Zero Covid Lessons

May 14, 2022

Concepts are less persuasive than actual experience. You know, in the abstract, car crashes are undesirable; then you are in one and the scream of tires, metal crunching into glass and a massive adrenaline jolt forever changes your perception of risk. Covid is doing the same, particularly in China.

China’s Covid experience forces the recognition of a simple truth—in an authoritarian system, the only thing that matters is who is in charge. There may be an army of intelligent, hard working, thoughtful technocrats beneath the Leader (and in China there are), but they lack power. Given fewer constraints, the Leader can either move a country ahead like Singapore’s Lee Kuan Yew or veer off course, like Mao or Putin.

Xi’s Covid leadership, which once looked shrewd, is exacting an increasingly high cost, including:

• Hundreds of millions of Chinese locked in their homes for weeks,

• A contracting economy, which will depress global growth and earnings.

• Snarled global supply chains, which will make inflation more persistent and

• China’s elite beginning to wonder if their system’s flaws are intolerably high, which may lead to more brain drain.

To make things even more complicated, despite China’s reality and Putin’s disastrous Ukraine invasion, a significant slice of the US and Europe supports their own home-grown authoritarian leaders.

When Policy Touches You, Perceptions Shift

While China’s initial Covid control was better than the US and Europe, the latest Omicron variant has upended Zhongnanhai’s strategy. The CCP locked down China’s equivalent of New York City—Shanghai—on … March 28. Many other cities are similarly impacted.1 Stories and footage includes children, wailing, separated from parents who test positive and are forcibly removed, families locked inside their apartment with bolts (fire risk?), people denied medical care for urgent non-Covid conditions while others look for food.2

Up until this point, President Xi’s version of socialism with Chinese characteristics did not, by and large, directly touch many of China’s elite or it did so in way that could be downplayed. The arrest and in some cases execution of hundreds of thousands of corrupt officials and CEOs, the attack on tech giants, renditions and the crackdown on Hong Kong caught the attention of the foreign press but seemed periphery to the business and personal lives of many in China.

A heavy handed leader was like bad weather, something out of one’s control to be tolerated with as much grace as possible. Talking too directly about politics, particularly with a foreigner, was considered poor taste. Moreover, from the Chinese elite’s perspective, the West produced riots, high crime, refrigerated trucks stacked with Covid corpses and Trump, hardly the signs of a superior system.

Now the duration of China’s lockdown is shifting perceptions. The vaccines readily available in China don’t work well3 and President Xi is not willing to either admit that or buy mRNA vaccines. The elite is increasingly talking about keeping kids who are abroad abroad for longer and themselves getting residency permits elsewhere, like in Singapore, or moving money abroad.

By the way, I saw the same in Russia. It was easy to ignore Putin’s increasingly poor policy choices until they became too extreme and hundreds of thousands of the best software engineers, doctors and business people hastily fled. Similarly, Xi’s crackdown in Hong Kong is leading to an outflow of talent. I’ve shared the chart below before, poverty and authoritarian control drive people away.4

China’s Lockdown Contributes to Global Stagflation When Assets Are Expensive

To be sure, Xi faces a dilemma both in terms of perception and tactics. Admitting China’s own vaccines don’t work well would be a blow to prestige. One of Xi’s core aspirations has been to restore China’s pride after what is widely known as a century plus of foreign humiliation at the hands of the Brits, French, Japanese and Russians. Today, Chinese propaganda blames the US for much that is wrong with today’s world, including the war in Ukraine. Moreover, if Xi loosens controls, Chinese will die. China’s own scientists suggest over 1 million will lose their lives.5

However, the longer Xi maintains zero Covid, the more China’s economy weakens and supply chain problems worsen. China is the second biggest economy in the world, but it typically grows faster than the US, meaning the contribution to global growth is bigger out of China than the US. Said differently, the more Xi insists on maintaining his current policy, the more we enter a stagflationary (low growth, high inflation) environment. The companies you hold in your portfolio—like Apple and others—sell a lot of product in China, so expect earnings to be hit.

As I noted last week, the Federal Reserve can’t control supply chains. All they can control is demand, which clearly needs to fall a lot to get inflation lower. Even though US stocks and bonds have been hammered this year (down over 15%), prices have actually not adjusted that much relative to history. Below is an updated chart from Yale’s Robert Shiller on the PE or cost of buying a share of earnings. PEs were about 10 the last time inflation was a big problem. If earnings stay the same as they are now (which seems doubtful) and PEs fall from where they are right now (20 as opposed to the trailing number Schiller uses), that is still a significant re-pricing of stocks. (THIS IS NOT INVESTMENT ADVICE).

Chaos and Control Versus Happy Medium

Why Xi follows such a policy is complicated. Before the pandemic, I traveled to China regularly, not only the major cities like Beijing and Shanghai but also to Harbin, Kunming, Nanjing and others. I like China, my Chinese friends and got a thrill out of speaking my limited but enthusiastic Chinese.

China is a tough place to administer with, historically, two modes—authoritarian control or disorder. There are few periods where they find a happy medium. Of course, that’s over simplifying 5000 years of history. At the same time, it’s difficult to understand someone like Xi without having a sketch of Chinese 20th century history in your mind.

The current heavy-handed structure comes after wrenching historical change. Like Russia, China had a monarch up to the early 20th century. In other words, the system of government had not significantly evolved in thousands of years even as technology transformed the West. Europe began to edge away from a Sovereign, in fits and starts, in the Middle Ages. In England that transition is still underway.

Once that last Chinese dynasty collapsed in 1911, it was not replaced with anything coherent. For much of the first half of the 20th century warlords controlled different areas and foreign invaders took over massive slices of territory. Stumbling efforts to create and enforce a Constitution and rule of law by leaders like Sun Yet-sen failed.

As with Russia, Communists stepped into this leadership void. Communist ideology was a more modest adjustment from a dynastic one compared to Democracy. Communism preserved authoritarian leadership but transferred the process of selecting a chief to what the Communists believed was a meritocracy.

Xi is the inheritor of that history and operates within its confines though, like an emperor, his power is largely unchecked. This type of structure is brittle. That’s one reason why so many emperors don’t die natural deaths, as my guest Yuhua Wang noted in a March podcast. For more background on China, check out my podcast with Gao Xiqing.

The US Variant

The US approach to Covid is also instructive. About 1 million are dead, due in part to a disorganized initial response and also because 40% of the population won’t take the vaccine. However, most US readers of these posts have benefitted enormously from access to mRNA vaccines and can now largely live as they did pre-Covid. Despite the apparently obvious contrast between Russia, China and the US, a significant part of the US craves authoritarian leadership.

Like authoritarian leaders everywhere, Trump offers simple slogans for a complex reality. Only a minority of the country are strong Trump supporters, but only a minority supported Russia’s Bolsheviks or China’s CCP, too. Recall that 147 members of Congress, or 27%, voted to overturn the 2020 election.6 If the opposition isn’t well organized or given to infighting, they lose, which is what happened to China’s early 20th century democracy supporters. If 24% more of the US Congress becomes sympathetic with Trumpism, watch out. Almost certainly high inflation and a collapsing stock market will be blamed on Democrats and increase the odds of such a cataclysmic rupture.

Investment Implications

There are a few of them. First, regarding overall asset allocation, given where inflation is (high) and the Fed hiking (still early), I think assets remain unattractive. If 60% stocks, 40% bonds is the normal asset allocation a typical mutual fund recommends, I am -18% stocks, -5% bonds and +9% long commodity producers with the rest in illiquid credit, real estate or hedge funds. In other words, I am far from the typical portfolio. I’ve also got a lot of cash. Second, I’ve pulled all my money from Russia and China. Watching what is going on in Ukraine, you’d think that Xi would renounce any effort to take Taiwan. But he isn’t doing that. In fact, he has stepped up military drills. Given that I can’t predict if he will or won’t attack Taiwan, for a US-based investor like me Chinese assets are too risky. I will be watching the mid-term and 2024 elections in the US carefully. If things get sticky, I will look at moving money abroad. THIS IS NOT INVESTMENT ADVICE. INVESTMENT INVOLVES RISK OF LOSS. I’VE EXPERIENCED THAT LOTS OF TIMES.

• Geopolitics