The United States is the largest economy in the world as of the writing of this article and is considered the most powerful nation. It is thus difficult to think of another country surpassing the U.S. to become the economic superpower of the world, but Ray Dalio (Trades, Portfolio) believes that the day China takes the helm is not far away.
Because equity market returns are closely tied to the economic growth of a country or region, an investor needs to pay close attention to macro-economic developments. This makes it important to evaluate the guru’s claim and to determine the best course of action to generate attractive returns by allocating assets efficiently.
The U.S. is still ahead, but China is not far behind
According to data from the International Monetary Fund, the United States has remained the world’s largest economy since 1871. In 2019, the country accounted for the largest share of the global economy, but China was not far behind.
Source: IMF
The World Bank projects China to overtake the U.S. by 2050 to become the biggest economy in the world, and a comparison between the economic growth rates of these two nations in the last five decades serves as a reminder that, like a growth company that has reached market saturation, the U.S. is no longer the high-growth machine it used to be.
Source: The World Bank
In a LinkedIn post titled “The big cycles over the last 500 years” published on May 21, Dalio brings to light that the world has seen a few economic superpowers over the last five centuries. He goes on to highlight the fact that none of these countries were able to hold on to their leading position indefinitely. The below chart published by the guru is a visualization of the relative strength of several leading economies over time.
Source: Ray Dalio (Trades, Portfolio) via LinkedIn
The Netherlands and the United Kingdom were at the helm before the United States. Over the last couple of decades, China has gained relative strength whereas the U.S. has retreated from the highs reported in the 1950s. According to Dalio, there are six different stages of the cycle behind the rise and decline of economic superpowers:
- Peace, prosperity and productive debt growth.
- Debt bubble and big wealth gap.
- Debt bust and economic downturn.
- Printing money and credit.
- Revolutions and wars.
- Debt and political restructuring
After the sixth stage of this cycle, the guru says a new world order will prevail as the current nation at the top of the global economy will fail to hold on to its dominant position. Today, the U.S. is in a mature stage where it is impossible to grow at the same high-single-digit rates associated with China and India. Because of this, it would be a good idea to gain exposure to international equities, especially the shares of Chinese companies, to secure sustainable long-term returns from a portfolio of equity investments.
An important macro-economic relationship
In the long run, stock prices follow corporate earnings (even though they may follow news in the short term). Therefore, companies that can grow their profitability over the years will likely prove to be the best investments that deliver stellar returns to investors. The ability of a company to grow its earnings, on the other hand, depends primarily on the macro-economic situation of a country. As illustrated in the below chart, after-tax profits of U.S. companies have grown along with the economic growth of the country since the global depression of 1929.
Source: MSCI/U.S. Department of Commerce
Going by this data, it’s easy to figure out that the exponential growth of the Chinese economy will lead to higher corporate profits. This would form the backdrop for shares of Chinese companies to head higher in the next couple of decades.
US Investing in Chinese companies might change forever
Diversifying into Chinese equities in order to capitalize on the country's high growth rates seems to be a good strategy for investors. For now, there are various options available to do this, and investing in Chinese companies listed on American markets is the most popular way of gaining exposure to this high-growth country. However, a proposed change in the regulatory framework might bring about dramatic changes to the ability of Americans to invest in Chinese companies.
The Senate passed a bill on May 20 to regulate foreign companies listing their equity securities on U.S. stock exchanges. Historically, the Chinese Accounting Law and the Archive Law prohibit local companies from disclosing their audit reports to the Public Company Accounting Oversight Board of the U.S., and this has remained an obstacle for this institution to ensure the transparency and accuracy of the numbers published by Chinese companies listed on U.S. markets. If the recently approved senate bill gets the green light from the House, any foreign company that fails to provide audit work papers to U.S. regulators for three consecutive years will be delisted from the respective U.S. stock exchanges on which their equity securities trade.
The escalating tensions between the U.S. and Chinese governments paint a pessimistic outlook for any successful collaboration on this front, and investors might have to shift their investable assets to Asian markets to gain exposure to billion-dollar Chinese companies such as Alibaba Group Holdings (BABA, Financial) in the future. Alibaba has already taken the initiative to list its securities on the Hong Kong Stock Exchange, and other Chinese companies are likely to follow this lead.
Takeaway
A thorough understanding of developing macroeconomic trends can go a long way in helping investors generate alpha returns from their equity investments. There is a strong relationship between the economic growth of a country and the performance of equity markets.
Today, China is fast emerging as a global economic superpower and Ray Dalio (Trades, Portfolio) agrees with the World Bank's expecations that the world economic order will soon change, which China becoming the largest economy in the world by 2050. This highlights the opportunities of investing in Chinese equities.
However, the spectacular fall of Luckin Coffee (LK) in April after the company discovered an internal accounting scandal serves as a reminder of the dangers of looser accounting regulations in China, and it’s high time for local regulators to improve the transparency of the reporting process to attract international investors.
For now, investors need to tread carefully, as U.S. regulators might be delisting some Chinese companies from American stock exchanges. Thus, U.S. investors may want to wait until the regulatory and political outlooks stabilize before hunting for bargains in China.
Disclosure: I do not own any shares mentioned in this article.
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