Round 2: Chen Zhao And Marko Papic on China

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0:31all right welcome everyone into a friday chat between uh chen zhao the macro maven of montreal look at that unanticipated alliteration i hope you're ready for a lot of those uh so macro macro maven of montreal that's what i'm gonna call you chen uh and i'm marco poppich i'm chief strategist the clock tower group also uh if chen had a coaching tree i would be on it because i work for chen and with chen at bca research chen is the founder uh and chief global strategist at alpine macro and chen i want to start off right away uh you and i had a conversation about a year ago everybody was basically batting down the hatches bearish uh asking be and you know a lot of people are bearish a lot of the time but uh you basically call the soft landing or the no landing um you got that right uh 12 months ago uh bullish and equities as well i believe somewhere around there uh around the summer of 2022 um and uh you know that's a great great call definitely showed the value of independent research like alpine macro a lot of investment banks got that wrong where do we go from here?

1:46You made a great call 12 months ago. Where do we go next 12 months? Well, thank you, Marco, for your kind words. I mean, I don't know whether I'm a Mac or a Mac Maven, but hey, you know, you and I work together. We've always had a lot of fun, so we'll continue to have fun. But, you know, with regard to that question, I think the important thing here is there's a lot of confusing signals, because if you think about the economies, think about business cycle, you know, the performance, the behavior of the U.S. economy was completely absolutely unusual. What do I mean by that? Usually one says high interest rates tighten monetary obviously very aggressively.

2:33You wouldn't expect that economy going to slow. You wouldn't expect that economy is going to probably get getting into recession, especially judging by the magnitude of the yield curve conversion. You know, we talked about that before, but none of the slump actually has taken place instead. I mean, the economy looks like it's beginning to strengthen. Now, we have heard a lot of explanations, but I don't see any convincing explanation why the U.S. economy on a sudden has regained strength. I think my interpretation, my explanation of this unusual strength of U.S. economy, which is completely unprecedented in the U.S.

3:23history, I analyze it with the fact that actually fiscal Aussie is extraordinarily pro-cyclical this time around. This is the first time ever in the U.S. history, meaning when the Fed was tightening monetary policy, the administration, the Biden administration actually is pumping a lot of physical stimulus into the system. So how big? It's massive. We're talking about five to 6 % of GDP in terms of physical thrusts. That has been applied to the US economy from pretty much third quarter last year, all the way till now. I think this basically explains why the US economy has remained very resilient.

4:08That's probably explains why the US economy has actually already begun to accelerate. That has also explained why the bond market has done for it. But I think that is all about the statistical stimulus. Now, some of our clients probably know that we turn more cautious on stocks in recent months. The reason for that is, again, has everything to do with this physical stimulus. I think the physical stimulus is not going to stay here. I don't think it's a sustainable story here. The very reason that we have this big pop-up in physical stimulus is really because of the Biden administration's three big spending and investment packages, the initial impact of that package that actually gave you this big physical impulse.

5:00But I think as time goes by, the net impact of these packages is going to die down. That's why I think I'm still very hopeful that for the remaining of the year, for the remainder of the year, maybe first half of 2024, I think once the fiscal stimulus start to be withdrawn, then the US economy will probably be left with the interest rates that are way too high. Think about the physical stimulus that not only prop up growth but also prop up rates much higher than would than they would otherwise that's why i don't know exactly the timing uh that's why i feel that uh this physical stimulus right now probably is peaking as we speak and will over time die down so that's why i think you know if you want to be a controlling guy you want to be a little bit careful on stocks because when the physical stimulus is withdrawn and the economy probably could go into some kind of a slump but that is going to be good for bonds because everybody nobody want bond everybody want to sell bonds so I think I want bonds at this point I want to be a little bit overweight duration that's you know that really sum up the uh the macro story for the moment Marco back to you no it's interesting you know because if you look at um Google trends if you look at on Bloomberg sort of news trends, soft landing has exploded as a term, as a narrative.

6:33Recession has collapsed. And what you're saying is like, yeah, that's exactly the moments that I want to be cautious. Last 12 months ago, that was completely opposite. Your colleague, Harvinder Kalluray at Alpine Macro, just published a really interesting piece, higher R star or longer lags. And so it's pretty definitive here that you guys are sitting on the longer lags side of the equation. I think I'm a little bit more open to there being a higher R star, just because the U.S. consumer is pretty healthy. So you make the argument that savings, the excess savings has been whittled down. At the same time, the U.S.

7:13consumer spent 12 years deleveraging. So their balance sheets were really healthy when we dumped that$3 to$5 trillion on their checking deposits. So I'm not sure if they're going to necessarily panic right as the savings expires. But you make the point, it doesn't really matter. It's logging the truth either way. Fiscal is being withdrawn. Maybe it's not three months, but six or eight months, but we're at the end of the cycle. You were saying there's going to be an impact on higher yields. Yeah, I think, Marco, you raised a very interesting question, to be honest. this R-star issue. Anyway, this is not sort of observable, nor is it directly measurable, but we can only infer that through so-called revealed preference, meaning the economic performance of the market.

8:06So far, the revealed preference seems to suggest that R-star would probably be higher, even though we don't know whether the rates, the economic performance, or stock market performance was cost because it was caused by short-term factors such as fiscal stimulus or because caused by a longer term issue such as a higher mutual rate. My thought here is this, the mutual rate probably, you're right, probably slightly higher than before but how much higher I don't know. I think I don't see, usually when you talk about our scenario you're talking about demographic issues, you're about productivity you talk about all this long-term uh horses i don't think that thing have changed much since the pandemic if there's anything change i think you put your finger on something that is really important if there's anything changed and observable is a savings rate you guys the household sector savings rate just moved down from pre-pandemic of nine percent to today four percent i don't think it's going to go back to nigh if it doesn't go back to nigh then uh you removed one uh key lag on this sort of low uh low r star low neutral rate argument so precisely because of the u.s balance sheet is getting better that's why they probably are not going to be squeezed to save a lot a lot more but that's probably a reason about how much know pre-pandemic the average real rate is about 0.5 percent we're talking about long term and a year tips you about 0.5 so i say i'll double that i say equilibrium um real rate is about a one percent and then inflation expectation right now is a steady 2.2 so you add them up you've got about you know 3.2 so now i have to deal with the so-called term premium what is the term premium i mean term premium uh the fed estimate there's all other places some some estimates say still negative others say maybe positive so i i want to be aggressive i want to be cautious so let's take a point in term premium so you're really talking about 3.7 to 3.8 but anyway But obviously, it still tells you that the fair value is somewhere 3.7, 3.8, way lower than today's bond yield.

10:41That's why I feel like I'm still inclined to be a more positive side on bonds. Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo. See a trading opportunity? You'll be able to trade it in just two clicks. Feel ready? You can move to real money with as little as$100 once your account is approved.

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12:01So that's a really important point. I mean, the savings rate is very difficult to forecast, obviously. And I would argue that the number one factor when people try to forecast how quickly this savings will happen is the savings rate. And I think that consistently over the last 12 months, economists have gotten this wrong because they're not adjusting for psychology. college. I mean, think about what just happened in 2020. We were told the Great Depression was upon us. We were told the Spanish flu was upon us. And the household net worth in the United States of America went up as percent of GDP for the first time in human history.

12:38You as a human being became wealthier during a recession. Why would you increase your savings rate? What lesson did you learn as a consumer, as a household over the past four years? And I think the lesson you learned is to YOLO. So that's where I stand with that question. But of course, as you said, the neutral rate is an unobservable factor, which is great for you and me. We're professional BSers, of course. We don't have to do the math. So that's a beautiful, beautiful I mean, everybody I have a PhD, yes Exactly Okay, so let me ask you something though This is something that we're What I always love When you and I work together I always like how you would break down Complex Economic complex Concepts to, you know The rest of the world To the plebs And I consider myself One of them, of course My background in academia Is political science, not economics So I was very fortunate to work with folks like you.

13:41And one of the things that I think a lot of people confuse is the yield curve. The yield curve has been negative. Now, I talk about the yield curve. There's two theories about it. It's either a harbinger or a hammer, or maybe a little bit of both. What I mean by that is that from what I understand, from what I learned working with you is that it's either a harbinger of something bad happening, because basically central bank has low and high. And then as the collective wisdom of the market starts to get worried about the long term, about the 12 and beyond, it moves from risk assets to the bond market, the long end comes down.

14:20And therefore, the yield curve inverting is a harbinger of something bad. The other theory, of course, is that it's actually a hammer. It is going to hammer. It's actually going to have an impact on the economy because banks struggle to lend when the yield curve is negative uh they borrow short-term lend long-term and of course you know when the yield curve is inverted they don't make money so um i think it's probably a little bit of both um i don't know you know better than me but in this situation shouldn't we be worried because let's say let's say i'm right let's say that my bullish view that american households are going to yolo is correct okay cool you're still right that their savings that they've accumulated the excess savings is going to whittle down i would argue i don't care then that is irrelevant they learned the wrong lesson from covid they're going to borrow they're going to go out they're going to put those vacations on credit cards don't tell me about their excess savings american household psychology has shifted now the problem with my view of course is that if the yield curve continues to be inverted banks may not be willing to land in that environment and not just for households but also for people where do you sit on this how should we interpret what's happening to the yield curve and is it going to be right yet again so in the recorded history the yield curve inverted about 39 times i'm talking about uh two to ten but 39 times this is so you know there's over predict about a uh one and a half recession so you know that's why lots of people use that as signal but of course when you have inverted curve it will inflict damage for sure the banking system is the the top one that you know because the banks are all borrowing short lending long so if you revert a curve your toes especially your margin get screwed so that's no question that's why you had this uh regional banking crisis um flared up and that of course the Fed is came in and clamped down.

16:21But here, how do I see that? Right now you can see the curve is it's a steepening. We have a bare steep steepener that is working now. Is it not really the shorter in the curve is projecting ever higher short rates? That's not the case. If you look at the curve, it is just projecting that the holding period be longer. It's about the same rates, but longer. That's why the mathematics is that if you hold it forever, let's say, at this level, then your long end of curve is going to converge eventually to the short end of the curve. So that's why I think right now, this is a very critical call still on the inflation.

17:09If inflation turned out to be way softer than the market was afraid of, then I think the bulls along the shorter and the curve is going to risk downwards. I think that's why we still have to make a call on inflation. Inflation, if inflation turned out to be right, then you're probably going to be okay, even though you have a curve inversion. Now, again, Marco, don't forget, there's a 6 % physical expansion on the background that is working against the inverted curve. even though you type you you know the degree of the inversion in my view really reflects the short-term impact stimulating impact of physical expansion if he injects six percent of the stimulus in the system we know that it's a short-term stimulus we know that it's going to stoke up growth and we know that it's going to create upward pressure on interest rates but long in the curve understand that is hey this thing is not going to be sustainable that's why i think there is a element of physical uh expansion that is also embedded in this yield curve that's that's my interpretation that's why you can have a scenario where you have inversion but without recession because of the propping up effect by the physicals uh by the fiscal policy yeah and i think one of the things that many economists have underestimated is that the fiscal policy uh not just 21 but even 2020 lived man that's massive it's a massive even today it's a massive six percent of the td man oh man but that's right and it actually lives on uh yeah the checking account of consumers longer than people expect for example korean war after korean war we had a very vicious fiscal flip recession but that that's because the fiscal stimulus stayed on the korean peninsula as tanks and airplanes that were destroyed.

19:12The fiscal stimulus of 2020 and 21 lived on the consumer balance sheet. And I think that's what you're describing as these latent effects of what we've done. Last question for you on the macro front that then we're going to open up to the audience. And also, you can ask me whatever's on your mind. A lot of questions for you, Marco. Cool. Okay, good. So then I'll do a last one for you. China, that was another thing you got right 12 months ago. So, you know, basically, I think the collective wisdom of the investment community was that zero COVID was super bad. And then by the extension of that logic, removing zero COVID is super good.

19:54I mean, some of the investment banks out there in Q1 of this year were calling for a new leveraging cycle, like consumers were going to re-leverage in China and bring us more growth. That hasn't happened. you were super bearish 12 months ago to me it looks like China's undergoing this is something that we've been talking about for five years China is undergoing secular segregation very similar to the American experience my question is this right now everyone's kind of bearish in China for a good reason isn't there risk here to the upside because if we learned anything from 2022 too it's that policymakers in china once they decide to do 180 degree false shift they do it they all messed around so if somebody explains balance sheet recession if like they fly richard ku to beijing and he explains the denominator effect yeah to xi jinping and convinces him isn't the risk here like boom falls to shit yeah that's a very fair question Marco I look at the Chinese shares they're trading in a single digit it's already become a call option it's not really stock market anymore everybody's lean China now here there are two things I want to keep reminding people what are the Chinese economic problems Basically, I keep thinking about that.

21:27But basically, the problem can be summed up in two points, both at a macro level and at a micro level. At the macro level, the issue is very clear. They got a very serious oversaving problem. If you look at the household savings rate, it was skyrocketed to about 40%, 45%. Whereas the investment, we're talking about the desired investment private sector. Basically, it's non-existent. You know, this just came down. That is basically a massive issue. That is a very serious issue that actually brought down Japan in terms of nominal GDP growth. You can see Chinese nominal GDP growth is grinding towards 4%, which is the lowest level ever in that country's history.

22:14But we know that if you have an oversaving problem, you'll have to either see output contract or price decline or some combination of both. Unless, unless the government sector comes in and spent a heck of a lot more money for the private sector to keep the economy more or less in balance. So that's the macro issue. A huge imbalance between savings and investment. Of course, I don't want to go through why the investment has been so weak. Of course, the private sector having a problem. But most importantly, the Chinese urbanization process is more or less mature. So you build all these highways, you build all this fully-train system, you know, what else it got, right?

22:58You basically build them all. That's why the desired investment is not there anymore. That's the macro problem. You know, Xi Jinping's policies are on the map over the last 10 years. I mean, he's not really pro-business. He's not really pro-private ownership. He's not really into reform. instead into political control communist ideology centered policy. So that basically really undermined private business confidence. You know the private business is on the wrong, they are steered. You know if they're not sure what the future holds for them, why the hell they want to invest, right? That's also factoring into the growth, weak growth, weak investment, weak confidence and things like that.

23:46So these are two big issues. In my view, the first issue is reasonably easier to deal with. You just go in and spend a heck of a lot more money and borrow from the private sector and spend it. The Chinese public sector's debt is better low still. They can do that. But the problem here is Xi Jinping is very reluctant to do it. Why? Because we have, We means the foreign experts just kept telling the Chinese government don't do it If you fighting our republic sector that you're gonna have trouble down row, but he's very reluctant. He's very into deliveraging That's where the problem is you'd be me originally calling into a deflation So my bad is this the situation right now is not terribly enough so that they are forced into a major action yet.

24:43So that's why he's gonna do piecemeal reflation here and there. At the same time, the growth is gonna run lower and lower until something that really bad happens. I don't know what it is. I mean, think about the zero COVID policy. That's a Xi Jinping. He's a hallmark in his policies that, that, hey, don't be bothered by all this Western press. Stay steadfast. So we're having to stick to the plan until, until what? Well, the COVID policy until the goddamn economy broke down. So that's why he just buggered off. You know, everything break loose. So I'm concerned that he's going to make the same mistake.

25:26Hey, steadfast. Don't let me know. Well, I'm going to flood the system with steamers. Right now, this is the time you want flood the system with the steamers. But he's not going to do it. So I think I think the government's going to grind lower and lower until something bad happens. I don't know what that is. But hey, I don't think this downside is completely exhausted yet. But we're getting there pretty quickly. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

26:02Well, you know, there was a question from the audience, actually. has Xi Jinping stimulated the Chinese economy before? And the answer is a definitive, absolute yes. So there is a perception out there that he's an Austrian economist or that he is a card-carrying member of the Tea Party, as I joke often about Xi Jinping. But in 2015-16, they did use the PBOC balance sheet. They used the PSL facility to basically do shantytown redevelopment. 2012-13 basically they did the anti-corruption campaign which caught them by surprise about how much it slowed down the economy 2014 they did offset that so he has been a pragmatist slash populist before and I think you're right they've learned the wrong lesson from the West basically if you look at the pattern of their policies it's a stop and go whenever he stimulate he steps in, we call it start a grow.

27:02Every time we try to delirate, we call it a tank. Basically, you can see the tank here and there are three or four cycles, basically, following that pattern. This is what I would say is this is kind of political. And in the West, in the West, we took too long to realize that an absolute Marxist communist like Yanis Varoufakis was right. and then you have to stimulate through the public. I mean, unfortunately, this is when Keynesians are right. There is no other way. Unless you want to have the Great Depression, the public sector cannot, the private sector cannot organically reduce their debt. You know, that does not happen.

27:42Because if the growth slows down, their debt relative to growth is going to go down. Duh. Math 101. Now, in the West, we were dumb. We believed in the Tea Party and the Angela Merkels of the world that somehow austerity will magically help us. And as a consequence, the political outcomes were, of course, rise of anti-establishment parties and rise of populism across the Western world. So things like Brexit, Donald Trump's election, rise of Podemos in Spain, rise of Syriza in Greece, AFD in Germany, Fratelli d 'Italia in Italy, Five Star Movement, so on and so on and so on. And in seven years, we went from interest rates to QE, and then pause, and then fiscal after 2016-17.

28:32I don't think China has seven years to dabble with anti-establishment. I don't think China has seven years to dabble with these kind of, in a way, release valves. Democracies have a release valve. We can get angry. We can give the elites a collective middle finger by voting for somebody who is anti-establishment. In China, you don't have that. There's no such mechanism. That's right. And so people are pissed off, become social harassed, some stuff like that, or too bad. You just suffocate the thing all day to some very bad end. So that's the sad part. He broke the rule. So what else you want me to say?

29:17Because in the past, if you made a mistake, you got to take your term. Then the next one is always, the next team is always hopeful, right? Now, I don't know when. When is the end? And this time, there is no Prime Minister Li Keqiang to blame for your mistakes. And I think this – so this is where I'm a little bit more on the side that he will do what he's done in the past. I agree with you. It's going to get a lot worse. But I think that when they turn, they'll turn faster than we did in the West. It's not going to take them seven years. It's going to take them three to seven months. And when they turn, they're going to have to turn big.

29:56and you will just suddenly wake up, you'll wake up one day, and all the housing is for a living, not for speculation, will be erased. I think you are absolutely right, Barry. He's already under huge stress because the people I spoke to inside China, everybody's pissed off. I mean, I think as a leader, it's not a sort of a new thing that you piss off some people. but man it's not very easy to piss off everybody and he he is pissing off everybody that is basically telling you how much stress he's under and everyone's bearish uh by the way i mean like everybody's bearish everybody's a pessimist onshore consensus is deeply deeply bearish i agree there's a there's another question just really quickly why are chinese crude purchases so high with a weak economy are they stockpiling for war uh i would say no oil prices were relatively weak for the last 12 months and Chinese simply based their purchases on the price of oil.

30:58So yes, oil prices. Also, Russia actually offers very, very good prices to Chinese. So that's an additional incentive for them to stockpile some cheap Russian oil, for sure. Absolutely. Okay, so I'm now open for your questions. I got about a bunch of questions. The first thing, of course, is this intriguing story out of Russia, I mean, Purgosin. Now, what the hell is going on? You must have some interesting story. I know that everyone has their own take. You always have a very interesting take on this kind of stuff. Let me take it away, man. I mean, first of all, I'm very surprised that Purgosin has managed to survive for as long as he has.

31:47Look, the entire story of Wagner is a very weird one. If you follow geopolitics wars, civil wars, international wars, it just doesn't happen often that a country of the kind of stature and power that Russia has outsources its national security to a private group. This does not happen. And no, the United States did not do the same in Iraq. Private security and military contractors that the United States has used were used for diplomatic security, for base perimeter security. They were not used to assault entire cities in a significant way. So the rise of Wagner is a sign of destabilization of Russia.

32:38You can go back and read Machiavelli's The Prince to understand why relying on mercenaries is a clear sign of weakness. So then when the mutiny happens and the fact that they're not blown out of the sky or that Russia doesn't use its air force to attack the column of about 5 ,000, 6 ,000 mercenaries, I mean, that was also a weird situation. the way that that whole situation was resolved, was basically for those being given asylum in Belarus, and then popping up in Africa, you know, continuing to do business deals. The entire episode is, I think, a sign of real political destabilization. Now, people can stay in power as the power shrinks.

33:24And this is an important point. President Assad remains the president of Syria Like, he is president of 67 % of Syria, as opposed to before the civil war that started in 2012, he was president of 100 % of Syria. So you can lose power as you stay in power. And that's something that's very important. I think too many people are indexing on whether or not President Putin is still in the Kremlin. He is, but he's clearly losing control, direct control over certain segments of the country, of institutions, and of power projection. And the fact that he shot out the private jet out of the sky, to me, means absolutely nothing.

34:12I mean, great, you know, slow clap. Wow, well done.

34:19It doesn't reinforce his power base, I guess, right? That's your key point. It's basically, you just try to knock down one potential opponent. Does that mean that Wagner is completely dismembered right now? Yes, I think so. I think Wagner is completely dismembered from what we understand. They're being integrated into command and control of the Russian military. but mutinies happen when things are going bad mutinies don't happen when things are going well right right and and so the fact that wagner mutinied uh also tells us that the perception in elite circles in russia is that things are going bad and you know it's prigosen today it's some kernel tomorrow that's right so that erosion now why does this matter for investors You know, what does this mean?

35:09I would just say this. I used Assad as an example of someone who is in power, but his power is weaker. Another person I could use is Yeltsin. Yeltsin was in charge of Russia throughout the 90s. Russia was politically destabilized during that period. Now, why did this matter for global macro investors? Well, it didn't because we didn't care about export of commodities. Commodities were in a bear market in the 1990s. Russian oil exports have, have during this period of political destabilization, i.e. the Yeltsin regime, they have, didn't really impact oil prices at all. What will happen if Russian oil exports have over the next five years because of political destabilization?

35:54And by the way, political destabilization does not mean civil war, does not mean roving bands of warlords. It just means that the macro context in Russia becomes less conducive for investment. In that scenario, I think you can have a world where Russia fails to meet the expectations of commodity supply, whether it's metals or whether it's oil. And I think that's the long-term implications of Russia for the next five to 10 years. Well, you talk about this commodity stuff. I heard a theory. i thought it was interesting because uh you you for sure you know that actually the uh the ukrainian offensive is not going well yeah um the uh which is actually from a control because most of people in the west just want russia to be defeated uh you know what's going on the ground is not really uh for the pleasure of the western politicians and population are large but there is a theory I'd like to hear your opinion, which is always different.