Geopolitics And Financial Markets Coming Together: The $US Gives China Fits, But The People’s Liberation Army Could Change That

Yesterday saw another volatility spike in equity markets that built up on dislocation in the currency markets, hinting at a repeat of the fiery experience in March 2020. Overnight the markets continued in the red but by late morning they were green and currencies stablized. The volatility risk premium points to a higher market over the next few days, but my technical reading of key stocks in the S&P 500 is neutral. Yesterday's cross-asset action brought one positive factor for US stocks. The US yield curve fell and in the current context that is bullish. Expect the S&P 500 to be range-bound over the next few days.

China is now giving the all-clear to its coal companies to produce, which may be due to the spike in volatility in financial markets and the associated fears among investors that the global economy is slowing precipitously. In particular the currency markets suffered from a spike in the cross-currency basis due to a dollar shortage in overseas markets, an unwelcome reminder of the contagion that spread in 2020 when the Fed had to jump in with massive monetary stimulus to stop the slide in global equities. Ahead of a week-long holiday China is trying to stabilize expectations by lightening up on its own private sector, which is critical since the Communist Party cannot afford to see unemployment rise.

The geopolitical calculus is critical since China is now faced with a more antagonistic US that could hurt China’s trade surplus with only modest repercussions for American politicians. Biden has positioned the Democrats to carry on the Trump mantle of trade wars and military posturing, which likely forces the Republicans even further to the right to reclaim the China issue. Since China doesn’t want to slim down its export machine at the same time its clamping down on its crown jewels in the private sector, it not only depends on its trade surplus for a large segment of its GDP but also on the $US to make that trade happen. This is because the $US is critical to global trade, and is the only reserve currency that nations rely on. The reason the Yuan can’t become a major reserve currency is the Chinese trade surplus, which accumulates $US instead of sending out Yuan to the world. So key for China is slowly developing the Chinese consumer to divert its GDP more inward (like the US) and to project military might that would rival the US and thus make countries confident in a bipolar world of global security, and so willing to use the Yuan more and the $US dollar less. China has built up the PLA but so far has only one modern aircraft carrier and relatively modest capabilities, and virtually no combat experience since the disastrous war with Vietnam in the late 1970s. Two ways it can project military might despite these deficiencies are to constantly harass Taiwan, and to make itself an arctic power like some but not all of the major military players. If China can become a major player in the arctic despite not being a arctic nation, it will send a signal that the major players have compromised with China militarily.

Brookings notes: “The recent deployment of four Chinese People’s Liberation Army Navy (PLAN) ships to the waters off Alaska’s Aleutian Islands further highlights the growing chessboard of naval operations in the Pacific. The message from China was clear — that they maintain the ability to strategically challenge the United States homeland and that their naval operations are increasingly capable of long-range sustained deployments. We should not, however, assume that this message is meant for the U.S. alone, nor assume that this is only a tit-for-tat in response to U.S. freedom of navigation operations in the South China Sea. As Elizabeth Buchanan, a lecturer in strategic studies at Deakin University in Australia, told Arctic Today in a recent interview, this may be a signal to Russia as well as the U.S. that Chinese access to the Arctic is not negotiable.”

That China is willing to strain its relations with quasi-ally Russia is testament to the geopolitical-economic quandary China is in because of America is the liberal capitalist icon and still the top power in the world. So far China is shrewdly making moves to change that, while investors are generally sanguine since Chinese growth is well above nearly every nation except India.

My current market positions include a large cash position, and the following holdings: Activision (ATVI), Amgen (AMGN), Apple (AAPL), Gibraltar Industries (ROCK), Johnson & Johnson (JNJ), 3M (MMM), Pfizer (PFE) and a hedged position in the S&P 500 (UPRO and SPXU).