by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including new estimates of Russian military casualties to date and a call from the Ukrainian president to accept nothing less than total victory.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including concerns that continued Chinese military exercises in the Taiwan Strait may represent an effort to take full control of that body of water.

Russia-Ukraine:  There has been little change in the disposition of Russian and Ukrainian forces over the last day.  The Russians have made few, if any, territorial gains in Ukraine’s northeastern Donbas region, focusing instead on reinforcing their positions near the southern city of Kherson, which they seized early in the war.  The Russians also continue to launch missile and long-range artillery strikes across Ukraine’s territory.  The Ukrainians appear to be focused on launching strikes against Russian troop concentrations and logistics nodes in the country’s southern and eastern regions, using advanced, long-range strike systems provided by the West.  More broadly, Ukrainian President Zelensky has declared that his country will not accept a partial victory that leaves Russian troops on Ukrainian soil in a frozen conflict that might persist for years.

• In the first report of its kind, the U.S. Defense Department yesterday estimated Russia’s casualties to date amount to 70,000 to 80,000 of the 150,000 or so troops it has deployed to the invasion.  A rough rule of thumb would suggest that about one-quarter of the casualties, or up to 20,000, were killed.
  • The enormous loss rate goes far toward explaining Russia’s failure to achieve any of its key objectives in the invasion, although it is now having some success replacing lost troops through “volunteer” battalions, mercenaries, and the like.
  • Of course, various reporting now suggests that the Ukrainians have also lost large numbers of troops, although they continue to hold the exact number as a secret.
• Meanwhile, the Biden administration has announced plans to send $1 billion in additional military aid to Ukraine, marking the largest single drawdown of equipment since the start of the war.  The latest package will include additional ammunition for high-mobility artillery rocket systems (HIMARS), tens of thousands of rounds of artillery and mortar ammunition, anti-armor systems, and armored medical treatment vehicles.
• On the sanctions front, the prime ministers of Estonia and Finland have asked the EU to stop issuing tourist visas to Russians to keep them from skirting existing sanctions on traveling and doing business in Europe.  The new sanction is due to be discussed at an EU summit in October.

Russia-China:  According to recent reports, three prominent scientists working on hypersonic missiles at a Russian research lab in Siberia have been arrested on charges of treason in just the last few months.  The reports indicate the scientists were suspected of selling secrets to China, which has a well-advanced hypersonics program.

• Illustrating the seriousness with which Moscow viewed the security breach, the scientists were immediately whisked away to Lefortovo Prison, the nasty former headquarters of the KGB in central Moscow.  One of the scientists reportedly died there within days.
• If true, the reports are a reminder that China and Russia are still competitors, even if they continue to draw closer in military, economic, and political relations.

China’s Belt and Road Initiative:  Bangladeshi Finance Minister Mustafa Kamal has warned that developing countries should think twice about taking more loans through China’s controversial Belt and Road Initiative as global inflation and slowing growth add to the strains on indebted emerging markets.

• Last month, Bangladesh was forced to appeal to the IMF for financing help after running into balance-of-payment issues due to both high debt and skyrocketing costs for imported energy and other commodities.
• Once one of Chinese President Xi’s main foreign policy tools to curry favor among poorer countries by providing loans for infrastructure projects, the BRI has now become embroiled in controversy for creating debt traps, forcing countries to transfer collateral assets to China, and benefiting Chinese companies more than the emerging markets themselves.
• The BRI controversy has become a key reason why China has begun to face political and economic pushback in its foreign relations around the world.  As such, it has helped bolster anti-Chinese sentiment in the U.S., which will keep alive policy initiatives to curtail U.S.-China trade and investment.

China-Taiwan:  The People’s Liberation Army has extended its military exercises around Taiwan for a second day, prompting Taiwanese Foreign Minister Wu to warn that China may use the drills to establish full control over the Taiwan Strait.  Importantly, Wu seemed to characterize Chinese actions as moving beyond the “first island chain” and therefore threatening global shipping and trade throughout the region.  Indeed, China has also announced a series of military drills in the northern Bohai and Yellow Seas near Japan in the coming weeks.

• Indeed, one key result of the exercises around Taiwan is that Chinese officials are now openly boasting that they have “obliterated” the median line of the strait, which both China and Taiwan had previously respected as the boundary between their waters.  Chinese military officials and commentators add that the PLA will now establish regular operations on Taiwan’s side of the line.
• As evidence that the new Chinese stance could result in a dangerous U.S.-China confrontation, a senior official at the Pentagon said the U.S. military would continue to operate, fly, and sail through the Taiwan Strait, including in the coming weeks.

Iran Nuclear Deal:  EU mediators have put together what they termed the final text of an agreement to restart the 2015 deal limiting Iran’s nuclear program.  However, top leaders in both the U.S. and Iran continue to signal misgivings about signing, and it remains unclear whether the new agreement will come into force.

Japan:  In contrast with investors betting the Bank of Japan will soon need to tighten its monetary policy to keep up with other major central banks, radical reflationist Goushi Kataoka is now arguing that Japan should take advantage of today’s global inflation pressure to loosen monetary and fiscal policy to generate inflation once and for all.  However, Prime Minister Kishida continues to signal the opposite, naming a relative inflation hawk to replace Kataoka when he left the BoJ’s monetary policy board last month.

• Kishida’s next major BoJ decision will be to find a replacement for Governor Kuroda when he retires next April.
• Kuroda’s insistence on maintaining loose monetary policy and yield curve control has been a major reason for the yen’s extreme weakness against the dollar.  Any move to tighten policy would tend to boost the yen.

United Kingdom:  In the race to succeed Boris Johnson as Conservative Party leader and prime minister, Foreign Minister Liz Truss continues to lead polls of party members but has created some headwinds for herself by suggesting she wouldn’t consider any additional “handouts” to families struggling with Britain’s soaring energy costs, while continuing to call for corporate tax cuts.  That’s given a bit of a lift to Former Chancellor of the Exchequer Rishi Sunak, although he still faces an uphill battle in the remaining three and a half weeks of the race.

Colombia:  The newly inaugurated government of President Gustavo Petro, a former leftist guerilla, unveiled a plan to hike taxes on the wealthy and on major commodity exports to finance rural development and social programs for the poor.  Among the tax hikes, the proposal introduces a wealth tax on savings or property worth more than $700,000, as well as a 10% windfall tax on exporters of the country’s main commodities—oil, coal, and gold—that have benefited from high international prices.  The plan will likely raise concerns about higher taxes and regulation on corporations throughout Latin America, where leftist governments have recently swept into power and look like they will continue to do so.

U.S. Economic Outlook:  In an opinion article today, bond market guru Mohamed El-Erian argues that despite last week’s strong July labor market report and a possible cooling in the July Consumer Price Index tomorrow, it’s still too early to sound the “all clear” for the economy.  First, he notes that some labor market indicators, like job openings and initial jobless claims, are already sending up red flags.  Second, he also notes that the Fed remains far behind the curve in cutting inflation and is likely to keep hiking interest rates aggressively.

U.S. Pension System:  According to the Wilshire Trust Universe Comparison Service, public pension plans in the U.S. lost a median 7.9% in the year ended June 30, marking their worst annual performance since 2009 and decreasing many of the plans’ financial cushion for future retirees.

• The pension plans’ decline in fiscal 2022 was actually a bit better than the performance of a standard portfolio of 60% stocks and 40% bonds.  By one measure, a portfolio like that would have posted a negative total return of 9.7% in the year to June 30, reflecting weakness in U.S. equities, foreign equities, and corporate and government bonds.
• However, we note that a more diversified portfolio that encompassed a significant allocation to commodities likely would have performed better than the 60%/40% portfolio.  Indeed, many university endowments and public pension funds include such allocations, as do all of Confluence’s asset allocation strategies at the moment.

U.S. Digital Currencies:  As early as next month, a bipartisan group of House legislators plans to introduce a bill that would encourage the Fed to accelerate its work on developing a U.S. digital currency.  The legislators are concerned that the U.S. central bank is falling behind similar efforts in China and other countries.

View PDF