Chris Gottscho, Portfilio Manager

China and the Investment Implications of Weakness in the Chinese Economy

— by Chris Gottscho

In 2014 exports to China accounted for about 1% of U.S. Gross Domestic Product (GDP). Yet with all the recent headlines about the Chinese economy, not a single article we’ve read in the past few weeks mentions this number, which does not surprise us.

The investor Leon Levy said that he was uniquely qualified to analyze the investment markets since he received an A+ in a college course on abnormal psychology! As we have often pointed out, we do not think we can successfully time the market. For that matter, we feel no one can since the very good long term returns of stocks are concentrated in a startlingly small number of days in any given year or decade. Put another way, if Warren Buffett feels he cannot tap dance into and out of the market successfully, there is no reason to think we can either.

In terms of China, American politicians have been complaining for years about the lack of Chinese buyers for American goods. This is, at least for the moment, a good thing. If you own an investment in a large American seller of bricks, chocolate, or other goods and services, what goes on in China or elsewhere is important only insofar as it impacts the sales, earnings, or cash flows of your investment. Given the above mentioned 1% of U.S. GDP, that effect is very limited for most American businesses. Moreover, consumer spending in China is remarkably low compared to that in developed countries. The upshot of this low consumer spending is that China could have all sorts of economic and financial issues, but consumer spending could remain resilient given its low base.

As we look around the world at other countries, many of them have a far higher percentage of GDP being generated from exports to China. This is one reason that we think some of these emerging markets are toast, at least for now. Of course, the lack of rule of law, rampant corruption, and centralized control of economies do not help these emerging markets -- or China for that matter. For example, a slowdown in China could be very painful for Chile, where a large part of GDP is dependent on selling to the Chinese. Therefore, an investment analysis of any company needs to consider how much product is getting sold not just to China, but in places like Chile. A slowdown in China would be very bad news for a copper or oil producer who has to deal with lower prices due to reduced Chinese demand, but other companies might benefit from these lower prices (not to mention American consumers). If the Chinese currency goes down, some companies can buy imported goods for less (e.g. Costco).

We think in the long term China will do fine economically. However, the eagerness of wealthy Chinese to move their money to the U.S. and other developed countries remains startling. To some extent, that says it all regarding where one should invest.

The growth in China has been amazing for many years dating back to the 1970s. A friend of mine who visited Beijing in the late 1970s said just about the only car he saw during his time there was the one he was in – everyone rode bicycles. Today, China is a huge economy, but one where we think the economic data is whatever the powers that be decide to invent. There are quite a few problems with this making up of numbers – a big one, though, is that is obscures the tremendous amount of debt that has been taken on in the Chinese economy to fuel growth.

Nobody really knows what the Chinese balance sheet really looks like. We think the Chinese are going to have to work through some tough financial issues (by the way, U.S. banks’ exposure to China is less than 1% of assets held in the American banking system). Again, though, what goes on in the Chinese financial system is not the key question – we focus on the outlook for the individual companies we invest in. That said, we agree with former Treasury Secretary Paulson, who in 2015 wrote in “Dealing With China: An Insider Unmasks a New Economic Superpower:”

It is not a question of if, but when, China’s financial system, particularly the trust companies, will face a reckoning and have to contend with a wave of credit losses and debt restructurings. The commercial banks will also have to deal with a higher level of bad debts. That’s the inevitable outcome of economic growth that is too dependent on debt-financed fixed investment in infrastructure, real estate and manufacturing. The issue is how big the losses will be and whether the resulting disruption in the financial market can be kept from spilling into the broader economy.

It is impossible to predict with any certainty the timing or severity or even the immediate cause of a financial crisis.

As Secretary Paulson says, the when cannot be predicted accurately – perhaps the Chinese debt reckoning is starting to happen now, maybe not – nobody knows, including the Chinese. Even if the debt reckoning for China is starting to happen now, though, we believe the key to investment performance is what a company will sell next year and going forward, and whether the business will earn money from those sales. Please remember what we have written to you before – saying you can time the market is saying you can tell when the five best days will be in each year going forward – unlikely to happen.

A good example of how easy it is to be wrong on macro bets can be seen in a recent New York Times article, “Keynes: Great Economist, Mediocre Currency Trader.” After discussing what you’d guess, that Keynes, one of the greatest macro thinkers of the past hundred years, did fairly poorly investing based on his macro calls, the article pointed out that Keynes:

in the 1920s tried to time stock picks. But his returns were low, and he took a big hit in the market crash of 1929. In the 1930s, he shifted toward a long-term approach of buying stocks with good long-term potential and holding them indefinitely … his returns improved.

We do not like our success to hinge on broad macro calls, because it is way too easy to get them wrong. In addition, folks should remember they live in the U.S., not China.

As always, please call or email us with any questions that you have. 

This letter contains the current opinions of the authors and Norman Fields, Gottscho Capital Management, LLC; such opinions are subject to change without notice. This email is distributed for informational purposes only. References to particular investments or types of investments are for illustrative purposes only and are not recommendations to buy or sell such investments. Nor are these references indicative in any way of performance returns in the accounts we manage. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as a recommendation of a particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Bonds may decline in value due to market, interest rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Commodities contain heightened risk including market, political, regulatory, and natural conditions. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate his or her ability to invest long-term, especially during periods of downturn in the market.
Norman Fields, Gottscho Capital Management, LLC
1120 Avenue of the Americas
Fourth Floor
New York, NY 10036