Huawei Quarantine Accelerates Tech ‘Balkanization’ Trend

“The three core issues of concern to China are the cancellation of all tariffs, that trade purchases be in line with reality, and that the text of the agreement be revised so as to be more balanced. These issues must be resolved. This trade friction has made us more aware that we have shortcomings in terms of economic structure, quality of development, and core technologies. [We must] enhance the sense of urgency in accelerating indigenous innovation and resolve the bottleneck imposed by insufficient mastery of core technologies. CCP Propaganda Department Commentary on the US confrontation in People’s Daily newspaper last Friday

We have regularly covered the rise of China’s tech sector over the past decade and the complacency in Silicon Valley which has only recently been shattered by Huawei’s threatened dominance of the global 5G rollout. The ‘balkanization’ trend already evident in software ecosystems from messaging to payments will now extend to hardware throughout the supply chain – there will be a China centric physical internet architecture over the next decade centred on Huawei as much as a software one around companies like Alibaba, Tencent and Bytedance with the big ‘neutral’ EM markets like India a key battleground.

In the near term, the notion that China can be quarantined as a technology supplier looks naïve – alternative vendors like Nokia and Ericsson make 5G hardware with Chinese partners in mainland factories for sale globally, leaving their equipment vulnerable to malicious tampering – will they have to relocate production to ‘safe’ locations to sell into the US? If so, the global rollout will be significantly delayed…

Huawei has been rapidly vertically integrating with its own chip making subsidiary, HiSilicon, producing highly advanced 5G designs, albeit fabricated (as for Apple and Google) by TSMC. As a Chinese tech VC contact told me in Shanghai last October, cut China off from TSMC and it would be casus belli like the Japanese oil embargo in 1940. If the US is serious about confronting China’s competitive threat on a sustained basis, it needs to boost government R&D spend on basic science (instead it’s been cut), deepen the capacity of domestic tech supply chains via education investment and targeted tax credits or cutting off broader Chinese access to advanced GPU chips and postgraduate student access to STEM courses at colleges such as MIT and Stanford. Those moves would be expensive and disruptive for the US economy and are still possible future steps if relations become even more antagonistic.

China offers uniquely low (marginal) consumer electronics assembly costs plus high-volume flexibility. You can never replicate the mainland factory dormitory model in the US or even Korea and Taiwan. The increasingly well educated rural migrants filling Foxconn factories are the ultimate ‘on demand’ workforce – manufacturing elsewhere would mean higher assembly costs/decreased flexibility thanks to the constraints of current generation assembly line robotics.

Even with high levels of automation, a fully US assembled iPhone would likely cost about 40% more at the factory gate (with Apple gross margins at ~37%, the current tariffs imply a price rise of about 15% to offset the impact, unless the RMB plunged toward 7.5 versus the USD). For instance, Quanta Computer, the largest laptop maker in the world with clients from Apple to Dell, warned last week that the logistical costs of shifting consumer electronics production out of China could prove as expensive as the tariffs themselves. 

Automation is part of the answer to offshoring from China but changes the business model – assembly by Chinese migrant workers is a marginal cost for a factory owner; robots are a fixed cost, although the assembly of an additional unit has zero marginal costs (excluding overheads like maintenance etc.). New AI software will help but it’s still expensive and time consuming to program factory robots to perform multiple tasks.

The implication of this shift from marginal to fixed costs is that there is a heavy incentive to stick with a specific design: any change requires significant capital investment to update the robotic assembly line – the flexibility of the entire consumer electronics sector will deteriorate, with higher inventories and fixed overheads once it loses China’s unique attributes as a global production base – given wafer thin margins, consumer prices will trend higher even if a face saving deal could avoid further tariffs.

Relocating the supply chain for smartphones or laptops will be hugely disruptive, wherever the destination and it certainly won’t be the US – the much-hyped Foxconn factory to make TV screens in Wisconsin has become a fiasco, despite $4bn in tax breaks and subsidies. The lack of a skilled manufacturing workforce will be a key constraint on US re-shoring, as much as logistics considerations – flying components in from Taiwan/S. Korea to assemble phones in the US makes little sense.

The effort to lobotomise Huawei looks ill thought out and will have generated intense lobbying by the most adversely impacted US suppliers – there will likely be some nuance in the implementation. However, the endgame is now clear and US tech companies will have to mitigate ongoing compliance risks by reducing exposure to Chinese SOEs. We’ve seen a few companies like Go-Pro begin relocation (to Mexico in this case), but this will now accelerate while China will race to become a ‘full stack’ technology power by mastering semiconductor fabrication and an indigenous mobile operating system.

In the case of both Iran and Huawei, the US has unilaterally exercised its global power over international bank payments systems and key technologies like the Android OS to exercise brute force geopolitical leverage – the lesson drawn by many in Europe and Asia is that alternative architectures are now needed. Ultimately, China which remains the only country apart from the US to understand the critical value of ‘platform’ software and is catching up rapidly in AI and quantum computing research, will become an even more formidable competitor to the US tech giants. The Xi 2025 plan, whose ambitions triggered panic in Washington from the Pentagon to Congress, will now be implemented sooner, by any and all means possible.

 

China Consumption Shifting From Property to Pensions…

One of the biggest issues for global investors over the next 3-5 years is that China may be running out of prospective home buyers as the prime household formation age cohort shrinks, creating a secular slowdown in a sector which directly generates 13-15% of GDP and in its wider spillover impact closer to 22-25%. Consumption in China doesn’t neatly fit the Western ‘life cycle’ model of neoclassical economics (e.g. housing tends to be bought in advance of marriage/household formation and left unfinished and empty until that point) but the structural demographic shift will transform housing demand as much as the shape of monetary and fiscal policy. Beijing’s efforts since 2015 to boost the birth-rate by easing restrictions on family size always looked likely to fail, given the ever-rising costs of child rearing and fertility trends across developed urban Asia.

Japan’s experience in recent decades indicates that when rapid growth begins to slow in an economy with very high corporate and household savings driving fixed investment, demand can prove extremely difficult to manage, particularly when demographic decline sets in simultaneously. This is particularly true if the deliberate promotion of credit growth and asset price bubbles has been part of the mechanism used to sustain demand. The tactical stance has been overweight China and AXJ despite still poor earnings and macro momentum but structural growth constraints are becoming binding as rising debt and declining demographics interact to radically change policy trade-offs, while the US is now intent on blocking or at least slowing significantly the technology upgrade path.

The real story behind China’s well documented economic imbalances is not just about structurally weak consumption versus investment as a share of GDP but also a large-scale net transfer of savings from abroad (and particularly the US) to the mainland corporate sector, a process which the White House, with broad bipartisan political support now seems committed to ending, whether a new trade deal is concluded or not. China’s plan to move up the value chain rapidly by ‘acquiring’ foreign IP to boost productivity as the workforce and investment intensity declines will now be much harder to achieve, even if it doesn’t in the worst case lose access to advanced semiconductor imports.

The country has an ongoing growth tailwind from urbanization (currently at 59% on official data, but by global standards likely 5-6 points higher), a remarkably advanced digital economy and payment systems, first world transport infrastructure in and between the major cities (and soon communication via 5G), and a growing number of globally competitive companies in mid-tech industrial and consumer markets. However, its economic dynamism will face a growing demographic drag as resource are diverted (whether public or private) to fund rising healthcare and pension costs.

Births last year dropped by 2m to 15.2m, and the median age will reach 48 by 2050, or about 10 years older than the US now. The total number of working-age adults (aged 16-59) fell by 0.44 % to just over 897m while the growth in the pool of rural migrant workers fell sharply, rising just 0.6% to 288m, down from 1.7% in 2017. The national old-age dependency ratio is already at 15%, and twice that in some depopulating peripheral provinces. The population on official data grew by 5.3m last year or 0.38% and Beijing has estimated that China’s population won’t peak until 2029 at around 1.44bn, but some demographers believe that tipping point has already arrived.

The ‘extensive’ growth model of adding more workers and capital becomes untenable as demographic decline starts. So too is the highly expansionary monetary policy that saw the PBoC balance sheet and M2/GDP ratio explode. That never generated much consumer inflation, as it was largely sterilised via housing which absorbed excess migrant labour and industrial capacity as a concrete inflation sink isn’t sustainable much longer. At the same time, the sterilisation of exporter dollar earnings and build-up of net foreign assets on the PBoC balance sheet and Treasury buying by SAFE is also winding down, as FX reserve growth peaks peak.

US demands to eliminate the bilateral deficit simply hasten the existing trend toward a current account deficit. Whatever the exact demographic glidepath, China is going to have to employ its human capital much more efficiently over the next couple of decades and refocus on intensive, productivity led growth. Global investors are going to have to adjust to the perpetual motion machine that drove global capital flows from the late 1990s not just stalling but going into reverse i.e. China will likely become a substantial net portfolio capital importer over the next decade, as it needs to fund soaring fiscal deficits, just as aging households begin running down savings…

With 12% more males than females in the 15-29 age cohort, having an apartment boosts prospects for marriage, and that factor as well as migrants buying properties to retire to in their home provinces helps explain much of the 45-50m ‘empty’ apartments that generate scare headlines. In China, housing has taken on the role of a ‘dowry’ for male offspring that gold has traditionally for female ones in India, but the 34m overall male surplus will rise and create a growing pool of involuntarily unmarried men (so-called “bare branches”). The home ownership rate among young Chinese households is consequently very high, thanks to help from parents who in a major city will have built up huge housing equity. Demographics will clearly begin to impact this cultural support for real estate, as the number of 20something males enters steep decline.

The 20-29 age cohort, the main source of new demand for housing, will have declined by about 80m by the mid-2020s from its peak in 2012/13 and the proportionate decline is similar for the teenage cohort behind them, slowing pre-emptive parental demand. A rising divorce rate and proportion of never married (in the case of many males, not by choice but economic circumstance) will offer some support to housing demand, but alongside a dramatic slowdown in migration, the overall fundamental demand picture will deteriorate materially.

Pension coverage is now relatively high for a country at China’s income level but the income generating assets to fund defined benefits are hugely inadequate and this is where boosting private assets and returns becomes critical to maintaining systemic solvency. The pension funding deficit covered by central government is likely to reach over $150bn annually by next year. Deeper capital markets (including ultimately access by foreign mutual funds with local distribution partners) supported by pension savings inflows are a key part of the wider reform agenda. Current contribution rates for state/SOE pensions are far too low; private pensions and employer annuities (i.e. the addressable market for the insurers) are just over a quarter of total assets with the basic pension/national social security fund comprising the balance.

That ratio will gradually shift over the next decade in favour of private assets – the public pension system’s 43% replacement rate (ratio of annual benefits to final salary) implies a significant cash flow deficit will open up that could amount to over $1.5trn within a decade. Insurers will be a key part of the funding solution – weak capital markets and regulatory changes slowing premium growth have been a drag but they remain a key China exposure as inadequate social provision, from healthcare to pensions, is funded directly by individuals.

Total pension assets are just over 10% of GDP compared to 35% in Korea and HK. Assets will have to grow dramatically over the next decade to close the funding gap and the private share of total pension assets (currently sub 30%) will become dominant. Beijing already has the fallout from local government deleveraging and SOE restructuring to absorb which will see central government debt/GDP double to 70-80% over the next 3-5 years from the currently reported 37% – bailing out the pension system as well simply isn’t realistic. Assets managed by Chinese insurers have already reached over $2.6trn, even as new policy premium sales have slowed since 2016.   Solvency rules are now closer to international norms – capital requirements had been based on simple metrics of size but will now vary in line with how quickly policies turn over and how premiums are invested. Firms that rely excessively on short duration policies or invest heavily in equities must hold a much bigger capital cushion.

The slide in bond yields and A-shares has inevitably hit investment returns (as evidenced by the recent China Life profit warning), but offsetting this is an improving competitive landscape. The restrictions on wealth management product issuance (bank WMPs were offering yields of about 5.4% a year ago versus an average guaranteed rate offered by universal insurance products 30-70 bps lower) has seen retail investors return to insurers. Even with foreign firms likely to grow their share from the current low 5% base as the market opens, investors seem too bearish on life insurer growth prospects, with the key stocks on sub 1x price to embedded value multiples. As with education, investors in the asset gathering/private pension theme have to see through regulatory volatility to focus on the secular tailwind for revenue growth.

China Housing Booms on Land Shortage…

‘The property sector contributes about 15% of GDP directly, but up to twice that on a broad multiplier basis on HKMA estimates, while real estate accounts for about 70% of household assets. On a cyclical basis, the housing market has been improving since mid-Q1, despite the misguided Spanish/Irish property crash parallels drawn by some observers (ignoring the huge equity cushion, the lack of securitization or a secondary market to propagate panic selling etc.). Ongoing easing measures and liquidity displacement from equity markets will boost property in the leading Chinese cities further this summer. Ultimately, the government desperately needs the fixed investment cycle in real estate to stabilize…’ Macro Weekly, May 22nd 2015

‘Mainland developer destocking continues to tighten the market as sector lending picks up. Indeed, the chart showing cumulative real estate floor space started versus sold is a critical one right now – it shows the huge inventory build-up in recent years has peaked, ex the Tier-3 cities – it’s hard to see destocking going much further. Your view on global cyclicals/materials as well as Chinese momentum hinges on whether you believe that property investment is set to stage a rebound.’  Macro Weekly, Jan 11th 2016

It was clear by mid-2015 that a cyclical rebound in China’s property market was looming, driven by healthy fundamental demand as inventory levels peaked, yet this critical macro inflection point was bizarrely overlooked by most commentators. We’ve gone from a China ‘running out of FX reserves’ consensus narrative in January to a ‘running out of apartments’ one now i.e. the feared deflationary impulse has become an inflationary one for the global economy, even before housing investment catches up with the inventory cycle.

Indeed the surprise has been the relatively weak new build response, but the suggested Q1 overweight bet in domestic deep cyclicals exposed to the construction cycle as well as global materials/mining has outperformed substantially this year. The largest Chinese cities have joined many in the West from San Francisco to Dublin and London where soaring prices have failed to generate significant developer new supply, partly because of zoned land and funding shortages.

This latest property boom is therefore very different to the 2009-2013 one, when developers and local SOEs rather than households were the driving force and leveraging aggressively. Given the fevered price surge, which is reaching even third tier cities, it’s remarkable that new starts fell over 19% y/y in September. Rapidly shrinking inventories offer fundamental support, although the recent spectacular pace of official price growth (exceeding 30-40% y/y across several of the 15 largest cities) is clearly unsustainable.

The backdrop remains broadly positive – rapid urbanization (from an official but likely understated 56% in 2015) is spurring first-time housing demand; demand for housing upgrades will increase alongside rising incomes as about 40% of urban households are living in low-quality housing built before 2000 while there are more than 230m people aged 20-29 who will be first time buyers over the next decade. The affordability ratio nationwide was at the lowest end of the historical range at just over 7x income as of the end of 2015, making property relatively attractive as interest rates fell and A-shares imploded. The ratio of house prices to household disposable income in Tier-1 cities was just under 15x at the end of 2015 and has now risen to about 20x, approaching HK levels and well above London/NY.

However, these conventional metrics are distorted by the huge amount of space hoarded as ‘concrete deposit boxes’ by the top 1% of households (who own about 25% of vacant space) and substantial undeclared ‘grey income’ for the elite. An alternative ‘reality check’ is to look at housing wealth versus national income; aggregate Spanish residential property peaked at about 460% of GDP in 2007; Australia (and NZ), considered the frothiest global real estate markets alongside Canada (and a surge in Chinese buying has been a major factor in all three) are now worth over 350% of GDP.

The US peaked at just under 200% and is now 140%. China’s property market is worth 350-400% of GDP at current price levels. Land remains the key form of collateral within corporate balance sheets and the wider financial system, as with Japan in the 1980s and national average prices are up 5x since 2004 on the independent Wharton/NSU/ Tsinghua index, and 11x in Beijing. It’s important to note that Spain, the US and Ireland all saw a dramatic supply response to rising prices which alongside the collapse in credit availability helped crash the market 40-50% peak to trough post 2008. China doesn’t face the same series of shocks but real estate is now clearly overheated and calming the market is becoming a policy priority for Beijing.

The bottleneck is what has been historically been a rapid new build response in China capping price surges is land. In the first nine months of 2016, residential land supply in 100 medium and large cities dropped by 10% y/y, even as apartment sales soared. In Shanghai and Beijing, land supply through September dropped by 33% and 80% respectively y/y. The recent trend of developers bidding aggressively for premium land is directly due to low levels of zoned land for sale (itself partly a function of the ongoing anti-corruption drive, which has created local government paralysis in what has been a very lucrative activity for city level bureaucrats).

Significantly, the Shanghai government has just tightened regulation on the financing of land purchases – developers are not allowed to buy land using financing from banks, trusts etc. but from internal funds. Developers violating the new regulations would lose the deposit they make before auctions and will be banned from purchasing land in Shanghai for three years but this looks more a supply than demand side issue.  The only sustainable solution is significantly more land and new floor space supply over the next year, further boosting producer prices and cyclical growth momentum, even as housing prices peak.