Hostile Takeover

Fears Mount of Chinese Intervention in Hong Kong

Beijing is mobilizing troops at the border and the protest movement is hoping to attract thousands of demonstrators following the occupation of the airport this week. The threat of a military intervention appears to be growing in Hong Kong.

By Bernhard Zand in Hong Kong

Police in Hong Kong fire tear gas to clear pro-democracy protestors in the city.

Carrie Lam applied for high office herself, and Beijing ultimately granted her the appointment.

These days, though, it must be a kind of living hell.

It's Tuesday morning, and Lam, the chief executive of Hong Kong, walks out into the garden of her official residence dressed in a blue suit. The oleanders are in bloom and birdsong fills the air. An opposition group is there to give her a petition protesting police violence and she walks up to one of the men, who immediately grabs her hand and won't let go. "Hong Kong is being governed by lies!" he yells. "Corrupt police!" the others chant. Members of her security contingent rush up to free Lam from the man's grasp.

Unsettled, she returns to the air-conditioned government residence where the Hong Kong press corps is lying in wait. The journalists assail her with questions, some yelling at her without waiting for an answer. "Don't talk about 'the police' and 'the people.' What is your own responsibility?"

"Don't lecture reporters. Do your job and answer the questions!" "Are your hands tied by Beijing?" "Yes or no? Precise answers."

Lam offers evasive, formulaic responses and a rather weak performance. At one point, she fights back tears and the cameras begin clicking.

When she abruptly ends the press conference after half an hour and turns to leave the room, as the South China Morning Post newspaper has reported, a journalist asks: "Mrs. Lam, many residents are asking when you will die!"

Peering into the Abyss

The frustration and aggression that have built up in Hong Kong over the last 10 weeks have made their way into the civil rituals of daily public life. Demonstrations and counterdemonstrations have become an almost daily occurrence, along with bloody police operations and violent altercations. The city, which was long on par with Singapore as an Asian example of efficiency, discipline and cosmopolitanism finds itself facing the threat of societal and political disintegration. On Tuesday morning, Lam warned against allowing the city to fall "into an abyss where everything will perish."

Peering into that abyss is a terrifying experience -- and not just for Chief Executive Lam and the pro-Beijing business and financial elite, who have much to lose. Many critics of China have also begun to recognize the risks of these leaderless, decentralized demonstrations which have rocked the city -- risks highlighted by the increasing amount of rioting on the fringes, even though the protests have managed to attain some successes.

The abyss China's leadership has in mind became clear with the more aggressive language it has adopted since the occupation and temporary closure of Hong Kong's airport earlier this week. The protests are showing "the first signs of terrorism," a spokesman for the government's Hong Kong and Macau Affairs Office said on Monday, following up on Wednesday with a statement denouncing "quasi-terrorist" acts. It's the kind of language that was used just before the deadly crushing of the protests on Tiananmen Square 30 years ago.

Global Implications

That, in fact, is what Gary Locke, the former U.S. ambassador to China, is warning against: a second Tiananmen -- and he doesn't generally have the reputation of being a man prone to exaggeration. In contrast to U.S. President Donald Trump, who on Tuesday announced on Twitter the findings of American intelligence agencies that Beijing was amassing troops on the border to Hong Kong. Since then, the armada of vehicles has been documented by satellite images and even Chinese propaganda photos. It is enough to quell any remaining doubts that the crisis has global implications.

But what demands are the demonstrators pursuing and what tactics are they employing, 10 weeks after the protests began? How far are they willing to go to push through their demands and how far is Beijing willing to go to stop them? What might an agreement between the Hong Kong government and the opposition have to look like in order to prevent Chinese intervention? And what role, if any, might Chief Executive Lam play?

There is no doubt that Lam bears the lion's share of the blame for the current crisis. It was her government that needlessly introduced an extremely controversial law this spring that would allow Hong Kong to extradite crime suspects to China. She even refused to back down when millions of protesters took to the streets of the city in June. But it was Lam's masters in Beijing who, five years ago, had laid the foundations for the current massive uprising by rejecting demands for democratic elections from the Umbrella Movement without making the slightest concession.

Hong Kong Chief Executive Carrie Lam at a press conference on Tuesday at which she warned against falling "further into the abyss."
Hong Kong Chief Executive Carrie Lam at a press conference on Tuesday at which she warned against falling "further into the abyss."

Now, the opposition is even more insistent on pushing through the Umbrella Movement's demands. They are also insisting that the chief executive step down, though that stipulation, like the demand for the complete revocation of the extradition law, has largely taken a backseat to the central aim of the demonstrations: universal suffrage. Only half of the Hong Kong parliament is elected democratically, and the chief executive is chosen by a group dominated by Beijing loyalists.

"From the very beginning, I haven't understood what is driving Carrie in this crisis," says a person who has been closely monitoring Lam's rise over the course of several years. "Yes, she has always been determined and ambitious. But she was also smart." Her prudence, that person says, seems to have abandoned her this year.

"A month ago, her resignation could still have had an effect," says the opposition politician Avery Ng, 42. "Either way," says protest leader Wong Yik-mo, 33, "she no longer has enough political energy to push anything through."

For people like Ng and Wong, another question has become more important: How can the protest movement remain visible and relevant globally without scaring away the citizens of Hong Kong or provoking an intervention from the central government in Beijing? Ng is the leader of the League of Social Democrats party and took part in the Umbrella Movement protests in 2014. His role models are classic resistance figures like Gandhi, Martin Luther King and Nelson Mandela. "We continue to believe in non-violent resistance," he says, adding that the movement should curb the influence of "fringe elements" that seem to prefer violence -- both to protect the young radicals themselves and to avoid endangering their overarching goals.

Wong, who is a member of the organization Civil Human Rights Front is one of the organizers of the recent protests and says: "We need both, the peaceful ones and the radicals."

'We Make Mistakes, But We Learn from Them'

The 2019 movement has drawn on the lessons of the 2014 failures, says Wong, and is leaderless and decentralized, more mobile and more innovative. "We vote on our positions in anonymous online forums," he says. "What matters is how many 'likes' an individual proposal receives, not the name of the member who made it." The demonstrators of today are also technically savvier than their 2014 predecessors. For communication, they rely on a constantly changing slew of apps and issue warnings to each other of police operations and looming offensives. "We make mistakes, but we learn from them," he says -- such as deciding on Wednesday to issue a public apology to airport employees and travelers for the inconveniences they encountered as a result of the occupation.

Such methods, of course, don't allow for the precise control of the movement, as Wong himself admits. According to the principle of swarm intelligence, the number of possible decisions is just as large as the number of members in a certain chat group, with the corresponding consequences.

Avery Ng believes that this structure represents a danger, particularly given that many of the demonstrators are young and, he believes, underestimate the risk of violence. Shortly after the most recent wave of protests began, Ng was arrested and locked away for several weeks, thus missing the largest of the demonstrations. In jail, he says he met student leader Joshua Wong, the icon of the 2014 Umbrella Movement. Condemned to inactivity, the two eagerly followed the events on television, with Ng saying that he became increasingly uneasy the more he observed "our techniques" and "incoherent strategies."

Calls for Restraint

Even Edward Leung, the founder of the radical independence movement who is currently serving a six-year prison sentence, recently issued a call for restraint. In recent weeks, his motto has become something of a battle-cry for the young demonstrators: "Liberate Hong Kong. Revolution of our times!" In his open letter from prison, Leung called for moderation: "I earnestly call on you not to be dominated by hatred -- one should always stay vigilant and keep thinking when in peril."

The protest movement's relationship to violence has not been completely established. Positions run the gamut from strict non-violence to the so-called Marginal Violence Theory, which holds that certain provocations of the police are acceptable. Nobody, though, is supporting any kind of "terrorism," as the movement has been accused of by Beijing propaganda.

On the contrary, two incidents in recent days have strengthened those calling for restraint. Last weekend, a young woman on the fringe of a demonstration was struck by a projectile and apparently lost her right eye. At the same time, a video began making the rounds of a protester being brutally pinned to the ground for several minutes despite bleeding heavily from his mouth and begging for help.

"Images like that frighten many people," says activist Wong Yik-mo. "They now need to see a peaceful demonstration." It's a point on which both Wong and Avery Ng agree.

After weeks of one-off actions that often escalated into street battles, a major protest is now planned for Sunday of the kind seen at the beginning of the movement in June, when hundreds of thousands of protesters took to the streets. Both Ng and Wong are hoping that the rally will end peacefully and send a clear message to the governments in Hong Kong and Beijing that the majority still supports opposition demands. And that the opposition does not condone violence.

Medics assist a woman who suffered a facial injury during the police deployment: "Images like that frighten many people," says activist Wong Yik-mo.
Medics assist a woman who suffered a facial injury during the police deployment: "Images like that frighten many people," says activist Wong Yik-mo.

Such a message would be much more difficult for Beijing to counter than the riots of the past few days. Particularly damaging to the protesters' image is the fact that some of them beat up an alleged spy at the airport on Tuesday who then turned out to be a journalist with the Global Times, a nationalist Chinese tabloid. Even before that, images of an attack on the Liaison Office of the Central People's Government in Hong Kong stirred up considerable anger in mainland China.

Creeping Integration

Even the leadership in Beijing would need a valid, obvious pretext to justify a military intervention in Hong Kong to its own people. Images of angry, masked demonstrators would clearly be better suited for such a justification than those of hundreds of thousands of silent marchers or protesters singing church hymns.

At the moment, it is impossible to tell whether China will intervene in Hong Kong. Willy Lam, 67, a professor at the Chinese University of Hong Kong and a leading China expert who lived and worked in Beijing until the Tiananmen uprising, considers a military assault unlikely. "They won't use the garrison," he says. "Deploying the People's Liberation Army would antagonize the United States too much."

Still, this assessment should not be seen as an all-clear. Lam sees a Chinese plan unfolding in Hong Kong that began before the recent protest movement and is likely to last for some time to come. He says Beijing is pursuing a strategy in Hong Kong that is similar to its approach in the Tibet and Xinjiang autonomous regions -- creeping integration that is taking place at many levels, including the political realm, the economy and the police.

"We have, for example, strong evidence that police officers from the neighboring Chinese province of Guangdong have already crossed the border and changed uniforms," he says. "This will be the pattern of the future," he says -- police and intelligence service activity along with the arrests of hundreds of protesters. "By September or October, you will see Beijing installing tighter control, and even more so in the years to come," he says.

Strong Controls

Beijing already exercises tight control over local politics, the media, the police and security services through its Hong Kong Liaison Office. Lam says the Chinese infiltrated the protest movement some time ago. "We have evidence that police have camouflaged themselves as demonstrators," he says. Such a thing is more difficult to prove when it comes to intelligence agents, "but even among the protesters, some wonder whether it was agents provocateurs who may have radicalized the movement."

That alone, though, wouldn't be enough to explain the escalation of violence in recent weeks. The activists themselves crossed the threshold of "marginal violence," he argues. But the agents' actions also played an important role. "In principle, the protesters are responsible for their own actions, but the agents are exacerbating the situation," Lam says.

It seems doubtful at the moment that a protest movement guided by digital networks is much of a match for China's tightly organized security services. The Communist Party, which itself began as a conspiratorial movement, has a long tradition of infiltrating opposition organizations -- and it undoubtedly now has a high level of digital literacy.

The influence of Beijing's secret services in Hong Kong also seems to extend to criminal networks. There have been three attacks on protesters in recent weeks, but also attacks on bystanders who were completely uninvolved. They have been attributed to the "triads," organized crime groups with some mafia-like characteristics. At times, the police took suspiciously long before intervening in fighting in the Yuen Long, North Point and Tsuen Wan districts, some of which resulted in serious injuries.

China expert Lam doesn't want to dole out advice to any of the parties involved, but he does say that he personally doesn't think the occupation of the airport for days on end was a good idea. On the other hand, he believes Hong Kong Chief Executive Carrie Lam could deescalate the situation significantly, even at this point, by allowing an independent inquiry into police violence, as the protest movement has demanded.

Final Subjugation

But Lam says it will be difficult to get Chinese President Xi Jinping on board, because he considers the events in Hong Kong to be a "color revolution" -- a term used by Beijing for the uprisings in the former Soviet bloc and the Middle East, which the Chinese regime believes are the influences of "Western forces," meaning the United States. "The problem," says Willy Lam, "is that China's leadership may believe their own conspiracy theory."

On Wednesday, U.S. President Donald Trump surprised his Chinese counterpart with a strange tweet. He praised Xi Jinping as a "great leader" and wrote: "I have ZERO doubt that if President Xi wants to quickly and humanely solve the Hong Kong problem, he can do it. Personal meeting?" Later, he added that Xi should meet with the protesters.

Trump appears to be as flippant in his approach to the situation in Hong Kong as he has been in his dealings with North Korean dictator Kim Jong Un. In contrast to his predecessors, Trump has so far shown little interest in the human rights situation and "humane solutions" in China.

But this also underscores a misunderstanding: Trump views the situation in Hong Kong as an opportunity to link, at least in the near term, the current crisis with another China problem -- the trade war between the world's two largest economies, even alluding to that notion in a tweet directed at China's president. It's the only subject that really seems to interest him in this context.

For Xi, on the other hand, Hong Kong is the setting for the realization of a long-term plan: the final subjugation of a city that remains rebellious today.

But for the people of the city, Hong Kong is their home. And they fear for its future and for its identity.

The new commonplace

Six charts that explain the state of markets

Making sense of investors’ mood

IN THE AUTUMN of 2008, strange and novel things happened in financial markets, such as the emergence of negative yields on Treasury bills.

In times of fear, the safest assets are at a premium.

What was once strange is now ordinary.

Negative yields are a familiar feature of European bond markets. But such is the anxiety about the world economy that they are spreading.

In Germany, interest rates are negative all the way from cash to 30-year bonds (chart 1).

In America yields are still positive. But the curve is inverted: interest rates on ten-year bonds are below those on three-month bills (chart 2).

The last seven recessions in America have been preceded by an inverted yield curve.

Nervous investors are reaching for the safety of the dollar. The yen and Swiss franc, habitual sanctuaries, are among the few currencies that have risen against it (chart 3).

The price of gold, another haven, is at a six-year high. That of copper, a barometer of global industry, is down from its recent peak (chart 4).

Faced with uncertainty, the go-to market for equity investors is America’s. It has left others in the dust (chart 5). MSCI’s emerging-market share index leans heavily towards “Factory Asia” (China, South Korea and Taiwan), which is in the eye of the trade-war storm. Europe’s markets lean towards banks and carmakers, which suffer in downturns.

Investors fret that the rich world is slowly becoming Japanese, with economies that are too feeble to generate inflation. Forecasts of inflation in the swaps market have fallen sharply (chart 6).

A fear in 2008 was that deflation might take root. The fear remains.

Oh Yes! The Recession Is Coming
by: Victor Dergunov

- It's been quite some time since the U.S. has experienced a recession.

- Unfortunately, investors may not have to wait much longer, as the S&P 500 and stocks in general are likely in the early stages of a bear market already.

- Inverting yields, worsening economic data, U.S./China trade tensions, high stock valuations, increased demand for safe-haven assets, and bearish sector rotation are clear red flags that a recession is approaching.

- Moreover, the S&P 500's technical image appears to be deteriorating, and if the SPX goes below 2,725 we are likely in a bear market already.
Oh Yes! The Recession Is Coming
It’s been quite some time since the S&P 500 (SP500) has been in a bear market, and the U.S. has not experienced a recession in over 10 years now. In fact, we are now in the longest economic expansion in U.S. history, even surpassing the 1990’s bull market that eventually led markets to the pinnacle of the dotcom bubble.
S&P 500 Long-Term Chart
Unfortunately, it appears that market participants may not have to wait much longer, as there are clear recessionary clouds on the horizon. Inverting yields, negative interest rates, weakening economic data, rising inflation, unintended consequences from the U.S./China trade war, high stock valuations, and other detrimental economic factors may be too much for the Fed and for the U.S. economy to handle.
Therefore, unless several key constructive economic and monetary factors materialize relatively quickly, a recession coupled with a grizzly bear market in the S&P 500 and in stocks in general seems extremely likely within the next 6-18 months. Furthermore, bear markets typically begin around 6 months before an official recession is recognized, thus we may already be in the early stages of a bear market in stocks.
Yields Inverting at an Unprecedented Level
Treasury yields are not just tightening, they are inverting, and they are inverting at an unprecedented level. In fact, the 2-year just topped the 10-year, the 3-month is yielding more than the 30-year, and the 30-year Treasury is at an all-time low, and is likely about to break below 2%.
Key Rates
U.S 30-Year Treasury Long-term Chart
Why this is happening
One of the reasons is that the Fed is embarking on a new easing path, that will likely be a multi-year process. Bond investors understand that the Fed will bring longer term rates lower, and are rushing in to lock in any kind of yield they can before rates go even lower, or negative.
The other reason is that demand for longer-term treasuries is picking up because more market participants are expecting a recession to materialize in the near future. Thus, they are moving capital into “safe-haven” assets like bonds.
Let’s look at prior instances throughout recent history when yields have inverted.
If we look at a 30-year chart we can see a clear correlation between yield curve inversions and recessions. Most recently we saw this phenomenon occur around the 2000 crash, right before the great recession of 2008, and now. If we go back further throughout recent history, we can see bond inversions occurring prior to recessions well before 2000 as well.
Also, I want to point out that overall rates are on a never-ending slope lower. In 2000 the rate inversion occurred around 6.25%, in 2007 it occurred at around 5%, and this most recent inversion is occurring at about 2.5%.
This indicates that due to the enormous amount of consumer and government debt in the U.S. the economy simply cannot function (expand) in a “normalized” rate environment. This also implies that this trend will likely continue and the “new normal economic environment” in the U.S. will likely resemble something that we see in Japan.
Extremely low, or negative rates, possibly on a prolonged or permanent basis, increased central bank intervention in the form of more QE, possibly even corporate bond, stock and ETF purchases, etc.
If you would like to read a detailed article about America’s impending debt crisis and how it correlates with what we are seeing occur in markets now, I strongly suggest you read my “America’s Impending Debt Crisis” article here. The “new normal economic reality” in the U.S. may end up looking a lot like Japan’s economic situation in recent decades.
Negative Yields in the U.S. a Real Reality
There is now over $15 trillion in negative yielding government bonds around the globe. This is unprecedented, and once again points to that due to enormous amounts of government and consumer debt developed economies cannot expand without bringing key rates down to below zero.
Image Source:
Moreover, Alan Greenspan recently said that “there is no barrier” to negative yields in the U.S.
This is a global trend now, and the U.S. will not only get sucked into it, but in time may become the leader in zero or negative rate policy.

Weakening Economic Data

Another troubling factor that is pointing to an upcoming recession is the weakening economic data in the U.S. (I will be discussing data primarily in the U.S. despite weakling data coming out of many nations, implying that a global recession may be on the horizon, not one just in the U.S.)
Just over the past few weeks we’ve seen ISM manufacturing employment, and ISM manufacturing PMI for July come in substantially worse than expected. ISM manufacturing employment came in at just 51.7 vs the expected 53.4 figure and ISM manufacturing PMI came in at 51.2, well below the expected 52 figure.
At the same time, inflation is on the rise, as average hourly earnings increased by 0.3% MoM in July vs the expected 0.2% increase, and average hourly earnings increased by 3.2% YoY vs the expected 3.1% number.
Now, you may say Victor, this is good news, it appears that American workers are earning more than they did a year ago, so this is good for the economy. Yet, if we look at core CPI numbers, we see a similar trend, as core CPI MoM came in at 0.3% vs the expected 0.2%, and YoY core CPI increased by 2.2%, vs the expected 2.1%.
In other words, prices are rising, inflation is increasing, and wage growth is unlikely to keep up with the rise in inflation in the current and upcoming economic environment. This suggests that prices on goods will continue to rise at a faster pace than wage growth, ultimately putting pressure on consumer confidence and spending.
As the U.S. economy is about 70% consumer based, this trend could reflect very poorly on GDP growth and will likely help push the U.S. into a recession within the next 6-18 months.
In fact, we are already seeing this occur in the consumer confidence index CCI as it is down to about 100.4 from its peak of around 100.9 at the start of 2018.
CCI 5-Year Chart
Image Source:
You know what else is troubling about the current trend in consumer confidence?
It is that just about every prior peak has coincided with a recession. The CCI peaked in the late 1980s right around the time of Black Monday in 1987. Next we saw a major peak right around the time the dotcom bubble burst in 2000, we saw it peak around 2007, right before the great recession, and we may have seen it peak in early 2018, suggesting that a recession is likely a lot closer than many market participants anticipate.
CCI Long-Term Chart 
Other Concerning Leading Indicators
An Apparent Problem in Housing
Now, let’s move on to housing. New home sales for June came in lower than expected, 646K vs 660K.
Existing home sales also missed estimates for June, coming in at 5.27 million vs an expected 5.35 million.
Existing home sales fell by 1.7% MoM instead of an expected drop of just 0.2%.
Building permits were disastrous in June, 1.22 million, vs an expected 1.3 million, down by 6.1% MoM, vs an expected drop of just 0.1%.
The recent housing data is troubling, as it indicates a substantial slowdown in the residential real estate sector, a key forward looking indicator of the overall U.S. economy.
Freight and Trucking:  Another Troubling Sign Of a Slowdown
I would also like to draw your attention to the apparentslowdown in the freight/trucking industry. The trucking industry is experiencing excess capacity and lower volumes. Now, this is likely in part due to higher tariffs on Chinese goods, and the situation may worsen if trade relations persist to deteriorate. Also, it’s not just trucking, similar phenomena can be observed in the shipping and in the railroad industry as well.
Unemployment Rate: Another Red Flag
Let’s look at unemployment figures next. So, we keep hearing how the economy is doing great because unemployment is at or near a 40-year low, etc. This is true, the “official” unemployment numbers are the lowest we’ve seen in decades. However, if we take a closer look, it appears that the unemployment rate may have bottomed and is now starting to tick back up again.

U.S. Unemployment Rate 5-Year Chart
Moreover, if we take an even closer look, we will notice that just about every major bottom in the unemployment rate has preceded a recession. Just look at recent history; the unemployment rate bottoms and a recession begins in 1970, it bottoms and a recession begins in the late 80s, the unemployment rate bottoms again around 1999, and the dotcom bubble explodes, it bottoms around 2007/2008 and the great recession begins.
U.S. Unemployment Rate Long-Term Chart
Unemployment Rate Bottoms Correlations With Recessions Source:
We’ve seen the unemployment rate bottom at 3.6%, a multi-decade low, now it has ticked up to 3.7% for the last two months, and if this trend continues, why should this time be any different? The bottoming of unemployment is a great counter indicator and right now it is signaling that a recession is likely approaching, and is likely to arrive much sooner that many investors believe.
Corporate Profits May be Peaking
As we look at a chart of corporate profits we see a steady rise from when the Trump Administration took over in 2016. This was in part due to infrastructure spending projects as well as huge corporate tax cuts President Trump awarded corporate America, bringing down the corporate tax rate from 35% down to 21%.
However, much of the capital received from these giant tax cuts went to corporate buybacks, and not into long-term infrastructure growth projects as “intended”. Thus, the tax cuts had a very limited and transitory effect on overall growth in the U.S. economy. Instead, much of the excess capital went toward buying back shares, which made stock prices appreciate.
Now we may begin to see “hangover effect”, as the economy slows and corporate profits decline, the U.S. corporate sector may enter an earnings recession very soon.
U.S. Corporate Profits Since Trump Took Office

In fact, we saw a large QoQ decline in Q1, and while Q2 may provide slight YoY growth, corporate profits are likely to slide further due to China/U.S. trade tensions, and an overall economic slowdown around the globe.

Bearish Small-cap Performance
Another troubling factor suggestive of a bear market is the massive underperformance in the Russell 2000 index. Typically, small caps should be leading the way in a bull market but they are not. In fact, they are doing the opposite.
Chart Data by YCharts
If we look at the Russell 2000 Index (IWM) performance vs other major market averages like the Nasdaq 100 (QQQ), DJIA (DIA), and SPX (SPY), we see a drastic underperformance on the Russell 2000’s part. While the three major averages are up between 2-3% over the past year, the small-cap index is lagging substantially, down by 11%.
Most companies in this index are smaller companies with mostly exposure to the U.S. market, which does not show a lot of faith in the future growth of the U.S. economy. The other major averages are comprised of multinational companies, but as economic growth around the globe continues to slow we are likely to see these averages crumble as well.
Bearish Sector Rotation
One of my favorite elements to observe is sector rotation, as it shows where investors expect the economy is headed. Much like with high demand for bonds, gold, and other “safe-haven” assets, investors tend to pile into “defensive sectors” like utilities, consumer staples, real estate, and healthcare. These are less cyclical sectors, their stocks typically pay decent and relatively stable dividends, and they usually hold up better than cyclical sectors during a bear market/recession.
Let’s look at sector rotation over the last year
Chart Data by YCharts
We see that outside of healthcare, the three of the most defensive sectors of the economy are up by double digits over the past year, substantially outperforming all major averages.
Additionally, utilities and real estate are at or near all-time highs, while consumer staples are not far behind.
Now, let’s see what is happening with the more cyclical sectors
On the other hand, if we look at the more cyclical sectors they are mostly in the red for the year.
Except for technology and telecom services, all other sectors are down over the past year, with energy and oil services names leading the way. This further shows that investors have been rotating away from more economically sensitive, cyclical names and into safe-haven sectors like utilities, real estate, and staples.
However, there is one big problem. The “safe-haven” names have become drastically overbought and now appear to be dramatically overvalued. Let’s take utilities for example; these are now trading at around 23.54 times this year’s earnings estimates. This is quite expensive on a historical basis as these are low growth companies that typically trade in the 10-15 P/E ratio range. One could argue that they are overvalued by 50% or more right now.
Let’s look at real estate. Real estate is another sector that doesn’t typically trade at a high P/E ratio, yet it is currently trading at over 28 times this year’s EPS estimates. Consumer staples are trading at over 27 times this year’s EPS estimates. Healthcare is trading at 29 times this year’s EPS estimates.
The point is that investors have piled into these “safe” names, but have bid up their stock prices so high that they are trading at valuations you would typically see in rapidly growing tech stocks, not sluggish safety names. Therefore, they appear to be grossly overvalued now, and when the recession comes, multiples along with stock prices will likely contract considerably, possibly by 50% or more.
By the Way, Other Sectors aren’t Cheap Either
Materials are trading at about 20 times this year’s EPS estimates. Information technology is trading at about 29 times this year’s EPS estimates. Industrials are trading at 26 times this year’s EPS estimates. Consumer discretionary names are trading at about 25 times this year’s EPS estimates, and communication services are trading at around 27 times this year’s EPS estimates.

The only two major sectors trading at reasonable multiples in my view are financials, at about 10.5 times this year’s EPS estimates, and energy, at around 12 times this year’s EPS estimates. However, there is good reason for these sectors to be trading at a discount.
Banks are in a tough predicament with rates going lower, the economy slowing, and the possibility for higher default rates, and energy stocks are extremely cyclical and largely depend on the price of oil which is in a bear market right now, down by about 27% from the highs reached last October.
There are no major bright spots as far as stocks are concerned going forward in my view. Sure, the Fed may be able to pull a rabbit out of its hat and inflate stock prices slightly higher from here, but this will be temporary and transitory, as a recession will occur eventually regardless of what the Fed does. Also, the Fed may be behind the curve already, as it typically has been in the past (perhaps most notably in the 2007-2009 crisis).
The Fed Cannot Fix Everything
The bottom line is that the Fed is not a group of magicians. Yes, the Fed can lower rates to try to stimulate economic growth, and they can implement more QE to try and delay the inevitable recession, but in the end these measures (if they work, and that is a big if), they will only inflate an even bigger bubble.
Therefore, the Fed cannot fix everything; they can perhaps engineer a “softer landing”, but the recession is likely to materialize regardless of what the Fed does over the next 6-18 months.
Trade War is Weighing on Growth
The Trade War is not likely going away any time soon, it is likely being “postponed” with the recent announcement of pushing back tariffs on some Chinese goods until December 15th.
Please notice that China has not made any concessions on its part.
This is because China is in a more powerful position right now. Its economy is growing at over 6% GDP, and the U.S. is projected to deliver under 2% (baseline), around 1% in a slower growth environment, and negative 1-2% in a recessionary scenario. I believe U.S. GDP YoY growth could go negative as early as Q1 2020, which may imply the S&P 500 and stocks in general are in a bear market already.
China GDP Growth YoY
U.S. YoY GDP Growth and Projections
Valuations are Very Rich
I spoke about sector valuations being expensive before. Please, also keep in mind that in a slower or recessionary economic environment these valuations will only become more expensive.
In fact, it appears that the Shiller P/E ratio may have peaked in 2018 at around 34. Shiller P/E Ratio Long-Term Chart

Now it is trading at around 28.5, which is still extremely high by historical standards. The median for the Shiller P/E ratio is about 15.74, which implies the S&P 500 may be overvalued by roughly 80% right now. Also, for the SPX to get back to its historic median, the S&P 500 would need to decline by roughly 45% from current levels.
Such a decline could bring the S&P 500 down to about the 1,562. Yes, I know, this seems almost unrealistic, but if history is any guide, it is very plausible, and it could even overshoot to the downside in a worst-case scenario possibly bringing the SPX below 1,500 in a grizzly bear market mauling.
Technical View
I typically discuss detailed technical conditions with members of my Marketplace service, but I think it is important for everyone to get a quick technical glimpse into what is going on with the S&P 500 right now.
Let’s look at the SPX chart
Things do not look good to put it lightly. We see a very bearish head and shoulders pattern developing. The neckline is around the key support level of 2,725. If the S&P 500 breaks down below this level then there is a very high probability that we are in the early stages of a bear market, and not just another correction.
Moreover, we are seeing relatively “orderly” declines, no major panic selling, relatively low volume, etc. This is not good, as it implies that institutions are likely starting to systematically reduce stock positions, don’t want to spook markets, and want to do it in an orderly way to avoid panic, and reduce their exposure to large losses.
In other words, this may be the time when institutions begin to get out of stocks, but want to do it in a way to limit their losses by selling to retail and other investors that usually arrive in the later end of a bull market cycle.
The Bottom Line: Simply Too Many Red Flags to Ignore
The signs are clear, and most are pointing towards the materialization of a recession and a bear market in the U.S. Since bear markets typically precede recessions by about 6 months, we could be in a bear market already.
Signs of the upcoming recession include but are not limited to:
  • Inverting yields in the U.S.
  • Record negative yielding debt around the globe.
  • Longer-term treasuries at or near all-time lows.
  • Increased demand for “safe-haven” assets (gold, treasuries/bonds, defensive sectors, etc.).
  • Bearish sector performance/rotation.
  • Significant underperformance in small-caps (Russell 2000).
  • Worsening economic data; especially in housing, manufacturing, fright/trucking/railroad sectors.
  • Record low, but rising unemployment rate.
  • Worsening consumer confidence.
  • Worsening corporate profits.
  • Extreme amounts of consumer, government, and corporate debt.
  • Prolonged Trade War tensions that will likely cause corporate profits to decline further and will make Chinese made goods more expensive for U.S. consumers.
  • Signs of higher inflation.
  • The Fed may be behind the curve.
  • Expensive valuations in the SPX and in most stocks/sectors in general.
  • A very troubling technical image.

These negative developments imply that the U.S. economy is slowing substantially, and is likely to slow down more rapidly than is currently anticipated. In fact, a recession within the next 6-18 months seems extremely likely in my view. As bear markets typically precede recessions by about 6 months or so, the S&P 500 and stocks in general are likely in the early stages of a bear market right now.  

When Leninists Overreach

Russian President Vladimir Putin and Chinese President Xi Jinping have for years flexed their foreign-policy muscles and consolidated power at home. But Russia and China now appear increasingly isolated on the world stage, and the question now is whether they have finally gone – or soon will go – too far.

Nina L. Khrushcheva


MOSCOW – Ongoing street protests in Hong Kong and Moscow have no doubt spooked the authoritarian duo of Chinese President Xi Jinping and Russian President Vladimir Putin. The Moscow protests, the largest in many years, must be keeping Putin up at night, or they wouldn’t be dispersed with such unabated brutality. Yet rather than hold a dialogue with the people, Putin has been demonstrating that he is in control, even preening for photos in a tight leather outfit with his favorite motorcycle gang.

Nonetheless, the demonstrations have become a poignant sign of Putin’s declining popularity, including among Russian elites, whose views matter in ways that other forms of public opinion do not. For two decades, the Russian elite’s rival factions have generally seen Putin as the ultimate guarantor of their interests – particularly their financial interests. But as Russia’s economy has sunk into sanctions-induced stagnation, Putin’s leadership has started to look like more of a roadblock than a guardrail. Fewer and fewer Russians still accept that “Putin is Russia and Russia is Putin,” a mantra that one heard regularly just five years ago, following the Kremlin’s annexation of Crimea.

Moreover, Putin’s hope that US President Donald Trump would improve relations with Russia has begun to look short-sighted, if not downright delusional. Although Trump has weakened American institutions and undermined Western alliances, which has played into Putin’s hands, the White House has also rendered US foreign policy utterly unpredictable. Worse, the Trump administration is now systematically unwinding the arms-control accords that long brought some degree of certainty to nuclear affairs.

Russian elites know that their country is as ill-prepared to win a nuclear-arms race with the United States now as the Soviet Union was in previous decades. The recent explosion of a nuclear-missile engine at a test site on Russia’s northern Arctic coast is a grim reminder of a deep-seated incompetence. And unlike Putin, Russian elites are deeply worried that alienating the US will make Russia a de facto vassal state vis-à-vis China.

The protests in Hong Kong, which show no sign of abating, are likewise the product of authoritarian overreach. They began with a proposed law that would allow Hong Kong citizens and residents to be extradited to the Chinese mainland. Given how clumsily the legislation was presented by Hong Kong’s Beijing-backed leader, Carrie Lam, it is possible that the Chinese leadership was only dimly aware of it and its potential political impact. Nonetheless, the Chinese government’s response to the protests has been increasingly self-defeating.

For starters, the People’s Liberation Army has been openly threatening to intervene to shut down the protests against Lam’s government. And in cases where pro-government “triad” thugs, most likely based on the mainland, have shown up to assail protesters, the police have been conveniently absent. As everyone in Hong Kong knows, these extrajudicial beatings had to have been sanctioned by Xi’s government.

More ominously, Xi may have already decided that the time for “one country, two systems” has passed. China, he might argue, can no longer tolerate a functioning quasi-democracy within its territory, despite the agreement it accepted as a condition of Hong Kong’s return to Chinese sovereignty in 1997. Concerned about Taiwan and its political drift ever further from the mainland, Xi may be thinking that a harsh Hong Kong policy will scare the Taiwanese into line. If so, he has forgotten that bullying Taiwan has only ever yielded the opposite of what China intended.

Then again, Xi may be contemplating something even worse. If he has concluded that Trump’s “America First” administration would do nothing to protect Taiwan, he could be considering a lightning military strike on the island to bring it back under the mainland’s control. But this, too, would be a mistake. Given the broader context of Sino-American relations, even the Trump administration would likely respond to Chinese military adventurism in Taiwan. Besides, the US need not engage in an open military confrontation with China to make aggression toward Taiwan more trouble than it is worth. The US Navy still has the capacity to cut off the sea lanes supplying energy and minerals to China, regardless of whether it is actively engaged in the South China Sea.

As with Putin, overreach seems to be Xi’s default position nowadays, judging by his handling of the trade war and aggressive behavior toward China’s neighbors. In fact, Xi’s muscle-flexing has been so heedless that China now finds itself increasingly isolated diplomatically. Almost all the world’s leading military and economic powers – the European Union, India, Japan, Brazil – maintained pragmatic relations with Xi’s predecessors. But they have since grown increasingly wary of China, with some even moving closer to the US (in the age of Trump, no less).

As in Russia’s case, China’s elite will no doubt have noticed that Xi is turning the country into an international pariah. The outside world may assume that China’s senior leadership is as subservient to Xi as the Kremlin is to Putin. But that is also what many thought about the Soviet politburo and Nikita Khrushchev back in 1964. Khrushchev was ousted before the end of the year.

There is an old joke in which the long-serving Soviet foreign minister, Andrei Gromyko, quips, “We had to remove Khrushchev. He was so reckless a gambler, we would be lucky to hang on to Moscow if he continued.” Khrushchev was indeed impulsive when he precipitated the Cuban Missile Crisis. But he was motivated by a desire to maintain military parity with the US. He did not share the Stalinesque delusions of grandeur that seem to be driving Putin and Xi to wager their own countries’ futures.

Today, no one should assume that either leader will be spared Khrushchev’s fate, or even Stalin’s grim death, which was long rumored to have been perpetrated by his own entourage, whose members had tired of his despotic overreach.

Nina L. Khrushcheva is Professor of International Affairs at The New School. Her latest book (with Jeffrey Tayler) is In Putin’s Footsteps: Searching for the Soul of an Empire Across Russia’s Eleven Time Zones.

Under attack

The trade war is leading some firms to crimp investment

Much depends on whether hostilities between America and China intensify

“THERE’S TARIFFS on games and tariffs on toys—try explaining tariffs to your little boy. Santa’s workshop is struggling, you’ll find yourself saying. I think the reindeer are backed up with their sleighing.” Wendy Lazar, who runs a company called I Heart Guts, submitted this peeved poem to the United States Trade Representative (USTR) in June. As an importer of children’s toys from China, she was complaining about how the trade war could squeeze her firm.

She is not alone. In boardrooms across America, business people are scrambling to assess the impact of the latest escalation in the commercial confrontation between the two superpowers.

For most firms the easy bit is calculating the immediate financial impact of more tariffs on demand, prices and costs. That can be done in a spreadsheet. Far harder is working out how to rejig your strategy and long-term investment plans to adapt to a new world of enduring trade tensions. Fund managers and Wall Street traders have begun to reach their own conclusion—that investment may slump, possibly triggering a recession. Hence the violent moves in markets since the first week of August, with a rush towards safe bonds and a sell-off in equities.

That sell-off picked up pace on August 1st when President Donald Trump’s administration announced the imposition of tariffs on $300bn of Chinese goods, at a rate of 10%, starting on September 1st. On August 13th the USTR announced a delay covering about two-thirds of the goods in question, including mobile phones, smartwatches and toys, which would be subject to duties starting on December 15th.

As Mr Trump explained later that day, the move would allow American shoppers to splurge in the run-up to Christmas. The press release announcing the delay arrived at 9.43am; between 9.40 and 9.45 shares in Apple rose by 3%, and the S&P 500 share index jumped by 1%. But by the following day the stockmarket—and the iPhone-maker’s share price—slumped again as investors fretted that a global downturn might soon be on the cards.

America’s expansion may be cooling as it enters its second decade, but GDP still grew at a respectable pace of 2.1% in the second quarter of 2019, and the unemployment rate is a brag-worthy 3.7%. The direct effect of the tariffs should be small: in 2017, before hostilities began, goods trade with China amounted to just 3.2% of GDP. Even including the additional levies planned for December, they represent a tax rise offsetting only a fifth of the cuts introduced by the Tax Cuts and Jobs Act of 2017.

What really matters, though, is the wider effects of the uncertainty created by the trade war on corporate behaviour. Most companies make plans over a five- to ten-year horizon and invest in assets with a life of 10-20 years. But with each new tariff announcement, the rules for trading their products become less stable. And the scope of the trade war has expanded beyond goods to technology and currencies. Perhaps the international banking system, shipping companies or foreign joint ventures could be next. The most sophisticated firms try to gauge such risks.

The high level of uncertainty is measurable. A study from 2016 by Scott Baker of Northwestern University, Nick Bloom of Stanford University and Steven Davis of the University of Chicago quantified policy uncertainty in America using newspaper reports. Their index of trade-policy uncertainty has soared in recent months (see chart).

And such increases in uncertainty tend to have real effects. The researchers found that increases in their index were associated with dampened investment and slower hiring. More recently, Ryan Sweet of Moody’s Analytics, a financial firm, finds that changes in business confidence and economic-policy uncertainty appear to predict changes in managers’ capital spending.

Given all this, how is investment in America holding up? In the second quarter non-residential business investment shrank at an annualised rate of 0.6%. The question is to what extent the trade war is the culprit, rather than industry-specific factors, domestic economic trends or the global manufacturing cycle. To get a sense of this The Economist has analysed around 2,400 listed American companies in 42 sectors, taking into account both their investment levels and how dependent their sector is on Chinese inputs.

Firms with a higher degree of Sino-reliance do seem to have scaled back investment. The 20 sectors most exposed to inputs from China accounted for a third of total investment by the 2,400 firms. In total these sectors saw aggregate capital spending drop by 1% in the past four quarters compared with the prior year. Meanwhile the other 22 sectors, which are less exposed to China, saw investment rise by 14%. The analysis is simple: other factors may well have played a role.

But business executives too report an effect on investment. A survey compiled by the Federal Reserve Bank of Atlanta in January found that trade tensions had crimped investment by 1.2%. Tariffs were mentioned in a quarter of all earnings calls among companies in the S&P 500 index in the second quarter of 2019, according to figures from FactSet, a data-analytics firm.

One of the sectors most exposed to China is chemicals. In July Jim Fitterling, chief executive of Dow, a big producer, told investors on an earnings call that he would keep capital spending “tight” until he got “better visibility”, adding that he thought a trade deal was needed to “get some confidence back in this market”.

Wall Street economists are also crunching data on how trade-policy uncertainty is altering companies’ behaviour. In June researchers at Goldman Sachs had been sceptical that the trade war was hampering investment, pointing out that overall policy uncertainty was low. But more recently they have altered their view, finding that, after adjusting for underlying trends, sectors that sell more to China (rather than those that buy from it) were seeing slower investment growth than those that were less exposed.

Goldman’s economists also found that tariff announcements were associated with worsening financial conditions (higher borrowing costs, lower equity prices or a stronger dollar).

Expectations of interest-rate cuts by the Federal Reserve have only offset half of the shift in financial conditions. Overall the analysts reckon that, including indirect effects, the hit to GDP would be 0.6%—material, but not enough to tip America into recession.

The overall picture, therefore, is that there is now good evidence that the trade war is leading some firms to crimp investment. Pessimists worry that the knock-on effect from this capital-spending stumble could be far-reaching and more painful than the likes of Goldman expect. In the long run it could sap productivity. In the short run it could cause firms to scale back hiring.

That could then damage consumers’ confidence.

Much depends on whether hostilities between America and China intensify. On August 13th Mr Trump said that he had a “very, very productive call” with China’s leaders. But few on the ground take seriously the prospect of a lasting reconciliation. Jake Parker of the US-China Business Council, a lobby group, reports that his members have realised that the threat of future levies would still lurk even if a deal were struck and tariffs lifted. Blows to China’s economy could also spill back to America.

And Mr Trump has plenty more ways of injecting fear into the economy. He must decide whether to reinstate onerous restrictions on American companies that do business with Huawei, a Chinese telecommunications giant, by August 19th. His labelling of China as a currency manipulator could ignite a currency war.

If the sickness that is now visible in most trade-exposed sectors spills over to the rest of the economy, that would set off a downward spiral that not even lifting tariffs, and allowing in Ms Lazar’s stuffed toys, would reverse.