On the current state of the US economy, and the effect on China, and how to deal with.

If you do not fully understand this, it does not matter.

What you need to do is just keep to the strategy: invest every month, in quality en preferably cheap stocks, on a monthly basis, and keep this up for as long as you can.

Current situation in America

1. US running around a 6% deficit (spending more than they make)
2. ·Difference needs to be loaned, which is done by issuing government bonds
3. This needs to be paid back, with the additional cost of debt: interest
4. In the meanwhile: global demand for US government bonds is falling
5. Deficit needs to be cut otherwise supply demand dynamics of debt are unholdable: nobody will want to buy them, they have to become more attractive (interest rate must go up, supply demand argument)
6. So debt is becoming more expensive for the US to issue
7. Debt will devalue and with it USD will devalue because debt is cash and cash is debt (if you have to promise more and more cash to someone to get the same amount of debt issued, one unit of cash is worth less) (already happening)
8. What must happen to prevent debt crisis: interest rate must be lowered in order to alleviate debt burden (make debt cheaper to issue) (and or tax increases and other means to make the deficit smaller)
9. But in the meanwhile: Trump is making tax cuts and tariff wars that are inflationary (so prices rise) (contra-productive short-term politically driven policy problem)
10. Central banks hike interest rates on the short-term to prevent inflation (this is their mandate, not to manage debt and deficit) (conflict of interest type problem) (already happening, Fed “not concerned about US economy, not inclined to cut rates”)
11. This makes the debt even more expensive (for the US to issue)
12. Even larger proportion of GDP goes to servicing of debt
13. Promises of US being able repay debt and service interest rates becomes ever more unlikely – you get the same in debt between people and businesses (those interest rates move with the public debt interest rates)
14. Credit disappears (credit is nothing more than a promise, when it is believed promises cannot be kept, credit disappears just as easily as it appeared due to the promise)
15. Thigs that were believed or supposed to happen do not happen
16. Businesses and people get in trouble, political unrest increases
17. Economy contracts, equity market crash
18. Federal reserve must eventually decide to accept inflation and moves to cut interest rates to try to save the economy
19. Enter stagflation period (low growth, high inflation)

That brings us to the question: how will this affect Chinese equity markets? You realise now the importance of debt.

Indebtedness of both economies

In the US, Government debt-to-GDP is ~120%. In China this is roughly 60%. However, China has something called Local Government Financing Vehicles, or LGFVs). This obscure local debt is not directly included in the central government’s budget, but the central government must somehow bail out these local governments (?..I think, or they will have tricks for this… it’s obscure, that is a risk) if their investments do not yield. If you include LGFV’s China is more or less as indebted as the US.

So you cannot say for certain China is less indebted than the US. However, Chinese bond yields remain low at around 1.75, so the Chinese debt is much cheaper (for China). (US is around 4% now). Also China has much stronger GDP growth than the US. So, in general, the Chinese economy seems to be in a better position from a debt perspective. They have announced new fiscal stimulus and indicated they will do “whatever it takes”. In Xi I trust.

Correlation of both equity markets in times of crisis

The current state of the equity market in the US strongly resembles that of 1999: “the internet bubble”. Another interesting comparison is the “big financial crisis” of 2008, which is the subprime mortgage induced crisis which originated in the US.

1999 internet bubble: The Chinese and U.S. stock markets showed low correlation due to China’s limited integration with global financial systems.

2008 financial crisis: The correlation between the two markets increased, reflecting China’s growing integration into the global economy. Chinese stocks fell together with US stocks. You can already see the sentiment pivoting, and with it you see Chinese (tech) stocks fall together with their US counterparts. Sad reality that people don’t want to see: When the US falls, we all fall.

Prime example from history to teach us is the 2008 sub-prime crisis. Fun fact: at the time in 2008 everyone thought the problem would be a US problem only, or even better, a problem only relevant in the upper most risky packaged securities the US housing market, not even affecting the broader US housing market.

Valuation comparison

Chinese technology stocks are still very cheap (see previous posts), this will dampen the effect of the US induced crisis. They are a strong buy from a long-term perspective.

Global rotation out of US argument

When the world wakes up to the above listed 19-step occurrence, they must sell their US investments and they must go look for good investment opportunities elsewhere. China will be a logical place to look. This will also dampen the negative effect from the US induced crises.

Conclusion

The pending US crisis must be seen as a, or even the, major threat to your Chinese tech investments. They will suffer in the short-term, but not as much as US equities I believe. A US crisis does not effect the fundamental investment rationale for China shared in previous posts. This leaves you with two options on how to deal with your Chinese investments:

–       Option 1: Sell everything and wait and see

–       Option 2: Keep buying periodically (what I will do)

You can also do a kind of mix and then evenly spread the sold amount to the purchases over a long period, for instance three years.

Option 1: drawback: difficult to determine when to buy again. If the US crisis does not happen, or if it does not affect Chinese equities as strongly, or people are quicker than expected to realise China is the alternative to the US, you lose.

Option 2: drawback: you will suffer in the short-term. However, due to the cost averaging from buying every month the effect is dampened. You get to purchase cheaper and cheaper undervalued securities as the crisis goes on. This strategy is not reliant on any market timing and will in both instances, crisis or no, be a good move on the long-term. I find this beautiful.

Further considerations: The psychology of investing, an analysis of both options

I get more questions about how do you deal with the emotions of investing. To filter out emotions from investing it’s important to analyse the emotional implications of your investment options.

Option 1: Selling would mean you are not invested. If equity markets then rise this is “opportunity cost”, and it is as costly as “real” investment losses, but easier to accept because people feel less inclined to take responsibility for not investing, rather than investing, which is of course, an illusion. You need to realise this. Furthermore, option 1 is preferred because it allows you to trade on your fear, satisfying your desire for peace of mind. So you know: option 1 is emotionally attractive.

Option 2: This is psychologically the less preferred option. You will feel resistance to this option. Why? Simply because option 2 implicates short-term pain. People find it difficult to accept. What if it goes down forever, or for a too long time, they fear. So you know: option 2 is emotionally unattractive.

The stock market is a mirror reflecting public opinion and emotions. To ask how to deal with the emotion of investing is to ask how to deal with emotions of life. To do the latter you can study ancient philosophy and wisdom, and through experience, become harder and wiser. The beauty of it is that because not so many people are willing to do this, it leaves a lot of opportunity on the table. Accept suffering, let go of fear. Accept fear, let go of suffering.

What if it goes down forever? This is a violation of one of the deepest principles of the universe, namely relativity (yin yang). A curve with only a crest, or a trough, is yet to be observed. By studying yin yang philosophy you can realise: this question does not make sense.

Try to see your investments as a thirty year project, and the US crisis as an opportunity to buy low on a super long-term perspective.

What is inflation?

Inflation is said to be: “rising prices”. But this is not true, this is only the effect you experience. Inflation is the devaluation of your money. How is that possible?

Your money is devaluing as the amount of money in the system is increasing. Governments and central banks, who have an interesting alliance, are creating the extra money. As there are now more units of the same amount of value, one unit is worth less, and you have inflation.

Why does it exist?

The below sounds ridiculous but is 100% technically correct. In easy language without finance and accounting terms:

Inflation exists because of the way our economy is managed. If the government wants to stimulate the economy and spend EUR 1000, it can make the central bank create EUR 1000 from nothing. Printed money, new money.

This money is spend on let’s say projects, and enters the economy. Let’s follow EUR 100 of this money, which ended up on a government clerk’s checking account with a commercial bank. The bank sees the new EUR 100 and thinks nice – we can now lend out EUR 900. Yes, the bank can lend out much more than it has received, and creates a loan for which it will receive interest (something), from a loan which is created from? Nothing.

And this is the miracle of being able to create something from nothing. But that is not how the world works, the world is a zero sum game. Where there is a winner, there is a loser. So where is this purchasing power that the governments and banks created coming from? Inflation. The devaluation of money. You can see inflation like a direct tax.

So who benefits from inflation? Well. The closer you are to the money machine, the better. Since that is where all the new units of value (EURs in this instance) are created. Who is the closest? Governments, who task the central bank with the printing of money. Thereafter banks benefit, who create something (interest) with the money created from nothing. Also the people receiving the loans from the banks, executing projects, benefit. They get to use the money created from nothing (again typically more wealthy and educated people tend to do this).

Who is furthest? Regular people. They suffer because they have to pay more for groceries, through “rising prices”. You noticed this for sure yourself. These people are so far from the money machine, they do not get any of the benefits. Also, regular people tend to invest less, which is a good way to deal with inflation. You see how the rich get richer, and the poor get poorer.

Managing an economy

This way of dealing with the economy, by manipulating interest rates and creating money to manage inflation, is called: “Keynesian economics”. This is what is currently thought in universities, I studied it myself, “modern macroeconomics”.

Keynesian economist argue that a little bit of inflation is good, around 2%. Why? A little bit of inflation, encourages borrowing (since it would be cheaper today than tomorrow, you will pay the loan back with units which are valued less), as well as spending (things are cheaper today than tomorrow. In the opposite case, deflation, it would be best to save, things are getting cheaper tomorrow (read, your money is worth more tomorrow).

So how come our money changes value so quickly?

The history of money

Back in the day, you would trade some apples for some wheat. But what if you don’t want apples? The solution is money, a trusted medium of exchange, the most liquid one. Liquid means sellable basically. You are not sure you want apples, but you want money, as you know you can use it everywhere.

So what do we choose as money? First know that capitalism, which is basically a free market system, is a natural phenomenon. Peoples around the world, even who are not in contact, tend to develop a free market and also money.

Usually the best money is something which is in limited supply and very expensive and difficult to produce or find. Otherwise you just get that the whole economy shifts to producing / finding this “money”. It would devalue the money and defeat the purpose (hyperinflation) and also who is left to do other productive things?

Gold and silver was the logical choice around the world, but there are many other documented materials used. In the end we ended up gold, since silver is more easy to find and also used more in industry.

Gold is interesting, it is chemically impossible to destroy and create. The rings worn by your roman ancestors are still somewhere, in your necklace maybe. Even diamonds can be created – so I would invest in gold over diamonds.

Hard money vs. soft money

So if you cannot find, destroy, or create gold, it’s value must be relatively fixed. That’s right. There is no printing gold. This is called hard money.

Then, we moved to something called a gold standard. Exchanging super tiny pieces of gold is not practicable, so we created paper bills which are exchangeable for a fixed amount of gold. Still, hard money.

Then, in order to further stimulate the economy (opinions are divided as you might suspect), we moved to fiat money. This is soft money. This is money as you are using today, EUR or USD, which are not exchangeable for a fixed amount of gold, and can be created against zero costs, unlimitedly. As you read above this is done by governments and central banks.

Keynesian (modern) economists believe that this is good. Austrian (classical) economists believe this is bad, that we should move back to something resembling a gold standard. Fortunately I am too uneducated to make any claims about how we should manage an economy.

Keynesian vs. Austrian economics

The discussion of how to manage an economy, quick version.

Keynesian economists believe that fiat money is good, it allows us to manipulate inflation, which is good, and print money, which is good. They argue that this view is empirically backed by numbers. They take some kind of scientific method. Which in my opinion is interesting, since experimentation is not possible in economics and is the core of the scientific method. But who am I. Also, Keynesian economist do not exactly have a great track record. Many problems exist with the current model.

Austrian economist believe that fiat (creatable) money is evil, it is created by governments and central banks to get richer and more powerful by creating something from nothing as explained above, and that we should move back to a gold standard. They believe Keynesian economics is hocus pocus bullshit to justify this great theft of wealth from the masses. A rather big claim also. Also, note that this method is not proven to be better than the Keynesian method.

It’s a question of ideology almost, which is dangerous. Proving something sensible in economics is difficult. Often things are made complicated for the sake of it.

So now what

I know now you have more problems and doubts than you began with. At least one fact is: inflation is a direct tax, and is making people far away from the money machine poorer. There are some things we can do:

• Get closer to the money machine (more for later when you have some money): use debt for productive projects. You will repay with units that have lost value.
• Invest in things like gold, which have a fixed supply (unlike fiat money, which is valued less and less every day)
• Invest in raw materials, wheat, corn, diesel, oil, etc. They hold value for the people and are in limited supply
• Invest in regular stocks, they are not a perfect hedge for inflation but this is just the sensible thing to do (average return per year is 8%)

People forget, that by not investing, you are 100% invested in fiat currency. Something which is losing value quickly as the total quantity is being increased by central banks and governments. You would also not put 100% of your wealth in let’s say one stock or one raw material. Well that’s what most people are doing, but then with fiat money. A ridiculous choice. Don’t sleep, invest.

I hope this article helps with understanding the economic situation and motivates some to take action and adjust.