China's Countdown Continues, Russia's Turning Point And Conflicts Galore

Includes: DIA, FXI, GLD, QQQ, RSX, SPY
by: Carlos X. Alexandre

As we enter a new year, the stock market prediction game takes front stage, and the odds are 50/50 that anyone will be right as far as the positive/negative call is concerned. But the probability is even lower if one predicts a specific return on investment. Assume that one can choose a whole number between -25% and 25%, and within that range the odds of getting it right is 1/51 (zero included), or 1.96%.

Almost three years have passed since I wrote "China Is Not A Bubble: It's The Hindenburg," and while the country's economy has vacillated between ideology and fantasy, the clock keeps on ticking and billows of smoke continue to pour out. Although I am not a predictor of stock market performance for practical reasons, the Shanghai Composite Index is down 30% since then (chart below), and that is only a small indication of the underlying trouble that the country must still endure. Apparently the cheerleading has not been matched by the flow of capital into Chinese stocks.

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Everyone can recall how the ongoing mantra of yesteryear centered on the chorus that China would save the world, along with its BRIC brethren. Needless to say, Brazil, Russia, India and China have failed to live up to expectations, domestically speaking, much less on a global scale. Revisiting the well defined global economics model that will remain in place for decades will refresh the public's investment perspective.

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China's third Plenum, the be-all and end-all of central planning, was widely anticipated and met with much fanfare, leading to an unusual event.

The Communist Party has for the first time sent teams to explain to foreign officials in countries in Asia, Africa and Latin America the content and goals of the third plenum of its 18th Central Committee. A team sent to Laos, led by a deputy president of the Chinese Academy of Social Sciences, delivered a series of lectures from December 18 to 22. The visitors were received by Laos' vice president and spoke to an audience of 600. They explained decisions reached at the third plenum in detail and played an animated video titled "How Leaders Are Made."

"How Leaders Are Made?" One cannot make this stuff up in the 21st century, as it resonates of propaganda emanating from some two-bit banana republic. Without a doubt, domestic political pressure is building, and we must forget about the plenum's objectives, reforms and free-trade zones because those are the tell-tale of despair, while the ultimate goal is to preserve the Communist Party's hold on power at any cost.

Meanwhile, debt continues to expand to keep the Hollywood type building façades standing and to desperately reinforce the virtues of state capitalism. According to Want China Times, "China's total debt is 215% higher than the country's GDP, indicating that its economic development has relied heavily on capital from loans and that the total factor productivity has not improved." Yes, building bridges to nowhere that fall on occasion and housing inhabited by insects has become the economic strategy of choice. Moreover, the central bank attempts to deal with shadow banking - biting the hand that feeds you - is nothing more than smoke and mirrors.

The PBOC hopes that higher money rates will ultimately force banks to cut their risky lending, but for now demand for loans and other forms of financing from the state firms and local governments that suck up the bulk of funding remains strong.

The government knows that shadow banking is needed and the whole system is beyond the point of no return, regardless of what is tried. Suggestions about a shift to domestic consumption still make the rounds, but culture is an obstacle that is not about to change anytime soon, and subtly highlighted by Song Guoqing, an advisor to the PBOC.

China may not be able to end its reliance on investment and exports for growth over the next three to five years despite plans for economic restructuring. "In the near term - over the next three to five years - it will be difficult for China to restructure its economy due to the nation's high savings rate," said the economist who is also an academic member of the People's Bank of China's monetary policy committee. "That means China will need to rely primarily on investment" for growth.

All of this is taking place as American manufacturing is "reshoring," with labor costs driving decisions. According to a survey by The Boston Consulting Group, "21 percent of a sample of 200 executives of large manufacturers were either already relocating production to the US, or planning to do so within the next two years. A further 33 percent said they were considering it, or would consider it in the near future."

Stories about government debt rollovers - there's no money to pay creditors - non-performing loans, bank write-offs and corporate defaults are too numerous to count, and one must consider that, even then, much of the information is rinsed before publication. It all seems surreal but the reality is that the debt problem is not a new experience in China.

The hangover from a credit binge that powered China's swift recovery from the global financial crisis, combined with the economy's slowdown, has prompted expectations of a repeat of the early 2000s, when Beijing shored up its major banks with hundreds of billions of dollars.

On the topic of Chinese data's reliability, a timely report fills the void as it pertains to the "official" non-performing loan ratio which stood at "0.97 percent as of October 1, 2013."

A survey of 1,604 executives at 76 banks conducted jointly by the China Banking Association and the auditing firm PricewaterhouseCoopers found a whopping 40 percent of respondents estimated the nationwide, all-bank non-performing loan ratio rose in 2013 from 2012 to between 3 percent and 5 percent.

The difference is that a decade ago nobody paid much attention to China and calls for the country to become a roaring tiger were unheard off. Even the BRIC story was simply based on population, but if it wasn't for the enormous trade deficits with the West, China would have bitten the dust a while back. Ironically everything happens in a seemingly scripted sequence, whether we see it or not. The generational change is best summarized by the South China Morning Post's article titled "The Chinese people will not allow a return to the old Maoist days."

As mainlanders become richer and hundreds of millions join the middle class, they have become a formidable force to push for progress in the country, demanding more transparency, accountability and rule of law to protect their property and rights. Even for mainlanders who claim they long for Mao's era, most merely want a greater effort to root out corruption, narrow income inequality and tackle injustice to achieve a more equitable society.

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As the generational economic cycle indicates, 1997 was the turning point with large scale privatizations being an admission that the regime and its ideology were unsustainable, while being masked by a new era of progress that was built on the export model. But the progress itself was the political Achilles' heel. Along comes the silly island conflict, known as Diaoyu Islands in China and Senkaku Islands in Japan, in an effort to build the nationalistic spirit and provide much needed distraction from domestic troubles. That's how the game is played, although the tone was set after the U.S. flew B-52s through China's new air defense zone.

After this cycle ends, a generation will be required to pick up the pieces, deal with the mountain of debt, and correct the current economic mistakes designed to prop a declining regime, which will extend the stabilization phase into 2045. In my book published in 2010 (shameless plug), I outlined the three core mistakes that the Chinese government made and here's the conclusion:

And that is the third and principal oversight. The new "market economy," if one can call it that, opened the door of opportunity to their citizens and gave them a taste of capitalism in action, something that they had never experienced... When people, regardless of color or creed, experience freedom or something they want, even in a somewhat controlled fashion, they will not let go.

Interestingly enough, the U.S.S.R. (Russia) cycle provides a reference for China, with capitalism reforms introduced in 1965.

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Meanwhile, and with Russia's exports representing about 30% of GDP (U.S. is about 10%), last month Russian Economy Minister Alexei Ulyukayev downgraded economic growth for 2014.

Russia's Economy Ministry cut its forecast for economic growth in 2014 by half a percent Tuesday amid warnings that stagnation was set to persist. Gross domestic product will expand 2.5 percent in 2014 and 2.8 percent in 2015, down from the previous estimates of 3 percent and 3.1 percent respectively.

However, the important development is the country's standing in the global geopolitical stage and how Russian people cling to nationalism, with the "victories" in Syria and Ukraine lending credibility to President Vladimir Putin. Despite a 3 point pullback in the polls, he still enjoys 61% approval, an enviable statistic by any measure, and his grip on power will only solidify as Russia enters the cycle's acceptance phase after the introduction of "DWART" - Democracy With A Russian Twist - in 1989. The dissolution of the U.S.S.R. in 1991 was only a formality. The recent terrorist attacks targeting the Olympic games in Sochi will only help Putin as he steps forward to defend the Russian people and builds upon his power expansion, while creating an aura of democratic sensibility by releasing Mikhail Khodorkovsky, the imprisoned oligarch.

Despite similar political paths taken by China and Russia over the last three generations, the Chinese end game, as the cliché goes, will be different than in the USSR and an understanding of both cultures, geography, customs and overall differences is of the utmost importance, and there's no space here to dig that deep. Here are the good news: There's plenty of time to adjust!

Lastly, and far more important, the escalation of social unrest and armed conflicts around the world cannot go by unnoticed unless one is living under a rock or watching "The Real Housewives of Beverly Hills," which, unfortunately, is common behavior. Looking at the Arab Spring of 2011, which actually started during the late autumn of 2010, what we see are revolts against long-time dictators that ended up opening a window of opportunity for Jihadists. Certainly sectarian violence in the Middle East is nothing new, but there was an interesting observation made back then by Christopher Boucek and Karim Sadjadpour.

In many places, it increasingly looks like a proxy war between Iran and Saudi Arabia... The challenge is that both countries view power and influence in the region as a zero-sum game. If Iran gains, Saudi Arabia loses-and vice versa. In Saudi Arabia there is not just a fear that Iran wants a greater role in the region, there is alarm that Iran wants to control the region.

It's undeniable that Jihad is alive and well, Iraq is under fire, Syria is and will be an unresolved mess from a Western perspective, and Iran continues to march toward its goal of becoming a nuclear state. Meanwhile, the ongoing negotiations with Iran can be summarized in three simple points:

1. The West does not want another conflict that will blow more holes into their coffers and disrupt the energy market, especially Europe, and will go to great lengths to avoid bullet diplomacy.

2. Iran has no intentions of abiding by anything and continues to buy time, while its activities will proceed toward a well known goal without independent and reliable verification. Once Iran has the bomb, the conversation changes, period. Unlike North Korea, whose intent is to keep the regime in power, Iran wants to reach beyond its borders.

3. Israel knows all of the above, is between a rock and a nuclear bomb, feels that it is being thrown to the wolves, and realizes that it has been officially categorized as collateral damage.

When Benjamin Netanyahu called the West/Iran nuclear deal "an historic mistake," he probably didn't know just how historic it was. Or maybe he did! As it stands, something must give in a serious and disruptive manner over the next 24 months, leading to a wider conflict with the enormous potential of being reminiscent of the 1940s in scale, and hinging on ideological, religious and racial differences with poor economics as the background and fueling sentiment. Definitely a turn of events that nobody wishes for, but it will redefine the geopolitical landscape for generations to come. World War II did that, and it's humanity's cyclical behavioral predictability at its best.

That will be gold's (NYSEARCA:GLD) catalyst - instability, not doom - and will be the metal's last hurrah before its cycle ends as well. Although it's virtually impossible for the U.S. not to be dragged into the conflict, the extent to which the U.S. will participate will be defined by its own interests and access to oil, and, as an ironic counterbalance, the shale boom came in the nick of time to ease the impact. From this vantage point, the black swan looks more like an angry goose with its tomia in plain sight. Now back to our regular programming: Go Dow, go!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.