here is an old maxim in China: “He who chooses to ride the tiger goes wherever the tiger goes.” This has gained relevance for investors after China decreed over the past weekend that private schools set up to tutor Chinese students will have to become non-profit in order to continue operating. One entrepreneur saw his firm’s $15 billion valuation shrink by 98 percent in a day.
The attack on tutoring, which the Chinese government described as “injecting capitalism into education,” will probably not be the last effort to rein in entrepreneurs in China. It follows a pattern of attacking Chinese companies that have listed securities abroad to raise capital, such as Alibaba, Tencent, Didi Global, and others. The common thread is that these firms are innovative, collect data on their customers, and have created great wealth outside the Communist Party. Just as it is the nail that sticks up from the board that gets hammered back down, so it is the innovators that fall into the gun sights of the Chinese government.
To better understand the dynamics at play, understand that the Chinese military and the Chinese Communist Party are one and the same. For years China followed the Soviet Union’s example of total government ownership. They also suffered from inefficient production due to overstaffing of government-owned factories due to cronyism. This was reversed under the tenure of Deng Xiaoping (1977-89), who understood that China could not move forward unless the entrepreneurial nature of its people was harnessed. During his term, factories were transferred to private ownership through public stock sales. Industries became more efficient, and living conditions were greatly improved. With economic opportunities so abundant in the cities, people flocked from the rural areas much in the same manner as Americans did a century earlier.
Because economic advancement was shared more by the urban areas than the rural, tension began to mount between the two. Rural areas began to grumble about the lack of government focus and funding afforded them compared to the cities. Children visited their parents and discovered they had less and less in common. Of great interest to the military, there were fewer rural people to recruit into the armed forces. This was especially alarming because most of the soldiers come from the countryside, where local avenues for improvement are limited, education is more primitive, and enthusiasm for the government is less questioned.
Finally, as the current leader Xi Jinping (2012-present) knows, revolutions are started in the countryside. They then spread to the cities. There were incidents of uprisings in the provinces. The military took note. With less of a surveillance system on its people in the country compared to the urban areas, the party decided to err on the side of conformity, this option being the first choice of totalitarian regimes everywhere.
Things like private tutoring struck a chord among the rural populace. Most could not afford such things, nor was it accessible without the internet service, which many lack. As the party began to see a deepening divide between rural and urban populations, it opted to defer to the rural to keep solidarity within the party.
In the same fashion, those who were perceived as ostentatious in their success were reminded of where they came from and where they live. In the west, with its emphasis on the individual, displays of wealth are considered optional. Sometimes such displays are considered distasteful by those who critique the nouveau riche, but this is usually as far as it goes.
In China, such displays invite harsh rebukes from party officials who feel that those who choose to stand out due to their success must be made examples for others not to emulate. In some cases, rebukes can take the form of prison sentences for charges that would not hold up anywhere else. Occasionally wealthy people disappear from public view for weeks at a time to return far less extroverted.
To the extent that this crackdown on private companies shares anything in common with the west, it is in the area of data. Both western and eastern governments are growing increasingly alarmed about the volume of information collected on people and its private use. It looks increasingly likely that antitrust laws will be used against large tech companies by US and European regulators. China, with no concept of antitrust, prefers to cut to the chase.
The implication of this change in attitude towards both large technology firms and foreign investment is sobering. China has been the fastest-growing securities market in the world. For this reason, it has been a magnet for US investment funds. There may come a time when extracting one’s investments from China may be impossible. This is a cautionary tale of international investing. It will be interesting to see where the tiger chooses to go.
The Economy
After all the stimulus pumped into the economy during the COVID pandemic, it has now come time to see what the economy can do on its own. This is a topic of great interest.
Growth rates for the second half of 2021 range from 2-6%. While this is still a positive number, it is a definite deceleration from earlier in the year.
Employment continues to vex the expansion. While returning to work takes time, it may also take higher wages for entry-level jobs.
Interest Rates
Interest rates have declined in the past quarter against most forecasts that they would increase. This decline can best be explained by the almost $900 billion that has flowed into the US from foreign investors since the first of the year. As China and other areas look less stable, investing in the US becomes more attractive.
The inflows have affected both bond yields and stock prices. How long the funds will stay in the US is anyone’s guess, but they provide yet another source of market elevation so long as they remain.
Most bond forecasts call for increasing interest rates. Even $900 billion cannot offset a deficit of $3 trillion and counting.
Inflation
Inflation spiked in July to over five percent. While the rate is expected to moderate, there is no forecast of decline.
As inflation stays elevated and is acknowledged by more of the investment public, there will be an insistence that investments earn a return in excess of inflation. By category, bonds are the most vulnerable in this scenario.
The Stock Market
Stocks appear to be setting records for overall price and valuations. The issue is whether this can go on. If it can’t, what will rein it in?
With the concentration of large tech stocks in the conventional indexes, the owners of the associated funds may find their appreciation of 17.5 percent year to date to be illusory if congress does go after the companies on antitrust grounds. So too will a declining level of economic growth make valuations questionable, although such a declining level of growth will affect everyone, although not equally.
With valuations not seen since the dot com era of 2000, it may be a good time to know what one owns. History may not repeat, but it can display facets of commonality.
Warren M. Barnett, CFA
July 27, 2021