China’s meteoric rise to a global economic powerhouse appeared unstoppable until it stopped. Now, with deflation looming and an economy in shambles, other asset managers are scrambling for an explanation of these newly discovered China risks—risks that we at Strive Asset Management have been alert to since our founding.
All that may be true enough. But it misses the bigger picture: The same macroeconomic factors that led to China’s rise are now the cause of its fall. U.S. investors should consider portfolios that appropriately mitigate the risk of Chinese investments.
According to the Cobb-Douglas production function, economic output comes from three inputs: labor, capital, and what economists call total factor productivity (TFP). TFP can be thought of as how efficiently labor and capital can be utilized, usually through technological innovation. TFP is what sets countries apart. While labor and capital are relatively commoditized, TFP is often considered the primary contributor to gross domestic product (GDP) growth. It’s what allows countries such as the United States, which has never been more than a 10th of the world’s population, to consistently contribute upward of one-third of global GDP.
China’s rising prosperity, in turn, fueled investment. Western societies and their often state-backed pension systems began to supply billions of dollars in investor capital.
Since the Cultural Revolution, China has been unable to develop technological advancements on its own but has supercharged its raw production potential by imitation or, in many cases, outright intellectual property theft. Most of China’s largest businesses—such as Tencent, Alibaba, Baidu, and Luckin Coffee—are knockoffs of innovations developed elsewhere. These Chinese businesses only exist because of Western capital, Chinese Communist Party (CCP) protectionism, and internet censorship, which shields these imitators from their more nimble international competitors.
In 2023, China’s population dropped below that of India, meaning it is no longer the world’s most populous country—a title that it is unlikely to regain. The declining labor force threatens China’s position not only as a global producer but also as a global consumer. Multinational companies will no longer be lusting over China’s consumer base, willing to set common sense and business judgment aside for a chance to open shop.
Then there’s TFP. China’s aggressive intellectual property theft has become so bold that Western governments and companies have begun to take note. The Biden administration is restricting our most advanced artificial intelligence hardware exports to China. A diminished Chinese economy also means less leverage to demand that U.S. companies form joint ventures or hand over technical information as a condition for doing business there. A mass exodus of Western companies means less technology to steal.
China cannot replace the stolen innovation on its own. By design, the country lacks the individual liberty, economic freedom, and profit incentive required to create the innovation that has driven most of the economic growth in the modern world.
China’s rise to become the second-largest economy over the past roughly half-century is an impressive accomplishment and a testament to the power of even the smallest improvements in economic freedom. However, the CCP’s tight grip on the factors of production is increasing the risk of China’s investment while also sowing the seeds for its economic decline. U.S. investors should take note.