Growth, Gridlock and How U.S. - China Tensions Shape the Global Economy

---

• For all the post-pandemic ups and downs, the U.S. economy has been incredibly resilient. What are the forces that continue to delay an economic downturn?
• The Fed still aims to engineer a decrease in the rate of inflation. But deflation is its own risk, says Chen Zhao, Founding Partner and Chief Global Strategist at Alpine Macro.
• Zhao, a native of China, is critical of President Xi Jinping as well as Presidents Biden and Trump. What’s his take on the U.S.-China relationship?

The U.S. Federal Reserve “is navigating by the stars under cloudy skies”: That’s what Fed Chair Jerome Powell told an audience of economists at the annual Jackson Hole Economic Symposium last month. 

In this uncertain economy, the Fed has to walk a finer line than usual. While inflation has steadily declined since its 40-year high in June 2022, the current rate (3.18% as of July 31, 2023) is still too high for the U.S. economy to bear. Its target is (and will continue to be) a solid 2%. The economy isn’t cooling as many expected, and the labor market “rebalancing process is incomplete.” 

But Powell’s “cloudy” remark reportedly was a nod to the “r-star” or “r*” — the mythical paradigm of a “neutral” interest rate that neither stimulates nor restricts economic activity — and which is impossible to gauge in real time. It’s a moving target, dependent on a number of constantly fluctuating economic factors. 

Chen Zhao, Founding Partner and Chief Global Strategist at Alpine Macro, thinks the world will return to its pre-pandemic low-inflation environment. But whether interest rates will sink down to zero is another matter. 

“It has everything to do with your judgment call on r* equilibrium,” he says. “Before the pandemic hit, r* was plus or minus 1%.” 

Zhao’s prediction is that the new normal will be a lower r*. That’s because a steady state of economic growth “consists of two things and two things only,” he says. “Labor productivity growth plus labor force growth.”

That’s just a taste of Zhao’s lively chat with host Alan Dunne on a Global Macro episode of Top Traders Unplugged. Their wide-ranging conversation includes Zhao’s takes on everything from Fed tea-leaf reading to stagflation and “bond vigilantes.” Here, we recap highlights from their discussion about the U.S. economy compared to the Chinese economy, U.S.-China trade and the relationship between the two superpowers. 

Growth vs. gridlock

American labor productivity growth is always relatively steady (between 1.5% and 2% over the last decade or so). But in recent years, the size of the U.S. labor force itself has been lagging. It’s close to 0% (along with the rate of population growth as a whole). The gap between GDP and the number of jobs required for the labor force to grow is staggering. Today, 1.9 million fewer Americans are working than in February 2020.  

Zhao thinks we might see steady-state growth drop due to the labor force growth deficit alone. He points out that the government could “resolve that problem easily” by opening the immigration/guest worker process in an effort to fill these positions. But he admits there’s little appetite for initiatives like that among the citizenry or the Congress, and neither Biden or Trump (both the presumptive 2024 nominees from their parties) seem to be pro-immigrant or pro-immigration.

“The best we can hope [for] is gridlock in the United States,” says Zhao. “Gridlock is always good. Government can’t do anything except just run at normal.” 

Zhao thinks we will experience partisan gridlock in the coming years. To him, that’s preferable to any major political change because, as he puts it, “either of them [Biden or Trump] getting elected will be a disaster to me … I don’t know why the Americans have to choose between those two.”

Disinflation and demographics

When he was working on his doctorate in economics in the late 1980s, the government of Zhao’s native China sent him to the United States to study. Then, as now, the Chinese economy was a “hot topic.” Today, his insights are invaluable to the many investors who want to make decisions from an informed, global macroeconomic perspective — including us at Top Traders Unplugged. 

Alan asks Zhao to weigh in on whether China is the disinflationary force it (arguably) was when it joined the WTO in December 2001 — as well as his take on the nation’s changing demographics.

Zhao thinks that China is no longer a force for disinflation and that the “demographic stuff is completely overrated.” China was once the most populous nation on Earth. Now, India has a bigger population, but the Chinese economy has grown five times bigger. 

In the early ’90s, India had about 500 million people, while China’s population stood at about 800 million. At the time, the Chinese economy was about 30% bigger than India’s; now, it’s five times bigger. 

“India has won the population race but lost in the economy,” Zhao adds.

Macro and Micro problems

There are two sides to the “China problem,” Zhao says. One is a macro issue and the other is a micro issue, but a much bigger, “fundamental” concern.

“Basically, it’s because of Xi Jinping,” he explains. “Xi is a populist leader. He has no clear economic philosophy in his policy. He’s just moving back and forth. He talks about all things, everything. Nobody understands what the hell he’s talking about, to be honest.”

Zhao says that private businesses have lost confidence in Xi.

“Think about it. If you don’t know what he is really up to, why on earth [would] anybody use their own money to invest in that economy?” he asks. “Nobody wants to. That’s why lots of private entrepreneurs are trying to get out.”

The “macro issue” is that the Chinese government “is basically scared by its own shadow,” he adds. “We in the West told them that they cannot build up their debt too much … so they don’t. [But] if they don’t lever up, they’ve got an over-savings problem. … It’s a classic example of savings that far exceed the desired investment.”

In that scenario, the only viable adjustment process is a price decline, an output decline or both. Right now, he sees major metrics of the Chinese consumer price index beginning to fall. He thinks China needs to “drop that debt argument and just go on a spending spree — or actually subsidize consumer spending.”

He suggests that the government give consumers a spending coupon with an expiry date. Perhaps each household could receive $10,000 in spend-it-or-lose-it subsidies. But “they are just not that imaginative,” says Zhao. “He [Xi] is a bad policymaker, period.”

Throwback or foreshadowing?

Moving forward, Zhao predicts that “the world will basically go back to a 2018-19 type of situation, primarily because I don’t see anything that will fundamentally change.”

The hostility between China and the U.S. erupted during that time, and he expects tensions to continue. 

“The fundamental judgment call has to be on saving versus desired investment. The developed world, where the population gravitates towards zero to negative growth, all of a sudden [exhibits a] very strong desire for investment.”

But we have to remember that a nation’s population growth directly correlates to its “natural aggregate demand growth,” so we can’t expect demand to increase if our population doesn’t.

“Think about Japan,” Zhao says, noting that “Japan’s investments … [are] basically replacement investments,” meant to ensure its “capital stock is not completely obsolete.”

2018 and 2019 were certainly less eventful than 2020, but the pre-pandemic environment wasn’t without its challenges. If we’re going to return to the economics of that era, Alan wonders whether Zhao has concerns about it from a global risks perspective. 

Those years — and actually, the “20-teens” as a whole — were “not very rosy,” Zhao agrees. But he notes that low inflation isn’t inherently a good thing. (It all depends on your investment perspective). But he explains his specific analogy: In 2018, quantitative tightening was quite a problem. 

“Remember how it went down about 15% or so, and then Jerome Powell basically chickened out eventually? We might have that kind of situation, too.”

There are a number of known risk factors to consider when looking ahead to 2024 and beyond. But if the pandemic taught us anything, it’s that the biggest risks are the least anticipated ones. And the geopolitical environment is much different today.

“The world is arguably way worse than five or six years ago,” says Zhao.

‘The supplier gets a haircut’

Whatever happens, returning to pre-pandemic inflation levels will take a deflationary shock. Will that shock have anything to do with the U.S.-China relationship? 

“The two biggest economies in the world are basically trying to disengage from each other,” says Zhao. “That cannot be good news. I don’t know what, exactly, will be the shock, but I can see a lot of problems.”

The rift between the two countries “has already slashed China’s economic growth by no small amount,” he adds. That’s why he thinks it’s quite possible that the next big deflationary shock has something to do with their relationship. 

“China is a producer, America is a consumer,” Zhao explains. “When your customer is pissed off, usually it is the supplier that actually takes the heat. China is a supplier. When America is pissed off, the supplier gets a haircut.”

The ongoing Chinese real estate crisis is another wrinkle in the U.S.-China drama. Economic trouble in China could have domino effects throughout the global economy. But Zhao only says that it will lead to disinflation.

“From a macro trading investing perspective, how would you play it out?” Alan asks him.

“Bullish on the bonds,” Zhao replies. “I think Chinese local currency bonds are probably going to be at 1% yield per year.” 

Alan asks what kind of impact that could have on China’s currency.

“They [Chinese government leaders] probably don’t like the currency to be at this level … they want the currency to be a little bit weaker,” says Zhao. “But right now, they are also very mindful of hostilities [toward] China. They don’t want to piss off too many countries. There is no question in my mind that if you have deflation, the way out is to get your currency down.”

For the past few decades, we’ve been able to count on China “to reflate and to bail out the rest of the world in terms of growth,” he adds. “This time around, it’s not happening.”

Get comfortable with being uncomfortable

Zhao says that economics and investing are “forever a learning process,” one that’s still ongoing for him personally. His advice to the Top Traders audience: “Always ask yourself, What is the most difficult trade today? Do the most difficult trade. That is usually the right one. … “If you feel comfortable, you’re not going to make money. That’s a guarantee.”

---

This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.