The Outsider Perspective Issue 283 | The Beltway Outsiders

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Good Friday Morning, especially to March Madness, which claimed its first victim on Thursday: The Kentucky Men’s Basketball team. Kentucky and Indiana lost to the schools St. Paul’s and St. Mary’s, respectively. The Catholic Schools won on St. Patrick’s Day — how’s that for some fun madness?

This week, I’m going through the meltdown in China’s stock market and the uncertainty surrounding the next steps for the US and China. Links to follow.

Where you can find me this week

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[03/14/2022] The looming global food crisis – Conservative Institute

[03/18/2022] Federal Reserve finally attacks inflation. Is it too late? – Conservative Institute

China’s stock market meltdown and the uncertain next steps.

Entering 2022, one of the things I said to watch was China’s economy. One of the things I pointed to was Evergrande and the liquidity crisis in China. Despite the focus on Ukraine and Russia, I don’t want to lose sight of the severe economic issues in China and the impact those issues have here.

Compared to previous valuations, the Chinese real estate market was already trading at pennies on the dollar. The tech sector, and their stock markets in general, have followed suit in 2022. Here’s Yahoo Finance describing the collapse into this week:

A tech-heavy index of U.S.-listed Chinese stocks has fallen 41% in just 2 1/2 months — almost equaling the 2021 rout. Since its peak last year, the once red-hot benchmark has fallen by a record 75%, erasing $1.1 trillion in market value as Beijing’s close ties to Russia, regulatory headwinds and a zero tolerance Covid-19 policy sent investors fleeing.

The selloff has been so extreme that the Nasdaq Golden Dragon Index, which includes stocks like Alibaba Group Holding Ltd. and Baidu Inc., now trades at a rare discount to the S&P 500 Index, reversing its valuation premium of almost 100% from June.

E-commerce giant Alibaba now trades at a record low valuation of 9 times forward earnings — one of the cheapest high-growth plays in the U.S.

“Despite the better valuations that we see, we’re not buying China yet,” said Joost Van Leenders, senior investment strategist at Kempen Capital Management. “We still see too much uncertainty to even start drafting a proposal to buy them.”

The Hang Seng Tech Index of Hong Kong-listed stocks sank 8.1% Tuesday, bringing its decline over the past three sessions to 22%. That’s the biggest three-day drop ever for the index, based on data going back to 2015.

The losses these stocks have experienced is equivalent to the 2008 financial crisis plunge in China. Imagine watching Amazon’s stock drop 75% in a few months because that’s what China is experiencing.

There’s been a bounce up from these stocks in the second half of this week. That positivity comes from China’s central bank’s statements promising to support markets. That reassurance has helped people return some money into the sector, but the economic issues are real.

A recent analysis of the Chinese economy suggests their GDP growth would fall to around 2-3% for the rest of this decade. This kind of growth would be disastrous for a government used to GDP growth in the 8-12% range (or higher). The CCP has a lot of hard questions ahead of it as they experience a severe drawdown in economic growth.

China and the United States face the same geopolitical events and economic conditions but must approach them differently. The Russia-Ukraine war impacts both countries, along with restrictions on critical commodities like oil, food, and more. These events are hitting on a back-drop of supply-chain disruptions, pandemic shortages (no one knows how many people in China died from COVID, but we know their vaccines don’t work), and more.

The response by China and the United States will be different too. China faces an economic downturn, and it will loosen its financial policy. China will rely on lower interest rates, looser monetary policy, etc.

The United States has to raise interest rates and engage in an economic tightening to tackle inflation. Both China and the United States could experience a recession from their actions.

However, while all these economic factors are important, the leaders face overriding political issues. At the end of the year, China has its political upheaval, where Xi is expected to take permanent power. In the United States, the 2022 midterms loom, and Biden does not want a recession to make those midterm results even worse.

For the Chinese Communist Party, the message Xi has started preaching of “common prosperity” has meant targeting the wealthy in Chinese society (many of whom could challenge him). How far can Xi take this message while tanking the Chinese economy and still retain power? Tyrants of the past like Mao or Stalin had absolute power. It’s unclear whether Xi has such power now.

For Biden, the calculations are equally tricky. Either you have the Fed focus on killing inflation by hiking interest rates. An aggressive interest rate policy would likely kill the economy’s demand-side (while fixing none of the underlying issues) and trigger a recession. Volker did exactly this from 1980 to 1982 in combating stagflation from the 1970s.

But it doesn’t appear Biden wants to chart an aggressive path. The current plan seems to take a slower approach of attacking inflation while blaming lingering inflation on Putin. Can the Fed chart this course and accomplish a low inflation world without triggering a recession or economic pain? It’s possible. But it seems unlikely.

In this weird moment, I find myself in agreement with former Obama economic advisor Lawrence Summers. He penned two op-eds in the Washington Post before and after the big Fed meeting this past week. His first column was before the meeting, trying to shake the Fed over to his point of view:

The Fed is charting a course to stagflation and recession: Central to fighting inflation is showing that a new paradigm is in place — and so far, the Fed hasn’t been willing to do what’s needed.

The second column, written after the FOMC meeting this week, declared the Fed had failed.

The stock market liked the Fed’s plan to raise interest rates. It’s wrong: The central absurdity in the Fed forecast is the idea that a super-tight labor market will somehow coincide with rapidly slowing inflation.

Summers essentially argued that the Fed needed to take an aggressive plan of action, hike rates higher and faster, and get the pain over upfront. Summers essentially wants the Fed to follow a Volker-like path. His criticism is that the Fed is making assumptions about inflation like it did last year when Summers wrote jeremiads over inflation that the Fed and White House ignored. Those assumptions can be flawed.

Tim Carney summed up the assumptions nicely:

We owe a debt of gratitude to Gabriel Chodorow-Reich, an associate professor of economics at Harvard, for coining the phrase “immaculate disinflation” to describe the Fed’s persistent belief that it can bring down inflation painlessly. While it is not unimaginable that inflation could largely fall on its own, the Fed has not clearly articulated a theory about why it expects this to happen. Is it expecting an imminent loosening of supply constraints? Does it think energy prices will plunge soon? Or something else? It would probably help if the Fed let us in on the source of its faith.

The debate in the United States is open and direct. We know the risks and can see what the policymakers are doing in real-time. We cannot see the same in China, where the communist ruling party obscures everything.

If the US government can get things wrong, how much worse can a government built on tyranny and fear get it? One of the points I’ve made repeatedly about Xi and China is simple. If they’re more focused on retaining power this fall than fixing the economy, the pain radiating from China could have ripple effects.

For now, the meltdown in Chinese stocks isn’t impacting the United States. It’s also possible we’re near the bottom of the Chinese stock fallout. But in a volatile environment, never assume anything.

Where do we go from here? Some of these answers depend on Russia’s war in Ukraine. As I wrote last week, China has some decisions ahead on how they help Russia. It’s still unclear (at least to me) what China will do.

The White House says that US intel indicates Russia has requested aid from China. I have no doubts about that report. Biden’s administration is going further by attacking ways China is helping Russia. This line is a bit too far to me, China and Russia have natural economic relations, and China is pouncing on cheap exports from Russia as Europe turns its back. China is walking a “tightrope” at the moment, trying to place nice with the West while still getting things from Russia. But China isn’t doing everything Russia wants.

China is trying to have everything at once. What happens if they get pushed? That’s unclear. I believe this is even more unclear once you factor in the shakeup in Chinese politics coming this fall and the economic fire in China’s markets.

Where China ends up will dictate how the United States responds. Politically, the White House needs a credible scapegoat for all economic ills. Right now, that’s Putin, and they’d love nothing more than to add China.

We’ll see how things shake out, but there’s no pressure on China to make an immediate decision. I’m sure Putin and the US would love a decisive shift by China, but they’re not incentivized to do that right now. China does have domestic issues, and that’s where their focus will remain. Xi needs to sustain a political base to consolidate power. If he loses that in a random foreign adventure with Russia, that would be costly.

Biden has less wiggle room. He has to control Europe’s response to the war, attack inflation domestically, and hold on while the Fed raises interest rates. Inflation numbers will improve year-over-year in a few months because inflation this year will get compared to high inflation from last year. But even given that, people won’t believe the reports because they’ll see the same high prices and shortages in stores.

Plenty of uncertainty ahead.

Links of the week

Hunter Biden Paid Tax Bill, but Broad Federal Investigation Continues: The Justice Department inquiry into the business dealings of the president’s son has remained active, with a grand jury seeking information about payments from around the world. – NYT

Now that Joe Biden’s president, the Times finally admits: Hunter’s laptop is real – NYPost Editorial Board

Sure Seems Joe Biden Knowingly Lied about the Hunter Biden Laptop Story – Charles C. W. Cooke, National Review

The New York Times hates to say The Post told you so – Michael Goodwin, NYPost

Hunter Biden Is All Kinds of Scandals, All Rolled Into One – Jim Geraghty, National Review

The New York Times Suddenly Discovers Hunter Biden Laptop and Corruption Investigations Are Real – Andrew C. McCarthy, National Review

Will the Ukraine War End the Age of Populism? – Ross Douthat, NYT

Russia’s state TV hit by stream of resignations – BBC

Stock Traders Brace for a $3.5 Trillion ‘Triple Witching’ Event – Yahoo Finance

Homes Earned More for Owners Than Their Jobs Last Year: Increase in value of typical U.S. home exceeded median worker income for first time, Zillow says – WSJ