For this week’s Big Interview, I sat down with our resident sinologist, Scott Chan.

Scott Chan (pictured here) is the lead analyst for our publications Real World Investing and The Complete Investor. Scott also contributes to Personal Finance.

Scott moved from China to the U.S. with his family at the age of 10. He earned undergraduate degrees from New York University followed by an MBA degree from the Zicklin School of Business at Baruch College.

A truly multicultural person, Scott reads Chinese and speaks fluent Mandarin and Cantonese Chinese. Those are handy skills nowadays.

Most of my questions for Scott pertained to the escalating tensions between America and its most formidable economic rival, China.

John Persinos: President Trump and Chinese leader Xi Jinping are scheduled to meet at the G20 conference, June 28-29, in Osaka, Japan. Hopes are high on Wall Street that the two leaders will resolve the trade conflict at the G20. What are your expectations? If Trump and Xi don’t come to terms, will stocks probably sell-off?

Scott Chan: I don’t expect a deal to happen at the G20. I don’t think the market expects a deal either. I think the market is more relieved than anything that the two sides will talk again. After all, there can’t be a deal unless there’s dialogue first.

As long as the two presidents emerged from their meeting with some pledge to continue to work things out and show some signs that the talks are moving, the market should be fine with that.

Even before the planned G20 meeting of the presidents, the teams from both sides will meet to resume trade talks. I expect they will do most of the heavy lifting in the negotiation process.

Analysts are downgrading corporate earnings expectations for the second quarter, largely because of slowing global growth and the damage to business conditions from tariffs. What are your expectations for second-quarter profits for the S&P 500?

In the first quarter, S&P 500 companies collectively had their first year-over-year EPS decline since 2016, dropping 0.3%. Yet this wasn’t so bad compared to the glooming forecasts heading into the earnings season—I had seen forecasts for a drop of as high as 4%.

As we progress through the final days of the second quarter, the consensus for the second quarter seems to be a drop somewhere near the 2.5% mark. Feeding into the expectation is that many companies have lowered the bar for themselves by cutting guidance.

Generally, companies prefer to keep expectations low to make it easier to “over deliver.” When it’s all said and done, I expect the actual decline to be 2% or better. Provided no negative surprise comes from the trade talks, the market should take the earnings season in stride.

The EPS change forecast may look especially bad compared to the strong profit growth rates last year, but the 2018 numbers were inflated by the tax cut. Companies enjoyed lower tax rates in 2018 compared to 2017. Companies don’t have this comparison boost this year.

In response to U.S. tariffs, China is threatening to restrict its exports of rare earth elements. Many analysts consider this move to be China’s “trump card,” pun intended. If America’s access to rare earth metals is restricted, how serious would it affect our economy? Or is China bluffing?

China controls less than 40% of the world’s reserves of rare earth elements (REE). However, where China has the stranglehold on supply is processing. It controls nearly all of the world’s REE processing capacity.

Every non-Chinese REE producer (including America’s only REE mine, in California) has to ship what they produce to China for refining into consumable and high-value forms. Processing REE is an expensive and dangerous endeavor that produces radioactive and chemical byproducts harmful to the environment, which is why the U.S. has been happy to let China do the work.

Some 80% of U.S. REE imports come from China. So clearly China has the ability to cut off supply and force REE prices to soar, disrupting many industries and threatening national security (most, if not all, advanced U.S. weaponry uses some components made using REE).

Although the U.S. government has known about the vulnerability for many years, it hasn’t been able to develop any solution. The government does have some stockpiles, but most of it isn’t in usable form. It’s unknown how long stockpiles could meet demand if the China tap is turned off.

If there’s a silver lining to this, it’s that China probably wants to dangle the threat more as a negotiation tactic than to actually carry the threat through. To restrict supply for a significant amount of time would light a fire under other countries and accelerate the development of more processing plants, which in the long run would reduce China’s grip on REE and cost them a valuable bargaining chip.

China has been punishing U.S. farmers in Trump-supporting “red states” by finding alternative sources for key agricultural products, such as soybeans. Will the damage to U.S. agricultural exports prove long-lasting or can it be quickly reversed?

If we get a resolution to the trade dispute, the agricultural market should recover without too much trouble. I expect an eventual trade agreement (assuming there will be one) would include a commitment from China to buy certain amounts of agriculture products from the U.S. If the trade war continues indefinitely though, then the pain will persist because the Chinese market is so huge.

Many analysts are sounding the alarm about China’s so-called “debt bomb.” Is this a threat to the world’s second-largest economy and could it trigger a global financial crisis? Or are concerns about Chinese debt overwrought?

Although we shouldn’t just dismiss China’s elevated debt level, I doubt China’s debt will trigger anything close to the financial crisis of about 10 years ago.

Unlike, say, America’s debt, most of China’s debt is owed to itself. China’s foreign debt is only about 13% of GDP, very low by world standards.

China also has a high domestic savings rate hovering near 50% of GDP, roughly twice the world average. In addition, unlike the U.S., China’s one-party authoritarian government gives Beijing more control over its economy.

China will do everything necessary to avoid a financial crisis. The best way for the Communist Party to stay in power and avoid social unrest is to keep a stable economy and its people’s wallets and bellies full.

If China just let its debt—and most importantly high-risk debt—continue to balloon unabated, eventually events would spiral out of control despite the mitigating factors I’ve just mentioned. However, Beijing has actively taken steps to curb risky lending practices. It’s a challenge to balance risk with growth, but the one-party system allows China to make decisive moves.

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