by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! The market is processing the latest PCE price index data. In sports news, Tottenham Hotspur defeated Manchester United to make it to the semifinals of the Carabao Cup. In today’s Comment, we will discuss why the government may be headed for a shutdown, explain the reasons we remain confident that dollar strength will continue, and provide an update on Germany as it prepares for new elections. As usual, the report will conclude with a roundup of international and domestic data releases.

Government Shutdown: A government shutdown looms after President-elect Donald Trump and Elon Musk rejected a stopgap spending bill and called for the elimination of the debt ceiling.

• There is growing uncertainty about whether a shutdown can be avoided before the Friday deadline. Republican lawmakers met on Thursday to discuss an alternative spending package aimed at reaching broader consensus. The proposal would extend funding until mid-March, similar to the previous plan, but would exclude unpopular provisions such as a pay increase. It would also allow Congress to raise the debt ceiling twice through budget reconciliation. These adjustments are designed to give lawmakers greater flexibility next year to advance their agenda without negotiating with Democrats.
• This week’s dispute over government funding is likely a way to prevent a bigger fight  over the debt ceiling, which expires January, from derailing Trump’s agenda. Typically, there are three budget reconciliation processes used for revenue, spending, and the debt ceiling. The purpose of these bills is to allow for government funding without the threat of a filibuster. While this measure has facilitated the passage of legislation to keep the government funded, it has also been used to push through major legislation like the Affordable Care Act, the Tax Cuts and Jobs Act, and the Inflation Reduction Act.

• The market’s best chance of replicating its 2024 performance hinges on confidence in the incoming administration’s ability to implement its agenda with minimal obstacles. While high expectations for growth (which have been driven by anticipated tax cuts and deregulation) create optimism, they also heighten the risk of a market pullback if complications arise. A comprehensive budget resolution that facilitates legislative progress and avoids another divisive debt ceiling debate could strengthen investor confidence and drive higher asset prices as 2024 concludes.

Greenback’s Rise: The US dollar is on track to have its biggest annual rally since 2015, and we think there is evidence that this could continue in the coming year.

• The US dollar spot index has surged 7% year-to-date, primarily driven by market expectations of increased US GDP growth and relatively restrictive monetary policy. Despite concerns about a potential economic slowdown in 2024, the US economy managed to outperform other G-7 nations. This robust economic performance has enabled the Federal Reserve to exercise greater restraint in easing monetary policy compared to its peers, ensuring that inflation continues to progress toward its target.
• Tariffs are likely to have a positive impact on the US dollar. The possibility of a universal tariff regime has led investors to flock to the dollar as a safe-haven asset. This is because if the US were to implement such tariffs, it could have significant negative consequences for the global economy, particularly for major exporters to the US. In response to these potential economic risks, central banks such as the Bank of Japan, European Central Bank, and People’s Bank of China have recently shown reluctance in maintaining tight monetary policies.

• The continued strength of the US dollar will likely persist as long as investors maintain confidence in the stability of the US economy and the Federal Reserve’s cautious approach to reducing its policy rate. However, the dollar may become vulnerable to changes in market expectations, particularly if global economic growth begins to accelerate or if there are doubts about the severity of potential tariffs. For the time being, we believe that the US dollar will continue to strengthen throughout the coming year.

German Elections: Europe’s largest economy is heading for early elections in February as voters seek a party capable of reversing the country’s economic slump.

• Current polls indicate that voters are likely to shift to the right in the next election, with the center-right Union parties (CDU/CSU) and the far-right Alternative for Germany (AfD) projected to secure 32% and 18% of the vote, respectively. While this would theoretically give them enough support to form a government, ideological differences make a coalition between the two unlikely. This could create opportunities for left-leaning parties to play a role in the next government. Despite declining popularity, the center left Social Democratic Party’s expected 16% share could prove pivotal in forming a centrist coalition.
• A stronger-than-expected victory for the AfD party could significantly impact European markets. The party advocates for Germany’s withdrawal from both the European Union and the shared currency system. In its place, it proposes a “Europe of Fatherlands,” emphasizing cooperation among sovereign states without forming a unified superstate. If victorious, AfD plans to push for a Brexit-style referendum, allowing voters to decide whether Germany should remain in the EU. A poll earlier this year revealed that only 29% of Germans saw more advantages than disadvantages in EU membership.

• Although the chances of AfD gaining power remain slim, its new platform is likely to pressure other parties into resisting some of the EU’s stricter regulations. This could lead to a softening of the country’s unpopular climate goals as it seeks to bolster its weakening manufacturing sector. Additionally, there may be efforts to limit the number of asylum seekers accepted. A strong performance by AfD, however, could weigh on the euro and potentially drive-up bond yields across Europe.

In Other News: Amazon workers have gone on strike at several locations, indicating that labor still has leverage to demand higher wages. Senators are urging President Biden to extend the deadline by 90 days for ByteDance to sell the US assets of TikTok, in a sign that law is facing renewed pushback.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning. The market is digesting the latest GDP data. In sports, Real Madrid secured its fifth trophy of the year by winning the FIFA Intercontinental Cup. In today’s Comment, we’ll analyze the Federal Reserve’s latest rate decision, explore why long-term bond yields continue to rise, and review the Bank of Japan’s choice to maintain its monetary policy stance. As always, the report includes a roundup of key international and domestic data releases.

Fed’s Hawkish Cut: The Federal Open Market Committee voted to cut rates but also scaled back the number of projected rate cuts for 2025.

• In a widely anticipated decision, the Federal Reserve lowered its target range for the federal funds rate to 4.25%–4.50%. While most policymakers endorsed the move, Cleveland Fed President Beth Hammack dissented, advocating for no change. Alongside the rate cut, the Fed revised its economic projections, raising its 2025 inflation forecast from 2.1% to 2.5% and reducing its expected rate cuts from 100 to 50 basis points. During the press conference, Fed Chair Jerome Powell cautioned that the outlook for rate cuts could shift if inflation moderates further next year.
• The Federal Reserve’s ability to lower interest rates in 2025 will depend on inflation trends during the first quarter. In the first three months of 2024, monthly inflation peaked, driven by sharp increases in financial services, insurance, and housing costs. While the preceding months have moderated, the spike complicated the Fed’s efforts to meet its target inflation rate. The latest Personal Consumption Expenditure (PCE) price index indicates that while headline inflation was 2.3% year-over-year, underlying price pressures, excluding the surge from the first quarter, have moderated to an annualized rate of 1.9%.

• The Federal Reserve’s future policy rate decisions will hinge on inflation trends in the first quarter. If inflation moderates during this period, the Fed may adopt a more accommodative stance. Conversely, if inflation accelerates, a more restrictive policy may be necessary. This is because reducing inflation becomes more challenging after the first quarter, as spring and summer inflation trends have aligned with historical norms over the last two years. Consequently, we advise investors to remain cautious, as interest rates could move in either direction depending on how inflation unfolds.

Bond Market Roars: The 10-year Treasury yield has surged amid growing deficit worries and the Fed’s less accommodative policy stance.

• On Wednesday, the 10-year Treasury yield climbed to 4.5%, a level not seen since May. This rise was primarily driven by growing uncertainty about the Federal Reserve’s potential to cut interest rates in 2025. Since the Fed’s rate cut in September, Treasury yields have increased by nearly 90 basis points as investors became increasingly concerned that a widening budget deficit could exacerbate inflationary pressures. The Congressional Budget Office’s recent upward revisions to its forecasts for inflation, unemployment, and long-term interest rates have further fueled these concerns.
• Uncertainty surrounding next year’s policy direction, particularly the potential inflationary impact of tariffs and tax cuts, may be driving up bond yields. A recent study underscores the inflationary risks associated with these policies, estimating that a 10% tariff increase could raise the PCE price index by 0.6%, a 60% tariff on Chinese goods could add 0.4%, and a combination of both could increase it by 1%. Additionally, the proposed tax cuts, which are expected to boost aggregate demand, could further exacerbate inflationary pressures.

• Long-term Treasury yields are likely to be highly sensitive to fiscal policy changes in the year ahead. If the Trump administration proposes sufficient spending cuts or scales back some campaign promises, the bond market is likely to respond favorably. Moreover, tariffs, which are likely to face legal challenges, could prove less inflationary than currently anticipated. While we recognize the potential for upside risk in Treasury yields, we remain cautiously optimistic that market fears may not fully materialize.

The BOJ Holds: Japanese central bankers opted to maintain the current monetary policy stance, indicating a strategic pause before potentially implementing a third interest rate hike.

• The Bank of Japan (BoJ) held its benchmark interest rate steady at 0.25%, aligning with market expectations. However, one policymaker dissented, advocating for a rate hike to 0.5%. While policymakers expressed concerns about potential wage pressures, the decision to maintain the current rate likely reflects worries about the potential economic impact of US tariffs. During the press conference, BoJ Governor Kazuo Ueda hinted at the possibility of a future rate hike, possibly in January or March, when the central bank has a clearer understanding of wage pressures.
• Japanese policymakers’ persistent adherence to accommodative monetary policy has exacerbated concerns about their ability to effectively control inflation. This sentiment was reflected in the yen’s (JPY) depreciation following the central bank’s decision, surpassing the key 155 JPY level against the dollar. While overall inflation appears to be moderating, core inflation, excluding volatile energy prices, remains above the 2% target, signaling persistent price pressures. Notably, service sector inflation has accelerated, indicating that businesses are increasingly capable of passing on rising labor costs to consumers.

• The Bank of Japan’s decision to maintain low interest rates underscores the potential for countries to employ accommodative monetary policy to mitigate the potential negative impact of tariffs. By keeping their currencies relatively weak, these countries aim to maintain export competitiveness. However, this approach may lead to higher inflation within their own economies. As tariff tensions escalate, the dollar is likely to strengthen due to increased demand for a safe-haven currency. Furthermore, a lack of progress in global inflation could boost the appeal of commodities as investments.

In Other News: Russian President Vladimir Putin has expressed an openness to meeting with Donald Trump, a discussion that could potentially pave the way for resolving the conflict in Ukraine. Meanwhile, the US government is facing an increased risk of a shutdown as Elon Musk and Trump oppose a continuing resolution to prevent it.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! The market is closely watching for the Federal Reserve’s latest rate decision. In sports, Real Madrid’s Vinícius Júnior has been awarded FIFA’s The Best player, a moment many see as restoring balance to the football world. In today’s Comment, we’ll preview the Fed’s decision, analyze the Dow Jones’ recent slump, and provide an update on Brazil. As always, we’ll conclude with a roundup of key domestic and international data releases.

Fed Decision: While the Fed is expected to cut rates today, markets will focus on the accompanying economic projections.

• The latest CME Group FedWatch Tool indicates a near-certainty of a 25 basis point rate cut today, with a 95% probability priced in. This confidence stems from reassurances from Fed officials and signs that the economic risks have become more balanced between inflation and unemployment. Earlier this month, Fed Governor Christopher Waller and Atlanta Fed President Raphael Bostic both signaled openness to a rate cut. Additionally, the November CPI inflation report, while up year-over-year, largely aligned with market expectations. At the same time, the unemployment rate has risen back to its 2024 peak level.
• While the rate cut at this meeting is widely anticipated, the market will be closely watching the number of rate cuts projected for 2025 in the updated dot plot. The September dot plot indicated that Fed officials expected to cut the federal funds rate target by a total of 100 basis points in 2025 to a range of 3.25%-3.50%. However, stronger-than-expected economic growth and inflation’s failure to reach new lows have prompted officials to call for a slower pace of rate cuts heading into the new year. As a result, the market now projects that the Fed could cut rates by 75 bps next year.

• In our view, the Fed’s ability to cut rates will be determined by inflation’s progress in the first three months of the year. As the chart above illustrates, the start of this year saw the widest gap between monthly PCE price inflation increases and its three-year pre-pandemic average. This divergence led several officials to question the need for rate cuts in 2025. Consequently, if inflation remains stubbornly high at the beginning of next year, the central bank may be less inclined to implement the projected rate cuts. This could mean that the Fed may end up cutting less than what the market currently expects.

Dow Jones Trouble: Recent S&P 500 and NASDAQ gains contrast the declining Dow Jones, highlighting the increasing influence of tech giants.

• The Dow Jones Industrial Average Index extended its losing streak to nine consecutive days on Tuesday, marking its longest downturn since the Jimmy Carter administration. The Dow Jones Index has not benefited from the rally in tech stocks, as only four of the Magnificent 7 companies (Amazon, Microsoft, Apple, and Nvidia) are included. Additionally, the index has been significantly impacted by the struggles of healthcare services following the tragic killing of the UnitedHealth CEO and the incoming administration’s plans to regulate pharmacy benefit managers.

• The poor performance of the Dow Jones is another example of how concentrated equity markets have become in recent years. Tech stocks have been the primary drivers of the S&P 500’s performance this year, with the Magnificent 7 accounting for nearly 60% of the gains, which allowed them to increased their combined share of the S&P 500 to nearly 35% in the first six months of the year. This increased concentration means the overall index performance is highly sensitive to changes in sentiment toward the tech sector.

• Going into next year, we expect momentum to continue playing a major role in equity performance. As a result, we anticipate that mega cap tech companies will thrive as long as market expectations remain relatively unchanged. We believe that in 2025 many investors will flock to familiar names in search of safety amid concerns about elevated inflation and uncertainty regarding fiscal and monetary policy. However, the increased concentration of the S&P 500 suggests that the index is highly susceptible to exogenous shocks, which we will be monitoring closely in the coming months.

Brazil’s Problems Deepen: Brazilian markets have plummeted as investors have sought to reduce their exposure to Latin America’s largest economy due to concerns over its widening deficit.

• On Tuesday, the Brazilian real (BRL) plummeted to a record low, prompting investors to reduce their exposure to the country’s debt and equities. The market turmoil was triggered by the lower house’s approval of a spending package that included weakened measures to curb spending if revenue falls short of expectations. While the central bank intervened to stabilize the currency, serious concerns persist about Brazil’s fiscal situation, which is likely to continue weighing on investor sentiment, especially as lawmakers prepare to pass three additional proposals.
• The country’s budget deficit has reached 10% of GDP, exceeding the levels recorded during President Luiz Inácio Lula da Silva’s first term. In response, Lula proposed a plan to cut annual spending by 70 billion BRL ($11.5 billion). However, the inclusion of income tax breaks in the bill have raised concerns over the budgets’ ability to rein in the deficit. Compounding the issue is the speculation that lawmakers may weaken provisions affecting social spending. Additionally, a key measure to rein in military pension expenses has been delayed until next year, further casting doubt on the plan’s timely implementation.

• Brazil’s reluctance to make tough decisions to curb spending suggests that the central bank will likely bear the brunt of the burden. To prevent the country’s widening deficit from exacerbating inflationary pressures, the Central Bank of Brazil may need to tighten financial conditions. This policy could eventually weigh on the country’s GDP growth potential and negatively impact equities. However, if lawmakers adopt a stricter stance on the budget or if government revenues exceed expectations, investors may reconsider their outlook on Brazil.

In Other News: Nissan and Honda are reportedly discussing a potential merger as a strategy to increase their size and competitiveness in the automotive industry. Meanwhile, congressional lawmakers have reached an agreement to avert a government shutdown, which is expected to alleviate market uncertainty.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with new developments in Japanese monetary and energy policy. We next review several other international and US developments with the potential to affect the financial markets today, including a shock resignation by Canada’s finance minister and signs that President-elect Trump wants to reduce the US defense budget to help pay for extending his 2017 tax cuts.

Japanese Monetary Policy: As investors focus on the Fed’s monetary policy decision tomorrow (see below), the Bank of Japan will be holding its latest policy meeting on Thursday. Based on current futures trading, investor opinion is basically split on whether the BOJ will hike its benchmark interest rate or hold it steady at the current level of 0.25%. BOJ policymakers remain keen to normalize Japan’s interest rates if inflation and economic growth meet expectations, but government officials want rates to remain low to boost growth rates.

Japanese Energy Policy: The government has released a new study showing nuclear power will be Japan’s cheapest baseload electricity in 2040, at 12.50 JPY ($0.08) per kilowatt-hour. In its prior long-term forecast, the government said natural gas would be Japan’s cheapest baseload electricity in 2030, but the new study shows that emissions mitigation requirements would push its all-in cost above that of nuclear over the longer term. The findings support the government’s plan to double down on nuclear power in Japan’s long-term energy mix.

• Notably, the study also showed that the all-in cost of solar-generated electricity would exceed that of nuclear power in the long run. According to the study, that’s due to the need for batteries and other equipment to make up for solar energy’s intermittent nature.
• The findings are consistent with our expectation for increased nuclear energy investment around the world in the coming years. That, along with China’s program to boost its arsenal of nuclear weapons, will likely buoy uranium prices in the coming years as well.

China: Illustrating how China is prioritizing its effort to dominate the world’s electric-vehicle market, the Foreign Ministry has reportedly begun recruiting science and technology graduates to serve in embassies around the world. As part of the recruitment process, the candidates were tested on their knowledge of Communist Party ideology and their understanding of EVs. Once hired, the candidates will presumably use their embassy positions to help open those local markets to Chinese EVs.

United Kingdom-China: The Labour Party government of Prime Minister Starmer has reportedly decided to downgrade its promised in-depth study of UK-China relations and the security and economic risks they entail. According to the sources, the decision to opt for a quicker, more cursory, less critical review was made to avoid spoiling Starmer’s effort to repair the UK-China trade relationship.

• Starmer is desperately trying to re-ignite the UK economy, which has been in a funk ever since Brexit and the coronavirus pandemic. One problem has been a loss of trade with the European Union since Brexit and the UK’s failure to coax the US into a free-trade deal to replace it. With the US now so isolationist and protectionist, Starmer is turning to China for new trade opportunities and potentially better growth.
• The situation illustrates the geopolitical risks the US faces as it adopts more isolationist and protectionist policies, including potential new tariffs and other trade barriers against even its core allies. As noted in our new Geopolitical Outlook for 2025, those policies could weaken the cohesion of the US geopolitical bloc. In a worst-case scenario, they could even incentivize US allies to draw closer to adversary countries such as China, Russia, Iran, or North Korea.

Turkey-Syria: According to US officials, Turkey and its militia partners are building up troop levels on the Syrian border in apparent preparation for a large-scale incursion into the country. Ankara’s most likely goal would be to seize Syrian territory populated by US-backed ethnic Kurds before President-elect Trump takes office again in the US.

• The Syrian Kurds and their brethren in Turkey dream of forming a Kurdish republic on territory taken from both Turkey and Syria. To press the issue, a Kurdish terrorist group has long staged attacks in Turkey. Therefore, Ankara has a strong incentive to take control of the Kurds’ territory while the Syrian government is largely dysfunctional following the fall of President Assad last week.
• Turkey’s move would come as Israel continues to attack Syrian military sites to keep Assad’s chemical weapons and other advanced arms away from the new Syrian government or terrorists.
• The possible Turkish incursion is a reminder that the fall of Assad doesn’t necessarily mean a quick return to peace and stability in Syria or the broader region. The volatility means the region’s globally important energy resources will remain at risk of disruption in the near term.

Argentina: New data shows that gross domestic product grew by a seasonally adjusted 3.9% in the third quarter, marking an end to the sharp recession that began in late 2023. The growth came largely from rebounding consumer spending and corporate investment as Argentines adjusted to the Milei government’s sharp budget cuts and deregulation program. In response, the yield spread between Argentine and US government bonds fell to 677 basis points, versus more than 2,000 basis points one year ago.

Canada: Finance Minister Chrystia Freeland, who had been one of Prime Minister Trudeau’s most loyal and trusted aides, abruptly tendered her resignation yesterday and released a blistering letter attacking Trudeau’s plan to release fiscal stimulus ahead of US President-elect Trump’s threatened import tariffs. Instead, Freeland argued that Canada should keep its fiscal powder dry to address any fallout from US policy in the future.

• In the latest opinion polls, support for Trudeau and his center-left Liberal Party is far below that of the center-right Conservative Party. Freeland’s resignation will therefore add to the enormous pressure on Trudeau to resign. However, Trudeau has steadfastly refused to give up and said he intends to campaign for re-election next year.
• On top of Trump’s threatened tariffs against Canada, the increasing political and policy uncertainty in the country is likely to discourage new investment and consumer spending. That will probably weigh on both economic growth and Canada’s financial markets well into 2025.

US Monetary Policy: The Federal Reserve begins its latest monetary policy meeting today, with its decision due tomorrow at 2:00 PM ET. Based on current futures trading, the policymakers are widely expected to cut the benchmark fed funds interest rate by 25 basis points to a range of 4.25% to 4.50%. The bigger question is what their updated economic and financial market forecasts will look like.

• In their September projections, the policymakers stated that they expected to cut the fed funds rate by another 1.00% over 2025, to a range of 3.25% to 3.50% by year’s end. They expect perhaps another couple of small rate cuts in 2026.
• Given the US economy’s continued growth and sticky price pressures, we would not be surprised if the new projections this week call for fewer future rate cuts and a terminal rate higher than what investors currently expect. That could set the stage for some financial market volatility when the decision is released on tomorrow.

US Defense Budget: According to Axios, President-elect Trump has told former Fox News commentator Pete Hegseth, his nominee for defense secretary, to prepare for a smaller US military budget. The report quotes Trump as telling Hegseth, “I expect you to do more with less. They’re spending too much money, and we’re not getting anything for all that money.” The report is the clearest sign yet that Trump may not follow the traditional Republican playbook of hiking defense spending to support a “peace through strength” foreign policy.

• We continue to believe that today’s increasing international tensions and greater assertiveness by the China/Russia geopolitical bloc will lead to bigger defense budgets worldwide in the coming years. Indeed, that’s already happening in much of Europe and Asia. However, we’ve also noted that US political polarization, isolationism, and “America First” sentiment have held the Pentagon’s budget in check. Trump’s statement is a warning that the US defense budget could face outright cuts.
• We suspect that Trump wants to find savings in the defense budget to help pay for his tax cuts and other promised initiatives.
• Against this backdrop, the major defense firms in Europe and Asia may have better prospects than the major US defense contractors, which would likely face reduced funding for the big, expensive, “exquisite” weapons systems they specialize in.
• On the other hand, some of the US’s savings will likely be channeled toward smaller, more innovative start-ups or young companies with defense-related technology, such as drone makers and artificial intelligence software providers. Those small, innovative defense firms could eventually become great growth stories.
• To reiterate, though, this scenario is probably not yet set in stone. President-elect Trump’s coalition includes many traditional defense hawks who want to boost the defense budget to counter China and its bloc. For example, the Republicans’ former Senate Majority Leader, Mitch McConnell, has a new article for Foreign Affairs magazine arguing for building a stronger US military rather than cutting it.

US Industrial Policy: The Department of Energy has granted a $755 million loan to Australian firm Novonix to build the US’s first large-scale synthetic graphite plant in Chattanooga, Tennessee. The investment aims to break the US’s dependency on China for the graphite needed in electric-vehicle battery production. It’s also another example of how growing US-China frictions are fracturing global supply chains and prompting re-industrialization in the US.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with the latest signs of economic weakness in the eurozone. We next review several other international and US developments with the potential to affect the financial markets today, including the naming of a new prime minister in France, disappointing economic data from China, and a few words on monetary and fiscal policy in the US.

Eurozone: In a speech today, European Central Bank Chief Lagarde signaled that she believes the ECB has re-established price stability in the region and can now continue to cut interest rates. According to Lagarde, “The direction of travel is clear, and we expect to lower interest rates further.” The statement confirms widely held expectations that the ECB will continue to cut rates to support the eurozone’s flagging economic growth. Reflecting that, the euro today is trading slightly weaker at $1.0503, near its lowest level in more than a year.

• In the latest evidence of the eurozone’s economic malaise, S&P Global and Hamburg Commercial Bank today said their December composite purchasing managers’ index came in at just 49.5, slightly higher than last month but still below the level of 50 that indicates expansion.
• The weakness stemmed largely from contracting activity in the manufacturing sector, while the service sector posted growth.

Germany: To set the stage for new elections, parliament is expected to hold a confidence vote today on Chancellor Scholz, who leads the center-left Social Democratic Party. If Scholz loses as anticipated, the elections would likely be held in mid-February, and the winner would probably be Friedrich Merz of the center-right Christian Democratic Union. However, the ascendant far-right Alternative for Germany party is considering tactically voting for Scholz to keep him in office and delay the rise of Merz, who wants to increase Germany’s support for Ukraine.

France: Days after his previous prime minister was deposed in a no-confidence vote, President Macron on Saturday named veteran centrist politician François Bayrou to replace him. Bayrou is expected to name his ministers in the coming days. However, Bayrou will face the same political problems that the previous prime minister faced, such as his proximity to the unpopular Macron and the fact that his coalition’s minority government can easily be toppled if parliament’s large left-wing and right-wing blocs decide on another no-confidence vote.

• Bayrou’s priorities now will be to pass a special law to roll over the 2024 budget and then to pass a formal 2025 budget that begins to address France’s yawning budget deficit, which has started to spook investors.
• The most likely scenario going forward will be for France to face an extended period of political and policy uncertainty, with negative implications for the French economy and financial markets.
• Underscoring the bleak prospects for France’s budget consolidation and improved economic competitiveness, Moody’s on Saturday unexpectedly cut the country’s sovereign debt rating to Aa3, three notches below its top rating. However, in a sign that France’s troubles are already priced into the markets, the yield on the country’s benchmark 10-year government bond is barely changed this morning at 3.029%.

United Kingdom: On Sunday, the UK officially joined the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, as originally announced last year. Acceding to the TPP marks Britain’s biggest trade deal since Brexit, granting lower tariffs and easier trade rules with countries including Japan, Australia, New Zealand, Canada, Mexico, Chile, and Peru.

• Since the US isn’t a member of the TPP, the economic benefits of accession are limited. London estimates that joining the TPP will only boost the UK’s annual economic output by about 2 billion GBP ($2.5 billion) a year in the long run — less than 0.1% of gross domestic product.
• The more important impact of Britain’s accession may geopolitical. As a full member of the trade pact, Britain can now influence whether applicants China and Taiwan may join the group.

United Kingdom-China: British authorities have banned a suspected Chinese intelligence agent from re-entering the country after discovering he had ties to Prince Andrew (the king’s brother). The authorities have reportedly discovered that the Chinese agent gave money to the prince, who then gave the agent access to Buckingham Palace, the Ministry of Defense, and meetings with former UK prime ministers.

• In response, King Charles is reportedly considering banning Prince Andrew from Buckingham Palace’s Christmas celebrations. The reports also claim the prince could be forced to move to the Gulf region for asylum.
• Both China and Russia have adopted aggressive, no-holds-barred approaches to their intelligence gathering and secret influence campaigns against the West. If the allegations against Prince Andrew are true, it would only be the latest example of how successful those intelligence operations have become. Western media and voters have been quite complacent about these attacks to date, but there is some chance that an especially egregious operation could spark pushback and ratchet up geopolitical tensions.

China: Official data from this weekend showed November industrial production was up 5.4% from the same month one year earlier, versus a rise of 5.3% in the year to October. Fixed-asset investment in January through November was up 3.3% year-over-year, versus 3.4% in the January-October period. In contrast, November retail sales were up just 3.0% on the year, after a 4.8% rise in the year to October. The data suggests Beijing’s recent economic stimulus program has boosted corporate activity, but consumers remain more skeptical.

South Korea: On Saturday, Parliament impeached President Yoon for his attempt to declare martial law on December 3. Fully 204 of the chamber’s 300 members voted in favor of the measure. Prime Minister Han Duck-soo will now be acting president until the Constitutional Court decides whether to affirm the impeachment, which could take as long as 180 days. If the court affirms, new presidential elections would have to be held within 60 days.

• The court is currently short-handed due to recent resignations and a stalemate over their replacements. Therefore, all six of its current members would have to vote to affirm the impeachment before Yoon can be thrown out of office.
• Yoon therefore probably still has a chance to keep his position. Nevertheless, because of his deep unpopularity and the strength of the political forces against him, South Korea could be in political limbo for some time, which will likely weigh on the country’s economy and financial markets.

US Monetary Policy: The Federal Reserve will hold its latest monetary policy meeting this week, with its decision due on Wednesday at 2:00 PM ET. Based on current futures trading, the policymakers are widely expected to cut the benchmark fed funds interest rate by 25 basis points to a range of 4.25% to 4.50%. The bigger question is what their updated economic and financial market forecasts will look like.

• In their September projections, the policymakers expected to cut the fed funds rate by another 1.00% over 2025, to a range of 3.25% to 3.50% at year’s end. They expected perhaps another couple of small rate cuts in 2026.
• Given the US economy’s continued growth and sticky price pressures, we would not be surprised if the new projections this week call for fewer future rate cuts and a terminal rate higher than what investors currently expect. That could set the stage for some financial market volatility when the decision is released on Wednesday.

US Fiscal Policy: The Wall Street Journal today reports that Republican leaders in Congress are leaning toward prioritizing tax cuts over measures to reduce the federal budget deficit when the new legislative term starts next year. To mask the impact of extending the 2017 tax cuts, some of the leaders reportedly advocate changing the official methodology for calculating how their decisions affect the budget. The debate suggests at least some Republicans are looking to do whatever it takes to extend the tax cuts, despite the impact on the deficit.

• Under current budget rules, the baseline deficit in future years is the estimated shortfall assuming today’s legislation is in place or expires as currently written. The 2017 tax-cut law expires at the end of 2025, so under today’s rules, the baseline deficit for 2026 and beyond would reflect a snap-back of tax rates to the higher levels prevailing before 2017, i.e., tax revenues would likely rise, and the baseline deficit would be smaller.
• The proposal being considered would assume the 2017 tax cuts don’t expire, even though extending them would require an act of the new Congress. Under this methodology, baseline tax rates would stay low, and the assumed deficit for comparison would remain large. In other words, extending the tax cuts would be “free,” and deficit impacts would be calculated only for new measures, such as President-elect Trump’s promise to eliminate taxes on workers’ tips.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! The market is digesting the latest data from Broadcom as it assesses the outlook for chipmakers heading into the new year. In sports, LeBron James’s son achieved a career-high 30 points during his first G League road game. In today’s Comment, we delve into the incoming Trump administration’s latest tax proposal, the impact of the automation debate on inflation, and the factors behind the British economy’s recent struggles. As always, our report includes a summary of key international and domestic data releases.

Tax Details: The Trump administration provided a glimpse of what may be included in a tax package on Thursday.

• Economic advisors within the administration have proposed doubling the State and Local Tax (SALT) deduction cap from $10,000 to $20,000. This measure is positioned as a compromise to address the concerns of residents in high-tax states, following the president’s campaign promise to eliminate the cap entirely. The proposal aims to improve middle-class living standards while mitigating perceptions of favoring the wealthy. The move also suggests that the incoming president may take a more pragmatic approach in office than he did on the campaign trail.
• The decision to increase the SALT deduction cap rather than eliminating it was driven by concerns over the growing national deficit. Before the election, Treasury yields rose as investors worried about an increase in government borrowing to finance additional spending. Initial estimates projected that these spending plans would add $7.5 trillion to the deficit over the next decade. While the administration expressed optimism that stronger GDP growth could potentially offset these costs, recent Congressional Budget Office estimates suggest a more mixed economic impact from the tax changes.

• The market’s assessment of the future US budget deficit may be overly pessimistic. As previously discussed, the Trump administration, like its predecessors, is likely to temper its campaign promises to make them more budget friendly. A potential compromise could involve extending the Trump tax cuts for an additional four years, rather than making them permanent. That said, we remain most optimistic about the proposed corporate tax rate cut, as it could be essential in securing continued corporate support while implementing potentially less business-friendly policies.

Labor Fights Back: The possibility of another port workers’ strike in January will likely test the new president’s ability to balance the interests of labor and capital.

• President-elect Donald Trump voiced support for the International Longshoremen’s Association, which represents over 45,000 union port workers on the East and Gulf coasts. In October, workers went on strike to oppose employer use of automation. Employers argue that automation is necessary to reduce costs and maintain competitiveness, while the union contends that it will lead to significant job losses. On Truth Social, Trump argued that “the amount of money saved [through automation] is nowhere near the distress, hurt, and harm it causes for American Workers.”
• The ongoing debate about automation and artificial intelligence (AI) carries significant implications for long-term inflation. Federal Reserve officials believe that productivity gains from technological advancements and increased efficiency could help lower inflation to the 2% target while supporting economic growth. As a result, the implementation of automation and AI will be important if the government would like to pursue tougher immigration and trade policies without negatively impacting inflation.

• Keeping a close watch on the dynamic between labor and capital will be crucial in assessing the president’s ability to navigate opposing factions within his coalition. His primary challenge lies in balancing his goal of bringing down inflation without hurting wage growth. As shown in the chart above, much of the inflation reduction over the past two years has come at the expense of workers. To rebalance this, the Trump administration may need to shift the wage burden away from consumers and onto corporations, possibly by encouraging firms to slow their adoption of certain disruptive technologies.

British Slowdown: The UK economy contracted again, marking the second consecutive month of decline and hindering the Labour government’s growth goals.

• Economic output dropped 0.1% in October, according to the Office for National Statistics. The weak performance was a surprise, as initial forecasts had predicted an uptick. Now, there are concerns that the economy may also contract in the fourth quarter. Following the report’s release, the pound sterling (GBP) weakened by 0.3% against the dollar to $1.26, as investors began to factor in a potential widening gap between UK and US interest rates and weakening GDP growth projections for 2025.
• The decline is a major setback for Prime Minister Keir Starmer’s Labour government, which has made economic recovery a cornerstone of its agenda. The party has pledged to deliver the fastest per capita GDP growth in the G7 for two consecutive years by the end of this parliamentary term — a feat last achieved in the 1970s. However, the goal remains far out of reach, with the UK’s economic growth ranking second to last among G7 countries in Q3.

• The weakness in growth is likely to prompt the Bank of England to lower interest rates more aggressively to prevent the economy from further deceleration. Recent forecasts from policymakers within the BOE projected 0.3% growth in the fourth quarter, leading the group to believe a more gradual approach to rate cuts would suffice. However, the latest negative economic data could necessitate more rapid rate cuts than initially anticipated. Assuming this is correct, we can expect downward pressure on the pound sterling and upward pressure on the US dollar.

In Other News: The Trump administration is reportedly aiming to curb the influence of bank regulators by placing them under the Treasury Department in a move that could have significant implications for the Federal Reserve’s independence. French President Emmanuel Macron has appointed François Bayrou as prime minister in a bid to ease concerns over political instability.

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