As our readers know, in our various posts THE UPCOMING BEAR MARKET on January 19th 2018 and EUPHORIA ! on January 22nd 2018, we timed the top of the 2016-2018 bull market almost to the day.
Since then, most equity markets went either sideways or in outright bear phases and the US equity market – and US technology in particular – was the only segment of the global equity markets to deliver positive performances as the US economy and corporate earnings benefitted from the shot in the arm of the Trump tax overhaul voted in December 2017.
In the first quarter of 2018, Donald TRUMP launched his Trade wars on Mexico, Canada, Europe and China creating havoc and uncertainty.
At the same time, rising interest rates in the US coupled with Sanctions against Turkey and Russia created panic in emerging markets and several countries with high current account deficits and large foreign indebtedness suffered sever attacks on their currencies.
In our posts TRADE WARS ARE THE WARS OF THE 21st CENTURY, AND AMERICA WILL LOSE THAT ONE , SANCTIONS AS WEAPONS OF MASS DESTRUCTION and CHINA MALAISE ? of April, July and August 2018, we analyzed the potential consequences of the Trade War on China.
We came to the conclusions that the USA would not win that ill-conceived trade war, but that it would ultimately bring China to allow its currency to rise.
Chinese equities lost 30 % of their value – a US$ 5 trillion wipe-out – in the past eight months and are now trading where they traded in 2014, before the big 2015 rally.
Simultaneously, the market interpreted the Trade War and the temporary weakening of the Chinese economy as elements that would drive the Chinese Yuan lower. Hedge funds and Chinese investors pushed the Chinese currency down from 6.25 in January to 6.86 yesterday, leading the PBOC to re-ibstate guidance on the foreign exchange rate and stop the fall.
In our post BUY CHINA ! and ADDING TO CHINA ! of July and August 2018, we made the case that the economic fears about a China slowdown were overblown, that the impact of the US trade war would be limited to 0.5 / 0.7 % of GDP at most, and that Chinese equities had reached valuation levels that were compelling enough to start investing in Chinese equities in a big way.
Last night, Donald Trump ordered 10 % tariffs on another US$ 200 Billion of Chinese goods imported to the US, to be increased to 25 % on January 1st 2019. He made sure that some of the essential components used by US majors such as APPLE Inc. were excluded of the scope of the tariffs.
Today, the Chinese equity markets rose sharply with the CSI300 closing 2 % higher and the Shanghai Composite adding + 1.82 % despite the negative news…
We take it as a sign that the Chinese Government is determined to fight the US and will not allow Donald Trump’s trade war to develop into a Chinese equity bear market that could have significant economic consequences for China.
To us, today’s price action marks THE END OF THE CHINA MALAISE and signals the beginning of a new bull phase in Chinese assets.
We analyze below what is likely to happen next in an all-out US – China Trade War
From an Market standpoint
We highlighted in our various posts recently that Chinese equities were trading at major long-term support levels and exceptionally attractive valuations.
In the bear phase, local and international hedge funds have been building massive short positions and the price action of individual stocks in the past two weeks indicates that domestic investors have been liquidating their holdings indiscriminately regardless of valuations.
That was particularly evident in several auto and component stocks that reached valuation levels unheard of in the past 15 years.
However, selling pressure abated in the past two weeks and traders and hedge funds failed to take the indexes below their key support levels.
Last night, Donald Trump’s move to slap a 10 percent levy on $200 billion in Chinese goods from next week was certainly not good news, but the fact that investors rushed back into the market and are covering their shorts is an extremely bullish indicator.
With Asian equities near the cheapest valuations in more than two years, emerging-market stocks in a bear market and the Shanghai Composite Index closing at the lowest since 2014 on Monday, the impact of the trade war has certainly been fully accounted for.
From the Trade War standpoint
Investors are now waiting for China’s response.
Chinese Vice Premier Liu He, President Xi Jinping’s top economic adviser, was convening a meeting in Beijing today to discuss the government’s response to the U.S. tariffs.
We expect the retaliation to be strong and damaging to the US economy
China has accepted the fact that it has to go through the trade war and that this trade war is a personal crusade of Donald Trump, and not of America.
As we highlighted in our post DONALD TRUMP’S POLITICAL SUICIDE, China has no choice but to wait and to inflict as much pain as it can from now till the Nov 8th Mid-term US elections in the hope that Donald Trumps’ political standing will be weakened.
Donald Trump was elected in 2016 with a popular vote deficit of 2’000’000 voters and the Republican Party is highly divided on his methods and international agenda. And corporate America is the main contributor to the Republican Party’s finances.
Senior Wall Street executives met in Beijing on Sunday with current and former Chinese officials and bankers at a hastily organized session to find ways to strengthen financial ties between the United States and China and reduce the strains of the Trade War.
Yesterday, the group — which included executives from Goldman Sachs Group, Morgan Stanley and the Blackstone Group among others — met with Vice President Wang Qishan, the right hand man of Xi Jinping, the country’s leader.
New trade talks between the two governments were tentatively scheduled between Steven Mnuchin, the Treasury secretary, and Liu He, a Chinese vice premier,later this month in Washington. Stephen A. Schwarzman, Blackstone’s chief, has been playing a critical role in organizing them.
But the Chinese have indicated that they will pull out of the talks if Mr.
Trump follows through on his threat to impose tariffs on another $200 billion in Chinese goods and we expect them to do exactly that.
Moreover, we expect the Chinese to hit directly and significantly US corporations such as Boeing, Ford, General Motors, IBM, Apple, Microsoft and most of the large American financial institutions.
Until now, China showed a lot of restraint in the Trade War escalation and kept the door open to negotiations. This has probably come to an end yesterday.
The Trade War is a highly frustrating situation for Corporate America.
Even as they won tax cuts and regulatory rollbacks from the Trump administration and the Republican-controlled Congress, Corporate America appears to be unable to stop the trade war.
Wall Street and Main Street have long gambled that helping China would pay off.
China has been slow to open its vast market and tightly controlled financial markets, and American businesses have built their long term growth strategy on the opening up of the strategic Chinese consumer market – the largets in the world.
The worsening trade war will certainly stymie that progress and hurt other foreign businesses as well. It will also probably help South east Asia somewhat by re-directing sourcing of components to other Asian Nations, and a greater focus of Chinese corporations to sell their products in Asia rather than the US.
Lou Jiwei, China’s former finance minister, said in a speech on Sunday that China could block exports of crucial components for Western supply chains if the trade war continued.
Such a move would disrupt American businesses and although it may trigger efforts by US corporations to shift factories away from China in favor of countries like Taiwan, Korea or Vietnam, the process will be long and costly.
In the mean time, US consumers are likely to pay higher prices for their usual products, not a positive in an economy where the return of inflation is already the main issue at the moment.
Finally, China’s huge amount of foreign exchange reserves gives it a major leeway on the US economy. We doubt that they will use it before the results of the US mid-term elections but they could easily start off-loading their US$ 1 Trillion of US Government bonds, pushing US interest rates higher, a sharp negative for the US economy and corporate America.
In the process, they would lift their own currency rate and trigger an inflow of capital into the Chinese currency and capital markets.
Contrary to popular belief, a rising Yuan and rising Chinese asset markets would be a great positive for an economy that is now relying primarily on domestic consumption.
A rising Yuan would also allow the PBOC to implement easier monetary policies and cushion the structural deceleration of the Chinese economy as it matures.
Over the past three decades, China has emerged as a major global economic growth driver and has become a strategic market for most American corporations.
In a highly competitive and globalized world, US companies have everything to lose from being cut out form the largest consumer market of the world and the main beneficiaries would be Chinese companies themselves and the European and Asian competitors of American corporations.
Until now, the Trump administration’s trade hawks have so far prevailed against Wall Street and Main Street voices of trade moderation, such as Mr. Mnuchin, a onetime Goldman Sachs executive.
That is partly because until now, the trade war hasn’t shown President Trump much political downside.
US equities kept on rising, and the cost of the tariffs have not yet been reflected in the prices of goods sold by US corporations but manufactured in China.
This is about to change.
Yesterday roll-over of the US stock market – and of tech in particular – may be a sign that Mr. Trump has taken one step to many in fueling uncertainty and may be triggering a sell-off that could turn into a real rout in the over-owned and over-extended US technology sector.
A long awaited US correction may have started yesterday and we had several technical warning signals in the past few weeks that a significant move could happen anytime soon.
Yesterday, the underbelly of the options market was flashing a major warning sign for U.S. stock bulls.
The Cboe SKEW Index breached 150 last week, reflecting a surge in demand for out-of-the-money put options versus calls on the S&P 500 Index. The elevated level may be evidence that a blow-up in U.S. stocks — returns two or more standard deviations below the mean, also dubbed a ‘black-swan’ event — may be happening soon.
A correction in US equities ahead of the mid-term elections would be the one thing that American voters would not forgive Donald Trump for, especially if it is linked to his US – China Trade crusade
Most Americans don’t care about China, they care about their 401-K plans.
From the economic standpoint
Within this context of Trade War, investors have taken heart from
China’s commerce minister saying the nation is confident in achieving its economic targets.
China is not worried about either the Trade War itself or the economy.
Most Chinese and foreign economists calculate that even in the worst case scenario where all goods imported from China to the US were subject to a 25 % levy, the impact on the China’s GDP would not exceed 0.5 to 0.7 %.
In fact, the latest data show that the Chinese economy remains on a solid path of growth.
Contrary to expectations, China’s trade surplus with the U.S. rose to a record in August. China’s trade gap with the U.S. widened to $31.1 billion during the month, despite exports climbing at the slowest pace since March. Shipments rose 9.8 percent in dollar terms while imports climbed 20 percent.
China’s trade surplus with the world and with the US is STRUCTURAL by nature, and it is mainly due to the structural undervaluation of the Chinese Yuan.
No country generates Trade Surpluses consistently for decades unless its labor force and productivity are structurally competitive.
What it means is that Tariffs will not do much to resorb the Trade Surplus and the only solution, as we have advocated many times in the past, is a substantial rise in the value of the Chinese Yuan.
Until now, China has been resisting this harsh reality and refused to allow their currency to rise. However, the changing nature of their economy and the need to compensate the negative effects of the Trade War may accelerate the acceptance of this structural change.
Politically, China will use the current Trade War to position itself as an active supporter of multilateralism and of globalization while painting the US as the isolationist and protectionist nation.
A rising Yuan will accelerate the use of the Chinese Yuan in International transactions and allow easier monetary policies without sacrificing on the de-leveraging of the Chinese economy.
China’s economic growth remains strong at 6.7 % and will decrease naturally towards 6.5 % as its economy matures.
The Chinese consumer continues to power ahead…
While industrial production remains stable growing 5 % per annum.
In other words, the current malaise does not justify a full 30 % decrease in the value of Chinese equities that were already amongst the cheapest in the investable universe.
From the psychological standpoint
This is where Donald Trump’s trade war on China is both ill-conceived and dangerous for the USA.
Yesterday’s announcement on tariffs on $200 billion-worth of Chinese
goods came Tuesday Beijing time, just as the nation was preparing a nationalistic commemoration of resistance to foreign humiliation.
Sept. 18, 1931 marks the Mukden Incident, when dissident Japanese soldiers staged a fake attack on a railway line near the modern Chinese city of Shenyang as a pretext to their country’s invasion of Manchuria.
China’s increasingly jingoistic turn under President Xi Jinping has turned this anniversary into a sizable event, marked with memorial ceremonies, school assemblies and air-raid sirens blaring in some cities, and this year a film screening in Washington.
Since 2014, Beijing has introduced three public holidays to commemorate aspects of the war with Japan, two of them taking place this month.
The Chinese memory of the “Lost Century” the 19th century, where China was weakened by opium and parts of its territory occupied by foreign nations is still extremely vivid.
Thinking that Beijing will agree to make wide-ranging changes to its economic model in response to threats from Washington is like thinking that Donald Trump would change his policies because Wladimir Putin threatened him.
The history of Trade wars is not new in China.
It begins in the early 19th century, when the European vogue for Chinese tea and manufactured goods left the Qing Empire with a substantial trade surplus. The British East India Company sought to redress this balance by paying for Chinese goods with the opium it grew in India. That stopped the drain on its silver reserves but fueled a growing addiction crisis in China.
The trade eventually prompted China’s equivalent of the Boston Tea Party, when Qing officials seized about 1,300 metric tons of opium in 1839 and destroyed it on an island at Humen in the mouth of the Pearl River.
Unlike its American precursor, though, the Humen incident was a disaster, sparking the First Opium War and, ultimately, the hand off of Hong Kong to the British.
While many Chinese citizens may be more conscious of the Great Leap Forward, the Cultural Revolution, and the post- Tiananmen crackdown, the country’s leaders still remember the Opium Wars, and the further conflicts that characterized the long decline of the Qing Empire.
Official rhetoric describes the whole period as a century-long “national humiliation” that only the Communist Party was able to reverse.
Today, China has a significant trade surplus again.
Once again, the world’s pre-eminent trading nation is complaining about it.
Once again, Chinese leaders suspect that the appeal to free trade is an excuse to seek wide-ranging changes to the Chinese state.
The weakness in Chinese stocks in the last few months is, in many ways, a symptom of the country’s continued focus on deleveraging and refusal to take a more stimulative path in response to the threats from Washington.
At the same time, it’s hard to see how current officials would be able to hold on to their own prestige were China to agree to any treaty with the West under pressure.
Donald Trump is making a phenomenal mistake in believing that such method will work with China and those hoping for a victory by Christmas to avert the proposed increase in the latest tariff rate to 25 percent from
the current 10 percent should watch out.
This isn’t just an economic fight for Xi, or the Communist Party. To them, this is history repeating itself.
And this time, they’re determined to be the victors.
America should worry about the development, helped or not by the Chinese Government, of an anti- American sentiment in China, their biggest market and calls for boycotts of American products.
China will close its borders to American products and American companies if the US does not change its attitude.
The main loosers, as we predicted many months ago, will be American companies and the US economy.
And while doing that, China will ensure that its own economy is doing well.
And to that effect, it will adopt stimulative policies, induce a stock market rally and make the Chinese Yuan appreciate markedly.