Are Chinese and US equity valuations codependent mirror images?

Apologies for a somewhat tortured title, and also for what is almost certainly an overly schematic and shallow treatment of the question that does not grapple with actual numbers. But I hope its an interesting question/answer and I’ll try to make it short.

In a graph that has received much airplay on social media, China is now the world’s manufacturing superpower, accounting for roughly 1/3 of global manufacturing output at the end of 2021 (31% to be exact, but I’m taking statistical license here).  China alone accounts for almost as much of the world’s manufacturing output as North America and the EU combined, while the East Asia/Pacific region as a whole accounts for roughly half global manufacturing. None of this should be a surprise to anyone who has bought any manufactured items or seen any large pieces of machinery in recent years. And it would be remiss of me as a card-carrying celebrant of Globalization 2.0  not to note that for all the moaning about the deindustrialization in the North Atlantic Basin, at roughly 50%, East Asia’s share of global manufacturing output is far closer to its share of global population than was the North Atlantic basin’s share of c. 57% in 1980.

But be that as it may, that’s not what I’m here to write about. I’m thinking instead of the relationship between the rise in China’s manufacturing share and the rise in the US share in free-float global market capitalization. As of December 28, the US weight in the all-country world index was 62.57%, or roughly 2/3, almost certainly the highest that any country has ever been. Meanwhile, the Chinese equity market (as proxied for this purpose by the China ETF FXI) has gained less than 1% a year over almost 20 years). This has occasioned lots of questions about how these two numbers are completely at odds with each other—how, people ask, can China’s share of global output have kept rising without having an comparable impact on the valuation of its publicly-traded capital stock versus that of the US. I should belatedly note here that I just saw a very interesting tweet from Michael Green pointing out that Chinese market capitalization has increased dramatically, but equity performance has been held down by persistent dilution.

There are two answers that I see frequently—the first is that China’s growth numbers are “fake,” which means either completely fabricated, or (marginally more charitably) represent epic wasteful spending on infrastructure and real estate. There might be something to both of these answers, but I also suspect that both are overstated and really not that interesting (for what it’s worth). The second answer is that there are large chunks of Chinese industry that are in fact productive and generate earnings and are not overly encumbered by debt (a description that clearly does not apply to real estate developers). Even so, global and local political and regulatory uncertainty on several fronts leads to persistent discounts in terms of multiples. This would seem to be the case for China’s large onshore tech giants like Alibaba or Tencent, but I don’t think these are the companies pushing the bulk of increase in Chinese share of global manufacturing value-added.

This brings me to the third possibility, which I like to think of the most interesting one. This stems from the unusual nature of soft-budget constraints in China. I said here that one kind of soft-budget constraint is when governments keep shoveling money at single enterprises that are so bad at making things that the result is shortages and/or inflation. But the other is when governments keep shoveling money at multiple enterprises that are so good at making things that prices collapse, no-one is profitable and yet they keep making them. And the joke is that the first model stands for CCCP, or Consistently Crappy Consumption Products, while the second stands for CCP, or Cost Curves Plummeting.

This is interesting IMO for a few different reasons. The first is because it captures one of the key sources of dissatisfaction that led to the collapse of the Warsaw Pact—shortages of stuff that people wanted—combined with external borrowing to finance imports to allay that dissatisfaction, which eventually led to Balance of Payments crises in multiple countries behind the Berlin Wall. And the second is because it might help explain how one of the dominant spillovers from the Chinese economy into the rest of the world is persistent disinflation or outright deflation.

The third, which brings us back to the title, is what that disinflation means for the rest of the world. I have suggested here and here that China has grown in good part by operating in the global economy as generator a series of positive supply shocks in tradeable goods whose benefits have accrued less in the form of Chinese enterprise profits (or at least that portion of them available to owners of their publicly-traded equities) and more in the form of a) gains to the owners of existing bonds in developed countries b) a consumer surplus in importers of Chinese manufactures and c) a consequent ability to redirect the boost in disposable incomes from that consumer surplus primarily to nontradeables, the gains of which will accrue either to owners of existing non-tradeables (if these are supply-constrained) or to producers of new ones. (if they are not). The sweet spot for equities outside China then is to be a direct or indirect beneficiary of serial disinflationary Chinese supply shocks, duration sensitive, and have little to no exposure to competition from Chinese tradables. Perhaps the leading sectors of the US stock market just tick more of those boxes (with perhaps one very prominent exception), than those of its peers. And to throw in a final ironic note while keeping this under a 1000 words—one answer to the question of “Where Do Profits Come From” might be “Chinese fiscal and quasi-fiscal deficits.”

I hope this was somewhat interesting, if not actually useful. If this all seemed like so-much macrobloviation, I would like to remind you that my first blogging effort  was titled “Lots of Pointless Handwaving.”

And I just remembered you are owed movie recommendations and/or dad jokes. LA Neonoir (films made from the 70s to the present set in the 30s - 50s) is a hallowed genre anchored by Chinatown and LA Confidential (both streaming right now on Prime and Netflix, but I can’t remember which one is where). But I also recommend the following three if you’ve never seen them—True Confessions (Dunne/Didion script with Duvall and De Niro) currently on Prime; Devil in Blue Dress (wonderful adaptation of Walter Mosley starring Denzel Washington directed by Carl Franklin); and Hollywoodland (amazing work by Ben Affleck starring as George Reeves, the TV Superman). All three are marked by exceptional texture that IMO captures what the city probably felt like back then.