Democracy vs Autocracy and China’s Pending Isolation

• A new geopolitical alignment is taking place, separating democracies and autocracies.
• This is raising the cost of capital for countries that are not democracies – and driving an economic and political wedge between those countries that operate liberal democracies and those that do not.

When assessing different countries as an investment destination, favourable characteristics flow from the principle of individual liberty. Strong property rights, freedom of expression, an independent judiciary with a coherent rule of law, sound representative government that is limited in its power – all flow from the primacy of freedom. These inalienable rights are the bedrock that underpin capitalism and prosperity over the long term.

But over the last 30 years, investors had been willing to set some of these considerations aside. The primacy of individual rights receded in importance when assessing countries. Investors broadened out their consideration of jurisdictions based on low cost and growth potential.

This incoherence was possible largely because of a very slow-moving geopolitical re-alignment. During the Cold War, there was a simple dividing line between allies and enemies: a country either operated a capitalist system or a communist one, and the world was divided accordingly.

As the Soviet Union collapsed and China started embracing capitalism, the world entered a more muddled geopolitical phase. Capitalism was victorious but a new long-dated tension was created, between capitalist democracies and capitalist autocracies.

As former communist countries like Russia and China opened, there was hope that the presence of capitalism would lead these countries towards democracy. In the early years, investment returns in these countries were high. Investors were willing to run the risk of investing in autocratic systems because the returns were high enough to compensate for the risks – and if countries embraced democracy all the better – returns would rise even further.

In recent years, the hopes of autocracies moving toward democracy have been dashed. This has occurred at the same time as the growth rates and return profiles of these countries have declined. The upside has been reduced, or removed completely, yet the risks of investing in these jurisdictions never went away. Insecure property rights, corrupt judiciaries, heavily curtailed freedom of expression, all remain giant headwinds to long term returns.

As these investment realities become more obvious, a new geopolitical alignment of the world is taking shape. The dividing line is as simple as it was during the Cold War, but instead of capitalism vs communism, it now appears to be democracy vs autocracy.

This separation of the world may well have been pre-ordained, but it has been put into sharp relief by the war in Ukraine. No democracy with a free press could pursue this war. International investors in Russian assets were wiped out in a matter of days. It turned out that the appropriate discount rate for Russian investments was 100%. And the foundations of Russia’s strategic blunders lay in authoritarianism.

As this geopolitical alignment becomes sharper and clearer, investors are rightly questioning the safety of their investments in other autocracies, in particular China. Markets have increased the discount rate on Chinese assets significantly in recent months. The more authoritarian China appears, the higher the discount rate and the lower the valuation of Chinese assets.

It is easy to fall into the trap of applying economic logic to authoritarian regimes. Russia was not assumed to invade Ukraine because it would be so damaging for their economy and to Russian living standards. Similarly for China: their exports to Russia amount to just 1.95% of the total. Their exports to western democracies amount to 70%. There is no economic logic in aligning with Russia. Chinese prosperity can only be damaged by this support. And yet China has announced its friendship “without limits.”

By supporting Russia, China is choosing to accelerate its isolation from the west, which in turn is a choice to be less prosperous.

Below we show global GDP by political system. We use the Economist’s Intelligence Unit’s Democracy Index to classify countries. They have four classifications, full democracies, flawed democracies, hybrid regimes and authoritarian regimes. In the pie chart below we have combined both flawed and full democracies.

 

Global GDP by Political System

China and Russia dominate Authoritarian GDP, making up nearly 80% of it. The remainder of note include Saudi, Iran, the UAE, Iraq, Egypt and Vietnam. Hybrid systems are dominated by Mexico, Turkey and Nigeria. This segment also includes Hong Kong and Bangladesh.

It does not require great foresight to see that in a world that bifurcates between democracy and authoritarianism, one side is set to lose. With capital flows and trade concentrated in democracies, the outlook for western economic growth and living standards will be boosted, whilst flows will dry up for authoritarian regimes and reduce their economic potential. This trend would also be self- reinforcing.

So why do some countries take an increasingly authoritarian path at the expense of living standards? The most simple explanation is likely due to radically different incentives. In democracies, legitimacy can only be delivered over the long term by competence and prosperity. But the central focus of authoritarian regimes is not prosperity, but the continuation of the regime itself.

Over the last two decades the Chinese Communist Party has been able to achieve some domestic legitimacy based on its competence in managing the economy and lifting growth rates. China was raising living standards faster than in other countries and so there was no obvious challenge to their control or approach.

But the Chinese economic model of subsidised exports is running out of road. Resource scarcity from agricultural land, to water, to minerals and energy is a major strategic headwind*. Severe demographic weakness is starting to bite. Leverage is high. The Chinese trend growth rate is now low and raising living standards will be difficult this decade. The Chinese Communist Party is not going to be able to achieve much legitimacy through economic outcomes in the coming years.

This weakened economic backdrop raises the incentive of the Chinese regime to become more authoritarian to stifle domestic dissent, and to find an enemy abroad who can be blamed for these weak outcomes. Russia has already acted on the same principle. Russia’s terrible demographics and kleptocracy guarantee bad economic outcomes, and so Russia needs a permanent enemy to blame for their regime to survive.

What does this mean for markets?

Whilst the market is already starting to handicap these risks in locally listed assets, there is not much of a valuation discount for companies with high revenues coming from China.

In the Lightman European Funds we have some holdings with revenue sourced from China, but our exposure is low and has been reduced in recent months. These reductions were largely driven by company specific reasons, but we are now imposing a higher cost of capital on Chinese revenue in our valuations. This does not mean China is completely off-limits, but it does mean we are applying a higher risk profile and a lower valuation to Chinese sourced revenue. We would also believe it to be a mistake for companies to expand investment in the country, unless the political direction changes.

One reason why the fund’s exposure to China is relatively low is because of our zero weight to the Luxury Goods and IT sectors. We believe both sectors are significantly overvalued. China dominates global luxury and IT demand. Western technology companies tend to have deeply integrated supply chains in China which would be extremely complex and expensive to unwind. A process of re-shoring is slowly beginning, with companies like Intel starting to shift supply chains back to the west, but this will take years to complete. Our zero weight to IT and Luxury has helped our funds’ relative performance in recent months and we expect this to continue.

This scenario of a new international alignment becomes difficult to assess with respect to commodities. The Lightman European Funds have exposure to companies in the commodity sectors, where we see low valuations and strong earnings growth. Commodities are obviously fungible and largely essential for economies to function. China remains an important player in these markets, both on the demand and the supply side. This new world order may provide upside risks to materials where China is a large exporter, but a lower trend growth rate for China will also impose downside risks where China is a large consumer. Our funds are focused on holding businesses selling materials where the supply demand balance can benefit from these geopolitical developments.

Supply chains and ESG accelerating change

Beyond the earnings and discount rate perimeter, we could expect this new alignment to impact globalisation and supply chains. When companies are looking to make investments abroad this decade, they are more likely to invest in countries that are established democracies with acceptable records on human rights.

ESG is likely to become an agent in this change. To date, ESG considerations have largely been bound to the corporate sphere. Companies have been viewed as islands and assessed by their own internal performance. But this boundary is now beginning to break down. The jurisdiction where companies operate is beginning to matter, irrespective of the profit opportunity.

Companies with operations in Xinjiang where the Uyghur population are based have faced significant pressure in recent years. Nike, Coca Cola, Apple, Adidas, H&M and others have been caught in the crosshairs of the Uyghur Forced Labor Prevention Act, signed into law in the United States on December 23rd 2021. Global multinationals and investors take on great risk by doing business in this part of China.

Xinjiang is China’s largest province, representing over 17% of the country’s landmass. It produces significant quantities of cotton, polysilicon, sugar and coal. The production and industry of this province is obviously deeply intertwined with the country as a whole. It is extremely complex for investors to determine whether the sourcing of materials used in Chinese factories outside of Xinjiang have come from that region.

With 17% of the Chinese landmass off limits, it is realistic to raise questions about the viability of doing business in the country as a whole. Whilst it is premature to make a judgement today, it is conceivable that we will reach a point in the future where doing business in China, will by itself, reduce the quality of a company’s ESG status. The more authoritarian China appears to the west, the faster this re-categorisation will take place.

Inflation from the supply side

Investors are accustomed to analysing inflation from the demand side. Here it is natural to assume higher interest rates will break the back of demand which in turn breaks inflation. But a lot of today’s inflation is from the supply side.

China’s steady decoupling from the world economy is inflationary. New supply chains are causing bottlenecks with higher costs of production and delivery. This is likely a multi-year story.

Paul Volcker was credited with breaking inflation in the early 1980’s with aggressive rate hikes. But a large part of inflation’s decline was from the supply side. Major oil exploration investment in the North Sea, the Gulf of Mexico and the Alaskan North Slope all started in the mid 1970’s. These investments led to a surge in oil supply that arrived in the early 1980’s, which caused the oil price to more than halve between 1980 and 1986. Volcker is credited with inflation’s collapse, and no doubt played a large role, but the supply side was likely as important.

Today’s geopolitical re-alignment puts upside pressure on inflation from the supply side and so rate hikes may not be as effective until the supply side responds.

Investment Action

Whilst this note predicts continued geopolitical disruption, there are investment approaches that ought to be able to navigate this scenario.

• The jurisdiction where companies operate is set to matter more. It is prudent to be cautious of companies with heavy exposure to autocratic regimes.
• Higher rates and sustained inflation are likely. This continues to council for a value bias as the best protection against losses.
• Highly valued securities of any type are vulnerable. Investors should focus on free cash flow today and not free cash flow that may or may not materialise in the future.

Whilst the demarcation of this new world order is perilous, a more sharply defined separation of economic prosperity and investor flows has the potential to push countries down the reform path. In the last decade, there have been limited penalties paid by countries pursuing authoritarianism. This has led to badly misplaced confidence from the world’s dictators. But the sands are now shifting. Over time, an alignment of capital flows with western values has the potential to promote and expand democracy and individual rights significantly.

The LF Lightman European Fund has a median PE ratio of 9.3, a price to book of 1.2 and a price to sales of 0.8. The fund’s weighted dividend yield in 2022 is 4.8%. Our holdings have strong balance sheets with 30% of our non-financial holdings with net cash and over 60% with net debt to ebitda of less than 1x.

Whilst we are nervous about equity index performance over the coming years in many geographies, we believe the LF Lightman European Fund can still generate positive absolute and relative returns this year and in the years ahead.

Sources:
Foreign Affairs, Michael Beckley, Hal Brands, Odd Arne Westad, Stephen Kotkin, S&P Global Platts, Jeff Currie, Economist Intelligence Unit, Bloomberg, Lightman Investment Management

*Unrivalled by Michael Beckley, Cornell Studies in Security Affairs