Tag: China

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How tariffs could break America

“To me, the most beautiful word in the dictionary is tariff….it’s my favorite word.” ~ Donald Trump, October 2024

Americans’ experience with tariffs is mixed. The Smoot-Hawley tariffs of the 1930s prompted retaliatory tariffs and trade barriers from trading partners, causing a collapse in international trade that badly hurt US manufacturers. The tariffs were misguided because, at the time, the US ran large trade surpluses, which made it vulnerable to retaliation.

Now the US runs large trade deficits, of between $60 and $100 billion per month, which makes it far more difficult for trading partners to retaliate effectively.

US Monthly Trade Deficit (billions)

Stephen Miran, Trump’s nominee for chairman of the Council of Economic Advisers, wrote a 40-page “job application” in October. In it, he praises Trump’s past performance with tariffs in 2018 and proposes restructuring the global trade system. However, misguided use of tariffs could damage the US.

Miran proposes implementing import tariffs, mainly targeting those trade partners that run large trade surpluses with the US, notably China. China’s global trade surplus has expanded to more than $100 billion per month, and a large percentage of this trade is with the US.

China: Monthly Trade Surplus

Import Tariffs

A tariff on imports will likely provoke two main responses: retaliatory trade barriers and a stronger Dollar.

Retaliation

We can expect trading partners to erect trade barriers to target politically sensitive industries in the US. In the 1930s, Europe responded with import restrictions on US automobiles, hurting the Ford Motor Company. Nowadays, China will likely restrict exports of critical materials in markets it dominates—like germanium, gallium, and rare earth elements—targeting semiconductors, electric batteries, and defense technologies. Another Chinese favorite is tariffs on agricultural imports like soybeans, targeting mid-west farmers. Electric vehicle imports are another obvious target, particularly Tesla because of Elon Musk’s proximity to the president.

Tesla (TSLA) has fallen 39% from its high in December.

Tesla (TSLA)

The Dollar

The Dollar will likely strengthen if trading partners do not retaliate against increased tariffs. A stronger Dollar will tend to offset the cost of the tariff to consumers, as in 2018-2019, when the Yuan weakened markedly against the Dollar.

Yuan per US Dollar

The result was that the US current account showed little benefit from the 2018-2019 tariffs.

US Current Account Deficit

To the extent that the exchange rate adjusts to absorb the effect of the tariff–so that the Dollar price of the imported goods does not change–the tariff is effectively a tax on the foreign exporter. However, the cost incidence is not that straightforward.

Cost Incidence

A central argument for tariffs is that the exporter, not the US consumer, bears the cost. However, it’s not that simple.

Miran cites a 2019 NBER paper by Cavallo, Gopinath, Neiman and Tang which found that the dollar import price increased by the amount of 2018-2019 tariffs, and that appreciation of the Dollar did little to offset this. “The move in the currency didn’t pass through into import prices.”

Pass Through of Tariffs to Import Prices

While Miran is correct that there may be longer-term adjustments, the study makes an important distinction. US producers responding to retaliatory tariffs on their exports were forced to bear a large percentage of the cost. Export prices for affected goods (red below) fell sharply relative to exports without tariffs (blue).

Affect of Retaliatory Tariffs on Export Prices

The difference is that US agricultural exports were a non-differentiated product with ready substitutes. China imposed a tariff on US soybean imports, comfortable in the knowledge that importers would increase orders from alternative suppliers like Brazil. So US farmers were forced to cut prices to compete.

The tariff cost for differentiated products, with no ready substitutes, such as high-level semiconductors and equipment, is far more likely to be borne by the customer.

Weakening the Dollar

Miran recognizes that the strong Dollar will harm exports and speculates that strategies could be employed to weaken the Dollar. However, that would increase the cost incidence on the consumer.

Efforts to weaken the Dollar would likely undermine its role as the global reserve currency and accelerate the migration of foreign central bank reserves to gold bullion as a reserve asset.

There are three likely negative consequences. First, a falling dollar would reduce foreign support for US Treasury markets, driving up long-term interest rates that would hurt financial markets and the economy.

Second, discouraging direct foreign investment in US financial markets—by tearing up tax treaties, for example —would cause an outflow from mega-cap technology stocks, Treasuries, and other key foreign investment targets. The result could crash financial markets and the economy.

Third, printing Dollars to buy assets in a sovereign wealth fund or other strategies that involve increased fiscal spending are likely to fuel an increase in inflation.

Weakening the Dollar may also involve lowering US interest rates vis-a-vis trading partners. However, this assumes that foreign central banks will not respond in kind and that the Fed will cooperate, ignoring the inflation risk.

Re-industrialization

The aim of tariffs is to create a favorable environment for establishing new industry. However, there are many barriers other than the price of competitive imports.

First, you need a skilled workforce with the education and training required to run new factories. Companies establishing semiconductor foundries in the US, for example, under President Joe Biden’s CHIPS and Science Act, have encountered skills shortages. (The Economist)

Then you need infrastructure. ALCOA, the largest aluminum producer in the US, relocated smelters to Canada because of advantageous electricity costs. CEO Bill Oplinger says the increased tariffs would not entice it to return. (Reuters)

You also need to secure the key materials required to support new industries, whether bauxite to supply aluminum smelters, copper for EVs and turbines, or critical materials–like gallium, germanium, and rare earth elements– for high-tech industry. China has spent the last two decades tying up supply contracts, and the US is a late arrival to the party.

Conclusion

Tariffs on imports will likely provoke retaliatory tariffs from trading partners, which could harm international trade and exact a cost on both economies. The US is in a strong position because of its large trade deficit; so it can inflict greater damage on its competitor. However, we should not ignore other forms of retaliation like restricting access to critical materials, where there are no ready substitutes, and erecting other trade barriers that impose a cost on US exporters.

Under no circumstances should tariffs be placed on imports of goods where there is no readily-available substitute. The US consumer will bear the cost.

The Dollar will also likely strengthen in response to US tariffs on imports, which could partially offset the cost of the tariff to consumers. However, a strong Dollar will reduce the competitiveness of US manufacturers in export markets. Miran speculates that the US may be able to offset this by policies to weaken the Dollar. But you can’t have your cake and eat it too.

Efforts to weaken the Dollar could also undermine its role as the global reserve currency, crash financial markets and the economy, or cause a resurgence of inflation. If not all three.

A strategy to re-industrialize the US economy requires a holistic approach. First, ensure that you build up the necessary skills and resources through a comprehensive education and infrastructure program and secure supplies of key materials. Then, progress to the next stage of establishing the groundwork for a new global trade and currency accord. Ignoring the first stage is like putting the cart before the horse.

An impatient president has surrounded himself with a team unlikely to oppose him. Developing a program to re-industrialize the economy will require skill, patience, and meticulous planning. It could take the better part of a decade, but that seems unlikely to happen.

Acknowledgments

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Threat of a US-China trade war boosts gold

Donald Trump’s reversal on tariffs on Canadian and Mexican imports caused a sharp rebound in the S&P 500. However, tariffs on Chinese imports remain in place and have elicited a response from the Middle Kingdom.

Stocks

The S&P 500 retraced to test resistance at 6000. Respect would confirm a correction.

S&P 500

Six of seven mega-cap technology stocks showed losses, with only Meta Platforms (META) recording an up-day.

Top 7 Technology Stocks

Financial Markets

Financial market conditions remain stimulative, with Moody’s Baa corporate bond spread narrowing to 1.45%, the lowest level since 1997. This indicates the ready availability of credit.

Moody's Baa Corporate Bond Spreads

Treasury Markets

Ten-year Treasury yields continue to test support at 4.5%. Respect will likely confirm an advance to test resistance at 5.0%.

10-Year Treasury Yield

US Economy

ISM Manufacturing PMI improved to 50.9%, the highest level in 27 months, indicating a recovery in the sector.

ISM Manufacturing PMI

New orders jumped to 55.1%, indicating expansion.

ISM Manufacturing New Orders

However, the Prices sub-index also increased, indicating inflationary pressures.

ISM Manufacturing Prices

Leading industry sectors also warn of a slowing economy. Airfreight and logistics (blue) plunged by more than 10% and would flag a recession ahead if joined by a decline in either containers and packaging (orange) or road and rail (green).

Leading Industry Sectors

China Tariffs

China has slapped tariffs on US imports in a swift response to Donald Trump’s duties on Chinese goods, renewing a trade war between the world’s top two economies as America’s President seeks to punish Beijing for not halting the flow of illicit drugs.

Mr Trump’s additional 10% tariff across all Chinese imports into the US came into effect at 12.01am Eastern Time on Tuesday (5.01am GMT).

Within minutes, China’s Finance Ministry said it would impose levies of 15% for US coal and Liquid Natural Gas and 10% for crude oil, farm equipment and some cars and trucks. The new tariffs on US exports will start on February 10, the ministry said.

China also said it was starting an anti-monopoly investigation in Alphabet Inc’s Google, while including both PVH Corp, the holding company for brands including Calvin Klein, and US biotechnology company Illumina on its “unreliable entities list”.

Separately, China’s Commerce Ministry and its Customs Administration said it is imposing export controls on tungsten, tellurium, ruthenium, molybdenum and ruthenium-related items to “safeguard national security interests”. China controls much of the world’s supply of such rare earths that are critical for the clean energy transition. (Evening Standard)

Dollar & Gold

The Dollar Index retreated from resistance at 110, but respect of support at 108 will likely confirm another test of 110. The threat of increased tariffs is expected to strengthen the Dollar and increase upward pressure on long-term interest rates as foreign central banks sell reserves to support their currencies.

Dollar Index

Gold broke resistance to set a new high at $2,816 per ounce. Expect retracement to test the new support level at $2,800, but respect will likely confirm our target of $3,000.

Spot Gold

Conclusion

Canada and Mexico are a sideshow, with China likely to be the primary target of US sanctions imposed by the Trump administration. China’s swift retaliation is expected to lead to escalation.

China is in a far weaker position because of its large trade surplus with the US. A trade war is expected to hurt Chinese manufacturing and raw material imports. However, the US will also likely suffer an economic slowdown as global trade shrinks.

We expect the Dollar to strengthen, driving up long-term Treasury yields, which would be bearish for stocks and bonds.

We also expect a trade war to boost demand for gold as central banks reduce their exposure to US Treasuries.

Acknowledgments

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Progress…. with Chinese characteristics | Jim Grant

….Yet as the world’s second-largest economy continues to slog through the aftermath of its debt-driven economic miracle-cum-titanic housing bubble, policymakers put their best foot forward – with Chinese characteristics. Thus, aggregate financing fell by nearly RMB 200 billion in April from the prior month, data released over the weekend show, marking the first outright contraction in that metric of broad credit availability in nearly two decades.

True to form, the government looks to sweep those inconvenient figures under the rug, as Bloomberg relays that seven separate research notes from local brokerages commenting on that data release were scrubbed from the WeChat social media platform as of this morning.

Then, too, regulators have switched off live trading data showing foreign investment flows on the mainland Shanghai and Shenzhen exchanges via the Stock Connect trading link. That move, which was telegraphed in an April announcement, follows word that foreign direct investment registered at just $10.3 billion during the first quarter, down 56% from the first three months of 2023.

~ Jim Grant, Grant’s Almost Daily

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Why China’s efforts to resolve hidden government debt could fall short | Caixin Global

Local governments make extensive use of local government finance vehicles (LGFVs) to conceal debt and present a healthy balance sheet. The hidden debt presents a major risk for central government as the economy threatens a debt-deflation spiral.

From Caixin Global, March 14 2024:

China’s central government has rolled out a new round of measures since the second half of last year to help local governments swap or restructure their off-the-books borrowing in a bid to control debt risk.

However, the sheer scale of the country’s local government hidden debt — up to more than 70 trillion yuan ($9.8 trillion) according to some estimates, more than twice Germany’s GDP — means that the measures at best are far inadequate and will provide only temporary relief to what experts say is a looming liquidity crisis for regional authorities….

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Eleven reasons for optimism in the next decade

This might seem more like a wish list than a forecast — there are always risks that can derail predictions — but we believe these are high probability events over the long-term.

Our timeline is flexible, some events may take longer than a decade while others could occur a lot sooner.

Also, some of the reasons for optimism present both a problem and an opportunity. It depends on which side of the trade you are on.

#1 US Politics

The political divide in the United States is expected to heal after neither President Biden nor his predecessor, and current GOP front-runner Donald Trump, make the ballot in 2024. The first due to concerns over his age and the latter due to legal woes and inability to garner support from the center. A younger, more moderate candidate from the right (Nikki Haley) or left (Gavin Newsom?) is likely to be elected in 2024 and lead the reconciliation process, allowing Congress to focus on long-term challenges rather than political grandstanding.

Nikki Haley
Gavin Newsom

Nikki Haley & Gavin Newsom – Wikipedia

#2 The Rise of Europe

Kaja Kallas

Prime Minister of Estonia, Kaja Kallas – Wikipedia

Europe is expected to rediscover its backbone, led by the example of Eastern European leaders who have long understood the existential threat posed by Russian encroachment. Increased funding and supply of arms to Ukraine will sustain their beleaguered ally. NATO will re-arm, securing its Eastern border but is unlikely to be drawn into a war with Russia.

#3 Decline of the Autocrats

We are past peak-autocrat — when Vladimir Putin announced Russia’s full-scale invasion of Ukraine on February 23, 2022.

Vladimir Putin

Vladimir Putin announces invasion of Ukraine – CNN

Russia

The Russian economy is likely to be drained by the on-going war in Ukraine, with drone attacks on energy infrastructure bleeding Russia’s economy. Demands on the civilian population are expected to rise as oil and gas revenues dwindle.

Fire at an oil storage depot in Klintsy, southern Russia

Fire at an oil storage depot in Klintsy, southern Russia after it was hit by a Ukrainian drone – BBC

China

The CCP’s tenuous hold on power faces three critical challenges. First, an ageing population fueled by the CPP’s disastrous one-child policy (1979-2015) and declining birth rates after the 2020 COVID pandemic — a reaction to totalitarian shutdowns for political ends.

China's birth rate

Second, is the middle-income trap. Failure to overcome the political challenges of redistributing income away from local governments, state-owned enterprises and existing elites will prevent the rise of a consumer economy driven by strong levels of consumption and lower savings by the broad population.

Third, the inevitable demise of autocratic regimes because of their rigidity and inability to adapt to a changing world. Autocratic leaders grow increasingly isolated in an information silo, where subordinates are afraid to convey bad news and instead tell leaders what they want to hear. Poor feedback and doubling down on past failures destroy morale and trust in leadership, leading to a dysfunctional economy.

Iran

Ayatollah Ali Khamenei

Iranian Ayatollah Ali Khamenei – Wikipedia

Demographics are likely to triumph in Iran, with the ageing religious conservatives losing power as their numbers dwindle. The rise of a more moderate, Westernized younger generation is expected to lead to the decline of Iranian-backed extremism and greater stability in the Middle East.

#4 High Inflation

The US federal government is likely to avoid default on its $34 trillion debt, using high inflation to shrink the debt in real terms and boost GDP at the same time.

US Debt to GDP

#5 Negative real interest rates

High inflation and rising nominal Treasury yields would threaten the ability of Treasury to service interest costs on outstanding debt without deficits spiraling out of control. The Fed will be forced to suppress interest rates to save the Treasury market, further fueling high inflation. Negative real interest rates will drive up prices of real assets.

#6 US Dollar

The US Dollar will decline as the US on-shores critical industries and the current account deficit shrinks. Manufacturing jobs are expected to rise as a result — through import substitution and increased exports.

US Current Account

#7 US Treasury Market

USTs are expected to decline as the global reserve asset, motivated by long-term negative real interest rates and shrinking current account deficits.

Foreign Holdings of US Treasuries

Central bank holdings of Gold and commodities are likely to increase as distrust of fiat currencies grows, with no obvious successor to US hegemony.

#7 Nuclear Power

Investment in nuclear power is expected to skyrocket as it is recognized as the only viable long-term alternative to base-load power generated by fossil fuels. Reactors will be primarily fueled by coated uranium fuels (TRISO) that remove the risk of a critical meltdown.

TRISO fuel particles

TRISO particles consist of a uranium, carbon and oxygen fuel kernel encapsulated by three layers of carbon- and ceramic-based materials that prevent the release of radioactive fission products – Energy.gov

Thorium salts are an alternative but the technology lags a long way behind uranium reactors. Nuclear fusion is a wild card, with accelerated development likely as AI is used to solve some of the remaining technological challenges.

#8 Artificial Intelligence (AI)

Scientific advances achieved with the use of AI are expected to be at the forefront in engineering and medicine, while broad productivity gains are likely as implementation of AI applications grows.

#9 Semiconductors

Demand for semiconductors and micro-processor is likely to grow as intelligent devices become the norm across everything from electric vehicles to houses, appliances and devices.

McKinsey projections of Semiconductor Demand

#10 Industrial Commodities

Demand for industrial commodities — lithium, copper, cobalt, graphite, battery-grade nickel, and rare earth elements like neodymium (used in high-power magnets) — are expected to skyrocket as the critical materials content of EVs and other sophisticated devices grows.

Expected supply shortfall by 2030:

Critical Materials - Expected Supply Shortage to achieve Net Zero by 2030

Prices will boom as demand grows, increases in supply necessitate higher marginal costs, and inflation soars.

#11 Stock Market Boom

Stocks are expected to boom, fueled by negative real interest rates, high inflation and productivity gains from AI and nuclear.



Conclusion

There is no cause for complacency — many challenges and pitfalls face developed economies. But we so often focus on the threats that it is easy to lose sight of the fact that the glass is more than half full.

Our long-term strategy is overweight on real assets — stocks, Gold, commodities and industrial real estate — and underweight long duration financial assets like USTs.

Acknowledgements

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ASX 200 tests support

The ASX 200 retreated from resistance at the high of 7600 and is now testing support at 7400. Breach would warn of a correction to test primary support at 6750.

ASX 200

The Financials Index has similarly retreated from resistance at 6800. Reversal below 6650 would warn of a correction.

ASX 200 Financials

The A-REIT Index would likewise warn of a correction to test 1200 if support at 1440 is breached. The recent rally was in response to falling long-term bond yields.

ASX 200 REITs

The correction in yields is secondary in nature and is unlikely to reverse the long-term up-trend. Further increases in long-term yields are expected to weaken A-REITs.

10-Year AGB Yield

Healthcare also rallied strongly in the past two months but could reverse if long-term bond yields strengthen.

ASX 200 Healthcare

Consumer Staples are in a strong down-trend. Breach of support at 11500 would warn of another decline.

ASX 200 Staples

Discretionary has surprised to the upside, breaking resistance at 3200. A Trend Index trough at zero indicates buying pressure. Retracement that respects the new support level would signal a further advance.

ASX 200 Discretionary

Energy rallied to test resistance at 11000 but a Trend Index peak below zero warns of selling pressure. Another test of primary support at 10000 is likely.

ASX 200 Energy

The All Ordinaries Gold Index fell sharply as the US Dollar strengthened. Follow-through below 6500 would warn of another test of support at 6000.

All Ordinaries Gold Index

The ASX 300 Metals & Mining Index is falling sharply as China’s recovery falters. Another test of primary support at 5600 is likely.

ASX 300 Metals & Mining

China

Rate cuts and measures to stimulate the Chinese economy have been modest as the PBOC is trying to protect the Yuan from further depreciation against the US Dollar.

ASX 200 Discretionary

The result is slowing growth and deflation as weak demand persists.

China & India Inflation

Conclusion

Falling long-term bond yields have boosted Financials, REITs, Health Care and Consumer Discretionary sectors but the correction in yields is secondary and we expect this to reverse in 2024.

The Metals & Mining sector is falling sharply as China struggles to overcome weak demand while at the same time protecting the Yuan from further depreciation against the Dollar.

Our overall outlook for the ASX 200 remains bearish. Breach of support at 7400 would warn of a correction to test primary support from the October 2022 low at 6750.

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Our 2023 Outlook

This is our last newsletter for the year, where we take the opportunity to map out what we see as the major risks and opportunities facing investors in the year ahead.

US Economy

The Fed has been hiking interest rates since March this year, but real retail sales remain well above their pre-pandemic trend (dotted line below) and show no signs of slowing.

Real Retail Sales

Retail sales are even rising strongly against disposable personal income, with consumers running up credit and digging into savings.

Retail Sales/ Disposable Personal Income

The Fed wants to reduce demand in order to reduce inflationary pressure on consumer prices but consumers continue to spend. Household net worth has soared — from massive expansion of home and stock prices, fueled by cheap debt, and growing savings boosted by government stimulus during the pandemic. The ratio of household net worth to disposable personal income has climbed more than 40% since the global financial crisis — from 5.5 to 7.7.

Household Net Worth/ Disposable Personal Income

At the same time, unemployment (3.7%) has fallen close to record lows, increasing inflationary pressures as employers compete for scarce labor.

Unemployment

Real Growth

Hours worked contracted by an estimated 0.12% in November (-1.44% annualized).

Real GDP & Hours Worked

But annual growth rates for real GDP growth (1.9%) and hours worked (2.1%) remain positive.

Real GDP & Hours Worked

Heavy truck sales are also a solid 40,700 units per month (seasonally adjusted). Truck sales normally contract ahead of recessions, marked by light gray bars below, providing a reliable indicator of economic growth. Sales below 35,000 units per month would be bearish.

S&P 500

Inflation & Interest Rates

The underlying reason for the economy’s resilience is the massive expansion in the money supply (M2 excluding time deposits) relative to GDP, after the 2008 global financial crisis, doubling from earlier highs at 0.4 to the current ratio of 0.84. Excessive liquidity helped to suppress interest rates and balloon asset prices, with too much money chasing scarce investment opportunities. In the hunt for yield, investors became blind to risk.

S&P 500

Suppression of interest rates caused the yield on lowest investment grade corporate bonds (Baa) to decline below CPI. A dangerous precedent, last witnessed in the 1970s, negative real rates led to a massive spike in inflation. Former Fed Chairman, Paul Volcker, had to hike the Fed funds rate above 19.0%, crashing the economy, in order to tame inflation.

S&P 500

The current Fed chair, Jerome Powell, is doing his best to imitate Volcker, hiking rates steeply after a late start. Treasury yields have inverted, with the 1-year yield (4.65%) above the 2-year (4.23%), reflecting bond market expectations that the Fed will soon be forced to cut rates.

S&P 500

A negative yield curve, indicated by the 10-year/3-month spread below zero, warns that the US economy will go into recession in 2023. Our most reliable indicator, the yield spread has inverted (red rings below) before every recession declared by the NBER since 1960*.

S&P 500

Bear in mind that the yield curve normally inverts 6 to 18 months ahead of a recession and recovers shortly before the recession starts, when the Fed cuts interest rates.

Home Prices

Mortgage rates jumped steeply as the Fed hiked rates and started to withdraw liquidity from financial markets. The sharp rise signals the end of the 40-year bull market fueled by cheap debt. Rising inflation has put the Fed on notice that the honeymoon is over. Deflationary pressures from globalization can no longer be relied on to offset inflationary pressures from expansionary monetary policy.

S&P 500

Home prices have started to decline but have a long way to fall to their 2006 peak (of 184.6) that preceded the global financial crisis.

S&P 500

Stocks

The S&P 500 is edging lower, with negative 100-day Momentum signaling a bear market, but there is little sign of panic, with frequent rallies testing the descending trendline.

S&P 500

Bond market expectations of an early pivot has kept long-term yields low and supported stock prices. 10-Year Treasury yields at 3.44% are almost 100 basis points below the Fed funds target range of 4.25% to 4.50%. Gradual withdrawals of liquidity (QT)  by the Fed have so far failed to dent bond market optimism.

10-Year Treasury Yield & Fed Funds Rate

Treasuries & the Bond Market

Declining GDP is expected to shrink tax receipts, while interest servicing costs on existing fiscal debt are rising, causing the federal deficit to balloon to between $2.5 and $5.0 trillion according to macro/bond specialist Luke Gromen.

Federal Debt/GDP & Federal Deficit/GDP

With foreign demand for Treasuries shrinking, and the Fed running down its balance sheet, the only remaining market  for Treasuries is commercial banks and the private sector. Strong Treasury issuance is likely to increase upward pressure on yields, to attract investors. The inflow into bonds is likely to be funded by an outflow from stocks, accelerating their decline.

Energy

Brent crude prices fell below $80 per barrel, despite slowing releases from the US strategic petroleum reserve (SPR). Demand remains soft despite China’s relaxation of their zero-COVID policy — which some expected to accelerate their economic recovery.

S&P 500

European natural gas inventories are near full, causing a sharp fall in prices. But prices remain high compared to their long-term average, fueling inflation and an economic contraction.

S&P 500

Europe

European GDP growth is slowing, while inflation has soared, causing negative real GDP growth and a likely recession.

S&P 500

Australia, Base Metals & Iron Ore

Base metals rallied on optimism over China’s reopening from lockdowns. Normally a bullish sign for the global economy, breakout above resistance at 175 was short-lived, warning of a bull trap.

S&P 500

Iron ore posted a similar rally, from $80 to $110 per tonne, but is also likely to retreat.

S&P 500

The ASX benefited from the China rally, with the ASX 200 breaking resistance at 7100 to complete a double-bottom reversal. Now the index is retracing to test its new support level. Breach of 7000 would warn of another test of primary support at 6400.S&P 500

China

Optimism over China’s reopening may be premature. Residential property prices continue to fall.

S&P 500

The reopening also risks a massive COVID exit-wave, against an under-prepared population, when restrictions are relaxed.

“In my memory, I have never seen such a challenge to the Chinese health-care system,” Xi Chen, a Yale University global health researcher, told National Public Radio in America this week. With less than four intensive care beds for every 100,000 people and millions of unvaccinated or partially protected older adults, the risks are real.

With official data highly unreliable, it is hard to track exactly what impact China’s U-turn is having. Authorities on Friday reported the first Covid-19 deaths since most restrictions were lifted in early December, but there have been reports that funeral homes in Beijing are struggling to handle the number of bodies being brought in.

“The risk factors are there: eight million people are essentially not vaccinated,” said Huang Yanzhong, senior fellow for global health at the Council on Foreign Relations.

“Unless this variant has evolved in a way that makes it harmless, China can’t avoid what happened in Taiwan or in Hong Kong,” he added, referring to significant “exit waves” in both places.

The scale of the surge is unlikely to be apparent for months, but modelling suggests it could be grim. A report from the University of Hong Kong released on Thursday warned that a best case scenario is 700,000 fatalities – forecasts from a UK-based analytics firm put deaths at between 1.3 and 2.1 million.

“We’re still at a very early stage in this particular exit wave,” said Prof Ben Cowling, an epidemiologist at the University of Hong Kong. (The Telegraph)

China relied on infrastructure spending to get them out of past economic contractions but debt levels are now too high for stimulus on a similar scale to 2008. Expansion of credit to local government and real estate developers is likely to cause further stagnation, with the rise of zombie banking and real estate sectors — as Japan experienced for more than three decades — suffocating future growth.

S&P 500

Conclusion

Resilient consumer spending, high household net worth, and a tight labor market all make the Fed’s job difficult. If the current trend continues, the Fed will be forced to hike interest rates higher than the bond market expects, in order to curb demand and tame inflation.

Expected contraction of European and Chinese economies, combined with rate hikes in the US, are likely to cause a global recession.

There are two possible exits. First, if central banks stick to their guns and hold interest rates higher for longer, a major and extended economic contraction is almost inevitable. While inflation may be tamed, the global economy is likely to take years to recover.

The second option is for central banks to raise inflation targets and suppress long-term interest rates in order to create a soft landing. High inflation and negative real interest rates may prolong the period of low growth but negative real rates would rescue the G7 from precarious debt levels that have ensnared them over the past decade. A similar strategy was successfully employed after WWII to extricate governments from high debt levels relative to GDP.

As to which option will be chosen is a matter of political will. The easier second option is therefore more likely, as politicians tend to follow the line of least resistance.

We have refrained from weighing in on the likely outcome of the Russia-Ukraine conflict. Ukraine presently has the upper hand but the conflict is a wild card that could cause a spike in energy prices if it escalates or a positive boost to the European economy in the unlikely event that peace breaks out.

Our strategy is to remain overweight in gold, critical materials, defensive stocks and cash, while underweight bonds and high-multiple technology stocks. In the longer term, we will seek to invest cash in real assets when the opportunity presents itself.

Acknowledgements

  • Hat tip to Macrobusiness for the Pantheon Macroeconomics (China Residential) and Goldman Sachs (China Local Government Funding & Excavator Hours) charts.

Notes

* The yield curve inverted ahead of a 25% fall in the Dow in 1966. The NBER declared a recession but later changed their minds and airbrushed it out of their records.

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Deconstructing Evergrande’s effect on China

Elliot Clarke at Westpac says that China will be able to withstand the shock of Evergrande’s collapse and that power outages are a bigger threat.

We still think that the property sector contagion is part of a broader issue that China will struggle to overcome, as Michael Pettis succinctly explained:

China’s debt problem

Tweeted by Prof. Michael Pettis:

In the past — e.g. the SOE reforms of the 1990s, the banking crisis of the 2000s, SARS in 2003, the collapse of China’s trade surplus in 2009, COVID, etc. — whenever China faced a problem that threatened the pace of its economic growth, Beijing always responded by accelerating debt creation and pumping up property and infrastructure investment by enough to maintain targeted GDP growth rates. It didn’t adjust, in other words, but rather goosed growth by exacerbating the underlying imbalances.

That is why it had always been “successful” in seeing off a crisis. But when the main problem threatening further growth becomes soaring debt and the sheer amount of non-productive investment in property and infrastructure, it is obvious, or should be, that accelerating debt creation and pumping up property and infrastructure investment can no longer be a sustainable solution. All this can do is worsen the underlying imbalances and raise further the future cost of adjustment.

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What would Putin do?

The Communist Party of China has an unwritten contract with the 1.4 billion people living under its rule: they will tolerate living under an autocratic regime provided that the CCP delivers economic prosperity. So far the CCP has delivered in spades. A never-ending economic boom, fueled by exponential debt growth as investment in productive infrastructure grows ever more challenging.

But they are now familiar with the law of diminishing marginal returns: governments can’t just keep spending on infrastructure without falling into a debt trap. All the low-hanging fruit have been picked and new infrastructure projects offer lower and lower returns as spending programs continue.

That was probably the primary motivation for the CCP’s Belt-and-Road Initiative (BRI): to source more productive infrastructure investments in international markets. But the COVID-19 pandemic brought the BRI to a shuddering halt and the CCP is unlikely to maintain its exemplary growth record — no matter how much they fudge the numbers.

Xi Jinping is faced with an impossible task: how to placate 1.4 billion people when inflation sends food prices soaring and ballooning debt precipitates a sharp rise in unemployment and falling wages. The CCP has been preparing for this very eventuality for some time. Investing billions in surveillance and social credit systems, brutal crackdowns on religious organizations and minorities, suppression of democratic forces in Hong Kong, the latest take-down of tech giants — Jack Ma’s Ant Group and Tencent Holdings — which could form a focal point for democratic opposition, and beefing up internal policing. These are not the whims of an autocratic regime but a desperate attempt at self-preservation. China’s internal security budget is even bigger than its military budget (WION).

Xi Jinping

Behind that inscrutable facade, Xi Jinping is a worried man. Even with all the technology and forces of suppression at his disposal, confronting an angry population of 1.4 billion people is a daunting task. In his darkest hours he must have asked himself the question: WHAT WOULD PUTIN DO?

Even if you don’t believe the RT hype of the bare-chested deer hunter, judo expert and chess grandmaster — a combination of Chuck Norris and Garry Kasparov — you have to give Vladimir Putin credit for surviving 20 years as the head of a murderous regime where only the strong and completely ruthless stay alive.

Vladimir Putin

What would Putin do? The answer must have hit Xi Jinping like a 500 watt light bulb: INVADE CRIMEA. Vladimir Putin enjoyed record popularity at home (if you can believe Russian opinion polls) after invading Crimea. Despite the economic hardships that the Russian people had to endure from Western sanctions. The only force more powerful than hunger is a wave of patriotic nationalism.

Now being the canny fellow that he is, Xi figured that Crimea was too far away to be much use. Luckily for him, there is a handy substitute. An island of 23.5 million inhabitants, living under a democratically-elected government, only 180 kilometers away, across the Taiwan Strait.

Conclusion

We expect the CCP to fuel a wave of nationalist fervor to distract the 1.4 billion people living under their harsh rule from the economic hardships they are about to endure. Conflict over Taiwan is an obvious choice.

At present the PLA is conducting daily incursions into Taiwanese airspace, to map ROC air defense systems and wear down defenders with “response fatigue”.

ROC Reports Incursion by 28 PLA Aircraft

The CCP would not want to interfere with the Beijing Winter Olympics but may use it as a distraction — straight out of Putin’s playbook.

Melik Kaylan at Forbes:

I can say one thing about Vladimir Putin without fear of contradiction: he cares about timing. When he’s up to no good, he loves a sleight-of-hand distraction in global headlines. In 2008 [invasion of Georgia], the Beijing summer Olympics served as cover. More recently, the Sochi Winter Olympics ended just three days before Russia marched into Crimea.

Notes

  1. The 2022 Winter Olympics — also known as Beijing 2022 — is scheduled to take place from 4 to 20 February 2022.
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