The Evolving Situation in China

 

The second major issue overhanging markets at this time is the evolving situation in China.  China was ahead of the curve in implementing lockdowns and implementing stimulus when COVID emerged on the scene in early 2020, and as a result was the first to show signs of economic recovery.  The path since then has been decidedly more bumpy, as President Xi's “zero COVID” stop/start campaign, the unwinding a mortgage debt bubble, and, more recently, drought-related energy shortages have buffeted China’s economy and wrought havoc on global supply chains. 

 

We view China as a key economy to monitor for several reasons.  First, China’s export-based economy put it on the leading edge of the supply chain issues that have sent global inflation sky rocketing over the past year.  Second, China has raced past Europe in recent years to take the number two position in term of global GDP, and hence become a key customer of U.S. companies.  For example, during the earnings call last week, Nike called out softening China sales, which represents 15% of their total revenues, as contributing to their decision to lower sales guidance for the year ahead.  Finally, tensions between China and the U.S. have been increasing in recent years, from threats to the sovereignty of Hong Kong and Taiwan, to the potential de-listing of Chinese companies from U.S. exchanges unless they comply with western accounting practices.

 

The 20^th National Congress of the Chinese Communist Party meets on Oct.16, and President Xi  Jinping hopes to extend his rule for an unprecedented third 5-year term.  He does so at a time of meaningful crosswinds that threaten to derail the world’s fastest growing economy:

 

 

In the short term, Xi has focused on stimulus to buffer the impact of the country’s “zero covid” policy whose lockdowns, travel restrictions and mass testing policies are wreaking havoc on supply chains, causing youth unemployment to jump higher (~20%), which is in turn exacerbating the unwind of a property bubble that has been building for the past 20 years.  (For some perspective, the influence of China’s property market on their economy is only half as big as the U.S.’s was during the 2008 – 2009 cycle, where real estate peaked at 12% of U.S. GDP and mortgage loans represented 65% of GDP).  There have been glimmers of hope on this subject in recent weeks, with executives from Moderna meeting with Chinese officials as reported here and China’s first MRNA based vaccine getting approval (albeit in Indonesia).

 

The stimulus has been massive, with rate cuts, tax cuts and government spending amount to 8% of GDP in 2022, about the same levels that China maintained during the lockdowns of 2020, and ¾ of the levels seen during the credit crisis in 2009.  

(Source: Piper Sandler, August 31, 2022)

 

 

But China simply cannot afford another wave of COVID – their elderly population is too vulnerable.  Less than 60% of China’s population above the age of 80 are fully vaccinated as reported here, which is far less than other developed nations like Japan, the U.S. and Canada.  If a wave of COVID moved through China like Omicron did elsewhere, experts here predict that it would overwhelm critical care capacity, peaking at 15.6x of the existing ICU capacity in China and resulting in 1.55 million deaths.

 

As with the situation in Europe, we remain optimistic that policymakers will be forced by the weight of evidence to pivot and tackle the issue head on.  Effective vaccine distribution and education on its benefits has clearly lowered the hospitalization rates, especially among those over 70, here, so it stands to reason that it will have similar success in China. Stimulus should stabilize their economy and buy Chinese officials time in the short term.  Meanwhile, as with Europe and Russian gas, the global supply chain will continue to pivot away from Chinese manufacturing centres, as evidenced most recently by Micron shifting chipmaking capacity to Japan, and Toyota building a lithium supply chain in Australia.  As it has with other shocks, the global economy will adapt, in time, and drive on.