Looking into this Tumultuous World and What’s Next? (Part II)

What we have today is definitely not a Garden of Eden, and unfortunately what’s coming next could be much worse.

Written by Prominent Ventures (A Member of HCM Capital)

In “Looking into this Tumultuous World and What’s Next? (Part I)”, we have covered topics associated with global monetary tightening, economic slowdown, inflation, debt bubble, and energy crisis. Now, it’s a good time to turn our attention to the Eastern part of the world: China, the second-largest economy in the world. Today, China faces significant economic downward pressures from demand contraction, supply shock, and expectation weakening. More importantly, most of China’s economic contributors have certain issues in terms of sustainability, and current supporting policies are offset by restrictive public health policies. So at the end of the day, the economic outlook in China is not any better than the rest of the world, and it’s relatively certain that China is also heading toward a chaotic economic cycle.

But should we just be upset, stay depressed, and stop doing anything? Absolutely NO! In fact, economic depression is just another round of capital reallocation, and it’s the preparation for another round of economic prosperity. Of course, the recession will be a tough process and is definitely bad for certain groups, but it could be good for others. More importantly, even though the global depression looked inevitable, it becomes more important to focus on what we should do instead. Like Ayrton Senna once said, “You cannot overtake 15 cars in sunny weather…but you can when it’s raining.”

Again, this article has nothing to do with inspiring stories or crisis responses. But, we could provide our analysis of assets or strategies that might be useful in response to the upcoming chaotic macro environment. Now, before we come to that topic, it’s really important to pick up what happened over the last several months, and what’s likely to happen next.

1. What about China?

Now let’s direct our attention to China, the second largest economy but mostly mysterious to individuals outside due to language barriers, limited transparency, and political propaganda.

1.1 Is China’s Export Sustainable?

We will start with China’s export, the most significant contributor to China’s economy since 2021. Specifically, the latest number of China’s export is $314.9 billion, only slightly lower than $332.7 billion in July. However, the latest China’s export growth rate is only 7.1%, significantly lower than 17.9% in July 2022 and the average level since 2021.

It’s obvious that the latest export numbers in China suggest a distinct slowdown of this economic factor. Why does it drop so abruptly? The most important reason is the weakening in foreign demand, mostly caused by the monetary tightening policy around the world.

Figure 2 illustrates this obvious foreign demand destruction around the major economies. Specifically, China’s export to USA experienced a -3.8% growth rate. As a reference, China’s export to the US has not appeared negative growth rate since May 2020. Moreover, China’s export growth rates to the EU, Japan, ASEAN, Korea, India, and Brazil have declined by 12.1%, 11.3%, 8.4%, 10.5%, 36.7%, and 28.2%, from that of the previous month respectively.

So, it’s needless to say that China had a bad export month in August. Will China’s export bounce back or will it keep trending down? Honestly speaking, China’s export slowdown is inevitable, especially given the monetary policy tightening and economic problems around the world. The latest global composite PMI is 49.7, and the previous number was 49.3. Even though the number looks better, it indicates a contraction in economic activities as long as this number is below the threshold of 50.

Overall, as we do not foresee the pivot of global monetary tightening yet, China’s export will have a limited possibility to bounce back in the short term. Then, one of the most important pillars of China’s economy is not sustainable, at least for the next 6 to 12 months.

1.2 Will Policy Easing in China’s Property Sector Work?

In the last article, “Demystify China Economic Matters in Question”, we talked about how bad China’s property sector is. And we believe it’s a good time to briefly update the latest situation of China’s real estate market and explore the latest policy easing in China’s property sector.

So, let’s look at the latest data for the property sector. In terms of investment, the latest growth rate in the real estate industry is -6.2%, worse than -5.2% in the last month. At the same time, the growth rate in sales of commercial properties is still significantly negative, -23.0%, while this number was -23.1% in the last month. Overall, it’s not hard to notice that China’s property sector does not bounce back even with the cut in a bunch of policy rates.

Why is this? There are several factors behind this. Firstly, it’s still important to point out that ZERO COVID-19 policy limits the upside potential of the whole economy. The uncertainty of these public health policies makes people concerned about the sustainability of their income and weakens their expectations of the economy and thus the prospect of the housing market. Moreover, monetary easing so far is very limited. The cut in policy rates ranges from 5bps to 15bps, and such minor cuts are very unlikely to have supporting effects on the whole sector. Finally, there is an obvious mismatch between the demand and supply in the housing market. In fact, demand is concentrated in first- and second-tier cities, while the supply is excessive in third- and even fourth-tier cities. As we cannot move apartments around, there is no feasible solution to this mismatch.

So, in response to the ever-deteriorating property sector, China’s central bank announced that it will lower the interest for housing provident fund loans by 15bps from Oct 1, 2022 and gradually relax the lower limits of the average interest rate for the first mortgage by the end of 2022. Meanwhile, China offered tax refunds for residents who buy new homes within one year of selling their old homes.

So many policies, Hah! Will they work? No! The bottom line here is that these policies have so many limits, and they are conservative in the first place. The objective of these policies is to stabilize rather than boost the property sector again, and it looks like China’s central government would like to pay more attention to long-term economic sustainability rather than short-term easing of this “vintage car”.

1.3 Infrastructure Investment is not the Cure

As China had so many economic pressures from export, the property sector, and public health policies, China’s central government did try to stabilize (remember not to boost) the economy through infrastructure investment. Did it work? On the one hand, the latest infrastructure investment has a growth rate of over 10%, while this number was an average of 2% back in 2021.

On the other hand, the positive effects of those efforts are mostly interrupted by the large-scale lockdowns caused by the ZERO COVID policy.

More awkwardly, the local government has a limited budget to provide more capital for infrastructure construction. Since 2022, China’s central and local governments have spent a huge amount of fiscal expenditures on infrastructure investment, normalized nucleic acid testing, and supporting MSME, with an average growth rate of around 6%. At the same time, the government’s budget is extremely tight, with the latest growth rate of -8%, and this growth rate has been negative since April 2022.

There are several reasons behind the plunge in governments’ revenue. On the one hand, land selling used to be the most important source of fiscal income, but now it is not reliable due to regulations on the property market. The latest land transacted areas and prices have experienced a plummet with -49.7% and -42.5%, respectively. Alternatively, the tax income is also limited due to the low profitability of enterprises and the tax relief requirements.

Ultimately, the gap between the government’s expenditures and revenues will become even wider and unsustainable for aggressive investment. Then, the governments will have to raise more funds through bond issuance. However, this is not viable for the long term either, as China is very conservative in its monetary policy due to the monetary tightening outside. At the end of the day, the governments will be forced to step back, and the economy cannot keep counting on governments’ efforts.

1.4 Is Consumption Recovered?

What else? Consumption, the last pillar of China’s economy. In fact, China’s consumption has never fully recovered since the pandemic. Worse still, serious implementations of ZERO COVID policies further depress consumer confidence and thus the domestic demand.

What is the latest outlook on China’s consumption? Actually, it’s getting better but not good enough to stabilize the economy. Specifically, the latest growth rate in retail sales of consumer goods is around 5.4%, which was 2.7% in the last month. The most important contributor to this bounce back is actually the retail sales of autos, which has a growth rate of over 15.9%, a significant jump from 9.7% in the last month.

Specifically, the boost in auto sales comes from the bunch of purchase tax reductions and exemption policies.

Moreover, if we take a closer look at the structure of consumption, the bounce back is somewhat driven by the resumption of catering services. The latest catering service growth rate is 8.4%, and the previous number was -1.5%, about a 10% jump in growth rate. On the one hand, the bounce back comes from improvements in domestic demands, mostly due to very supportive policies. On the other hand, the low base from the last summer somewhat contributes to the higher growth number this time.

Meanwhile, retail sales of commodity are relatively stable over time, with the latest growth rate around 5.1%, while the previous number was 3.2%. From the economic data perspective, it looks like China’s consumption is in the middle of recovery. But is it?

In fact, China’s consumption did have certain resumptions after the end of the large-scale lockdown in Shanghai. However, the recovery is very limited given that the ZERO COVID policy is still there. As long as China has this serious public health policy, consumption will have very limited upside potential as people are so afraid of being identified as the close contact with positive COVID and they will avoid shopping and dining outside.

At the same time, it makes nonsense to blame everything on the ZERO COVID policy, as there are other factors that result in this domestic demand contraction.

One of them is the general economic slowdown since later 2021, mostly because of the contraction in the property sector. Normally, the property sector contributes to 5% to 10% of the GDP growth by itself. If we consider the value chain with this sector, the real estate industry could affect 20% to 30% of China’s economic growth. Today, the latest number indicates that this sector actually drags the economic growth rate by -13%, the biggest reason why China has such significant economic downward pressures.

With more economic pressures, the employment market in China is cooling down even without the large-scale lockdown. Back in August 2021, the overall unemployment rate in China was 4.9%, and it went up to 5.5% in Feb 2022, even before the large-scale lockdown in Shanghai. Today, the latest unemployment rate is still 5.3%, better but not as good as 2021 or the pre-pandemic level with an average of 4.9%.

You might argue that it’s just a 0.3% to 0.5% difference, does it matter? It does if you consider the population base in China, around 1.5 billion, then you will notice how many people are unemployed and how many people do not have a sustainable income to live, not to mention consumption and dining outside.

Now, a lower employment rate will directly hurt the income of most households. The latest disposable income growth rate is 3.6%, while this number was 6.3% back in the second quarter of 2021. Eventually, with less income sustainability, households in China have limited capacity and thus the ability to consume.

The other side effect of economic slowdown is the weakening in expectations about future economic growth. As people become more and more pessimistic about the economic outlook, they prefer saving rather than consumption, especially as China has a very long history of saving culture. Therefore, it’s not hard to notice the deposit rate has increased over time with this weakening expectation.

Figure 12 illustrates that today’s average deposit rate is around 41.3%, much higher than the 35% before the pandemic. As China’s households have more incentives to save rather than to consume, the slow recovery in China’s consumption is not that surprising at all.

Will China’s consumption have a strong bounce back later? The answer is probably NO in the short term. Today, scattered COVID outbreaks are very likely to appear during this upcoming winter, and the overall pandemic prevention situation is still grim. Therefore, the pace of consumption recovery is more likely to slow down again.

In the long term, it is possible that China will have fewer restrictions in terms of public health policies. At the same time, China will gradually complete its industrial transformation from the property sector to new energy and high-end manufacturing. Ultimately, China will find its new economic engine. At that specific point, China’s consumption will have its real bounce back. However, the bottom line today is that this scenario won’t happen shortly.

1.5 Let the CNY Exchange Rate Go

So we just covered China’s economic fundamentals, now it’s a great time to look at the hotspot issue in today’s China, the continuous weakening of CNY against the USD over the last several months. Specifically, back in August 2022, the average spot exchange rate of USD/CNY was 6.8, while the latest number is around 7.2. This is a 7% depreciation of CNY against USD, a very serious currency weakening in the currency markets.

Why did this happen? One of the reasons comes from what we have discussed, China’s economic slowdown has contributed to the weakening in the CNY exchange rate. However, China’s economic fundamental is not the main issue this time.

In Figure 14, we could take a closer look at the RMB CFETS exchange index. This index is basically the exchange rate of CNY relative to the weighted average currency value of a bunch of currencies, including EUR, YEN, USD, etc. Or, you could simply think about this index as the demand for CNY relative to foreign currencies.

Now, it’s not hard to notice that the demand for RMB does not have significant plummets over the last several months, at least not as magnificent as what we got from the USD/CNY exchange rate.

So, it’s not hard to point out that the deprecation of CNY relative to the USD is not necessarily driven by the weakening of CNY but caused by the continuous appreciation of USD.

According to the US dollar index, USD has appreciated over 17% since Jan 2022 when the US dollar index was 96.2, while the latest number is 113.3.

Why does the US dollar appreciate this much? It is actually directly related to the Federal Reserve’s restrictive monetary policy. Since March 2022 when Federal Reserve started to raise the policy rate, the US central bank has hiked the federal fund rate by 300bps. In response to higher interest rates, investors are unwilling to bear higher interest payments. Therefore, the credit expansion will transform into credit contraction, and the money supply will shrink accordingly. To support this argument, we could take a look at the money supply in the US. The latest M2 growth rate in the US is only 4.08%, which was over 20% back in 2020 and over 10% for most of the time in 2021.

When the demand is relatively constant, the shortage of supply will increase the value or price of the goods. This principle could also apply to the price of the currency. When the US dollar has a relatively constant demand, the contraction in the US dollar supply will make USD more valuable than other currencies.

The other way to look at this deprecation of CNY against USD is the divergence in the monetary policy of the two economies. As the US Federal Reserve keeps tightening its monetary policy, China’s central bank (PBOC) actually lowers several key policy rates, such as the repo, MLF, and LPR, to stabilize the property sector and thus the whole economy.

Such a divergence in monetary policies leads to a very wide yield spread between the US and China. Think about this, if you have the option to buy either a US treasury bond or a China government bond with the same terms, except the yield. Specifically, the US treasury bond will offer you a yield of 4%, while you could only 2.7% from China’s government bond. Which one do you prefer? Of course, the higher yield US treasury bond, especially since the US treasury bond is still considered the safest and most liquid asset in the world.

That’s exactly what happened today. The latest yield spread between China and the US is around -1.3%, while this number was 2.2% at the beginning of 2021. As the US treasury bond becomes more attractive than China’s government bond, more investors will sell CNY for USD in order to purchase the US treasury bonds. This pattern somewhat contributes to the recent weakening of CNY relative to the USD.

What’s going to happen to the USD/CNY exchange rate next? We do not expect the comeback of the US dollar in the short term. As the latest US inflation rate is still 8.2%, the US Federal Reserve will be very unlikely to hold back the monetary tightening. By the end of 2022, we might observe more 75bps hike in policy rates, and the USD will become even stronger.

From the CNY perspective, there are two possible ways that China could strengthen its currency. One is to tighten its monetary policy, the same as the Federal Reserve did in this year. However, China has certain constraints to do so. One constraint is the current economic downward pressures that require a neutral position in monetary policy to smooth out the economic cycle. The other important constraint comes from the high leverage ratio in the property sector. The average debt rate of China’s real estate industry is 68%, and the depressed real estate market makes these debt repayments relatively overwhelmed. Therefore, China’s central bank needs to be very careful about the monetary policy to prevent the system credit risks originating from the property sector.

So, monetary tightening is not a feasible solution. What else? China could choose to lower the foreign exchange reserve ratio and asks major banks to sell a huge amount of US dollars and Treasury securities. This is definitely a feasible solution, and China has done so since April 2022.

Is this strategy useful? Honestly speaking in the short term, such a move could only marginally ease the pressures on the deprecation of CNY but could barely reverse the trend of the weakening in CNY against USD, as the divergence in monetary policy and tumbling economic fundamentals are the dominant determinants behind the strengths of the currency.

For a medium and long-term horizon, the value of CNY is largely dependent on the overall outlook of China’s economy, which is highly uncertain today. But eventually, China’s economy will have a stronger bounce back after the successful industrial transformation and upgrading. The bottom line here is that it takes time.

It’s interesting to point out that the weakening in CNY is not necessarily bad for China’s economy, as the depreciation in the currency could support the growth of export and smooth out the short-term economic pressures. On the other hand, the risks of capital outflow are limited due to restrictive capital mobility in China. Therefore, at the end of the day, China might just keep dumping the US dollars and Treasury securities to prevent the very wild move of the CNY and let the CNY exchange rate go within an acceptable range.

2. What’s Coming Next?

So far, we have covered so many macro patterns that happened over the last several months. In Part I of this series, we have covered global monetary tightening, economic recession around the world, long-term debt cycle, and energy shortage. In this specific article, we pay greater attention to the economic issues in China, such as the export, property sector, infrastructure investment, consumption, and CNY exchange rate.

Now, it’s the right time to look into what is going to happen next. In Part I of this series and previous sections, we have made very brief predictions on each macro pattern we have covered. Let’s have a comprehensive summary here. Shortage in energy and commodity is not a transitory issue and will last for an extended period given the underinvestment in CAPEX for most energy and commodity suppliers. As inflation will not easily disappear due to supply constraints, central banks are likely to keep tightening their monetary policy. In this global tightening cycle, credit contraction around the world will put greater pressure on the economy, and a global economic recession is inevitable.

What’s left? The debt bubble is still in the shadow. The debt bubble does not come to such a giant level out of the air. Back in 2020, most central banks implemented an extremely expansionary monetary policy that incentivized dramatic credit expansions. That’s why the current debt level is several times of GDP in the world.

Specifically, the latest debt-to-GDP ratio for the US is around 118%, according to the Bank of International Settlement. As a reference, this number was 58% before the 2008–09 financial crisis. As long as the debt-to-GDP ratio is above 100%, the government cannot pay back its own liability even if they put the whole economy on the table.

Worse still, this is not unique to the US. This credit expansion spreads across both developed and developing countries. In Europe, the latest government’s Debt-to-GDP ratios is 67.7%, 114.3%, 152.6%, and 117.7% for Germany, France, Italy, and Spain, respectively. In fact, those numbers are even higher than in the period of the European sovereign debt crisis.

Today, in the context of global monetary tightening and higher policy rates, the default of such overwhelmed liabilities will become inevitable. Now the question is what is going to happen with the bust of this debt bubble. At the very beginning, some debtors will need to sell all of their assets to pay back their liabilities and could even go bankrupt. Meanwhile, the creditors do not expect that they could get the full amount back, and they will lose parts of their wealth in this clearing process.

Several bankrupt debtors and the loss of wealth from a group of creditors. Is this the end? No, it’s not enough with this debt level, several times of the whole economy. In other words, the debt crisis will never end until the whole economic system crashes to nothing. And we know that the governments won’t let this happen, so what will they do? They will print an even greater amount of money to inflate away the debts we have in the economy. Even though the principal amount of the debt is the same, the intrinsic value is quietly diluted.

So problem solved, right? In terms of the debt crisis, yes and it’s just for now. But from the perspective of our wealth or our savings, absolutely NO. When central banks start another round of money “printing”, what happened to our fruit of work: our fixed salaries and our savings? They are devalued indirectly, as we need to spend more for the same food, beverage, electricity, gasoline, housing, etc, as excessive money supply makes everything else scarce.

This happened before in the 1940s, and history does not repeat itself but it rhymes. That’s what is going to happen, excessive money supply and extremely high price level. This will not happen immediately but gradually and then suddenly.

Now, what should we do? Like Jeff Booth has often stated:

“Abundance in money creates scarcity everywhere else, and scarcity in money creates abundance.”

So now we have an abundance of fiat money from every country in this world, we need to search for scarcity or the “harder” assets.

What is the hard asset? As you might notice, governments can increase the amount of money supply with a simple snap. So fiat money is definitely not a hard asset but just easy money. In contrast, if it’s relatively hard to increase the supply of the asset, then that’s the hard asset, at least it is harder than the fiat.

So, what hard assets do we have today? In fact, most commodities are hard assets, at least for the next several years. You could argue that if commodities have a significant increase in price, commodity suppliers could easily produce more, and commodities are not really “hard” assets in this scenario. You are not wrong, but it’s not an accurate statement. Why? On the one hand, commodity suppliers have very limited CAPEX investment over the last decade, so they cannot easily increase the supply of commodities, at least within the next three to five years.

The other fact is that we are heading toward an energy transition period, from cost-effective fossil fuel to renewable energy (You could argue that fossil fuel is not hurtful, and renewable energy is useless, but this energy transition is on its way). Therefore, traditional commodity suppliers face greater uncertainty about the utility of their products, and they are less willing to make further investments into traditional commodities, as these assets could become stranded if there are some innovative breakthroughs in the renewable energy.

So now we are on the same page that the energy and commodity supply cannot be easily improved in the next several years, even with a higher price. In this context, if central banks decide to increase the money supply again (they will and have to do so!), the devaluation of the currency itself will inflate the price of energy and industrial commodities, as long as central banks cannot print oil, copper, and gas. Then, the commodity becomes a good store of value.

It’s important to point out what happened to commodities back to the QE in 2020 and 2021. We have mentioned several times that there is a disastrous global monetary easing back in 2020 when the US dollar had a money supply growth rate of over 20%. What happened to commodities? Their prices are boosted. From 2020 to 2021, Oil, gas, copper, and aluminum have increased in value by 36%, 117%, 57%, and 58%, respectively. It’s needless to say that such a hike in price cannot only be driven by the gap between demand and supply. In fact, the dominant player behind is the debasement of the currency, caused by money “printing”. In other words, the devaluation of currencies will make other things more valuable, like commodities.

Even though the commodity could be an appropriate store of value for the next several years, it’s not going to be reliable in the long term, as we could complete this energy transition period at a faster pace. So, we need to come back to the traditional safe haven asset, GOLD. In human history, gold is so far the most reliable safe haven asset not because of its shining look but due to its scarcity. Even with thousands of years of technological developments, we can only produce gold at around 2% per year. More importantly, gold has the highest stock-to-flow ratio about 62, while this number is 0.25 for crude oil and 0.06 for copper. Overall, we cannot simply increase the supply of gold, which makes gold a really hard asset and a very reliable choice in response to the next round of flooding in the fiat money.

Last but not the least, with the testing and development over 13 years, bitcoin becomes the hard asset due to its characteristics of fixed supply, decentralization, well-designed incentive structure, and Proof-of-Work (PoW). More importantly, it’s still in the process of growing even harder. Honestly, it’s impossible to explain bitcoin within an article, not even to mention several paragraphs, but we could briefly point out how “hard” bitcoin is.

Figure 24 could illustrate the fixed supply of bitcoin. In fact, bitcoin is designed to have about 21 million in total. So, in the long-term, we will have smaller numbers of new bitcoin, and the monetary inflation of bitcoin will eventually trend to 0. More importantly, the combination of decentralization, well-designed incentive structure, Proof-of-Work (PoW), and the size limit on each block could protect this essential characteristic of bitcoin, at least they succeed in doing so over the last 13 years.

From the stock-to-flow ratio perspective, the latest ratio for bitcoin is around 58, which is very close to gold’s number, 62. This number could provide further support for bitcoin’s scarcity. More importantly, as bitcoin has a hard cap, the scarcity of bitcoin is expected to increase over time. At the end of 2025, bitcoin will have a stock-to-flow ratio of over 120, which is twice of this ratio for gold. The bottom line here is that bitcoin has the potential to become a very hard asset given its sophisticated characteristics.

At the end of the day, it’s important to point out that we are not trying to persuade you to purchase oil, gas, copper, aluminum, gold, or bitcoin. We are here to share our ideas about hard assets and how hard assets could protect your savings, and your wealth from the next round of manipulations in the money supply. As a reminder, the hard asset is not definitely a tangible asset but an important concept incorporating anything that is safe and hard to produce by a centralized party.

3. Conclusion

In this part, we have covered a lot of topics about China’s economy. We also tried to predict what is going to happen to the economy and discussed several hard assets in response to the potential financial tsunami. Before the end of this article, here are the summary on what we have discussed:

• 1) China’s export was the most important pillar in the economy since the second half of 2020, but it is not robust given the foreign tightening environment.
• 2) Conservative monetary expansion cannot save China’s property sector, and since this sector is not part of China’s long-term economic development strategy, policies will tend to stabilize rather than boost this specific industry in the future.
• 3) Infrastructure investment in China is not the cure to the economic problem as China’s local governments are facing overwhelming burdens from fiscal deficits.
• 4) Recovery in China’s consumption relies on the relaxation in ZERO COVID policy, the stabilization of the economy, and the reinforcement of economic expectations.
• 5) Depreciation in CNY relative to USD reflects both the weakening of China’s economic fundamentals and the significant appreciation of USD. As the risks from a further devaluation of the CNY are limited, China will not try to reverse the trend and let the CNY go within an acceptable range.
• 6) As the current debt level is several times of the economy around the world, the only feasible solution to this debt bubble is to have another round of monstrous global monetary easing, inflating the price level to an incredible level.
• 7) In response, we should find the “hard” assets, including oil, gas, copper, aluminum, gold, bitcoin, and anything that is safe and hard to produce by a centralized party.

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