by Franklin J. Parker, CFA
The Summary
- It is Fed week! The Federal Reserve meets this week, and the stage has been set for an announcement of a quicker end to their money-printing program. This would pave the way for raising interest rates much quicker. The plan that was originally set to end in June of 2022 now appears to be ending in March/April of 2022. This is the new baseline expectation for markets, so any announcement that varies too much from that will likely see markets reprice. In short, all eyes are on the Fed meeting.
- At 6.8%, inflation is the highest it has been since 1982. The Federal Reserve is obviously concerned with these figures, and has retired the term “transitory” citing ongoing troubles with supply chains, etc, that do not appear to be resolving themselves as quickly as expected. Of course, expanding the money supply by 50% in the last 18 months seems to be conspicuously absent from Fed commentary, but that is why they are suddenly so eager to stop printing money. Another challenge with the inflation story is the ongoing decoupling of the global supply chain from China. China has been a global inflation-absorber for the past 40 years. With that relationship changing, inflation may once again be a concern for policymakers.
- Biden and Putin spent 2 hours on the phone last week seeking a solution to the escalating Russia-Ukraine tensions (Russia has amassed 90,000+ troops on its border with Ukraine). In addition to natural gas supplies to Europe (of which Russia supplies just over a third) and the obvious concerns over geopolitical stability, Ukraine is likely viewed as a barometer of Western commitment by the Chinese Communist Party. With their eyes on Taiwan, an uncontested Russian invasion of Ukraine would likely be seen by the CCP as a green light for a low-cost/uncontested annexation of Taiwan. While Ukraine would not be of much economic significance to US markets, Taiwan is a major supplier of high-tech components and equipment. So, a CCP-controlled Taiwan would further disrupt supply chains and increase costs and shortages of goods.
- In sum, my portfolio view has been that the Fed’s money-printing and the ongoing reopening of the economy are pushing risk prices higher. With the Fed winding down that program sooner rather than later, and the reopening of the economy most over, markets may begin to run into a headwind (though probably not until after another earnings season or two). As I have said before, raising interest rates and ending quantitative easing both serve to shrink valuations, but not necessarily prices. By my read, however, late spring may see a significant drawdown in stocks as markets reprice the macroeconomic environment, with a fairly quick recovery afterward. In any event, caution and risk control are warranted.
The Details
A friend of mine, Victor Xing, pushed out a piece last week talking through some points that are often overlooked in discussions of the US-China relationship. When it comes to Taiwan, Victor says, it meets all the criteria for a significant tail-risk event.
The key variable that is often overlooked is the Chinese cultural concern with saving face. Individuals will do seemingly irrational things (like worsen their financial position) to retain their honor and save face. US defense policy, however, tends to overlook this fact. So, by pursuing policy that makes the CCP look bad with regards to Taiwan, US policymakers tend to provoke a reaction that they would not otherwise expect because the CCP is very concerned with saving face, even to their own detriment.
It is my personal and comparably uniformed view that the US lacks the political will to pursue a hot war with our largest trading partner over Taiwan, despite the rhetoric. The economic costs and pain would be significant—for both sides—and “victory” would be about who can tolerate the most economic pain. In that respect, China has significantly more political will than the US. Taiwan is a nice-to-have to the US, but hardly worth losing a presidential election. To China, by contrast, Taiwan is of great strategic importance.
At any rate, investors would do well to watch the decaying US-Chinese relationship closely. With every subsequent erosion in relations, the cost of acquiring Taiwan becomes lower to the CCP. For investors, beyond the standard concerns of war, a Chinese acquisition of Taiwan would turn the supply chains of many of our high-tech goods on their heads.
Chart of the Week
Inflation is a phenomenon with some interesting quirks. One of those quirks is that consumer’s expectations for inflation can influence inflation itself. As this week’s chart shows, when inflation is low, consumers tend to hold a constant view of what future inflation will be. However, when inflation turns higher, consumers tend to assume that higher inflation dominate in the future. This is a big challenge for policymakers because expectation is a variable they cannot control.
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