End of Hong Kong means 3 systems, not 2

In a 1992 speech in Fulton, Missouri, Mikhail Gorbachev stated ‘Humanity is at the major turning point. We live in a watershed era. One epoch has ended, and a second one is

commencing and no one yet knows how concrete it will be’. He was right then, and if the speech were given today, these words would also ring true.

The fall of communism was the key event in catalyzing globalization. It was the bookend that opened up new trends that saw the flow of people, money, commerce and importantly, of ideas and cultures. In particular, the fall of communism led to a sharp rise in the creation of new countries (some 34 have been created since 1990), and in the spread of democracy (between 1988 and 2005 the proportion of countries classified as Free rose from 36 to 46% globally according to Freedom House).

Since the fall of communism, the ripple of globalization through the world has lifted billions out of poverty and spawned new technologies. This great period in world history is now at an end, decisively crashed by the coronavirus crisis, having already atrophied in the face of rising indebtedness, trade wars and the vandalization of international institutions by populist leaders. Now, with deadly and decisive timing, the bookend that closes the period of globalization is the subsuming of Hong Kong.

The introduction of new, harsh security laws in contravention of the process of the Basic Law, will severely curb the identity and livelihood of one of the world’s unique cities. Hong Kong played a role in the first wave of globalization in the 19^th century and has been prominent in the recent one.

The import of the likely end of Hong Kong’s ‘two systems’ is that at a much greater level it marks the arrival of ‘three systems’, or what I call a multipolar world dominated by the US, China and Europe.

China has acted to hush Hong Kong because of the threat that protests pose to the Communist Party in China (and the position of Xi Jinping), and also because, with the West in disarray, China is in a relatively powerful position. The potential significance of China risking Hong Kong’s role as an international financial portal is that it has decided that the time is come for Shanghai, Shenzen and the Greater Bay Area to become China’s financial hub. This is bad news for those in Hong Kong who think that the economy will continue to thrive in the light of the new security laws.

As such this may mark a move away from an approach that seeks to integrate China with international financial markets, and toward one that deepens China’s markets in the Chinese ‘way’, so that they are overseen by Chinese rather than Western corporate governance rules. China has notably already made this transition in its treatment of the internet.

China’s effective ending of ‘two systems’ in Hong Kong also comes at a time when friction is rising in its interaction with democracies – especially India and Australia (both of whom are members of the QUAD defense grouping with the US and Japan).

Elsewhere China’s assertiveness means that the US and the EU will have to become more singular. Europe (EU) will in my view, soon force its member states to adhere more consistently to its values (Hungary and less so Poland here) and is beginning to make a move towards a greater fiscal role for Brussels.

It is also worth noting that the exit of Britain from the EU is consistent with the end of common law in Hong Kong in that both events underline the decline of Britain’s role in the world and the degeneration of political leadership in England.

That leaves the US. If Gorbachev saw the US today he would likely not be surprised that it has so far retained its military and financial dominance, but by the same token, not astounded that it has failed to harness the benefits of globalization for all Americans.

With the benefit of a few years in the Kremlin, Gorbachev might even remark that the coronavirus has hit the US in all of its weak points – the labour market, inequality and healthcare. To that end the American response to what is happening in Asia, and to the rise of the Chinese ‘Leviathan’ like model, must be to strengthen its own economy, society and institutions, and not to weaken them as President Trump is doing. Leaving the World Health Organization is a strange way for America to help the people of Hong Kong.

Have a great week ahead,

Mike

Shemozzle

Mike Tyson is apparently coming out of retirement. America may need him. Last week on the Sino-Indian border Line of Agreed Control (North Sikkim to be precise) there was a mass brawl between Indian and Chinese troops. Helicopters (China) and fighter jets (India) were scrambled to add heft to the situation, which left several injured. The incident recalled the word ‘Shemozzle’ a Yiddish word that denotes chaos, uproar and confusion. In Ireland, sports commentators have used it to describe fights between opposing hurling or Gaelic football teams.

I fear that ‘Shemozzle’ now enters the lexicon of geopolitics, not least because tensions between nations are rising. One relationship to watch is that between China and Australia, where trade, political and diplomatic relations are worsening. I advise my Chinese friends to be wary – every time Australia play Ireland in ‘Compromise Rules’ football, there is a large scale ‘Shemozzle’.

The notion of a ‘Shemozzle’ is not a bad one to describe the world – tensions are rising as governments try to advance beyond lockdowns, and scarce resources such as vaccines will be fought over. In addition, the tension between markets and the reality of the economic damage from the coronavirus is growing.

In my April 4^th note (https://thelevelling.blog/2020/03/28/why-did-nobody-notice-it/) I laid out three broad scenarios – an optimistic one called ‘Easter’ which outlined how much of the crisis could be over by the end of April, a more sober one called ‘Summer’ which flagged late summer as the point at which we should have largely mastered the effects of the virus, and then a tail, very nasty scenario called ‘Winter’ where the effects of the virus drag on and the economic damage is severe.

As it stands, it seems that equity markets have priced in the optimistic ‘Easter’ scenario while it looks more likely that economies and societies will get ‘Summer’. The tension between high equity markets and the real world betrays a range of factors – the oversized role of the Federal Reserve and wealth inequality for instance.

I am focused on the performance of small cap indices and bank stocks (as opposed to tech stocks) as the lead indicator of where the economy and markets will go, given the risk of a credit crunch. In general, the performance of banks has been very weak, with some like Wells Fargo in the US hitting March lows and others in Europe (e.g. Société Générale) hitting their lowest levels since 1991.

At the other end of the market the outperformance of technology stocks also reflects a lack of forward thinking that in the US as in other countries, corporate taxes will have to rise in order to offset the generous stimulus programs put in place by the government. The five large tech companies (FAANG’s) who make up 22% of the market capitalization of the S&P 500 index are vulnerable here, given their earnings. This is perhaps the so-called ‘black swan’ that investors have not priced in.

To stick with the idea of ‘black swans’, a phrase that is now in the popular lexicon as meaning a high impact event as opposed to a highly improbable one a la Karl Popper’s conception of the term, the two recurring ‘swan’ questions I keep hearing are ‘will Europe breakup?’ and ‘will the US and China go to war’. That people continue to think about these questions shows that in effect they are not focusing on events (black swans) but processes.

In particular, the evolution and deterioration of the relationship between the US and China is a process that bears watching. In a week where the Economist front cover declared ‘Goodbye Globalization’ an opinion poll from the Pew Research Centre showed that close to 65% of Americans have a negative view of China. This compares with only 30% some ten years ago and the darkening in Americans’ views of China tightly tracks the demise of globalization.

With rhetoric picking up, and supply chain restrictions on Huawei now more severe, there are three elements of this relationship to watch in the short run. One is the friction between China and American allies in Asia (Australia) amidst talk in China that it needs to prepare itself for military conflict. Another is the shift in supply chains, the most interesting development here is Taiwan Semiconductors’ decision to invest USD 12 bn building a plant in the USA. Also, China may respond in kind to the Huawei announcement on Monday.

Then finally, is the politics – lambasting China, however illogically (the President has stated that cutting ties with China would save USD 550 bn) creates political capital for Donald Trump, and as such we should expect no let up in anti-China rhetoric until November. The question is what damage this does to trade and diplomacy, and whether it leads to a real ‘Shemozzle’.

Have a great week ahead,

Mike

Globalization crashes

That a rugby match in Dublin between Italy and Ireland can be cancelled because of a virus that germinated in a market in a Chinese city, may be a chain of events that appeals to amateur chaos theorists.

In my view, the panic caused by the coronavirus illustrates how easily interconnected the world has become, how fluidly people move from one location to another, and how national infrastructure and policy systems are still so very different.

Having written about the coronavirus a few weeks ago (‘Humanity and Adversity’, Feb 2, https://thelevelling.blog/2020/02/02/humanity-and-adversity/) I thought that markets at least would quickly work through the implications. That it has not been the case owes much to another form of sickness – overexuberance in financial marketplace. The catalysts provided by the coronavirus are now treating this (in the short run the sell-off is nearly complete, and we will rally mid next week).

Ironically, in an age of machines, and where social media companies are dominant in many senses, markets are responding to the risk that humans will have less physical interaction with each other and will enjoy less physical forms of consumption (travel, shopping and consumption).

As I write, it appears at least from official numbers that the virus is somewhat contained in China, and globally the number of cases looks to have peaked. Here though, the risk is that the Chinese authorities rush people back to work and, like the Spanish flu in 1918, there is a bigger second (and third) wave of the virus.

The passage of the virus across the world has, even at what might be an early stage, revealed and further provoked a number of changes in our world.

The first relates to trust. There is widespread suspicion inside and beyond China that the authorities there have not been upfront about the true extent of the virus. Some, like US Senator Tom Cotton even believe that the virus is man-made. To that end, while China’s handling of the crisis will on one hand reinforce the sense that it can marshal huge swathes of its population, on the other the trust of outsiders in the Chinese authorities will diminish. The Belt and Road Initiative may be a casualty here. Distrust can also channel itself in other ways. If in the future China has a debt crisis, investors are likely to sell first than wait for a true picture to emerge.

Within China this episode has clearly damaged the Communist Party, though it is very hard to see how this will play out in public life, or even through social media discourse. My sense is that the Chinese authorities will react in at least two ways. One is a fiscal stimulus made up of tax breaks, support for small businesses and an acceleration of infrastructure programs.

The other more interesting one is to take what has been done in the domain of social control and social credit scoring and apply this to healthcare. I can envisage a sharp rise in self-diagnosis, tech based medicine and a related set of incentives for people to allow their health data be monitored by the state. If it happens, many in the West would consider it insidious, though given the fear created by the virus, many Chinese might acquiesce.

The second effect of the coronavirus crisis is that it is yet another event that makes visible the arteries of globalization and leaves them atrophied. That there has been little to no coordination between nations speaks to a sense of a fractured world, and the performance of the WHO reinforces the view that like the WTO, its time has come.

There will be a sharp short-term hit to world trade from the coronavirus (hotels, airlines are the obvious ‘victim’ industries though I think that ‘elite’ forms of travel and healthcare will continue to thrive), but in the longer-term it will also reinforce the sense in governments and some companies that security of production is increasingly important.

To that end, the rise of national champions and the relocation of production to ‘home’ countries (pharmaceuticals is an example) will continue. In many different ways, the coronavirus, like the 2019 trade war, will force a rethinking of globalization by corporates.

Other megatrends may also be rethought. India and many parts of Africa are the only parts of the world where urbanization rates are still relatively low, though where the rate of urbanization is now picking up. The coronavirus crisis is a very clear reminder of ‘smart’ urbanization is terms of the health, data gathering and communication implications, and in this way the lessons for Wuhan are yet to be learnt. For example, it is only emerging that 40% of the coronavirus cases in Wuhan were transmitted in hospitals – and the same may be true of both Italy and Iran.

As this adjustment process happens, there will likely be one constant, which is the vogue of central banks to meet any threat to growth and attendant dip in markets with more liquidity. Liquidity provision and rate cuts will not solve the process of adjustment away from globalization, and in the long run they may channel this process down the wrong path because cheap money increases the risk that investment decisions are badly made.

Have a great week ahead,

Mike

Humanity and Adversity

Adversity for some often breeds humanity in others. It was not the case last week when US Commerce Secretary suggested that the coronavirus sweeping China would help bring manufacturing jobs back to the US, and in doing so would further reset the trade relationship between the US and China.

The virus is the first major domestic crisis that the Chinese authorities have faced since perhaps, the mini economic crisis brought on by the side-effects of the global financial crisis. As such it is a policy test, and a watershed moment in the relationship between the Chinese Communist Party and the people it governs. In this respect, China may join other large countries or regions where the social contract between the people and those who govern them is being severely stressed.

In the UK, the social contract has been left in tatters by Brexit, in the US the idea of the ‘American Dream’ is undercut by falling human development rates and stark inequality, while in Europe there is general confusion on the part of the grass-roots as to what ‘European values’ are in a tangible sense. So far, Asian countries have done better here, Japan is an example.

China’s social contract, which uncharitably could be referred to as a Leviathan one, is simply put, an exchange of liberty for prosperity. It has held over the past thirty years, largely due to the prosperity and startling physical infrastructure development that the CCP have engineered and very tight political control. To date, most policy challenges have been met with success, to the extent that a long article in the New York Times in 2019 referred to China as the ‘land that failed to fail’.

Given the tragic human cost and the consternation that the coronavirus is causing, there are reasons to think of this as a watershed of sorts for policy in China.

One is that the spread of the virus may highlight the limits of high economic growth in China. The intensive movement of people within the country, urbanization and a hyper connected transport network are economic assets, but also pose risks. In his book ‘How Nature Works’ the Danish physicist Per Bak likens socio-economic systems to piles of sand.

The sand piles can continue to build until, upon the addition of a marginal amount of sand, they collapse. Similarly, cities and nations grow until that growth produces side-effects (the health scares in the rapidly urbanizing London of the mid 19^th century that gave us the engineering genius of Joseph Bazalgette, are another example).

There will be many side-effects of the virus crisis. One may be an economic stimulus program that is focused on upgrading healthcare infrastructure and health related education in China.

Another aspect is diet. One of the first thematic investment notes I put together (some ten years ago) was on the topic of ‘Feeding Asia’, or rather how diet in countries like China would come to resemble that in the West and as a result how demand for dairy products, fruit, meat would go parabolic (it did for a while).

This particular crisis may see another step change in diet in China, toward – and I am speculating – synthetic meats, a stronger tendency towards organic foods, greater demand for seafood related foodstuffs and for vitamins/food supplements generally.

Two other related areas are worth thinking about. The first is how this crisis reflects on China’s ‘Leviathan’ approach to government. Has technologically enabled central control of society allowed the authorities to prevent the spread of the virus? Or will this episode begin to sow doubts in the minds of Chinese in the government’s ability to safeguard them. Relatedly, China’s social media networks have both spread alarming scare stories, whilst at the same time served to coordinate people and facilitate remote family get-togethers over the holiday period.

Concomitantly, the crisis will serve the interests of those factions within the Communist Party who on one hand argue for greater central control of Chinese society, versus those on the other who argue that the next phase in China’s development is, like the USA in the 1930’s, to deepen its social welfare system. As such, it will deepen the numerus rivalries and factions within the Party.

Finally, more broadly, a few weeks ago (‘Peak Markets, Peak Trump’, 12 January) I wrote about markets ability to coldly appraise the financial impact of events. They are doing so again now with the coronavirus crisis, though it seems to me that markets are primarily pricing the cost of firm’s reactions to the crisis (i.e. cancelled flights, disrupted supply chains).

Economically sensitive assets – government bonds, copper, oil are all much weaker, and in particular emerging market currencies look vulnerable. I suspect that volatility will continue to spill over to stocks, at least till we are in mid February. ‘Peak Markets’ ay have been the right headline after all, I still wonder about ‘Peak Trump’.

Have a great week ahead,

Mike

Remaking a World on Fire

It has been an eventful year for me, but the most striking moment was witnessing the fire at Notre Dame cathedral. Having run towards it, I was unprepared for the extent of the conflagration, green and orange flames bellowing out of the church as the sun blazed angrily in the background. It was a traumatic evening, where thousands of onlookers were silenced by the significance of what they saw.

At the same time, it would be wrong of me to try to draw a parallel between such an apocalyptic event and the state of our fracturing world, though that thought is at the back of my head, not least given the way in which the ‘old’ world order is increasingly vandalized by politicians, not to mention the outbreak of protests around the world.

A better parallel, as supersized cranes moved around Notre Dame this week, is that the time it will take to rebuild and remake the church, some five or more years, will also be the period of time required to put the era of globalization behind us and have the makings of the ‘next world order’.

The roadmap towards this ‘order’ will look something like this – economically the world will grapple with the ‘next recession’ which will be more severe in indebted economic sectors (China’s economy, corporate USA and some emerging countries), and will eventually culminate in some form of world debt conference. Once this is accomplished, the quest for a model of organic economic growth will begin.

Politically, I hope that we will see more independent, bottom up efforts by individuals and new groups/parties to rethink what the contract between people and those who govern for them will look like. Then in terms of geopolitics, the world will be increasingly dominated by the ways in which the three great ‘powers’ – the EU, USA and China pursue different paths on issues like the internet, democracy, human development and finance. This is a limited, big picture sketch, the rest is of course in the Levelling.

Forecasting – really more a form of ‘macrotainment’ than a science – is easier on a five year view, but given it is the end of the year, I also want to offer up a few pointers on at least two events over the next few months.

First, I expect economic and political headlines to be first driven by the unravelling of China’s credit boom – we will hear more about defaults of indebted Chinese companies and resulting pressure on its banks. Expect ‘China is Spain’ to be a headline we see a lot. The policy task for China’s leaders will be complicated by ongoing protests in Hong Kong and importantly, the result of Presidential elections in Taiwan on January 11^th. My guess is that one result will be a drop in Chinese interest rates in 2020.

Second, impeachment will deepen America’s divides. With the process now started, it looks for right or wrong, that the Senate will not vote to impeach President Trump. The trial itself, especially if likes of Mick Mulvaney and John Bolton are called as witnesses, will prove a spectacle.

If we bear in mind that Bill Clinton responded to his impeachment with airstrikes on Iraq, then Trump’s emotional letter to Senators is mild by comparison. He may try other means of weaponizing impeachment – link it to the stock market (Trump has sent 21 tweets about the stock market in the last 30 days, the most since 2018), trade policy with Europe or immigration.

The immediate political implication of the Senate not impeaching the President is that the Democrats lose their ‘silver bullet’ against Trump, and with it the sense that morality, the law and institutions are powerful buttresses against bad behavior. In turn, this will colour the Democratic Presidential selection process. The Democratic candidate will need to have a very clear policy message, an ability to scrap with Trump in the political gutter (see my October 13 blog ‘Don the Robber’, https://thelevelling.blog/2019/10/13/donthe-robber/). So far, none of the leading Democratic candidates is strong on these points (someone like Mike Duggan of Detroit could fit this bill in my view).

For Trump, and his supporters, a failed impeachment will open up the road to the acceleration of his policies on immigration, trade (EU) and on identity-based politics. Mounting, structural risks like climate damage and indebtedness will get worse. The next election will be driven by identity, race and values, and there is a very good chance that Trump could win.

So, enjoy this Christmas, there is plenty of disruption to come in 2020!

I am back in touch on January 12.

With best wishes, Mike

@Donthe Robber

Donald Trump’s reneging of the Kurds in northern Syria, his cynical treatment of Ukraine and his weak ambivalence on the Hong Kong protest movement may fit the pattern of his usual behavior, but to those outside the US these developments cut away the moral, military and diplomatic backstops that the US has provided to rest of the world for the last seventy years.

These acts pull up the drawbridge on the old liberal order, and now set in motion a fragmenting world of ‘patriots’, as he might put it. Another four years will render this regression permanent, with many yet unseen, negative consequences.

While many Americans will be happy that President Trump is committing fewer resources to what are other people’s problems, they must also realize that the cost of this is the end to American exceptionalism – this will have long lasting implications for the dollar, US multinationals, the security of America and Americans, for American culture and even for basketball.

For those who care about these things there are several things that can be done.

To start, technocrats, former public servants or even ‘experts’ from the military, economic policy, diplomacy and human development led sectors like education, need to speak loudly and clearly about the damage being done to America’s credibility, its institutions and human capital. Jim Mattis for example, entirely missed the opportunity to do this with his recent book.

Then, moderate Republicans, who if they have a sliver of moral courage and an ounce of sense, must start to put the future of the US – at home and abroad – ahead of career expediency. As it stands, they are more supine than many of the emerging nation governments they disdain. The very least they can do is stop blocking the rule of law, and the cloaking of the transparency of government.

As this occurs, the President will fight back. His greatest talents are his ability as a gutter scrapper, and his instinct for how to caricature his opponent’s weaknesses. He flatters and bullies, belying his own foibles. What no Democrat, or Republican for that matter has done so far, is to match him in this respect. Some might feel it is beneath them but it is the only way to loosen his electoral base.

Whomever succeeds in taking on the President will need to show that @DontheRobber is robbing the future to prop up the scam that the present is ‘great’. Corporate tax cuts, an alarming rise in corporate and government debt and a fiscal deficit that is unusually large for an economy in expansion, have all boosted the economy in the past three years, to cripple it in the future.

Record levels of wealth inequality rob the public in general, and the next generation. Equally, a short-term focus on a damaging trade war is disturbing corporate investment and supply chains, while the lack of real investment in education will rob the economy of a key source of productivity. Blindness to the consequences of climate change will rob many of the President’s supporters of their livelihoods as we move into the 2020’s.

The trade agreement with China, yet to be finalized, is a fine case in point. It falls far short of the terms that had initially been proposed, doesn’t at all tackle the concerns corporate America had and leaves open too many points of uncertainty. To their credit, the Chinese have done very well here.

In politics, the modus operandi of the President and those who enable him is robbing public life of any vestige of civility and fraternity, and risking divisions that will carry through this century.

The sense that America, its social fabric and its economy, are being robbed is just one, clear way of encapsulating the consequences of current policy making from the White House. It is now breaking old conventions, alliances and economic relationships on a nearly daily basis, and the cost of this needs to be made tangibly clear to Americans, lest the country, like a real estate speculation gone wrong, is sold away to opportunists.

Have a great week ahead,

Mike

A World of Patriots and Dreamers

Last week’s UN General Assembly reflected a number of emerging trends – the miring of public life in older democracies (US and the UK) in banality and controversy, and the flourishing of climate change as a mainstream political issue, are just two.

These trends are part of the fracturing of the old-world order, and pointers as to where the new order may lie. Underlying each of them is the contentious issue of how political debate is conducted.

One striking statement at the UN was President Trump’s remark that ‘The future does not belong to globalists. The future belongs to patriots’. Practically, coming from the leader of the world’s superpower it is another nail in the coffin of globalization, in addition to being an embarrassing conflation of the meaning of nationalism with patriotism.

One of the ironies in Trump’s many grand statements is the way they echo in China. In fact, China is well ahead of Trump in conceiving of how to put the ‘country ahead of the global’. A memorable example was the 2017 World Economic Forum when the Chinese leader Xi Jinping made a speech that claimed the mantle of globalization for China (from the USA).

The curious aspect of this is that while China is a large spigot in the world economy, it is one of the least globalized countries in the world (it ranks in the bottom quarter of nations according to my own measure of globalization). In his own way, Trump is reacting to this, but his crude view of China does not do justice to its history nor the amplitude of its ambition.

Well before MAGA (Make America Great Again) Xi Jinping coined the term ‘China Dream’ in a speech when visiting the National Museum of China in November 2012, having taken the office of general secretary of the Communist Party. The 70^th anniversary of the founding of the People’s Republic which occurs next Tuesday 1st October, will bring this into sharper focus.

China’s view of itself in the future, or the Chinese Dream, is colored by past generations of economic and cultural greatness. Recall that at the time of the Founding Fathers, the United States was but an emerging, even frontier economy and that at that time China accounted for nearly 40 percent of the world economy. By 1950, 150 years later, America made up a third of world economy, and China’s share had shrunk to 10 percent.

Given this backdrop China wants to elevate itself to a position of economic power (perhaps regional dominance) and of policy power in Asia with its own regionally relevant rule-based order so that it is, at the very least, not subject to the domination of Western countries and institutions (the film Amazing China, to be found on Youtube,gives a sense of this and of what is ahead).

China’s rise over the past thirty years has not been given enough credit by commentators and politicians in the West. Few of them are really curious about Chinese history and the Chinese approach to economics, politics and society. Mike Pence’s speech to the Hudson Institute last October was a sign of this, and one of the great challenges China will face in coming years is the realization in Washington and Brussels that China is pulling level with them in some domains.

Looking ahead, the great risk for China is that the ‘Dream’ runs out of momentum, economically in that growth slows, and politically in that people in China question a model that exchanges liberty for stability. The underlying risk is that not having experienced a formal recession in close to twenty years there is a great deal of inefficient capacity built up in China and that a downturn will expose this. If it does, rising unemployment will create a new political challenge for the all-powerful Xi Jinping.

In this respect, the manner in which China manages the protests in Hong Kong will provide a clue as to how the Communist Party will manage emerging political challenges. A physical, confrontational approach will open up many risks – political contagion, sanctions on the Hong Kong economy and a loss of soft power. A more drawn out approach that contests the legitimacy of the ‘two systems’ and that penalizes locals in Hong Kong by slowing the local economy may well dampen the crisis from a Chinese perspective. It must then confront the tenor of elections in Taiwan in early 2020.

Political volatility is thought to be the preserve of the West. One of the great surprises of the early 2020’s may be the way it spreads across emerging countries, with China as no exception.

Have a great week ahead,

Mike

All consequences are at your risk

The Chinese military garrison in Hong Kong released a video under the banner ‘All consequences are at your risk’. This an excellent dictum, though only when applied to the behavior of investors, banks and central banks in financial markets. Readers of The Levelling will know that I think the consequences of risk taking across markets are badly distorted, and risk taking and risk baring are mis-aligned.

The dictum might also be applied to President Trump’s twitter account, whose latest salvo has been to up the ante in the trade war between China and the USA after a very lukewarm meeting between US and Chinese officials in Beijing. China, which has been relatively restrained during the trade war will now respond, potentially with a boycott of certain US goods. US tech and capital goods companies look vulnerable.

Then, I should say emphatically that the ‘consequences/risk’ dictum should not apply to largely peaceful crowds in Hong Kong who protest in favour of democracy and an open society of sorts. China, for its part in the domains of economics and technology, has shown an ability to learn from both history and other countries. It should also do so with regard to the situation in Hong Kong and resist the urge to adopt a heavy handed approach.

While the backdrop of the trade dispute helps to paint events in Hong Kong as a context between China and the West, this is not the case, my sense is that the protesters are more standing up for their preferred ‘system’ than against China. A more violent response will change all this.

One of many reasons I drawn to the case of the Hong Kong protesters is the parallels with Levellers. The Levellers were generally constructive in their approach and experts at pamphleteering (the social media of the day). Similarly, the Hong Kong protesters have a (rather short-term) list of demands and are also particularly resourceful, deploying lasers against facial recognition cameras. The second reason is that the Levellers failed in their project, as many other idealistic, reform minded movements have. Recall the brutal way the Arab Spring was suppressed. The Hong Kong movement need to study the history of other groups, and guard against being outmaneuvered.

One trigger that may upset the balance of power is the scope for damage to the Hong Kong economy, property market and financial sector, and any contagion they may hold for international markets.

A transformation of the protests into a deeper conflict would have grave humanitarian and political implications, and I am simply reflecting my own expertise in focusing on the economic consequences here.

First, the Hong Kong stock market is the fifth largest in the world, heavily dependent on financial and property stocks, and a crucial gateway for Chinese companies that want to access liquid markets and international investors. A sell-off would be contagious via an unwind of investor positioning, the unwind of investment products and heightened credit risk across Asia.

Secondly, the Hong Kong property market, one of the pillars of the local economy, is one of the most precarious in the world in terms of valuation. A house price to income ratio of 18 times is eye watering in a market where the purchase of property is funded by relatively large cash deposits. Also, the property market is heavily financialized in terms of the number of funds and investment products that are tied to it.

The third risk is the Hong Kong dollar peg. In recent months the Hong Kong Monetary Authority has been spending more of its large reserves in supporting the peg. A stronger dollar, combined with lower local interest rates in Hong Kong has put upward pressure on the peg.

Well-established currency pegs are very hard to break, but any signs that the HK peg is pushing its lower limits in the context of a weaker local economy will at least fuel speculation about the peg. This in turn can lead to negative feedback on the local economy and property market, and by extension may also see investors worry more about the yuan. When the yuan weakens, international markets go ‘risk-off’.

There is now an unfortunate ‘perfect storm’ of factors gathering – stronger dollar, deeper trade dispute, acute tension on the streets of Hong Kong. For the sake of people in Hong Kong I hope it doesn’t worsen, though if it does expect contagion to spread quickly to financial markets.

Have a great week ahead,

Mike

What Boris should say on Hong Kong

St Mary’s, Putney – site of the Putney Debates

I spent much of last week in London where in between meetings and torrential rain I managed to get down to Putney to pay homage to St Mary’s Church. Those of you who have read ‘The Levelling’ will at this stage know that the nave of St Mary’s is adorned with the following quote ‘For really I thinke that the poorest he that is in England hath a life to live as the greatest he.” It comes from Colonel Thomas Rainsborough, an officer and military hero in Oliver Cromwell’s New Model Army and a leading member of a group called the Levellers.

The Levellers were a prominent mid 17th century group who created the first popular representation of constitutional democracy in the form of their Agreements of the People. Standing in front of St Mary’s I wondered what the Levellers might think of today’s world and its bizarre goings on.

In particular two political events, or rather processes, might interest them – the election of the next Tory leader and by extension British Prime Minister, and protests in Hong Kong, both of which are watershed moments.

To start in Westminister, where Boris Johnson has taken the lead in the Tory leadership race, and with Jeremy Hunt or, my wildcard bet Rory Stewart, as the likely challenger to a Boris centric No. 10. The Levellers liked their politicians to be modest and honest as the following quote shows ‘by woefull experience found the prevalence of corrupt interests powerfully inclining most men once entrusted with authority’. In that respect they would eschew the cult of personality that has infected the Westminster circus.

The Levellers, being a practical lot, would also scratch their heads at the lack of really concrete policy proposals from the major candidates. They would also worry that the spectacle of Brexit has distracted so many in politics from the business of government and that as a result there has been a policy holiday whilst elected officials have engaged in three years of parlour games. This lack of policy leadership is now showing in infrastructure, crime and social cohesion and is an underlying risk for the UK in general.

In that respect most Britons have had enough of Brexit, many will think it can’t get any worse. They may be wrong. Once the Tory leadership contest is over the Brexit circus will start over again. When it does, the risk is that any forbearance the EU showed Theresa May evaporates, and that it takes a tougher line on financial services for example. This will come as little comfort to business people, workers and the Treasury.

One last thought on Brexit, which is that in my view Brexit is really a national crisis of identity that happens to have been channelled towards European politics. One sign of this crisis of identity is the lack of voice and diplomatic clout that Britain has with regard to the situation in Hong Kong.

I recall the television pictures of bowed head of Chris Patten at the handover ceremony in 1997, an image that perhaps said more about Britain’s place in the world than that of China (incidentally one of the interesting elements of the handover was a memorandum that Prince Charles authored on it – there are not many copies in circulation but worth a read if you can find one!).

Indeed, few of the Tory leadership candidates are willing to speak forcefully about the situation in Hong Kong at a time when many natives of the city regard the current protest as a vital test and perhaps the decisive one at that. For those in Hong Kong that I have spoken with, the culture, way of life and public life of Hong Kong are at risk of being subsumed.

From a markets point of view the reaction to protests in Hong Kong has been relatively muted and should remain so given that the extradition Bill has been delayed. In the event that tensions rise again, the risks are high given that Hong Kong is the fifth largest stock exchange in the world, has probably the most overvalued property market and a currency peg. One might well argue that the economic and sentiment impact of Hong Kong being subsumed by China should be comparable to those of Britain leaving the EU.

Against this background, one news item to watch, beyond the US-China trade dispute, is a speech on US foreign policy (vis a vis China) by Vice President Mike Pence on June 24 at the Wilson Centre in Washington. The last such speech by Pence in October 2018 at the Hudson Institute was I felt, breath taking in its hostility to China, and there is a risk that ahead of the G20, we get a repeat of this.

As a last word, my sense at this juncture is that markets are vulnerable to a resetting of very dovish rate expectations by the Fed, to the realisation that the trade dispute between the US and China is a schism rather than a tiff, and that the earnings season sees recent macro weakness played out in profit and loss statements. Safe assets are very well bid – look at bunds and gold – risky assets are looking complacent.

Have a great week ahead

Mike

From the Banquet at Hongmen to Hong Kong

…as I was saying…regular readers of the Sunday letter will know that I have taken a break from it in recent weeks to recast the note around my forthcoming book ‘The Levelling’, and I hope that some will be happy it is back.

For those of you who are new to my list (please let me know if I should not have you on the list, or if you have colleagues or friends who would like to join it) I will send out a letter each Sunday morning (the one time people have a chance to read something) that mixes history, politics, markets, geopolitics and economics.

Given the intersection of these factors a good place to start this week is the Banquet at Hongmen, which occurred in China in 206 BC. In an age that is in Game of Thrones overdrive the story of Hongmen will appeal to many (indeed there is already a film about it called White Vengeance (2012)). In China, the tale is short-hand for duplicity and assassination and it featured in the Chinese press last week as part of the more popular response to President Trump’s tariff increase on China.

As an anchor point, ‘Hongmen’ serves a number of purposes that of course effortlessly dovetail into the themes of The Levelling. The first is that internal politics matter – Hongmen occurred at a time when the Qin and Han dynasties were contesting power. In this regard, for all that we hear today about the 2020 Presidential election campaign, we hear equally little about political debate within the Communist Party on topics like trade and relations with the USA.

Second, the cycles of the rise and fall of nations matter a lot. China has had many such cycles and America has effectively to complete a full cycle. Some may feel that this comes across in the bravoura of America’s interaction with other countries, but we should also bear in mind the context and patience that China’s history affords its leadership.

A third related point here is that China’s long history has given it a deep culture and sense of civilization. This is lost on some. Kiron Skinner a State Department official has recently tried to cast US-China relations as a ‘Clash of Civilisations’. This is a lazy use of Samuel Huntington’s work. A better parsing of the situation is multipolarity, where the world moves away from globalization towards a system driven by three large regions (US, EU and China) who do things in distinctly different ways.

In this context, the trade dispute is a marker of China’s rise and the belated realization of America’s elite as to how it should curb this. Tariffs are not at all the apt tool. There are better avenues. For example, America is extremely powerful financially, in terms of the usage of the dollar, depth and centrality of its markets and the power of its banks. Indeed, one could argue that the US is more hegemonic in finance than it is militarily.

Another avenue is leadership in international rules and standards. Many new fields such as artificial intelligence, genetic editing and cyber war have grown so quickly that they have bypassed international laws, philosophies and norms regarding them. One challenge for the US is to take the lead in outlining new standards and laws in these areas. Unfortunately this is something it does not appear prepared to do, especially in areas like climate change. If anything the US is ceding soft power to China.

To jump to finance, the market view of the trade dispute is that some form of resolution will be forthcoming. The drop in volatility on Friday suggested that US markets are moving from being positioned for a risky outcome, to one that is more sanguine. Other Asia centric ones like the KOSPI index South Korea and the Australian dollar will need to strengthen in order to give the all clear.

If a trade deal is struck, it will mark the beginning of a formal rivalry between the US and China, the start of more ‘nation first’ patterns in consumption and corporate investment and the end of bodies like the World Trade Organisation. There may be many more flash points.

Here, many tend to focus on great naval battles of the future in the South China Sea. In my view, one looming touchpoint is Hong Kong, where there is a fierce debate ongoing around a proposal to permit the imprisonment in China of those sentenced by courts in Hong Kong. For a city-state with a very expensive housing market, dollar currency peg and large stock market, this may be one area where geopolitics again ripples through markets.

Have a great week ahead,

Mike