Video Transcription:
The Escalating Trade War Between the US and China (w/ Mike Green and Marko Papic)
MIKE GREEN: Mike Green, I'm here in Los Angeles with Marko Papic of Clocktower Group. Marko, you and I have known each other for many years, first at BCA and before that, you're actually at Stratfor, although I wasn't aware of that. Let's talk a little bit about your background. Starting on that point. You're not from the United States or even Canada for that matter. You're a Serb, and so on all matters of death, we can discuss these things. How did you get out of Serbia? Tell me about your childhood. MARKO PAPIC: Well, first of all, it's great to be back on Real Vision. I think we did a hit on Brexit couple years ago, so thank you for having me back on. Yes, my background is different. I was born in Yugoslavia. I'm one of the few people who at six years old, had to have their father explain to them what it means to be something else. When you're born in a country that has identity, that has a sense of self, and then that evaporates, that's a really interesting moment in your life, because then you have this moment when you have to be told that you're something else. I was born in Yugoslavia, it became Serbia. Lived in Iraq for a very brief period of time. When the country started to fall apart, we actually moved to Jordan. Of all the places in the world, we moved to Amman, Jordan and so I think that I'm one of the very few people who escaped war by going to the Middle East, not from it. It was great three years there, then three years in Switzerland. Things were starting to get better and better, if you will. I remember being in Jordan, in Amman, in American community school there. It was hilarious, because my first day, I said I don't care to one of my friends. He said, well, you can't say that, you get a detention for saying I don't care. I was like, are you serious? Where I come from, eighth graders have guns. That was my childhood. And then I went to school in Canada, University of British Columbia. If I don't have a lot of time to explain to people where I'm from, I just say I'm from BC. Then I went to University of Texas. That's where I was doing my PhD, and got a job at Stratfor in 2007, and then ended up at BCA Research in 2011. MIKE GREEN: Stratfor is known for their geopolitical analysis. One of the things that you brought to BCA was a viewpoint, and this is where I first started reading your stuff-- was a viewpoint on constraints and that the world is governed by this idea of what can't people do? You talk a little bit about your theories on how constraints matter and why they matter and why that's what you follow. MARKO PAPIC: First of all, I believe that in order to add value, to people who don't speak your language, you have to show up with a framework. When I was hired by BCA Research, the premise was that I was going to be able to help investors with political and geopolitical analysis. How do you do that? Well, you have to give them a framework with which to think. I don't think this is anything groundbreaking. I think a lot of investors share this framework, whether they know it or not, but a constraint based framework is really useful because it allows you to focus on the material reality that constraints policymakers. You don't just throw up your hands and say, like, I can't predict what policymakers want. Because that's true, you can't. You can't get inside their head, but you can forecast, what are the material constraints that are going to force them to do stuff that they don't want to do, necessarily. What I always say is that constraints are not optional, and they're not subject to preferences. But preferences are optional, and they're subject to constraints. What do you want to focus on? Something that's optional, and subject to something else, or constraints, the material reality, not the ephemeral preferences? The basis of this framework is basically that Niccolò Machiavelli was wrong, that no matter how much virtue the prince has, he or she will never be able to survive the vagaries of Fortuna. Focus on Fortuna, focus on the material reality. MIKE GREEN: When you say a constraint, most people tend to think about that meeting something like, well, you can't do that. Yet we say that often in finance, we talked about a debt to EBITDA level, or we talked about evaluation level, we'd say that can't possibly happen, that can't make sense. But a lot of things have happened that people say can't, so how do you avoid identifying false constraints, i.e. interest rates can't go below zero? MARKO PAPIC: I think in politics, that's also the case as well, but I think what you always have to gauge is constraints versus the power that policymakers have to overcome their constraints. You have to really think about. You have to know a lot empirically about the world. That's the part where giving this framework to someone is one thing, but actually, having them use it properly is difficult. It's like taking a lesson from a tennis coach. He can show you how to hit the backhand real well, but you may not be able to do it. What do I mean by this? Well, let's take the trade war. A lot of people would have used constraint-based framework to say that President Trump would never pursue a trade war because American companies don't want it. Because the CEOs don't want it. Because farmers don't want it or because he doesn't have the authority to do that. That would all have been wrong, because if you actually looked at the reality, you would have known that Congress has passed-- now we all know this, several pieces of legislation since 1971 to basically reverse engineer presidential authority when it comes to tariffs so not only do you have to have a framework and a systematic approach to political analysis, you also need to know a lot about politics and geopolitics, you need to focus on the right constraints. MIKE GREEN: One of the things that I find that people struggle with this framework, and as we've discussed, I have a similar view, is that we're in a dynamic system that has very little information you can extract from it, but if you can know where something can't go, you can actually start to articulate behaviors. One of the things that I find is that people use constraints to articulate their existing bias-- government spending must be constrained, government debt is bad, and people will have to pay higher interest rates for the penalty of engaging in bad things. There's this huge tendency to exert your bias associated with it. I think one of the things that's interesting about you is-- and I would argue, in part, it's because of a childhood spent in many different places, you're far less willing to say can't. It takes a lot for you to articulate that this can't happen. What do you think's out there right now that can't happen? MARKO PAPIC: That's a great question. First of all, I agree with you 100%. I think that you have to meditate on your biases. I think that's literally meditate, spend time washing yourself with your biases, and being aware of them. I think it is easier for me to not do that, because I just care less about the things that other people care about. You have to adopt a nihilist attitude. When you walk through the door, and you put yourself in your office and you're doing your job as an investor, you can't care about things too much. That's the first issue and I think that goes for both the investing and analyzing politics and geopolitics. In terms of what can't happen right now, I think that what cannot happen is you are likely not going to go back to the last 30 years. That's what can't happen, and that can't happen because the structural underpinnings of the last 30 years, which I would characterize at three things-- one, American unipolar moment in terms of preponderance of American power. That's being eroded, not for any reason to blame any administration, not because of any mistakes, just because of rise and fall of empires, it's just a natural occurrence. Second, the dominance-- ideological dominance, intellectual dominance, laissez faire as a concept, I think we're not going to go back down that path either because of 2008, because of the pain over the last 10 years, because of income inequality. Finally, I think this globalized world that's based on an assumption that absolute returns to trade are more important than relative gains, which is very dangerous because of course, when countries go away from thinking in absolute terms and to relative, that's a cognitive switch that once it's turned on, it's unlikely to be turned back on by any administration. What I can say with certainty, and I know this is a cop out to your question, but I can say that we're not going to have another moment of 30 years where investors don't have to worry about geopolitics. It's a very self-serving statement, too. MIKE GREEN: Why do you say that's self-serving? MARKO PAPIC: Well, I think it's self-serving because I've made a career out of trying to make sense of geopolitics for investors. MIKE GREEN: Other people have described this as a bull market in politics, that this is the type of framework that we're in. I think that what you've said is a very astute observation. We can't go back in time for two reasons. One is, the arrow of time only goes in one direction. The second is if you think about it, the difference between potential and kinetic energy, really 40 years ago, we were near a high point. Prior to the Reagan Thatcherite Revolution, we're at a high point in terms of government intervention and action. You've now seen that go to it's somewhat logical conclusion, and it started to climb back. I think one of the things that's so interesting about China is an ascendant China represented an alternative. It functionally took the American model and said, you don't have to do this. Other regions have done something similar like Singapore, Japan, et cetera, but the scale was so much smaller that they didn't represent the same type of dynamic. When you think about China, in this period, you can only go forward, what does it look like to you over the next couple of years and on the shorter term? MARKO PAPIC: I think China is going to struggle, because there's a lot of inconsistencies inside of China. There's an inconsistency between China that's on the coast, and that's in the interior. There's an inconsistency in China that is looking to maintain state champions in China that desperately wants entrepreneurialism and creative destruction to move up the value chain with the US. There's a China that wants to open up its domestic markets to foreign investors, so that it becomes a challenge to the dollar as a reserve currency, but there's also a China that wants to control the outflows. I think those consistencies are going to have to be resolved, and I think that that's going to create a lot of volatility inside China. I think the China over the next 10 years is not going to look like China today. In particular, what that means is that if China truly wants to challenge the US, and I think they do. They want to become a regional hegemon at the very least, if they're not there already. What China is going to have to do is going to have to create a sense domestically that you as a foreign investor wants to be in China, you want to store maybe some of your wealth there. I mean not all of it, but a proportion of it. It's not going to be crazy to diversify your reserves by having a little bit inside China, they want that. They want to be able to deal with their current accounts. They want inflows, not just outflows. They are going to have to make a case for the rest of the world why China is also part of the reserve currency world. To do that, that's going to check some of their ambitions, and that's why I do think we're on a trajectory towards a secular conflict between US and China. It's something I articulated in 2012 and 2013 while at BCA Research. I firmly continue to believe that, but I also believe the constraints on both countries are such that we're not just going to linearly end up in a Cold War, because China itself has a high degree of desire and need to continue to be part of the global financial and trading system. MIKE GREEN: Can China do that, though? Can China make the choices, or is China too far down the path in terms of a need to depreciate their currency because of the pressure on the financial account for example? If they were to lift capital controls and tried to open the country, which seems like it would be a requirement for somebody to consider placing a significant fraction of their wealth in their MSCI reallocations notwithstanding? MARKO PAPIC: Absolutely, yeah, they're getting into trouble. At some point over the next decade, they're going to have to make a decision on how to do this, and it could be a very violent transition, where there are some massive outflows. Can they do it? I think they can, but the first thing they're going to have to do, I think, before they open up, is they're going to have to recapitalize their banks. They're going to have to do what they did in 2000s, which requires a lot of domestic pain. Why? What they did in '97-'98 is they went through their industrial overcapacity, something like 60 to 90 million people lost their jobs in Northeast China. It was a very painful event, but it was a necessary event to clean out the rot in the industrial part of China. It was necessary in order to then recapitalize the banks, only after that was resolved. MPLs basically jumped from nothing to like 15% in a matter of weeks. China will have to go through I think one of more of those events, and to do that, they're not going to be able to open themselves up before they do that. They do have the ability to recapitalize, the banks basically print more money, purge the SOEs that are not competitive, and then only open up after that. To do that, they can't do that in in a constant state of panic and conflict with the US, which is why I think what's happened over the last two years is they understand this the tradeoff. That's why China's been deleveraging since 2017, since after the Party congress actually even began before the 2017 Party Congress. It surprised a lot of people, they haven't really stimulated as much as they have in the past. They're aware of the problems with just recycling the same SOEs that are uncompetitive, but there'll likely be more volatility ahead. MIKE GREEN: If I look at China circa 1997-'98 and the recapitalization of the banking sector that happened at that point, by and large, what occurred in that time period was a reorganization of China from servicing internal demand in a very inefficient way, and opening up and freeing up resources that could be applied to servicing the West. And so they were able to absorb that relatively easily largely because FDI is storming into the country. How do they do that without debt? How did they do that with the surplus of labor, the urbanization process now being gone? How do they do that with both that and demographics starting to work against them? MARKO PAPIC: I think it's all about domestic consumption obviously. They themselves think that that's the path and so one of the ironies of that is that they will have to focus on domestic consumption of domestically produced goods, which is why when I've thought about this in the past, I always thought there was a China that was going to be protectionist first, not the other way around. Of course, it has been, but it did a lot of consumer goods from the West to come into the economy and to be sold. You can buy Johnson and Johnson shampoo, you can buy a Buick. I think that China will have an incentive over the next 10 years to favor domestically produce goods. I think in a way, what's happening right now, is helping them because they have like a patriotic reason to abandon Apple and focus on Huawei sales domestically. That is the only way to make this shift to focus on consumption domestically of domestically produced goods and to move some of the production away from the coast into the interior, which is really just 100 miles away from the coast. Whether that's going to work out, I don't know. I'm skeptical, but it could. They could still capture some of the labor discount if they were able to move the production themselves internally. That is a much more mercantilist China. It's a much more self-contained China, and it's China that tries to become a little bit more like the US because that will mean that they're less open to vagaries of foreign powers. That's the plan. Can they do it? I think jury's out. I think there will be obviously challenges, just like Japan had challenges to reorient their economy, but that's the only path they can take at this point. That means that the path is much more domestically focused economy driven by consumers buying domestically produced Chinese goods. MIKE GREEN: This is where I think I may break from you on China, because I look at the Chinese market and I look at the components of aggregate demand, which in simple terms, is just the number of people times their consumption basket. The number of people is shrinking now, and so you have a constant inward shift in aggregate demand in an economy that is by and large, has been protectionists already, displacing Apple with Huawei in China is not meaningfully going to change Huawei's shipments of smartphones with Xiaomi or others. Where does the growth come from in that model? MARKO PAPIC: Well, the one thing you're leaving out is productivity growth. Unless it's going to collapse, and I think it will eventually unless they do the reforms. Productivity growth is the other part of potential GDP growth rate along with labor force growth, and you're right. Labor force growth is zero or negative. Productivity growth, though, in China remains quite high. Their potential GDP growth rates still remains double that of the US. MIKE GREEN: Do you think those numbers are actually correct, because the reported productivity numbers we received just use the GDP, which is remarkably invariant, and by most metrics, somewhere to 20 to 25% overstated? MARKO PAPIC: I think they're definitely in decline. Absolutely. Why? Well, they're in decline because China has moved away from creative destruction. They are they're aware of this. That's why they've done the domestic restructuring so much as they have over the past two years. To answer your question, I think that we agree on the challenges. I'm not saying that they're going to be successful, I'm just saying that they've identified correctly the problem with China. What they've identified correctly is that they are overly exposed to export oriented economy. They have identified correctly that their SOEs are dragging the economy in a way that they have to encourage the privately-owned enterprises. That's what they're trying to liberalize their interest rates, so the privatel- owned enterprises, the POEs get the same interest rates of the SOEs. They've identified that they need to boost domestic consumption, which is why they're doing welfare reform. They're trying to make the population not have to save for retirement by buying condos in tier three cities that will never do anything. They've identified all these things. It's just going to be a very difficult process to deal with, but I also think that that's why the binary narrative of China, like China overtakes US or China collapses, I think there's something in between. There might be and I think that something in between is possibly the last remaining source of alpha on the planet, where active management can be passive management. What I mean by that, is that yes, this is very, very scary, and very weird, but I do think that getting China right will probably create opportunities for investors betting on different parts of China. MIKE GREEN: Do you think that the narrative exists in the middle-- that that's the consensus, or do you think that one of the two extremes is basically a bimodal consensus? MARKO PAPIC: Right now, I think the consensus that a binary consensus has fallen away, but I think for most of my career, over the last 12 years, there's been a binary consensus. MIKE GREEN: Either it will collapse or it will take-- MARKO PAPIC: Basically, the world split into two. The bulls and the bears, there's very little in between. I think that perhaps because both the bullish and bearish views of China have proven to be incorrect, I think you're right that consensus right now is in this mushy middle. MIKE GREEN: My sense is that it's bimodal, that basically 85% of Wall Street substantively assumes that China is still the future in one form or another. There's a relatively vocal 15% that is out there saying, no, it's not. The 15%, by and large, have had a really, really difficult run in terms of the ability to put investment and capital to work profitably for an extended period of time and so if anything, I would think the capital is 95.5 at this juncture. It doesn't seem like there's a lot of betting that China is actually going to fail. MARKO PAPIC: That said, that hasn't worked out, because emerging markets have technically I think, in my view, been in a bear market since 2011. Now, there have been moments when emerging markets and commodities in China plays have rallied for 12 to months. We saw it in 2017, where the bearish narratives didn't work out, but by and large, if you're right that 95% of capital has been betting on China being the future, that capital's been wrong since 2011. MIKE GREEN: I think that's probably been the case, though. I think that'll certainly be supported. If we go back and we look at the narrative from 2011, and I might date it a little later, 2015-- MARKO PAPIC: Beijing consensus, that's when it emerged. MIKE GREEN: Exactly. Yeah. MARKO PAPIC: That's my view, like, this isn't going to happen. China's not going to be the future in the way that people think, but also, I think that, at some point, you have to ask yourself, why hasn't China collapsed? And I don't think the answer is, well, you just waited well. I think the answer might be, well, it hasn't collapsed, because they've learned the lessons of Japan. They've learned the lessons of Soviet Union, and they're taking their time. They're slowly trying to restructure the economy, and China still has enough capacity to continue to slowly move the economy way. You can see that. Fixed asset investment to percent of GDP has fallen. They have started doing these financial reforms, which are causing their growth rates to decline significantly. They are pulling back on some of the credit. They haven't stimulated this year as much as they have in the past, and they are using macro prudential controls on the housing market to ensure that the housing market is not the source of another stimulus. That's surprising. A lot of people earlier this year did get very excited about emerging markets, because they thought, here it is, again, China's being China. They're not. They are being more cautious this time, and I think that people like Liu He have convinced Xi that he needs to be a lot more prudent. That's a good thing, but it also means that China overtaking the US, or rather becoming the next global superpower is unlikely to be the narrative. That is probably also wider, being much more cautious in the trade war than you would have thought. MIKE GREEN: How do you see that? What does that mean being more cautious in the trade war? MARKO PAPIC: Well, I mean that China has not tried to provoke the US. I mean there's retaliate to the tariffs, which everybody knew they were going to put them on, its face saving measures. But you have a situation in Hong Kong, they are being very strategically patient about it. I think that's interesting. I think it shows a degree of patient thinking, strategic thinking same with rare earth. They could have used that as a tool much more bluntly. They just floated the idea, which we always knew was on the menu as one of the retaliatory moves. They haven't targeted any American company more than they have over the last 10 years. There hasn't been a tick-up in official non-tariff barriers to trade. In fact, what they've done over the last 12 and 18 months is try to accelerate the opening of different sectors. They are trying to placate the US by passing through some of the offers they've given previous administrations, like the Obama administration-- will expand our negative list, will put more industries, will open up more of them. They are doing that behind the scenes. I think that they could have been a lot tougher into negotiations and I think their strategic patience suggests that maybe they have-- they've been hit by President Trump and they're saying like, oh, well, maybe it wasn't our moment right now. Maybe we need another decade before we can competently fight with the US for hegemony in East Asia. MIKE GREEN: It's interesting, because I perceive it very differently. I actually think that what we've seen from China is an exceptionally strong response given the constraints. Because at the end of the day, the customer is always right. MARKO PAPIC: Yeah, I've used the same phrase myself many times. That's right. MIKE GREEN: And the US is the customer and so if we say, we're really unhappy with the product, you can say, well, I'm not going to give you a refund, or I don't want your business anymore. It seems extremely counterproductive when you still got inventory and production facilities, et cetera. You may try to diversify your customer base away from that customer. The simple reality is, is China runs roughly a $500 billion trade surplus with the United States and a roughly $500 billion trade deficit with the rest of the world. And so their current account is basically balanced. MARKO PAPIC: Absolutely, and it's all the US. MIKE GREEN: And the only source of funds is the US, so they're not really in a strong negotiating position to begin with. MARKO PAPIC: I disagree with that, and that's where game theory really helps us out. What I mean by that is the real world is not a game of chicken. The real world is not just two people driving a car at each other and seeing who's going to swerve first. You have to think about material power when gauging the strength of two actors, like China and the US. US absolutely has more material power, because of what you're saying. It is the customer. Chinese usual threats of selling their Treasury hoard and stuff like that, it's just vacuous. Those threats are vacuous. However, we have to think about tolerance of pain as one of the measures of power in a diet, like the US and China. When it comes to tolerance for pain, China, compared to the US actually has deeper tolerance of pain. They don't have a no-withdrawal cycle, they couldn't care less about Chinese equities, really, unless they collapse like they did in 2015. They really just care about employment and they can use that up with fiscal spending for a period of time. Now, I'm not saying the China thinks on a decade long thesis, the usual things-- Chinese policymakers are long term thinking, Americans are short term. That's not what I'm getting at. I'm simply saying this, China can withstand pain of a trade war maybe 12, 18 months longer than the Trump administration can. That's why I think they've been holding up. They're holding up because they believe that Trump is going to ultimately succumb to the pressures of the stock market, and to the pressures of the coming election. If recession probabilities go up in the US, that is a hard constraint as much as there is one on President Trump because he needs to be reelected, and it's very difficult to be an incumbent president and run against a recession. I mean many presidents have failed on that front, especially the last two lost incumbency. I think that's what you're holding out. It's as simple as that, they're hoping that they can withstand this pain, that their half-life of tolerance of pain has a different function from that of the US and so they'll hit their pressure point later, even though if that pressure point is actually, as you correctly say, much closer on a material power basis. MIKE GREEN: I tend to think that it's a little bit more of a trope that the US has a very low tolerance for pain when it's focused in an external enemy. I use that term loosely. It becomes easier. MARKO PAPIC: But that's a challenge then, Mike. Here's why. I think the last Gallup polling shows that 17%-- I might be wrong, some should fact check it, but these, like 17% of Americans think that China is a number one threat to the US. I think most Americans think that the member of the other party is a bigger threat to the US. Now, that can change. That can change very quickly, but then a narrative is something that President Trump would have to start making right now and he's avoided doing that. There are some clear-- he could be using Hong Kong, he's not. He could be using what's happening Shiyang, he's not. He's actually leaving the trade possibility open by not building the usual narrative of China's an enemy. That's why I think you will struggle to see the bipartisanship that people think exists for a confrontation with China. I think that's, again, a secular theme for sure, but in the short term, I don't think that the American public would say, you know what, I'm cool with the recession because China is the greatest threats to the US. I think that is something that's going to be very difficult to sell to the American people, especially when the last recession, what they're mentally anchoring to, was severe. MIKE GREEN: Again, I actually think that we're more in agreement than we're not, so I share your expectation that some form of a deal will be arrived at at least in this passthrough. I find it interesting, because I'm not entirely sure for the reasons that I articulated that China actually can take a deal. MARKO PAPIC: Well, absolutely, that's the big question mark. MIKE GREEN: If there's anything that degrades that $500 billion that's coming in from the United States, and they need to figure out some way of degrading that $500 billion that's coming into China from the rest of the world-- MARKO PAPIC: But it would, but it would. Think about it, if you're buying more soybeans from America, you're not buying from Brazil. If you buy more Boeings, you're not buying Airbus. I think they're comfortable with this beef and Boeing deal, but you're right, though. The big question mark is not, to me, what President Trump does. I think the constraint's pretty clear. The question is will China entertain America? Because the way I see it right now is that Trump really cares about process. He cares about the show, showbiz, we're in LA. He cares about what this all looks like. In a way, it's like professional wrestling. He's in a ring, and he's taking that plastic chair. He's beating Xi over the head and whispering burst the ketchup thing, just burst the ketchup in your face and it looks like you're hurt. That's important to President Trump for a lot of reasons. Political capital is very important with the marginal voter in Michigan, in Wisconsin, Pennsylvania. These people delivered him to presidency. He needs to show that whatever deal was concluded is a robust deal. Now, how are voters in America going to gauge the robustness of a trade deal with China? Are they going to read it? Do they understand intellectual property right theft of China, 300 to 500 billion as President Trump says? Are you going to read the technology transfer clauses? No. They're going to gauge the robustness of that deal by how many ketchup packages Xi burst on his face as President Trump was pummeling him with that chair. I think that that's what's happening right now. I think that that ultimately gets us to some deal that President Trump can sell whether you and I, and other globalist elites think that it was right or not. I'm just joking. MIKE GREEN: We are absolutely globalists on it. MARKO PAPIC: Yeah, look at this place. Let me just go back to your point, though. Is Xi comfortable being pummeled with a plastic chair in the ring? That's something that I have a much lower conviction view on. I think that China's not ready to challenge the US. I think that's a material constraint. I think it would behoove him to take the deal. I think he will be silly to not take a deal, and here's why. President Trump may be the last commercial mercantilist president of America. I think that everyone who follows Trump is going to be actually tougher in China than President Trump is. President Trump will take a deal that fundamentally narrows the trade deficit with China. I think he'll take that deal. I think he will take that deal even if it doesn't curb their technological process, even if it doesn't set limits in South China Sea. But every subsequent president, even Joe Biden, will be much more captured by the national security state of the United States and will therefore push China on those issues much harsher. I think that's why if Xi holds out, he will make a strategic mistake, he will go against his constraints, and then we will have, I think, a market right at that point, because China will be challenging the US when it's not ready. MIKE GREEN: That's what I actually think is underway for two reasons. One, I think people tend to use the wrestling analogy, because it does feel very fake. It does feel fake, certainly versus what we remember is feeling genuine. But in wrestling, you get paid by the same person. Everybody works for the same guy, Vince McMahon. That's not the case in politics. It is really a question of if Trump swings the plastic chair, which is typically a metal chair, and so actual injury does occur. It's really questionable whether Xi wants to take that abuse. The second thing that I struggle with is the narrative of country versus an individual. It tends to be relatively rare through history that the individual makes the choice that's not to their benefit, but instead for the country. That's what sets the United States apart from most of South and Latin America, is leadership that ultimately articulated, I don't want to be king. I'll step to the side, two terms is enough. That's a president that doesn't stand well supported in most other regions around the world. For Xi to wait 10 years, it's far from clear that he has that capability. MARKO PAPIC: Yes. Well, again, that's why the problem with the view that there will be a deal I don't think comes from the US side. It comes really from not knowing fully what the constraints are in China. That said, I do think that there's something here that we should point out. We don't exist in a unipolar world anymore. We don't exist in a bipolar world. We exist in a multipolar world. This has been in my view, the case since 2011, since 2010. What that means is that there's not one or two great powers, there's multiple great powers. Political science research shows, so formal research, theoretical research shows that in a multipolar world, it is very difficult to focus on relative gains. In a direct conflict, such as China-US. Why? Simple reason without going into the math, very simple reason, because someone's going to take your break. That's why late 19th century, and pre-World War II era was full of examples where countries knew well that they were going to go to war and they traded with each other to the maximum. Because if you were United Kingdom and you didn't trade with Germany as it was rising from 1871 to 1914-- MIKE GREEN: France would. MARKO PAPIC: Boom. Exactly. You lost that piece of the pie. In 1901, 1903, the United Kingdom-- many members of the UK cabinet were writing like, look, these guys want to take our supremacy away, they are the enemy. Trade basically only burst in 1914 when the war started. Japan-US, trade was remarkably stable well until 1941. In 1942, the trade was basically equivalent to what it was in 1930, despite the fact that nobody was an idiot here, everybody was very cognizant of what's happening. That's what I think a huge constraint for the US ultimately is, and for China as well. Just because they understand that they're each other's enemy doesn't mean that they're going to bifurcate the world. Now, I personally thought that there would be bifurcation until basically, 6 months ago, until I started rereading some of this literature in political science that's basically been forgotten for the last 30 years. What I've realized is that, look, we don't live in a post-World War II era anymore. We don't live in a '50s, '60s, '70s, '80s, '90s, 2000s. We live in the 1890s. We live in the 1900s. If that's true, if that's true, if we're in a multipolar world, US and China can both be enemies, and there can still be some commercial relationship guarded, truncated, eliminating high tech things, but it's not going to end overnight. That's why it makes sense to make these strategic retreats if you're Xi with the eye on the ultimate prize, which is that you're trying to compete with the US. MIKE GREEN: Yeah, I agree with that although I think that there's an additional constraint on China, which is time. The longer time goes forward, the weaker China becomes largely because of its demographics and so its ability to fill feel the military, its ability to project for us externally deteriorates for this population. MARKO PAPIC: I would disagree with that. I would disagree with that, just because size of your military is irrelevant today. In fact, when I tried to gauge geopolitical power quantitatively, I've taken specifically through national capability index from the correlates of war project. You take specifically size of the military, because we don't have trench warfare and I suspect that if China was to fight wars, it would be very light turn on manpower. It would be over land and sea, because that's where the power projection is. It's geographically massively constrained in the interior, the Himalayas, the Tibetan Plateau, Siberia. I think they understand that this is going to be about tech. It's going to be about quantum computing. It's going to be about AI. It's going to be about drones. It's going to be about cyber. And so in that way, they could still challenge the US quite a bit in East Asia. The other problem that the US has, is that the US has over the last 30 years really focused on beating the crap out of very weak countries. Take the aircraft carrier, aircraft carrier is a beautiful piece of technology if you're going to bomb Serbia. But if you're going to fight China, what you've just done is you put all your eggs in one beautiful basket that costs about $20 billion, and can be shredded into link weenie by hypersonic cruise missiles, which China has and which is it's developing. Now, America is developing countermeasures to this. There's real guns. There's other ways to like deal with this, but the point here is that it's not really about manpower, it's about tech, which is why China can still be a serious competitor to the US on the tech front. MIKE GREEN: Again, I think I would push back on that. It's not about manpower, it is about tech, I agree with you in the initial stages. But ultimately, what manpower brings or labor force brings, a growing labor force, is actually the ability to supply, to replace the troops that have been lost, to replace the $20 billion aircraft carrier with the next generation one that is more impervious. On that base-- MARKO PAPIC: I don't know, Mike, though. If we're talking about China having to replace dead soldiers, we're talking about a world where we should all be owning guns and gold, and that's pretty much it. So you're right, at the extreme, but I think that what we're really dealing with here are two countries that are going to be rivals, that are going to be maneuvering with each other. And I think that if they have less manpower to replace a million people, I think they'll still be okay with like, 200,000 under arms. MIKE GREEN: It's possible, but again, we're talking about to staff that military at all and to put them at risk, you're talking about putting the only child of the Chinese family. You're talking about taking out the pampered princeling and putting them there, whereas the United States, because it has positive immigration pressures, one of the clearest paths into the United States is actually through military. MARKO PAPIC: That's right. Well, I think in absolute terms, though, China will still have enough. Like, if you compare it here. It's possible, but I think it's a great point. I never thought of the princeling carrying weapons, that's a that's a great point. All the more reason for them to delay confronting the US in-- MIKE GREEN: But again, there's this tension of can we delay? Does that make us stronger, or does it make us weaker? I would argue that it very clearly makes them weaker, which is why it feels to me that this could be the moment. MARKO PAPIC: It could be and one thing I would say, though, is when you look at all-- what does China want? What does China truly want? I think what China truly wants is a regional hegemony. I don't think he wants a global hegemony, so both the bulls and the bears of China are wrong. There's this narrative that China's the middle kingdom, it never wants to oppress anyone. Okay. Well, it's pretty much a European nation states today, so he wants what every other country wants, which is security. How do you develop security? You develop security through regional hegemony, which is why all the realists in political science always say, once you accomplish that, you whet your appetite, and you start looking for global hegemony. We're not there yet. They want regional hegemony. Where I would disagree with you is, and maybe agree with you at the same time, is I think that regional hegemony will be possible within the next 10 years, because the trade links between China and its neighbors are unlikely to be reversed. If you chart linearly what's happening right now, US trade-- total trade, imports and exports with East Asia x China is basically flat. In 2004, US and China basically traded with East Asia at the same level in terms of absolutes, in terms of total trade. Today, like-- MIKE GREEN: China's multiples. MARKO PAPIC: Right, and I think even if China somehow just like stays there, over the next 10 years, those commercial links between South Korea, Taiwan, Singapore, Malaysia, Philippines will stay where they are. I think that that gives China the potential to strengthen its regional hegemony vis a vis the US. It's like a fair complete. That's basically on its way. Now, where I agree with you, though, is that the global hegemony may be out of reach for China, and I think it will be. And so there might be at this moment over the next decade where China has managed to get regional hegemony and goes for broke, goes for global, and that's where they will potentially fail. But I think we're one step removed from that, and I think they're currently focused on regional hegemony, and that's why it does make sense to delay the confrontation with the US. If they don't, they will make the same mistake that Japan did in 1941. MIKE GREEN: I think it's going to be interesting. As I said, I think we're actually very close to the moment and I agree with you that for China, it is a question of, do we move now? Do we move later? MARKO PAPIC: We don't really know well, but one thing we do know, Mike, is that Chinese policymakers have made massive mistakes over the last 18 months, massive mistakes. I don't know who advises them, but whoever does, has been telling them fairy tales. One thing, for example, was that the midterm elections would be a rebuke against the trade policies of President Trump. Wow, swinging a miss, Sherrod Brown, a Democrat senator from Ohio, crushed his Republican opponent. Precisely because Sherrod Brown is a longtime protectionist. Not a single democrat ran a campaign base on trade. Second massive swinging a miss by Chinese policymakers was putting a lot of emphasis on farmers. Every time that I speak to a sovereign client, or sovereign entity in China, they always say, but listen, won't the farmers rise up and say, well, look, they're putting tariffs on our goods. That's the same mistake, by the way, not universal to China. Canada did the same thing where they tried to target these districts that did a lot of trade with Canada. Absolutely, no. These are rural areas of America. They're not going to make a decision purely because of economic reasons. There are also other issues-- cultural, social, they're not going to vote for Democrats, just because they can't sell soybeans. It's going to take them a long time and a lot of economic pain to abandon the Republican Party. China has made-- sorry to interrupt you-- just China's made these policy mistakes in interpreting America and that is, I think, the biggest danger to the market right now, that China makes another mistake and says to itself, you know what, any deal with Trump is a short term deal, let's not give him a deal. Somebody easier will come down the pipeline. This is where I really disagree. The reason we're at the moment of apex of globalization, the reason that this last 30 years are now in a structural change have very little to do with Trump. Trump was a man for all of his time, but the time is such that there is a bipartisan agreement in the US to be tough in China. Congress wanted to destroy ZTE, Congress passed the FIRRMA Act. President Trump actually alleviated the pain on ZTE, President Trump actually changed the FIRRMA Act so it's not as anti-China as it was. This is their last moment to make a deal, in my view, for China, and this is the last commercial mercantilist president. If they don't understand this, then we've got a problem because things will just get worse. MIKE GREEN: Yeah, again, I think you and I are more aligned on this than in disagreement. I would also add to that narrative the dynamics that particularly the left is bringing in pollution, climate change, China is the ultimate source of all these issues. Human rights is where I was going to go next. And so we're creating the cultural narrative, the emotional and moral narrative in the United States to prepare ourselves to think of China as the enemy, and I think that's only picking up steam over time. MARKO PAPIC: I think it is only picking up and it's going to continue, and so China has this limited window, whether they know it or not, and Trump doesn't bring that baggage, if you will, to the fight. MIKE GREEN: Well, and I agree with that, as well, because you have a president who has articulated his skill set as a dealmaker, and whether those deals are substantive and value added, or whether they simply exist as pieces of paper that have been indicated that some negotiated agreement has been arrived up by a master negotiator. It feels to me that that dynamic is very much in play, particularly as we head into next year, and so things that I'm thinking about are the currently very depressed US agriculture commodities, soft commodities in particular may represent opportunities for investors, as we look forward. Now, it would feel like a much more classic late cycle signal. MARKO PAPIC: Or rest of the world versus US. US continues to outperform in terms of equity markets, that shouldn't happen in late stage cycles. If you think of a '99 blow off rally in the S&P 500 and NASDAQ, actually Euro Stoxx outperformed the S&P 500. But I think to that point, I think it's very important that we segregate our views into time horizons. Look, I don't want to come off here at the cameras as sanguine on US-China relations, if there's been anything that I have in my career been a bear on, it's this US-China relationships. You can have a very, very negative view of US-China's secular view and cyclically have a different point of view. This is because no Cold War or enmity or rivalry has been a straight linear line. There's ebbs and flows. For every Berlin airlift, there is an attempt to détente and then the Cuban Missile Crisis, and then another attempt to détente. We are now in a moment that I think for very temporal constraint based reasons could actually lead to some détente. It will serve President Trump, it'll serve probably I think, President Xi. Then from President Trump's perspective, if he wins the election, he can restart the trade war with China. From China's perspective, those 18 months are not to waste. They can arrive at a much closer level of technological parody on semiconductor production as an example. They can use 18 months of détente, they could put it to good use. That's why I think it's very important. What I feel is happening right now, a lot of folks in the financial industry who really dismissed the US-China narrative as a problem have not arrived late to that thesis and have committed to it fully and expect really just a linear path to a Cold War. And I think that that is something to maybe push again. MIKE GREEN: You highlight this idea that people have swung hard to this view that it's going to happen now and that China is going to fall apart. How do you think about the evidence for that? What are you seeing in the market that leads you to believe that? MARKO PAPIC: Well, that-- or more that the trade deal will not happen. MIKE GREEN: The trade deal will not happen. MARKO PAPIC: Yeah, I think that's consensus now, it won't happen before the election. I think just there's extreme pessimism about global economy, that global economy will continue to deteriorate. That's why bonds have rallied as much as they have. I think that's a key indicator of that. The converse of that is the strength of the US dollar and also the performance of emerging market, FX and equity markets. MIKE GREEN: You work with Clocktower Group, and Clocktower Group associated with hedge funds, venture capital and FinTech in particular and you run the Macro Strategy Group within here and so you spend a lot of time talking to hedge funds. Would you agree that this is the narrative in terms of why bonds are working and why you're seeing this conservative construction in terms of portfolios? MARKO PAPIC: Absolutely. We've seen a stark shift from earlier in the year where there were a lot of dollar bears. There's a lot of EM bulls. We've seen a structural shift that suggests that the macro community in general has become a lot more bearish and that the bets on the US recession, global recession have picked up quite a bit. MIKE GREEN: Now, when you talk about bets on bonds, and the idea of the bonds had performed-- one of the things I'm seeing in the hedge fund community is overwhelming popularity, not of bullish bets on bonds, but actually on steepeners. Feels very consensus that yes, the Fed is going to cut, but the backend is going to sell off on renewed inflation concerns or a cycle continuing, et cetera. MARKO PAPIC: For like most of Q2, I think that has been a popular bet, but actually, over the last 30 days, I would say that there's just actually capitulation even steepeners and that there's an even more pessimistic bets are being put in. Some hedge funds that have been extremely concerned about-- not extremely concerned-- not concerned at all about the recession, but more about inflation, late cycle easing that would cause some of the steepening are now shifting away from that and just believe that there will be just a recession. MIKE GREEN: How would that positioning be represented? What would you see people taking on? MARKO PAPIC: Well, I think that again, generally speaking, safety in the US and leaving everything else abroad. MIKE GREEN: So flows out of EM into the short end of the Treasuries, 2-Years-- MARKO PAPIC: Absolutely. There is a bullishness about the bond market that they basically steepens the curve because the front end goes down, but even just flattening as well as both ends go down because there's actually recession risk. MIKE GREEN: When we think about that type of positioning and that type of bearishness, I'm just struggling to reconcile that when I look at things like open interest on Treasury futures, which are near record levels of short, which just suggest to me that the steepener is still very much in play. MARKO PAPIC: That could be the institutional investors, and I think what we've seen is that just more and more hedge funds are capitulating on recession. MIKE GREEN: And you don't share that view in total or? MARKO PAPIC: I don't. I do think the probability of recession has risen, and I think the fundamentals continued to show that the odds of a recession or at least a nominal recession, like 2015-'16 have risen. The question for me, though, is, is that priced in already with the 10-Year where it is? I think that a nominal recession, at least, the 2015-'16 style is already priced in within the bond market. Now, the question is, will policy come in and move us away from a further deterioration into a recession or not? I would say that it will. I think the policy will arrive in time to move us away from a recession. The problem is that equity market may need to go down further before that policy reaction comes. MIKE GREEN: What do you ascribe the divergence between what the bond market is showing and what the equity market is showing, in the US at least? I realized the rest of the world is not quite as bullishly priced in. MARKO PAPIC: I think TINA, there is no alternative, especially as yields go down, investors may still be feeling that they need to be in equities. I mean the dividend yield in the US is now higher than the 10-Year. Maybe that's part of the narrative that's keeping especially institutional investors invested in equities, because they have a mandate for returns. MIKE GREEN: When they think about those returns, when they think about that dynamic, they're effectively saying equities return more than bonds, because they're so low. MARKO PAPIC: Even though the dividend yield level, you're getting a guaranteed return on your holdings of equities. It's higher than what you're going to get on the 10-Year. If you have a mandate for a particular return to your investors, you have to maintain some exposure somewhere. But of course, that only works until the moment when you think a recession is imminent, and so I think that that's perhaps one of the remaining things that have to happen that institutional investors and retail investors have to start getting scared about a recession. If that happens, I think the policy will then react massively. MIKE GREEN: And by policy, are you referring to fiscal or are you referring to monetary? MARKO PAPIC: Actually, I'm referring to three things-- the Fed, trade war, and Chinese stimulus. I think those are really the matter. The fiscal have already happened. We already got a two-year budget deal between the Republicans and Democrats. I think European, there's a lot of folks in the macro community are talking about fiscal policy in Europe, fiscal policy always-- MIKE GREEN: Germany already spend $50 million apparently. That's a joke MARKO PAPIC: I know. 50 billion. It's great. MIKE GREEN: I think it was a million, actually, not billion, but it's-- actually, yeah. MARKO PAPIC: Well, I think, look, Europeans will do fiscal, but after a recession, obviously. I think that the real question to me is, does a trade war and those China stimulate more than it has right now, and does the Fed become-- does it start an easing cycle, not just this mid-cycle adjustment? Those are the three that I would focus on to see whether the world goes into a recession or doesn't. MIKE GREEN: If I were to push you in terms of what are the signposts that would direct you to further raise your probability of recession, what would it be? What are you looking for? MARKO PAPIC: Well, first and foremost, I would want to continue to canvas the manager community in China for information. One of the great things that we've built over the last 10 years at Clocktower is we have an office in Shanghai, and we have a really good pulse on the manager community in China. The reason this is important is because hedge fund managers in China just want to make money. They're not trying to sell you a political narrative. They are just like everyone else, and they've been pretty bearish over the last, I would say 36 months, correctly so. They correctly forecast the slowdown in 2018. They've been bearish all throughout 2018 and 2019. What I would be watching for is whether or not this community basically turns even more bearish. I think that China will need to do more than just stabilize domestic economy for the world to avoid a recession so we would need to see some pickup in fiscal spending. They are very, very clear that they don't want to use the housing market. You're not going to have the stimulus in 2015-'16 or 2012, but it doesn't mean that they can't pick it up a little bit. The second thing that I would want to watch is whether the trade war is enough. I have a pretty high conviction view that over the next quarter or two, we are going to see some truce between the US and China and maybe a deal that people call non-substantive but enough for the markets. The problem with that is with it require an equity collapse in the US, a correction 10%, 15%? The other issue is that if that happens, will it also require Trump to feel a significant impact on his polling? If that does happen, there's a whole new problem for us as investors to worry about, which is that if Trump gets hit in the polls, that actually increases the likelihood of people like Elizabeth Warren or Bernie Sanders picking up in the polls, and then on the US front, you may continue to see this delay in business investment. MIKE GREEN: Yeah. I think that feels right. It is frustrating when we have this type of conversation, in part, because the entire macro picture so closely hinges on what happens particularly in China. It becomes really challenging to move outside of that, because that's so much of the underlying dynamic. I'm really looking forward to the next 12 months to figure out what happens. As I said, I think this is a bit of an inflection. I think you would agree with that, but maybe have a more sanguine view on a short term. MARKO PAPIC: Well, here's the thing. Maybe I think that the trade war is more likely than you do, but I think we both-- MIKE GREEN: The trade war conclusion. MARKO PAPIC: Or a détente, but what if it's too late? I think the fundamentals are pretty negative across the board, you're really stretching to find some green shoots of growth, like Swedish, like exports are taking up a little bit, oh, great. You're really like looking with a magnifying glass, but domestically in the US, I fear that there's something wrong with animal spirits in the US, and you can see that in CapEx intentions, in business investment. Overall, yes, the consumer is holding firmly, but consumer is not a really good source of predicting where the economy is going. The consumer is always good until they're not. Unemployment, consumer sentiment or very coincidental backward looking, business investment is telling you that CEOs are basically delaying investing in the US, and that's weird. Why aren't you doing that? Because of a trade war somewhere else. Why are they delaying investments into domestic economy? Because of a trade war? Maybe there's something deeper, and that something deeper is maybe that US election actually matters a lot more than we think. Nobody I talked to in the hedge fund community or anywhere thinks to Joe Biden is going to win. Nobody, and I think he has a fairly good chance because there's a Nash equilibrium on the left developing in the Democratic Party, but that could be wrong. What if Warner or Sanders catches a bit over the next 12 months? Those CapEx intentions and those business investment decisions will be delayed further, and so you could have a situation like where I end up being right on the trade war and it doesn't matter one bit for the global or US economy. MIKE GREEN: Yeah, I am a little bit more skeptical than you are, and I actually share that concern. Rich Bernstein, many, many years ago, pointed out the dynamic that the cyclicality of business investment really is the business cycle. I agree with you that there's a hesitation to put money out. I'm more sympathetic to the business community, I think, than most are in terms of why that hesitation exists. Part of it is that we exhibit a world in which excess capacity is already a permanent feature so by definition, investing sends a signal to your competitors that you're prepared to compete, may not actually be necessary in a world of very slow growth that we experience. It could be quite counterproductive. I would love to make this a more regular thing. You're one of my favorite people in terms of your analysis and I'm down here in Los Angeles a lot as you know. Can we get you back on in about 6 to 12 months to talk about your views and see how things shake out in the trade war? MARKO PAPIC: Absolutely. I think it'd be great. MIKE GREEN: Fantastic. Marko, I appreciate it. MARKO PAPIC: Absolutely. MIKE GREEN: Take care. MARKO PAPIC: Thank you.
