Dear Subscribers,
The President is giving investors heartburn but his tactics,
if I read him correctly, are aimed at giving his negotiators some leverage in
dealing with China. The trade deficit
with China alone in 2017 was $375 billion.
In the first two months of 2018 the trade deficit with China has
increased by 10% over the same period as last year. Looking back at 2007 (before the financial
crisis) the deficit between the two countries as a mere $258.5 billion, meaning
it has grown by 45% in that time span.
Much of that increase is due to the theft of IP (intellectual
property). Some IP has been legally coerced
from multinational companies from the U.S., Europe and elsewhere. If you don’t hand it over you can’t do
business here.
China also cornered the market in most rare earth elements a
few years back by using its position at the time as the swing supplier. It could produce more rare earth elements
than it needed domestically so it would flood the global market with excessive
supply driving down the price thereby causing the closure of many mines outside
of China. Most notably for U.S.
investors was the closure of the Mountain Pass mine then owned by Molycorp
which spent a lot of money closing down its mining and refining operations.
Then China decided to restrict the supply of rare earths
which resulted in the price rising quickly.
Molycorp and other mining companies then spent a lot of money closing,
borrowing heavily, to reopen those mines and search for new resources. Billion were spent around the world on mine
infrastructure to take advantage of the higher prices. But then, as supply began coming back onto
the world markets, China once again flooded the market with cheap supply
forcing the prices down and many mines into bankruptcy. Chinese companies then went on a buying
spree, picking up many world class rare earth mineral reserves on the
cheap. China now accounts for around 95%
of world production of rare earth elements.
Rare earth elements are necessary in many electronic devices
as well as magnets and military equipment.
We can’t build missiles, planes or guidance systems without rare
earths. We also can’t build smart
phones. Further rare earth elements are
used in alloys to harden and strengthen metals such as steel and aluminum while
reducing the overall weight. These are
necessary to reduce the weight of cars, trucks and planes in order to improve
fuel efficiency. While we’re at it, the
rare earth metal, cerium, also makes such things and catalytic converters
possible to improve emissions from internal combustion engines. Wind turbines require huge magnets which rely
on rare earth metals. The list goes on
and on.
The problem is that while rare earth metals are in abundant
supply on a global scale those elements rarely occur in concentrations that
make mining financially feasible. The
Chinese have basically cornered the market and become the only reliable source
for resources that are critical to so many products we all take for
granted. The latest move by the Chinese
companies is an attempt to corner the global market on cobalt. Why is cobalt important? It is necessary for the production of
batteries. Everyone is so focused on
lithium that they forget that small amounts of cobalt are also necessary to
build lithium-ion batteries for smart phones, electronic and hybrid cars, back
up battery systems for facilities, home and the electric grid, as well as many
other electronic devices.
The big difference is that there are several sources of
lithium buy very limited supplies of cobalt, most of which are located in the
Democratic Republic of Congo, much of it mined
by hand. China already supplies 85%
of the world demand of refined usable cobalt oxides. The other 15% primarily comes from Finland,
but the source of the unrefined cobalt is still the Congo.
China has identified another critical resource that it can
easily control to take advantage of the coming increase in demand. EV (electronic vehicle) battery demand for
cobalt in 2017 was about 26,000 tones.
McKinsey, a global consultant, predicts that EV battery demand will
increase to 550,000 tones per year by about 2026. The price of cobalt has increased from
$26,000 per ton in 2010 to $90,000 per ton today. The increased demand combined with limited
supply options means that the price could go stratospheric in coming
years. Controlling the supply of such a
critical resource could put China in control of several more growth
industries. If the EV adoption worldwide
goes as projected, China could require all automakers to build their cars in
China. That is essentially what it did
with many electronic manufacturers using its strangle on rare earth elements.
So, the point to this potential trade war is much more far
reaching that the media has explained.
If America continues to sit on its hands, as our presidents have done
over the past two decades, our military and many of our manufacturing companies
will become solely dependent upon China for strategically critical
materials. We would not be able to build
fuel efficient cars, trucks or buses.
Nor would we be able to build planes and defense systems to defend
ourselves without permission from China.
China’s government does not want a level playing field. It wants to control the world economy and it
is making all the right moves to create that reality. This is not to say that China is doing anything
most other nations would not do if the rest of the world allowed it. Chinese leadership has been smart and the
rest of the world, including the U.S., have been downright dumb. They took advantage of us all and we were
stupid enough to let them do it.
Now, something needs to be done about it before it gets even
worse. President Trump may not be going
about it the way others would have him approach the situation. But, if we are not willing to take any risks
in the short term we will surely lose our economic independence at some point
in the future. It is just a matter of time
and time is running out.
Still, I do believe that most of what this U.S.
Administration is doing in all its bluster amounts to no more than positioning
itself to enable a better outcome at the negotiating table with China and other
trading partners. So, let’s think about
how bad this could get and what the more likely outcomes might be.
So far, a volley has been shot across the bow by America
toward China. China then shot a
retaliatory shot across the U.S. bow.
The U.S. shot another, even louder warning shot and is now awaiting the
response. To summarize:
U.S. = $50 billion tariffs against Chinese goods;
China now announces a $50 billion in tariffs against the
U.S.;
U.S. = addition $100 billion in tariffs against China.
The total of U.S. exports to China amount to about $150
billion per year. If China retaliates
with a quid pro quo response they will, in effect be placing tariffs on 100% of
U.S. exports. But the U.S. will still
have an additional $225 billion of imports from China upon which it could set
tariffs. This path, should it play out,
results in more pain to China than to the U.S.
So, what might China do to inflict more pain on the U.S.?
Well, it could sell even more (or even all) of its USD (U.S.
dollar) reserves and bonds. That would
create two problems for the U.S. but also another one for China. One probable result would be higher interest
rates in the U.S. and higher inflation for both countries. It could also result in credit downgrades for
both countries sovereign debt. Both nations
would end up buying less from each other hurting the respective economies. But that likely results, as mentioned
previously, in more damage to China than to the U.S. The value of the U.S. currency could fall
relative to other major currencies. On
face value, China might like that. But,
neither they nor any other U.S. trading partner would like the end result. A cheaper USD means our goods and services
would become much more price competitive in the global market. More producers would want to build plants and
produce what they sell to Americans in America to retain market share. The U.S. would be able to export more to the
rest of the world and China less.
The Federal Reserve may resort to buying U.S. debt, if
necessary, to shore up our economy and keep interest rates from rising too
fast. Other trading partners would also
lose export revenue to U.S. domiciled companies unless they took action. But if the U.S. focuses its tariffs on China
leaving the rest of the world pretty much unscathed what will those other
governments do? Would they risk jumping
into the middle of a trade war knowing full well that it would create a global
recession potentially as bad as the Great Depression?
The more likely response would be for trading partners to attempt
to manipulate their respective currencies lower against the USD. But, since the Chinese Yuan/Renminbi is
basically pegged to the USD, Chinese exports would then become more expensive
as a result, assuming the USD strengthened.
So, the net results would be only a temporary weakening of the USD
unless the Chinese government removed the peg.
But that would end up with the Chinese Yuan/Renminbi value rocketing
higher against most currencies of developed countries meaning Chinese goods
would become more expensive.
There is a very complicated web of interdependencies to play
out should both sides continue along the current path. The U.S. economy is more likely to survive an
all-out trade war better than that of China.
It would hurt everyone, but it would most likely cause much more lasting
damage to the Chinese economy. Of
course, this is all just my opinion and nobody, outside a few subscribers, are
listening (and maybe not even all of you).
The bottom line is that both sides understand the stakes and
the probability of it going that far is remote, in my humble opinion. But, in order for the U.S. to make any
headway in negotiations Chinese leaders must believe that our President is
crazy enough to back up his bluster. And,
he must not be the first one to swerve in this game of chicken. If he does, China wins.
Next, we need to have a better understanding of the
process. First of all, when the
President signs an executive order there is always a waiting period of 30 to 60
days before the tariffs are allowed to be implemented. After the implementation waiting period
expires there is a window of six months within which implementation must be
initiated or the tariffs will expire without being imposed. Why are the delays built into such documents? It should be obvious: to allow for a
negotiated settlement. Also, the tariffs
can be partially implemented at any time during the implementation window
piecemeal or fully implemented at the whim of the effecting party.
So, both sides have a lot of chips left to play before the
game is over and it could very well take until late summer or early fall before
any real damage is done with tariffs.
Both sides have a lot to lose but if China wins again, the entire future
world population will pay the price. If I
were a gambling man I would wager that Mr. Xi blinks first and a negotiated
settlement that is better for all parties (including our allies in Europe and
around the globe); well, except for maybe China. But the better outcome is a win-win which is
what the U.S. is striving for as opposed to a win-lose, which leaves China as
the eventual global winner. This should
be about balancing trade by removing artificial barriers to free trade rather
than winning at the expense of everyone else.
I believe that is where we are heading and what the U.S. wants. The big question left: Is China willing to
play fair with the rest of the world or will it risk everything to remain on
its path toward world economic dominance?
Whatever the outcome it will be interesting to watch the
gamesmanship coming from both sides. I
believe the most probable outcome will be one which opens up the Chinese market
more while allowing China’s leadership to save face. In the mean time, depending on how long this
media fiasco lasts, the markets will continue to be roiled. But, until actual significant actions are
taken the fundamentals underlying the U.S. economy remain strong. I consider this extreme volatility as a
potential opportunity to search for bargains should they appear.
Respectfully and Candidly,
Mark Bern, CFA
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