How to play the trade war’s worst-case scenario


We may want to hope that the trade friction will get resolved, but the fact remains that in the past three months, the situation has deteriorated, with new tariffs being imposed and the rhetoric from President Trump becoming nastier by the day.

I do think The Donald has good intentions when he wants to rebalance the out-of-whack trade relationship with the Chinese, but his abrasive approach gives me pause. I am afraid it will backfire and the Sun Tzu disciple from Beijing will use his own strategies against Trump, worthy of a military maneuver described by the famous general in “The Art of War.”

For example, China stopped buying U.S. agricultural products completely, which is different than imposing tariffs on U.S. agricultural products. In my view, this is a move by the Chinese to target MAGA-hat-wearing farmers as a weapon against The Donald in the next election. (For more, see “When the unthinkable happens: U.S.-China trade negotiations break down for good.”)

Divergent views

It is very hard to read the Chinese, and they surely want it that way. Furthermore, experts on China have diametrically opposed views. Russell Napier, who used to be the strategist at CLSA (formerly Credit Lyonnais Securities Asia) during the Asian crisis, thinks China is a disaster waiting to happen:

“The other side of low growth in world foreign reserves is the low growth in the money supply of exchange-rate targeting regimes. These problems are particularly acute in China, with broad money growth at its lowest in the post-Mao era. The country’s debt-to-GDP ratio is rising at probably the fastest rate ever for a big economy in peacetime. This is the economy that we are told is de-gearing and reflating! It is not, and the burden of the economic adjustment enforced by the end of the growth in its foreign-exchange reserves, and hence money supply, will probably be deflationary and will involve debt default. China will probably move to a flexible exchange rate, thus creating the freedom to grow and inflate away these debts. It is that exchange-rate adjustment that will destroy the current global monetary system.”

— Russell Napier, in Financial Times, Jan. 14: “Cracks are opening in the global monetary system. Central bankers have bought growth by sacrificing financial stability.”

I agree. The interesting part is that a few years after Napier gave up his strategist title but remained as a consultant to CLSA, he left shortly after state-owned Chinese securities firm Citic bought CLSA. Because I have known that Napier is a strategist who can see far, I would like to think that he left as he thought that the Citic marriage would turn out to be the integration disaster it turned out to be.

Under a scenario of massive Chinese devaluation, global inflation will go down and Chinese inflation will go up, as they inflate away their debts. That said, other global currencies have very serious issues, as Napier notes, so hard assets are the way to go. The hardest asset of them all is gold bullion.

Previously, I had thought that accelerating monetary tightening by the Federal Reserve and a dollar short squeeze could push the gold price under $1,000 an ounce. The monetary tightening by the Fed is now history, and it probably ended in December 2018, if one studies the growth of high-powered money supply and dates the last Fed rate hike. With $15 trillion in global bonds with negative yields and a threat of Chinese devaluation, the dollar does not have to go down for gold to go up. We may end up being in a situation that gold bullion is going up as the dollar is going up, even though historically that has not lasted long.

It has to be stressed that buying gold bullion bars is not the same buying gold bullion ETFs and certainly not the same as buying as buying gold stocks. Gold stocks are not a hedge, but operating companies that can go bust; gold bullion is a hedge. Because of the milking of the larger bid-ask spreads in gold coins by many dealers, bullion is the better choice. Kitco is a reputable source for gold bullion.

The next best thing are ETFs that are backed by physical bullion like the Sprott Physical Gold Trust

PHYS, -0.49%

 and Aberdeen Physical Standard Gold Shares

SGOL, -0.65%,

which have fees of 0.36% and 0.17%, respectively. There’s is also VanEck Merk Gold Trust

OUNZ, -0.60%.

It is very important that large purchases are spread over more than one ETF and that investors consider the different restrictions of which ETF shares are easily redeemable into gold, as well as which trust price is as close to NAV when buying with limit orders only. (For more, see “A gold ETF that lets you redeem shares for gold.”)

Glass half-full view on China

Chris Wood, whom I would describe as an expert on China, took over as CLSA strategist in 2001. I have a very high opinion of Wood (who no longer works for CLSA, but U.S.-based Jefferies). Chris used to call the Chinese “comrades” in his weekly research, which is now a Jefferies research product. Comrades they are, as they run their version of state capitalism like true Communist party members. So when Chris tells the world that China is OK (see Aug. 6 Grizzle article, “China’s economy still strong despite trade and tech war”) and Russell Napier says it’s a disaster waiting to happen, it’s like two experts looking at the same picture and one says, “This is definitely white,” while the other says, “It’s all black.”

I am in the Russell Napier camp. I realize that Jefferies has to do business in China and the Chinese expect flattery when doing business, but black is not white in any language. When Citic bought CLSA they did so in order to create a “Goldman Sachs for China,” but because they imposed a true comrade of a new chairman in the face of Zhang Youjun, the top talent left and Jefferies performed the brilliant business maneuver to pick it up. One cannot run a top-rated securities firm like it is a division of the Communist Party of China, as that would destroy it, which is what appears to be happening with CLSA. Too bad, as I have probably never read better written research, even though in the case of China we agree to disagree. It would appear that instead of building a “Goldman Sachs for China,” Citic is devouring CLSA in Bear Stearns’ fashion, where the formerly forward-thinking agency brokerage is losing its identity and, what’s most disturbing, its top talent.

WIth all these caveats, if there is a trade deal, any multinational that is pressured by the trade friction with China would rebound. That does not mean that gold bullion will go down, though, as I think the Chinese yuan is still at risk for devaluation, even with a trade deal, and the euro still has existential problems.

True capitalist economies have economic cycles

It’s very simple. This business of force-feeding credit every time the Chinese economy slows, with lending quotas and all kinds of other tools, is resulting in rising indebtedness and a slowing economy, which is a lethal combination. The Chinese practice a weird form of state capitalism, and they think this system is better than capitalism with less government intervention, because so far they have managed to prolong their economic expansion.

Still, I don’t believe economic cycles can be eliminated. The end of the Chinese credit cycle could create something similar to the Great Depression of the 1930s or the Great Recession of 2008. Which one it will be, I am not sure, as I have not yet seen the comrades’ policy response (see chart).

Technically, both Napier and Wood are right. But in my view Napier is talking about longer-term strategy and Wood is correctly describing short-term tactics. But as the legendary Chinese general Sun Tzu correctly pointed out in “The Art of War,” strategy without tactics is the slowest route to victory, while tactics without strategy is the noise before defeat.

Someone needs to send The Donald a copy of “The Art of War” — and pronto.

Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates.

Source : MTV