Today’s China will never be a superpower

It cannot afford it, and the single-party state will not allow the necessary reforms

Charles Parton


President Xi Jinping speaks at the National People's Congress in Beijing, March 2018 © Reuters


China wants to be a superpower, or even the global superpower, by the middle of this century. That is the meaning of Xi Jinping’s second “centennial goal”: becoming a “strong, democratic, civilised, harmonious and modern socialist country” by 2049, the 100th anniversary of the founding of the People’s Republic of China. It won’t be so.

Whether you use the original definition of superpower status — the possession of pre-eminent military power and the ability to project it globally — or whether you broaden it to include economic, political, cultural and intelligence power, and the ability to shape international governance, what matters is the long-term capacity to pay for it all.

The costs China bears today are small compared with those it would need to shoulder — for decades — as a superpower. Its military expenditure falls far short of America’s. Domestically, the costs of repression and stability are said to be even greater than the budget of the People’s Liberation Army. An ageing population of 1.4bn requires a comprehensive social security system. The costs of rectifying the environment are mind-boggling.

Assume no US growth until 2049 and China’s GDP would need to increase at nearly 6 per cent every year (few believe it has been that high of late) just to match America’s 2018 per capita income. Such smooth growth defies all empirical experience. It also assumes that the renminbi peg survives in perpetuity. George Magnus, in his excellent book Red Flags, lays out why the peg is crucial and why it will break within five years.

China had been driving up an economic cul-de-sac and needed to find a new road. Hence, in 2013 Xi Jinping launched his reform programme, declaring that the economic model of the time was “uncoordinated, unbalanced and unsustainable” — words used earlier by former premier Wen Jiabao and repeated in 2017 by politburo member Yang Jiechi. That year, a think-tank of China’s National Development and Reform Commission described reform progress as minimal. Today, the Rhodium Group’s excellent quarterly evaluations assess reform progress as rudimentary.

This is no surprise. There is a contradiction at the heart of reform, between the Leninist need to hold on to the levers of economic power (to avoid the rise of economic interests that might turn political and mutter “no taxation without representation”) and giving more play to the market.

Reform aside, there are three obstacles to China’s long-term economic growth. The first is the debt problem. At some stage, the costs of debt have to be borne, whether by people, companies or the government, and whether by inflating debt away, increasing taxation or cutting public investment and spending.

The second obstacle is demographics. While China’s population will continue to grow for perhaps a decade, its labour force is already shrinking — precipitously. China’s official birth rate of 1.6 children per woman is one of the world’s lowest, even as its population ages. The costs of social security, of caring for the elderly, will be enormous. Labour productivity must rise very quickly.

Another demographic fact is worrying in terms of instability: gender imbalance. The old one child policy reinforced cultural preferences, meaning that over the coming decades China will have between 30m and 40m men in the sexually active bracket of 20-40 years of age who will not find a partner. Their frustration may lead to unrest and instability.

The third problem, and perhaps the greatest, is a looming water crisis in 12 northern provinces that account for 41 per cent of China’s population, 38 per cent of its agriculture, 46 per cent of its industry and 50 per cent of its power generation. Neither water transfers nor desalination can prevent severe economic, social and political dislocation. What is required, if it is not already too late (and climate change looks likely to make the region drier), are massive changes in agriculture, industry and people’s lifestyles. A prime instrument would be the correct pricing of water. But raising the price by many times, as the head of one Beijing water company suggested (only to be told to pipe down), is politically impossible: the Chinese Communist party (CCP) fears that the resulting dislocation and inflation would cause unrest.

It is commonly said that if any government is capable of pushing through change, however unpopular, it is the CCP. If that were so, Mr Xi would not have expended so much energy in cajoling and excoriating officials for failure to implement his policies. The governance model is flawed: 1.4bn people cannot be governed using top down fiat and inspection, while eschewing self-regulation.

Yet Mr Xi has specifically turned his back on four useful allies: the rule of law and an independent judiciary, which is essential for business and private sector confidence; a free press, for example to help expose corruption or abuse of the environment; civil society, from where ideas, innovation and pressure flow; and some sort of political accountability, to encourage officials to work for the benefit of the people and not of themselves or the party.

All four of those allies weaken party controls and risk leading eventually to a pluralist system, undermining one party rule. So the CCP rejects them.

To the factors above can be added a lack of trust by the people in the CCP. Nationalism is an inadequate substitute. To give one example of this lack of trust, consider the internationalisation of the Chinese currency. A superpower must surely have a currency that is freely traded throughout the world. But what would happen if China opened its capital account? Because the people don’t trust the party, today’s capital flight would become a flood. Investors would abandon the current destination of their savings, the domestic housing market. Its collapse would precipitate a recession and unemployment. And the number one fear of the party is instability caused by unemployment. If you claim credit for all good things, you also earn discredit for the bad.

Could innovation come to the CCP’s rescue? A high-tech society with high productivity might help China grow out of debt, need fewer workers and cope with less water. Mr Xi himself in a January 2016 speech said that “Innovation is China’s Achilles heel”. He may be right.

The devotion of great resources to scientific research may help China to produce exciting technologies. But this might, as in the Soviet Union, be on too narrow a front. Many scholars (admittedly, western) have concluded that the motor for the rise of Europe was the free flow of ideas. A taste for iconoclasm and a refusal to accept convention may also have helped. CCP control is sympathetic to none of those. Culture, reinforced by politics, does not favour the unconventional. And with prioritisation of state-owned enterprises over the private sector, added to tightened party control over business, education and society, it is legitimate to wonder whether in future the likes of Huawei, Alibaba and Tencent will emerge as easily.

Some point to the CCP’s flexibility: in 1978, who could have imagined that it would slough off so much dogma? But there is an important difference between the first 30 years of reform and the last 10. Earlier, the interests of reform and of party members were heading in the same direction: much money could be made, legitimately and not so legitimately, by following the dictates of reform. Now, even with a restricted role for the market, they are heading in opposite directions. The war on corruption reinforces this.

The likelihood is that we have reached “peak Xi”, or perhaps “plateau Xi”, since China will continue to be a powerful country. In the recent words of Chen Deming, minister of commerce until 2013: “Do not take it for granted that China is number two, and do not make the assumption that we will be the number one sooner or later.”

What does this mean for liberal democracies? If China’s rise is not inexorable (nor its collapse inevitable: it will remain a major power), we must in the meantime be more resolute in defending our security, interests and values. We should resist any tendency towards pre-emptive kowtowing to China. We must promote what is essential for long-term prosperity, not least respect for international law, which China may further flout as its problems increase.

In sum, despite our present woes, we should have more faith in our systems. Their virtue is not English oak, but more Chinese bamboo: they bend in the buffeting winds, but don’t break.

Those who said that China’s rise would lead to convergence with liberal democracies are now accused of getting it wrong. But the obverse of the same coin, that unless China changes its systems, it has no chance of being a superpower, may be correct.


Charles Parton is a senior associate fellow of the Royal United Services Institute, a think-tank. He was an adviser to the UK House of Commons select committee on foreign affairs inquiry into China.

Some Luxury Brands Look Frayed Second-Hand

Discounts in the resale market can give investors clues about which labels need investment or won’t sustain their pricing power

By Carol Ryan


A Cartier Panthere watch. Brand owner Richemont met the challenge of the second-hand market by buying U.K. reseller Watchfinder last year. Photo: Stefan Wermuth/Bloomberg News


Websites that sell second-hand handbags and watches show shoppers quickly which brands hold their value over time. They should also influence how investors think about luxury stocks.

The market for second-hand luxury is growing fast. Independent consignment stores and traditional watch dealers have done a sideline in pre-owned products for decades, but e-commerce has paved the way for a more global breed of merchants. Sites like The RealReal, Watchfinder & Co. and Vestiaire Collective connect sellers with a deep pool of buyers world-wide, and are winning over consumers by hiring experts to authenticate products and restoring items such as watches to near-mint condition.



The resale market poses the biggest challenge for watch companies like Switzerland’s Compagnie Financière Richemont ,which owns Cartier and Vacheron Constantin, and Omega-parent Swatch. Second-hand watch sales amount to $3.3 billion a year, according to Credit Suisse estimates, equivalent to 10% of the entire market.

With deeply discounted watches readily available on the second-hand market, buying new looks less attractive. Cartier’s Panthère watch in yellow gold currently sells for $25,000 on the brand’s official U.K. website. A mint, virtually identical, authenticated model from 15 years ago is for sale on Watchfinder for a quarter of the price.

A related challenge is that greater transparency about which products don’t hold their value could undermine certain brands’ ability to raise prices in the primary market. That explains why watch companies are trying to exert greater control over second-hand trading. Richemont bought U.K. reseller Watchfinder last year for an undisclosed sum.

In an industry light on data, visibility on pricing also offers shareholders a reliable measure of how consumers view products and brands. In the case of watchmakers, the conclusion is a depressing one: Investors can’t buy into the best brands. Only privately held Rolex and Patek Philippe fetch a resale premium among the top-end names. Richemont’s timepieces don’t hold up as well, with some Jaeger-LeCoultre models discounted by as much as 40%.

Sales of used handbags, clothing and footwear are also worth roughly $3.3 billion a year, according to Credit Suisse, but that amounts to just 1% to 2% of the much larger market for so-called soft luxury. The second-hand channel therefore doesn’t yet pose a big threat to groups like LVMH Moët Hennessy Louis Vuittonor Gucci-owner Kering, which guard their largely proprietary distribution networks zealously. 






And pricing of pre-owned handbags often confirms what shareholders already know: Hermès, the priciest consumer stock in Europe, is the only luxury brand whose bags are more expensive in the second-hand market than they are straight from its boutiques. A Birkin bag—a product Hermès sells in carefully constrained numbers—is 7% more expensive on The RealReal than a new bag. Louis Vuitton’s Neverfull canvas tote also fares well despite being widely available: A discount of just 4% shows the brand’s strong cachet.

Other products are steeply discounted. Bags made by Italian labels Tod’s and Salvatore Ferragamoare marked down 60-70% in the second-hand market. That jars with racy stock-market valuations: Earnings multiples are roughly 30 times projected earnings for both brands. Takeover and turnaround hopes explain some of the froth. U.S. luxury companies Tapestry and Capri are on the hunt for European brands, with the latter having bought Versace last year for $2.1 billion. But shareholders could also be underestimating the brand investment that will be needed to win over shoppers.

Investors should keep a close eye on second-hand luxury-goods prices. The risk is that labels with a big discount could soon get a corresponding one in the stock market.


Bonds Could Be The Fade Of A Lifetime

by: The Heisenberg


Summary
 
- The world is in love with bonds, and it's not hard to understand why.

- The trade war is back (with a vengeance) and to quote one analyst, "nobody in the investing universe believes inflation is an actual ‘thing’ anymore."

- With 10-year US yields at their lowest since 2017 and analysts rushing to slash their year-end yield targets, it may be time to fade consensus.
 

Hate spreads faster than love and fear sells, which helps explain why April's "nascent reflation" narrative is seemingly dead and buried.
 
Thanks in no small part to trade concerns, this week saw the return of the late-March "growth scare" story, as told by bonds, whose "voice" is always pretty ominous at times like these.
 
10-year yields in the US pushed to their lowest since 2017 on Thursday. 30-year yields fell to the lowest since early last year. In Australia, benchmark yields hit a record low. German bund yields touched -11bp. And on and on. The purple-shaded boxes in the top pane of the visual denote, in order, the bond rally in late March and its ongoing sequel.
 
(Heisenberg)
 
 
Every locale has its own unique dynamics, of course. But the common thread is that renewed trade tensions effectively deep-sixed the economic optimism seen in April, when better-than-expected data out of China (e.g., March activity numbers and Q1 GDP) suggested the world's second-largest economy had bottomed, and was on the verge of inflecting. Recent data out of Beijing threw cold water on that story, though. Indeed, activity data for April showed the Chinese economy decelerating again, even before Donald Trump's latest escalations in the trade conflict.
 
"Our simulations show that the negative effects on US GDP rise to 0.5% with across-the-board 25% tariff on China and to 0.9% with a 25% tariff on all auto imports", Goldman wrote, in a note dated Tuesday, adding that "the all-in growth effects on China are similar to the US", although the math that gets you there is different. Here's a visualization of the projected GDP drag across regions and under different scenarios:
(Goldman)
 
 
A slew of downbeat data out Thursday underscored Bank of America's "mark to misery" justification for slashing year-end yield forecasts across the board. Japan's manufacturing PMI slipped back into contraction territory, the flash PMI for Germany in May printed below the expansion line for the fifth straight month, Ifo business confidence fell to the lowest since 2014 and then, in the final straw, Markit PMIs for the US missed estimates with the manufacturing gauge printing the lowest since September 2009.
 
Little wonder, then, that the world is enthralled with bonds. It's a love affair - a duration infatuation, if you Will.
 
But, as my buddy Kevin Muir (formerly head of equity derivatives at RBC Dominion and currently head of research of global and domestic investment products at East West Investment Management) put it on Friday, "the funniest part of this love affair with fixed income is that less than half a year ago [the smart money] was equally convinced bonds were heading lower."
 
In his note, Kevin cites JPMorgan’s Treasury survey, which shows client longs sitting at the highest levels since 2010. When you throw in Nomura's risk parity model (which betrays a 3-standard deviation DM bond allocation) and EPFR data which shows that since the Fed’s dovish pivot in January, global bond funds have seen some $160 billion in inflows, you can understand why the "love affair" characterization is being bandied about.
 
 
(Bloomberg, Nomura, EPFR)
 
 
But how much sense does this actually make? A lot, if you believe the global economy will indeed succumb to the trade war and roll over in earnest. However, do note that tariffs (and protectionism in general) are facially inflationary. Here's another visual from the Goldman note cited above which shows the bank's projections for inflation under the same trade war scenarios:
 
(Goldman)
 
 
In their own trade war update, Nomura's North American economists wrote the following (this is from a note dated Tuesday as well):

"We believe that the impact of the tariffs that are already in place – 25% on $34bn of imports imposed in July 2018; 25% on $16bn imposed in August 2018; and 10% on $200bn imposed in September 2018 – on consumer prices has largely materialized. The combined impact from the increase from 10% to 25% on $200bn in imports (tranche three) and the 25% tariff on the addition $300bn in imports (tranche four) is estimated to be large as the volume of imports subject to those changes accounts for about 20% of total US goods imports. Moreover, the composition of the fourth tranche is weighted more towards consumer goods relative to previous tranches. There appear to be few readily available alternative sources for many of the consumer goods included in the fourth tranche." 
The bank does note that the effect on inflation from the tariffs won't be permanent, but it could be "substantial" in the near term.

Now, consider the effect tariffs on the remainder of Chinese exports to the US will likely have on Beijing's decision calculus when it comes to stimulus. Thus far, China has avoided kitchen-sink-type stimulus, in the interest of not inflating bubbles, both in the real economy and in financial assets. But a piecemeal approach will become less tenable in the event the Trump administration turns the screws even tighter. Remember, there's a sense in which the global cycle (i.e., the reflation impulse) lives and dies by Chinese stimulus. If China does go pedal-to-the-metal (as it were) in a bid to offset the drag from more tariffs, that's inflationary.
 
Meanwhile, the Fed is of course conducting a policy framework review that many believe will ultimately lead the FOMC to adopt a modified approach to inflation which could include tolerating (or encouraging) overshoots to "make up" for previous shortfalls. This is a big deal, and it's going to start grabbing more headlines over the course of this year.
 
The point (in case it's not clear enough) is there are all manner of potentially inflationary dynamics on the horizon and, right now, you'd be hard pressed to find anyone who believes that inflation is going to suddenly come roaring back. Hence, the infatuation with bonds.
 
Well, if everyone is wrong when it comes to inflation, that bond "love affair" is going to look woefully offsides.
 
"What can drive yields higher? Inflation, which nobody in the investing universe believes is an actual ‘thing’ anymore", Nomura’s Charlie McElligott wrote Thursday.
 
It goes without saying that if the global economy does not in fact roll over, then the recent rally in bonds will be faded, potentially into the reflationary dynamics outlined above.
 
In that case, the bond overweight would be akin to lit kindling and any reflationary impulse from China, the effects of the tariffs and/or a signal from the Fed that policymakers will pursue "new" methods to avoid consistently undershooting their inflation target, would be gasoline on the fire.

I'll just close with a couple of additional excerpts from Kevin Muir, who I'm sure will be delighted to see them reiterated:

"Almost all of you will dismiss this as idiocy. I get it. Sentiment is so lop-sided I know this will not be warmly received. But back in October when I preached caution with short positions even though “Bond Kings” were selling with both fists, it also was derided. I have learned that sometimes you have to not worry about your reputation and just do what you think best. 
Remember, the hard trades are most often the right trades. And I ask you - what could be harder than fading the current bullish bond sentiment?"

Plain-Vanilla Debt Could Bring Pain in Next Crisis

Amid concerns about rising corporate debt, ordinary investment-grade bonds deserve more scrutiny

By Aaron Back


The Federal Reserve earlier this month highlighted corporate debt risks, including plain-vanilla bonds. Photo: chris wattie/Reuters


Federal Reserve Chairman Jerome Powell warned this week of dangers from rising business debt, saying it makes the U.S. economy more vulnerable. He follows many analysts and investors who have raised alarms over the growth in leveraged loans and the securities they are packaged into.

But these concerns shouldn’t overshadow potential risks in ordinary corporate bonds—even investment-grade ones.

Earlier this month, the Fed’s financial stability report highlighted corporate debt risks, including plain-vanilla bonds. The share of investment-grade bonds rated in the triple-B category—the rung just above speculative grade—has reached record levels, the Fed noted in the report.

According to Fitch Ratings, BBB-category bonds—which includes BBB+ and BBB- ratings—accounted for 59% of investment-grade bonds outstanding in 2018, up from just under half in 2011. That is equivalent to around $2.2 trillion of debt that could be vulnerable to downgrades in the next economic downturn.



The Fed sees potential domino effects if large amounts are lowered to speculative or so-called junk status. It notes that, among U.S. financial institutions, insurers are the biggest investors in corporate bonds and that they face higher capital requirements for holding speculative-grade debt. For life insurers, when a bond is downgraded to speculative grade, the after-tax capital charge for holding it more than triples, according to the National Association of Insurance Commissioners.

If insurers become forced sellers after these bonds are downgraded then they could flood the smaller, less-liquid market for speculative-grade debt, the Fed warned, causing further ripple effects.

Not everyone is so alarmed. In a December note, S&P Global estimated that perhaps $200 billion-$250 billion of debt could be downgraded to speculative grade in a recession as severe as the last one. That sounds like a lot, but the ratings firm notes it would be similar to past downturns as a percentage of the speculative-grade market.

Among bond issuers, especially high leverage ratios are concentrated in industries with less cyclical risk, S&P added, including utilities, real-estate investment trusts, and consumer staples.

But every downturn is different. For instance, even in boom times it is already apparent that consumer staples, including packaged food and household goods, aren’t as stable as they used to be. Shifting consumer tastes and disruption from e-commerce are putting pressure on sales and margins. This pressure could intensify in a recession as consumers become more price sensitive. Leverage in this sector has also been run up by aggressive merger activity.

Sometimes the biggest risks lie not in exotic places but seemingly mundane ones. Investment-grade bonds deserve more scrutiny.