An important geoeconomic hotspot

Wednesday, 27 July 2022 — Albert Park

[7 min read]

Dear Reader,

In his last edition for The Daily Reckoning Australia, Jim Rickards explained the importance of geoeconomics for understanding the investing environment we are in now.

Today, he will focus on one critical hotspot for strategic thinkers — China and Taiwan. While much attention is being given to the Russia-Ukraine conflict lately, it’s important not to forget the possibility of invasions elsewhere.

And Jim Rickards is perfectly positioned to explain this conflict and how it could impact your investments. Keep reading to find out more.

Regards,

Callum Newman,
Editor, The Daily Reckoning Australia

Dear Reader,

A critical hotspot engaging strategic thinkers today is the potential for a Chinese invasion of Taiwan. Of course, China has the world’s largest population, the world’s second-largest economy, and the world’s fourth-largest nuclear arsenal.

As a result, China is at the centre of many more complex dynamics than the Taiwan issue. Still, none have as great a potential to expand into a shooting war between great powers (the US, China, Japan, and Australia) than a move by China to invade Taiwan.

Again, some background is a good way to begin the analysis. Following the defeat of Japan in the Second World War and the end of the US occupation of Hopeh and Shantung provinces, the Chinese Communist Party — led by Mao Zedong — and the Nationalist Party — led by Chiang Kai-shek — resumed a civil war for control of China that had begun in late 1928.

By 1949, the Communist Party had taken control of mainland China, while the Nationalist forces retreated to the island of Taiwan and some smaller nearby islands. Both forces declared themselves to be the legitimate government of China, with the Communists proclaiming the People’s Republic of China (PRC) and the Nationalists proclaiming the Republic of China (ROC).

Comparisons of PRC and ROC based on size are slightly misleading, because two-thirds of mainland China is mostly uninhabitable deserts, mountains, and high plateau. Still, there’s no question that mainland China dominates the comparison by size and population. But Taiwan has a significantly higher per capita GDP and has emerged as a technology giant on the global stage.

Who’s in charge?

The US recognised the ROC as the legitimate government of China from 1949–79, at which time the US began full diplomatic relations with the PRC. This change in policy was initiated by Richard Nixon and Henry Kissinger, with Nixon’s historic visit to Beijing and Shanghai in 1972.

The US has nevertheless maintained informal relations with the ROC despite recognition of the PRC using various institutes and NGOs as channels. The US is a major arms supplier to the ROC, although no formal defence treaty exists.

Importantly, China has never considered Taiwan to be a separate country. It’s referred to as a ‘breakaway province’. Any country that offers any diplomatic recognition to Taiwan is punished with severe trade and financial sanctions by China. Lithuania discovered this recently when it allowed Taiwan to open a representative trade office in its capital, Vilnius. Lithuanian exports to China immediately collapsed, as China imposed a near-total trade embargo.

The period from 1949 to today has been an uneasy status quo in which Taiwan has thrived economically, and China has experienced a period of world-historic economic growth, beginning in 1979 and growing exponentially since 1994, under the leadership of Deng Xiaoping and his successors. The two-government fiction was maintained, even as countries around the world moved to recognise the PRC and deal with the ROC informally.

One of the biggest breakthroughs has been the rise of ROC investment in PRC and the integration of the two economies, especially in the areas of high tech and manufacturing. Those who travel from Shanghai to Taipei are familiar with the fact that the flight departs from the ‘domestic’ terminal, not the ‘international’ terminal, because China regards Taiwan as part of one country.

The liberals’ unrealistic expectations of Communist China

This status quo might have continued indefinitely if not for two critical developments: the disillusionment of liberal elites in the West and the rise of Xi Jinping in Communist China.

From the advent of globalisation in 1989 until the global financial crisis of 2008, liberals in the West clung to the idea that economic growth in China would lead to political liberalisation. In a nutshell, liberals believed that with enough time and enough prosperity, China would become ‘just like us’.

This elite plan for the gradual liberalisation of China was the driving force behind the admission of China to the World Trade Organisation in 2001 and the inclusion of the Chinese yuan in the IMF’s world money basket (the SDR) in 2016. China didn’t technically qualify for WTO or SDR status, but it was being ushered into these elite clubs on the view that China would soon conform to what are known as the rules of the game.

This view was amplified by the huge numbers of Chinese students attending elite US universities. The belief was that Chinese students attending Harvard, MIT, and the University of Chicago, among other schools, would return to China, assume leadership roles, and implement polices like those being pushed by elites in the US who had attended the same schools.

This rosy scenario was captured in an excerpt from Foreign Policy on 19 January 2022:

‘After the Cold War, Western elites concluded that realism was no longer relevant and liberal ideals should guide foreign-policy conduct. As the Harvard University professor Stanley Hoffmann told Thomas Friedman of the New York Times in 1993, realism is “utter nonsense today.” US and European officials believed that liberal democracy, open markets, the rule of law, and other liberal values were spreading like wildfire and a global liberal order lay within reach. They assumed, as then-presidential candidate Bill Clinton put it in 1992, that “the cynical calculus of pure power politics” had no place in the modern world and an emerging liberal order would yield many decades of democratic peace. Instead of competing for power and security, the world’s nations would concentrate on getting rich in an increasingly open, harmonious, rules-based liberal order, one shaped and guarded by the benevolent power of the United States.’

Realist observers never put much stock in this view. They insisted that communism was a pervasive ideology, that the Chinese Communist Party maintained rigid control, and that any dissenting views would eventually be wiped out. China would take the economic gains (and intellectual property theft) from interaction with the West but would otherwise stay on the Communist road.

The realist view was always correct, but it took the liberals 30 years to see reality. The awakening of the liberal elite to the reality of Communist China — including slavery, genocide, concentration camps, thought control, arbitrary arrest, and torture — is now in full swing. Detailed policy responses vary, but Democrats and Republicans are united in the view that China is an adversary, if not an outright enemy, and needs to be confronted on both economic and humanitarian grounds.

So make sure you keep this reality in mind when you’re investing…

Regards,

Jim Rickards,
Strategist, The Daily Reckoning Australia

This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events. Learn more here.

Dear Reader,

Jobs. And houses. Houses and jobs.

Those are the two pillars of US middle class living standards.

Jobs provide income. Houses are assets that can be readily sold. But it looks to us like the housing pillar is beginning to crack.

Here’s the latest, from TheStreet: ‘More Americans Are Canceling Home Purchases. Here’s Why’:

‘For two years, home sellers have had all the leverage. Now, that may be changing, as more home buyers are canceling [sic] purchase contracts.

‘According to new data from Redfin, about 60,000 U.S. home sales fell through in June 2022. That’s about 15% of transactions that went into contract for the month, and it's the highest share of cancellations since April 2020.’

Consumers are very sensitive to interest rate changes — and for good reason. The difference between a 3% mortgage on US$200,000 and today’s 5.8% is nearly US$500 a month.

Which is why demand for refinancing has fallen 80% over the last year.

Fake wealth

We remind readers that in a healthy economy, wealth increases as goods and services are offered. But in the fake economy of the last 30 years, people enjoyed fake wealth by refinancing debt at lower and lower interest rates.

Lenders don’t draw down savings; they create new money. This new money is what bids up asset prices — stocks, bonds, real estate. People feel richer when their assets go up in price. But it’s a mirage. And then, when the refinancing stops, the fake wealth disappears.

Let’s back up to get a better view.

The feds pumped up the supply of money and credit for decades — leading to today’s grotesque economy. Instead of encouraging saving and investment, the Fed’s ultra-low interest rates led to speculation, borrowing, and waste — with trillions of dollars squandered by the government and the private sector. The feds ‘invested’ in bailouts and boondoggles that would never produce a positive return. Private investors funded businesses that lost money year after year…or bought cryptos that never produced any wealth in any form.

Then, in the COVID panic, the feds went too far. Cutting back on the supply of goods and services (lockdowns)…while printing trillions’ worth of new ‘demand’ (stimmies, PPP, deficits, money printing)…was sure to lead to higher prices. Even Former Treasury Secretary Larry Summers saw it coming. And now it’s here. The latest readings showed inflation at 9.1% — highest in 41 years.

All of a sudden — but not surprisingly — the Fed finds itself ‘behind the curve’. Consumer prices are rising. But the Fed’s lending rate is far below where it needs to be — about 700 basis points (7%) too low. So the Fed has begun a ‘tightening cycle’ — too little, too late.

A bull to bear

Meanwhile, the return of consumer price inflation coincides, more or less, with two other major shifts. After 40-plus years, the credit cycle is also finally rolling over. And the bull market in financial assets has turned into a bear market.

Stocks turned down at the end of 2021. They had been going up for most of the last four decades. Now, they have given up about 15% of their value. There is nothing very noteworthy about this correction. Except! The other downturns — 2000 and 2008 — happened when the Fed was not so far ‘behind the curve’. Then, the Fed could lower its key interest rates and get the party going again.

This time, the Fed must raise its lending rate to fight inflation. In other words, it can’t jolly investors up with lower rates…nor can it make it easy for households to refinance their debt. This is the major difference between today and every other sell-off since 1982. This time, the correction will have to run its course. At least, for now.

That is why ‘buying the dip’ probably won’t work. And it’s why US households may soon feel pinched.

Bonds topped out about two years ago, with the yield on the 10-year T-note (which varies inversely with bond prices) at only 0.59%. It’s now more than 3%, or five-times higher. As the leg bone is connected to the ankle bone, mortgage rates are connected to bond yields. As recently as October 2021, homebuyers could borrow below 3% for a 30-year mortgage. Now, they’ll pay 5.5%.

That’s a big difference. And the consequences are just beginning to show up. Here’s The Washington Post: ‘The US housing market is entering a “deep freeze” as surging borrowing rates and sky-high home prices hit buyers, Moody’s Zandi says’:

‘Data on Wednesday showed a drop in existing home sales to a two-year low in June. The National Association of Realtors reported seasonally adjusted sales hit a rate of 5.12 million last month, the lowest since June 2020, and below expectations for 5.38 million.

‘“It makes sense, with the higher mortgages conflating with higher house prices, first-time homebuyers just can’t afford to buy in. They’re locked out, and trade-up buyers, they’re locked in because if they sell and buy, they’ve got to get another mortgage at a higher rate and their monthly payments are going to rise,” Zandi told CNBC’s “Power Lunch” on Wednesday.’

Refinancing is history. So is, we predict, the bull market in house prices.

Stay tuned...

Regards,

Bill Bonner,
For The Daily Reckoning Australia