Deep Throat: July 2018

I had initially thought I'd be doing a post about Alibaba's 20-F Annual Report right about now since they usually file in the middle of June. Unfortunately, it's still not been filed, even though by SEC Rule, it's due by 8/1/18. Luckily, Alibaba's reality TV show accounting department, as we've learned over the years, has mastered the art of suspense and slight-of-hand, always revealing amazing, incredible information at the eleventh hour, when the market least expects it.

Since they are taking so long to get it done I'm sure this filing will be an absolute masterpiece! I can't wait to see what they come up with.....more gigantic gains from new asset valuations? Hundreds of newly formed off-shore money laundering "investees"? Giant CCP funded stock buy-backs? Brand new classes of stock issued, allowing even more investors all over the globe to get in on the ground floor of this unstoppable beast? Perhaps E-Commerce in Antarctica? A distribution hub ecosystem at McMurdo base? My heart's a flutter with anticipation!

On the other hand, when you're just "makin' shit up" we might wonder why it's taking so long to prepare the report in the first place?

Anyway, since the 20-F isn't out and I've got some free time after a wonderful, refreshing Canadian sailing vacation, visiting some friends across Lake Erie, I thought I'd take a few pages to tackle the gory details of our relatively new, wag-the-dog, easy to win TRADE WAR!!!!

THE TRADE WAR!!!!!!

Let's start, by way of background, on the political and economic policy that got us to where we are today.

The best example of the driving force and philosophy behind our escalating trade war and Section 301 Case with China (and to some extent the world) is Peter Navarro's June 2018 tome entitled:

How China’s Economic Aggression Threatens the Technologies and Intellectual Property of the United States and the World

Since the title of this report, issued on White House letterhead, scared the living crap out of me, I thought best that I read it in its entirety. I'd invite you to do the same.

https://www.whitehouse.gov/wp-content/uploads/2018/06/FINAL-China-Technology-Report-6.18.18-PDF.pdf

As you can see, it's a lengthy piece with roughly 20 pages of allegations, 150 footnotes and a 30 page Appendix documenting China's decade of "cheating" and economic atrocities that the rest of the world has, unfortunately, allowed to happen. According to Navarro, China is apparently the West's financial version of a "smokin' hot bad girlfriend" who keeps getting drunk and maxing out our credit cards on spas, handbags and designer clothes. We tolerate it for a while because she's smokin' hot....but eventually, we have to move on.

Navarro did a great job of documenting exactly what's been happening. Whether it be outright IP Theft, Acquisitions, Counterfeiting, Reverse Engineering, etc. Mr. Navarro points out, for lack of a better descriptor, that China has been, kicking America's technology-ass for about a decade. Because I'm on a mixed-metaphoric roll today, like the guy who's been playing and losing the shell game, the administration has finally taken the time to describe how, once enlightened, they've discovered that there was never a "pea" under any of the shells in the first place. (Our "smokin' hot BGF" has, of course, had her deceptive little hand on the shells the entire time.)

For example, after Apple contracts with FOXCONN to manufacture all of their products on mainland China, should we really be surprised when ZTE, Huawei and Lenovo start selling devices that look and feel exactly like iPhones for half the price? (Author's Note: I actually Like my Moto Z-Force 2 better than my wife's iPhone) It also should be no surprise that Chinese software seems to have the same code that was initially designed by US developers, prior to the CCP persuading those same, US educated developers to quit working at Google and "come home". Should we be shocked and dismayed to see every US and EU luxury brand for sale on Amazon, for pennies on the dollar, through third party off-shore sponsored store fronts? When we search "GUCCI bags" on Amazon we get lots of items that look just like the real thing (from third party store fronts littered with grammar and spelling mistakes) on sale for under $50! Awesome!

Taking it further, if you follow my blog, you know I believe that most Chinese financial statements should begin with "Once upon a time" and these misrepresentations have caused roughly $2 Trillion of Western Capital (Stocks, Bonds & Debt) to be misallocated to businesses of, to be kind, dubious value.

When we look at real estate in China we see miles of vacant cities, fake towns and goofy decaying facades all designed to conjure an image of wealth and prosperity. We see "Little Manhattan", "Florentina" (or "little Florence"), the Hangzhou "White House", several Eiffel Towers and at least two near full size replicas of Niagara Falls. Are we really to believe that this vacant opulence is representative of the China dream? The CCP has inexplicably chosen these odd, non-productive, easy-to-do, uses of capital over cleaning up the air in Beijing or providing drinkable water to their population.

https://www.chinaghostcities.com/

In one breath the CCP/NBS reports rock solid 7%-ish GDP growth, like clockwork, yet they somehow stumble onto an extra $23 Trillion (Nearly twice the equivalent of the entire US Money Supply-M2) in Shadow Bank debt that they didn't know they had? That's a hell of an "Ooppsss"!

Given the above, we really have to ask ourselves, is anything the CCP does or says even remotely credible? What, if anything, can we believe? Again, these anomalies are not an accident. These are brilliant people who know exactly what they are doing and understand the costs, risks and benefits of their actions and misrepresentations. Yet, we Westerners are surprised that our technology and capital is flowing unabated into China by any means necessary? Really? From my perspective as an insurance man, it seems to me that we've left our "technology car" running with the keys in it, seemingly abandoned in a parking lot in a bad neighborhood for a couple of days and upon our return, we can't believe that it was stolen!

Unlike most Administration communication, Mr. Navarro's work wasn't initially Tweeted, nor was it punctuated with smiley faces, exclamation marks and/or written in ALL CAPS. IMO this new, out of character delivery style really enhanced the report's credibility and emphasized the importance of this document. It was actually pretty well done.

All that said, unfortunately, there was really nothing new in Mr. Navarro's report. The report was a compendium of complaints, anecdotes and violations, nearly all of which had been published and described in the various financial press referenced and properly cited in the 150+ footnotes. Anyone who's been following this has at least some recollection of most/all of these entries, events and footnotes. I'm also really hoping that there are actually vast treasure troves of "top secret" additional government data/research that further justifies Mr. Navarro's views on tariffs and the intended impact on our relationship with the Chinese, but I have my doubts.

Now let's take a look at what our Congressmen and Senators have been taught to think.

Congressional Research Service 7-5700 (www.crs.gov) RL33536

Probably the best source to get info on topics near and dear to our Congressional hearts and minds is the Congressional Research Service (CRS). This non-partisan army of roughly 600 Economists, Lawyers & Scientists with a $100 million plus budget, provides the nuts & bolts analysis of the issues (and talking points) for our legislators so they can wrap their minds around complex topics that, to be frank, you have to be brilliant to even begin to understand. The CRS, in essence, is the "brain" of our legislative leadership. Their work is essential. It's their job, generally, to let our Senators and Congressman know what might (or might not) happen if they pass (or don't pass) specific legislation.

The link below is a list of some of the things they've recently been involved in. They provide background on everything from Supreme Court nominees to Energy Policy. It's fascinating stuff.....

https://fas.org/sgp/crs/misc/index.html

Anyway, the author of RL33536 - US-China Trade Issues, is an extremely talented, highly educated, experienced gentleman by the name of Wayne Morrison (WMorrison@crs.loc.gov). I'd invite you to read the report in its entirety. It's great work.

Of course, since the purpose of this blog is to save my readers some time and give a fresh perspective. Here are the bullet points of the report with a one line comment describing the content contained in the section. Feel free to reference the page number if you are intrigued.

Pg. 1.) A Summary of the chronology of the SEC 301 Investigation which lead to the current actions the administration is taking against the Chinese Government, as first discussed in the above cited "Navarro Report".

Pg. 4.) Summary of the development and history of US China Trade policy from 1979 to present. Excellent perspective on how we got to where we are today and the ramifications of operating under market driven rules with a closed/managed economy trading partner.

Pg. 17.) US/China Investment Flows including US Securities and FDI. Detailed data/tables describing the amount of public & private capital flows and significant investments.

Pg. 30.) US/China Trade Issues and "State" Capitalism. Analysis of SOE impact on the global stage.

Pg. 56.) China's Currency Policy. A very brief, and in my view, incomplete overview of how China's managed currency can impact trade.

Pg. 58.) The Trump Approach. The 2017 National Security Strategy Report describes a number of economic policies which the administration objected to as well as possible responses and subsequent negotiations.

Pg. 60.) The "301" Case. Details on the various retaliatory tariffs potential economic costs of implementation and escalation.

Pg. 74.) Made in China 2025. An analysis of the various initiatives which the Chinese government is implementing in order to become a world technology leader and preeminent world economic power.

I hope you took the time to read the report. Again, it's an outstanding piece of analysis.

That said, just for fun, now, let's pretend we are Senators or Congressmen/Congresswomen for a moment. What's the first thing I would ask after reading the report? That's right! I'd ask myself "If I get on board the tariff train, how many votes will it get/cost me?"

To answer this question we can start with Figure 18 (Pg. 69). For every round of 25% tariffs on every $150 Billion of Imports the US would lose 587,000 non-manufacturing jobs (retail/delivery/ warehouse/office/etc.) and gain 132,000 manufacturing jobs. If we extrapolate with "simple math" ...(You folks know how I love "simple math"), since we're talking about $500 Billion in tariff eligible goods now, we can guess that 1.97 million (500/150 x 587,000) non-manufacturing jobs might be in jeopardy. The good news is that we'd gain 440,000 manufacturing jobs.

Simple math tells us that the political impact of 440,000 employed (happy) voters would be more than offset by the 1.97 million unemployed (pissed off) voters.

Under the above $150 Billion retaliatory scenario the report concludes the following:

U.S. GDP could fall by 0.26% or $49.2 billion (2016 dollars);
Farm property income could fall by 15.01% (Farmers always get screwed in America);
U.S. exports and imports could drop by $105.5 billion and $341.2 billion, respectively (2016 dollars)

So now let's see which states might be most impacted if we go down the "easy to win" trade war path. Although the chart below only reflects a $30.6 Billion reduction in export losses and expected retaliation (rather than the $105.5 Billion described above) we can again rely on "simple math" to extrapolate. The states most impacted are described in Figure 19 (Pg. 70) below:

Now let's take a look at the Senators that you'd think would be leading the bipartisan charge to prevent this tariff folly (I'll explain why this is "folly" below), hoping and fighting to keep a significant number of their voters out of the unemployment lines.

Louisiana - Bill Cassidy - Republican
Louisiana - John Kennedy - Republican
Washington - Maria Cartwell - Democrat
Washington - Patty Murray - Democrat
California - Diane Feinstein - Democrat
California - Kamala Harris - Democrat
South Carolina - Lindsey Graham - Republican
South Carolina - Tim Scott - Republican
Alabama - Doug Jones - Democrat
Alabama - Richard Shelby - Democrat
Illinois - Tammy Duckworth - Democrat
Illinois - Dick Durbin - Democrat
Texas - John Cornyn - Republican
Texas - Ted Cruz - Republican
Kentucky - Mitch McConnell - Republican
Kentucky - Rand Paul - Republican
Michigan - Gary Peters - Democrat
Michigan - Debbie Stabenow - Democrat
Ohio - Sherrod Brown - Democrat
Ohio - Rob Portman - Republican

You can, of course, also put the dozens of related House Reps into in mix. I might also consider throwing John Boozman and Tom Cotton on the list (Arkansas Republicans) since I doubt Walmart management would be all that supportive of a 25% cost increase. (See: Amazon, Walmart and Chinese Potting Soil.....). Hypothetically, I'd also guess that Amazon management would probably be fully on board with a full blown trade war. The broad brush rationale is that much of the stuff/junk for sale on the Amazon platform is knock-off product sourced from and sold on questionable storefronts, beyond the reach, or under the radar of US Regulation & Enforcement. (Tariffs aren't paid on smuggled goods) and, like stopping illegal immigration and securing our border, the cost of the enforcement effort is YUGE! As a result, Amazon market share, albeit of a shrinking pie, might well increase as a result of increased tariffs and a trade war.

From a legislators perspective, a Tariff is a silent, regressive tax that raises the ire of their constituents. In fact, tariffs might be one of the most regressive forms of silent taxation available to a government, right up there with excise taxes on fuel (buried in the pump price or utility bill) and sales taxes on food and clothing (unavoidable at the register). The Tariff (or increased cost on competing domestic good) in the end, is always paid by the consumer, unless they choose to go without the product all together. The Tariff/tax is always a much greater burden on those less well off folks who consume all (or more than all) of their income when compared to wealthier consumers. In any case, because of the regressive nature of Tariffs, the end game is two fold: 1.) If demand is relatively inelastic, like with food and fuel, the Tariff/tax hits the poor harder, a reverse Robin Hood effect, if you will, potentially taking from the poor and funding, for example, an income tax cut for the 1%.... and; 2.) If demand is relatively elastic, (i.e. discretionary purchases like new cars, flat screen TV's, etc.) a Tariff causes consumers to buy less of a good, or simply not to buy it at all. Which would, of course, be recessionary.

The recessionary trade war "double whammy" here, of course, is that as consumer prices are going up, jobs are going away.

Moreover, the even more insidious "triple whammy" is that as these recessionary price increases and job losses accelerate, they would be occurring in the teeth of the FED tightening. No wonder the Administration (like every administration) has been railing against the prospect of higher interest rates. The danger here, as history has shown, is that the FED is always fighting the last war. Based on Chairman Powell's latest testimony, there's a good chance that the FOMC will misread the signals being sent by our "fake" economy and in a Volker-esque show of determination, continue to raise rates well into a "Bottom 60%" recession while the "Top 40%" seemingly continues to thrive.

To sum it up, legislators generally don't like, or tolerate, recessionary policy which smacks their constituents around. So we can expect quite a Congressional brouhaha coming over the next few months. Simple enough?....Yes? No?

Of course, as US Prices go up and US Consumers buy less, Chinese sweat shops and factories will make fewer American goods. If the CCP can't find other markets for their output a few Chinese workers might lose their jobs and slip back into poverty. Some Chinese children will have their production line hours and quotas cut back or may even be sent home when the Walmart, Nike and iPhone orders slide. As I've opined for years, this really isn't a problem for the CCP, they will mitigate the impact by printing more money, kicking the can down the road and keeping people busy hitting their arbitrary 7% GDP target by hook or by crook. The Communist Party bosses have a tremendous advantage over our silly democratically elected leadership. China's citizens must silently accept their fate. They don't have a vote.

The Currency and the "Folly"

Here's the problem. With a few exceptions/limitations, the US$ (as well as the Euro, Yen & Pound) can all be converted to any other major currency, at anytime, at any bank, anywhere in the world, at a market rate. The currency value (exchange rate) is calculated by bankers based solely on the available supply/demand of the currency as well as the perceived prospects or "intrinsic value" of the issuing government's underlying economy. The currency is backed by the "full faith and credit" of the issuing Central Bank. Governments, through their Central Banks, of course, intervene from time to time, but in general, market forces determine the exchange rate. Just like every other major currency (except for one), the dollar "floats".

I'm trying to be clear here, because even though he's brilliant, Mr. Morrison missed something really, really important in his report to Congress. I've copied him on this post so I'm hoping he updates his report and passes this critically important information along to our legislators. Here it is:

The RMB DOES NOT FLOAT!

As I've mentioned many times in this blog the exchange rate (RMB valuation) is absolutely and intentionally bloated. The RMB exchange rate is based on a fraction of China's Money Supply which, like the fake facades of the "Little Manhattan" skyline and "Florentina", is intended to create a grotesque distortion of the real Chinese economy and national wealth.

One statistic I like to keep track of is the "Offshore RMB" (ORMB) in circulation as compared to China's M3. It's an indicator of the PBOC's ability to peg the value to a target.

In March of 2015, when the Offshore RMB hit its peak, the stockpile of Offshore RMB hit 1.8T RMB, compared to China's total M3 of 126T RMB. In other words, 1.4% of China's Money Supply was usable to close offshore transactions in March of 2015. Today, we see that China's M3 has ballooned to 174T RMB, a 46% increase in just three years, while the ORMB has actually decreased to less than 1.1T RMB today. The ratio of ORMB to China's M3 has actually decreased to 0.6%, again making it possible to set a fictitious, inflated value for the currency with minimal ongoing intervention.

The FRED chart below (which I've published variations of in prior posts) illustrates the absurdity of this condition.

Even though China's M3 has increased 252.7% (Red line) from 1/1/2009, compared to an increase in US M3 of "only" 69.7% (Blue line), the RMB has actually appreciated 2.2% (6.68 vs 6.83 - Black line) during the same period.

The ramifications for this are, in the words of our administration....YUGE!

Simply put, the reason US Tariffs on Chinese goods are a "folly" is that because of their managed/off-shore "dual" currency mechanism, the PBOC has printed (and continues to print) enough Mao-nopoly money to pay any tariffs we choose to levy, or in fact, "buy" just about anything their little communist hearts desire without impacting the mainland economy. As expected, on cue, when the President announced he was considering expanding tariffs to all $500 Billion of Chinese imports the PBOC immediately announced an "Are you sure you want to do that? shot-across-the-bow" offsetting depreciation, roughly the equivalent of the current tariffs.

The reality is that the PBOC indeed has been manipulating the RMB for years, but not the way the administration thinks. Rather than intentionally weakening the RMB, they've been fighting tooth and nail to protect its value in the wake of the YUGE! expansion of their money supply. Think of the wealth that's been created over the last decade simply by tripling the money supply over the last few years while keeping the exchange rate constant. During the period above, on a converted US Dollar basis, China's M3 increased from US$7.2T in 2009 to US$27.4T while US M3 has increased from US$8.2T to US$14.0T. I've asked this before, but why in the name of Milton Friedman does the Chinese Economy require so much currency (twice the value of US M3) to run effectively? Again, the simple math tells us that it doesn't. Simple math tells us that, if it wasn't for the managed dual onshore/offshore currency the value of the RMB would/should be somewhere around a third of what it is today. If it wasn't for the iron clad SAFE controls and offshore restrictions, Chinese citizens, businesses and banks would be converting RMB to assets denominated in other major currencies at a breakneck pace.

In any case, what we're talking about now is semantics. We all know what's going to happen, but as Warren Buffett often quips, "We just don't know when or how big it will be.". Traders and the talking heads have proclaimed (last week) that we are on the brink of a full blown currency war. Economists describe all sorts of process metrics and theoretical machinations whereby financial asset classes eventually find their intrinsic value. Financiers describe the intervention methods Central Bankers use to manage their respective money supplies. The White House Tweets about the RMB "Dropping like a rock!" In any case, that seems to be where we're headed.

As I've said many times before, the PBOC will fight like a pack of rabid dogs to prop up the RMB value using any means necessary, including redoubling the onshore money supply and tightening offshore (usable) currency. So we'll see how far this revaluation/depreciation goes. It might stop at 8:1.....or simple math, and history (the Weimar Republic), or even today's candidate for "Currency mis-manager of the year", the Venezuelan Central Bank (Hey....a million % inflation isn't so bad...) tells us that there's a chance it can spiral out of control quickly. On the other hand, if the Chinese people have plenty of money, they won't think they are poor....until, of course, they start running out of food.

The Economy

By definition, if you are reading this blog, you are familiar with the concepts and the material presented herein. Therefore, you are probably doing pretty well. Things are going great! From your point of view the economy is humming along. I'm guessing you are pretty smart, have a college education and work in a financial/professional environment. You might have some passive income, some savings, at least a few investments and generally care about your finances and the future of same. If you have followed this blog for a while, you might find this hard to believe, but we (you and I) tend to look at the world with a "glass half full" attitude. Economists might say, because of our perspective, we have an "Optimism Bias". I hate to burst your bubble, but you/we are an anomaly in America. You/we are the exception. We're not the rule.

If you are fortunate enough to own/run or be employed by a retail/service business in America, as I am, you'd have a much different perspective. If you work with America's industrious, smart, talented, working class, retired, young, poor, octogenarian, illiterate, professional, millennial, single mom, widowed, etc., etc. folks you'd conclude relatively quickly that many of them are doing everything they can....just to get by.

Oddly, when I watch/read the headlines and the financial news I see streams of blurbs nearly every day describing our "strong" and "robust" economy. The White House, Bloomberg, Fortune, the Wall Street Journal, and even the recent statements and remarks by Jay Powell in his testimony before the House Financial Services Committee....and nearly everyone with a platform.... all continually marvel at the strength and resiliency of the US Economy.

The most interesting thing about this disconnect is, that the numbers don't come close to supporting the optimism/bias.

Let's start with the real wages of the good hard working folks who I've just described as "barely getting by." The chart below describes their plight.

Since 2007, Median Real wages in America for folks who usually work full time have increased a whopping 4% in eleven years. Not 4% per year......4% in eleven (11) years. The wages of the American worker are barely keeping up with inflation. I will admit that there's been a bit of a recovery since 2014, but again, if an employer told you that they would guarantee you a 1% increase a year (and no more) in your paycheck....would you be salivating over the opportunity to take the job?

The talking heads also tout the "near 4%" unemployment figure indicating that the economy is running at or near full employment. I think I've even heard somewhere that the economy is running at an "all time high" or some such nonsense.

You'd think, with stagnant wage growth like we see above, that we can only assume that there are millions of folks who are unemployed or under employed......and you would be correct.

Here's the statistic I like to look at. In the chart below we calculate the percent of the total population who usually work full time, indexed to 1997. I like to look at this ratio because it calculates the the ratio of working people who are supporting non-working people, over time.

As we can see, the ratio of workers to total population, after a decade of near-ZIRP interest rates, is finally back to the 1997 level, but well below the pre-Dot-com bubble and pre-Housing crisis levels. (shown by the light blue bars). I'd describe employment, at best, as improving a bit from the depths of the financial crisis....You'd think that after a prolonged period of unprecedented stimulus and record low interest rates, our economy should be humming along at a China-like 7%+ GDP growth rate. Everyone should have a job and wages should be skyrocketing if this policy were truly effective.....yet, we're far from an "all time high".

So from what I can see, we have fewer people working and they are working for relatively low wages. Combine that with Ray Dallio's survey that 60% of American's can't scrape together $400 in an emergency and that doesn't sound like most Americans might be thinking "Hey....I'm doing great!"

So why is there such a disconnect? Let's take a look at the last chart below.

The simple chart above (The Wilshire 5000 Market Cap vs. the Fed Funds rate since 1997, indexed to 100) describes, I think quite well, the source of the disconnect.

If you are reader of my blog, a manager, investor, banker, politician or even a Federal Reserve Governor who follows these things, we can see that we've had, at least since 2009, the greatest uninterrupted investment environment, probably since the Roaring 20's. The Shiller CAPE is at 32.6, the second highest level in history (surpassed only by the valuation prior to the dot-com bubble). Valuations are YUGE!!

You, my readers, and I have likely all prospered. We've made boatloads of money. We've all watched our home values and retirement accounts relentlessly tick up year after year. It's been a great run. I don't see how it could have been any better. We should be really proud of what we've been able to accomplish, digging ourselves out of the financial crisis and recovering, even though, unfortunately, 60% of our neighbors are still in deep shit.

So Here's The End Game

The "easy to win Trade War" is a no win proposition for the American people. Again, it's a reality show, wag-the-dog, America First head fake intended to stir up the biases of the electorate.....that's all it can possibly accomplish.

As long as the Chinese keep the RMB under control, in a measured depreciation, everything will be fine (sort of). A couple of America's crowned jewels (Apple, Walmart, the banks, etc.) will hit a few bumps in the road. The FED, at the slightest hint of a slowdown will accommodate, replacing the "lost" money and asset values that have been silently transferred to the Chinese elites over the last decade. We'll be back to QE "infinity". Ray's "60%" will bump up to "80%", a few businesses will close up and an industry (or two) will be irreparably harmed. Politicians will, of course, blame the FED, just like they did in the good old Volker days, and life will go on.

On the other hand, the worst case scenario would be that the PBOC loses control of the depreciation and the RMB collapses. I doubt that will happen. After all, Chinese Central Bankers are really smart folks. They've been able to snooker the West out of Trillions of dollars of wealth over the years and they're not encumbered by those pesky political, human rights and Fourth Estate considerations. On the other-other (third) hand, last year they managed to stumble upon and disclose US$ 23 Trillion of Shadow debt that they apparently didn't know they had, so who the hell knows?

If the RMB does indeed end up in the Weimarian-scrap-heap of financial history's imploding currencies, at that point, all bets are off. In modern history, we've never seen anything close to the "World's Second Largest Economy" go bust. That, my friends, would be YUGE!!

Well, that's it for today. Courtesy of Chinese financial policy and the West's failure to intelligently react to it, like all good things, yet another party is coming to an end. Hopefully, we'll all be politely asked to leave, with a little fair warning and some going away presents and party favors, rather than given a surprise boot in the ass out the door at the stroke of midnight.