Mao 2.0

On Monday, the S&P 500 endured its worst beatdown in months. Yes, stocks are on the expensive side — the current P/E ratio for the S&P 500 is a bit worrisome at 31. I say only “a bit worrisome” because the forward number is 21.

Still, even at 21, a lot of earnings growth is already priced in, so the upside story isn’t thrilling. 

There’s an FOMC meeting ending today with a statement about interest rates. No one expects a change on rates, but there’s definitely some anxiety about when the Fed will start to taper its $80 billion in monthly quantitative easing (QE).

We have a debt ceiling rapidly approaching, and the infrastructure bill saga is sapping some of the enthusiasm for commodity stocks. 

But all these little worries just served as a backdrop for the Evergrande bombshell that really hit home on Monday. 

If you don’t know, Evergrande is a property developer in China. China’s entire economy is basically a “borrow and build” economy. It depends on rising prices, rising lending, and rising debt. Evergrande has $300 billion in debt, with a big $83 billion payment due tomorrow that the market thinks will not be made. 

Evegrande has basically failed already. Much of its construction activity has stopped. Suppliers may not get paid. And Chinese homebuyers may not get the property they’ve already paid for. 

And of course, U.S. investment banks have investments in China’s property market and in Evergrande. 

This is a liquidity event, a classic “descent into recession” scenario. Chinese suppliers don’t get paid, homebuyers lose their money, and the trickle effect of lost money can mean layoffs, less spending, lower production, and slower growth. 

It’s hard to imagine an outright recession in China. We’ve gotten pretty used to China being the engine of growth for the world as it builds its way into the 22nd century. 

The real estate market in its entirety accounts for about 25% of China’s GDP. That is unsustainable because eventually, everything that needs to get built is built. I can’t tell you that China’s “borrow and build” economy is hitting the endgame, but Chinese President Xi’s actions suggest that the endgame may be at hand. 

China’s Problem

China’s debt-to-GDP ratio is roughly the same as it is for the U.S. But there’s really no comparison between the two because of a little thing called productivity. U.S. GDP is over 70% driven by consumer spending. And U.S. consumers have jobs we get better at. We get raises, we pay our bills, we go out to eat, and we don’t save money. 

China’s savings rate is around 44%. Much of the personal wealth is contained in housing. Rising property value is not the same as a raise. It’s not liquid and it doesn’t get spent. 

For China’s economy to truly become sustainable, that savings rate has to fall. And President Xi is committed to making this happen. He has made it his mission to rebalance the Chinese economy away from debt-intensive fixed investments and toward a consumer-driven model. 

Sounds great. But stop and think about how you would go about actually making this happen. Good question, right? This is not a job I would want…

That’s why, on July 19, I told you it was time to sell Chinese stocks. And I mean all Chinese stocks.

What Could Go Wrong?

It was back in July that Didi Global (NYSE: DIDI) went public in the U.S. Didi is like a Chinese Uber. Three days after that IPO, the Chinese government changed the rules on Didi and caused the share price to drop 50%.

The government went on to clamp down on tech companies, online education companies, gaming companies, entertainment companies, and, yes, real estate companies. 

The problems at Evergrande have been brought on by changes in credit rules. So if China’s property market goes boom and people lose money, the blame can be laid right at Xi’s feet. 

And here’s my ultimate point on all this. Xi is trying to create what’s been called a “state-driven economy.”

Somehow, he’s got the cojones to think he can just plan the whole thing out and have the government dictate every aspect of its economy. And that’s in addition to dictating every other aspect of the Chinese people’s lives. 

Seems like there was another Chinese guy that thought he could do this. It didn’t go well. 

It’s just not possible for one person or a small group of people to plot and plan an entire economy. An economy has to grow organically, to reflect the character of the people who live within it. 

Xi is going to make mistakes. Potentially huge mistakes. Spare yourself the risk and just stay away from Chinese stocks.

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.