China’s Disturbing Vision

By John Mauldin

And once you see it, you cannot unsee it.

I’m not alone. Here is what we are observing at macro scale:

That it has been common knowledge—something we all knew that we all knew—since the Nixon years that by simply exporting capitalism and free enterprise, we would unshackle the forces of freedom in China.

That this common knowledge is [now] breaking.

Today, we all know that we all know that the influence of the Chinese Communist Party over what you and I do has been aided, not thwarted, by the nominal Chinese embrace of capitalism. I think that this—not the NBA, or Hearthstone, or Disney, but common knowledge about the distorting effects of concentrated power on the efficiency of market outcomes—is the real main event.     

—Rusty Guinn, Epsilon Theory

I have been writing about China for almost the entire 20-year history of this letter. We have had multiple intense and focused sessions on China at the Strategic Investment Conference. It is highly likely that we will do so again next year.

China’s growth has been one of the most important economic events in human history. It has moved more than 300 million people from what was essentially a medieval bare-bones existence to fabulous cities, built one of the most incredible transportation and railroad systems in the world, all the while allowing entrepreneurs (what a concept for a communist regime) to create some of the world’s largest and most creative companies. All this is staggering.

On the other hand, China did this on an incredible mountain of debt raised in just the last few decades while generating some of the worst pollution in history. Their monetary system is a potential nightmare.

Two-thirds of the population still lives in utter poverty. Over one million Uighurs are locked up in what are, for all intents and purposes, concentration camps. Citizens are routinely arrested and tortured for resisting government edicts. The stories coming from China are frightening to Western minds.

This sort of thing isn’t new. Millions died of starvation because of bureaucratic ineptitude and fear during Mao Zedong’s “Great Leap Forward.” Not to mention the purges of intellectuals who disagreed with Mao.

And then came the Cultural Revolution:

The movement was fundamentally about elite politics, as Mao tried to reassert control by setting radical youths against the Communist Party hierarchy. But it had widespread consequences at all levels of society. Young people battled Mao’s perceived enemies, and one another, as Red Guards, before being sent to the countryside in the later stages of the Cultural Revolution. Intellectuals, people deemed “class enemies” and those with ties to the West or the former Nationalist government were persecuted. Many officials were purged. Some, like the future leader Deng Xiaoping, were eventually rehabilitated. Others were killed, committed suicide or were left permanently scarred. (NY Times)

We in the West simply cannot understand the soul-searing aspect of the Cultural Revolution. It was the Great Depression to our grandparents’ generation on steroids. It cemented the power of the top-down, authoritarianism of the Communist Chinese Party. That imperative underlies the entire culture today.

But then came Deng Xiaoping. And while he allowed (and may have ordered) the killing of students in Tiananmen Square, he also embraced some aspects of capitalism. Then Kissinger and later Nixon went to China, and as Rusty Guinn said in the quote above:

That it has been common knowledge—something we all knew that we all knew—since the Nixon years that by simply exporting capitalism and free enterprise, we would unshackle the forces of freedom in China.

And thus was born the pervasive idea that China’s embrace of capitalism would unleash something that at least resembled a Western sense of values and liberty, a country we could do business with.

The potential was indeed huge. One Western company after another was swept up in the allure of breaking into the China market, willingly surrendering intellectual property and control for the potential of massive profits.

That common knowledge, something I readily admit to embracing because it fit into the world that I knew and understood, basically stayed the same until the last few years. Although there have been cautious voices about China for decades, the main narrative has always been that of China will somehow change.

That seems to have ended now, initially for economic reasons, then more and more because the Chinese government’s actions began more obviously diverging from the naïve view of China that a large majority of the West previously held.

Yes, we were all aware of the continual affronts to intellectual property, disregard for basic civil liberties, the treatment of minorities, and the increasing encroachment of the surveillance state, something only mildly hinted at in George Orwell’s 1984.

But surely, we can work a trade deal? One that protects intellectual property and opens up the Chinese market to American companies? That seems to be the narrative that markets are looking for. But it may not be the narrative we get…

Hong Kong and the NBA

In Hong Kong, somewhere between 1–2 million people (out of a 7+ million population) have taken to the streets protesting an extradition bill proposed by Beijing. These protests have been ongoing and persistent. That the extradition bill has now been withdrawn is seemingly not enough to satisfy a smaller but active protest group.

And then came the furor over the NBA. The general manager of the Houston Rockets, Daryl Morey, tweeted out a small and rather innocuous message of support for the Hong Kong protesters. Note that Twitter is not allowed inside of China. This should have been a nonevent. Almost any NBA referee would have overseen it as no harm, no foul.

But it set off a furor within China. Contracts were canceled and the government demanded Morey be fired.

Think about that for a second. Some low-level bureaucrat pressured businesses to cancel contracts and then demanded an American organization tell one of its members to fire one of its employees who had exercised what we over here think of as free speech.

Note that NBA basketball is one of China’s most popular sports. China is a growing market and moneymaker for the NBA. To his credit, NBA Commissioner Adam Silver defended the right of free speech and says there was “no chance” the league would discipline Morey over that tweet.

This was business as usual from the Chinese perspective. It is something every American company that does business in China has to deal with. You don’t criticize the Chinese government. You block access to information the government wants hidden. You use maps that are Chinese-government approved. The list goes on and on.

The key “tell” is that the Chinese actually expected a reaction and felt they had the right to dictate to US companies and organizations, which because of prior acquiescence on the part of companies and organizations, led them to believe they would be successful. Most of their “arm-twisting” is done behind closed doors and out of the view of the public. This was not…

And this is where the common knowledge narrative is beginning to break down.

The United States and the rest of the West are not dealing with 1.3 billion Chinese citizens and human beings. The country is run by the Chinese Communist Party which controls almost every facet of life for everyone there.

Over the last three or four years I’ve become increasingly uncomfortable with China’s ambitions. There has been a surge of research pointing to the fact that the Chinese military has openly planned to be the dominant world power by 2049. And while many of these documents have been withdrawn, there is no doubt that they were written. I have talked to people who have been in the libraries and read them in China. This desire for dominance has always been a latent force, but one that was convenient to ignore, except that now we can no longer ignore it.

China’s Vision of Victory

One of the best current books on the topic is Dr. Jonathan Ward’s brilliant and well-written analysis in his book, China’s Vision of Victory. Jonathan is the founder of Atlas Organization, a Washington DC- and New York-based consultancy focused on the rise of India and China, and on US-China global competition. He is a frequent guest on numerous TV shows talking about China. A US citizen, Dr. Ward studied philosophy, Russian, and Chinese at Columbia University as an undergraduate. He earned his Master’s in Global and Imperial History and his PhD in China-India relations at the University of Oxford. He speaks Russian, Chinese, Spanish, and Arabic, and spent 10 years backpacking and studying throughout China, India, Russia, Latin America, Southeast Asia, Europe, and the Middle East. He is one of the most interesting and earnest young men I have met in a long time.
I’m going to summarize a few of his thoughts and then expect we will go into more detail next week, along with discussing other experts. That being said, there is a growing consensus that behind the Chinese economic colossus is a threat to not just the United States and other Western democracies, but the very concepts of free speech and personal liberty, not to mention property rights and the rule of law, that we consider the foundations of civilization.

If something so utterly meaningless as a tweet about Hong Kong rises to the level that it requires “thought control” then what is next? Let’s look at a few of Jonathan’s main points:

1.   China’s leaders envision a world in which China becomes the dominant global superpower—and breaks apart the US-led rules-based order

China’s leaders, from Mao Zedong to Xi Jinping, have passed along a vision of “national resurrection.” This is known today as “the great rejuvenation of the Chinese nation.”

This “rejuvenation” is an ideological vision in which China’s premodern position as the world’s dominant empire will at last be restored. This will end what China’s leaders call “the century of humiliation” at the hands of other imperial powers. This concept and its variations have been communicated for decades to the Chinese public, and it remains the guiding ideology of the CCP.

The CCP’s ambition is not regional, but global. It wants to create a new global order with China at the center, known as the “Community of Common Destiny for Mankind.” This means breaking apart the US and Allied world order and replacing it with a system in which China’s values, power, and restored national glory emerge victorious.

2.   The core of China’s global strategy is economic and industrial power

China’s strategy is built upon economic and industrial power. China’s leaders have exploited decades of engagement with the advanced industrial economies to harvest technology and make advancements on a grand scale.

The result has been the creation of an industrial base that now holds competitive advantages against the rest of the world economy. China has become the entire world’s manufacturing base. It has a $14 trillion GDP that some think will surpass the US economy in real terms within a decade. It has already surpassed the US in terms of total global trade volume.

China’s economic plan includes dominance of key regions and industries:

  • “The Belt and Road Initiative” envisions the integration of Europe, Africa, Asia, and even Latin America into an economic system with China at its center.

  • “Made in China 2025” envisions manufacturing dominance in strategic industries from robotics to shipping and aerospace.

3.   If the economic and industrial foundation is laid, global Chinese military power and submission to Chinese interests will follow

China’s leaders are also busy converting their civilian industrial base into military power.

Both the “Belt and Road Initiative” and “Made in China 2025” intertwine with military endeavors:

  • The “Belt and Road Initiative” is also the geography of an expanding Chinese military: Chinese naval exercises with Russia and Pakistan take place throughout the geography of the Belt and Road. From the South China Sea to the Mediterranean, China’s expanding military has been tasked with protecting “the ceaseless expansion of national interests.”

  • “Made in China 2025” harmonizes with the program of “Civil Military Fusion”: this instructs that innovation in the civilian industrial base must be brought to the Chinese military as it seeks to “close the gap” with the US military and US Allies. China now seeks dominance across fields as diverse as undersea warfare, outer space, artificial intelligence, quantum computing, next generation IT, and joint force warfighting.

In the meantime, Xi Jinping speaks regularly of “preparing to fight and win wars.” From Europe to the Middle East, from the Indian Ocean to the Pacific, there is no region that is left out of China’s strategies for economic or military influence: China even has diplomatic engagement strategies for Africa, Latin America, and the polar regions.

If the economic foundations are laid, then the rest will follow.

Clashing Values

We were talking about 1984-style government surveillance long before 1984. It took time but now the technology is here. The Chinese government is enthusiastically embracing it. Chinese citizens receive a “social credit” score that essentially measures their value to the regime. Facial recognition systems keep track of movement. The government logs who you talk to, what you buy, where you eat, and where you are traveling, not to mention your reading and media habits.

Set aside whether this is compatible with human rights. This surveillance is a lot of work and expense, so you have to ask: Why do it? I’m not sure we know. Of course, it’s the government that is interested in self-preservation. But, other than in Hong Kong, Chinese people don’t seem particularly bothered by the watching, or the things the government might do with the information. The cultural imperatives are alien to American minds.

With the exception that that acceptance may be less widespread than it seems. This tweet came across my inbox last week:

Source: @hancocktom

When 22–36% of any group of citizens in a country if given the chance to leave would do so, that says the underlying unrest is much greater than we think. And we know there are thousands of protests, generally about local issues, every year within China.

Regardless, it is happening, and it forces us to face some uncomfortable facts. Our largest trading partner has a radically different view of personal freedom and the role of government. Are we okay with that?

Whatever you may think, this creates a serious problem for American brands that want access to the Chinese market. They have to obey local laws in the places they operate, and it gets sticky when countries have polar opposite requirements.

Herein lies the problem. If Xi Jinping simply wanted to rule his country in his way, and was willing to let the US system operate as it does, we could probably have a manageable relationship. There would be friction but we could trade and get along. But no, what he wants is to censor all criticism of his government from anyone, anywhere.

And why is that? Because modern technology means that criticism anywhere will get back to China. Yes, they have their “Great Firewall” and they try to control the media. They’re pretty good at it but not perfect. Even small leaks are big problems.

This sets up a clash with Western values that I’m not sure anyone can possibly resolve. The US is not going to stop our citizens and visitors from exercising free speech. It is a core value to us and one that American companies must respect. But that makes it very difficult and maybe impossible for those same companies to sell their products in China.

But the problem may go even deeper.

Unlike the Cold War years, in this order there will be no “Third World.” Every country will have to adopt either US or Chinese technology standards, then align its entire economy around them. That’s going to put some governments in tough spots. Japan, the EU, UK, and others will want to have a foot in both camps. That’s not going to be possible.

This will force a serious re-engineering on the multinational companies who heretofore thought they could serve both worlds. They can’t. They will have to choose as well, and then adjust their marketing strategies, product plans, and supply chains. This will take years and be very expensive. Investors will likewise have to rethink valuations, particularly for those companies with Chinese growth plans.

This is not to say that we simply disengage entirely from China. That will not happen nor should it. But we should stop giving them the technology and tools to improve their military and the potential for their control of our economic livelihoods not to mention our liberties and free speech. It is actually that important. But that will wait for next week.

Quick business mention: If you would like to find out what types of investments I think are interesting given my outlook, I invite you to visit Mauldin Securities and find out what my “Team Mauldin” network can do for you. We work with investors at all net worth levels, and who may be looking for either total wealth management or specific opportunities that fit my philosophical framework. There are a number of private partnerships and offerings that I find very intriguing, especially those that are geared toward producing income. (In this regard, I am president and a registered broker with Mauldin Securities, LLC, member FINRA and SIPC. I am also an investment advisor working with CMG. Please note, Mauldin Securities LLC receives compensation from its partners for my referrals.  Mauldin Securities is not affiliated with Mauldin Economics.) Find out what my network and my partners at Team Mauldin can do for you.

Houston, Philadelphia, and Dallas

Sometime in the next few weeks I have to get to Houston, then later in November I will be traveling to Philadelphia to look at potential biotech and antiaging opportunities, before returning to Dallas for Thanksgiving weekend.

We are coming up on the expiration date of our Over My Shoulder package offer. For just a few more days, you can avail yourself of the full-length video collection from our ”7 Deadly Economic Sins” week, combined with a discounted monthly subscription to our service and a second valuable bonus gift.

If even a few of those deadly economic sins hit us as hard as I predict they will, your Over My Shoulder subscription will be more than worth the small monthly fee. After all, being prepared for the future is priceless. Click here for the details.

And with that, I’ll hit the send button and wish you a great weekend.

Your watching the tectonic plates of geopolitics shift analyst,

John Mauldin
Co-Founder, Mauldin Economics

What a decade of monetary policy innovation has taught us

Tools helped to avert a deflationary spiral but came with lingering side-effects

Philip Lowe, Jacqueline Loh

Central banks, such as the US Federal Reserve chaired by Jay Powell, need to strike the right balance between providing guidance that reduces uncertainty and unduly narrowing down central bankers’ options to respond to changing circumstances in the future

The global financial crisis presented central banks with unprecedented challenges, and their response was to take extraordinary actions. A decade on, we can say that these measures succeeded in saving the global economy from deflation, but also introduced some distortions in a few areas of the capital markets.

Many central banks introduced unconventional monetary policy tools following the crisis. They embarked on large-scale asset purchases and expanded lending programmes, increasing their balance sheets to historic levels. Interest rates were cut below zero in several countries.

Two committees at the Bank for International Settlements released complementary reports today assessing the effectiveness of unconventional monetary policy instruments and analysing the impact of large central bank balance sheets on market functioning.

Unconventional policy tools emerged out of necessity. In the countries hardest hit by the economic crisis, the financial sector stalled and stopped doing its job, hamstrung by losses and drained of liquidity.

The subsequent recession sent unemployment soaring. With inflation and interest rates at low levels, the limited room for conventional policy manoeuvre was quickly exhausted.

On balance, central bankers say that the results of unconventional policies have been positive.

Interventions helped smooth investor and consumer expectations and jump-start markets.

Research by bankers and academics points to a positive response of economic activity to the extra stimulus provided by unconventional tools. The risk of a deflationary spiral was largely avoided, though inflation still undershot central bank objectives. Balance sheet-expanding policies aimed at improving market functioning delivered on this front.

The path has been neither smooth nor straight, and some policies have been more successful than others. The reports conclude that corrections to the initial plans were necessary in view of the experience gathered in the course of implementation.

Balance sheet policies aiming primarily to provide monetary stimulus had some side-effects on market functioning — especially in terms of reducing the availability of bonds in the market — which were addressed by central bank countermeasures.

In addition, the style of central bank communication about policy intentions and use of these tools had to be adjusted to changing circumstances and fine-tuned to the interpretations that market participants gave to policy messages.

Monetary policy is a powerful but not very precise tool and prolonged easing can have side-effects. In part, it works by stimulating aggregate expenditure in a slump by encouraging investors and consumers, who have become overly cautious, to take more risk. Unconventional tools work the same way and, as the reports discuss, protracted use may also encourage imprudent behaviour by market participants.

In a world with open financial borders, it also has spillovers. Investors obtaining cheap funding at home can seek returns abroad, and recipient economies need to manage capital flows in a way that is consistent with their own priorities and needs.
The central banks that used unconventional policies report that these tools have earned a place in their policymakers’ toolbox. They can provide additional policy space and flexibility, allowing a central bank to achieve its mandate when conventional tools have reached their limits. In a world of low inflation and structurally low real rates, they may become increasingly important.
Another lesson is that the tools need to be complemented with measures that reduce side-effects. Such measures could include securities lending facilities that mitigate the scarcity effects from central bank asset purchases, and policies that reduce the impact of negative rates on banks funded by retail deposits.
Money markets must maintain sufficient capacity to function after the extraordinary liquidity is withdrawn, and central banks must preserve operational flexibility to address unexpected changes.
Central banks also need to strike the right balance between providing guidance that reduces uncertainty and unduly narrowing down central bankers’ options to respond to changing circumstances in the future.
The reports suggest that unconventional tools’ effectiveness can be strengthened if central banks communicate that they are willing and able to use them. This is best done in a way consistent with each bank’s legal mandate and institutional framework. Central bank credibility is a major determinant of the effectiveness of monetary policy and this applies as well in the use of unconventional tools.
At the same time, their use is best seen as one component of an overall public policy framework that encompasses fiscal and prudential policy responses. Policymakers should avoid placing a disproportionate burden on monetary policy.

Philip Lowe is governor of the Reserve Bank of Australia and chair of the Committee on the Global Financial System at the BIS. Jacqueline Loh is chair of the BIS Markets Committee and a deputy managing director at the Monetary Authority of Singapore

America Is Losing the Chinese Shopper

China was once eager to spend on U.S. brands. Then citizens of the world’s biggest country shifted their allegiances.

By Julie Wernau | Photographs by Giulia Marchi for The Wall Street Journal

Li-Ning is a Beijing sportswear brand that has become fashionable in China. Here a woman shops in a Li-Ning stand in Beijing.

BEIJING—Political controversy isn’t the only problem American companies face in China.

They are also up against adversaries like Three Squirrels.

In just seven years the maker of nuts, seeds and fruits has become one of the country’s most popular snack sellers. Its cartoon squirrel characters have become so popular that there’s now a Three Squirrels theme park under construction and an online show with hundreds of millions of viewers. Its sudden popularity is making it difficult for iconic American snack brands like the Oreo to gain more favor. Even with special flavors like seaweed-flavored Oreos, Oreo Wasabi and Oreo Spicy Chicken Wing.

For years, American companies looked to China as a land of new opportunity. Now a new reality is settling in: The Chinese consumer isn’t about to save the day for Western brands.

“Now the quality is similar, so why not buy China?” saidGao Yang,39, who works in home decoration, as he browsed in a Beijing mall. Once an avid buyer of Nikeand Adidas products, Mr. Gao said he has switched exclusively to Li-Ning, a Beijing-based sportswear brand that has become fashionable in China. In a Hill+Knowlton Strategies survey in 1998, virtually no Chinese respondents said they thought Chinese brands were cool. 

American brands now face two major challenges in a country that is increasingly a foe of the U.S. on matters of trade and geopolitics. One is that local Chinese brands are getting stronger.

The other is that Chinese consumers are increasingly turning away from foreign brands because they have run afoul of Chinese politics. The result is that some American brands that used to be cool are falling out of fashion.

The recent NBA flap in China was a reminder of just how quickly Chinese attitudes can turn on Western brands. Within hours of a tweet—later deleted—by the Houston Rockets’ general manager expressing support for Hong Kong antigovernment protesters, stores removed Rockets gear and sponsors pulled deals with the NBA. All game broadcasts were canceled. Searches for Rockets merchandise on e-commerce sites yielded friendly error messages encouraging shoppers to consider something else— perhaps a toy rocket.

Li-Ning mimicked American competitor Nike with a stylized “L” resembling Nike’s swoosh on its sneakers. The logo is still the same but the company is succeeding on its own merits. Its profits were up 35% year over year in the six months ending June 30.

Other foreign brands, including Asics, have had to apologize to China in recent years after upsetting local consumers on sensitive topics. This week Apple Inc. removed a crowdsourced map service that allowed Hong Kong demonstrators to track police activity. The decision came a day after the Chinese Communist Party-run People’s Daily newspaper called the app “toxic software.”

The shift signals a possible end of an era. For years, it was customary for Western executives to tout their plans for dominating China—a market they felt they had to win as markets elsewhere matured. But foreign consumer brands now hold a smaller market share in the categories tracked by McKinsey & Co. than at any time since the global financial crisis, according to a Wall Street Journal analysis of research from the U.S. consulting firm, incorporating data from Euromonitor and IHS Markit.Market share losses were particularly evident in categories such as pet food, passenger cars, videogames, smartphones and appliances. 

In 2011, 70% of smartphone sales in China were from three foreign brands: Nokia Corp., Samsung Electronics Co. and Apple. In the first half of 2019, the top three—Huawei, Oppo, and Vivo—were all Chinese, with 71% of the market between them.

Ebbing market share might still be OK for some Western companies, given that China’s market is also getting bigger. But China’s retail sales aren’t growing as fast as they used to.

Many consumers are now burdened with mortgages and other debts.

Retail sales have slowed to an annual growth rate of about 7% to 8% a year, compared with 15% or more a few years ago.

Some Western companies, including Carrefour SA, Amazon Inc. and Uber Technologies Inc.,have decided China is too complex or costly to win for some of their major businesses, and have closed or sold them off after facing powerful local rivals who were able to largely control the market.

Ford Motor Co., Apple Inc. and others remain committed, but are struggling to meet expectations. Amazon said it continues to serve Chinese consumers through its cross-border e-commerce business and remains committed to China. Uber didn’t respond to requests to comment. Ford didn’t comment. Carrefour provided no further comment beyond its press release detailing the transaction.

The willingness of Chinese consumers to keep buying foreign products matters more to the global economy than ever. China now contributes roughly a third of global growth, and is the world’s second biggest source of household wealth, according to Credit Suisse.

China is expected to surpass the U.S. as the world’s biggest consumer market in 2021, according to New York-based research firm eMarketer, with analysts predicting China will have more than $5.8 trillion in retail sales. 

 Above, Chen Xiangpeng, 26, poses for a portrait in Beijing after shopping at a Chinese clothing brand. Zhang Qi, 33, poses for a portrait in front of Gap, an American clothing brand. She just shopped for her two children, who are 3 and 5 years old.

If more Chinese consumers buy locally, or don’t spend as much as hoped, that will force Western companies—and economies—to rely more heavily on domestic buyers in their home markets to keep growth ticking. While consumption has been largely strong this year for the U.S., it is nowhere near the growth happening in China and recent data warned it may not last.

As the Chinese economy shifts inward, McKinsey predicts between $22 trillion and $37 trillion of economic value—or between 15% and 26% of global gross domestic product—could disappear as supply chains shrink and other changes ripple through the global economy.

Many Western companies are still thriving in China. Nike itself recently reported a 22% jump in quarterly sales in China, to nearly $1.7 billion, and has seen double-digit growth in China every quarter for the last five years. Beauty and personal care brands have gained market share.

Some Western brands have thrived by tweaking their products to make them feel more Chinese. After initially losing market share to an upstart Chinese coffee chain called Luckin Coffee that emphasized delivery counters and smartphone transactions, Starbucks Corp.has prioritized more local flavor, including opening a store in Tianjin in a historic building designed by a Chinese architect.

The company worked with preservationists to retain everything from a giant glass dome to the original counters once belonging to the Zhejiang Xinye Bank. It also added a tea bar with marble countertops that it says demonstrates “deep respect for thousands of years of tea tradition.”

Its results have improved in part because of initiatives that are similar to those of its local competitor—a large number of new locations, delivery service and stores for people “on-the-go.” 

KFC and Pizza Hut, now part of Yum China, have adopted many locally-influenced products in China that would be unrecognizable to American consumers. KFC sells various versions of the traditional Chinese porridge breakfast. Photo: Qilai Shen/Bloomberg News 

Some other U.S.-originated brands, like KFC and Pizza Hut (now part of Yum China), are now owned by Chinese companies and have adopted many locally-influenced products that would be unrecognizable to American consumers. For instance, Pizza Hut in China has pizza topped with durian, what some call the stinkiest fruit on the planet. And KFC sells various versions of the traditional Chinese porridge breakfast.

But even successful brands are having to watch their backs more than before. Li-Ning—the sportswear company whose full name is Beijing Li-Ning Sports Goods Co.—mimicked its American competitor with a stylized “L” resembling Nike’s swoosh on its sneakers.

Today it is succeeding on its own merits even though the logo is the same. “I think it shows my patriotism,” said Xiong Junming, 40, covered in gear from Beijing-based sportswear brand Li-Ning at a Beijing pedestrian mall. Mr. Xiong said he had just purchased four pairs of the brand’s shoes, along with some sportswear. He said he used to wear Nike but now Chinese quality has caught up.

Li-Ning recently began making a badminton line in cooperation with its national team, with rackets and footwear endorsed by Chinese stars in badminton, a wildly popular sport in China. Another clothing line, called “Deconstruction,” is aimed at “Chinese culture, street fashion and basketball attitude,” a nod to emerging street basketball culture in China. In the six months ended June 30, the company’s profits rose 35% year-over-year, though total revenue is still much lower than Nike’s.

Nike didn’t respond to requests for comment. Li-Ning declined to comment.

Many American companies miscalculated how difficult it would be to gain a permanent foothold in a country that has turned toward patriotism. In a Brunswick Group survey conducted in June, 56% of Chinese consumers said they’ve avoided purchasing an American product to show support for China’s position in a continuing trade war with the U.S. A Credit Suisse survey last year found that more than 90% of Chinese consumers between ages 18 and 29 would prefer to buy domestic appliances.

Other companies are finding it harder to sell to Chinese shoppers who now have some of the same debt worries that weighed on Americans. For every dollar of GDP generated in China last year, its households owed 54 cents, according to the International Monetary Fund. Households will owe 68 cents per dollar of GDP by 2024. U.S. consumer debt is 60 cents per dollar.

 Some American brands that used to be cool are falling out of fashion in China, where nationalism is on the rise. Above, people walk past a Beijing storefront for HLA, a Chinese clothing brand. Below, customers walk past an entrance of a Walmart Inc. store in Xiamen, China, last August. Walmart recently announced it would invest $1.2 billion in distribution centers across China over the next two decades. Photo: Qilai Shen/Bloomberg News 

The shift in favor of domestic brands in China began taking off about three years ago, before the recent upsurge in patriotic feelings. Chinese brands were trading up in quality and innovation. Chinese consumers were also becoming more sophisticated, and less easily impressed with foreign names. Surveys show many now want products that express something about their identities—which increasingly involve pride in being Chinese.

Hollywood studios are among those affected. Last year for the first time, China’s top five grossing films were all Chinese. Recent blockbusters have included Operation Red Sea, based on a 2015 mission to rescue Chinese citizens in Yemen, and Wolf Warrior 2, a 2017 action film that features China as a benevolent force inside Africa.

American studios have responded by attempting to do more projects jointly with Chinese backers, though that risks eroding Hollywood’s role in dominating global popular culture. IMAX’s chief executive, Rich Gelfond, summed up what he thinks it takes to succeed in China nowadays: “Be as Chinese as you can be. Try to make it a win-win situation. Play for the long-term.”

Another area that has gotten tougher for western brands is food. Yonghui Superstores,a grocer based in Fujian province, is on track to surpass the market share of Walmart Inc.after its revenue grew 20% last year amid a rapid expansion of its fresh supermarkets and the benefit of an early start in China’s hotly competitive fresh grocery delivery market.

Walmart is now pivoting to invest in stores that are hybrid pickup and delivery centers. The company recently announced that it would invest $1.2 billion in distribution centers over the next two decades. It has built 40 depots just for delivery. “In China we have to constantly move fast,” said Daniel Shih, Chief Corporate Affairs Officer for Walmart in China.

Mondelez, the Deerfield, Ill. maker of the Oreo, meanwhile, is still searching for a way to increase its market share 23 years after introducing the country to the iconic American sandwich cookie. Mondelez InternationalChief Executive Dirk Van de Put acknowledged at a conference in September that the company spent too much energy focusing on legacy brands that had worked well elsewhere. Mondelez International generates only about 1.8% of its sales in China, according to FactSet.

    China is expected to pass the U.S. as the world’s biggest consumer market in 2021.

What makes Mondelez’s challenge more difficult is the rise of snack upstarts like Three Squirrels, which managed $1.5 billion in sales in 2018 selling nuts, seeds and dried fruits. That made it China’s largest snack retailer on China’s major online retail sites, according to Equal Ocean, a Beijing investment research firm. It expects to have 10,000 franchise stores in the next five years, according to the company’s prospectus, or about five new stores a day.

“We want to be the biggest and the best snacking company in the world, and as part of that, you need to win big in China,” Mr. Van de Put said. “One of the issues in the past why our growth was smaller or lower was because we were only focused on those power brands.” It has recently switched strategy by focusing on boosting the local brands it has acquired in China.

This year, one of those local firms launched a new rice wafer snack with purple yam and black rice flavors. Mondelez, according to Euromonitor, was able to claw back lost market share for the first time since this data was collected in 2012. Mondelez doesn’t break out its China business separately.

“The company doesn’t play in the same categories with Three Squirrels,” Mondelez said in a statement.

A recent flap over a tweet from the Houston Rockets’ general manager expressing support for Hong Kong antigovernment protesters was a reminder of how quickly Chinese attitudes can turn on Western brands. Here people walk past an NBA store in Beijing.

Even China’s luxury goods market—dominated for years by Western names—is changing. After Chinese president Xi Jinping’swife wore a trench coat from Guangzhou-based luxury brand Exception de Mixmind in 2013 during a state visit to Moscow, consumer sentiment about local alternatives has started to improve.

Many foreign luxury brands still post strong results in China. But McKinsey warns that among younger consumers, barely half of luxury buyers now care about brand names, with a growing number purchasing Chinese products. Among their parents, virtually none would have considered anything Chinese luxurious.

Western luxury brands faced consumer boycotts in August for labeling Hong Kong as a separate entity from China. Versace, Coach and Givenchy were among the foreign brands that posted apologies on Chinese social media.

—Bingyan Wang and Fanfan Wang contributed to this article.

The rich world

Economists’ models of inflation are letting them down

Why has the “Phillips curve” failed at both ends?

ONE OF THE economic models named after William Phillips is physical. The Phillips hydraulic computer uses flows of water to simulate flows of money in the economy; its success helped earn Phillips a job at the London School of Economics in 1950. Today economists can bring the full power of modern computing to their calculations.

But they still depend utterly on another Phillips eponym: the curve tracing the relationship between inflation and unemployment (see chart). It comes in various flavours, but the basics underpin central banking. If unemployment falls too low, inflation will rise; too high, and it will fall.

Over the past decade the “Phillips curve” has failed at both ends. First came the so-called “missing deflation”. The financial crisis sent rich-world unemployment soaring to 8.5% by the start of 2010. Both theory and experience suggested that this should have caused a prolonged slump in inflation. But it did not.

The IMF wrote of “the dog that didn’t bark”; some economists argued that unemployment had become structurally higher (meaning it would not affect prices). It was only once oil prices collapsed in late 2014 that the rich world faced serious disinflationary pressure, with the euro zone falling temporarily into deflation in 2015 and 2016.

By then, however, labour markets were recovering. Unemployment fell and then fell some more. Today the proportion of 15- to 64-year-olds with a job is at a record high in two-thirds of OECD countries. Pockets of continued high joblessness remain in places such as Spain and Italy but, for the most part, missing deflation has become missing inflation.

The Phillips curve you can still find in the data is extraordinarily flat. Economists at Goldman Sachs estimate that a one-percentage-point fall in American unemployment, for example, is associated with a 0.1-0.2-percentage-point rise in inflation—so small as to be difficult to perceive. Some economists argue that it is increasingly viable to forecast inflation without any regard to unemployment at all.

There are three potential explanations for a flat Phillips curve, none of them entirely satisfactory. The first is that it is a statistical artefact. In a recent working paper, Michael McLeay and Silvana Tenreyro of the Bank of England argue that the relationship between inflation and unemployment is subject to “Goodhart’s law”: that observed statistical relationships collapse once they are exploited by policymakers (not to be confused with the “Lucas critique”, which says that some relationships cannot be exploited at all).

Suppose a central bank cares about both unemployment and inflation. In a downturn it will ignore higher inflation if it needs to get unemployment back down. Yet when unemployment is low, central banks will react hawkishly to any sign of fast price rises.

Over time those preferences will create an artificial positive correlation between inflation and unemployment, offsetting the underlying causal relationship running in the other direction.

This argument has some traction. In 2011, for example, a spike in commodities prices pushed inflation up but most central banks ignored it to focus on healing their scarred economies.

Later in the decade, amid low unemployment rates, monetary policymakers became more attuned to the risk of overheating. It would be odd, however, to explain low inflation by appealing solely to deliberate choices on the part of central banks, when they themselves profess to be confused by inflation’s quiescence.

Moreover, the argument does not suppose that unemployment can fall for ever without inflation surging. Even if a flat Phillips curve over time is no surprise statistically, today’s particular combination of low inflation and ultra-low unemployment still can be.

What to expect when you’re expecting

The second potential explanation concerns inflation expectations. The public’s ability to anticipate an overheating economy, or at least to notice prices rising faster and adjust their expectations accordingly, is supposed to be a driving force behind the Phillips curve. Firms should raise prices and workers should demand higher wages as soon as they see a boom coming.

Such expectations seem to be getting stickier. Canada, New Zealand and Britain have barely reacted to short-term changes in inflation since 2000, according to the World Bank. Benoît Cœuré, a rate-setter at the ECB, has studied the sensitivity of households’ fears that inflation might spiral out of control to perceptions of current price rises. Before the euro the two were closely linked; in the era of the single currency the link has been severed.

In America, too, inflation expectations react more slowly to economic data than in the past, according to research by Damjan Pfajfar and John Roberts of the Federal Reserve. It might be that prices now rise so slowly that it is no longer worth paying attention to economic news.

There is little doubt that without the amplifying effect of inflation expectations the Phillips curve should be flatter. But although expectations are supposed to be important, they are not supposed to be everything.

Eventually, economies must find that rising demand runs up against supply constraints. Hence the third, and most credible, explanation: that the Phillips curve still exists, but is “non-linear”.

Prices and wages could suddenly and quickly accelerate should unemployment fall beneath some threshold at which everything becomes unanchored.

Where might such a threshold lie? Answering that question requires breaking the inflation puzzle into its constituent parts. First, to what extent are firms’ costs—most importantly, wages—rising? Second, are firms passing on those costs by raising prices?

The link between unemployment and wages has loosened but remains intact. In America and the euro zone wage growth has risen gradually in recent years as labour markets have tightened. America is further ahead, but in both cases the figures remain underwhelming by historical standards: 2.7% and 3.2% respectively, as this report went to press. Only in Britain has wage growth really taken off, reaching 4%, its highest since 2008, in July.

Still, in most places the link between employment and wages remains discernible. The only real exception is Japan, where wage growth is flat despite monetary policy under the “Abenomics” programme driving a remarkable jobs boom (see chart). Japan’s culture of lifelong employment, in which some workers find it hard to move companies for higher wages without losing social status, is probably part of the explanation.

Elsewhere it is the second link, between wages and prices, that seems to have vanished. On neither side of the Atlantic has core inflation displayed the same gradual upward trend as wages. Britain is an exception, but it has also had an inflationary devaluation of its currency since its vote to leave the European Union in 2016.

There are two ways to have wage inflation without price inflation. The first is a productivity boom, hitherto absent. The second is if firms’ profit margins fall. There is clear scope for lower margins in America, where since the mid-2000s firms have enjoyed profits, as a share of GDP, that have been historically high.

Profits have begun to come down in recent years as wage growth has risen. The question is how much further they might yet fall, given that America’s high profit margins also reflect a lower level of competition in the economy. Outside America margins are lower and so profits provide less of a buffer between costs and prices.

In summary, if you wanted to tell a story about when inflation might take off in the rich world, it would go something like this. Wage growth is strongest in America, but so are profits. Once margins fall, firms will have no choice but to raise prices. In Europe profits are lower, but so is wage growth, because Europe’s labour market has not boomed as much as America’s. If it ever does, inflation will budge.

The Phillips curve is non-linear, meaning that prices will suddenly rise sharply only once economies cross the inflationary Rubicon. Central banks will have to fight the subsequent overheating or risk losing control of inflation expectations, as they did in the 1970s. Japan, with its entrenched deflationary mindset and unique labour-market institutions, is a special case.

The problem with this story is that financial markets do not expect it to happen. As this report went to press, the price of swaps implied that America’s consumer-price index between 2024 and 2029 will rise by an average of just 1.9% per year. Because the Fed targets an index that tends to undershoot the CPI by about a third of a percentage point, this implies missing the central bank’s 2% target by a long way.

In Europe the same measure of inflation expectations languished around 1.2%. Sometimes policymakers try to explain away markets’ low inflation expectations by saying that they are driven by a lower risk of very high inflation, rather than a change to traders’ central expectations. But this does not sit well with the idea of an inflection point in the Phillips curve lurking, ready to catch central banks off-guard.

Perhaps markets expect that recession, or at least an end to the jobs boom, will render the argument moot. But the puzzle has been enough to prompt a search for disinflationary forces beyond monetary policy and labour markets. One is technological progress.

Why the Fed Is Losing Potency

Neither consumers nor businesses are responding as forcefully to Federal Reserve rate cuts as they used to

By Justin Lahart

The Federal Reserve, led by Chairman Jerome Powell, is expected to lower rates this week. Photo: eric baradat/Agence France-Presse/Getty Images

Federal Reserve rate cuts ain’t what they used to be.

Fed officials will almost certainly lower their target range on overnight rates by a quarter point at the conclusion of their two-day meeting Wednesday, marking the third cut this year. They have framed their efforts as insurance moves, aimed at cushioning the economy against the effects of slower global growth and tariff uncertainties rather than rescuing it from recession.

The Fed’s shift from tightening in 2018 to easing in 2019 has made for easier financial conditions, with stocks at record highs and corporate bond yields and mortgage rates sharply lower. Yet it hardly seems like a fire has been lighted under the economy. Economists surveyed by The Wall Street Journal estimate gross domestic product grew at a 1.6% annual rate in the third quarter after growing 2% in the second quarter and 3.1% in the first quarter.

It might be just a matter of time before the rate cuts kick in. But long-term rates, which have some of the most direct influences on household and corporate borrowing costs, started falling in anticipation of easier Fed policy nearly a year ago, leaving plenty of time for effects to filter through. The risk is that the Fed’s policy simply isn’t as potent as it once was.

Consider the housing market. Lower mortgage rates have certainly been good for it, driving a rebound in home sales. This in turn has been a plus for the overall economy, just not as much as it might have in the past.

That is because housing represents a smaller share of the economy than it used to. Money spent on residential investment, which includes new-home construction, among other items, now accounts for about 3.7% of gross domestic product. In the 50 years before the last recession that figure averaged 4.9%. Similarly, money spent on furniture and appliances—items that are often bought after a home purchase—also command a smaller share of GDP than they used to.

Another way Fed rate cuts can affect consumer spending is by pushing up the value of assets such as stocks and homes. But wealth effects appear less potent than they used to be, perhaps because stock-market and housing wealth have become more concentrated in the hands of the well-to-do.

Companies also don’t appear to be responding to low rates as forcefully as might be expected. Business investment contributed far less to growth in the second and third quarters than it ought to have considering the drop in interest rates, Morgan Stanleyeconomists estimate.

One explanation is that low borrowing costs won’t induce companies to spend on new equipment if there isn’t enough final demand to put that equipment to use. So if consumer spending isn’t responding as forcefully to lower rates, neither will spending by companies. Add in concerns about global growth, trade tensions and narrowing profit margins, and it is easy to see why companies might not be in a rush to go out and spend.

New research from economists Ernest Liu,Atif MianandAmir Sufipoints to an additional factor: When rates are very low they initially lead industry leaders to invest heavily, discouraging competitors who can’t keep up. Eventually the leaders face few competitive threats and become “lazy monopolists” that don’t invest much either.

The problem is compounded by the higher borrowing costs that smaller firms tend to encounter. Small businesses polled by the National Federation of Independent Business last month said the average interest rate they paid on loans of one year or less was 6.7%, which compared with 6.9% in January. Over the same period, yields on one to three year investment-grade corporate bonds, which larger companies can issue to fund their borrowing needs, fell to 2.3% from 3.4%, according to ICE Data Services.

If the economy is less responsive to Fed rate cuts, the Fed might have to cut rates even more deeply than it used to in order to boost growth. One implication of that is that Wednesday’s expected rate cut might not be the last. Another is that whenever it faces a recession, the Fed could have even less ammunition than seems apparent.