Podcast: Play in new window
- Country Garden now paying 118% on its debt
- Equities spike up in dangerous bear market rally
- When does the shoe drop on the real estate market?
Xi Whiz – China’s Getting Scary
November 2, 2022
“It is important to look at the enthusiasm in the U.S. markets and realize the fragility that we have on a global basis because these are things that in an interconnected financial world do matter. Even if they’re not in the limelight, they’re incredibly important. The Chinese currency continues to reflect and increase stress, even with the People’s Bank of China and the Commercial Bank interventions of selling the U.S. dollar in support of yuan. Chinese currency hit its weakest level since 2007 this week.” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
Your family is a very talented family, your wife, very much into the arts. Your son now is playing a leading role in a musical. He had his first night this weekend.
David: That’s right. And then as you often have with the afternoon shows, there’s a little bit of a lull. They’re quiet shows. The audience is a little less engaged for those.
Kevin: It’s the kickoff. Yeah.
David: That’s right. So, Anastasia, we’re bringing in a little Russian conversational aspects and songs as I hear him sort of warming up his voice in the shower. It’s really—
Kevin: This was your teenage boy, is— Yeah, and now he is singing— You know, Anastasia. It reminds me, back, oh, 34, 35 years ago when I first started, Dave. I had someone call me. I can’t remember if they became a client or not, but they told me that they were friends with the real Anastasia, the one who had actually lived through the execution in 1918. Of course, there’s always been this legend about the Anastasia, and you and I are reading a book right now called The Story of Russia. So we’re thinking in these terms, but it’s interesting. Disney picks up on these themes. You don’t necessarily know if you’re being told the true story, but you are being told an entertaining story.
David: Absolutely. Well, the other entertaining story that I had, crossed my desk this last week was the positive GDP figures. I thought they were remarkably entertaining.
Kevin: Oh, yeah, we’re doing well, aren’t we?
David: Well, after two quarters of negative GDP, we end up in a positive print of 2.6%. And as you look into it, probably the most fascinating aspect, I think the most entertaining aspect, was called the deflator. The deflator is how they account for inflation. And so that adjusts the number, and, as it turns out, their inflation input runs around 4%. And I’m thinking, well, the annualized rate is still north of 8. So how did you get that cut in half just in time for the show?
Kevin: Well, you can add or subtract numbers. Joe Biden was talking the other day, and he said we had 54 states in the United States, so I think you can use whatever number you want, but listen—
David: You count a deck of cards, there’s probably 54 cards as long as it’s jokers included, right?
Kevin: Or the two extra aces. Remember the two extra— Oh, the ones in your sleeve, right? Is it? Well, sometimes you— Speaking of shows, have you ever looked at a line and seen a lot of people wanting to go into something that you’ve never heard of before, and you’re like, Gosh, am I missing something?
David: We’ve all done that. When you go by a restaurant and there’s not a soul inside, you say to yourself, there’s got to be a good reason.
Kevin: Right. Right.
David: Even if it’s not true. That’s the running assumption. Meanwhile, the restaurant next door that’s flowing out under the streets and has a line of 45 minutes wait, you think, they got to know something I don’t know.
Kevin: Well, should I have been buying stocks last week, Dave? That’s what I wonder.
David: Well, that’s right. I mean, we’ve got a multi-week rally in play here with U.S. equities. Last week’s moves for many of the indices were equal to a decent year’s worth of returns, right? So—
Kevin: I missed that by the way. I missed that.
David: Now granted, we may have had some classic painting of the tape at month end, right? We’ve got October 31st coming through, and I think there’s a few mutual fund houses that have October 31st as a fiscal year-end. So performance gaming may have run wild coming down to the line.
Kevin: Do you think possibly though people are thinking that Powell’s going to pivot? Do you think he actually would before the election?
David: Well, there is some positive engagement in the equities markets based on that assumption. Positive energy is gaining steam as we move towards Powell’s comments, with heightened expectations of Fed language that reflect an easing of interest rate policy pressures. We’re going to have a 75 basis point increase. That’s still expected this week.
Kevin: But aren’t they starting to paint into this that it’ll slow down after that?
David: That’s right. The desired language, at least from Wall Street, is the moderation of pace from that point forward. But I think you’ve got some things mitigating against that. A combination of wage inflation, low unemployment, and a massive equity rally. They all sort of marshal against the Wall Street hope of pivot language.
What’s intriguing is that central banks all over the world have noted the fragile nature of the financial markets, and with cracks appearing in recent weeks in Europe and in the UK with growing problems in the swaps and the repo markets—so this is the International Capital Market Association, which was sounding the alarm on European market dysfunction, particularly in the repo and swaps markets—and collectively, central banks have collectively shifted tone.
You’ve got Lagarde for the ECB. Yes, they raised rates—but a small, not a big stick. But she did, as Roosevelt suggested, speak softly. So the market speculators love that calming and permissive tone. And along with that, you had the Bank of Canada, the Bank of England, even a handful of the Federal Reserve reps just prior to the blackout period. This is a period of time before Fed meeting where you’re not supposed to say anything. So they said as much as they could, of a dovish nature, before the blackout period.
Kevin: And so they’re pretending to be doves at this point. Are they really doves?
David: What’s not clear is whether or not their language reflected Powell’s position, but the tone they struck nonetheless was a shot in the arm for the equity investor.
Kevin: Well, yeah, but what about the earnings? I mean, the earnings were abysmal.
David: In a lot of cases, you’re right. These are sort of tech bellwethers, which is one of the reasons why the Dow Industrials have pulled ahead in terms of not only the bounce, but closing the performance gap this year. So when I say gaining steam, there’s a positivity in the market that glided right past the abysmal earnings reports of Microsoft and Texas Instruments and Intel and Amazon and some of the forward guidance they gave. Of particular interest to me was Google. The market bias in equities is higher for now, but with bad news being read as good news once again—
Kevin: Isn’t it strange? Yeah. When the earnings are bad, go buy the stocks. Look at Amazon, especially their cloud services.
David: Yeah. And ad spending. That’s what stood out to me on Google. Ad spending on the decline is just one indicator of executives battening down the hatches for a slower business cycle. And you’re right, Amazon’s disappointing AWS—their cloud services—that confirms that business spending is being curtailed.
There’s three sources of spending. Broadly speaking, you’ve got business investment; you’ve got consumption, or consumer spending; and then government spending. And a lot of that’s deficit spending. They don’t have everything, but they can spend more if they need to. Businesses appear to be growing cautious. So one of those three you can start to discount now, and you wonder if at the margins that doesn’t accelerate the trend towards recession—even though, again, we get this GDP print of 2.6%. Happy days are here again. We’re now making up for lost time. Even with this sort of statistical chicanery relating to the deflator, again, in the fours versus an actual inflation rate of eight. It’s kind of obvious.
Kevin: One of the tunnels we’ve talked about is the November through April good months. We’ve passed through the months which were the tunnel that were bad months in the stock market. Are we really just seeing a seasonal adjustment right now—things kicking in when people buy stocks from November to April?
David: Maybe, maybe. I mean, yes, we are technically through the September to October gauntlet, but that weak period followed by a good period, November to April, those are considered good months, largely driven by retirement account funding at year-end and the push to, again, similarly fund accounts leading up tax season there in April, which increases inflows into equity mutual funds. And we’re not really seeing traffic into mutual funds as much as we are people stepping in and buying stocks. In the past three weeks, Bloomberg reports that inflows into single stocks as a percentage of the S&P 500’s market capitalization, in the last three weeks they’ve been in the 99th percentile of history.
Kevin: Wow.
David: You’ve got to go back to 2007 and ’8 for precedent, right?
Kevin: Yeah, but look what happened after that.
David: These were prior to the declines of 2008.
This is all consistent in my mind with the notion that we’re in a counter-trend rally. Counter trends are sharp and very short in nature. So in a bull market, you can grind higher, right? Bull market, you’re gaining value and then you correct lower very quickly. You get these little air pockets that you get to moments of doubt where people kind of double clutch and sell, and then all of a sudden you see confidence regained. In a bear market, the counter-trend rallies are to higher levels, but they’re typically short and sharp as well. And a part of the energy in a counter-trend rally in the context of a bear market is driven by short covering. So you’ve got folks that have been hedging downside, and they get to a point where they say, Well, now I’m losing on the short side, maybe I need to cover that. And that represents active buying into the market, driving prices higher.
Kevin: So when you’re in a bear market, there are periods of time where there’s enthusiasm, there’s positivity, and those can create those very vertical climbs.
David: Well, that’s right. So it’s enthusiasm, it’s positivity, which to me is the mark of a mid-course— Again, we talked about the three phases of a bear last week. This is sort of mid-course sentiment within the context of a bear market because you think you’re getting in on value, and the end of a bear market takes on a different tone altogether. It’s kind of the element of despair.
Kevin: That’s when nobody will touch the stuff, right?
David: Yeah. And we noted last week that value—value as measured by CAPE, the cyclically adjusted price-to-earnings—to be on par with the 2009 lows, which were frankly well above the previous bear cycle lows, is still 30% lower from current levels. So we’ve had a correction, we’ve got radical positivity in the marketplace today, which doesn’t mark a broken spirit within the equity market—
Kevin: But their shares are still 30%-plus higher than they should be relative to their earnings.
David: Sure. There’s exceptions to that. If you look at a company like Facebook, off 74% from its peak, it’s trading at a hundred dollars a share, what’s fascinating is they spent the better part of $50 billion buying back shares at $300 a share, and now it trades at two-thirds less than that. My general advice to an executive group would be buy low and sell high. But I understand there’s a different rationale. You can step in and buy high, and, well, I guess it frustrates your shareholder base if you’ve wasted money, but—
Kevin: Well, in the last decade—
David: [Unclear] aside.
David: Yeah. In the last decade, that’s what the stock market was, was share buybacks with companies. So if this thing continues to go down, it’s a double whammy because their earnings are going down as well, right?
Kevin: Yeah. A few years ago, volatility seemed dead.
David: Yeah, we would talk about it. It was just quiet, dead quiet. This year, the S&P—this is the S&P 500—that index has had 40 sessions which have registered 2% moves in either direction.
Kevin: So that’s considered a shaking, a pretty substantial shaking.
David: Yeah, these are big moves. These are very big moves. Yeah. I mean, again, you’re talking about a single session, like one day, 2% or more. These are very volatile markets. Reuters noted that these numbers were only surpassed during the height of the pandemic selloff back in 2020—before that, the depths of the global financial crisis, 2008, 2009. Volatility is of a radical nature today, and it’s not healthy. You see it in the fixed-income markets as well. You see it in the currency markets. These are intriguing moves, in part because they are destabilizing in and of themselves.
Kevin: In the short run, it reminds me of schizophrenia because you have positivity and then you have negativity, and then you have positivity. But there’s been an awful lot of household wealth lost this year that still hasn’t been made back.
David: You’re right. But it’s been focused in the equities market, which I think is worth noting. Year-to-date losses from household net worth are just about six trillion dollars. This is in the U.S., and this is without a real haircut from real estate assets—yet. And yet is the key. You’ve got mortgage rates which are higher, and over time that will be a factor in the repricing of residential property. The first thing you see is volumes drop. That comes first. Then stubborn price concessions are eventually—
Kevin: Well, look at the loan officers. Last year, they were pretty busy. These days, they’ve lost most of their business, or at least half.
David: Mortgage demand is now down 50% from a year ago. So again, back to that issue of volume preceding price. We’ve seen a decline not only in sales, but again in mortgage apps. And part of this is refi, of course, which is really no rationale, for very few numbers pencil if you’re trying to refi at these kinds of rates. But you look at new home sales and existing home sales, and the same story is there. Volumes are on decline, but price isn’t, right?
The average new home price as of September hit 13.9% higher from a year ago. Here we are at $470,600 per unit, and at 3% in terms of a mortgage rate, there’s a crowd of people that can make payments. But at over seven, the crowd shrinks. And so, too, will the price. This becomes mathematical at a certain point, adding more downside pressure to household net worth because, as we said earlier, the $6 trillion lost year-to-date has really been exclusively in the mutual fund and stock category, and has had nothing to do with the larger piece of household net worth, which is tied in real estate. And I think that’s a key point because household sector net worth hit an all-time high of 150 trillion, 150 trillion in the fourth quarter of 2021, up from the previous peak in 2007.
Kevin: Yeah, remember they called, on the Economist magazine, the bull market, an everything— the everything bubble.
David: Yeah, the everything bubble is what took us from 70 trillion to 150, right? So we get to a bear market peak in 2007 of 70 trillion, and this is with radical real estate pricing. Now we’ve got a combination of real estate pricing even at a higher level, with a bunch of other assets that have followed suit, including equities and bonds and everything else. So we get to 150 trillion, Q4 2021. This has been one heck of a bull market in everything.
There’s still a hundred percent difference. Again, just looking at the hundred and what is it? 43? $143 trillion in total net worth. There’s still a hundred percent difference between the 2007 peak and where we’re at today. A lot of ground to give back as real estate and the bull in everything becomes a bear in everything.
And I had a friend comment on our Commentary last week. He said, “Man, that was really negative.” To be honest, I don’t live in a world of negativity. I just live in a world of trying to judge value. Is it something overpriced or underpriced? And we do this every day as consumers. If somebody says, “Hey, I’ve got a Ford F-150 and it’s for sale for $150,000.” You’d say, “That’s overpriced. I’ll pass,” right? But if you said, I’ve got a Ford F-150 and it’s for sale for $17,000 and it’s got low miles and it’s been a one owner vehicle and it’s been well maintained, you say to yourself, in this environment, that’s a steal. You’re not considered a bear for seeking value. You just don’t want to overpay. So we live in this interesting emotional space where only when it comes to the future structure of our retirement and the hopes of a “better life,” do we consider a value play negative thinking. And it’s never negative thinking.
Kevin: Dave, you have to make money management decisions every day. I hope you’re not an optimist, and I hope you’re not a pessimist. I hope you’re objective. The other day, Friday, one of the guys in the office came to me and he said, “Hey, your rear passenger tire is a little low.” I had so much to do that day, I just wanted to wish that it wasn’t. And I went out, and I got the gauge out, and sure enough, a 32 pound tire should have actually had 32 pounds in it. It had 11. Well, I took it over. There was a nail in the tire. Now, was I an optimist, was I a pessimist, or did I just objectively have to change my plans based on the nail in the tire?
David: This is just a judgment of value. If interest rates have come up, we have to see a correction in price in real estate. And if there’s a correction price in real estate, we have another component of household net worth which takes a hit.
Kevin: But when people feel a certain way, it does affect the market.
David: That’s right.
Kevin: When people that feel poorer, they spend less.
David: And there’s the economic impact. It’s the reverse of the wealth effect, right? More money on your balance sheet. You spend more because you’re comfortable that you’re not going to run out of dough. But with less money on the balance sheet, you begin to wonder, am I going to run out? Is it time to go back to the college days of ramen noodles and beans and weenies? When people feel poorer, they spend less. So it’s been mutual funds, equities, pension entitlements that are tipping over and headed lower.
Kevin: And real estate hasn’t done that yet, except for my block. I live in a circle type of drive, about a half a mile long. There are two houses for sale. They put those signs up in the last month or so. They might be late to the party.
David: I think, in some respects, real estate looks to be having one of those Wile E. Coyote moments. You’re contemplating gravity, you haven’t yet yielded to it, right?
Bloomberg featured commentary on Friday, specifically on the commercial property market, so not residential, but commercial property. And they said that the cost of debt on commercial property has risen so fast that it’s now more expensive to finance many real estate deals than owners are currently earning on rent. Translation, $5½ billion of new commercial mortgage-backed securities have negative leverage. Debt exceeds the returns on the asset. Debt payments are exceeding the income, right? For those of you who know real estate, cap rates being below interest rates, that’s not a good idea. Prices are going to have to adjust lower, and this is not negativity or positivity. This is opportunity for someone who would like to put some money to work in the real estate market at some point. And translation: Just be patient.
Kevin: And if you can pay cash for real estate, in a way you can short real estate, because you can hold cash— In a way, that’s shorting real estate. Cash or gold, and then go into real estate as it goes lower.
Speaking of shorting, there are good timing and bad timing starts for short funds. And then there’s good managers, and I don’t know, I want to be careful what I say about the short fund that just recently started, but they’re losing awful lot of money. Talk about bad timing.
David: Well, we start our tactical short commentary every quarter with an explanation that we are not a hundred percent short. We vary the exposure in light of market conditions.
Kevin: Doug is careful. Doug is careful.
David: We can be a hundred percent short, but you have to mitigate risk. And for anyone to be a hundred percent short on an ongoing or automatic basis is kind of indifferent to risk.
Kevin: It’s a losing strategy, pun intended. Short, shortsighted losing strategy.
David: Yeah. So a recently launched short ETF competes with our Tactical Short. And this is run by a 40-year veteran, somebody who knows the markets. They’ve managed to lose 21% straight out of the gates. That’s one-month performance, down 21%.
Kevin: That’s a hard way to start.
David: Yeah. So for those of you who joined us last week on the Tactical Short call last Thursday, you know we’ve done a lot better than that performance-wise. I encourage you to review the recording if you missed it, but what this points out is that this rally is hair-raising and it’s dangerous. If you’re not carefully managing risk on the short side, this baby could rip your head off.
Again, as I mentioned earlier, I think this is a short-lived rally where you’ve got a powerful dynamic, but it’s countertrend. That’s the nature of countertrend moves in the market—short and sharp. How far it goes in the interim is anyone’s guess, which is one of the key reasons for having risk controls in place.
Kevin: And it’s important to understand, there are certain things that do happen on the short timing side that are not actually trends. Getting our head around— I’m going to move to China just for a second because we’ve been talking about this the last few weeks. It’s really hard for us here in the United States to get our head around the radical shift that has occurred in China, both politically and economically. The meltdown of the debt that’s happening in China, where you have interest rates in the hundreds of percent, those are bonds that are just failing. But we also have the anointing. Isn’t that what it was called in Financial Times? The anointing of Xi and his new methods.
David: Yeah, no—
Kevin: His new old methods, let’s put that way.
David: It’s a change in emphasis. It’s a little bit more internal in its orientation. Essentially, you’ve got three distinct groups in China: the laboring masses, the party, and the elites. And these three distinct groups have a script to follow. The laboring masses, they continue to scratch out an existence with the hopes of entering the middle class. And frankly, they’ve been the hardest hit during the Covid lockdown. And now they’re groaning already as multiple variants and an increase in cases have introduced degrees of lockdown once again. If you listen to Xi Jinping’s speech, caution is the first principle. Security is paramount. Driving control— Again, this was reiterated in Xi’s coronation as a reflection of recent success: “Look, we don’t have the death count that other countries have.” And again, this is commentary supporting, “here’s what success in China looks like—superiority in an approach to management of people and processes vis-à-vis the Western world. You will be safe even if you are not free.” And this is a social transaction. What I don’t know is how many people in China are excited about this kind of social transaction where, yes, you’re guaranteed safety, but it’s at the expense of freedom.
Kevin: A couple of weeks ago, you were reminiscent of 1917 in Russia. We brought Russia up in the beginning through Anastasia, and it’s strange that there’s a Disney show called Anastasia. With everything that went on 1917, you said, “Would you go long the ruble in 1917?” And you wouldn’t have because, of course, the things we’re seeing Xi talking about were very much similar to when the change occurred in Russia. So, Disney, I don’t know. Will Disney make a movie about the takeover with Xi?
David: Maybe. This is fascinating because after several weeks of rising Covid cases in China, lockdowns are coming back. This week, Shanghai Disney closed.
Kevin: Speaking of Disney, they closed.
David: But they closed with tens of thousands of visitors still inside. So it’s not you can’t come in—
Kevin: Trapped in Disneyland, in Chinese Disneyland.
David: Yeah, yeah, yeah. Kind of interesting because you can leave only after you have a negative Covid test. This happened a few years ago, and there’s like 30,000 people locked inside. They did it again, and you’re stuck.
Kevin: Wow. It’s a small world, but it’s a very small world.
David: It’s a small world after all, which if you think about it, being trapped in a small world, this would be my father-in-law’s worst nightmare.
Kevin: Oh, really?
David: That’s not a ride that he likes. But economic uncertainty, if you just think about what this says, economic uncertainty remains high across China, with new variants triggering varied degrees of lockdown. I mean, if I went to a local store and thought, in a tough moment I may be stuck in this store or this mall or this Disneyland. You could be locked in a small shop like the Disney goer.
Kevin: That’s sobering actually.
David: You just don’t necessarily enter the normal consumption patterns that you would have otherwise. We already know economic growth is on a deceleration curve, and this is going to continue to impact commodity consumption. It’s going to continue to impact the global GDP stats as we get to the year-end. And now with Covid resurgent in China, this is, again, one more thing that weighs on demand for a whole variety of things. So we’ve got the laboring masses, we’ve got the party, and we’ve got the elites. It’s been the elites that have had the hard pill to swallow thus far as it relates to common prosperity—
Kevin: Because they were told to give some of their money away. They were strongly encouraged to give some of their money away.
David: Well, just imagine a suggested donation where you don’t really have a choice. I mean, that’s the awkward suggested donation. No real choice.
Kevin: Yes, but this is common prosperity, Dave, Don’t we all win?
David: Redistribution of wealth in recent years has been, well, it’s been voluntary, sort of. Now we move into a more muscular phase where Xi does not see the same future that Deng Xiaoping saw. He has a different vision for China. He has a different vision of some getting rich first and then prosperity being common on the basis of a rising tide. You now have party principles, you have expressions of loyalty to its chair as more important than opening the way for others to ascend the socioeconomic ladder.
Kevin: There’s a strange parallel as we read this story of Russia. Russia, the pattern of the czars, the czar had a tremendous amount of power. It was almost like a dictatorship, and it was a dictatorship that was actually fueled by the connection with religion, the Russian Orthodox Church. It sort of enhanced it to where he was on God’s mission. In a strange way, it seems that this is not communism that we’re talking about, this common prosperity. It sounds like a form of dictatorship or czar-like ship in China.
David: There is a similarity, and the way that Xi has set himself up is sort of the person with a messianic vision for China, and that vision comes back to the core ideals of the party. So success is going to be redefined according to a party standard, along with things like human rights, freedom of expression, dissent, education. I mean, all these terms will have fresh meaning, all taking on not sort of a rose-colored, but a very reddish tint in their definition.
Kevin: But does that make him vulnerable? A dictator has to have complete control over everybody. Or if you’re really not having anybody else to scapegoat it out, you’re really responsible for the success or failure of your country and you’re going to be held accountable for it. Am I right on that? I mean, has he taken more responsibility than he is going to want to have if something goes wrong?
David: Fascinating conversation with Kaiser Kuo and a gal who’s written a lot really good stuff on China, Susan Shirk, and this notion that paranoia is actually quite common when you have totalitarianism because now all of a sudden you don’t know where your enemies are coming from. But Xi seems to have this sort of superior script for the three contingents of actors, the masses, the party, and the elites, and relishes the role of director.
Kevin: Produced by, directed by, acted by, sung by, everything by.
David: Ian Johnson was writing for the Council on Foreign Relations, and he raised the question you did. “However, if Xi directs everything, doesn’t that make him more vulnerable?” So Mao was able to redirect blame for failed policies. He had a lot of party adherence, which he was able to sort of scapegoat and say, “Oh, it’s their fault,” and they took the fall for it, right? Mao was very concentrated in his power, right? But he still had the ability to slough off critique. Xi’s putting himself at the center of everything, and that does take on the risk of critique. Johnson said Xi’s basically constructed a system that makes him look strong in the short run, but leaves him no place to hide.
Kevin: But he has the illusion of a team behind him who are also helping him make the decisions.
David: Yeah. The team of 24 and seven, they weren’t elevated because they represented a diversity of viewpoints. They’re there because they create a wonderfully harmonic echo chamber for the nation’s lauded voice. The reborn Mao, this is Xi himself. So, I mean, who would step out and critique the most powerful leader since Mao? You know what the consequences are. You weren’t asked for your opinion, you were asked if you are loyal to the party, which has a specific meaning. Xi Jinping’s prerogatives. So Xi’s purge thus far has been of the powerful elites, and of course, again, the sort of soft pedaling, the requirement of engaging with common prosperity. You can see it in other areas where there’s been a realignment of social media outlets, where you know the voice has shifted and the willingness for people to offer an alternative message has simply disappeared. The new China is going to project a unified and coordinated messaging. In the old days, we called it propaganda, and it’s going to have multiple audiences.
Kevin: So when Elon Musk took over Twitter, the bird became blue and free. But what we see with Xi is, the bird’s red and it’s going to be absolutely controlled. In a way, it’s the opposite of what happened at Twitter.
David: Yeah, it’s still sort of minorities dictating majority views, because if you look at less than a hundred million party members, right? You’re really talking about the propaganda tools within China being targeted at non-party participants in China—
Kevin: Are we talking five or 10% of the populace are party members—
David: Less than 10%.
Kevin: Okay.
David: If you call it a billion and a half, and there’s 97 million. It’s a small number, relatively speaking, but then you’ve got the global audience. Propaganda can have two audiences, domestic and international. At least on the domestic side, I think we’ve entered into this new phase where you should practice some self-control and restraint. Those would be the wisest ways of navigating the years ahead. Unless you relish the Uighur-type outcome, think differently. You will discover the magic of re-education. By the time you leave this place, perhaps not the happiest place on earth, but you will think like you should think.
Kevin: When we talked about glasnost perestroika, there had been five glasnost perestroika’s before the last one, and the idea was to loosen the ropes on the people. Let them be free for a while, and then tighten them again. The China of today is not the China of Nixon’s era. Are we seeing the old China reemerge at this point? Now, however, they’re much, much larger, much more powerful. But are they exhibiting the same neurosis that they had from the past?
David: Yeah. In many respects, not in all respects, but in many respects. Earlier this year, Geremie R. Barmé—probably pronouncing his name incorrectly—but he’s from Australia, a very famous Sinologist, teaches at the University of Canberra. “The Xi Jinping new era is a doleful time,” he said back in April. “Here’s China having achieved in the terms of its own modern history unprecedented riches—hard-won, if draconian, social stability, extraordinary achievements in every major field of pursuit. Yet it’s as brittle, bitter, self-absorbed, and neurotic a nation as it has been at any other time since the end of the Qing Dynasty.
Kevin: So, resiliency, when you talk about brittle and bitter and self-absorbed, that’s not resilient. I mean, the term resilient would mean that they’ve got flexibility. Is their past success over the last decades, is that possibly coming off the tracks? You were talking about Susan Shirk, she wrote a book called Overreach: How China Derailed Its Peaceful Rise. Is that happening?
David: Yeah, that’s out in the last week. I admit I haven’t read it yet. She was interviewed by Kaiser Kuo on his very informative Sinica Podcast—it’s one of the only podcasts I occasionally tune into. And the theater—if you look back at this last week in China—the theater of the past week in China, in which Xi is the lead, was a stated repudiation—a stated repudiation—of party rule, and a full-throttle defense of concentrated power.
Kevin: That’s that dictatorship.
David: Yeah, so the collective leadership which was instituted by Deng Xiaoping, this is being dismantled, and you’ve got strong man controls in place. This has been undone by Xi Jinping, and he spent two hours telling you all the ways in which the old era, this middle era of weakness in Chinese history, needed to be closed. And the weak era, of course, is Deng Xiaoping, his predecessors who were open to the reforms of the West. Again, it smells and feels like glasnost perestroika coming to a close, where all of a sudden there’s a tightening of controls, a closing of the gates, more than just at Disney.
Kevin: And that’s never good for markets. It’s never good for markets. Would you loan money right now on real estate in China? Would you buy stocks that are tied to China right now? Totalitarianism is never good for the markets.
David: No, and I mean, we discussed the Chinese equity markets, going back to the markets. Xi’s third term, the reaction there in the stock market in Shanghai, the Hong Kong exchanges, is nothing less than violent, nothing less than violent. But the debt markets are in an even worse state, and every day looking more and more like a death spiral. And again, we talk about this many weeks in a row, Vanke, the strongest balance sheet and the best bet for survival amongst the Chinese developers, has had its yields continue to ratchet higher. As yields ratchet higher, it’s telling you the stress and strain is increasing. We started the year at a 3% yield on their debt. Just a few weeks ago, it reached 10. Last week 16, today 21.
Kevin: Wow. A sevenfold rise. That’s amazing.
David: That’s as good as you get. Country Garden has jumped from a hundred percent to 119% from last week to this week. I mean, a hundred percent is nothing to sneeze at. That’s the largest of the largest developers in China, but not under the worst pressure by any stretch. The rest of the sector stretches, in terms of their yields on debt, 165 to 257%.
Kevin: So can the People’s Bank of China— I mean, we’ve gotten so used to interventions, central bank interventions. Can they do something about this?
David: Well, this is one of the reasons why, circling back around to China, to a lesser degree, Japan, it’s important to look at the enthusiasm in the U.S. markets and realize the fragility that we have on a global basis, because these are things that, in an interconnected financial world, do matter. Even if they’re not reflected on as frequently as they should be, even if they’re not in the limelight, they’re incredibly important.
The Chinese currency continues to reflect an increased stress, even with the People’s Bank of China and the commercial bank interventions of selling the U.S. dollar in support of the yuan. Chinese currency hit its weakest level since December of 2007 this week, right? Bloomberg reports that the PBoC has now cycled through most of its policy tools, leaving it with some tough choices. When you look beyond the currency, which is a very important tell, just as the yen is an important tell, Chinese commercial bank credit default swaps, what it costs to ensure against default in your major commercial financial entities in the mainland, they’ve moved to the next level higher.
Kevin: So insurance on volatility, basically, or insurance on failure, has gone up from 38 basis points to 126 basis points?
David: Well, that’s with Chinese sovereign CDS. That’s not with the commercial banks. Commercial banks are higher than that. If you’re talking about the possibility of default in Chinese sovereign debt, tough spot. We’ve seen the migration from 38 basis points earlier this year to 126. Sovereign CDS is not yet comparable in China to the weakness that you would find in a place like Turkey or Russia, but it has already caught up with Mexico, and it’s approaching that level. And it shifted much higher off of a low base.
Kevin: Well, the difference between Turkey and Russia and Mexico is they’re not almost as large an economy as the United States. I mean, we’re talking about one of the largest economies in the world, yet here in America you never hear about it. I mean, honestly, I’m surprised we don’t get comments from people saying, “Hey, why does David always talk about China?”
David: Because the number two economy is circling the drain. The number two global economy is circling the drain, and we’re pretending like that doesn’t have ripple effects into our markets. We could talk supply chains, right? We could talk the structure of finance and what happens to financial entities. You understand? We’ve got financial firms here in the United States who have been doing everything they possibly can, up to and including breaking the law, to have a presence in China. They want a piece of that action. What action exactly? You’re talking about a very dangerous financial structure within China, and anyone with exposure to China is going to feel it, is going to feel it.
Kevin: Where are the media outlets from the West talking about this stuff?
David: Right now we’re focusing on everything else. That’s right. Acute stress in the Asian debt markets is largely ignored by western media outlets because what they want to do is drum up more positivity for equities. Nobody wants to lose money. I don’t want to lose money. Nobody does. But the big stories highlighted in the financial news media here, they support a bullish case, and where there is silence, that silence is chosen. So, for the record, the changes in Chinese policy-making circles are not positive. Flight capital’s picking up. Currency weakness is obvious, and it’s going to force further action on the part of Beijing. Beijing has no intention of following the Japanese into a messy currency decay, and so we read articles like this from the Financial Times last week. Discussion of wealthy Chinese initiating their exit plans from the country.
Kevin: Bug-out of bags.
David: Again, we’re talking about the second largest economy in the world, which just went through their five-year plan—strategic plan—for the country, and we can ignore it, right? But when you have the wealthy Chinese initiating their exit plans from the country, this just points to another dimension of Xi’s power consolidation. My favorite quote from the article, “family motto has always been, ‘Keep a fast junk in the harbor—’” which of course is a boat. “‘Keep a fast junk in the harbor with gold bars and a second set of papers.’” The article goes on to say, “The modern-day equivalent would be a private jet, a couple of passports, and a foreign bank account.” I’ll stick with the boat and the bars.
Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at McAlvany.com, M-C-A-L-V-A-N-Y.com, and you can call us at 800-525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.
