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Last Week's Stock Market Crash – An Advance Warning
Peter T. Treadway

The premises of this war {over} the huge bilateral trade deficit with China are very peculiar. The presumption is that the U.S. is better and more efficient than any other country, and if we don’t export more than we import, China must be cheating. Any economist would say that premise is absurd. We live in a multilateral system. When we save less than we invest, there will be a trade deficit.

Nobel Economist Joseph Stiglitz in This Week’s Barron’s

As this blog went to press, the stock market was soaring. But this follows a mini crash last week. There are those who argue that the US portion of the mini-crash was simply a healthy correction for a stock market that had gotten ahead of itself. That the US will remain a place of refuge for global capital while the rest of the world descends into hell.

I think that’s totally wishful thinking.

US companies will be reporting quarterly earnings over the next month. The earnings should be great – even fantastic. Of course the market will be looking at the future guidance. That’s less a sure thing.

The Headwinds Ahead

The Fed has been signaling for quite some time that it was going to tighten so the market should not have been surprised. And the American stock market rose significantly in 1999-2000 when the Fed was raising rates. But things may be different this time. The increase in rates – particularly on the long end—signals a universal increase in the cost of capital. This may be a special negative for so many high fliers like Netflix (NFLX), Spotify (SPOT) and until recently Amazon (AMZN) which for so long have not been required to have earnings and have had effectively a zero cost of equity capital. The same reasoning may apply to the venture capital pre-IPO market where until recently capital has flowed like water.

The markets and the Fed among other things seem to have a fear of inflation. Higher inflation implies higher interest rates. This fear is ironic since for years the world’s central banks including the Fed worried that there was no inflation. An insane worry in my opinion but now the Fed seems to have become careful about what it wished for.

But why is there a sudden worry about inflation? The standard answer is that the economy near full employment is running hot. Standard Phillips curve explanation. But there is another answer. President Trump has declared war on globalization and to a large extent technology. In prior years it has been globalization and technology that have served up what economists called “good deflation.” But now the American President is serving up “bad inflation.”

And not only that. Trump brags—rightfully in this case—about his tax cuts juicing up the American economy. But now he is imposing new taxes called tariffs, with dubious constitutionality and massive economic inefficiency. The Lord Trump giveth and the Lord Trump taketh away.

At the heart of Trump’s war on globalization is China. China has been called the world’s factory, an exaggeration perhaps but one that drives Trump and his base crazy. It doesn’t matter to Trump and his base that American companies like Apple make fortunes designing products while, with Confucian discipline not so plentiful in America, multitudes of Chinese laborers manufacture and assemble these products for modest wages by American standards. It doesn’t matter that the American midwestern industrial heartland has had an economic revival in recent years and the US is now effectively at full employment.

An economic war with China brings considerable collateral damage for American companies, especially those in tech. They will lose a major market for their products and possibly a shut-down of their manufacturing operations. There are three great centers of technology in the world today—the US, East Asia (China, Korea, Japan) and Europe (a definite weak third). Technology is a global phenomenon, with the US, East Asia and Europe joined at the hip. Examples of collateral damage are popping up.  For example, Intel (INTC) and Nvidia (NVDA) both have joint projects with Chinese auto companies to develop autonomous cars. But according to the Nikkei Asian Review, the Japan Automobile Manufacturers Association and the China Association of Automobile Manufacturers have just signed a memorandum of understanding in Tokyo to cooperate on setting international standards for self-driving technology. All this supposedly in anticipation of American export controls. The American companies are way ahead any Japanese competitors so the Japanese option is a second-best back-up strategy.  Bad news for China, bad news for Intel and Nvidia.

For Trump, mercantilism, an economic doctrine seemingly discredited almost three hundred years ago, rules the day.  Mercantilism may be succinctly defined as the economic theory that wealth is stimulated by the accumulation of positive trade balances, which a government should encourage by means of protectionism. Intellectually mercantilism was replaced by Adam Smith’s division of labor and David Riccardo’s comparative advantage. Legions of economists building on the work of Smith and Riccardo have refined what has become the doctrine of free trade.  In Trump’s eyes, Adam Smith, David Riccardo and most economists can be damned.

Made in China 2025

Made in China 2025 is a Chinese program which is, at its core, is a blueprint to realize the incredible 21st century opportunities offered by accelerating technology. The Trump people have painted it as a sinister Chinese plan to dominate the world technologically and militarily. According to the Trump Administration, China does not have the right to develop its country to its full potential. For sure, given the response this plan has received in Washington and elsewhere, from China’s perspective Made in China 2025 has been a public relations disaster.

There can be no denying that differences in the US and East Asian economic models (especially China’s) do present problems in a global trading system. The US has a bottom up, free market ideology which overall has made it number one in tech.  Admittedly there have been plenty of examples of US state interventions and deviations from this model. The East Asian model in contrast is one of state guidance and interventionist industrial policy but with a surprisingly vigorous private sector. Taiwan Semiconductor (TSM) and Samsung (005950.KS) began with significant state financial support. The US never complained. These are complex issues but ones that will not be resolved by hurling tariffs and invectives at China.

Peter Navarro is Trump’s key economic advisor. The Navarro strategy, outlined in his book Crouching Tiger, is to keep China poor so to maintain American global hegemony.  His book is all about how China is gaining military advantage over the United States. His real objective is for the United States to maintain its global military hegemony while he cloaks his arguments in a mercantilist economic framework.

An overt policy of making China poor is one which will sow lasting resentment in China against the United States. The policy is doomed to failure in the long run. China has so many assets. China has a Confucian tradition of discipline and high savings rates and 1.4 billion relatively bright people. The highest average IQ scores in the world (Ashkenazi Jews excepted) are found in East Asia. There are now economists who think intelligence levels do matter for a country’s development. (See Garett Jones, Hive Mind, How Your Nation’s IQ Matters So Much More Than Your Own) China’s large population is an unmatchable source for massive data, a key ingredient in the development of Artificial Intelligence. And, as anyone who travels to China knows, the Chinese people are obsessed with technology to a degree that is unequaled anywhere else in the world. And of course in Asia China has the “home court” advantage. Time will tell if China’s Belt and Road Initiative makes economic sense but historically China has always dominated its neighborhood when its dynasties were strong.

China cannot be replaced in the global manufacturing supply chain. America can only make China poor by making America poor. A military confrontation between the two countries is unthinkable. The assertion that China has been stealing American IP should be viewed dispassionately. For example nobody forced American companies to go to China and agree to form JVs.

America should be planning to negotiate with China as equals. That day will come.

One More Bad Inflation Factor – Iran

Iran’s “normal” oil output is 3.8 barrels per day. The United States is reimposing sanctions on Iran thus taking a portion of these barrels off the market. Supposedly other producers such as Libya and Saudia Arabia have made up for this cut. But it’s still potentially inflationary.

The US dollar is the world currency. If a country or company violates US sanctions, the US can cripple its banking system. Or shut down its semiconductor supplies, as in the case of ZTE. It would seem that the Trump people never met a sanction they didn’t like. The Trump hard line is not limited to China. And it’s not good for stocks.

Advice for Investors – Caution

The optimists believe that Trump’s mercantilist rantings will turn out to be a bargaining strategy and that trade agreements will eventually be signed with all the major powers including China. Meanwhile the American economy continues strong. The optimists expect the tariffs to be eventually dropped. The agreement just signed with Canada and Mexico is cited as what is to come. The Europeans and Japanese will be next and then finally China.  No question– if the optimists are right, the stock markets will soar.

Trump’s flexibility on the trade front will depend on two things. First, the stock market. This is an indicator for the American people for how well the economy is doing. The Trump Administration has been bragging about how the stock market has been doing. Trump cares about the stock market. He can blame the Fed if the market goes down but lots of people are going to blame him. If the market goes down, he may change course. Second, there are the midterm elections. While Peter Navarro and his fellow travelers like Robert Lighthizer might be able to shrug off electoral losses as unavoidable collateral damage, Trump the politician may think differently.

We should not assume Trump agrees with everything in Peter Navarro’s book. For one thing, Trump reportedly doesn’t read books.

I hope the optimists are right. But if we need a stock market crash to get Trump to soften his trade policies, that’s not good news for investors.

Chinese stocks may be cheap but now is not the time to buy. We need to see just how far Trump is willing to go to hurt China. The coming decision by Treasury Secretary Mnuchin about whether China is a currency manipulator is the next test. In my opinion the answer should be “no” but politics not economics may determine this decision. Meanwhile China is struggling with its own homemade debt problem. Any stocks with a big China connection (eg Starbucks (SBUX)) are suspect.  Apple (AAPL), with its production facilities in China and with China one of its major markets, is the BIG HOSTAGE.

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