The Pomp Podcast - #1248 Darius Dale on Why China's Economy Is Collapsing

Starting point is 00:00:00 What's up everyone? This is Anthony Pompliano. Many of you know me as Pomp. You're listening to the Pomp Podcast, which is my effort to find the most interesting people in the world and sit with them for hours while I ask questions in an effort to learn. So it would mean the world to me if you would subscribe to the show on your favorite audio platform, watch episodes on YouTube, and tell your friends and family about the podcast. My goal is to help millions learn from the world's most interesting people. So let's get into today's episode. Darius Dale is the founder and CEO of 42 Macro. In this conversation, we talk about the current situation in the Chinese economy. There's a lot of debt, there's all sorts of liquidity

Starting point is 00:00:40 traps. And all of a sudden, a lot of investors who are very excited about investing in the region seem to be pulling out and changing their mind. Darius breaks it all down. And I always enjoy talking to him because I learned so much. Here's my conversation with Darius Dale. Anthony Pompliano runs Pomp Investments. All views of him and the guests on his podcast are solely their opinions and do not reflect the opinions of Pomp Investments. You should not treat any opinion expressed by Pomp or his guests as a specific inducement to make a particular investment

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Starting point is 00:03:58 All right, guys. Bang, bang. I've got Darius here with me. Darius, there's a lot of stuff going on in the Chinese economy. Where do you want to start? It's a lot going on. So thanks for having me back. It's always a pleasure to be here with your audience.

Starting point is 00:04:08 We'll start with the Evergrande debt default that we got yesterday. One of their subsidiaries defaulted on nearly $600 million worth of principal and interest payments due on the 25th. Now, this is a little bit concerning in the context of two things. One, Evergrande has $328 billion worth of debt outstanding, by far the largest of any property developer in the world. and they're headed to court at the end of next month in Hong Kong to discuss a potential liquidation. So this could get ugly. Again, this is a very large, systemically important company in China that the government is hoping to ring fence in terms of a spillover contagion to the broader economy. But who knows how this could actually ultimately unwind. Now, when you think

Starting point is 00:04:56 about the Chinese economy, one of the pieces that you had talked about, I think, for months was China's central bank was really in control of global liquidity for a while. There was liquidity globally going up, but in the Western world, it seemed like we were draining liquidity and it really was just China pumping tons and tons of liquidity in. Explain a little bit this liquidity trap that you've kind of been paying attention to and why the Chinese economy opening up into such a problem. Yeah, astute observation, my friend. So yeah, you're absolutely right. It was China and Japan primarily pumping trillions of dollars of US dollars into the global liquidity system, really from the beginning of Q4 of last year through the end of Q1 of this year. And this

Starting point is 00:05:35 is why we saw such a dramatic recovery in things like Bitcoin, things like the U.S. equity market, broader equity markets broadly. That's obviously inflected since then. But specifically as it relates to this chart, one of the things we saw, we predicted going back to early part of this year was that China was in a liquidity trap prior to COVID. And if they were not going to do large-scale fiscal stimulus to effectively help the economy get out of the liquidity trap, which is effectively once you start accumulating too much debt, your ability to grow and use incremental debt for growth as opposed to debt service, it becomes this sort of reflexive cycle that is hard to get out of. We've seen this in other economies, namely Japan. So we had this

Starting point is 00:06:17 view that if they don't issue large-scale fiscal stimulus, they were going to wind up back in that kind of hamster wheel type process of economic development that they were experiencing in 2019. And that's exactly what we're seeing. So this chart here shows Chinese real GDP growth or shows real GDP growth on a cross-sectional basis across the main emerging market economies. Each data point on the graph is representative of the trailing 10-year Z-score, which is the normalized change versus that mean. And what we see is that by and large for the last decade, Chinese growth has been below trend as persistently below trend for the last decade, with the exception of kind of early 2021. We're seeing the same dynamic with headline CPI as well. So China struggled to

Starting point is 00:07:01 generate inflation as well in this economy. So it's very much looking like the Japanese economy did in the early 1990s. Now, one of the pieces that China has is a heavy degree of debt, which you've pointed out over and over and over and over again. How is that playing into this? Yeah. So in our opinion, this is part of the reason why we have not seen a large fiscal stimulus. It's such like a damned if you do, damned if you don't, right? Because the Keynesian textbooks would say, pump a bunch of money in the economy through the budget deficit, and then it'll create demand. And they'll be the reflex of demand creation and yada, yada, yada. We all know those textbooks to be flawed at this point. But that's kind of the general thought out there. But there's another school of thought out there, really, that's developed since Japan has slided into its liquidity trap, which is debt is the problem. The more debt you continue to slap on the private sector balance sheet, the more unlikely it is that they're going to be able to get out of this economic malaise. And so in this chart, we're showing Chinese private non-financial sector credit to GDP ratio. So the total amount of debt in the private sector, in the Chinese private sector, divided by their nominal GDP.

Starting point is 00:08:08 And then we're comparing that on a cross-sectional basis to other major economies. As you can see, the U.S. is down there at 151%. Eurozone is at 157%. Japan's at 185%. Again, another economy that struggled with this liquidity trap thesis. But as you can see, China is just way, you know, kind of way out there on its own in terms of the major economies in the world with 227% debt to GDP in the private sector. And this has been a real big issue in terms of, again, not being able to generate the incremental demand to show robust economic growth and robust inflation is, in our opinion, why the Chinese economy and its asset markets have really struggled here today. How bad is their debt problem compared to the U.S. debt problem? I mean, it's very worse. I mean, it's about 70,000 basis points worse in that regard. I mean, there's no magic number, there's no magical critical threshold, but what we know is economies with low debt exposure and low debt service ratios tend to have much better economic performance because they have the ability to lever up and create demand. If you're already levered, your ability to lever up incrementally and create demand is really challenged in the sense that a lot of your incremental income growth goes to servicing existing debt as opposed to creating new demand in the economy. And that's exactly what we're seeing here on slide three, where we show debt service ratios for Chinese economy and the rest of the world.

Starting point is 00:09:34 And so very similar to China's non-financial sector credit GDP ratio, China's debt service ratio, which is a percentage of private sector income that's being allocated towards servicing existing debt, is a little bit over 20%. And that number is, you know, effectively the highest in the world. You got India up there, or sorry, not India, Brazil's up there at 27%, but we know, we don't have to get into this now, but Brazil has a whole host of reasons why that is the case in terms of its interest rate schemes. But, you know, in terms of like countries with normal capital markets or reasonably normal and deep capital markets, China's kind of out there on its own some with 21 percent, you know, a fifth of their income is going to service existing debt. You know, that compares to 15 percent in the U.S., only 13 percent in the Eurozone and 16 percent in Japan. So this is a structural headwind to Chinese growth. You know, again, if one fifth of all the dollars you get go to servicing existing debt, you only have 80 cents left or really 79 cents left to actually create demand and growth in the economy. So this has been an issue for the Chinese economy, and it's going to continue to be an issue as long as China continues to lever up its private sector balance sheet.

Starting point is 00:10:40 Now, you also have this chart here that shows that China is downshifting from kind of the growth mode, if you will. There's been tons of investors who have been pouring tons of capital from the Western world into China. Many people thought that that's where a ton of returns are going to come from. Well, if they're downshifting from growth mode, does that mean that those investments may actually not pan out or there may not be as many investment opportunities in the future as people originally thought? Yeah, no, I agree.

Starting point is 00:11:06 I mean, I think the China story is not dead, but it's certainly very, very different than the one that we were used to, particularly in the kind of the 2000s and early 2010s. You know, that was a Chinese growth story that was built upon, you know, the leverage and the debt accumulation that companies like Evergrande now have on its balance sheet in terms of, you know, creating capacity and supply in the real estate sector. China had this large, you know, large scale, you know, cultural migration, you know, to domain cities from rural areas in the economy. And that was really positive. And it's still this sort of underlying trend of economic growth in China. the problem is they built all the buildings first. They built the buildings too quickly. And so that's kind of an issue as we look forward in time and think about where Chinese growth is headed from here. Now, that doesn't necessarily mean we're going to get reprieve as investors

Starting point is 00:11:55 from China's demand for things like energy products. What I'm showing in this chart here on slide four is China's, their imports, their commodity imports by volume. The first of the panel shows crude oil imports, we're almost at a new all-time high, you know, going back to the high we made shortly after the lockdowns of 2020 in terms of their crude oil imports. But we're actually still down 38 percent in terms of their copper imports. And so the reason that matters is because crude oil, you know, this is a commodity that really tends to fan inflation and really create a lot of inflation all across the global economy, whereas something like copper is more indicative of Chinese underlying demand for physical goods and raw materials. And ultimately,

Starting point is 00:12:34 it's going to be correlated with Chinese growth, particularly growth in terms of fixed asset investment, real estate investment, property development, et cetera, things that have caused China to create a lot of growth in the broader global economy. This is a different Chinese economy. It's going to be a different Chinese economy because those debt dynamics are not going anywhere anytime soon without something that looks like a debt jubilee or wide-scale bankruptcy, which is obviously being very, very negative from an asset market response perspective. And when you start seeing so much talk changing, like there is this thing, what can the government do in China, do you think, to re-solicit funds back?

Starting point is 00:13:11 Is there just like fixture economy? Is there some sort of like marketing strategy that they could pursue? Is there some sort of tax scheme that they could use as an incentive? Like if you're the Chinese government, what would you do to get American investors or Western investors more excited, even though the data is telling you that maybe that's not such a good opportunity? Yeah, that's a great question. So we did a big deep dive on fourth turnings. We did a big empirical study on what that actually means from an economic standpoint, from a financial market standpoint, in our most recent monthly macro scouting report.

Starting point is 00:13:42 And one of the key conclusions, there are many key conclusions. I highly recommend everyone kind of check out that research. One of the conclusions is that deglobalization is almost a certainty. I mean, there are no certainties when you look out into the future, but studying how trade relationships have unfolded in previous foreturning episodes, it's a very high probability that we continue to decouple. This is not just China. It's all countries in the world that are experiencing this foreturning phenomenon, which is US, most of Western Europe, parts of Asia, parts of Latin America. We're all kind of all synced on this same foreturning phenomenon right now. We're going to experience decoupling and resource scarcity and things of that nature. So

Starting point is 00:14:18 expect more sharp elbows at the table from that regard. In terms of answering your question specifically, I think one of the things that Xi could do to win over Western supporters and kind of tell the world that China Inc. is open for business is to create new government-sponsored investment opportunities in the economy for new technologies, AI, healthcare, things of that nature, get the world away from what we're all so used to China doing, which is creating a bunch of buildings. Some empty, some not. A lot are still empty. And that's obviously created a real capacity issue in terms of, you know, oversupply of, you know, kind of low-income housing in China, but, you know, sort of, you know, over, or sort of unaffordability in terms of a high,

Starting point is 00:15:00 you know, kind of higher quality housing in China. And there's one final thing I'll say about this sort of, you know, kind of fractured and in what our opinion is an increasingly fractured relationship with respect to Sino-U.S. relations. I think the worst thing that happened to China is arguably the same thing that the worst thing that could have happened to the treasury market, which is freezing of Russian assets with the war in Ukraine, because all it did was alert the world to the dangers of authoritarianism, right? You know, like we basically became an authoritarian regime in that regard, you know, sort of unilaterally deciding to effectively default on treasuries, at least for the treasuries that we owed to Russia.

Starting point is 00:15:37 And in our opinion, I think investors are looking around the world saying, where else can people act like this? Well, we know Russia and China are going to be high on that list in terms of authoritarianism and what it could ultimately mean for your investments. So in my opinion, China's kind of damned if it does, damned if it doesn't. It doesn't mean there aren't going to be investment cycles in China and big trades. The reopening trade was a trade, but ultimately, in our opinion, the kind of longer-term outlook for Chinese investment, whether it be through the structural indebtedness or the declining demographic profile, it's just poor. And I think a lot of investors are looking at places like India, Brazil, Indonesia as alternatives.

Starting point is 00:16:12 Yes. Now, when you see these trends changing, you see kind of this debt issue, the liquidity changing, the U.S. continuing to keep very tight financial conditions. Are you changing anything in your portfolio right now based on this information? No, no, we have not. As you know, we run a systematic portfolio construction process that the output of that process has had us in somewhere between 50 and 60 percent cash for six, seven weeks now. So we're just clipping coupons, waiting for an opportunity to get back fully invested. I still believe there's right tail risk to price and particularly in the equity and credit markets. I don't think we're close enough to a recession for this current market correction to devolve into something

Starting point is 00:16:50 that's more deleterious, nor do I think that we're going to see a significant tightening of monetary policy that could create a crash in and of itself, much like what we saw last year. So in our opinion, I think this is probably still a regular run of the mill correction in the equity and credit markets. And so I suspect our systems in the coming weeks and months will get incrementally allocated towards those types of asset classes. But we know we're pretty later in terms of late innings on this business cycle. And ultimately, we're going to have to manage some risk as investors. We just don't think we're there yet. All right. Where can we send people to find you on the internet or find out more about 42 Macro? I appreciate you, brother. So yeah,

Starting point is 00:17:25 42macro.com. Come check us out. As I mentioned, definitely check out that 420 Macro Scouting Report that we put out at the beginning of this month. I highly recommend everyone just download it, print it out, put the slides in your wall. You're going to be looking Adam for the next 10 years. And check us out on Twitter. DariusDale42 is my Twitter handle. I appreciate you very much. Everyone's wall is going to get decorated now and will do this again in the future. Exactly. We'll start a wallpaper business. Cheers.

The Pomp Podcast - #1248 Darius Dale on Why China's Economy Is Collapsing

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