by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion about how investors’ expectations of the Fed’s rate hikes are impacted by a possible recession. Next, we give our thoughts about U.S. foreign and domestic policy. Finally, we review the latest developments from China.

Economy in Focus: Fresh data on Wednesday dented hopes of a soft landing, much to the chagrin of markets.

• A tightening labor market and a slowdown in residential construction have added to concerns that the market has not fully bottomed. The number of first-time claims for unemployment insurance fell unexpectedly to a four-month low in the week ending January 14. The sharp decline in benefits suggests that the Fed’s attempts to cool the labor market by raising rates have not been effective. Meanwhile, building permits rose at a slower pace than housing starts for the second consecutive month in December, signifying a possible decline in future U.S. economic activity.

• The market responded negatively to these reports as investors weighed the possibility that the Fed could raise interest rates while the U.S. heads into a recession. The S&P 500 and the Dow Jones both fell 0.8% on Thursday. Meanwhile, the two- and 10-year Treasury yields remained below the fed funds rate, indicating that the market anticipates that the central bank may be looking to cut rates soon. Although the latest Atlanta GDPNow forecast shows that GDP expanded at an annualized rate of 3.5% in Q4 of 2022, last month’s data suggests that the economy quickly ran out of steam toward the end of the year.
• Despite tough talks by officials, investors do not believe that the Fed will be able to push rates above 5% this year. On Thursday, Fed Governor Lael Brainard and Boston Fed President Susan Collins joined the chorus of policymakers warning markets that the Federal Reserve will continue to hike rates to combat inflation. However, investors are skeptical as to whether these officials will hold true to their word. Futures and options flow activities suggest that traders believe the Fed will be done with its hiking cycle after its March meetings. This optimism may partially explain why equity futures are slightly up this morning. If the Fed shocks markets by raising rates during a recession, U.S. equities will be negatively impacted.

Looking For a Fight? While lawmakers in Congress are debating whether to raise the debt ceiling, Washington is trying to rally its allies to take on Russia and China.

• The U.S. Treasury was forced to take extraordinary measures to prevent the government from breaching its debt limit. The stalemate in Congress over whether to increase the government borrowing cap threatens to push the country into default which could have disastrous consequences on the U.S. financial system. Although Senate Majority Leader Mitch McConnell offered assurances that the debt ceiling would be raised, there does not seem to be a path toward agreement anytime soon between the two sides. Republicans are pushing for spending cuts, while Democrats want to raise the ceiling without any strings attached. If history serves as a guide, talks will likely go down to the wire as the two groups hold out for leverage.
• On the foreign policy front, the U.S. and Germany are in a dispute over delivering military vehicles to Ukraine. The Germans do not want to send any of their own tanks unless the U.S. sends theirs first. The row over who should send tanks exemplifies Germany’s reluctance to help Ukraine in its war efforts and threatens to undermine Western unity. As we have mentioned in previous reports, the war in Ukraine could cause fractures within the European Union and the North Atlantic Treaty Organization (NATO). Although the issue does not pose short-term risks to financial markets, the situation may accelerate efforts to deglobalize.
• Additionally, the U.S. and its allies are working together to hinder China’s ability to develop advanced military technology. Washington would like to hobble its Indo-Pacific rival by restricting access to semiconductors used for weaponry. Major chip-producing countries Japan and the Netherlands are expected to agree to limit the sales of their technology to China by the end of the month. Beijing views semiconductors as crucial to its endeavor to surpass the U.S. economically and militarily. However, previous investment schemes have not yielded satisfactory results. As a result, there is growing speculation that China may seek to invade Taiwan in order to have access to the nation’s chips.
  • Because of this, U.K. Prime Minister Rishi Sunak would like his country to develop its own chip industry so that it is not dependent on Taiwan for semiconductors.

Energy Rises: As China’s COVID wave approaches its peak, there are growing concerns that the return of Chinese demand may lift inflation overseas.

• The Chinese economy may be poised to come roaring back as COVID cases begin to ease. Vice Premier Sun Chunlan says infections have fallen to a “relatively low level.” The announcement indicates that the Chinese government is prepared to further reduce restrictions to help provide a boost to the economy. As the country prepares to celebrate the Lunar New Year, Chinese travelers are expected to receive extra scrutiny in other countries. As a result, tourists may stay home during the holiday which should be supportive of domestic spending.
• China’s reopening is already having an impact on commodity prices. The price for materials such as copper and aluminum have surged 12% and 11%, respectively, to begin the year. Meanwhile, crude oil demand is expected to jump to an all-time high by the second half of the year. The pick-up in commodity prices is related to concerns that the end of COVID restrictions will make it easier for manufacturers to ramp up production and encourage spending from consumers.
• The potential rise in commodity prices will complicate efforts by central banks to combat rising inflation. Energy prices represent a heavy component within consumer price indexes. Thus, a sharp increase in prices could cause a major setback in the central banks’ abilities to contain rising inflation. The inflationary threat posed by China’s reopening may explain why policymakers have been reluctant to end policy tightening. That said, China’s reopening does have some winners. The rise in commodity prices should boost the stock markets of export-producing countries such as Brazil and Canada.

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