Geopolitical Developments: Optimism & timidity in Europe vs. Insecurity & Boldness in Eurasia

Geopolitics are negligible to the markets right now, but will likely crash the wall the worry later this Autumn, as an insecure Eurasia causes problems for a divided West. Presently the volatility risk premium points to a higher market over the next few days, 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. The US yield curve is falling and in the current context that is bullish. But there was also one negative factor across global asset classes. Inflation expectations are rising based on measures of Treasuries and TIPS. Taken together, the market looks set to overcome these concerns and rise moderately over the next few days.

Key developments this week were China’s Communist Party (CCP) continuing persecution of firms and individuals, despite the hurt it’s causing to Chinese retail investors in equities, commingling uneasily with verbal fire between the US & Russia and drone fire between Iran and the West.

1) The CCP is clearly insecure about the social power of firms and rich entrepreneurs as well as entertainers and artists, and lately this has buoyed US equity markets & hurt the Yuan as capital flows have tilted back to the US and away from China. One reason for this insecurity is the cosmopolitan nature of the Chinese middle class, particularly in Shanghai, which augurs for a more liberal and less culturally unified China than anything seen since the imperial days of prior centuries. The CCP needs cultural authority to mitigate its crimes against ordinary Chinese since the 1950s — both the horrific suffering catalyzed by Mao & his zealots and more recent persecution executed by Xi. Culturally-based economic & social policies that stoke historical pride would keep China’s huge middle class from revolting against such persecution: But Brookings notes “400 and 500 million Chinese enjoy a middle-class lifestyle with private property, personal automobiles, improved health care, accumulation of financial assets, and the ability to afford overseas travel and foreign education for their children…The average value of household assets among Shanghai residents was $1.2 million.” Not only does this materialistic and global cosmopolitan lifestyle vitiate culture and interest in history, but Brookings notes something even more ominous for the CCP: “Yet constituent members of the Chinese middle class are unified in their appreciation for the middle-class lifestyle, the development of a market economy at home and economic integration abroad, the protection of private property rights, a policy emphasis on education, environment and ecology, food and medicine safety, and government accountability and transparency. The prevalence of public discussion about these topics indicates that the middle class’s self-consciousness, group identity, and shared values are all on the rise…China’s legal education and profession are profoundly shaped and influenced by Western legal doctrines that have made their way to China through international educational exchanges. A good example is the birth and growth of China’s legal clinics, which were initiated and sponsored by the Ford Foundation.” This is a huge problem for the CP, as this cultural affinity for Western values has nothing to do with either imperial China or the CCP’s vaunted socialist ideology.

Still, one thing in the CCP’s favor is skepticism re the US. Brookings notes “Many Chinese elites are deeply familiar with two major events in the 1990s, namely Japan’s “lost decade” of economic growth and the collapse of the Soviet Union. Some official Chinese sources have implied that both episodes were products of an American conspiracy.” Fear of a similar plot against China might ultimately be enough to tip support in favor of the CCP’s authoritarian rule.

2) Delta COVID hasn’t dented confidence in the US equities, as the S&P 500 is at record highs and low trading volume is in line with the past summers (i.e., pre-COVID summers). The key issue with delta COVID is high load factors, which are in turn boosted by lack of immunity: i.e., vaccine hesitancy and poor rollouts. The equity market reflects broad confidence that both will improve, spurred on by fears of delta COVID if nothing else. These are key variables to project in order to make investment decisions. Per AP, “about 80,000 people protested in cities across Italy last weekend, while thousands have marched in Paris for the past three weekends, at times clashing with police. More than 200,000 marched across France on Saturday, 14,000 of them in Paris, in the biggest show yet…In France and Italy, demonstrations against vaccine passes or virus restrictions in general are bringing together otherwise unlikely allies, often from the political extremes. They include far-right parties, campaigners for economic justice, families with small children, those against vaccines and those who fear them.” But other parts of Europe are more hopeful. “Denmark pioneered vaccine passes with little resistance. Belgium will require a vaccine certificate to attend outdoor events with more than 1,500 people by mid-August and indoor events by September. Germany and Britain have so far resisted a blanket approach, while vaccinations are so popular in Spain that incentives are not deemed necessary.” There is also reason for hope in France and Italy. “Vaccine demand in Italy increased by as much as 200% in some regions after the government announced the Green Pass, according to the country’s special commissioner for vaccinations. In France, nearly 5 million got a first dose and more than 6 million got a second dose in the two weeks after President Emmanuel Macron announced that the virus passes would be expanded to restaurants and many other public venues. Before that, vaccination demand had been waning for weeks…A full 15% of Italians remain resistant to the vaccine message: 7% identifying themselves as undecided, and 8% as anti-vaccine, according to a survey by SWG…he biggest reasons for hesitating or refusing to get vaccinated, cited by more than half of respondents, are fears of serious side effects and concerns that the vaccines have not been adequately tested. Another 25% said they don’t trust doctors, 12% said they don’t fear the virus, and 8% deny it exists.”

3) Another geopolitical source of suffering and injustice that fails to change investor confidence is the corruption in central and south asia. Here China is making strides, arguably doing what American investors aren’t willing to do: invest. DW notes “Chinese investments are capturing Pakistan's economy” not simply because of Chinese households save so much that Chinese firms have funds to invest abroad (proportionately more than the US or even Germany) but because “Given this terrible law and order situation, many Western countries and businesses were not willing to invest...” China by contrast invests boldly despite terror directed at Chinese workers and firms. While these investments have dubious value in social and ecological terms, the CCP’s boldness in securing close allies among its neighbors contrasts with the US and Western Europe: this is an asset that helps maintain domestic confidence and allows the CCP to maintain its authoritarian policies.

4) Another Central Asian issue of key importance to markets is negotiations between Biden and Iran regarding sanctions. Should the US waive sanctions Iran could supply the world with more oil, driving prices down. But what seems inevitable (a return to the JCPOA, with little to say on missiles) may take awhile as Iran is fragile and Biden is likely unworried about oil prices since the US to an extent benefits from higher prices. Key for Iran are protests agains the govt, which it fears Biden, Israel and the West may be trying to exploit. As the Atlantic Council notes “Ethnic minorities—including Azeris, Kurds, Arabs, Balochis, and others—who live mainly in peripheral areas, make up close to half of Iran’s population and pose a significant challenge to the Islamic Republic.” But ironically such protests don’t make it easier for Biden to negotiate, as they effectively help the theocracy hold the country together. “Despite growing protests in recent years, many Iranians, including opponents and critics of the Islamic Republic, still seem concerned about the possibility that the alternative to the current regime could be even worse and that a revolutionary change could lead to political chaos and might be exploited by Iran’s enemies to disintegrate their motherland. This concern has grown even stronger considering the experience of the Arab Spring in the last decade. Not only does the chance of exploiting ethnic divisions to incite minorities to revolt against Tehran seem slim, it may turn out to be counterproductive and encourage many Iranians to “rally around the flag” to preserve their country’s territorial integrity.

Moreover, they note “In addition, as academics Ramus Elling and Kevan Harris have shown in their study based on an extensive social survey conducted in Iran in 2016, many Iranians do not always unequivocally define their ethnic-cultural identity and sometimes see themselves as belonging to more than one ethnic group.”

5) Russia’s cyber-crimes and antagonism to western democracy is yet another geopolitical issue with practically no impact on US equities, arguably because Russia isn’t a complete threat. At least not yet, since natural resources dominate the economy and demographics aren’t supportive. Per Jamestown Foundation, “It is impossible to hide the plain fact that in 2020, Russia’s population declined by 700,000 people. This year may see an even sharper drop.” But they also argue that Russia’s weaknesses likely make it more dangerous than its strengths. “Putin is caught between the greed of his “oligarchs” and the ambitions of his siloviki (security services personnel). He may be enjoying every luxury his status as “great leader” provides, but dark visions of inescapable global violent conflict increasingly cloud his judgment. Biden’s reference to a “real shooting war” was intended as a warning about the risks of cyberattacks, but Putin apparently believes that Russia’s interminable war with the US-led West can remain “hybrid” for only so long. It is this conviction, exploited by the top brass and fueled by self-deceiving propaganda, that makes Russia dangerous.”

Yesterday I added a position in Blackrock (BLK) and sold out of Korn-Ferry (KFY). Other market positions include longs in Facebook (FB), MKS Instruments (MKSI), Titan Machinery (TITN), and nearly hedged position that is net long in the SPX (UPRO and SPXU).