The Crash On Wall Street

A summary of Prof Wen Zhao’s analysis:

The Dow Jones crashed more than 2,000 points on Monday 9 March 2020. Trading had to be suspended for 15 minutes to calm sentiments and also to rule out computer glitches. The obvious explanation for this crash is the coronavirus fear reaching a peak as Europe and America grapples with the pandemic. Reports that China may be beating COVID-19 fell on deaf ears as few investors trust China’s data. We’ll come to that in a moment.

Prof Wen Zhao believes that this crash is due more to the crash in oil prices than fears over the pandemic. The short term trend for the market is downwards. How does a crash in oil prices affect China? For this we need to go back to Phase One of the trade deal between the US and China.

The deal takes steps to root out several practices that irked the White House and bipartisan members of Congress, including intellectual property theft and forced technology transfers, in exchange for Chinese market access, according to text released by the White House. It also details a $200 billion increase in Chinese purchases of US goods over two years — a priority for Trump. What is the most valuable commodity that China buys from the US that can balance the trade deficit? Oil. But if China buys oil from the US, Russia is going to suffer.

Some background info from The New York Times 9 March 2020

For the last three years, two factors have been hugely influential in the oil markets. The first has been the surge of shale oil production in the United States, which has turned the country from a large oil importer to an increasingly important exporter. The second is the alliance between Saudi Arabia and Russia, which recently have cooperated in trimming production to try to counter shale’s impact.

Now that cooperation between two of the world’s three largest oil producers — the third is the United States — appears to be at an end. Saudi Arabia, as the dominant member of the Organization of the Petroleum Exporting Countries, last week proposed production cuts to offset the collapse in demand from the spreading coronavirus outbreak. Russia, which is not an OPEC member, refused to go along. And the impasse has turned into open hostilities.

The standoff was ominous for the industry. Not only had OPEC and a wider group of producers — together known as OPEC plus — failed to agree on new cuts, but they had also failed to sign off on the extension of 2.1 million barrels a day in previous trims that would expire at the end of March. That created the danger of a tremendous flow of oil coming onto a market that was already hugely oversupplied and experiencing a steep slump in demand.

The natural gas pipeline from Russia to China was only opened in December 2019. Only a few months after operation, China is going to buy oil and gas from the US instead. Understandably, Putin is enraged. One retaliative strategy the Russians could adopt to prevent a wastage of their natural gas pipeline is to destroy the market for oil by increasing output. On 11 March 2020, Saudi played the same game and increased their output to 13 million tonnes a day. They are even offering a discount to their regular customers. With this latest move, the price of oil may dip below $30 a barrel.

Of course, slashing prices won’t benefit any of the producers. The Saudis are hoping to squeeze Russia’s profits and bring them back to the negotiating table so they could set a new price for oil. Meanwhile, it has been estimated that if oil price drops below $58 a barrel, Saudi would be in deficit. The Russian economy, on the other hand, is less dependent on oil. Even at $30 a barrel, it would still be pretty much business as usual in Russia. But Saudi has an edge over Russia in another area. It has more customers.

As neither country stands to gain from this price war and the US is likely to suffer quite badly, there is a chance that they will come to an agreement. As for oil producers in the US, they have the advantage of low cost extraction technology. During the last crash in 2014, most US oil companies were able to hang on for at least 2 years. Nevertheless, Trump has every reason to pressure China into buying close to $200 billion worth of oil from the US.

Still, Xi Jinping is caught between a rock and a hard place. He could either offend Russia, its political ally or offend the US, its economic ally. Stocks, like water, will find their own level. They will eventually bottom out. Low oil price supports the US economy, lowering production costs. As companies move back to the US from China, some US industries stand to gain from low oil prices. Prof Wen Zhao believes that money that has been drained out of Wall Street will eventually return to Wall Street because there is no better place in the world to park it.

This is evidenced in the aftermath of the 2008 subprime mortgage crisis. Money that have fled from Wall Street ended up in even less reliable markets like European and emerging markets like China. That was when China took bold steps to compete with America for world leadership. China was very attractive till 2015 when it overstretched itself. It’s now a ticking time bomb.

In bear market now, Prof Wen Zhao estimates that Wall Street may show signs of recovery from May. As for China, resuming production may not help much in its recovery as overseas orders are few at this time and may get even fewer.

In recent days, communist cheerleaders appear to be gloating as the pandemic spreads like wild fire in Europe and America. The long term outlook for the American economy, however, is good. China’s economy, on the other hand, is unlikely to recover any time soon. Going back to Phase One of the trade deal, the agreement may have been inked, but it’s not known when China could import that $200 billion worth of goods from the US. It’s an important lesson for Trump. Agreements with China don’t count and in recent weeks, they have taken a step in the direction of recognising Taiwan even if it means offending China.

The US House of Representatives on 4 March 2020 unanimously passed the Taiwan Allies International Protection and Enhancement Initiative Act (TAIPEI Act). The lightly revised TAIPEI Act was passed with a unanimous vote of 415 to zero. The bill aims to discourage Taiwan’s diplomatic allies from cutting ties with the island country due to pressure from Beijing.

Taiwan may be the place to watch in the coming months.