Geopolitics growing threat to risk assets

US monetary policy is set on a tightening course. Any variability is just a question of manipulating expectations around the speed of interest rate increases. Inflation is above target on a quarterly basis; unemployment is low and continues to decline. Under Powell @federalreserve, the Fed is moving away from targeting an ever-higher stock market—recognizing the risk inherent in such a policy. Reflecting this, his erstwhile private equity partners are selling whatever assets they can.

Monetary policy in Europe and Japan remains in emergency mode—reflecting the structurally weak condition of their economies. In Europe, this means primarily Italy—and in Japan, it means the Yen. The Yen will shoot higher if monetary policy tightens, precipitating another deflationary shock. But that’s not all: The real structural change for both Europe and Japan will come when they join the developing global arms race.

The front-runners in this race are the dictatorships of Russia and Communist China. This is a theme that is only just beginning to dawn on the West, and on financial market thinking. Narratives can be slow to change—but they will change. Both countries are structurally vulnerable in different ways, but both respond to their vulnerability in the same way: by tightening internal controls, by murdering opponents and by muzzling the press, while claiming to represent the national interest as they increase tensions on their borders.

Russia is a dying nation with a shrinking population, an energy export-dependent country run by a kleptocratic regime. It threatens neighbors, buzzing their airspace and building armed force on the borders of central Europe. However, it does not have the staying power to sustain a conventional war—and thus it is all bombast. However, Putin tries to stir up trouble wherever he can to gain tactical advantage. Hence, his efforts to help North Korea evade sanctions and to meddle in the Middle East, which once again is becoming a tinderbox.

China is a different story—and a much bigger threat to both world peace and the markets. China’s debt-to-GDP ratio is historic by any measure, yet it is involved in a massive arms buildup that (whether it wants to or not) the West will have to respond to. The military bases in the South China Sea are not the problem. They would disappear in the first hours of a real war—just like the two new British aircraft carriers. The real threat comes from Beijing’s massive investment in AI and robotics and related technologies. Indeed, US intelligence already believes China to be ahead in quantum computing.

Whatever the truth of that, many technologists believe that whoever makes the breakthrough to a self-improving AI first, wins. If ever there was an automatic trigger for global nuclear war this would be it, since it could very easily trigger a preventive strike to preserve national survival. Billions are being spent on research—something will come of it!

That aside, China’s massive debt is the debit side of equally massive overinvestment—and this is clearly an area of Chinese vulnerability to US sanctions. If China cannot sell its surplus output in world markets, then it will have to write it off, generating large financial losses a credit crisis and domestic unrest—the Communist Party’s biggest fear. The historic solution to this sort of existential problem is to find an external enemy.

In walks Donald Trump—who now “has the cabinet he wants.” It looks like a war cabinet to us. The Administration is shorn of devil’s advocates—indeed, of anyone to restrain Trump. In fact, the people around the President now seem to have a vested interest in escalation. It is clear that China is seen as the enemy, and pushback is underway. Over the coming months, we will see where the stress points show up; but we still believe that North Korea had better negotiate in good faith, or a strike on its nuclear facilities will follow.

Intermingled with this is the developing trade war, that is in reality a proxy for the cyber war that is really already being waged. China has abused the free trade system, and uses espionage on a grand scale to steal commercial secrets. Why it has taken Western governments so long to respond to this is a mystery, but now we have a US Administration that is taking the gloves off.

 Against the backdrop of a darkening sky markets are under pressure:

Currencies and Commodities:

“King Dollar” is advising Trump. Perhaps @larry_kudlow has told him that a debtor country cannot afford to see a run on its currency. In any case where can investors go? Geopolitical risk is rising. This is not really debatable blame it on who you will. We have not changed our view that the dollar index should hold the 88 level give or take a percent and that a multi-week rally is coming. The fundamental background is positive on the monetary and trade fronts where Fed policy and energy exports are leading the way. Geopolitics would be another support factor. If so we are asked, why has the dollar been so weak over the past year? This is a fair question in light of the fact that interest differentials have moved steadily in favor of the dollar over this time frame.

It could be put down to capital flight but then how do you explain the remarkable inflows into US equities? One credible hypothesis is that the markets believe the Trump administration will devalue the dollar—hence the record long Euro spec positions. The spec positions are small compared to the multi-trillion dollar carry trade into global asset markets. As US policy becomes clearer there is a risk of this unwinding. The technical picture is increasingly supportive if not yet definitive. The next hurdle is 90.60. Failure here would trigger a test of the 87 level and then we go to 95.

The equivalent pivot point for the Euro is 1.2217. Below this level would confirm a high in place. Meanwhile we have to live with continued choppy action.

Increasing the risk that one final test of the highs is possible for the Euro is the action in the Pound. The decline from the January high at 1.4340 looks corrective suggesting that high will be tested or exceeded somewhat. An interest hike in May is likely for the UK but that is likely to be it for the cycle. Otherwise we remain structurally bearish on the Pound which remains in a secular bear market.

We are still expecting dollar/Yen to form a countertrend rally to 108.4 to 109.4 for an opportunity to sell it. The bullish background for the Yen develops as risk capital returns home.

A$ to retest the highs: The A$ has probably formed a consolidation pattern versus the US$. A rally back to the highs may get under way soon. Near term the 78.6% retracement level at 0.7638 should limit the near term downside.

CRB still bullish. The commodity index has also completed a corrective consolidation and looks set to rally back to the highs.

Crude Oil building a top: WTI briefly overcame its declining trend line that we thought would limit the rise. Instead the 78.6% retracement at 64.82 limited the upside and set the condition for a decline to test the prior swing low. Now retest of the rising trend line appears likely about $2 above Friday’s close of $62.34. That test will provide a selling opportunity.

It is probably residual dollar weakness that will aid the commodity complex to retest highs, but we think gold has formed a low albeit one that may be retested. It is the ultimate defensive investment and the global background is deteriorating. Patient investors will be rewarded. This applies to the metal as gold equities will fall with the stock markets

Equities:

The technical pattern has turned firmly bearish in many markets and exhaustion highs are due in others. Bear markets don’t begin against a backdrop of bad economic news but most often against extremely good but unsustainable trends. Underlying monetary growth and other leading indicators have been warning us for many months that a peak was at hand and the technical signal was set in January and we called the top on the 29th.

The 50 and 200 day moving averages have formed dead crosses in many European Indices where the falling 50 day moving average cuts down below a falling 200 day moving average. Most European Indices are in rallies that appear to be corrective in nature. Many US Indices may be close to completing corrective highs. The #FOMC meeting this week is likely to be the next major economic driver. The balance of risk is tilted towards a tighter stance sooner rather than later. We therefore see bond yields ending their recent consolidation and heading higher to make new highs over the coming weeks. The 10 year note is likely to test 3%, a major resistance level.

Last week saw the peak in the last index standing. The #NASDAQ has been the front-runner in this last stage of the bull market reflecting the mania in technology stocks.

Technically the Nasdaq has finally made new all time highs. Near term there may still be further near term upside before the major high is in place. A close below the last swing low will confirm a high is in place.

The S&P500 has probably completed a retest of the high. However continued strength and a confirmed close above 2800 will open the door to new highs. A decline to a minimum of the rising 200 day moving average should get under way soon.

The DAX tested prior support at 11869 to form a temporary low. Ideally the rally under way should now test the prior minor resistance high at 12602 before resuming the downtrend.

The FTSE100 has formed an impulsive low at a strong support level which has limited prior declines. The current rally should test the prior resistance at 7326. Further downside can then be expected.

Showing some global correlation, the Nikkei found support at the 200 day moving average after an impulsive fall. The rally under way may have may be peaking despite not testing prior resistance at 22500. It will follow other markets lower with similar fundamental justification.

The Hang Seng Index should have peaked. The rally looks corrective. The index reflects the huge bubble in HK real estate but the index oddly has been correlating with the US NASDAQ. Overall we expect it to decline initially to test the February swing low at 2900. A near term rally towards 3200 would be a selling opportunity.

Malcolm Tulloch

The writer is director of the firm Tulloch Research. The company provides bespoke advice to clients on macro-opportunities in financial markets.

“Intuition is a product of accumulated experience”

Tobias Truman