Geopolitical Developments: China Is Slowing But Ironically That Feeds Bullish Sentiment

A Bloomberg report that Chinese homes sales are slumping as the Evergrande saga deters buyers isn’t roiling either the Chinese Communist Party (CCP) or the markets this week. Global growth and the profits that swing with it may take a small hit but investors are sanguine as we rebound from September’s swoon. The volatility risk premium points to a higher market over the next few days (though volume may be light since the VRP could easily reverse and catch investors offside), 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 action in major currencies indicates the $US is weak. But there was also one negative factor across global asset classes: the US yield curve is bear flattening. Expect the S&P 500 to be range-bound over the next few days as the Autumn consolidation continues.

China’s handling of Evergrande and the broader property sector has stunned investors as the CCP has clearly signaled it’s tolerating lower growth as the price for instilling some discipline in the financial and real estate sectors. An op-ed in the Financial Times notes “…political analysts argue there is growing evidence that the leadership’s campaigns to reshape the economy are constraining the countercyclical responses that markets are accustomed to seeing.” Given the huge number of risks the CCP has to handle, the fact that it’s willing to endure lower growth is testament to simple confidence. The CCP believes not only does it possess all the technical, cultural and military solutions to its internal problems, but that the citizenry is similarly patient enough to endure a temporary slowdown in growth. This political confidence signals to investors that Chinese growth will pick up next year and carry much of the EM world along with it. That is one reason I’ve been calling the recent downturn a consolidation rather than the start of a bear market.

Along with confidence comes arrogance, so expect CCP to routinely say and do things that are offensive and unpredictable by western standards. Partly this is due to the high pressure on CCP given the large plate of issues they face, and partly it’s due to lack of experience and sophistication. Investors can expect that while the Chinese will hurt and bluster the US when it can, they won’t harm the golden goose of trade by doing irreparable harm to America, and that’s another reason to be bullish long-term on the markets. Provocations against Taiwan and Japan will not lead to war or even trade wars, but they will boost China’s global standing as America and Europe have no idea how to keep China in line with common standards of decency.

China will gain stature at America and Europe’s expense but one area that can’t either be smothered or finessed is North Korea (DPRK). Kim Jong Un’s recent erraticism is off the charts and there is little the CCP can do to tame their fellow communist. The reason is that any instability in the DPRK creates a potential migration issue for Northeastern China, which is a relatively backward part of China to begin with. The CCP wants KJU to liberalize and get his economy more in line with China’s, so that a political solution to the nuclear problem becomes feasible. But KJU isn’t cooperating, as he knows he can’t risk much liberalization nor wants to compromise with anyone while he builds his arsenal and threat capacity.

Al Jazeera notes “North Korea is grappling with sanctions, flood damage, food shortages and a massive trade hit, yet its currency, the won, has surged 25% against the US dollar this year... There are competing theories for why it’s happening, ranging from Kim’s pandemic border closure killing demand for foreign currencies to the isolated country instituting a crackdown on their use... Imports from China, North Korea’s biggest trading partner, dropped more than 90% year on year every month from August 2020 to February this year, with declines continuing thereafter, according to the Korea International Trade Association, a trade group in Seoul. Satellite images show how once-busy bridges and roads between North Korea and China became empty after the border closure, according to Ramon Pacheco Pardo, a professor of international relations at King’s College London...North Korea’s unofficial exchange rate, which is tracked by the two news outlets, is formed in the country’s “jangmadang,” local markets that have grown to become a large informal economy. Its official rate has been steady at around 100 won per dollar for the past decade, an artificially strong level with no use as an indicator. The unofficial rate is around 5,200 won per dollar…Running a private currency exchange is illegal in North Korea, so the two media companies, Asia Press International of Japan and Seoul-based Daily NK, use secret human networks inside the isolated country to compile their rates, according to Jiro Ishimaru, a journalist at Asia Press International, and Lee Sang Yong, editor in chief of Daily NK.”

So while the DPRK’s economy contracts (evidenced by lower imports) KJU increases his military threat capacity and that poses a double risk to China. It’s likely that should KJU lose patience he will attack Japan, and that will be devastating to global confidence. So the CCP has a deep need to improve its own military stature to keep KJU within the bounds of sanity, and will do so at the expense of Taiwan and Japan’s peace of mind and consequently that of the American foreign policy and military establishment. For the markets, this means every Chinese provocation is actually a show of confidence that China is growing and stable, which in turn powers global growth. And every shock from KJU is just another brick in the wall of worry to climb. I doubt the long-term impact is good from these developments, and consequently long-term market returns will be sub-standard. But for now these developments make investors sanguine and that is why it’s critical to be positioned for a return to the bull market once the current consolidation ends this month.

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