Monthly Archives: June 2019

Last Week Today. President Trump and China’s President Jinping confirmed they will meet at the G-20 Summit this week in Osaka, Japan. | The White House disclosed it had explored the legality of demoting Federal Reserve Chairman Jerome Powell due to administration’s frustration with his unwillingness to cede to President Trump’s desire for lower rates. Looks like that frustration will be addressed in July as discussed in “De-hawked” below. | Geopolitical tensions with Iran increased when the Islamic Revolutionary Guard Corps downed a $176 million RQ-4A Global Hawk, one of the U.S. military’s most advanced surveillance drones, over the Strait of Hormuz. See “Chokepoint” below.

Financial Markets. Central bankers signaling looser monetary policy (see “De-hawked” section below) gave investors the “all clear” sign to buy everything. The S&P 500 gained +2.2% while bond prices rallied to push yields lower across the board, including the global benchmark 10-year bond whose yield briefly fell below 2% for the first time since 2016. International stocks rallied as well as the Developed ex-US Index tacked on +2.6% and Emerging Markets pushing higher by +3.5%. The commodity complex was bid (Gold +4.3%, Silver +3.2%) and the potential for conflict in the Persian Gulf added to an already ebullient energy market, with WTI Crude gaining 9.7% to $57.60 per barrel. The US Dollar was the odd asset out, declining -1.4% on the week, providing a tailwind for commodities and international stocks and hope for the struggling U.S. manufacturing sector, which has been suffering from a strengthening USD.

For specific weekly, month-to-date and year-to-date asset class performance, please click here.

It’s Back. Facebook revealed details of Libra, a cryptocurrency it plans to launch in 2020. Unlike other cryptocurrencies, Libra will be pegged to a basket of standard currencies, including the US Dollar and Euro, to avoid volatile price swings. Speaking of price swings, after falling from a high of $20,000 to a low of $3,200 in 2018, Bitcoin has rallied more than 240% to about $11,000 (as of the morning of June 24th).



De-hawked. First the ECB, then the Fed, then the BOJ. It was a week in which central bankers abandoned hopes of normalizing interest rates, in yet another sign that central banks are ill-equipped to combat global deflationary pressures ten years after the Great Recession. Indeed, the central bankers did their best to assure the markets “we got this” with regards to slowing global growth and recalcitrant disinflationary pressures. On Monday, European Central Bank (ECB) President Mario Draghi announced that the central bank is prepared to use monetary policy to stimulate the economy “in the absence of any improvement.” On Thursday, Governor Haruhiko Kuroda from the Bank of Japan (BOJ) offered the possibility of future stimulus.

Sandwiched between those two bankers, representing the world’s most important central bank, Fed Chairman Powell delivered a message on Wednesday that was even more dovish than market expectations: “In light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming economic information…and will act as appropriate to sustain the expansion…”. The phrases in bold are emphasized because for the first time this cycle, the Fed dropped its categorization of persistently low inflation as a temporary or, in Fed-speak, a “transitory” condition. That change in view explicitly clears the way for the Fed to cut interest rates to keep the expansion going. Recent weakness in the Empire Manufacturing Index (May showed the largest monthly decline in history), the Philadelphia Fed’s Manufacturing Business Outlook Survey, and the preliminary Markit Manufacturing PMI make incoming economic data over the next six weeks pivotal. If the data does not improve, look for the Fed to cut interest rates at their next meeting in July, perhaps by as much as 0.5% given Powell’s view that more aggressive action is warranted when rates are close to the zero lower bound (i.e., 0%).

Chokepoint. Most have heard of the Strait of Hormuz, especially recently with the attacks on oil tankers in the region two weeks ago and the downing of a U.S. military drone last week. Moreover, references to the importance of the region to global oil supply are common. But how much oil is actually transported through the region? The answer is 21 million barrels of oil per day (mbd), which equates to approximately 21% of daily global consumption. For the geographically challenged (myself included) The Strait of Hormuz is a narrow maritime passageway that connects the Persian Gulf and the Gulf of Oman.


Source: U.S. Energy Information Administration

The Persian Gulf is the Middle Eastern counterpart to the Pacific Ocean’s “Ring of Fire.” For the Persian Gulf, the danger comes not from shifting tectonic plates but from the different religious factions who are vying for power in the region. Keep in mind that the Persian Gulf is bordered by Iran, Iraq, Kuwait, Saudi Arabia, Qatar, the United Arab Emirates (U.A.E.), and Oman – the bona fide who’s who of Middle East unrest that also produces about 1/3 of total global crude oil supply.

For these countries, there are few viable options to bypass the Strait of Hormuz and get their product to market. Saudi Arabia and the U.A.E. have pipelines (see chart above) capable of moving oil to locations outside of the Strait of Hormuz, but total capacity is only 6.8 mbd or less than 1/3 of the total oil produced in the region. Hence, the strait, which is only 35 nautical miles wide at its narrowest point, is critical to global oil supply.

The charts below show the volume of oil shipped through the Strait of Hormuz (left) and the destinations for that oil (right).


While the U.S. is becoming increasingly energy independent, Asian countries are reliant upon Middle Eastern countries for a large portion of their oil demand. Given the importance of the strait to global commerce and Iran’s ability to impact traffic within it, it’s understandable why Iran uses it as leverage in trying to negotiate an end to U.S. sanctions. While it’s infeasible for Iran to close the strait for an extended period, the potential for (or actual) Iranian provocations will keep oil markets on edge. In a worst-case scenario (which seems increasingly plausible with news that a planned U.S. military strike on Iran last week was aborted at the last minute), a war in the Persian Gulf would push oil prices significantly higher and threaten the already tepid pace of global growth. Optimistically, cooler heads will prevail.

How the Mind Works Against Successful Investing (Entry #2 in a series on Behavioral Finance)

We begin our study of how specifically the mind works against successful investing with an exploration into Emotional Biases. As a review, at a high level, we divide biases into two categories:

  • Emotional biases lead to errors when feelings influence reason.
  • Cognitive biases lead to faulty reasoning based on mental shortcuts.

We are starting with Emotional Biases because they are more challenging to correct. Emotional biases are subjective, whereas Cognitive biases are objective. In truth, nearly every bias we will discuss infects our reasoning at some level. However, in shining a light on these biases by explaining what they are and how to address them, we should be able to minimize their influence with a little work. So…. let’s get to work.

Loss Aversion

One of the most potent forces affecting decision-making in financial matters is Loss Aversion. The researchers (Daniel Kahneman and Amos Tversky) credited with identifying Loss Aversion described the bias in simple terms “losses loom larger than gains.” As it turns out, losses loom A LOT larger than gains as research studies have shown the pain of losing is psychologically about twice as powerful as the pleasure of gaining. The results of these studies show the disproportional relationship between losses and gains, as highlighted in the chart below. In this particular study of participants’ reactions to gains and losses, a $0.05 profit (horizontal axis) is valued (vertical axis) at slightly less than 20, whereas a -$0.05 loss has a negative value of 40.


Are you Loss Averse? Consider a situation in which you are presented with two options for investing $50,000. Which scenario do you prefer?

   A) Be assured you will get back $51,000.

   B) Have a 50%/50% chance of either getting back $70,000 or $35,000.

If you answered A, you are demonstrating a Loss Aversion bias. Answer B not only offers higher potential upside ($70,000) but is also a statistically better bet because when you multiply the probabilities by the outcomes, the result is $52,500.

What’s interesting about the Loss Aversion bias is that while “Loss” is in the name, the bias affects decisions about both winning and losing investments. Indeed, the influence that Loss Aversion has on winners vs. losers transforms risk-taking behavior.

The old Wall Street maxim “You never go broke taking a profit” is factually correct, but the strategy for successful investing is to minimize losing positions while maximizing gains on winning investments. No investor will get every investment right, so it’s essential to capture a significant portion of the potential profit from lucrative investments to offset losing positions and continue to grow your portfolio. However, investors often sell winners too early out of fear that gains will be lost. As such, winning investments often stimulate risk-averse “take the money and run” behavior.

In contrast, losing positions encourage risk-seeking behavior. Research shows that investors don’t like to realize losses by selling positions with a negative return. Said differently, investors often hold-on to losing investments in the hope the price will rise to at least break-even. “Hope is not a strategy” is good advice and holding onto a position experiencing losses, in the absence of compelling evidence for the price to recover, is irrational and risk-seeking. That is, the potential for the investment to decline further in price introduces additional risk to the portfolio.

In sum, hanging on to losing positions and selling profitable investments too early decimates portfolio returns in the long-run.  However, we are not advocating for selling every investment that loses money in the short-term and retaining all winning investments, as that approach can work against long-term portfolio appreciation as well. Instead, we are advocating for a middle ground. On that investment-decision-making middle ground investors acknowledge the pull of their emotions, but then set them aside and focus on data to make evidence-based buy/sell decisions.

Be well,


Last Week Today. Mexico’s government agreed to move forward with adopting the USMCA trade agreement (aka, NAFTA 2.0) following President Trump’s announcement he would not levy illegal immigration-related tariffs on Mexico. | Two oil tankers were attacked in the Gulf of Oman, shortly after passing through the maritime bottleneck known as the Strait of Hormuz. Iran was quickly implicated but denied involvement. Given the importance of that region to global oil transportation, the +2.2% rise in oil prices was somewhat muted considered prices had fallen -4.0% the day before on oversupply concerns. Six ships have been attacked in the volatile area in the last two months. | The 10-year German Bund (the benchmark for European bonds, and the poster-child for negative yields) hit a record low yield of -0.25%. Today, nearly $12 trillion worth of bonds are trading with negative yields as Global central bankers search for solutions to persistently low inflation. Speaking of which, U.S. Core CPI slowed from 2.0% to 1.8% in May. | In Hong Kong, an estimated two million protesters (or about 1 in 4 citizens) literally took their lives into their own hands and successfully prevented the government from passing a law allowing citizens to be extradited to China, where the legal system is less forgiving. There’s power in numbers.

Global equities see-sawed their way forward tacking on about +0.3% last week to build on June’s strong start (MSCI ACWI +4.0% MTD). Emerging and Frontier market stocks led the way with gains of +1.0%, while U.S. stocks added +0.5% (S&P 500 +5.0% MTD). Yields on bonds continued to grind lower, with the yield on the 10-year U.S. Treasury bond twice touching 2.05% intraday (the lowest level since September 2017). Equity and bond prices are telling a different story. While bond prices are signaling a significant slowdown in global growth, stock indices in Australia, Argentina, Brazil, Greece, and Russia are near all-time highs. These aren’t the strongest of economies, so it begs the question of whether equity investors or bond investors are correctly forecasting global economic strength.

For specific weekly, month-to-date and year-to-date asset class performance, please click here.

Consumption Function. On a very positive note for the economic outlook, real (inflation-adjusted) personal consumption, which accounts for nearly 70% of the economy, bounced back in April and May. Following a Q1 annualized growth rate of only 1.3%, data released last week showed consumption is growing at an annualized pace of 3.9%. Our no recession in 2019 thesis and a continuation of the “Good But Not Great” GDP-growth-trend hinges on the strength of the consumer, who appears to be in fine financial shape (low unemployment, rising wage, low debt service ratios, etc.). Thus far, Mr. and Mrs. Consumer are not disappointing.


Sources: U.S. Census Bureau and FTN Financial.

Following the retail sales report, the Atlanta Fed raised its Q2 GDP forecast to 2.1% (from 1.5%), in line with the post-Financial Crisis trend growth rate.


Paging Mr. Powell. The Federal Open Market Committee (FOMC) meets Tuesday and Wednesday this week. After the meeting, the FOMC and will provide updates on their outlook for interest rates and the economy. Investors are loading up on bets the Fed will cut rates by July and then two more times later this year. Fed Futures indicate a greater than 85% probability of a Fed rate cut at their next meeting in July, and a non-trivial 25%+ chance of a rate cut this week.

It’s unlikely the FOMC will cut interest rates this week unless they want to surprise the market. Before Fed Chairman Alan Greenspan’s push for greater transparency 25 years ago, the Fed operated in relative secrecy and did not announce changes to interest rates.  Back then, investors relied on Wall Street’s “Fed watchers” to interpret the Federal Reserve’s monetary policy by observing the Fed’s Open Market Operations (i.e., the buying and selling of U.S. Treasuries to maintain a specific Federal Funds Target interest rate). The modern Fed professes transparency and forward guidance, so a surprise is improbable. A more likely scenario is Chair Powell acknowledging a slower growth rate than in 2018, reiterating that the Fed is watching the trade situation closely, and repeating the refrain that the Fed stands ready to act if necessary (i.e., the “Fed Put” option is alive and well). Given the magnitude of bets that a Fed rate cut is imminent, that type of message may be viewed as disappointing by the market.

How the Mind Works Against Successful Investing: Biases Framework

To say the human brain is complex is like saying it’s “a little” warm outside during a South Texas summer. How people make decisions, which is but one multifaceted activity performed by the brain, remains to be fully understood, but extensive research has provided some insights.

One conclusion from the research shows the frailty of human decision making. Specifically, when people face complex problems, they have difficulty formulating a rational approach to solving the problem. Instead of describing the problem, assembling the necessary data, and spending time to synthesize the information, humans generally try to simplify. People lock into a subset of the available data, typically discarding the most complicated information (which may ultimately be relevant) and settle for a solution that is “good enough.” Subjective judgments about which specific information people select as important to their decision are inherently biased by existing beliefs, past experiences, and/or emotions. These biases, in turn, often lead to a sub-optimal decision and outcome.

As it applies to finance, in theory, members of an economy make decisions based on logic that lead to “wealth maximization.” In reality, however, psychology and emotion dominate the decision-making process, leading to unpredictable or irrational behaviors. Researchers have identified more than 50 specific biases that affect individual investor decisions. These biases can generally be categorized as follows[1]:

  • Emotional Biases – irrational decisions based on instinct or impulse, rather than conscious calculations. It’s generally accepted that this category of biases is more challenging to correct than cognitive biases as they are more difficult to detect. Whereas decisions from Cognitive Biases can be demonstrated as illogical (e.g., a conclusion can be shown to be mathematically inaccurate), Emotional Biases emerge from peoples’ personal experiences and are based on how they feel rather than how they think.
  • Cognitive Biases – systematic errors in thinking that cause us to act irrationally repeatedly. These biases can be thought of as the “hardwiring” of the human brain and are likely a legacy from our hunter-gatherer ancestors when speed of decision-making was more important than accuracy for survival.[2] Cognitive Biases often occur because of heuristics, mental shortcuts we have developed to make decisions when time is limited. Sometimes heuristics can be useful for making quick decisions, but the downside of heuristics leads to two categories of biases that can negatively impact investment decisions:  (1) Belief Perseverance – sticking with the status quo, even as newly available information conflicts with that decision; and (2) Information Processing – assimilating data illogically.

With this as a framework, next week we’ll begin our exploration into specific ways the mind works against successful investing. Depending on the complexity of the biases and length of the review, we will generally cover one to three biases each week. In all, we will explore approximately 20 behavioral biases in the coming months. When we finish, you should have a solid understanding of why decision making is challenging, be able to identify potential biases and adjust for them in your daily life to create better outcomes.

Be well,


[1] Credit to Michael M. Pompian, who created this taxonomy in his book Behavioral Finance and Wealth Management, a key resource for our exploration into the topic of Behavioral Finance.

[2] As an aside, the book Thinking Fast and Slow by Nobel laureate Daniel Kahneman is a fantastic exploration of biases that result from the human brain’s two modes of thought. System 1 is fast, instinctive, and emotional. System 2 is slower but more deliberative and logical.

Last Week Today. The Department of Justice (Apple and Alphabet – aka Google) and the Federal Trade Commission (Facebook and Amazon) announced antitrust investigations into the market power held by large technology platforms. For a change, Republican and Democratic lawmakers agree on something – big technology companies are too influential in Americans’ political and economic lives. Change (and massive legal bills) are coming to these companies. | While visiting the United Kingdom, President Trump appeared to extend a hand to the country, hinting at a trade deal if Britain leaves the European Union. | The World Bank cut its 2019 global growth outlook from 2.9% to 2.6%, citing risks from trade tensions. | President Trump announced an agreement with Mexico to reduce the flow of migrants to the southern border, thereby eliminating the imposition of escalating tariffs set to begin today.

Global equities bounced after four consecutive losing weeks as a thematic trifecta leaned toward risk takers:

  • Monetary Policy: Comments from the Federal Reserve fell in line with market expectations for interest rate cuts.
  • International Trade: Progress, and ultimately an agreement, was reached with Mexico, preventing the opening of a new front in the U.S. trade war.
  • The Economy: Economic data was sufficiently soft to keep the Fed on the path toward rate cuts… at least that’s how the market interpreted the May labor market report.

Domestic equities led the way, with the major indices rising 4% or better, while international developed market stocks gained 3.2% (MSCI EAFE Index). Looking back, equity markets have moved a lot, but they’ve made little progress since early 2018. Indeed, for the last 18 months, the S&P 500 has mostly remained in a 15-percentage-point-wide channel centered around 2,650, periodically supported or bashed by one or more of the themes listed above.

For specific weekly, month-to-date and year-to-date asset class performance, please click here.


Sources: Bloomberg Finance, L.P., and Covenant Investment Research.

Extended periods of relatively flat performance are not unusual in any asset class. However, it’s easy to get distracted by the news headlines and associated volatility that wreak havoc with the human mind and effective decision making. There are several ways one can combat some of the obvious behavioral biases that impact all humans: work with an experienced advisor to create a financial plan, construct thoughtful portfolios that allow you to “stay in the game” and not be a forced seller, and education. On the latter topic, we are introducing a new series within Covenant’s Weekly Synopsis focused on the human mind and investing.

Behavioral Finance. Over the coming weeks, we will begin a knowledge series on behavioral finance, called “A Look at How the Mind Works Against Successful Investing.”

Behavioral finance is, at its core, the application of psychology to how financial decisions are made. Traditional financial models assume that market participants always act in a rational and wealth-maximizing manner, which is why traditional models typically fail to make accurate, detailed predictions. In contrast, behavioral finance studies mental shortcuts humans have developed that may have been useful to the survival of the species, but that lead to irrational investment decisions. The difference between traditional financial models and behavioral finance models is summed up nicely by professor Meir Statman, PhD, “People in standard finance are rational. People in behavioral finance are normal.”

This series should be an interesting and informative look at how emotional biases and cognitive errors affect perceptions and, ultimately, investment decisions. We hope that by studying and sharing critical tenets of behavioral finance, we can help expand literacy on the topic, leading to a community of better investment decision makers.

Capitulation. The bond market has been screaming that monetary policy is too tight (i.e., the deeply inverted yield curve) and it appears that the Fed is finally coming to a similar view. Early last week, James Bullard, President of the St. Louis Fed, suggested the Fed may have gone too far with its rate hiking campaign. “A cut may be warranted soon…The narrative on global trade has darkened. Monetary policy looks too restrictive in this environment.” To be fair, Bullard has been suggesting for some time now that Fed policy may be too restrictive.

On the other hand, Fed Chairman Powell’s 180-degree pivot from December 2018’s hawkish stance is nearly complete. During a speech in Chicago on Tuesday, in his prepared remarks, Powell said “We do not know how or when these trade issues will be resolved. We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion with a strong labor market and inflation near our 2% objective.”

The Fed is unlikely to cut rates at their meeting next week (June 18-19), but they could certainly set the stage for a rate cut at their meeting in July. By the way, based on the futures market, investors are expecting the Fed to undo all the rate hikes from 2018 by cutting rates a full 1% by year-end 2020 (-0.65% in 2019 and -0.30% in 2020).


Right on Cue. If the Fed needed an economic nudge to consider cutting interest rates, Friday’s employment report was tantamount to a shove in that direction. Nonfarm payrolls rose by only 75,000 (vs. the consensus estimate of 175,000) in May. Moreover, the two previous months’ jobs gains were revised down by a total of 75,000, resulting in a net employment change of zero. As the chart below highlights, a month of low job creation is not unprecedented, but it (along with fading wage pressure which registered 3.1% year-over-year in May vs. 3.4% in February) hints that trade disputes are having a real effect on business confidence.


Be well,


Last Week Today. S&P 500 earnings season concluded with corporations reporting year-over-year profit growth of roughly 1.5% in Q1. A pretty thin margin of expansion, but impressive relative to analyst expectations of a 4%-5% decline heading into Q1. | President Trump broadsided Mexico (and the markets) late Thursday Tweeting that the U.S. will put 5% duties on all Mexican imports on June 10, incrementally rising to 25% in October, unless Mexico stops “illegal migrants” from entering the U.S. | China’s manufacturing Purchasing Manager Index (PMI) declined to 49.4 (a reading below 50 indicates negative growth), blamed by most observers on the trade war with the U.S. The employment index fell to 47.0, the lowest reading since 2009 (Source: FTN Financial). | Q1 GDP was revised down by 0.1% to an annualized real (inflation-adjusted) rate of 3.1%.  While still the fastest Q1 growth since 2015, keep in mind that Q1 growth was boosted by a large build in inventory levels, and we expect GDP growth to track back towards 2%. | The Fed’s favored measure of inflation, Personal Consumption Expenditures, rose only 1.6% year-over-year in April. Well below the Fed’s target of 2%, one is left to wonder when the Fed will recognize (or admit) that the “transitory” deflationary effects are in fact, structural and that monetary policy is too tight.

Global risk assets capped off a lousy month with another losing week. Equities are struggling to gain traction, slipping on a combination of slowing global growth and trade tensions. As of Friday, the losing streak included four consecutive negative weeks for the S&P 500 and Nasdaq indices, and six for the Dow Jones Industrial Average Index (first time since 2011). For a change, international equity indices outperformed domestic equities in May, though all recorded negative performance:



MSCI All Country World Index (ACWI)



MSCI Europe, Australasia, Far East Index (EAFE)



S&P 500 Index



Nasdaq Index



*Performance is inclusive of dividends. Source: Bloomberg.

It’s also worth noting the yield curve inverted further last week providing a market indicator (to go along with fundamental economic data showing slowing growth) that the Fed needs to cut interest rates. Currently, one can buy a U.S. Treasury bond maturing in three months and that yields 2.3% or they can purchase a bond matures in 20 years and earn the same interest rate.

Tariffs for All. Someday, we may learn there is a carefully conceived strategic plan behind the Administration’s decision to exacerbate longstanding U.S. supply chains via tariffs on Mexico. But for now, the surprise announcement was puzzling for at least two reasons:

  • At a time when the U.S. is competing with China for future global supremacy via a trade war, it would seem logical to build stronger trade alliances with our allies to isolate China further.
  • Mexico is the U.S.’s second largest trade partner by both imports ($353 Billion in 2018) and exports ($266 Billion), which equated to $1.18 million of trade every minute in 2018. According to the Wilson Center’s Mexico Institute, a nonpartisan policy think tank, there are 4.9 million U.S. jobs at risk if trade stopped with Mexico. Said differently, 1 out of every 29 workers in the U.S. has a job supported by trade between the U.S. and Mexico. The states most dependent on normalized trade relations with Mexico are California and Texas, as shown in the graphic below.


Source: MarketWatch

What if a trade deal is not the objective for China or the U.S.? We first published this piece in October 2018. Since then, the prospects of a near-term trade deal for the U.S. and China shifted from likely to unlikely, at least on the surface. But what appeared like progress in the trade deal may have been China making nice on terms they never intended to honor. Since last October, the relationship between the two competing superpowers has deteriorated materially, and the trade war expanded to new fronts:

  • Corporations: the U.S. targeting Huawei and China announcing an investigation into FedEx this past weekend.
  • Key Production Inputs: China’s threat to cut off access to rare earth metals.

In light of these recent events, it seems worthwhile to revisit the longer-term strategic implications of how the U.S. and China regard one another.

Many celebrated the trade agreement with Mexico and Canada (the “USMCA”) as the first step in a broader strategy to further isolate China in global trade, thereby increasing pressure on Chinese President Xi Jinping to come to the negotiating table. [Editor’s note: As mentioned above, the USMCA is in jeopardy, but the agreement is salvageable, and its role in a broader trade battle remains relevant. ] However, what if the NAFTA revamp instead merely opens the door to a prolonged battle with China? This is the thesis of Arthur Kroeber, an analyst for the well-regarded macroeconomic research firm Gavekal. Kroeber posits that a fairer trade agreement for the U.S. with China is not what’s at stake. Instead, the stakes are much higher and focus on China’s existential threat to continued U.S. global dominance.

Politics were a primary source of motivation for President Trump to complete the USMCA deal because more than half of U.S. states count Mexico or Canada as their largest export market. Absent an agreement, the Republican party would have invited increased political vulnerability in the mid-term elections. Moreover, neither Mexico nor Canada presents a threat to U.S. geopolitical power. However, with China, the situation is decidedly different:

  • China is the top export market for only five states, reducing political fallout from a trade stalemate.
  • China presents a clear-and-present danger to U.S. influence in Asia (i.e., China’s “Belt and Road” project designed to secure trade links with Central Asia, Europe, and Africa).
  • China represents a strategic threat as they have openly stated their intent to surpass the U.S. to become a leading producer of cutting-edge technology, such as artificial intelligence.

Fundamental to the last two points, a subset of President Trump’s advisors consists of trade warriors and national security hawks who now see an opportunity to reverse China’s growing global influence. In sum, the political limitations are looser and the long-term implications far higher in the dispute with China as compared to Canada and Mexico.

If Kroeber is correct, the objective of U.S. policy is to break or, at least, severely reduce the reliance of U.S. companies to manufacture goods in China. Evidence of success would be U.S. companies moving manufacturing operations to other countries, removing a critical source of intellectual property and business investment from an obvious strategic rival. For example, last week Bloomberg reported that the Chinese military had embedded microchips in servers used by at least 30 U.S. companies (including Apple and Amazon), as well as the Department of Defense and Department of Justice, to gather intellectual property along with trade and government secrets. It’s notable, relative to Kroeber’s thesis, that this act of espionage was first discovered in 2015 but is just now being made public. This revelation alone is likely to reduce U.S. management team’s enthusiasm for investing in China and will assist the U.S. government in its efforts to break the China-US manufacturing supply chain.

On the other side of the world, and the geopolitical chess match, China may not be all that interested in rushing to strike a trade deal with the United States. If China’s long-term strategy is to compete with the U.S. for global leadership, it will need to consolidate regional power, de-link its currency from the U.S. Dollar, and take steps to be viewed as a safe harbor for countries to invest excess currency reserves, according to Gavekal’s Founding Partner, Charles Gave.

As it turns out, China has been moving in this direction for several years now. For example, the “Belt and Road” venture is a massive infrastructure project that will increase China’s financial and commercial cooperation with more than 70 neighboring countries across the Eurasian land mass and beyond.


Concerning further de-linking the Chinese Renminbi (RMB) from the U.S. Dollar, earlier this year, China took a significant step forward by launching an RMB-denominated oil futures contract. Importantly, the launch of the futures contract strategically lines up with the near completion of hydrocarbon pipelines between Russia and China. The ability to hedge oil prices in the local currency via the RMB-oil futures contract makes RMB a more attractive medium of exchange and reduces the need for China to pay Russia in U.S. Dollars for imported Russian oil.


Finally, to provide a repository for countries’ excess currency reserves, in early 2017 the Chinese government opened its bond market to foreign investors via the “bond connect” program to serve as the Asian equivalent of a risk-free asset. The government did so after several years of ensuring that Chinese bonds outperformed traditional safe-haven assets, like the German Bund and U.S. Treasuries, to attract investors. Indeed, since the beginning of 2013, Chinese bonds have outperformed both U.S. and German equivalents, and foreign holdings of Chinese bonds are now 1.5+ trillion RMB, an increase of more than 60% from a year ago (source: Bloomberg). If the bonds continue to perform and the RMB remains stable, at least relative to other Asian currencies, Chinese sovereign bonds will allow governments in the region to invest excess capital within Asia.

These articles illuminate the deeper strategic objectives of the two most powerful countries in the world. Most observers still believe the U.S. and China will eventually reach a trade deal as it seems to be in both countries best immediate interests. That may still be the case. However, if Gavekal’s theses prove accurate, trade is merely a pawn in each country’s longer-term strategy.

Early warning signals that Kroeber is correct include the U.S. levying higher tariffs, limits on visas for Chinese tech workers and students, and sanctions on Chinese companies with a record of cyber-espionage. If Gave’s thesis is accurate, China will delay substantive trade negotiations choosing instead to use this time to more firmly entrench itself as a regional hegemon. As the famous Chinese military strategist, Sun Tzu wrote: “He who knows when he needs to fight, and when he doesn’t, will be victorious.

Kroeber and Gave are fundamentally speaking about two sides of the same geopolitical coin. The reasons the U.S. may not be interested in a trade deal with China reflect the Chinese government’s actions to compete head-to-head with the U.S. for global supremacy.  What’s interesting about Krober and Gave’s theses, unlike most macroeconomic discourse, is that they are not mutually exclusive, and both may be correct.

Be well,