As the positive headlines on the Chinese trade front multiply, we have seen stock market action in January that is exactly the opposite of what we saw in December: We’re now seeing relentless buying with every dip.
I think it would be hilarious if the S&P 500 Index SPX, +0.89% ends up near 2,800 points if a trade deal is signed, which is where it started in December. (For those keeping track, the intraday Christmas low was 2,347.)
The dark comedy here stems from the realization that there were a number of factors reinforcing each other in the fourth-quarter market decline, but none of them was economic deterioration in the United States, which in theory should be the driving factor behind any stock market action. (For more, see “No bear market for stocks in 2019 because economy, earnings will keep expanding.”)
Read: George Soros blasts China’s Xi as ‘most dangerous opponent’ of open societies
I have often said in this column that there will be a trade deal based on the realization that the domestic economic situation in China is very precarious and the lack of a trade deal will make matters a lot worse for the Chinese economy. Multiple media outlets reported that the Chinese made an offer in mid-January to go on a bigger-than-$1-trillion-dollar buying spree in a bid to eliminate the trade deficit by 2024. (For more, see “China’s hard landing? Watch prices on these three things, not economic data.”)
I think this is a very good offer and one that will be the basis of a trade deal — no matter that the U.S. side wanted results much faster than 2024. The reason that the trade deficit has kept growing, despite the trade tensions and some added tariffs, is the strong economy in the U.S. and the fact that many key goods are no longer manufactured domestically (see chart).
I believe that the U.S. trade deficit with China can be eliminated completely, as the Chinese have been employing a very clever trade policy — to the detriment of the United States. Since China is a hybrid economy, Chinese state buyers control where China buys from. The Chinese have been running trade deficits themselves (i.e., trade surplus for the partner country) with many countries they consider key partners, so that they can increase their political influence. If China is the No. 1 trading partner for South Korea, for example, Chinese influence in South Korea can increase while U.S. influence decreases, despite the sizeable U.S. military presence there. There are numerous other examples where China is the No. 1 trading partner and the Chinese buy more on purpose — so that they can be more influential politically.
On the other hand, because the Chinese could get away with this clever maneuver, worthy of masterful Sun Tzu disciples, the American side has been enabling this activity by tolerating it, that is, until President Trump showed up. Both Republican and Democratic administrations are at fault here as neither George W. Bush nor his successor, Barack Obama, did anything to stop this Chinese trade policy.
It has to be noted that the trade deficit numbers in 2018 would be horrific in absolute terms (estimated to be $879 billion, according to the Paterson Institute of International Economics), yet in relative terms things were a lot worse during the second George W. Bush administration, when the current account deficit as percentage of gross domestic product (GDP) hit 6%. That same number is 2.4% for President Trump.
The thorny issue here is the state-sponsored intellectual property (IP) theft by Chinese entities that the Trump administration wants to eliminate. I am not sure how one proves such activities and what venue one can use in order to enforce such grievances. This type of activity has been going on for a long time in global business — and Japan used to be pointed out as the culprit for many years — but what is going on in China seems to be on a significantly larger in scale. Ironically, the Japanese too have a grievance on the same issue with China when it comes to IP theft.
Oil is the driver of the improving U.S. trade balance
If you said shale-oil production helped the trade deficit improve in the past 10 years, you would be correct. Since U.S. shale-crude-oil production has recently surged to nearly three times the rate it was in 2008, and took out its previous all-time high peak from 1970, its relative effect on the trade deficit became much less meaningful (see chart).
Today, China is the largest importer of crude oil. For decades that spot was reserved for the United States. As the Chinese economy has dramatically slowed, as evidenced by the sharp fall in crude oil prices, confirmed by the sharp fall in industrial metals, the price of crude oil has fallen rather sharply.
It is interesting to note that the rebound in the London Metals Exchange Index is much smaller than the rebound in the crude oil price since the December 2018 lows, both on a relative and absolute basis (see chart). That tells me that sentiment is driving the price of crude oil and not necessarily demand, since we are in the seasonally weak period for crude oil (September-March) and investors are positioning themselves for a trade deal. I do not expect the Chinese economy to turn around on a dime after a trade deal is announced, which I believe will happen within the 90-day period ending March 1, notwithstanding any extensions that would be possible if the parties are close to a deal but the details have not been hammered out yet.
That means that the rally in crude oil is a rally to sell, not a rally to buy.
Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates. The opinions expressed are his own.