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Sunspots and cycles

20 May 2024 Old Mutual Wealth Investment Strategist, Izak Odendaal

Amid the hustle and bustle of daily life, it is easy to forget how small we are. It would take 1.3 million Earths to fill up the sun.

The past week saw massive solar storms, explosions on the surface of the sun that emit electromagnetic radiation. When these electrically charged solar particles hit the Earth’s magnetic field, they are funnelled north and south towards the poles. In the upper atmosphere, they crash into oxygen and nitrogen atoms, resulting in the spectacular aurora light phenomenon. This is usually more visible in the Northern Hemisphere, but last ‘s week solar storm was so big even South Africans could catch a glimpse in places. There is potential peril amid the beauty. These geomagnetic storms can also knock out communication equipment, but fortunately not this time.

Solar activity varies over an 11-year cycle, and the last few days saw the peak of this round. The sun’s magnetic poles also flip at the end of every cycle, unlike on Earth where it happens rarely. Yes, even the mighty sun is subject to cycles.

For investors, understanding the difference between cycles and structural trends is vital. So much of what we deal with in markets has mean-reverting tendencies. What goes up, eventually comes down. However, there are also structural trends that persist for long periods. Demographics is one. A low birth rate one year does not give way to a high birth rate the next year. Instead, a low birth rate compounds over time as there are fewer girls who can grow up to be mothers.

There was a time when the US economy was so dominant, it was effectively like the sun in our solar system. In 1960, with only 6% of the global population, the US share of annual global economic output (GDP) was 40%. Today its share has declined 25%, and China has emerged as a real competitor in the economic sphere. Adjusting for the different cost of living in the two countries which is much lower in China – on purchasing power parity basis, in other words – the Chinese economy has overtaken the US. However, it remains at number two when measured at market exchange rates. More importantly, its rapid catch-up with the US since the 1990s has stalled.

Chart 1: China GDP as a share of US GDP at market exchange rates

Source: LSEG

The two countries have very different economic models, and not just because one is notionally communist, while the other is the red-blooded home of free markets. More than two-thirds of US national income goes to households who spend most of it. Therefore, analysing US economic trends always starts with the shape of the consumer (more on this below). In China, household income is 60% of GDP but household consumption is less than 40% of GDP. The difference is saved. Chinese households save much more than almost anywhere else in the world, now or in the past.

As many commentators and Western policy advisers have pointed out, a more balanced Chinese economy, and one that could enjoy ongoing sustained growth, would be one where households spend more and save less. Getting there is not easy, however.

Chinese households save a lot due to big gaps in the social safety net and the low returns earned on these savings. The state-owned banking system offers depressed deposit rates, so that cheap credit can be extended to favoured businesses. Equities have been flat for more than a decade, and the option of earning a decent return in the property market has now evaporated. Demographics are also often mentioned as a driving factor, since the one child policy means that each person theoretically might one day support four grandparents.

This abundance of savings leads to domestic over-investment. No country invests such a high share of GDP (around 40%). This has given China amazing infrastructure, such as the most impressive high-speed rail network in the world, but most of it operates at a loss.

The amount of economic growth that each yuan of investment creates has therefore been falling over time, meaning that growth has been propped up over the past decade or so by a massive debt binge, much of it related to the property bubble. It is somewhat paradoxical that an economy with too much savings would also have too much debt, but that is what we’re dealing with.

Cyclical uptick
These are the structural challenges. The cyclical picture is an economy that came out of Covid lockdowns in weak shape. This is confirmed by persistently low inflation, a sign of weak overall demand. Rather than supporting households, as in the US, the government largely supported businesses. In particular, electric vehicles (EVs), batteries, solar panels and computer chips have emerged as favoured sectors. But since production exceeds what can be consumed locally, much of this must be exported. Last year, China became the world’s biggest vehicle exporter, having long been a net importer of cars.

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