While the AI boom has captured most of the market’s attention this past year and propelled the benchmark U.S. stock market (the S&P 500) to a record high, another market quietly reached a new record high last month: Japan’s Nikkei index.  Prior to this point, the Nikkei had the ignominious distinction of the longest bear market on record (at 34-years), as Japan suffered through a prolonged period of economic malaise (nominal GDP growth has averaged about 0.4% for the past 25 years) due to a toxic combination of chronic price deflation, weak corporate governance and poor demographics.  

Please bear with a short history lesson on global macroeconomics, which should set the stage.  Japan enjoyed an economic miracle in the post-war period from 1950 – 1990.  Japan emerged from a rapid period of industrialization in the 1950s and 1960s that led to sustained double-digit economic growth.  This was powered by both the Japanese consumer and the export of cars (think Toyota, Honda) and consumer electronics (think Sony, Toshiba, Panasonic and Canon).  But Japan’s success sowed the seeds of its own undoing. The 1985 Plaza Accord between the US, France, Germany and the UK was designed to eliminate the massive US and European trade deficits with Japan by allowing the Yen to appreciate against various currencies, making their products more expensive to global consumers. Japan responded by a massive monetary easing program to devalue its currency, which, in turn, led to excessive real estate investment and a bubble that burst in 1989 and, to this point, has yet to recover.  Poor demographics exacerbated the issue, as an aging population in Japan shifted from spending on goods, to aggressive savings, which led to a long period of deflation.  In short, lower prices in goods and real estate created a mentality of waiting for prices to fall and deferring decisions to buy, with money invested in low yielding bonds with a view to preserving value as prices fell – the classic deflationary spiral.   Only the aggressive “three arrows” plan of Prime Minister Abe, introduced in 2012, with fiscal, monetary and structural policy tools designed to de-value the Yen, and a bit of luck in the form of the global inflation shock that followed the pandemic, has allowed Japan to exit this deflationary spiral. 

 

Since 2015, there have been many comparisons drawn between China now and Japan in the 1990s:

 

• Property Bubble.  A property bubble expanded and collapsed due to structural over-investment and major changes in demand.
• High Levels of Debt with Over-Investment in Export-Driven Infrastructure.  China’s total non-financial debt / GDP ratio approached 297% of GDP at the end of 2022, similar to Japan in the 1990s.  This was created by a massive boom in government spending on fixed investments which peaked at 47% of GDP in 2010, far exceeding the 35% peak in Japan in 1990.
• Poor Demographics.  China’s one-child policy has led to an aging population: the share of the population aged 65 and above was 12.6% in China in 2019, which is close to the 12.7% peak in Japan in 1991. (In Canada, it sits at ~19.0%!).
• Tense Global Trade Relations.  The massive trade deficit between China and the U.S. has challenged U.S. economic superiority and created massive supply chain risks which were made evident during the pandemic.  Like Japan in the 1980s, auto exports are a trade flashpoint (particularly EVs), though semiconductors, rare earth minerals, and APIs used by the pharmaceutical industry are arguably more existential threats. China’s tacit support of Russia’s invasion of Ukraine, and continued posturing over Taiwan’s sovereignty have further soured the mood.
• Cooling Economic Growth.  China’s boom in the 2000s saw GDP growth average roughly 11% (similar to Japan’s boom in the 1960s and 1980s), which has since cooled to 5%. 
• Falling Inflation.  Japan’s real estate, stock market and infrastructure bubble unwind killed inflation, and 30 years of changing demographics entrenched deflation.  China’s inflation peak in 2008 and while the rest of the world has been battling supply chain induced inflation since 2020, China’s inflation has hovered in the 0-2% ran

While there are clear parallels, there are two important distinctions:

• Debt Bubble is confined to local government and State-Owned Enterprises.  Over the past 30 years, China has weathered two major financial crises and successfully emerged from each.  This is owing to their robust internal controls and well-capitalized banking system.  Meanwhile, China’s state government debt to GDP ratio of 77% is well below the U.S.A. at 120% and Japan at 221%.  This distinction is important, as the debt issue does not extend to the sovereign/central government level, which is largely financed by local savings, not foreign investors (by comparison, foreign lenders control >30% of U.S. Government debt). (Source: Sophus Capital)

 

• Centrally controlled economy.  Because the Chinese economy is strictly controlled and the financial system is largely restricted to foreign investors, China can segregate pools of bad debt to contain potential contagion effects (particularly in its banking system).  This points to a “savings and loan” type of reckoning rather than a broader loss of confidence.  Moreover, as China’s response to Covid established, they can utilize monetary, fiscal, regulatory and trade levers much more fluidly (and effectively) than Japan or the rest of the world can.

 

Key Observations: 

 

A lot will change in the year’s ahead, and it’s difficult to predict how the world will evolve.  But here’s our observations on how the impact of a slowing (and aging) Chinese economy could be felt:

• Emerging Markets Stocks.  Chinese stocks comprise ~25% of the MSCI Emerging Markets Index, and the 60% peak-to-trough decline in the MSCI China Index from 2021 – 2022 explains most of the 25% decline in the Emerging Markets over that period. Holding the broader Japanese Stock Market was an unsuccessful strategy from 1989 – 2024, but that doesn’t mean individual stocks can’t outperform:

 

• Toyota delivered 8.4% annualized returns for Canadian investors from March 1989 – March 2024.  By comparison, Canadian stocks (TSX Composite) returned only 7.7% over the same period, and the Nikkei 225 Index returned a paltry return of 1.9% annualized.

 

• China’s tech giants are very cheap and continue to enjoy strong revenue growth: Alibaba trades for 4.5x EV/EBITDA and has grown its revenues at a 17.7% annualized pace for the past 5 years; Amazon trades for more than 5x as much as Alibaba and yet has grown its revenues at the same pace.

 

Proceed with Caution on Multinationals.  China is very important for many global multinationals and has been the centerpiece of many of their growth strategies.  Here are two examples:

• Apple.  Sales to China comprise ~20% of Apple’s total sales and ~40% of Apple’s global sales.  After they entered the Chinese smartphone market in 2010, Apple’s sales grew more than 20-fold within 5 years and recently accelerated to a new high of $70B in each of the past two years.  For context, since 2010, Apple’s China’s sales have grown at a 39% annualized clip, more than 3x the pace of their sales from the rest of the world.  Talks of ban on iPhones for employees of government agencies and state-backed companies should not be ignored.

 

• Procter & Gamble.  Sales to China comprise 9% of P&G’s revenues, up from 6.5% in 2009.  However, P&G is a low-growth company that would have experienced even lower growth if we stripped China’s contribution out of the equation.  Top-line revenues for P&G grew at a 0.46% annualized rate from 2009 – 2024.  If we strip out the sales to China, P&G’s revenues would have had growth at only 0.28%/year over that period.  (source: Bloomberg)

 

• Supply Chain Pressures and Inflation.  China has “exported deflation” for over 30 years, as a low-cost manufacturing center for cheap goods.  As their population ages and their working population declines, it is only natural to assume that wage growth will accelerate and those costs will be “passed through” to the end consumer.  Rising trade tensions and protectionism would only exacerbate this issue.  As part of his 2024 election campaign, Republican candidate Donald Trump is proposing a baseline 10% tariff on all U.S. imports and a levy of 60% or higher on imported Chinese products.
• The Music Never Stopped.   Japan comprised 18.2% of global GDP in 1994 and now comprises only 4.2%.  For context, China comprised 18.3% of global GDP in 2021.  From Japan’s peak in 1994 to the end of 2022, World GDP grew at an annualized pace of 4.7% from $27.9B to $100.6B (source: Macro Trends).  Global stocks have enjoyed even higher returns during this period, with an annualized return of 8.2% (MSCI World CAD$) from March 1994 – March 2004 (source: Bloomberg).  Companies adapt, pivot, and change to prevailing market conditions.  Even if one (major) part of the global economy is slowing down, another is rising to fill in the gaps. We anticipate the broader Emerging Markets (ex-China) to fill that role.  Of note, India is expected to eclipse China as the largest country by population in 2050.  By that time, Nigeria should have a larger population than the U.S.

 

Bottom Line:  Diversification is the hallmark of any good investment strategy, and should underpin steady growth going forward.  Investments in the Emerging Markets (whether bonds or stocks), broadly speaking, tend to perform best when the trade-weighted USD$ weakens, and hence make them an excellent hedge against U.S. holdings in portfolios.  Better yet, they are very inexpensive, offer higher yields, and access to the fastest growing parts of the world (e.g. Emerging Asia) underpinned by solid long-term demographic trends and strong balance sheets (it may surprise some, but key Emerging markets like Brazil and India have much lower levels of debt to GDP than the U.S. does IMF Government Debt to GDP ). 

 

There is a broad perception that investing in a particular region or geography means that returns should align with the growth prospects of that region.  While that may be accurate in a passive or index-based strategy, it does not necessarily hold true when pursuing an actively managed approach.  We would argue that a bigger driver of long-term investment success is to align yourself with teams that recognize developing risks (both to the upside and downside) and position you to make the best of them.