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FT : China property: running out of options as fallout spreads to shadow banking (23/11/2023)

China’s repeated attempts to tackle its worsening property crisis resemble firework displays — full of light and sound, quickly extinguished.

Property stock prices have burst upwards with each new set of government measures to boost the market, only to collapse shortly thereafter. This week’s rally should not differ. 

Shenzhen, one of the most expensive cities in China, offered new edicts to lower downpayment ratios and relax other regulations from Thursday, according to state-run media. Beijing is also expected to provide more financial support for struggling developers in coming weeks. 

Bargain hunters have sought out shares of local developers. Country Garden, China’s largest private developer, rose by a quarter on Thursday, bringing gains for the past month to 50 per cent. Peer Sino-Ocean Group’s share price is up 45 per cent.

Countless policy changes over the past two years have done little to encourage a sustained return of buyers, necessary to stabilise property prices. Home sales at China’s 100 top developers fell by 28 per cent in October as property investment dropped the most in eight years.

Beijing must then encourage more lending, ensuring that developers have access to liquidity. But even that effort may soon hit its limit. Net interest margins at the largest state-owned lenders fell to a record low at the end of the first half. At 1.74 per cent, that has now fallen below the reference level required by the People’s Bank of China for commercial banks.

In particular, the four biggest local banks, Bank of China, Agricultural Bank of China, China Construction Bank and Industrial and Commercial Bank of China must shoulder the burden of added lending. As a result loan yields are falling. ICBC, the largest state-owned lender, now trades below 0.4 times its tangible book value, a fraction of its regional peers.

For the lending to developers, analysts expect cumulative non-performing loans to go as high as 15 per cent.

The fallout has spread to China’s shadow banking sector — non-bank financial institutions that lend to higher-risk industries. Zhongzhi, one of the biggest, may have a shortfall of $36bn. It has warned that it is “severely insolvent”. Systemic financial risks are mounting. Risk-averse investors should not chase these property companies.

Financial conglomerate had disclosed $36.4bn shortfall to investors last week after missing payments

Chinese authorities have opened a probe against Zhongzhi, one of the biggest conglomerates in the country’s sprawling shadow financing market, days after the group declared that it was “severely insolvent”.

Beijing police said that Zhongzhi was suspected of committing “illegal crimes”, and that “mandatory criminal measures” have been placed on a number of suspects, including one surnamed Xie. The statement did not specify the suspects’ alleged crimes or details of the measures being taken.

Zhongzhi had disclosed in a letter to investors last week seen by the Financial Times that it was facing a shortfall of about $36.4bn, renewing concerns over China’s $2.9tn opaque shadow financing sector and its exposure to the troubled property sector and wider economic slowdown.

The company wrote that it had total assets of just Rmb200bn ($28bn) against liabilities of up to Rmb460bn. It added that “internal management ran wild” following the departure of “multiple senior executives and key personnel” in the wake of the death in 2021 of founder Xie Zhikun, who it said had “played a pivotal role in decision-making”.

Zhongzhi and its affiliate investment group Zhongrong missed payments on several products earlier this year, prompting concerns of a spillover from the country’s property sector crisis, which has been rocked by a series of developer defaults, into shadow financing, which often supports real estate development.

Chinese policymakers have rolled out a range of piecemeal support measures in an effort to reverse the slowdown in the property sector, which previously accounted for more than a third of economic growth. This month, regulators instructed state banks to increase credit to cash-strapped private developers to a “reasonable” degree.

Zhongzhi did not immediately respond to a request for comment.

Beijing police said in a statement late on Saturday on social media platform WeChat that authorities were attempting to recover assets and encouraged Zhongzhi investors to report relevant cases and leads to assist in the investigation.

In September, Chinese authorities used the same language in regard to Evergrande chair Hui Ka Yan, saying he had been placed under “mandatory measures” on suspicion of involvement in “illegal crimes” as the world’s most indebted developer was struggling to restructure its offshore debts.

The designation could refer to law enforcement actions ranging from summons to residential surveillance or arrest and detention.

Zhongzhi was founded in 1995 by rags-to-riches magnate Xie Zhikun, and expanded to become one of the country’s biggest non-bank financiers, with business interests spanning financial services and wealth management, mining and new energy vehicles.

Xie was replaced following his death by Liu Yang, his nephew and chair of Zhongrong.

In August, police were called to Zhongzhi’s Beijing headquarters to resolve issues with retail investors as outcry grew over failed payments from three of the group’s four wealth management businesses in June. The fourth wealth management company later also stopped making payments, investors said.

Recovery after falls suffered in wake of October 7 attacks make currency top performer this month

The Israeli shekel is the world’s top performing currency this month, driven by billions of dollars of purchases by the central bank since the outbreak of the war with Hamas.

The currency has risen by around 8 per cent in November to 3.74 shekels per dollar on Friday, more than reversing a fall of nearly 6 per cent in the first 20 days of the conflict when investors took fright at the potential for a war to escalate across the Middle East. 

The rebound is a sign that investors believe the war will remain contained while also reflecting confidence in the Israeli government’s strong balance sheet and the bank’s willingness to defend the currency. The currency has also been supported by billions of dollars of financial inflows from abroad.

“The rally reflects the easing of geopolitical tensions, especially perceptions that the risks of spillovers from the conflict in Israel into the wider region have eased,” said Oliver Harvey, a senior FX strategist at Deutsche Bank. He added that the shekel “typically performs well with higher US equities and we have seen a big rally over the last month”. 

The recent rally has also been fuelled by an unwinding of “extreme” short positioning — bets on lower prices — and the Bank of Israel’s willingness to use reserves to offset excessive currency weakness.

Earlier this month it disclosed its reserves had dropped by $7.3bn in October as it sought to defend the shekel against further declines.

“The BoI did a pretty good job defending levels beyond 4.00 per US dollar and the disclosure of central bank FX [currency] intervention firepower managed to suppress speculative short shekel flows,” said Luis Costa, head of emerging market sovereign credit at Citibank. 

Attention will now turn to the central bank’s monetary policy decision on Monday, with a stronger currency giving it more room to cut interest rates as economic growth is hit by the war against Hamas.

The BoI — which targets an inflation rate of between 1 and 3 per cent — has kept interest rates at 4.75 per cent since May, over which time Israel’s annual headline inflation rate has cooled from 4.6 per cent to 3.8 per cent.

Markets are currently pricing in only a small probability of a rate cut at the meeting on Monday, but anticipate that a reduction is likely within the next three months.

S&P Global Ratings this week forecast a 5 per cent contraction for Israel’s economy in the last three months of this year. The BoI has already lowered its growth forecasts for the year to 2.3 per cent. 

Last week JPMorgan said it expected Israel to run a budget deficit of 4.5 per cent next year, up from a previous forecast of 2.9 per cent. 

Costa said there was a “good likelihood” the BoI would start cutting interest rates in the first quarter of next year. This “may spark a new mini-cycle of shekel weakness”, which would be amplified by any weakness in the global technology services sector, an important sector for Israeli exports. 

But Kamakshya Trivedi, head of global FX at Goldman Sachs, said that at current levels the shekel was “still undervalued” owing to declines earlier in the year, when investors were focused on uncertainty around judicial reforms. 

“Valuations, per se, are not an obstacle for further appreciation if geopolitical risks de-escalate and global tech stocks continue to trade well,” he said.

US exchange lists new options tracking gold, oil and Treasury ETFs

Trading in a controversial type of derivative known as “zero-day” options is spreading to Treasury and commodity markets, as Nasdaq and other exchange groups try to replicate a boom that has transformed trading in US stock indices. 

Nasdaq this week listed a series of new options contracts tracking some of the most popular exchange traded funds investing in gold, silver, natural gas, oil and long-term Treasuries. 

Options contracts give investors the right to buy or sell an asset at a fixed price by a given date. Trading a contract on the day it expires is known as zero-day trading and can be used to bet on or hedge against extremely short-term market moves.

Zero-day trading in options tied to the S&P 500 index boomed in popularity during the coronavirus pandemic. Initially viewed as a temporary phenomenon driven by speculative retail traders, the surge sparked concern among some analysts and regulators that it could create systemic risk by exacerbating market moves.

However, Nasdaq’s move is the latest sign that exchange groups are betting that zero-day trading will become a longer-term trend across different assets.

Several industry executives said they expect more US exchanges to follow suit with additional options on ETFs that do not track a specific index now that Nasdaq’s has been approved by regulators.

Greg Ferrari, Nasdaq’s head of exchange business management, said investors were looking for ways to take positions around risky events such as Federal Reserve meetings.

The new listings will make it easier to zero-day trade by adding contracts that expire on Wednesdays, in addition to the existing Friday expirations. Options tend to become cheaper the closer they are to expiry, so adding more days of the week on which contracts expire reduces costs for investors.

Ferrari said Nasdaq hopes to add more contracts expiring on different days of the week over time if the options prove to be popular.

“When investors are trying to precisely manage their exposure, having a defined product that expires on same day as the event itself is exactly what they are clamouring for,” he said.

In August of this year, zero-day options accounted for more than 50 per cent of overall S&P 500 options volume, according to exchange group Cboe, compared with 5 per cent in 2016.

Exchanges and market makers have pushed back against claims that zero-day trading could cause volatility and have disputed the popular image of it as a market dominated by retail gambling.

“We see this phenomenon servicing all types of investors,” said Ferrari. “There are lots of different use cases for short-dated options . . . all the evidence says the risk profile of the trade is contained because of the deep liquid ecosystem. That’s why we’ve taken this measured step forward.”

The new expiries were approved by the Securities and Exchange Commission.

Recent moves by Nasdaq’s rival Eurex, which is owned by Deutsche Börse, suggest the zero-day trend is starting to gather momentum in Europe too. Eurex launched daily expiries for options on the Euro Stoxx 50 index in August. Last week, it added similar options tied to Germany’s benchmark Dax index. 

Liam Smith, head of US corporate strategy at trading firm Optiver, said “having more granular ability to express an opinion [through new expiries] makes sense.”

He said Optiver was supportive of a further expansion to enable zero-day trading in options tied to single stocks, but said such a move would be more complicated and is unlikely to come before the end of next year.

EU states call on Brussels to rethink shipping emissions charge

Southern European shipping nations say measures risk diverting business away from European ports

Major European shipping nations are resisting the EU’s plans to charge vessels entering their waters for emissions, saying the policy could divert maritime trade away from the bloc.

In a letter to the European Commission, seen by the Financial Times, ministers from seven EU countries including Spain and Italy have called for the option to pause plans to include shipping in the EU’s emissions trading scheme (ETS) from January. The letter said the move risks driving business away from European ports, while offering limited environmental benefit.

“The ETS regime that will enter into force in 2024 may induce emissions to other parts of the world and even increase the volume of [greenhouse gas] emissions through longer routes to avoid calls at EU ports,” said the ministers.

It could also have “serious impacts on our import and export sectors” and investments in ports, they said.

Under plans to tax shipping emissions within its limited jurisdiction, Brussels will soon require shipowners to buy credits for every tonne of CO₂ emissions they produce on journeys between two EU ports, as well as half of their emissions on shipments between an EU port and a non-EU port.

The rules will be introduced incrementally with all emissions covered by 2026.

Europe’s current price is about €80 a tonne. Lloyd’s List, the shipping news and analysis company, has estimated that if the EU carbon price remains between €80 to €90 per tonne of CO₂, total tax revenues from the coverage of shipping by the ETS could amount to more than €11bn annually.

The ship most likely to face the highest ETS bill was the cruise liner MSC Grandiosa, it said. It could face an €11mn annual bill in 2026.

Despite saying that they supported the overall aim of the policy, the ministers, who also included those of Greece, Portugal, Cyprus, Croatia and Malta, said that shipowners were likely to find “loopholes” and divert trade through non-EU ports along the Mediterranean coast such as Morocco’s Tanger Med or Egypt’s Port Said to avoid the additional cost.

Rules have been adopted by Brussels to prevent evasion through these two Mediterranean ports because they are less than 300 nautical miles from EU shores, but the ministers said this was “not sufficient”.

The ministers called on the commission to issue a public statement with a “commitment to address with concrete measures” risks to the EU’s ports associated with the introduction of the levy.

Environmental and trade experts have pushed back against ministers’ claims about the loss of trade.

Philip Damas, head of Drewry’s supply chain advisory, said there was a “possibility” that vessels could use non-EU ports to avoid taxes on their emissions, but the risk was “low” and would depend on the size of the overall economic gain, after the costs of any additional port stops were taken into account.

Tristan Smith, a shipping and energy researcher at University College London, said “carbon leakage” to countries outside the EU “can be real”. But he criticised calls for more non-EU ports to be included in the scheme besides Tanger Med and Port Said, pointing out that this would simply shift the risk further to different ports.

The commission said that there were measures within the legislation to avoid risk of evasion and that Brussels would “monitor closely the effects of this and if there is a need for adjustments we are ready to look at that”.

Germany faces threat of creeping deindustrialisation, warns steel boss

Salzgitter CEO says steel and chemicals producers must commit to country, despite high energy costs

The chief executive of steelmaker Salzgitter has warned that Germany’s big energy users must commit to the country as a base to stave off the creeping deindustrialisation of Europe’s largest economy.

Gunnar Groebler, who joined Germany’s second-largest steelmaker two years ago, told the Financial Times that if manufacturers of materials needed by industry, such as steel or chemicals, were to leave the region due to high energy costs “you run the risk of losing the whole value chain” of production.

His comments come as 32 per cent of surveyed industrial companies in August told the German Chamber of Commerce and Industry (DIHK) that they favoured investment abroad over domestic expansion — double the 16 per cent identified in the previous year’s survey — amid concern over a future without cheap Russian gas.

“If I were to follow that lead, then we are going to deindustrialise this country,” Groebler said, adding that “from a societal perspective, I think we as an industry also have a responsibility”.

The remarks come in a difficult month for German industry as several large climate-related projects, such as long-awaited rail infrastructure investments, have been thrown into doubt after the government froze payments from a climate and transformation fund.

The freeze followed a decision by Germany’s top court that €60bn allocated to the fund, designed to help decarbonise industry, was illegal.

Groebler confirmed that €1bn of subsidies promised by local authorities to help Salzgitter build plants that can run on both gas and cleaner hydrogen were secured, despite the problems surrounding the climate fund.

The company is planning to have the first of these plants running by 2026.

The German steel industry is making a big bet on future demand in Europe for so-called green steel, as it pours billions of euros into a transition that will eventually see it replace gas furnaces with technologies reliant on clean hydrogen and electricity.

Salzgitter, which is based on the outskirts of the eponymous city where it employs 5,500 people, has been bullish on the future of carbon-reduced steel and promised not to use any more coal in its production by 2033, when it expects to have cut its carbon footprint by 95 per cent.

There remains, however, a question mark over how demand for green steel would be affected if large-scale industrial environment-friendly projects were to be scrapped.

“[The funding gap] puts a lot of pressure and responsibility on the German government to actually come up with a tentative solution, and relatively quickly too,” said Groebler.

“I would really urge them to not stop the train [of decarbonisation] because if you stop, you will need much more energy to get rolling again.”

Chair of National Infrastructure Commission says government will have to pay for tunnel under London

The National Infrastructure Commission chair has poured cold water on Rishi Sunak’s plan to get private developers to fund an expensive tunnel under London connecting the HS2 rail line to Euston in the heart of the capital.

Last month Sunak cancelled the northern leg of the high-speed railway line, but confirmed that HS2 would run from Euston station in the centre of London to Birmingham in the Midlands.

The UK prime minister claimed that taxpayers would save £6.5bn on the Euston development because developers would pay for the tunnels, tracks and station in exchange for profits from developing houses, offices and shops.

But Sir John Armitt, chair of the National Infrastructure Commission, told the Financial Times that developers would not fund the tunnel needed to connect Euston to the next HS2 terminus in west London.

“You’ve still got to dig 4.5 miles of tunnel and that won’t be paid for by the private sector,” he said in an interview. The commission, set up in 2017 as a Treasury agency, is the government’s official adviser on infrastructure.

Armitt added: “At the end of the day the government will need to be ready to fund the core civil engineering for the final miles of the project.”

His comments cast doubt on the savings the government has claimed from Sunak’s dramatic changes to HS2 that the prime minister announced at the Conservative party conference in Manchester.

The £57bn rail line is Europe’s largest infrastructure project and has been beset by cutbacks, cost hikes and time delays since work started nearly a decade ago.

According to an October government estimate, HS2 now could return “possibly as little as 80 pence for every £1 invested by the taxpayer”.

Under current plans the line is set to run between Euston and Birmingham, including a new large station in west London at Old Oak Common.

The stretch between Old Oak Common and Birmingham is not expected to open for at least another six years while Euston, where work has been paused and there is no agreed plan, will open much later.

Last week, the top civil servant at the Department for Transport, Dame Bernadette Kelly, told MPs that the private sector at Euston would “ideally fund the station approaches and we are also looking for private funding to cover the whole cost of running from Old Oak Common to Euston”.

At another committee hearing last week, transport secretary Mark Harper said the “most obvious comparison” for the public-private model the government planned at Euston was the regeneration of Battersea Power Station, on the south bank of London’s river Thames.

Harper said that at Battersea Power Station the government had “levered in £9bn of private capital”, extended the Northern tube line and “delivered a new underground station by the private sector”. 

“That’s a good indication of what’s possible [at Euston],” he told MPs.

Armitt dismissed the comparison, however, saying that the bulk of that private investment at Battersea “was for real estate investment, rather than for the new Northern Line connection”.

He said that if HS2 did not run all the way to Euston, it would require changes to plans at Old Oak Common and would put pressure on the Elizabeth Line, which has an interchange at the west London changes.

“Ultimately HS2 needs to get all the way into Euston to ensure the scheme is attractive to passengers and doesn’t place huge burdens on the Elizabeth Line,” said Armitt.

The Department for Transport said the line would finish at Euston, “as has always been the case”.

Pointing to the development of Battersea and that at King’s Cross, a DfT spokesperson said “The new plan for Euston represents a world-class regeneration opportunity that offers greater value for money for taxpayers. Our approach has been successfully carried out recently . . . and there has already been significant interest from the private sector to invest.”

Bill Anderson says group is generating a series of promising new drugs after R&D strategy change

Bayer’s chief executive has blamed an “old chemistry mindset” and a chronic lack of investment in research by his predecessors for a thin drug pipeline that has dragged down the group’s share price.

“We had several years of under-investment up until about 2018. Bayer was not sourcing novel, cutting-edge molecules [and was not] going for really important targets,” Bill Anderson told the Financial Times in an interview after the German group shocked shareholders by abandoning a late-stage trial of one of its most promising new drugs.

As a consequence, “the late-stage pipeline is thin relative to the patent losses we have in the next years”, he said. “I can’t fix what didn’t happen eight or 10 years ago.”

Bayer last week abandoned a trial of blood-thinner asundexian after it did not work as hoped to treat heart disease. The setback over a drug that was supposed to generate up to €5bn in annual sales at its peak caused Bayer’s already struggling stock to fall 18 per cent in a day. Patents for its two best-selling drugs are also expiring over the next three years.

Bayer is left with three prospective blockbusters that it hopes will generate more than €1bn in annual sales each: a treatment for prostate cancer, for chronic kidney disease and to treat menopause symptoms.

“I like the late-stage assets that we have,” Anderson said but added that the lack of new market-ready drugs was caused by an “old chemistry mindset” that was prevalent at Bayer until five years ago when the company made radical changes to its R&D strategy. But until then, he said, Bayer’s thinking was: “If we had enough chemists and labs, then eventually they’d come up with something. That’s not a strategy.”

The thin pipeline of drugs is reflected in the company’s share price performance. The stock recently fell to its lowest level in more than a decade. “Investors tend to look at what’s going to launch in the next three years,” said Anderson.

However, he stressed that the R&D strategy adopted five years ago will overcome these issues over time. The group’s head of pharma, Stefan Oelrich, who moved to the job from rival Sanofi in 2018, axed 40 per cent of the old R&D programme, focusing on cell and gene therapy and spending billions of euros to acquire companies that specialise in the field.

“I feel really good about our R&D team, our R&D strategy and the quality of the early stage pipeline,” said Anderson, adding that Bayer was now operating “a machine” that is generating a series of promising new drugs. In 2023 alone, he added, Bayer filed applications for eight investigational drugs, including treatments for cancer and cardiovascular disease.

“This is a business with 10- to 15-year product life cycles,” he said. “We did a major turnaround in our pharma R&D pipeline beginning five years ago. That is going to pay off in year seven, 10 or 12 years from when it started.”

The new chief executive, who has been in the job since the summer and previously ran Roche’s pharma division, disagreed that Bayer’s pharma unit was too small to keep up with larger rivals. He argued that the size of an R&D budget was not an automatic guarantee of success.

“Two of the companies that had the lowest R&D spending a decade ago were Eli Lilly and Novo Nordisk. They’re two of the most valuable pharma companies in the world today,” he said, adding that the companies developed “an extreme focus, discipline and scientific rigour”.

Global turmoil has created opportunities, especially in emerging markets and commodities.

With wars raging again in Europe and the Middle East, and U.S.-China tensions on the boil, the political order that underpinned markets for decades is under serious threat. So, too, is the financial order, as the U.S., Europe, and even Japan exit the zero-interest-rate era, and the U.S. and China face deteriorating fiscal health. In other words, after years of relative peace and prosperity, seismic changes could lie ahead. That is an opportunity for investors.

With wars raging again in Europe and the Middle East, and U.S.-China tensions on the boil, the political order that underpinned markets for decades is under serious threat. So, too, is the financial order, as the U.S., Europe, and even Japan exit the zero-interest-rate era, and the U.S. and China face deteriorating fiscal health. In other words, after years of relative peace and prosperity, seismic changes could lie ahead. That is an opportunity for investors.

What to do now? Barron’s sought the advice of four of the savviest market watchers we know, who took us on a virtual global tour of investment hot spots in a Nov. 3 roundtable discussion held on Zoom, and in follow-up conversations. From the bull market unfolding along the Istanbul-to-Jakarta axis to the economic liberalization taking place in parts of Latin America and the Middle East, our roundtable panelists see reasons to cheer the global transformation under way, notwithstanding some painful dislocations. They also see plenty of well-positioned companies around the world with irresistibly priced shares.

Our international experts include Joyce Chang, chair of global research at J.P. Morgan; Louis-Vincent Gave, co-founder of Hong Kong-based Gavekal Research; Matthew McLennan, co-head of the global value team at First Eagle Investments, who oversees $86 billion; and Rajiv Jain, chairman and chief investment officer of GQG Partners, which manages $107 billion.

An edited version of the roundtable discussion follows.

So far, the war in the Middle East hasn’t ruffled U.S. investors. Why is that?

Louis-Vincent Gave: Most actors in the region have been busy trying to de-escalate. Perhaps that is why the markets have brushed this off, as horrible as the events have been. Also, the days when the Arab world would embargo oil to Europe or the U.S. [because of their support for Israel] are over, as about 75% of oil exports from Saudi Arabia, Iran, and the United Arab Emirates now go to Asia. Plus, the U.S. is broadly self-sufficient when it comes to energy.

Matthew McLennan: A cautionary note: Thucydides, in the History of the Peloponnesian War, wrote that the course of war cannot be foreseen. We must be open-minded to the nonlinearities that could arise, given the nature of war and the tendency of conflict to spread.

There is also a broader aggregation of strategic interests crystallizing here that supports an anti-Western narrative. In the 1900s, [Halford John] Mackinder developed the theory that whoever controls the Eurasian heartland controls the world. There has been a clear emergence of this Heartland Axis, with the Russians inviting Hamas representatives to Moscow and [Russian President Vladimir] Putin having been invited to China to meet with [Chinese leader] Xi Jinping.

Joyce Chang: We haven’t changed our overall economic and commodities forecast [as a result of the war]. Since 1967, there have been 20 major military confrontations in the Middle East and North Africa, 11 of them directly involving Israel. Other than the Yom Kippur War in 1973, none had any lasting impact on oil prices. As of now, oil flows haven’t been impacted.

State actors are trying to de-escalate the current situation, but we worry more about the nonstate actors. More generally, my concern is that people think of many geopolitical and macro risks as spiking and then de-escalating. What if we are in a new period in which high and volatile interest rates or geopolitical risks become more chronic?

Joyce Chang, Managing Director and Chair of Global Research, J.P. Morgan. PHOTOGRAPH BY COLE WILSON

One risk that investors are trying to assess relates to China. What is the status of China’s economic recovery?

Rajiv Jain: The situation isn’t nearly as bad as the sentiment. Economic data seem to be improving. Commodity markets are telling a similar story. Growth is slowing, but given China’s size, growth of 2% or 3% today is more powerful than growth of 7% or 8% 20 years ago. And geopolitically, for now, both the U.S. and China seem to be trying to mend fences. On the margin, I am more positive than I had been, but we have just 8% of our portfolio in China in our emerging markets strategy.

Chang: We have raised our economic growth forecast for China to 5.2% from 4.8% at midyear. But one of the issues is China’s debt burden. Debt rose to 282% of gross domestic product at the end of last year, and it is another 10 percentage points higher this year.

China is adding one trillion renminbi [about $139 billion] to its fiscal deficit as it supports targeted public spending by local governments. We have seen this [type of] increase in its fiscal deficit only three times before. It suggests that China is shifting toward less conventional policy and prioritizing a grand scheme to deal with local government debt that is more proactive and transparent, even if it means a higher deficit and lower medium-term growth.

One of China’s key policy challenges is weakness in confidence—domestic and international, whether among corporates, households, or home buyers. The risks in the property sector, which has been in a multiyear decline, are also still significant. About 60% of the property bonds outstanding at the end of 2020 have been effectively wiped out, given the defaults over the past 2½ years. That’s a big share of the economy.

What are the ripple effects of this downturn in property?

Chang: China’s potential growth might continue to slide in the coming years from around 6% in prepandemic years to 3.5% to 4.0% in 2025, and stabilize in this range. That is a faster slowdown compared with our 2021 estimates.

This will have reverberations, but fewer than before the pandemic. In the past, we estimated that every 1% decline in China’s growth would dent global growth by about half a percent. Now, the hit is about 0.2% of global growth, as the impact of U.S. shocks is greater than those emanating from China. However, spillovers occur across emerging markets, so we see a 0.7% hit for those that are commodity exporters.

Louis Gave, CEO and co-founder, Gavekal Capital. PHOTOGRAPH BY TONY LAW

Gave: Chinese real estate was the big growth driver for the world from 2000 to 2014. It hasn’t been for a while, due partly to the fact that trees don’t grow to the sky. Also, the Chinese government actively tried to curtail the rise in Chinese property prices, while simultaneously making life challenging for real estate developers through much tighter lending policies.

But even as Chinese real estate has had another poor year, iron ore and energy prices have held up. The next big story for global growth is the integration of the Eurasian heartland Matt mentioned. If you draw an axis from Istanbul to Jakarta, you’ve got 3.6 billion people with strong demographic and income growth, and not a day goes by without a new infrastructure spending plan.

Abu Dhabi just said it is going to spend $50 billion on infrastructure in India. Big spending on infrastructure is also the case in Indonesia, Vietnam, elsewhere in the Middle East, and even Turkey, whose shares have done just as well this decade in dollar terms as U.S. stocks. The new bull market is this Istanbul-to-Jakarta axis. That’s what is going to drive commodity growth. China isn’t imploding. We are just moving on to a bigger and better story.

What does this mean for globalization?

Chang: Deglobalization has been a myth. It is more that trading patterns have shifted. There is the Middle East corridor and the Latin America corridor, and also connector economies that are important in the supply chain, including Mexico, Poland, Vietnam, Indonesia, and Morocco, which is part of the electric-vehicle-battery supply chain.

Gave: For the past 30 years, if growth came from somewhere, it came from the U.S. or China. You would buy Indonesia or Brazil if China did well. That hasn’t been the case for the past three or four years.

It is also the first time in 30 years that almost every emerging market has brushed off a more hawkish Federal Reserve. In 2013, when the Fed said it was thinking about perhaps starting to tighten monetary policy, [financial] markets in Indonesia, India, and Brazil imploded. This time around, these bond markets have outperformed by 20% to 40% against U.S. Treasuries. This is an absolute game changer.

Why is that?

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Gave: U.S. Treasuries are supposed to be the anchor of our financial system, and have failed at that task in the past two years. You can’t have an anchor asset that loses 20% over 18 months!

Increasingly, countries such as Chile are realizing that if they are trading with Brazil, that trade doesn’t have to be in U.S. dollars. This matters tremendously because as more trade moves into local currencies, the need to keep both reserves from central banks and working capital for companies in U.S. dollars diminishes.

McLennan: The fiscal deficit in the U.S. was 3.7% [of GDP] in July 2022 and will probably be more than 7% this year by our estimates—at the peak of the economic cycle. This is a catastrophic fiscal outcome that markets have yet to fully digest because last year’s fiscal expansion [including price escalators in entitlements and spending related to the infrastructure bill and the Inflation Reduction Act] has given the illusion of resilience.

This presents great risks. We have a structural fiscal issue in the reserve currency of the world, at the same time the Americans sanctioned the ability of the Russians to access their reserves. What incentive is there for others to accumulate dollar reserves? The ratio of the gold price to the iShares 20+ Year Treasury Bond exchange-traded fund [ticker: TLT] has almost doubled since late 2021, a signal that the real value of Treasuries has declined relative to gold.

Do you see a new anchor emerging for the financial system?

Chang: No. U.S. bonds remain the anchor. Certain features of the U.S. system—specifically, its deep and liquid capital markets—are prerequisites for reserve status and do not exist to the same extent elsewhere in the world. Other countries still want to hold their savings in the dollar. Saudi Arabia, for example, is still pegged to the dollar. I wouldn’t exaggerate de-dollarization.

That said, we have seen a shift in the commodity markets, where we estimate 20% of commodity trading is being settled in nondollars because of the Russia sanctions, and we are seeing a de-dollarization in China of overseas assets. China shifted away from the dollar to a significant extent, even though it still has a lot of U.S. Treasury holdings. We are also seeing rising purchases of gold by emerging markets. In our longer-term forecast, we see a 2% depreciation of the dollar annually.

Jain: We have never sanctioned such a large commodity exporter before. Russia is the world’s largest exporter of fertilizer, food, and arms, so [the sanctions] have forced the world to use fewer dollars. And rather than accumulate dollars and hold Treasuries, countries might as well invest domestically to improve infrastructure. In the Middle East—Saudi Arabia, Bahrain, Oman, or Qatar—countries are opening up their economies. There is a sea change happening. Good policies have come from countries with poorly performing markets over the past 10 years. The game is shifting.

What does all of this mean for investment portfolios?

McLennan: We probably saw a generational low in the cost of capital in 2021. As we move away from that and think about the emerging sovereign risks in the developed world, gold is a potential hedge. But we are also more diversified than the MSCI World Index, which is nearly 70% in U.S. stocks. Our portfolio is closer to 50% U.S. and 50% foreign.

Jain: The emerging markets stake in our global portfolio is the highest it has been in 15 years, but we have nothing invested in China. We have been pouring money into Turkish stocks, including the airline Turk Hava Yollari [THYAO.Turkey]. In Indonesia, another investment, Bank Mandiri Persero [BMRI.Indonesia], is a $35 billion state-owned bank selling at nine times earnings and seeing double-digit loan growth.

While Europe is on a fast track to socializing everything—from taxes on share buybacks to nationalizing utilities—emerging markets are privatizing. Brazil has privatized more than 50 companies. India’s Prime Minister, Narendra Modi, has been saying the government shouldn’t be in the business of running businesses. That is music to our ears!

Which other companies are beneficiaries of privatization?

Jain: We have been adding to Adani Enterprises [512599.India], which is valued at about $30 billion, the same as Airports of Thailand [AOT.Thailand]. Yet, Adani’s airport assets alone are worth that much over the next few years, without accounting for its other assets, such as green hydrogen, roads, data centers, and mining services. About a third of Indian air passengers go through Adani’s airports, and 40% of Indian container volume goes through its ports. The stock has compounded at an annual clip of 30% in U.S. dollars over the past 25 years but is still attractive.

How can a stock still be undervalued after that kind of growth?

Jain: Adani has one of most successful records of incubating businesses that I have seen globally: They have spun off more than $75 billion worth of companies from Adani Enterprises.

Adani Enterprises was the target of a short seller earlier this year who alleged widespread fraud, which the conglomerate has denied. What is your take on the situation?

Jain: Almost all of the allegations had been dismissed by Indian high courts previously, and were dismissed by the Indian Supreme Court a few months ago. Adani Enterprises is the flagship business of the Adani Group, which just tapped the market for the biggest syndicate loan in Asia last month, funded by a dozen major global and Indian banks. Even the U.S. government has invested in Adani Group by financing a Sri Lankan port-related project it operates.

What else is attractive in emerging markets?

McLennan: Today, emerging markets are priced for imperfection, expecting either recession or sluggish conditions. The U.S. is priced for a soft landing, and the odds are that it probably won’t be soft.

Our largest stake in Mexico is FEMSA [Fomento Economico Mexicano (FMX)], which controls the network of OXXO convenience stores and the world’s largest Coca-Cola bottler. Mexico has been a beneficiary of some of these deglobalization trends, given its proximity to the U.S., and FEMSA is a business with demonstrable competitive advantages.

What is the outlook for Europe?

Chang: There is more concern about a mild recession. The uncertainty about inflation remains high, as wage pressures could rise. More broadly, there are structural growth problems, with Germany, the “sick man of Europe,” at Europe’s core. The existing growth strategy—sourcing cheap natural gas to service insatiable demand from China—has been upended. Plus, the U.S. is aggressively pursuing industrial policy, and tariffs remain. But the core issue for Europe is consumer “malaise,” with the savings rate above prepandemic levels.

Jain: European energy prices have skyrocketed after the Russian war. The math doesn’t work anymore for German industrials that relied on cheap Russian gas as an input. European policy makers are also hurting the automobile sector, one of their largest and most competitive industries, by banning internal combustion engines in six or seven years. The industry can’t compete with the Chinese on electric vehicles, so it is trying to start a trade war. The problem is that the entire supply chain for electric vehicles comes from China.

Gave: Europe has a lot of problems but two silver linings: Nobody is expecting anything good out of Europe, and European bank shares are up a lot. Big meltdowns in markets tend to come from bank troubles. The only place you find that today is in the U.S. Bank shares are getting taken to the cleaners—and that’s while the economy is growing at 4.9%. If there is going to be a crisis, it is more likely in the U.S.

U.S. bank stocks are struggling for many reasons.

Gave: Inverted yield curves, etc. But [U.S. banks] are on the other side of the $15 trillion capital wipeout in U.S. Treasuries.

McLennan: Retail banks in the U.S. have often been the canary in the coal mine. In the mid-2000s, retail banks had problems in their residential lending portfolios, and then we had the subprime crisis in 2008. The problem in the regional banks this time has been in sovereign securities, so maybe the dynamic of the next crisis is going to involve some sort of sovereign issue in the U.S.

Given the risks you’re discussing, where do you find protection in the markets?

Jain: Taking a five-year view, oil is probably the most defensive asset. Profitability has improved across the sector, and capital spending is down by more than half. In China, Brazil, and India, we have a newfound love for state-owned enterprises because governments are acting aggressively to invest.

For example, we own Petrobras [PBR] in Brazil, which is selling for 4.5 times earnings, and has a 10% to 15% dividend yield and some of the best production growth prospects over the next six or seven years. In Europe, we own TotalEnergies [TTE]; Patrick Pouyanné is one of the best CEOs in the industry. The stock trades for six times earnings, yields 5%, and the dividend is growing.

Gave: For the past 30 years, you would build your [stock] portfolio and add a U.S. 10-Year Treasury bond on the premise that if something bad happened, bonds would save the day. This has failed to work for the past three years because of fiscal trends, de-dollarization, and a changing world.

The only asset negatively correlated to stocks and bonds is energy. Higher energy prices would dish out more pain, triggering further selling of bonds, while the consequent higher interest rates would trip up equity markets. Today, not running a heavily overweight energy position is setting yourself up for a potentially disastrous outcome.

McLennan: With so much focus on the energy transition and the cumulative level of underinvestment, the average age of producing resources has been cut in half over the past 15 years. Among our top holdings are Exxon Mobil [XOM] and SLB [SLB]. They are generating great cash flow and have balance sheets better than many sovereigns. Pricing for oilfield services can rise a lot further, and energy often becomes an important vector in an unanticipated geopolitical development.

Chang: We are also overweight commodities and energy and looking at more bond proxies, like utilities and staples. Although it isn’t our base case, if oil prices rise to $120 a barrel and stay there for two quarters, that will kill the global expansion. If oil goes to $100, you can take half a percent off global growth.

What does a slower China mean for commodities and other companies tied to its growth?

McLennan: When Japan underwent its adjustment in the 1990s, demand for certain [product] categories, such as the cognac business, never fully rebounded. Our largest luxury investment is Richemont [CFR.Switzerland], the holding company for Cartier. If the consumption rebound in China is weak, that is going to weigh on that business. One source of comfort: Pricing has been far less aggressive in watches and jewelry than in handbags, so perhaps there could be some spillover [demand] into hard luxury such as jewelry. The company has gradually outperformed precious-metal pricing, given its measured expansion of square footage and product categories.

Jain: The Chinese are increasing their savings rates again. It has been a tough environment, with the [Covid] lockdowns and meaningful white-collar job losses. The psyche has changed. That is why we don’t like the luxury sector in Europe. I don’t think LVMH Moët Hennessy Louis Vuitton [MC.FRANCE] is returning to double-digit revenue growth anytime soon, especially now that it is a $400 billion behemoth.

McLennan: We have a barbell mind-set when faced with these types of uncertainties. For example, you can own Richemont but might also want to own companies that have already been depressed [by China’s slowdown], such as specialists in factory automation. You look for companies with strong incumbency, like IPG Photonics [IPGP], which has a 65% market share in fiber lasers and will benefit if China recovers, but also as new factories are built elsewhere. It trades at a single-digit multiple of cash flow. It has net cash and is buying back stock.

We also want potential hedges against sovereign or geopolitical risks, such as gold bullion. We own Wheaton Precious Metals [WPM], the leading gold and silver streaming company, which has produced great returns relative to gold or silver. [Gold streamers agree to purchase a percentage of a mine’s production at a predetermined price.]

Speaking of geopolitical risks, how is slower growth likely to impact China’s approach to Taiwan?

Chang: Military conflict with Taiwan shouldn’t be a focus in the near term. The resumption of bilateral communication between the U.S. and China has reduced the risk of miscalculation and accidental conflicts, which had been a concern since former Speaker Nancy Pelosi’s visit to Taiwan last summer. Notably, at the recent Asia-Pacific Economic Cooperation summit, the U.S. and China agreed to resume military dialogue.

China is the No. 1 trading partner to 120 countries in the world. Even if it is slowing, it is going to have the largest middle class in the world. But there is a huge difference between doing business in China right now and being a portfolio investor.

If you are in China to gain exposure to the domestic market or Asia, you really haven’t changed your strategy that much. If you are in China [producing or sourcing] for the U.S. market, you might feel like you’re under more scrutiny and have had to rethink your strategy.

Gave: The view that China is doing so badly that it is going to invade Taiwan to distract people is a very Western one. China isn’t invading Taiwan. This is way beyond the capabilities of the People’s Liberation Army.

The political situation [in China] is the real issue. Following the crackdown on real estate, education, and technology, the perception among Chinese entrepreneurs and local officials is that the central government is no longer a friend but a foe. At the local level, what used to be done quickly now takes forever; that is a huge brake on growth.

What are investors missing about China?

Gave: There is a positive story: China’s trade surplus pre-Covid was roughly $25 billion. Today, it is triple that, or roughly $75 billion. China has moved up the export value chain in the past five years. It is now the biggest car exporter in the world and a world-class competitor in a number of industries that nobody associated it with five years ago, from power plants and turbines to railroads and telecom equipment. As China moves up the value chain, so do salaries, jobs, and China’s technology innovation. Making cars, nuclear-power plants, or railways is a complicated business, and China has achieved this in a way that very few other economies have.

What should investors own to be exposed to China’s maturation?

Gave: Think about the beneficiaries as China takes over industries. Tesla [TSLA] is priced as though it will be the world’s biggest car company forever, but there is no doubt that BYD [1211.Hong Kong] will be the biggest. Then, why shouldn’t Fuyao Glass Industry Group [3606.Hong Kong] be the biggest glass company in the world? I own both and think it is going to be extremely hard to compete with them.

McLennan: You have to be selective. We have tepid medium-term expectations for China’s growth. When everyone thought Japan was a mess with bad demographics, deflation, and debt, a lot of interesting companies came out of that. In China, although there are questions about the assurance of property rights long term, some of that is being discounted more than several years ago. That is why we’re starting to become more open-minded to opportunities.

We own Prosus [PRX.Netherlands], which owns about 30% of [Chinese Internet and gaming company] Tencent Holdings [700.Hong Kong]. Tencent has shifted from near-reckless expansion to a more measured approach focused on efficiency gains. Prosus trades at a meaningful discount to the value of its stakes in Tencent and other holdings [including Indonesian e-commerce company Ula, European food-delivery companies Oda and Delivery Hero [DHER.Germany], and Indian fintech PaySense among others], and is buying back stock.

Which other global themes aren’t getting enough attention?

Jain: A lot of countries are going to run tight on power. Most emerging markets can’t afford liquefied natural gas at $12 or $13 per million British thermal units. Unless we are OK with blackouts, coal will have to make a comeback. Thermal-power plants are being set up in Japan and Korea. And for all the clean energy you hear about in Europe, guess who is the biggest buyer of Colombian coal from Glencore [GLNCY]? It’s Germany! We own Glencore, which gets almost 40% of its earnings from coal.

Chang: But there are still questions about China’s economic model and whether the Chinese economy can rebalance toward domestic consumption. There are also geopolitical questions, such as whether the U.S. will take more steps to restrict China’s access to technology, incentivize companies to source domestically, or increase scrutiny of investors’ China holdings.

There is still U.S. and China exceptionalism because of the two countries’ roles in the global economy and international monetary system. The U.S. is the reserve currency, and China has a closed capital account. As a result, many of the trends we have discussed that look unsustainable, including debt burdens and high fiscal deficits, could be sustained for a while in these countries.

Thanks, all.