China is in Trouble

Today, China is in deep trouble.

The residential market has cratered. Consumers are angry, as they’ve lost money. Citizens are angry. There have been many, many lockdowns.
Cement cities are being torn down. Banks are in trouble. Safe CD-like investments offered through the banks backed by real estate in ghost cities are now known to be unsafe and nearly worthless. The banking industry is in a massive contraction/it is broken.
The impact is a reduction in consumer spending.
China is in recession, and it is no longer the economic engine of the world.
The Chinese leadership has slammed on the breaks… China is in deep trouble.
Global peace is facing a risk not seen in decades.
According to the book China’s Vision of Victory by Jonathan Ward, China’s agenda has now become clear to the free world.
The world benefited from low-cost Chinese manufacturing for the last twenty years. Prices came down and stayed down. The Chinese government encouraged and financed low-price manufacturing to gain market share and, in many cases, steal IP.
But the world has woken up. Companies are leaving China for friendlier shores where they won’t get caught in the geopolitical line of fire. Friend-shoring has arrived.
Manufacturing is shifting to Vietnam, Singapore, Mexico, friendly countries, and back home…
This all comes at a higher cost. It impacts company earnings unless they can pass those costs on to consumers.

Europe:

Europe is a mess.
The structure of the Euro was imperfect from the start. It was envisioned as a union of countries, which is different than a union of states.
It allowed less financially sound southern countries to benefit from Germany’s low interest rates. Debt levels swelled.
Rogoff and Reinhart studied hundreds of years of history and documented that debt becomes an impediment to growth. The line in the sand is 100% debt-to-GDP.
Italy is 352% of GDP, Portugal is at 440%, Spain is at 402%, France is at 549%, Ireland is at 888%, and even Germany is well above the important 100% threshold at 313%.
Mario Draghi presided over the European Central Bank during the Eurozone crisis and became famous throughout the world for saying that he would be prepared to do “whatever it takes” to prevent the Euro from failing.
He has failed as prime minister of Italy. A new far-right leader is likely to win the September 25 election.
Europe is a mess, as you’ll see in the following chart. Italy may crack first. But it could be any of the European countries. My focus is on Europe simply because of the politically challenging structure of the European Union.
Inflation is high in the U.S., and even higher in Europe.
Merkel closed all of the nuclear energy plants and shook hands with a mafia leader, Vladimir Putin.
The Nordsteam II is his economic weapon. Germany made itself dependent on Russia and China.
A strategic miscalculation.

Oil – Middle East & Russia

Russia has limited excess capacity and is using oil in its economic war with Europe and the U.S.
Russia is selling their oil to other countries at a discount but they have limited excess capacity, and with Haliburton’s exit from Russia, talent is lost. Their technology is far behind. Russia’s production is hurt by the exit.
The US has excess production capacity with vertical and offshore drilling. However, there is little new drilling due to Biden’s ESG objectives so oil companies are returning cash to shareholders, either through increased dividends or share buybacks. The number of new leases issued under Biden is at an all-time low.
Trying to partner with Iran for oil is a mistake as long as the country is run by radical leadership. There is no good business with bad people!
Our new OPEC friend believes that even if we cut a deal with Iran, the supply is not enough to move the needle, and their drilling technology is decades behind.
That spells higher prices even if Iran comes back on.
The strategic petroleum reserve in the U.S. is low and will need to be replenished. This buying demand should support higher prices.
Winter is coming, and governments are advising citizens to cut back on energy use, especially in Europe due to Putin’s chokehold on supply.
Even California, with its mission to go 100% EV by 2035, is telling its citizens to cut back and refrain from charging their electric vehicles.
While it’s an inspiring goal, the system is not equipped to deliver wind and solar energy….. yet. Nuclear energy, yes, fossil fuels, yes.
We’ll get to a much better fossil-free world, but we are nowhere near that point, and we need oil, natural gas, and nuclear to get there. Windmills require tons of cement and forged steel, for instance. We need some fossil fuels to make that happen.
Oil and natural gas shortages mean logistics costs rise, manufacturing input costs rise, and consumer utility costs rise, which means inflation rises.
Oil is likely going up in price.

United States – The Fed & Markets

I take Powell at his word in regard to his conviction to fight inflation.
Few in the press are noting the Fed is pulling $95 billion per month out of the system. Think of it as draining liquidity out of the system.
This is happening at the same time the Fed is raising interest rates. I expect another 75 bps bump in September to 3.25%
Inflation above 5% has never come down until the Fed funds rate was higher than inflation.
Inflation is at 8% and likely declining. We have a ways to go.
QE is different than QT. This QT is different than prior periods of tightening.
September won’t be the last rate hike. And I believe the Fed will tighten until something breaks.
Then more sugar (QE). Then a better outlook for equities.
The first wave of the market sell-off was margin selling. The level of margin debt has declined significantly. Still high, but not insanely high (see chart).
The next wave will be earnings-driven, as in a drop in corporate earnings causing valuations to adjust lower.
The average bear decline market in a recession is in the high 30% range. My best guess, and it’s only a guess, is 3,200 on the S&P 500 Index. Logic is driven by fair valuations based on 58 years of valuation history and technical support. 3,200 is the pre-covid high.
The yield curve remains inverted. A recession is unavoidable. Frankly, they happen, they are somewhat healthy for the business cycle, and we always get through them.
The U.S. economy and the markets are not yet out of the woods.

US Economy

For now, US economic indicators show few signs of a recession. In contrast, China’s economy has been slowing amid lockdowns, while the Eurozone and the UK face an economic contraction as the energy crisis worsens. This divergence sent the US dollar to the highest level in nearly two decades.
US job creation remains above pre-COVID levels, with 315k payrolls added in August.
In a positive development for the Fed, more Americans reentered the labor force last month, moving the unemployment rate higher and boosting the labor force participation rate.
Export orders slumped, which points to weaker US exports ahead.
The stock market still points to downside risks for US manufacturing activity.
Construction spending declined for the second month in a row in July, driven by softer residential construction.
Vehicle sales remain soft amid tight inventories
The ISM Services PMI topped forecasts, showing robust service-sector growth in the US.
With no signs of recession in services, Treasury yields jumped.
Price pressures persist but are well off the highs, which points to slower consumer inflation ahead.
A similar PMI report from S&P Global paints a very different picture, suggesting that service-sector activity is contracting rapidly for global services.
Auto loan delinquencies have picked up this year.