DEAL OR NO DEAL / CREDIT BUBBLE BULLETIN

Deal or No Deal

Doug Nolan


What went wrong? Clearly, all the positive talk from both the U.S. and China painted a much too rosy picture of trade negotiation progress. From the Wall Street Journal (Lingling Wei and Bob Davis): “The new hard line taken by China in trade talks—surprising the White House and threatening to derail negotiations—came after Beijing interpreted recent statements and actions by President Trump as a sign the U.S. was ready to make concessions, said people familiar with the thinking of the Chinese side.”

“…The U.S. thought China agreed to detail the laws it would change to implement the trade deal under negotiation. Beijing said it had no intention of doing so…” “The hardened battle lines were prompted by Beijing’s decision to take a more aggressive stance in negotiations… They said Beijing was emboldened by the perception that the U.S. was ready to compromise. In particular…, Mr. Trump’s hectoring of… Chairman Jerome Powell to cut interest rates was seen in Beijing as evidence that the president thought the U.S. economy was more fragile than he claimed.”

In the most comprehensive and insightful article on the subject I’ve read so far, a Reuters article (David Lawder, Jeff Masson, Michael Martin, Chris Prentice, Dan Burns, Jing Xu and Ben Blanchard) presented compelling analysis:

“The diplomatic cable from Beijing arrived in Washington late on Friday night, with systematic edits to a nearly 150-page draft trade agreement that would blow up months of negotiations between the world’s two largest economies, according to three U.S. government sources and three private sector sources briefed on the talks. The document was riddled with reversals by China that undermined core U.S. demands, the sources told Reuters. In each of the seven chapters of the draft trade deal, China had deleted its commitments to change laws to resolve core complaints that caused the United States to launch a trade war: Theft of U.S. intellectual property and trade secrets; forced technology transfers; competition policy; access to financial services; and currency manipulation.”

Why would Beijing return a 150-page draft with “systematic edits” that they surely knew would risk blowing up months of negotiations? “Liu last week told Lighthizer and Mnuchin that they needed to trust China to fulfill its pledges through administrative and regulatory changes… Both Mnuchin and Lighthizer considered that unacceptable, given China’s history of failing to fulfill reform pledges.”

The U.S. was demanding that China change existing laws to incorporate trade concessions along with agreeing to “an enforcement regime more like those used for punitive economic sanctions – such as those imposed on North Korea or Iran – than a typical trade deal.”

China views U.S. demands to change laws as an infringement of national sovereignty. And I can imagine Chinese officials have utter disdain for a U.S.-dictated “enforcement regime.” Xi and Putin’s private talks - and close personal relationship - surely coalesce around their mutual revulsion to U.S. hegemony including its aggressive command of international organizations and authority over punitive economic sanctions. The U.S. was pushing vehemently for concessions the Chinese likely considered red line issues. Beijing made the calculated decision to push back. Have increasingly contentious U.S. military excursions in the Taiwan Strait and South China Sea been a factor? Less than a trust-building exercise. Huawei? How much is Maduro on the hook to the Chinese? Kim Jong Un (aka “Rocketman”) up to his old tricks mere coincidence?

That so many things are coming to head is no coincidence. Late-stage historic global Bubble.

The rise of insecurity, populism in the U.S., President Trump and the Chinese as a popular (can’t lose) political target. The rise of Chinese economic might, financial power, technological prowess, global influence and rapidly expanding military capabilities. The multi-decade global Bubble has caused unprecedented wealth inequality, uncertainty and fragility – within and between nations. And an increasingly disenchanted U.S. middle-class has manifested into a country deeply divided economically, socially and politically – more distrustful of its institutions and seeking scapegoats.

In China, a meaningful segment of society has attained wealth beyond what was previously imaginable. A historic Bubble has inflated economic output, perceived wealth and expectations. With their Bubble faltering, the Communist Party has tightened its grip. Beijing can use the long history of foreign interference to deflect blame for its mismanagement of Chinese finance and resulting deep financial and economic structural maladjustment.

The odds of a trade negotiation blowup have rather obviously escalated. Yet both sides are viewed as in almost desperate need of a deal. Ramifications for a breakdown in the Chinese/U.S. trading relationship are so awful markets are convinced it can’t happen. Besides, there’s the Trifecta of Market “Puts” – Trump, the Fed and Xi. Market support is regarded more dependable than ever after the January Powell U-turn, this week’s cut in Chinese bank reserve requirements, and a U.S. election that gets closer each and every day.

With Chinese Bubble fragility so acute, few believe Beijing will risk a blowup. For the U.S. administration, a favorable trade deal with China will be a crowning achievement heading into 2020 elections. For Making America Great Again, it certainly doesn’t hurt politically to appear to have beaten the Chinese into submission.

Assuming a trade deal is eventually consummated, I don’t see the U.S. and China coming out of talks as cordial trading partners (i.e. NAFTA, South Korea and Japan). Instead, these two adversaries will have even less trust, along with a clearer appreciation for the intensity of their ongoing competitive rivalry, irreconcilable differences and likely future clashes. It’s reasonable to view trade negotiations as the first salvo of confronting global superpowers.

Back in the late-eighties Bubble when the Japanese were to “take over the world,” it was in the context of their superior manufacturing capabilities and rapidly expanding financial might. There was no concurrent military buildup or global ambitions outside of expanding trade and investment. Sometimes competitor perhaps, but the Japanese remained very much in the U.S.’s back pocket. That Toyota and Honda were offering U.S. consumers higher quality products was a big problem for Detroit. But there was no fear of the Japanese becoming a threatening geopolitical adversary. No Arms Race.

The bursting of the Japanese Bubble had only secondary geopolitical ramifications. Facing an increasingly destabilizing Bubble, policymakers were primarily focused on the wellbeing of Japanese society and the soundness of domestic finance, the asset markets, and overall economic structure. The potential for waning global influence and heightened geopolitical risk wasn’t an issue. While they would have had some justification, there was no proclivity to blame the U.S. “hegemon” or “foreigners” more generally. Post-Bubble dissatisfaction was, repeatedly, discharged at the ballot box.

I tend to look at the Chinese Bubble, with its 1.4 billion citizens and unprecedented government control over finance, the economy and society, as the climax of a multidecade global Bubble that, in important respects, gathered initial critical momentum in Japan. China, however, has used the Bubble to incredibly expand its global economic, financial, technological and military ambitions. One cannot overstate the global ramifications for a faltering Chinese Bubble. There is a multidimensional Arms Race aspect – economic, financial, technology, military and geopolitical power.

Despite Friday’s “national team”-supported 3.1% rally, the Shanghai Composite sank 4.5% this week. China’s CSI 500 Index was down 7.8% in the first four sessions of the week, the CSI 300 Financials 8.6%, the CSI Small Caps 7.8% and the growth/tech ChiNext index 9.5%. Hong Kong’s Hang Seng China Financials Index fell 7.8% this week. The Chinese Renminbi declined 1.3% (4-month low), with the Offshore Renminbi sinking 1.6%. This week revealed that the U.S. and China are not close to a deal as was widely believed. It also offered important confirmation of the China Fragility Thesis – markets and currency.

As goes China, so goes the emerging markets. Asian equities were under pressure. Major indices were down 4.0% in South Korea, 3.9% in India and 3.5% in Taiwan. At the “Periphery of the Periphery,” Turkish stocks were slammed 5.8%. Indices were down 4.7% in Poland, 3.2% in Czech Republic and 2.6% in Russia. EM currencies were under modest pressure for the week, with around 1% declines for the Chilean peso, Colombian peso, Indian rupee and Mexican peso. Friday’s 3.5% surge in the Turkish lira almost fully erased losses from earlier in the week.

European shares were weak, led to the downside by the banks and financials. Germany’s DAX fell 2.8%, France’s CAC40 4.0% and Italy’s MIB 4.1%. Europe’s STOXX 600 Banks Index dropped 5.9%, with Italian banks hit 7.6%. Japan’s TOPIX Bank index fell 4.4%, underperforming the Nikkei’s 4.1% decline. The vulnerable European “Periphery” saw 10-year sovereign spreads (to bunds) widen 19 bps in Italy and 24 bps in Greece.

For U.S. risk markets, it’s in the eye of the beholder: resilient or complacent. The S&P500 dropped 2.1%, with the Nasdaq100 down 3.3%. Investment-grade corporate CDS increased only modestly, while junk bond spreads increased to the widest in a month. The gains in Bank CDS were mostly small. Ten-year Treasury yields declined six bps (to 2.47%) – as an auction drew the weakest demand (bid-to-cover) in a decade. The fireworks were in the VIX. After ending last week at 12.87, the VIX traded up to 18.80 Monday morning before closing the session at 15.44. The VIX then spiked as high as 23.38 in Thursday afternoon trading before closing out the week at 16.04. Writing/selling put options has been free “money” since the Powell U-turn. Crowded Trade.

Deal or No Deal, this week had me pondering the next crisis. It will, after all, be the first international market crisis in an era of competing global powers. Do the rivals come together or seek advantage at the other’s expense? I grimaced some months back when President Trump began using his Twitter account to troll the struggling Chinese markets and economy. And in this age of the strongman head of state, where will this leave central bankers when things turn dicey? Has the era of putting a select group of like-minded global central bankers in a room and empowering them to orchestrate a strategy to reliquefy the world run its course?

May 10 – Bloomberg (Shawn Donnan, Saleha Mohsin and Ye Xie): “President Donald Trump’s administration told China it has a month to seal a trade deal or face tariffs on all its exports to the U.S., even as both sides sought to avoid a public breakdown in negotiations despite a developing stalemate. The threat was made during talks in Washington on Friday, hours after Trump upped the ante by imposing a second round of punitive duties on $200 billion in Chinese goods. The talks are under close scrutiny across global financial markets, and U.S. stocks turned positive after negotiators on both sides said the session had gone fairly well. In a series of tweets that cheered markets further, Trump… declared that the talks with China had been ‘candid and constructive.’ ‘The relationship between President Xi and myself remains a very strong one, and conversations into the future will continue,’ he said. Further talks are possible, but there’s no immediate plan for the next round, according to a person familiar with the negotiations.”

Should be an interesting month. The Chinese would appear content for now to walk softly while carrying a big stick. What is that stick?

May 8 – Reuters (Yawen Chen and Kevin Yao): “Chinese banks throttled back new lending in April after a record first quarter that sparked fears of more bad loans… Chinese banks extended 1.02 trillion yuan ($150.16bn) in net new yuan loans in April…, well below analysts’ expectations of 1.2 trillion yuan in a Reuters poll and March’s surprisingly strong 1.69 trillion yuan… Outstanding yuan loans grew 13.5% from a year earlier, slightly lower than expectations and March’s 13.7%. Growth of outstanding total social financing (TSF), a broad measure of credit and liquidity in the economy, slowed to 10.4% from a year earlier from 10.7% in March… Total TSF in April fell much more than expected, to 1.36 trillion yuan from 2.86 trillion yuan in March.”

China’s Aggregate Financing increased $199 billion (1.36 TN yuan) during April, about 18% below estimates and down 23% from April ’18. In addition to weaker-than-expected bank loans, there was continued weakness in various “shadow lending” components along with local government special bonds. Aggregate Financing expanded $721 billion the first four months of 2019, about 8% ahead of comparable 2018 growth.

And while April was below expectations, y-t-d Bank Loan growth of $1.0 TN was 13% ahead of comparable 2018. Bank Loans were up $2.482 TN, or 19.0% over the past year. The expansion in Consumer Loans slowed markedly from March’s $133 billion to April’s $79 billion. Y-t-d Consumer Loan growth of $349 billion ran about 2% ahead of comparable 2018. Consumer Loans expanded 17.3% over the past year, 40% in two years, 75% in three years and 138% in five.

April’s Credit slowdown is likely a reflection of Beijing’s decision to somewhat tighten lending conditions. It will be interesting to see if policymakers now shift back to easier conditions.