The Bull Case for China: The Best Opportunity Right Now? | Louis Gave

0:00China comes into this crisis, I think, better prepared than pretty much anybody out there, mostly through luck. China today has more oil and storage than the rest of the world combined. It has more natural gas and storage than the rest of Asia combined. It has more fertilizer and storage than the rest of the world combined. The reason China has all this is because eight years ago, the U.S. told China no more semiconductors. And China thought, oh my God, they can block us from this. They can block us from anything. We better store up on everything. Look, if you're looking for places in the world that have deep, deep vulnerabilities on their bond markets, there's a few countries that stand out.

0:38What always matters is the percentage of bonds owned by foreigners. And today there's three countries that stand out. One is yours, the UK, and yes, bond yields are going up there. The other is mine, France, and the third is the United States. These are the three countries that essentially depend on the kindness of strangers to keep the lights on. Now, when I look at China today, what I find is the country today that has the lowest cost of capital, the lowest cost of labor, the lowest cost of electricity, and has the world's cheapest currency, and it's not even close. And that makes for a very powerful combination.

1:20Welcome to the Master Investor Podcast with me, Wilfred Frost, where we celebrate and learn from the success of the greatest investors, business leaders and politicians in the world giving you, our listeners, the edge. The Master Investor Podcast is sponsored by LSEG, Interactive Brokers, the World Gold Council and BNY Investments. Please do remember the views expressed in this podcast are for general information purposes only. Nothing in the podcast constitutes a financial promotion, investment advice, or a personal recommendation. More on that in the show notes. My guest today is Louis Gav, the founding partner and CEO of GavCal, one of the best and most unique research companies in the world, providing market research to buy-side firms as well as having their own 6 billion AUM buy-side firm themselves.

2:16And when they were founded in 1998. They had a particular tilt to try and focus on Asia, which they felt at the time was undercovered, but cover all markets globally now. I've been an avid reader of GavCal Research for years since I graduated and joined Newton Investment Management in 2008. They are thoughtful and different and fantastic. And it is a real pleasure to welcome Louis to the podcast. Louis, great to see you. This was a very, very flattering introduction. I'm very grateful, Wilfred. I think only about half what you said is probably true. But even if half is true, it's, it's very flattering in itself.

2:55So thank you so much for this. Well, you've got 45 minutes ahead to live up to it, which is good. I've set the set the bar high. I've sort of switched my plan on this in the last six weeks since since the war began. And there's so many global topics that I think, as I kind of alluded to in the intro, you write about and think about much more than so many of the commentators we hear from. And I want to get to all of that, China, Japan, India, Brazil, and very much more. But need to kick off with the war and the impact that it may or may not have from markets here. You think the most likely outcome is that the US claims some kind of victory and walks away even if tolls exist in the strait?

3:39I think so. Look, let me kick off first with a disclaimer. I'm not a specialist on the Middle East. I spend most of my time looking at what's happening in Asia more broadly and, to be honest, more specifically in China. But what we're really looking at is, you know, given what's happening in the Middle East, how does this impact our region and the rest of the world? And here there's both dark clouds and light clouds and silver linings, perhaps, these dark clouds. The dark clouds is obviously Asia. Most of the Middle Eastern oil was going to Asia. And so this is a real problem for us. So that is the reality.

4:26And that's why I think everybody in Asia is pushing towards some kind of development, even if the development means paying a toll on the trade of Hormuz, even if with that money, the IRGC stays in power longer and ends up reinforced. At this stage, I think everyone in Asia is like, fine, let's just get that. So perhaps there's an element of wishful thinking to my position of saying, look, that seems like the most likely outcome at this stage because the US can't regain the Strait of Hormuz by military force. And so the only way it's going to reopen is through some kind of diplomatic settlement.

5:09Now, and, you know, the probably this, again, the sooner the better. And I think most of the US allies, rather in the region, whether the, you know, the local countries or the Europeans or the Asian allies of the United States are pushing the United States in that direction, saying, look, we can't keep this closed forever. So get something done. And if that does get done, is that a massive positive for oil prices? Or is in fact, there's still quite a lot of risk and complication priced in to that less negative outcome than we have now? When you say positive, you mean oil prices come back down?

5:49Yes, sorry. Yeah. Sorry. No, no. Just making sure we're on the same page. Look, I think the big challenge we have is even if it reopens tomorrow, we now have a six weeks to two month air pocket in the global economy because the ships that should be arriving now are no longer arriving. And even again, you reopen tomorrow, the ships are going to take quite a while to come back out. And so however you cut it, we're looking at a two-month supply chain dislocation for the world here. And of course, it's not just oil. It's the natural gas. It's the fertilizer. It's the sulfuric acid. It's the urea. It's the fertilizer.

6:27It's like all these things. And these can, of course, compound, right? If you don't have the fertilizer today, you're not planting. And so I think the inflationary shock coming from this is pretty much now baked in the cake. And of course, the longer we stay closed, the bigger the inflationary shock. But that brings me to the silver lining to this perhaps crisis, is that in an age where all of a sudden we are experiencing this massive inflationary shock, Like the, I think that the times when the US and China could turn around and try to trip each other up and you'd have these trade wars and these threats of tariffs and this is now gone.

7:12I think because of this, China and the US are almost condemned to get along. They might not want to, they might not like to, but Trump and Xi are scheduled to meet four times in the next 12 months, which has never happened, by the way. You've never had a U.S. president or a Chinese president scheduled to meet four times over a 12-month period. And I don't think they're going to meet to discuss the weather. And so you have these four meetings, which should be a reset of the U.S.-China relationship. And I think in the wake of the Iran war, it might very well be a very positive reset, where essentially the U.S.

7:48says, you know what? We can't take two inflationary shocks at the same time. We can't antagonize China and at the same time have this trade of Hormuz closed. It's sort of one or the other. I don't think you can do both. That's really interesting. I want to unpack that in that positive view and China specifically in a moment. Just dwell on the sort of negative view for me for a moment. I think you said that the inflationary shock is already baked into the cake, meaning in the economy to come. Is it priced into the market or are people underestimating the actual impact this is going to have on both inflation and GDP growth in a lot of those countries you mentioned across Asia?

8:30So I would say it really depends on your markets. I think it's increasingly, you're starting to see the crises in the world's poorer countries, the Pakistans, the Sri Lankas, etc., where you're already seeing fuel rationing, where you're already seeing food prices go up aggressively. to your question, is it priced in the markets? You could say, well, you know, fertilizer prices are now up by more than a third and gasoline prices are up by about 30 % in the United States and by 40 and 50 % in Europe. So you could say, well, look, you know, it is priced here. Here it is. Is it priced in the price of equities, of bonds?

9:12To be honest, I don't think it is. And I think it is again because perhaps we haven't yet felt the full shock and i think we haven't yet felt the full shock for a few reasons the first is up until a week ago the boats were still arriving from the belize because they'd left six weeks ago right and it takes six weeks to go to most destinations so we we haven't had yet the empty boats the empty boats are starting now when the ports literally no one's arriving so the the real shortages essentially start now but they probably don't really start for another six weeks or two months because in this misfortune that we're now experiencing, at least we had two previous crises.

9:54We obviously had the COVID crisis of 2020, and we had the Russia crisis of 2022. And with that, I think most businesses started already to move away from just-in-time inventories to more just-in-case. You'll remember that this was one of the big themes, that the just-in-case was one of the big themes following the Russia's invasion of Ukraine. All of a sudden, everybody starts to say, well, you know what, maybe I should have a little more helium since Ukraine's a big helium producer. You know what, maybe I do need to store more electricity. I do need to store to re-up my grid. So take Europe as an example.

10:35I think it's fascinating that today, the electricity price spike in Europe is nowhere near as bad as what we had in the Ukraine war. So for now, I think we came into this crisis perhaps a little bit better prepared than the previous two. But you can only run down your inventories for so long. And this is why, if this lasts another six weeks or two months, I think the economic pain really starts to get felt. And then the market pain will be there as well.

11:07This episode of the Master Investor Podcast with Wilfrid Frost is sponsored by BNY Investments, a trusted partner for many delivering financial solutions to investors and institutions worldwide. This sponsorship does not constitute financial advice. This episode is sponsored by the World Gold Council, the global experts on gold. They championed gold as a trusted strategic asset, provided market-leading research to help investors understand gold's role and modernize how gold is owned, traded and used, developing industry standards and market infrastructure. Learn more at goldhub.com.

11:52Just before we move on to market specifics and some of the positives. Touch on Europe for me. Does it affect everyone the same? Are there different short and long term effects like there are for Asia as well? So I think when you look at the problem from the Middle East, there's several categories of products that are being impacted. The obvious one we all think about, of course, is energy. And here, if you look across Europe, you have different countries whose economies are more or less energy intensive and whose own economy have to import more or less energy from the Middle East. So if you take my own country or France, we're actually not in that bad spot because we do have a lot of hydro and we do have a lot of nuclear for us to fall back on.

12:41And so we're a lot less dependent on imported energies than, say, Germany. Germany also happens to be quite an industrial economy, which is energy intensive. So Germany might be more vulnerable to what's happening. it's not like everything is smooth sailing for France because the other thing that the Middle East is extremely important for is fertilizer and so far somewhat amazingly but grain prices have not moved up if you look at wheat if you look at corn if you look at soybeans if you get all the grain prices they really haven't moved up so unless come unless come harvest time wheat prices go up I think you're going to get like massive food massive farmer riots in France Now, you could say, well, that's an easy prediction.

13:27That happens every year. But I think this year is going to be, come harvest time, September, October, it's going to be particularly, particularly bad. Well, I wonder whilst you're on France, to get your view on this, I wonder whether the back end of the year with the necessary, the need to pass a budget and a looming presidential election, whether the bond market reacts as well. I mean, looking at the UK, the 10 years back above 5 % today, you'd kind of look at the French bond market and think it's relatively calm, all metrics considered. I wonder if that worsens as we near the back end of the year as well.

14:03You're absolutely right. I think, look, if you're looking for places in the world that have deep, deep vulnerabilities on their bond markets, there's a few countries that stand out. And for me, the ratio has never been debt to GDP. I think that's a silly ratio. You're comparing a stock and a flow. So what always matters is the percentage of bonds owned by foreigners. This is a guide of whether domestic savings are enough to essentially keep governments going along. Governments need to fund themselves in one of two ways. They could say, okay, fine, I'll fund myself through taxes. But there's people who don't like paying taxes, but who like lending money, who have a high savings rate and who like lending money to their government.

14:50But China is a prime example of this today. China has fairly low taxes, but has the lowest bond yield in the world because Chinese people save a lot and all the savings go into government bonds. And so Chinese government gets to borrow cheaper than anybody. And as long as you borrow from your own citizens, you can keep that going forever. And you can keep it going for a very, or forever is a long time, but you can keep it for, the problem becomes when you start borrowing from foreigners. because one day foreigners wake up and say, you know what? Why do I own all these French bonds? Or why do I own all these British bonds?

15:25I don't like the politics. I don't like this. I don't like that. I'm out. And today there's three countries that stand out that borrowed disproportionately from foreigners. One is yours, the UK. And yes, Borneo's are going up there. The other is mine, France. And the third is the United States. These are the three countries that essentially depend on the kindness of strangers to keep the lights on. And again, that doesn't mean that that stops, but it means that all of a sudden you are vulnerable. Really interesting. And I want to touch on the US side of that in a moment. Before we move off the war, you guys did a really interesting piece recently on defense stocks, which we all would have expected to be shooting through the ceiling off the back of the war.

16:11They've rolled over somewhat. Talk me through your assessment of that. So I've actually been bearish defense stocks for a little bit. And my take is actually quite different, is that warfare has changed massively. I think Ukraine was a prime first example of this. And then the Red Sea and the Houthis was a second. And now we obviously have a third element of this. The reality is that since World War II, every effort by every military was first and foremost to control the sky. If you control the sky, then chances are you're going to control the battlefield. And controlling the sky was an extremely, extremely expensive proposition.

16:58Fido planes cost a fortune. Satellites cost a fortune. And with the Ukraine war, we found out that actually controlling the sky cost a few tens of thousands of dollars. The drone warfare has completely upended the military equation. It's all of a sudden, why pay$275 million for an F-35 seaplane? And not only the controlling the skies, but the delivery of firepower has also been upended. With a$50 ,000 drone, you can now sink a billion-dollar battleship. And so that equation – and to take down the$50 ,000 drone, you need a$2 million Patriot missile. So the spending has become so asymmetric. And you're seeing this today in the Persian Gulf where the U.S.

17:54Navy cannot be within 1 ,000 miles of Iran, which then raises a whole question mark. It's like, what's the point of a Navy if you can't get it close to where the battlefield is? Because who wants to, these aircraft carriers now cost$6 billion if they can be taken out by a$50 ,000 drone. The maths just don't work. And so we are living through right now, essentially an upending of both the financial and the, I would say, the geopolitical infrastructure of the past 80 years. You and I grew up in a world in which we had three key assumptions that we could take for granted. The first assumption that everyone took for granted is that you saved in US treasuries, whether you were an individual, whether you were a company, whether you were a government, you saved in US treasuries because in a crisis, that was the most deep liquid markets and you could transform your treasuries into commodities.

18:56So if you're Japan and there's Fukushima and you decide to shut down your nuclear power plant, you can sell your treasuries and buy oil and coal and natural gas and you get through the emergency that you're having. That assumption was essentially broke down with the Russia-Ukraine war. When we seized Russia's treasuries, we said, you only get access to treasuries if we say you do, we being the Western world and really being the United States. So that was the first assumption. And the response to this, everybody turned around and said, fine, then I'm going to buy gold instead. And so central banks became huge buyers of gold.

19:37Gold prices tripled. The second assumption was by buying gold is I can transform my gold into oil or into food or into fertilizer whenever I need because the US Navy controls the world's seaways. Because I can always have my stuff, my fertilizer delivered by the US Navy. That assumption has just been destroyed. So that's the second assumption that has now been left for rubbles. And therefore, you have to question, going back to your question on defense, if the US Navy can no longer control the seaways, what's the point of spending all this money on defense? I'm much better off buying$50 ,000 drones and$80 ,000 ballistic missiles from China.

20:24So these defense companies live off the sale of systems that cost millions of dollars and that are now obsolete. And that's where we are in warfare today. Just to pick up on something you said in the middle of that, the second big assumption we've lived our lives on that the U.S. will keep the waterways open. And I guess we touched on this on the top, but we presumably don't know what follows that yet. And what is the big implication of it that everyone's going to have to do more homegrown? And whilst we transition for countries like the UK to be able to do more of that, we're going to have higher inflation.

21:03That's exactly right. I think what ends up on the other side of this, look, if you're India, let's take India as an example, because India is really impacted by what's going on in the Middle East right now. India has roughly 700 billion US dollars in treasuries that they kept for the rainy day. That was the rainy day fund. Well, the rainy day just occurred. It's right now. And they're looking around saying, okay, what I need is fertilizer. What I need is food. What I need is natural gas. What I need is energy. And I can't transform my US treasuries into the fertilizer that I need. Literally, India called up China because China still has fertilizer.

21:43And China said, and India said, name your price. I know you have storage. The reason China has storage of everything. China today has more oil and storage than the rest of the world combined. It has more natural gas and storage than the rest of Asia combined. It has more fertilizer and storage than the rest of the world combined. The reason China has all this is because eight years ago, the US told China, no more semiconductors. And China thought, oh my God, they can block us from this. They can block us from anything. We better store up on everything. So they stored up on everything. So China comes into this, inventory is loaded up.

22:15So now everybody, Philippines, Thailand, India is calling up China, say, can we buy some of your fertilizer? Name your price. China's like, no, mate, sorry. I'd love to help. Keep in mind because I, you know, got to take care of my own people first. And so to answer your question, the end results, whether you're UK, whether you're in India, whether you're Philippines, is you're going to turn around and say, you know what? What good are these US treasuries? What good is this stock of gold? I can't sprinkle my gold on my fields to grow food. I can't shove my US treasuries in the gas container of my car for the gas container to get going.

22:51So everybody around the world coming out of this. So even if it ends tomorrow, the reality will remain that the US no longer controls the world's waterways. And in that environment, everybody's got to build up inventories. So depending who you are, you need different things. Like Chile isn't going to build a copper reserve and Canada isn't going to build an oil reserve. They don't need it. They've got it here. On this front, Europe as an aggregate is really the main thing is we're energy deficient. That's broadly it. Like the rest of the stuff we can actually produce as an aggregate in Europe.

23:25And So the end result of this is that everybody's going to turn around and need to have much smarter energy policies. And here, this is perhaps another silver lining to this crisis, is that our energy policies in Europe have been completely upside down. I think that the crisis of Ukraine, the crisis in Iran is forcing us to review this and saying, OK, you know what? We need to do what China did, which is embrace energy in all of its form. So solar, bring it in. Wind, bring it in. Nuclear, bring it in. Natural gas, oil, coal, we're going to do it all. Today, China produces more electricity than the US and Europe combined.

24:06And the cost of electricity in China is a fraction of what we pay in Europe or even what North Americans pay. This is going to have to change. And I think it is going to change. And by the way, that's another reason to think one of the silver linings of this crisis is people will now suddenly turn to China, both Europe and the United States, and they've been pushing China away for the past eight, nine years. They're going to turn around and say, actually, you know what, China? I will have those solar panels, please, because I need them. So please send them over. You know what, China? The sub$10 ,000 electric cars that you produce, I would like them, please.

24:41Send those over. You know what, China? those cheap wind turbines, those clean coal power plants, those nuclear power plants that you produce at half the cost of France, we'll take them all. Thank you very much. We need them. So coming out of this, I think, is a much more realistic appreciation of our own weaknesses, whether in Europe and North America. I think to a large extent in Europe and North America, We overestimated our strengths. We're like, you know what? We can ramp up our cost of electricity. We can afford to have completely idiotic energy policies, and our system will cope. Turns out it won't.

25:24Let's touch then on your view on China, because it sounds like the war just doubles down on the view you've held for a while, which is that you think China is structurally undervalued. Oh, look, China comes into this crisis, I think, better prepared than pretty much anybody out there, mostly through luck, mostly through luck. Again, I think it's hard to underestimate the trauma for the Chinese policymakers of the 2018 decision to block China from semiconductors. the Chinese policymakers genuinely panicked. You see this in the bank data. It's one of my favorite charts to explain what's happened in China the past seven, eight years.

26:09If you look at bank data, at bank lending to real estate and the consumer, starting in 2018, it plummets and all the money goes to industry. What happened in 2018, when we blocked them from semiconductors, is the Chinese policymakers turned to the banks and said, guys, we need to become self-sufficient on every single industrial vertical. Because they're blocking us on semiconductors today. Tomorrow, it could be car parts. It could be tires. It could be turbines. It could be anything. They clearly want to trip us up. So we have no choice but to become self-sufficient. And so all of China's savings, which happened to be massive, it's by now a big economy and with a very high savings rate, all of China's savings were redirected essentially into building up national resiliency.

27:01And so today, and I think the crisis that ended up happening for China wasn't the crisis that they'd expected. I think the one they were expecting was that at some point the US would ramp up the import restrictions into China. So it's not the crisis they were expecting, but at least they got ready for a crisis. So coming into this, they're ready for it. None of us are. Nobody else is.

27:53Master Investor. This episode of the Master Investor podcast is brought to you by LSEG, the leading global financial markets, infrastructure, data and analytics provider. To learn more about how LSEG connects businesses, investors and markets worldwide, visit lseg.com.