China

Japan’s Defense White Paper 2017 – Chinese military jet incursions up 30-fold in 10 years

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Should Japan just close its eyes? The Japanese Air Self Defense Force (JASDF) has had to scramble jets almost 3x a day to intercept Chinese PLAAN aircraft flirting with Japan’s sovereign borders according to the 2017 Defense White Paper. Since 2007, the JSADF has seen an almost 30-fold jump in activity. With respect to the disputed Senkaku Islands, the PLAAN and PLAAF have been operating drones “inside” Japanese sovereign territory. While Japan can take some comfort with the US Forces stationed throughout the country, China’s increasing belligerence in the region is obvious.

With respect to China, the JMoD wrote,

China is believed to be making efforts to strengthen its asymmetrical military capabilities to prevent military activities by other countries in the region, denying access and deployment of foreign militaries to its surrounding areas (“Anti-Access/Area-Denial” [“A2/AD”] capabilities), and recently, pursuing large-scale military reforms designed to build its joint operations structure with actual combat in mind. In addition, China is rapidly expanding and intensifying its activities both in quality and quantity in the maritime and aerial domains in the region, including in the East and South China Seas.

In particular, China has continued to take assertive actions with regard to issues of conflicts of interest in the maritime domain, as exemplified by its attempts to change the status quo by coercion, and has signaled its position to realize its unilateral assertions without making any compromises. As for the seas and airspace around Japan, Chinese government ships have routinely and repeatedly intruded into Japan’s territorial waters, and China has engaged in dangerous activities that could cause unintended consequences, such as its naval vessel’s direction of fire control radar at a Japan Maritime Self-Defense Force (MSDF) destroyer, the flight of fighters abnormally close to SDF aircraft, and its announcement of establishing the “East China Sea Air Defense Identification Zone (ADIZ)” based on its own assertion, thereby infringing the freedom of overflight.

In the South China Sea, China has continued to take unilateral actions that change the status quo and heighten tension, including large-scale and rapid reclamation of multiple features, establishment of outposts there, and their use for military purposes, based on China’s unique assertions which are incompatible with the existing international order, and has made steady efforts to create a fait accompli. In addition, a Chinese fighter is alleged to have flown abnormally close to and conducted an intercept of a U.S. Forces aircraft. These Chinese activities represent serious security concerns of the region encompassing Japan, and of the international community.

For this reason, China is urged to further increase transparency regarding its military and enhance its compliance with international norms. It is a key task to further strengthen mutual understanding and trust by promoting dialogue and exchanges with China, and make further progress on measures to build trust, such as measures to avoid and prevent unintended consequences in the maritime domain.”

Sadly Japan is unlikely to get the answers it wants to hear. So as trivial as submitting to Chinese pressure to change an in flight magazine map might seem to many, the bigger picture is what is happening on the security front. As Churchill once said, “you cannot reason with a tiger when your head is in its mouth!

 

US airlines tell China to take a hike over Taiwan

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Despite the immediate and characteristic folding by in-your-face virtue signaling Qantas and other airlines to remove the word “Taiwan” from the airline in-flight magazines and websites, American airline leaders have decided to tell China to go take a jump saying it is a matter for governments, not airlines to discuss such foreign policy matters. Full credit to China for pushing the boundaries of how powerful the rest of the world thinks it is by the speed of which they roll over and play dead. It doesn’t take much to envisage when the Chinese authorities start to demand ‘real’ things. While leaders in Australia mock the activities of Xi in the Pacific or the Maldives by the irrelevance of the size of free trade agreements to China, they completely overlook the strategic importance of the naval ports China is linking together across the globe.

Of course trivial demands to change maps in inflight magazines on the surface is a backhanded way for the Chinese to prioritize landing slots but the action below the waves is clear. Start with tiny demands and ratchet up the volume and see where the breaking point is. Authoritarian rule at its finest. Where have we seen this before?

Sadly the principle lost on many is that those nations/airlines that “stand for nothing, fall for anything

Qantas gets a taste of its own medicine

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Qantas CEO Alan Joyce has had a taste of his own medicine. Forever a boss ramming social activism at shareholders’ expense down the throats of passengers and staff, China is demanding that the airline remove “Taiwan” off its maps and the airline is likely to comply. True colours. While happy to pontificate to others, Joyce falls into line when real dictators bark orders. So much for the social justice of Taiwanese clientele. Sold down the river without a fight.

Why didn’t Qantas engage the Dept of Foreign Affairs to officially complain about such a ridiculous request? Even if it is odds on that Foreign Minister Julie Bishop would chicken out of such an opportunity, it is a precursor at how China is happy to bully its neighbors around even on trivial things such as in-flight magazines. Then again why wouldn’t the Chinese do this if they know how quickly and easy they can get compliance?

Tyrannies don’t do diplomacy. And too many democracies don’t defend it.

GEzus Priced super far?

US Corp prof.pngIt is not rocket science. Generally higher interest rates lead to lower profitability. The chart above shows that quarterly pre-tax US profitability is struggling. We took the liberty of comparing the profitability since 1980 and correlating it to what Moody’s Baa rated corporate bond effective 10yr yields. An R-squared of almost 90% was returned.

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With the Fed moving toward a tightening cycle, we note that the spreads of Baa 10yrs to the FFR has yet to climb out of its hole. During GFC it peaked at 8.82%. It is now around 3%.

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Why not use the Aaa spread instead? Well we could do that but looking over the last decade the average corporate debt rating profile looks like this. We have seen a massive deterioration in credit ratings. If we look at the corporate profitability with Baa interest rates over the past decade, correlation climbs even higher.

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Corporate America binged on cheap credit over the last decade and given the spreads to Aaa ranked corporate bonds were relatively small, it was a no brainer. In 2015, GE’s then-CEO Jeff Immelt said he was willing to add as much as $20 billion of additional debt to grow, even if it meant lower bond grades. We can see that the spread today is a measly 0.77%. Way off the 3.38% differential at the time of GFC. Still nearly 50% of corporate debt is rated at the nasty end.

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We shouldn’t forget that the US Government is also drunk on debt, much of it arriving at a store near you. $1.5 trillion in US Treasuries needs refinancing this year and $8.4tn over the next 3.5 years. Couple that with a Japan & China pulling back on UST purchases and the Fed itself promising to taper its balance sheet. So as an investor, would you prefer the safety of government debt or take a punt on paper next to junk heading into a tightening cycle?

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In any event, the 4.64% 10yr Baa corporate bond effective yield is half what it was at the time of GFC. Yet, what will profitability look like when the relative attractiveness of US Treasuries competes with a deteriorating corporate sector in terms of profitability or balance sheet?

Take GE as an example. Apart from all of the horror news of potential dividend cuts, bargain basement divestments and a CEO giving vague timelines on a turnaround in its energy business things do not bode well. Furthermore many overlook the fact that GE has $18.7bn of negative equity. Selling that dog of an insurance business will need to go for pennies in the dollar. There is no premium likely. GE had a AAA rating but lost it in March 2009. Even at AA- the risk is likely to the downside.

Take GE’s interest cover. This supposed financial juggernaut which was at the time of GFC the world’s largest market cap company now trades with a -0.17x interest coverage ratio. In FY2013 it was 13.8x. The ratio of debt to earnings, has surged from 1.5 in 2013 to 3.7 today. It has $42bn in debt due in 2020 for refinancing.

By 2020, what will the interest rate differentials be? There seems to be some blind faith in GE’s new CEO John Flannery’s ability to turn around the company. Yet he is staring at the peak of the aerospace cycle where any slowdown could hurt the spares business not to mention the high fixed cost nature of new engines under development. In a weird way, GE is suffering these terrible ratios at the top of the cycle rather than the bottom. Asset fire sales to patch that gaping hole in the balance sheet. Looks like a $4 stock not a $14 one.

A tick for Turnbull

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It is a rare occasion that CM praises the Turnbull government. However, the actions taken to say “NO” to a special UN investigation on Israel’s activities on March 14 are worthy of congratulation. Two reasons;

1) the UN Human Rights Council (HRC) is stacked with countries (Cuba, China, Saudi Arabia, UAE, Qatar) with woeful human rights records and have no place dicatating impartiality. When the HRC has looked to investigate Israel more times than the rest of the world combined one doesn’t have to question bias. In the last 3 years, Israel has been the subject of 83 of 97 UN General Assembly resolutions. 86%. The UNHRC has zero credibility – period.

2) Hamas openly came out and admitted that 50 of the 62 dead were its own terrorists. 84% accuracy of those carrying handgrandes and other weapons. Yet honestly, who brings their children to an area where there is risk (and plenty of warning) of live fire? It is pretty simple. If you don’t want to get shot then don’t put yourself in a zone where there is a high likelihood of such. If no one turned up on the border, the body count would have been zero. As written last week, Hamas is far happier with sacrificing lives than Israeli Defence Forces are taking them.  When Hamas websites call for killing Israelis for those that break through, can you honestly blame Israel? The Israelis are not out to make headlines any worse than they already are. They are defending their sovereign borders and the reality is any of us would expect our armed forces to do the same if they were under siege.

The UN has long outlived its usefulness. Robert Mugabe is considered an ambassador for WHO. How he could possibly pass a sniff test on any level is beyond most. Such is the bias within that the UN, in an attempt to strike back at Trump’s intended cuts, considered deploying Blue Helmets in Chicago to help stem gun violence. These people are unreal.

It was once said, “if the Palestinians chucked their weapons into the sea there would be peace. If the Israelis threw their weapons into the sea there would be genocide.”

Waking up to a horror of our own creation

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Some will say I am a pessimist. I’d prefer to be called an optimist with experience. At only age 16 (in 1987) I realized the destructive power financial markets had on the family home. Those memories were etched permanently. We weren’t homeless or singing for our supper but things sure weren’t like they use to be. It taught me much about risk and thinking all points of view rather than blindly following the crowd. That just because you were told something by authority it didn’t mean it was necessarily true. It was to critically assess everthing without question.

In 1999, as an industrials analyst in Europe during the raging tech bubble, we were as popular as a kick in the teeth. We were ignored for being old economy. That our stocks deserved to trade at deep discounts to the ‘new economy’ tech companies, no thanks to our relatively poor asset turnover and tepid growth rates. The truest sign of the impending collapse of the tech bubble actually came from sell-side tech analysts quitting their grossly overpaid investment bank salaries for optically eye-watering stock options at the very tech corporations they rated. So engrossed in the untold riches that awaited them they abandoned their judgement and ended up holding worthless scrip. Just like the people who bought a house at the peak of the bubble telling others at a dinner party how they got in ‘early’ and the boom was ahead of them, not behind.

It was so blindingly obvious that the tech bubble would collapse. Every five seconds a 21 year old with a computer had somehow found some internet miracle for a service we never knew we needed. The IPO gravy train was insane. One of my biggest clients said that he was seeing 5 new IPO opportunities every single day for months on end. Mobile phone retailers like Hikari Tsushin in Japan were trading at such ridiculous valuations that the CEO at the time lost himself in the euphoria and printed gold coin chocolates with ‘Target market cap: Y100 trillion.’ The train wreck was inevitable. Greed was a forgone conclusion.

So the tech bubble collapsed under the weight of reality which started the most reckless central bank policy prescriptions ever. Supposedly learning from the mistakes of the post bubble collapse in Japan, then Fed Chairman Alan Greenspan turned on the free money spigots. Instead of allowing the free market to adjust and cauterize the systemic imbalances, he threw caution to the wind and poured gasoline on a raging fire. Programs like ‘Keep America Rolling’ which tried to reboot the auto industry meant cheaper and longer lease loans kept sucking consumption forward. That has been the problem. We’ve been living at the expense of the future for nigh on two decades.

Back in 2001, many laughed me out of court for arguing Greenspan would go down in history as one of the most hated central bankers. At the time prevailing sentiment indeed made me look completely stupid. How could I, a stockbroker, know more than Alan Greenspan? It was not a matter of relative educations between me and the Fed Chairman, rather seeing clearly he was playing god with financial markets.  The Congressional Banking Committee hung off his every word like giddy teenagers with a crush on a pop idol. Ron Paul once set on Greenspan during one of the testimonies only to have the rest of the committee turn on him for embarrassing the newly knighted ‘Maestro.’ It was nauseating to watch. Times seemed too good so how dare Paul question a central bank chief who openly said, “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant.”

We all remember the horrors of the collapse of Lehman Brothers and the ensuing Global Financial Crisis (GFC) in September 2008. The nuclear implosions in credit markets had already begun well before this as mortgage defaults screamed. The 7 years of binge investment since the tech bubble collapse meant we never cleansed the wounds. We would undoubtedly be in far better shape had we taken the pain. Yet confusing products like CDOs and CDSs wound their way into the investment portfolios of local country towns in Australia. The punch bowl had duped even local hicks to think they were with the times as any other savvy investor. To turn that on its head, such was the snow job that people who had no business being involved in such investment products were dealing in it.

So Wall St was bailed out by Main St. Yet instead of learning the lessons of the tech bubble collapse and GFC our authorities doubled down on the madness that led to these problems in the first place. Central banks launched QE programs to buy toxic garbage and lower interest rates to get us dragging forward even more consumption. The printing presses were on full speed. Yet what have we bought?

Now we have exchange traded funds (ETFs). Super simple to understand products. While one needed a Field’s Medal in Mathematics to understand the calculations of a CDO or CDS, the ETF is child’s play. Sadly that will only create complacency. We have not really had a chance to see how robots trade in a proper downturn. ETFs follow markets, not lead them. So if the market sells off, the ETF is rapidly trying to keep up. Studies done on ETFs (especially leveraged products) in bear markets shows how they amplify market reactions not mitigate them. So expect to see robots add to the calamity.

Since GFC we’ve had the worst post recession recovery in history. We have asset bubbles in bonds, stocks and property. The Obama Administration doubled the debt pile of the previous 43 presidents in 8 years. Much of it was raised on a short term basis. This year alone, $1.5 trillion must be refinanced.  A total of $8.4 trillion must be refinanced inside the next 4 years. That excludes the funding required for current budget deficits which are growing despite a ‘growing economy’. That excludes the corporate refinancing schedule. Many companies went out of their way to laden the balance sheet in cheap debt. In the process the average corporate credit rating is at its worst levels in a decade. Which means in a market where credit markets are starting to price risk accordingly we also face a Fed openly saying it is tapering its balance sheet and the Chinese and Japanese looking to cut back on US Treasury purchases. Bond spreads like Libor-OIS are already reflecting that pain.

Then there is the tapped out consumer. Unemployment maybe at record lows, yet real wage growth does not appear to be keeping up. The number of people holding down more than one job continues to rebound. The quality of employment is terrible. Poverty continues to remain stubbornly high. There are still three times as many people on food stamps in the US than a decade ago – 41 million people. Public pension unfunded liabilities total $9 trillion. Credit card delinquencies at the sub prime end of town are  back at pre-crisis levels. We could go on and on. Things are terrible out there. Should we be in the least bit surprised that Trump won? Such is the plight of the silent majority, still delinquent after a decade. No wonder Roseanne appeals to so many.

A funny comment was sent by a dyed-in-the-wool Democrat, lambasting Trump on his trade policies. He criticized the fact that America had sold its soul for offshoring for decades. Indeed it had but queried that maybe he should be praising Trump for trying to reverse that tide, despite being so late to the party. Where were the other administrations trying to defend America all this time? Stunned silence.

Yet the trends are ominous. If we go back to the tech bubble IPO-a-thon example. We now have crowd funding and crypto currencies. To date we had 190 odd currencies to trade. Of that maybe a handful were liquid – $US, GBP, JPY, $A, Euro etc – yet we are presented with 1,000s of crypto currency choices. Apart from the numerous breaches, blow ups and cyber thefts to date, more and more of these ‘coins’ are awaiting the next fool to gamble away more in the hope of making a quick buck. Cryptos are backed by nothing other than greed. Yet it sort of proves that more believe that they are falling behind enough such they’re prepared to gamble on the biggest lottery in town. One crypto used Wikipedia as a source for its prospectus.

Yet the media remains engrossed on trying to prove whether the president had sex with a porn star a decade ago, genderless bathrooms, bashing the NRA, pushing for laws to curtail free speech, promoting climate change and covering up crime rather than look at reporting on what truly matters – the biggest financial collapse facing us in 90 years.

There is no ‘told you so’ in any of this. The same feelings in the bones of some 30 years ago are back as they were at the time of Greenspan and Lehman. This time can’t be avoided. We have borrowed too much, saved too little and all the while blissfully ignored the warning signs. The faith and confidence in authorities is evaporating. The failed experiment started by Greenspan is coming home to roost. This will be far worse than 1929. Take that to the bank, if it is still in operation because you won’t be concerned about the return on your money but the return of it!

For Life

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If Xi Jinping’s 3.5 hour speech wasn’t enough to torture the bladders and eyelids of attendees at the last plenary session several months ago, it seems the 10-yr presidential term limit is about to be thrown out meaning Xi can rule for as long as he likes. While many criticize the current US administration for its authoritarian behaviour it is not a lick on this. His grip on regional geopolitics from here on will challenge the resolve of its neighbours, most likely thrusting them into the bosom of the US. Watch US arms deals in Asia take off.

Also note India announced last week it is now building a major military base in the Seychelles to combat China’s influence in territorial waters. China has already got Sri Lanka on board with the Port of Hambantota which allows PLA Navy ships to dock. China is also funding Pakistan to help build the backdoor to India’s north via the Karakoram Highway.

Interesting times ahead.