by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equity futures are higher as investors await this week’s economic releases. In sports news, the Indiana Pacers were able to tie up the series with the New York Knicks. Today’s Comment explores why declining consumer sentiment may spell bad news for some companies and why small-cap companies are eager for a Fed pivot. We also provide an update on the war in Ukraine. As usual, our report ends with a summary of the latest international and domestic data releases.

Feeling the Squeeze: May saw the biggest one-month drop in consumer sentiment since 2021; however, the pain was not evenly spread.

• The University of Michigan Survey of Consumer Sentiment fell from 77.2 to 67.4, missing expectations of an increase to 78.0. This disappointing report was driven by rising inflation expectations, as households grew increasingly pessimistic about price increases moderating to pre-pandemic levels. The survey showed that consumers expected inflation to increase to 3.5% next year and eventually to moderate to 3.1% in the next five years. Although there is a lack of strong correlation between inflation expectations and indexes like CPI or PCE, the change in sentiment reflects a broadening trend of weak economic data.
• The recent drop in consumer sentiment reinforces concerns about slowing consumer spending — a trend that many companies hinted at in their latest earnings reports. Despite exceeding expectations, corporate earnings suggest executives are noticing that households are tightening their belts. This cautious spending is particularly evident among discretionary purchases, since companies like McDonald’s, KFC, and Starbucks have reported significant pushback against higher prices. The impact is felt most acutely by low-income households, while higher-income earners have shown greater resilience. In Q2, mentions of low-income consumers by companies have more than doubled when compared to the highest level seen in the past five quarters.

• Although consumer surveys suggest that households are under pressure, it is unclear whether that will lead to a broader consumption pullback. A breakdown by income shows consumer expectations remain relatively optimistic among middle and high-income households. Notably, attitudes of middle-income earners improved from the previous month. However, the sizeable decline in the overall index suggests that low-income earners are feeling less confident in dealing with rising prices. In the short term, there might be a more significant impact on the upcoming election than on the broader economy, but this trend could have long-term consequences.

Small Cap Risk: Despite attractive valuations, investors remain wary of smaller companies, perhaps until the Fed signals an interest rate cut.

• Over 75% of the debt held by companies within the Russell 2000 index needs to be refinanced within the next five years. This is a significantly higher proportion compared to the S&P 500, where nearly 50% of the debt is due at that time. These companies are particularly vulnerable to changes in interest rates because they rely more heavily on floating-rate debt compared to their larger, investment-grade counterparts. As a result, these companies have a heightened dependence on monetary policy decisions as a decrease in policy rates could drastically improve their financial performance.
• Small-cap investors stand to benefit significantly from a successful soft landing by the Fed. These companies are also highly sensitive to fluctuations in the business cycle and real interest rates. Thus, the possibility of declining borrowing costs and improved growth led these companies to outperform their large-cap counterparts toward the end of 2023, for the most part. This relationship is not just a US phenomenon. European small caps have also been able to take off this year due to interest rate cut expectations and signs of an impending economic recovery. The Stoxx Europe Small 200 Price Index has surged 7.5% year-to-date, nearing its 2023 return of 10%.

• Despite some economic setbacks, a strong case can be made for US small and mid-cap companies. Not only do these firms have better valuations when compared to their large-cap counterparts, but their strong domestic focus likely protects their revenue from being significantly impacted by currency fluctuations and geopolitical events. Additionally, while Fed Governor Bowman’s recent comments dampen hopes for a rate cut, the possibility remains for one if inflation eases and unemployment keeps climbing. Nevertheless, this week’s release of the PPI and CPI reports for April could provide crucial clues on the Fed’s path, as inflation is expected to cool from the previous month.

Next Phase in Ukraine: Russian President Vladimir Putin is seeking a new approach as his country faces growing financial pressure from the West.

• Putin replaced Defense Minister Sergei Shoigu with Andrei Belousov, an economist and former first deputy prime minister. This reshuffle highlights Putin’s attempt to re-evaluate Russia’s military strategy, as Russian forces aim to consolidate their gains before Ukraine can leverage additional Western funding. The apparent uneasiness in these moves may also be reflected in Russia’s consideration of lowering the threshold for activating its nuclear weapons and its decision to ramp up recruitment as it recently brought female convicts to serve on the battlefield. These efforts have become more pressing as Putin gets closer to taking over Kharkiv.
• The Russian need for a victory in Ukraine comes amidst growing signs that it is becoming increasingly more costly for Moscow to maintain its war efforts. The European Commission has proposed the first-ever sanctions on Russia’s liquefied natural gas industry, signaling a significant escalation in efforts to sever economic ties with Moscow. Although it would not affect imports, it would prevent EU countries from re-exporting Russian LNG. The measure would complicate purchases of Russian gas for Asian countries like China and India, which have become key buyers since the war began in February.

• Despite waning media attention, the war in Ukraine remains a critical issue, which demands close monitoring. French President Emmanuel Macron’s emphasis on the potential need to send troops to Ukraine underscores the possibility of a wider European conflict. Furthermore, the growing push by the West to restrict Russia’s ability to get help from other countries is likely to exacerbate the trend toward global fracturing and undermine supply-chain security. Therefore, the recent reprieve in gold and oil prices may not hold if European threats continue to escalate.

In Other News: China is expected to hold a major bond sale as it looks to boost its economy. This is a sign that global growth may pick up this year. Meanwhile, more Americans are eying retirement, indicating that the labor market may remain tight for some time. In Spain’s Catalonia region, the Socialist Party dominated recent regional elections. This suggests that the pro-independence movement is losing favor.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are off to a great start as investors welcome signs of an economic slowdown. In sports news, the Cleveland Cavaliers scored an upset victory over the Boston Celtics last night. Today’s Comment explores how decisions by foreign central banks to cut rates before the US Fed will influence the dollar’s strength. We also explain how recent changes to money market redemption rules will affect bond yields. Finally, the report explores the specific difficulties Canada is facing with immigration. As always, our report concludes with a summary of recent international and domestic data releases.

Lead from Behind: Most central banks in the West are set to cut policy rates this summer, while US monetary policy remains in limbo.

• Central banks around the world are signaling a shift toward looser monetary policy. This week, the Bank of England joined the Bank of Canada and the European Central Bank in hinting at potential interest rate reductions in June. These follow the Swiss National Bank’s recent rate cut, with further easing expected from it this year. In contrast, the Federal Reserve in the United States is on a different path. It is expected to hold rates steady at least until September, with most market participants anticipating cuts only later in the year, likely November or December.
• A Federal Reserve which is hawkish compared to its global counterparts could buoy the dollar, particularly given the robust growth of the US economy. In 2023, GDP growth in the US accelerated to its fastest pace in two years, while the eurozone and UK economies stagnated. This strong performance has attracted investors to the dollar, especially as the Fed signaled a more cautious approach to potential interest rate cuts earlier in March. If this trend holds, the dollar’s strength against other currencies could accelerate, especially if Fed officials continue hinting at the possibility of holding rates steady or even raising them by the end of 2024.

• Nevertheless, there is still a good chance that the dollar’s rise will face some resistance. Despite the Fed likely holding off on rate cuts in June, tapering quantitative tightening could ease financial pressures and lower Treasury yields. This would narrow the interest rate differential for longer-term government bonds compared to other countries. Additionally, recent data suggests a potential slowdown in US GDP growth, while some peer economies appear to be gaining momentum. As a result, the divergence between interest rate and growth may narrow later this year.

Regulatory Shift: New SEC guidelines may help the government resolve some of its Treasury supply problems.

• In 2023, the SEC implemented new rules requiring liquidity fees for investors redeeming shares from certain money market funds during periods of financial stress. This regulation aims to prevent a repeat of the liquidity issues seen in March 2020 and will take effect in October of this year. To avoid these fees, some money managers are exploring strategies to navigate the rules, while others have chosen to close their funds altogether. The new regulations are expected to impact roughly $6 trillion in money market fund assets and will likely have some spillover effect into the fixed-income market.
• This rule change arrives at a critical juncture, coinciding with rising fiscal debt and a hawkish monetary policy stance. Money market funds have surged in popularity as investors seek to capitalize on both the potential for higher short-term interest rates and daily redemptions. However, with fees now attached to withdrawing funds during times of market stress, institutional investors may be forced to park more of their money at the Fed overnight facilities. This shift should allow the Treasury to tap into additional funds as it seeks to finance government expenditures.

• The recent market rule change for money market funds, coupled with the observed market reaction, suggests the government may be seeking to cultivate banks and institutional investors as a primary source of demand for government debt. This shift in dynamics implies that lawmakers might be strategically using regulations to maintain the attractiveness of bonds, particularly as government issuance is expected to increase over time. If this is the case, it could help the government control yields, particularly as it prioritizes short-term debt issuance. Theoretically, this approach could help mitigate the overall rise in government borrowing costs, which should improve financial conditions.

Build It, They Will Come: A Canadian solution to its demographic problem has mixed results as the government looks for a middle ground.

• This year, Canada is adjusting its immigration approach to address strains on social services and housing. The government is taking steps to manage immigration levels by limiting student visas, reducing admissions of temporary foreign workers, and capping the number of permanent residents. This shift marks a change from Canada’s previous focus on attracting immigrants to offset its demographic challenges caused by an aging population and low birth rates. Notably, immigration fueled a significant portion of Canada’s population growth in 2023, with nearly 98% of the 3.2% increase coming from newcomers.
• Despite recent adjustments to its immigration policy, Canada’s focus on attracting skilled workers has yielded positive results. Immigration in the first quarter of 2024 significantly boosted the workforce in skilled trades, with 13 occupations seeing their numbers double the average of the previous year. This influx of skilled labor has helped address the shortage of construction workers, a crucial factor in Canada’s plans to ramp up residential construction and tackle the housing shortage. The Royal Bank of Canada predicts that it will need an additional 500,000 workers by 2030 to help balance the housing market.

• Canada’s recent adjustments to its immigration policy highlight the demographic challenges facing many developed nations. Strict immigration policies, coupled with low birth rates, could strain government finances in the future. As a result, repaying the debt might necessitate unpopular measures like austerity or higher taxes. To address these challenges, governments might explore coordinated monetary policies. However, this approach could lead to unintended consequences like inflation or lower consumption. The market environment has generally benefited commodity assets as investors look to real goods during times of uncertainty.

In Other News: President Biden is preparing to impose tariffs on Chinese EVs as he seeks to prevent Beijing from dumping its overcapacity into the US. Separately, Israeli Prime Minister Benjamin Netanyahu has vowed that his country is willing to stand alone as it looks to defend itself from Hamas.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are trading lower following a weaker-than-expected bond auction on Wednesday. However, in a thrilling turn of events, Real Madrid secured a comeback victory against Bayern Munich, booking their spot in the Championship Final against Borussia Dortmund. Today’s Comment explores how the earnings outlook from Intel reflects the US-China rivalry’s impact on tech companies. We’ll also examine why the Federal Reserve might hold off on further interest rate hikes and how Germany is working to lessen its dependence on China. As usual, the report concludes with a wrap-up of international and domestic data releases.

Rubber Meets Road: Intel’s earnings outlook offers a real-world example of how the shifting geopolitical landscape can harm corporate profits.

• Semiconductor giant Intel exceeded first-quarter earnings expectations but cautioned about a revenue dip due to a new US ban on chip exports to China. While Intel is maintaining its revenue forecast within its $12.5 billion to $13.5 billion range, it anticipates falling short of the midpoint. This revised outlook follows the US Commerce Department’s decision to revoke the licensing rights of Huawei Technologies to purchase semiconductors from both Intel and Qualcomm. The announcement triggered stock price declines for both companies. However, Qualcomm later clarified that its business with Huawei was already limited and will likely cease entirely.
• The weak outlook comes as the US tightens the screws on China’s chip access. In 2022, the Biden administration, along with allies like Japan and Europe, limited chip sales to certain Chinese companies to prevent their use in military weapons. These efforts proved inadequate, though, as Chinese firms continued to improve the quality of their semiconductors. Last month, US lawmakers were angered that Huawei’s new AI laptops were powered by American-made Intel chips, leading to calls for more chip restrictions. This episode highlights the tightrope that tech companies must walk as they are caught between escalating geopolitical tensions and government policy shifts.

• Despite their strong start this year, semiconductor companies face potential headwinds from rising US-China tensions. This is because tech companies, as measured by the Invesco QQQ ETF, have a greater exposure to China than the broader S&P 500 index. However, there are safer alternatives to large cap tech companies. Midcap companies, with their focus on the US domestic market and strong financials, might offer a hedge against those risks due to their lower exposure to trade disputes.

Restrictive Enough: As the Consumer Price Index continues to disappoint, central bankers are increasingly concerned about whether monetary policy is sufficiently tight.

• Minneapolis Fed President Neel Kashkari weighed in on the current state of monetary policy in a Wednesday note. While acknowledging current policy is stricter than it was prior to the pandemic, Kashkari pointed to a robust housing market as evidence that more action might be necessary to get inflation back to its 2% target. This aligns with recent comments from Fed Governor Michelle Bowman. Over the weekend, she expressed concern that rising immigration might be putting upward pressure on shelter price inflation, as supply struggles to keep pace with demand.
• Anxiety about tightening credit conditions is emerging despite a seemingly easier residential mortgage market. The latest Senior Loan Officer Opinion Survey (SLOOS) shows banks are indeed tightening lending standards for commercial real estate and consumer loans. However, for residential mortgages (excluding subprime), the survey indicates a slight easing in the previous quarter. This divergence suggests the Fed’s policy may not be having a consistent impact across all loan sectors. It’s important to note, though, that despite this easing of financial conditions, demand for home purchase loans remains well below pre-pandemic levels.

• The Federal Open Market Committee (FOMC) minutes, due to be released in two weeks, could provide key insights into the ongoing debate regarding the Fed’s monetary policy stance. During the press conference following the recent decision to hold rates steady, Fed Chair Powell remained tight-lipped when questioned about the possibility of another hike. The minutes from this past meeting may reveal whether any committee members advocated for a rate increase. This, if confirmed, could significantly alter interest rate expectations, especially if the upcoming April CPI data continues the trend of high inflation as seen in the past three months.

Berlin’s Shift: Germany aims to build a closer relationship with the US as it increasingly views China as a threat to its interests.

• Germany’s trade winds have shifted dramatically. The US has surpassed China as Germany’s top import partner for goods and services in the first quarter of 2024, ending China’s eight-year reign at the top. This change reflects China’s sluggish economic growth, but also likely stems from Germany’s growing reservations about its reliance on Chinese imports. German businesses are facing a mounting challenge in China. Soaring compliance costs, coupled with Beijing’s policies that favor domestic companies, are creating a difficult operating environment. While German Chancellor Olaf Scholz has tried to assuage these concerns, there have been few signs of success or improvement.
• In 2023, Germany formally designated China as a “partner, competitor, and systemic rival,” reflecting a strategic shift meant to reduce its dependence on the Asian nation. This attitude change comes as Germany has expressed concern that Beijing may look to resolve its overcapacity problem by dumping its excess goods into Europe. Furthermore, Germans have become sharply critical of China’s backing of Russia. Last week, a cyberattack, which breached emails of the Social Democratic Party, was linked to Russia. Additionally, allegations surfaced that China and Russia may have offered financial incentives to a German lawmaker in order to influence policy in their favor.

• Germany’s economic slowdown has been heavily influenced by its exposure to China, and this fact could play a major role in its shift towards the US. A change could offer long-term advantages for German companies. A potential turn inward by China might prioritize domestic firms at foreigners’ expense. At the same time, the US, with its strong dollar and commitment to open markets, could favor allies like Germany. However, the transition will likely be slow. German firms, especially carmakers with deep ties to China, will likely lobby their government to manage the deteriorating relationship and mitigate potential disruptions.

In Other News: The Bank of England signaled a potential rate cut in June following its policy meeting. This could be a sign that it believes inflation is under control and will likely lead to further weakness in the pound (GBP). Separately, President Joe Biden warned Israel that the US would halt arms sales if it invades Rafah, in a sign of growing friction between his administration and Israel. Political tensions are also on the rise in Germany, with a recent attack on a former German mayor.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some notes on the stock market winners of the pandemic years and fundamentals in the silver market. We next review several other international and US developments with the potential to affect the financial markets today, including notes on Japanese and Swedish monetary policy and prospects for inflation in the US.

Global Stock Markets: The Financial Times today carries an interesting report noting that the 50 large-cap stocks that appreciated the most in 2020, amid coronavirus pandemic, have lost about one-third of their value, or $1.5 trillion, since then. The data shows just how short-lived many of the changes and disruptions of the pandemic actually were. Importantly, we’ve noted similar snap-backs in some key economic data series.

• Without a doubt, the pandemic also caused many longer-lasting stock market winners and economic changes.
• Nevertheless, the dramatic short-term disruptions in the finance and economic data will make it harder for economists and investment strategist to use pandemic-era figures for their models in the future.

Global Silver Market:  Data from the International Energy Agency shows China and other countries around the world are boosting their investment in photovoltaic cell factories. Since solar cells use a lot of silver because of its high electrical conductivity and other features, the new investment is driving increased silver demand and higher silver prices. The data helps explain why we have recently added silver to our more aggressive asset allocation strategies.

Japan: At an economic conference today, Bank of Japan Governor Ueda said he would be willing to hike interest rates earlier than planned if consumer price inflation looks set to worsen again. He specifically cited a risk that the weak yen (JPY) could feed into broad price increases. The statement adds to the evidence that many major central banks are pulling back from their previous predisposition to cut interest rates.

Sweden: Despite the “higher for longer” approach to interest rates taken by the Federal Reserve, the Bank of Japan, and other major central banks, other institutions are proceeding with cautious rate cuts. The Riksbank today cut its benchmark short-term interest rate from 4.00% to 3.75%, as widely expected. That makes Sweden only the second rich, industrialized country to cut rates this cycle, following Switzerland’s cut in March. Both central banks are responding to Europe’s recent soft economic growth and falling inflation.

United Kingdom: In a fresh sign of chaos and falling political fortunes, two members of parliament for the ruling Conservative Party have defected to the main opposition Labour Party in the last two weeks. In an especially dramatic move yesterday, Dover MP Natalie Elphicke “crossed the floor” just moments before the start of Prime Minister’s Questions, the weekly debate in the parliament chamber between Prime Minister Sunak and Labour Leader Starmer. The developments add to the sense that the Conservatives will lose big in this autumn’s elections.

Argentina: Faced with persistently high inflation that has eroded the purchasing power of the peso (ARS) and forced consumers to pay for purchases with huge wads of bills, the central bank for the first time has begun printing 10,000-peso notes. The new notes are five times more valuable than the largest previous denomination, consisting of 2,000-peso notes.

United States-China: The US Commerce Department has revoked export licenses that until now allowed Intel and Qualcomm to supply semiconductors to Chinese telecom technology giant Huawei for its laptop computers and mobile phones. The move signals that the Biden administration intends to keep up its effort to weaken China’s geopolitical threat by impeding the country’s technological development. The change is also likely to spur Chinese retaliation, further advancing the spiral of tensions between Washington and Beijing.

US Consumer Price Inflation: While President Biden contends with the political fallout from the high inflation of 2022 and 2023, new analysis from Axios warns that if former President Trump is re-elected in November, key planks of his agenda could boost inflation again. Specifically, the analysis says Trump’s goals such as increasing import tariffs, cutting taxes, clamping down on immigration, and pressuring the Fed to keep interest rates low would all be potentially inflationary.

• We take no position on who should win the election, as it remains too close to call.
• Rather, we think the significance of the Axios analysis is that broader geopolitical forces and domestic political realities in the US are likely to make the economic environment more inflationary going forward, no matter who wins the election.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with projections that global exports and imports are set to grow faster again in 2024 and 2025. We next review several other international and US developments with the potential to affect the financial markets today, including a readout on Chinese General Secretary Xi’s visit to Paris, weak factory orders in Germany, and the latest financial projections for the US social security system.

Global Trade: The International Monetary Fund, the World Trade Organization, and the Organization for Economic Cooperation and Development are all predicting that growth in international trade will accelerate in 2024 and 2025. Overall, the organizations are calling for trade growth to accelerate from about 1% in 2023 to almost 3% in 2024 and even more in 2025.

• The expected acceleration in trade largely reflects the booming US economy, which is benefiting from higher wage growth, increased productivity, reindustrialization, and fiscal stimulus.
• Higher US demand is likely to draw in increased imports, which will likely help stimulate many foreign economies and give a boost to their financial markets.

European Union-China: In his visit to Paris yesterday, Chinese General Secretary Xi called for a global ceasefire during this summer’s Olympic Games and offered a few minor concessions on China-EU trade. Nevertheless, European Commission President von der Leyen and French President Macron warned Xi that the EU would defend its domestic industries if China keeps dumping excess production on the Continent at unfairly low prices. The warnings suggest trade tensions between the two economies will continue to worsen, perhaps eventually to a trade war.

Eurozone:  As Europeans mull how to fund stronger armed forces to deter Russian aggression, top eurozone leaders have proposed re-purposing the European Stability Mechanism (ESM) to make low-interest defense loans to member countries. The ESM was established in 2012 to help struggling countries that had lost access to global debt markets, such as Greece. The fund now has about 422 billion euros ($454 billion) and no new economic need, so some officials think it could be a relatively painless way for eurozone nations to hike their defense spending.

• Nevertheless, re-purposing the ESM for defense loans would likely require a major political and bureaucratic effort.
• The fact that officials are considering such a move serves as more evidence that the Europeans are genuinely worried about possible Russian aggression against them.

Germany: March factory orders fell by a seasonally adjusted 0.4%, far weaker than expected. In addition, February orders were revised down to show a fall of 0.8%. Orders over the three months ended in March were down a whopping 4.3%, largely reflecting weaker demand for aircraft, ships, and train cars. The figures underscore that German economic growth remains quite tepid, which is likely to pull down activity and profits throughout the EU.

Australia: The Reserve Bank of Australia today held its benchmark short-term interest rate unchanged at 4.35%. The policymakers noted that consumer price inflation continues to moderate, but much slower than previously anticipated. They also raised their inflation forecasts and warned that interest rates may not change until mid-2025. That adds to the evidence that major developed-country central banks are increasingly likely to hold interest rates “higher for longer,” dashing investor hopes for rate cuts that would boost stock and bond prices.

Israel-Hamas Conflict: As it had warned, Israel last night began striking Hamas targets in the southern Gaza city of Rafah, shortly after the Israelis said a truce deal accepted by Hamas was insufficient. The Israelis have sent tanks into the area this morning and seized a key border crossing into Egypt. As we noted in our Comment yesterday, the new Israeli attacks will likely rekindle worries that the conflict could broaden and further isolate Israel politically.

Russia: After winning re-election in March, President Putin today was inaugurated for yet another six-year term. In his inaugural address, Putin signaled he will double down on his effort to maintain close ties with China and help it build a “multi-polar” world that would no longer be dominated by the US.

Russia-United States: Russian police in the far eastern city of Vladivostok have arrested a visiting US Army soldier on charges of stealing from a local woman. The arrest of the soldier, who had just finished a tour of duty at a US military base in South Korea, gives the Kremlin another prisoner that it will likely try to use as leverage against the US in various bilateral disputes.

US Social Security System:  The trustees of the Social Security system yesterday said the fund for retirees should be able to pay all scheduled benefits until 2033, unchanged from last year’s projection. Due to the increasing number of retirees and slower growth in the cohort of younger workers paying into the system, benefits would then have to be cut some 17% unless Congress took steps to transfer general tax revenues into the system.

US Artificial Intelligence Industry: The Wall Street Journal today carries an article saying Apple has been working to develop a specialized processing chip for running AI programs in the company’s data center servers. The chip would not be used for training AI models, but for implementing AI applications that Apple will offer its customers. The project illustrates the evolving division of labor among different firms looking for a competitive advantage in the evolving AI industry.

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