Month: January 2025

China’s economy grew by 5% in 2024, which was exactly the target announced by the government at the beginning of the year. The 2025 target will be announced at the annual Two Sessions conference in March and, no doubt, confirmed at the start of 2026. Though these growth numbers are dutifully parroted by the IMF and the World Bank, they cannot be compared to the GDP data provided by most countries. While GDP is normally calculated post facto based on measures of output, in China it is presented ex ante as political guidance for economic agents, most importantly banks and local governments. In China, this is made possible by the overwhelming power of the central government and the Communist Party. Since the end of China’s Economic Miracle (1986–2010), this system has become increasingly divorced from market reality because resource allocation has been made more challenging by declining productivity growth and worsening returns on capital investments.

China’s post-miracle growth since 2010 has been accompanied by an enormous increase in debt levels. As shown in the chart below, China’s debt-to-GDP ratio has nearly doubled since 2010, mostly to fund infrastructure projects with rapidly declining returns. The current ratio reported by the Bank for International Settlements (BIS) is probably significantly understated because China’s GDP has been arguably overstated over the past decade by some 20–30%.

Large infrastructure investments made in China decades ago led to enormous increases in productivity, which enabled China’s “economic miracle.” On one of my first visits to China in 2000, I drove on a newly built 100-mile highway linking Shanghai to Hangzhou. It was an eerie experience: the road was entirely deserted. Today, this is one of the busiest highways in the world. That same visit, a train ride the 650 miles from Shanghai to Beijing took 16 hours. Today, 240,000 people every day make the same trip by bullet train in about four hours. That same year, Shanghai had three bridges crossing the Huangpu River, which divides the city. Today, there are 24 structures crossing the Huangpu, providing Shanghai with world-class infrastructure on par with Paris, London, or New York- cities that built most of their infrastructure by the 1930s. :

This kind of highly productive investment in infrastructure took place all over China from the mid-1990s until around 2010, accompanied by the greatest process of urbanization the world has ever seen. These kinds of investments are one-time effort that cannot be replicated. Over the past decade, quality infrastructure projects have become scarce, but that doesn’t stop politicians from churning out more highways and bullet trains with dubious utility.

Below, we review a few examples that characterize the nature of infrastructure spending in China today, many of which are trophy projects driven by politicians and the enormous construction/engineering lobby.

High-Speed Rail Expansion

China State Railway (CSR) has ambitious plans to expand its high-speed rail network from 30,000 miles today to 37,500 in 2030 and 45,000 in 2035, mostly into sparsely populated regions. To put this into context, the rest of the world has 9,200 miles of high-speed rail (almost entirely in Europe and Japan), and current plans are for an additional 800 miles by the end of the decade. CSR has spent $500 billion over the past five years and accumulated one trillion dollars in debt. Returns on investment have plummeted, amid reports of empty trains and stations.

Airports, Dalian Jinzhouwan International Airport

China increased airport capacity by 45% over the past five years. The latest five-year plan (2026–30) calls for 140 new airports, to be located mainly in China’s sparsely populated Central and Western regions. Located off the coast of Dalian in Liaoning province, the Dalian Jinzhouwan International Airport is being constructed on a 21-square-kilometer artificial island, making it the world’s largest offshore airport upon completion. The project includes four runways and a terminal designed to handle up to 80 million passengers annually. Dalian is a moderate-sized provincial city with a population of 5.5 million, which already has an airport with a capacity of 20 million passengers annually.

Eco-Cities Initiatives

The Xiong’an New Area is an enormous urbanization project sponsored by Xi Jinping that showcases “Xi Jinping Thought” concepts, such as “ultimate Chinese modernization” and “high-quality productive forces.” The aim is to build a green, highly livable, and innovative “city of the future” with a “noble character and artistic temperament.” $200 billion will have been invested in Xiong’an by 2027, not including the expense of expropriating 124 square miles of prime farmland 60 miles south of Beijing. The city is a creation of bureaucratic urban planning with minimal participation of private interests. Though many government agencies are being forced to move to Xiong’an, their employees may not follow to what is characterized as a “ghost town.”

Solar

China is building a vast ‘Solar Great Wall’ that will power Beijing with green energy. Located in the Kubuqi Desert in Inner Mongolia, known as the Sea of Death, the project, expected to be finished in 2030, will be 400 kilometers (250 miles) long and 5 kilometers (3 miles) wide, and achieve a maximum generating capacity of 100 gigawatts, enough to meet the energy needs of Beijing. This project alone would represent 70% of the current capacity of the U.S. The project may be a godsend for China’s beleaguered solar panel manufacturers, which, incentivized by government subsidies, have invested $50 billion from 2011 to 2022 to bring capacity to 1,200 gigawatts, double total global demand in 2024.

 

Emerging markets underperformed the S&P 500 in 2024, extending a long losing streak. This marks the seventh consecutive year of underperformance and the thirteenth in the last fifteen years. Only Taiwan and Argentina (actually in the Frontier Market Index) managed to outperform the S&P 500 .

The U.S. market appears to be experiencing a blow-off rally, fueled by a broad consensus on an immaculate soft landing for the U.S. economy and optimism about AI-driven productivity growth. The U.S. market is also benefiting from a remarkable expansion in profit margins, driven almost exclusively by the “Magnificent Seven” technology giants, which is reflected in high expectations for earnings growth in 2025.

The strength of the S&P 500 can be attributed to two factors: first, a remarkable decade-long expansion in profit margins, of which about 60% was caused by lower interest rates and globalization, two trends that are now clearly in reverse; and second, an expansion of earnings multiples, which has brought valuations to extremely high levels on most measures.

The valuation premium of the S&P 500 over the MSCI EM Index closed the year at high levels, surpassed only by the 2016–2018 and 1998–1999 periods. The rising valuation premium over the past three decades may reflect the U.S. market’s transition from one dominated by capital-intensive cyclical businesses to one dominated by capital-light companies with persistent and rising monopolistic profits. Unfortunately, this transition has not taken place in emerging markets, except for a while in China until Chairman Xi squashed the tech sector to “safeguard social harmony.”

Earnings growth has been the main driver of the S&P 500’s outperformance relative to emerging markets over the past ten years, as shown below. From the inception of the MSCI EM Index in 1986 until 2014, earnings growth was similar in both markets, but a dramatic split occurred from that point on. While emerging markets have been in a prolonged earnings slump, S&P 500 earnings have surged since 2014, largely due to the spectacular margin expansion of the tech giants. Although the strong dollar has contributed, it accounts for only about 20% of the relative outperformance. Thus, the key question for investors is: How much longer can the “Mag 7” phenomenon continue?

The chart below estimates the current expected returns for emerging markets and the S&P 500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings (CAPE) ratio, which calculates the average of inflation-adjusted earnings over the past ten years, helps smooth out earnings cyclicality. This tool is especially useful for highly cyclical assets like emerging market stocks and has a long history of use among investors, gaining popularity more recently through the work of Professor Robert Shiller at Yale University. We use dollarized data to account for currency trends, and the seven-year expected returns are calculated assuming each country’s CAPE ratio will revert to its historical average over time. Earnings are adjusted according to each country’s position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (October 2024).

As logic dictates, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those with CAPE ratios above their historical average. These expected returns are based on two key assumptions: first, that the current CAPE levels relative to historical averages are unjustified; and second, that over time market forces will correct the discrepancy. Historical data strongly supports the second assumption over seven- to ten-year periods, though not in the short term (one to three years). The model may give a false signal if a country’s historical CAPE average is out of sync with its current growth prospects. For example, one could argue that Chile’s current growth prospects do not justify its historically high CAPE ratios. The same may be true for the Philippines.

The following chart shows country returns for 2024 in relation to which markets had the highest 7-year expected returns at year-end 2023. Of the markets with high long-term expected returns, only Peru and Turkey currently have good momentum characteristics. The chart shows that the CAPE ratio was not predictive of performance returns over this period, as is frequently the case. Over one to three-year time frames, momentum, narrative, liquidity, and cyclical conditions have a much greater impact on performance than long-term valuation parameters. Nonetheless, when “cheap” markets on a CAPE basis exhibit short-term outperformance (one year or less), investors should take note, as the combination of value and momentum is compelling.

Looking ahead, Peru and Turkey may be well-positioned to perform over the next year, as they offer both cheap valuations and momentum and are in the early to middle phases of their business cycles. However, rising geopolitical tensions and sluggish global growth create an unfavorable investment environment. As always, a strengthening dollar indicates the need to remain focused on dollar-denominated quality assets.