The Valor Blog.
Investment News and Views, Direct from Our Team.

Chinese overtaking the US?

There was a recent article which states that the OECD expects the Chinese economy to overtake the US by 2016. I generally have a great deal of respect for the OECD as they have a collection of above average independent thinkers. On this simple exercise of straight line extrapolation of future growth, I think they may be a little off.

Humans are terrible at predicting a change in trends. This is why very few economists predicted the GFC. The human brain loves symmetry and so most find it easier to just assume current trends will continue. Unfortunately things like reversion to the mean, valuations returning to normal, black swan events and unwinding of excesses in economic systems destroy most straight lines.

One day the Chinese economy may overtake the US, however I believe that day is still a way off.

The main reason the Chinese economy is growing at such high rates is because they are expanding their  building of empty apartments and offices by over 20% per year (to be fair, a small percentage of these apartments and offices are being used, maybe 25% or so). So this means that China will be building over 70% more empty apartments and offices by the year 2016.

Unlikely…

I have been to a number of Chinese cities to see with my own eyes the vast stretches of empty real estate. It has been fascinating to see this growth in empty offices and apartments. I first noticed it in 2008 at the Beijing Olympics and was perplexed as to why there were hundreds of office buildings in Beijing completely empty. At the time, I was not aware that this was the tip of the iceberg. As someone who gets paid to travel the world and observe from the front line what economies are doing, I find the Chinese economic “miracle”(experiment) truly fascinating.

What you see in this video is not an exaggeration, it is the norm in China. It worried me a few years ago when I realised the situation. It is far worse now, however it could continue to bubble away for a little longer.

China has a lot going for it over the long term. They have transitioned their economy out of the dark years of the 60’s and 70’s and brought hundreds of millions of people out of poverty over the last 40 years. I expect that over the next 40 years, their average incomes will continue to rise. This trend is unlikely to fix the damage from the previous administration, who overcooked the economy with too many unproductive assets. As described by Wen Jiabao, the Chinese economy truly is “unstable, unbalanced, uncoordinated and unsustainable”. The only difference between now and 2007, when Wen first made this statement, is that  now there is a lot more debt!!!

So far I have been wrong in predicting the exact timing for the slowdown in China. I would have thought that being a command economy that they would pull in the reins and attempt an orderly slowdown. They began to tighten the reins early last year, but since then, they have pumped up enormous amounts of stimulus through the shadow banking system with wealth management products. This growth in off balance sheet debt is very worrying. With the current boom flourishing unabated, the eventual slowdown becomes far more painful.

Those punters buying the iron ore and coking coal miners are hoping that the OECD’s straight line projection is correct. The Australian goldilocks economy is desperately clinging onto China’s “treadmill to hell” policy of building its way out of its over building problem.

At some stage their SimCity experiment will have to address the issues as described by the game description on Wikipedia:

For the success of a city, players must manage its financesenvironment, and quality of life for its residents.

So far the finances are looking very stretched, the environment is choking its residents and its people have to pay exorbitant multiples of average wage just to buy an apartment.

Only time will tell, however I would suggest there are far better investment thesis than betting on straight line projections of China’s growth from this current point in time.

The biggest question I would love to have answered is how much a slowdown in China will spill over into the non-mining sectors of the Australian economy. The future is never clear, but at Valor Private Wealth, we are quite skeptical that the remainder of the Australian economy is immune to a Chinese slowdown. The latest run up in the banks share prices suggest that the rest of Australia is completely ignoring this risk.

The beautiful fact that investing is a “no strike called” game means you don’t have to swing at every ball. So at Valor Private Wealth, we will sit this cycle of Chinese growth/slowdown out and let others take risks we think have poor upside for the significant downside risks ahead.