Geopolitical Developments: The Dove Of Peace Needs To Land On The Federal Reserve

Geopolitical disaster is far from the minds of investors this week, and key to maintaining investor equanimity is the Fed restraining its hawkish rhetoric regarding inflation. The volatility risk premium points to a higher market over the next few days (though volume may be light due to both seasonal factors and because the VRP could easily reverse and catch investors offside), while my technical reading of key stocks in the S&P 500 is bullish. Yesterday's cross-asset action brought one positive factor for US stocks. Oil's chart is signifying global growth. But there were also several negative factors across global asset classes. Gold is signalling inflation fears. The US yield curve is bear flattening. Inflation expectations are rising based on measures of Treasuries and TIPS. Consequently expect the S&P 500 to rise a bit more toward 4830 before consolidating.

The Fed’s views on inflation are critical to the geopolitical trajectory since US interest rate policy typically pulls the rest of the world along with it, both by forcing other nations to alter their rates in the same direction and even more profoundly, by changing the value of the $US. In the current context, if the Fed is seen as hawkish on inflation then American short-term interest rates will rise while long-term rates will fall if the market expects the usual recession to follow. Since pre-pandemic US growth was seen as just 1.5% (on a real basis, or inflation-adjusted) a rise in interest rates and its many negative effects (i.e., the wealth effect of a stock market decline, rising rates for mortgages, trade finance and bank loans) likely swamp the normal growth drivers (e.g., productivity, immigration) and cause the US to fall into a recession. Since the US is the major world importer and its short-term rates are higher than nearly everywhere but China, an American recession not only causes a pullback in other nations’ trade but also raises their interest rates, further choking their own domestic growth. Last week I discussed how this would impact Turkey and by extension its negative impact on the Middle East and West Asia, but just as geopolitically dangerous would be the impact on China.

China is vulnerable to global growth since its GDP is highly linked to exports while its domestic consumption is limited by a poor pension and healthcare system and the newfound fears about conspicuous consumption engendered by Xi Jinping’s twin thrusts of anti-corruption and leftist rhetoric re economic equality. The global growth slowdown in the wake of the pandemic caused Chinese growth to fall several percentage points, while the 2008 GFC recession was so threatening to China that it turned on the fiscal and monetary spigots to help save its economy and the Asian region. Even with that stimulus the trend in Chinese GDP has been negative, and now the consensus view of long-term Chinese growth is now just 4-5%, so another global recession would pull Chinese growth down to around 3% and lower domestic confidence in the Chinese Communist Party (CCP). The CCP would doubtless blame the US for engineering such a drop in confidence, since the US and China are locked in a Thucydides trap.

The reason China can’t turn on the spigots and counter an America-driven drop in trade and rise in interest rates is the CCP is battling a glut of wasteful property speculations (e.g., Evergrande) while trying to shore up its anti-Western Maoist credentials. The Chinese populace knows the CCP doesn’t want to bail out the profligacy of the monied, so any drop in global economic confidence will cause a deep pullback in Chinese property prices, which make it even less likely the CCP will enact a large bailout. A large drop in property prices is a perfect seed for financial contagion, as Fitch notes recently notes (“China Property Stress Scenario Points to Contagion Risk”).

Fitch states: “A stress analysis of Chinese property developers publicly rated by Fitch Ratings has highlighted potential liquidity strain for close to one-third of the portfolio under a severe scenario involving a 30% decline in residential home sales revenue in 2022

Under our stress assumptions, we estimate 12 of 40 developers rated ‘B-’ or higher would experience a net cashflow deficit. Developers in the ‘B’ category are most affected. We have assumed the majority of bank borrowings and trust loans can be refinanced. However, creditor confidence can weaken swiftly, which would sharply worsen refinancing capabilities.

Property-related sales are an important source of funding for local and regional governments (LRGs) in China as capital revenues (mostly from sales of land-use rights) account for a median of 25% of their annual fiscal revenues. A fall in these revenues would affect LRGs’ ability to support highly geared local-government financing vehicles.”

So the CCP’s leftward tilt would hamstring its provincial governments and pull China into a recession, likely incentivizing the CCP to lash out at the US and stoking geopolitical fears of war in the South China Sea. That in turn would redound on investor confidence, further putting globe at risk. The Fed needs to back off its hawkishness to avert this scenario.

My current market positions include a large cash position, and the following holdings: Activision (ATVI), Amgen (AMGN), American Express (AXP), Johnson & Johnson (JNJ), 3M (MMM), Titan Machinery (TITN) and a small net long position in the S&P 500 (the levered inverse ETF SPXU and levered ETF UPRO).