«We Are Heading Into a Great Environment for Emerging Markets»
Louis-Vincent Gave, co-founder and CEO of Gavekal Research, talks about the most important investment topics in the new year and reveals where he would invest now.
Louis-Vincent Gave is an astute observer of geopolitical and macroeconomic developments and their impact on financial markets. The analyses of the co-founder of the Hong Kong research boutique Gavekal are required reading for numerous investors worldwide.
In an in-depth interview with The Market NZZ, Gave shares his views on the end of China’s zero-Covid policy, his thoughts on inflation and the Fed, the outlook for gold and commodities – plus, he says why it’s wrong to hope for a return of the boom in technology growth stocks.
«The Fed is talking like they want inflation below 2%, but I’d say that as soon as they get it to 4 or 5% they will start to back off»: Louis Gave.
When you look at 2023, what are the most important developments from an investor’s perspective?
The most important macro event is China’s reopening. Granted, I’m a guy who spends his whole day looking at China. If to a hammer everything looks like a nail, to someone who spends his time looking at China, what happens there is important. I’m happy to acknowledge that bias. What we witness today is the second biggest economy in the world opening up after having been on lockdown for three years. And we know how this plays out, we have seen this script when the US or Europe reopened: Pent-up demand causes a surge of consumption.
The speed with which the Party leadership has decided to get rid of its zero-Covid policy has baffled many observers. What happened?
People have misconceptions about the nature of political power in China. Most Westerners think of China and the CCP as this horrible dictatorship, which in some ways it is, but it’s not North Korea. They spend a lot of time doing surveys and listening to people. If people complain about pollution, they cut down on coal. If people complain about property being too expensive, they crack down on developers. It was interesting to see what happened a few months back, before the 20th Party Congress, when there were lockdowns in Chengdu and in Shenzhen. There were big demonstrations, and immediately one could see that the local Party leadership backed off. When Westerners look at demonstrations in China, our minds usually see the traumatic images of 1989. The reality though is that you get demonstrations all the time in China. It’s not covered in the Western media, because it’s mostly about local issues. Polluted water, corrupt officials, land being stolen, whatever. The important thing is: The Party always gives in. They blame middle management, they fire the local Party official and give in.
The same thing happened with their Covid policy?
When you saw demonstrations all over China against zero-Covid, you knew the game was up. That’s why we’ve seen a 180-degree turn by the Party leadership. Now the government doesn’t even publish the numbers anymore. They control the flow of information, that’s why I think hardly anybody will officially die of Covid anymore. They will die of pneumonia, the flu or old age, but not of Covid. It’s over. Now China is reopening rapidly.
What will that mean for the economy in China and the world?
First, we’ll get a surge in consumption. You have to remember that it’s not three months, but three years of pent-up demand. Going into the pandemic, households in China had about 8 to 9 trillion RMB in cash in their bank accounts. Today that number is 15.5 trillion. It has gone up more than 50%, because for three years all that people did was work and go home. They are more cashed up than ever before. Plus, mortgage rates have just dropped 150 basis points. In the West, when people came out of the lockdown and saw that interest rates had fallen by 50 or 75 basis points, they decided to buy a new apartment or a new BMW. There was a surge of consumption driven by low interest rates. Well, in China, mortgage rates are at record lows today. The same goes for car loans. How big is the release of pent-up demand in China going to be? It’s going to be enormous.
But in the near term, a gigantic Covid wave will hit China.
Yes. During the first few months, everybody will get Covid. Remember the summer of 2021, when there were hundreds of cancelled flights in the US every day, because the pilots called in sick? When we saw 100 container ships sitting outside the Los Angeles ports, because there were no truck drivers? This is where China is heading: Everybody will call in sick. If you are Apple, and if your business model depends on 100’000 workers showing up at your factory, you will see a shortage of workers in the next six months. Most of the industrial workforce in China still lives in corporate dormitories where the virus will run rampant. So the next six to nine months are going to be all about a massive increase in Chinese demand on the one hand, and massive production dislocations on the other.
«OECD government bonds in general are the most dangerous asset class. They are fundamentally condemned.»
That doesn’t sound very deflationary for the world economy.
Not at all. That’s why I think the hopes of inflation dropping quickly in 2023 may be overdone.
Markets saw a strong rally in November on the basis of the hope that we have seen peak inflation and peak Fed hawkishness. Was that a mirage?
I think we have seen peak hawkishness, but we haven’t seen peak inflation. We don’t have a lot of modern examples of inflation in the industrialised world, and nobody who is still active in markets really remembers the Seventies. I don’t pretend I do. But when you look back in time, inflation in the Seventies was very volatile, partly because of base effects, partly because once inflation moves into wages, you get a spurt and then it slows down and then you get another spurt. Inflation would shoot up to 7% and then fall back to 3 and then up to 9 and then back to 4. I think we will have a decade of that to look forward to.
What makes you think central banks won’t succeed in beating inflation?
One reason is the inflationary pressure we get from China’s reopening. But more importantly: The reality is that for all the Fed’s hawkishness, for all the tough talk, in the backdrop you hear the establishment economists, the Paul Krugmans, the Olivier Blanchards, coming out and advising that the Fed should say they want to bring inflation down to 2%, but really once they bring it to 4% they should back off. This goes back to one of my core beliefs that we discussed two years ago when I said that inflation was going to come back with a vengeance: Policymakers actually want inflation. They don’t want it to be too high, they don’t want 8 or 9%, but they want it at 4 or 5%. Because that kind of inflation is how you deal with the excess debt in the system. So, the Fed is talking like they want inflation below 2%, but I’d say that as soon as they get it to 4 or 5% they will start to back off. That will plant the seeds for inflation to come back quickly in the next upturn.
The other big macro topic for 2023 is the risk of a recession in large parts of the world economy. How do you see that playing out?
If you were playing recession bingo, you’d be filling all the boxes on your card: The inverted yield curve, the ISM manufacturing survey below 50, leading indicators in negative territory. It’s all there. Except China’s reopening, which spells boom for parts of the world.
Do you see the risk of a nasty recession in America?
The US is slowing down, undeniably, but I don’t think we’ll have a massive hard landing. At least not in the next six to nine months. The amount of stimulus that was injected during the pandemic, both fiscal and monetary, will still take quite some time to filter out of the system. We’re just not there yet.
Do you agree with the idea that the Fed will soon be confronted with a hard choice: Either to engineer a hard recession to get inflation down to 2%, or to allow inflation to remain elevated around 4%?
I don’t, because I don’t believe it’s even a choice. Most people think of the Fed as having two mandates: price stability and employment. But it actually has a third mandate that nobody ever talks about: Making sure the Treasury market stays functional to make sure the US government gets funded. Which one of these three is the most important? If push comes to shove, they won’t be able to make a choice. The Fed will have to keep the government funded. Looking at the numbers, you see that the interest expense on US debt over the next couple years, with the rollovers that need to happen, will rise from $900 billion to $1.4 trillion per year. Spending for Social Security is roughly $2.2 trillion per year. Tax proceeds in a non-recession year are about $4 trillion. So, rather soon, Social Security and interest expenses alone will basically make up all of the tax receipts. There will come a point where the Fed just can’t raise interest rates further. They need to keep the government on the road, and without printing money, without lower interest rates, the Treasury market will melt down.
Given that view, you would still avoid Treasuries?
Very much so. I think OECD government bonds in general are the most dangerous asset class. They are fundamentally condemned. OECD government bonds are the most overowned asset class with no future whatsoever because most governments have lost the ability to increase their revenue through increases in taxation. The only way these debts can be paid off is through structurally higher inflation and financial repression. You would be much better off being 100% in equities than being in the 60/40-portfolio that every banker advises you to be.
There seems to be a consensus among professional investors that given the likelihood of a recession, Treasuries with their 3.5% yield are the asset of choice. You disagree?
Absolutely. Why would you want to own Treasuries? Because there will be a horrible recession? Well, that would mean the dollar would tank, because the Fed would have to reverse and go back to quantitative easing. Sure, bonds might go up 15% in that scenario, but if you are losing 30% on the dollar, what good is that in terms of your consumption power? Given this backdrop, I’d rather want to own emerging market currencies or the Singapore Dollar.
So, you expect a consumption boom in China, inflation in the US plateauing around 4%, and the Fed having to pivot away from its tough stance in order to avert a funding crisis for the US government. How would you play that environment as an investor?
One way to play it is of course through assets in China. But in their wisdom, most Western investors have decided that China is uninvestable. Every investment committee has spent the past three months selling everything they had in China, so it’s hard for them to turn around and buy China again. But they can buy Japan, Korea, Indonesia, Malaysia, or Thailand. All the places that benefit from an increase in Chinese demand.
«Gold is a low beta way to play emerging markets. You get the same trend, with less volatility.»
You’re bullish on emerging markets?
Yes, plus Japan. Japan and China are each other’s biggest trade partners. Japan exports a lot of things that China wants, including automobiles but also tourism. Pre-Covid, tourism was 7% of Japanese GDP, and most of it was from China. When we talk about emerging markets in general, it’s important to look back to 2022: The three key themes in the past year were, one, a much tougher Fed, two, a much stronger dollar, and three, lockdowns in China. If one year ago we had told ten investors that these would be the key themes in 2022, what do you think they would have said about emerging markets?
Run for the hills?
Exactly. Investors are used to seeing emerging markets as a derivative play on China and the dollar. What I find fascinating in 2022 is that we have seen outperformance from Brazil, India, Indonesia, Mexico, or South Africa – from every major EM ex China. And this applies both to bonds and equities. This is highly unusual during a Fed tightening cycle. EM were outperforming when they were facing terrible macro headwinds, now these headwinds are turning into tailwinds: China is reopening, the dollar is rolling over, and the Fed is pretty much done tightening. I think emerging markets are going to rip. They’re a hugely underowned asset class.
Has the property market downturn in China seen its bottom?
There are two different issues on the property front: Property prices and construction activity. I think when it comes to prices, we have seen the bottom. We now have a lot of government support and the lowest mortgage rates on record. I’m not sure however that property developers react to this rebound by massively increasing production. I see a striking parallel today between Chinese property developers and US shale oil producers. Remember, US shale producers were showered with cash, they all massively increased capacity. Then prices collapsed after 2014, and a number of them went bust. The ones that didn’t go bust had the scare of their lives. When oil prices then went up again, the frackers didn’t increase their production. They rather bought back their debt at 70 cents on the dollar. Why? Because they went through a near-death experience. It’s the same story with Chinese property developers: They massively added capacity, prices collapsed, some went bust, many nearly did. So as money comes back in and property prices rise, I think they will take their cash and buy back their bonds at 50 or 60 cents on the dollar. So property prices in China will come back up, but I’m not sure construction will.
What’s your view on commodities, then?
I am a bull on commodities. But something is nagging me, and I constantly try to think where I could be wrong. The first thing is construction activity in China. For the past twenty plus years the main source of marginal commodity demand was construction in China. But if the activity in the Chinese real estate market will not bounce back, what impact will that have? Plus, there is something else: In recent years, Chinese commodity imports from Russia have gone through the roof, from $4bn to $11bn per month – which is remarkable as construction has collapsed in China. Why would Chinese commodity imports from Russia triple? One explanation is that they have stockpiled.
Could that be an explanation why the oil price is not higher today?
I remain a raging bull on energy, as I’ve been for several years. If you had told me six weeks ago that China would scrap its zero-Covid policy, I'd have said that the oil price would jump to 100 $. Instead, we have gone from 80 to 70. Seeing this, you scratch your head and ask yourself where you got it wrong. Perhaps it’s just a matter of time, perhaps it’s because they have stockpiled a lot. Given that China can buy oil from Russia at a 30% discount, and given that China is the marginal price setter for oil, one could argue that 70 $ per barrel is the right price in this environment.
«Being short the yen is an extremely dangerous proposition here.»
What about gold?
It sure looks like a good environment. For me, gold is a derivative on emerging markets. Most of the physical demand comes from India, China, Russia, the Middle East. People there buy gold partly because they don’t trust their financial system, partly for traditional reasons. So when people get richer in India or in China, gold goes up. If I’m right that the coming year should see a boom for emerging markets, then gold tends to ride along. Gold is a low beta way to play EM. You get the same trend, with less volatility.
You mentioned Japan being a beneficiary of China’s reopening. The yen has suffered a steep drop this year. What’s your take on the yen?
The yen is crazily undervalued with a binary potential outcome soon. Why? Because we’ll get a change of leadership at the Bank of Japan in April. The current governor has tied himself to a policy of yield curve control, which has crushed the yen. Imagine tomorrow they put you in charge of the BoJ: Will you want to stay with that policy or will you say you will review it, given that inflation is now at 3%? As we get closer to April the market will start discounting the likelihood that the new BoJ leadership will not want to be tied to the previous guy’s position. We've already seen tremors of that when the BoJ adjusted their policy on December 20th. Being short the yen is an extremely dangerous proposition here.
Wouldn’t an appreciation of the yen adversely affect Japanese equities?
In the old days, there used to be this one for one correlation. That was when the Japanese economy was in the doldrums and the only game in town were the exporters. Price movements were driven by foreign investors, and they all wanted to own the exporters, the Toyotas, the Keyences, the Fanucs. But today, hardly anyone is invested in Japan anymore. And growth is less reliant on just the exporters. So the correlation between the yen and equities is no longer as strong. This year, Japanese banks for the first time in many years have done well.
What about European equities? Everybody seems to hate them.
I don’t. But you’re right, everybody hates European stocks. Europe suffers from a lack of growth, energy uncertainty, and the loss of Russia as a market has hurt many companies. For these reasons, Europe got derated. But the Euro is cheap today, which gives you a set-up of an undervalued market in a fairly cheap currency. So I wouldn’t be too negative here. The marginal growth in Europe really comes from the ability to export to emerging markets. When they do well, Europe gets dragged along for the ride.
You’re bullish on emerging markets and Japan, on commodities and somewhat bullish on Europe. You're bearish on OECD government bonds. What about US equities?
Many investors buy US equities because they think they are the cleanest among dirty shirts. I disagree with that. I see many investors just waiting to pile back into the likes of Microsoft, Meta or Alphabet based on the premise that the Fed is done tightening. I think they are missing the point. It doesn’t mean that FAANGs can’t rally. They can. But the reality is we’re going through a transition in markets. Bear markets are there for a reason, which is to transfer leadership from one group of stocks to the next. If you sit around waiting for the Fed to pivot to then buy tech growth stocks again, it’s like you were sitting in Tokyo in 1992, waiting for the BoJ to cut so you can buy Fuji Bank again.
So you’d say the worst thing is to jump right back to the old darlings?
Yes. The US growth bull market of the past ten years was an awesome bull market. But it’s over. Meta won’t make new highs, Google won’t make new highs for a long time. That was the previous bull market. It’s over. Time to move on.
Louis-Vincent Gave
