• Jan

The Eagle versus the Dragon and implications on financial markets (2020-2024)

The eagle

The eagle has dominated the globe since the end of World war 2. While its rise has been solidified through that event, the accumulation of so-called "full-spectrum-dominance" came slowly within decades later. The formation of political alliances guided the winners of WW2 and the rebuilding of the global economy through the new monetary system was a strong starting ground.

Still, the dominance aspect as defined today shows the most through high living standards, strongest financial system, an abundance of the credit markets to outlast the shortfalls, and perhaps most of all the technological superiority for the military and domestic side in the cumulative output and next-gen status.

None of such features comes granted or guaranteed to last, as it is primarily (historically) held through deflecting the challenging powers and always maintaining the upper hand, using the many methods in the playbook, for either the greater good of the internal population of such country or the long term plans that such power might have for the whole global population itself. The eagle has learned and applied many methods from similar dominant powers of history and elevated them on many levels (Roman and British empires as two closest ones) where the deflection of weak challengers against strong challengers is its primary external policy guide in order to weaken the power of strong challengers constantly.

The dragon

The dragon's rise was unexpected and the fastest of any in history. The economic boom was achieved through a strong integration in the middle of the cold war era, where the dragon was used as a counter-balance against the bear on the north; it was one of the critical achievements for the eagle to sustain southern Asia pressure and contain the bear, by lifting the dragon to the higher heights economically.

After the bear entered the hibernation phase in the early 1990s and economic collapse, the plan was merged into prolonged globalization for the dragon. The dragon would carry the heftiest weight of spreading the deflation into the west, providing a cheap labor force and goods, which provided the spring ground for one of the fastest economic rises within the recorded history. Within just 40 years, from a very low-key developing market economy, to now almost to a good extent, a developed market in many areas and productivity unmatched in many areas as well.

As the economic productivity has risen, so have the plans for the future, and many of those are no longer just held within the ground of where the dragon resides (belt and road initiative); as they stretch, they come into the territory of the eagle, since in globalized economy, what is or what is not one's territory or playground is actually a very stretched term, as in globalized world the distances get less meaningful. In today's era, one's economic territory can be well out 1000s of miles of actual physical borders of the state itself, especially when it comes for the three key players, the eagle, the dragon and the bear.

The biggest game in town

In financial markets, the competitive aspects between economies are always layered; regardless of market niche or asset class, there is always some origin, the architect of it all. And the rest of the layers in the game are reactionary to the top layer, often in a very deceptive manner. Many of what happens within a specific ecosystem can be explained through the rules of competition; since all ecosystems of nature are somewhat competitive, and competition is a strong force within the evolution of nature (and same applies to humanity), it often leaves a good starting ground for where the chain of actions for specific events follow down. In the game of geopolitics, there is no greater force than the competition, when a macro observer tries to justify any moves of the participants, the competition aspects have to always be the core from which the judgment of the situation should be made.

The relationship between status quo preservation and the challenger situation is the key unavoidable event to happen, which repeats through history every so often. The majority of status quo powers try to avoid it, by pre-weakening the challenger through the divide-et-impera tactic, but that does not always work, as it did not in case for the dragon. The name for "biggest game in town" comes from the fact, that once this situation is in play, the forces that will be drawn to the global economy and the financial markets will be by majority lead from this, as this will become the key driver for the behavior of many financial assets, especially on longer time scales. This should explain why personally i have been placing so much time studying this over past 6 years, and placing much attention to any traders or investors in daily relations with. One cannot ignore the biggest game in town as it impacts every market.

Just as ecosystems in nature circulate between very lush and plentiful environments of higher cooperation to the cycles of very dry, colder cycles of stronger competition and struggle within ecosystem might increase in such case many folds, the same applies for cycles within geopolitics. The "Pax Romana" only lasts for so long before it no longer exists because the cycles of "lush" environment between the status quo superpower and its challengers are limited in duration. Every once in a while, typically sooner than within a span of 100 years, a new challenger rises to the point where it becomes a match to the ruling status quo. When it does, the Pax Romana has no further application, as one of the key abilities to sustain such a cycle is for status quo power to have no real strong challengers. Therefore lush cycle and Pax Romana go hand in hand, usually combined with strong globalization, meanwhile once cycle shifts, the deglobalization takes place and the capital flows reflect that, along with the global rise in inflation usually.

This then leads for a typical cycle in geopolitics to be split between the eras of globalization and deglobalization, each representing the lush or dry conditions for global capital markets.

For example, when globalization is on the rise and the status quo (the eagle) has no major challenger, there often is no strong primary (top of the pyramid) driver leading the actions present across, at least not to great extent, for macro economic or market driven aspects (since that is the key focus of article, the application of this situation on certain markets).

But when the deglobalization enters into override (such as with the beginning of 2016 and especially the start of 2020), it will shift the flows in financial markets, and usually keep them sustained there for at least 10, or in some cases more than 30 years. This is expressed in the reformation of political alliances, the repricing of global commodities, weakening of certain currencies, and many other changes.

Meaning that under such conditions, it is straightforward for:

-Political or national security agendas to start influencing the business cycles (shutting of many restaurants across the globe in 2020 for example, due to biowarfare),

-The slowdown in growth of major economies (first slowdown of the dragons economic growth),

-The supply chain prioritization (decoupling),

-The major increases in debt-fueled economic activities (huge base currency growth by FED last year) to prop up the economic growth,

-The prices of basic resources or commodities (rally in commodities by 100% over yoy), etc...

Knowing when the global macro game kicks into this deglobalization drive is of utmost importance for any macro investor, or investor/trader in general, as the actions that take place in the future will be much more self-explainable or less challenging to figure out ahead.

By the way, "deglobalization" is just a common phrase thrown out there, in reality, the worlds economy as a whole rarely faces a real deglobalization, in reality especially in modern economies of the past 200 years, what happens is that the globalized supply chains restructure between the participants differently, more towards others, less towards the rest, shifting from one area of deeper integration more towards another area of previous neglect. This means that globalization as a whole (globally) is still present usually at equal levels, it is just different from play to player ratios from before.

Only to lay this out, because most of my observations of active market participants is that many are unable to tie together the pieces of puzzles to fit where the agendas are coming from. Mostly due to either lack of interest in geopolitics itself or just a lack of interest into trying to figure out agendas of each players involved. Typical macro trader or investor spends too much time reading the news, with absorbing the "reasons" suggested by media, rather than trying to figure out their own agenda, objectively:

-They might see a crash in crude oil prices in 2014 but unable to connect the dots to the macro game of why it happened. Surprisingly many observers believe that crude oil can crash 70% just without any reason present, no agendas.

-They might see the increase in tariffs on Chinese products in 2018 but cannot see if that means to be permanent or just temporary. Lack of historical context, trade conflict escalations, rarely just go back to previous state before they go much worse.

-They see sanctions on the Russian economy in 2014 but cannot connect the dots on how the crude oil collapse ties to all of this as well. Since Russia is major crude producer, strike on the energy revenues and international sanctions is a double whammy, from the agenda makers.

That is a typical issue for many, the inability to see the higher end agendas, which leads to the un-firm formation of opinions on markets direction for near future, especially for specific countries. Which then leads to the fact that most of market analysts are just a "macro tourist", they just watch the news without placing anything into needed context, making logical conclusions on daily basis without really having a firm context. And one of the main issues is the lack of in-depth research. It takes a lof of research to build solid read on the geopolitical agendas, way more than a typical reader or market observer thinks it does. One article a day on typical news site is by no means enough.

The significance of studying history in-depth

Without studying history and researching the implications on financial markets across a wide spectrum of asset classes, one will not be able to build a decent framework for 5 years ahead. Without history, anything will become just a guess or an over-reaction or under-reaction. Only the historical behavior can really explain what has been happening on the scene between the eagle and the dragon over the past 5 years, and what might come for the next future years.

It is critical not to be the typical "macro tourist" who clicks through the media and tries to make justifications or "predictions" based on what is read using only common sense with minimal daily input. Reading news or the latest macro events is only useful when placed under the correct context, whether that is one's personal experience or history study. But chances are if you have not been present on the planet for more than 60 or 80 years, your personal experience will be minimal, and seeking history to provide clues will be a must. The younger the people are, the more skewed or unobjective their perception on geopolitics is usually, due to lack of "live" experience of seeing things, and usually, as well lack of research.

To highlight the fact, that before one is tracking the news on daily basis actively, the solid foundation should be built first by studying history, else there wont be any context to place current/recent events into. For anyone interested, since this is market-oriented content, keep your study aim on past 200 years as this is where the modern markets have developed with enough of quality data, to compare the actions relative to market assets. Stretching studies too broadly could lead to too much wasted time, it is better to sharpen the focus into right direction, especially if limited on free time.

Studying the structure of both economies and their weaknesses, rather than being lost within media noise on daily basis

Traders or investors task is not trying to predict 10 years ahead of where the "winners" in terms of countries for best investing opportunities or highest capital inflows (which is highly rewarding, but very difficult to figure out) or which nation has the right to lead the world. Figuring this out is difficult and just not practical as it creates too many biases (inability to flip), the view should be more segregated into chunks, taking it step by step where the opportunities are, on year to year basis.

Remember, one can frontrun the market just a bit so that you have an edge, but not too much to the point where you are too ahead and market just does not respond for long time to your insights, because it needs too long to catch up. Skillfull investor or trader knows how to balance this well. It is, therefore, better to use history as a projection of what might happen next within the 3 years span in terms of actions taken or reactions from each side. Meaning, placing aside the typical ideological views of judging the strength of eagle through "democracy" and dragon through "technocratic totalitarianism" and trying to justify the position of either two just from that and how the market forces might apply to each. It is more meaningful to anticipate the in-between actions that are likely to be taken from both sides and then trying to anticipate what reactions might be at specific market spaces. Rather than figuring out where the long-term winner is, figure out the tactic, so you know where the echos of such tactical moves will take place, and which financial assets might reflect them, whether it is the delisting of stocks, tariffs, capital restraints, sanctions or similar actions.

Remove ideology from your trading or investing biases, figure out the tactic each player might choose, and how that might echo into the specific market of interest.

Always remember, your task as investor or trader is not to justify or criticize the actions of either participant. It is only to figure out potential agendas, and the flows they might create. Nothing more than that. And yes, that is a far more difficult task.

The key core tactic that observer should extract potential insight, is to operate within the typical tactic chosen historically, between status quo and challenging power, the tightening versus expansion dynamic as this will have major consequences on not just political dynamics, but markets especially:

With this in mind, it should not come as surprise that the formation of Asian pro-eagle alliance (India, Japan, Australia, South Korea) was formed in 2020 as an offspring of the tightening tactic, and from the opposite side initially the dragon using the belt and road initiative (BRI) (2013-2020) as the core footprint for expansion, economically and to strengthen the same ties to political alliences across the Eurasia.

With the above tactic in mind, and historical guidelines, the typical exchange and shifts happen trough the import and exports as the main force that drives the capital markets, or especially certain assets, some of which is outlined below.

Look for weaknesses in the import sector, as imports are the quickest way to "import" the inflation without having control

This section will only make sense if one studies the situation between many status quo and challenger situations historically through the history (16 cases, four very well documented on the import/export side) and how the dynamics took in the shifting of trade flows and the impact it had on inflation for each of country in such case.

Usually, what happens, one of the participating powers is more asymmetric in its imports versus exports balance versus the other, relatively speaking towards the control it has over supply chains. Lack of control over supply chains and considerable exposure towards imports is usually problematic as it can easily lead to an increase in inflation and erodes the economic productivity long term, especially if such participant is unwilling to take control over supply chains by force, which generally means using military force.

There is a lot to be said under this subject, but to keep it on point. The current struggle between the eagle and the dragon will be heavily focused on the imports and exports and the supply chain weaknesses that each of the participants has. most likely This dynamic will be the leading part of how each participant will likely try to push their leverage against the opponent, and this is where the core of long term market moves will spring out, such as the heavy rally of commodity prices and semiconductor chip companies in the past year and a half. Getting familiar with what each of the participants has as a weakness (does not produce it internally, but needs it in high demand) and what is each participants strength (has internal production of such specific goods, and these goods are highly in demand across the globe) should be the primary factor to focus as study point.

Example of dynamics that might take place, and influence the market moves heavily:

-cutting of crude oil supply chains to the extent in Asia, or increase of crude oil prices (weakness for the dragon), impact on all global markets

-cutting or disturbing of supply chains of semiconductors to produce high grade internal electronic equipment (weakness for both), impact on equity markets

-internalizing electric vehicle production and banning competitive companies within each participants (weakness for the dragon, as a lagging player), impacts of flows on equities

-increased tariffs on basic goods imported at high capacity for the eagle(weakness for both but the dragon taking much heavier downside), impact on equity markets (BABA for example)

-decrease of exports of rare-earth materials from the dragon (weakness for the eagle), impact on equity markets


Those are just five basic examples, but there are hundreds of further to expand on. Look on the import and export table to see where the key weak spots and strong spots of each economy is, especially on import side as those items are the most proned to inflation, if supply chain issues come about.

The eagle and the bear cold war as a guide and Russia 2014 "escapade"

When it comes to attrition-based conflicts between two major powers which are both unwilling to enter into a direct conflict, there is often the same playbook that the "tightening player" or "expanding player" is using. This typically means finding for tighten-er the soft spots within the opponent's economy, challenging power, and using the leverage to inflict the long-term pain. Usually, this means inflicting self pain that is projected on the whole globe, and as a result status quo hopes to take less damage than the challenging power. In many cases, the actual core mechanics of such actions are all inflationary, regardless of outcome of the long term winner. And regardless of the tactic chosen, the result is always some form of asymmetric inflation, which is then projected on specific assets such as raw materials, consumer goods, energy, or many others.

This leads to the fact that whether one takes the escalation (at least in the initial stages) between the US and Britain or the US and Soviet Union, the inflationary pressures soon start to come up, as the result of forced deglobalization, which destabilizes the trade flows and distribution/supply chains which are in most cases inflationary as a result. As the inflation spikes up, both players start to take the damage out of such action, but it very much depends on which side is more exposed to that particular "asymmetric inflation." For example, a power that is a strong energy producer would benefit from rising oil prices to an extent (the eagle). In contrast, strong energy-consuming-importing power such as the dragon would take much more inflationary and negative economic pressure. And while yes, some might argue well, there is a lot to say about if the high prices really do benefit the economy of the initial power in such a case, the real answer is, it does not even matter when taken into the context of cold conflict. It only matters weighing the damage or positive impacts on one side of such power versus the other. The tactic has to be taken within the right context as those who triggered it (the strategic administration) are not really thinking about the internal economy only but rather looking the global picture as a whole. But do not mistake, both powers (in fact whole global economy) does take hit from such engagement, no one is left out.

The response is usually internalization/deglobalization to increase self-sustainability

Returning to a more recent modern example of small-scale cold war conflict between the eagle and the bear (under which EU was a critical component to play a role in between on side of the eagle), it can be observed typical reaction to how the response is carried towards self-sustainability. The reason is few folds, but when the initiator uses the tactic outlined above, to focus on the weakest spots of the opponent powers economy/system, or those spots most exposed to global supply chains (which was for the bear: energy, food, capital investing inflows), in most cases, the response of such power will be to reduce the negative exposure to this links by trying to increase self-sustainability and produce as much as possible internally, decreasing the number of imports, and finding whatever other market that is open for their exports, once the primary exporting routes are cut. This is one of tactics used to curb the inflationary pressures. It comes at large short term costs however. The same can be observed in the current plan formulation by China, as prioritizing especially technological self-sustainability within the next 5-10 years, which actions were triggered under previous US administration, when the administration started to tighten the grip on supply chains between the two countries.

Forced de-globalization is basically the result from both sides; one side is intentionally tearing the globalized supply chains, meanwhile, the other side is doing just the same to better control the damage and reliance on the imports or to shift the distribution of exports. Such actions then (historically) lead to rising inflation, however as mentioned, this is done very selectively; the rise of inflation does not mean that currency starts to lose value drastically and quickly (although that does happen over a while); it happens intentionally within specific sectors, materials or services rather than currency at least initially. The pressures on currency usually come lagging behind, few years later.

Growth or resilience, either-or, but one cant have both.

One interesting aspect is that the more you research and think about how each administration (from both eagle and dragon) is approaching this issue, it's all very repetitive looking from historical context. Basically, anyone studying the playbook of how attrition-based engagements work on a large scale as this one, the tactic can be laid out 5 years forward, using history as a guide. One can't really figure out all the micro moves, but the broad tactic is relatively known as there is only so much of "improvisation" that can be done by either power, as the rulebook of law, economics, military tacts does not change too much over time.

But if it is not difficult to figure that out using history as projection, so the question is why would then the challenging power not predict that ahead and prepare well before it happens with the right counter tactic, if history is clear on it, and surely there are thousands of professional analysts and strategists employed by each administration to study it. Or to put it into the words/quote of Theoden: "How did it come to this?"

All of which is true, but let's lay out some facts, why sometimes the nations are like tanker ships, unable to steer in directions due to limitations tied by current circumstances.

The key planners and think tanks of the dragons administration have already outlined well ahead in early 2000s that a "challenging situation" at some point is unavoidable if the dragon keeps growing at the speed it has projected for its near future and the aspirations that might come out of it.

But for the country in such a position, two opposite tactics can be chosen (either or), which explains why the dragon did not have much chance to prepare well ahead, and it explains to the extent as well why the eagle was hesitant for so long. First tactic being focused at maximum growth and globalization and the second being self-oriented, with lesser exposure to globalization and mercy of status quo powers, but at the cost of weaker growth.

When a country is achieving growth at the scale that dragon does, this can usually be done by strong globalization, which dragon underwent since late 1980s. Sure there are stronger internal growth stories, such as Japan after WW2, but most of those stories have the presence of large international capital influxes and strong opening up to the global supply chains. And for one to sustain such high % GDP growth rates, it is not really possible to play a defensive tactic at the same time, preparing the economy just in case if status quo reverses globalization.

Once a country is growing at a fast speed, it is often done through the process of opening, and the opening is almost the inverse of self-sustainability or high degree of self-reliance.

Open economy, especially one that has a strong global supply chain presence is at the same time exposed in many ways (such as the economy of dragon). Think of those arteries of economy, but arteries can get clogged too, and if they do...

This leads to an inability to really cover the key strategic weaknesses well. Country can pick either a high growth at the expense of creating many weaknesses, or to pick a much slower growth and build a much more self-reliable economy that can be resilient to outside agendas of status quo powers (something that Russia semi tried after 2015s).

In case of the dragon, much of it was done by picking a route number one, although a good amount of "hedging" was done as well. This explains why no matter how much man power of strategists and analysts that such power can place to study the issues of creating a robust economy that can withstand the wrath of status quo, it really is limited in doing so because picking route number one, already creates a lot of weak spots within economy, due to globalization exposure regardless of preparation. Meaning, the economy is at the mercy of outside player.

This basically leads to very similar issues across all those situations historically. The fast-rising challenger has plenty of weaknesses because the fast rise is usually achieved through globalization aspects (especially in modern era). This also explains why almost every time the tactic is chosen by the initiator it is following similar scenarios, regardless of which specific countries are participating.

Growth and resilience, as per the subtopic title can be quickly explained through equity markets. High-growth companies have many weaknesses because as the global growth turns south, they are the first to take hits. Resilient companies are slower at growth but can withstand interruptions better systemically, their weak spots are not as big. This is why in the downturn of equity index and economy, the growth sector takes the biggest hit often the first. Precisely the same applies to countries and the economy as whole, especially for extra high growth economies.

Inflation and potential markdown on currency

Now to not get too political or historical, because none of that is the intent of this article, since the focus on the blog is mostly about trading and market-related subjects, there is something that the reader should fully understand, however. If events over past 5 years confirm that this is the unavoidable clash between both the eagle and dragon and that asymmetric inflation is likely to result in upcoming years, the question would be what assets would be impacted by that and what potential directional trades might come out of it. Or at least what trends might develop in certain assets such as commodities, currencies or equities that traders can join and extract the edge from. In my view, there might be several different broader and some smaller niches to focus on. A broad niche, for example, might be a currency since the weakness in the currency of both such strong trading partners might happen as a result, as imbalances between the deficits escalate along with other many inflationary reasons. But the difficulty is that shorting a currency under such a big scale macro play that might be unfolding for years if not decades is just not that practical until there is momentum behind it.

Basically, if one takes all historical examples of the past 200 years, the currency does not take a hit for a while until all of a sudden it does. Usually, at that point, the central bank is no longer able to keep rates higher than the inflation is rising, which leads to spiraling inflation, for the weaker player in such asymmetric conflict. And the key is, this only applies to whichever of the players is the weaker or much weaker relative to another one as that is critical to determine the side that will have such behavior present, for currency and capital outflows. Typically global capital flows shift towards the safest player, the status quo, and generally the better performing economy for each (after 5 years).

While both currencies of such nations can drop, in FX markets if one picks an X/Y currency pair, obviously the chart will weigh against the weaker currency, therefore the stronger currency even if it has an inflationary impact it does not matter, as all it matters are ratios. How much does the currency of a weaker economy drops against the stronger, even if both eventually do fall lower, due to inflationary pressures, USDCNH (dollar versus yuan) being such a currency pair example, but it goes beyond the currency of two major participants, as proxy currencies matter as well.

To keep it short, there is a play on currency, a long term (5 years) short swing play, but the question is how one would manage that position as the trend might be very choppy on month to month basis, but much cleaner on year to year basis, making it relatively difficult to trade on short term basis. And to start the trade in direction of such trend, initiation and clear trend progression has to start in first place. Key tip would be, look for both central banks, and look which one is unable to hike rates, or is hiking them substantially behind the actual inflation rate. That currency is likely to drop sharply. It might be that both engaging powers take a hit (some historical examples of that) but in most cases, it is one side that takes much larger decline, hence the trade is asymmetric and a short on X/Y pair.

The currency example above is a broad view, 5 years, for example, as mentioned since it might not be easy to time the trade. But the example of the Russian 2014 situation shows that it actually happens very fast in some cases, making it solid intraday play, but only if the negative pressures on the economy happen rather fast, relative to the size of its output. The ruble dropped heavy just within a year since the key pressures were applied against the Russian economy on so many different scales, but the crude oil collapse being a key driver of that. Usually, the specific catalyst is needed, and it has to be very strong in magnitude to potentially create an "in-play scenario" on shorting the currency.

Example of currency cascade on Russian ruble in 2014:

This was still one of the sharpest trading opportunities in FX markets over the past several years, not just in risk to reward ratio, but as well as in resolution speed, since ideally in a perfect world for trader the trades resolute as quickly as possible, to free up the tied capital.

Smaller niche examples might be selective inflationary presence due to supply chain disruptions, such as as iron ore or raw wood. If such a market has decent liquidity, it can be traded on the long side, using the tightness of supply to drive long trades. Many such resources follow such theme lately, but if one does not have a broad market view, most of those might only be seen in hindsight as obvious, hence missing the trade opportunity. However, if taken the long term aspect of most of the cold conflicts, would it be likely to expect that such high prices might remain elevated in such materials for a while and that they are not just once come and done type of thing, especially if supply chains from political perspective keep restricting between not just the eagle and dragon which are center of this, but rather all the other key producers such as regional players which are resource providers and are required to "pick a side" from a political stance, which includes all Asian economies. All of which can be very much visible over the past year in action, since the start of the liquidity event in March 2020.

Hence the opportunities for such long trades, in the example of iron ore as one relatively more exotic, a low liquid market will be further present.

Iron ore example, rally due to supply chain tightness and supply shock.

Equity market performance for the US under inflation spike era

There is a consensus that if inflation is gradual and under control, it can be positive for equity markets. There are many cases globally and historically to support that point. If inflation rises too much and unexpected or quickly, and if rates follow the upside, then the growth will be damped, and generally, that is not positive for the stock market. While the equities might still perform well under such an environment, the currency often loses value too quickly while the gains of equities are offset by the devaluation of the currency. However, when it comes to the largest liquid currency and relative stability of the US economy versus the rest of the world, there are advantages that the US generally has against many other economies.

But to not speak too broadly or too theoretically, there are few points that traders or investors should follow to position well in a potential higher inflationary environment which is already present; the question is will it be sustained over next years (presence of elevated inflation).

SPX performance in inflation spike, under the height of the cold war (which resembles similar conditions to current next 2 years likely, but in relative terms not absolute).

As the images show, the equities struggled to print fresh highs because the inflation mounted too much pressure on many companies. The situation today has some differentiation which is that the financial and technology sector form a higher portion of the economy today (and are not as exposed to inflation as import/export sectors) than three decades ago, which might offset and help to lift equity markets a bit more, at least in my view. Therefore my opinion is not as "toppish" as it would have been for the 80s (in hindsight), but it is reasonable enough to expect that if we do have a bull market for the next three years on SP500, it will be plenty of chip-chop action in between, it probably will not be as smooth as 2021 has been.

Spike in inflation versus prolonged inflation

A significant distinguishing difference to make is when the macro environment globally or specifically for the US is under just a spike in inflation which lasts for about a year or two and then returns to previous regular rates, versus the environment where the inflation remains elevated and is rising and does not return to the previous state for a while.

Often after a major financial crisis, the inflation will spike but usually return to normal within a year. What is so different is when the inflation is spiked and sustained as it was in the 70s to 80s shown in the example above, is that it does not return to normality for a while. The difference is significant in terms of how it impacts financial assets such as equities or currencies. It places the burden on the progression of equities, dampens the growth, and pushes currency lower, especially if the central bank does not hike rates high enough. In my view, we are not in the first case, but rather second case, where the inflationary pressures will remain for a while, at least 2 or 3 years, could be more.

But something to keep in mind, all inflation increases are usually following the spiked behavior. It usually ramps up relatively quickly; the gradual rise in inflation is more of a myth, or perhaps something that only can be said if one stretches the chart window "wide enough". But in reality, once inflation kicks in, it comes with a swipe. The question only remains, will it correct back relatively quickly (as it often does), or will it re-spike again soon enough and merge into a higher inflationary environment over a while. To answer that, usually structural issues of economy will answer that question. An economy that is unable to adapt will have elevated pressures of inflation for while, meanwhile more robust and adaptive economy will eventually get inflation under control and the spike will correct to previous levels. (Two very broad examples of this are Venezuela 2014-present on one side or the US on the other side 2008-2010).

If the reader takes everything on the article written and places it into historical context, the point being made in the article is that current inflation is probably not just a short-term spike but rather might be sustained. From my view, using all the data combined, we are likely replaying the 70s and 80s era, where the inflation was ramped as a part of the anti-Soviet strategy (even though that remains only a tinfoil hat theory publicly and general theme is that it happened due to "coincidence reasons and wrong policies"), and we are likely to see the same roll-out in next ten years. However, the difference is that the inflation is not going to rise to the levels seen in the 70s (i.e., 15%) but will rather remain in lower numbers (due to globalization and technological deflationary forces), perhaps in between 4% to 7% for the Core CPI. This is due to a more globalized world and more resistance to inflation in general compared to 50 years ago, at least from my view. Due to much bigger abundance of all global products (excessive supply), the inflation will not spike to any scary levels, but it will be higher substantially relative to any prior years before 2020.

Current inflation surge Y/Y for US.

The dollar long

However, the play that I do believe has high certainty is the long play on the dollar. Dollar long and emerging market short on currencies. My personal view is that I highly disagree with those in view that emerging markets can outperform in an inflationary environment versus developed markets such as the US; if anything, exactly the opposite might play out, as long as we are talking on the currency side (FX market). It is likely to see the dollar rally over the next two or three years against many emerging markets and exotic currencies globally, as the global capital flies to safety, among the other reasons—risk on, risk-off.

One thing worthy of mentioning, the central banks that are in the best position to hike rates (highest performing equity markets, not as high inflation, labor growth) are likely to outperform on the currency side versus other countries that are not in an as good position. This is one of the main reasons why I believe that dollar will outperform many other developed and emerging markets, which are in a much stricter position to hike rates, and therefore lift the currency in the next years. And if there is a cascade of emerging market debt upcoming, it will lift the bid on the dollar trough the dollar-denominated debts that will have to be paid back.

The squeeze play: crude oil

The role of the article, should not be too "prediction" based, as often things do not age well that way, or might take a while before they play out. But rather the intent is to look at key supply chain-related issues from a historical perspective and global location basis to use all the above reasons on how the tactic of focusing on critical weak spots in the opposite engaging players might work, whether those are intentionally or non intentionally triggered (random event vs non random).

It would not be irrational to assume that at some point in the future, the crude oil could see a major price escalation, followed by a certain geopolitical event or just supply chains of ships and tankers clogging the ports causing the issues for countries that import large amounts of energy. If such an event would happen, then chances are it would create potential long-term, lasting supply reduction in the crude oil market and the stocks that are exposed to it under many different countries and exchanges—basically a 2003 replay.

The significance of such an event is not to be under-estimated in terms of the impact of trading or investing opportunities it could give, especially if it were sustained, for example, with a year or two of duration. Could the global economy sustain very high crude oil prices? It can, but the question is at what price; for each country, the answer is different; it is all about the weak spots. Who imports more, who exports more, etc.

The case above is not a fantasy story, as the actions of the dragon's administration in 2020 clearly indicate that deal with securing nearby crude oil supply chains in Iran at a huge scale show that the dragon's administration is well aware of such a potential scenario and what it might do if resulted, over a long term. Reliance on Saudis flows failed back in the 2018 coup detat, and hence the priority was given elsewhere. However with that said, obviously Hormuz is a whole another issue in itself, its closer, but the weakest energy choke-point in the world ("potentially").

To sum it up, from personal view there are two likely events to happen in next 1-2 years which are both energy bullish (short/mid term):

  1. (highly likely) Supply chain chaos, which slowly reduces the supply of energy and therefore keeps prices creeping higher for months, but the prices creep up slowly.

  2. (potentially) Hormuz event, which cripples the outflows of crude to large portion of Asia, placing significant positive price pressures on energy

Coal, natural gas squeeze (crude oil lagging behind but is likely to play a catch up)

This article was written by a majority in August of 2020, more than a year ago. Still, I decided not to publish it yet and let some of the plays come to fruition first so that the reader gets better context, rather than declaring the author of the article as a straight-up tin-foil-hat case (as most of the things mentioned took several months before they came into play).

One of those factors being that coal and natural gas coming into squeeze currently are the main connection driver to crude oil; however, the actual implications might only be felt once the crude oil reacts and not before (due to larger portion of economic activity related to it), which also makes sense that the cascade of chain reaction makes from time perspective sense to be delayed until crude comes within the picture (in my view in next few months).

This is not to say how much the crude can rally, but rather be ready from the trading perspective as a potential continuous rally over the following months, without looking back, even as the Asian economy comes into a significant stand-still. This is more about inventory imbalances and the clogged supply chains as pressure on the whole equation, rather than the economic growth of either country contributing to it.

However, to keep the devil's advocate hat on, the counter-weight to that thesis would be, if Asian economy heat comes down a lot, the decrease of demand would crunch the energy prices.

There are two major opposing forces at play, clogged supply chains which are price positive and global (but mostly Asian) economic downturn which is price negative. Both of those are and will be in play for next 2 years, the question is which will outbalance the other, and what kind of hiccups will be present in between, and how long those will last (shift from oversupply to overdemand).

A hint, keep an eye on for next several months: Strait of Hormuz.

There is a chance of March 2021s, Evergreen replay.

The new crude oil: semiconductors

If one takes that technological revolution of fast advancing sectors and even further inclusion of tech into the productive capacity of economies of near future and the projections for the next 30 years, then it shouldn't be much of surprise that core chip designing companies might play a major role in future. If semiconductors are part of every advanced tech product, and the ability to produce smaller and more advanced chips can have a big leg against the competition, then the companies or countries with the most advanced chips hold the superior hand. The competition for which will be fierce, and will be one of key focuses and macros in play over next 5 years, for both of major consuming players of which are the eagle and the dragon.

It is not much surprise why the stocks of semiconductor companies rallied over past months, as shortages pressures mounted, however this is not the first time it has happened. Shortages in semis space are not unusual, but there is a significant difference if shortage is of geopolitical nature, as this one might not be resolved any time fast (which is being the case currently). One such historical example would be when the US restricted Japan for semiconductors (or the Japan did it, depending from which angle one looks at), which resulted in a smaller scale but similar events to current 2020 events, however since the semis as that time did not represent nearly as large portion of economic linked activity it should not be surprised why this time it will be much more prolonged lasting (and impacting prices).

The purpose of such implied action is that it caps the ability of such a country to outcompete at the highest level the status quo. While if the country is still under a "chip-restriction diet", it will still grow and expand technologically, but it might be unable to globally outcompete the best companies from the status quo power. Those restriction diets impact every business that has electronic production manufacturing or the consumer who is a buyer of such products at the end of the line. No one is excluded, therefore as an investor or trader; one might carefully check which companies / tickers (that one is investing in potentially) have firm reliance on semiconductor imports but are potentially placed on the secondary priority list as the US takes first priority (Apple etc). Investing in such might turn problematic.

On the other hand, increased prices and lack of chips impact all such companies in decreasing their productivity, and therefore not meeting previous year's expectations, under-performing the earnings reports. This is and will be in play for the next two years, most likely.

This situation is/was in progress between the eagle and dragon recently where Huawei and few other companies were restricted on next-gen chips, forcing them to stick to their own, lesser grade. In the semiconductor space, basically, it is challenging to beat the economy at producing better grade chips once such a primary country already has 5 or more years of advantage, and "restriction diet" is usually applied against such counter-part challengers as a result of it, making it even more difficult to out-compete, reducing long term competitiveness if such companies export into developed markets, where demand for highest grade tech products is.

The center of gravity for next few years: Taiwan (TSMC)

As one of the key global producers, Taiwan's TSMC will most likely play an important role in how prices might react, how specific partnerships are formed, and any positioning of Taiwan on either side would likely dictate that. But from trading or investing perspective, this is not that relevant, as it more about maintaining the current standard. The real shift might come if there is a major geopolitical issue between China and Taiwan in the upcoming years.

The implications of any issues between China and TSMC on supply chains (decreasing the supply of chips to China, which is one of the worlds key electronic producers), the prices of electronic goods or stocks of public companies would skyrocket very quickly, since the demand for those products globally would not decrease in such case, yet the output would.

Since TSMC produces such a large capacity of chips for many countries that consume electronic products, any real disruption of supply chains due to geopolitical events would have serious implications; from a market perspective, it could rally the prices of certain chip producing companies (NVDA) or, potentially crippling their prices if supply restrictions would get too severe (TSLA).

Bull case:

From the TSMCs perspective and ticker TSM that trades on the NYSE market, in my view, the long-term view is very bullish, as it is not to be underestimated how much in demand their products will be. As the G5 tech products ramp up the need for chips, even more, it should be relatively decent for long-term investing type of hold on the stock.

Bear case:

However with that said, if there is any major geopolitical issue that involves Taiwain (which under the projection of history is very likely as all countries surrounding the dragon are likely to come under pressure), then a major disruption could also be heavily bearish for the ticker. The risks are very high and while not priced in, if any serious military escapades start, the reaction on ticker TSM would be swift and 10% drop can happen in a blink of an eye (even if it took 3 months to rally that much). And by that is meant, even if nothing really happens, but it gets to the point where it might look like it might (Israel-Iran situation for example) the heavy bear reaction would likely happen regardless.

TSM is given just an example, but in fact, the same pro-cons argument could be applied to many different companies within the Asian region for the next 10 years. Mostly opportunities with big hidden risks (but not so hidden if using the context of history).

The safest semiconductor investments from personal view are those positioned in US or Europe, which have internal production (as much as possible) and are not highly reliant on exporting far abroad, or importing too much of bare bones technology to create their products. The more that company might lean to opposite of that, the bigger risks there will be in next years.

The technological superiority of eagle since WW2, the biggest piece of the pie "open for grab."

Starting since the early 1950s, the US has led the globe in technological innovation, especially at the amount of productivity and capital that it was able to output. In today's economy, the QQQs index and one of the strongest assets of the US economy are Silicon Valley based companies, all of which was established bit by bit, over past few decades.

The role of the world's reserve currency (the dollar) does not come around just by itself. Certain standards have to be sustained for global capital to feel the need/want for influx into the US, or an aspect of dominance in raw materials (energy currently), services, or technology has to be ensured for one to get a status of reserve currency. Sure the formation of new global financial system under lead of US after WW2 played a major role to that, but that by itself is not enough.

All of this enables the eagle to outspend the rest of the countries and use strong monthly deficits.

The ability to outspend (while not being under pressure to repay the debts as many other emerging countries), is not to be underestimated (as long as inflation is kept relatively under control).

Key tech companies of the US today present today a major role for the US economy, however this is quite underestimated by most market participants or geopolitical observers.

As the amount that technology contributes to GDP of all countries escalates drastically over next years (relative to total GDP input from other services) (robotics, A.I., automation), it will be that much more important for the US to remain a key dominant player if it wants to sustain the role of global reserve currency and its benefits. Losing that position, where another player would start to outcompete it at the speed of A.I., robotics, bio-engineering, or other next-gen technologies, would start to pose increasing long-term issues and capital inflow issues. The above outlined is one of the core reasons why the previous administration of the eagle started to form an escalation (tariffs, supply chain dislocations, sanctions...). It also explains in hindsight why over the past 3-7 years, the dragon has been so focused on pushing in the technology as the primary target for China 2025 initiative and few other smaller-scale plans.

The biggest pie of them all is to outdo the leading role of the eagle since that will be the biggest potential revenue influx and technological dominance and determining factors for global reserve currency for the next 50 years. The role of technological superiority and output % will get only more and more important as the years go forward and the impact of Moores's exponential law kicks in, and with it, the fate of global reserve currency (who and when).

For one to understimate the competitive seriousness of this, would be to miss the whole macro picture of next 5 years.

Formation of key alliances on technology, supply chains, and military cooperation

Just as within any such previous historical case, once two such major powers get involved in deglobalization, the regional players are somewhat forced to pick a side. The need to pick a side depends on each country individually, and their locations and needs, basically, not everyone can afford neutrality in such cases (Switzerland stereotypical recent example). Such positioning, in fact, has already been taking place, as mentioned before, and will further be present over the years, but all of which might have much deeper implications to potential market actions than assumed at first glance.

Three major deciding powers are currently being: Japan, Germany, Australia, India.

Each of those economies will be placed under strain to pick a side, and within the interest of most is to play the 50-50 game as much as possible due to economic partnerships they have to eagle and dragon, but the actual question would be, at which point will there be a deconstruction happening over while, as 50-50 will not be tolerated by either of the key two players. This can mostly come at the expense of tariffs or sanctions, or some different types of blockades. However, the maneuvering ground is minimal because none of the two key players would want to lose their economical relationship to any of the four powers. In the case of Australia, that did happen, however, relatively fast.

The reason why pointing all of this out, is because there will be plenty of investment opportunities as a result of this restructuring process in next 5-7 years, and at the same time many pitfalls if one does not pay close attention to. Australian markets and certain companies being the best recent example of past 1-2 years (some very bullish some very bearish).

Coronavirus "lockdown experiment" and the impact on supply chains