Doug Noland: Crossing Red Lines

By Doug Noland on July 25, 2020

Michael Bond comments: From an investment point-of-view remember that Apple along with many US firms are deeply integrated with China in terms of manufacturing and supply-chain.

Exerpts:

Here at home, the bursting of the ‘90s “tech” Bubble spurred reflationary policymaking and the resulting mortgage finance Bubble. What was not to like about “globalization”? The U.S. could deindustrialize – and clean its air in the process. Services suited policymakers just fine. And all the cheap imports kept CPI low, ensuring endless easy money to inflate equities, bond and asset prices more generally. Besides, all those dollars flooding the world from Current Account Deficits would just be recycled back to U.S. Treasuries and financial assets. Miraculous. What could go wrong?

I seriously doubt China’s banking system inflates from $8 TN to $43 TN during this cycle without Trillions of “Bubble Dollars” flooding the world and its resulting reserves horde. U.S. crisis and QE1 provided China a blank check for a massive $600 billion 2009 stimulus plan. And Chinese Credit – along with investment, manufacturing, apartment Bubble, economic boom, technological advancement, military buildup, global influence peddling, and ambitions for superpower status – never looked back.

For years now, CBB analysis has focused on the interdependence of historic U.S. and Chinese Bubbles. “Decoupling” has commenced – spurred on by COVID. Myriad uncertainties and fragilities ensure intense pressures on both the Fed and PBOC to keep their respective systems afloat. Crazy equities, for now, luxuriate in the thought of ultra-easy money for as far as the eye can see.

Meanwhile, the safe havens sense one hell of a crisis brewing. Ten-year Treasury yields this week traded below 0.6%, with German bund yields holding at negative 0.45%. And the metals are on fire. Gold was up 5% and silver jumped almost 16% this week. Surging industrial metals prices add further intrigue. I doubt prices are surging on economic prospects. In a world of such uncertainty and unfolding mayhem, all the metals are viewed as Stores of Value. Will future historians see this week as pivotal for Red Lines Being Crossed?

The Shanghai Composite traded as high as 3,382 during Tuesday trading, before reversing 5.5% lower to end the week at 3,192. The Shanghai Composite previously surged 16% over eight sessions (June 30th to July 9th), highlighted by a 5.7% jump on July 6th. This index sank 4.4% on July 16th – and then fell 3.9% in Friday trading. China’s growth-oriented ChiNext Index sank 6.1% Friday.

COVID stimulus stoked Bubble Dynamics for global risk assets, certainly including Chinese equities. This Bubble has turned unstable. Chinese stocks reversed sharply lower after the U.S.’s shocking closure of China’s Houston consulate. Fundamentals and geopolitics do matter.

July 23 – Reuters (Fred Imbert): “China said the U.S. move to close its Houston consulate this week had ‘severely harmed’ relations and warned it ‘must’ retaliate… Washington… gave China 72 hours to close the consulate, which it said was ‘to protect American intellectual property and Americans’ private information,’ a dramatic escalation of tension between the world’s two biggest economies. Chinese Foreign Ministry spokesman Wang Wenbin described the U.S. allegations as ‘malicious slander’ and said the ‘unreasonable’ move had ‘severely harmed’ relations. ‘China must make a necessary response and safeguard its legitimate rights,’ he said…”

It has been an alarming deterioration in U.S./China relations over recent months. Bubble markets have been content to disregard what has been a virtual collapse in relations over recent days and weeks.

The unfolding U.S./China cold war is most regrettable. The only surprise, in my eyes, is that the relationship held together as long as it did. It was destined to mature into an intense superpower rivalry. From a Bubble Analysis perspective, the boom cycle fostered the perception of an expanding economic pie. Cooperation and integration were considered mutually beneficial. It was also unsustainable.

Stark changes in perceptions and relationships are fundamental to the bursting global Bubble thesis. The economic pie is stagnating rather than expanding. It’s become a zero-sum game – an inevitable new zeitgeist accelerated by COVID. Even as their respective Bubbles floundered over the past 18 months, an attitude persisted that the U.S. and China needed to work together to ensure stability. No more.

A local Houston television station Tuesday broke the story of fire engines responding to smoke coming from the Chinese consulate. Aerial photographs captured fires in three burn barrels in the consulate’s courtyard. Wednesday the State Department announced they had given the Chinese 72 hours to close the Houston consulate and leave the country. China is fuming.

From the New York Times (Keith Bradsher and Steven Lee Myers): “In the Chinese telling, Beijing is under assault, as the Trump administration goes after it with increasing intensity on trade, technology and human rights. All in a matter of weeks, the United States has sanctioned Chinese officials over the ruling Communist Party’s policies in Hong Kong and the western region of Xinjiang, cut off Chinese companies’ access to American technology and challenged Beijing’s claims in the South China Sea. The party’s propaganda outlets struck a nationalistic note on Friday, vowing that Beijing would hold firm in the face of mounting pressure from the United States.”

There’s no longer a shred of doubt. Beijing can blame its problems on the United States – and it will be credible to its riled citizens. The U.S. over recent weeks has been frenetically Crossing China’s Red Lines (like kids skipping over cracks in a sidewalk). We’re in the thick of election season – and the current administration might be short-timers. But huge – likely irreparable – damage is being wrought upon the most paramount of global relationships.

July 23 – Wall Street Journal (Kate O’Keeffe and William Mauldin): “Secretary of State Mike Pompeo called on the Chinese people to alter the ruling Communist Party’s direction in a speech explaining the Trump administration’s full-throttle response to an assertive China. Chinese leader Xi Jinping is a ‘true believer in a bankrupt, totalitarian ideology,’ Mr. Pompeo said. He stopped shy of explicitly calling for regime change, urging allied countries and the people of China to work with the U.S. to change the Communist Party’s behavior. The Communist Party ‘fears the Chinese people’s honest opinions more than any foe,’ Mr. Pompeo said… at the Richard Nixon Presidential Library… The U.S. ‘must also engage and empower the Chinese people,’ he said.”

It was crafted with history in mind (and to poke China in the eye). I’ve pulled significantly from Secretary of State Mike Pompeo’s Wednesday speech, believing it is both historic and unsettling. Pompeo may have “stopped shy of explicitly calling for regime change,” but in the eyes of China’s top leadership he surely Crossed the Reddest of Lines.

Pompeo: “Next year marks half a century since Dr. Kissinger’s secret mission to China, and the 50th anniversary of President Nixon’s trip isn’t too far away in 2022. The world was much different then. We imagined engagement with China would produce a future with bright promise of comity and cooperation. But today – today we’re all still wearing masks and watching the pandemic’s body count rise because the CCP failed in its promises to the world. We’re reading every morning new headlines of repression in Hong Kong and in Xinjiang. We’re seeing staggering statistics of Chinese trade abuses that cost American jobs and strike enormous blows to the economies all across America… And we’re watching a Chinese military that grows stronger and stronger, and indeed more menacing.”

“Look, we have to admit a hard truth. We must admit a hard truth that should guide us in the years and decades to come, that if we want to have a free 21st century, and not the Chinese century of which Xi Jinping dreams, the old paradigm of blind engagement with China simply won’t get it done. We must not continue it and we must not return to it… The free world must triumph over this new tyranny.”

“The truth is that our policies – and those of other free nations – resurrected China’s failing economy, only to see Beijing bite the international hands that were feeding it.”

“…A quote from the speech that General Barr gave…‘The ultimate ambition of China’s rulers isn’t to trade with the United States. It is to raid the United States.’ China ripped off our prized intellectual property and trade secrets, causing millions of jobs [losses] all across America.”

“President Nixon once said he feared he had created a ‘Frankenstein’ by opening the world to the CCP, and here we are.”

“…We have to keep in mind that the CCP regime is a Marxist-Leninist regime. General Secretary Xi Jinping is a true believer in a bankrupt totalitarian ideology. It’s this ideology, it’s this ideology that informs his decades-long desire for global hegemony of Chinese communism. America can no longer ignore the fundamental political and ideological differences between our countries, just as the CCP has never ignored them…”

“That the only way – the only way to truly change communist China is to act not on the basis of what Chinese leaders say, but how they behave… President Reagan said that he dealt with the Soviet Union on the basis of ‘trust but verify.’ When it comes to the CCP, I say we must distrust and verify. We, the freedom-loving nations of the world, must induce China to change, just as President Nixon wanted. We must induce China to change in more creative and assertive ways, because Beijing’s actions threaten our people and our prosperity.”

“We know too that if our companies invest in China, they may wittingly or unwittingly support the Communist Party’s gross human rights violations.”

“…Our Department of Defense has ramped up its efforts, freedom of navigation operations out and throughout the East and South China Seas, and in the Taiwan Strait as well. And we’ve created a Space Force to help deter China from aggression on that final frontier… We reversed, two weeks ago, eight years of cheek-turning with respect to international law in the South China Sea.”

“But our approach can’t just be about getting tough. That’s unlikely to achieve the outcome that we desire. We must also engage and empower the Chinese people – a dynamic, freedom-loving people who are completely distinct from the Chinese Communist Party… The CCP fears the Chinese people’s honest opinions more than any foe, and save for losing their own grip on power, they have reason – no reason to… For too many decades, our leaders have ignored, downplayed the words of brave Chinese dissidents who warned us about the nature of the regime we’re facing. And we can’t ignore it any longer. They know as well as anyone that we can never go back to the status quo.”

“But I call on every leader of every nation to start by doing what America has done – to simply insist on reciprocity, to insist on transparency and accountability from the Chinese Communist Party. It’s a cadre of rulers that are far from homogeneous. And these simple and powerful standards will achieve a great deal. For too long we let the CCP set the terms of engagement, but no longer. Free nations must set the tone. We must operate on the same principles.”

“We cannot repeat the mistakes of these past years. The challenge of China demands exertion, energy from democracies – those in Europe, those in Africa, those in South America, and especially those in the Indo-Pacific region. And if we don’t act now, ultimately the CCP will erode our freedoms and subvert the rules-based order that our societies have worked so hard to build. If we bend the knee now, our children’s children may be at the mercy of the Chinese Communist Party, whose actions are the primary challenge today in the free world. General Secretary Xi is not destined to tyrannize inside and outside of China forever, unless we allow it.”

“So we can’t face this challenge alone. The United Nations, NATO, the G7 countries, the G20, our combined economic, diplomatic, and military power is surely enough to meet this challenge if we direct it clearly and with great courage. Maybe it’s time for a new grouping of like-minded nations, a new alliance of democracies. We have the tools. I know we can do it. Now we need the will. To quote scripture, I ask is ‘our spirit willing but our flesh weak?’ If the free world doesn’t change – doesn’t change, communist China will surely change us. There can’t be a return to the past practices because they’re comfortable or because they’re convenient. Securing our freedoms from the Chinese Communist Party is the mission of our time, and America is perfectly positioned to lead it because our founding principles give us that opportunity.”
“Indeed, Richard Nixon was right when he wrote in 1967 that ‘the world cannot be safe until China changes.’ Now it’s up to us to heed his words. Today the danger is clear. And today the awakening is happening. Today the free world must respond. We can never go back to the past.”

The U.S. has Crossed China’s Red Lines – have U.S./China relations crossed the Rubicon? I’ve for years now feared this rivalry risked deteriorating into confrontation. Such analysis doesn’t seem as wacko these days. And sure, U.S. stocks ended down slightly for the week, as manic markets somewhat began to take notice. It was fascinating to contrast market complacency with regard to collapsing U.S./China relations, to analysts histrionic response to the EU agreeing to debt mutualization (and grants to nations) as part of its COVID stimulus package.

July 20 – Associated Press (Raf Casert and Samuel Petrequin): “Weary but relieved, European Union leaders finally clinched an unprecedented 1.82 trillion euro ($2.1 trillion) budget and coronavirus recovery fund early Tuesday, somehow finding unity after four days and as many nights of fighting and wrangling over money and power in one of their longest summits ever. To confront the biggest recession in its history, the EU reached a consensus on a 750 billion euro coronavirus fund to be sent as loans and grants to the countries hit hardest by the virus. That comes on top of the seven-year 1 trillion euro EU budget. At first the grants were to total 500 billion euros, but the figure was lowered to 390 billion euros.”

Italian yields ended the week below 1% for the first time, with Greek yields down to a record low 1.05%. The euro closed the week at 1.1656, the high since September 2018. “Whatever it takes” ECB stimulus finally has its faithful partner: EU debt mutualization. As bullish thinking goes, no longer must markets fret a collapsing Italy seeking to exit the euro currency. European monetary integration’s weak link has been fortified.

Count me skeptical that this week’s EU compromise opens the floodgates for years of joint Eurobonds, with finance flowing freely to Italy and its “Club Med” neighbors. COVID created unique and pressing issues – and in four tough days of negotiations leaders from the 27 member nations mustered a compromise. But we haven’t heard the last from the “frugal four” (Sweden, Denmark, Austria and the Netherlands). Markets shouldn’t go too crazy in their mental extrapolations and “fiscal union” dreams. Deep philosophical divisions have not been resolved. Indeed, bitterness and animosity were likely reinforced. Going forward – post-COVID – I don’t expect widespread public support for fiscal union or EU handouts.

July 23 – Bloomberg (Joe Light): “Hedge funds and mutual funds are among bond holders that could lose $2 billion as a consequence of U.S. lawmakers letting millions of homeowners delay their mortgage payments… At stake are so-called credit-risk-transfer securities whose owners include fixed-income funds run by Franklin Resources and AllianceBernstein Holding LP. The securities, which threaten to lead to estimated losses of between $1 billion and $2 billion, are intended to shift the risk of borrower defaults on Fannie Mae and Freddie Mac mortgages to private investors. The issue is an unintended side effect of the response to the global health crisis. As the U.S. economy shut down in March, Congress rushed to pass the $2 trillion CARES Act, which included a provision that allowed forbearance on loans backed by Fannie and Freddie for as long as one year if borrowers were impacted by the pandemic.”

We’ve only begun to scratch the surface of COVID ramifications. Perhaps a small silver lining – it should quell the idea of privatizing Fannie Mae and Freddie Mac. The CARES Act provision for forbearance on Fannie and Freddie mortgages offers a timely reminder that the bulk of U.S. mortgage risk is nationalized. And in difficult times this nationalization will be explicit – and costly for the U.S. taxpayer. I am opposed to private sector skimming “profits” during the good times only to leave skin and bones and worse for when things turn bad. We’ve seen enough of that.

COVID is accelerating myriad trends and dynamics: bursting global Bubbles, Fed and global central bank inflationism, global economic structure, U.S./China relations and the world order more generally.

The U.S. dollar index dropped 1.6% this week to the low since September 2018. The dollar fell 2.0% versus the euro and Swiss franc and 0.8% against the Japanese yen. Interestingly, China’s renminbi was the only major currency down versus the dollar this week (0.37%). Against the euro and Swiss franc, the renminbi lost a notable 2.3%. The renminbi fell 1.2% versus the yen. Meanwhile, gold bullion surged $92, or 5.1%, to $1,902 – just below the all-time high from September 2011.

It’s intriguing to see both the dollar and renminbi underperform global currencies in a week when U.S./China relations took a turn (dive) for the worse. “The truth is that our policies – and those of other free nations – resurrected China’s failing economy,” Pompeo asserts. How China was capable of rising to global superpower status in only a couple decades will be debated for decades to come. Many were complicit. Virtually everyone wanted to participate in the historic boom. Who wasn’t willing to overlook longer-term ramifications, while disregarding red flags flying in abundance?

I’m not confident history will fault the Federal Reserve and decades of unsound money. The U.S. has run persistent Current Account Deficits for more than thirty years, flooding the world with dollar liquidity. Serial Bubbles began in Japan in the mid-eighties, then to Mexico, SE Asia, Russia, Brazil, Argentina, Iceland and so on. It would eventually make it to China.

China ended 2002 with international reserve holdings of less than $300 billion. U.S. Bubble period trade deficits saw Chinese international reserves spike to almost $2.0 TN by the end of 2008. Things then went crazy. QE1 was instrumental in China’s reserves inflating another $1 TN by 2011 – on their way to 2014’s $4.0 TN.

Original Post 25 July 2020

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