Biden Can’t Run But Only Stumble Over Competing Priorities, To The Detriment Of Global Stability And Confidence: The Geopolitical — Stock Market Connection

The wall of worry for equities is as broad as the Great Wall of China but the bulls are focused more on height than breadth. If the Fed can only let the economy flow naturally then inflation will decline, growth will stabilize and high valuations will bring in capital gains tax revenues that bring down the budget deficit and leave both Democrats and Republicans happy. Such jejune reasoning ignores the numerous reasons why American workers are less productive, the Fed is more worried about the future and the political climate is deteriorating, not improving. But for now the bulls can push their simple argument and hope that earnings reports validate them. Consequently the volatility risk premium is pointing to a range-bound market over the next few days, while my technical reading of key stocks in the S&P 500 is neutral. Yesterday's cross-asset action brought several positive factors for US stocks. The US yield curve is falling and in the current context that is bullish. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. But there was also one negative factor across global asset classes. Copper is pointing to declining global GDP expectations. Expect the S&P 500 to rise modestly toward 4200 over the next few days.

The bulls claim that high valuations and a low premium to treasury bond rates are justified by a rosy outlook for earnings over the course of the decade. But with sticky inflation, a smaller labor force, strains on immigration and threats to default on US debt, this argument is preposterous unless AI or some as yet unexploited technology results in a productivity boom akin to the computer revolution of the 1970s and 80s. There’s scant evidence of a productivity boom, while there’s ample evidence of persistent inflation.

One source that hits Americans viscerally is gasoline and electricity prices. Here the geopolitical-economic-markets connection is similarly visceral, driven by a vector of terrible Middle East policies among other similarly desultory political ventures by both Democrats and Republicans. Iraq is the most egregious example, since it has a material impact on oil prices and thus US inflation, and by extenstion Fed policy, interest rates and the valuations of equities. US policy toward Iraq has reversed America’s reputation as a reliable global hegemon, taking a nasty but stable nation and destroying all stability. 20 years on from the Iraqi invasion and instability persists, slaking American strategic power and causing higher oil prices, thus doing double damage to American welfare.

Oilprice.com notes “Although Iraq has substantial oil resources, with over 143 billion barrels of proven reserves in 2016, it is currently experiencing an energy crisis. Its 42 million inhabitants face regular blackouts and damaging electrical surges. At present, around one-third of Iraq’s gas and electricity comes from Iran. However, these deliveries are often disrupted, resulting in power cuts. Iraq is now facing increasing pressure from international organisations to diversify its economy away from oil and natural gas in preparation for the global green transition…Iraq is the second biggest oil producer in OPEC, and crude production provides around 90 percent of the country’s income. The oil-rich nation exported over 1.2 billion barrels in 2022, averaging around 3.3 million bpd. In late March, producers were forced to shut in and reduce output from multiple northern Kirkuk oilfields in the Kurdistan region (KRI) in the north of Iraq due to the closure of the country’s northern export pipeline. The halt to Iraq’s oil trade meant a slump in oil exports of 200,000 bpd in March and a rise in oil prices to $80 a barrel.”

Worse still is the prospect of renewed violence based on both Shia-Sunni hatred but also intra-Shiite rivalry. Brookings notes “Sadr decided to give up his hopes of forming a majority and (perhaps temporarily) withdrew from Iraq’s political fray. The miscalculation paved the way for Mohamed Shia al-Sudani, a Maliki proxy and Dawa stalwart, to be appointed prime minister in October. This political outcome has been a boon for the PMF. The organization has further entrenched itself in the Iraqi state, widening its economic capabilities, diversifying its revenue streams, and expanding its patronage network

Sadly the Democrat’s focus on expanding the public sector instead of dramatically cutting it back means Biden is burdened with an anfractuous environment of hundreds of competing priorities and intra-policy dynamics that make it impossible to coherently achieve anything concrete. Naturally foreign policy suffers the most, as there is nothing America can do to curb the prospect of more violence in Iraq and consequently more risk to oil and gasoline prices.

As zinc prices fall and manufacturing across the West declines into recession it’s clear that not only will global growth fall but inflation will be hard to bring down. That spells lower confidence in earnings and higher interest rates, a double whammy for equities. Along with cultural trends that attenuate the work ethic and communicative efficiency, the prospect for above-average valuations is dim and as investors digest earnings reports this will become clearer, paving way for a return to the October lows.

My current positions include a very large cash position, 3M (MMM), Pfizer (PFE), the levered ETF UPRO and inverse levered ETF SPXU, all of which net out to a modestly long position in large-cap equities.