The Crumbling Chinese Market

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A Chinese financial and economic crisis has been in the forecasts of many analysts for years, including my own. So far, it has not happened. Does this mean China has solved the problem of how to avoid a crisis? Or is the crisis just a matter of time, set to happen sooner than later?

My view is that a crisis in China is inevitable based on China’s growth model, the international financial climate and excessive debt. Some of the world’s most prominent economists agree. A countdown to crisis has begun.

Jim Rickards speaking on stage

Your correspondent addressing a conference of the chief economists of major Chinese banks and foreign banks doing business in China. This conference took place in Shanghai and offered great networking opportunities to discuss issues of mutual interest with the top financial economists in China. These meetings included the chance to have breakfast with the heads of precious metals operations of the four largest gold dealers in China.

As I explained above, China has hit a wall that development economists refer to as the “middle income trap.” Again, this happens to developing economies when they have exhausted the easy growth potential moving from low income to middle income and then face the far more difficult task of moving from middle income to high income.

The move to high-income status requires far more than simple assembly-style jobs staffed by rural dwellers moving to the cities. It requires the creation and adoption of high-value-added products enabled by high technology.

China has not shown much capacity for developing high technology on its own, but it has been quite effective at stealing such technology from trading partners and applying it through its own system of state-owned enterprises and “national champions” such as Huawei in the telecommunications sector.

Unfortunately for China, this growth by theft has run its course. The U.S. and its allies, such as Canada and the EU, are taking strict steps to limit further theft and are holding China to account for its theft so far by imposing punitive tariffs and banning Chinese companies from participation in critical technology rollouts such as 5G mobile phones.

At the same time, China is facing the consequences of excessive debt. Economies can grow through consumption, investment, government spending and net exports. The “Chinese miracle” has been mostly a matter of investment and net exports, with minimal spending by consumers.

The investment component was thinly disguised government spending — many of the companies conducting investment in large infrastructure projects were backed directly or indirectly by the government through the banks.

This investment was debt-financed. China is so heavily indebted that it is now at the point where more debt does not produce growth. Adding additional debt today slows the economy and calls into question China’s ability to service its existing debt.

China’s other lifelines were net exports and large current account surpluses. These were driven by cheap labor, government subsidies and a manipulated currency. These drivers of growth are also disappearing due to demographics that reduce China’s labor force.

China is facing competition by even cheaper labor from Vietnam and Indonesia. Trade surpluses are also being hurt by the trade wars and tariffs imposed by the U.S.

Meanwhile, the debt overhang is growing worse. China’s creditworthiness is now being called into question by international banks and direct foreign investors.

The single most important factor right now is the continuation and expansion of the U.S.-China trade war. When the trade war began in January 2018, the market expectation was that both sides were posturing and that a resolution would be reached quickly.

I took the opposite view. Trump waited a full year from his inauguration before starting the trade war. Trump has given China every opportunity to come to the table and work out a deal acceptable to both sides.

China assumed it was “business as usual” as it had been during the Clinton, Bush 43 and Obama administrations. China assumed it could pay lip service to trading relations and continue down its path of unfair trade practices and theft of intellectual property.

By January 2018, Trump decided he had been patient enough and it was time to show China we were serious about the trade deficit and China’s digital piracy. Since the trade war began, the U.S. has suffered only minor impacts, while the impact on China has been overwhelming.

The deteriorating situation in China is summarized nicely in this excerpt from an article dated Feb. 5, 2019, and titled “The Coming China Shock,” by economists Arvind Subramanian and Josh Felman:

Back in September, we saw some discontinuity in China’s economic performance as inevitable. Even if the country was not heading for a full-blown crisis, we believed it would almost certainly experience some combination of rapidly decelerating growth and a sharply depreciating exchange rate. That prognosis has since become even more likely. With global economic growth and exports declining, China’s economy is on track to slow further relative to the 6.4% growth recorded in the fourth quarter of 2018. The double-digit average achieved from the 1980s until recently has never seemed more distant.

The impact described by Subramanian and Felman is illustrated in the chart below. This chart shows the price and volume of trading in the iShares China Large-Cap ETF (NYSE:FXI).

FXI peaked at $54.00 per share on Jan. 26, 2018, almost exactly on the day the trade wars began. The index has trended steadily downward from there to the current level of about $42.50 per share, a 21% decline with volatility along the way.

Chart

This decline is only a partial reflection of the trade war impact. Wall Street has consistently underestimated the hard economic toll the trade war has taken on China. Wall Street formed the view that the trade war would be short and of minimal impact. Instead it has stretched for 14 months with no end in sight.

The tariffs imposed by the U.S. on China so far have dramatically slowed the Chinese economy. Yet those tariffs are minor compared with what’s in store.

March 1, 2019, is the deadline for the current “truce” in the trade war intended to facilitate negotiations. U.S. demands — especially in the area of verifiable limitations on the theft of U.S. intellectual property — are impossible for China to meet because it depends on such theft to advance its own economic ambitions.

It is highly unlikely that the outstanding issues will be resolved by March 1. Some minor issues may be resolved and some “deal” announced. A deal may include a reduction in the U.S.-China trade deficit through larger purchases of U.S. soybeans by China.

But the big issues including limits on U.S. investment in China, forced technology transfers to China and theft of intellectual property will not be resolved.

The best case is that the deadline will be extended and the trade talks will continue. The worst case is that the truce will fall apart and the U.S. will impose massive tariff increases on Chinese exports to the U.S. as planned. Either way, China’s export-driven economy will continue to suffer.

Given these economic, trade war and political head winds, weakness in China is only getting worse.

And China’s leadership can only hope the damage can be limited before the people begin to question its legitimacy.

Regards,

Jim Rickards
for The Daily Reckoning

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China Snared in “Middle-income Trap”

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A large number of China analysts are concluding that growth in China is slower than the official government reports. In fact, growth is even worse than the pessimists imagine.

The statistics on Chinese GDP growth for the fourth quarter of 2018 and the full-year have been widely reported. Quarterly growth was 6.4% (annualized), the lowest ever reported. Full-year growth for 2018 was 6.6%, the lowest since 1990.

Those weak figures have to be adjusted downward to take account of consistent cheating by China in terms of accurate reporting of data. Private surveys show even lower annual growth, about 5.7%, compared with the official figures of 6.6%.

But that’s not the end of the downward adjustments. Both the official Chinese growth figures and the private surveys show investment is about 45% of total Chinese growth. About half of Chinese investment is pure waste in the form of white elephant infrastructure that is unneeded and cannot pay for itself and ghost cities that will never be occupied or used before they are obsolete.

These infrastructure projects do provide hundreds of thousands of jobs and billions of dollars spent on cement and excavation, along with steel and glass, but they produce no value. If China’s reports were subject to customary accounting standards, that “investment” would be written down to zero.

This write-down puts actual Chinese growth closer to 4.2%. Considering the exponential growth in debt needed to support these investments, China is best viewed as an inverted pyramid of massive debt supported by modest growth; this is a recipe for a debt panic and financial collapse.

As dire as these numbers may be, there’s no surprise in them. China is behaving like almost every emerging-market economy, albeit with more debt. Only naive Wall Street analysts and cheating Chinese Communist officials would extrapolate the former high-growth figures into the future. Expert development economists know better.

Multilateral agencies such as the IMF and the Organisation for Economic Co-operation and Development (OECD) divide economies into “low income,” “middle income” and “high income.” The dividing lines are measured in annual per capita income denominated in U.S. dollars. Low income is zero to $7,000 per year. Middle income is $7,000–17,000 per year. High income is above $17,000 per year.

China today is about $8,800 per person; near the center of the middle-income category. For comparison, the U.S. figure is about $60,000 per person and Switzerland is about $80,000 per person.

As late as the 1960s and 1970s, development economists believed that the most difficult economic task for poor countries was to move from low-income to middle-income. From there, it was believed that the path to high-income would be direct and self-sustaining. It turns out these assumptions were incorrect.

Moving from low-income to middle-income is actually straightforward. It’s just a matter of reducing corruption, providing for a reasonable rule of law and facilitating migration from the countryside to cities.

From there, simple assembly-type jobs will be plentiful with the help of domestic savings and foreign capital. The path to middle-income status follows directly.

The truly difficult task in development economics is moving from middle-income to high-income. For this transition, more is needed than simple low-cost manufacturing. The economy must employ high technology and create more high-value-added products.

This is difficult because of the resources needed to obtain the high technology in the first place and the expense and time needed to train a workforce to utilize the technology. This is why companies such as Apple guard their technology so carefully and why countries like China work so hard to steal the technology.

The only countries since the Second World War to make the transition from middle-income to high-income are South Korea, Taiwan, Japan and Singapore. The rest of Asia, South America and Africa (if they are not low-income) are stuck in what’s called “the middle-income trap.”

In short, it’s easy to grow at 10% per year (China’s growth rate just a few years ago) when millions are flocking from the countryside to the cities and low-value factory jobs are plentiful.

It’s not easy to grow above 4% when the migration stops, the factory job growth stagnates and a trade war begins. China is moving quickly to the 4% growth plateau, a not-unusual result in emerging markets.

China has no clear path out of the middle-income trap despite their well-honed ability to steal Western technology. Technology theft is being made more difficult by Trump’s confrontation with China over trade.

China’s problems will not be going away anytime soon.

Regards,

Jim Rickards
for The Daily Reckoning

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Multiple Risks Are Converging at Once

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Since the end of QE and the “taper” in October 2014, the Fed has been trying to “normalize” their balance sheet and interest rates. The balance sheet needed to be reduced from $4.5 trillion to about $2.5 trillion through “quantitative tightening” or QT, which is tantamount to burning money.

Interest rates needed to be raised to around 4% in stages of 0.25%. The purpose of QT and rate hikes was so that the Fed would have the capacity to lower rates and increase the balance sheet (“QE4”) again to fight a new recession.

The rate hikes started in December 2015 (the “liftoff”) and the balance sheet reductions started in October 2017. Both started slowly but have gained momentum. Rates are now up to 2.5% and the balance sheet is just below $4 trillion.

The Fed’s problem was that actual rate hikes were about 1% per year and the balance sheet reduction at $600 billion per year had the effect of another 1% of rate hikes. Would the Fed be able to achieve its goals of 4% rates and a $2.5 trillion balance sheet without causing the recession they were preparing to fight?

It turns out the answer is no. In late December, Fed chair Powell announced the Fed would be “patient” on rate hikes. That means no more rate hikes until further notice. Now, the Fed has also apparently thrown in the towel on balance sheet normalization.

When QT began, Janet Yellen said it would “run on background” and would not be an instrument of policy. Ooops. Now the Fed is ending it so it clearly is an instrument of policy.

Right now, my models are saying that Powell’s verbal ease is too little too late. Damage to U.S. growth prospects has already been done by the Fed’s tightening since December 2015 and the Fed’s QT policy that started in October 2017.

The 2009–2018 recovery has already been the weakest recovery in U.S. history despite a few good quarters here and there. And there’s little reason to expect it to pick up from here. In fact, growth is slowing.

GDP expanded 3.4% in the third quarter of 2018, which looks good on paper. But the trend is pointing down. Q2 growth was 4.2%. This trend tends to confirm the view that 2018 growth was a “Trump bump” from the tax cuts that will not be repeated. And Q4 GDP, which has been delayed due to the government shutdown, will probably be lower than Q3.

Some of the major banks have downgraded their Q4 GDP forecasts after yesterday’s poor retail sales report.

Goldman Sachs, for example, previously projected fourth-quarter GDP to expand at 2.5%. Now it’s down to 2.0%. Its projections for the rest of the year are no better. JPMorgan also revised down its previous Q4 forecast from a previous 2.6% to 2.0%. And Barclays lowered its Q4 forecast from 2.8% to 2.1%.

Even the Atlanta branch of the Federal Reserve, which is known for perpetually overestimating GDP, has cut its Q4 forecast by almost half. A little over a week ago its reading was 2.7%. But after yesterday’s retail sales report, its latest forecast comes it at just 1.5%.

We also have other signs the economy is slowing down. A report this week revealed a record seven million Americans are now at least 90 days behind in their car loan payments. There is also a student loan crisis unfolding.

Total student loans today at $1.6 trillion are larger than the amount of junk mortgages in late 2007 of about $1.0 trillion. Default rates on student loans are already higher than mortgage default rates in 2007. This time the loan losses are falling not on the banks and hedge funds but on the Treasury itself because of government guarantees.

Not only are student loan defaults soaring, but household debt has hit another all-time high. Student loans and household debt are just the tip of the debt iceberg that also includes junk bonds corporate debt and even sovereign debt, all at or near record highs around the world.

But it’s not just the U.S.

China and Europe are both slowing at the same time. China’s problems are well-known. And while the causes may vary, growth in all of the major economies in the EU and the U.K. is either slowing or has already turned negative. Markets see the global slowdown (despite Fed ease) and are preparing for a recession at best and a possible market crash at worst.

Still, why has growth slowed down at all?

The answer has to do with debt, Fed policy, political developments, as well as currency wars and trade wars. Specifically, the U.S. and China, the world’s two largest economies, are discovering the limits of debt-fueled growth.

According to the Institute of International Finance (IIF), it required a record $8 trillion of freshly created debt to create just $1.3 trillion of global GDP. The trend is clear. The massive debts intended to achieve growth are piling on every day. Meanwhile, many of the debts taken on since 2009 are still on the books.

The U.S. debt-to-GDP ratio is now 106%, the highest since the end of the Second World War. The Chinese debt-to-GDP ratio is a more reasonable 48%, but that figure is misleading because it does not include the debts and guarantees of provinces, state-owned enterprises, banks, wealth management products and numerous other entities that the government in Beijing is directly or indirectly obligated to support.

When that additional debt is taken into account, the real debt-to-GDP ratio is over 250%, about the same as Japan’s.

Debt-to-GDP ratios below 60% are considered sustainable; ratios between 60% and 90% are considered unsustainable and need to be reversed; and ratios in excess of 90% are in the red zone and will produce negative growth along with default through nonpayment, inflation or other forms of debt repudiation.

The world’s three largest economies — the U.S., China and Japan — are all now deep in the red zone.

What is striking is the speed with which synchronized global growth has turned to synchronized slowing. Indications are that this slowing is far from over. While growth can create a positive feedback loop, slowing can do the same.

Warnings of economic collapse are no longer confined to the fringes of economic analysis but are now coming from major financial institutions and prominent economists, academics and wealth managers. Leading financial elites have been warning of coming collapses and dangers.

These warnings range from the IMF’s Christine Lagarde, Bridgewater’s Ray Dalio, the Bank for International Settlements (known as the “central banker’s central bank”), Paul Tudor Jones and many other highly regarded sources.

Coming back to the U.S., the Fed may have avoided a recession for now, but they have left themselves far short of what they’ll need to fight the next recession when it comes. That could lead to another lost decade. The U.S. looks more like Japan with each passing day.

Investors can profit from this with a combination of long-volatility strategies, safe-haven assets, gold and cash.

Regards,

Jim Rickards
for The Daily Reckoning

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A Trained Monkey Could Do Better

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The first time I appeared on live financial television was August 15, 2007. It was a guest appearance on CNBC’s Squawk Box program at the early stages of the 2007-2008 financial crisis.

Of course, none of us knew at that time exactly how and when things would play out, but it was clear to me that a meltdown was coming; the same meltdown I had been warning the government and academics about since 2003.

I’ve done 1,000 live TV interviews since then, but that first one remains memorable. Carl Quintanilla conducted the interview with some participation from Becky Quick, both of whom could not have been more welcoming.

They and the studio crew made me feel right at home even though it was my first time in studio and my first time meeting them. Joe Kernan remained off-camera during my interview with his back turned reading the New York Post sports page, but that’s Joe. We had plenty of interaction in my many interviews over the years that followed.

When I was done, I was curious about how many guests CNBC interviewed over the course of a day. Being on live TV made me feel a bit special, but I wanted to know how special it was to be a guest. The answer was deflating and brought me right down to earth.

CNBC has about 120 guests on in a single day, day after day, year after year. Many of those guests are repeat performers, just as I became a repeat guest on CNBC during the course of the crisis. But, I was just one face in the midst of a thundering herd.

What were all of those guests doing with all of that airtime? Well, for the most part they were forecasting. They predicted stock prices, interest rates, economic growth, unemployment, commodity prices, exchange rates, you name it.

Financial TV is one big prediction engine and the audience seems to have an insatiable appetite for it. That’s natural. Humans and markets dislike uncertainty, and anyone who can shed some light on the future is bound to find an audience.

Which begs a question: How accurate are those predictions?

No one expects perfection or anything close to it. A forecaster who turns out to be accurate 70% of the time is way ahead of the crowd. In fact, if you can be accurate just 55% of the time, you’re in a position to make money since you’ll be right more than you’re wrong. If you size your bets properly and cut losses, a 55% batting average will produce above average returns.

Even monkeys can join in the game. If you’re forecasting random binary outcomes (stocks up or down, rates high or low, etc.), a trained monkey will have a 50% batting average. The reason is that the monkey knows nothing and just points to a random result.

Random pointing with random outcomes over a sustained period will be “right” half the time and “wrong” half the time, for a 50% forecasting record. You won’t make any money with that, but you won’t lose any either. It’s a push.

So, if 70% accuracy is uncanny, 55% accuracy is OK, and 50% accuracy is achieved by trained monkeys, how do actual professional forecasters do? The answer is less than 50%.

In short, professional forecasters are worse than trained monkeys at predicting markets.

Need proof? Every year, the Federal Reserve forecasts economic growth on a one-year forward basis. And it’s been wrong every year for the better part of a decade. When I say “wrong” I mean by orders of magnitude.

If the Fed forecast 3.5% growth and actual growth was 3.3%, I would consider that to be awesome.

But, the Fed would forecast 3.5% growth and it would come in at 2.2%. That’s not even close considering that growth is confined to plus or minus 4% in the vast majority of years.

If you have defective and obsolete models, you will produce incorrect analysis and bad policy every time. There’s no better example of this than the Federal Reserve.

The Fed uses equilibrium models to understand an economy that is not an equilibrium system; it’s a complex dynamic system. The Fed uses the Phillips curve to understand the relationship between unemployment and inflation when 50 years of data say there is no fixed relationship.

The Fed uses what’s called value-at-risk modeling based on normally distributed events when the evidence is clear that the degree distribution of risk events is a power curve, not a normal or bell curve.

As a result of these defective models, the Fed printed $3.5 trillion of new money beginning in 2008 to “stimulate” the economy only to produce the weakest recovery in history. Now, the cycle of monetary tightening has been ongoing in various forms for nearly six years.

Let’s not be too hard on the Fed. The IMF forecasts were just as bad. And the “the wisdom of crowds” can also be dramatically wrong.

It does not have very high predictive value. It’s just as faulty as the professional forecasts from the Fed and IMF.

There are reasons for this. The wisdom of crowds is a highly misunderstood concept. It works well when the problem is simple and the answer is static, but unknown.

The classic case is guessing how many jellybeans are in a large jar. In that situation, the average of 1,000 guesses actually will be better than a single “expert” opinion. That works because the number of jellybeans never changes. There’s nothing dynamic about the problem.

But, when the answer is truly unknown and the problem is complex and dynamic such as capital markets forecasting, then the wisdom of crowds is subject to all of the same biases, herding, risk aversion, and other human quirks known through behavioral psychology.

This is important because when academics say “you can’t beat the market,” my answer is the market indicators are usually wrong. When talking heads say, “you can’t beat the wisdom of crowds,” I just smile and explain what the wisdom of crowds actually does and does not mean.

By the way, this is one reason why markets missed Brexit and Trump. The professional forecasters simply misinterpreted what polls and betting odds were actually saying.

None of this means that polls, betting odds, and futures contracts have no value. They do. But, the value lies in understanding what they’re actually indicating and not resting on a naive and superficial understanding of the wisdom of crowds.

Does this mean that forecasting is impossible or that the experts are uninformed? Not at all. Highly accurate forecasting is possible.

The problem with the “experts” is not that they’re dopes (they’re not), or they’re not trying hard (they are). The problem is that they use the wrong models. The smartest person in the world working as hard as possible will always be wrong if you use the wrong model.

That why the IMF, Fed, and the wisdom of crowds bat below .500. They’re using the wrong models.

But here at Project Prophesy, I can confidently say I’ve got the right models, which I developed for the CIA working in collaboration with top applied mathematicians and physicists at places like the Los Alamos National Laboratory and the Applied Physics Laboratory.

It’s these models that let me accurately forecast events like Brexit and the election of Donald Trump, while all the mainstream analysts laughed in my face. It’s not that I’m any smarter than many of these people. It’s just that I use superior models that work in the real world, not in never-never land..

These models do not assume equilibrium systems and normally distributed risk like mainstream models. My models are based on complexity theory, Bayesian statistics, behavioral psychology and history. They produce much more accurate results than all of the alternatives.

This is the methodology behind my forecasts, which allows my readers access to actionable market recommendations they won’t find elsewhere.

Regards,

Jim Rickards

for The Daily Reckoning

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Jay Powell’s Gift to Markets

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Fed Chair Jay Powell did not deliver any early Christmas presents to the markets last month, but he did pop the cork on a bottle of Champagne as a belated New Year’s gift on Friday, Jan. 4.

With just a few words, Powell sent the most powerful signal from the Fed since March 2015. Investors who understand and properly interpret that signal stand to avoid losses and reap huge gains in the weeks ahead.

First, let’s focus on Powell’s comments. Then we’ll explain what they actually meant.

The Fed has taken a March rate hike off the table until further notice. At a forum in Atlanta two Fridays ago, Powell joined former Fed chairs Yellen and Bernanke to discuss monetary policy.

In the course of his remarks, Powell used the word “patient” to describe the Fed’s approach to the next interest rate hike. When Powell did this, he was reading from a script of prepared remarks in what was otherwise billed as a “roundtable discussion.” This is a sign that Powell was being extremely careful to get his words exactly right.

Fed Chairman Jay Powell (left) joined former Fed chairs Janet Yellen and Ben Bernanke

Fed Chairman Jay Powell (left) joined former Fed chairs Janet Yellen and Ben Bernanke at a roundtable in Atlanta recently. Powell revived the word “patient,” which was last used by the Fed in December 2014. It’s a powerful signal of no rate hikes until further notice.

When Powell said the Fed would be “patient” in reference to the next rate hike, this was not just happy talk. The word “patient” is Fed code for “No rate hikes until we give you a clear signal.” This interpretation is backed up by the Fed’s past use of verbal cues to signal ease or tightening in lieu of actual rate hikes or cuts.

The word “patient” has a long history in the Fed’s vocabulary. Prior to March 2015, the Fed consistently used the word “patient” in their FOMC statements. This was a signal that there would not be a rate hike at the next FOMC meeting. Investors could do carry trades safely.

As long as the word “patient” was in the Fed’s statements, investors knew that there would be no rate hike without warning. It was like an “all clear” signal for leveraged carry trades and risk-on investments. Only when the word “patient” was removed was the Fed signaling that rate hikes were back on the table. In that event, investors were being given fair warning to unwind carry trades and move to risk-off positions.

In March 2015, Yellen removed the word “patient” from the statement. That was a signal that a rate hike could happen at any time and the market was on notice. If you had a carry trade on and were relying on no rate hike, then shame on you.

In fact, the first rate hike (the “liftoff”) did not happen until December 2015, but the market was on notice through the June and September 2015 FOMC meetings that it could happen. (The liftoff was originally planned for September 2015, but was postponed because of the U.S. market crash in August 2015. This crash was due to the shock 3% China currency devaluation on Aug. 10; U.S. stocks fell 11% in four weeks.)

Now, for the first time since 2015, the word “patient” is back in the Fed’s statements. This means no future Fed rate hikes without fair warning. This could change again based on new data and new statements, but a change is unlikely before March at the earliest. For now, the Fed is rescuing markets with a risk-on signal. That’s why the market rallied that Friday and has reversed December’s downward trend.

But we’re not out of the woods. Just because the Fed signaled they will not raise rates in March does not mean that all is well with markets. The U.S. stock market had already anticipated the Fed would not raise rates in March. The statement by Powell confirms that, but this verbal ease is already priced in. As usual, the markets will want some ice cream to go with the big piece of cake they just got from Powell.

On the one hand, if we’re at or near the start of a bear market it will take more than a Fed pause to offset that. On the other hand, there’s no reason for markets to crash based on the U.S. economy alone since the Fed may make more candy available by continuing to use the word “patient” in March. So we’re in wait-and-see mode.

Meanwhile, there’s an even bigger threat on the horizon — China. Unobserved by many analysts, the Chinese are reducing their money supply even faster than the Fed.

The Fed’s signal on rates says nothing about Fed reductions in the money supply under the quantitative tightening (QT) program. The U.S. money supply reductions are going ahead at $600 billion per year.

China is burning money even faster to prop up the yuan in the midst of a trade war with Trump. What does it mean when the world’s two largest economies, comprising 40% of global GDP, both hit the brakes on money supply?

Nothing good. Milton Friedman demonstrated that monetary policy operates with a lag of 12–18 months. These U.S. and Chinese monetary tightening policies started just over a year ago. The initial impact of what has already been done by the central banks is just being felt now.

This means that the U.S.-China tightening will continue to be felt over the next year regardless of what the Fed does in March. Stopping rate hikes now is like hitting the car brakes when you’re driving on a frozen lake. You’re going to slide a long time before the car comes to a halt. Let’s hope you don’t hit a soft spot before then or you’ll end up underwater.

Of course, the China and U.S. domestic growth and monetary policy narratives converge in the trade war discussions going on now. The continuing trade war is another head wind to growth. No doubt Powell had this scenario in mind when he opted to use the word “patient.”

The risk to investors is that markets are on a sugar high because of Powell’s recent comments. But the sugar will soon wear off and the Fed won’t provide more until March at the earliest. By then, the reality of slower growth in China and the U.S. and a lack of substantive progress in the trade wars will give the market a dose of reality like getting hit with a cold bucket of water in the face.

Evidence for this slowing comes from the latest Atlanta Fed update to their fourth-quarter GDP forecast, which now projects 2.6% growth after being as high as 3% earlier in the quarter.

What are the implications for investors of belated Fed ease combined with signs of weaker growth in China and the U.S.?

Right now, my models are saying that Powell’s verbal ease is too little too late. Damage to U.S. growth prospects has already been done by the Fed’s tightening since December 2016 and the Fed’s QT policy that started in October 2017.

The U.S., China and Europe are all slowing at the same time. Markets see this (despite Fed ease) and are preparing for a recession at best and a possible market crash at worst.

One potential catalyst is the start of the Chinese New Year celebration of the Year of the Pig. Kicking off with the Little New Year on Jan. 28, this celebration actually stretches over two weeks and is accompanied by reduced productivity and liquidity in Chinese markets. That’s a recipe for volatility.

We also have a Fed FOMC meeting on Jan. 30. No rate hike is expected, obviously, but there will be a written statement issued. Markets will be looking for the word “patient” in print, and if they don’t find it, there could be a violent reversal in the sugar high that started two Fridays ago.

Investors should prepare now before markets reprice.

Regards,

Jim Rickards
for The Daily Reckoning

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Here’s Where the Next Crisis Starts

This post Here’s Where the Next Crisis Starts appeared first on Daily Reckoning.

The case for a pending financial collapse is well grounded. Financial crises occur on a regular basis including 1987, 1994, 1998, 2000, 2007-08. That averages out to about once every five years for the past thirty years. There has not been a financial crisis for ten years so the world is overdue. It’s also the case that each crisis is bigger than the one before and requires more intervention by the central banks.

The reason has to do with the system scale. In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses.

This means a market panic far larger than the Panic of 2008.

Today, systemic risk is more dangerous than ever because the entire system is larger than before. Due to central bank intervention, total global debt has increased by about $150 trillion over the past 15 years. Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system and have much larger derivatives books.

Each credit and liquidity crisis starts out differently and ends up the same. Each crisis begins with distress in a particular overborrowed sector and then spreads from sector to sector until the whole world is screaming, “I want my money back!”

First, one asset class has a surprise drop. The leveraged investors sell the sinking asset, but soon the asset is unwanted by anyone. Margin calls roll in. Investors then sell good assets to raise cash to meet the margin calls. This spreads the panic to banks and dealers who were not originally involved with the weak asset.

Soon the contagion spreads to all banks and assets, as everyone wants their money back all at once. Banks begin to fail, panic spreads and finally central banks step in to separate winners and losers and re-liquefy the system for the benefit of the winners.

Typically, small investors (and some bankrupt banks) get hurt the worst while the big banks get bailed out and live to fight another day.

That much panics have in common. What varies in financial panics is not how they end but how they begin. The 1987 crash started with computerized trading. The 1994 panic began in Mexico. The 1997–98 panic started in Asian emerging markets but soon spread to Russia and the big banks. The 2000 crash began with dot-coms. The 2008 panic was triggered by defaults in subprime mortgages.

The problem is that regulators are like generals fighting the last war. In 2008, the global financial crisis started in the U.S. mortgage market and spread quickly to the overleveraged banking sector.

Since then, mortgage lending standards have been tightened considerably and bank capital requirements have been raised steeply. Banks and mortgage lenders may be safer today, but the system is not. Risk has simply shifted.

What will trigger the next panic?

Prominent economist Carmen Reinhart says the place to watch is U.S. high-yield debt, aka “junk bonds.”

I’ve also raised the same argument. We’re facing a devastating wave of junk bond defaults. The next financial collapse will quite possibly come from junk bonds.

Let’s unpack this…

Since the great financial crisis, extremely low interest rates allowed the total number of highly speculative corporate bonds, or “junk bonds,” to rise about 60% — a record high. Many businesses became extremely leveraged as a result. Estimates put the total amount of junk bonds outstanding at about $3.7 trillion.

The danger is that when the next downturn comes, many corporations will be unable to service their debt. Defaults will spread throughout the system like a deadly contagion, and the damage will be enormous.

This is from a report by Mariarosa Verde, Moody’s senior credit officer:

This extended period of benign credit conditions has helped many weak, highly leveraged companies to avoid default… A number of very weak issuers are living on borrowed time while benign conditions last… These companies are poised to default when credit conditions eventually become more difficult… The record number of highly leveraged companies has set the stage for a particularly large wave of defaults when the next period of broad economic stress eventually arrives.

If default rates are only 10% — a conservative assumption — this corporate debt fiasco will be at least six times larger than the subprime losses in 2007-08.

Many investors will be caught completely unprepared. Once the tsunami hits, no one will be spared. The stock market is going to collapse in the face of rising credit losses and tightening credit conditions.

But corporate debt is not the only dagger hanging over the economy. Credit conditions have already begun to affect the real economy. Student loan losses are also skyrocketing. Losses are also soaring on subprime auto loans, which has put a lid on new car sales. As these losses ripple through the economy, mortgages and credit cards will be the next to feel the pinch.

Have we already seen the beginning of the next crisis? No one knows for sure, but the time to prepare is now. Once the market falls apart, it’ll be too late to act.

That’s why the time to buy gold is now, while it’s cheap. When you need it most, once the crisis hits, it’ll cost a fortune.

Both the panics of 1998 and 2008 began over a year before they reached the level of an acute global liquidity crisis.

Investors has ample time to reduce risky positions, increase cash and gold allocations and move to the sidelines until the crisis abated. At that point there were bargains galore for those with cash.

An investor with cash in 2008 could have preserved wealth during the crisis and nearly quadrupled his money since then by buying the Dow Jones index at 6,550 (even with the recent turmoil, today it’s still around 23,600).

Relatively few investors did this. Instead they suffered from “fear of missing out” as markets rose until the panic began. They persisted in the mistaken belief that they could “get out in time” if markets reversed, not realizing that reversals happen much faster than rallies. They held onto losing positions hoping they would “come back” (they did after 10 years) and so on.

Simple behavioral biases stand in the way of doing the right thing almost every time.

For now, it’s not clear which way things will break next. Volatility is back and markets are still in a precarious position. Fed chairman Jay Powell threw markets a bone last Friday when he basically said all rate hikes are off until further notice and that he’s willing to scale back QT “if needed.” Markets have naturally rallied since Powell’s remarks.

If you still need proof that today’s rigged markets still require support from the Fed, here it is. But it’s far from clear the next crisis can be avoided at this point.

You don’t want to be heavily exposed to these markets. It’s far better to get out too early than too late. You should not be the last to be get ready. Start now to decrease equity allocations and increase your allocations to cash and gold so you can weather the coming storm.

Preparation means 10% percent of your investible assets in gold or silver and another 30% in cash. That allocation will preserve wealth and provide dry powder for bottom-fishing in the crisis to come.

Regards,

Jim Rickards
for The Daily Reckoning

The post Here’s Where the Next Crisis Starts appeared first on Daily Reckoning.

2019 Headwinds Are Getting Stronger

This post 2019 Headwinds Are Getting Stronger appeared first on Daily Reckoning.

In 2017, every prominent economic forecasting entity was shouting from the rooftops about “synchronized global growth.” This was a reference to the fact that not only were certain economies growing, but they were all growing at the same time.

Chinese GDP growth had come down but was still substantial at 6.85%. U.S. GDP growth was posting solid gains of 3.0% in the second quarter of 2017 and 2.8% in the third quarter. Japan and Europe were not growing as quickly as the U.S. and China, but growth was still accelerating from a low level.

Synchronization was a big part of the story. Growth was not isolated and episodic. Growth was fueling more growth in what seemed to be a sustainable way. The world economy was firing on all cylinders.

Then in 2018 the global growth story came screeching to a halt. Japanese growth went negative in the third quarter of 2018. Germany also went negative. Chinese growth continued its drop (6.5% in the third quarter) instead of stabilizing.

The U.K slowed partly because of confusion around Brexit. French growth slid amid riots triggered by a proposed carbon emissions tax. Australian home prices declined precipitously because export orders from China dried up and Chinese flight capital slowed to a trickle due to Chinese capital controls.

The U.S. economy held up fairly well in 2018, with 4.2% growth in the second quarter and 3.5% growth in the third quarter. But much of that growth was inventory accumulation from foreign suppliers in advance of proposed tariffs.

That inventory growth will likely dry up once the tariffs are either imposed or abandoned early this year. Fourth-quarter growth in the U.S. is currently projected at 3.0%, continuing the downtrend from the second quarter.

What happened?

Much of the global slowdown has to do with the high degree of interconnectedness of the global economy and the extent of global supply chains. The flip side of synchronized growth is a synchronized slowdown. Just as growth in one economy can lead to increased exports for trading partners, a slowdown leads to reduced exports.

Still, why has growth slowed down at all?

The answer has to do with debt, Fed policy, political developments, as well as trade wars. Specifically, the U.S. and China, the world’s two largest economies, are discovering the limits of debt-fueled growth.

The U.S. debt-to-GDP ratio is now 106%, the highest since the end of the Second World War. The Chinese debt-to-GDP ratio is a more reasonable 48%, but that figure is misleading because it does not include the debts and guarantees of provinces, state-owned enterprises, banks, wealth management products and numerous other entities that the government in Beijing is directly or indirectly obligated to support.

When that additional debt is taken into account, the real debt-to-GDP ratio is over 250%, about the same as Japan’s.

Debt-to-GDP ratios below 60% are considered sustainable; ratios between 60% and 90% are considered unsustainable and need to be reversed; and ratios in excess of 90% are in the red zone and will produce negative growth along with default through nonpayment, inflation or other forms of debt repudiation. The world’s three largest economies — the U.S., China and Japan — are all now deep in the red zone.

European growth is also slowing down. While the causes may vary, growth in all of the major economies in the EU and the U.K. is either slowing or has already turned negative.

What is striking is the speed with which synchronized global growth has turned to synchronized slowing. Indications are that this slowing is far from over. While growth can create a positive feedback loop, slowing can do the same.

The interconnectedness of global growth was summarized in this quote from Stephen “Sarge” Guilfoyle, director of floor operations for the New York Stock Exchange in a recent column for TheStreet’s Real Money:

There is an old adage, “When America sneezes, the world catches a cold.” What if the world’s two largest economies (U.S. and China) sneeze at the same time? Wait. I can top that. What if the U.S., China, the EU, Japan and the U.K. all sneeze at the same time? What if all mentioned are either involved in trade disputes, and/or the perverse use of both fiscal and/or monetary policies while suffering from heightened political risk? Oh, and at least temporarily, the U.S. faces a partial government shutdown as well. That’s a strong sort of fiscal/political mix.

Well, we already have the partial shutdown, now over two weeks old. On the political front, it’s sufficient to say that the dysfunction is getting worse, not better, and it will have an adverse effect on investor portfolios.

Democrats took charge of the House of Representatives last week on, Jan. 3, and they will use their committee control to launch literally dozens of investigations into “Russia collusion,” Trump’s business dealings, Trump’s inaugural financing, Trump’s tax returns, campaign finance, regulatory reforms, appointments and much more.

But Republicans continue to hold the U.S. Senate. They will use their committee control to hold hearings on FBI corruption, Intelligence Community abuse of spying powers, Hillary Clinton’s private server that held classified information and Democratic coverups on Benghazi, tea party IRS attacks, the Clinton Foundation “pay for play” deals with former Secretary of State Clinton, false accusations related to the confirmation of Justice Kavanaugh and more.

In short, it’s war.

Some of these hearings are political stunts just for show. They will make great headlines over a one-day (or one-hour) news cycle but won’t lead to any substantive charges or changes. Yet other hearings could have grave consequences — especially those that may result in criminal charges, including the Clinton Foundation case.

Hanging over all of this is the specter of impeachment. The impeachment process begins in the House of Representatives. If the president is impeached, the matter is referred to the Senate for a trial. If convicted in a Senate trial, the president is removed from office and the Vice President (Mike Pence) becomes president.

Conviction in the Senate requires a super-majority of 67 votes to remove the president. Republicans currently hold 53 Senate seats. Assuming all 47 Democrats vote to remove the president, 20 Republicans would have to switch sides and vote to remove President Trump from office. This is extremely unlikely to occur.

The worst case for impeachment is that the House impeaches Trump but the Senate does not vote to convict him so he remains in office. The best case is that the House makes noise about impeachment, holds hearings but in the end does not vote to impeach.

Either scenario will be positive for Trump’s reelection chances in 2020. Americans may dislike a lot about Trump’s day-to-day demeanor, but Americans are also fair-minded people on the whole.

They will see impeachment as another over-the-top move by Democrats (like the made-up “Russia collusion” story) and actually begin to sympathize with the president. Trump is also a master at turning attacks around on his opponents.

Whether impeachment happens or not and whether Trump benefits or not is unimportant for investors. What is important is the impact of political dysfunction and uncertainty on portfolios.

There the news is not good.

Regardless of the outcome of impeachment, investors should be prepared for a bumpy ride as headlines swing from good to bad and back again for Trump.

Meanwhile, the Fed is raising interest rates and reducing its balance sheet. The Fed’s balance sheet has been reduced by $375 billion in the past 14 months. That balance sheet is scheduled to fall by another $600 billion this year and $600 billion the following year until the balance sheet reaches a level of $2.9 trillion by the end of 2020.

This kind of extreme balance sheet reduction is entirely experimental. It has never been attempted before in the 106-year history of the Federal Reserve.

Analysts estimate that reducing the balance sheet by $600 billion per year (the current tempo) is equivalent to increasing the fed funds target rate by 1% per year. This implied rate hike comes on top of the 0.25% rate hikes the Fed has been announcing every quarter. QT and actual rate hikes taken together are increasing rates by 2% per year from a 2.5% base, an extreme form of monetary tightening.

The Fed is tightening into weakness and will have to pivot towards easing once it becomes obvious. But it may very well be too late.

The bottom line is that uncertainty reigns and it’s not going away anytime soon. Investors can profit from this with a combination of long-volatility strategies, safe-haven assets, gold and cash.

Regards,

Jim Rickards
for The Daily Reckoning

The post 2019 Headwinds Are Getting Stronger appeared first on Daily Reckoning.

Jerome Powell Caves to Market

This post Jerome Powell Caves to Market appeared first on Daily Reckoning.

Fed Chair Jay Powell just sent the most powerful signal from the Fed since March 2015. 

He has pretty much taken a March 2019 rate hike off the table until further notice. At a forum hosted by the American Economic Association in Atlanta last Friday, Powell used the word “patient” to describe the Fed’s approach to the next interest rate hike. 

When Powell did this, he was reading from a script of prepared remarks in what was otherwise billed as a “roundtable discussion.” 

This is a sign that Powell was being extremely careful to get his words exactly right. When Powell said the Fed would be “patient” in reference to the next rate hike, this was not just happy talk. The word “patient” is Fed code for “no rate hikes until we give you a clear signal.” 

This interpretation is backed up by the Fed’s past use of verbal cues to signal ease or tightening in lieu of actual rate hikes or cuts. Prior to March 2015, the Fed consistently used the word “patient” in their FOMC statements. 

This was a signal that there would not be a rate hike at the next FOMC meeting. Investors could do carry trades safely. Only when the word “patient” was removed was the Fed signaling that rate hikes were back on the table. 

In that event, investors were being given fair warning to move to risk-off positions. 

In March 2015, Yellen removed the word “patient” from the statement. In fact, the first rate hike (the “liftoff”) did not happen until December 2015, but the market was on notice through the June and September 2015 FOMC meetings that it could happen. 

Now, for the first time since 2015, the word “patient” is back in the Fed’s statements, which means no future Fed rate hikes without fair warning. 

For now, the Fed is rescuing markets with a risk-on signal. That's why the market rallied last Friday. But we're not out of the woods by any means. 

The U.S. stock market had already anticipated the Fed would not raise rates in March. Friday’s statement by Powell confirms that, but this verbal ease is already priced in. As usual, the markets will want some ice cream to go with the big piece of cake they just got from Powell. 

The next FOMC meeting is Jan. 30. If the Fed does not repeat the word “patient,” markets could be in for an extremely negative reaction.

Looking ahead to rest of 2019, what are my models and methods telling us today about the prospects for the economy and markets?

The answer to that question requires an overview of many markets and sovereign economies around the world. While forecasts for China, the U.S. and Europe may differ in many particulars, what they have in common is interconnectedness.

For example, a slowdown in China due to excessive debt and trade wars can reduce exports from Europe. In turn, reduced European exports can slow down European purchases of raw materials and other inputs and lead to a weaker euro. 

The weaker euro can translate into a stronger dollar, which causes disinflation in the U.S. That disinflation can increase the real value of debt burdens in the U.S. if nominal growth is lower than the increase in the nominal deficit.

In other words, what happens in China does not stay in China. The world is densely connected. Any sound analysis must consider the ripples spreading out from any one factor. 

We need to look at the synchronized global slowdown, the Fed’s misguided policies, currency wars, trade wars and political dysfunction in the U.S. to arrive at conclusions and forecasts for the U.S. and beyond.

All this takes place against a backdrop of mounting global debt.

According to the Institute of International Finance (IIF), it required a record $8 trillion of freshly created debt to create just $1.3 trillion of global GDP. The trend is clear. The massive debts intended to achieve growth are piling on every day. Meanwhile, many of the debts taken on since 2009 are still on the books.

This is a crisis waiting to happen. The combination of slow or negative growth and unprecedented debt is a recipe for a new debt crisis, which could easily slide into another global financial crisis.

The Fed will have to pivot back to loosening, including a possible reintroduction of quantitative easing. But by then, it may be too late.

Below, I show you why the economic head winds are getting stronger as we begin 2019. What can you do to prepare? Read on.

Regards,

Jim Rickards
for The Daily Reckoning

The post Jerome Powell Caves to Market appeared first on Daily Reckoning.

The Government Could Shut Down Tonight

This post The Government Could Shut Down Tonight appeared first on Daily Reckoning.

Remember the “tea party” revolt in 2009–2010 against government bailouts and government spending? Remember the “fiscal cliff” drama of Dec. 31, 2012, when Congress raised taxes and cut spending to avoid a debt default and government shutdown? Remember the actual government shutdown in October 2013 as Republicans held the line against more government spending?

Well, congratulations if you do, because everyone else seems to have forgotten.

The days of caring about debt and deficits are over. Republicans passed the Trump tax cuts that will increase the deficit by $1.5 trillion on a conservative estimate, and probably much more. Then Republicans and Democrats “compromised” on eliminating caps on defense spending and domestic spending by agreeing to more of both.

That repeal of the so-called “sequester” will add over $300 billion to the deficit over the next two years.

Then there’s a tsunami of student loan debts in default that the Treasury has guaranteed and will have to pay off. Finally, the higher interest rates from this debt will add $210 billion to the annual deficit for every 1% increase in average federal debt funding costs.

Today we are looking at $1 trillion-plus deficits as far as the eye can see. That’s extraordinary enough. What is more extraordinary is that no one cares! Democrats, Republicans, the White House and everyday Americans are all united in totally ignoring the fact that America is going broke.

This euphoric mood in response to more spending won’t last. The growth is not there to pay for the tax cuts, and the economy is not even growing fast enough to keep up with the growth in the debt. Credit rating agencies are preparing reviews that will likely lead to a downgrade in the U.S. credit rating and higher interest costs for the Treasury.

When the crisis of confidence in the dollar and related inflation arrive, there will be no particular party to blame. The entire system is turning a blind eye to debt, and the entire system will have to bear some part of the blame.

We have a highly dysfunctional political system, with plenty of blame to go around.

Which brings me to a looming government shutdown scheduled for midnight tonight if a budget deal cannot be worked out.

Each fiscal year (Oct. 1 through Sept. 30) the government must be funded either through individual appropriations bills for separate departments and agencies or through “omnibus” legislation that funds multiple agencies with one gigantic bill that very few members of Congress actually read.

Any failure to pass an appropriation bill or omnibus bill on time results in the affected agency or the entire government shutting down at least with respect to “nonessential” personnel.

If a deadline is going to be missed, the Congress can pass a “continuing resolution,” or CR that keeps the government open using the prior year’s spending levels until the new appropriation can be worked out.

Eventually the appropriations bills must be passed, which is why they are the one vehicle where some bipartisan cooperation is needed.

Currently, a December 7 continuing resolution has been extended by two weeks to today because of the death of former President George H.W. Bush and the subsequent congressional activities surrounding his funeral services.

We can expect either a decision on a funding agreement by midnight tonight, another continuing resolution, or a federal government shutdown.

President Trump has insisted that over $5 billion be apportioned to fund the border wall that he promised during his campaign. Last year Trump suffered a political defeat when he didn’t get his funding. This year he seems determined to get it.

The House has actually passed a spending bill that allocates $5.7 billion for the wall. But it has to pass the Senate in order to go ahead. Senate Minority Leader Chuck Schumer has insisted that it wouldn’t get through the Senate. But Trump insists he won’t sign the bill unless it includes funding for the wall, and he says he’s prepared to let the government shut down:

“If the Dems vote no, there will be a shutdown that will last for a very long time.”

This could come right down to the wire. It no deal is reached the government will (partially) shut down. You might not remember, but the government actually shut down for two days back in January. Before that, the last shutdown occurred in 2013, which lasted 16 days.

But despite pervasive political dysfunction in Washington DC, there is one important piece of legislation that I expect to achieve bipartisan support in the coming months. This legislation would be a one-trillion dollar infrastructure spending bill that would extend its spending to all fifty states.

Both parties agree that enormous improvements are needed in highways, bridges, airports, railroads and public amenities. Democrats like infrastructure spending because most of the jobs created are union jobs that offer relatively high pay and benefits.

Republicans like infrastructure spending because the suppliers include firms that provide steel, heavy equipment, cement, asphalt and the technology behind the operating systems.

Both parties like infrastructure spending because it’s popular with voters and results in tangible progress unlike the intangible benefit programs that voters can’t see.

The Democrats can support “jobs, jobs, jobs” while the White House can say they’re out to “Make America Great Again.”

It’s a win-win for the two parties and the voters.

Of course, a bill of this type will add one-trillion dollars to the deficit, but at least politicians could claim that the benefits to the economy in terms of wages, equipment sales, safer highways and airports and reduced travel times will outweigh the added deficits; the new infrastructure will produce added growth for the economy.

Best of all, the infrastructure spending would be “made in America.” These are not the kind of projects that can be outsourced to Mexico or China. The projects would use U.S. steel, U.S. equipment and U.S. workers. At a time when the U.S. political process is breaking down into acrimony and accusation, both parties might like a bill the benefits the country and makes the politicians look reasonable.

Funding the Department of Transportation, which oversees infrastructure spending, could be the catalyst for companies that provide materials for structural improvements to the nation’s highways and bridges.

This is a great opportunity for investors who take advantage of the infrastructure spending spree that could begin soon.

Regards,

Jim Rickards
for The Daily Reckoning

The post The Government Could Shut Down Tonight appeared first on Daily Reckoning.

New Cold War With China Possible

This post New Cold War With China Possible appeared first on Daily Reckoning.

On Saturday, Dec. 1, at the end of the G-20 meeting in Buenos Aires, President Trump and his team of trade and finance advisers had dinner with President Xi Jinping of China and his team.

The purpose was to discuss the ongoing trade war between China and the U.S. Trump’s team had presented the Chinese team with 142 specific trade demands.

The two sides went over the demands one by one during the course of their two-hour dinner. When they were done, both sides announced a 90-day “truce” in the trade wars. China agreed to negotiate in good faith on the demands and the U.S. agreed to delay the imposition of tariffs scheduled to go into effect Jan. 1, 2019, until March 1, 2019, to give the negotiations time to proceed.

This was not a final deal, but it did allow markets to breathe a sigh of relief. The initial response of the stock market was a rally.

But just hours after the Trump-Xi announcements, Canada arrested Meng Wanzhou, the CFO of Huawei, in Vancouver, British Columbia. The arrest was at the request of the United States, which had issued an arrest warrant for Meng last August on numerous charges including money laundering, espionage and selling telecommunications equipment to Iran in violation of U.S. sanctions.

Meng was arrested during a stopover in Vancouver on a flight from China to Mexico. She was avoiding U.S. territory but was apparently unaware of the U.S. arrest warrant and the degree of cooperation between Canada and the U.S. on criminal matters and extradition.Huawei is the largest telecommunications equipment manufacturer in the world and one of the largest tech companies in China. Meng is the daughter of Huawei founder Ren Zhengfei.

The arrest of Meng threw global markets into turmoil. The Dow Jones industrial average index fell over 1,400 points, a 5.5% swoon, from the close on Monday, Dec. 3 to the close on Friday, Dec. 7. As of the Friday close, the Dow was down for the month, quarter and year. By the way, as of today, Dec. 13, it’s still down on the year.

By Sunday, Dec. 9, Canada was asking that Meng remain in jail pending the outcome of a hearing on whether she should be extradited to the U.S. to face a criminal trial. Meng’s lawyers were arguing that she should be granted bail and was not a flight risk because she owned property in Vancouver. She also argued that her health would be adversely affected by further incarceration. The Canadian court took these claims under advisement and planned to rule soon on the bail and extradition.

Jim in China

On a recent trip to Nanjing, China, I was permitted inside a secure research facility of Huawei, one of the top technology companies in China. Huawei is the world’s largest telecom equipment provider and a leader in the global rollout of 5G smartphone systems. Canada has arrested the CFO of Huawei, who is being held for extradition to the U.S. on charges of money laundering, espionage and violation of U.S. sanctions on Iran.

The Huawei arrest was more than a shock to markets. It was also a shock to the U.S.-China trade war negotiations. Both sides pledged to keep the negotiations on track, but China was publicly outraged by the arrest.

China told the Canadian ambassador that there would be “severe consequences” if Canada did not immediately release Meng. China’s Vice Foreign Minister Le Yucheng told the U.S. ambassador to China that “the actions of the U.S. seriously violated the lawful and legitimate rights of the Chinese citizen, and by their nature were extremely nasty.” Le also said, “China will respond further depending on U.S. actions.”

The Meng arrest is significant in its own right, but is even more significant when taken in the full context of U.S.–China relations and the possibility of a new Cold War.

Huawei is not only China’s largest telecommunications firm; it is a leader in the rollout of 5G technology for mobile phones. Huawei is alleged to have deep ties to the Communist Chinese government and the People’s Liberation Army (PLA).

Huawei founder Ren Zhengfei started his career as a military technologist at the People’s Liberation Army research institute. U.S. intelligence estimates that Huawei is de facto controlled by PLA and has engineered trapdoors and other devices in Huawei equipment that allow Huawei to spy on customer message traffic and to capture private data.

The U.S. has already refused to allow Huawei to make acquisitions of U.S. companies and has banned Huawei from sales of equipment to the U.S. government. The U.S. has also urged its intelligence partners in the “Five Eyes” (U.K., Canada, Australia and New Zealand) to do likewise. Huawei’s business is suffering worldwide just as the 5G tech implementation begins.

The next steps in the case are still pending. The British Columbia court needs to decide on bail and possible extradition. If Canada extradites Meng to the U.S., she will almost certainly face a trial on criminal charges unless a plea deal can be worked out. In a worst case, Meng will spend years in a U.S. prison. At best, the case will inflict major damage on U.S.-China relations and the prospects for peace in the trade wars.

In the meantime, the 90-day “truce” that Trump and Xi negotiated in Buenos Aires is still officially in force.

The Chinese could offer token concessions and use the 90-day window to cook up new happy talk. Their hope will be that after 90 days of negotiations and some minor concessions, the U.S. will be reluctant to break the peace or impose the additional tariffs.

The 90-day period will also give the Chinese lobbyists time to gin up opposition to tariffs from U.S. agricultural importers. This is an important political constituency for Trump as we move closer to the 2020 presidential election season. Trump needs support from agricultural states like Missouri, Iowa and Wisconsin to win his second term as president. It seems the Chinese understand U.S. politics better than most Americans.

The Chinese are also notorious for saying one thing and doing another. They will gladly sign an agreement that calls for reductions in the theft of intellectual property and then turn around and keep up the thefts (perhaps with a more covert method).

The Chinese have consistently broken their word when it comes to trade, beginning with their admission to the World Trade Organization in 2001. They will do it again once they tie the U.S.’ hands on tariffs.

The good news for the U.S. is that the Chinese tricks are fairly well-known by now. Trump’s most trusted and powerful adviser on trade is ambassador Robert Lighthizer, who was at the dinner. Lighthizer sees the Chinese for what they are and knows the litany of broken promises and lies better than the Chinese leadership.

If substantive improvements with adequate verification cannot be agreed upon with the Chinese by April 1, 2019, Lighthizer is ready to immediately raise tariffs on China. President Trump agrees with Lighthizer and will not hesitate to raise the tariffs. At that point, the trade wars will be back with a vengeance.

Regards,

Jim Rickards
for The Daily Reckoning

The post New Cold War With China Possible appeared first on Daily Reckoning.