One of the sources of optimism entering 2023 was that China was finally “reopening” after their long and agonizing Zero-Covid lockdown.

Not only is the China-related optimism long gone, but markets are increasingly worried about the economic situation there.

Although a lot of the news relates to a vastly overindebted property company whose bonds are trading for 35 cents on the dollar, the issues are much greater.

First, growth is slowing. Real gross domestic product is expected to be 5.2 percent in 2023 and 4.6 percent in 2024. In most economies, including our own, that would be shooting the lights out.

In China, though, that’s well below trend. Since the start of their current economic revolution in the early 1970s, built on low-cost production to the west and infrastructure buildup internally, real GDP growth was 9.3 percent.

Real GDP growth was slower in the last 10 years, at 6.2 percent, but that’s partly because the zero-covid policies lead to two years of growth between 2-3 percent. If we take those out, we could say that trend growth in the last 10 years was over seven percent.

Slower growth is leading to higher unemployment. Like GDP, the raw numbers look okay with a forecast rate of 5.2 percent in 2023, but that’s well above the 4.0 percent average for the last few decades.

And instead of dealing with inflation, the Chinese are looking at deflation. Their July data shows deflation of -0.3 percent. We keep looking at lower inflation rates, or deceleration, but not actual deflation, like they are right now.

Deflation is hard to deal with because consumers respond to lower prices by putting off purchase, which slows growth, which sends prices lower creating a vicious cycle.

The heart of the problem is twofold. As noted above, the prosperity of the last half-century was built on being a low-cost producer to the west and debt-fueled internal building on homes and infrastructure. Both of those trends appear to be at or near the end of their booms.

The low-cost production has two issues. First, wages have risen enough that there are other low-cost producers.

Second, given the covid response and geopolitical tensions related to Taiwan and a more general military build-up, western companies and countries are lowering their risk by finding other places to produce cheap goods, which fits with the first issue.

The construction boom is in trouble because there appears to be an overcapacity issue, and builders have so much debt that they can’t seem to deal with any slowdown at all without missing interest payments.

This hasn’t gone unnoticed by investors. For US dollar-based investors, Chinese stocks are down -7.0 to -8.0 percent so far this year, while emerging markets as whole are up 3.3 percent. That compares to 15.1 percent for the S&P 500, meaning that the divergence between Chinese and US stocks is more than 20 percentage points.

China represents about 30 percent of the primary emerging markets fund that we use, and emerging markets represent about five percent of our equity portfolio. If you have a 60/40 stock/bond portfolio, that means your direct market exposure to China is less than one percent of your portfolio – not something to lose any sleep over.

The bigger issue is that China’s economy is the second largest in the world, and if they have a major issue, it will impact the US economy. Fortunately, their troubles are coming at a time when our economy is outperforming expectations, which is another way that we all benefit from diversification.