China Tech Crackdown and Era of Superabundant Capital

August 5, 2021

Source: Bloomberg Source: Bloomberg

Every few years, I take my son back to China to visit family and friends. When we are there, I always want him to spend more time with my brother’s or my friends’ kids. However, it can be very hard to arrange a playdate, since parents are often busy driving their children from one tutoring class to another, leaving hardly any free time to play.

In my experience, Chinese children and parents deal with very high stress levels. The “don’t let your kids lose at the starting line” mentality has made raising Chinese children very expensive and stressful. Private tutoring companies have thrived, boasting marketing slogans like, "If you don’t let us tutor your child, we will tutor his classmates.”               

I am happy to see new regulations that target the private education industry. Three major regulations include:

  1. Private companies that teach compulsory school must be nonprofit.
  2. All tutoring related to the core school syllabus is banned during holidays and weekends.
  3. Foreign firms cannot hold shares in private education companies or use variable interest entities to do so.

As a result, Chinese parents no longer have to pay exorbitant fees for different extracurricular classes, and the kids finally have free time during weekends and holidays. This is great news for middle-class Chinese families, in my opinion.

In addition to changes in the private education industry, the government is pressuring tech firms to foster competition, raise minimum wages for gig workers and improve data security. Alibaba and Tencent have announced that they would gradually open their services to one another, while Meituan announced they would pay insurance for delivery drivers and cut fees for partner restaurants. The tech giants have learned from Jack Ma’s downfall last year.

Over the last 20 years, China has mostly emulated the laissez-faire capitalism approach of the U.S. when handling big tech companies. Now, China is taking a different stance with more state intervention. It will be very interesting to see which approach produces more innovation and benefits for society. One main reason China can afford the crackdown, and is not afraid of capital flight, is because of the current superabundance of capital.

This superabundance is apparent in the U.S. market: record valuations for equities, record tights for credit spreads, record household wealth and close-to-record lows for Treasury yields. The Federal Reserve (Fed) is the main driver behind these developments. Abundant capital has deep implications for society, corporations and investment strategies, which would be worth a separate article. Here, I will just touch on the reflexivity between capital and business.

AMC, which was on the edge of bankruptcy last year, offers one example of the impact of sudden capital abundance. The five-year credit spread of AMC had been around 20%, implying a 33% annual default rate if we assume a 40% recovery rate. Then, meme trading in January significantly boosted its share price. AMC took advantage of the massive stock rally and raised equity capital.

Now, the implied probability of default for AMC is around 13%. AMC is even in a position to acquire theaters on the cheap. The sudden infusion of equity capital has changed the trajectory for AMC and given it a chance to win big in a post-pandemic world.

The abundance of capital also drives down investment returns. For a long time, institutional investors, myself included, have been hoping for a return to a more normal investment environment with more interesting and rewarding opportunities. However, when we look at the market pricing, it is not encouraging:

  • The real interest rate is at a record low for the next 10 years.
  • Inflation over the next 10 years will be 2.4%, higher than any period over the last 15 years.  
  • The average Fed fund rate will be just 1.5% between 2026 and 2031.

The market is forecasting a very weak economy. And even though inflation will be higher than the Fed’s target, Fed policy will remain accommodative for the next several years. The combination of a weak economy and easy monetary policy is supportive of asset valuations. Under this scenario, it is not likely that asset prices will come down much, and capital will continue to be abundant. Elevated asset valuations might be here for a while.

Of course, market expectations can change, and the key driver is still inflation. If inflation proves to be more permanent and higher than the Fed’s comfort zone, we might start to see a more aggressive monetary policy response. At this moment, even though the Consumer Price Index data is strong, the market has fully embraced the Fed’s “transitory” rhetoric. In the coming quarters, I will be watching inflation data closely.      

Key Takeaway      

How to balance the power of big tech will be a challenge for all major countries in the coming years. Market pricing shows that the Fed won’t tighten monetary policy much in this cycle and capital will continue to be plentiful.

Tags: China | Technology | Federal Reserve | Credit spreads | Treasury yields | Inflation | CPI | Monetary policy

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