by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts on the future path of interest rates and why we still believe that the hype surrounding artificial intelligence is far from over. Next, we examine the struggles of the West to address the growing cost of climate change. Finally, we review the ongoing tensions between the U.S. and China and discuss how the rift may impact future diplomatic talks.

More to Come: Investors are anxious about central bank meetings which has weighed on equities.

• A surprise rate hike by the Bank of Canada on Wednesday has contributed to concerns that other central banks are not finished hiking rates. Earlier this week, European Central Bank officials insisted that the bank will continue to raise interest rates throughout the year. Meanwhile, members of the Federal Open Market Committee have signaled that they may not be ready to pause hikes indefinitely. Economists expected the ECB to raise rates over the next two meetings and pause for the remainder of the year. Meanwhile, the latest CME FedWatch Tool prediction of a rate cut by December is at 39.1%, much lower than the 98.9% that was forecast a month ago.
• Investors are hesitant to purchase risky assets due to the uncertainty regarding future borrowing costs. Higher interest rates are likely to exacerbate recession risks, especially as government data suggests that economic growth is slowing. According to data collected by EPFR, tech funds saw $1.2 billion in outflows in the week ending June 7; its first weekly loss in 8 weeks. The withdrawal comes amidst concerns that the Federal Reserve will not be able to navigate a soft landing. On Thursday, jobless claims surged to their highest level since October 2021. Thus, adding to evidence that the labor market is starting to cool and the economy is losing steam.

AI Losing Momentum?: While the market has recently become wary of tech stocks, we believe the AI boom is likely not over yet. The technology is still in its infancy stage and is expected to grow more prominent in the next few years. In recent months, more businesses have been trying to integrate generative AI into their business processes, with some even hiring consultants to help with the transition. It is speculated that the technology will be capable of automating about 40% of available service jobs within the next decade. While it is premature to say that the disruptive nature of the technology will lead to an equal amount of job displacement, we believe that AI will drastically improve efficiency and cut costs.

Smoke Spreads: The recent wildfires in Canada have caused widespread air pollution in a sure sign that the West needs to do more to combat climate change. However, it is not clear whether the West has the resources needed to do it alone.

• Canadian smog has entered states along the East Coast, will soon be moving south, and is expected to last until next Monday or Tuesday. This is the worst wildfire season in Canada’s history, which typically runs from May through October, and has led to flight cancellations and school closures. The cause of the fires has been attributed to lightning, which tends to be more prevalent when the weather is dry and hot. However, world leaders have also blamed climate change. President Joe Biden and Canadian Prime Minister Justin Trudeau have argued that more needs to be done to reduce carbon emissions.
• Making matters worse, the return of El Niño is expected to bring extreme weather conditions throughout the year. After remaining dormant for four years, the climate pattern has now resurfaced. Forecasters give it a 56% chance of being strong and an 84% chance of exceeding “moderate” strength. A strong El Niño typically brings cold and dry winters to northern Europe and more precipitation to southern Europe. These conditions will likely lead to higher energy demand due to an increase in household consumption. On a positive note, European countries are better positioned to deal with these challenges now than they were before the invasion of Ukraine.

• Western governments will likely be forced to make uncomfortable decisions if they want to follow through on their climate change goals. Neither North America nor Europe has the ability to produce enough electric vehicles to meet projected targets. In order to accelerate the development of clean technologies, both regions have offered subsidies for companies to build manufacturing facilities. This new investment will likely help expand production, but it does not appear to be on pace to meet future demand. In fact, without imports of cheap renewable energy technology from China, these regions will likely be unable to meet many of their targets. As a result, the West will have to choose between easing its targets or becoming more friendly with China.

Bloc Rivalry: The United States and China are engaging in increasingly provocative behavior, even as the two countries make plans to hold talks.

• There is more evidence that Beijing is expanding its efforts to spy on the United States. On Thursday, it was reported that Cuba has agreed to allow China to build a spy facility on the island. The facility could allow Beijing to eavesdrop on electronic communications across the southeastern section of the U.S. The Pentagon learned of the plan to build the surveillance facility a few weeks ago, but it is not yet clear whether construction has begun. The report comes two weeks after Microsoft (MSFT, $325.25) accused China of hacking critical U.S. infrastructure, and a couple of months after a Chinese spy balloon was found in U.S. airspace.
• At the same time, the United States is looking to bolster its military presence in the Indo-Pacific region in response to China’s growing military threat. Japan and Taiwan have agreed to improve intelligence sharing with the US military and will begin exchanging real-time data from naval reconnaissance drones. South Korea also announced this week that it had upgraded its alliance with the U.S. to a nuclear-based relationship. The two countries have discussed nuclear planning to create deterrence on the Korean Peninsula, but no final agreement has been reached on the deployment of U.S. weapons.
• Rising tensions between the major powers have cast doubts on the chances of a thaw in relations between the U.S. and China. However, Secretary of State Antony Blinken is still expected to travel to China next week in an attempt to restore high-level diplomatic and military ties. During the visit, Blinken will seek to address a range of issues, including trade, human rights, and security. Although it is unlikely that the two countries will become best friends, there is a growing recognition that both sides have a stake in de-escalating tensions. China’s economic recovery has struggled to take off, and U.S. businesses have urged the White House to reconsider its strategy of decoupling from the Chinese economy. Therefore, a positive breakthrough in U.S.-China relations would likely be welcomed by markets.

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