China Plays Hardball While America Parties On:

Welcome TSIBR readers to the first major essay update of 2010. Before we begin, allow me a word regarding my life and this blog. Longtime readers understand that this blog is, in effect, Josh Kane, Ph.D., writing a book in real-time, that will be presented in the future as having been written in real-time during one of the most momentous junctures in known human history. That’s a mouthful, but what it means is that this blog has a key motivating factor, beyond readership, that will keep it going whether people visit or not… we’ll be here. Nevertheless, people have been visiting, and I couldn’t be more pleased or grateful; the more hits I get, the more excited I become about this project, and it shows in the quality of the work. But please understand that Joshua Kane is only one man, a man that spends a lot of time investing, working on his entirely unrelated academic book (as an avenue toward re-entering professional academia at a high level if I ever should so choose), and raising his son.

That being said, I believe there are two main ways that this blog can serve the general public: 1) By getting out in front of backpage news stories that will soon burst into headlines. 2) By tactically providing key insights into stories that have already broken into headlines. I try my best to do the former with great alacrity and precision, but the task is beyond difficult. So I most often find myself stuck in number two, which is where we are now – providing key and unique insights into stories that have already broken. I hope, and profoundly believe, readers will find the following insights and interconnections somewhat unique and ultimately useful. In two major essays posted over the next two days we’ll be covering TSIBR’s 2010 market outlook first, and in the second essay the developing situations in Yemen, Af/Pak, Iran, and all of their many interconnections. Away we go…

TSIBR 2010 MARKET OUTLOOK:

So far early 2010 seems to be shaping up like early 2008; and that should not be surprising, as nothing fundamental has changed since that time. At the beginning of 2008 the markets had reached a point where all the monetary excesses of the previous decade had gravitated into commodities; some called this a bubble, TSIBR called it inflation. The commodities ‘bubble’ was the only real way for Wall Street to make money in 2008, and since Wall Street had become the entire economy (another consequence of monetary excess), the entire economic edifice built up around Wall Street was bound to crumble if the commodities ‘bubble’ burst. Starting in June of 2008, with oil soaring towards $150 and global fears regarding inflation mounting, the financial authorities of America, led by the Fed, pricked the commodities bubble, by raising interest rates and using other more surreptitious methods of preventing money from flowing into key commodities. By that August the wheels were coming off the entire global financial system, and we entered a period of acute and rapid deleveraging that tanked prices in all asset categories across the globe (what TSIBR referred to as a deflationary wave).

The solution to that problem of course has been to fire up the printing presses to levels heretofore unforeseen in a bid to reflate the economy, and it has worked, kind of… HOWEVER, we are right back in the same situation we were in prior to the collapse, i.e. the only real place for Wall Street to make money is the commodities ‘bubble’, and Wall Street remains the economy. As long as the Fed continues printing as necessary to keep the commodities bubble inflated, the wheels will stay on the financial system. But what happens when oil again approaches $150 and the world begins to fear hyperinflation? Second half of 2008 redux, but probably far worse this time, mainly because Bernanke has already thrown his whole playbook at this mess, and everybody knows it.

So how does TSIBR plan to play these churning waters – the TSIBR portfolio will be looking to game rising gold, energy, and agriculture prices with a mix of ETFs, midcap, and large-cap stocks. However, TSIBR will be on the lookout for events that will tip us back into acute deleveraging at a moments notice. Kane’s finger will be on the sell trigger daily, believe dat; the possibility is there for a stock portfolio to drop by half in a blink of an eye this year, believe dat; trade accordingly.

Now let’s look at some of the potential occurrences that would likely foment a renewed bout of acute deleveraging (i.e. collapsing asset prices), and there are many. Here Paul B. Farrell reviews 12 of the most erudite financial and market mavens the world has to offer, most are scarily pessimistic, and expect a renewed and deeper collapse within the next two years:

http://www.marketwatch.com/story/12-dr-dooms-shred-2010-investing-optimism-2010-01-05?pagenumber=1

Meanwhile the banks are still very much on life-support, and are in no shape to withstand any sort of serious financial downturn or renewed crisis:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aNQ2cLJ8kCLo&pos=6

Most attempts at reworking loans have failed, and new foreclosures will be hitting key markets, thus the housing sector looks to be rolling over again. A few bad housing numbers would tank the entire US stock market quickfast:

http://www.marketwatch.com/story/pending-home-sales-index-plunges-16-2010-01-05?siteid=nwham

http://www.nytimes.com/2010/01/05/opinion/05tue1.html?hp

Additionally, commercial real estate, globally, has yet to fully correct from a decade of excesses, and as TSIBR harped on last post, the issues in commercial real estate are sizeable, complex, largely remain hidden on bank balance sheets, and intricately intertwined with the sovereign debt crisis. That complex intersection is the most likely area where an event could suddenly develop that would have Americans waking up to a 20% general loss in their stock portfolios, even though Europe has far more exposure to emerging sovereign debt / global commercial real estate problems. That is because if the Euro tanks (which it will on sovereign debt default fears), the dollar rises, and commodities get smacked in the US market. The three following articles review the key issues and interactions:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aD30hm2UDGeU&pos=3

http://online.wsj.com/article/SB10001424052748704398304574597832779853024.html

http://www.bloomberg.com/apps/news?pid=20601110&sid=a1R_ghfZ20rw

While the following articles focus more specifically on the EU and the serious potential for a default coming from Greece and/or Spain (and let’s not forget the Eastern European and Baltic states besides):

http://www.marketwatch.com/story/debt-disaster-fears-rumble-from-athens-to-london-2009-12-16

http://www.marketwatch.com/story/ecbs-stark-warns-no-bailout-for-greece-2010-01-06

Here we have an article covering the rushed opening of the tallest building in Dubai, and the world, now named after the Abu Dhabi King, whom so far has deigned to save Dubai’s butt. Nowhere are the intersections between sovereign debt and commercial real estate more clear than in Dubai. We’ll not re-delve too far into that here, but just take a look at these pictures and quotes – tell me they don’t scream the apogee of a deluded age:

http://www.dailymail.co.uk/news/worldnews/article-1240280/Burj-Dubai-tallest-building-world-opens-just-months-debt-crisis.html

Moving on, let’s review how Chinese-American relations are fairing during this economically momentous era. In a few words – not too well. Here is an excellent article by Morgan Stanley economist Stephen Roach that reviews the potential for a double-dip in 2010 (Roach places the likelihood at 40%), and closes by mentioning that deteriorating Chinese-American relations might in and of themselves foment a double-dip:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a1J8dLRoGYgU

China is really playing hardball here, and Americans don’t get it at all. While paying lip service to the importance of the dollar, China is moving at breakneck pace to diversify away from dollars while lingering fears of crisis put a bid under US Treasuries, thereby camouflaging China’s determined path towards exit. And of course, what is China doing to diversify? Shifting into commodities in a big way:

http://online.wsj.com/article/BT-CO-20100103-703765.html

http://www.reuters.com/article/idUSTRE5BS33Y20091229

TSIBR is convinced that China has few interests in the US coming out of its indebtedness to China in a way that allows the US to maintain and enjoy continued hegemony and supremacy in the world. It makes far more sense for China to expect a dollar collapse, and position itself accordingly so that it comes out of that dollar collapse in an entirely strengthened position vis-à-vis the US. When the dollar collapses, China will have all the resources it needs to further and heighten its power. Will the US?

One can see that China is playing this kind of hardball, with little respect for former US power, and even less for current US economic institutions, and even less for future America, in the way that Chinese officials are managing their currency, trade, and derivatives portfolios. To begin with, the main factor behind global imbalance and monetary excess has been China’s constant decades long devaluation of the Yuan. As TSIBR has covered and covered, the global economy will never find balance without China floating the Yuan, but China will float the Yuan only when it is in China’s interest to do so. In other words, only once China feels diversification out of dollars is proceeding rapidly enough will China begin to let the Yuan float. This is because when the Yuan floats, the dollar will tank.

The game that is on then is this: China wants American debt to be rather meaningless to its overall economic prospects before it floats, which means that the US has to become rather meaningless to China’s future economic prospects before China will float. In the end, the US will default on its debt, but China will hardly be hurt by this because China will have moved enough of their dollars into commodities (and anything else they may need) before the collapse, and therefore emerge relatively unscathed. The consequences for the US meanwhile would be absolutely disastrous, as a Weimar type hyperinflation sets in. That is the game China is playing, and if the US doesn’t wake up to it soon, its going to be left an economic shell of itself, hollowed out by shrewd Sun Tzu type Chinese financial hardball. Peruse the following series of articles on Chinese-American financial/trade relations and tell me you don’t read this hidden Chinese Agenda between the lines:

Trade war brewing:

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aWprXfE.mEZQ

China’s recent refusal to pay Goldman Sachs on state-owned company derivatives losses is another hidden avenue by which a renewed bout of acute deleveraging could obtain. As the following three articles explain:

http://www.ft.com/cms/s/0/9d3ce434-e029-11de-8494-00144feab49a.html?nclick_check=1

http://news.goldseek.com/RickAckerman/1260255720.php

http://www.reuters.com/article/idUSSGE5BS09T20091229

The world needs a global currency, and yet China won’t even cooperate on the Yuan:

http://www.business24-7.ae/Articles/2009/12/Pages/26122009/12272009_b60d075ae8834ca981282abc0ee85802.aspx

http://www.bloomberg.com/apps/news?pid=20601087&sid=acJMghnTtDt4&pos=5

http://www.bloomberg.com/apps/news?pid=20601080&sid=aLHD8QY9fQsU

In the final analysis, the key imbalance that has caused all of the other imbalances in the global economy is China’s refusal to float the Yuan and America’s allowance of this for well over a decade. TSIBR is of the mind that there is no escaping the current levels of imbalance without entire reconstruction, which for obvious reasons requires near-absolute collapse. Truthfully, the sooner the collapse comes the better it will be for the US. China is only gaining in power, if they can wait to float the Yuan until it doesn’t hurt them much, meaning the US and its dollars are relatively meaningless to China and its resources at that point, then the US will have entirely lost the game for future global economic and political power. The consequences for American children could be grave.

That being said, does TSIBR believe the imbalances of 2010 will resolve in a hyperinflationary melt-up and then crash, or will a sudden renewed bout of acute deleveraging (a deflationary wave) take us by surprise before that point? These are the two most likely paths going forward, but which is most likely? Prior to 2008 TSIBR was firm in its belief that the path would be hyperinflationary to the end. Now we’re far less certain. What became clear in late 2008 is this: yes the government has the power to print up dollars at will, and yes, in the final instance the government will print up dollars at will. But the global financial system has become unimaginably complex, and although the government can print dollars, what it cannot do is get those dollars everywhere they are needed at once in order to forestall panic; and once panic sets in that problem becomes only greater, until panic finally subsides. This then is the path that TSIBR sees most likely in 2008: building inflationary pressures until some surprise event stokes panic thus causing a renewed bout of acute deleveraging, with the dollar and Treasuries rising as everything else rapidly sells off. Stay nimble, stay informed, and stay tuned. TSIBR turns to the political side of the 2010 political-economic coin tomorrow.

Joshua Kane