Tuesday, September 17, 2019

EU Trade Deficit With China Destined To Grow

Europe Runs A Solid Trade Deficit With China
While we read a great deal about the huge trade deficit America runs with China it is important to understand we are not the only one. Other countries also have this problem. Europe as a whole runs a solid trade deficit with China. In some ways, this is balanced by the EU having a surplus with America. Still, in many ways, a growing trade deficit with China bodes poorly for the EU as they look down the road.

Reuters reports the European Union’s trade surplus in goods with the United States and its deficit with China both increased in the first seven months of 2019. Eurostat, the EU statistics office, reported the European Union’s surplus with the United States grew to 100.8 billion dollars in Jan-July 2019 from 88.6 billion in the same period of 2018. During that time the EU’s trade deficit with China expanded to 120.9 billion dollars from 109.2. This comes at a time that trade figures are adding extra strain to global tensions.

The Items These Countries Trade (click to enlarge)
This brings up the importance of what countries buy and sell to each other. If a county's exports are not centered around products where they have a core advantage over time they can see them erode. I contend part of the problem the EU has going forward is that much of the EU is simply uncompetitive. This means unless it takes strong action to halt the importation of cheap Chinese consumer goods it will be flooded with them in coming years. Since Europe does not sell China much in the way of "raw goods" it has little to balance this trade.

Simply put, the EU and the companies that call it home lag in both innovation and technology. The most innovative companies based on the number of patents they received in 2017 were IBM, Samsung Electronics, Canon, Intel, LG, Qualcomm, Google, and Microsoft, in that order. Note how European companies are absent from this list. Adding to their lack of industrial leadership is the matter of over-regulation that stifles EU companies from moving forward. When it comes to low-cost production they are also beaten by China and other Asian countries. This has caused Brussels to join Washington in complaining that China wants free trade but does not play fair.

The auto industry is just one example of the EU losing its ability to compete. A recent article titled, "European Carmakers Face Perfect Storm" delves into how European carmakers are facing what could turn out to be a major crisis. It is being created by EU regulators which are driving automakers to cut emissions at great cost. The EU has been enforcing emission caps on cars but beginning next year they will be reduced further to 95 grams of CO per km. This means a slew of electric vehicles will be rolled out but there are no guarantees that people will want to buy those cars. These cars will be much more expensive to build, estimates are each one will cost over $10,000 more to produce, so just because many people claim they are a greener alternative does not guarantee a market for them.

Click Here To View C919 Article
In future years the EU is expected to continue slipping further behind in many areas. Politico reports that Washington is preparing to announce tariffs on billions of goods from the European Union.  This follows a decision by the WTO which has just ruled in favor of the US in a case against Airbus. This ends a multi-year transatlantic dispute between the world's two largest aircraft manufacturers over whether Airbus had benefited from illegal state subsidies. Unfortunately, for both America and the EU the Chinese state-owned aviation manufacturer Commercial Aircraft Corp of China (COMAC), has been busy developing the C919, which is seen as China's answer to the Boeing 737 and Airbus 320.

The C-919 hits right at the core market of both companies. COMAC is yet to release the price tag of the jet, but a report by China National Radio predicted that it would likely to be sold for around $43 million. This is much cheaper than a Boeing 737 or an Airbus 320 which each cost around $80 million $100 million respectively. It does not take a rocket scientist to calculate how rapidly China can ramp up production. This is just the sort of thing that dooms the EU into an unwinnable position. The EU will be hard hit if America is successful in trimming its existing deficit with the region while its deficit with China widens.

Footnote; This article is in some ways a follow up to a previous post titled; "China Is cutting A Path through The Turbulence." The article delves into how China's One Belt One Road agenda includes developing much stronger trade ties with Europe. The link to that article is below.

Thursday, September 12, 2019

Central Banks Low Rate Solution Remains Problematic

This Simplistic View Of Economy Is Problematic
One of the most remarkable features of our current economy is that interest rates are flat or negative in real terms and many people are advocating they need or should go lower. This is not completely unprecedented. Real rates were negative after the second World War and again in the 1970s. Across the world, the central banks have raced to the bottom lowering interest rates only to find little relief from the slow economic growth that has haunted their economies for years. What former Fed Chairman Ben Bernanke, started as a program to support and prop up the economy has over time morphed into the main driver of economic data.

It is becoming clear the actions Ben Bernanke took that enabled and even encouraged the central banks to go down this rabbit hole have had more than a few negative consequences. An argument could be made that the power of lowering interest rates is a one-off that has largely run its course and is largely behind us. The truth is a policy of creating debt and stacking layer after layer of it behind the curtain has dampened the ability of consumers to move forward. Even at super low-interest rates, a great share of income must now be used to service past obligations. This leaves less money available for new purchases which has a major dampening effect going forward.  

Between the low-interest rates that have propelled investors into high-risk assets in search of a positive return on their money, and money being pumped into the system, the markets have become distorted and disconnected from the economy. Frequently overlooked is that low-interest rates do not extend down to low-income individuals with poor credit and many people fall into this category. This tends to fuel inequality and punish the poor. Policymakers aided by the media thrive at presenting simplistic but flawed answers to solve both economic and society’s problems which will require little or no effort from the masses. Unfortunately, the concept that a rising tide floats all boats or trickle-down economics tends to heavily favor the rich.

Then there is also the "inflation factor" which nibbles away at our standard of living Even as many economist claim inflation is not an issue for the many Americans forced to pay higher food, rent, and health insurance premiums little comfort is forthcoming. Currently, much of the recent economic data indicates lower-interest rates have been a "one-time" economic tailwind that is rapidly weakening and lost its kick. This puts both the central banks and the economy between a rock and a hard place. The big issue is where we go from here, regardless of what you name it, this is the box Ben Bernanke created when he painted both himself and the Federal Reserve in a corner. Adding to our woes is the Federal Reserve's failure to make any serious efforts in pushing the government to address structural problems thus delaying necessary adjustments to make America more competitive.

Debt Has Grown Faster Than GDP (Click to enlarge)
The level of interest rates is normally viewed as an effort to balances several forces at work within an economy such as the desire for saving with the demand for investment or consumption. Negative real rates reduce the incentive to save and indicate that businesses are reluctant to invest in new projects. Central banks attempt to offset this during a very weak economy by lowering rates. These policies aim to discourage saving thus boosting consumer demand.  

Sadly, the low rates geared to encourage business borrowing and boost employment also tend to encourage savers to take on more risk than they should as they search for higher yields. This can create a full "risk-on" mentality that can wash away common sense. It can also fuel what is known as "the fear of missing out." As stated earlier, the policy of rapid credit expansion while an interesting concept frequently is accompanied by negative consequences. Reports from the Bank for International Settlements point to a number of other problems that negative real rates can cause such as tempting borrowers into ignoring their balance-sheet problems. This tends to allow problems to fester making it more difficult for central banks to raise interest rates in the future.

This is being put to the test in China where we see the amount of GDP growth generated by each infusion of new stimulus decrease year after year. At the end of 2015, the Chinese debt to GDP ratio stood at 258%. This can be viewed as an indication of economic exhaustion and overcapacity results from continually priming the pump. Way back in 2014 Wei Yao Of Societe Generale warned the debt ratio of Chinese companies had reached 30% of GDP which is seen as a sign of financial crisis because it means companies are on the verge of no longer being able to pay the interest on their debt. This creates a situation known as a "Minsky Moment " where the debt pyramid can collapse under its own weight as the debt "snowball" keeps getting bigger without contributing to the real economy. At the time she pointed out the total credit in China's financial system was estimated to be as high as 221% of GDP and had surged almost eight-fold in just 10 years.

When an economy is growing rapidly, there is generally an abundance of profitable investment opportunities and businesses are happy to borrow at high real rates. Real interest rates set a hurdle by which profitable projects should be judged. If the rate is held at an artificially low level for too long, a big danger is that capital will be misallocated and flow into speculative investments. Banks may also become too optimistic about the ability of borrowers to repay, and fail to make adequate provisions for bad debts. It also encourages banks to borrow short-term from the central bank and lend long-term to the government. This is a public subsidy that should cause more taxpayers to scream foul!

Another problem is that pensions also invest in bonds using the income to fund future payouts. As yields fall it creates a situation that makes it harder for pensions to remain solvent while honoring future obligations. Low-interest rates in the developed world also spill over into emerging markets, pushing up exchange rates, increasing speculation, inflating commodity prices and causing asset bubbles. We must keep in mind that when rates do eventually rise we will most likely see a painful unwinding of these investments.

Savers also suffer from these low-interest rates because it means that every dollar of savings spent becomes more difficult to re-earn or replenish. Lower rates in effect cause many older people to hoard their wealth. This translates into baby boomers keeping that older car for an extra 50,000 miles, to cancel remodeling projects, and make the grand-kids fund their own education in an effort to extend the life of their savings. This often means that with less interest income they are purchasing a lot fewer electronic gadgets and spending vacations in the backyard. Tens of millions of Americans are either in this position now or about to become so.

On the flip-side, many people with little savings have rushed out to buy cars and expensive items they really can't afford and pulled consumption forward. Ironically, as the country's most responsible citizens hunker down we see lenders leaning into the wind and playing Russian roulette with high-risk loans to those with poor credit records that may never be repaid or have to be written down. The premise being that when you charge interest in the high teens even after the write-downs you come out ahead. The bottom-line is that all the above trends and reactions to lower interest rates feed into a situation that is not particularly healthy, fair, or logical. As a result of these low-interest rates this "recovery" has been built on a false base and been far less robust than originally hoped. The legacy of Central Banks pursuing the "low rate" solution may turn out rather ugly when all is said and done.

Thursday, September 5, 2019

Farmageddon Is Real And Farmers Are Suffering

Farmageddon is real and very painful for a small segment of America. According to the Book of Revelation in the New Testament of the Bible, Armageddon is the prophesied location of a gathering of armies for a battle during the end times. Today many farmers living in America's farm belt are facing tough times with no end in sight. The trade war with China has taken a toll by bringing grain exports to a near halt.  This has caused grain prices to tumble adding to the list of blows hitting farmers. While the number of people employed on farms has declined over the decades farming remains a big business and has a huge impact on many communities. In these areas, the money flowing into local businesses as farmers sell their crops is evident in everything from truck sales to the little things common in everyday life such as dining out or getting a haircut.

Net Farm Income (click to enlarge)
The USDA's farm income forecasts are released three times a year. While little noticed by the average person living on the coast or in one of our many large cities this is a big deal. As mentioned earlier in this article farm income is not contained in a closed-loop but spills into other parts of the economy. Many areas in the heartland of America have not experienced the benefits showered upon Wall Street, because of this we should not be surprised if the gloom covering many areas of the country does not lift anytime soon. The chart to the right shows a "forecast of income" but fails to take the impact of the trade war into full consideration.

Sadly, getting support to the average working farmer is more difficult than it might seem. A recent article in AgMag claims About 9,000 "city slickers," that means, people living in luxurious neighborhoods in large cities received a farm bailout from the Trump administration's recent effort to minimize the impact of the trade war on farmers. An updated Environmental Working Group (EWG) analysis of Department of Agriculture data revealed that many recipients of the relief money live not in farm country but in large cities or other decidedly non-rural locations. These urban recipients of the bailout include members of farm families, landowners, and investors that provide land, capital, equipment for farms or make operational decisions for how a farm is run.

Modern Farming Is Capital Intense
Farm real estate debt is expected to reach $263.7 billion in 2019, a 5.1 percent annual increase. Of this real estate debt accounts for 61.8 percent of total farm debt. Due to the weakness in the prices of crops and livestock, many farmers today suffer cash flow issues and struggle to get financing to plant crops. Farmer access to capital continues to be primarily in the form of debt. Commercial banks and the FCS have become more cautious as bankruptcy filings in the Seventh Circuit (Illinois, Indiana, Wisconsin) and Eight Circuit (N Dakota to Arkansas) have hit a10-year high. Most operators try to hang on when grain prices are low, hoping to still be in business when prices increase. Efficient farmers with manageable debt levels have the flexibility to stay profitable throughout the cycle but the smaller often less efficient farmers generally feel a huge impact from a drop in income and tighter lending criteria.

Adding to the already bad situation down on the farm is the negative feedback flowing from the recent decision by the EPA to ramp up the number of waivers that it grants to the refining industry, absolving some smaller refiners of the requirement to buy ethanol. The Trump administration's shocking decision to approve 31 and deny only six 2018 waiver requests has left the bio-fuels industry reeling was incensed. The Renewable Fuels Association (IRFA) Executive Director Monte Shaw stated in a press release. “With this action, President Trump has destroyed over a billion gallons of bio-fuel demand and broken his promise to Iowa voters to protect the [Renewable Fuels Standard].”  This caused futures prices for corn-based ethanol to plunge to a five-year low for this time of year and down roughly 25 percent since June. “The Trump administration has totally annihilated the margins for ethanol producers,” Charlie Sernatinger, head of global grains futures with ED&F Man Capital Markets, told the Wall Street Journal.

The EPA’s decision is merely the latest in a series of blows from Washington and the hits keep on coming. The U.S.-China trade war has battered the U.S. Midwest, as farmers have all but lost access to the Chinese market. China has turned to Brazil for ethanol and soybeans. Prices for U.S. soybeans, corn, and other agricultural commodities have plunged. Corn prices had rebounded after the Midwest was soaked in record-breaking floods that threatened corn plantings, however, the latest data from the U.S. Department of Agriculture shows that yields are not expected to be as hard hit as previously expected. Normally this would be good news for farmers but higher-than-expected supply has sent corn prices tumbling.

Several months ago JPMorgan told clients the American agriculture complex is on the verge of disaster, with farmers caught in the crossfire of an escalating trade war. Modern farming is a capital intense business and over the years many farmers have taken on debt. They have come to count on income from grain exports to service their obligations. JPMorgan analyst Ann Duignan alerted investors that, Overall, this is a perfect storm for US farmers," Because of this, in May, Duignan downgraded John Deere's stock to underweight, pointing to the fundamentals in the farm-belt as "rapidly deteriorating."

Farm Implement Sales Have Tanked
The pain felt in the farm-belt is very evident at dozens of John Deere dealerships where the agriculture bust that has triggered massive tractor sales declines and left stores reeling. Reuters contacted dozens of John Deere Stores across the Central and Midwest U.S. in an effort to access what the trade war and adverse weather conditions have had on tractor sales this year. It reports that about a half dozen stores across the Midwest said sales in the first half of 2019 collapsed. One store, in Geneseo, Illinois, saw sales fall 50% from the previous year. Sales orders for tractors next season are down, this is an indication that farmers expect the bust will continue through 2020.

The USDA forecasts the farm sector’s risk of insolvency to be at its highest level since 2002. The value of land, the most stable asset on the farmer’s balance sheet is impacted by commodity prices, interest rates and the cyclical nature of farm income. From the farmer's point of view, Trump may have made a big mistake when he recently decided to hold off on additional tariffs on Chinese goods because it will drag out negotiations. The President's motivation seems to be keeping consumer prices in stores low over the holidays. Christmas sales make up a good share of retailers overall annual revenue. Unfortunately, his move also delayed a resolution to the trade talks by removing pressure on China to come to the table. The bottom-line is farmers can expect export sales of grain pushed back again because China views that punishing the American farmer is a chief weapon in the negotiations.

Tuesday, September 3, 2019

Euro-zone Woes Continue With No End In Sight

German Business Confidence (click to enlarge)
Recently we saw the euro's slump deepen after German business confidence extended its decline. The euro fell to its weakest level in almost seven years as weakening manufacturing put Europe’s largest economy on the brink of recession. The German GDP contracted in the second quarter and it could shrink again in the third, sending the economy into its first technical recession in years. It does not help that as Germany’s export-centered economy is struggling global trade tensions are worsening. With talk of the trade war back with a vengeance following Jackson Hole the German government has signaled it’s open to fiscal stimulus if the current downturn turns into a more severe crisis.

On top of this bad news, it appears the European Union is finally moving towards crunch time with the UK. Boris Johnson, the new Prime Minister of the United Kingdom, has taken the stand the UK will exit the union, deal or no deal, on October 31. The failure of the EU to negotiate in a fair way has led to this scenario and the negative implications of such a split may reverberate throughout the economy for years. This all leaves those of us watching Europe's combined economies wondering where they might get a spark that will ignite growth. Sadly, the answer has not revealed itself and it appears it could be all downhill from here.

This leaves much of the EU fate resting on the new incoming head of the ECB, former IMF chief Christine Lagarde and the hope she can pull a rabbit out of her hat and find a way to set things right. Lagarde's announced appointment is reviving praise as an experienced financial firefighter with a steady hand. Her greatest challenge is that she is replacing a man credited with saving the Euro-zone by means that will no longer work. If she departs from Draghi’s script, she will face fierce criticism but if she does not, the Euro-zone’s never-ending crisis is expected to spin out of the ECB’s control. Draghi attempted to save the Euro-zone by printing trillions of euros which funded bankrupt banks and allowed Italy, Spain and other stressed states to roll over their debts but has failed.

Low-interest rates and easy money have not cured Europe's problems and the area continues to face growing anti-EU sentiment. Looming before the region is the problem of envisioning exactly from where its next economic renaissance might flow. The source certainly won't be from a well-tuned and responsive political system or because of its growing ability to produce goods for a fraction of the cost of competing nations. Unfortunately for the Euro-zone, much of its problem can be viewed as one of "stagnation." Figures show that as of 2017 not a single European company ranked among the top fifteen technology companies in the world. It was mainly North American and Chinese companies that are driving the world forward. Still, more troubling is that of the top 50 global technology companies, only four are European and even those are slowing losing their edge.

Italy A European Debt Bomb Waiting To Explode
The truth is that in all reality Italy went bankrupt in summer 2011. Back then we saw interest rates on the national debt spike going out of control and Italy lost access to the financial markets. At that time the ECB and political authorities in Europe agreed to create around the country’s finances an artificial market to give the impression of stability and the appearance that Italy could work its way through its problems.

Italy is now forced to stay on this artificial support until the economic conditions improve and confidence is restored to where the country will have again access to real and normal credit markets. This most likely will never happen because not only is Italy mired in debt but it is also a mess politically. Not only the size of debt but the quality of the debt meaning the ability to repay it is an important issue. Because of the sheer dimensions of Italy as an economy and as a debtor, it dwarfs the problems posed by other countries that make up what has been referred to as the Euro-zone PIGS. All countries are not equal in size and the reason for their woes vary, however, propping up an economy is not a long term fix. The ECB loaning money to banks to have them purchase government-issued bonds is a scheme and instrument that allowed international investors to exit Italy in an orderly fashion but resolves little.

Not attempting to load onto the list of problems it still must be pointed out that on May 16th of this year when Bloomberg declared the EU migrant crisis over they may have been premature. This has proven to be a case of hope being placed in front of reality. The good news is the 150,000 migrants seeking to enter Europe illegally last year represents a 92% drop since 2015. Also, the article stated the number of people seeking asylum in 2018 was 646,000, less than half of what it was three years ago. Still, the issue remains politically divisive as ever. It is clear the EU’s member states do not share a common long-term perspective on migration from the Middle East and Northern Africa to Europe.

Who Should We Blame? (click to enlarge)
In the later part of July, French president, Emmanuel Macron, said European countries have made progress on plans to redistribute refugees rescued in the Mediterranean. Still, Italy's Salvini, who closed ports to NGO rescue boats, said the agreement underscored a demand that Italy continues to be the refugee camp of Europe. Salvini said Italy “does not take orders and is not a partner. If Macron wants to discuss migrants, come to Rome.” The fact is things are still up in the air as to what to do with the thousands of refugees still attempting to reach Europe.

Each day more attempt to cross the Mediterranean with Italy and a few other countries forced to bear the brunt of the problem. Salvini has accused the NGOs of running a “taxi service” for migrants and has demanded other European countries open their ports to the boats. This has resulted in NGO boats being forced into time-consuming negotiations between EU member states as they try to find a country willing to admit them each time they rescue migrants and refugees. Charities have criticized what they describe as Europe’s “campaign of criminalization” towards their rescue boats. This has led to a joint statement from the heads of the UN refugee agency UNHCR and the International Organization for Migration, it said: “The crucial role played by NGOs must be acknowledged. They should not be criminalized nor stigmatized for saving lives at sea.”

When all is said and done we in America have been shielded from a great deal of the bad news and migrant problem flowing out of Europe. In general, we hear little of the continuing yellow vest protest in France or no-go zones where police and delivery divers fear to tread. Instead, our media is focused on Trump's latest tweets. It seems we have enough of our own problems both economically and politically to keep us busy. Like many of the issues confronting America, the woes facing the Euro-zone economies are deep-seated and structural. Trying to avoid confronting them will not make them disappear but will simply result in more pain down the road. In time, much of this pain may come to the people of Europe in the way of a falling euro that strips them of their wealth.

Sunday, September 1, 2019

China's Currency Problem Is Worse Than It Appears

China's currency woes are worse than many people think and this is putting the yuan under pressure. When people point to China's large holdings of U.S. Treasuries as proof of China's solvency they frequently discount the amount of debt that has grown in the Chinese system. It is true the Chinese own a lot of U.S. debt, $1.123 trillion as of December 2018. Together Japan and China own about ten percent of  the U.S. debt, 5.1%, and 4.7% respectively. Japanese-owned debt doesn't receive nearly as much negative attention because Japan is seen as a friendlier nation and the Japanese economy appears more stable. While many Americans tout that China has us by the throat it is not true. Considering how rapidly debt and credit have increased over the years, it could be argued that a trillion dollars of debt is not nearly as relevant as it was a decade ago.
China Only Holds A Small Percentage Of US Debt

The main reason China bought up so many U.S. Treasuries over the years is that it wanted its currency pegged to the dollar. Dollar-pegging adds stability to the yuan since the dollar is viewed as one of the safest currencies in the world. This has been a common practice for many countries since the 1944 Bretton Woods Conference. Still, even though China owns these U.S. Treasuries, China is running a massive U.S. dollar shortage both on a corporate and a national level. Much of the problem stems from Chinese companies having roughly $2 trillion U.S. dollar-denominated debt owed to international investors.

Loans of this type are not uncommon, especially in developing nations. Much of global debt is denominated in U.S. dollars. This means the companies owing it need to pay both the principal and the interest payments to their lenders in U.S. dollars. This results in a demand for dollars and usually a constant flow of dollars out of the country. This is a totally separate issue from individuals or companies shifting wealth out of China to avoid the pain of currency devaluation or to escape its repressive regime. An article titled; China Continues To Prop Up Its "Unpropable" Economy, delves into how China continues to prop up a financial collapse and how China suffers under crushing debt. It contends due to the huge amount of debt China's demise can only be postponed but not stopped.

China's Debt Soared After 2008 (click to enlarge)
It expands on the proposition that since the 2008 financial crisis Chinese bank assets, and by implication liabilities, have exploded by an astounding $15 trillion, bringing the total to over $24 trillion. In other words, China has expanded its financial balance sheet by 50% more than the assets of all global central banks combined. This means that China's debt is now creating instability and has become the biggest wildcard in the global financial system. Continuing along this "one-way path," in January of 2019, Beijing injected a staggering $685 billion in new credit into its financial system. This injection was greater than the GDP of Taiwan the world's 21st largest country. 

Many of us are drawn to a good illusion and in some ways, it could be said that our culture has become obsessed with avoiding what is real. With this in mind, we must remember that politicians and those in power tend to go to extreme efforts to avoid taking responsibility for the problems they create and this has been done in China. History shows that one way a country can kick their gross domestic product higher is to build a false economy based on infrastructure or war. China's version of this is apparent in its "ghost cities." Unfortunately, when a country gorges at the trough of deficit spending that generates a big temporary boost in its GDP it also creates a wall of debt. One of the best examples of building an economy on such a foundation was demonstrated by Germany when it turned its economy into a war machine during the 1930s.

To understand the ramifications of the situation China now finds itself in we need only look at the finding of the 2009 bestselling book titled, "This Time Is Different." The book written in 2009 by Carmen Reinhart and Kenneth Rogoff. It chronicles eight centuries of financial follies in which financial meltdowns have typically followed real-estate bubbles, rising indebtedness, and gaping deficits. Their work adds credence to the belief that debt has consequences. The authors highlight a clear pattern of similarity between many of the defaults that have occurred throughout history and the situation developing today. Debt has been growing at an incredible rate across the globe but even more in China.

For years as they debate the true strength and sustainability of China's economy and its role as a global player has been debated by China watchers, economists, and investors. Those of us that paint a picture of future collapse and a day of reckoning are often accused of spreading "doom-porn" when we claim that the Chinese have masked over their dire situation by continually expanding credit. It is important to note that over the years each new wave of money has begun to lose its impact as the efficiency of stimulus waned and more and more of the credit was absorbed in supporting existing debt. The fact is few good investment opportunities currently exist in China and this causes much of the newly printed money to leak across the border inflating asset bubbles in other countries.

 China's Yuan Is A Small Player (click to enlarge)
Much of what is occurring in global currency markets has been "scrubbed away" by our complex financial system that tends to soften the edges of harsh moves obscuring their importance. Many people think things move and unfold in a logical way but  we should also consider the possibility the currency market is a manipulated scheme by central banks to create the illusion of stability. For a long time, I have maintained the view that currencies are trading in a false paradigm created by the coordinated collusion of the major central banks to limit currency volatility. The central banks know the collapse of any one of the world's four major reserve currencies would shatter the myth that the major currencies of today are immune to the fate that has haunted currencies throughout history.

In our modern global economy, a huge percentage of our wealth is contained within the rather closed system of fiat money. The laws and rules governing this system by their nature discourage freedom of movement into tangible assets. History shows that when the nations granting a currency have proven unable to control their budgets and are crushed under the weight of debt bad things happen. This situation frequently results in inflation. A key reason inflation has remained so low since 2008 is because people have been willing to store their wealth in paper instruments. The good people of countries like Argentina, Venezuela, Iran. and Turkey that held on to their country's currency have been financially raped as the currencies have fallen in value. Today they are far less wealthy compared to people in countries that have seen their currencies remain stable.

The rubber will meet the road as more countries that export to China question the value of the Chinese currency and demand payment in dollars and refuse the yuan. While China enjoys a trade surplus with America this is used to support trade deficits with many other nations. If at some point China decides to or is forced to sell its FX reserves to get access to U.S. dollars to help prop up systemically important firms it becomes a bit of a self-defeating exercise. When a currency implodes or fails, wealth is transferred from those improperly invested to survive such an event to those positioned to benefit. The canary in the coal mine portending of such an event may be the stories we hear of central banks and countries buying gold. In the future investors would be wise to prepare for a rude awakening due to a huge shift in the values of currencies.

Footnote; A recent article by on The Sounding Line delves into the idea the Chinese stimulus is not working anymore. The link to that article can be found below.

Sunday, August 25, 2019

Trump Continues His Effort To Be Too Clever By Half

Anyone with a lick of commonsense knew Trump's detractors would be gunning for him during his trip to Europe. Trump has not disappointed these people by continuing his effort to come across as too clever for his own good. This has gone so far that during the “Overtime” segment of HBO’s Real Time, former North Dakota Senator Heidi Heitkamp (D) made fun of Donald Trump even before he arrived at the G7 summit in France. She did this by doing an impression of Trump "pouting." Heitkamp said Trump will pout his way through the weekend because the other world leaders loathe him. While nobody cares about the opinion of this woman, sadly, many people tend to agree that Trump is held in low esteem.

To make matters worse Trump gave these people more ammunition when he said he has doubts about his actions. During breakfast with the UK's Boris Johnson at the G-7 meeting in Biarritz, France Trump acknowledged having second thoughts about the escalating the trade war with China. A top spokeswoman later tried to clarify his statement to mean he regretted not raising tariffs even more. Adding to the confusion was Trump's response to questions from reporters on whether he had any second thoughts about his escalation in the "tariff war" by saying, “Yeah, sure. Why not?”  When the question was repeated Trump replied: “Might as well. Might as well.” Another reporter then followed up seeking clarification, Trump responded, “I have second thoughts about everything.”

Trump Often Comes Across As Too Clever By Half
These are not the kind of words most voters want to hear flowing from the Presidents mouth on such important issues tied directly to the global economy. Remember this is a guy that fits the mold of a person that is, "too clever by half." This is an old British saying, it refers to someone who is too confident of their intelligence in a way that annoys other people.

Often the reason a person gets labeled this way is because they come across as arrogant. The word braggadocios has been used to describe Donald Trump, synonyms for this word according to thesaurus.com are blowhard, boaster, bragger, show-off, and windbag. None of these are very flattering and over time such behavior has a way of wearing on people which often results in a backlash accommodated with negative consequences. This may be why the polls continue to show Trump lacks broad support and his favorability ratings can't seem to get out of the cellar. 

Ironically, in the past when he took strong military action such as in bombing a Syrian airbase in reaction to a chemical attack that killed children, he did receive kudos, however, it was from "never Trump" people. The pop in his polls came from neocons and liberals who believe in intervention. In fact, many of the supporters that constitute his base were a bit down in the mouth. Another way to gauge how President Trump's base is reacting to his moods is how they react to the tweets he sends out at any time of the day or night. When he twitters the President is able to bypass the mainstream media but it often gets their attention and a fair amount of negative coverage. Still more important is the reactions to the messages he twitters can vary greatly among those who voted him into office.  

One thing many people find troubling is that during his time in office Trump has on more than one occasion brought America to the brink of war, and I don't mean with just one country or foe. You can flip a coin as to whether it is the Korean peninsula that will light up with a nuclear glow, Europe erupting into conflict with Russia, or we will awaken to find thousands of American troops being dispatched to the Middle East. Years ago an attorney cautioned me that when negotiating a deal I sometimes came across as a little coy, I have always questioned his terminology, however, admit that when young and leaning far into the wind I might have gone a little too far. My point is when you play fast and loose the potential that you may lose control of events increases dramatically.

A Growing Concern For Trump Supporters
Over time a number of articles have surfaced on the subject of Trumps "flip flops." Needless to say, this does not bode well for those seeking stability. Let me be clear, we are not talking about minor issues but some of the key issues of the day such as whether China is and should be pursued as a currency manipulator or whether he will try to get rid of Powell as head of the Federal Reserve. Even his stand on NATO which has a direct bearing on national security. He even threw his support behind the Export-Import Bank  after opposing it during the campaign. This leaves many of us a bit puzzled.

The mainstream media is quick to point out Trump's shortcomings and make a big deal over every falling out he has with his staff. Still, he remains brash and bold and supremely confident. While he claims he's running a well-oiled machine others give the impression that a revolving door needs to be installed to accommodate those rapidly becoming disenchanted with the way things are being run. Inside the White House, a bubbling cauldron of different ideas are competing for power and the President's ear. With this in mind, everyone should remember it was a populist message of "draining the swamp" that resulted in his election and while often discounted as "common folk" these voters are not necessarily as simple-minded as the pundits might lead you to believe. 

For many Americans supporting Trump was not easy or did not come naturally, however, they saw Hillary Clinton as even less acceptable. A series of recent flip-flops on positions are beginning to irritate and concern his base. If this continues they will begin to doubt what he is really about. If voters who supported Trump become convinced he is playing them for fools it is likely they will loudly voice their discontent. One argument to explain Trumps is that we are looking at a choice of style. Trump has repeatedly said he likes to play cards that are unexpected to keep the opposition off balance, however, when you unsettle those who support you it has a way of coming back to haunt you.

This article has been brewing for a while, like many voters, I viewed Trumps failure to move healthcare reform forward coupled with Republicans pathetic excuse for an answer to improve healthcare as far short of inspiring. This has raised a great deal of doubt about his ability to deliver on other issues and while Trump predicted that Democrats will own ObamaCare if it falls apart reality may not support his view. A recent poll from the Kaiser Family Foundation shows a majority of voters, 61 percent said they now blame Trump and Republicans for “future problems” with the healthcare law. It seems the GOP had their chance to fix it and are now responsible for any problems with it moving forward.”

While some of this can be explained away as a strategy change or that he is evolving it has and should raise concern. Part of the problem is we were promised better than this, and not only better but quickly, we were promised we would win so much we would get tired of winning. To hear Trump talk at times you get the idea he thinks it is all about him. For example, Trump has both praised and blamed himself for the strong dollar. “I think our dollar is getting too strong, and partially that’s my fault because people have confidence in me,” said Trump. This means whether he realizes it or not, by taking credit for things not directly flowing from his position he also opens and creates the situation where he may also be blamed and have criticism heaped upon him for things out of his control.

We must not underestimate just how polarized America is and because of that any event playing out poorly or a few bad news cycles can put Trump in a precarious position. A little humility on the part of Trump would go a long way towards defusing the anger that is beginning to smolder as his supporters witness a flip flop here and a flip there. With Trump detractors eagerly awaiting the day when he fails and receives his comeuppance Trump best remember who his friends are and that in Washington he has very few of them. There will be bad days, there always are, and before they erupt Trump would be wise to remember the message he put before the people that put him in office, if not the populist most likely unleash their wrath upon him.

Saturday, August 24, 2019

Liquidity Is Often The First Casualty In A Financial Crisis

During Market Carnage Liquidity Takes Flight!
For years investors have been rather complacent to the risk they faced and because of this, leverage has slowly built up within the system. It is important to internalize in your mind that buying the dip is not a trading strategy carved in stone. There is a reason we have been warned; "do not to try to catch a falling knife."

Sadly, banks have a way of failing us when we need them most and that is a big part of why liquidity is generally the first casualty in a financial crisis. A huge part of the problem is rooted in the economic tool known as leverage. The same massive gains leverage brings, also showers us with huge losses that rapidly paralyze both individuals and financial institutions. When volatility hits the markets any person or group with less than stellar credit are likely to find they are unable to borrow new money.

Often even those with good credit are forced to watch as even existing credit-lines are cut. The bottom-line is banks do not like to loan money to those that need it but prefer to line the pockets of those who dwell in their inner circle. Many of the credit-lines that existed prior to 2008 have gone the way of the dinosaurs with banks claiming new government regulations are to blame for the way they do business today. Much of this is hidden away in that pesky small print that exists is all the paperwork we sign when dealing with these institutions. This is especially clear in the commercial real estate market. CEO Chris Maher of New Jersey’s Ocean First Bank has already pulled back on refinancing transactions that let customers cash out on their debt, and has started reducing exposure to industrial loans. He told Reuters.

“In a downturn, industrial property is extremely illiquid,” he said. “If you don’t want it and it’s not needed it could be almost valueless.”

It is the slow movers and common folks that will suffer the brunt of a falling market. Phone lines get jammed and computer access backs up or becomes unavailable as "at market orders" flood the system. With this in mind, we should not rule out the possibility that much of the "smart money" has already exited the stock market in recent months or hedged in a way to minimize potential losses. Another problem for the bulls is that many shorts got out of the market long ago and today many traders are playing on borrowed money. This means the margin calls will be fierce. Market uncertainty combined with the desire to protect capital tends to create a "circle the wagons" mentality. The lack of liquidity it fosters will be particularly hard on high yielding and smaller markets with narrow appeal.
Liquidity Falls Off The Chart In A Financial Crisis
Uncertainty rules during a financial crisis and when liquidity drys up cash rapidly becomes king. Anyone doing a great deal of negotiating knows the one-word people wanting to reach an agreement don't want to hear is "IF"! This is why I will never call the holder of cash stupid unless it is during a long period of massive inflation.

We should remember how well banks fare if assets retrench will depend a great deal on the collateral they have glommed onto prior to the onset of the difficulties. Falling oil prices are already putting pressure on a slew of oil patch loans and bonds. It is also important to remember historically banks have been poor managers of any tangible assets that require day to day care. One thing banks do not need is a slew of properties defaulting on loans and coming under their control.

In a recent article, I questioned whether we have entered the period that may someday be referred to as "The Great Reset" where values might be shaken to their core. If so, the ramifications are that assets such as stocks could take it hard on the chin. When adjusted for inflation, the case could be made that stocks may not recover for decades. The market surge since 2008 has reinforced the myth that stocks move upward and always recover if you ride out market tantrums, however, this is not true. All those owning shares of GE, GM, and a slew of other companies caught up in the last crisis will confirm that holding on to an investment does not always make you whole. When markets cross into bear-market territory and retreat from their peak market psychology begins to change and "worry" becomes the word of the day.

During the December 2018 market pullback, the five FAANG stocks. Facebook, Amazon, Apple, Netflix, and Google/Alphabet together accounting for more than two-thirds of the Nasdaq-100's loss. When such high-flyers that are always being hyped in the news get whacked traders take notice. With liquidity on the wane and traders rather nervous this might be a bad time to buy the latest dip. Remember the market has climbed a long way in the last ten years without a major correction. While the idea of buying stocks when the market is out of favor sounds great pulling the trigger is difficult in an unstable market which causes many investors to alter their plans. Be careful out there, and remember capital preservation is job one!
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Saturday, August 17, 2019

The CPI Understates Inflation Skewing Our Expectations

The purpose of the consumer price index (CPI) is to reflect just how much inflation is eating into both our incomes and our savings. Consumer inflation has been estimated since the 1700s, by measuring price changes in a fixed-weight basket of goods. This method was seen as a way of measuring the cost of maintaining a constant standard of living. In the last 30 years, a growing gap has become obvious between government reporting of inflation, as measured by the CPI, and the perception of actual inflation held by the general public.

Currently, the government understates inflation by using a formula based on the concept of a “constant level of satisfaction” that evolved during the first half of the 20th century in academia. This extended into the BLS re-weightings sales outlets such as discount or mass merchandisers with Main Street shops. Those promoting this change claim it is simply another way to measure inflation and it still reflects the true cost of living. Politicians touting the benefits of this system created it as a way to reduce the cost of living adjustments for government payments to Social Security recipients, etc. By moving to a substitution-based index and weakening other constant-standard-of-living ties those reporting inflation have muddied the water as to just how much we are being impacted by inflation.

The general argument was that changing relative costs of goods results in consumers substituting less-expensive goods for more expensive goods.  Allowing for a substitution of goods within the formerly "fixed-basket" would allow the consumer flexibility in obtaining a “constant level of satisfaction." This adjustment to the inflation measure was touted as more appropriate for the GDP concept in measuring shifting demand and weighting actual consumption. Other tricks were also used to give the illusion of less inflation. In cases where the quality of the product are deemed by the government to be "improved" prices in the CPI, calculations are now adjusted lower to offset the higher quality. Extending this idea the Baskin Commission Report, December 4, 1996, actually used steak and chicken for its substitution example.

Bloomberg recently reported that a shopping trip to Walmart cost an astounding 5.2% more in June than it did just a year ago. Sadly, this is the type of inflation directly impacts many of the consumers that can least afford it. Recently product manufacturers like Coca-Cola, Pepsi, and Procter & Gamble all started raising prices across the board, which means that "something has to give." Retailers can only absorb so much of these increases before being forced to pass them on to consumers. Walmart values low prices and it is a key part of their marketing strategy but higher wages, transportation costs, and e-commerce investments have all pressured Walmart to bump some prices higher.

Click On Image To Enlarge
Many smaller specialty retailers like O’Reilly Automotive and Tractor Supply Company have also been hiking prices. Many of these hikes have been blamed on the trade war and tariffs but the economic reality for what is occurring goes much deeper. For years consumer prices have been held down by America importing goods from countries with cheap labor but that has a hidden cost which is the loss of manufacturing jobs. Another huge issue is that inflation varies drastically from one sector of the economy to another. When it comes to assessing real-world inflation that is having a direct impact on consumers, the Fed is conspicuously absent from this important conversation. The day to day increases in prices we see add credence to the informal evidence and occasional surveys that indicate the general public believes inflation is running well above official reporting. The numbers government pumps out today are politically motivated and the result of changes made in the 1990s when Washington moved to change the nature of the CPI.

These changes were promoted under the cover of academic theories and the sinister move was masked by the contention was that the CPI overstated inflation. Katharine G. Abraham, then commissioner of the Bureau of Labor Statistics, laid out her recollections in an August 1996 paper: “Back in the early winter of 1995, Federal Reserve Board Chairman Alan Greenspan testified before the Congress that he thought the CPI substantially overstated the rate of growth in the cost of living.  Greenspan's testimony generated a considerable amount of discussion but the general public paid little if any attention. In truth, the cuts in reported inflation were part of an effort to reduce the federal deficit without anyone in Congress having to do the politically impossible which was to register a vote that would harm the image of Social Security.

The Importance Of  The CPI (click to enlarge)
While the substitution-related alterations to inflation methodologies were made beginning in the mid-1990s the introduction of major changes to concepts geared towards making us feel better about things began in the 1980s. The aggregate impact of the reporting changes since 1980 has been to reduce the reported level of annual CPI inflation by roughly seven percentage points meaning there is no question as to the understatement of inflation. If the methodological changes did not reduce CPI inflation reporting significantly, the politicians would not have pushed the changes through. The important issue is that without these changes, Social Security checks would be more than double what they are today.

A big factor in a false cost of living is that the purchasing consumer is not given a choice when paying out-of-pocket the full price for a product declared to have quality improvements they do not want or need. An example of this is the government-mandated the use of a gasoline formulation that was to improve auto emissions. It added ten cents per gallon to gasoline costs, but that cost was excluded from CPI calculations even though the person filling his or her gas tank suffered the actual out-of-pocket expense. This is also clearly seen in new computer and televisions. New features are deemed quality improvements resulting in downside price adjustments to the CPI even when the consumer may not use or want them. Also absent from this formula is recognition of how housing prices vary so greatly across the nation. 

To understand how just how large the impact has been on the CPI it is important to note that 24.0% of the total current CPI-U (the CPI for all urban consumers) is rooted in the category of “homeowners’ equivalent rent of residences.” This means that instead of reflecting some measure of home prices, as was the case before 1983, the BLS estimates the cost of housing based on what homeowners theoretically would pay to rent their own homes from themselves. The BLS then estimates how much homeowners raise the rent on themselves each month. Starting in 1989, the BLS skewed these estimates further by beginning to adjust that imaginary series for quality adjustments that would make the consumer feel good or better enjoy their residence.

Years ago when America was experiencing what the late Allen Meltzer described as "The Great Inflation" his take was that inflation generally was not considered a major problem until it rose into the double-digit area. I maintain the manipulation of data to artificially lower the official rate of inflation feeds into the illusion of economic stability. This helps both politicians and central banks sell the idea that inflation is not and will not become a problem. This false information is then used by individuals to plan and make decisions concerning their investments and retirement needs. I further contend that inflation would be much greater if more money was flowing into tangible goods rather than paper investments and promises. For proof as to the real cost of inflation just look at the surging replacement cost resulting from recent storms and natural disasters. Beware, if you are taking the CPI numbers being reported to heart you will pay dearly in coming years.

Footnote; The following articles are related to this topic.

Sunday, August 11, 2019

Trade Is Not A Big Driver Of The American Economy

Expect the controversy over just how much trade contributes to America's economic growth to be ramped up as growth slows. Trade between countries is given far to much credit for being a big driver of our economy. It pales next to factors such as government spending and credit expansion. The fact is if John needs to buy a wheelbarrow for work it does not matter where it is built. John needs and will buy a wheelbarrow. Where trade does fit into this has to do with what country employes workers to make that wheelbarrow and how much it will cost. While John may save money if the wheelbarrow was produced in a low wage country trade has more to do with who benefits from commerce and should not be seen as a force driving us forward.

Trade Is Not A Big Driver (click to enlarge)
In many ways, trade should be seen as a way to increase access to a greater variety of goods at a better price but this only works over a long period of time if it is balanced. A county that constantly enjoys a trade surplus at the expense of their trade partners often reaches a position to exploit the weaker countries and generally does so. Throughout history, trade policies have had massive long-term ramifications on the strength of a nation's economy. The promise that increased trade will create new jobs has turned out to be largely a myth. Still, we hear the narrative spun by politicians playing the "fear card" with statements such as "We can’t let countries like China write the rules of the global economy.” This implies we will lose the power to control our own fate if we stand firm and protect what is ours.

While the President and the markets want the Fed to do more we should understand simply printing more money and lowering rates has lost its ability to create growth. In many ways, the Federal Reserve has become the great enabler responsible for allowing the world to embark on a huge and rapid expansion of debt and credit during the last decade. This global credit binge could not and would not have occurred without the Fed being totally complicit and agreeing to allow it to take place. As the world's most powerful reserve currency a strong dollar could have contained the economic overindulgence we have witnessed.

By their actions, the Fed has failed to force other currencies to toe the line or pay a stiff price. It has been the Fed that decided to allow the dollar to be used as a global prop. A major problem stemming from low interest easy money policies is that the quality of the growth it generates is often very poor and creates problems in the future. An example of this is the rise in sub-prime loans that fuel auto sales. Just how bad the situation has become tend to be papered over until the point where it can no longer be ignored and things collapse.

The demand that trade partners be fair has become the scapegoat for a sagging global economy at the end of a growth cycle. The real reasons for slowing growth flow from poor government policies and the recognition that quality growth trumps quantity. Trade is overrated as an economic driver which means when imports are reduced internal production simply takes up the slack. For a country like America which has a huge trade deficit, this is a good thing. Long-term planning and sustainable growth is key to a healthy economy. Instead of getting to the business of setting things to right, corrupt and lazy politicians and bankers across the globe play the blame game.

An article recently by Mohamed Aly El-Erian published on Project Syndicate states; "Trade tensions are a symptom rather than a cause of the world’s underlying economic and financial malaise. Moreover, an excessive focus on trade could deflect policymakers’ attention from other measures needed to ensure faster and more inclusive growth in a genuinely stable financial environment." He then goes on to write, "Monetary policy has not been very effective in boosting sustainable growth, but it has lifted asset prices significantly. This has further fueled complaints that the system favors the already-rich and privileged rather than serving the broader population"

History has shown that trade agreements with low wage nations are not the great job creators we have been told. Much of the "free trade" movement is driven by mega-companies desire for larger markets and greed. It is difficult to deny that in our modern world many large companies already have more power than most nations and their power continues to grow at an alarming rate. The desire of companies to both develop and control future rules has caused them to lobby individual governments into giving up control and becoming subservient to corporate “efficiency.”

It is these mega-companies and the money they wield that has hijacked the conversation about how much benefit creates. I contend that trade shifts growth and jobs from one country to another rather than simply adding to the equation in a substantial way. This translates into the companies and their owners or shareholders benefiting far more than the economy in general. In many ways, the global economy has become an ill-regulated business model tilted to favor big business and giant conglomerates. It is not difficult to make the argument this has been harmful to the smaller domestic companies that generate many jobs here in America, Apple is a prime example of this.

Circling back to the example of John and his wheelbarrow used at the beginning of this article, it is wise to remember that the economic cycle is rooted in reality. The Johns and Freds of the world only need so many wheelbarrows, when they have enough, they stop buying them until they are worn out and they need more. Low interest rates, super sales, and easy credit can only stimulate growth in these sales so much and often it is at the cost of future sales. As the economy slows and trade tensions rise expect more fingers to point at sagging trade as the culprit. The fact is, no matter what we have been told by those with an agenda, trade between countries is only a small factor in what produces quality and sustainable economic growth.

Sunday, August 4, 2019

The Yen Is A Major Conduit For Wealth Leaving China

The link between China and Japan recently raised its head in the currency markets when President Trump upped the ante over trade-talks. Following a session in Shanghai that yielded only anger, the American trade-talk delegation quickly left for home. It appears that China has little intention of altering its course and will concede little or nothing in future talks. This highlights that China is a state-run economy based on a business model geared to expand by crushing its competition. Within hours, President Trump threatened to increase tariffs on Chinese goods flowing to America. This signals a growing impatience on the part of the White House to move trade-talks forward and finalize a deal.  

China Faces Growing Trade Problems
Immediately currency markets witnessed the yen surge in response. This makes it difficult to argue that a correlation does not exist between the value of the yen and problems in China. The yen has become a major conduit by which wealth is transferred out of China. This tight relationship can be seen each time trouble surfaces in China's economy. When this happens the yen rises in value as wealth exits China through business back-channels. It is also important to remember that economic weakness in China carries over and has a negative impact on Japan's overall GDP. Feeding into this relationship is the fact Japan does not desire a stronger yen which hurts exports. Since the yen constitutes just about 4 percent of the global world currency reserve the boost in its value is generally short-lived as the wealth flowing out of China moves on to other countries across the globe.

Last year, the U.S. combined goods and services deficit with China was a hefty $309.8 billion US dollars. Presidents Trump and Xi Jinping at their April 2019 meeting at Mar-a-Lago mapped out a strategy to remove trade irritants from the overall relationship and established a 100-day plan to reach an agreement. So far this map has led nowhere. The opinion that China may be stalling in hopes that Trump is not reelected is gaining traction. This has generated a tougher attitude in the White House that could have decades-long consequences. Trump claims he is hellbent on ending China's system of subsidizing Chinese companies in a multitude of ways that allows them to export goods at slightly below cost in exchange for manufacturing jobs. This is not stupid it is predatory
Trade Deficit Continues Running Ahead Of  2018
As you may recall, in May with great fanfare the “initial results” of the plan were revealed in the form of a ten-point program.  Sadly, many of the Chinese concessions listed were pre-existing obligations that China had already agreed to. In truth, after stripping out the pre-existing Chinese obligations and including new American concessions the May 11th deal does little to decrease the U.S. trade deficit with China. We have seen this play out in recent months as the trade deficit continues running slightly ahead of last year’s near-record pace despite efforts by the Trump White House to reduce them

There is even talk of not implementing the new deal until 2025. Many Americans see this as totally insane and take it as a sign that America has no stomach for playing hardball. Other issues also play into this discussion, as we focus on China taking advantage of America we tend to give a pass to Japan. America's "far too generous" relationship with Japan is rooted in a longtime post-war relationship. I contend it is time to question whether Japan deserves such treatment considering the strong economic ties Japan has formed with China. Up until now, Trump has left Japan relatively unscathed when it comes to demanding trade concessions, however, just like Mexico, Japan has the potential to become a prime target because of the strong economic links it has developed with China. Trade flows are far more complicated than many people realize. Most Americans remain oblivious to the fact that because of the huge trade deficit Mexico has with China the money Mexico receives from trading with America quickly passes through its lands and flows to Asia.

Over the years Japanese direct investments and technology have played a critical role in the development and competitiveness of China’s global supply chains. A strong link exists between China and Japan because of these major investments in China. It is clear China has exploited this relationship to learn the advanced industrial skills and production techniques of its neighbor. An example of how strong those links are can be seen at call centers in China where young workers speaking flawless Japanese answer customer service calls for a Japanese company. In western Japan, a new commercial Chinatown is rising in Kobe City's rebuilt port area. Instead of the gaudy restaurants in old Chinatown, the new area contains nondescript office buildings that are leased to Chinese companies focusing on everything including biotechnology.

This increased trade with China while bolstering the Japanese economy has also driven costs down significantly for Japan's long-suffering consumers which also played into the deflation factor. As for the yen, with a government gross debt to GDP ratio of 253 percent, Japan has the unwanted title of ranking highest in the developed world. The recent budget requests by Japan's central government ministries and agencies for fiscal 2019 total a record-high 102.77 trillion yen. Recently Japan's trade balance has again swung into deficit territory and a matter that has not garnered enough attention is how the economic problems that continue to develop in China will most likely spill over and affect Japan.

Between slowing economic growth and rising protest in Hong Kong, it seems China's problems may be about to get worse. China's economy is hooked on new credit and government stimulus. China’s debt mania, by this I mean madness, craziness, and frenzy is now the largest ever experienced in the postwar emerging world. As the China story unfolds it is clear the scope for a debt meltdown in China remains immense. China watchers, economists, and investors have been forming battle-lines for years as they debate the true strength and sustainability of China's economy and its role as a global player. Those of us that paint a picture of future collapse and a day of reckoning are often accused of spreading "doom-porn" for claiming the Chinese have masked over their dire situation by continually expanding credit.

In January alone, Beijing injected a staggering $685 billion in new credit into its financial system and the money continues to leak out causing assets to rise across the globe. Today China continues to prop up the "unpropable," and yes, while no such word exists, when it comes to China's economy it should. A matter that has not garnered enough attention is how the economic problems that continue to develop in China will spill over and affect Japan. The Japanese economy is very vulnerable to a negative economic feedback loop flowing from China. Recent market action should not be misinterpreted as the yen strengthening, but as simply a temporary bump before the wealth moves on to a safer place. This wealth shift will have a major impact on currency markets going forward. expect the yen to be a popular vehicle by which wealth flees China and enters the global economy.