By Diana Choyleva

As my taxi pulled away from the Pudong airport, my anticipation ran high. Trips to China always confound expectations, and this time, thanks to Covid, I had been away for the longest period since I first visited the country in 2004.

On that first visit, the surprise was how quickly I felt strangely at home. The skyscrapers soaring into the Beijing sky were certainly impressive, but the city brought back much older memories for me. I spent my childhood years in communist Bulgaria, and the Beijing streets with their long monolithic rows of grey-brown apartment blocks, retained the feel of those years.

On this latest trip, I set off for Shanghai in early December after a Covid-induced four-year gap. I was looking forward to speaking to my Chinese interlocutors as I always glean much more about the direction of policy when on the ground.

On this trip, my agenda also included visits to non-financial companies to find out more about their specific business models. This was refreshing for me, as my previous fact-finding trips were more heavily weighted towards policymakers, financial institutions and industry organisations.

To my surprise, for the first time I felt I had a better handle on the top leadership’s direction of travel than the locals did.

I hope I have become wiser with age and my China knowledge has certainly increased. But to my mind the main reason was that my Chinese interlocutors were struggling to understand Beijing’s policy agenda and how to breathe life into China’s now moribund economy.

There are several reasons for this. Most Chinese analysts, investors and local level policymakers rely on their connections higher up the chain to find out what’s next on the policy front. But Xi’s centralisation of power means that now their personal contacts really need to be very close to the top in order to get things right. It’s not helpful that central directives have become more contradictory.

Moreover, my conversations were mostly with people under the age of 50. During this generation’s lifetime, China attained unusual societal stability and its economy went from strength to strength. Strong growth quickly washed away any trouble that ensued. But over the past four years, for the first time their everyday life become more constrained. They are experiencing deepening economic hardship without the swift and decisive policy stimulus of the past.

For the first time, I felt my outsider’s perspective – a Bulgarian living in London, and a macro-economist by training – helped explain what I was seeing best. It helped me flesh out the macroeconomic bones of some of our key investment themes.

Here are three of my takeaways:

Deepening deflation is bad news for equities

China is in the grips of serious deflation, whose severity is not captured by official CPI numbers.

In our reports over the past few months, we have argued that the GDP deflator is a better gauge of what is really happening in the economy. By this measure, China’s annual deflation averaged 1.5% in Q2-Q3 last year. By comparison, annual CPI inflation stood at zero during that time.

Yum China, a Fortune 500 fast-food restaurant company which licences the KFC, Pizza Hut and Taco Bells brands in China, illustrates why the GDP deflator is a better measure than CPI, even though the latter indicator has the advantage of being more timely.

As Chinese consumers tighten their purse strings amid lower wages and higher unemployment, they have “traded down” to buying cheaper substitutes of more expensive goods and services. For Yum China, which is considered a premium fast food firm in China, this has been bad news.

The CPI data, which is a weighted average of prices for a basket of goods and services representative of aggregate consumer spending at a given point in time, doesn’t capture this. The deflator, which is based on actual spending, does.

The latest CPI data for December showed consumer prices declining for a third straight month, down by 0.3% yoy. The average for Q4 was an annual fall of 0.3%. The Q4 deflator data, out next week along with the GDP release, is likely to show a bigger decline.

This will confirm our view that Chinese consumers are still very much in a “trading down” mode.

A technical aside, for those of you who follow these things closely: in developed economies the CPI index is reweighted annually to capture changing preferences in consumer spending. In China, the basket used to be reweighted every five years. Currently, it is unclear whether this is still the case, given the secrecy with which the calculation of the CPI data is shrouded.

Electric cars could be just one way China exports deflation 

On my way to my hotel in the centre of Shanghai I noticed that the vehicles on the road had mostly blue or green number plates, with green plates being predominant. It turns out that green plates mean an electric vehicle and blue means petrol cars.

China’s global dominance in the electric car industry, its over-investment in this sector and low prices are well known. Indeed, one of the investment themes that has preoccupied investors recently is whether China is going to export deflation to the rest of the world, either broadly as it tries to export its way out of its domestic doldrums, or specifically within certain sectors – for instance, electric cars – that suffer from particular overcapacity in China.

With Beijing finding it hard to come up with policies that could lead to a sustainable boost to consumer spending, we expect more policy action towards boosting exports via export subsidies, and a higher tolerance for a weaker yuan.

Later on I had the chance to test drive one of China’s electric cars – Nio.

The Nio felt well made, and it could accelerate fast. One interesting innovation is that they change the batteries in special stations rather than charge them, allowing busy drivers to get back on the road quickly.

Source: One of Nio's showrooms in Shanghai showing the map of the number of charging stations 

And – here’s a case of fact-finding in person yielding surprising insights – I have to confess I quite enjoyed the massage function in the passenger seat.

Tech war to intensify as China demonstrates resilience 

Another company I visited was semiconductor manufacturer Hua Hong, a specialty pure play foundry, which has so far not fallen foul of US tech restrictions on Chinese firms. In the semiconductor sector, I discovered a more confident attitude than a year ago.

Source: Hua Hong's wall of patents

Source: A plaque at the entrance to Hua Hong's offices with a distinct Communist feel

China is throwing a lot of money at its efforts to get around US technology restrictions. It has come up with some breakthroughs, such as advanced packaging, where combining three different chips with different functions together can create significant improvements. This brings China closer in performance to the advanced semiconductors that it has been denied by the US restrictions.

China’s ability to live with the restrictions and make some unexpected progress suggest we are likely to see further US action to constrain China in this space.

Meanwhile, the progress China has made has cost a lot of money and it is far from clear that it is commercially viable. The confidence that technological advancement can be achieved by state investment alone, with no concern for how it will sell, is something I recognize from my Bulgarian heritage.

Even so, the worry and disquiet we detect in the US should not be underestimated. Enodo Economics will publish an in-depth report on the state of play in this sector in coming weeks.

Conclusion

Four years away, and the discussions within China have shifted significantly. But on a grand scale the concerns of the outside world remain the same – China’s role as manufacturing hub to the world means that any trends sweeping China will soon have global impact.

Concerns that China’s low costs and industrial overcapacity allow it to out-compete manufacturing elsewhere are not new. What’s new is that the ability of the vast China market to absorb some of that production is faltering. That means even more goods will flow out of China, including in sensitive, capital-intensive, high-tech sectors like electric cars and semiconductors.

In an election year, American policy towards China is unlikely to become more accommodative. But politicians may find their tools to address strong outflows from China have become less effective. This is no longer a question of slapping tariffs on steel rebar.

Deflation, over-capacity – these are never simply economic problems, especially when they are over-flowing from someone else's territory. Investors need to prepare sophisticated strategies for a renewed bout of increased export competition.