What is Happening Here? – A few post-holiday thoughts

COVID 

The delta variant wave is broadly peaking, although this varies widely by country. Countries with higher levels of vaccination and immunity are moving from the pandemic to the endemic phase. Other countries continue to lockdown in a zero-COVID bid to protect low levels of infection spreading among largely unvaccinated populations. Australia, for example, remains in deep lockdown, with military and police enforcements. They have publicly stated that they will end lockdowns once Australia has a 70% vaccination rate for adults; it’s currently under 30%. There are curfews, restrictions on movement, new police powers, etc. In the Greater Sydney area, there are currently limits on how long you can exercise outside.

Economy

Q2 2021 was probably the peak year-on-year growth change for most economic indicators, critically GDP and inflation. As we head into the rest of this year, GDP growth will be positive but with a declining rate of change, meaning the economy is growing but at a decelerating rate. Fiscal stimulus and direct COVID support of the past 18 months are wearing off, and rents and other non-discretionary costs are increasing, which are now starting to squeeze consumers’ ability to spend on discretionary goods and services. There remain pent-up savings, but spending isn’t flowing as it used to.

China

China has had a perfect storm of bad news for investors in recent months. China was first into the pandemic lockdown, and first out of it; its credit cycle has been ahead of the rest of the world. China didn’t do large fiscal bailouts, so, ironically, more winners and losers are based on their various exposures than in other markets. More recently, President Xi has been performing a crackdown on eCommerce, private education, and IPOs. The severity of these moves has understandably spooked foreign investors as they grow concerned about China’s shift towards more state control. Third, China (and much of SE Asia) has had a surge in COVID-19 cases and associated lockdowns. Some of the world’s largest shipping ports are closed, with long lines of cargo ships floating outside those ports, disrupting global trade and creating yet more supply shortages.

The China political tail risk remains significant, but equity valuations are attractive, and sentiment could barely be any worse. With Chinese equities are already beaten down and the credit cycle already in negative territory, it is tempting to think that the worst of the domestic pain is now over. However, what happens in China impacts the rest of the world; we see higher shipping costs and product supply issues across multiple industries. It also has had significant dampening effects on global economic growth, represented recently by subdued industrial commodity prices.

Geopolitics

While the rapid collapse of the Kabul government is a significant setback for the US government’s reputation and integrity of the US government it is not necessarily a positive for China either. In reality, it is unlikely that China is relishing the chaos unfolding on its doorstep from an increasingly unstable Islamist neighbour. The Taliban is a unifying force in rejecting Western occupation. Yet, it has very few common principles governing the country they have come to control so much sooner than expected. They will almost certainly need external financing support. However, which funding partner they choose remains unclear.

There is a view that the US has deliberately offloaded its growing Afghan problem in this chaotic manner as an intended curveball for China. What is clear is that it will take several years for stability to emerge in Afghanistan, which could arguably pre-occupy China sufficiently to tone down its ambitions in Taiwan. As Ambrose Evans-Pritchard points out in the Telegraph, the long term consequences of this humiliating withdrawal and humanitarian catastrophe could yet have positive implications for the US and its allies. In his view, the evacuation of Saigon in the mid-1970s ultimately led, albeit obliquely, to the collapse of the Soviet Union a decade later.

Fed, the $ & Rates 

Despite its foreign policy blundering, the US $ has remains broadly at its recently elevated levels. As the world continues to open up, albeit falteringly amid the Delta variant, one might expect this situation to reverse. However, all eyes will be focused on the Fed (Jay Powell has a keynote virtual Jackson Hole speech on August 27th) to see any new signs regarding plans for tapering asset purchases. Luke Gromen said that the Fed is “trying to ride two horses with one ass”, and those horses are increasingly going in opposite directions. The Fed wants to boost the economy and keep asset prices up (one horse) while avoiding a major drop in the dollar and a perception of runaway inflation (the second horse). It is challenging to succeed at both at this extended phase of the debt cycle. In addition, as Mervyn King pointed out in a Bloomberg Opinion piece, the Fed and other central banks are increasingly taking on additional and increasingly political mandates on issues such as climate change, diversity and inequality. He argues that this trend risks the independence of central banks. Maybe we are past the point of no return, and no one any longer believes in central bank independence.

The Fed is increasingly looking as if it is behind the curve. The FOMC purposely let inflation run hot but became spooked into considering some tightening action when it ran hotter than expected. The problem is, economic growth rates may have already peaked, so if they do tighten, they will be tightening into an economy where momentum is slowing. Doing this increases the odds that the market throws a tantrum similar to Q4 of 2018. The White House will not want financial markets in meltdown while trying to put out the fire in Afghanistan.

It remains unlikely that the Fed will be able to raise rates, at least by any meaningful amount, nor reduce its balance sheet in any meaningful way if they hold to the new “average inflation” targeting, they espoused in May. There are many years of below-average (sub 2%) inflation over the last decade to make up for in upcoming years. The main central bank priority will be to keep the pedal to the metal, favouring lower unemployment over price stability.

It is also worth remembering that we are due a seasonal spike in US Treasury issuance in Q4 this year. As of early August, the Treasury has estimated c $800bn of issuance for the remainder of 2021. Currently, the Fed is acquiring $80bn a month in Treasuries. It is unlikely the Fed will reduce this programme just as its political masters’ requirements reach a seasonal peak.

All this suggests that any tapering talk from Jackson Hole will be general and conditional and not time-specific. Powell will not look to frighten the horses, particularly as he attempts to ride two (or more) at once.

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