Executive Summary
1. Trade wars, geopolitics, and the fate of the yuan. Beneath the trade-war back-and-forth is a stark reality: the era of Chinas massive accumulation of foreign exchange reserves is ending, and in coming years, Chinas currency is likely headed for a significant decline. Saber rattling goes on as both sides maneuver towards a deal: the U.S. blacklisting Chinese tech giant and national icon Huawei; China threatening the U.S. supply of technologically critical rare earth minerals. However, in the end, we believe the U.S. will succeed in getting a better deal than the one it has had for the past several decades — even if it is at the cost of a trade agreement which allows the Chinese to save face and salvage their national pride. When that deal comes, it will provide a boost for stock markets globally.
2. Market summary. With the inversion of the 3-month/10-year yield curve, recession fears are once again on the minds of U.S. investors. The sentiment in the air on a variety of subjects, including trade, is also negatively affecting investor psychology. Still, no element of our suite of recession indicators is yet flashing red. The inversion of the yield curve typically precedes the onset of a recession and a market top by months, or even years. Significantly negative market sentiment can itself help precipitate a recession, when it becomes extreme. We do not believe that this extreme has yet occurred. On other, less subjective and more data-driven points, such as the overall favorability of U.S. financial conditions, the lights are still green. While corporate profits have decelerated from the tax-reform peak of last year, they have not yet decelerated so severely as to sound an alarm. Therefore, we continue to believe that the U.S. market can rally further in 2019, particularly if a near-term conclusion is successfully reached in the trade impasse between the U.S. and China.
The brief trauma of uncertainty created by the trade conflict between the U.S. and China may have lasting and beneficial effects on other emerging-market manufacturing exporters. Last week we noted India — and in the long term, we continue to view India very favorably, especially as the Modi administration uses its new electoral mandate to deepen and accelerate the reforms that will make India a more attractive destination for global capital.
Caught by her own failure and perhaps the impossibility of the task set her, Britains Prime Minister Theresa May will resign, leaving the way open to a host of staunchly pro-Brexit contenders. Across Europe, Euroskeptics, the Greens, and the far left gained ground at the expense of established center-right and center-left parties, presaging an ongoing era of change and realignment in European politics. It could all be for the continents good — and will certainly be for the U.K.s, we believe, if a real Brexit occurs as planned on October 31.
There are technical signs of a rally for gold this summer, and of course, any further volatility from trade war news and poor investor psychology may be a reason for investor dollars to favor gold. The head of Russias central bank recently commented that, although they remain opposed to cryptocurrencies, there was the possibility that Russia could participate in the creation of a gold-backed crypto for use in international settlements.
Trade Wars, Geopolitics, and the Fate of the Yuan
The trade conflict between the U.S. and China has always had some level of geopolitical undertones. Those became explicit in Vice President Mike Pences speech at the Hudson Institute in October of last year. After describing a litany of Chinas alleged abuses in unfair trade practices, appropriation of technology, and geopolitical aggression, Pence noted:
These are only a few of the ways that China has sought to advance its strategic interests across the world, with growing intensity and sophistication. Yet previous administrations all but ignored Chinas actions. And in many cases, they abetted them. But those days are over.
At the time this speech was made, some worried analysts and reporters feared that it might indicate the beginning of a new cold war. We believed, and we continue to believe, that while the concerns expressed by the U.S. administration are rooted in reality, the rhetoric was not meant to cause a break in negotiation. Rather the U.S. wanted to convey to Chinese leadership that they were dealing with a new sheriff†who would be conducting tougher negotiations than his predecessor, and was willing to make public statements about what’s really going on behind the curtain.
Stinging National Pride
A recent statement in the state-run Beijing Global Times expressed some “core concerns†of Chinese leadership over the current state of the trade agreement that was almost agreed upon before talks hit their most recent snag and were adjourned. Two concerns were prosaic, and had already been widely discussed — a demand for the revocation of existing tariffs before the agreement is inked, and a demand for a realistic level of required purchases of U.S. goods by the Peoples Republic. The third, though was to improve the balance of the wording of the text. Every country has its dignity, and the text must be balanced. In other words, the blunt accusations of the U.S. have stung Chinese pride, and this is not a small matter.
Geopolitical Dimensions… and the Currency Backdrop
In recent news, the geopolitical dimensions of the conflict have focused on two areas: 5G technology and rare earths.
5G — the next-generation wireless technology — became a particular bone of contention when Meng Wanzhou, the Chief Financial Officer (and daughter of the firms founder) of Chinese telecom giant Huawei, was arrested in Canada for extradition to the United States. The U.S. accused Huawei of skirting restrictions on business deals with the Islamic Republic of Iran — but in essence, the action was a shot across the bow of one of Chinas most successful and influential global companies.
Back in March we wrote about Huaweis role in building the network of undersea cables that carry much of the worlds internet traffic — and concerns that at the behest of the Chinese government, Huawei could covertly monitor internet traffic, or even disrupt it altogether in the case of war. There are similar concerns around Huaweis burgeoning global role in 5G, a technology which over the next several years will come to carry much of the wireless broadband traffic around the world. The global 5G rollout will require the installation of millions of base stations in the worlds cities, and Huawei so far has a lead in being able to supply an integrated, turnkey solution, and leads in actual shipments of base stations.
The U.S. administration has expressed the same concerns about 5G that it has about marine cables — that in Chinas form of authoritarian capitalism, companies of Huaweis size and influence must necessarily work hand-in-glove with the central government. Remember that back in October, Bloomberg Businessweek reported that tiny, nearly undetectable spy chips had been found in Chinese-manufactured servers used by several major U.S. tech firms. This brought close public attention to the potential problem not just of software hacking, but of the even greater security implications of hardware hacks.
The U.S. has therefore been leaning hard on allies to deny Huawei a role in the buildout of their 5G networks — pressure that met with limited success. Two weeks ago, the U.S. upped the ante, blacklisting Huawei as an entity barred from doing business with any company in the U.S. For a moment, that threatened to pull the rug out from under the companys use of Alphabets [NASDAQ: GOOG] Android operating system, which would have been catastrophic for Huawei, which is the worlds second largest smartphone manufacturer, behind Samsung and ahead of Apple [NASDAQ: AAPL]. The U.S. then allowed some temporary exemptions, including GOOG — but after such an existential threat, Huawei is surely scrambling to get an Android lookalike operating system ready to go, as well as its own app store to replace Google Play.
Rare Earths: China Returns the Hardball
We’ve often written that the balance of power in the conflict between the U.S. and China is unequal — China is far more vulnerable to U.S. actions and sanctions than the U.S. is to Chinas. One weak spot that has often appeared in media coverage is “rare earths†— a topic we have addressed in previous years in these pages.
Rare earths†are elements, primarily in the lanthanide series of the periodic table of the elements, that are small but critical components of many modern technological products — especially batteries, magnets, lasers, exotic alloys, catalysts, nuclear controls, and advanced glass formulas for screens and lenses. They are not particularly — the most plentiful of them exist in the earths crust in greater amounts than minerals such as copper — but were named at the end of the 19th century because they existed in complex mineral deposits and were then challenging to mine and refine.
Rare earths deposits exist plentifully in many places around the world.
Source: Bank of America Merrill Lynch Research
However, although deposits are so widespread, production is currently not. Until the 1980s, the U.S. was the main producer, but over the course of the 1980s and 1990s, the Chinese government decided intelligently on the strategic value of rare earths. With government support, Chinese producers undercut their competitors, and production elsewhere in the world gradually shut down. The largest U.S. mine remains shuttered.
The U.S. Department of Defense report that came out last September on the security of the U.S. industrial supply chain noted the importance of rare earths in particular:
As part of the increasingly global manufacturing and defense industrial base, imports of strategic and critical materials, such as rare earths, have increased, causing a trade-off between supply dependency and lower costs. Rare earths are critical elements used across many of the major weapons systems the U.S. relies on for national security, including lasers, radar, sonar, night vision systems, missile guidance, jet engines, and even alloys for armored vehicles… Chinas domination of the rare earth element market illustrates the potentially dangerous interaction between Chinese economic aggression, guided by its strategic industrial policies and vulnerabilities and gaps in Americas manufacturing and defense industrial base. China has strategically flooded the global market with rare earths at subsidized prices, driven out competitors, and deterred new market entrants. When China needs to flex its soft power muscles by embargoing rare earths, it does not hesitate, as Japan learned in a 2010 maritime dispute.â€
That muscle flexing was recently demonstrated when Chinese President Xi Jinping visited rare earths production facilities in Chinas west — a visit clearly intended to underline Chinas dominance in this area.
The critical thing for investors to appreciate is that even here, Chinas threat lacks real bite. Supply chain disruption would occur in the short term if the U.S. had to source technological products from non-Chinese manufacturers; even a ban on rare earths exports to the United States would be incomplete because of such trans-shipments. It would be a headache for the U.S., not a catastrophe. In the long term, there are abundant rare earths deposits outside China; they simply need to be developed (or re-opened, in the case of the U.S.). As such ex-Chinese production ramps up, known reserves will also expand — we note that Brazils deposits are already known to be rich. The U.S. would be wise to use the current realignment of priorities to encourage rare earths production outside China — especially given the increasing role that will be played by advanced batteries in global transport over the coming decades.
Race Against Time For the Yuan
The real trouble for China, though, is a race against time for its currency.
Our favorite China analyst, Jonathan Anderson of Emerging Advisors Group, wrote in a piece last fall that in the long term, the writing is on the wall for Chinas currency — that is, in the long term, it very likely must fall, and must fall dramatically, as domestic broad monetary growth outstrips the countrys accumulation of foreign reserves. He notes that inevitably, that decoupling is what causes emerging-market currency pegs or quasi-pegs such as Chinas to collapse.
Much of Chinas growth in U.S. dollar terms over the past decades has in fact come from currency appreciation, as China has stored away foreign reserves.
Source: Emerging Advisors Group
But for many reasons, that huge foreign exchange war chest is not going to grow further. It will shrink.
First, however closed the Chinese financial system tries to be, it leaks — with about 2% of the banking systems assets finding their way out of the country through various kinds of theft and fraud each year. As the yuan weakens in coming years, that flight will only accelerate. (This is one reason why the Chinese government does not want its people trading cryptocurrencies.)
And second, Chinas era of massive trade surpluses is ending — both because of dissatisfaction on the part of trading partners such as the U.S., and because Chinese wages have risen and low-cost manufacturing has been moving to other, cheaper countries. It is a matter both of geopolitics and trade, and simple economics.
The Chinese authorities know that both of these things are true But in the long term, they seem stuck on using fiscal stimulus to encourage the growth that they must create in order to keep their people content with their style of rule.
That means that broad money in China, in the long term, will keep outstripping foreign exchange reserves; and that in turn means that something must give — and that something will very likely be the yuan.
Investment implications: China continues to have more to fear from trade conflict with the U.S. than the U.S. does from China. Major Chinese tech firms such as Huawei are highly vulnerable to U.S. blacklisting and diplomatic pressure. Chinas attempted return salvo, tacitly threatening industrially critical rare earths, will fall flat, as long as the U.S. is intelligent enough to incentivize domestic production and production by allies. Ultimately, China knows this, and again, we believe this is why a deal will be reached — and why the U.S. will, after hardball negotiations, agree to a deal that allows China to “save face†while still securing the most concessions on critical items that it can. When that deal comes, it will allow global stock markets to rally.
Market Summary
The U.S.
With the inversion of the 3-month/10-year yield curve, recession fears are once again on the minds of U.S. investors. The sentiment in the air on a variety of subjects, including trade, is also negatively affecting investor psychology.
No element of our suite of recession indicators is yet flashing red. As we have often written, the inversion of the yield curve typically precedes the onset of a recession and a market top by months, or even years. Some analysts believe that the additional presence of quantitative tightening, that is, the Federal Reserves reduction of its balance sheet, should make investors look at the yield curve differently. The evidence is inconclusive, so we believe that at most this indicator is yellow, not red.
Of course, significantly negative market sentiment can itself help precipitate a recession, when it becomes extreme. We do not believe that this extreme has yet occurred. On other, less subjective and more data-driven points, such as the overall favorability of U.S. financial conditions, the lights are still green. While corporate profits have decelerated from the tax-reform peak of last year, they have not yet decelerated so severely as to sound an alarm.
Therefore, we continue to believe that the U.S. market can rally further in 2019, particularly if a near-term conclusion is successfully reached in the trade impasse between the U.S. and China. How the market responds to that announcement when it comes — the strength and composition of the ensuing rally — will shape our view of the rest of the year; we will keep you apprised.
China and Emerging Markets — and India
Like the U.S., China will likely also resume its rally when a trade deal is concluded with the U.S., even if it leaves open the necessity to reach agreement on more difficult disputed points in the future. The trade conflict, even when it is resolved, will ultimately have significant effects on other countries which have hitherto mainly been part of Chinas supply chain.†The brief trauma of uncertainty created by the trade conflict between the U.S. and China may have lasting and beneficial effects on other emerging-market manufacturing exporters. Last week we noted India — and in the long term, we continue to view India very favorably, especially as the Modi administration uses its new electoral mandate to deepen and accelerate the reforms that will make India a more attractive destination for global capital.
Europe and the U.K.
Caught by her own failure and perhaps the impossibility of the task set her, Britains Prime Minister Theresa May will resign, leaving the way open to a host of staunchly pro-Brexit contenders. Britain went to the polls in European elections that Brexiteers had hoped would not be happening — and returned a stomping victory to Nigel Farages Brexit Party. Farage then demanded a seat at the table in the ongoing Brexit process. Across Europe, Euroskeptics, the Greens, and the far left gained ground at the expense of established center-right and center-left parties, presaging an ongoing era of change and realignment in European politics. It could all be for the continents good — and will certainly be for the U.K.s, we believe, if a real Brexit occurs as planned on October 31. However, we would not rule out untoward events in the meantime — even the engineering of a second referendum that puts the kibosh on Brexit entirely.
Gold and Cryptos
As we noted last week, there are technical signs of a rally for gold this summer, and of course, any further volatility from trade war news and poor investor psychology may be a reason for investor dollars to favor gold.
We noted that the head of Russias central bank recently commented that, although they remain opposed to cryptocurrencies, there was the possibility that Russia could participate in the creation of a gold-backed crypto for use in international settlements. It would be interesting to watch its adoption, if it were launched.
Thanks for listening; we welcome your calls and questions.
