wknd notes: Russia's the Distraction, China's the Issue

The US and EU account for over 50% of global GDP and have the world’s largest bilateral trade relationship, exchanging $1.1trln of goods and services annually; there’s no more integrated economic relationship on earth. One-third of world trade involves the US and EU - the US is humanity’s #1 customer, accounting for 18% of all imports, the EU is #2 at 15%. Total US investment in the EU is 3x higher than its investment in all of Asia. EU investment in the US is 8x higher than its investment in India and China combined. The US and EU have 880mm people (12% of total population), $180trln of wealth (65% of global wealth) and own nearly all of humanity’s intellectual property. To be sure, we have our differences, but heaven help this planet’s divided nations if we set those aside and seek material advantage.

Overall: “Mr. President, ladies and gentlemen, when I was invited by the President to the White House, I had one intention: I had the intention to make a deal today,” announced Jean-Claude Juncker, camera’s clicking, a media whir, history in the making. “And we made a deal today,” continued the President of the European Commission, as a shockwave circled the planet. You see, throughout Europe’s timeless saga, never had a single politician cut a real deal on behalf of the entire continent, though not through any lack of effort. Many fought to attain the power of a united Europe - the Romans, Charlemagne, the short Frenchman with an ulcer, Austria’s most famous Adolph. Juncker’s unlike them all. He’s a creature of Europe’s modern union, a concept born of utter exhaustion, profound weakness. After a few thousand-year fight with itself, the continent abandoned ambition, and became a tourist attraction for wealthy Americans and Chinese, who swarm its antique cities, admiring their ancient achievements, aspirations. “So we had a big day. Very big. We met right here at the White House to launch a new phase in the relationship between the United States and the European Union — a phase of close friendship; of strong trade relations in which both of us will win; of working better together for global security and prosperity; and of fighting jointly against terrorism,” said Trump, triumphant. “The European Union is going to do better, stronger, bigger. We will therefore work closely together with like-minded partners to reform the WTO and to address unfair trading practices, including intellectual property theft, forced technology transfer, industrial subsidies, distortions created by state-owned enterprises, and overcapacity,” continued our President, describing China, America’s only rival, the one remaining world power with any true ambition. And so now the real economic war begins, with America and Europe allied. 

Week-in-Review (expressed in YoY terms): Mon: PBOC injects $74bln into Chinese banks via MLF loans, BOJ considering changes to asset buying program (10yr JGB yields jump to 0.08%, global bond yields continue higher), Mnuchin looking for sanctions relief for Rusal, Trump threatens Iran with severe consequences, existing home seals -2.2% (3rd mthly decline driven by severe housing shortage), S&P +0.2%; Tue: Chinese stocks hit 1mth high on PBOC liquidity injection (renminbi hits 1yr low then rebounds), Japan PMI manu -1.4 to 51.6 (20mth low), Turkey leaves rates unch (lira plunges), German manu PMI +1.4 to 57.3 (1st rise in 7mths), German services PMI -0.1 to 54.4, Trump pledges $12bln in aid to US farmers hurt by tariffs, Congress moves to ban stealth fighter exports to Turkey, Nasdaq hits record high, Kimberly Clark warns on higher input costs, S&P +0.5%; Wed: BOJ reportedly considering changes to its equity-purchase program, Saudi Arabia suspends oil shipments through Red Sea due to Yemen conflict, German business outlook falls for 8th mth, GM cuts 2018 forecasts on rising costs (tariff fallout), US new home sales 8mth low (inventories tick higher, median price -4.2% to $302k), Ford cuts guidance on higher input costs due to tariffs, Trump/Junker come to trade agreement (short on details but generally positive), Trump/Putin meeting delayed until 2019, S&P +0.9%; Thur: 10yr JGB yields touch 0.10% (6mth high), Korea GDP +0.1 to +2.9% (exports +4.5%, imports +0.9%), Imran Khan wins Pakistan election (critical of US policy in region, wants stronger China relations), ECB rates unch (affirms plan to end QE by Dec and keep rates unch at least through summer 2019), Draghi “inflation uncertainty receding but trade risk prominent,” Facebook misses (shares plunge 20%), S&P -0.3%; Fri: Japan’s BOJ intervenes in JGB market (pushes yields below 0.10%), North Korea returns US soldier remains, Putin announces open invite for Trump to visit Moscow, Turkey CPI +15.4%, US Q2 GDP +4.1% (fastest since Q3 2014), Twitter warns (shares drop 20%), Amazon quarterly profit record $2.5bln, S&P -0.7%.

Weekly Close: S&P 500 +0.6% and VIX +0.17 at +13.03. Nikkei +0.1%, Shanghai +1.6%, Euro Stoxx +1.7%, Bovespa +1.6%, MSCI World +1.1%, and MSCI Emerging +1.8%. USD rose +1.2% vs Turkey, +0.6% vs China, +0.6% vs Euro, +0.2% vs Sterling, and +0.2% vs Australia. USD fell -10.6% vs Bitcoin, -4.6% vs Ethereum, -2.6% vs Chile, -2.1% vs Mexico, -1.7% vs South Africa, -1.5% vs Brazil, -1.3% vs Russia, -0.7% vs Canada, -0.5% vs Indonesia, -0.3% vs Yen, -0.3% vs India, and -0.1% vs Sweden. Gold -0.7%, Silver -0.3%, Oil +1.3%, Copper +1.7%, Iron Ore +3.4%, Corn +2.0%. 5y5y inflation swaps (EU +2bps at 1.72%, US +3bps at 2.44%, JP flat at 0.40%, and UK +3bps at 3.44%). 2yr Notes +8bps at 2.67% and 10yr Notes +6bps at 2.96%.

2018 YTD Equity Indexes: Saudi Arabia +15.8% priced in US dollars (+15.8% in riyals), NASDAQ +12.1% priced in US dollars (+12.1% in dollars), Norway +10.8% in dollars (+10.9% in euros), Portugal +7.4% (+10.7%), UAE +10.1% (+10.1%), Russia -0.4% (+8.7%), Russell +8.3% (+8.3%), Finland +4% (+7.2%), New Zealand +2.6% (+7.1%), India -0.3% (+7.1%), Colombia +9.8% (+6%), Netherlands +2.6% (+5.8%), S&P 500 +5.4% (+5.4%), Brazil -7.1% (+4.5%), Taiwan +0.9% (+4.1%), Australia -1.6% (+3.9%), France +0.6% (+3.7%), Israel -1.8% (+3.2%), Sweden -5.4% (+2.3%), Czech Republic -2.1% (+1.4%), Canada -3% (+1.1%), Denmark -2.4% (+0.7%), Euro Stoxx 50 -2.4% (+0.7%), Mexico +6.7% (+0.6%), Italy -2.6% (+0.5%), UK -2.9% (+0.2%), Japan +1.3% (-0.2%), Germany -3.5% (-0.4%), Austria -3.5% (-0.5%), Belgium -4.3% (-1.3%), Malaysia -1.5% (-1.5%), Spain -4.7% (-1.8%), Ireland -5% (-2%), Switzerland -4.2% (-2.2%), Singapore -4.1% (-2.3%), South Africa -8.6% (-2.7%), Argentina -33.7% (-2.7%), Thailand -5.3% (-3%), Chile -7.7% (-3.5%), HK -4.2% (-3.7%), Indonesia -10.9% (-5.8%), Greece -9.2% (-6.3%), Poland -11.5% (-6.4%), Korea -10.8% (-7%), Hungary -14.6% (-8.7%), Philippines -15.5% (-10%), China -17% (-13.1%), and Turkey -35.4% (-17.1%).

Timelines: (2006) China’s State Nuclear Power Technology Corp signs $8bln JV with Westinghouse then takes 75,000 technical docs on its latest AP1000 reactor. (2006) Westinghouse’s PA servers are repeatedly penetrated by the Chinese, technical and R&D docs are stolen. (2015) China breaks ground on the CAP1400 nuclear reactor, a Westinghouse AP1000 clone. (2018) Brookfield buys bankrupt Westinghouse for $4.6bln. (Today) China is building reactors in Pakistan and Romania, with scheduled projects in Argentina, Britain and Iran. They’re bidding on Saudi, South African and Turkish projects. 

Perspective: “Russia at its very worst is a moderate threat to the US,” said the investor. “They have modest regional ambitions. They’re mischievous. But plenty of countries don’t do what we want.” If they wanted to nuke us, they would’ve during the Cold War. “China is the real strategic threat. They’ve coopted much of the US political and financial system,” he said. “Wall Street makes a ton of money from China.” No one that matters makes money from Russia. “It’s so telling that everyone is in hysterics over Russia. It’s a distraction that makes you wonder if the Chinese aren’t enabling or pushing the narrative.”

Perspective II: “The best way to bring Beijing to its knees is by running a tight monetary policy in the US,” continued the same investor. “China has the world’s most overleveraged, fragile financial system.” In 2008, China’s total debt-to-GDP was 140%. It is now roughly 300%, while GDP is slowing. “The economy is held together by capital controls. If those fail, the whole system fails.” The capital flight in 2015/16 cost the government $1trln in reserves, and that was with ultra-dove Yellen in charge. Imagine what would have happened with Volcker at the helm. “The Chinese are dying to get their money out.”

Perspective III: “Engineering a decade of rolling Chinese financial crises would be the most effective foreign policy the US could run,” continued the same investor. Forget about the South China Sea, don’t bother with more aircraft carriers, just let Beijing try to cope with their financial system. “And we’re 80% of the way there – we instigated a trade war, implemented a massive fiscal stimulus, which created the room to raise interest rates,” he said. “The combined policy mix makes capital want to leave at the same time it makes the dollar more attractive and effectively shuts down new investment inflows to China.”

The Consigliere: “Made in China 2025 is a policy that came out with great fanfare,” said Peter Navarro, White House Trade Advisor, referring to Beijing’s overarching strategic industrial plan, unveiled in 2015 by Premier Li to move China up the value chain. “The Chinese are now suppressing it from being referenced in public because they don’t want people to know the intent of the plan, which is to capture 70% of global production in the emerging industries of the future within the next 7yrs. Think about that. And as President Trump has said, ‘If we lose the industries of the future, we won’t have a future.’”

Anecdote: “Every investor needs a mental model,” said the CIO. “Without one we’re lost.” We weaved through New York. “I developed mine years ago,” he said, crossing Lexington, mid-block, diagonally, headed south. “Markets move in cycles. After a euphoria comes the fall. But euphoria tends to persist.” The lights toggled on our approach to Park and 61st, we made our way, a steady pace. “Late cycle, if enough people ignore the warning signals, markets continue higher,” he explained. “Holding your breath and staying long far past the time it’s obviously crazy is intellectually unsatisfying.” That doesn’t make it wrong. A good model prevents you from exiting the cycle early. “My model is to stay invested until something really important breaks. Cycles very rarely fizzle out.” We crossed Madison, a crowded crosswalk, 59th toward Central Park. “And I’m not talking about emerging markets, they always blow up when the Fed hikes. But that never signals the cycle’s end. It’s an intermediate sign. When emerging markets go, there’s still money to be made being long developed markets.” We turned down 5th Ave, bypassing buggies, sweating horses, The Plaza. “When you build a model, defining various market states, transition phases, one thing becomes abundantly clear. Knowing how much road is left ahead is far more important than knowing your destination.” A whiff of the University Club pool swirled around 54th. We passed St. Patrick’s, Bronze Atlas shouldering our world, and cut through Rockefeller. “You’ll never know how high valuations can climb. All you can identify are signs that something is breaking. At the cycle’s end, most investors dismiss these, giving you time to get out.” I now saw he was leading us to Times Square, its frenzied glow. “China is this cycle’s weak link. And it’s just now starting to get interesting.”

Good luck out there,

Eric Peters

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.