Geopolitics A Ticking Bomb?

We still maintain, the failure of the S&P 500 to sustain above the bear market retracement zone, bears watching into tomorrow’s cash session (US markets closed for Memorial Day tonight) particularly as sentiment continues to flip flop and upside momentum looks to be stalling. However, as we have previously noted, risk assets are not being driven by pervasive uncertainties and reopening realities. The hope trade is firmly rooted in abundant liquidity and the promise of more if necessary, along with the speculative flows of retail traders driven up the risk spectrum via the lack of alternative (TINA) and the expectation that rates will remain low for an extended period. The rise of zero commission trading and ease of online account opening has fuelled the retail flows, which in the long run may serve to democratise financial markets. However, there is also the continued expectations that central banks will fix all ills and are equipped to backstop asset prices against a fundamental backdrop that has arguably never been so uncertain. The sharp rebound of March lows in turn drives continued speculative behaviour, as the fear of missing out (FOMO) becomes a driver and in this paradigm markets remain biased to the upside.

Fundamentally, it seems markets have run ahead of reality in pricing the recovery, particularly given a wide range of consumer, economic, and pandemic (vaccine/2^nd wave) probabilities exist. For that reason, we remain on high alert for the “trading on hope” narrative reversing and remain cautious on the short-term risk reward across equities at present levels.

Are rising US/China trade tensions enough to snap the positive bias? Markets have typically traded on the hope that the rhetoric is worse than reality when it comes to the US/China disentanglement. Now it seems that each day brings fresh evidence that the relationship has permanently changed and the global geopolitical architectures, which have long been fraying, are moving closer to breaking point. The ideological differences and political fragmentations that drove the original US/SINO confrontations are on full display and the tectonic shifts like, the East/West divide, Splinternet, and supply chain relocations we talked about when trade tensions first emerged are now coming to fruition. Beijing revealed plans on Friday to impose laws on Hong Kong that would ban subversion, secession, foreign interference and any acts that threaten national security. With China’s strike on Hong Kong comes the ultimate test of whether this US administration’s hawkish position on China “bark” is worse than the “bite”. Particularly as the tough stance on china plays into the election strategy and diverts attention from the handling of the health crisis, whilst shifting blame to China.

The rebuttal from the US will be closely watched, to date White House economic adviser Kevin Hassett has stated that the US government is “absolutely not going to give China a pass” and is threatening punitive actions. Revoking Hong Kong’s special trading status, along with sanctioning individuals and entities involved in enforcing the proposed new security law in Hong Kong have been floated, but talk is cheap and we await the US response.

Although the CNY fix today was stronger than estimated, illustrating the PBOC acted to slow the CNY decline, the fix was the weakest since 2008. USDCNY bears watching closely as a barometer of China’s intent and proxy for the state of US/Sino relations, the PBOC has previously made it very clear the Yuan is not a one-way bet and do not want a disorderly panicked move. However, the slow and steady depreciation is in play. The yuan will weaken to offset renewed tariff risk but also remains under fundamental market pressures. As the $CNY exchange rate approaches 7.20, no doubt angst will be on the rise but the manner of the depreciation will determine the resultant risk asset response. The more disorderly, the greater the fallout.