How about recession in China?

What to Worry about Today: Forgetting history.

Those who forget history are doomed to repeat it, or something like that. Last Saturday was the anniversary of the Lehman failure. Everybody and his brother published timelines, explanations of hidden causes, ten things we learned, etc. We read most of it and came away no wiser. The crisis happened and Lehman failed because stupid people borrowed money when they were not qualified to borrow, other stupid people rated the boatload of bad debt as good, and stupid overleveraged investors bought it. It was a scam from beginning to end, if not an intentional one. It should have been nipped in the bud but deregulation was reckless and enforcement under-manned. No one went to jail, generating endless grievance and giving us Trump. Authers provides a good summary of articles at the FT if you really want more.

This time the history we are forgetting is trade war history. Again, every economist worth his salt has published essays explaining why trade wars are bad and nobody actually “wins.” The Trump trade war with China will raise prices for domestic companies and consumers, destroy relationships that took decades to build, have effects more long-lasting than we know even if the war is ended with the end of Trump, and damage the US reputation permanently. You can’t count on a nation that would elect a Trump. Along the way, a pinball effect can come along and bring sudden, unexpected failures, including perhaps failures inside a long chain of merchandise and financial links in odd places, not excluding China.

Most importantly, a trade war can easily bring recession. It won’t be long before talk starts up again about how a 10-year recovery from recession is about due for another recession. We can get recession without a financial crisis, but we can’t get a financial crisis without recession. We don’t see a financial crisis yet—no, our crisis is political—but you can build a US recession scenario ten ways--today.

You can also imagine how a financial crisis can be manufactured out of the trade war. How about recession in China? This would be a new event for them and it’s not clear they will know what to do, smart though they be. Maybe the Chinese stock markets give up the ghost. We saw it with the demise of the Nasdaq-lookalike Neue Markt in Germany. Maybe China lets the yuan float as far down as traders want to take it, setting off a true currency war. Then Trump would pressure the Fed, maybe firing chief Powell, to prevent US rates from being hiked and trying to devalue the dollar.

The end-game is when China announces it is selling all of its Treasuries, flooding the world markets with surplus paper and driving the yield down to what? Zero? We may say that’s okay—it will buttress the stock market and lower the cost of funding the government—but it’s far from okay. When the leading superpower of the day can’t sell its sovereign debt, the global applecart is turned upside down. The loss of confidence starts at the top and permeates downward. Fish rots from the head. Bond markets freeze. A lot of other markets freeze, too, on sheer panic far beyond uncertainty and perception of risk. Can risk perception rise to 100%? Why not?

Well, that’s the worst-case scenario. It is not generally accepted. But it’s out there.

Outlook: The stock market may be content to brush off trade war worries, but the bond and FX markets are quaking in their boots. On the whole, trade war raises risk aversion and that is dollar-favorable. But the market is sometimes inconsistent on this point. We tend to think the trade war is already fully priced in to currencies, but discounting is hardly ever “full.” We are vulnerable to whatever retaliation China comes up with, not to mention Trump escalation:  “If China takes retaliatory action against our farmers or other industries, we will immediately pursue...tariffs on approximately $267 billion of additional imports."

Perspective is hard to find. One analyst notes that the US economy can easily absorb the tariffs, which will affect about 12% of total imports. The average tariff increase will be 1.6% across all imports, “so tiny compared to the 1930s, when they were 20%," according to the chief economist at AMP Capital Investors. Another analyst calculates that the tariffs will raise costs to the average American household by $300/year, manageable by all but the poorest. The WSJ notes that as was the case with Japan, the tariffs will force Chinese exporters to raise the quality of their goods. True but not useful.

We should probably assume that for the time being, or at least until we hear from China, the market will putter along as it is. But a Shock is almost certainly on the way. The deduction here is to reduce the size of positions. By a lot. China can do something that will be deeply dollar-negative. And China knows it.

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