Making Sense of a World in Kaos
- The interconnection between macroeconomics and geopolitics is stronger today than ever before.
- Although our nations, economies and cultures are also quite intertwined, we can expect powerful institutions to act in their self-interest.
- Investor and thought leader Michael Kao calls our contemporary milieu a “geopolitical mosh pit,” in part because of the tension between China and the West.
In a world intricately connected by vast networks of political, economic and cultural ties, geopolitics has taken on fresh significance. As we grapple with the challenges and opportunities that technology and globalization pose, the power centers of government and business — like central banks and OPEC+ — act in their own interests first.
Michael is a 30-year finance veteran with a resume that includes Canyon Capital Advisors, Goldman Sachs and his own firm, Akanthos Capital Management. He “retired” in 2019 to manage his family office and share analysis via Substack, Twitter and the Kaos Theory podcast.
Since late 2022, Michael has been concerned about China’s “vulnerable” debt situation. He thinks the People’s Bank of China (PBOC) balance sheet is a “complete facade” and that the nation is “Enron writ large.”
China manages its national budget with a “centrally planned, investment-led economic approach which is all financed by all these state-owned enterprises, the [infrastructure initiative] ‘One Belt, One Road’ projects [and] Local Government Financing Vehicles [LGFVs]. It’s all off-balance-sheet. But they have a huge debt problem,” Michael says.
In the short term, he sees oil and the Chinese yuan in a “dangerous short-term doom loop.” Coupled with the tense relationship between China and Taiwan, as well as China’s declining birth rate, “doom” doesn’t seem like hyperbole.
In fact, Michael worries that a major deflationary bust caused by China could be a “global black swan event.”
What would that look like, and what does it mean for investors?
Michael joined Cem Karsen and me for an episode of Top Traders Unplugged’s Global Macro series to talk about his big-picture macro views, the relationship between the U.S. and China, the state of the oil market and much more. Here, I recap some of his insights on China’s debt crisis, the interplay between the yuan and the dollar and the influence of OPEC on our complex web of geopolitics.
An ‘Odyssey’ of currency
Michael likes to use an analogy to explain the PBOC’s quandary: It’s akin to Homer’s Odysseus “trying to cross the strait between the Scylla and the Charybdis,” he argues. In his analogy, Odysseus is the PBOC, the Scylla monster is a weak yuan and the Charybdis is a strong yuan.
“A weak yuan would mean [the central bank] could potentially import commodity-based inflation since China imports 90% of its oil, which is dollar-based. But it also potentially sets off its debt bomb.”
That’s because we don’t know just how much U.S. dollar-denominated debt China carries.
“A lot of people say that it’s all local-currency-based. I know, though, that at least all of the One Belt, One Road debt is dollar-based. So I think they have the potential.”
He calls the U.S. dollar a “ball in a China shop” — a wrecking ball, that is.
Michael cites the U.K.-based economist Andrew Hunt, who conducted a study of 36 of the largest banks in China, to illustrate his point.
“The discrepancies that he and his team found, versus the publicly available balance of payments data, show a [difference] of $4 trillion,” Michael says. “That’s a scary thing to me, in and of itself.”
A strong yuan is bad for China because its entire economy is “export-driven,” targeting the Western consumer, he notes.
“We’re in a competition with the world central banks to see who can out-hawk each other, so that’s not going to hold.”
He also thinks China will have serious pressure to devalue its yuan if Western consumers “start to really buckle” — in other words, if consumer spending plummets, as it might in a recession.
The monster match
Michael predicts China will be “steering the ship closer to that Scylla monster” soon: that the yuan will lose value along with plunging oil prices.
“Oil has collapsed despite two OPEC cuts,” he says. “I’ve written that I think they are premature — because OPEC cuts are themselves restrictive and they’re basically fighting the Fed.”
He is concerned about another possible black swan event in the petroleum markets: a rift between Saudi Arabia and Russia.
“We all saw what happened in COVID … Before OPEC became OPEC+, Saudi Arabia and Russia got into a pissing match over market share and absolutely destroyed the oil market,” he explains. “That’s when WTI went to negative $38 a barrel.”
Michael thinks OPEC infighting “emboldens the PBOC to weaken the yuan without worrying about importing commodity-based inflation.”
Will China launch a ‘kinetic escalation’ in Taiwan?
The fragile relationship between China and Taiwan only complicates matters. One of our guests from last year, Peter Zeihan, who has long believed in the possibility of peace between the two nations, just called the likelihood of China invading its neighbor a “coin toss.”
Michael, who is a fan of Peter Zeihan’s books, says the author’s long-term geopolitical predictions have been quite prescient.
Paraphrasing Zeihan, Michael says that China (despite its size) has “a serious demographic issue” and is “woefully unprepared to start a big, kinetic escalation across the street.”
But as Michael notes, Zeihan makes the point that Xi, like Vladimir Putin, has isolated himself by suppressing any dissent.
“Who knows what goes on in the mind of a dictator who has cut himself off from a good feedback loop of information?” Michael asks.
To Michael, a possible invasion is a “gray rhino risk” — which he defines as a risk that is “poo-pooed [and] discounted by everybody.”
However, the political implications of that rhino would be devastating.
“It would be very, very hard for the U.S. to intervene because the world will say [China and Taiwan] want to get together peacefully,” he explains. “But I think geostrategically, it would be disastrous for the U.S. and the West.”
That being said, he thinks one of the biggest geopolitical risks for the U.S. and the West “is actually a bloodless coup scenario.”
Semiconductors and superpowers
Because so many consumer goods are made in Asia (and because it’s home to a huge percentage of the global population), instability there has knock-on effects all over the rest of the world.
Taiwan Semiconductor Manufacturing Company (TSMC) is one of the world's largest and most advanced semiconductor manufacturing companies. TSMC’s chips are integral to many of our everyday electronic devices, including smartphones, computers, and automotive systems. Apple, NVIDIA and Qualcomm all rely on TSMC’s manufacturing capabilities. But the Chinese government considers Taiwan a part of its territory — and the threat of a military conflict between the two nations is very real.
This ongoing political tension poses risks to TSMC, as well as the entire global semiconductor supply chain.“TSMC alone is a very dangerous choke point in the semiconductor supply chain,” Michael argues. “But then Taiwan’s position in the first island chain represents a crucial way for China to break out and project power outside of that.”
Cem points out that even though China is structurally weak from a geography, commodity and demographic perspective, a hot war between China and Taiwan would be an alarming development for their neighbors — including Japan, South Korea, Vietnam and the Philippines.
“I think it’s an incontrovertible reality that if [the Chinese] lose, as projections say, about 500 million in population in the next 25 years,” says Cem. “[That’s] just based on the one-child policy and demographic shifts, especially without any major immigration, which they don’t have — they have an input problem.”
China’s labor force is “one of its few sources of strength and has been for some time,” Cem adds. “I think that’s what makes the semiconductor issue so important: It’s a labor replacement.”
The rise of AI only underscores the need for China to embrace technology as its labor pool dwindles.
“Maybe, to your point, there may be a reconciliation,” Cem tells Michael. “But I don’t think they’re willing to let Taiwan move away [from its commitment to independence]. It’s too much of a risk, given how fragile their position is as it stands.”
Accuracy vs. precision
As always, geopolitics is an imprecise and sometimes unpredictable discipline.
“I always used to tell my analysts: I would much rather be generally accurate than precisely wrong,” Michael says. “What I always worry about is getting lost in the weeds and looking at a specific set of data without considering a broader framework. I think that is more important than ever.”
After all, his work is about predicting the future.
“As an analyst and investor, you’re trying to anticipate where the puck is going,” he adds. “Not where the puck has been.”
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.
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