Geopolitical Developments: Putin Will Soon Be Alone And The Markets Are Myopically Cheering For It

An existential moment of equivalent import to the Cuban Missile Crisis and the Yom Kippur Arab-Israeli war of 1973 will soon hit the West. Putin is on course for escalation to the nuclear brink while Ukraine valiantly forces his army to take huge losses and his economy to collapse. What will push Putin to escalate his regional war into a global moment will be China’s response to his desperation. I expect Xi Jinping to act like a rational uncle and tell Putin to deal with the consequences of his malevolence alone, which is where Biden and Europe can stand up to him and firmly place the West inside the war over Ukraine. The result of this will be Putin’s demise. But until that moment arrives global investors are watching Putin’s incompetence and cheering for a happier resolution, driving equity markets higher despite bond market ructions. 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 short-term technical reading of key stocks in the S&P 500 is bullish. But there are several negative factors across global asset classes. Oil is pointing to stagflationary conditions. The action in currencies signifies $US strength. The US yield curve is bear flattening. Inflation expectations are rising based on measures of Treasuries and TIPS. Consequently expect the rally to fizzle out when the S&P 500 hits 4550, setting up for a major downturn toward month-end.

China failing Putin would leave him with only one clear ally ready to take action, namely Kim Jong Un, who is hardly a reliable partner. Consequently Putin would be effectively alone and assuming he makes modest progress in Ukraine while taking huge losses and watching his economy crater, escalation will follow. The key here is China’s incentive to follow the West and refuse meaningful aid to Putin. Economics favors Europe and the US over Russia as China’s main priorities, while Putin’s irrationality combined with his army’s incompetence severely dents Chinese respect for Russia. Given the religious undercurrent I discussed last week, that makes escalation nearly guaranteed. The West faces an existential question ahead and China knows it will hardly be immune to the response.

Consequently it’s in China’s interest to act rationally and show Putin an off-ramp that brings him back to reality once the West calls out his cards. This means China will take more Russian energy exports eventually, at favorable terms, rather than now. As the Carnegie Endowment notes:

“China relies on a single pipeline for importing gas from Russia and has been wary about becoming more dependent, but given attractive concessions, a second pipeline is now being constructed. China has other options if oil and gas supplies from Russia are disrupted, but the surge in prices will dampen consumption and investment.”

In the meantime China will impress on Putin how it’s suffering for his malevolent war, due to its intense economic relationship with the West that dwarfs its relationship with Russia. Carnegie further notes:

“UN data indicates that China exported only about $70 billion of goods to Russia in 2021, while exports to the EU and United States totaled over $1 trillion…Global supply chains were already under stress before the crisis. Now add a breakdown in Euro-Asia transport links, including shipping lanes in the Black Sea, lengthened air routes from Europe to Asia because of the need to bypass Russian airspace, and unreliable rail links connecting Europe through Russia and Central Asia to China. As the center of Asia’s production-sharing network, China has much to lose with this fractured global supply chain. Reputational damage will exacerbate the situation, as Western buyers drop Chinese suppliers to protest Beijing’s policies.”

Putin may have banked on China seizing the moment to forever eliminate the West’s hegemony, but his myopia regarding his own economy matches his myopia regarding Chinese interests. Given China’s volatile weather patterns and historic fear of famine and drought, Xi Jinping can’t afford to let food supplies and prices get out of hand for too long. The COVID epidemic that originated in China already did damage to supply chains, so Xi can’t be seen as abetting further damage by abandoning Ukraine, especially given China’s economic ties to that country. Ukraine is one of the key breadbaskets to the world, as the European Council On Foreign Relations notes:

“Ukraine has more arable land than any other European country and 25 per cent of the world’s total volume of black soil, which is particularly fertile. This has helped Ukraine become a global agricultural powerhouse. Together, Russia and Ukraine produce around 27 per cent of the world’s barley, 34 per cent of its wheat, and 73 per cent of its sunflower oil. Most exports of these products move through Odessa and other ports on the Black Sea, which are now closed to commercial shipping.”

Putin’s losses today are the markets’ gains, but the whole world suffers from food shortages and rising prices. Expect the markets to soon follow as economic and geopolitical reality sinks in.

My current positions include a large cash position, Goldman Sachs (GS), 3M (MMM), Pfizer (PFE), Starbucks (SBUX), Titan Machinery (TITN) and the levered ETF UPRO.