Imbalances persist, but the geopolitical and economic context has changed.

Ahead of the Washington Summit on Thursday where Xi Jinping and Donald Trump will meet face to face, Christy Tan, Senior Investment Strategist, Franklin Templeton Institute notes that the global economy has entered a new phase.

“The familiar early 2000s configuration of China as the world’s capital expenditure engine and the United States as the world’s consumption engine has inverted.^[1]

“The central investment implication is straightforward: the next stage of global imbalances favours assets tied to productive capacity in deficit economies and domestic absorption in surplus economies. The US must build, and China must consume. The investors who recognise that inversion, and who remain disciplined about valuation, policy risk, and geopolitical uncertainty, will be better positioned for this new regime,” says Tan.

The early 2000s world was built on a powerful complementarity. China produced; America consumed. China saved; America borrowed. China accumulated reserves; the US supplied safe assets. China built factories, cities, ports, roads, railways and housing; US households absorbed the output through rising leverage, expanding housing wealth and strong real consumption.

“This system was imperfect and ultimately unstable, but for a period it generated strong corporate profit opportunities on both sides,” she adds.

In the United States, retailers benefited from cheap imported goods and expanding consumer purchasing power. Housing related firms benefited from lower rates, mortgage credit creation and rising home prices. Consumer finance firms benefited from rising leverage. Autos, media, restaurants, apparel, logistics and import distribution were all tied to the strength of domestic demand.

“The US was the world’s consumer of last resort, and its equity market reflected that role. In China, the dominant themes were buildout and scale. Urbanisation created extraordinary demand for housing, cement, steel, glass, copper, power, heavy machinery, construction services, rail, ports and banks. World Trade Organisation accession opened global markets to Chinese producers, while internal migration supplied labour and coastal provinces became export platforms.^[2]

“In that environment, capital expenditure was not a symptom of excess; it was the foundation of productivity growth. China’s corporate winners were often those that supplied, financed or executed the buildout.

“That world was held together by globalisation, relatively benign geopolitics, expanding trade and a broad assumption that economic integration would deepen over time. External imbalances were large, but they were embedded in an integrating system. The US–China imbalance was not only a macroeconomic condition; it was the operating model of global growth.”

Tan says “The current backdrop is very different. Imbalances persist, but the geopolitical and economic context has changed. The world is no longer organising around maximum efficiency, open ended integration and low cost production. It is increasingly organising around resilience, security, redundancy, strategic capacity and political alignment. Tariffs, export controls, sanctions, investment restrictions, industrial policy, defence spending and supply chain diversification have moved from the periphery to the centre of economic policy.

“That shift matters because global imbalances are no longer housed within a cooperative globalisation regime. They are now housed within a competitive geopolitical regime. The old pattern was fragile because it relied on leverage and excess demand. The new pattern is fragile because it relies on a deficit country with fiscal strain and a surplus country with weak household demand and excess productive capacity.”

She adds “The United States remains a consumption powerhouse, but the marginal opportunity has shifted. The consumer is still large, but the most important investment question is no longer how much more the household sector can borrow and spend. It is whether the US can convert domestic and foreign capital into productive capacity. Several constraints define the new US opportunity set like the digital economy has become physical, electricity has become strategic and industrial capacity has regained political value. Defence and national security have become structural growth markets. The US defence industrial base is being asked to support deterrence in Europe, the Indo Pacific, the Middle East, cyber space and outer space. The opportunity extends beyond prime contractors to suppliers of electronics, propulsion, shipbuilding, drones, cybersecurity, satellite systems and dual use technologies.”

The important point is that the US opportunity is now less about final household demand and more about capital deepening. The investable question is: which firms help the US overcome constraints in compute, power, labour productivity, supply chain resilience and national security?

“China faces the opposite challenge. For many years, capital formation was the correct investment lens. The country needed roads, ports, housing, power plants, factories, airports, urban transit and industrial capacity. The corporate opportunity was linked to the physical transformation of the economy.

“But the very success of that model has reduced its future return. China is no longer structurally underbuilt in the way it was in the early 2000s. It remains capable of world class infrastructure and manufacturing execution, but broad investment led growth now faces diminishing returns. Property investment has softened, and local governments face sizable debt burdens. Capacity growth in several sectors has outpaced domestic demand.^[4] Exports remain strong in many advanced manufacturing categories, but that strength increasingly generates trade friction abroad.

“The result is that China’s sustainable opportunity set has shifted toward consumption and services.

“The China opportunity is more conditional than the US capex opportunity. US productive investment is already visible in data centres, semiconductors, defence budgets, power demand, and industrial policy. China’s consumption transition requires policy support. It requires a willingness to shift resources from producers to households, from local government investment to social welfare, and from export competitiveness to domestic income growth. That is economically sensible, though it involves complex structural and institutional coordination across multiple levels of government.”

Tan says “This distinction is crucial for investors. The reversal is clear, but not symmetrical. In the US, the capex opportunity is active, observable, and increasingly consensus. The risk is valuation, concentration, and execution bottlenecks.  In China, a potential recovery in consumption presents a different opportunity set, supported by attractive valuations and improving sentiment. The key consideration is the pace and extent of policy support and whether it translates into a sustained recovery in household demand and consumer confidence.

“China can still produce compelling opportunities in advanced manufacturing, batteries, electric vehicles, automation, robotics and industrial technology. But those are not the same as the broad capex story of the early 2000s. They are more selective, more exposed to tariffs and export controls, and more dependent on technological upgrading than on catch up urbanisation. The broad macro opportunity is no longer China builds but it is China rebalances.”

——-

Notes:
[1] Dollar, D. (2014). Sino shift. Finance & Development. International Monetary Fund.
[2] World Bank. (n.d.). Four decades of poverty reduction in China. Open Knowledge Repository.
[3] International Monetary Fund. (2024). Changing global linkages: A new Cold War? (IMF Working Paper No. 24/76).
[4] International Monetary Fund. (2024). People’s Republic of China: 2024 Article IV consultation (IMF Country Report No. 24/258).

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China is well-positioned to meet the challenges that new technologies, climate change and a stagnant pool of labor pose.

For most of the past 40 years, investors, policymakers and interested observers have become used to the idea of China as a fast-growing, emergent economy, well on its way to achieving middle-income status, with every hope of continuing along a path of resounding economic success.

Recently, however, a different story has surfaced. This one portrays China as stumbling badly, weighed down by long-term challenges related to excess debt and investment, an aging population, the end of globalisation, and the adoption of policies inside and outside China that may frighten off investment and consumption.

In a new recent paper uncovering China, Christy Tan, Investment Strategist at the Franklin Templeton Institute says “In our view, the truth about China is neither as optimistic as some had earlier believed, nor as pessimistic as is currently fashionable. Rather, the central narrative is one of China in transition. China is shifting from an economy underpinned by extraordinarily high and probably unsustainable rates of savings, investment and debt accumulation to something else.

“Such a transition is not easy, but it is also not unusual. At similar stages of their development, other countries, including the United States, Japan and various successful East Asian economies, witnessed something similar.

“Whether investing in China directly or into themes that are linked to China’s economic prowess, the set of opportunities and risks related to China investment strategies is fundamentally shifting. What has worked in the past may not be so fruitful going forward. But fresh opportunities are also arising.

“In short, pessimism that China might get stuck in a middle-income debt trap appears exaggerated. China faces challenges but has extraordinary potential. It has a dynamic and innovative private sector, access to skilled labor, and is well established in the global trading and financial systems. Its odds of overcoming its challenges are greater than many think.

“During China’s rapid ascent into the world economy in the 1990s and early 2000s, the prevailing investment wisdom could be summed up as “buy what China buys, sell what China sells.” China’s voracious appetite for energy and raw materials, underpinned by rapid industrialisation and urbanisation, meant that investors could happily seek out opportunities in global mining and energy production.

“China’s increasing dominance of low value-added manufacturing meant that global investors shunned those same industries in the West on account of low-cost competition.

“Selling to the increasingly affluent Chinese urban middle class was another favored strategy. European and US consumer brands coveted brand-conscious Chinese consumers, with investors in hot pursuit.

“Going forward, the investment landscape will likely change, in our view. A China in transition away from investment encumbered by mounting loan losses is unlikely to see the rapid growth rates for basic materials, other commodities and energy.

“To be sure, China’s absolute levels of demand probably won’t fall off a cliff, but the period of rapid growth has already come to an end. Similarly, as Chinese consumers become more sophisticated and,  like higher income households worldwide, shift their preferences to services, brand buying habits will switch.

“As overall consumption rises as a share of GDP and as the consumption of services becomes more important, growth opportunities will become more apparent in sectors such as insurance, wealth and asset management, pension services, education, travel, personal care and new commerce.

“Similarly, business spending needs are shifting. Bricks, mortar, glass, steel, and heavy machinery will remain in demand, but are unlikely to be high growth areas. Instead, business services including consulting and financial advisory services, information technology, AI, big data analytics, and the design and implementation of robotics are areas where investors should anticipate higher growth. In short, there is every reason to believe that China remains an investment opportunity, both within China and with companies that offer products and services that address China’s shifting spending habits.

“China’s growth disappointments in the past five years have understandably raised questions about its long-term economic dynamism. Some of that is mere extrapolation of the recent past into the future.

“But it is also true that China is confronted with a multi-year adjustment to a misallocation of resources in property construction, with a corresponding increase in bad debt. Unwinding those excesses is apt to be a drawn-out process, one that may act as a drag on domestic growth for years. The slowing pace of globalisation and a backlash against China’s exports (as well as restrictions on high-tech exports to China) are further hindrances to growth

“A China in transition away from investment encumbered by mounting loan losses is unlikely to see the rapid growth rates for basic materials, other commodities and energy.

“But the underlying dynamism of China’s domestic economy remains intact. Gone are the days where Chinese entrepreneurs produce based on global demand and trends but are now trend leaders. It has and will continue to spur innovation and create new growth and investment opportunities.

“It is likely that government policy will aim to boost consumption’s meagre share in national income. Chinese consumer fundamentals, needs, and tastes continue to evolve. Accordingly, China is likely to offer astute investors fresh and exciting avenues for growth.

“Equally, investors must also adjust to new realities. Global investors are emphasising the importance of being on the ground with the right partners to navigate the rapid changes and identify the right opportunities.

“Owing to its sheer size, legacy imbalances, an aging population and slowing globalization, it’s unlikely China’s economy will return to its high growth era of past decades. Just as important, the sources of growth will shift away from what worked (construction, infrastructure, expansion of large-scale, low value-added manufacturing) into new areas of innovation, healthcare, renewable energy and industries that serve the local consumers.

“Given China’s considerable engineering skills, its access to global markets, finance and know-how, its dynamic domestic sectors economy, we believe it is well-positioned to meet the challenges that new technologies, climate change and a stagnant pool of labor pose.”

The Franklin Templeton paper considers the following scenarios in detail:

• The middle kingdom evolution: What’s shifting beneath the surface?
• Decoding China’s success
• China’s hurdles: unmasking major challenges
• Unleashing the dragon: Exploring opportunities
• How should investors judge opportunities and risks in China?

Read the paper.

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