The China Syndrome
The volatility that we warned of in our last newsletter finally arrived in December and thankfully resulted in some very strong gains in our client portfolios. What had been a disappointing year turned into a good year. And while we are only a week into the New Year at the time of writing, those positive trends in our investments have continued thanks to the high quality nature of our selections.
The volatility that we discussed in October is getting worse and it may require a move to cash at some point this year but we’re hesitant to be proactive in raising cash because the Federal Reserve has shown itself to be almost entirely focused on stock prices. Having studied the history of central banking this is a somewhat blasphemous statement but through a succession of crises starting in October 1987 through to the present, the Fed has trapped itself into being an enabler of riskier corporate policies along with riskier stock market strategies.
When it comes to the way a company is capitalized, or where they get funds for investing in operations, equity is the riskiest part. This is so because when a company goes into bankruptcy, bondholders, banks, employees, and suppliers all get paid before any money can be distributed to stockholders.
During the 2008 financial crash, the drop in the stock market coincided with a drop in the corporate bond market. Investors lost confidence in American business such that a massive liquidation of investment was taking place much like the 1929 stock market crash. Without acknowledging it, the Fed appears to have changed its basic function from being a bank that provided liquidity to domestic US banks during illiquid times such as September of 2008 to being a quasi-bank that provides liquidity to market participants in order to ensure that asset prices remain elevated.
This distinction is critical for understanding Fed policies, in my opinion. The stock market is much easier to influence than the bond market because the Fed can use agent firms to trade index options and futures. In effect, they can provide buying power on days the stock market is at risk of a major sell-off.
Since corporate bonds are less risky than stocks, maintaining/raising the value of stocks has the same effect as raising the value of corporate bonds. Because national setbacks such as Covid have not led to a liquidation of corporate assets, the US banking system is effectively secured against drops in collateral values. At the end of the day, the Federal Reserve’s primary job is to protect the US banking system.
We can see from the chart below, the unintended consequences of this policy is that corporations have felt safe enough to more than double the amount of corporate debt since the Great Financial Crisis of 2008.
This next chart gives us an idea how a rise in corporate debt has actually fueled the corresponding rise in the S&P500. The reason is that corporations have been able to substitute corporate bonds for equity by borrowing money in the corporate bond market to buyback company shares.
During good times, this approach makes stock markets rise because it creates the illusion that corporate earnings are stronger than they truly are. This is because earnings are divided by a smaller number of corporate shares outstanding. Basic math: if you hold the numerator constant but reduce the denominator, the result will go higher.
In the above chart, while the denominator (corporate bonds) has doubled, because the stock market has been rising at a faster rate, it tells market participants that risk has declined. The critical question is whether this is true – or not?
Investing in physical plant and buying machinery to make things is very risky. You’re always threatened by competition and the business cycle. If a company fails to sell enough of their production, their costs per unit rise. This is what is known as “operating leverage”. In this way, it’s easy to incur losses in competitive markets.
Perhaps the best example of this risk is in the semiconductor industry. The photolithography machine below will set you back around $150 million. A manufacturer needs to sell a LOT of chips to pay for such a machine – and the high cost engineers to operate it!
This is why Taiwan Semiconductor and Samsung dominate the manufacturing of these high end chips. If other companies tried to move in on the manufacturing side of the market, everyone would suffer losses. These two companies take the chip designs of companies such as NVIDIA, Broadcom, and QUALCOMM and produce the physical chips for them using machines like the one shown above.
There are other companies that make chips but these two companies dominate the nanotechnology processes that allow chip transistor sizes to decline towards the size of an atom, becoming faster and more powerful as a result. Computer chips are basically transistors on a piece of silicon. Taiwan Semiconductor can put 173 million transistors on a square millimeter of silicon.
This represents extremely advanced technology and Taiwan has become the dominant semiconductor manufacturing nation in the world. They currently produce 63% of the world’s chips in their factories. Keeping in mind just how much Covid has hampered the world’s production of chips; try to imagine what would happen to the world economy if mainland China were to invade Taiwan. Destruction of these advanced factories has the potential to drive the world economy into depression. Semiconductors are now as important as water, food, and fuel to the global economy. The only difference is that semiconductor demand is quite a bit more variable than these other necessities, which means that producers can go from profit to loss very quickly.
Over the years, I’ve written extensively about China because its ascension into the ranks of developed economies has been rapid which created enormous change in the global supply chain as well as the cost of industrial materials. Without strong economic activity in China, the price of industrial inputs from metals to chemicals will likely decline. In addition, demand for semiconductors and software will also decline.
I’ve been negative on China for twenty years for a wide variety of reasons. China seemed to invest for market share which is different than investing for profit. When a company invests for profit, the surplus over costs is available to pay down debt. With China, they seemed to over-invest in everything and when they ultimately got to excess capacity, the government would fund new projects to use up the excess capacity. These projects, such as the Belt and Road Initiative, have largely been total failures.
But it wasn’t just these measures. China has 6% of the world’s arable land and 18% of the global population yet they have destroyed the relatively little arable land they have and their lack of pollution control has destroyed their potable water. Much of China consumes water that is unfit for human consumption. The result is that China has been importing massive amounts of agricultural products in recent years because they can’t feed themselves. This works when they are running a large trade surplus but that surplus should go away over the next ten years and along with it, China’s access to the dollars demanded by international agricultural markets.
The primary reason is that Chinese Premier Xi Jinping is moving away from the economic policies of Deng Xiaoping, the former Chinese Premier credited with reforming the Chinese economy. Strangely, Xi is moving back to the failed policies of Mao Zedong which means isolationism and privation. In his speeches, he’s been telling the Chinese people to prepare for hardship. It appears that he wants to dominate the South China Sea, including Taiwan, and that spells further trouble for the global supply chain.
The difficulties have already started. China doesn’t have a vaccine that works against the original Covid virus nor do they work against the Delta variant. As a result, it seems that Covid has hit China far worse than other countries. At present, factories in the Yangtze River Delta region are closed, along with cities that include Tianjin and Xi’an.
The result is a crashing real estate sector that employs roughly 20% of the Chinese workforce. Small business employs roughly 80% of urban workers and around 4.37 million small businesses have closed in China during 2021. Small and medium sized firms are responsible for 60% of Chinese GDP and 50% of taxes. Besides outright closings, small and medium businesses have been furloughing workers at a rapid pace. The Chinese government doesn’t provide accurate economic data but some analysts believe that unemployment is already at a 20% level.
Government workers in wealthier provinces near the coast are experiencing 15% to 20% pay cuts. The coastal provinces, where the bulk of manufacturing takes place, are still experiencing the negative effects of the Chinese Communist Party’s (CCP) attempts to chastise Australia by inhibiting purchases of Australia’s high value coal. The result has been rolling blackouts in these industrial regions, which further complicates the issues in the global supply chain.
Lastly, we know that China will have the oldest population in the world within five years as the negative effects of the “one child” policies that started in the 1980’s causes a sharp drop in China’s population over the next 30 years. So a declining workforce that now has to face authoritarian Communist rules as the country loses export market share yet still need to import much of its food is going to be able to grow?
We’re preparing for the end of China as a growth engine in the world economy while acknowledging geopolitical volatility will rise as a direct result.
Moving the global supply chain to East Asia was responsible for much of the disinflation we experienced between the mid 1990’s and the start of Covid. Outsourcing to companies that lacked a profit motive, in a region that doesn’t care about the environment, allowed for massive economies of scale to develop in a wide array of industries.
Furthermore, because demand was highly predictable until Covid, the logistics industry was able to keep the cost of moving goods around the world to a very low level. Below is a chart of the Cass Freight Index which is an index of freight costs and volume across the customer base of Cass Information Systems. This chart shows that apart from the financial crisis of 2008 and the Covid crisis of 2020, freight costs have been largely predictable.
The problem isn’t so much the freight costs; it’s the bottlenecks at ports such as Ningbo in China and Long Beach in California. There is also a problem with actual supply since Chinese factories have been quarantined for long stretches since Covid started. Where the logistics companies were able to plan to have capacity where and when it was needed in the past, most are waiting for ships to be unloaded or for trucking companies to move the goods. In effect, it’s one giant mess that will be with us long into 2022 thanks to current problems in China.
The global supply chain is largely an external problem but actions by the Biden Administration to reduce domestic oil and gas output are pushing up the price of oil and gas in the US. You can see from the chart below that the price of oil started to rise the day after the last Presidential election. The price of oil has moved from $35 per barrel to over $80 per barrel.
The next chart shows the weekly production of crude oil in the US. From the time the new Administration took office in January of 2021, weekly crude oil production in the US has dropped between 10% and 23%. This is the primary reason for higher oil prices in the US.
Some will argue that the increase in vehicle miles driven since January explains some of the increase in oil prices but that doesn’t add up as the price of oil in January of 2020, just before Covid hit, was $65 per barrel. In addition, vehicle miles traveled is still 6% below its peak in January 2020.
Based on speeches given by various members of the Biden Administration, the primary reason for instituting policies that restrict domestic oil output is the stated goal of replacing carbon based energy with green energy. In particular, many in the Administration have been cheering the higher oil prices because they believe the higher cost of gasoline will spur demand for electric vehicles.
Regardless, much of the increased US inflation can be directly attributed to government actions. It’s important to recognize this fact in order to understand the likelihood of continuing inflationary pressures. The problems in the supply chain will ultimately be corrected but the inflation attributed to government policies is permanent absent political change. In other words, higher prices are here to stay.
Early in 2021, we put a couple of stocks in the portfolios that were supposed to take advantage of new policies directed to push acceptance for electric cars. The value attributed to the equity in Tesla is obscene and reminiscent of the tech bubble that popped in 2000. So we added a couple of names that would take advantage of the need to expand the electric power grid in the US in order for electric cars to be viable. Both stocks have been stinkers because nothing substantive is being done to build out the infrastructure for electric cars.
A year ago, Texas was hit by a harsh cold spell accompanied by ice and snow. I hadn’t realized this but 20% of Texas electricity had been provided by renewables such as wind and solar. The result was that wind turbines froze up and solar panels became covered in snow and this led to massive power outages at a time when home owners had to turn up their electric heaters to stay warm.
Texas became a gigantic “brown out” where the state lost power because it was impossible to replace the lost “green” energy with emergency back-up systems. The petrochemical industry was hit badly resulting in the need to shut down expensive processing facilities. This ultimately led to shortages of gasoline, chemicals, and other by-products from the refiners. And we all know what happened next; we had to pay higher prices for just about everything made with petrochemicals – which are just about everything!
Europe has experienced similar problems following a conversion to green energy. Not only do Europeans pay high prices for electricity, they experience periodic brownouts in regions especially aggressive at adopting green energy. The result is that green energy advocates are trying to change the definition of green energy to include nuclear energy!
Bringing the discussion back to the US, it’s going to take substantial investment in our national power grid in order to increase usage of electric cars. To date, I haven’t seen any evidence that we have a serious plan for this. Furthermore, market acceptance of electric cars seems to be fairly limited today as most people don’t see the utility in switching from gasoline powered vehicles.
Ultimately, I expect a compromise to take place somewhere over the next ten years where the US increasingly adopts hybrid technologies that allow a partial shift to electric in an efficient way. Instead of making massive investments into our electric grid, we can turn our vehicles into electric generators when they run on gas.
In the last newsletter, I discussed the impact on corporate profitability of being unable to get product from the supply chain or having to reincorporate previously outsourced operations back into the company’s earnings model. Probably the best example of this is Ford’s deal with Global Foundries to consider a joint venture operation for making chips for Ford’s trucks.
There’s another big impact on corporate profitability and that is the impact of inflation on consumer spending, which ultimately impacts corporate profitability. December’s Consumer Price Index (CPI) rose by 7% which far outstrips the growth in real wages. This means that we, as consumers, will have to start deciding what we’re going to cut out of our monthly budgets.
What people cut out of their budgets will impact corporate earnings and ultimately stock performance. At GeoVest, we anticipated this jump early last year which is why our portfolios are full of companies that have the ability to raise prices because they sell products that are not easy to cut out of our monthly budgets. It took a while to be proven correct but our strong returns in November, December, and so far in January bear this out.
The reason it took a while is that the American Rescue Plan of 2021 directed the US Treasury to send out $1,400 to low income wage earners plus $1,400 for each dependent. Not only did this help push up consumer prices in 2021 but it also allowed people to forego making difficult decisions on their budgets until later in the year.
You can see from the chart below of personal current transfer payments – that’s what we call government aid – that US consumers got two big checks since Covid hit. The first one in 2020 didn’t have a huge impact on inflation but the second check in 2021coincides with a jump in inflation. This is why we had to wait until the end of the year for our stock recommendations to perform well.
For the present, this is the right approach but I strongly expect 2022 to give us some opportunities to get into long term growth categories. The primary reason is that I expect China to lose a LOT of foreign companies and industrial market share to places in the world that are not as restrictive as the Chinese Communist Party (CCP).
The GeoVest Approach
As I wrote in the last newsletter, this jump in inflation will force the Federal Reserve to stop adding to the size of its balance sheet and perhaps raise short term interest rates. That’s precisely what is happening – at least that is what they have been talking about in recent meetings.
The first ten months of 2021 were much like the Internet boom of 1999 while the last two months started to resemble the bust like 2000. The message is clear: when the Fed is pumping money into the system, jump on the growth bandwagon, but when the Fed stops pumping money into the system for any reason, get defensive.
At some point in 2022, I expect the Fed will start pumping again and when that happens, we plan to have a broader buy list prepared to take advantage of not just the Fed’s policy changes but the reality of a world that is less dependent on China. Instead of the wild trading strategies that have dominated the last two years, we plan to stick to our proven long term strategies. Thank you and it’s our continued pleasure to serve you.
Philip M. Byrne, CFA
Chief Investment Officer