by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with some new research confirming our positive view on the global defense industry going forward. We next review several other international and US developments with the potential to affect the financial markets today, including some notes on the Israel-Hezbollah attacks over the weekend, a shut-off of petroleum exports from Tunisia, and a wrap-up of the Federal Reserve’s conference at Jackson Hole, Wyoming.

Global Defense Industry: New research by Vertical Research Partners suggests the world’s top 15 defense contractors will log total free cash flow of $52 billion by 2026, double the amount they generated in 2021. Half the free cash flow in 2026 will come from five top US defense firms (excluding Boeing), while much of the rest will come from top European producers. The analysis is consistent with our often-stated view that today’s increased geopolitical tensions will prompt higher defense budgets around the world in the coming years.

• Separately, the head of the International Atomic Energy Agency, Rafael Grossi, warned in a Financial Times interview that more countries are feeling pressure to develop their own nuclear weapons. According to Grossi, “There are all these tensions, this possibility of alliances being weakened and countries having to fend for themselves. This is where the nuclear weapon factor, and attraction, comes back in a very unexpected way.”
• Grossi’s analysis echoes our view that factors such as the geopolitical aggressiveness of key authoritarian countries and weakening alliances within the US bloc could spark a new, global nuclear arms race in the coming years. From an investment standpoint, that suggests that there could be opportunities not only in defense stocks, but in commodities such as uranium.

Israel-Hezbollah: On Sunday, after US and Israeli intelligence suggested the Hezbollah militants were preparing a major attack on Israel, the Israel Defense Forces launched a large number of airstrikes against the militant group’s rocket launchers in southern Lebanon. Hezbollah later said it had gotten off about 300 missile launches against Israel, but it tried to signal no more attacks would be coming for now.

• It’s not yet clear if the Hezbollah attack was meant to be the main retaliation for Israel’s recent assassinations of Islamist militants in Lebanon and Iran. If it was, it may suggest that Iran wanted to limit its direct involvement to insulate it from further hostilities with Israel. In any case, reports say Hezbollah’s rank-and-file were disappointed with the relatively small scale of the attack.
• In any case, it’s still impossible to rule out further attacks on Israel by Hezbollah, Hamas, or their Iranian benefactors. With Israel’s war on the Hamas government in Gaza continuing, the risk of dangerous escalation into a broader regional conflict remains.

China-United States: Some artificial-intelligence developers in China are reportedly getting around the US ban on selling advanced AI computer chips to the country by remotely and secretly accessing computer power based on top-of-the-line Nvidia chips in foreign facilities. These “decentralized GPU” services apparently aren’t illegal right now, but the US government may well take steps to clamp down on the practice as the US-China technology rivalry continues.

China-Philippines: Yesterday, Chinese navy and coast guard vessels again harassed a Philippine government ship bringing supplies to Philippine fishermen near Sabine Shoal, an area inside Manila’s exclusive economic zone claimed by both countries. The Philippine ship may have been intending to bring supplies to one of Manila’s coast guard ships, which has been anchored in the area since April, much to the chagrin of Beijing.

• As we’ve noted previously, Sabine Shoal is developing into another potential flashpoint between China and the Philippines, after the two sides recently agreed to cool tensions over the disputed Second Thomas Shoal.
• To reiterate, any Chinese-Philippine military confrontation has the potential to draw in the US, which has a mutual defense treaty with Manila.

China: New data from Dealogic shows the world’s top private-equity firms have virtually given up on new acquisitions in China as the country hits structural economic headwinds and geopolitical tensions with the West are making such deals riskier. The data is consistent with our view that slowing growth, worsening international tensions, and the world’s fracturing into relatively separate geopolitical blocs will make Chinese investments riskier going forward.

Tunisia: The government controlling Tunisia’s eastern half today said it will stop all petroleum production and exports to retaliate for the rival western government’s effort to take over the country’s central bank. The eastern government has declared force majeure over all oil fields, terminals, and export facilities, closing them down. The news has pushed global oil prices sharply higher today, with near WTI futures currently up 3.0% to $77.06 per barrel and Brent up 2.5% to $80.13.

Canada-China: Canadian Prime Minister Trudeau today said his government will impose new anti-dumping tariffs on a range of imports from China, including a 100% tariff on Chinese electric vehicles and 25% tariffs on Chinese steel and aluminum. The tariffs, which Trudeau said were aimed at “leveling the playing field” for Canadian workers, are another example of how the US geopolitical bloc is decoupling from China and its bloc. The spread of anti-Chinese tariffs is bound to anger Beijing and complicate its effort to re-ignite economic growth.

US Monetary Policy: As we previewed in our Comment on Friday, Fed Chair Powell used his speech at the opening of the central bank’s summer conference in Jackson Hole to confirm the policymakers will begin cutting interest rates in September. In a line for the ages, Powell said, “We do not seek or welcome further cooling in labor market conditions . . . The time has come for policy to adjust.” The most likely scenario is for the Fed to cut the benchmark fed funds rate by a modest 25 basis points to a range of 5.00% to 5.25%.

• Even though investors had long been expecting an interest-rate cut in September, the confirmation by Powell gave a boost to stocks and bonds on Friday. The S&P 500 price index jumped 1.15% to a near-record 5,634.61, while the yield on the 10-year Treasury note fell to 3.8070%.
• Going forward, there is still some question about the pace of any further cuts. Unless there are more signs of real stress in the economy, the policymakers could well prefer a slow, steady series of 25-basis-point cuts extending into 2025. With investors holding massive amounts in money market accounts, an erosion of the yield on those accounts coupled with a soft landing in the economy could potentially prompt a massive rotation back into stocks and a melt-up in equity prices.

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