Geopolitical Developments: Waiting For China To Hammer The Nail Into Putin’s Coffin

Banking on China to do the sensible thing requires patience, and happily for investors the equity markets continue to myopically rise as the horrors in Ukraine persist. I expect Putin and his inner circle will eventually realize that no one will help Russia avert a depression, making their days numbered as returning body bags eviscerate their domestic popularity. In that time span I expect the market rally to peter out and reflect geopolitical and economic reality. But for now we are in rally mode and 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 one positive factor for US stocks. The action in major currencies indicates the $US is weak. But there was also one negative factor across global asset classes. Inflation expectations are rising based on measures of Treasuries and TIPS. Expect the S&P 500 to be range-bound over the next few days.

Key to Russia’s negotiating stance is Putin’s confidence in domestic stability and his own security. The pusillanimity of Russia’s inner circle is readily apparent and while Putin must be paranoid, he is likely used to functioning under such conditions. But domestic stability hinges on confidence in the regime and fear of it, so the dramatic decline in human welfare and living standards must be seen by the average Russian as temporary, else Putin is in trouble. So China takes center stage as the potential Russian valve to economic resilience. The consensus is this won’t happen and Russia is about to fall off a cliff.

The FT notes (in an editorial from Rockefeller International): “For all the focus on how Russia’s economy is in trouble, isolated and battered by western sanctions, China, its most important ally, faces serious tremors as well. No other major country is showing deeper sinkholes of economic trouble...”

This is not only because of The Communist Party’s futile zero-COVID policy but a host of other factors. The attenuation of confidence in the CCP due to its handling of Hong Kong, the uncertainty the CCP engenders through its needless arrogance towards all of its neighbors, and the internal risks from years of state-directed investments in property, all combine to pressure capital markets and evoke market manipulation from China’s National Team, further denting confidence in investing in China. The FT editorial further notes:

“Property is critical to growth in China. About 25 per cent of gross domestic product and 40 per cent of bank assets in China are tied to the property market, where estimates of the effective default rate on high-yield bonds are close to 25 per cent, a record high. Dependence on foreign capital is high, but in February foreigners sold off China’s local currency government bonds at an unprecedented pace, twice the previous monthly high.”

Adding to this is China’s artless attempt to finesse the Ukraine War. Reuters notes “Beijing’s close ties with Moscow may be rattling foreign investors. A study by the Institute of International Finance found that China has been experiencing “unprecedented” capital flight since Russia invaded Ukraine. The study found no similar outflows from other emerging markets, adding insult to injury.”

So Xi Jinping is unlikely to suffer economic uncertainty for his little brother Putin, or to risk exports to the West in order to facilitate exports to Russia. What Putin is effectively asking Xi to do is violate US sanctions and give Russian companies a way to pay for goods and services without relying on the $US and the SWIFT bank messaging system. This is naive, as China has tried for years to develop an alternative to SWIFT and has little to show for it. As S&P notes:

“CIPS handles about 5% of the volume that Swift does, according to Junyu Tan, an economist at French investment bank Natixis specializing in Asia thematic research….The space will be quite limited in the short run for China's financial infrastructure to help with the sanctions on Swift for Russia…Over time, it can become a second best, but possibly a far distant second best…What Russian needs is hard currencies, which they won't be able to get from a shared financial infrastructure with China, if any, which provides only yuan that can only buy Chinese goods…The yuan is not a convertible currency, they still don't have easy access to other currencies."

Consequently I still expect Putin to be taken out as his inner circle does the calculus and recognizes Putin’s futility. The Ukraine War will be a signal change to the geopolitical context for the West, but it’s now clear the timetable is unpredictable. While we wait the markets will likely trend lower as various uncertainties combine with higher interest rates to sap investor confidence.

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.