The fourth quarter is historically the strongest for equities and this year’s Q4 is starting off in sympathy to historic trends. Banks got earnings season off to a strong start. While most companies still must report third quarter results, the trend suggests a very solid earnings season. The biggest question is whether AI momentum can continue to lift the half dozen behemoths that top the S&P 500 or whether there might be any hints that the pace of growth is starting to ebb. Earnings last week from Taiwan Semiconductor, who’s foundries manufacture most of the fastest chips strongly suggest that the capex buildout continues unabated. But the focus during earnings season will be on the rate of growth of revenues derived from the increased use of AI. That saga will play out over the next two weeks.
While that happens, the election campaign is now in its final two weeks. To date, there hasn’t been an October surprise that can suddenly change the tone of the election. The media will continue to pick apart some of Donald Trump’s over the top remarks while waiting for Kamala Harris to talk specifics. Parenthetically, I find the strategies of both somewhat strange. Both sides have strong bases, and each spends much of their time playing to them. Yet the undecided voters are in the middle. They don’t go to rallies, they are sick of all the campaign ads that exaggerate and distort and would like some real hint of what each would do. We know a bit of Trump’s policies, such as tariffs and nationalism and we know that Harris is likely to follow a path similar to President Biden. Beneath the Presidential race, odds seem to be increasing, according to pollsters, that the Republicans will regain control of the Senate. In the House there are about two dozen seats that are too close to call. Their outcome will determine who controls the House. But can the Speaker, whether Republican or Democrat control their caucus with a narrow majority similar to what we have today? Republicans have shown for two years that they cannot. Any substantive legislation has required Democratic support. Should the Democrats win the House, they face a similar problem trying to bring the extreme progressives and the handful of moderates left on board at the same time.
The net result is likely to be that whoever is elected President will have a tough time moving anything substantive through Congress. If Harris wins but Republicans capture the Senate, anything that will be passed will need compromise. If Republicans sweep, they have a somewhat better chance, but history of the past two years suggests it won’t be easy. From Wall Street’s perspective however, movements to lower taxes, or at least keep rates near where they are today, coupled with efforts to unravel excessive regulations, would be supportive of better growth prospects. Whoever is elected should benefit from the productivity gains associated with AI likely to emerge over the next four years. As for the promises of tax-free Social Security, overtime, and tip wages, those are not likely to get universal support among either party without an alternative revenue offset. One can add to that list expanding child related tax credits, additional student loan forgiveness, and large tax credits for first time home buyers. All those headlines telling us each candidate’s proposals will expand budget deficits by some outrageous number neglect the probability that none of these campaign “promises” are going to make it into law.
Momentum during this election season has swung back and forth. Each side got a temporary boost after their party’s conventions. Right now, polls still suggest a dead heat. All “leads” remain well within the margin of error. At this point, I wouldn’t expect anything substantively new from either candidate. There is always room for some last minute surprise. The big hope, or at least my big hope, is that the outcome is accepted and the tumult of four years ago (or 24 years ago) can be avoided.
I want to switch and talk about China briefly. China has been a major growth engine for the world economy since Deng Xiaoping emerged as its leader in 1978. In 1978, China’s population was still well under 1 billion but growing close to 1.5% per year, approximately double the pace of growth in the U.S. Over the past four and a half decades, China has persistently grown at high single digit rates as its population swelled to 1.425 billion in 2020.
But times are changing. Population wise, China has stagnated, even starting to decline. GDP growth is also slowing. In China, growth comes from four buckets, real estate, infrastructure, consumer spending, and trade. Trade alone adds 2-4% to annual growth. Its biggest trading partner, by far, is the United States. China exports over $500 billion of goods to the U.S. A large part of that surplus in invested in U.S. Treasury securities, partly due to the high quality of our debt but more importantly because China chooses to peg its currency to ours rather than let it float freely.
While China’s growth is enhanced by roughly 3% annually as a result of its trade surplus, U.S. growth is diminished by our trade deficit also approximately 3% of GDP. Thus, if one subtracted out the impact of trade the Chinese economy internally is growing at a low single digit pace while our economy would be growing closer to a mid-single digit figure. Go figure. Pun intended.
I mentioned three other buckets feeding China’s economy. Real estate, about a third of its domestic economy, is a mess. Too much debt. Way too many unoccupied units. That worked while China was adding hundreds of millions of people as many moved from the farm to the city. But without growth, and with limited opportunities for employment in the big cities, filling those empty buildings isn’t going to happen. Real estate prices are falling. The government has taken multiple steps to stabilize the market but those are Band Aids on deep open wounds. Just as our financial crisis of 2008-2009 took many years to unravel and stabilize, the same is likely to hold true in China.
The next bucket is infrastructure. China’s central planners are likely to stimulate activity here, but will building unneeded roads or steel mills help in the long run? One route out would be to increase trade by dumping subsidized goods on foreign markets. The weapon against that is tariffs. We all know where Trump stands on that but even Biden has kept most of Trump’s tariffs in place.
The last bucket is the consumer. He’s flush with cash. China is lowering interest rates to entice him to spend more. But the Chinese have been through a lot over many decades and are very conservative financially as a result. In addition, China lacks safety nets for retirees like Social Security and Medicare requiring all to save more. Parents are often forced to move back in with their children. Given that China’s population is aging, this problem is only going to become more acute until it is addressed.
Central planning and government support have their advantages. Roads get built in months, not years, or even decades as we see in our country. When China focuses resources on something, rapid progress can ensue. But central planning cannot overcome the laws of economics or nature. The one-child policy has been a disaster. Even though it was abandoned more than five years ago, there are few signs of changing birth rates. Many young Chinese who go overseas for education would choose not to return but must to prevent harm to their families. As Xi has tightened control, immigration into China has slowed. So has the flow of foreign capital. While a few Chinese companies have developed a presence overseas (e.g., BYD electric cars and TikTok), most of the largest non-government companies in China are domestically focused. On the world stage, China’s exports are either basic materials (e.g., steel) or products contract manufactured for others from apparel to iPhones.
What all this means is that China, which accounts for roughly 20% of world GDP is no longer going to be a growth engine. In fact, if it continues to move in ways that isolate itself from the world’s largest economies, soon it will be a drag. By some forecasts, China’s population will decline by over 40% by the end of this century. Obviously, the impact on corporate America will vary. There are many U.S. companies that derive 10-20% of their revenue or more from China while others, purely domestic (think homebuilders, for instance) do no business at all with China. As China adjusts, the impact is quite clear, especially at the high end. Luxury goods sold in China or to Chinese nationals are in decline. The art market is going through a significant correction as a result of a lack of Chinese demand.
When most of us think about China economically, we think of stealing intellectual property, or government spying (it goes both ways). Some of that was the Chinese way of catching up. The backlash has been a ban on high tech exports to China and restrictions on how Chinese companies can operate around the world. As investors, however, we must look at China through a different lens. When I was a kid, “made in Japan” had the same connotation as “made in China” has today. Good quality at a cheap price, but nothing particularly innovative. That all changed as names like Toyota, Sony, Honda, and Toshiba emerged. Toyota and Sony quality were unrivaled. There is no counterpart to that in the Chinese economic story so far although TikTok is very popular in the youthful social media world and BYD now makes more EVs than Tesla. Central planning depletes the juices of innovation.
It is unlikely any other emerging country will replace China as the world’s growth engine. India now has more people and is growing, but it’s GDP is barely 20% of China’s. While India is more entrepreneurial than China, it is also much more bureaucratic. The only other top 10 nation that would be labeled “emerging” from an economic standpoint is Brazil, a country with unstable governance whose economy is based on food and natural resource production, hardly a recipe for replacing China as the world’s growth engine.
Thus, while AI offers hope down the road as a productivity enhancer that will stimulate economic growth, the catalyst that China and other emerging markets gave to world GDP has dissipated. In China’s case, excluding the impact of trade, it is quite likely that China within just a few years will be a drag on growth, not a contributor.
Today, Kim Kardashian is 44. Israeli Prime Minister Benjamin Netanyahu is 75. Judge Judy turns 82,
James M. Meyer, CFA 610-260-2220