Geopolitical Developments: Bullishness Resounds Around The World But That Necessitates Keeping The China Shop Pristine

China’s geopolitical and economic policies have so far helped global investors feel confident about multinational profits and consumer demand, and at current valuations the equity markets are allowing no room for political mistakes. 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. Most macro indicators are positive but there is one negative factor across global asset classes: the US yield curve is rising and in the current context that is bearish. Expect the S&P 500 to rise modestly over the next few days.

With equities as relatively high valuations (i.e., a forward PE of 21 for the S&P 500) investors require not only robust earnings growth and a stable macroeconomic policy framework, but also modest geopolitical risks. Omicron is seen as potentially lowering risk since it’s contagiousness makes it more likely nations get to herd immunity and higher vaccination rates, thus lowering tensions regarding migration and the prospect of economic lockdowns. But China is the outlier to this bullish forecast, since its zero-tolerance policy effectively forestalls herd immunity. Now it’s becoming clear China’s leadership is on edge because of fears of having the wrong strategy for the pandemic, and thus potentially suffering an onslaught of infections as a result of the Winter Olympics which would catalyze a further economic slowdown.

The South China Morning Poist notes “Although 85 per cent of the Chinese population have received at least two doses of vaccine, it has emerged that inactivated vaccines – most widely used in China – can hardly defend the population against the new variant, as laboratory tests revealed little to no neutralising activity…In the short term, China will have to make sure there are no unpleasant surprises when it hosts the Winter Olympics next month, and the upcoming national congress has also been factored in as the country holds fast to its current Covid-19 strategy…China could just be buying time in hopes of effective therapeutics and vaccines eventually being developed, Huang said.”

This high-wire act is naturally making the Communist Party (CCP) nervous and this is playing out in China’s foreign policy, as the CCP fears losing more stature as its strategic partners lose ground due to the pandemic and their own shortsighted policies.

The Pakistani newspaper Dawn notes “In the current disruptive times, China seems to be on the edge with a very limited appetite for mistakes by even strategic partners. For the first time in recent history, the Chinese leadership had publicly expressed displeasure over the handling of CPEC affairs in Pakistan. China was said to be uncomfortable with the security arrangements at CPEC project sites and Pakistan’s desire to renegotiate sealed deals. The appointment of the technically strong advisor (Khalid Mansoor) has not proven to be sufficient to get the CPEC ball rolling again...”

Pakistan is a key ally of China not only because it fosters a relationship with Muslim West Asia, but because Pakistan keeps India from pursuing an aggressive foreign policy that could tip the Indo-Pacific towards the West. Consequently China has been an all-weather friend to Pakistan despite that nation’s dysfunctional policies. Patience is now wearning thin and Pakistan’s dual civilian-military leadership are not helping matters with their short-sighted economic policies regarding development and the procurement of energy imports. Al-Jazeera notes “Pakistan has become a fast-growing import market for LNG as local supply has subsided over the last few years. But competition for the fuel — used as an electricity feedstock and for heating and cooking — has intensified due to global shortages, sending spot prices to levels that Pakistan can’t afford.”

Dawn further notes “The Covid-induced lockdown last year battered the small and medium enterprises (SMEs) harder than generally assumed. Relevant indicators suggest that it disrupted the whole ecosystem of the huge informal economy. Many labour-intensive small businesses that had closed down during the lockdown (March-May 2020) could never make it back. Probably this explains why 3.9pc growth last fiscal year felt like a recession.”

With the Winter Olympics approaching the CCP will be on edge and any flare-up between China and India, or the Taliban in Afghanistan or the various flash points in the South and East China Seas, will likely provoke an outsized reaction and lead equity markets into a risk-off mood. For now the bulls are in charge but highly leveraged to a stable and rational China.

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).