THROUGH THE
LOOKING GLASS
US AND CHINA
How do investors navigate
a world in which is
and is ?
As the foundations of our economic principles are being upended, market certainties have been flipped upside down. Seemingly inevitable recessions never arrive. Countries poised for mighty surges lurch into the ditch. Economic leaders become laggards.
The global economy today resembles a world dreamed up by MC Escher, where figures ascend and descend gravity-defying stairs, not knowing where it all leads. Just when investors think the staircase is leading one way, it takes them in the opposite direction.
To make sense of this universe of market paradoxes and conundrums, investors must wrap their heads around the two prime examples of our new upside-down reality: the United States and China—and the dramatically shifting dynamics playing out between the two.
In the US, the strength of the American consumer continues to confound analysts, as consumption on small and big-ticket items alike is keeping economic recovery alive in spite of interest rate hikes—making the nation an anomaly on the world stage.
“The US economy has been shining remarkably at a time when the rest of the world is either in the doldrums or losing growth momentum,” says Eswar Prasad, Senior Fellow at the Brookings Institution.
The surprising resilience of the US market has also shaken confidence in mechanisms long relied upon to determine the trajectory of the economy. For over 200 straight trading days and counting, 10-year yields have held below 3-month rates, signaling a contraction in the economy; the same inversion preceded the last eight recessions.
But such a contraction has yet to arrive, and the US bond market hasn’t sounded recession alarms for so long a period in at least six decades. Even if the downturn hits, the disconnect between the traditional warning and actual outcome signals analysts may need to fundamentally change how they gauge the economy’s health.
Even more unexpected than the American economy’s recent acceleration has been China’s slowdown. China’s deteriorating economic fundamentals in the wake of its post-pandemic reopening have rattled analysts who were certain that China’s economy would rebound. Instead, a real estate bust is accompanied by mounting problems, from manufacturing contraction to record youth unemployment.
“There have been moments in the last 20 years when China seemed to be growing very well and the US was limping along,” says David Dollar, Senior Fellow at the Brookings Institution and former economic and financial emissary to China for the US Treasury Department. “The narrative was about the relative decline of the West, the US included. Now you don’t hear that. The US economy is doing surprisingly well. And the Chinese economy is doing surprisingly poorly.”
What analysts got wrong: The anticipated unleashing of pent-up demand that they expected never happened.
“The Chinese people had a fair amount saved up in bank accounts in particular, but it was really their deliberate choice to save the money,” Dollar says. “Now the buildup of banking deposits is on a trend. It reflects what the Chinese people want—which is to put away a good chunk of their income because they’re worried about uncertainty in the capital markets, making it rational to save up a lot of money, in case there’s another shock.”
Though strong signals from China indicate the country could be heading toward Japanification, Dollar points to distinct differences that suggest an alternate path.
“The housing bubble in Japan was totally unprecedented—at one point Tokyo was worth more than the whole United States—and China hasn’t allowed a nationwide bubble on the same scale,” he explains.
China’s problems are different—and potentially more devastating.
On top of its aging population and shrinking workforce, China’s decline in durable goods consumption and private-sector investment are signs of dramatic shifts. Growth will continue to decline if Chinese households and small businesses continue to favor holding cash over illiquid investment—a trend that can’t be corrected without significant policy changes from the Chinese government.
Investors who have been preparing for China’s rapid ascendancy must now consider something radically different: a weakened China facing its greatest economic challenge in a generation. At the same time, the US is leaning into diversification away from China—a shift that is further complicating China’s growth.
The US has become more confrontational and restrictive toward China, implementing policies that it says are not intended to crush the Chinese economy, but are de-risking efforts aimed at reducing American vulnerabilities, including policies to loosen China’s grip on sensitive industries, using the so-called “small yard and high fence” strategy.
Dollar says that China’s distrust and skepticism of US aims are warranted.
“We don’t have policies that fit the model of ‘small yard, high fence,’ starting with a 25% tariff across the board for about half of what we import from China,” says Dollar. “That’s beyond a small yard. That’s way out into the fields.”
The series of US tariffs and subsidies, started during the Trump Administration, are having a clear and measurable impact. Through the first six months of the year, the US traded more with Mexico and Canada than with China for the first time in nearly 20 years.
“China’s exports to the US are down by 25%—that’s a pretty big shock,” says Dollar.
And so the map of global trade is being redrawn. But if this era of uncertainty has taught investors anything, it’s that they should be questioning their assumptions in order to find new perspectives. Because like everything else in our Escherian world, de-risking is not what it appears.
“We live in a very complex trading world where you have a lot of global value chains that cut across several borders during the production process,” says Dollar. “And some of the apparent decline in US-China trade is really just a reorganization of value chains. If you focus on the value added that’s occurring in the trade, there’s less than meets the eye.”
In other words, American ties to China aren’t being severed; they’re becoming more entangled. The US may be redirecting its demand from China to preferred trading partners, but production in those places is becoming more reliant on Chinese inputs.
Considering these dynamic shifts, investors should re-evaluate their approaches—a change in perspective could lead to new opportunities like those in the electric vehicle industry, which finds itself in the crosscurrents between the US and China. With eight Chinese vehicle manufacturers investing in Mexico in the last year alone, China’s EV push into America’s southern neighbor is why motor vehicle imports from China to Mexico are up 197% from 2020 to 2022.
“Even without getting the benefits of free trade between the US and Mexico, we have relatively low tariffs on things that come in from Mexico, so these Chinese electric vehicles could potentially come into the US market with a potentially modest tariff,” says Dollar. “You definitely find China strengthening its ties with a lot of other countries that in turn have pretty deep economic relations with the US.”
That the two countries remain inextricably linked means any shift in dynamics between the two will have even bigger ripple effects across the markets going forward; the stakes are only getting higher.
To find a path forward, Michael Dicks, Chief Economist and Deputy Head of Research at PGIM Wadhwani, advises that investors challenge their reliance on historical insight. In an era defined by tail events—events that defy expectations, and which cause assets to move more than three standard deviations from their current price—there’s no room for complacency.
“When looking at past data, you’re making an assumption that the future will be like that data, but you need to take another step,” says Dicks. “Are there multiple regimes or different environments that we’ve seen in the past during which you need different sorts of tools to correctly measure the likelihood of those left tail events?”
One way to deal with those unknown unknowns, he says, is to ensure that agility is built into investment strategies.
“Whatever happens, whatever scenario plays out, you’re quick to react to the fact that you’ve identified a new regime or a new environment,” says Dicks.
But reactionary thinking alone won’t solve the problem—investors need to be proactive, reducing risk ahead of known events that could further upend the foundations of our assumptions, like elections, in light of the new cadence of unforeseen outcomes across the geopolitical and economic landscape.
That unpredictability defines the new Escherian world for investors. It’s a world in which it’s more critical than ever to question the way we’ve been looking at things—to change our perspective and flip it upside down. Only then can we begin to see where the staircase is actually leading.
THE Upside / Downside
GLOBAL ECONOMY
DOWNLOAD REPORT
In a time of
unprecedented DOWNSIDE,
Imagine the UPSIDE.
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This is a puzzling moment in the US. It is a very perilous one for China. That makes this a very uncertain moment not just for the two countries, but the world.”
Eswar Prasad
Senior Fellow,
Brookings Institution
Analysts obviously got something wrong on China.”
Senior Fellow,
Brookings Institution
David Dollar
The world is shifting, and shifting more aggressively and dynamically than it has in the past.”
Chief Economist and Deputy Head of Research, PGIM Wadhwani
michael dicks
China faces the risk of massive capital outflow as the economic downturn motivates investors to move money overseas.
How do investors navigate
a world in which up is down and down is up?
How do investors navigate
a world in which up is down and down is up?
down
up
up
down
As the US moves to diversify trade from China, other nations have seen their share of US trade skyrocket. China’s share, by contrast, is plummeting.
Despite efforts to diversify, the US remains reliant on Chinese imports. However, this reliance is now one step removed.
Over 75% of US solar imports now come from Vietnam, Malaysia, Cambodia and Thailand. But behind the scenes, China remains crucial, providing machinery and components—like polycrystalline silicon—
that ultimately shape imports to the US.
polycrystalline silicon
SOLAR PANEL
Source: Bloomberg Terminal,
Future Market Insights, July 2023
DO ALL ROADS LEAD BACK TO CHINA?
Increase in imports/exports over five years (2017-2022)
CHINA
US
Change in share of US trade (2017–2022)
SHIFTING
TRADE WINDS
Source: Bloomberg Terminal, September 2023
+41.5%
Mexico
+16.7%
THAILAND
INDIA
+36.8%
MALAYSIA
+7.1%
VIETNAM
+92.9%
CHINA
-22.1%
CHINA
US
Stubbornly high inflation forces the Fed to raise interest rates
Tightest labor market since World War II pushes wages higher
New-home sales rise to highest level in over a year
Household savings near record low
Deflation risk rises, adding urgency to potential stimulus
Youth unemployment reaches record high
New-home sales hit steepest monthly decline in a year
Household savings skyrocket as consumer spending stalls
Source: Bloomberg, September 2023
The US and China are experiencing radically different economic dynamics following the pandemic.
DIVERGING PATHS
Echoes of Japanification
Familiar signals raise fears that China may be spiraling into a liquidity trap, similar to Japan at the end of the 20th century.
Household debt
debt-to-gdp ratio
fertility RATE
Youth unemployment
Inflation
Sinks as rest of world holds steady
Peaks at 10.1%
Falls to 1.26, the country’s lowest level ever
Climbs to 145%
Surges from 26% to over 60% of GDP in under two decades
Cools as rest of world battles soaring prices
Soars to 21.3%
Falls to 1.09, the country’s lowest level ever
Hits record 281.5%
Skyrockets from 28% to 62% of GDP in a decade
CHINA
2010—2023
1971—2005
JAPAN
Bloomberg, IMF, Population Reference Bureau, National Business Daily, National Bureau of Statistics, The Japan Times
IMPORTS FROM CHINA
EXPORTS TO US
