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Newsletter 12

31 May 2019

Hegemony Reality - USA v China

Historically, bond and equity markets have moved in opposite directions although in the long run there is strong correlation in returns. Recently, we are seeing a new phenomena where bond yields have fallen and so have the value of equities. So what appears to be driving this? Of course there is no single factor, but a range, including the US Federal Reserve Quantitative Tightening (QT) where its balance sheet has shrunk from $4.5 trillion to around $3.5 trillion, the US budget deficit is now $1 trillion and this needs to be funded, nervousness about future economic growth, as bad times generally follow good ones.

The US economy has benefited from the Trump tax cuts, unemployment is very low and money is cheap. This year the US 10 year treasury continues to fall and is now 2.24% and the inversion with the 3 month and 2 year treasuries continues to swing between normal/flat and inverse.  

Over the last few weeks it has become apparent from actions taken by the US and Chinese Governments that the dispute is much more than a free trade and intellectual property ownership battle. President Trump’s executive order barring Chinese technology companies accessing the US market reveals this is a power struggle over “the mechanisms used to control access to data” which is part of the broader battle between Democracy based Capitalism  v Communism controlled Capitalism, and between these two super powers exerting hegemonic influence across the global. 

Previously, the consensus was that a trade deal would be reached and the world would move on; however this battle has morphed into this high level order matter, so it will take some time to play out. This dispute has significantly impacted on the value of Asian equities and theme based investing, e.g. Robotics, although in time valuations must return as Asia is the fastest growing region of the world with the majority of the world’s population, if you include India living in the Asian region. BREXIT has already been well factored into valuations a long time ago even though BREXIT is a debacle.

China’s annexing the Spratly islands and building a military base is an example of these super powers confronting each other militarily, while the Chinese ‘Belt and Road’ initiative is another aimed at extending its influence. Foreign Government’s central banks buying and holding Chinese bonds and the inclusion of Chinese A class shares in key global indices are further examples of China’s economic integration and growing influence. The Chinese see its currency, the Renminbi, as being a world reserve currency.  

If recent Australian economic data continues on the current trend, e.g. increasing unemployment and zero CPI, along with the US/China trade war that will flow through to Australia, then after 28 years the Australian economy may be heading for a downturn, particularly if the rest of the world does. Interestingly, tariff increases in the US which imports a lot more of Chinese goods than China does of US goods may lead to price driven inflation in the US, and as the USD is the world reserve currency any inflationary pressures will be exported to countries like Australia, increasing the downward pressure on the AUD. As we all know a lower AUD makes exports cheaper while simultaneously driving up the costs of imports and making overseas holidays more expensive.

As China continues to grow economically and militarily, the global hegemonic battle with the USA has become a reality rather than a theoretical matter.

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