Geopolitical Developments: Volatility Inches Back As Russia Offers To Reset The Balance of Power

The equity market’s consolidation this week has fomented a modest rise in volatility which feels outsized when considering the S&P 500 is just 3.3% off its all-time highs. What accounts for it is not inflation fears of the prospect of a mistake by the Fed, but geopolitical developments in the way Russia and the US argue over Europe. I see this as settling down since Russia has little incentive to take major risks at this moment, leading markets back to old highs later this month. 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), while my technical reading of key stocks in the S&P 500 is bullish. Yesterday's cross-asset action brought several positive factors for US stocks. Copper's chart is signifying global growth. The action in major currencies indicates the $US is weak. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. But there was also one negative factor across global asset classes. Oil is pointing to stagflationary conditions. Expect the S&P 500 to rise modestly over the next few days.

The reset to the balance of power centers on Russia putting troops in Cuba or Venezuela. IF this were to happen investors would cut down equity valuations since there would be little hope of low interest rates forever or of real economic growth rising above its mediocre long-term average of sub-2%. This risk is driving volatility and extending this consolidation.

The reason Russia can make a credible offer to reset the balance of power is the US is locked in self-absorbed policies while Europe is fundamentally disunited. As I discussed Monday, there is no prospect of the American democrats linking with European social democrats and presenting a common front to autocratic Eurasia. The pandemic has hurt all sides, but America is continuing to squander any chance of gaining the upper hand.

US policy during the pandemic simply gave the middle and lower classes a one-time opportunity to consume, so consumer balance sheets improved temporarily but consumers increasingly spent this surplus since materialism is a cultural norm. That has caused inflation which partially redistributes money back to firms and thus to capital. The end result is a one-time increase in material living standards but no change in the long-term where the average American has to work considerably to keep up not only with automation and other corporate drives toward efficiency, but now also to permanently higher prices. The result is that both growth and inflation will settle back to sub-2%, yielding nominal GDP growth at sub 4%.

Corporate efficiency drives combined with limited productivity that workers bring to their jobs means the distribution of wealth continues to deteriorate, disrupting politics such that trust diminishes further and both parties exploit this toward growing their power via the state in ways they favor. But social spending is limited since public sector debt is now much higher, thus the left will focus on growing the state’s regulatory apparatus, which will further constrain real GDP growth. The strict divide between left and right has been the status quo since the 1970s, and in the past this status quo has been stable since there was little external threat to America and social spending kept the left content and lower-class Americans satisfied that the upper classes cared enough to redistribute money. The left and right fought each other through the 70s and up to the GFC, with productivity failing to rise uniformly and thus inequality growing, but since America offers so many materialistic escapes from the burdens of work and political schlerosis the average American maintained a degree of contentment and that bred stability.

But this is changing as Russia, China and North Korea are seriously challenging the balance of power, driven by China’s economic surplus and Russia’s ability to maintain its economy compared with the deterioration it faced under communism. Now that America’s public sector debt exceeds GDP, there is no room to maintain social spending, particularly as baby boomers retire and immigration policies keep new workers from entering. Russia and China can see this and consequently they see America remaining self-absorbed and the protest and riots of 2020 resurrecting in the years ahead as inequality grows. This gives them the opportunity to reset the balance of power. I don’t see this happening anytime soon, but the prospect has already unnerved markets.

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), Starbucks (SBUX), Titan Machinery (TITN) and a long position in the S&P 500 (via the levered ETF UPRO).