Fed rocks market, but Recession and China’s Surveillance State are long-term bigger risks

Blain’s Morning Porridge Nov 3 2022 – Fed rocks market, but Recession and China’s Surveillance State are long-term bigger risks

“In 1970 China was 1% of global GDP. In 1800 it was 33%, dominating silk and ceramics.”

Today: The Fed roiled markets over the pace and scale of rate hikes, but ultimately markets are about growth. The big issues were not thinking about enough are global recession, slowing trade, and the threats China’s evolution into a Surveillance State raise for future growth.

If it’s not policy mistakes that do for markets, then it’s a “no-see-em” event, or simply discovering we’ve misunderstood the actuality, and been looking at the wrong things all along. Maybe we have a combination of all three? We’re all fixated on the fall-out from yesterday’s “interesting” US Federal Reserve action and inflation, and trying to predict what it all means for markets – but maybe our attention is focused on all the wrong things?

The Fed surprised no-one by hiking 75 basis points. It was the statement and the subsequent press conference that jarred the market as the details proved indigestible. Stocks dived. Bonds widened. There are underlying pressures clearly visible in the US economy – earnings pressure, consumer spending, second hand car prices (now that free money and supply chain shortages of on new cars aren’t helping), and mortgages at 7% slowing the housing market – but what the Fed is really watching is the hot jobs market!

Strip yesterday’s Fed down to the basics: Fed Head Jerome Powell delivered a “I don’t know, let’s wait and see” message to markets. It was very short-term. Rates will go higher, but the pace of rate rises might slow – which flies in the face of historical experience showing short/sharp rate hike cycles to dramatically slow economic activity are painful, but are the most effective way to deal with inflation.

Delay is fatal when addressing inflation. Last year inflation was described as “transitory”. (Central banks employed the expression in hope, rather with any real belief.) That was a mistake. Inflation is a pernicious beast. It quickly becomes entrenched – in the form of rising wage demand pressure, which is exactly where the US economy now finds itself: witness American Airlines pilots turning down a 12% raise after UA pilots rejected 15%. Once wage inflation is established, slowly rising rates are likely to fan it higher as consumer/workers demand more to meet their payment obligations.

Meanwhile, the market frets about rising rates pulling down the current strength of the economy. The hope is the Fed will balance rates (ie keep them low) to keep the high-employment pace of the economy: if rates don’t have to go much higher to undermine that growth, then the Fed can pivot towards growing the economy by juicing it with higher rates.. again. Yay!

Hope is never a strategy.

If all you are doing is watching US Jobs Numbers (due tomorrow) then you are probably watching the wrong thing. Wage demands follow the economic action. The question we should be asking is – what is going to lead the global economy up, or down?

If there is one thing to watch, it’s the Shanghai Containerised Freight Index : SCFI. Inflation is the bludgeon that panics economies, recession is the knife that hobbles them. Container prices have crashed.

The most significant comment in markets yesterday was not Jerome Powel, but International shipping giant Maersk warning about global trade “moving backward”, and rising recession risk. Maersk manages about 17% of international shipping. It now forecasts global container traffic will decline between 2-4% this year – cutting its previous estimates of flat growth. Maersk CEO Soren Skou nailed it: “There are plenty of dark clouds on the horizon. This weighs on consumer purchasing power which in turn impacts global transport and logistics demand.”

Recession, like Winter in Westeros, is coming…

Ultimately, there is one big picture question that troubles global investors – how do we invest in growth? To understand that, you need to figure where the opportunities lie. Which means pulling out a map of the global economy.

You can then overlay that map with multiple issues like new technologies, demand and supply, demographics, supply chains, resource allocations, competition and productivity, and a host of other complexities – including as the UK has learnt to its cost, and the US may shortly be reminded of – like functional political competency. Understand these to dig deeper into each of the aspects to figure out opportunities within the global economy.

Understanding the shape of the global economy is basic. How it works is next.

Just a few years ago we blithely assumed the global economy was pivoting around the Pacific where China would set the pace as the globe’s forge, producing everything. Europe would move towards political and fiscal unity (rather than just the flawed monetary union of the Euro). US economic vibrancy ensured its’ economy would continue to set the global tone – I still expect it will.

But, otherwise, nothing is quite what we expected.

The key is China. China has been exporting deflation around the globe since it joined WTO – making goods cheaper. Its economy thrived lifting millions out of poverty. The Chinese Communist Party was able to bask in rising affluence and meet its Iron Rice-bowl compact with the workers – jobs and prosperity. 7% growth was the norm. That’s the picture it shows to the world.

What if everything we think and know about China is wrong? What if it’s a hollow dragon? The following is just me trying to think out of the box.. and I’ve not been there for years… but what if.. What if? What if China is not the economic miracle we think it to be?

This week’s Hong Kong financial forum is a good reverse indicator. It flew in the face of the new US/China cold war. There were legions of Western investment bankers kow-towing to the new jade emperor to get a slice of whatever juicy business might be coming. We had the humiliation of UBS’s CEO telling China mandarins how “pro-China” markets are. But the reality is few leading financial CEOs turned up, using an approaching storm as an excuse. Even Chinese officials attended by video. However deeply HSBC’s CEO abases himself, Hong Kong is no longer one of the Globe’s great financial trading centres. I looked very much like the end of the party.

More telling was the way the whole China market rallied on wholly unsubstantiated rumours light-touch Covid restrictions will replace the current lockdown regime. Stocks rallied despite government denials. It all makes the China market look a little more suspect.

I suspect the CCP saw what was coming for the Chinese economy sometime ago:

• Far from being a paragon of a successful state-directed economy with capitalist underpinnings, it is, perhaps, all a pretension.
• The China reality is an economy heading towards serious economic catastrophe on the back of local and state corruption, unwise policy decisions prioritising short-term spending over long-term returns, over-leverage, the unsustainable property market, inequalities and soaring debt crises.
• The reality may not be a worker’s paradise, but an authoritarian, bureaucratic state that’s as mired as anything in the West.

China’s economic slowdown has been accelerated by the Covid crisis, and ongoing lockdowns – which look extraordinary from a Western perspective. I suspect the CCP has used Covid deliberately for its own purposes – a fantastic opportunity to enhance itself as ruler of a Surveillance State. It has put in place strict Covid controls and the rigorous enforcement of phone-app rules to control the population. Meeting anyone, going anywhere or gathering requires a green light on your phone, which can be overseen, administered, and cracked down by the security forces.

As the Chinese economic miracle fades, as the economy struggles with its internal inefficiencies, and international opinion becomes more hostile over Taiwan and Climate Change (China is back to its long-term addiction to Coal for energy), the prospects for internal dissent will rise. 10 years ago, China may have faced a Tiananmen Square level industrial and social unrest if the CCP failed to deliver growth. Today, the CCP is prepared with its enhanced surveillance powers and tech to contain internal dissent without the world noticing.

I may be completely off-the-mark and wrong. Different views make for markets.

In terms of investment opportunities in China..  Over the coming year China is either going to become one of the biggest stories on the Morning Porridge – or its going to fade away into irrelevance in terms of investment opportunities. It’s looking pretty binary:

• We can take a view that China assets are undervalued, or
• We can decide Chinese businesses are valueless because the CCP no longer regards them as private enterprises, thus private investors can expect no protections or consideration.

Usually, the truth lies somewhere in the middle, but I do suspect this time, the outcome could be a starkly binary as presented above.

This thinking was triggered by a discussion in the office. Shard’s head of research, the excellent Ernst Knacke who is of the opinion (for all the right fundamentals, businesses, growth and other factors) that at least some of the major Chinese Tech firms are looking cheap to fair value. There is a holding company which owns a massive slice of one of these Mega Stocks (70% of its’ base), to invest in it by proxy through the Dutch firm’s deeply discounted Net Asset Value (NAV) of -42%.  If China is investible – that’s a trade definitely worth looking at – and it’s a trade I will be happy to broker for you.

Five Things to Read This Morning

FT – I spent 10 days in a secret Covid detention centre

FT – Fed should make clear that rising profit margins are spurring inflation

BBerg – China Stocks Rally Cut short amid Signs Covid Zero Here to Stay

WSJ – Fed Tries to Thread the Needle, Drawing Blood

Torygraph – Europe’s next debt crisis is only just begining

Out of time, and back to the day job…

Bill Blain

Strategist – Shard Capital