Looking into the China Crystal Ball I see… 1920’s USA?!?

I am a believer in looking back to look forward, sadly evident from the suits I wear. As inevitable as garbage and Monday mornings, the hotchpotch of human fallacies — greed, short memories and the “this time it’s different” positive bias — are the almost animalistic forces that drives the ebb and flow of economic cycles. Misbehaving at work, literally.

The deceleration of China’s growth is well documented, which, I would like to point out with all 20 fingers and toes, is a slower growth rate not a negative one. A compound 5–6% nominal GDP growth rate over the next five years would be order-the-second-most-expensive-red-wine-on-the-menu party time for most major economies (I’m looking at you G8!). The evidence on the ground shows some stressed sectors, particularly in tier one cities which are effectively mature low-growth micro-markets. A slower growth rate is, for many executives and entrepreneurs, a relieving breather from the breakneck speed of the previous two decades, and all the operating risks that come with rapid balance sheet and working capital growth. Adjustments have definitely needed and I have seen many cases of business heartbreak, but well-managed private companies operating in large, non-commodity niches are still registering healthy double digit growth. Entrepreneurs are still innovating, fortunes are still being made, and consumers are still spending. Even the much maligned offline retail sector continues to grow at 6%. On top of this, everyone still believes, rightly so, that the government will pull all the Keynesian levers at their disposal to save the day:

In spite of the optimistic operators and investors, many a naysayer are foreseeing an imminent jolt-the-teeth hard landing for China, the most prominent of which is George Soros, who put the probability of such an occurrence at an even “100%”. As the wise Yoda would say, “not mince his words, he does”. An apocalyptic prophesy from someone so venerable struck enough of a nerve to procure an unusual direct rebuttal from the government mouthpieces. Mr Soros has put his money where his mouth is, placing big bets in anticipation of major economic turbulence. Can he be right, or perhaps it’s about time his spot-on macro-economic predictions revert back to the mean?

There is no lack of numerical analysis on China’s macro-economic trends, almost to the point of analysis paralysis. My main takeaway is that the opinions on a hard landing vs gradual deceleration are all well-represented, with western analysts favoring the former and on-the-ground operators favoring the latter. There is not much more I can add on this front. Instead, I would like to conjure the spirit of Marty McFly and look back to see the future.

Your honor, I would like to introduce exhibit A, the United States from the 1800 to 1929. The conflux of undercurrents that pushed the US towards its status as a bona fide global superpower are eerily similar to China today. Throughout most of the 1800’s, US industry was viewed as a “me-too” economy, heartily stealing textile machinery technology and know-how from the more advanced Britain, much to the chagrin of their competitors across the pond. The officially condoned flouting of British intellectual property and treason laws was instrumental in underpinning their own industrial revolution as a low cost producer of textiles, and many notable textile empires were built upon stolen technology.

The beginning of the 1900’s saw the unleashing of innovation in the US. GDP was growing rapidly and created plenty of opportunities. To take today’s parlance, the hottest startup sector at the time was automobiles. Outside of railroads, land travel was still largely conducted by leg power, two for the poor, four for the rich. There were over 100 new ventures hoping to build horseless carriages founded between 1989 to 1902. Henry Ford, a farmer’s son who rose up to become Chief Engineer at the pioneering Edison Illuminating Company by his 30s, received angel funding for a high-end automobile company which flamed out spectacularly. He tried again and was forced out of his second car venture. Undeterred, he tried for the third time, founding the predecessor to the Ford Motor Company in 1903, building one of the world’s greatest fortunes by bringing reliable cars to the masses.

Underpinning all the growth was the rapid urbanization of the United States (starting to sound familiar?), albeit much of it was driven by a large influx of young migrants, whereas China’s migration to cities has been internal. From what was almost an exclusively rural population a few decades before, 30% of Americans lived in cities by 1900. This unleashed a slew of business activity, with retail and commercial spaces springing up from the ground. During this time, a penniless migrant named Andrew Carnegie built and sold what was to become US Steel for $350m (that’s not adjusted for inflation folks), an incredible fortune. The problems associated with rapid urbanization was also prevalent — heavy pollution, increased crime, unaffordable housing, infrastructure bursting at the seams. However, the population was young, the country had peace and there was hope for a better life.

And then the music stopped.

In the lead up to the crash of 29 October 1929, speculation in the stock market was fever pitched. In the nine years prior, the bulls were running amok as the Dow Jones Industrial Average rising approximately 100% a year. Irrational exuberance much? As the economy indicators slid and household debt continued to rise, panic set in and volatility went through the roof. The collapse permeating through the London Stock Exchange triggered a massive slide to the deep, dark unknown. Like the “national team” in China, America’s financial elite tried to prop up the market but was overwhelmed. The high level of margin on stocks meant selling pressure was accelerated. The crash may not have been the primary cause of the ensuing Great Depression, but it help trigger the bursting of a credit-fueled bubble and was a good indicator of business sentiment.

In the following years, thousands of banks failed, massive unemployment was commonplace in the cities, and a negative pall was cast over the financial markets and businesses in general for many decades. The political consequences were not unlike the a Western world today. Whilst taking a few years to take hold, the anger of the masses meant that political discourse became much more radical on both ends of the spectrum, and were much more nationalist and populist.

Perhaps this is an over-simplification, and I am well aware there are many differences between the United States then and China now. We also know much more about economic management than a century ago and are better at it. But the gist of the story is that human fallacies are what creates economic cycles. There is no macro-economic utopia whereby an economy and capital market rises forever. By kicking the can down the road, problems will accumulate and magnify. Greed is good, but only in a rising market, and the higher they climb the harder they fall. It seems that without a change of direction China is moving down a similar path.

So what about timing then? If you take your cue from Mr Soros, the China 2016 credit-fuelled growth binge reminds him of USA 2005, about three years before we came a Goldman banker’s hair breadth away from economic extinction. The credit cycle matches with similar levels of productivity decrease and rising real asset prices fuelled by unabated growth in leverage. He also started putting on shorts against Asian currencies about three years before the Asian Financial Crisis hit, so this looks like the magic number. For Mr Soros’ well-documented false alarms, we should take a step back and remember this was the man that broke the Bank of England and made a cool $24b fortune by shorting into every major credit bubble since then. He has proved many optimistic governments wrong (I believe Dr Mahathir called him a “moron” for betting on the onset of the Asian Financial Crisis). History is on his side and investors would be brave to not take heed.