Geopolitical Developments: China Can’t Risk Breaking Its Economic Miracle To Aid Its Eurasian Allies, But Biden Won’t Exploit This And The Markets Know It

Yesterday the S&P 500 broke under last week’s trading range and this confirms we are in the middle innings of a bear market, with a retest of the February 24 lows imminent. Geopolitical risks vie with economic risks as the main instigator of bearish sentiment, with transnational linkages that center on China. To its North Russia is regrouping militarily and economically is a bid to avoid humiliation and depression. To its West its key geopolitical clients are flailing in the face of debt traps that China inadvertently laid upon them. The globalization of US businesses means the the US equity market can’t hold out as an island of safety for very long unless the US takes decisive action to confront these risks. The US volatility risk premium points to a higher market over the next few days my technical reading of key stocks in the S&P 500 is bearish. There are several negative factors across global asset classes. Gold is signalling inflation fears. Oil is pointing to stagflationary conditions. The action in currencies signifies $US strength. The US yield curve is bear steepening. Inflation expectations are rising based on measures of Treasuries and TIPS. Expect the S&P 500 to fall over the next few days as Biden plays it safe.

The War in Ukraine enters another critical phase with the Russian offensive in the Donbas. But now the talk is not about Russian victory but rather a conceivable rout by the Ukrainians, and what Putin would do in consequence of such humiliation. Assuming sanctions bite deeper and the finance authorities can’t keep propping up the ruble as exports decline, Putin could escalate with the nuclear option and try forcing the West to yield concessions. Key will be whether China sticks with Putin or not, and a telling sign is what aid or weapons China is currently sending Russia. Both US intelligence and logic suggest China is doing little to help Putin, and would thus be unwilling to back him if he took even bigger risks as the War goes against him.

The fundamental issue for China is Xi Jinping’s ambitions and the confidence he has to take foreign policy risks. Most likely Xi won’t be distracted from pressing domestic concerns, since his moronic COVID policies are piling onto a decline in growth expectations and threatening to push the whole world into stagflation. ING notes “China’s GDP in the first quarter still enjoyed moderate growth, with the damage from lockdowns mainly visible in consumption. But support from fiscal and monetary policy has not been enough to fully offset the damage to GDP created by the lockdowns. We may need to revise our GDP forecasts further if fiscal support does not come in time.”

Further evidence comes from China’s reluctance to help its important South Asian clients as they undergo unrest and political uncertainty. Sri Lanka is in turmoil and Pakistan is inching closer as the economy cracks while debt comes due and Imran Khan vows to repeat his successful insurgency against the established political dynasties. The Carnegie Endowment for International Peace notes “Pakistan’s debt exposure also poses a significant near-term challenge. Pakistan had benefited from the pandemic-related debt service suspension program that was launched by the G20 and concluded at the end of 2021. According to IMF data, about $15 billion in foreign debt service obligations are due starting in July, about two-thirds of which appears to originate from Chinese sources, likely related to the China-Pakistan Economic Corridor. While Pakistan is not as debt-distressed as other emerging markets, such as Sri Lanka, these debt service obligations do pose a sizeable dilemma for the new government at this stage.”

If China is reluctant to extend relatively trivial amounts of aid to its existing clients like Sri Lanka and Pakistan, in the context of a major rivalry with India, then why would Putin expect China to court sanctions and decoupling in order to extend weapons, aid and credit to Russia, for a war China has not even endorsed?

Putin is heavily leveraged to a powerful victory in Ukraine that makes him a bigger player on the world stage and entices China to sacrifice Western ties for deeper partnership with Russia. But this looks increasingly impossible as Russia is taking large casualties securing the the sliver of a land bridge in the Eastern region of Ukraine, Talk of Ukraine winning the war if the West gives more weaponry is becoming common enough that China must take it seriously. The odds are that Putin stages a Potemkin victory celebration on May 9 and this implicit humiliation convinces China to remain on the sidelines, giving Putin’s inner circle more confidence to take him out before he threatens WWIII.

Exploiting this weakness is in the strategic interests of the West, but it looks unlikely given the statement by German employers and unions that cutting off Russian gas isn’t in German interests. Foreign Policy notes “Leading German employers and unions joined on Monday to oppose a Russian gas embargo, arguing that it “would lead to loss of production, shutdowns, a further de-industrialization and the long-term loss of work positions in Germany.” The announcement is likely to inform the thinking of Chancellor Olaf Scholz as European leaders debate further bans on Russian energy imports.”

As Biden dithers and Ukraine suffers the geopolitical and macroeconomic uncertainties rise and this is weighing on markets. I continue to expect much lower lows in the S&P 500, with a possible bottom around 3700.

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.