Reading Tea Leaves

Hong KongTranslated directly, Hong Kong means ‘fragrant harbor’. It is surrounded by nine peaks euphemistically referred to as the nine dragons, thus the references in the marketing logo shown below. As the world’s 11th largest trading economy Hong Kong is well positioned as China’s financial doorstep to the world. So much so that it has become a crossroads for numerous monetary and fiscal luminaries. While I sought out several interviews, I was surprised by numerous interactions that I obtained through generally incidental meetings. This experience has been frequently described by titans of business and military generals; there is nothing as powerful and enlightening as being on the ground.

Hong Kong Asia's World City

Historically, conventional wisdom held that generals with armies have decided wars, and more recently, titans of business with cash (individuals or even entire countries as seen with Chapitalism). However let’s not forget how the resulting peace is negotiated and then implemented . . . by the bureaucrat armed with policy. This visit to Hong Kong especially reinforced this idea. My biggest take-away: Market forces have nothing to do with the emerging isolation/protectionism in this part of the world.

Rather than merely a quaint thesis developed over the past several years at ACM, I believe that what we are witnessing is completely driven by pure policy – with no collateral damage concern for those not included in the sphere of protectionism. This sort of policy will likely and significantly add to the current massive economic turbulence.

In the 2000’s, the Chinese government earnestly set out to spread influence via development aid to their most important trading partners. During the past three years the so-called western ‘developed nations’ have found themselves leveraged up some 26 to 40 times. Meanwhile, the economies that China focused on remained at less than 12 times leverage – reasonable levels proven over the past 3,000 years. This is quite a feat considering the pressures of globalization pushed by the USA and Europe. Incidentally China is reportedly at just 7 times leverage.

An intended structural effect of the low leverage is a stabilization of cross currency exchange rates. Thus just as the US$ has been important to encourage world trade because it was a reliable means of steady exchange, so too are the Asian and major Chinese partner currencies becoming stable, or ‘reliable’, in relation to each other. This will cement stable trade for them, and at the same time reduce the need for the US$.

Many have speculated on what the Chinese might do in order to further delink the Yuan from the influence of the US$. While many reading this may howl that they ‘are doing nothing’ as shown by the Chinese seeming insolence at allowing the Yuan to float freely and revalue (increase in value), we are likely witnessing a back door to this policy emerging via commodities.

For example, because storage levels have been very low, grain prices have been walking a tightrope for the better part of the past four years. It took a global financial crisis to halt rapidly rising prices in 2008. Some readers might even remember stories across the globe of food incited social unrest. Now food prices are again nearing 2008 highs. This is partially because of crop failures in Russia and China as well as reduced harvests in Canada and the USA this fall. Lower supply means higher prices. However, prices began to rise before markets knew of the impending crop problems. What if China has been quietly purchasing vast quantities of grains as part of its currency reserve diversification plans? Based on recent conversations I believe that they have, and continue to do so.

It is as if China is playing the part of Briar Rabbit who would repeatedly say to the fox that was trying to eat him, “Don’t throw me into that briar patch.” Of course Briar Rabbit wanted to be thrown into the briar patch . . . that way he could escape! So it is with China. Regardless that garlic has increased some 20 times in price over the past year, or even the lowly potato has increased 6 times in price, China has a Briar Rabbit type maneuver up its sleeve. China’s agriculture related inflation, and energy inflation too, can be substantially arrested by allowing the Yuan to be revalued upwards. The effect would make a stronger Yuan that can be used by the populous to buy more food and petroleum products than before the revaluation. So, for the Chinese much of current inflationary pressure would be swiftly abated. Not so for the USA and Europe.

Unlike the Yuan and other proximal currencies, developed countries of the world have no upward pressure on their currencies that would help absorb inflation. In fact, because of the difficulties of deleveraging, maturing bureaucracy, maturing demographics and a flight of capital to the East, developed country currencies purchasing power has been declining for a decade. This time the Chinese, Association of Southeast Asian Nations, and the Shanghai Cooperation Organization (SCO) don’t appear to care much about balancing trade with the West. For it is the policy of self preservation that is their prerogative now. It was only last week where the world witnessed that China and Russia have decided to abandon the US$ for their cross border trade. This arrangement was signed at the recent annual SCO summit held in Tajikistan. Maybe now the significance of my piece some weeks ago about Central Asia and the SCO is coming into better focus.

Hong KongA revaluation of the Yuan would also cause additional issues for the developed nations. A stronger Yuan will lead to stronger demand for food as well as just about anything that Chinese desire. Herein resides my best guess at how very high rates of inflation may arrive in the USA. First, it takes about six to nine months for higher food prices to work their way into finished products. So late in the first quarter of 2011 is when we should see the summer related grain inflation arrive in stores. Predictably the Federal Reserve will claim that the increase in the inflation was expected because of their recent attempts at inflating the economy. Unfortunately, this assertion would be wrong. If history is any guide, the pushing of inflation through Federal Reserve quantitative easing (printing money) will likely begin to show up near the end of the second quarter. This would give an additional, and shocking, boost to inflation – perhaps as bad as that seen last in the late 1970’s. The final kicker for inflation may be what has been described above. With a falling US$ and a Chinese shopping population emboldened with a stronger Yuan, things like food and energy would become even more difficult to buy for the average developed nation household.

This policy driven approach is radically different than the market driven forces that most of us are used to. If it unfolds as roughly described above, there will be extreme turbulence in many types of asset prices. From stocks to precious metals to money markets denominated in various currencies, it could be very difficult over shorter periods of time to ‘believe’ just what is a solid investment strategy. That is why it is important to set the course for portfolios now – when the winds are somewhat calm. For it is likely that for the first time in decades, US$ and EU€ ‘cash’ will be the primary asset class to avoid due to the ravages of policy fanned inflation.

So, if history is a competent guide, economic isolation and its effects are likely what await the world. To understand this people do not need to have skill in reading tea leaves, they merely need to pay general attention to the rhetoric and actions emanating from across the Pacific Ocean.