by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning!  It’s Opening Day for major league baseball.  In the financial markets, it’s a “risk on” day: equities and commodities are moving higher, while the dollar is weaker but interest rates have reversed higher.

In today’s Comment, we open with China news where Taiwan’s president has arrived in the U.S., and both China and the U.S. are hardening their blocs.  Markets are up next, with a look at banking.  International news follows, and we close with an update on the war in Ukraine.

China News:  Taiwan’s president is arriving in the U.S. today.  Steadily, China and the U.S. are pressing other nations to choose with whom they will align despite resistance from nations wanting to avoid such a choice.

• Taiwan President Tsai Ing-wen will visit the U.S. and Central America this and next week. Semi-official visits of Taiwanese leaders tend to aggravate Beijing and this trip is no exception.  The focus of the tension is an expected meeting between House Speaker McCarthy and Tsai.  Much like former Speaker Pelosi’s visit to Taiwan, China is threatening to respond negatively to the meeting.  The administration is taking great pains to portray the tour as “private,” meaning it isn’t officially a state visit.  We also note that McCarthy is meeting Tsai in California, not Washington, next week.
  • We will be closely watching to see how Beijing reacts to the trip. In the wake of Pelosi’s visit, China seemed to be practicing a blockade.  Our expectation is that China is less likely to invade Taiwan, but more likely to blockade it instead.  Amphibious invasions are very hard, and China has no real experience with such operations.  Given that the official position is that Taiwan is a province of China, exercising such a control, like a blockade, would fall into an unclear legal situation.  If China does something similar this time, it would likely increase the odds that if/when China moves to take control of Taiwan, a blockade may be the preferred tactic.
  • We also note that National Security Advisor Sullivan had a call with Wang Yi, China’s top diplomat. The White House has been trying to place guardrails around the U.S./China relationship for some time, but events continue to keep tensions elevated.  We note that there was no readout from the call, but we would not be surprised to hear that the Tsai visit was part of the discussion.
• One of our geopolitical themes has been the idea that the world is evolving into a China-led bloc and a U.S.-led bloc. As this process continues, both group leaders are trying to woo nations into “their” alignment.  This process is taking on multiple forms.
  • We note VP Harris has recently made a trip to Africa. This continent is likely to become increasingly important in the coming decades.  Not only is it a source of key minerals for the energy transition, but it also has young people, something that the developed nations are increasingly beginning to lack.  The U.S. is promising increased investment in Africa.
  • It isn’t just countries that are being pressed to choose. Companies are too.  After three decades of globalization when production was moved to China, the U.S. and China are slowly unwinding their economic interdependence.
  • As part of its Belt and Road Initiative, China has lent large sums to frontier economies. As often occurs, some of these loans have failed, forcing China into the unfamiliar role of providing emergency support.  Although this is a short-term problem for Beijing, if it is handled well, it could increase China’s influence.
• In a recent Bi-Weekly Geopolitical Report, we discussed China’s moves to undermine the dollar system. We note that Brazil and China have agreed to use their own currencies in bilateral trade.  China has also settled an LNG trade in CNY.  In a related development, Saudi Arabia is taking preliminary steps to join the Shanghai Cooperation Organization, a China-led Eurasian bloc.
• The southern U.S. border is perhaps the prime gateway for immigrants. Although most of those attempting to cross the border are from the Americas, there has been a surge of Chinese nationals reportedly showing up on the Mexican/U.S. frontier seeking asylum.
• As it turns out, the crypto exchange Binance (BNB, $319.21) has deep ties to China, something it tried to hide from U.S. financial regulators.
• China is seeing a new surge in African swine fever, and if not contained, this event could lead to reduced pork supplies.

Markets, Economics and Policy:  We update the latest on the banking issue.  There is also a growing realization that margins matter to inflation.

• Fractional reserve banking is fraught with risk. Banks take deposits and, through leverage, expand the money supply through lending.  Depositors don’t think of their money in the bank as a loan; there is almost a belief that the bank has taken your money and is holding it in an envelope with your name on it.  Of course, that isn’t the case.  It instead lends that money into the economy, and, as long as depositors don’t demand their funds all at the same time, the system provides ample, low-cost credit to the economy.  However, if a large number of depositors decide to get their money back, chaos can develop.  Essentially, societies that use fractional reserve banking make a tradeoff—cheap credit but with the potential for occasional crises.
  • Over time, governments have tried to address this problem. Deposit insurance has been one response.  By ensuring that the money will be there, the impetus to “go get it” and thus triggering a bank run is dampened.  But by guaranteeing deposits, bankers can take excessive risks, leading to the moral hazard problem.  In the U.S., the response has been to limit deposit coverage, although in practice, all deposits are usually covered.
  • Another way governments have addressed this issue is to allow banks to avoid pricing their assets at market. This means that there is a bit of uncertainty as to the value of bank assets at any given time.  Since bank loans are often unique, it may be difficult to actually price these assets.[1] Although when banks have securities on their books, these can be priced.  To avoid asset price volatility, banks are allowed to claim that a security will be held to maturity.  Since bonds usually expire at par, there is no price risk as long as the bond doesn’t need to be sold in order to meet depositor demands.
  • It has become increasingly apparent that large banks become so important to the economy that governments can’t allow bank runs or failure. To deal with this situation, large banks are heavily regulated.  In most nations, large banks are the only choice, but in the U.S., due to our fear of economic concentration[2] (especially in banking), we have a strange mix of a few very large banks and a whole bunch of small ones.  Unfortunately for the small banks, there is some degree of uncertainty about how depositors will be treated.  Thus, we are seeing something of a “slow motion” run on small banks.  Although most financial crises occur quickly, some take a long time. For example, the savings and loan debacle took over a decade to resolve.  This problem of large vs. small banks might be similar.
  • Because small bank failures are rarely systemic, they tend to get a lighter regulatory treatment. But after recent bank failures, regulators are looking to expand regulation, which may lead to fewer banks.
• In economic theory, inflation is usually addressed in simple terms; e.g., it’s all about the money supply or supply constraints. In reality, it can be devilishly complicated.  One factor gaining attention is that market power can lead to inflation if margins are maintained.
• The debt ceiling issue has sort of fallen from the news, but it remains a threat to stability. The House GOP seems no closer to a plan on how to address it.
• Young graduates are finding a tentative job market. As we note below, initial claims remain remarkably low and stable, which likely reflects labor hoarding.  Firms loath to lose current employees, fearing the cost of replacement.  However, it may be leading to a lower number of new graduates being hired.

International News:  Russia detains a Wall Street Journal reporter, Britain gets a trade deal, and Cargill stops carrying Russian grain.

• WSJ reporter Evan Gershkovich has been detained by Russian security services on charges of spying. He was reportedly investigating the Wagner group.  This is a high-profile event and will likely weaken already fraught relations.
• Britain has joined the Indo-Pacific trade bloc, the CPTPP, which is the successor of the failed TPP. The U.K. is the first nation to join the group since its founding in 2018.
• Cargill, a top 10 exporter, announced it will stop handling Russian grain.
• The German ruling coalition is showing signs of stress. The Greens are increasingly out of step with the Social Democrats and the Free Democrats.

War in Ukraine:  There are renewed concerns over the safety of the Zaporizhzhia nuclear plant.  Russia has been shelling the region around the plant and both sides are increasing troop strength around it.  The IAEA is trying to work out an arrangement to prevent the plant from being directly attacked.  This is the largest nuclear plant in Europe and although the cores are in hardened containment units, a direct attack could lead to a potential catastrophe.

[1] Private equity does something similar.

[2] This is why we have 12 Federal Reserve districts, for example.

View PDF