It seems fitting here in our last Insights note of the worst year ever to discuss… Surprise!-- the coronavirus. Besides the fact that it is all that we have talked about for eleven months and that it’s just hard to break the habit, Covid-19 will continue to be a big deal in the coming year.
______________________________________________________
The more we learn about the origins of the coronavirus, the more the case against China grows. We now know that, sometime in late November, it was known at the highest levels of the Chinese Communist Party that something awful was brewing in Wuhan, and it wasn’t much later that it became clear to them that they had a new type of coronavirus on their hands. We now know that the Chinese government hid all of that information from its own people and especially from the rest of the world. This allowed for more than 10,000 Chinese residents a day to fly directly to the United States for a period between late November and Trump’s travel ban on January 31, with a large proportion arriving in California and Washington.
A study in The Lancet argues that if China’s government had transparently shared information on the outbreak and had taken immediate steps to quarantine Wuhan and the surrounding region, the rest of the world could have avoided more than 90 percent of the subsequent deaths from COVID-19. The London think tank, the Henry Jackson Society, issued a report in April showing that Beijing owes the G7 nations $4.3 trillion in coronavirus-related damages. On the back of that same report, four former Cabinet Ministers and 11 other Conservative MPs jointly wrote to the Prime Minister to ask for a “rethink” of relations with Beijing.
While the emergence of vaccines stands to end the pandemic, the international effort to hold China to account is only just beginning. The United States and other nations must hold China responsible not for retribution but rather to impose incentives for the Chinese Communist Party to do better next time. (That’s basically all that economics is-- the science of incentives.) It seems likely that nations will need to inflict even more forceful measures to effectively incentivize China to realize the full costs of its recklessness and that those measures will play a significant role in growing the new global order that will begin to take shape in 2021.
Of course, despite its propaganda, China has long refused to observe international norms, and that makes any remedy that relies on international law and courts likely to fail. It intervened to kill American troops in the Korean War, even though U.S. intervention had received the sanction of the United Nations Security Council. It has attacked most of its neighbors, including Russia, India, and Vietnam, in violation of international law, and it has annexed unwilling territories, such as Tibet. Most recently, it has constructed artificial islands in the territorial waters of other nations in the South China Sea, simply ignoring The Hague’s decision that found the islands to be a violation of the laws of the sea.
Senators Marsha Blackburn and Tom Cotton recently introduced bills to strip China of its sovereign immunity, which could render Beijing liable to lawsuits in American courts. Some state attorneys general have filed suit against China for the harms caused by the coronavirus, and members of the House of Representatives have asked Attorney General William Barr and Secretary of State Michael Pompeo to sue China in the International Court of Justice. However, for the reasons cited above, these strategies are not likely to be successful.
On the other hand, the United States could expropriate Chinese property in the United States, even to the point of cancelling Chinese-held treasury debt, and use the proceeds to compensate Americans harmed by the pandemic.
These are the means to which China would be most susceptible, but there are real risks to such strategies for the U.S. The obvious ones are that it would raise doubts among nations about the rule of law in the United States and our country’s strong defense of property rights and that cancelling Chinese-held U.S. debt would probably trigger severe disruption in the market for U.S. treasuries. However, tit-for-tat retaliations from China will probably hurt China more than the United States, as Australia, India, Japan, and the United States are actively building alliances to contain Beijing.
To be clear, I personally feel like something has to be done in multi-lateral cooperation by the international community to compel China to behave differently next time, and at this point, yes, I wholeheartedly expect a “next time.” Objectively, though, most experts don’t really expect the U.S. to cancel Chinese-held debt anytime soon, although one might suppose that even jawboning about it may increase volatility in financial markets in the coming years.
There are plenty of other problems within China’s own borders right now anyway. There has been a recently renewed scrutiny of the variable interest entity (VIE) legal structure that is used by many Chinese companies like Alibaba due to Chinese laws that prohibit foreign ownership in certain industries. U.S. shareholders actually own shares in a Cayman Islands-based company without hard assets or earnings that is connected to the operating business in China—a structure that has long raised concern.
The scuttling of fintech giant Ant Group’s initial public offering last week rattled investors and returned the regulatory risks inside China to center stage. Beijing said it was investigating Alibaba, without providing further details, and it just ordered Ant Group, the company’s finance unit, to be broken up. The reality is that the regulatory environment within China has always been murky at best and a good reason to invest elsewhere, and we got another good look this week as to why.
(It has been a long time since I was in b-school, but we were always taught that Chinese companies have three sets of books-- those for the government, those for investors, and the real ones. I suppose the more things change, the more they stay the same.)
______________________________________________________
Most of the major investment banks have provided their outlooks for 2021 at this point, and we’d characterize their general sentiment as very bullish. Here at RG, we’re not particularly enthusiastic about the beginning of the year, but we do expect the second half of the year to revisit robust earnings growth and economic expansion across the globe. Everywhere but China.
We utilize research from just about everybody on The Street, but any regular reader of our column knows that I love the team at Goldman Sachs. Goldman’s expectations this year for global growth are above-consensus at 6.3% in 2021, with their growth expectations exceeding consensus in all major economies except China.
As for the magnitude of any soft patch during the first half of the year, it will be a direct function of how much fiscal support is delivered. That said, with vaccines developed and now being distributed, the second half of 2021 looks set to see a meaningful acceleration in the pace of economic growth. Equity markets remain focused on this dynamic and assume that policy will continue building a bridge to post-pandemic normalcy, at which time low real yields, contained inflation, easy financial conditions, peak earnings and a substantial equity risk premium will take over.
This favorable growth backdrop leads us to believe that pro-cyclical assets remain well-positioned heading into 2021, and we expect higher equity and commodity prices, tighter credit spreads, steeper rates curves and a weaker Dollar. But given that the market has already moved in a pro-cyclical direction in response to positive vaccine news, we see the largest potential gains where we see the furthest technical room to run: commodities, emerging market assets, and breakeven inflation. While we expect some softness for stocks early in the year, we’ll brashly call for the S&P500 to make it up in the second half and to finish up approximately 12% in 2021 and for small-caps and India to do even better. Therefore, we emphasize:
Broadening global exposure that focuses on company-specific opportunities rather than geographic beta-- especially in China.
Moving down in market capitalization to seek exposure to secular growth themes while reducing the concentration and regulatory risk of current mega-cap growth companies.
Complementing high quality core bonds with private credit for potentially attractive yield premiums and diversification benefits.
Investing sustainably through environmentally, socially, and economically aware strategies.
______________________________________________________
Perhaps as much as anyone, I maintain an inability to comprehend the maliciousness of Xi Jinping’s actions. Particularly as a parent, my mind revolts against the notion that the world now faces such a monster. Democracies have always had difficulty recognizing evil, though, which is why we expect geopolitical clarity to become a contributor to stock market gains in the coming year. I hope it’s worth it.
______________________________________________________
Thank you for your readership during this very trying year. Your feedback, likes, and shares here on Insights and your referrals of friends and family to our firm continue to be very much appreciated. 2021 will mark the third year since we left Wells Fargo to establish the RG Investment Group, and over that short time, we’ve shared in the births of your children, your moves to new cities, job changes, the passing of loved ones, the launching of new businesses, the acquisition of your companies, home purchases and retirements, and I know I speak for Rhonda and Perlie when I say that we’re grateful for our relationships and wish you and your families a very happy and prosperous New Year!
For disclosure information please visit: https://www.rgbarinvestmentgroup.com/terms-and-conditions
Comments