By Kirk Spano
President-elect Donald Trump has already started to take a hard line with China as he prepares to enter office. His telephone call with Taiwan's President Tsai Ing-wen was the first step toward confronting China on various issues. The next was complaining about China's perceived currency manipulation.
Make no mistake about it, once Donald Trump becomes president, his relationship with China will be among those having the greatest impact on the American economy. If the Chinese decide, for one reason or another, to push back on the United States, make no mistake about this either, at least as far as this corner’s opinion is concerned, America would very quickly enter recession.
There is a common wisdom that China will not want to risk economic conflict with the U.S. for fear of hurting their own economy. That thought process only goes so far. China is not the representative democracy that the United States is. They are much more willing to endure pain to many of their people than we are if it advances their longer-term goals.
Four issues with China
Here are four things that are in play between China and the incoming Trump administration.
First is the issue of currency manipulation. Trump has outright accused China of currency manipulation. He believes that China has devalued their currency to the detriment of American manufacturing. Most evidence suggests this is not true.
Connected to the currency issue is that of trade. Trump believes that China has an unfair advantage due to China pushing their currency down. He also appears to be believe that China is not allowing a fair trade playing field. He's probably somewhat right about that.
There is also the participation and adherence to the Paris Climate Agreement. Trump is threatening to back out of it. China is telling him not to do so.
Finally, there is the issue of Taiwan. The "one China" policy is cut in stone with Beijing. If President Trump somehow thinks he can negotiate over Taiwan, he will have to be willing to use military force to back his position. It should be very apparent that is an extremely dangerous concept.
China's actions and reactions
Over the past two years, the Chinese have slowly sold U.S. Treasurys in an effort to hold their currency up relative to the dollar (not push it down). Keeping their currency higher was intended to help their bid to have the yuan added to the International Monetary Fund's (IMF) Special Drawing Rights (SDR) along with the dollar, yen, euro and pound. The yuan was added a few months ago.
There are other closed-door ideas at play with China's selling of U.S. debt as well. The Chinese bought a lot of American debt after the financial crisis to help repair the global economy. They do not want to hold that debt forever. When the Fed stopped QE two years ago, the Chinese were given a chance to provide liquidity to the markets by selling some of those Treasurys. I believe it is likely this that was by agreement with the U.S.
Trump has suggested that the U.S. could renegotiate its debt or threaten to default as part of international negotiations. This is directed at China, which is America's largest creditor. The idea that China will be swayed by this is, frankly, laughable. A default by the U.S. or a dramatic devaluation would hurt Americans far more than the Chinese government.
If China's leaders decide that they must make a point and flex their muscle, I believe it would take the following form. First, the Chinese would stop selling U.S. Treasurys into the market causing the dollar to rise dramatically. This would allow China to clear much of its inventory into the American market.
I believe the next move would be a massive one-off purchase of oil from Saudi Arabia by the Chinese. This would give China very large oil reserves and Saudi Arabia more power to influence the dollar and negotiate with President Trump who has called for cutting oil supplies from Saudi Arabia.
Finally, I believe once pressure mounted, both China and Saudi Arabia would sell large quantities of U.S. Treasurys into the market pushing the dollar down dramatically. This would push the price of oil up dramatically. Saudi Arabia would benefit as it prepares to IPO Saudi Aramco. China would benefit from holding more oil and fewer dollars. China would take a major step toward becoming a more consumer led economy due to the previously cleared inventory and then stronger yuan. The U.S. would plunge into recession as it loses international trade and influence faster than it otherwise would have naturally occurred.
The China and U.S. relationship
Too many people underestimate the symbiotic nature of the American-Chinese relationship. Since Nixon moved to create more partnership, both the U.S. and China have benefited. So, while many Americans were displaced as their lower skilled jobs moved abroad, we know that most job losses were actually related to technology changes and that America benefited by being able to buy goods at cheaper prices.
Most proud Americans very much underestimate the economic power that China wields now. China's rising power makes sense and should not be viewed as some existential threat. They have five times more people than the United States. Either they or India will be the largest economy in the world in the next generation. We must accept that and figure out how to benefit from that growth, rather than turn away from it.
So, while anything is negotiable, it is important to maintain the symbiotic relationship with China. If we decide to make it more confrontational, then we will suffer the consequences of a conflict that can only end badly for us.
I have a tactical overlay to managing money. While I analyze situations, I like to watch and see how things play out before making significant investment changes. I've learned over time it is important to maneuver in real time with little speculation. In the case of preparing for the Trump and China relationship, we have to keep very close tabs on developments so we can adjust accordingly.
In a recent blog post, I suggested that 2017 would be a reset year . I believe that the major U.S. stock markets are likely to drop 20%-30% at some point in 2017 on the uncertainty of the Trump transition, the slowness of implementing policy, another wave of baby boomer-required minimum distributions from retirement plans and the general overvaluation in the stock market. That is the good scenario, so I am a seller of SPDR S&P 500 ETF /zigman2/quotes/209901640/composite SPY -1.44% .
If conflict manifests with China, the coming correction will be much larger and the recovery much slower. I have been suggesting that people accumulate cash on my "slow growth forever" argument. There's very little time left to do that in my opinion.