by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with multiple reports out of Asia.  Even though China is largely shut down this week because of the Lunar New Year holiday, several news items today reflect how its growing military strength and aggressiveness are having an impact on other countries in the region.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including growing signs that the U.S. labor market is softening as the economy heads into a likely recession.

China:  Although news flow from China will be limited this week because of the Lunar New Year holiday, we are seeing reports that the massive new wave of COVID-19 infections sweeping across the country is now slamming rural areas.  The infections have reportedly peaked in China’s major cities, but the rural healthcare system is now under extreme strain.

Japan:  The country’s parliament, the National Diet, opens its 150^th regular session today, with contentious debate expected over increased defense spending, policies aimed at children, and extending the life of nuclear reactors.  Especially heated will be Prime Minister Kishida’s call for increased taxes to pay for a massive hike in defense spending, which has split his party and thrown his leadership into question.

Australia:  Last week, the Australian government announced that it will replace its European-made Taipan military helicopters, a decade earlier than planned, with U.S.-made Black Hawk choppers from Lockheed Martin (LMT, $443.28).  The 40 Taipans, made by EU aerospace champ Airbus (EADSY, $32.29), have had quality and maintenance issues for years.

• The decision to replace them with Black Hawks illustrates how the developing boom in global defense budgets is likely to disproportionately benefit U.S. defense firms, given their technological leadership, proven quality, and production capacity availability.
• For those reasons, we continue to overweight U.S. defense firms in our updated asset allocations strategies this quarter.

New Zealand:  The ruling Labor Party has named Chris Hipkins, the former education minister, as the country’s new prime minister after Jacinda Ardern announced her resignation from the position last week.

• So far, Hipkins has not outlined a detailed policy program, but he has indicated that the cabinet reshuffle announced earlier by Ardern would go forward, which includes keeping Finance Minister Grant Robertson in his role.
• That would indicate that there will be policy stability and continuity in New Zealand in the near term, which investors will appreciate. However, the Labor Party is still polling poorly and is at risk of losing power in the October elections.

Sri Lanka:  Yesterday, the government said it had received assurances from Chinese officials on the board of the International Monetary Fund that they would approve the country’s proposed debt restructuring, meaning China has fallen in line with previous assurances from India and Japan.  If approved by the IMF board, the restructuring would unlock some $2.9 billion in loans from the institution to help Sri Lanka through its current debt crisis, which includes a default on its debt last May.

United Kingdom:  The Bank of England today said 16 top life insurers passed a recent stress test examining how they would manage with mass credit downgrades and greater client longevity.  However, the institution warned that the insurers may be overly optimistic about their ability to sell down assets in a financial crisis, especially as other financial companies may be trying to sell assets at the same time.

Russia-Ukraine:  Russian forces are reportedly making new progress in pushing the Ukrainians back from the front lines in the southern part of the country, especially in the region around Zaporizhzhia.  The new push suggests that President Putin’s autumn mobilization of hundreds of thousands of fresh conscripts may be helping renew Russian combat power.  On a related note, the Ukrainian government said that it will mobilize fresh reservists to give its front-line fighters a rest.

• Separately, after seeing his political star rise to the point where he could openly disparage the Ministry of Defense and, by implication, Putin himself, financier Yevgeny Prigozhin has reportedly begun to lose influence in the Kremlin because of his Wagner Group mercenaries’ failure to capture the eastern Ukrainian city of Bakhmut. Making matters worse, Prigozhin’s ally General Sergey Surovikin was unable to turn his strategy of bombarding Ukraine’s civilian infrastructure into tangible military gains and last week was demoted to deputy commander of the war.
  • Prigozhin’s waning star could remove a political threat to Putin and ensure that he will retain power at least in the near term.
  • That could reinvigorate Putin’s effort to rebuild and strengthen Russia’s conventional military forces over time.
• In terms of Western support for Ukraine, German Foreign Minister Baerbock signaled yesterday that Berlin “would not stand in the way” if Poland wanted to transfer its German-made Leopard tanks to Ukraine. To test whether Chancellor Scholz has really acquiesced in the idea, Poland said it will formally request German approval for the transfer, as required by its purchase contract for the heavy tanks.  If Germany approves, it could unlock additional Leopard transfers from countries such as Finland, Sweden, Denmark, and Portugal.

Brazil-Argentina:  At a summit this week, the leaders of Brazil and Argentina plan to approve the launching of preparations for a new common currency designed to facilitate trade between the two countries and reduce their dependence on the U.S. dollar.  The “sur” would take many years to develop, and it would initially be used in conjunction with the current Brazilian real and Argentine peso.  Only then could it replace the real and the peso and potentially be adopted by other regional countries.

• Nevertheless, despite the uncertain and long-term nature of the project, the initiative shows how some countries, especially those with deep economic or political ties to China, are looking for ways to reduce their exposure to the greenback.
• As a reminder, our analysis indicates that both Brazil and Argentina will belong to the evolving “Leaning-China” geopolitical bloc, based largely on their exports to China. If China eventually succeeds in developing a digital, commodity-backed form of its yuan to serve as the reserve currency for its geopolitical bloc, as we think it could, the sur could be a secondary reserve currency for that bloc or even be subsumed into the Chinese reserve currency.

U.S.-China Military Competition:  In a webinar with the Council on Foreign Relations last week, U.S. Air Force Secretary Frank Kendall said that he has shifted his service’s focus heavily toward defending against China simply because China in recent years has shifted its focus toward defeating the U.S.  As examples, Kendall cited how the Chinese military has shrunk its army to free up resources for its air force and navy.  He also cited China’s decision to make its Strategic Rocket Forces a separate service, which has a focus on developing long-range precision missiles that could attack U.S. military bases and aircraft carriers in the Asia Pacific region.

• On a more positive note, Kendall also noted that the new Chinese military is still unproven and may not perform that well in real-world operations. He also noted that the U.S. has developed a number of secret capabilities for which the Chinese probably haven’t prepared.
• All the same, Kendall’s discussion suggests that China is preparing to challenge the U.S. in the Asia Pacific region much more aggressively than most Americans probably realize. It’s encouraging that the various U.S. services are responding comprehensively, but Kendall’s statements underline how the risk of conflict with China is rising.

U.S. Executive Branch:  Following reports that White House Chief of Staff Ron Klain will resign, President Biden is expected to name his former pandemic advisor, Jeff Zients, to the position.  Respected more for his organizational skill than his political instincts, Zients also served as former President Obama’s director of the National Economic Council and as supervisor of an operation to fix bugs on the government’s health insurance website.  He has also twice served as acting director of the Office of Management and Budget.

U.S. Labor Market: Spotify (SPOT, $97.91) said today that it will lay off 6% of its global workforce, becoming the latest information technology company to retrench after over-expanding during the halcyon days of the COVID-19 pandemic.

• Recent layoffs have been concentrated in the technology, real estate, and financial services industries, but there is growing evidence that the layoffs are creating a broader softening in labor demand.
• For example, recent data shows that in December, about 826,000 unemployed workers in the U.S. had been out of a job for about three and a half to six months, up from 526,000 in April 2022.

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