· We would be wary of the trade. Firstly, if buying China is intended to help diversify away from the AI trade, this looks misconceived. China is more levered to the AI infrastructure theme than its stockmarket performance would imply.

· Secondly, regulators usually curb equity issuance when the market is falling. On this occasion, however, equity dilution is surging. Nothing better illustrates the fact that the stockmarket is primarily seen as a tool to fund strategic priorities.

· Thirdly, the post-2021 property bust has left China with a domestic demand shortfall that heavy government borrowing is struggling to offset. At best, the ‘six networks’ plan will steady the ship; the structural changes needed to unleash stronger private consumption growth seem unlikely.

· More broadly, China’s governance regime – autocratic state capitalism – means there is little rationale for positioning Chinese equities as a strategic holding in a global portfolio, notwithstanding the rising technological and geopolitical standing of China in the world.

· State capitalism - control of the commanding heights, the prioritisation of investment over consumption, capital controls and policy-driven lending - was effective in marshalling the resource reallocation needed to drive a prolonged period of catch-up growth. But it makes it difficult for companies, even if privately owned, to achieve sustained high returns on capital. This explains why Chinese equity returns have disappointed over the longer term.

· Meanwhile, Xi Jinping’s consolidation of power has turned authoritarianism into autocracy, bringing greater policy uncertainty and a more assertive stance on the world stage. This adds to risk aversion and warrants a valuation discount.

· An AI bust would hit exports, a rare economic bright spot, and only heighten the challenges facing state capitalism. Despite policy initiatives such as ‘anti-involution’ and China’s version of ‘value up’, there is little evidence Beijing has the appetite for the comprehensive governance reforms required for stronger productivity growth and improved returns on capital.

· In a sense, the infamous call back in 2022 that China was ‘uninvestable’ was on the mark, in that strong, sustained absolute returns are likely to remain elusive within a governance framework that constrains the pursuit of shareholder value.

For the full report, please visit https://johnpaulsmith422.substack.com.

Governance and Markets

Analysis and views for investors

By JP Smith

· The fundamental idea underpinning the concept of ‘emerging markets’ in the early 1990s was that they would grow more rapidly than mature economies, especially as sovereign and corporate governance converged towards ‘best practice’, centred on free markets and liberal democracy. It was also presumed that strong economic growth would lead to strong equity returns.

· It turned out that it was not “The End of History” after all. Rather than converging on Western ideals, emerging market governance frameworks have fragmented, often in a manner that has undermined economic performance and compromised investment returns.

· Governance has mattered: the biggest investment disappointments have come in emerging markets that adopted policies and systems centred around state capitalism and/or dirigiste interventionism, such as Russia, Venezuela, Turkey and China.

· In addition, the conveyor belt that was implicitly envisaged at the outset - whereby maturing emerging markets would be promoted to developed status, to be replaced by newly emerging nations - has broken down. The main EM equity benchmark is today dominated by two markets - Korea and Taiwan – that are essentially developed. Worse, since they are highly leveraged to the global AI infrastructure buildout, the EM index has become strongly correlated with the same thematic that is driving US markets. That’s made for strong performance since October 2022, but this is not the diversification EM was originally expected to provide.

· It also means EM equities have become a less straightforward play on a weaker dollar. Investors wishing to play this theme should are better off in EM debt, where benchmark constituents are more consistent with the layman’s understanding of an emerging market. Indeed, the shift in many emerging markets towards more autocratic governance regimes, prioritising stability over growth, has arguably strengthened the relative case for EM sovereign debt.

· Many asset allocators still fail to recognise that the original rationale for treating a diverse bunch of less developed countries as a quasi-homogenous universe driven by a powerful secular theme no longer makes sense. Hence much of the money flowing into EM equities still goes into benchmark products. Even supposedly active investors often differ only modestly from the benchmark.

· A far better approach is to disaggregate and discriminate, treating each market as a standalone investment opportunity demanding independent evaluation. At the very least, one should invest in an EM fund that thinks similarly and pays little heed to the index.

Em A Broken Benchmark

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· That requires stablecoins to evolve from being a crypto bridge to becoming an important part of domestic and international payments – by enabling faster, cheaper, programmable 24/7/365 payments on public blockchains.

· There’s an obvious opportunity in cross-border payments, where inefficiencies remain glaring. Stablecoins are already gaining traction in countries with weak banking systems and unreliable currencies. Automated business payments and AI-related commerce offer promise. But domestic consumer payments may prove a harder nut to crack.

· While stablecoins promise to catalyse innovation, there are important geoeconomic considerations that influence how global policymakers view them.

· US officials champion stablecoins as an instrument to sustain American financial hegemony, a strategy dubbed ‘cryptomercantilism’. Yet this comes at a time when many countries are increasingly concerned about their dollar dependency and vulnerability to coercion.

· Stablecoins can also potentially disintermediate banking systems, which runs counter to the precepts of ‘national capitalism’, whereby policymakers endeavour to channel their country’s savings more toward domestic investment needs.

· The ECB’s push to launch a retail Central Bank Digital Currency (CBDC) reflects its determination to preserve ‘monetary sovereignty’ and to secure Europe’s ‘strategic autonomy’. The e-CNY has similar motivations. But design challenges and historical global experience question whether this will prove an effective strategy.

· Stablecoins and CBDCs represent tokenised versions of real-world assets. In principle, anything can be tokenised: money market funds, bonds, listed and unlisted equities, commodities, real estate and a host of other assets.

· That includes bank deposits. Though still a nascent concept, here lies a third way for countries anxious about stablecoin encroachment yet sceptical of retail CBDCs.

· Tokenised deposits, like stablecoins, can fund the cash leg of an on-chain transaction. But crucially they augment existing payments rails rather than disrupting them. They safeguard monetary policy transmission and ensure that central banks retain oversight over wholesale settlement.

· Commercial banks are vulnerable to deposit flight should stablecoins or retail CBDCs gain significant traction. In contrast, deposit tokenisation retains their central role in credit intermediation. Viewed through a geoeconomic prism, this seems a far more logical outcome.

Extended essay attached.

Geoeconomics And The Future Of Money

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· First, undermining confidence in the veracity of economic data is ultimately self-defeating. The more America behaves like an emerging market, the higher the risk premium investors will demand. The threat of data manipulation could send shivers through the market for inflation-linked securities.

· Second, the incremental erosion of institutional credibility is an obvious potential catalyst for a demonstrably overvalued dollar to mean revert.

· Finally, the previous two points strengthen the investment case for real assets. But assets with contractual inflation linkages, such as some infrastructure and real estate, carry the same potential risk as TIPS: their protection is only as good as the integrity of the data.

· One ideally is looking for assets that can act as inflation hedges without relying on formal indexation. Equities, in principle, fall into this category – provided one enters at a reasonable valuation. Farmland and forestry have historically provided robust inflation protection, and industrial commodities can hedge a spike.

· Ultimately, though, nothing stands to benefit more from statisticians being fired for releasing displeasing data than that ancient store of value: gold.

Shooting The Messenger

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· So whose currencies look contrarily cheap on the same metric? Japan, Sweden, Norway, Korea and Canada. If the dollar is to embark on a sustained and significant real depreciation trend, at least some of these could potentially appreciate quite substantially.

· A second reason to be structurally bearish on the dollar is that foreign investors have accumulated a vast $33trn stockpile of portfolio investments in the US, often currency unhedged, at a time when America is adopting an increasingly unilateral approach to the global economy and its financial markets.

· It’s worth noting that global investors ‘liberated’ themselves of some $63bn of US securities in April, in the aftermath of the announcement of reciprocal tariffs and the subsequent escalation of trade tensions with China. The most notable seller: Canada! The putative 51^st state has plenty of profits it might want to book after five years of strong US asset price gains. The same could be said of North Asia and Singapore, the Eurozone, the Scandinavians and the Swiss.

· A third reason to be structurally bearish on the dollar is the growing threat of fiscal dominance. The signs are that Congress will pass what might be called One Big Budget Busting Act, whilst President Trump continues to throw brickbats at the Fed.

· But poor public finances are far from an exclusively American problem. Only a handful of the major fiat currencies offer both a positive real policy rate and a <3% GDP budget deficit outlook – namely Korea, Taiwan and Singapore in Asia and commodity producers Australia, Canada and Norway.

· The most roadworthy fiat today? I’m minded to pick the NOK. Norway’s oil windfall results in huge external and budgetary surpluses, yet the real exchange rate has depreciated significantly in recent years. Having historically feared Dutch disease effects, today it looks like the country could actually do with onshoring a bit more of its oil revenues to strengthen the currency.

· The broader message is that whilst the dollar looks particularly unappealing, few of the major fiat currencies offer a compelling alternative. All the more reason, then, to take real assets – with a scarcity value and/or the potential to protect against inflation – more seriously.

In Search Of A Roadworthy Fiat

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· I don’t think so - for two important reasons.

· Firstly, the White House may have taken a step back in its tariff levies, but that still leaves it one big step forward from a few months ago. We are still looking at the biggest, fastest increase in America’s effective tariff rate since the Civil War. Beyond the near-term macro impact, this is a sea-change of historic consequence.

· Secondly, the President appears to see his grandstanding – the “great television” of slapping down Zelensky in the Oval Office, the egregious reciprocal tariff formula – as a useful negotiating tactic: the notion of escalating to de-escalate.

· The problem for the economy and financial markets is that short-lived threats can have a long-lasting impact. This is the notion of hysteresis: the idea that shocks can scar, in this instance by altering the probability distribution of potential future outcomes.

· Firstly, the now exceptionally high level of economic policy uncertainty is unlikely to revert fully to pre-Trump norms. For example, the upcoming bilateral trade deals look set to address largely cosmetic issues; global imbalances will endure. The danger, then, is that these agreements have a distinctly short shelf life as Trump soon starts complaining again about America being “ripped off”.

· In addition, whilst the ‘guardrails’ thankfully held on this occasion, a number of tail risks – from undermining Fed independence to the occupation of Greenland – are now just that little bit less unthinkable following the Rose Garden Affair.

· A higher level of uncertainty boosts the option value of ‘waiting and seeing’. It seems plausible to argue that this will serve as a headwind to many companies’ investment and hiring decisions. And for investors, a higher level of risk should be compensated for by higher risk premia.

· Admittedly, there is little evidence at present of hysteresis in share prices. Thanks to reportedly record buying by US retail investors, Wall Street has stormed back from its initial plunge. A puny equity risk premium represents a big, brave bet both that corporate profits will be little affected by recent events and that there will be no further outbreaks of ‘Trumpstanding’.

· Treasuries offered little hedging value during the tumult, even as recession probabilities spiked. Yet the latest estimate for the bond term premium is still relatively modest and a big test awaits with the upcoming budget deliberations.

· It’s in FX markets where a hysteresis effect today seems most evident. A temporary shock has woken foreign investors up to the risks they are running in having historically high exposures to US assets, many of which appear to be unhedged. The lasting effect of the April surprise is likely to be a prolonged and substantial de-risking, driving a decline in the real value of the dollar.

Hysteria And Hysteresis The Lasting Effects Of The Rose Garden Affair

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· This reflects forty years in which the US has run current account deficits averaging nearly 3% GDP, funded primarily by portfolio and ‘other’ capital net inflows, as opposed to inward direct investment.

· You can’t easily redeem a factory, but you can redeem an investment in the stockmarket or the bond market, call in a cross-border loan or withdraw a dollar deposit. On that basis, one can classify such positions as ‘speculative capital’.

· To be clear, most foreign holders of these instruments would not normally consider their investments to be ‘hot money’. Rather, they form part of a globally diversified pool of long-term savings, and some of these exposures are held for prudential purposes.

· But these are not normal times. The Pax Americana that encouraged the construction of globally diversified portfolios is over. A new era – Vis Americana – has begun.

· Some $33.5trn of the pool of speculative capital is portfolio investments: foreigners hold $8.8trn of Treasuries, $6trn of US corporate and other bonds and $18.6trn of US equities.

· This includes $1.4trn of portfolio investments owned by China, which has clearly been at loggerheads with America for some time. Hence it is no surprise to see that Chinese holdings have dropped by roughly 25% since just before Donald Trump was first elected President.

· But many countries that would long have considered themselves closely allied to America now also find themselves in the crosshairs, threatened with punitive tariff rates or the withdrawal of the US defence shield, being hectored for being ‘insufficiently democratic’ or even being threatened with imperialist bluster.

· Europeans have more than $15trn of portfolio investments in the US. Canada has almost $3trn. So does Japan. So do Korea, Taiwan and Singapore between them.

· Foreign investors in such countries suddenly find themselves struggling to fathom both the fast-changing US domestic political situation and what Vis Americana means for international relations and the global economy. They’ll be asking themselves whether the current equity CAPE ratio, bond term premium and inflation-adjusted value of the dollar represent adequate compensation for this new, much more elevated level of uncertainty. And they’ll also be hearing calls to, for example, “buy Canada” or keep European savings in Europe.

· The reassessment process has clearly begun: the dollar no longer behaves as a risk-off asset, now that the risks chiefly emanate from the White House. And Treasuries are certainly not behaving as one would historically expect now that investment banks are calling for recession.

· But the readjustment has a lot further to run. This is a secular change, not a one-stop reset. By no means will the majority of speculative capital leave America, but enough will to make for a trend.

An X Ray Of America's Achilles Heel

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· But the scope for substantial further de-escalation from here is constrained by the fact that Trump needs tariffs, to fund tax cuts and to force companies to build production facilities in the US, all part of the MAGA economic masterplan.

· Moreover, Trump still believes to his very core that trade deficits mean you’re losing. Reciprocal tariffs highlighted a belief that pretty much all countries are ‘bad actors’, using primarily non-tariff barriers to disadvantage America. Peter Navarro will surely rise again, arguing to his boss that the global trading system represents an existential national security threat that demands urgent action.

· The problem with this is that there are economic and political realities that constrain foreign governments’ ability to bend the knee. They cannot credibly commit to balanced trade when they don’t control relative domestic investment and savings rates. And Navarro’s non-tariff barriers are not just about product standards and border checks; they also cover issues of national sovereignty such as VAT and tech regulation.

· Meanwhile, Xi Jinping appears to have concluded that demonstrating a willingness and capacity to absorb more pain than President Trump strengthens his bargaining position when talks do eventually occur. The Chinese economy is not going to be opened up whilst there’s a Cold War going on. But America still relies heavily on its products.

· Even if the various bilateral negotiations go well and Trump is satisfied with relatively cosmetic concessions, we are still set for the biggest, fastest hike in America’s effective tariff rate since the Civil War. And if the President decides he wants bigger wins, his only credible bargaining strategy is a policy of capriciousness. This story could be far from over.

· Two conclusions therefore seem inevitable. Firstly, US corporate profits look highly vulnerable. Supply chains have been screwed up, the inevitable weakening of economic activity induced by elevated uncertainty will make for negative operating leverage, and companies may come under pressure to absorb cost increases and avoid ‘unpatriotic’ price rises.

Secondly, the events of the last week only strengthen the conclusion that Pax Americana is at an end and Vis Americana has begun. The rest of the world owns ~$15trn of US debt securities and ~$18trn of US equities. American caudillismo and the upending of the global order asks serious questions of these asset owners. The weakness of the dollar and bonds - as well as equities - in the aftermath of Liberation Day suggests that they are starting to come up with some answers.

Act One Scene One

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Summary

The Trump team envisages that America’s external deficit will narrow due to fiscal tightening and an increase in domestic investment that revives manufacturing capacity, with limited economic pain if they can get the sequencing right. However, there are many reasons to doubt this sunny outlook.

Few economists would argue that tariffs are the optimal policy tool to achieve rebalancing. Even fewer would advise that they be introduced in a manner that maximises uncertainty and complexity. But it is the way in which protectionism symbolises a much broader shift in foreign policy that ultimately has the greatest potential impact on the economic project.

The dollar has been overvalued for some time; ordinarily, one would be looking out for one of those once-every-decade moments in which the US real exchange rate turns and begins a prolonged movement in the opposite direction, which alone would have important implications for global investing. Instead, something far more epochal is playing out: the end of Pax Americana, as seen in the hostility towards allies, the shift to a ‘spheres of influence’ geopolitical mindset, and the challenging of both internal and external constraints on the power of the American presidency.

This has the potential to catalyse a re-think by global investors of their capital allocations. Between them, Europe and Canada hold over $17trn of US securities; adding Japan takes this to over $20trn. American caudillismo and the upending of the global order asks serious questions of these asset owners. Does it make sense to be so heavily positioned in US equities amidst such political and economic turbulence, especially given still lofty valuations? And perish the thought, are Treasuries quite as risk-free as assumed?

A concerted move to reduce today’s elevated foreign exposure to US assets can both kickstart a long-term dollar depreciation trend and put sustained pressure on Wall Street. That, in turn, would tighten financial conditions and induce a negative wealth effect that prompted an increase in the US personal savings rate. That way lies a more painful, more rapid method of balancing the American current account.

The rest of the world will have to accommodate American rebalancing, regardless of how it is secured. A booming domestic military-industrial complex, tapping savings that previously would have been channelled to US markets, is the most obvious adjustment mechanism. This seems likely to play out in Europe, although it will require the kind of political breakthroughs that the continent has often made in a crisis, including increased debt pooling and a revived push at economic integration.

Demographics and stretched public finances suggest that Japan would find it harder to absorb significant capital repatriation. The risk is that adjustment comes via a significant yen appreciation that erodes corporate savings. For corporates, the most effective defence is to lever up to buy back shares, aiming to induce a positive wealth effect that tests the potential for the household savings rate to go negative.

The stockmarket will also be an important part of China’s adjustment process. The nature of the domestic political system argues against a significant drop in the country’s household savings rate. But that won’t stop policymakers trying to goose equities further to create a positive wealth effect.

Short dollar, long gold and long international equities-vs-US are consensus trading shorts, but it will take years for global capital to re-position portfolios.

Vis Americana

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