Blain’s Morning Porridge – August 21st 2019 – Mind the Dragon

Blain’s Morning Porridge  – August 20th 2019

“If your enemy is temperamental, seek to irritate him. Pretend to be weak, that he may grow arrogant.”

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Bill Blain’s Charity Walk –

So much to think about… but mostly China.. 

Things you don’t normally see in The City of London:  This morning I spotted a young lady walking down Fenchurch Street – elegantly dressed in a business suit and carrying a surfboard under her arm.  Summer must be coming back!  Just in time for my Charity Walk next week!

The big question:  Is Donald Trump a visionary with some vast all-encompassing plan which we mere mortals simply don’t have the imagination to understand.  Or has he just lost it?  Cancelling a trip to Denmark because the government won’t discuss selling him Greenland sends some very aggressive signals to Denmark and thus Europe.  And then the White House economics fool says something equally destabilising supporting his logic.  What next?  Trade war on Copenhagen?  Banning the Little Mermaid from Disneyland?  I really can’t see any upside – but then I lack Trump’s world view.  (And yes, I know Greenland is bursting with valuable rare earths…)

Meanwhile, Kyle Bass is in the headlines: he notes the US is “the only country with an integer in front of our bond yields!”  He’s expecting them to trend lower on the basis the US$ is going to attract money from everywhere, pushing yields lower.  “We have 90% of the world’s investment-grade debt. We have the rule of law and we have a decent economy. All the money is going to come here.”  I suspect he’s spot on. The unintended consequences of the last 10-years of globally distorted money at artificially induced low rates has been a stalled global economy, rising income inequality and massive asset price inflation.  The current trend towards zero will exacerbate it.. but its probably great for asset prices (terrible for savers!)

And, as expected the Italian government fell y’day.  Still a good chance the Italy can will get kicked further down the road.  There is a strong likelihood of a new coalition government hanging together long enough to put off new elections till next year.  In the medium term its likely Salvini gets in next year with the support of Eurosceptical Forza Italia and conflict with Europe becomes inevitable over the budget.  A problem delayed is a problem delayed – which Brussels will be thankful for.

However, the big big issue remains the Dragon in the China Shop…  

Fascinating article in the Wall Street Journal y’day: “Trump is losing the Trade War With China”.   It says Trump has failed to win concessions, is damaging the US economy, has made the US look isolated, and is costing US jobs and higher consumer prices.  All these are facts.  But do they mean the US is losing the war?   Its complex….

I’ve been trying to work out what the reality re China might be.  In recent months the Chinese have been exhibiting increasing resilience against Trump’s destabilising and disruptive trade outbursts. Does this mean they are confident they can win at trade war, can continue to deliver rising prosperity to the Chinese people, and remain on course to become the world’s largest economy?  Or are the Chinese bluffing?

What’s happening is far more complex than a simple trade spat.  Trump believes he’s championing America by challenging China to act fairly and adopt more equitable trading practices.  Ultimately that would benefit both nations.  It looks like his approach and timing is just wrong – but maybe he’s playing a blinder of a game.  It’s a basic precept of Sun Tzu: “Know your enemy and know yourself and you can fight a hundred battles without disaster.”  I am sure Trump will have been given a copy of the Art of War (I’ll bet its unread and propping up a wobbly table in some hideous Trump Tower.)  But, he is definitely irritating the Chinese.

The Chinese are not playing for the same rewards.  For Trump its immediate gratification and the next election.  He cares not whom he insults.  For the Chinese it’s a matter of mianzi (which means far more than simply “face”).  It’s about being seen to play with prestige, dignity and winning well (or more correctly, not losing badly.)  It’s about the long-term rather than next November.  The challenge for China is to be seen not losing the trade war the US has precipitated, and ultimately still coming out on top – they are fine to lose 100 battles to win the war.  They see this as a long-term struggle that’s already taken 70-years.  They have no qualms about taking even longer to ultimately win.

Trump is playing to win elections next year – a fundamental and critical flaw in all democracies.

If it was a simple tit-for-tat trade war, China’s options would be severely limited.  This year, bilateral trade between the two countries is down between 15-20% depending how its measured.  It hurts China more.  The US has now enacted tariffs on over $550 billion of Chinese exports – roughly three times the $180 bln the US exports to China.  Hence the weakening in the Renminbi – China’s exports get cheaper while raising the costs of imports.  Both these factors hit the people Trump planned to help – the US agribusiness sector.  Trump has even delayed some of the last tariffs, fearing a holiday-season slump will depress retail sales and his electoral chances.

However, a weaker RMB hits Chinese property developers and corporates – they’ve been actively borrowing dollars to finance real estate in China.  Now they face a currency hit, plus slowing demand. Painful for the property firms, but something the Chinese can live with.  They can also live with short-term economic downturn – retail sales are down.  Capex is down.  Housing sales are down.  The Bank of China has space to make further tax cuts and to keep credit conditions accommodative – in the short-term (which is well past the next US election), China can struggle on.  What about the threat the Chinese may dump Treasuries?  Unlikely.  It would either precipitate a T-Bond crash, or a Fed buy programme  – both of which would hurt China most!

Its’ clear China growth was slowing before the trade war – it’s probably closer to 3% than 6% growth. China consistently overstates growth, meaning it’s going to take years, if ever, to overtake the US economy.  At the same time, its growth has been heavily dependent on “liberated” western tech to drive it.  If the economy slows because tech access is cut off, or it becomes obvious the economy is no longer catching up, then the Chinese government loses face. The nation also faces massive environmental challenges resulting from its dash-for-growth years.

I suspect the reality is China faces two non-exclusive potential outcomes:  Either it develops its own tech ecosystem and maintains growth in competition with the west, and/or it faces a 1990’s Soviet-style economic unravelling – constantly chasing the West, never catching up, being out-spent and out-competed by a still thriving US economy.  Already it’s seeing its position at the centre of the new global supply chains being usurped by cheaper and more friendly competitors across Asia: India, Vietnam, Thailand and Indonesia.

The unravelling scenario looks a distinct possibility.  One-child policies have caused a massive gender imbalance now being felt in the country’s demographics.  It’s changed the way people live – one child is the norm.  The economy faces a got “old before it got rich” crisis.  In terms of developing their own Tech base, China has established critical leadership in areas like AI and cyberspace.  As the workforce ages, they need to maintain productivity via the own AI and Tech ecosystem to pay for retirees. Perhaps they can.

But…. It’s also possible the Chinese economic planners have already concluded they can’t win a growth race with the US.   Maybe they challenge on a different front?  China has developed military capabilities the American’s never expected.  Their new ballistic Carrier-Killer missiles and swarm targeting tactics can keep the American’s well outside Chinese and Asian littoral waters – giving them far greater freedom of action across Asia.  China may decide to be tough.  Without its carriers, the American’s lack air-cover.  China can’t afford to let rest of Asia ready to replace China in Global supply chains – that would be excessive loss of face.  Maybe the Dragon flexes its wings…

And then there is Hong Kong.  Lots of folk are fretting about how significant a melt-down might be. But, how important is Hong Kong as China’s open trade and finance door?  It was once – but no longer.  If the Chinese police were to march in, the US wouldn’t really care.  They’d see it as fantastic opportunity to lambast Chinese human rights violations, but it’s basically a China problem.  A bloody re-enactment of Tiananmen is in no one’s interest – and the Party knows it could cost them international face.  The level of international condemnation would be unparalleled.  So why risk it? China may decide Hong Kong is irrelevant – and not worth invading – although that’s a face issue in itself!

Meanwhile… in a galaxy far, far away….

Brexit – Boris demands new deal with no Backstop.  Brussels says FROAD.  He is off to see Merkel and Macron.  How many different ways is Boris going to hear the same thing?  He will shrug, and say:  “So be it. Your call. You have my phone number. We are exiting. Preferably with a deal.  Call me when you want to chat.”  He will get back to Blighty, make a magnificently amusing speech.. and we will all hold our breath..

Out of time and back to the day job…

Bill Blain

Shard Capital