Weekly Market Insights 05.31.22

From Mao to Deng and Back Again

Financial Markets

Equity markets made a remarkable recovery this past week, ending a seven week losing streak.  It is difficult to say if this strong showing is just a bounce in a down market or the beginnings of a recovery.  There are still plenty of concerns for investors to ponder.  Inflation, although recently showing signs of peaking, remains elevated. New virus strains continue to appear, monetary tightening is underway, and the Russia-Ukraine war shows no sign of abating.

Economics

Global economics has been perplexing lately for a number of reasons.  Volatile economic indicators have added to the confusion because conflicting signals can be either negative or positive signs for both the economy and financial markets. A good example is what we wrote in the markets section.  The latest statistics showed inflation moving in the right direction, but will that continue?  No one knows, but the important question for investors is whether the Fed considers it significant.

We have been promising something on China for some time.  What follows is clearly not exhaustive, since that would take volumes.  Instead, we will provide a snapshot of some issues that we consider important.  China’s great size geographically, economically, and militarily makes it a vital country in the global landscape.  We hope this discussion inspires serious thought amongst our readers.

China is a very old country with a storied past.  Its written history begins at 2100 B.C. with the Xia dynasty.  Since the early 20^th century, Chinese leaders have been trying to retrieve China’s past glory that they believe was stolen from them by foreign imperialism—a case of destiny disrupted.  Unfortunately, nostalgia is often romanticized and incorrect.

After World War ll, Mao Zedong and the communists won the ensuing civil war, and Mao closed China to the non-communist world.  Mao was far more anti-west than Stalin, and China and its people suffered dramatically.  He made some terrible decisions, and the population suffered from great famine, persecution, and poverty.  An example of poor policymaking is his decision to eradicate Eurasian Tree Sparrows as part of a broader hygiene campaign.  Mao ordered them to be exterminated without considering potential repercussions, and the next year the locusts arrived.  Without their natural enemy in the sparrows, they created one of the worst famines in history.

When Mao died, Deng Xiaoping came to power, and he dramatically changed China’s direction.  He was ambivalent when it came to economic philosophy.  If a particular action helped the country and its people, then he would do it.  Perhaps his most famous quote concerned his view on economic ideology.  He said, “It doesn’t matter whether a cat is black or white, as long as it catches mice.”  From the beginning of Deng’s reign, China rapidly advanced to become one of the world’s largest economies. This trend lasted until the ascent of Xi Jinping. At first, most analysts felt he would continue Deng’s economic philosophy, but he unexpectedly reversed course.  China’s economy since then has been dominated by government decree.  Although the country’s economy in aggregate is very large, looking at GDP per capita is a better metric when judging welfare.  By this measure, China ranks 77^th in the world, behind countries like Costa Rica and the Dominican Republic.  Clearly, China’s problems are long standing and ongoing.¹

A short list of some of China’s most pressing economic problems include a reliance on State Owned Enterprises (SOE), a growing debt crisis, a command economy that stifles innovation, and no independent central bank which leads to currency valuation concerns.  President Xi appears to think he is protecting the people or assuming more power by abandoning markets.  By doing this, he accomplishes nothing good.  What he does accomplish is higher prices, continued inefficiencies, lower productivity, and the need to import new production methods.

Politically, China is somewhat isolated.  Its only real allies are Russia and North Korea.  Economically, they are not much of a benefit and more of a hindrance.  China has been trying to create a regional alliance to help address this problem without much apparent luck.

As the world emerges from the pandemic, it will be interesting to watch how supply chains readapt.  Within the global trade arena, China was and remains a large and vital player.  This may change as companies react to shortages and continued disruptions.

China is a large country that has seemingly lost its way.  There is no reason China can’t regain its rapid growth, but it needs to alter its path.  The question, of course, is will it?

Conclusion

The United States’ economy remains in a state of flux.  Inflation continues to be unacceptably high, although it may be slowing.  Consumption remains a positive, as is employment.  There are also early signs that supply chains, if not returning to normal, are at least getting better.

Europe’s economic performance has been worse than that of the U.S, as the region continues to suffer to a greater extent from the conflict in Ukraine.

China appears to be in a far more difficult position both economically and politically.  The country has much to deal with.  None of it can be easily addressed, particularly in the absence of open markets.

We haven’t written about Russia a great deal.  Although it is a large, populous country, it reminds us of Saudi Arabia in the 1970’s, as its economic importance is almost exclusively reliant on energy.  Russia’s true economic impact at the moment stems from the war and how long it continues to conduct hostilities against the Ukraine.

While challenged on several fronts, the U.S. economy seems better positioned than many.

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