May 21, 2019

Idioms are defined as fascinating phrases which add color to otherwise more complex discussions – a way to make them more understandable to a broad audience. In this case, the appropriate idiom for China’s latest move is the concept of a “silver bullet.” According to Merriam-Webster, a silver bullet would be the appropriate description for “something that acts as a magical weapon,” especially “one that instantly solves a long-standing problem.” If the Chinese devalue the yuan, they think they may win the trade war and fix their horrendous debt overhang that otherwise is guaranteed to cause a massive recession. Such a contraction could be as serious to China as the 2008 Great Recession or the 1930s Depression in the U.S.

Japan, as you may know, has had some very serious issues with long-term deflation, a shrinking and aging population, credit bubbles, a busted financial system and a Nikkei 225 Index that is still just half the peak level it registered in 1989 – 30 years ago. That is the kind of future China could face.

In that light, Sara Sekine, a Nikkei reporter, saw a story I penned about the likelihood of a “hard landing” in China, so she called our corporate office and got my cell phone and called me the next day. As a good reporter, Ms. Sekine asked me some hard and pointed questions. The hardest, and the one that I could not precisely answer, was this: “When is this Chinese hard economic landing going to arrive?”

I could not answer this question because I do not believe it is possible to answer it with precision, yet I do believe the recession, when it comes, will be absolutely brutal due to the monstrous debt overhang that has built up in the Chinese economy over the past 20 years. Whether it ends up like the Great Recession of 2008 or the 1930s Great Depression will depend precisely on the Chinese government policy response.

This chart shows similar stock market peaks in Japan and China.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The Great Depression, starting in 1929, could have been only a bad recession if it were not for the collapse of global trade caused by the 1930 Smoot-Hawley Tariff Act. The longer name of this disastrous Act was: “An Act To provide revenue, to regulate commerce with foreign countries, to encourage the industries of the United States, to protect American labor, and for other purposes.” While there has been no “Donald Trump Tariff Act” that has passed Congress, the President is disrupting U.S./China trade relations and it could get a lot worse before it gets better. As hopeful as this situation looked two weeks ago, it now looks like tariff tensions could last for a long time.

Exchange Rate Manipulation is a “Sun-Tzu-Style” Maneuver

Unlike the 1930s, it is unlikely that a bi-lateral trade war can cause a recession in the U.S., although a heightened degree of uncertainty can disrupt the savings and investment cycles, which would ultimately disrupt economic activity. In China, however, there is too much debt in the system and too much reliance on exports. As President Trump has pointed out so often, China exports more than $500 billion to us, but we export just over $100 billion to them, so “they” have a lot more to lose in a prolonged trade war.

The other problem in China – which has nothing to do with the trade war – is the monstrous debt bubble in China. Due to their infamous lending quotas of state-run banks and their loosely regulated shadow banking system, the total debt is hard to calculate, but we know that it has ballooned in the past five years. I think that China’s total debt-to-GDP ratio has grown from 100% to about 400% in the last 20 years.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Could it be that the Chinese never intended to make a serious trade deal? Could it be that the only way to deflate part of their mountain of debt is to devalue the Chinese yuan, and the only way the world financial community would accept such a devaluation would be as a response to a 25% U.S. tariff? It sure could, as such a calculated failure of the trade negotiations would be a maneuver worthy of true Sun Tzu disciples.

The yuan was once devalued by 34%, in December 1993. Such a devaluation today would put it near 9.31 per dollar. It closed Friday at 6.95. Such a devaluation, if it comes, would be a profoundly deflationary event for the global financial system, after which I would expect the 10-year Treasury to drop below 1%.

To the disappointment of the Nikkei reporter who called me after I discussed these same issues, I do not believe that the exact sequence of such events can be predicted ahead of time, as the trigger here is the yuan devaluation. Only a select few around Xi Jinping know if such a decision has been made, and they are not talking, but I do believe the chances of a yuan devaluation are high and that such a devaluation may happen soon if the trade war with the U.S. intensifies, as it seems to be doing at this very moment.

About The Author

Ivan Martchev
INVESTMENT STRATEGIST

Ivan Martchev is an investment strategist with Navellier.  Previously, Ivan served as editorial director at InvestorPlace Media. Ivan was editor of Louis Rukeyser’s Mutual Funds and associate editor of Personal Finance. Ivan is also co-author of The Silk Road to Riches (Financial Times Press). The book provided analysis of geopolitical issues and investment strategy in natural resources and emerging markets with an emphasis on Asia. The book also correctly predicted the collapse in the U.S. real estate market, the rise of precious metals, and the resulting increased investor interest in emerging markets. Ivan’s commentaries have been published by MSNBC, The Motley Fool, MarketWatch, and others. All content of “Global Mail” represents the opinion of Ivan Martchev

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