The Chaos of Conflict Spreads and Burns the Hopes of Central Bankers
David Haggith

The demise of China's economy and the rise of war in the Middle East is spreading globally as economic damage. Central bankers are now warning that it is making their inflation fight much harder.

The Dow ended another doggy day down as the S&P eked a tiny speck upward while bond yields continued to rise as the market continued to price Fed rate cuts out further as prospects for inflation become more heated. 

Investors still believe rate cuts are coming, but some have started to question when the Fed will begin lowering borrowing costs and how quickly it will move. While the S&P 500 has notched a fresh record high this month, Treasuries have pared some of their gains and the dollar has perked back up as a result….

"Markets seemed to be seeing the Fed through rose-colored glasses to end 2023," said Helen Given, FX trader at Monex USA in Washington. "With the new year, price expectations have begun to shift."

They were rose-colored glasses, and those who wore them are seeing red now; yet, those who were wearing them still believe the Fed actually talked about a pivot at its last meeting, as the article above continues:

A dovish pivot at the Fed's monetary policy meeting in December bolstered investor hopes that the central bank's tightening cycle was over and rate cuts were approaching.

Except that there never was “a dovish pivot” at the last meeting; however, the marketeers keep believing they heard one, so strong was the delusion. So …

More recently, several officials have pushed back against the perception that monetary policy easing is imminent, saying they need more evidence that inflation will return to the central bank's 2% target and stay at that level before they commit to interest rate cuts.

They push back because they never even suggested a pivot at their last meeting. 

As a result, investors now expect the Fed to deliver its first interest rate cut in May, instead of March.

Maybe if the economy is foundering on the rocks by then!

As the bond market continues to realign with reality in terms of how the Fed is continuing to be pressed hard by inflation to stay at its fight, yields are becoming attractive enough to start pumping a little money out of stocks. 

More China breaking

The false enthusiasm that pushed stocks and bonds up also could be seen in investors views about the Chinese economy last year, where many went long early last year because the giant panda was, in their view, about to roar to back to life after nearly dying from its Xiro Covid policy. Now, they are learning the hard lesson I kept pounding last year because they failed to recognize that central planning had all but destroyed the Chinese economy. Heck, the US economy barely survived its short-term Covid closures. Likewise, the rest of the world; but the Supreme Dictator closed his nation down for over a year.

It was easy to figure out that, with all the damage the short-term lockdowns caused in the US, that China’s damages would run much deeper. It was also not that hard to observe that the true depth of damages to the US economy took well over a year to become evident, which is what I said back then we’d see. It would, I said, look like the economy had fired right back up because many things would come right back on as soon as government threw the switch it used to shut the economy back to “on” again. However, over time, we’d start to figure out what things never did come back on properly again. Sure enough: the economy roared into action, and then it has taken years to figure out how badly broken the labor market was. It took over a year for the Fed to figure out how badly it had lit inflation on fire. We’re still struggling with all of that.

Which is all to say that betting on a quick restart for China’s economy after a much bigger shutdown, was an obvious fool’s bet, and hedge funds are now realizing how bad of a bet it really was. Their denial is breaking as reality keeps pounding the delusions out of investor’s greedy heads that saw what they wanted to see in ‘23 because they were clamoring for more of that easy money.

Hedge Fund Stars Who Got China Wrong Are Paying a Big Price

For veteran hedge fund investor Chua Soon Hock, 2024 was supposed to herald a multi-year rise in Chinese stocks and the opportunity of a lifetime. Instead, his fund’s sudden demise sends a warning to fellow China bulls: stick to your guns at your peril.

Denial breaks hard.

Chua’s Asia Genesis Asset Management Pte told investors this week the $330 million fund would close after it was badly burned by wrong-way bets on Japan, and by falling Chinese markets that he largely blamed on inaction by policy makers, including President Xi Jinping.

You have to find something to blame it on other than on yourself, I guess, for being such a fool to believe such a thing in the first place. There was never any way that China was going to come right back after so many months of continuous, extreme, self-inflicted damage, and it was clear how single-minded Xi was in making sure he locked down all of China until the last particle of a Covid virus disappeared. It is the same risk we have from central global planners like the WEF. They get ideas in their heads that seem to work well in theory, but they enact them, as they did with theirCovid policies, in an experiment on the entire world!

One of the things I warn about regularly is that, the bigger denial is, the harder it breaks:

“I am writing to you with a heavy heart and utmost regret,” Chua said in a letter to clients saying their cash would be returned after an almost 19% plunge this month. “My confidence as a trader is lost.”

That is the risk of markets getting too far out of line with reality. The correction is harder. So, what does that tell you about what is likely coming for the US stock market whenever reality finally beats it over the head enough to recognize the battle with inflation is far from over? The Fed gets it, but they don’t seem to get that any hint from them that they may start talking about when to start talking publicly about distant future rate cuts is all it takes to give minds that desperately want the Fed’s easy money back exactly what they need to re-ignite their Fed fantasies.

Chua’s plight shows how even the most experienced fund managers have been ensnared by a China market meltdown exacerbated by Beijing’s limited policy support. Li Bei, a long-time China hedge fund bull, admitted to mistakes after suffering the worst losses of her career, while global investment firm T. Rowe Price Group Inc. has seen the value of its China holdings fall by 80% over years from its peak.

The bigger the delusions, the harder they fall.

“All the evidence I’m seeing is that the economic data is a lot weaker than I thought, than anyone thought….”

Apparently, they don’t know the people who subscribe here because the data was not weaker than anyone thought.

China keeps making rescue efforts for its stock market, currency market, andeconomy; but I keep warning people those efforts have been failing left and right, and the latest ones will, too, because the problems are much bigger than the cure and demand serious reforms. Already, we see in the news today that the latest efforts have, again, failed. 

When Zhang tried to buy the dip last week, he was quickly forced to sell to cut his losses. He’s since dumped all stock holdings.

“It was so scary — don’t bottom fish,” Zhang said….

The exits jam up quickly when markets crash.

Even one of China’s best-performing macro hedge funds has struggled. Shanghai Banxia Investment Management Center’s Li, who manages more than 10 billion yuan predicted a bull market in October 2022, betting on a rebound in corporate profits and the property sector.

Last year her flagship fund plunged almost 15% - the first annual loss in at least six years….

“I did make the mistake of assuming a quick victory,” Li said in a post on WeChat Tuesday. She added that the intensity of China’s policy response to its faltering economy failed to meet her expectations.

In all, more than $6 trillion has been wiped out from the market value of Chinese and Hong Kong stocks since a peak reached in 2021.

The damage happening to investors who were way out of touch with how much damage China had done to itself is hitting the US like it is China. Some may remember how China’s economic and currency troubles several years ago did some serious damage in the US. Well, those troubles are much bigger this time.

Each feeble attempt at restoring China’s behemoth economy from its severe crash comes up far short, and the government’s efforts are still spotty and desperate.

Apart from the public pledges, authorities had sought to limit declines in stocks by giving financial institutions so-called window guidance, a typical way of indirect government intervention. 

Some hedge funds were told to restrict short selling in China’s stock index futures market, Reuters reported. At least two state-owned insurance firms were told Monday to refrain from selling more onshore shares than they purchased, Bloomerg reported. Last week, the nation’s largest brokerage suspended short selling for some clients. 

Not only do the exits jam up quickly, but sometimes the government slams them shut, as we see here. However, when you start telling investors they have to stop shorting your stocks, you may worsen your troubles. It’s like telling your citizens not to take their money out of banks. Nothing is sure to trigger a run faster than that. It’s like begging for mercy. If that doesn’t work, lie your way out by trying to stoke more delusions:

Chinese Premier Li Qiang went to the World Economic Forum in Davos last week with a mission to present a positive image of the economy and schmooze financial elites: "Investing in the Chinese market is not a risk, but an opportunity."

The message fell flat.

As soon as Chinese markets reopened the next day, a years-long sell-off in stocks and other assets accelerated….

"The news was not the data. It was Li Qiang in Davos…. It was really underwhelming and bewildering. It doesn't show confidence."

You cannot lie your way out of an economic collapse like this or arm-twist your way out by telling investors to stop shorting your stocks. You have MAJOR economic repair that people need to see happening, and you will have to climb your way out of it for, at least, a few years and will likely experience lasting damage that echoes through your economy for years to come:

What markets were looking for was a clear roadmap for how China planned to resolve a deepening property crisis and a local government debt crunch, and how it plans to address a debt-fuelling imbalance of low consumption and high investment.

Still seeing red at the Red Sea

China is not the only thing that is matching down to my dire expectations. Everyone is catching on now to the reality that the Red Sea war is a serious problem and is also not going away quickly. I’ve been warning for weeks that it will send up inflation that was already marginally rising, and that is now daily news.

Oil climbed higher today partially on news that inventories are going down more quickly than expected, but also on growing concern that the Red Sea conflict with the Houthis will last longer than expected. Brent broke past $80 per barrel today.

Oil rose to surpass a key psychological level after US stockpiles declined more than expected…. Crude has been confined to a narrow range this month, with geopolitical risks in the Middle East countered by expectations of increasing supplies from producers outside of the Organization of Petroleum Exporting Countries…. Traders are assessing the latest US-led strikes intended to halt vessel attacks by Iran-backed Houthis in Yemen. Central Command hit two anti-ship missiles aimed into the Red Sea. Elsewhere, US forces carried out airstrikes on a Tehran-backed militia in Iraq.

War throughout the rich oil region is going to keep pressuring oil prices, and oil prices pressure everything else. Of course, this war is also pressuring the prices of anything that gets delivered normally through the Suez Canal, and we see news about that getting rapidly worse, too:

Red Sea Turmoil Sends Economic Shockwaves Far and Wide

Two months of missile, drone and hijacking attacks against civilian ships in the Red Sea have caused the biggest diversion of international trade in decades, pushing up costs for shippers as far away as Asia and North America. The disruption is spreading, fueling fears of broader economic fallout….

Repeated rounds of retaliatory strikes by the US and its allies, as well as a multinational naval operation to patrol the waters, haven’t stopped the assaults by the Houthi militants that followed the start of the Israel-Hamas war.

I reminded readers awhile back that those who thought the US and it numerous allies in this conflict would readily sweep the Houthis out of the way should remember how Afghanistan went and how the mission was not quite accomplished in Iraq in 100 days as was once thought, too. Actually, I applied that latter part to US Treasurer Yellen’s comment that the Fed’s mission in fighting inflation had been accomplished. Dream on!

The battle around the Red Sea has affected a quarter of all the shipping traffic in the world—some directly, many indirectly because, as I pointed out, ships are moveable. That means high demand for more ships to reroute in one area creates higher prices through all markets as companies pull ships off North Sea routes to move them to suddenly more profitable routes around the Cape of Good Hope.

Again, we see how denial blinds people from seeing what they should see:

“So far, many executives and investors have consistently undershot the potential for this risk to emerge,” said Alexis Crow, who specializes in geopolitics and long-term investing at PricewaterhouseCoopers LLP. “This is perhaps predicated on a misguided assumption that the Israel-Hamas conflict remains contained.”

Though there’s no sign the higher costs are boosting inflation yet, central bankers are already warning of the risks. Christine Lagarde, president of the European Central Bank, cited “the coming back of supply bottlenecks” as one of the four key risk factors she’s watching. Low water levels are already slowing flows through the Panama Canal.

I’ve been keeping my eye on the Panama Canal for you, too, saying this double-whammy to supply lines is going to make the Fed’s fight that much harder, and they were already being pushed back on by sticky inflation. 

A spike in oil prices would be another risk for inflation if the conflict disrupted supply.

“So far I think we have been lucky in that we haven’t seen an oil tanker get hit.” said Saad Rahim, chief economist at Trafigura Group, one of the world’s biggest commodity traders. “That could be really something that then focuses the mind.”

Actually, we have seen tanker traffic get hit, if not directly by missiles, by companies not wanting their tankers to run through that area.

On the turquoise waters off Yemen, there are signs the tensions may be getting worse.

I could imagine that it might not take that long for the allies to knock out most of the Houthis biggest weaponry and slow their efforts, but so long as even sporadic smaller missiles make it through, ships will be reluctant to go through the area. I don’t think I should let my imagination go to such a quick reduction in troubles around the Red Sea. Lack of progress by the West against them is being paraded by the Houthis.

The global attention is something the Houthis, a militant group from the remote mountains of Yemen, have been craving for years. The car-transport ship they hijacked in their first attack is now docked off the country’s coast, an attraction for local residents.

If it weren’t for the actions of the US and its allies, “we would not have become a regional and international force,” Mohammed al-Bukhaiti, a member of the Houthi Political Council, said in a phone interview from Sanaa. He vowed that the attacks will continue as long as Israel’s assault on Gaza and blockade of the enclave do. “We are confident that we will win regardless of how much they mobilize forces,” he said.

So, never underestimate the ability of Iran to sneak more weaponry into Yemen or of the Taliban in Afghanistan to transfer the US weapons Joe Biden gave them to Yemen so the Houthis can return them to their original owner.

And, so, the war rages on in the news today:

US hits Iraq militia sites and anti-ship missiles in Yemen as fight with Iranian proxies intensifies

The U.S. military struck three facilities in Iraq and two anti-ship missiles in Yemen operated by Iranian-backed militias that have attacked U.S. personnel and ships in the region as the United States tries to keep the Israel-Hamas war from spilling over into a wider conflict.

And, so, the war keeps seeping out more broadly. Thus, even if the Red Sea gets settled down some by Western allies taking out Houthi weapon sites, flames burst out in completely different areas as others become emboldened to jump into the fray.

Iraq’s Prime Minister Mohammed Shia al-Sudani said the strikes “blatantly violate Iraq’s sovereignty” and contribute to an “irresponsible escalation….”

Both fronts — land attacks in Iraq and Syria, and sea attacks originating from Yemen — have seen a significant uptick in launches and counterstrikes over the last few days.

So …

Red Sea Shipping Crisis Rekindles Inflation Fears

The disruption to traffic via the Red Sea/Suez Canal route could continue for months and ultimately result in sustained higher freight costs and a shortage of container ships, which are now bound on longer routes via the Cape of Good Horn, analysts say. 

The current chaos is likely to continue for weeks—or months—until the shipping and maritime transportation industry settles on a “new normal”. 

Until then, the higher freight costs and the delays in deliveries could reignite inflation and make the road to easing interest rates bumpier than central banks thought it would be a month ago.  

Yup. Investors better give up those delusional hopes of a Fed pivot during a year that promises more chaos than most of us have ever seen because many factors other than this war are going to be contributing to the chaos, even though this war could do the job all by itself if it keeps lighting more and more of the Middle East on fire.

As for that person quoted above who oddly said that this shipping crisis had not hit oil yet…

Oil tanker traffic has also been impacted by the threat to commercial shipping near the Bab el-Mandeb Strait and the Red Sea, prompting oil majors and top trading houses to divert traffic to the longer route via Africa. 

Shell was the latest to halt all shipments via the Red Sea last week. In the middle of December, another UK-based supermajor, BP, temporarily suspended all shipments via the route, “in light of the deteriorating security situation for shipping in the Red Sea.” 

Of course it has.

It is delusional to think it hasn’t. How could it not? If you were piloting a one of the world’s largest ships full of flammable and ecologically damaging material, would you take it through an area with missiles streaking overhead? You don’t have to have a tanker hit to have tanker traffic disrupted as much as all other traffic.

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