The Far East Trade:

A perspective on the possible emergence of China’s Renminbi ¥ as the world’s new reserve currency, and the global economic rumblings as it unfolds

It is hard to not admire the bull market we have seen in equities over the last few years, and not believe the

U.S. economy is back in full throttle. The equity market’s chisel run-up from the depths of disaster, through the morass of mayhem, to now near the peak of its all-time ascension can only be summed as remarkable.  That’s if you believe in free lunches!  Last week’s one day 25-basis point slide in the 10-year treasury, in the face of positive economic news, apparently was the “canary in the coal mine”, and a signal to the broader markets we may be heading back to base camp.  

In contemplating the inevitable, and the rationalization that the markets were likely fueled by the Fed rather than on real economic growth, has left market experts befuddled. Their trophies of investment brilliance were more hype than truth.  In light of the fact that I have been long-term bearish on the U.S. dollar for quite some time, the recent market action reinforces my macro view that the U.S. markets will be an inhospitable place to be a bull. 

The Trade Winds of Fortune:

It has been obvious for quite some time that to look for strong sustained economic growth, you would be wise to head east, and the Far East to be exact.  Stretching from the rim of the Northeast Pacific, to the feet of the Himalayas, is the land of the “Rising Yuan”.

The commonsense in migrating east is not simply to purely invest in Asian markets, but more importantly to get a more intelligent understanding of which way the “trade winds” of investment opportunity are blowing.  Having to migrate to some far away land, chasing fortunes and adventure is reminiscent of the tactics used by swashbuckling characters, interlopers of the high-seas, as they too famously sought out the trails of the world’s bounties. For these unappointed money managers, in some circles, known as pirates, determining the opportunities for immense returns also required, not unlike today, great intelligence, navigational skill, risk and courage.   Preferring the wisdom of seasoned traders over a galley of PhDs, their judgment often did uncover direction and location of a great deal of the world’s wealth.  In juxtaposing the two realities regarding a massive migration of capital, the commonalities are strikingly similar.  The logic of profiteers was surely not based on quantitative analysis, but on the realization that where there is real fortunes being made, there is a higher likelihood of gaining wealth.

The China Unwind:

For the China bulls, the 10% year-to-date decline in the Hang Seng Index, and the recent less than stellar economic news about the woes in China’s domestic economy, hasn’t bode well for “beast is in the east” theory.  Summed up in classic “Wall Street” edict, China is an increasingly complex market with various independent economic drivers, that each plays an integral role in shaping the China story.  What that really means is, internally China is still an emerging market, cleaning up a wild wild west mentality, where often the failure of an enterprise was viewed as, not about the lack of execution, but rather not enough money was thrown at it.  Begs to ask the question, why are you not there already?

This aptly named, shadow banking system exist throughout mainlain China, and is the chief mechanism for the distribution of capital to China’s equivalent of main street.  Of course operated by government officials, who are part of the fabric of the PRC (Communist Party), in some sense, this loose lending practice can be construed as our famous “hearts and mind” operation we exercised in Iraq.  By the way, has Congress given us a full report on  the “return on capital economics” of lending by helicopter?  I certainly think it should be part of our on-going “quantitative pleasing” program I will discuss shortly.

It goes without saying, in land of the rising Yuan, this shadow banking scheme has piled up a “Shanghai” amount of bad loans on the books of the PRC, but it only gets worse.

If there is one thing we learn while walking by an economics 101 class in session, is money has to find a home!  At the crux of China’s current economic malaise is the liquidity squeeze -  a direct result of “hot-money” fleeing the main-land, as exorbitant expectations of American-like returns became difficult to realize.  Not unlike the go-go days in the U.S. real estate markets, Chinese were investing excessively in real estate, and tapping the over-valued land, to facilitate the shadow banking industry that provided perhaps well over a trillion in speculative loans to their burgeoning economy.  Realizing the PRC was about to severely curtail the sky-rocketing rise in real estate prices, fast money and foreign financiers weren’t willing to stick around to see the after effects of China’s Central Banks punitive measures. Perhaps a good idea…

The goal of the Central Bank was simple.  Rein in speculative lending in its shadow banking industry. In a series of swift, but draconian measures, the party in China’s real estate market was brought to a halt.  One measure that distinctly comes to mind, is the increase in the initial equity capital requirement (“down-payment”) to upwards of 60%.  Seriously folks, that’s all it took to chase the wolves off the sheep farm, and I doubt the legislation was written on more than two sheets of paper.  More than likely the calligraphy was scribed and posted to a tree, and with China’s equivalent of “Hans Zimmer” on the Gongs, the entire town was notified of the new rules.  Of course the enactment of the law was much more sophisticated, but you get the picture.  China was having no part of real estate driven inflation hijacking their rise to hegemony status.

What’s left behind is carnage my friends.  The kind that brings most Fiat systems to their knees or to the printers if you have a willing populace.  As it stands today, with land values possibly two to three times above fair market value, the resulting write-downs or revaluation has been painful to the Chinese nonetheless. So much so that the Chinese over-exuberance may lead to a 3% to 5% hit to GDP.  Unlike the U.S., with over three trillion in foreign exchange reserves, this minor pullback is likely to barely register on China’s economic Richter scale.

The Rise of the Machine:

As the rest of the developed world is tinkering with their economic engines, in seeking out new industries for growth , China is actually stepping on the accelerator. Realizing its low-margin manufacturing industry is becoming less profitable as the country’s labor cost increases, China is embarking on new initiatives to increase production in high-margin industries.  It is expected China will ramp up manufacturing of cars, airplanes, heavy equipment, and machinery within the next year.  Moreover, per a recent conversation I had with Dr. Alfred Liu, President of Chinese engineering and architectural firm AEPA International, China has embarked on the development of an enormous technological city near the Yellow River Delta area outside of Beijing.  Ok, enormous probably does not register on the imaginary scale, but maybe the fact that this new purely technology city may approximate half the size of Manhattan would put things in perspective. 

It should be a surprise to no one, that China has gained the technological expertise to move up the value chain of manufacturing and development. After all some of the largest companies in the U.S., including General Motors, Ford, Caterpillar, General Electric, and Boeing have moved substantial segments of their production business to the Far East. Be it driven by greed or hasten by trade unions, it can only be assumed that these U.S. manufacturers envisioned a wealthier China that would be buying incalculable amounts of these very same products someday.  Before I go on, let’s digest that thought process for a sec.  Say I’m one of these overpaid executive, Boeing to be exact.  My planes are made in at various plants in China, then shipped to my facilities in the U.S., so we can “Lego” it together, then sold back to the Chinese at prices reflecting “made in America”.  Wow, I hope you guys got that, because that makes complete sense to me (sarcasm)!

Well I’m not going to ridicule these brilliant executives much, since they were partially clairvoyant, the Chinese are much richer now, and we can safely assume a bit more clairvoyant also. Since, not only will China have the benefit of advanced capabilities to move up the value chain of manufacturing, more than likely they will have the customers of these American companies too.

The “People’s Currency”, the Renminbi (aka the Yuan):

If we follow the recent trends in bilateral trade treaties, we would see that this year alone China has gone from having only two direct foreign currency trading relationships, the U.S. and Japan, to now at least six and growing.  Albeit, not likely to massively trade outside the mainland, I would venture to say the opportunity to outright directly trade in Chinese currency, the Renminbi (“RMB”) is near.  Matter a fact, what’s more remarkable is the push to internationalize the Renminbi, is just as much coming from China’s trading partners as it is from China, and get this - increasingly some of these trading partners are America’s staunchest allies, which I use rather loosely given our current state of affairs.  Backing up my point is an interesting speech, on July 3rd by Joachim Nagel, an Executive Board member of Bundesbank, the equivalent of the U.S. Federal Reserve, in Frankfurt, in which he stated,

“given China’s growing economic importance, the internationalization of the Renminbi seems long overdue”.  Joachim went on to say, “The high level of interaction between China's and Germany's real economies highlights the necessity for a more active Renminbi trade”.

Nowadays you can’t be sure that Washington is listening to anything except what’s going on in the echo chamber, but considering that one of America’s staunchest allies is ostensibly calling for an alternative to the U.S. dollar, has got to be viewed as a definite signal that the “demise of the dollar” is now accelerating. 

Bear in mind, this speech follows on the heels of a $33 billion bilateral currency-exchange swap agreement between the U.K. and China in mid-June, the first such bilateral currency agreement with a major European nation. Further, just prior to the U.K.’s move to the Renminbi,  Australia and New Zealand had decided to ditch the dollar in its billions in bilateral trade with China.

What’s all this to say? The takeaway is not the monetary value of the currency agreements - after all, China now has over $2 trillion in cross-currency agreements with over twenty countries, but more so it reflects China’s “comfort” strategy to slowly chip away at the dollar as the world’s reserve currency.  In essence, China’s is befriending America’s allies, in an effort to mitigate the usual suspects actions in seeking to undermine the possibility of the Reminbi gaining hegemony currency status.  In my estimation, if Europe goes, so goes the dollar. China knows that, and it needs Western Europe to gain complete comfort in trading the Yuan. As such, this is the precursor to the desires of true global investors: the opportunity to invest worldwide in Yuan denominated assets, which according to Joachim Nagel is the next evolution in the Renminbi.

The Bulls and the Bullion:

If you have been following us, you would have already heard of the recent wars in the currency pits over the machinations between bullion and paper gold (Gold ETFs).  Frankly, it is impossible to have a global battle for currency supremacy, and not have the crowd spill over into the world’s gold pits.

The ongoing saga reflects a mysterious conundrum  as a result of the disconnect in pricing between physical gold and paper gold.  Let’s face it, investors large and small, want to purchase physical gold, the hard-stuff, irrespective of the fact that physical often trades with a bid/ask “premium” relative to gold ETFs. Much of this can be attributed to retail Indian buyers, who are willing to over-pay for the precious metal.  Unless you’re Indian, you should consider yourself fortunate you don’t have to buy Gold to pass on as a “dowry” (marriage gift).  I’m sure the question has been asked by some enterprising Indian, if he could give GOLD ETFs (“GLD”) as a gift instead of gold jewelry.  Suffice to say it is quite apparent the idea was rejected, since Indians are more than willing to out-bid any other buyers in the market.

In the trading lands of El Dorado, where conspiracies ring supreme, gold bulls and bears are locked in their never-ending debate, about the daily directional movement of gold.  As a former corporate bond sales trader, this is an enigma to me.  In considering that both Indian and China have a permanent bid in the markets, how can gold go anywhere but up.  Here in lies the rub – rather than the price of gold be dictated by the trading in actual gold, it is supposedly determined by market factors in the paper market.  Hence, outside of market-movers and long-term investors, speculators dabbling in gold, have been increasingly cautious on the market, as the recent mysterious massive March and April sell-off in the precious metal, as depicted in the chart (see Fig 5), has definitely had gold investors spooked.  So much so, even the Chinese may have muttered the word, “quantitative easier”.  Nonetheless, China remains undeterred, and with twice as much cash as the entire world’s gold bullion, even a quantitative easier, with money to literally burn, doesn’t want to get in front of that gold bull. 

Quantitative Pleasers:

While the next evolution of the Renminbi looks bright, the future of the dollar looks totally bleak. The analysis boils down to the “signal and the noise”, which is the aptly phrased euphuism by statistician, Nate Silver, for seeking out signs to determine likely outcomes.  Well the sign of the long-term weakness in the dollar should have been Friday’s 25-basis point spike in 10yr yields (see Fig 6) coupled with the sell-off in stocks on relatively good news. Given the fact that the Fed is printing $85 billion in cold cash every month ($1 trillion annually) to keep rates down, and increase asset prices, this was not the sort of fireworks Bernanke was expecting for Independence Day.

As if the elephant in the room was trying to hide, here is something to contemplate, what if the stock markets were only rallying for the past few years, because the Fed had the accelerator on the printing press? And if so, what will happen to the markets when the Fed runs out of ink.  It would be more than likely be a Code Red DEFCON, financial apocalypto. And waiting to find out, is like waiting for a flight attendant to announce to evacuate after a not so soft landing.  Nonetheless, Bernanke did say sometime in mid-2014 the Fed “may” cease these liquidity measures, mysteriously coded as Quantitative Easing.  At this point the numbers are so large, that the markets have skipped the semantics game of “may end”, “will end”, or “could end”, and have begun the process of exiting the dollar. 

As if the destruction of U.S. Economy was not enough to stop the planet from spinning, the economic doldrums in Europe and Japan are likely to put the “dollar loving” world in complete mean reversion. Europe’s quandary is what to do with the gangrene festering in its southern sovereigns.  Whatever the problems are, it must have been in the (Mediterranean) water, or is it simply a coincidence that Greece, Spain, Portugal and Italy can’t seem to survive without hundreds of billions in loan commitments from their Northern European partners. The normally low-key Germans are increasingly growing more frustrated, as they see no end to the begging, in light of the fact that beggars have piled up debts that exceed 100% of their respective GDP.  To make matters worse, the on-going austerity measures have been slow to revive these struggling states, and with unemployment hovering over 25%, the beggars have become frankly, ungrateful.  In the case of Greece, it’s safe to say, they probably don’t know what Euros look like, their fiscal state of affairs has been so poor for so long, they are odds on favorites to be the first Euro member to escape the land of Hades via bankruptcy.   It can be said, the level of European discontent is definitely reaching a crescendo.  After suffering massive indigestion from bad U.S. investments, Europeans are slowly coming to terms with the idea of opening their economies to China and the likely millions in Chinese tourist – if not on the mainland, definitely on the Mediterranean.    

Perhaps in as worse a shape psychologically, as it is economically, Japan only recently came around to the realization that sticking its head in the sand hasn’t worked for the last fifteen years.  At least it wasn’t the solution to rid the country of its persistent stagflation.  Similar to the mindset of their prized sushi chefs, Japan’s precision like, minimalist approach to “quantitative easing”, had only brought about quantitative pleasing.  Since the only people pleased about the no growth, over-priced, un-inspiring Japanese economy, were the Japanese themselves – oops! Make that the South Koreans. So, much so, South Koreans can’t even contain their euphoria.  Think about it – from a branding perspective, any company that thinks it would be cool to have a Super Bowl car commercial, with a bunch of hip-hop mice “aka, hood-rats” strolling out of a car dancing to “LMFAO’s, Party Rock”, has got to be ecstatic about life. Be it Kia, Hyundai, or Samsung, their U.S. marketing strategy is all about excitement.  Apparently, the whole country has gone “Gangnam Style”.  Well given Japan’s “Texas” style, $1.4trillion quantitative easing campaign, Japan’s new Prime Minister, Abe Shinzo has taken a samurai sword to the currency. Firmly establishing Abenomics, and his intent to devalue the Yen, and bringing the party to Japan. 

As the chart in Dollar-Yen trading activity shows  (see Fig 7),  Mr. Shinzo has sliced almost 10% of the Yen since the Bank of Japans “QE” announcement.  

Although nowhere close to the 30% to 40% massive devaluation experts believe needs to take place, it’s a good start.  Japan’s action is likely to have a significant negative impact on economies in the Far East, but provide a big boost to its once mighty industrial conglomerates like Toyota, Honda, Hitachi, and Mitsubishi.   I wouldn’t bet against the Japanese, in some sense I think they could be the biggest winners in light of China’s growing dominance.  In some sense, I think the Chinese are more concerned about their ancient adversary next door, the Japanese than profiteers in the West.

The Overview:

The synopsis of the global trend in the international markets illustrates the obvious.  There was simply way too much partying in the Fiat system, and the music has stopped. Unfortunately, the reality hasn’t sunk in with many political leaders, and worse of all it hasn’t registered with the populace.   As if in harmony, the Fed, European Central Bank, and Bank of Japan have synchronized their efforts, and are literally printing trillions of dollars in paper to supposedly kick-start their stagnant economies and stave off, or create inflation. Wait a minute, how can it be to both fight and create inflation? Well therein lies the madness of it all.  If you listen to Mr. Abenomics, they want inflation, but if you decipher the coded double speak of Bernake, they want none of it.  And since Europe doesn’t have one voice, we have to assume they are just trying it out to see if it works, and by their recent overtures, if it does not, they will be trading in their Euros for Renminbi.   Unquestionably, the after effect of the abusive excess is an economic hangover that is yet to completely unfold.  The tsunami of debt portends a wave of incredible inflation, and continuing economic weakness that will last for quite some time.  In this market, the key to success will be to play ahead of the curve, and play in liquid markets.  From a macro perspective, a properly positioned portfolio with meaningful exposure to the best of the best in the BRICS, commodity laden countries, and invested across high growth stocks, precious metals, energy, interest-bearing and floating-rate assets is likely to out-perform traditional investment strategies, and mitigate the impact of inflation.