Financial Markets & Corporations

Let’s turn to financial markets.

If you look at Chinese strategic plans—China is remarkable in the extent to which it makes strategic plans public—we see China successfully implementing its goals to build global financial liquidity for its currency and its bond and equity markets. This goal requires hard work by the Chinese and coordination with financial centers and various allies, including the Russians.

Despite China’s significant efforts to build financial liquidity, the U.S. dollar remains, as The Economist describes it, “Dangerous but dominant.” As of 2017, the IMF reserve currency reports indicated that 62% of global reserve holdings are in the U.S. dollar, and 20% are in the Euro. The Chinese renminbi represents only 1.23% of global reserve holdings. The Chinese continue to put the global financial infrastructure in place to change this imbalance. The Chinese now have currency hubs in more than 12 major global financial centers. The Chinese are creating the swap and other capacity they need to make sure that their currency and bonds stay liquid. They’ve recently opened up their bond market for direct investment in a significant way.

You can learn a lot by watching prices in the currency and stock markets. The United States launched the current trade war when the Chinese stock market started to outperform the U.S. stock market in early 2018. In part, the rise in the Chinese stock market was due to a decision in 2017 by MSCI, a leading U.S. index company, to include mainland Chinese shares in its emerging market ETF.

As of January 20, 2018, the Friday close before Monday, January 23, when President Trump announced his first trade tariffs, the Chinese large cap ETF FXI was up by 8.7% for the first three weeks of the year, ahead of the S&P 500, which had risen 5.1%. Trump kept announcing tariffs and tweeting headlines until, lo and behold, the Chinese stock market had underperformed the U.S. stock market for the first half of the year. FXI was down -10.1% at June 30, 2018, compared to the S&P still in the black at 1.2%. As of August 30, the S&P was up 8.10% and FXI was down -8.81%.

The Chinese equity markets are sizeable. The Solari Report published a Wrap Up on the Chinese stock market in the 3rd Quarter 2015. Now, the Shanghai and Shenzhen markets have reached market capitalizations of $8.5 trillion. Hong Kong is at $4.4 trillion. Altogether, they are at $13 trillion—still less than one-half of the U.S. equity markets. The New York and NASDAQ together are $33 trillion. Japan’s equity market capitalization is approximately $6 trillion.

When you appreciate that the Shanghai and Shenzhen were at zero in 1990, the Chinese have come quite far in a short period of time. At the same time, the Chinese stock market has significantly underperformed the growth of the Chinese GDP.

One of the challenges is that the Chinese stock market is such a big part of equity capitalization for all of the emerging markets. Of course, the Chinese growth rate is outperforming many of the other emerging markets. Again, income convergence is an Asian phenomenon. But whether it’s the rise of the Chinese bond market, the rise of the Chinese stock market, or the liquidity of the Chinese currency globally, China is implementing a long-term plan not only to build these markets globally, but to build out the payment and satellite systems and military presence that they need to support global liquidity.

I think that the big question for me about how far they can go and what they can accomplish comes back to the rule of law. I wanted to read a quote from Ai Weiwei about the challenge for China:

Police in China can do whatever they want; after 81 days in arbitrary detention you clearly realize that they don’t have to obey their own laws. In a society like this there is no negotiation, no discussion, except to tell you that power can crush you any time they want—not only you, your whole family and all people like you.

I certainly felt these concerns when I was in Hong Kong in 2017. Legal standards created and practiced over the last 100 years were being threatened by the encroachment of the PRC. As the Communist Party moved in, people’s personal wealth was in danger. Faith in the rule of law was eroding. This will threaten Hong Kong’s standing as the most innovative city on the globe.

Just as I say this about China and Hong Kong, you know my experience in dealing with American jurisprudence and the U.S. Department of Justice. I think the real message of the financial crisis for many people around the globe, including in Asia, is that you cannot trust the United States or the Anglo-American alliance because clearly there was a serious—if not complete—breakdown of the rule of law. A $50 trillion financial coup d’état is a lot of establishment illegality.

That breakdown has been global. Given the size of U.S. mortgage securities purchased by government, central bank, and sovereign wealth funds in Russia, China, and other investment-sophisticated countries, it is obvious that global establishments understood the extent of the U.S. housing bubble and mortgage and securities fraud they were financing.

If the bailouts were $24-$27 trillion, and $8 trillion would have paid off 100% of the single-family mortgages in the country, I’m sure the Chinese and Russians buying all of the Freddie Mac, Fannie Mae, and Ginnie Mae securities knew that there was significant collateral fraud.

The question is: How far does legal culpability for the financial fraud and the financial coup d’état go? Is the pot going to call the kettle black, or is everybody in the pot?

Asians have traditionally had a preference for gold, real estate, and hard assets. Asian retail investors have not had the same interest in buying stocks and securities as American investors. If you’re going to build out the global equity markets, you certainly need a growing middle class in Asia to participate in the equity and securities markets. That’s why the growth of the Chinese stock market is very much at the heart of whether or not you’re going to succeed at making this conversion. Will the Asian middle class invest in securities?

As we see the global and Asian middle class grow, we see more gold moving globally, particularly to Asia. Still, if you look at the official numbers from the World Gold Council, China and India are still far behind the United States and Europe. I would expect the rebalancing of gold and silver holdings to the East to continue.

Another big question is retirement. How will Asia and China cope? When we published our review of pension funds in the Annual Wrap Up this January, I pointed out that Asia’s and China’s pension fund assets are small despite sizeable aging populations.

Children in China have traditionally been expected to take care of parents in their old age. However, the growth of the middle class is also bringing materialism—even hypermaterialism—with children who are less likely to feel an obligation for their parents and grandparents and no compensating social safety net. (For hypermaterialists, everything comes down to time and dollars and cents.) How will aging populations survive when they do not have the pension funds or social safety net that the United States and Europe have? Hypermaterialism without safety will make for a bad world when new waves of automation come. If the working-age people are losing their jobs, they will lose their ability to care for older generations.

I have talked a lot on The Solari Report about global debt problems. Another important question in the financial area relates to Asia’s (particularly China’s and Japan’s) management of high debt loads. How are they going to handle a U.S. dollar bear trap if that should unfold? High dollar debt loads are painful when U.S. dollar trade declines and dollars become more expensive.

Most of the trade between the West and Asia is done by companies. If you look at our imports from China, China’s exports to the United States that Trump is wrangling about, a lot of that—60% or more—is essentially multinational companies and U.S.-headquartered companies setting up operations and sourcing from China. So, China is not selling us goods from Chinese companies; our companies are going to China and strategically sourcing in China. So, you wonder why Trump is yelling at China when he should yell at the American companies.

You can imagine why the Chinese officials and the engineers are getting frustrated. This time it’s not with a lawyer, but with a real estate developer.

If you look at the politics of these companies and their impact on this relationship, companies are not going to deal strategically; they are going to do whatever they must to follow the consumer. But they are also going to get caught in the middle between nation-states that think and act strategically and do not report to shareholders.

One excellent article in The Economist that I have pointed out numerous times—it is in the bibliography—is “The Retreat of the Multinational,” about how big multinationals have hit an already successful local juggernaut. There is no place where this is truer than in Asia, where there is significant growth in the local companies. This means growing local ability to compete, and consequently a shrinking of margins to the multinational and the retreat of the multinational back to its home markets. It’s why I think—as we go through this repatriation of capital back into the United States—that the large corporations will push Congress and state and local governments to help them increase their share of U.S. product and service markets. I think that U.S. small businesses will experience significant competition from larger companies.

What does this mean for you? It means significant corporate insistence on increasing market share in developed countries, both privatizing government operations and assets and using new technology, regulation, and automation to take over markets traditionally serviced by government, small business, and sole proprietors. In highly leveraged financial markets, pennies matter. Coca Cola’s global profits are generated $.01 a can at a time. Amazon and Walmart are now competing directly with your local cleaning lady and handy man to clean your house and repair your kitchen cabinet.

Next Chapter: Geopolitics & Geography

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