Macro & Strategy - November 2024

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Crossroads: Witnessing China’s Japan moment

U.S. elections are around the corner

Before digging into the topic in the title, we think a quick look at the U.S. election, set for November 5, is in order.

At this writing, the race is too close to call, but the math has become unfavourable to Kamala Harris, who needs multiple wins in battleground states (with Pennsylvania the golden prize) to clear a path to victory.

With the race this close, and uncertainty over the policies we will see in the event of a Trump win (Will it be a sweep? Or a divided government?), we propose to refer our readers to previous issues of the IAGAM Monthly (here and here) for a more thorough analysis of each candidate’s policies and potential market impacts. The implications for ChinaU.S. relations also loom large, as we’ll discuss in this piece.

As of late October, the markets seem to have priced in a fair share of a Trump win (60-70%, according to our view), meaning that a positive surprise for the Democrats might be more market-moving after the election. We wish our readers an entertaining election night and we’ll provide more in-depth coverage on the outcome next month.

Back to China

China’s authorities have been drip-feeding stimulus measures for about a month, as the world’s secondlargest economy struggles to regain momentum.

Much like Japan in the 1990s, China is at a critical juncture: it faces a complex set of challenges that threaten its long-term growth. With asset bubbles, demographic shifts, high debt levels, and policy constraints, the Chinese economy bears quite a resemblance to the one that caused Japan’s “lost decade”.

This month, we explore the parallels and examine why China might struggle to export its way out of its current troubles. We also assess the potential for geopolitical shifts, particularly how a Trump victory in 2024 could reshape global trade dynamics.

A deleveraging shock…

China’s real estate sector has long been a cornerstone of its economy, with a combined direct and indirect contribution of nearly 30% to GDP growth.

In 2023, for example, direct real estate activities contributed about 13% to China’s GDP, but when factoring in all related industries and their spillover effects, we find that the total contribution is estimated at 25% to 30%. This higher figure reflects the significant role that real estate plays in driving demand for a wide range of products and services in China’s economy, and also takes into account the broader impact of land sales on local government revenue as well as the linkages between real estate and sectors such as construction and heavy industry.

In terms of direct contribution, real estate activity has grown from 8% to 13% over the past 10 years as the economy has moved away from its industrial roots toward a services orientation.

In the wake of this boom, recent data suggest that this sector has become a major risk factor.

Overbuilding, rampant speculation, and heavy reliance on debt have led to an over-leveraged sector that is cracking under its own weight. The most recent data show that housing prices are in freefall, with the secondary-market decline approaching 10% on a yearover-year basis.

In comparison, Japan’s asset bubble burst in 1990, after property and stock prices had surged to unsustainable levels. Between 1991 and 1992, Japanese land prices fell by more than 20%, and the stock market dropped by nearly 60% from its peak. The bursting of this bubble ushered in Japan’s lost decade and a prolonged period of deflation and stagnation.

As for China, given the importance of housing as a share of household wealth (about 70% of household wealth is linked to real estate, versus 45% in Canada), a similar unravelling in real estate could trigger a significant deleveraging trend, igniting asset fire sales and pushing the economy into an extended downturn.

… leading to a balance sheet recession

China’s debt has ballooned across multiple sectors. Local government debt is estimated to be as high as $23 trillion, much of it tied to infrastructure projects that offer little return. According to the Bank for International Settlements, China’s total debt-to-GDP ratio exceeds 280% and continues to rise. Moreover, corporate debt in China is more than 160% of GDP, making it one of the most leveraged economies in the world.

This context mirrors Japan’s situation in the late 1980s, when high levels of corporate debt, combined with non-performing bank loans, created a credit crunch. As companies and banks focused on paying down debt rather than investing in growth, Japan entered a period of stagnation. China, with its similarly high debt levels, risks falling into a similar balance sheet recession whereby traditional monetary stimulus proves ineffective because economic agents prioritize paying down debt over spending or investing.

Monetary policy: pushing on a string

The People’s Bank of China has cut interest rates several times over the past year, aiming to stimulate demand and reduce the cost of borrowing. But, with the economy in a balance sheet recession, the issue is that households, businesses and local governments are coping with elevated debt levels and prefer to focus on debt reduction. The result: demand for loans has tumbled, and monetary policy has become ineffective.

The failure of recent monetary policy interventions to trigger growth suggests that China may be facing the same challenges as Japan in the 1990s, when even zero-interest-rate policies and massive liquidity injections failed to reignite growth.

Japan’s monetary policy, which included setting interest rates near zero and engaging in quantitative easing, was insufficient to spur demand because private-sector debt levels remained too high. The takeaway is that the modern quick fix of using monetary policy to sort out domestic economic issues is unlikely to work in today’s China, and fiscal policy becomes the focal point.

Fiscal policy to the rescue

Over the past 20 years, in orchestrating the transition to a more domestically robust economy, China has relied heavily on fiscal stimulus to drive growth, particularly through infrastructure projects and local government borrowing. But this approach has only exacerbated the debt burden, particularly at the localgovernment level, with many regions now struggling to service their debt. Fiscal stimulus has been a doubleedged sword for China, driving short-term growth but creating long-term risks, especially in the real estate and infrastructure sectors.

The path forward is thus relatively narrow. The federal government seems intent on delivering enough stimulus to reach the annual growth target of 5%, but the measures announced so far lack the boldness to convince markets and foreign observers that things are looking up. Two of the ideas that could be implemented but have not yet been announced would be for the federal government to simply invest in completing the real estate projects yet to be delivered and to propose a different revenue-sharing scheme for regional governments, which are currently incentivized to sell as much land as possible to refill their coffers.

Although we are cautiously optimistic that China will find the right path, we do acknowledge that the task is a delicate one. Similarly, Japan’s fiscal stimulus in the 1990s was significant but failed to spark sustained growth. Despite aggressive government spending, Japan’s private sector focused on paying down debt rather than increasing consumption or investment. In both cases, fiscal stimulus alone may not be enough to counteract the broader economic slowdown.

Adding to the urgent need for action, China has been grappling with producer price index (PPI) deflation for more than two years, and the increase in the consumer price index (CPI) is barely above zero. Although deflation hasn’t yet fully gripped China, the risk is rising. With slow consumer spending and tepid price growth, deflation could exacerbate the already heavy debt burden, as it did in Japan, where persistent deflation made real debt levels even more onerous and discouraged consumer spending and business investment alike.

Demographic challenges: China most likely got old before it got rich

China’s one-child policy created long-term demographic challenges, leading to an aging population and a shrinking workforce.

By 2050, China is expected to undergo a dramatic demographic shift, as the share of its population aged 60 or over jumps from 21% to almost 35%. Japan has faced a similar issue in recent decades: its rapidly aging population has contributed to lower economic growth and increased the burden on social services.

The aging of the population adds a long-term headwind to the current short-term issues the country is facing. As time goes by, China’s role as one of the leading growth engines of the world will erode, adding to the urgent need to clear the decks.

China’s export limits and global trade

Unlike Japan, which was able to rely on a weak yen and robust global demand to help it recover after the asset bubble burst, China’s position as the world’s second-largest economy means it has fewer options to export its way out of trouble. China’s trade surplus has been shrinking, and its global market share is already significant. Any further devaluation of the yuan would most likely invite retaliation from trade partners, limiting the effectiveness of currency adjustments in boosting exports.

Moreover, a Trump win could lead to a more hostile global trade regime. Trump’s previous term saw tariffs on Chinese goods and a pivot toward a more confrontational trade policy, which could be revived, especially with U.S. allies united by their collective frustrations over China’s trade practices and influence in global markets.

Silver linings and investment opportunities?

To counterbalance the economic headwinds, China has attempted to prop up its stock market, hoping to create a wealth effect that boosts consumer confidence and spending. Judging from recent communications, it appears that higher Chinese equity prices have become a policy objective. By encouraging domestic equity investment, China aims to foster a sense of financial stability. Even so, investing in Chinese equities remains a risky bet: the market is subject to significant government intervention, and the volatility of recent years makes it a precarious choice for long-term growth.

Still, with valuations relatively low and the government’s apparent willingness to push equities higher, we think there could be opportunities for those willing to navigate the risks.

Conclusion: a cautionary tale

Together, all these elements show that the Chinese economic situation has come to a crossroads, and a brand-new approach to economic engineering could be needed to avoid repeating the mistakes of the past.

China’s current economic landscape shares many characteristics with Japan’s in the 1990s, from asset bubbles and high debt to demographic challenges and policy ineffectiveness. With the future highly uncertain, these parallels offer a cautionary tale for policymakers and investors alike. As China navigates its economic transition, the risk of stagnation looms large, and global trade dynamics could shift significantly, particularly if geopolitical tensions rise.

Ultimately, China’s ability to avoid a protracted economic slump will depend on its capacity to implement meaningful reforms, reduce its reliance on debt-driven growth, and navigate an increasingly complex global trade environment.

Monthly positioning

We are maintaining our overweight position in equities relative to cash, with a particular focus on U.S. and emerging market equities. The current environment remains favourable for U.S. equities: the country’s activity is resilient, being near or slightly above trend, and has even accelerated recently, with readings on retail sales and employment showing a measure of re-acceleration. We think this context indicates a positive earnings outlook. With inflation gradually receding back to target, central banks can provide easing from restrictive interest rate levels to more neutral or accommodative territory, supporting equity multiples. The tech sector, a key driver of the U.S. market, given its heavy weighting, has so far reported decent third-quarter earnings. Over all, we think this context will continue to support U.S. equities, even with the uncertainty over the presidential election.

We also like Canadian equities, which we think will continue to benefit from the reduction in Canadian inflation, which is allowing the Bank of Canada to continue to normalize rates at a rapid pace, and from accelerating Canadian growth, which benefits the earnings outlook.

Furthermore, as already discussed, the improved outlook for stimulus measures in China is notable. Given the shift in communications from the Chinese leadership, indicating that rising asset prices now seem to be a policy objective, we think Chinese equities have the potential to recover, boosting emerging markets generally. With these markets still trading at low valuation multiples, we have positioned ourselves accordingly and expect a recovery in Chinese and other emerging market equities.

We have shifted to a neutral position on fixed income, a slight decrease from last month, primarily because of the much stronger growth momentum in the United States. Recent economic indicators have shown a considerable re-acceleration of growth. They do not yet represent a structural risk in the fight against inflation, but we have taken note of the reacceleration and adjusted our positioning to become more neutral on fixed income.

We continue to have a positive outlook on gold. The metal has been supported by geopolitical tensions and central bank allocations, and the coming U.S. election introduces a new element supporting gold: fiscal policy risks

As the presidential election campaign shifts into high gear, the potential for larger budget deficits stemming from fiscal policy outcomes presents a risk, leading us to maintain a positive outlook on gold as a hedge against potential fiscal challenges arising from the election.