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Year of the Rat Projections
Projection for 2020
Are you a man or a mouse?
Rats are survivors. Resourceful wit endears them to many in China where this low-brow character sits atop the Chinese zodiac. In the West, mythologies and folklore endow rats with superior senses. When they leave a ship, it is time to go! Facing an epidemic of seemingly thermonuclear proportions many wonder if the gods are telling us it is time to exit China.
Rather than race to burn incense to black swans, paying fealty to Taleb, we posit that this phrenzy is overblown and probably driven by the more common and pernicious disease known as the China Derangement Syndrome (“CDS”): a psychotic and seemingly incurable disorder that makes it hard for someone to think clearly, make good judgments, and understand reality. Patients with CDS catastrophize events, ruminating on ideas until a sensational narrative with viral Twitter capability is born.
While the coronavirus may present a grave health threat, it is important to keep things in perspective. This is not the 14th Century when mice traveling along the newly opened Silk Road decimated half of the Eurasian population. Nor is it 1918 when a weak war-torn herd battled the Spanish Flu. Make no mistake—the Wuhan bug will exact a significant toll on China, but it is prudent to maintain a sense of proportion and to act based upon probabilities; not succumb to the fear of the worst-case scenarios. Catastrophizing is a debilitating mental disorder.
It is nearly certain that through the first half of 2020, the Chinese economy will post abysmal numbers. The longer-term ramifications of coronavirus, however, will likely have a negligible, if not positive, effect on those who maintain focus. Indeed, for those who stay in the game the most pressing problem—beyond staying solvent and sane for the next two quarters—is how to maintain pace with the longer-term opportunities that abound. Savvy actors will buy (and build) on the dip, preparing for all this market continues to offer.
In this chaotic moment filled with the cacophony of newsfeeds written by hacks with an underdeveloped sense of history and mellifluous flair for hyperbole, it is wise to remember Rudyard Kipling’s advice to his son:
If you can keep your head when all about you are losing theirs…yours is the Earth and everything that’s in it.
We continue to have concerns about the rigidity and relative health of China’s institutional infrastructure (a problem that truly seems to be a global pandemic!), but no “rat kings” have been found, a sign portending the collapse of the State. As has been true for the last 30 years, the only ones who seem to gain from the “coming collapse of China” narrative are those seeking media attention or trying to move markets, ala Chanos.
China teems with medium-term potential driven by strong fundamentals including income growth that drives consumption, a robust transition to services as well as the consolidation, growth and rationalization of the manufacturing base which is undergoing a dramatic reshuffling and transformation.
While services and consumption are the rising stars, manufacturing will continue to play a pivotal role in both China and the global economy. The installed production base—human and physical capital—represents a deep supply chain impossible and frankly silly to displace given its ability to continue to add value.
Consolidation and trade dynamics will force manufacturers to modify business models. Some will scale up to world-class leaders while others scale down to high value-added specialists. Some will morph into design, sourcing and sampling rooms that manage high-volume/low mix production runs in lower cost country locations in SE Asia.
Decoupling is an inaccurate simplistic interpretation of events. We are remapping supply chains and resetting the US-China relationship which will most likely settle into a colder more balanced marriage in 2020 or shortly after the US election.
Much of what passes for “analysis” on China is unimaginative ill-informed drivel drawn from second-hand information. Indeed, a lack of accurate intelligence is often a key reason China continues to confound investors and operators who find it difficult to assess and navigate this expansive dynamic economy. Moreover, even if you can get it, thorough and honest analysis often generates contradictions and conundrums. Facts and trends may generate a story that sounds right but is actually far off the mark. Such uncertainty demands guesswork, led by a team that is empowered and allowed to fail.
For example, 2019 was a bad year for the auto industry in aggregate but not for everybody. Passenger vehicle sales dropped by 7.5% from about 23 to 21 million vehicles. This decline was predicable due to the subsidies offered over previous years for electric vehicles and compact cars as this government funding caused front-loading of purchases and distorted trends. Likewise, an ongoing misallocation of capital to vehicle makers, many funded and protected in regional markets, creates further imbalances and actions not driven by economic rationale.
Buried within this macro story of decline is a nuanced story of winners and losers. Auto makers with distinct value propositions are gaining market share while those who peddle junk lose. For example, General Motors joint venture sales of poor-quality dated models fell by more than 600,000 vehicles, about a 20% decline by volume over 2018.
GM-related ventures account for a stunning 36% of the total fall in vehicle sales in 2019. Ford’s strategic shift away from China aided a 12% drop to 200,000 vehicles. Conversely, Honda and Toyota both grew by more than 14% while Benz and BMW expanded by almost 20%. The balance of the sales decline (~1m vehicles) accrued to ~24 other OEs of whom only 10 made more than 500,000 vehicles in 2019, a production level not sustainable in most markets.
Overcapacity, protectionism and rapid shifts in consumer taste are common themes of “Capitalism with Chinese Characteristics”, a volatile process that creates distressed or stranded assets, low profitability and sometimes world-class organizations like Huawei.
We are at an inflexion point where traditional businesses either grow to a dominant position, shrink into a niche specialist or wither. Not unlike many markets, winners master tools of the digital age to continuously deliver better and differentiated products and services, meeting customers where they are and building companies to serve future demand.
But most importantly winners have a growth mindset. Psychologist Carol Dwek professed that people with a growth mindset will step toward challenges and welcome mistakes as learning opportunities. Two examples of this in China last year were Pernod Ricard and BASF. Leaders at these companies took bold steps to grow in 2019 and beyond. One by announcing the greenfield launch of China’s first whiskey distillery and the other by placing a $10 billion bet that engineering plastics demand will grow. This is true leadership: taking calculated risks and generating smart strategies that build for the future.
Dwek notes that the flipside of growth is a fixed mindset and a good example of this is the CCP’s economic policy which is fixated on control and stuck in a rut in terms of creating a dynamic economy in the sectors it dominates. However, we posit that facing declining growth and the hangover of too many Corona viruses, China’s apparatchiks will turn to privatization and deregulation. Something similar followed the Asian Financial Crisis when China began to offload nonperforming state companies and lay the groundwork for entry into the WTO in 2001.
Liberalization will resolve two problems, including meeting Trump’s demands for more access to the Chinese economy and restructuring moribund state-owned enterprises. Lord knows the healthcare sector, dominated by the State, needs upgrading given the travesty and tragedy in Wuhan!
The choreographed pageantry of building hospitals in eight days even managed to impress Trevor Noah, but pride in mass mobilization efficiency can easily turn to anger as people surmise that the outbreak was exacerbated by structural mismanagement. Attention can and will likely quickly turn to the lingering concerns about a lack of coherent economic policy and the ossified political infrastructure.
As such, our bet is that privatization will be used as both a red herring and a rallying cry, a heralding of great change and a call for continued unity. Non-core assets in industries outside of Alcohol, Tobacco and Firearms are the areas to watch, including automotive, chemicals, construction, finance, healthcare and industrial.
Chinese and Western folklore agree that mice visiting your home is a good omen, a sign that wealth will follow. At Alaris we look forward to an era which has the ingredients to repeat another roaring twenties decade when Shanghai also ruled the East. Prepare your reserve for the occasional exogenous event, aka black swan, but rather than worry about lighting, install a lightning rod, and a sign: Keep calm and carry on. Stay strong and boost that immune system!
Francis Bassolino is the Managing Partner of Alaris, an investment and advisory firm.