Primary Vision Insights – Enterprise Subscribers

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As we described in the previous report, global trade is slowing when we look at some key metrics. The shifts here aren’t limited to just the U.S. as global trade is indicating a much bigger global slowdown. Taiwan is central to electronics supply chains. Its ups and downs can give canary-in-a-coal-mine signals on global growth. The latest data are very weak:

Purchasing managers surveys indicate its manufacturing sector contracted in June and July. Production and demand slumped, with new export orders registering the biggest drop.

Industrial production rose just 0.7% year on year in June -- a steep slowdown from close to 10% growth at end-2021 and the slowest since early 2020 when the pandemic first hit.

We are seeing more pressure across the residual fuel/ heavy distillate side that is flagging even more of a global slowdown.

Taiwan is moving back to the center of attention as the Pelosi leaves the country, and China moves in to show strength. There are scheduled military drills to surround Taiwan, and China has “closed” the space to commercial ship and air traffic. The Taiwan navy is shadowing the Chinese navy to ensure they don’t make a pivot towards the coast but stay in international waters doing live fire drills. There have also been a significant number of PLA aircraft that have crossed into the Taiwanese side of the Strait. This has caused jets to be scrambled and meet the potential threat of Chinese sorties.

The below picture puts into perspective just how much trade flows around Taiwan. About 60%-65% of global trade in Asia moves through the Taiwan Strait. If China decides to remain for a long-standing blockade, it could put a sizeable disruption in not only global trade but the availability of microchips. The U.S. Navy also operates “Freedom of Navigation” passage through the region, which will likely be even more contested.

The brinkmanship has been shifting higher, and now we have the following update:

According to the Japanese defense ministry, China has fired four missiles over Taiwan itself.

If true this would be a big deal, marking the first time that the mainland has fired missiles directly over Taiwan’s landmass. (Bloomberg)

At the time of writing, neither Beijing nor Taipei had confirmed the overflight, but the People’s Liberation Army Eastern Command shared a state media article quoting Meng Xiangqing, a professor at National Defense University, saying it had taken place (Bloomberg):

“This can be seen as a clear signal to the Taiwan authorities that current drills have exceeded all previous ones in scale and deterrence.”

Get smart: The operative word here is deterrence.

Beijing wants to make its displeasure known but without risking actual conflict.

Get smarter: Nobody’s going to war over the Pelosi trip, but the precedent-breaking missile overflight suggests a dangerous ‘new normal’, and highlights the long-term risks of US-China brinksmanship over Taiwan.

The more competing military assets you have in one region the more likely an accident happens that can escalate rapidly. There have been countless examples throughout history at how RAPIDLY things can spiral when there is an error that is reciprocated- whether or not it was intentional.

Even though there is more around China showing “displeasure” we are reaching a boiling point that can see things get tricky quickly.

US Speaker of the House Nancy Pelosi may have left Taiwan, but Beijing’s “stern countermeasures” are just getting started.

The military exercises are the most massive of their kind in decades.

Scheduled to last for 72 hours, the drills kicked off Thursday at 12pm local time in six maritime areas surrounding Taiwan.

The People’s Liberation Army Eastern Theater Command said the drills would include conventional missile tests in the waters off Taiwan’s East Coast.

China has warned commercial airlines and ships to avoid passing through areas where the drills are taking place.

Get smart: Despite their scope and intensity, which will help the PLA tackle weaknesses in joint command and control, the mainland’s exercises remain political theater.

The point here is to express displeasure rather than spark conflict.

In order to know where we are today, it is important to appreciate where we have been. Our relationship with China has been worsening over the last decade, and we sit at a pivotal time in history. But the decision has already been made; we are heading into a new Cold War. In 1978, Deng Xiaoping recognized the need to reopen China to the broader world to expand a weakened economy and struggling growth. This required loosening or abandoning some of the core values of the communist dream and adopting a more capitalistic bent to stimulate growth. The great “re-opening” brought in a flood of investment. Relations improved throughout most of Xiaoping’s time in power, but even as China adopted a “friendly” tone towards the west, the issue of Taiwan’s status was always present, and then this pesky thing called “democracy” wanted to emerge in China. Most of those beliefs were expelled into other countries, and specifically Taiwan.

Nothing dies in a straight line—especially on a geopolitical front—but I go back to Tiananmen Square and the slow disintegration of relations that proceeded it. The damage was done, and public support quickly turned away from the Chinese Communist Party (CCP). There have been peaks and valleys along the way, but the trend has been moving in the wrong direction since this pivotal event. Fast forward to today, and we can see how President Xi came in with a splash by ending the Japan-China tension (lifting the ban on rare earth exports). He also wanted to push China into center stage by establishing government mandates such as “Made in China 2025” and the “Belt and Road Initiative” (BRI), attracting more foreign investment, and investing in local infrastructure. The latest policy to be introduced is the “Dual-Circulation Strategy” to address weak local consumption in their own country and try to drive GDP growth by stimulating the consumer. This quote captures the shift perfectly: “Deng Xiaoping said the Party would ‘let some get rich first.’ Xi Jinping is saying that enough people have gotten rich, and now it’s time to share the wealth more broadly.”

At the start of the 2016 election, we were already facing deteriorating relations with China (check out more on this in my previous Flamethrower article “China: Friend or Foe”). President Obama introduced the “Pivot to Asia” and gathered declassified intelligence that built an airtight espionage case against China and several state-owned enterprises. This included the espionage of Huawei installing backdoors into their equipment, which would be a huge problem if it were put in a server at the Pentagon or other sensitive site. Many countries have followed the U.S. model of restricting their products in any area of significant importance and telecommunications. So far, every member of Biden’s team has said all the right things. Most recently, new U.S. Commerce Secretary Gina Raimondo said “Chinese telecom companies—their behavior is a threat to American economic and national security. We’re going to use (the entity list) to its full effect.” So even with a new administration in office, the course clearly remains the same.

Costs of operations are inherently rising in China, and now with the Chinese Communist Congress taking place, President Xi is doubling down on the Communist playbook. Xi has initiated several “education” campaigns to revive faith in the Party Ideology:

• “We must educate and guide the whole Party in understanding how, through the extraordinary experiences of the Party, Marxism has profoundly changed China, and profoundly changed the world.” • In particular, it is necessary to deeply study and understand the Party’s theoretical innovations in the new era in the light of the historical achievements and changes in the cause of the Party and the state since the 18th Party Congress. [1] ”

Ultimately, his five main goals are:

• Being loyal to the party • Combining theory with practice • Serving the People • Engaging in reflection and self-criticism • Daring to struggle (Xi elaborated :“Struggle is what got our party to where it is today, and we must rely on struggle to win the future.”)

Xi is pivoting away from the Deng mantra of “let some get rich first.” The CCP is paying more attention to how wealth is being distributed throughout their society and how to increase domestic consumption to become more self-sufficient under the Dual Circulation Strategy. The “education” campaigns are rising, with more “structural” change to come following the FYP or 14th Five-Year Plan and GWR (Government Work Report).

According to Trivium, President Xi is framing many of these struggles against malicious forces abroad and subversive elements at home, which will only put more pressure on companies operating within the regime. Biden’s review provides a perfect cover to promote investment to “friendly” nations while the rhetoric worsens between China and the U.S.

A natural progression following the “Pivot to Asia” was a trade war or a growing cold war mentality positioning against expansion. The below chart breaks down where we sit on what was purchased vs. agreed upon in the Phase One trade deal with China. Tariffs came along with the Trump presidency, and so far, there has been little change from Biden on that front. “Weeks before the White House said it would keep tariffs in place on more than $350 billion in Chinese goods, Katherine Tai previewed the bad news to a group of U.S. business leaders. Tai, who is President Joe Biden’s pick for U.S. Trade Representative, told executives at a private meeting hosted by the Business Roundtable last month that lobbying for the duties to be removed wouldn’t work, according to people familiar with her remarks. Instead, companies keen to keep the so-called phase one trade deal—struck by the Trump administration and Beijing—should be prepared to live with the tariffs too, Tai said.” [3] Katherine Tai was approved with bipartisan support as she has spent her career being “tough on China,” and is in a key position to keep pressing on unfair trade practices and securing a more balanced backdrop.

More recently, China’s expansion started to get more aggressive in the worst way possible, and relations deteriorated faster following our country’s “Pivot to Asia,” which has shifted military resources and strengthened relationships in South East Asia. In response, China has accelerated construction programs across various islands, utilizing claims under the 9-Dash Line, which the UN and most countries do not recognize as legitimate claims.

When President Obama pressed the issue in the Rose Garden in 2015, President Xi claimed these locations were only for scientific purposes, but within six months they had air strips, advanced radar, satellite interlinks, all forms of missile protection, and military barracks.

The goal was to push the U.S. Navy farther away from the Chinese Coast and protect their false claims of the 9-dash line that was unanimously defeated in UN arbitration. As part of the Pivot to Asia, the U.S. began “Freedom of Navigation” operations as a way to maintain shipping lanes and disputing China’s claim that defies the Exclusive Economic Zones (EEZ) of their neighbors.

In 2013, President Obama launched a review of stolen IP and overall damage through the IP Commission Reports, [2] identifying the true economic cost of China’s deceit and passing laws to protect U.S. assets. Anyone who has done business with Chinese counterparts knows that the chances of any type of intellectual property being stolen is very high, leading to a Chinese-state owned (subsidized) company cropping up quickly to undercut your business. The depth of espionage was finally appreciated as U.S. Intelligence identified backdoors installed in hardware that Huawei had created/supported. This provided a way for Huawei (aka the CCP) to collect data and control the asset at will.

So now the stage has been set for a ramp in tensions, especially as the true cost of the Belt and Road Initiative (BRI) became public knowledge early last year after documents were leaked by Kenya. Several countries have canceled negotiations since the true impacts have come to light of what these “great rates” and “partnership” actually yield. The BRI was a key President Xi initiative to deliver a vertically integrated solution for their supply chain while exporting Chinese workers and goods into the market to spread a Yuan-based economy. All recipients of the money through loans and/or bonds are required to purchase all equipment, materials, and general services from Chinese companies. The original hope for the receiving country was to stimulate the local economy with jobs and functional infrastructure, but it ends up becoming debt diplomacy—either leaving the country buried in debt or defaulting on the project, allowing China the ability to take control. This has already happened with projects in Laos, Sri Lanka, and Bangladesh, to name a few. Pakistan and Nigeria are also asking for extensions on loans and delays on interest payments. China has made many of the strategic agreements to provide alternatives for their own supply chain to avoid choke points at the Strait of Malacca by cultivating rail capacity through the China-Myanmar Economic Corridor, Pakistan-China Economic Corridor, and the China-Europe Rail Route.

The ownership of key ports has also provided control over other countries’ flow of goods and has helped spread a Yuan based economy priced away from the U.S. dollar. China has actively been looking to limit the use of USD in their economy to regulate impacts of U.S. sanctions, as well as move away from a reserve system dominated by USD and Treasury Bills. The poor investments have caused issues within China, though, as collateral is limited and revenue assumptions on these projects are proving to miss even the lowest Chinese estimates. Regardless, China has been selling some Treasuries in order to pull forward more U.S. dollars to prop up foreign reserves against the rising bad debt expense . . . but were any of these investments ever about economic growth, or rather a land grab at all costs?

The amount of raw materials China requires to diversify themselves across the supply chain is huge, but it is also pivotal in achieving another key economic initiative: Made in China 2025. This official term was recently abandoned in the hopes of appeasing President Trump, but the economic push remains firmly in place. It is a state-led industrial policy to make China a global high-tech powerhouse and thought leader in the arena of advanced technology. “The program aims to use government subsidies, mobilize state-owned enterprises, and pursue intellectual property acquisition to catch up with—and then surpass—Western technological prowess in advanced industries.” [4] This plan was used to jump-start the industry of combining the BRI raw materials and industrial strength with AI, advanced robotics, bio-medicine, and other components of the “fourth industrial revolution.”

These shifts all come at a time when China’s economy is coming under a significant amount of pressure that is far from bouncing back. China is finally “abandoning” the GDP target as it is becoming near impossible to even remotely get close to 5%. We have said since last year that 5.5% was impossible to achieve given the headwinds China has been facing.

Citing “people familiar with the matter”, Bloomberg reported that in meetings with senior government leaders last week, ministerial and provincial officials were told:

The 5.5% target would “serve as guidance,” but “there won’t be penalties for failing to achieve it.”

Top leaders admitted hitting the target was no longer possible.

We hate (love) to say it, but we told you so.

Way back in December we predicted headwinds to growth would be too strong to hit a 5% target.

We said policy signals were out of line with the ostentatious 5.5% target when Premier Li Keqiang confirmed it in March, leading to a risk that stimulus would get out of control in H2.

By June, we had called it – it would be virtually impossible to achieve the 5.5% target this year.

But top leaders were more optimistic: They appear to have hung onto hope until at least mid-July, when Q2’s measly 0.4% growth brought things into focus.

The Politburo finally appeared to walk back the growth target last week.

Get smart: Beijing – and local governments – won’t abandon current stimulus efforts, especially with the 20th Party Congress coming up.

Get smarter: What it does mean is that Beijing won’t dial up those stimulus efforts to the messy max in pursuit of an impossible target this fall.

There has been some increase in activity on the service side, but after weeks of lockdowns there is bound to be a bounce. The problem remains that manufacturing is slowing with employment continuing to contract.

No matter what metric you use- Chinese employment has been struggling since 2019 and this is NOT caused by COVID. As we described above, the cost of doing business in China has been increasing and even before the supply chain disruptions ushered in by COVID- companies were looking to move away from China.

Capital outflows remain the name of the game as debt uncertainty only gets worse and companies/investors park their money elsewhere.

The Chinese consumer has also closed their pocketbooks (not like they were wide open to begin with) and confidence remains at record low levels.

China is facing a slowdown in exports, capital outflows, slowing foreign investment, and a decimated local consumer. There are very limited ways that the country can address so many issues, and given the amount of stimulus already used- I would argue only a recession is likely. China has been the “Buyer of Last Resort” for over 15 years, but now with the country tapped out- who steps in to save the global economy?

The CCP is falling back into its old view of trying to prop up the economy with Special Purpose Bonds. But, as I have been stressing for over 2 years now- the ability to generate any economic improvement has been zeroed out. The below is commentary where they are trying to push more into the market. If you remember, the CCP is pulling forward available SPB funds in order to accelerate the capital deployment.

On Friday, the State Council called for infrastructure investment to accelerate, but reiterated that funds need to be used appropriately.

According to a readout of the meeting – chaired, as usual, by Premier Li Keqiang – the State Council called for:

Investment to accelerate in projects included in the central government budget

Local governments to speed up their use of special purpose bonds (SPBs)

However, local authorities shouldn’t use that as an excuse to shovel money out the door.

“Projects must be mature, effective, and able to play a role as soon as possible”

“Investment should focus on effectiveness and timely decision making”

Moreover, the meeting warned that funds provided by policy banks shouldn’t be used by local governments to make up for funding shortfalls in their budgets.

And although the Politburo last week implicitly walked back its full-year target of 5.5% GDP growth, Premier Li made it clear that local governments aren’t off the hook:

“We need to keep the economy operating within a reasonable range this year.”

Get smart: In the past, it didn’t matter how stimulus was spent as long as it generated economic activity.

Get smarter: This time around, Beijing wants to have its cake and eat it too – it wants the stimulus to generate short-term growth and create long-term economic value.

Our take: Good luck with that.

Yes, economic growth will accelerate in the coming months, and yes, worthwhile investment will be made.

But given the lack of shovel-ready projects, and the immense strain on local government finances, these central government directives will prove almost impossible to fulfil and will almost certainly result in white elephants and bad debts.

We have called out that the multiplier of these bonds was .87, which just means that the bonds can’t even cover interest let only principal. And now- we have official confirmation that the SPBs were basically useless in 2021. What I find amazing is that they admitted to this level of the problem, which probably means its that much worse.

As of Wednesday, at least ten provinces had published audits of 2021 budget implementation.

The key takeaway: Last year, local governments did a shoddy job deploying special-purpose bonds (SPBs), which are earmarked specifically for infrastructure spending.

Per the audits, key issues with SPB management include (Sohu):

Unspent funds

Lack of suitable projects

Diversion of funds to pay government salaries

Some details (Caixin):

In Henan province, RMB 15.6 billion in SPB funds sat idle for over six months…

…while RMB 3.4 billion in SPB funds was misappropriated to pay salaries and other expenses.

Shandong province counted 36 projects that hadn’t met planning and environmental assessment standards when bonds were issued for them, delaying their deployment.

All of that has big implications for 2022.

Nearly RMB 2 trillion in SPBs have been issued since the start of May, alongside RMB 1.1 trillion in additional stimulus funding through the policy banks.

Get smart: The numbers in these audits are a bad sign for the prospects of H2 2022 stimulus.

If there are already billions in idle funds, there’s no reason to expect local governments will be able to deploy the additional RMB 3 trillion coming down the pike this year.

A large chunk of that stimulus will end up in wasteful projects and government worker paychecks, but even more is going to end up nowhere.

The upshot: Infrastructure spending won’t be the white knight that rescues China’s economy this year.

The problems on the developer side are only getting worse with more defaults and less payments being moved through the supply chain. As we described last week, there are trillions of dollars’ worth of assets that remain abandoned with no way to service the debt. We have seen mortgage holders refuse to pay their debt, but it’s easy to forget about the suppliers that also haven’t been paid. What about all that lumber, concrete, windows, nails, paint… EVERYTHING that hasn’t been paid for. Who makes those companies whole? Can they service the debt or lines of credit they took to finance themselves? This is a cascading event that only gets worse as the government and PBoC are limited in their ability to bailout these entities.

Sales across the board are just getting worse every month with limited ability for the companies to finance themselves while the consumer is getting hit hard.

The sheer size of these loans has only ballooned over the years making the problem MASSIVE with no easy way to “deflate” something that has grown exponentially.

The lack of household employment and income expectations will also keep their wallets closed to buy new homes but also just spend in general. On a cultural level (already), Asians are savers and now with a waning global economy and uncertainty- the little spending they do is shrinking even further.

Another area of problem is the slow credit impulses and how they are even maintaining a “positive” number by skewing the data. There isn’t a supply problem when it comes to the availability of debt but rather a demand issue. You can see that demand has actually been shrinking as profits at private companies are steeply negative and leverage issues are getting worse.

So if that is the case- how can they possible show a positive credit impulse?

They have managed this by having SOEs borrow new debt and retire old debt in order to show a transfer of ownership and underlying growth. This is how they can support the numbers even as industrial profits for private companies fall. SOEs are showing a profit, and they are pushing these companies to roll that profit into “new” debt but playing a financial game to keep the numbers supportive. But, we can expect the credit impulses to disappoint as the private sector stays firmly on the sidelines.

Loan demand across ALL private firm sizes is steeply negative and average out to about -13%. So we know these companies are losing money AND they already have a leverage problem keeping their demand for loans/bonds negative YET we have a positive credit impulse?

So even though they are pushing these loans and bonds- the “quota” for this stuff is an absolute lie as corporations avoid any new borrowings and governments can’t deploy SPBs. These infrastructure bonds won’t be able to find any home.

Especially as developers suspend even more construction, and it’s unlikely the banks take any new risk given their exposure is already very elevated to the real estate sector. This exposure can come from mortgages, supply chain companies, or the builders/contractors directly.

Many of them are already over exposed:

As more consumers ban together and refuse to pay their loans on projects that have been abandoned.

The government is trying to subsidize whatever they can (especially food), but the problems are mounting and the issues are only getting worse and bigger. Taiwan offers an opportunity to distract the populace and try to drive “some” form of unity… we can only hope a broader conflict doesn’t happen because of it.