The importance of capital formation
The below graph reflects the historical dynamics of capital formation—the percentage amount of gross domestic product, or GDP, at which capital is invested—in the United States, Japan, and China. As the graph reflects, China exhibits a tremendous level of investment as a percentage of GDP relative to the more mature economies of Japan and the United States—three times the level of the United States and just over twice the level of Japan. While the United States has been experiencing a decline in capital formation post-2008, Japan has been in a long-term decline in this area, with a drastic decline since its bubble economy burst in 1990. While all three countries have seen capital formation essentially flatline since 2009, the question arises: will China also see, at long last, an ongoing decline in investment? This article examines the possible cause of a potential long-term change in China’s investment dynamics, and considers the implication for China’s economy and equity markets.
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China’s deflationary threat
As noted in the prior series on consumption, the consumer price level in China has declined to 2.5% per annum. While this rate of consumer price inflation can be considered a fairly normal and healthy level in an economy (the central banks of the United States and Japan would give their eye teeth to get 2.0% inflation at the moment), the below graph of producer price indices indicates that there’s cause for concern.
Will PPI take down CPI and Chinese equities?
As noted in the prior article in this series, the growth rate in property prices in China has declined from nearly 24% per annum to a nearly 7.5% per annum from 2010 to date. Plus, as reflected in the below graph, producer prices turned negative in March 2012, and have yet to make it back into positive territory. China’s $586 billion stimulus package in 2008 certainly seemed to lead to a recovery in the overall economy. Plus, global monetary expansion in the United States and Europe, as well as aggressive fiscal measures, also supported global GDP growth—though after three years, the positive effects of these policy measures have apparently worn off.
Investment: Too much of a good thing?
As noted in the first article in this series, it’s possible that the rate at which new investment outpaced consumption growth has become problematic. And, despite the recent declines in fixed investment and construction in general, prices continue to decline. CLSA analyst Chris Wood notes that inventory-to-revenue ratios have reached record highs in the first quarter of 2013—rising from nearly 70% in 2007 to nearly 140% today—essentially doubling. Despite the low cost of Chinese manufactured goods, the inventory in China is rapidly accumulating at home, as well as on the shelves of Walmart.
Walmart: A canary in the global coal mine?
As the recent problems at Walmart suggest, we might be reaching the limit to how much low-cost Chinese manufactured goods or deflationary forces the world can import over a given period. While the growth of cheap exports from China is welcomed by economies that are running at or near full employment, it appears that these same cheap exports may be going too far in deflating the economies of their importers in an environment of heightened unemployment.
While economic theory would suggest that cheaper imports are typically a positive—freeing up labor in the importing economy for more productive purposes—the rate of outsourcing productive capacity, if excessively fast, can lead to near-term deflation and excessive labor dislocation in the importing country. As was the case in Japan post-1990, once deflation takes root in an economic system, consumption can decline, reinforcing a decline in productivity-enhancing investments, as seems to be happening in the United States.
Inventory overhang and investment hangover
As noted in the first graph in this article, possible that China’s investment binge may have gone on too far for too long, without sufficient growth in domestic consumption to absorb the overhang in domestically produced inventory. China’s apparent exportation of deflation has weighed heavily on US and European labor markets, where zero interest rates are still failing to create a stable level of inflation and improve labor conditions.
Unless we start to see more robust economic data coming out of the US and Europe, Chinese inventories are likely to remain high, and producer price indices are likely to experience further pressures, which will likely trickle into the broader Chinese economy, including the consumer price index, corporate profits, employment, and housing prices. In short, deflation could spread through the financial system like a virus. At the moment, the producer price indices in China would seem to be the domestic source of this virus, though it’s being cultivated by weak economic data in the US and Europe.
What does this mean for China’s equity markets?
This means investors should be very cautious. With public opinion largely in favor of keeping the debt ceiling in place in the US, the Obama Administration will face an uphill battle in maintaining the current level of government spending. Should US government spending falter, consumption of Chinese goods could also falter. However, predicting the reaction of the US equity markets is less clear-cut. Should the US government end up issuing fewer bonds as a result of limiting additional spending, interest rates in the US may decline as a result of declining bond supply, providing support to equity valuations.
On the other hand, if consumption in the US falls off a cliff as a result of sequestered spending, even lower interest rates in the US may not be enough to maintain economic growth and current levels of consumption. In the end, this could also pressure the golden era of corporate profitability that the US has enjoyed post-2008. As a result, it shouldn’t be too much of a surprise that US corporations are hoarding cash and buying back shares, as opposed to making larger investments in future productive capacity. If capital has apparently gone on strike post-2008, you can see why that may be.
For investors who think China can orchestrate a smooth deceleration in economic growth without significant disruptions to the banking system and also contain inflation, enhance productivity, manage investment growth, and grow domestic consumption, perhaps the weakness in Chinese equity prices over the past two or three years would present a more attractive price. China’s iShares FTSE China 25 Index Fund (FXI) is down roughly 15% from its November 2011 post-2008 highs. For China skeptics seeking to embrace the more recent economic trends seen in Japan and the United States, as reflected in Japan’s Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ), as well as the USA S&P 500 via the State Street Global Advisors S&P 500 SPDR (SPY) and Blackrock’s S&P 500 Index (IVV), the US and Japan markets may appear more attractive than China’s iShares FTSE China 25 Index Fund (FXI) and South Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further analysis as to why Chinese equities could continue to underperform Japanese equities, see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.”