by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

In today’s Comment, we will provide updates on U.K. elections, Draghi’s resignation, and possible price caps, all of which are potential threats to the Western bloc’s unification against Russia. Next, we discuss international news with a focus on China’s latest GDP. We end with an overview of U.S. news. Below are the top stories moving financial markets.

 Top Stories: Equity markets clawed back most of the early losses on Thursday after central bankers cast doubts about a potential 100 bps rate hike during the next Fed meeting. Meanwhile, disappointing earnings reports from J.P. Morgan (JPM, $108.00) and Morgan Stanley (MS, $74.69) led to concerns that the economy may be harming financial equities.

• Central Bank: Fed Governor Christopher Waller reaffirmed his support of raising the Fed’s benchmark rate by 75 bps in the Fed’s upcoming meeting, but could back a more considerable rate hike depending on the incoming economic data. St. Louis Fed President James Bullard mirrored Waller’s sentiment by suggesting that he also favors a 75 bps hike. The reluctance of Fed officials to respond aggressively to Wednesday’s hot CPI report suggests that the Fed may be concerned about the economy. Although it is unlikely that the central bank will pause rates anytime soon, Fed officials may be hesitant to signal further rate increases as economic conditions deteriorate.

Maintaining the Western Alliance:  New elections, rising prices, and varying levels of commitment are preventing the West from presenting a unified front against Russia. As the Western bloc struggles to stay on the same page, Putin’s leadership position is pivotal in demonstrating Russia’s willpower to maintain its war in Ukraine.

• UK. elections: An unexpected candidate has taken the lead in the race to replace U.K. Prime Minister Boris Johnson. Betting sites favor Penny Mordaunt to take over as the new leader of the Tory party, although five candidates remain in the running. Predictit.org gives Mordaunt a 56% chance of winning, while Sky Bet also shows her as an early favorite. Assuming she wins, it is unlikely that she will have a different foreign policy than the outgoing prime minister, and therefore U.K. commitment to Ukraine is unlikely to change. Nevertheless, Mordaunt’s victory should be favorable to assets within the U.K. as she is anticipated to provide some political calm to the country.
• Draghi’s resignation: Italian Prime Minister Mario Draghi offered to resign on Thursday; however, his request was promptly denied by Italy’s President Sergio Mattarella who insisted that Draghi wait a week before deciding on whether to step down. The political chaos comes at a vulnerable time for the country as a new Italian government may be less friendly toward the EU. News of Draghi’s resignation caused the spread between Italian and German bonds to widen by 16 bps. A government collapse will probably not impact Italy’s commitment to the war in Ukraine, but it could pave the way for the break-up of the Eurozone. Polls show that the populist party Brothers of Italy is favored to win the majority of seats in an election. The party leader, Giorgia Meloni, is a noted eurosceptic but a vocal supporter of Ukraine.
• Price caps: The West is making progress on price caps for Russian oil. The U.S. and EU have stated that they may be willing to withdraw their sanctions on shipping insurance and financing services in exchange for support of a price ceiling. The move would reduce the price the EU is paying for reduced-volume purchases of Russian crude oil to similar levels that China and India are currently paying. Although price caps are an attractive alternative to sanctions, it isn’t the perfect solution. In theory, countries can refuse to pay the market price for Russian crude; however, Moscow can then respond by not selling to them. As a result, countries must be willing to risk losing access to Russian oil for the plan to work. Europe appears to be the guinea pig in this experiment as its dependency on Russian crude means it will be the primary enforcer of the cap. Given the sensitivity that EU countries such as Germany and France had around securing their energy resources, they may not go along with it, especially in the winter.

International: Improvements in the Middle East and the potential for policy accommodation in China are both positive developments for international equities; however, rising energy prices remain a risk, particularly for countries with limited energy reserves.

• Israel-Saudi Arabia: Normalization between Israel and Saudi Arabia edged closer to reality after the Israeli government green-lit a deal to cede control of two strategic islands in the Red Sea. In exchange for relinquishing control, Israeli airlines will be allowed to use Saudi airspace for flights to China and India. In addition, normalizing relations within the Middle East creates a favorable investment environment for the region.
• Japan energy: To prevent a potential power crunch, Japan would like to bring up to nine nuclear reactors online to diversify the country’s energy sources. As an island nation, Japan does not have the same capability as larger countries (such as the U.S.) to mine fossil fuels and is forced to import to meet its energy needs. As a result, the global rise in commodity prices has pushed the country’s inflation to its highest level in nearly a decade. The new reactors will likely provide some relief for the country, but it won’t be a long-term solution. Japanese officials estimate that the reactors could provide up to 10% of the country’s electricity needs. Approaching wintertime, we suspect Japanese firms will struggle to maintain profitability as they cope with rising energy costs. Therefore, until the BOJ steps in and tightens monetary policy to improve the yen’s strength, we view Japanese equities as having elevated risk.
• China’s growth: GDP in China rose 0.4% from the prior year, much lower than expectations of an increase of 1.2%. The drastic slowdown in Chinese growth is likely related to the country’s property meltdown and Zero-COVID policy. The disappointing GDP number could pave the way for Beijing to provide additional fiscal and monetary support, which should be favorable for Chinese equities.

Recent developments in China and the Middle East should result in improved sentiment about international equities in the short term. However, a hawkish Fed, a stronger dollar, and rising energy prices pose a risk for emerging economies. That said, we believe that Chinese equities are particularly attractive as we suspect Beijing will attempt to boost the economy heading into the 20^th National Congress of the Chinese Communist Party later this year.

 Domestic: A cooling housing market, increased scrutiny, and lower government spending will likely weigh on market sentiment as investors remain risk averse.

• Housing: The supply of homes for sale rose for the first time in two years. The increase in homes on the market suggests that rising pricing and financial costs have started to weigh on demand. Although prices are unlikely to fall on a nominal basis, the decline in demand indicates that housing prices will rise at a slower pace. Because most households derive the majority of their wealth from an increase in the equity value of their homes, a sluggish housing market may lead consumers to spend less. As a result, the economy and financial markets could suffer because of waning consumer and investor sentiment.
• Antitrust: Tech companies face growing regulatory risk as government agencies seek to increase competition within the sector. The DOJ is set to reject concessions from Alphabet (GOOG, $2,207.35), paving the way for a potential antitrust lawsuit over the company’s online ad market dominance. The move to limit tech dominance has bipartisan support. The right feels that tech companies have used their market power to ensure their voice, while the left believes that tech companies have used their platform to profit from disinformation. As a result, we expect the tech sector to be a less attractive place to invest as rising rates and regulatory crackdowns will make it harder for firms to expand.
• Manchin out: Senator Joe Manchin (D-WV) has jettisoned any hope that he would support an economic package that contains new spending on climate change or new taxes. He will now only back legislation that lowers drug prescription costs or extends enhanced ACA subsidies.

Concerns about a possible recession in the U.S. will likely persist as the lack of government spending and slowdown in residential investment weigh on growth. While this will probably hurt pro-cyclical stocks, we suspect defensive stocks in sectors such as Health Care, Utilities, and Consumer Staples may be attractive. Tech stocks, though, will likely face greater scrutiny as governments worldwide look to break up these companies.

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