoughts on where he sees the best investment opportunities, on why the Fed doesn’t want to be blamed for an election victory by Donald Trump, and what it will take for financial markets to get a boost: «Xi Jinping has to convince us that he’s not an Austrian.»
«Commodities are moving sideways. But that is a shockingly bullish statement, given the weakness in China.»: Marko Papic.
Why should investors care about geopolitics?
Because we are in the process of transitioning from a unipolar to a multipolar world order. For roughly thirty years, from about 1985 onward, the world was unipolar. The United States was the sole world power. And in terms of economic and domestic policy, the Reagan-Thatcher revolution had won. That world is now changing, both in terms of domestic politics, with more polarization, and in terms of geopolitics. Multipolarity will be the order for years to come.
Many voices say we are in a new cold war between the US and China. Wouldn’t bipolarity be a better characterization?
No. Bipolarity and the talk of Cold War 2.0 mainly serves the American foreign policy establishment. The rest of the world simply does not agree with America about how threatening China is. The US and China are primarily vying for influence in the Pacific. That’s far away from Germany and France. So from a self-interested perspective, the Europeans should want to continue to sell Airbus planes to China. China, meanwhile, has no true allies. The main reason why I don’t see a bipolar world is because we can observe that most countries don’t act like it. If it was, you wouldn’t have India ignore the West and bathe itself in Russian oil, you wouldn’t have Saudi Arabia masterfully playing both sides. One characteristic of a multipolar order is that you can’t trust your allies. They are driven by self-interest.
Is the proposed enlargement of the BRICS club not a sign of China trying to build an alliance?
Absolutely not. China’s number one foreign policy priority since the 20th Party Congress last October was actually Europe. They are smart enough to know that Europe has to remain somewhat agnostic towards China. The BRICS enlargement may serve China’s interests, but it’s not anywhere commensurate with something like a China bloc. The leaders of Brazil, Saudi Arabia or India would be insulted if you suggested they were taking part in a China bloc.
Would you say that historically, the most fitting parallel to today would be the turn of the last century?
Yes, we had a multipolar world order from about 1870 to 1945.
That was a rather violent period.
Multipolarity can actually be peaceful, but it requires all the large countries to be involved. Think of the Concert for Europe era after the Napoleonic Wars. One of the many reasons why World War II happened was that the US, as the most powerful country in the world, turned inward after World War I and did not assume a coordinating role. Woodrow Wilson had tried to sell this to his domestic audience after WWI, and they rejected it. That’s an important parallel to today. Joe Biden is rebuilding alliances, he is pushing against multipolarity, but I worry that we will have another one of those moments where the isolationist impulse wins in America. That would be dangerous.
In a research report you have written that the US is taking a Machiavellian approach towards China. What do you mean by that?
They try to signal to the world that China is up to no good. They want to isolate China and provoke them to commit a mistake. But the rest of the world doesn’t buy the idea that China is that much of a threat. I actually think China has peaked as a global power five years ago. There is a strong domestic political component to this in the US. Americans across party lines only agree on two things today: One, that babies are cute, and two, that China is evil. This view was encapsulated in the speech by National Security Advisor Jake Sullivan at the Brookings Institution in April. I’m simplifying, but he basically said that the problems of the American middle class are China’s fault. Sullivan took many Trump views and adopted them into the language of the Democratic Party. He suggests that America can fix the problems of its middle class by being tough on China. But that also means there is no clear solution to the conflict. How can China offer America anything that will reduce tensions? The tensions are the goal.
The Chinese Communist Party also has an interest in domestic signalling, telling its population that the enemy is America. That creates a rather dangerous setup, doesn't it?
Yes, it does. But it’s important to understand: The rest of the world is not stupid. If you and I can read the Sullivan speech and see what’s going on, the Indian Foreign Ministry, the Brazilians, the Europeans, see the same thing. That’s why the world is not bipolar. Having said that, your point is correct: Domestic issues make it difficult for policymakers to sit down and make rational geopolitical agreements. For decades, we’ve never been in a worse situation between China and the US. The big constraint for Chinese policymakers is that they have to worry about economic growth. That’s why for China it’s very dangerous to lose all their relationships with the West. At the end of the day, their economy is still driven by exports. Even though exports as a percentage of GDP are in decline, half of domestic investment is tied to export demand. The CCP needs to deliver economic progress to fulfil their social contract with the population.
China's economy has stumbled badly. Why has the post-covid boom fizzled out so quickly?
In my view, China is in the early stages of a balance sheet recession. Just like Europe and the US experienced it in the years after the Global Financial Crisis. In short, a balance sheet recession happens when the private sector – households and corporations – is overleveraged and starts to repair its balance sheet by paying down debt. This means a collapse in aggregate domestic demand. That's one reason why China cannot afford to lose their markets in the West.
If your analysis is correct and they are in a balance sheet recession, they also need a boost from the government, right?
Absolutely. The central government should put a floor under growth by increasing fiscal spending.
In the past weeks, we have seen small scale measures, including rate cuts by the People’s Bank of China.
That is totally insufficient. Monetary policy alone is useless in a balance sheet recession.
What would you like to see? A bazooka stimulus like in 2009 or in 2016?
We won’t need to see a bazooka, but we need to see that they are putting a floor under growth. What I would like to see is fiscal stimulus from the central government balance sheet. They have to start doing big infrastructure projects. The last time they did that was the shantytown redevelopment in 2015/16.
Does China really have any infrastructure needs left?
They could do shantytown redevelopment again. Or infrastructure for EV, charging stations, a switch to renewable energy, including nuclear, as well as energy transmission lines. There are big things that China can still finance. The important thing is that they need a 180 degree turn. The piecemeal stuff is not enough.
Xi Jinping seems to be adamantly opposed to large fiscal stimulus.
Xi thinks like an Austrian economist. But in the end, he’s also a populist. And over the next six months, they will have to put a floor under growth. If they don’t, then China risks slipping into a full-blown deflationary balance sheet recession. It would be a policy blunder of historical proportions. The fact that they have stopped publishing youth unemployment numbers tells you something. In some cities, youth unemployment is 40% and higher.
Is the social contract between the CCP and the population at risk?
Absolutely. This is the worst situation for China domestically since 1989. I don’t worry so much about youth unemployment, though. Youth unemployment in Spain and Italy during the Euro crisis wasn’t fatal either. Youth unemployment in Serbia is over 70%, and nobody starts a revolution because of that. What should be worrying for the CCP leadership are the economic prospects of the middle class. They have invested their savings into real estate, they have bought condos in Tier 2 and 3 cities, so they could sell them in the future and use the proceeds for their health insurance and to send their kids to school. The decline in property prices undermines the savings pool of the middle class. In some cities, property prices, anecdotally, have dropped 80%. That’s a political risk for Beijing. They don’t need real estate to go back up, but they need to stabilize it.
Couldn’t the Party leadership decide to lash out against Taiwan, thereby channelling domestic discontent outward into a nationalistic project?
I doubt it. Of course, there is always a risk that leadership exports domestic discontent abroad through war. That is what Putin did in Russia. But the middle class in China is not stupid. I mean, if my savings are down 80%, what the heck do I care about Taiwan? Attacking Taiwan will make the domestic situation worse, it’s not going to solve it. It’s very dangerous for Xi to assume that he can replace domestic discontent with a nationalist goal. Putin never cared about the Russian middle class. But China is different, a lot of the middle class jobs are tied to the export engine. The calculus in Beijing will be against a war over Taiwan for a very long time.
The US economy, meanwhile, is much more robust than the consensus had expected in early 2023. The big question now for markets is whether the Fed is done raising rates or not. What’s your take?
As you know, we turned bullish on the US economy and equities one year ago, when it became clear that CPI had peaked. US consumers have healthy balance sheets, corporate capital expenditures are strong, and fiscal policy is crazily stimulative. I don’t expect a recession anytime soon. Having said that, the Fed is pretty much done. They might raise rates one more time by November, but that’s it.
What makes you so confident?
Because the Fed had a six month window, from March to September, to tighten by another 100 to 150 basis points if they had wanted to. And they should have. But then in March Silicon Valley Bank collapsed, and the Fed reacted by delaying further rate hikes and by opening the liquidity spigot. The window for the Fed is now closed. With Labor Day over, election season has begun. Elections are only 14 months away.
The Fed will refrain from hiking rates in the year before the election?
Yes. Because they are apolitical, they don’t want to raise rates before an election. They don’t want to be blamed if the economy slips into a recession. Meanwhile, Trump polls better against Biden than in 2020. So currently, with unemployment where it is, the stock market where it is and the US economy as resilient as it is, Trump is leading Biden. If you’re an FOMC member, looking at the next twelve months, you say to yourself that probably the economy will get worse. If you add more rate hikes, you increase the risk of a recession – which will practically guarantee a Trump win. And I don’t think it’s a conspiracy theory to say that members of the establishment don’t like a candidate that is anti-establishment.
Let’s recapitulate: The world is entering a multipolar order, China is stumbling into a balance sheet recession, the US economy is robust and the Fed is done hiking rates. What does this mean for investors?
First, the multipolar world order means that we are in the early stages of a secular capex cycle. Huge investments will be needed worldwide for the reengineering of supply chains and production capacities. On top of that, trillions will need to be invested into the buildup of renewable energy sources. This capex cycle should be very bullish for commodities and select emerging markets. The last time we had a capex boom was in the early years of this century, from 2001 onwards. However, in the short term, the weakness in China clouds the picture. It’s difficult to invest anywhere outside the US before China convinces you that it is putting a floor under growth.
So you'd say that the commodity supercycle is intact, it is just taking a hit from China right now?
Yes, 100%. Commodities are moving sideways, somewhat trendless. But that is a shockingly bullish statement, given the weakness in China. Five years ago, if China was acting the way it was, copper and oil would be down tremendously. The fact that this hasn’t happened tells you my bigger capex story. It’s not about China. It’s about the green energy transition and geopolitical redesign of supply chains. There is a reason that in macro circles, we call the copper price Dr. Copper. Copper has a PhD in economics. Oil is not quite that smart, but it at least has a Masters degree. Prices tell you something. Commodity markets are signalling: We can survive China. But China has to convince us that it’s not suicidal.
So we really need a stimulus signal from Beijing to break that dynamic?
Yes. It doesn’t have to be a massive stimulus. On a scale from 0 to 10, I would be okay with a 4. We just need to be convinced that Xi is not an Austrian. If Chinese policymakers convince us of that, you may not want to buy China, as it would probably continue to be a bad place for investors. But at least they will signal that the Chinese economy will stabilize at 4,5 to 5%.
Is the weakness in commodity and emerging market assets a buying opportunity?
Yes. But again, in order to validate this statement, China has to convince us that it is not suicidal. This capex cycle is not led by China, but China cannot collapse. A secular, multi year call always has deviations. During the capex cycle in the early years of this century, there was a recession in 2001. Sometimes you have down years. As a long term investor, you have to ask yourself if this is the moment to buy, because the market has given you an opportunity.
Which emerging markets would you buy?
First, let me make clear that when I'm talking about emerging markets, I don’t mean China. China is different. Other markets are much more interesting, for various reasons: They raised interest rates when we in the West should have. In 2021, they were orthodox, we were not. I mean, America is an emerging market judging from its behaviour. Brazil and Mexico were more orthodox. Two, they didn’t provide massive fiscal stimulus during the pandemic. Three, they survived two balance of payment crises between 2011 and 2020. In many of those economies, we now see the potential for both technology and demand to create a new consumer leverage cycle. And then on top of all those things, you have the secular capex cycle.
So: Buy Brazil and stay away from China?
Absolutely. Indonesia, Vietnam, Mexico, Brazil. Pretty much all of Latin America, with the exception maybe of Colombia, which has decided to move too far to the left. I also like Saudi Arabia. They play the geopolitical game very well, and they are trying to industrialize, not just in energy, but in downstream businesses.
At the end of 2022, many investors had come around to the idea that maybe the decade-long US tech outperformance was over. And yet, the big theme this year are the Magnificent Seven. Why?
Three reasons. One has to do with lower ten year Treasury yields. Bonds rallied during the first half of this year, anticipating a recession. Two, in March, SVB happened and the Fed opened the spigots. Plus the unexpected weakness of China has created the sense that we are in a disinflationary doomsday world, where the only thing you can own is big US tech. That created a capital flow into safety.
What role did the hype around Artificial Intelligence play?
That’s another factor that has pushed the Magnificent Seven higher. But I have a hard time accepting that. I don’t see why the Googles and Metas and Microsofts of this world will benefit hugely from AI. I think they will end up having to incorporate AI solutions for free into their product offering. I don’t see why their earnings should go up because of AI. And that’s why I don’t think the FAANGs will get another decade of outperformance.
Does that scepticism also apply to Nvidia?
No. Nvidia is a pick and shovel play. If there is a gold rush, buy the producers of shovels. Nvidia has a chip that everybody needs for AI. I also want to own the likes of ASML and Tokyo Electron, because if we need to build more infrastructure to build more Nvidia chips and because we want to recreate supply chains away from Taiwan, I want exposure to those capex stocks.
Is this year’s outperformance of the Magnificent Seven just a head fake?
Yes. But it’s kind of binary. I need to be correct with my view that China does stimulate, and that the Fed will be willing to be behind the curve and not raise rates further in an election year. If that happens, then we can have a pretty significant downtrend in the dollar in 2024. Then commodities and EM can get a bid. But first, China will have to convince us that they are not suicidal. Until then, the dollar might remain strong, and big tech might remain the place to hide.
What if you’re wrong and the US does slide into a recession?
Let’s say we will have a recession next year. Inflation will go below 2%, Treasury yields will drop, capex will collapse. That’s what happens in a recession. And then everyone will jump right back into the big US tech names, right? But that would be wrong. Recessions don’t end secular capex cycles. If we are in the same macro context, if America still doesn’t like China, if everyone is still trying to do green energy investing and diversify supply chains, then when the Fed cuts rates, we will go right back to the capex boom. A cyclical recession is not a reason to change a secular theme.
I see the bullish case for emerging markets. What about Europe and Japan?
They should do well in this world. But they are leveraged to China in many ways. In order to be truly bullish for European and Japanese equities, Beijing needs to pivot. If this is a cycle where the energy, industrials, and materials sectors do well, then Japan and Europe are well exposed to those.
What would make you say that you’re completely wrong, that the best trade is still the Nasdaq and investors should forget everything else?
Two things. One, China is critical. If China does turn out to be suicidal, it changes my view. The other thing: Manias create their own dynamic. If most investors think the only way to play the AI thesis is with the Magnificent Seven, then we could have a 1990s style rally in the dollar, driven by capital flows. If every pension fund manager says I want to own AI, and the only way I can do that is by buying the Magnificent Seven, then the dollar can appreciate. And an appreciating dollar is not good for the capex thesis, because it increases the costs of many capex goods including commodities to the point where that will impair investment. Don't forget that people in the investment world want to believe in narratives. Narratives are very strong. Do you remember the BRICS piece by Jim O’Neill, then at Goldman Sachs, in November 2001? A high schooler could have written it. Very simple stuff. Not to denigrate Jim O’Neill, by no means, that’s the brilliance of his piece, it created a powerful narrative. The greatest piece of sell side research ever written. Today, we’re still in a narrative competition. It might last for another twelve months.
Marko Papic
