Stay Open Minded

Bottom line for the markets: Right now, there is a tremendous amount of uncertainty in the world, whether you view it through a political, economic, or financial lens. For now, most of Pave’s volatility measures are acting as though there is little uncertainty.  With no clear picture of the outcome for a lot of important things, this is not the best place to be. For the next couple of quarters, it is prudent to invest carefully while remaining open to a wide range of possibilities and hedging outcomes. 

Modeling the Election

Much has changed this weekend, no doubt. We wrote the first Point on Friday, and while it may seem outdated, given that the ground below us has moved, we are still submitting it for your consideration. If Lichtman changes his views below, we will follow up.

Quantitative historian Allan Lichtman’s presidential prediction system is on a hot streak. He has predicted 9 of the last 10 U.S. presidential elections. His only miss was his forecast that Gore would win in 2000, so one could argue he is 9½ or 10 for 10. His system of the 13 Keys to the White House was created in 1981 by taking earthquake prediction models developed by a Russian geophysicist and applying them to politics. Its premise is that the winner is determined by how well the country was governed over the past 4 years and that the current campaign carries no weight. In his system, if the incumbent scores positively on 8 or more Keys, the incumbent is expected to win the election.

Lichtman’s score card has only 2 false Keys against Biden: the fact that he does not possess a national Ronald Reagan-type charisma, and that the House is in Republican hands. There are 7 positive and 4 unresolved keys, so all he would need is one of the following 4 to go his way into November: a resolution in Gaza, no dramatic change in Russia’s advance in Ukraine, no sustained social unrest domestically, and no surge in RFK Jr.’s campaign. However, recent events bring 2 of the 7 Biden positives into question: no scandal within the administration and no serious contest within the party for the nomination. Lichtman still believes both remain positive for Biden.

Jefferies’ Washington group mentioned that Lichtman noted an important swing factor: incumbency. If Biden steps aside, then the Incumbency Key is lost as well as the Serious Contest within the party Key (one could argue the Scandal key goes away as well) and the prediction flips to Trump. Therefore, under his system, Democrats should be worried about a “be careful what you wish for” scenario if Biden gets pushed out from within the party.

Is China Copying Something Else from the U.S.?

China’s housing crisis has been moving up in the world: the first defaults were directly from the real estate developers who pre-sold homes to consumers and ran out of money to complete them; then the problem overwhelmed many shadow banks who sold investment products to investors based on the promise of those cash flows. Now, it appears that the problems have percolated up and impacted many of the 3800 rural banks across China, in what could be a replay of the U.S. Savings and Loan Crisis 35 years ago. China is setting up entities to absorb failed banks similar to the Resolution Trust Corporation, which was set up in the U.S. to sell off or merge troubled banks. In the U.S., between 1989 and 1995, almost 750 banks were dissolved that had been similarly burdened by poorly managed real estate lending.

China’s rural banks represent 13% of total bank assets and are not well capitalized, nor do they have access to low funding sources available to the large state-owned banks. Thankfully, positive steps have been taken. A few local provinces directed a part of the proceeds from special purpose bond sales to bail out banks, and one bank repository in Liaoning has already absorbed 40 banks. Five other entities have also been established to buy and merge failing banks, with more to come. Unfortunately, there is a need for far deeper measures, because the real estate problem is enormous. Markets celebrated when the Chinese government allocated $41.5 billion for a relending program to complete delayed development projects, but that equals only 1% of the estimated $4 trillion total real estate overhang.

With real estate moving from a dominant economic driver to a downward influence, capital has been flowing to the industrial sector, a switch that carries unintended consequences. Annual net new bank loans to the industrial sector have grown six-fold to $614 billion, almost the exact amount that used to go to real estate. Expanded industrial capacity resulted in a boom in exports, causing the U.S. trade deficit with China to deepen further. This dynamic could result in even more severe U.S. tariffs imposed on Chinese imports, causing higher goods inflation and amplifying tensions.  

Ukraine Unfriendly Financial Fire

A potential regime shift occurred last week as NATO changed gears, labeling Beijing “a decisive enabler of Russia’s war against Ukraine” and issuing a demand to halt China’s support. The country has supplied semiconductors, software, and other weapons components to help Russia’s military. NATO’s declaration carries the threat of economic sanctions, and if that occurs, China will most likely retaliate, specifically hurting Germany’s prospects for an economic rebound because China is a major market for high end German exports. Last Friday saw China freeze assets and property of six U.S. defense firms and denied visas to their executives because they were selling arms to Taiwan.

Rising tensions could end up with the U.S. sanctioning Chinese banks that have funded Russian natural gas exports. Chinese banks could find themselves cut off from the SWIFT system, as did Russian banks after the Ukraine invasion. SWIFT is the network used by institutions worldwide for international money and security transfers, and if the U.S. Treasury’s Office of Foreign Assets Control (OFAC) cuts Chinese banks off from SWIFT, those institutions will lose a valuable funding source. Such a move could aggravate the real estate problems mentioned above, hurting Chinese banks, and problems could spill over to China’s enormous shadow banking system. The potential brake on such actions could be Treasury’s concern that a severe Chinese economic contraction will blow back to the U.S economy and financial markets. The weak Chinese GDP and Retail Sales data out last night confirms the business slowdown is worse than expected. NATO’s statement has increased global market risk, and we will follow developments closely.

What to Look for This Week 

1. Wednesday July 18 is a full day. At 8:30 am E.S.T, June Building Permits are released; Permits just hit a one-year low at 1.4 million, so equity markets could go lower if there is continued weakness supporting the recent data depicting a constrained consumer. At 9:35 am Fed Governor Waller speaks on the Economic Outlook; he could question the market’s consensus about a September rate cut by saying there is not enough data to decide on a rate cut by then. The Fed’s Beige Book out later that afternoon at 2:00 pm, and we will look at each of the 12 regional Reserve Banks Labor Markets section since Powell is concerned about weak employment.

2. Wednesday July 17 after the U.S. stock market closes, Taiwan Semiconductor reports its quarterly earnings. It is important since TSM stock has mimicked the moves of NVIDIA closely and should affect the direction of U.S. mega cap tech stocks. Consensus is for $1.34 earnings per share.

3. China’s third Plenum kicked off Monday July 15 and ends Thursday July 18. There are seven plenums every five years, and the third is important because it tends to set out economic policy plans for the next five years. If China’s leadership is serious about attacking the housing crisis, they may introduce a major stimulus package. Otherwise, expect platitudes about taking a global lead in disruptive technologies.