August '23

The First Real Challenge to Xi’s Grip on Power

So What: China is attempting to do something unprecedented. Recent signals suggest it won’t be able to pull it off – but underestimating China has not been a good bet for 74 years and counting.

China is an authoritarian state, there is no question about that – but it is not (yet) the sclerotic farce that Russia has become. Xi Jinping has shown the ability to change his mind when data shows his policies are wrong, and the Chinese electorate has shown far more affinity for the stability ensured by the Chinese Communist Party than most conventional Western media care to report.

The question is whether these qualities – namely, flexibility and loyalty to the regime – can endure the serious economic challenges that are driving both sentiment and performance in China down here and now.

As Rob Larity, Jacob’s partner at Cognitive Investments, has argued – China is attempting an economic restructuring whose success is historically unprecedented. But the history of the People’s Republic of China – founded after victory in a Chinese Civil War no one gave the Communists much of a chance to win – is itself historically unprecedented. So much of geopolitical analysis relies on history – and China offers 74 years of history of unprecedented achievements against all odds and conventional (read: Western) wisdom.

Let’s get into it.

Lykeion Research August 2023 Lykeion Research - August 2023.pdf 2 MB

China’s Problems

Let’s discuss the problems – which have their roots in China’s astounding success. China has become fabulously wealthy over the last thirty years.

• GDP is up 42x since 1992 and GDP per capita is up almost 35x. Imagine a blue-collar worker in whatever country you are reading Lykeion Research in seeing his annual income increase by a factor of 35 over three decades. The generation that has come of age in China over this time period has witnessed truly awesome changes.

The problem is simple – with great wealth comes great inequality.

• China’s coastal regions became the world’s factory and its interior regions remain relatively poor by global standards.

• Cities like Shanghai arguably share more in common with other major cities like Tokyo or London than with the rural hinterlands of China.

• Major Chinese tech companies, like Huawei, aspired to become more like Apple and Microsoft – not like the bloated state-owned enterprises that provided hundreds of millions of “iron rice bowls” rather than innovative products or impressive margins.

For thirty years, China has been a Communist country in form but not practice. When Xi Jinping first came to power, he often discussed the importance of “supply-side reform” – rhetoric closer to Ronald Reagan than Karl Marx. Indeed, the things that Communist countries aspire to be good at – redistributing capital equitably – have evaded the Chinese Communist Party, which has been all about debt-fuelled growth and ghost cities no one lives in and dumping cheap products into foreign markets for decades.

Where once it was acceptable for China’s leaders to promise prosperity – souring growth prospects and isolation from China’s top export market (the U.S.) means that promise now is an empty one, and China is caught between ensuring more growth via tried-and-true debt-fuelled stimulus and promoting the type of fiscal discipline and high value-added manufacturing a country with China’s prospects and demographics must embrace to avoid catastrophe. Worse still, China is stuck in a globalized economy even as politics between nations becomes increasingly governed by geopolitics. As Michael Pettis has outlined better than anyone, China’s rising debt is structural, and the Party can either keep kicking the can down the road or let growth slow down to “politically unacceptable levels”… which leads to unemployment.

China Isn’t Really Easing, Yet

Last week, China cut interest rates for the second time in three months. The Wall Street Journal and other publications described this as the PBoC “slashing” rates. In reality, it was a 15 bp cut – hardly the sort of cut you make if a problem is truly urgent. The much-ballyhooed measures of China’s State Council and National Development and Reform Commission have been more of the same – incentives to stimulate Chinese popular consumption rather than any real distribution of wealth. The only glimmer of true change – revisiting household registration laws (“hukou”) to increase social mobility – has exempted the major cities to which Chinese migrants most want to relocate, so its reform value is actually very limited. In other words: the “L-Shaped growth” (which in laymen’s terms means economic stagnation) Xi talked about in 2016 is here.

Will it remain? Can Xi maintain political authority whilst presiding over a slowing economy, a greying population, and younger generations that are struggling to find jobs, let alone expecting a 30x rise in their incomes over the next thirty years?

This brings us to two interesting recent political developments in China, which highlight some of the first real challenges to Xi’s grip on power we’ve seen in years.

• China’s now erstwhile Foreign Minister Qin Gang, who has been absent from public life for months, is officially out. Qin’s predecessor, Wang Yi, is filling the gap.

• The head of the People’s Liberation Army’s Rocket Force (which have a significant influence in global geopolitics as they oversee Chinese nuclear weapons) Li Yuchao, is under investigation for “disciplinary violations” after just 16 months on the job. Wang Houbin – previously deputy commander of China’s navy – takes over as commander of the rocket force, while party central committee member Xu Xisheng steps up as political commissar.

These are some of the biggest purges Xi has authored in years.

• We have no special insight into Qin’s fate – all we can say is that Wang is a steady hand, and Qin’s “Wolf Warrior” past may have been getting in the way of Xi’s attempt to patch up relations with the U.S., however temporarily. Still, Xi expended significant political capital with the choice only for it to go south in less than a year.

• As for the rocket force – bringing in outsiders from the navy to run the service is a way of keeping top-tier soldiers off-balance and preventing commanders from garnering too much loyalty from their troops (which would pose a threat to Xi’s consolidation of power).

Whether Xi is responding to an active plot against him or is simply engaging in some Maoist-style purges to keep rivals uneasy is impossible to know, but either way, these are important events that should matter to anyone trying to understand what is going on in China.

Key Conclusions

Our optimism about China is predicated on Xi’s control – and we thought he had wrangled control over the Foreign Ministry and the military years ago, opening up the chance to go after local governments and bureaucrat’s zombie SOEs to redistribute their wealth to the rest of the Chinese nation. These recent developments might be early signs that his control is looser than we anticipated.

That said, even if you are an optimist like us – which is to say, you think China will continue to display an amazing propensity to overcome unprecedented challenges – the short-term future must be grim.

If China is to ascend to great power status, it cannot be so dependent on the U.S. It must become technologically self-sufficient, all while upending a political structure decades in the making. The pessimist can point to two different scenarios.

• The more stable one would be a Chinese version of Japan’s “Lost Decades” – a disappointing performance without political revolution.

• The less stable is China comes apart at the seams, whether due to popular revolt or a war-gone-wrong.

The key consideration we’re keeping track of is Xi’s political capital and control – the stronger that is, the more likely it is he’ll try to implement real reforms, which means short-term pain for long-term prosperity. And in that case, the short-term bull case for China becomes hard to make. Ironically, if the pessimist is right, then being a bull on China is not unreasonable as we should see the stimulus impulse return with a vengeance as Xi will be forced to rob Peter in order to pay Paul.

Our Framework for Higher Yields

So What: We believe yields will stay higher for longer given significant treasuries issuance through year-end (primarily for deficit financing) and possible selling pressure from China and Japan.

U.S. Government 10-Year yields have broken out of a pennant formation. On a closing basis, yields have made a new high, with some forecasting yields to soon hit 5% (a psychological level that hasn’t been breached since 2007).

The yields debate matters because it helps inform us if we’re in fact already in a bull market (i.e. S&P is headed to new all-time highs), or if 2023’s stellar performance so far has simply been yet another elongated bear market rally.

These intermittent rallies within a broader bear market are difficult to call as they often look and feel like a true transition out of a bear market into a new bull market, but can easily catch investors off guard if the rally falls short and market gravity kicks back in.

• The reason why we care about trying to time the bottom of the bear market is that, on average, about two-thirds of the annualized performance of a bull market takes place in the first 10 months after the market has transitioned from bear to bull.

So, are we in a bull market or still in a bear market rally? That, in part, depends on how high yields rise, and for how long they’ll stay high. This will depend on four variables:

Economy

• Most measures of U.S. inflation have been declining, with headline CPI in freefall until last month. There would, however, be almost no incentive for the Fed to cut interest rates if CPI fell to zero, but unemployment remains low, equity markets remain strong, and GDP remains positive.

• In fact, their bias would be for further tightening because of the future implications of cutting too early. Policymakers are scarred by the historical specter of 1940s and 1970s inflation, each of which saw three consecutive spikes in CPI.

• Additionally, one of the Fed’s favorite gauges, the 5-Year 5-Year Forward inflation rate recently approached last year’s highs, helped on its way by crude oil breaking higher.

• Whilst forward inflation indicators are terrible at predicting actual inflation, they are a useful gauge of market sentiment. If they are rising back toward the highs, then policymakers might begin to worry that expectations of higher inflation are becoming entrenched, which limits their ability to switch towards easing.

• With that, we think that headline inflation will continue to fall, but we need unemployment to pick up and consumer spending (which is expected to drain excess savings by the end of the year according to JP Morgan) to cool off before the Fed can start easing (read: lower rates).

Positioning

• The non-commercial category (often called ‘speculative’ because it is predominantly hedge funds) is unequivocally short in the futures market, but we think that this is mostly because hedge funds short futures positions are held against a long basket of bonds (a basis trade). These neutral trades seek to eke out small returns on large positions but can easily distort what true sentiment positioning is.

• The segment of the investment community that is unequivocally outright long bonds are large asset managers that have been waiting for a recession to take place (where you’d expect bonds to move higher and yields to move lower).

• This means that should large asset managers change their minds about their long bond position, we could see forced liquidations that drive yields higher from here. Change in positioning from current levels, thus, poses a risk for bonds to move lower.

Overseas Investors

• Global bond investors don’t live in regional bubbles. If yields in one major bond market rise, they tend to have a knock-on effect in the same direction in other major markets (because they have become more attractive at the margin).

• The natural pressure from current Japanese growth dynamics is for yields to rise, but the BoJ is helping to manage that with Yield Curve Control. This is putting downward pressure on the Yen as they are forced to use more Yen to buy more bonds to control yields, therefore devaluing the Yen.

• If the Ministry of Finance wants to defend the currency, they can sell some of their U.S. Treasuries (i.e. sell U.S. dollars) to buy Yen. Selling Treasuries puts further upward pressure on U.S. yields. (Even if they are not doing this, the market understands that this dynamic is in play and is moving ahead of this).

• Japan is not the only country that might help yields in the U.S. move higher. The current macro problems in China could also have an impact. The economic re-opening never got going, issues in the property sector have resurfaced and exports have been disappointing. This will continue to weaken the CNY meaning that authorities, as they’ve done before, are likely to step in and defend the currency in order to allow for the CNY to adjust lower over time without collapsing.

• The easiest way to do that is, again, to sell U.S. Treasuries (i.e. dollars) and buy CNY when the devaluation gets too heated. Here is the chart of CNY versus the U.S. 10-Year yield. It’s not quite as convincing as the JPY vs. US 10-Year chart, but it’s very similar.

• Overseas investors, thus, also pose a risk for yields to move higher.

Future Issuance

• The bearish signal for the bond market coming from overseas investors matters especially given how the U.S. government is likely to issue $1.9 trillion worth of new U.S. Treasuries over the next 6 months to finance the budget deficit and refill the Treasury General Account. That’s a lot, even when considering COVID-19 years.

• The market should have the capacity to absorb that. But at what yield? The rejuvenated bond vigilantes are betting that it will be higher than 4%, and we wouldn’t bet against them. Future issuance, thus, will ensure that a bottom north of 4% will likely be in place through year-end.

Market Implications

• We think there’s a reasonable case to be made for yields to continue to stay high, well north of 4%. This means that expectations of a pivot will continue to be pushed back (i.e. instead of seeing fed funds move lower, we’ll see fed funds stay the same for longer).

• Higher rates will increase interest expense and therefore lower earnings expectations (EPS down). Lower consumer price inflation (CPI) means corporates won't be able to push through price increases which drove revenue growth over the last few years, and if producer price inflation (PPI - the cost of corporate inputs) stays flat or even increases, margins will be compressed along with market multiples leading to a contraction in valuations (as we saw in 2022).

• If the above materialize, equities should roll over, the bear market rally should give up its performance, and the hoarding of jobs that has kept a lid on the unemployment rate will end (companies hoard jobs when equity markets are performing well), increasing the historically low rate.

• Higher unemployment might trigger a recession, and we might finally see the tradable low we’ve been waiting for to build long-term positions. The timing of this tradable low will depend on how long lending standards remain tight (regional banks, many of whom have been downgraded in the last couple of weeks, could starve the economy of credit, and reduced credit availability could elongate a potential recession). This brings up shades of 2008, without a full-blown banking crisis.

• In one line, we believe only a recession can put a cap on higher yields, and until we see that recession take place, we wouldn’t favor being long bonds.

Gold’s Cup and Handle

So What: Gold has performed remarkably well considering the headwinds from higher yields, and a ‘Cup and Handle’ formation highlights long-term bullishness.

It’s rare for gold sentiment to be as lackluster as it is today. Sentiment towards the junior gold miners has probably never been worse, and the gap between the gold price and the performance of these stocks has been getting wider.

Part of the divergence is rooted in the performance of real yields (rising real yields are a headwind for gold and gold miners). However, we should note that the performance of gold has been remarkably strong considering the rise in real yields – in fact, gold should have performed far worse over the last 18 months (on the chart below, real yields are inverted).

If nominal and real yields continue to rise, then gold should still come under pressure in the short term. But in a recession, we should expect the authorities to provide more liquidity, via lower interest rates, more QE, or another fiscal boost.

• Over the last decade, gold has performed best when central banks were debasing their respective currencies. Rather than being a play on outright inflation, gold has been a play on fiat currency inflation.

• Whilst central bank largesse today may not be as great as it was during the 2010-2020 period, because they may be handicapped by higher base levels of inflation, we should still expect the monetary and fiscal levers to be pulled in a recession.

• This means that any significant weakness in gold in the short term should be interpreted as an opportunity to accumulate ahead of new all-time highs.

Gold’s Cup and Handle

Whilst technical formations don’t play out simply because they look like a textbook pattern, they do provide us with an excellent set of inflection points. Of note is the triple top in the $2,050-$2,075 region. If this breaks, we should expect investor interest to spike again.

• For some, the easiest strategy is to continue accumulating gold when it dips.

• Others may use the triple top as a strike zone for buying call options.

Three-month implied volatility in gold is closing in on the five-year lows, though a long gold strategy today probably requires a longer time frame. One year at the money implied volatility is below the 10-year average.

Whilst there are numerous other considerations when buying options (such as the forward prices for gold: the gold curve is upward sloping – the one-year forward is around $2,000 at the time of writing), investors may want to think about buying longer-dated calls with a strike price around the all-time highs. The important thing is to give the option a long enough time frame for a policy response to a recession to materialize.

Brazil’s Macro Case of Normal

So What: Charles de Gaulle purportedly once said, “Brazil is the country of the future… and always will be.” We can find no evidence de Gaulle is the original source of this famous turn-of-phrase… and think the future might be now.

It is easy to dwell on Brazil’s deficiencies.

• The country’s geography is not particularly forgiving, which means infrastructure costs a lot of money to build in Brazil (which is why Brazil has such poor-quality infrastructure).

• Peter Zeihan, arguably Jacob’s intellectual arch-nemesis, concludes in his recent book “Disunited Nations” that “Brazil will devolve from a nation-state to a much poorer series of disconnected regions that look more like regional satrapies than provinces of the same country.”

And we are certainly not oblivious to Brazil’s challenges.

• Brazil’s government has great plans to build inventories to guarantee food security and livestock feed supply, but Brazil doesn’t have the warehouses to follow through on those plans right now (its 2022/23 summer grain production outgrew total storage capacity).

• Not to mention Brazil’s dependence on fertilizer to grow its crops, which means the Brazilian government – whether ruled by left-wing ideologue like current President Luiz Inácio “Lula” da Silva or a right-wing ideologue like former President Jair Bolsonaro – has to make nice with countries like Russia (that supply the fertilizer) or China (which consumes Brazil’s surplus crops).

But all of this is to confuse contemporary politics and past performance as arbiters of what will happen in the future – and indeed, Brazil is starting to look like the country of the future, especially relative to some of the other dumpster fires in the region (looking at you, Argentina and Colombia and Peru).

Brazil’s current account has gone from deep deficits to surplus over the past 23 years. While the Argentine peso circles the toilet bowl, the Brazilian real – created in part as a response to the hyperinflation in Brazil in the 1990s – is one of the best-performing currencies of recent years. The Banco Central do Brasil was worried about inflation long before the U.S. Federal Reserve – and it changed monetary policy accordingly, despite harsh criticism from Bolsonaro and then from Lula.

Even the famously skeptical Economist magazine conceded at the beginning of August, “Investors are increasingly optimistic about Brazil’s economy.” Lula has not governed like a leftwing ideologue – instead, he has compromised often with the center-right parties that control Brazil’s legislative branch. Where Lula has been controversial, the central bank has simply ignored him. Indeed, it appears his government will pass much-needed tax reform – a goal that has eluded successive Brazilian leaders for decades.

As we’ve written previously, we think the world is on the cusp of a multipolar era, where political, economic, and military power will not be concentrated in the hands of one or two countries but will instead be defined by rising and falling great powers. Brazil is one such rising power.

• It faces no true competitors on its own continent.

• It is rich in raw materials and commodities and can parlay that wealth into investment in the infrastructure improvements the country desperately needs.

• Brazilian manufacturing ability is underrated and capacity can and will expand.

• Brazil gets almost half of its total energy and almost 80% of its electricity from renewable sources.

• As Robin Brooks, chief economist at IIF has said, “Brazil is on track to become the Switzerland of Latin America. A huge trade surplus is emerging, unlike any other country in the region.”

Macro opportunities like this don’t come around very often, and we look at weakness in the stock market as opportunities to add exposure to this theme at more attractive entry points.

The Unexpected Winners if Global A&D Spending Continues to Rise

So What: While Aerospace and Defense companies get the most attention when trying to express bullishness on increased defense spending, there are other sectors to consider.

According to Stockholm International Peace Research Institute, total global military expenditure increased by 3.7% in real terms in 2022, to reach a new record-high of $2.24 trillion. The United States accounted for 39% of the total – three times more than the next biggest spender, China. As you might expect, defense spending in Russia, Ukraine, and Eastern Europe all increased as a result of the Russia-Ukraine war. Defense spending was also up in Asia, however. Japan’s military spending increased by 5.9% between 2021 and 2022, reaching $46 billion, or 1.1% of GDP – the highest since 1960. India increased defense spending by 6% and Saudi Arabia by a whopping 16%. Countries around the world are preparing for a more violent future.

If you are looking for a boring but surefire path to performance, investing in the defense champions of the world’s rising powers is about as safe a bet as any other. But there are other ancillary beneficiaries of this trend that might not be as evident from the data – and which will enjoy success with greater relation to market forces rather than because governments have a geopolitical imperative to prop up defense companies.

Defense companies ultimately do one thing: they make weapons. But weapons cannot be made without components and airplanes/ships cannot fly/sail without fuel. The defense industry is as exposed – arguably more exposed – to the changes globalization has wrought on the economy than any other sector in the world. For instance, India has recently banned imports of Chinese components in the manufacturing of military-grade drones. Few if any Indian companies can make those components in India today, which means the Indian government must either support domestic companies to fill the gap or must source these components from countries aside from China – which will produce opportunities in its own right.

In our last Lykeion Research publication, we partially covered the extent to which the U.S., and indeed, the world, is dependent on China for the cheap supply of critical minerals – every mineral on this list represents a significant opportunity.

Our Thinking

• Technology will become the frontline of geopolitical competition in the 2020s and the three sectors that will become enmeshed with the future of national security are space, connectivity, and biotech.

• Russia, for example – in the midst of a war it is, at best, not losing, launched the country's first lunar mission (unsuccessfully) in nearly half a century, having already pledged to build a lunar base with China by the 2030s.

• COVID-19 was not an aberration: there will be more pandemics, and worse pandemics, in the future, and as the U.S. already demonstrated, the countries able to respond with vaccines and treatments quickest will do better than those that can’t (China).

• 5G is supposed to connect the world and empower automation, the Internet of Things, and artificial intelligence… and yet as recently as January 2020, Mavenir told the FCC in January 2020 that while U.S. radio design capacity is available, there are currently no U.S.-manufactured radios – they are currently made in Taiwan, South Korea, and China, all geopolitically risky areas. (In that same vein, Brazil launched an investigation into the Chinese dumping of fiber optic cables and related equipment into the Brazilian market – no doubt a prelude to Brazil protecting its own domestic manufacturing capacity of these and other “picks and shovels” of the data economy.)

This argument is not as elegant as say, oil services companies benefiting from increased capex from oil and gas exploration and production. Indeed, it requires maintaining close awareness of technological advances, which may render current technology obsolete in a short time span. Investor’s primary research focuses should be on finding the companies that inhabit the concentric circle where technological innovation, trade dependencies, and geopolitical competition meet.

Space, Biotech, and Connectivity are good starting points for generational investment opportunities.

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