Dear Valued Clients and Friends,
The stock, bond, and housing markets are in pretty real distress right now as higher rates re-price risk assets, and general instability in monetary policy becomes the natural consequence of years of excess and irresponsibility.
And yet, everyone is already talking about it, making it a far less compelling candidate for this week’s Dividend Cafe. I have covered plenty on monetary policy this year and it will remain a primary macroeconomic focus in my shop for years to come. And as far as the general equity market distress playing out, I do think a general primer on bear markets next week will be useful (I have already begun writing it in my head).
But this week, I believe we are due for a topic that may be more dramatic than even stock market volatility, inflation, or Fed breakage. I think that through the lenses we normally think about various international affairs, particularly as it pertains to countries we consider enemies of the United States, we are missing some economic and market-sensitive ramifications that will be important to better understand.
So grab your globe but not your passport, and let’s devote this week’s Dividend Cafe to a few matters of international significance. I confess up front that it may not all cheer you up, but I can promise you this: It is not going to be the standard level of depth you are often exposed to.
Let’s dive deeper, and jump in, to the Dividend Cafe …
The easy narratives
Whether one is on the right or the left politically, when it comes to probably the four major countries of significance in U.S. adversarial relationships, these narratives are generally pretty non-controversial:
(1) China – their economic size and significance complicates things, but we know they are by no means an ally, and there is a generally skeptical view of what they are doing despite our acceptance that there is a mutual economic reliance (with varying opinions about where that reliance is, and where it should be)
(2) Russia – we do not have much reliance on them economically, either as a producer or a consumer, but we know they mean a lot to Europe and that matters to us. The attack on Ukraine is seen in a bipartisan context (with only a few real fringe actors seeming to disagree) as perverse and condemnable. There is not a lot of consensus (or understanding) about what exactly should be done regarding Putin, other than mostly supporting “economic” support to Ukraine (money, arms, equipment, etc.), and almost universally opposing “military” involvement
(3) Iran – the left liked the nuclear treaty entered into with Iran back in 2015, and the right hated it. The right was thrilled when President Trump ripped up the deal, and the left was not thrilled. The right opposes re-entering it, and the left seems pretty content to not re-enter it as well. No one in the west seems to feel a burning desire for a reconciliatory move in our relationship with Iran. We do not need their oil, and basically these days most in the west do not want their oil. They are limited primarily by their own limited capacity for things outside of various acts of terror.
(4) Saudi Arabia – this is a more complicated matter, as they had been a transactional ally of the United States from 1946 until roughly 2010, with varying degrees of strain in the relationship off and on throughout those ~60 years. I wrote about this in a dedicated Dividend Cafe last year. From 9/11 to the U.S. fracking revolution to the killing of a journalist a few years back to COVID oil market flooding to the Biden administration’s pleading with them to increase oil production, it has been a volatile new century in U.S.-Saudi relations, with oil being the entire basis for both the relationship sensitivity and the relationship volatility.
There is a lot – and I mean, a lot – where various folks could disagree on what to do in the different scenarios in these four countries. But I think this general high-level assessment is pretty non-controversial for our starting purposes at giving a lay of the land.
Consolidating that list
It is complex enough if there are four different dynamics of sovereign nations to deal with as laid out above (economically, militarily, geopolitically, and strategically). What matters to us in Russia is different than what matters to us in China, etc. So while there is complexity in “four different situations,” there is also the benefit of compartmentalization – i.e. what matters in each situation is different, specialized, and unique, when seen from that perspective.
But here is the entire subject of Dividend Cafe, and perhaps the entire story of the international order right now and American concerns in geopolitics:
What seems like four different countries to us is more and more becoming ONE different country for them. Put differently, these four challenging situations are coalescing into one in complex and dangerous ways as they form alliances in opposition to the west.
An Axis of a Single Strategic Interest
The drivers (strategically) for each of these countries in their relationship to the United States (and really, the whole western world) are, indeed, different. What is at play right now is not where China or Russia or Iran may be different from one another, though, but rather in the one area where they are all the same: And that is, opposition to the United States as an economic super-power.
I believe Saudi would be more content than the others to see the United States in a position of economic strength (think: post-WW2, pre-fracking) if it meant more oil purchases. It is only because of our declining reliance on their oil production that our economic strength is less relevant to them.
But for the other three, there is allied reason to oppose U.S. economic primacy, even if for different reasons from Russia to China to Iran.
I am concerned about the economic and national security ramifications of any alliances between any of these nations for the simple reason that all four are essentially non-allies of the United States, and any one of them become stronger and more potent in their hostility to U.S. interests when coupled to another hostile country. That said, there is simply no question in my mind that it is Russia-China in unison that represents the greatest concern.
There was a lot of talk this week that China’s recent meetings with Moscow revealed a Beijing hesitant to support Moscow in the midst of their challenged aggressions in Ukraine. I would suggest that that takeaway is more hope than reality. The Chairman of the National People’s Congress in China was quite clear that he does believe the U.S. is the source of the problem in Ukraine, that NATO presence is a threat to Russia, and that China is in the same boat as Russia as a perpetual victim of U.S. imperialist intentions.
I am sure there can be rhetorical impressions of daylight between Russia and China and that there can even be substantive daylight, but what I am also sure of is that the enemy of their enemy is their friend, and they both see U.S. interests as an impediment to their respective interests.
What is next between China and Russia?
My preferred source on these matters of geopolitical signposts, Corbu, has suggested the following as things to watch to represent a growing coziness between China and Russia:
(1) China’s acknowledgment of Crimea as part of Russia
(2) Russian embrace of Chinese claims in the South China Sea
(3) China’s border dispute with India
I would add, as Corbu has throughout, that the intensity of China’s efforts to help mitigate the impact of western sanctions on Russia is a huge signpost, as well.
Russian angst and tail-risk
If NATO communication efforts are to be believed, and I have no reason not to believe them, Ukraine has made great inroads in recent weeks towards defending its country from Russia’s invasion. The extent of the success, how it holds, and where all of this goes from here is outside my lane, but there is a rather obvious question that Ukrainian success or progress provokes: Is what Putin does in defeat potentially more concerning than what he does in success?
From a market perspective and obviously geopolitical perspective, a plausible argument exists that the “severe risk” premium is enhanced by Putin’s struggles to defeat this small European nation. Would “feeling cornered” cause Putin to respond with chemical, biological, or even nuclear strikes?
Putin did not hesitate to pull the nuclear card in his address two days ago. It is based on his rhetoric that the west represents a grave and existential threat to Russia. It does not matter if we believe his version of reality to be true; it only matters if we believe that he believes his version of reality to be true.
Back to China on this
Whatever one feels about the Xi-Putin meeting of last week, it is incredibly noteworthy that three days after Putin met with Xi, he uttered his most escalatory and inflammatory rhetoric yet. China may not agree with Putin or support Putin in this, but whatever they said or did, it sure didn’t disincentivize this kind of talk. And that “empowerment” suggests to me a strong willingness for China to increase trade with Russia, proactively seeking mitigation of global sanctions efforts.
China is not dumb. They are absolutely going to continue saying that they desire a cease-fire in Russia-Ukraine and diplomatic, negotiated de-escalation. But their actions are indicative of a growing Sino-Russian alliance. More on the economic realities here in a moment …
As for Ukraine
I am not expecting a quick resolution to the Ukraine matter and find it hard to envision an imminent path to a cease-fire, let alone a withdrawal, a surrender, a retreat, or a treaty. If this conflict is to continue for six months or longer versus three months or shorter, I have to believe that leads to an extension of upward pressure on commodity prices into next year. Ultimately, a “war premium” is generally good for bonds (downward pressure on yields in a flight to safety) and good for commodities (but not the people buying them). Of course, there are monetary and economic forces in tension with this geopolitical story, but my point is that one-sided investment thinking (meaning, solely focusing on central bank action and ignoring geopolitical considerations) may prove an incomplete calculus.
Many analysts (including my friends at Corbu) believe this “war premium” extends the risk of headline inflation, and when it comes to commodity dynamics (agriculture, energy, industrials), I think they are entirely right. But what many others (including my friends at Corbu) believe is that this means an extension of Fed tightening, a deepening of Fed resolve on inflation, and an increase in severity towards upward-bound rates and monetary tightening. it is this latter conclusion that I am not so sure of.
The unknown to me is not as much around the growing risk of “war premium” headline inflation but rather what happens when the Fed breaks something and the Fed is forced to deal with the reality of:
(a) Their policies in monetary tightening have NOTHING NOTHING NOTHING to do with the inflation issues they are fighting, and
(b) Other scapegoats being available to blame, and
(c) Likely downward inflationary pressures in rent and housing providing an offset to the food/energy challenges, and
(d) Public contempt for recessions and unemployment, and
(e) Political contempt for being blamed for that public contempt
The financial community is filled with a consensus view right now that the Fed we SHOULD have (one immune to criticism who just plays by the book with no regard for capital markets) is now all of a sudden the one we DO have. I simply am not convinced. Unfortunately, like the other side of this view, I can’t quantify, price, or time where that point of resistance will prove to be, so it may seem unhelpful. But it is a dividing line on what the real monetary posture around these things will prove to be in 2023 (2022 is a lost cause).
Back to China again
Putin’s war matters. And China’s economic policies matter. And I think the point of this Dividend Cafe is to suggest that the two put together matter the most.
I have written for years as to what China’s real strategic imperatives are in getting respect as an economic super-power on the world stage are. They achieved their goal of being a global exporter of goods and now need to (a) Do so in better terms for them (i.e. less dollar-denominated, more renminbi-denominated), and (b) See stronger domestic/consumer forces develop instead of relying so heavily on exports. They want to achieve these things out of a belief that they are being mistreated by the United States who uses them to fund their deficits, and toys with the current account deficit our trade imbalance creates by being the world’s reserve currency.
The reality is that Russia is a marriage of convenience for China, but that does not matter. The impact to supply chains, currency, commodities, and more will be profound in the years to come. Russia has its agenda and it is anti-west. China has its agenda and it is anti-west. The fact that they have different reasons for their anti-westernness and different goals going forward is immaterial.
A Sino-Russian alliance is (a) Likely inevitable, and (b) A disruptive force in global economics
(1) If Saudi shows signs of taking their P’s and Q’s around oil production from Russia and China, it will highlight a further expansion of an anti-west alliance all driven by individual nation interests. I do not believe this is inevitable, yet, and I believe it could never be long-lasting, even if it does come. But as a temporary dynamic that denominates some oil purchases in Yuan, and certainly frustrates U.S. greenies by not doing their production work for them, I most certainly see Saudi marching to the beat of their own drum now, irrespective of how the U.S. feels about it. This has the potential to provide China and Russia an unexpected ally or resource in the months to come.
(2) The alliance of unfriendly nations is going to intensify what has already been a strong focus on manufacturing becoming more regionalized. Industrial migration closer to North America is happening, and could lead to a capex boom in a couple years that will be potent. I would call that bullish, though, not bearish, if it is properly understood and prepared for. How to execute on a thematic event matters, but first one has to identify the thematic event. We see re-regionalization as a five-year, non-partisan priority for investors.
(3) A tension will play out between monetary policy, domestic economic reality, and Russia’s war efforts in 2023. Macro and micro positioning has to consider all of the above, not just one.
(4) Things Russia and China can buy from each other instead of involving the U.S. as buyer or seller will intensify. This leads to sector ramifications that warrant better analysis.
(5) If you don’t believe CAPITAL MARKETS will matter in the years ahead of these specific geopolitical entanglements, you are going to be sorely surprised by what lies in store. The ability to wage war through capital – the attempt to destroy capital, to weaken it, to limit access to it, etc. – is the unspoken agenda of American opposition. Inversely, the U.S. will need and utilize unprecedented access and innovation in capital markets to fund equipment, semiconductors, energy capacity, commodity production, national defense, etc. This speaks to a need for capital intensity, at a time rates are high, at a time the economy is slowing. It speaks to a high-quality portfolio.
Quote of the Week
“No people can be bound to acknowledge and adore the invisible hand which conducts the affairs of men more than the people of the United States.”
~ George Washington
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I am sure the topics brought up in here deserve more treatment, and you will see that in the weeks and months to come. Expect more elaboration, implementation, and execution from us on these themes. To that end, we work.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet