The correction that hit U.S. stocks last week was a very typical seasonal affair — a little later than usual, but very much in the normal script. One of the typical things about it was that the reasons given for it were found only after it started, leaving many seasoned market watchers to conclude that if it hadn’t been the reasons given, the market would have found other reasons. This is not to say that the reasons are not real events and real market factors; they’re just not actually the looming catastrophe that fear makes them out to be while the correction is underway.
There were two reasons widely reported as the occasion for last week’s correction. First, rapidly rising U.S. interest rates and the prospect of a Federal Reserve bent on continuing the pace of rate rises through 2019. Second, an apparent impasse in the ongoing trade conflict between the U.S. and China, which highlights concerns about a widening divergence between an economically strong U.S. and weakening in much of the rest of the world. Such divergence would ultimately call into question the durability of the bull market in U.S. stocks, even if a recession still lies several years in the future.
The Truth Behind the Excuse
China does matter for the U.S. and for U.S. investors — perhaps most because if there is an event lurking out there that could tip the global economy into recession, one of the leading candidates would be a Chinese financial crisis. (Another potential ground zero for a future financial crisis, as we have often pointed out, is Europe, and Italian budget antics and fears of a “hard Brexit” may also have had something to do with last week’s market swoon.)
Still, although the U.S. would certainly be affected by a Chinese crisis, the U.S. has also been affected by two decades of Chinese trade and economic policy misbehavior. It is not just the U.S. pointing out the negative effects of Chinese trade and economic policy — many of the U.S.’ developed-world peers are coming around to a recognition of this long-term problem. Indeed, some of the frustration expressed by other countries about the current administration’s harsh approach to China is that they believe these harsh measures could make it more difficult to reach a deal that curtails China’s most egregiously bad behavior. They also want that behavior to be curtailed; they just disagree about the best way to do it.
The U.S. and China: A Shift of Stance?
Last week we brought your attention to a policy address by Vice President Mike Pence which laid out the administration’s grievances with China in an unexpectedly blunt way. It was so blunt in fact, that combined with administration’s overall approach, many wondered if it signaled a completely new phase in U.S.-China relations — effectively a new Cold War.
We don’t doubt the determination of the current administration to stop some of the ways China has abused its membership in the World Trade Organization (WTO) and has caused damage to U.S. economic interests as a consequence. We also don’t doubt that the administration thinks previous responses to China’s growing foreign policy ambitions weren’t robust enough, and that it intends to do more to secure U.S. hegemony in the longer term.
In his recent 60 Minutes interview with Lesley Stahl, President Trump said he doesn’t want to crush China’s economy: “I want them to negotiate a fair deal with us.” As long as that “fair deal” proves elusive, the pressure will be on, applied in a style different from many previous administrations. The U.S. doesn’t want to see China in recession or in the throes of a crisis, but it is willing to apply pressure where China is politically, economically, or financially weak in order to push Chinese negotiators to a better deal.
The fact is that China is much less of a threat than many popular analysts realize — less of a threat both economically and militarily. Part of the reason the U.S. knows that it can lean on China as heavily as it is, is that it is well aware of China’s weaknesses.
What are those weaknesses?
As we’ve pointed out before, China currently has two existentially important financial and economic mandates. It has to maintain economic growth as it transitions from an industrial-led to a consumer-led economy; if it doesn’t maintain growth, the population could become dissatisfied or even rebellious. And it has to maintain financial stability, since decades of rapid expansion have led to stresses and excess in the unofficial lending sector — a huge buildup of debt.
Increasingly, this twin mandate — maintain growth, and reduce excess leverage in the riskiest parts of the financial system — is becoming an impossible balancing act. Especially in the years following the global financial crisis, with external demand muted, the government relied on massive infrastructure investment to prop growth up — and that led to an accumulation of financial instability risks. More recently, perhaps since late 2016, those risks have become the top concern of China’s policymakers.
Now, in the face of the effects of U.S. tariffs, China’s economy is clearly decelerating. Deleveraging is ongoing, with liquidity being drained from the unofficial, shadow-banking sector. Modest easing, in the form of cuts to banks’ reserve ratio requirements, is barely sufficient to compensate for that deleveraging. Yi Gang, the central bank chief, says that there is still “plenty of room” to ease — through further reserve requirement cuts or through lower interest rates. But this skirts over the issue that the engine of China’s growth (and everyone else’s, for that matter) is small business — and small businesses have much less access to credit in the formal banking system.
All of this also means that the Chinese yuan is falling. Despite all the debate about China as a “currency manipulator,” it is far from evident that China is engineering a lower currency; on the contrary, in the face of all its economic and financial headwinds, it may well be engineering a higher currency, in part to maintain the effective demand of its citizens for the foreign goods they have come to see as emblematic of their success. In general, currencies fall when bad things happen to an economy. We think it is quite possible that some day next year, the Chinese yuan could fall drastically against the U.S. dollar. That would not be an unvarnished good for China’s rulers.
That brings us to our final point about the weakness hiding under media obsessions with rising Chinese power: internal dissension within the Chinese Communist Party.
“President For Life” Xi and His Opponents
President Xi Jinping has spent much of time in office strengthening and concentrating his power, including direct power over state security forces; this process culminated earlier this year in his declaration as “president for life” and the introduction of the concept of “Xi Jinping thought,” putting his ideological pedestal on the same level as Mao’s.
There was a wave of popular dissent in which citizens defaced his posters. What signaled that the resistance to Xi’s accession to Mao-like status was more widespread, was the sharp drop-off in spontaneous accolades from regional party leaders and cadres. Further, dissension began to be noted, quietly, between Xi and senior policymakers unhappy (for example) with his direction of the trade conflict with the U.S. Some, such as Vice Premier Liu He, have been sidelined.
Reports have emerged that the State Council has become a battleground of sharp disagreements over how to handle the country’s economic deceleration. Some officials, such as Xu Zhong, director of the research bureau at the People’s Bank of China, have made unprecedented public criticisms of policy; Xu said the Finance Ministry was “behaving like a hoodlum.” A prominent Tsinghua University law professor, Xu Zhangrun, wrote that “After 40 years of reform, overnight we’re back to the ancien regime.” (In case you missed that allusion, the term refers to the pre-revolutionary government of France, and so clearly carries an implicit threat of revolutionary reversal.) These are just a few examples of high-level public criticism; there are many reports of dissension within the government’s ruling elites from sources afraid to speak publicly.
Over all of this, it is difficult not to see the shadows of former leaders Hu Jintao and Jiang Zemin and their circles, who resent Xi’s self-aggrandizement and rejection of the circumspection and modesty of Deng Xiaoping, the reformer who opened China to the world after Mao’s death.
In short, China has a lot of problems — economic, financial, and political. Their robust and muscular resurgence on the world stage is much more a creature of western media sensationalism than of reality, and it is certain that the current U.S. administration knows it — and is willing to use that weakness as an occasion to set right some of the injurious policies China has pursued over the past 20 years in its relations with the developed world.
Investment implications: While current problems continue to develop, we do not view China as ripe for investment, in spite of declines in Chinese stocks. It is a venue for speculators only, and we suggest that if you trade China, you be cautious, maintain tight stops, and take quick profits.