Wednesday, October 10, 2018

Trump’s Poison Pills for China


A week ago I wrote about “China’s Syndromes.” I noted that aging demographic forces, which were significantly exacerbated by the Chinese government’s one-child policy, are already depressing the growth rate of real retail sales in China (Fig. 1 and Fig. 2). As a result, the government is scrambling to expand its overseas military and economic power to counter the structural weakness at home.

I argued that President Donald Trump is implementing policies aimed at either slowing or halting China’s drive to become a superpower. He wants to reduce America’s huge trade deficit with China by forcing US and other manufacturers to move out of that country. In the process, the US would no longer be financing China’s ascent with our trade deficit and providing technological know how that has been either stolen or extorted.

I didn’t have to wait long to get confirmation of my working hypothesis. Consider the following fast-paced developments:

(1) The President’s speech. In his 9/25 speech before the United Nations General Assembly, Trump said only the following about China, focusing on trade: “The United States lost over 3 million manufacturing jobs, nearly a quarter of all steel jobs, and 60,000 factories after China joined the WTO. And we have racked up $13 trillion in trade deficits over the last two decades. But those days are over. We will no longer tolerate such abuse. We will not allow our workers to be victimized, our companies to be cheated, and our wealth to be plundered and transferred. America will never apologize for protecting its citizens. … China’s market distortions and the way they deal cannot be tolerated.”

(2) The Vice President’s speech. In a 10/4 speech at the Hudson Institute, Vice President Mike Pence discussed the administration’s policy toward China in far greater detail. He started out by warning: “Beijing is employing a whole-of-government approach, using political, economic, and military tools, as well as propaganda, to advance its influence and benefit its interests in the United States.”

He accused the Chinese Communist Party of using “an arsenal of policies inconsistent with free and fair trade, including tariffs, quotas, currency manipulation, forced technology transfer, intellectual property theft, and industrial subsidies that are handed out like candy to foreign investment. These policies have built Beijing’s manufacturing base, at the expense of its competitors—especially the United States of America.”

He specifically berated the party’s “Made in China 2025” plan for aiming to control 90% of the “world’s most advanced industries including robotics, biotechnology, and artificial intelligence. To win the commanding heights of the 21st century economy, Beijing has directed its bureaucrats and businesses to obtain American intellectual property—the foundation of our economic leadership—by any means necessary.” He accused the Chinese of stealing US technology including cutting-edge military blueprints. “And using that stolen technology, the Chinese Communist Party is turning plowshares into swords on a massive scale,” he said.

He point-blank accused China of economic and military aggression abroad: “[W]hile China’s leader stood in the Rose Garden at the White House in 2015 and said that his country had, and I quote, ‘no intention to militarize’ the South China Sea, today, Beijing has deployed advanced anti-ship and anti-air missiles atop an archipelago of military bases constructed on artificial islands.” The result has been provocative and dangerous near misses between our two navies in the South China Sea.

Pence also documented instances of China using so-called “debt diplomacy” to expand its influence: “Today, that country is offering hundreds of billions of dollars in infrastructure loans to governments from Asia to Africa to Europe and even Latin America. Yet the terms of those loans are opaque at best, and the benefits invariably flow overwhelmingly to Beijing.”

The US has responded by boosting defense spending and slapping tariffs on China. These “exercises in American strength” explain why China’s largest stock exchange fell by 25% in the first nine months of this year. Got that? The US is targeting China’s stock market!

Pence accused the Chinese government of oppressing its own people at home. He railed about the Great Firewall of China “restricting the free flow of information to the Chinese people.” Even more frightening, he said, is the “Social Credit Score,” which, according to the official blueprint, will “allow the trustworthy to roam everywhere under heaven, while making it hard for the discredited to take a single step.” It will be implemented in 2020.

Pence also attacked the Chinese government for meddling in US politics in an effort to weaken America. He claimed that in June, “Beijing itself circulated a sensitive document, entitled ‘Propaganda and Censorship Notice.’ It laid out its strategy. It stated that China must, in their words, ‘strike accurately and carefully, splitting apart different domestic groups’ in the United States of America.”

There are lots more complaints about China in Pence’s speech. Clearly, the Trump administration’s policy toward China isn’t just about trade. A 10/5 NYT article critically stated that Pence in effect had declared a “New Cold War” with China. An alternative spin is that Pence was simply recognizing that China has launched an ever-expanding war against American interests.

(3) The poison pill placed in USMCA. A 10/5 CNBC article noted that there is a provision in the newly passed North American trade agreement, the United States-Mexico-Canada Agreement (USMCA, a.k.a. “the new NAFTA”), “which effectively gives Washington a veto over Canada and Mexico’s other free trade partners to ensure that they are governed by market principles and lack the state dominance.” In effect, that’s a “poison pill” aimed at China.

When Trump was elected, I observed that after eight years of government by community organizers, we were about to have a major regime change with government by dealmakers. US Commerce Secretary Wilbur Ross, a consummate wheeler-dealer when he was in the private sector, signaled on Friday that Washington may insist on including this poison-pill provision in future bilateral trade deals. “People can come to understand that this is one of your prerequisites to make a deal,” he said.

(4) JP Morgan’s bearish call. Last Wednesday, JPMorgan strategists wrote in a note that “[a] full-blown trade war becomes our new base case scenario for 2019” with 25% US tariffs imposed on all Chinese goods. They added, “There is no clear sign of mitigating confrontation between China and the U.S. in the near term.” In his 10/5 Barron’s column, Randy Forsyth noted that the bank’s strategists “estimate that 25% levies on all Chinese imports to the U.S. would trim earnings for the S&P 500 by $8 a share, from their original projection of $179 for 2019. ‘Such a downgrade would mark the first of the Trump era and potentially end the U.S. stock market rally, even assuming a forward [price/earnings] multiple of 17, unless some other offset materializes,’ they conclude.”

I agree that Trump will probably slap Chinese goods with an across-the-board 25% tariff. I think that the US economy will be strong enough to boost S&P 500 earnings by 6.8% to $173 per share, which has been our number for next year for a while. I don’t think that the escalating trade war with China will be the event that ends the bull market in the US (Fig. 3). However, it may already be marking the beginning of a severe and prolonged bear market in China (Fig. 4).

While financial markets were closed all last week in China for the Golden Week vacation, Hong Kong stocks fell for four consecutive days as investors grew increasingly concerned that the impact of the trade war is starting to show.

On Sunday, the People’s Bank of China slashed the reserve requirement ratio for large banks (currently 15.5%) and small banks (13.5%) by 100 basis points effective October 15 (Fig. 5). This is the fourth such cut this year. The prime rate is also likely to be cut soon (Fig. 6). Beijing has pledged to expedite plans to invest heavily in infrastructure projects as the economy shows signs of cooling further, with investment growth recently slowing to a record low.

CNBC reported yesterday, “On the back of the central bank’s announcement, China’s mainland markets traded in negative territory for much of their first trading day following the Golden Week holiday. Both the Shanghai composite and the Shenzhen composite fell more than 3.7% by the end of the trading day.” The two indexes peaked this year on January 24 and are down 23.7% and 25.0%, respectively (Fig. 7). China’s MSCI is down 26.0% from its peak on January 26. Hong Kong’s Hang Seng is down 21.0% from its peak also on that day (Fig. 8).

(5) Cyber war. The 10/4 Bloomberg Businessweek included a cover story titled “The Big Hack: How China Used a Tiny Chip to Infiltrate U.S. Companies.” The story is based on information from multiple intelligence and business sources who confirmed that Chinese spies attacked almost 30 US companies, including Amazon and Apple, “by compromising America’s technology supply chain, according to extensive interviews with government and corporate sources.” Operatives of the People’s Liberation Army inserted tiny microchips designed for spying in motherboards made in China and sold to American companies.

Both Amazon and Apple denied they had been hacked. Whether accurate or fake news, the story certainly could convince many companies to cut China out of their supply chains. That would fit in nicely with the Trump administration’s campaign to move production out of China back to the US.

(6) Bottom line. Trump’s fiscal, trade, and sanctions policies have boosted the dollar, oil prices, and interest rates. The risk, of course, is that these developments could punish not only China but lots of other emerging market economies as well. In the US, higher oil prices along with higher interest rates could also weigh on the US economy. Those are the major foreseeable risks. For now, I don’t see this all leading to a financial crisis or a recession. But I’m on alert: There sure are lots of poison pills out there!

Monday, October 1, 2018

China’s Syndromes


China I: Getting Trumped. I’m coming around to a new working hypotheses on the outlook for China’s economy. I think it could be much weaker much sooner than widely recognized. A significant slowing in the growth rate of inflation-adjusted retail sales over the past couple of years suggests that the aging demographic factor—attributable to the government’s previous population control measure—may be hitting consumer spending significantly already. As a result, Trump’s escalating trade war with China may very well hurt China’s economy much harder than widely realized.

Furthermore, what if Trump’s trade war with China isn’t just about trade? Yes, we all know it is also about intellectual property rights. But what if at heart it’s about China’s superpower ambitions—as evidenced by its moves to control the South China Sea, to build the “Silk Road” linking China to Europe by way of Central Asia, and to exploit the resources of Africa? The Chinese government, under President-for-life Xi Jinping, is intent on challenging America’s status as the world’s sole superpower. So why should the US continue to enable Xi’s geopolitical masterplan by allowing the Chinese to run a huge trade surplus with the US and to steal US technology?

The Trump administration’s overarching policy goal vis-à-vis China, therefore, may be first and foremost to use America’s economic power to slow, or even halt, the ascent of China into a superpower, which will challenge America’s interests around the world. If so, then any concessions that the Chinese make on trade and technology are likely to be rejected by the Trump administration. In other words, they have nothing to offer that would satisfy Trump other than an unconditional retreat from their geopolitical expansion plans, which they will never do voluntarily.

So Trump may very well raise the ante soon by slapping a permanent 25% tariff on all goods that the US imports from China. The goal isn’t to force concessions out of China but rather to get manufacturers out of China and into either the US (ideally) or to countries such as Mexico that do agree to the terms of bilateral trade deals with the US!

Of course, manufacturers who stay in China won’t be paying the 25% tariff: US consumers who buy China-made goods will be hit with that price hike. However, to remain competitive in the US, manufacturers are likely to scramble to other countries that can export to the US without having the US dollar price of their goods marked up by 25%.

I have one piece of anecdotal evidence that companies may be starting to move out of China already. A good friend of mine has a small business in Manhattan designing and selling high-end raincoats in the US. He has been manufacturing them in Vietnam. He stopped making them in China a few years ago because labor costs have been rising there, while they remain low in Vietnam. He told me he was shocked recently when his Vietnamese vendor had to lengthen delivery schedules from four months to six months because it was swamped with orders that used to be filled in China prior to Trump’s trade war.

Now consider the following recent developments before we review China’s depressing demographic outlook:

(1) Peter Navarro’s view. A Monday 9/24 CNBC article reported that Peter Navarro, director of the National Trade Council at the White House, said getting a trade deal with China will be tough: “The challenge is, they've engaged in so many egregious practices that it's far more difficult to make a deal with China than it would be with Mexico.” Navarro is a former economics professor and author of The Coming China Wars: Where They Will Be Fought, How They Can Be Won (2006).

A 6/24 Axios article quoted Navarro saying: “Since China joined the WTO [i.e., the World Trade Organization] in 2001, the U.S. has lost over 70,000 factories, more than five million manufacturing jobs, and suffered from substantially lower real GDP growth rates. As America’s manufacturing and defense industrial base has weakened, China’s has strengthened and we now face a strategic rival in places like the South China Sea whose military forces have been largely financed by the massive trade deficits the U.S. runs with China.”

Navarro had more to say on this subject in a 6/20 WSJ article titled “Trump’s Tariffs Are a Defense Against China’s Aggression: Beijing seeks economic and military domination by taking U.S. technology and intellectual property.” His opening paragraph said it all: “The Chinese government’s Made in China 2025 blueprint reveals Beijing’s audacious plans to dominate emerging technology industries. Many of these targeted sectors, such as artificial intelligence and robotics, have clear implications for defense. China seeks to achieve its goal of economic and military domination in part by acquiring the best American technology and intellectual property. President Trump’s new tariffs will provide a critical shield against this aggression.”

(2) Higher tariffs. Also on Monday 9/24, Washington slapped tariffs of 10% on $200 billion of Chinese products that include furniture and appliances, and the rate will increase to 25% by the end of the year. President Xi Jinping's government retaliated by imposing taxes on 5,207 US imports, worth about $60 billion. Products such as liquefied natural gas, coffee, and various types of edible oil will see a 10% levy, while a 5% tax will be imposed on items such as frozen vegetables, cocoa powder, and chemical products.

The US and China already had applied tariffs to $50 billion of each other's goods. Trump has warned that any retaliation by China would prompt Washington to “immediately pursue phase three, which is tariffs on approximately $267 billion of additional imports.”

Trump has overtly expressed his desire to narrow the US trade deficit with China significantly and to bring back manufacturing capacity to the US, so he may not declare victory in his trade war with China until Apple is making most of its iPhones in the US. It’s also conceivable that Trump may be mollified if Chinese leaders relinquish at least some of the country’s unfair trade practices, especially those related to foreign technology investment. But even if Trump’s negotiations with China and other countries don’t succeed in getting what he wants, they may succeed in providing more opportunities for the US to shop around for fairer trading partners.

Interestingly, cell phones and other household items is the largest category of imports to the US from China, according to the World Economic Forum. China isn’t the only place in the world to make cell phones, though. South Korean electronics giant Samsung is “now looking to fend off Chinese companies trying to dominate the market for inexpensive phones” by expanding manufacturing into India, according to an article in the 9/4 WSJ. The company’s new facility in a New Delhi suburb, to be completed in 2020, will eventually make 120 million handsets a year, or roughly one of every 13 phones in the world. Around 30% of those will be exported.

(3) Arms race. On Thursday 9/20, Washington imposed sanctions on a Chinese military unit for purchasing Russian weapons, claiming the transaction violated a US sanctions law known as “Countering America's Adversaries Through Sanctions Act,” which was signed by President Trump on August 2, 2017. The act imposed sanctions on Iran, North Korea, and Russia. The Chinese government summoned the US ambassador in Beijing over the matter and said Beijing would recall its navy chief from a visit to the US.

On 9/25, the US approved a $330 million arms sale to Taiwan in another sign of Washington’s support for the government in Taipei amid rising Chinese pressure on the country. In the latter years of George W. Bush’s presidency, Washington dropped annual weapons sales to Taiwan in favor of bundling sales every few years, a move that was seen as acquiescence to pressure from China. Under Trump, there may be a return to the routine sale of weapons to Taiwan, despite protests from China.

Meanwhile, China has sought to strengthen its claim to the South China Sea by building seven islands on reefs and equipping them with military facilities such as airstrips, radar domes, and missile systems. Five other governments claim territory in the oil- and gas-rich area, through which an estimated $5 trillion in global trade passes annually. Last Thursday, China called a recent mission by nuclear-capable US B-52 bombers over the disputed South China Sea “provocative.”

China II: Why Trump Won. Trump won on November 8, 2016 because he appealed to voters who lost manufacturing jobs after China entered the WTO and manufacturers left the US. Previously, I’ve shown a chart that clearly shows this development. It tracks US manufacturing production and capacity since January 1948 (Fig. 1). The two were on similar and solid uptrends—tracking at about 4% per year on average—until China joined the WTO during December 2001. Both have been flat ever since. I estimate that if the trend prior to December 2001 had persisted, US manufacturing capacity would be 77% higher than it was during August of this year (Fig. 2)!

We can also guesstimate China’s impact on jobs. Factory payrolls dropped 4.3 million from December 2001 (when China joined the WTO) through March 2010 to the lowest level since March 1941 (Fig. 3). They were still down 3.4 million through Election Day 2016 and 3.0 million through August of this year.

The ratio of US factory jobs to capacity has declined 24% since the end of 2001 through August of this year, presumably reflecting productivity gains (Fig. 4). If capacity had remained on its uptrend prior to China joining the WTO, factory employment arguably would be 53%, or 6.7 million jobs, higher than August’s level of 12.7 million. (We derived the percentage increase by subtracting 77% from 24%.)

So Trump’s victory on Election Day 2016 may largely reflect the hostile reaction of America’s manufacturing Heartland to China’s ascent, presumably at US factory workers’ expense.

China III: The Most Important Indicator. While manufacturing employment may be the key indicator explaining why Trump beat Clinton, inflation-adjusted retail sales in China may be the most important variable for tracking the impact of China’s increasingly dismal demographic profile on its economy. Consider the following:

(1) Real retail sales. Every month, the Chinese report retail sales and the consumer price index (CPI). We’ve been monitoring the yearly percent changes in both for many years (Fig. 5). The difference between the two is the growth rate in real retail sales. It has been on a downtrend since 2008-2010 when it typically exceeded 15%. During August of this year, it was down to 6.7%, one of the lowest readings since China joined the WTO at the end of 2001. It is down from 9.3% two years ago.

(2) Industrial production. Real retail sales has actually been growing faster than industrial production since early 2012 (Fig. 6). The latter has been growing around 6.0% y/y since 2015. It is likely to fall sooner rather than later if the downtrend in real retail sales persists (as suggested by the demographic trends discussed below) and Trump’s trade war weighs on exports.

(3) Credit. All of the above suggests that the Chinese government may have no choice but to continue propping up economic growth with debt-financed infrastructure spending. Bank loans (in yuan) have quadrupled in China since February 2009 (Fig. 7). Yet the Chinese are getting less and less bang per yuan. The ratio of Chinese industrial production to bank loans has dropped by roughly 50% since late 2008 (Fig. 8).

It’s possible that my analysis so far is too negative. Missing is the growing importance of services industries in China. Nevertheless, demography is destiny, and the Chinese government made an increasingly dismal global outlook on this front much worse in China.

China IV: Depressing Demographic Destiny. In Chapter 16 of my book, Predicting the Markets, I discuss China’s depressing demographic destiny. That discussion is especially relevant to today’s commentary:

“The fertility rate in China plunged from 6.1 in the mid-1950s to below 2.0 during 1996 (Fig. 9). Still below 2.0, it’s projected to remain so through the end of the century. Initially, the drop was exacerbated by the government’s response to the country’s population explosion, which was to introduce the one-child policy in 1979. While that slowed China’s population growth—to a 10-year growth rate of 0.5% at an annual rate in 2016 from a 3.0% pace in 1972—it also led to a shortage of young adult workers and a rapidly aging population.

“So the government reversed course, with a two-child policy effective January 1, 2016. Births soared by 7.9% that year with the deliveries of about 18 million newborns. But that was still short of the government estimates and might not be sustainable. At least 45% of the babies born during 2016 were to families that already had one child. [For more, see link.]

“Meanwhile, urbanization has proceeded apace, with the urban population rising from about 12% in 1950 to 49% during 2010; it was an estimated 57% in 2016 (Fig. 10). The urban population has been increasing consistently by around 20 million in most years since 1996 (Fig. 11). To urbanize that many people requires the equivalent of building one Houston, Texas per month, as I discuss in Chapter 2. I first made that point in a 2004 study.

“The move to a two-child policy is coming too late, in my opinion. China’s primary working-age population peaked at a record high of just over 1.0 billion during 2014 and is projected to fall to 815 million by 2050 (Fig. 12). By then, the primary working-age population in China will represent 60% of the total population, below the peak of 74% during 2010 (Fig. 13). The elderly dependency ratio will drop from 7.5 workers per senior in 2015 to 2.3 by 2050 (Fig. 14).

“In any event, despite the initial mini baby boom, the fertility rate is unlikely to rise much in response to the government’s new policy. Many young married couples living in China’s cities are hard-pressed to afford having just one child. An October 30, 2015 blog post on the Washington Post website, titled “Why Many Families in China Won’t Want More than One Kid Even if They Can Have Them,” made that point, observing that education is particularly expensive, as parents feel compelled to prepare their child to compete for the best colleges and jobs. Another problem is that most couples are the only offspring of their aging parents, who require caregiving resources that rule out having a second child. As it says in the Bible, ‘As you sow, so shall you reap.’”