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Economy & Markets Oct 17, 2024

The Thucydides cap on the China equity rebound trade

Michael Cembalest Chairman of Market and Investment Strategy for J.P. Morgan Asset & Wealth Management

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For participants in the China equity rebound trade: once you hit your return targets, take the money and run.

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[SWOOSHING]

Good morning, everybody. This is Michael Cembalest with the October 2024 Eye on the Market podcast, webcast. This one's entitled "The Thucydides cap on the China equity trade." I'm going to explain what I mean by that. People ask me about geopolitics a lot, and I guess I understand why. There's a lot of people out there that write about geopolitics all the time.

And I want to start—in case you were one of the people that read it. I want to start with the Eurasia Group, which is one of the political consultancies out there. In 2017, their publication was called Geopolitical Recession, and they had this preposterous opening salvo in the beginning of it. "This year marks the most volatile political risk environment in the post-war period, at least as important to global markets as the economic recession of 2008."

Now, something tells me that the Eurasia Group considers every year the most volatile political risk environment in the post-war period. But in any case, it was absolutely absurd to compare 2017 to the 2008 recession, which was the worst global economic downturn since the Great Depression. And if you're keeping track, global equity markets are up around 150% since January 2017. So if those are the geopolitical risk materials that you're reading, you should probably read something else.

In any case, geopolitical risk indicators are usually not that helpful for investors. We track a bunch of different variables to see which indicators over time are most helpful for figuring out market returns. And what we do is we figure out how much money would you make if you only invested when this signal was strong and you didn't own the market when the signal was weak.

And as we show in the table, that's included in the Eye of the Market, the most beneficial variables to follow are things having to do with payroll growth, industrial production—remember, the S&P is more of a production index than a consumption index because the S&P is very different than GDP. Leading indicators, financial conditions, business confidence. These are the variables that over time have the greatest and strongest investment signal benefits for investors.

There's a geopolitical risk index that we also look at. The sign is actually negative, which means that investors would have lost money by following it for investment purposes. So most of the time geopolitical risks are not super important for investors. And this rhymes with other research we've done showing that other than the Arab-Israeli War of 1973, most geopolitical events are gone from the market six months later, and '73 was the exception due to the OPEC oil embargo and Nixon's wage and price controls.

So as it relates—now, let's talk about how geopolitics relates to the China stimulus package. A couple of weeks ago on our pre-election piece where we also talked about the China stimulus package, I was optimistic on this thing. And this is a pretty impressive shot at giving the economy a jolt. It's got monetary and fiscal components, macro components. It's got market regulation components. They're trying to clear out some of the excess inventory and real estate. They're giving people incentives to buy back stock and to leverage investments in the markets.

And so it's a decent shot. They certainly did it under duress. When you look at monetary aggregates like M2 and foreign direct investment and consumer sentiment and property prices, the numbers were horrific. And so China acted here more out of desperation than anything else. But I thought it was a pretty decent package. And remember, when equity markets are trading at nine to 10 times earnings, don't need to know all the answers to all the questions to make money, because of how cheaply they were priced.

And sure enough, equity valuations popped on both the A-share market and MSCI China. They've retreated by 20% or 30% or so since their peak a little over a week ago, but they still look way below median. But I think that the concept of median here has to be rethought. And I think there's a cap on how much money can be made in Chinese equities, in part because of geopolitical issues, which I'll explain. And specifically in the title of this piece is, I think there's a Thucydides cap on Chinese equities.

So you might be thinking, well, what in God's name does that mean? Well, Thucydides was a long-forgotten Athenian historian and general. And then in 2017, Graham Allison and Harvard resuscitated him. And in his 2017 book, it was called, Can America and China Escape the Thucydides' Trap? And what is the Thucydides trap? He—Allison—looked at 16 cases over the last 500 years in which a major nation's rise disrupted the dominant state. And in 12 out of those 16 cases, it ended with an actual military conflict between the two powers, and only in four cases it didn't.

At the time, a lot of clients asked me about this because they saw it as a premonition and really a strong prediction of military conflict between the U.S. and China. I countered by saying the U.S.-China relationship is a little bit different. This is what I said at the time. And I have a chart in here that shows what I published back in 2017.

If you look at China and the U.S., the economic linkages between these two countries are much deeper than between adversaries over the last 100 years, for example, France and Germany in the '30s, China and Japan in the 1930s, U.S. and Iran in 2014, Israel with any of its neighbors ever, India and Pakistan. And so when you look back at all of the different periods, you don't find adversaries with massive amounts of bilateral central bank holdings of each other's debt, massive bilateral foreign direct investment and bilateral annual trade.

So I thought at the time there was something different about the U.S.-China relationship. I think it less today than I did in 2017. And what has changed is since 2017, China has hacked into over 200,000 internet-connected cameras, routers and other devices in Western countries. It has put malware and other kind of controlling software embedded in U.S. transport, telecom, water and energy and grid networks, including U.S. port cargo cranes.

It has hacked into U.S. government systems used for court-authorized network wiretapping requests. Imagine how sensitive that information is. It hacked into the U.S. Office of Personnel Management, and that doesn't sound like much. That's the department of the government that collects sensitive information from you when you're getting a high-level government security clearance. So China now has information on 22 million current and former officials. That's very sensitive, presumably things that people wouldn't want to have known.

They hacked into Equifax, with information on 150 million Americans. And they hacked into U.S. military platforms, development platforms for the F-35 fighter jet, Reaper drones, Patriot missile systems, combat ships, nanotechnology, space surveillance, tactical data links, other kinds of drone video systems, you name it. China has really engaged in an unprecedented level of both corporate and military espionage. And don't take it from me. Let me give you just four quotes in terms of how the relationship has changed.

This is from the Harvard Kennedy School historian on the subject. "Chinese businesses are required to work with its intelligence services whenever they are requested to do so, and these intelligence services are effectively their silent partners in Chinese commerce in terms of dealing with the outside world." FBI Director Wray, "China's hackers are positioning on U.S. infrastructure to wreak havoc and cause real world harm to American citizens, if and when China decides the time has come to strike." "It has made economic espionage a central component of its national strategy. China has a bigger hacking program than every other major nation combined, and has stolen more of Americans' personal and corporate data than every nation combined."

The head of the U.K. MI5 said that, "China has been engaging in sustained espionage on an epic scale, contacting over 20,000 U.K. individuals online, including those at companies linked to military supply chains." And then the Georgetown Security Studies Review had the following to say. "Even Chinese companies that are not state-owned enterprises are in practice subject to laws that compel them to provide open access and information to Chinese government. Therefore, foreign companies and joint ventures are essentially required to allow the Communist Party cells to be established inside of them, enabling theft of their technology and IP, whether it's in China or anywhere within the worldwide reach of the company's networks."

So I think this gives you a sense. We go into more detail in the Eye on the Market itself. We also have a chart in the Eye on the Market that looks at, since the year 2000, at the increase in publicly reported Chinese espionage and incidents, as reported by the Center for Strategic and International Studies, which is probably the longest-serving, well-known think tank in DC since 1962, was affiliated with Georgetown until the '80s, and is now independent.

They had some data that I converted into a chart. I mean, this is a laundry list of the largest companies and government entities in the United States, whether it's Boeing, Lockheed, the Navy, the Army, the Pentagon, NASA, gas pipelines, DuPont, Monsanto, Raytheon, Google, Verizon, Microsoft, water districts, Apple, Moody's, Siemens, United Airlines, U.S. Steel, the FBI, you name it. These are entities that Chinese espionage has targeted, and increasingly so since 2016, 2017.

So the bottom line is, I think, that the recriminations, retaliations and sanctions that come from this kind of thing have the potential to cap the upside for Chinese equities. And again, as a reminder, we had this in a prior Eye on the Market, China's already got the lowest pass-through from GDP to earnings in equity market returns. What does that mean? It means that if you look at the degree to which GDP growth translates into earnings growth and equity market growth, China's at the bottom of the list of all the countries that we look at. And this is what I think the BRIC people from 20 years ago who coined that term got wrong. They were right about higher GDP growth, but they were wrong about the implications for investors because of some of these pass-through issues that aren't really working.

So bottom line, when you combine some of the geopolitical issues with some of the economic issues, I'm going to quote the Steve Miller Band from 1976, "take the money and run." If you book profits on this China equity rebound, take your profits and move on because I think the upside is capped. Thank you for listening. We have a webcast, like a big client webcast, coming up to discuss some of the pre-election issues in play. Sometime, you should get an invitation for that. And thanks again, and we'll talk to you again soon. Bye.

[SWOOSHING]

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About Eye on the Market

Since 2005, Michael has been the author of Eye on the Market, covering a wide range of topics across the markets, investments, economics, politics, energy, municipal finance and more.

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