Macro-Economic Environment
While equity markets have tended to ignore conflicts such as the war in Ukraine and the most recent upheaval in the Middle East, bond markets are clearly taking note. There are times that you see non-economic factors manifesting themselves in economic trends, particularly when those trends are non-cyclical in nature. As we have written about in the past, the period some refer to as the “great moderation” involved very little friction: seamless trade, relatively little conflict (absent Iraq and Afghanistan which were both contained) and a symbiotic relationship with a developing China. The environment today could not appear more different and some of the implications of this shift are being felt within fixed income of late.
We believe that there is a direct connection between the increasing tension of East vs. West and a secular change in interest rates. Conflict has an economic cost and that price will ultimately be meted out by higher and higher rates of interest. The connection between rising interest rates and growing worldwide instability can be boiled down to a fight that exists in three main arenas: Capital, Commodities and Credibility.
Capital: The breakdown in global trade has not only led to shifts in existing supply chain relationships, it has also led to shifting sources of debt finance. It is not a coincidence that China has severely diminished its purchases of Treasury securities as there are less Dollars that need to be recycled. Highly indebted countries like the U.S. will be pressed to find consistent sources of capital necessary to fund its profligate spending.
Commodities: The war in Ukraine has been highly informative as to where the new battle lines will be drawn outside of the actual conflict itself. Countries like India and China paid little attention to international attitudes towards the Kremlin, choosing instead to take advantage of cheaper crude oil imports. Even the U.S. was considering a diesel export ban at the very height of the crisis last winter, potentially putting major allies at risk.
Credibility/Influence: Economic industrial planning doesn’t have much recent history in this country given that we generally choose to mostly let market influences dictate where capital is directed. However, the Chips Act and other recent attempts to control those sectors, which some deem vitally important to our national interest, show how much the U.S. is willing to override market forces.
While much is made of the potential for an armed conflict between the U.S. and China over Taiwan, what is overlooked is the need for the two superpowers to come together as possible intermediaries in today’s already existing strife. China holds great sway over Iran and Russia, two key players in the most significant global conflicts at present, and that influence is tied directly to its demand for key commodities that sit outside the purview of existing sanctions, namely crude oil. How much the U.S. must temper its existing adversarial stance towards China to address certain global flashpoints is an important question yet to be answered.
Takeaways: The global conflicts that we are seeing in the Middle East and Ukraine are part of a deeper, more far-ranging war between East and West. We see these battle lines drawn over capital, commodities and credibility. The collateral damage of this war will be ever higher and higher rates of interest.
Commodities/Energy
Another week, another mega-deal in the oil patch. This time it’s Chevron acquiring Hess for ~$60Bn in an all-stock transaction. The number of acquisition candidates on the board is dropping at a rapid clip as the YTD upstream M&A tally has surpassed $170 Billion. This “resource grab” is precisely what we expected and repeatedly called for, and comes in the form of company-specific strategic moves or by nations in leveraging geopolitical goals. An example of cross-industry protectionism illustrates the dynamics taking place on a global front. In response to further U.S. curbs on advanced semiconductor sales to China, graphite exports out of China (which accounts for a reported 60% of natural global production…and 90% of synthetic output) will be curtailed beginning in December. Graphite is an essential mineral necessary in the manufacturing of EV battery anodes.
Perhaps all of that Chinese graphite will be unnecessary. In addition to Ford abruptly halting construction of their EV battery plant in Michigan, GM has announced a few EV U-turns of their own. A collaboration between Honda and GM to co-develop a series of affordable compact SUV EVs has been canceled due to “the current business environment, rising costs for the project, and challenges with getting adequate driving range.” GM also recently abandoned their goal of manufacturing 400K EVs by the middle of next year and “delayed” the opening of an EV truck factory by a year. The next shoe to drop is likely the renouncement of an all-EV lineup by 2035.
The most intelligent EV transition by an automaker has been that of Toyota. The company was rewarded with calls earlier this year by U.S. pension funds to dump its Chairman (Akio Toyoda) due to his “slow embrace of EVs”. What some call slow, we feel is measured. Toyota is struggling to make enough hybrids to keep up with demand, while simultaneously making significant in-house strides with solid-state EV battery development. The stock prices of Ford and GM have gone nowhere over the past ten years while Toyota is trading near its peak. Perhaps CalPERS and the NYC Comptroller’s Office (Funds) should stay in their lane.
Takeaways: As we have noted, consolidation continues to commence amongst resource producers. This situation has become more acute with the world’s largest commodity exporter (Russia) essentially pushed into the shadows. The powder keg which is the Middle East has also reached the boiling point and risks sending energy prices much higher. With equities rolling over and rates marching higher (bond prices lower), the ideal place to hide out will be commodities.