by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

We open our Comment with an update on the Russia-Ukraine war, where we discuss how the conflict has become a competition of force generation and the two sides’ abilities to marshal resources for the fight.  Next, we review other international and U.S. developments with the potential to affect the financial markets, including a discussion of the Federal Reserve’s latest policy meeting, which starts today.  We wrap up with the latest news on the coronavirus pandemic.

Russia-Ukraine:  It is now clear that the war has become a competition of force generation.  The Russian military continues to seize small tracts of land in Ukraine’s eastern Donbas region, and it will probably capture the small city of Severodonetsk soon, but a wide range of evidence suggests it is too battered to do much more than that.  The evidence also suggests it won’t be able to rebuild its strength with sufficient new troops and equipment so long as President Putin declines to call a general mobilization.  Meanwhile, the Ukrainian military is running out of manpower, equipment, and ammunition (especially ammunition for its older Soviet-made weapons), and advanced weapons from the West are entering the battle only slowly.  In other words, the war has become a laboratory for “defense economics” like the world hasn’t seen in decades.

• In this situation, it looks like the war could well drag on.  The ultimate winner will probably be the country that most successfully martials its resources and the resources of its allies for the fight.  Russia may have the advantage in terms of sheer numbers of people, weapons, industrial capacity, and experience, but Ukraine has the will and flexible military management to use its limited resources more efficiently and with greater effect.  As long as Ukraine has access to Western military aid, it will likely continue to fight, although, at some point, the two sides will probably exhaust themselves and start searching for a negotiated solution.
• Mykhailo Podolyak, a leading adviser to Ukrainian President Zelenskyy, tweeted out a bold shopping list to tackle his country’s main equipment shortages and repel Russian forces.  Calling for “heavy weapons parity” with Russia, Podolyak said Ukraine’s needs include 1,000 155mm howitzers, 300 multiple-launch rocket systems, and 500 tanks.

Global Oil Market:  In its monthly market report, the Organization of the Petroleum Exporting Countries (OPEC) said production among its 13 members dropped by 176,000 barrels a day last month to average roughly 28.5 million barrels per day.  The report showed that modest output increases by Saudi Arabia, the UAE, and Kuwait were offset by declines in countries such as Libya and Nigeria.  The data buttresses concerns that despite OPEC and its partners pledging to hike output, they may not be able to.  If so, that would point to the potential for further large increases in energy prices and general inflation going forward.

United Kingdom-European Union:  As expected, yesterday, Prime Minister Johnson’s government unveiled a proposed law that would allow it to tear up parts of its Brexit agreement with the EU, stoking fears of a trade war and drawing condemnation from the trade bloc.

• The EU could eventually retaliate against the U.K. by revoking parts of the Brexit agreement, including the zero-tariff arrangements for each side’s goods, or move to suspend that agreement in its entirety.
• Johnson’s gambit aims to appease pro-Brexit members of his ruling Conservative Party, who are chafing at the protocol’s requirement for customs checks on goods traveling from Britain to Northern Ireland.  However, given the EU’s potential trade retaliation, the move is risky.  It could be a cloud over the British economy and financial markets in the coming months.

United States-China:  In a dramatic example of the way the world is fracturing into separate geopolitical and economic blocs, Congressional negotiators working on a U.S. competitiveness bill have agreed on language that would require U.S. companies and investors to disclose certain new outbound investments to “adversary countries” like China and authorize the federal government to review and block them on national security grounds.  The U.S. government has long regulated certain high-technology exports and inbound foreign investment, but the proposed law would mark a significant new increase in the government’s ability to regulate outbound investment that could benefit foreign adversaries.

• The rules would apply to outbound investments in sectors deemed critical to supply chains or involving designated “critical and emerging” technologies.  Those sectors and technologies include semiconductors, large-capacity batteries, pharmaceuticals, rare-earth elements, biotechnology, artificial intelligence, quantum computing, hypersonics, financial technologies, and autonomous systems such as robots and undersea drones.
• The provisions would apply to greenfield investments, such as the construction of new plants, to deals such as joint ventures that involve the transfer of knowledge or intellectual property, and to capital contributions. including venture capital and private equity transactions.
• The bill reflects the solidifying consensus in Washington that China aims to supplant U.S. global leadership and that American capital and expertise are aiding the buildup of Chinese military and economic power.

United States-Australia:  In a step that would help sever the U.S.’s reliance on Chinese rare earths and rare earth processing, the Department of Defense has signed a deal with an Australian firm to build one of the first U.S. domestic heavy rare earths separation facilities.  The U.S. currently has no operating commercial-scale processing facilities, raising concerns in Washington that the country could be cut off from these critical minerals in the future if relations with China deteriorate further.

• Under the deal with Lynas, China would be bypassed entirely from the production cycle.
• The Defense Department is also separately funding a heavy rare earth processing project at a mine in California.

U.S. Monetary Policy:  Federal Reserve officials today begin their latest policy meeting, with surging inflation readings leading some observers to think they could hike interest rates by a very aggressive 75 basis point.  We have even heard chatter about a possible 100-basis-point hike.  The policymakers will also release their latest “dot plot” projections for the economy and the path of future interest rates.

• A hike of 75 basis points would be the biggest increase since 1994 and would leave the benchmark fed funds rate in a range between 1.50% and 1.75%.
• Fears of aggressive monetary tightening, more pandemic lockdowns in China, and the growing risk of recession weighed heavily on a range of assets yesterday.  The S&P 500 stock price index fell a sharp 3.9% to end the day in bear-market territory, with a total decline of 21.8% from its recent high on January 3.  Cryptocurrency values continue to fall as of this writing, amid signs of greater turbulence for the industry.
• Notably, the U.S. yield curve also briefly inverted again overnight, which many investors will see as additional proof of an impending recession.  The curve is now basically flat, with the yield on the 10-year Treasury note at 3.321% and the yield on the two-year Treasury at 3.311%.
• While an aggressive hike could well push asset values down farther, investors should keep in mind that an unusually aggressive hike, like 100 basis points, could be taken as a sign that the Fed is getting ahead of the inflation problem and spark a market rebound.  We shall see . . .

U.S. Tech Industry:  Apple (AAPL, $131.88) is under investigation by Germany’s antitrust watchdog over whether the company’s tracking rules for third-party apps give it preferential treatment or undermine its rivals.  The move is the latest sign of growing regulatory risks for major U.S. tech firms.

U.S. Servant Economy:  One interesting take on today’s high inflation and rising interest rates is that they threaten the budding “servant economy,” consisting of on-demand services like those of Uber (UBER, $21.57) and DoorDash (DASH, $58.38).  With inflation accelerating and interest rates rising, funding for such startups may be drying up.

COVID-19:  Official data show confirmed cases have risen to  535,940,921 worldwide, with 6,310,750 deaths.  The countries currently reporting the highest rates of new infections include the U.S., Taiwan, Germany, and Australia.  (For an interactive chart that allows you to compare cases and deaths among countries, scaled by population, click here.)  In the U.S., confirmed cases have risen to 85,632,808, with 1,011,543 deaths.  In data on the U.S. vaccination program, the number of people considered fully vaccinated now totals 221,727,733, equal to 66.8% of the total population.

Virology

• In the U.S., the latest wave of infections appears to be topping out, but hospitalizations are still accelerating with their usual lag.  The seven-day average of newly reported cases stands at 106,795, down 2% from two weeks ago.  The seven-day average of people hospitalized with confirmed or suspected COVID-19 came in at 29,642 yesterday, up 9% from two weeks earlier.  New COVID-19 deaths are now averaging 324 per day, down 12% from two weeks earlier.
• A panel of advisers to the FDA will meet today to consider whether the use of the vaccine from Moderna (MRNA, $117.13) should be expanded to include children ages 6 through 17.  If the panel votes in favor, an FDA authorization could come within days, opening up the use of Moderna’s vaccine to children for the first time in the U.S.

Economic and Financial Market Impacts

• Although renewed pandemic lockdowns and mass testing in China have sparked terror among global investors, analysts at one Chinese brokerage see a silver lining.  According to the analysts, the 10.8 billion COVID-19 tests expected to be carried out in China from April through June will pump $26 billion into the economy, enough to lift the country’s economic growth rate by 0.62%.
  • Officials in Beijing have ordered that China’s free mandated testing be paid for out of local government budgets, so the spending will show up in China’s gross domestic product as “government consumption,” partially offsetting what is likely to be a significant drop in personal consumption spending.
  • One downside is that the big testing costs will be a financial burden for many local governments, especially those already struggling with high debts and rising interest rates.

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