The expectations coming out of the COVID pandemic was that China's economy would experience a rebound, but that has not materialized. In this episode we look at some of the potential reasons for that including a slowing housing market, the tapering of the migration from rural to urban regions and the buildup of debt.
Important Disclosures:
For institutional investors only. TD Global Investment Solutions represents TD Asset Management Inc. ("TDAM") and Epoch Investment Partners, Inc. ("TD Epoch"). TDAM and TD Epoch are affiliates and wholly owned subsidiaries of The Toronto-Dominion Bank. ®The TD logo and other TD trademarks are the property of The Toronto-Dominion Bank or its subsidiaries. The information contained herein is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information is distributed with the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein as well as any risks associated with such proposal or services. Nothing in this presentation constitutes legal, tax, or accounting advice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Certain information provided herein is based on third-party sources, and although believed to be accurate, has not been independently verified. Except as otherwise specified herein, TD Epoch is the source of all information contained in this document. TD Epoch assumes no liability for errors and omissions in the information contained herein. TD Epoch believes the information contained herein is accurate as of the date produce...
The expectations coming out of the COVID pandemic was that China's economy would experience a rebound, but that has not materialized. In this episode we look at some of the potential reasons for that including a slowing housing market, the tapering of the migration from rural to urban regions and the buildup of debt.
Important Disclosures:
For institutional investors only. TD Global Investment Solutions represents TD Asset Management Inc. ("TDAM") and Epoch Investment Partners, Inc. ("TD Epoch"). TDAM and TD Epoch are affiliates and wholly owned subsidiaries of The Toronto-Dominion Bank. ®The TD logo and other TD trademarks are the property of The Toronto-Dominion Bank or its subsidiaries. The information contained herein is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information is distributed with the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein as well as any risks associated with such proposal or services. Nothing in this presentation constitutes legal, tax, or accounting advice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Certain information provided herein is based on third-party sources, and although believed to be accurate, has not been independently verified. Except as otherwise specified herein, TD Epoch is the source of all information contained in this document. TD Epoch assumes no liability for errors and omissions in the information contained herein. TD Epoch believes the information contained herein is accurate as of the date produce...
Speaker 1:
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Speaker 2:
Hello and welcome to Actively Speaking. I'm your host, Steve Bleiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.
Speaker 3:
Welcome back to another episode of Actively Speaking. My guest today is Kevin Hevner , uh, a frequent guest on the podcast. Welcome, Kevin.
Speaker 4:
Um , morning Steve.
Speaker 3:
Today we're gonna talk about China. It's a topic that's been in the news a lot lately, certainly on the minds of many investors in recent months coming out of covid . Everybody I think, was expecting , uh, more of a rebound in China, and , and it doesn't seem to have materialized, and it's leading people to question the long-term growth story in China. And has something, you know, changed there? Is it not as as robust as, as we all thought it was gonna be in , in the past? So let's start out with , uh, an assessment, Kevin, on , um, you know, what is going on with growth in China?
Speaker 4:
Thanks, Steve . One way to think about it is through the lens of the, the housing market. And over the last 15 years, we've seen a pretty dramatic buildup in housing, for example, floor starts, these sorts of measures where it's accounting for over the last decade. It's accounted for about 20 to 25% of Chinese growth, sort of direct real residential real estate , um, activities that compares to say 7% in the us . So it's a pretty enormous number, and maybe you could argue well at the beginning stages of development. Maybe that makes sense. Uh , I think that's a difficult case to make, but if it's accounting for 20, 25% of growth over the last decade, a little bit longer than that, that means about, say, two percentage points of growth. And growth has averaged say , uh, 8% over the last two decades. Has this come from residential real estate? It does look like activity is downshifting pretty markedly. And, and with that, the strong tailwind moves to a headwind in probably deducting about one percentage points from growth. So just that alone , uh, housing, so going from plus two to minus one in terms of the impetus to growth is pretty big. At the same time, we have demographics kicking in and we've had a workforce that's been growing about plus two percentage points per year that's now subtracting by about one percentage point. So overall trend growth is downshifting from a number, say six to 8% per year to , we think that's closer to three to 4%, probably closer to 3% per year. So pretty dramatic changes over the last couple years in terms of the growth dynamic in China.
Speaker 3:
Ah , yeah. So you've used the expression bending, not breaking , uh, to describe that. Okay. Um , yeah, you know , uh, there was a , a , a rage a few years ago for videos on YouTube of all these massive collections of buildings being put up in China, residential towers that were completely empty and in some cases unfinished. What is that? I mean, what is happening with all of that? Uh, is, are those buildings being torn down? Are they finally being occupied?
Speaker 4:
Yes. So, so for example, in 2018 , um, the vast majority, I I think almost 70% of home cells were to people who already had a primary residence. So they were second or third , um, uh, homes for these people. In some cases they were rented out, but the rental yield was less than 2%. So it was pretty bad. Uh, it was not a great investment , um, proposition for people. And in some places, the real estate developers with the encouragement of local governments did build massive projects ahead of the population hoping people would come. In most cases, that worked out okay, but in a number of cases , um, it didn't work out well in the Wall Street Journal, for example, estimates that in 2018 there were still millions of vacant apartments have been built and no one had shown up. So that was an issue. And I think that is part of the, the top down growth model to build ahead of demand that you'll often, at least some of the time , um, build things that people don't want.
Speaker 3:
Yeah, I mean, my recollection is of course, that there was an expectation of continued movement of people from, you know, rural villages, the countryside into larger towns and cities. Has that, is that still going on that demographic shift that
Speaker 4:
That's still going on at the margin? That was, that was a huge driver of , um, growth in China from dung in 78 until at least two, you know, 2008, 2010. And to some extent that's the same thing as the Soviet growth model , um, with Lenin and Stalin as you move peasants into factories and you get big productivity boost with that. So that's, that's the model that's, that's well known , um, in , in a number of countries. So there , there still is a little bit of that, but in terms of the workforce, there's a little bit of benefit from moving from rural agricultural regions to urban regions, but that's very small. Now. There's also very small benefit from increased quality of the labor force. And that was also a big factor with people, you know, many people in 78 had very little education including senior leadership. Um, so now we have people with , um, primary, tertiary and , uh, university education, but the increment in terms of the quality of workforce is also getting quite small. And then you just have the big de demographic , um, effect going through , um, going through the workforce, shrinking by one percentage points a year. And, and given that housing is so central, if you look at the, the key , uh, cohort that buys homes, that's people who are 28 to 37 years old, that's peaked at just over 200 million people. But between now in 2040, that's going to decrease by just over 40%. So we've had a lot of , um, building of residential properties. Some of these aren't sold yet. The prices of these are pretty crazy. The home price to income ratio in China averages for, for major cities averages 38 times compared to about 15 times in major cities in the western world. So prices look pretty crazy. The demographic argument looks pretty bad. Uh , the number of buyers, and we can see this timeline playing out pretty clearly over the next 20 years is going to decrease markedly. So the , um, the residential real estate market is set for a very, very difficult time for the next two decades, and that's been the key driver of Chinese growth for at least the last decade . So yeah , I think it's difficult to exaggerate the challenges , um, China faces on this front.
Speaker 3:
So presumably there was a lot of , uh, debt associated with all of this real estate construction and , uh, the scenario you've just painted would imply that, that that debt is not long to be able to be paid back.
Speaker 4:
Yeah, so debt has surged , um, since 2006. The overall debt to GDP ratio in China, so that includes households, corporate and, and different levels of government has increased from about 140% to 360% currently. Uh , a lot of that is in the non-financial corporate sector. So there's been a , a lot of excesses, too much investment by that sector. Uh, some it's household, some is sort of hidden in local government financing vehicles, which is a bit difficult to see in . We've also seen the increase in households. A lot of this is mortgage debt. It's not very risky 'cause they do put up , um, very big , uh, down payments, typically 20 to 30%. So from the perspective of the financial sector, that debt doesn't have a lot of risk. But similar to the situation with Japan 30 years ago, the , the debt in , for example, the real estate development sector is, is very worrisome. And if you look at the , um, debt service ratios in China, they look really worrisome and they're running at levels that about twice the level in , uh, major G seven countries.
Speaker 3:
Um, let , let me change the focus a bit for a second. You've written a lot recently about , um, changes in globalization, you know, prompted to some extent by covid, but also by , uh, national security issues, given the geo geopolitical tensions between China and the rest of the world. Um, how have , how is that gonna affect you and the fact of, you know, all these sort of reshoring and onshoring going on in other countries? What's, what impact will that likely have on China?
Speaker 4:
So China is very clear when they're saying what their growth priorities are. President Xi doesn't like real estate as a growth driver. Um, and he is famous for saying since at least 2017, that that homes are for living, not for speculation, but in the five-year plans. And in many of his speeches, he comes out and tells us what his growth priorities are, and he does want China to be , uh, if not the leading industrial player in a lot of advanced technologies. So clearly green tech is very important, including, well the EV value chain with batteries and so forth. Um, different types of tech hardware , uh, including semiconductors, quantum computing software including ai, any AI actually you've got data, the compute requirements and the, the algos as part of that. And then all the, the, the tech industrial sectors and defense sectors going with that . So these , these are the priorities now as we de-risk our economy. And we also worry about the, the dual use nature of semiconductor chips and other equipment that we send to China. This does pose , um, challenges for China. China, it's , it's been very important to President Xi that China becomes more self-reliant, and that's a term that he likes to use, so that they don't have to depend on other countries, particularly the west for energy, for food, for semiconductors and things like that. So certainly for at least the last six years, this self-reliance has been a key priority for President Xi. But with the changes coming in the United States and the pieces of legislation, particularly last August, this has really turbocharged the process in China and the build out of semiconductors, quantum computing and a lot of these tech hardware and tech software areas.
Speaker 3:
Y you know, you mentioned before the , uh, analogy to Japan and the sort of quote lost decade of the nineties. I mean, there are, there do seem to be similarities and I , um, you know , I spent most of the 1990s actually as a portfolio manager focusing on Japanese equities. And there too , you know, the company , uh, the country had had this huge real estate boom in the 1980s. And , uh, sim also another similarity is this kind of centrally directed, you know , economic planning and , uh, you know, with the meaty in , in Japan had identified certain industries that they wanted Japan to, to be dominant in. Uh, and you know, and there was a time in the eighties when people thought that Japan was, was on course to be the world's largest economy. And Japanese, you know, investors bought Pebble Beach Golf course and Rockefeller Center and so forth. And , uh, and then that never really came to pass in terms of that, that , um, becoming the world's largest economy. What, what , uh, similarities do you see with the story in China and, and what differences?
Speaker 4:
I think the, the similarities are, are hard to deny. Uh , I think there , there's a lot of them . Um, you mentioned the, the debt buildup , um, that was certainly in the, the corporate sector in Japan in the eighties. Uh , a lot of it in real estate developers in these sectors. And this took a , a long time to come through. And as always happens, these sorts of levels of debt do we end up affecting , um, the financial sector, banks and others. And when I was working at the BOJ in the mid nineties, it was on this issue as we deal with all this debt that ends up on the balance sheet of the financial sector, how does this play out and how is it gonna affect , uh, other asset markets? And this is something which China is going to be facing now as well, is ultimately the financial sector, much of which is state owned or state directed is gonna have to do with these debts. And ultimately there will have to be injections by different levels of the government to help make things fall . There's , there's no way that you can avoid it. So that's similar to the situation. Japan , uh, demographic outlook is, is very similar. That was the second thing we mentioned. And then the third one being deflation. And , and the issue isn't so much consumer price inflation, be it food or energy or whatever, it's really asset price deflation. And it's hard to look at the, the real estate market in particular in China and not see a deflationary environment unfolding , um, for quite a long time. It's, it's not just gonna be a year or two, hopefully it won't be two decades, but I, I would think it would certainly be a decade. So there's always differences, but there's a lot of similarities. And ultimately, as you're implying in your, your question, what's driving this is this top-down model for growth , uh, where in which the government decides that they want to favor certain industries and they favor them through a weak currency, low interest rates, you have massive savings, but those, you know , those savings face financial repression, so interest rates that are much lower than , um, growth levels, this feeds into industry. You get industrial excesses from it and it from the consumer side, you have all these savings but not many investment outlooks. And then you build a , a housing bubble. So ultimately Japan is still struggling with changing their model to a more western style consumer driven model. I think China has zero interest in adopting a western style model. President XI is still very intent on a top down policy driven industry type model that isn't going to change. Um, and I think there at least Japan realized that they do have to change the model . It's been really difficult for it. I don't think China's anywhere near the point where they realize yet that this model they have in is does have fundamental flaws.
Speaker 3:
So one, you know, one blessing to the rest of the world when the Japanese real estate bubble collapsed was that while it hobbled the Japanese banks for years and years and years, and many of them were sort of insolvent, you know , on , on paper, but it just, you know, sort of, we'll paper over that and what we just, we'll go forward as if it's not the case. But it was sort of a closed system, you know, like the debt wasn't sitting on the banks of, of sitting on the balance sheets of banks in the US or Europe, unlike say, what happens in what became the great financial crisis 15 years ago, where the problem was that a lot of these , uh, bizarre derivative securities that , uh, whose value collapsed was in fact sitting on the balance sheets of banks , uh, in throughout, you know, the west. So is that, it seems to me that's similar that like if the, the problems about this debt in China seems to me, correct me if I'm wrong, are unlikely to have any sort of contagion effect outside of China?
Speaker 4:
Yeah, so from the perspective of investors, I, I think ultimately what this means is that the Chinese currency of vitamin BI think it's gonna be on , uh, have pressure for a long time. I think the equity market, which has already underperformed dramatically over the last decade, I think it continues to have a hard time in sectors like real estate. And overall the finance sector, they struggle for a long time. It's not just a year or two. It struggles for , uh, a very long time. Now, the reason why China bans it doesn't break is because there's so much domestic savings over as a percentage of GDP or for the household as a a percentage of income. It's two to three times what is normal in, in other western countries. So there's a lot of domestic savings. Um , there's a closed capital account. External debt levels are very low external debt level for China's about 21% of GDP , whereas say a hundred percent is normal for G seven type countries. So in terms of contagion effects into, or , uh, negative effects for other countries, I don't think there'd be huge directly. But there's a lot of indirect effects. For example, if you're a commodity producer and the, the demand growth for that commodity has come from Chinese growth, that's downshifting dramatically. So also iron ore, copper, all the traditional , uh, commodities, I think demand is gonna look very different from that perspective. Energy China continues to be very big energy , uh, importer easily the biggest in the world and that will continue. Um , China hasn't been a big demand driver for western growth. It has a enormous capital account surplus. So I don't think that will matter a whole lot. And then sort of the final area that people worry about is in terms of US treasuries and people wonder, for example, now the increase we're seeing US treasuries, how much that is being driven by China. And China certainly has been decreasing the amount of treasuries that they've been buying and their overall stock of treasuries held by China has been on a declining trend for the last couple years. And I would think that continues for a while as they focus on the dealing with the imbalances domestically.
Speaker 3:
So the reason I, I made the comment before when I was talking about the analogy with Japan about, you know, what went on in Japan with the , uh, meaty , the ministry of international trade , uh, industry , um, directing investment is that usually that kind of top-down , um, direction of investment doesn't work out very well. You know , um, people in government are not particularly skilled at determining what are going to be the, the industries that five or 10 years from now will be the winners. I mean, the governments have, have generally done a poor job around the world in, in picking winners and losers, whether it's companies or industries , um, within the, the , the capital reinvestment strategies that I help manage. Um, we do own a few names in China. Um, you know, in general the , the picture you're painting is <laugh> at the macro level is not particularly rosy. And, and again, capital allocation in general has not been done well by, by governments , uh, in China. Uh , i I would argue. Uh, but we do occasionally find companies there that, that we think are doing a good job of that and, and are able to reinvest at high rates of return on investment. But , um, you know, you do hear this, this phrase people use these days that , you know, quote China is uninvestible , uh, you know, the , what what you're saying would in some cases seems to support that the , the , the poor Macy outlook and the the debt overhang, et cetera. And we , we are finding , uh, a few individual names that we think are, are attractive. But, you know, what's, what's your take in general on the quote ? China is uninvestible?
Speaker 4:
I, I think it's, it's good to think about from the capital allocation perspective. 'cause I , I think that is ultimately the issue. And as you're suggesting, the government in Beijing, like governments everywhere are pretty terrible at capital allocation. And we're certainly seeing saying that, but to say China is an investible means you think that no one in China is a good capital al allocator. I think that's too strong a view overall, you know, since 2010 when we've seen the , the market underperformance of Chinese equities and it's, it's enormous like it's, it's 75% underperformance relative to the s and p , but this, this pretty much matches the underperformance of return in equity and return on capital of the Chinese market overall relative to the s and p. So there is a real issue with capital allocation, but that doesn't mean there aren't any companies that are good at allocating capital to generate a return on invested capital greater than their wac or companies that aren't good with returning shareholders through buybacks dividends and, and generating sustainable , um, shareholder yield. So my, my feeling is given the, the headwinds we see for the Chinese market and Chinese economy, it's difficult to justify an overweight position to Chinese equities on anything more than a , than a trading horizon. So if your horizon's 12 months to 18 months, I think you should be underweight China, but to say it's uninvestible. So go to zero. I think that's a very strong view 'cause there are some very good companies in China and companies which are good allocators.
Speaker 3:
Okay, well we'll leave it at that. Thanks , uh, Kevin for
Speaker 4:
Joining me. Oh, thank you Steve.
Speaker 3:
And , uh, we'll be back with another episode , uh, sometime soon. Thanks.
Speaker 2:
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Speaker 3:
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