The case for reading old economists and the elephant in the room in EM equities

I hope you’re enjoying the 2023 Chat-GPT advent calendar even if it is quite a deviation from the content normally posted here. Fret not, I will pepper the flow of advent stories throughout December with some economics, and a lookahead to markets next year.

I really enjoyed @EconTalker's conversation with @tylercowen, the founder of the most widely read economics blog out there, reminding us that there is still value in reading the grand old masters of economics. I enjoyed re-reading most of Keynes’ the General Theory for my essay on fiscal policy, and it was also fun to remind myself about Milton Friedman’s permanent-income-hypothesis for the essay on the life cycle hypothesis. But in reality, I fall foul of Tyler’s accusation of an economist who is probably not as well acquainted with the classics as I should be. I have read very little of Smith for example, I find Hayek very difficult to read, and as an economist interested in demographics, I also regret to say that I have only read few parts of Malthus in the primary versions. Fortunately for me and others, Tyler has made his new his new book—"GOAT" of economics—freely available, and I am looking forward to dig in over Christmas.

The elephant in the room in EM equities

In other news, I remain fascinated by the disconnect between the prospect of an accident in the increasingly tense relationship between the US and China and the fact that, in the world of finance, allocating money to EM equities still means investing around 40-to-45% of your funds into Chinese and Taiwanese markets. EM, ex-China, ETFs exist, but they ironically hold their biggest position in TAIWAN SEMICONDUCTOR MANUFACTURING. When Mr. Putin pushed the trigger on Russia’s invasion of Ukraine it took less than six months before all western investments in Russia had been virtually written down the zero, and I don’t see why we should expect it to be any different if and when a hot conflict kicks of between China and Taiwan, which invariably will pull the US into the fray. The latest reminder of this disconnect between geopolitics and the investment and asset allocation landscape comes from Project Syndicate article ominously warning that Western Firms Should Leave China Now, HT; Noah Smith.

“Since the 1990s, Western companies have invested a fortune in the Chinese economy, and tens of thousands of Chinese students have studied in US and European universities or worked in Western companies. None of this made China more democratic, and now it is heading toward an economic showdown with the US.”

It is not clear to me whether the authors are asking firms to ditch their Chinese presence and investments out of a sense of patriotism towards Western value or as an act of self-preservation. Maybe it is a bit of both.

To be clear, I think the idea of a hot war between the US and China over Taiwan is madness. I think the US bi-partisan consensus the article refers to, on a tough and uncompromising stance against China come what may, is writing a cheque that the US political economy, and quite possibly the country’s armed forces, won’t be able to cash if the chips are down. I think that a hot conflict between the west and China is a terrible prospect for Europe. I think that whatever you may think of XI Jinping, it is crude and ill-conceived revisionism to hold up China as someone we should not and can’t have any economic relations with, because it is now throwing its economic and military might around. The West encouraged the China we see today, and we need to learn to live with it, not sleep walk into a war with 1.4B people. Anyway, that’s just my view, and if you’re an investor you probably shouldn’t put too much stock into it. I agree with the general thrust of the article that;

Whatever happens in the next US election cycle, expect further sanctions and myriad other restrictions on trade with China. Unless the Chinese leadership changes course radically, a major trade war will become increasingly likely. The writing is on the wall: US investors should diversify their suppliers as soon as possible.

If you’re buying EM, and Chinese, equities because you think they’re cheap, there could be a reason for the discount. Ask anyone who picked up Russian shares at bargain prices in January 2022! More generally, western economic interests were forced, more or less overnight, to write off any assets, or real options, they had in Russia, and vice versa. That kind of disintegration of economic linkages are costly. Perhaps they’re necessary in a world where war is now depressingly back on the menu, and globalisation is entering a new phase, focused on buzz words such as near-shoring, friend-shoring, etc. But I don’t think we should be under any illusions of the economic costs of severing economic ties with China overnight, if it comes to that.