Friday, October 19, 2018

China's Next Revolution Is on the Horizon

The Mandate of Heaven will be withdrawn, and the autocratic regime overthrown.
The absolute confidence that China's political structure is permanent and forever is reminiscent of the absolute confidence in the 1980s that the USSR's political structure was permanent and forever. But the social contract that undergirds the Communist Party's absolute power in China is fast-eroding, and those who understand Chinese history sense the winds of change have shifted and the next revolution in China is already darkening the horizon.
The story starts in the Song Dynasty, which reached its zenith in the mid-1200s.
I've been pondering the excellent 1964 history of the Southern Song Dynasty's capital of Hangzhou, Daily Life in China on the Eve of the Mongol Invasion, 1250-1276 by Jacques Gernet, in light of the Chinese government's unprecedented "Social Credit Score" system, which I wrote about in May 2018: Kafka's Nightmare Emerges: China's "Social Credit Score".
The scope of this surveillance is so broad and pervasive that it borders on science fiction: Inside China’s Dystopian Dreams (NY Times)
In the Song Dynasty, arguably China's high water mark in many ways (before the Mongol conquest changed China's trajectory), social control required very little force. The power of social control rested in the cultural hierarchy of Confucian values: one obeyed the family's patriarch, one's local rulers and ultimately, the Emperor.
Author Edward Luttwak made the distinction between force and power in his fascinating book The Grand Strategy of the Roman Empire: From the First Century CE to the Third: power is persuading people to cooperate, force is making them obey.
Power is people choosing of their own accord to comply, for reasons they find sound and that serves their self-interest; there is little need for the application of force.
Power is highly leveraged; a relatively small police/military and judiciary is all that's needed. Force, in contrast, doesn't scale: it's enormously costly in capital and labor to monitor an entire populace and impose control and obedience.
While the Song Dynasty had a police force, a judiciary and an army, the populace generally managed itself via an internalized secular religion that placed the father, civil authorities and the Imperial state at the top of a natural order that enabled the harmony of Heaven and Earth. To disobey would be to threaten the harmony that served everyone.
In the early days of the Communist revolution (1949 to 1965), the majority of China's populace embraced the values and authority of the Communist regime, despite the hardships and setbacks of the Great Leap Forward (millions dying needlessly of starvation) and other centralized incompetencies.
But the Cultural Revolution that was launched with Mao's blessing in 1966 was only embraced by the youthful Red Guards. The rest of the society had to be monitored and forced to comply with the mercurial injustices and arbitrary nature of the Cultural Revolution, which imprisoned millions of China's most accomplished citizens in various forms of forced deprivation: house arrest (the most mild); forced relocation to rural labor, re-education (i.e. torture) and imprisonment. Many were killed without even the semblance of a judicial process.
In broad brush, the Cultural Revolution broke the power of the Communist Party and the government. Thereafter, the Party and the state only had force at their disposal.
The rise of broadly distributed prosperity (Deng's "to get rich is glorious") replaced the failed power of Communist ideology with a new social contract: obey the party and the state and you'll become prosperous.
If this new contract was rock-solid, why would China's government need the vast surveillance system they're putting in place for fine-grained control of the populace? Clearly, the leadership (Xi and his cabal) are aware that the prosperity is not permanent, nor is it being distributed evenly enough to harmonize Heaven and Earth.
Sensing their lack of social power, they are turning to technology to create a vast system of coercion (force).
Force is not a substitute for power. For this reason, the "Social Credit Score" system smacks of desperation. Xi et al. see the storm clouds on the horizon and are moving quickly to install an autocratic system of Total Information Awareness and Control.
But China's history is clear: the culture and the people prefer a system in which power is maintained through social norms, not force. With Communist ideology a dead force, and prosperity about to wither, what's left? A system of autocratic obedience backed by Orwellian technology and gulags.
The Mandate of Heaven will be withdrawn, and the autocratic regime overthrown. Perhaps the replacement social contract and political structure will still be called "Communist," but it will be a very different social contract and political structure than the current version.
Of related interest:



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Wednesday, October 17, 2018

Is the Greatest Bull Market Ever Finally Ending? (Hint: Follow the Money)

The key here is the gains generated by owning US-denominated assets as the USD appreciates.
Is the Greatest Bull Market Ever finally ending? One straightforward approach to is to follow the money, i.e. global capital flows: assets that attract positive global capital flows will continue rising if demand for the assets exceeds supply, and assets that are being liquidated as capital flees the asset class (i.e. negative capital flows) will decline in price.
Global capital flows are difficult to track for a number of reasons. A significant percentage of global mobile capital is held in secretive offshore tax havens and "shadow banking," and tracking global corporate capital flows is not easy. Capital held in precious metals may not be reported, and assets such as enterprises and collectible art may be grossly undervalued for tax purposes.
Toss in shadow holding companies, LLCs with obscure trails of ownership, etc. and a definitive account of global capital flows is ultimately a guesstimate.
Despite the limitations of tracking global wealth, Credit Suisse Research Institute's (CSRI) issued Global Wealth Report 2017 gives us some clues about where capital is flowing in and where it's leaving for safer, higher-yield climes.
The first step in measuring global capital flows is to note that conventional capital is denominated in currencies which fluctuate in relative value. Of the roughly $300 trillion in global assets (Credit Suisse pegs the total in 2017 at $280 trillion, but other estimates range well above $300 trillion), about $8 trillion or so is in precious metals, and a tiny sliver is in cryptocurrencies. (Bitcoin's total market capitalization is currently around $112 billion and Ethereum's market cap is around $21 billion--signal noise in the $300 trillion sloshing around the world seeking safety, low/zero taxes, capital gains and high yields.)
Foreign exchange matters. Say a money manager moves $1 billion out of U.S. Treasuries (denominated in the US dollar, USD) into bonds paying a hefty 15% in annual yield denominated in an emerging market currency.
If that currency loses 20% of its value vis a vis the USD annually, the capital loses 5% of its value / purchasing power despite the hefty yield.
The trick is to arbitrage yields and currencies so borrow in cheap currencies that are declining and buy higher-yielding assets denominated in currencies that are rising in value. For example, if a manager moved $1 billion out of a bond paying 4% in a currency that subsequently lost 30% of its value vis a vis the USD into a US high-yield bond paying 6%, the manager picked up 30% gains in FX and 2% in yield for a total gain of 32%.
For a variety of reasons, yields are rising in the US and the USD is gaining value relative to other currencies. Combine higher yields, relatively predictable safety and an appreciating currency, and the US has been attracting global capital.
These charts from Credit Suisse reflect this capital flow into the US and out of other nations. The phenomenal expansion of wealth in China is put into a different perspective here:with 4 times the population of the US and an economy roughly comparable in size, China's wealth has registered only 20% of the gains accrued by the US.
If global capital was buying empty flats in China, etc., and selling US-based assets, these numbers would be reversed. This suggests mobile capital is leaving China and other nations and moving into US-denominated assets.
Most of the gains in global wealth have accrued to the US and to the top 1%.The wealthier the entity / individual, the greater the rewards and opportunities for moving wealth into tax havens and safe havens such as Switzerland and the US, which is a massive tax haven in its own right.
Here's another snapshot of the global wealth pyramid: since the Pareto Distribution applies to wealth and income, we can guesstimate that roughly 40% of all global wealth is held by the top .2% or so. The top 8% (350 million people) own 85% of all global wealth.
Where is all this money coming from? Largely from debt which has expanded by over $100 trillion since 2001:
Corporations have poured earnings into stock buybacks at a torrid pace:
The net result is a gargantuan inflation in assets while real-economy wages and GDP have stagnated.
As long as US yields and the USD are ticking higher while the US economy continues expanding opportunities for capital to earn relatively safe yields and capital gains, capital will continue to flow into US assets, despite the nose-bleed valuations of assets such as stocks and left / right coast housing.
The key here is the gains generated by owning US-denominated assets as the USD appreciates. A 3% yield in US Treasuries isn't all that great, but add in 10% annual FX gains and you're netting a very healthy 13% annual return in relatively safe and liquid assets.
The greater the sums at risk, the more compelling these attributes become. If you need to protect $25 billion, and you want a liquid market you can exit without crashing the bid and exposure to FX capital gains, then USD-denominated bonds and stocks are an attractive option at this juncture.
Empty flats in China with zero yield and the potential downside of yuan devaluation--not so much.
In summary: follow the money. Smart money is mobile, opaque and constantly on the move seeking safety, tax shelters, yield and capital gains. If mobile capital continues flowing into US assets such that demand exceeds supply, the Bull Market will continue sloshing higher. Once supply exceeds demand and capital starts liquidating US assets, the Bull Market will end, perhaps with a whimper (stagnation) or with a bang (crash). Capital flows will dictate the outcome.


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Sunday, October 14, 2018

How Many Households Qualify as Middle Class?

By the standards of previous generations, the middle class has been stripmined of income, assets and purchasing power.
What does it take to be middle class nowadays? Defining the middle class is a parlor game, with most of the punditry referring to income brackets as the defining factor.
People tend to self-report that they belong to the middle class based on income, but income is not the key metric: 12 other factors are more telling measures of middle class membership than income.
In Why the Middle Class Is Doomed (April 17, 2012) I listed five minimum threshold characteristics of membership in the middle class:
1. Meaningful healthcare insurance (i.e. not phantom insurance with $5,000 deductibles, etc.) and life insurance.
2. Significant equity (25%-50%) in a home or equivalent real estate
3. Income/expenses that enable the household to save at least 6% of its income
4. Significant retirement funds: 401Ks, IRAs, etc.
5. The ability to service all debt and expenses over the medium-term if one of the primary household wage-earners lose their job
I then added a taken-for-granted sixth:
6. Reliable vehicles for each wage-earner
Author Chris Sullins suggested adding these additional thresholds:
7. If a household requires government assistance to maintain the family lifestyle, their Middle Class status is in doubt.
8. A percentage of non-paper, non-family home hard assets such as family heirlooms, precious metals, tools, etc. that can be transferred to the next generation, i.e. generational wealth.
9. Ability to invest in offspring (education, extracurricular clubs/training, etc.).
10. Leisure time devoted to the maintenance of physical/spiritual/mental fitness.
Correspondent Mark G. recently suggested two more:
11. Continual accumulation of human and social capital (new skills, networks of collaborators, markets for one's services, etc.)
And the money shot:
12. Family ownership of income-producing assets such as rental properties, bonds, etc.
The key point of these thresholds is that propping up a precarious illusion of consumption and status signifiers does not qualify as middle class. To qualify as middle class (that is, what was considered middle class a generation or two ago), the household must actually own/control wealth that won't vanish if the investment bubble du jour pops, and won't be wiped out by a medical emergency.
In Chris's phrase, "They should be focusing resources on the next generation and passing on Generational Wealth" as opposed to "keeping up appearances" via aspirational consumption financed with debt.
What does it take in the real world to qualify as middle class?
Here are my calculations based on our own expenses and those of our friends in urban America. We can quibble about details endlessly, so these are mid-range estimates. These reflect urban costs; rural towns/cities will naturally have significantly lower cost structures. Please make adjustments as suits your area or experience, but please recall that tens of millions of people live in high-cost left and right-coast cities, and millions more have high heating/cooling/commuting costs.
The wages of those employed by Corporate America or the government do not reflect the total cost of benefits such as healthcare insurance. Self-employed people like myself pay the full costs of benefits, so we have to realize there is no ideal average of household expenses. Some households pay very little of their actual healthcare expenses, other pay for part of these costs and still others pay most or all of their healthcare insurance and co-pays.
1. Healthcare. Let's budget $15,000 annually for healthcare insurance. Yes, if you're 23 years old and single, you will pay less, so this is an average. If you're older (I'm 64), $15,000 a year only buys you and your spouse stripped down coverage: no eyewear, medication or dental coverage--and that's if your existing plan is grandfathered in. (If you want non-phantom ObamaCare coverage, the cost zooms up to $2,000/month or $24,000 annually.)
Add in co-pays and out-of-pocket expenses, and the realistic annual total is between $15,000 and $20,000 annually: Your family's health care costs: $19,393 (this was before ACA).
Let's say $15,000 annually is about as low as you can reasonably expect to maintain middle class healthcare.
2. Home equity. Building home equity requires paying meaningful principal. Let's say a household has a 15-year mortgage so the principal payments are actually meaningfully adding to equity, unlike a 30-year mortgage. Let's say $5-$10,000 of $25,000 in annual mortgage payments is interest (deductible) and $15-$20,000 goes to principal reduction.
3. Savings. Anything less than $5,000 in annual savings is not very meaningful if college costs, co-pays for medical emergencies, etc. are being anticipated, and $10,000 is a more realistic number given the need to stockpile cash in the event of job loss or reduced hours/pay. So let's go with a minimum of $5,000 in cash savings annually.
4. Retirement. Let's assume $6,000 per wage earner per year, or $12,000 per household. That won't buy much of a retirement unless you start at age 25, and even then the return at current rates is so abysmal the nestegg won't grow faster than inflation unless you take horrendous risks (and win).
5. Vehicles. The AAA pegs the cost of each compact car at $7,000 annually, so $14K per year assumes two compacts each driven 15,000 miles. The cost declines for two paid-for, well-maintained clunkers and increases for sedans and trucks. Let's assume a scrimp-and-save household who manages to operate and insure two vehicles for $10,000 annually.
6. Social Security and Medicare Taxes. Self-employed people pay full freight Social Security and Medicare taxes: 15.3% of all net income, starting with dollar one and going up to $127,200 for SSA. But let's take a household of two employed wage-earners and put in $8,000.
Property taxes: These are low in many parts of the country, but let's assume a level between New Jersey/New York/California level of property tax and very low property tax rates: $10,000 annually.
Income tax: There are too many complexities, so let's assume $2,000 in state and local taxes and $5,000 in federal taxes for a total of $7,000.
7. Living expenses: Some people spend hundreds of dollars on food each week, others considerably less. Let's assume a two-adult household will need at least $12,000 annually for food, utilities, phone service, Internet, home maintenance, clothing, furnishings, books, films, etc., while those who like to dine out often, take week-ends away for skiing or equivalent will need more like $20,000.
8. Donations, church tithes, community organizations, adult education, hobbies, etc.: Let's say $2,000 annually at a minimum.
Note that this does not include the cost of maintaining boats, RVs, pools, etc., or the cost of an annual vacation.
Here's the annual summary:
Healthcare: $15,000
Mortgage: $25,000
Savings: $5,000
Retirement: $12,000
Vehicles: $10,000
Property taxes: $10,000
Income and Social Security/Medicare taxes: $15,000
Living expenses: $12,000
Other: $2,000
Minimum Total: $106,000
Vacations, travel, unexpected expenses, etc: $5,000.
Realistic Total: $111,000
That's almost double the median household income of $59,000. Note that this $111,000 household income has no budget for lavish vacations, luxury vehicles, large pickup trucks, boats, second homes, college expenses, etc. There is no budget for private schooling. Most of the family income goes to the mortgage, taxes and healthcare. Savings are modest, along with living expenses and retirement contributions. This is a barebones budget.
$111,000 household income is right about the cut-off point for the top 20% of household income. How close are you to the top 1%?
Toss in a jumbo mortgage, college tuition paid in cash, an aging parent to care for or any of a dozen other major expenses and the minimum quickly rises to $155,000, which puts the household in the top 10% of household income.
How can we even talk about a "middle class" when the minimum thresholds put the household in the top 20%? And we haven't even considered the ultimate  minimum threshold of middle class membership: family ownership of income-producing assets such as businesses, rental properties, bonds, etc.
The key takeaway of this chart is the concentration of the household wealth of the bottom 90% in the family home. The wealthy and upper-middle class own income-producing assets, while the bottom 90% own some life insurance, cash and pensions, but their largest asset by far is the family home. (They also "own" a tremendous amount of debt.)
The problem is life insurance, cash and pensions don't generate much income, and neither does the family home. Households counting on the equity in bubble-priced housing are not factoring in the unwelcome reality that all bubbles pop, even housing bubbles that can't possibly pop.
To have the equivalent security and generational wealth enjoyed by the middle class two generations ago, households have to check off all 12 minimum thresholds. I'm not sure there is a "middle class" any more; if we use these 12 minimum thresholds, the U.S. now has a super-wealthy class (top .01%), a very wealthy class (top .5%), an upper class (top 9.5% below the wealthy) and the rest (bottom 90%), with varying levels of security and assets but at levels far below what median-income households enjoyed in bygone eras.
By the standards of previous generations, the middle class has been stripmined of income, assets and purchasing power.


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