Conflict in the Middle East is one of the most persistent themes in current events. Not only is this true today, but Middle Eastern discord has dominated the news flow throughout most of our lives. At Confluence, we recognize that this enduring pattern of strife reveals the presence of many major fault lines that run through Middle Eastern society, politics, economics, and relations with the rest of the world.
A fault line is defined as a “divisive issue or difference of opinion that is likely to have serious consequences.” A major fault line is one in which the competing forces have both deeply embedded positions and the resources to support those positions. Many issues of this type characterize those in the Middle East, which explains why conflict in the region is so common despite repeated attempts at resolution. Investors must be prepared for this trend to endure for the foreseeable future, which will continue to meaningfully impact global affairs.
This report briefly reviews the main fault lines that define the Middle East from a geopolitical standpoint. This is not a complete list, but rather it is a selection of those we consider most enduring and impactful. Confluence does not take positions on these issues, but we will summarize and show how they produce complexity. We arrange these prominent fault lines in three layers: the ancient fault lines, the more modern ones, and the present-day issues that are currently causing “geopolitical earthquakes.” While these earthquakes do raise the risk of escalation into a broader regional war, we remind readers that the region has often witnessed this increased level of risk before without necessarily leading to further escalation. Rather than trying to predict the outcome, we recommend that investors pay attention to key implications, which we will highlight at the end of the report.
Good morning! Equity futures are up today as investors embrace a less hawkish Fed. In sports news, Borussia Dortmund edged out PSG with a narrow 1-0 aggregate lead in the Champions League. In today’s Comment, we delve into the FOMC’s decision to keep rate cuts on the table, examine the disappointing trend in economic data, and discuss the impact of a possible security pact between the US and Saudi Arabia. As usual, our report concludes with a round-up of international and domestic data releases.
Less Hawkish: The Federal Reserve failed to deliver the hawkish shift markets had feared in a sign that rate cuts are likely to remain on the table for the foreseeable future.
The Federal Open Market Committee (FOMC) decided to maintain the target range for its federal funds rate at 5.25% to 5.5%. In a separate move, the FOMC announced it will slow the pace of its securities holdings runoff with a reduction in its monthly redemption cap on Treasury securities, decreasing from $60 billion to $25 billion beginning in June. At the press conference, Fed Chair Jerome Powell downplayed the prospect of an immediate rate hike aimed at further curbing inflation. However, he emphasized policymakers’ heightened focus on labor market developments, suggesting their preparedness to cut rates if unemployment were to deteriorate substantially.
Markets seem to be taking comfort in Chair Powell’s cautious approach to interest rates, effectively dodging the scenario of a renewed tightening cycle. Before the decision, anxieties were mounting over whether persistent inflation would force the Fed’s hand back to rate hikes in order to fully extinguish inflationary pressures. The slowdown in balance sheet reduction further underscores the committee’s preference for a pause in tightening rather than new restrictions. The Fed’s dovish tone has sparked investor optimism, leading to revised rate cut expectations of two reductions starting in September. We would caution, however, that this optimism may be short-lived.
Powell’s comments suggesting a dovish stance might not represent the entire committee’s view, echoing a pattern from previous meetings. Notably, he sidestepped a question on whether further rate hikes were discussed if inflation worsens. This underscores the importance of studying the Fed’s speeches for clues on committee sentiment before the FOMC minutes are released. That said, Powell did reiterate that the committee is ready to act if the labor market cools unexpectedly. Consequently, a payroll figure below 125,000 and an unemployment rate exceeding 4.2%, while unlikely, could keep rate cuts on the table despite high inflation.
Negative Economic Surprises: Despite headlines touting strong economic data, a recent disappointing string of data points indicates that momentum may be shifting in the wrong direction.
Wednesday was hardly an anomaly. Consumer confidence, as measured by the Conference Board’s index, plummeted from 103.1 to 97.0 in April, defying expectations of a rise to 104.0. This unexpected decline was primarily driven by a steep drop in consumer expectations, the steepest in nearly two years. Further fueling concerns is a broader trend of emerging economic weakness. Citigroup’s Economic Surprise Index has been on a downward trajectory since February, dropping from a peak of 44.1 to 15.1. While it hasn’t dipped below zero yet, the sharp decline indicates a potential slowdown on the horizon.
Despite signs of a strong economy, recent data weaknesses suggest the expansion might be more fragile than previously thought. A key question remains, one that has not yet been fully addressed by the markets, regarding consumer tolerance for ongoing price increases. While businesses initially attempted to pass on these costs in early 2023, a closer look at non-seasonal data reveals they weren’t able to sustain this pace throughout the year, leading to a slowdown in price hikes, particularly in the summer months. If this trend persists, as the recent data suggests, companies may be forced to address cost pressures through workforce adjustments.
Saudi Defense Pact: The US and Saudi Arabia are nearing a security guarantee agreement, potentially opening the door to normalized relations between Saudi Arabia and Israel.
The proposed security agreement builds on discussions held before the October 7 Hamas attack on Israel. It could grant Saudi Arabia access to offensive weapons after a three-year freeze, allowing it to replenish missile stocks and potentially pursue uranium enrichment. Additionally, Riyadh would limit its purchases of Chinese technology in its key network exchange for US investment in Artificial Intelligence (AI). However, a major hurdle remains — the deal hinges on an Israeli withdrawal from Gaza and commitment to a Palestinian state, a difficult condition for Israel to accept after the recent conflict.
The proposed US-Saudi defense agreement could reshape the security balance of the Middle East, but it faces hurdles from both Israel and the US Senate. The Biden administration hopes economic incentives and a security guarantee will win over Israel, while assuring senators that Saudi Arabia won’t misuse weapons nor manipulate its oil production to harm US interests. However, navigating these challenges is difficult, especially given Israel’s strengthened right wing and waning trust in US security commitments. The deal’s prospects seem slim, but a potential path forward might still exist.
The ability to provide a counterweight to Iran in the Middle East may play a significant factor in garnering support from all parties. There is strong suspicion that Iran provided some level of support to Hamas during its conflict with Israel. Additionally, Iran’s actions since the conflict began have increased the likelihood of a broader military conflict in the region. The prospect of Iranian deterrence could incentivize Israeli Prime Minister Benjamin Netanyahu to engage in negotiations. However, a lasting agreement might necessitate strategic ambiguity from all parties regarding the Palestinian state issue, allowing for concessions without jeopardizing domestic support.
Good morning! Equities are down as investors await the Federal Reserve’s policy decision. In sports news, Real Madrid showed their fighting spirit again, securing a draw against Bayern Munich in a thrilling Champions League match. Today’s Comment examines our views on monetary policy, where we believe the market should be less focused on rate cuts and more on balance sheet reduction. We also discuss how investors are paying closer attention to earnings and whether China may look to stimulate its economy over the next few months. The report concludes with a summary of domestic and international data releases.
No Cut, No Problem: The market anticipates a hawkish stance from the Federal Open Market Committee (FOMC) after its meeting, but the Fed’s balance sheet plans shouldn’t be overlooked.
Strong economic data has cast doubts on the Federal Reserve’s plan to cut rates three times this year, as initially outlined in their economic projections. The CME FedWatch Tool now reflects a more cautious approach, suggesting one or two cuts are more likely. This shift aligns with the Fed’s wait for clearer signs of inflation subsiding. Tuesday’s employment cost index, showing a jump in wages and benefits from 0.9% to 1.2% in Q1, is a prime example. The data highlights persistent wage pressures, particularly for unionized workers whose compensation rose 6.3% compared to 4.1% for non-union workers.
Despite the economic data, the Fed might prioritize easing financial conditions through other means. Minutes from the March FOMC meeting showed that a majority of policymakers favored a measured slowdown in quantitative tightening (QT), specifically by reducing the pace of US Treasury drawdown while maintaining the current pace of runoff of mortgage-backed securities. The FOMC minutes didn’t provide a specific timeframe, but policymakers expressed a preference for a “fairly soon” implementation, likely indicating this summer or even this month. This move could help anchor Treasury yields and alleviate the risk of funding pressures in the repo market.
While a rate cut delivers a more direct economic boost, slowing the pace of QT could still offer some market relief. Unlike rate cuts, a measured slowdown in balance sheet reduction is unlikely to significantly impact consumer spending. This signals the Fed’s consideration of a less restrictive policy stance. However, we don’t expect it to completely rule out rate cuts in 2024. Instead, it will likely signal less confidence in its ability to lower rates moving forward. Given persistent inflation, our current forecast is for a maximum of two rate cuts this year, with a strong possibility of none at all.
Investors Not Deterred: Investors have shifted their focus to corporate earnings, scrutinizing the ability of companies to maintain profitability amidst tightening financial conditions.
Early signs from earnings season are positive. Over 80% of the nearly 300 companies that have reported have exceeded analyst expectations, defying concerns as the country continues to experience strong consumer spending growth. The S&P 500 has seen earnings growth of 5.6%, handily surpassing Bloomberg’s estimate of 3.8%. This strong performance is broad-based, with some companies reporting positive surprises exceeding 8% in earnings growth. This robust corporate performance appears to be a bright spot in the market as investors adjust to the possibility of fewer rate cuts from the Fed.
The focus of tech earnings this week shifts to the “Magnificent Seven,” a group of high-valuation tech companies. Investors are eager to see if these companies can justify their lofty stock prices. So far, the tech sector has shown mixed results. Disappointing outlooks from Meta and weak sales from Apple have dampened investor enthusiasm. However, a surprise dividend from Alphabet and robust cloud performances by Amazon and Microsoft have offered some relief. A strong earnings report from Nvidia later this month could give the Magnificent Seven a much-needed boost. However, considering the recent reports from fellow chipmakers AMD and Supermicro, such a performance might be unlikely.
Maintaining their stellar start to the year is proving difficult for major tech companies, suggesting much of their potential for growth is already reflected in their stock prices. This could explain the recent dividend announcements from companies like Meta and Alphabet, potentially aimed at appeasing investors seeking returns to offset the higher risks associated with tech stocks. However, such payouts are unlikely to become the norm, as tech companies prioritize reinvesting most of their earnings into research for the competitive AI landscape. This shift in focus could benefit less-favored sectors, particularly mid and small caps, which often boast stronger fundamentals.
China on the Move: Beijing is expected to announce new measures to help improve the country’s economic situation, while it struggles to deal with a struggling currency and slow growth.
The Politburo met on Tuesday and set a date in July 2024 for the long-delayed Third Plenum. The postponement of the meeting, originally expected in late 2023 (a year after President Xi Jinping secured an unprecedented third term), has sparked speculation about internal discussions within the party leadership regarding China’s economic challenges. The focus of the July Plenum is expected to be economic reforms aimed at modernizing the country. Additionally, the Politburo indicated a willingness to support the struggling economy through measures such as bolstering the property market and potentially reducing interest rates.
China’s rising yuan (CNY) is raising concerns about export competitiveness. While the yuan is loosely pegged to the dollar, it has appreciated against other Asian currencies — 6% against the Japanese yen (JPY) and nearly 3% against the Korean won (KRW) — sparking speculation of a devaluation. Although a weaker yuan might boost exports, it could also trigger capital flight, similar to what happened after the 2015 devaluation. This could harm financial assets and erode investor confidence. Despite these drawbacks, the People’s Bank of China’s ongoing warnings against speculators suggest currency intervention remains a possibility.
The delay of China’s Third Plenum sparks questions, but it could also indicate that the government believes there is a modestly improved economic situation when compared to a few months ago. The lead-up to the meeting may buoy Chinese stock markets as the government highlights the country’s growth prospects. While a currency devaluation is a lingering concern, it’s unlikely unless China faces significant economic pressure. However, despite tentative signs of progress, investors should remain cautious due to persistent geopolitical and regulatory risks.
Our Comment today opens with growing concern among top Israeli officials that they could be indicted for war crimes over their conduct of the war against Hamas. We next review a wide range of other international and US developments with the potential to affect the financial markets today, including several key economic statistics and a preview of the Federal Reserve’s latest policy meeting, which starts today.
Israel-Hamas Conflict: New reporting says Israeli Prime Minister Netanyahu has become increasingly concerned that he and other top Israeli officials could be indicted for war crimes by the International Criminal Court, which has been investigating Israeli and Palestinian conduct against each other over the last decade. The reports say Netanyahu is so concerned that he asked President Biden over the weekend to intervene to make sure the ICC doesn’t issue arrest warrants against him or his national security officials.
A spokesman for the US National Security Council issued a statement saying that the ICC has no jurisdiction over the Israel-Hamas conflict and that the White House does not support its investigations.
In any case, Netanyahu’s concern illustrates the risk that Israel is becoming increasingly isolated and is suffering significant reputational damage over its battle against Hamas in the Gaza Strip. As a result, the Israeli stock market, which had become an investor darling in recent years, could face years of headwinds.
Eurozone: Excluding price changes and seasonal effects, first-quarter gross domestic product rose 0.3%, beating expectations and easily reversing the revised 0.1% decline in the fourth quarter of 2023. The growth rate in January through March was the region’s strongest since the third quarter of 2022. Much of the growth reflected a renewed expansion in the German economy, which benefited from stronger investment and exports. Excluding the volatile food and energy categories, the core GDP price index was up just 2.7% year-over-year.
Germany: Little more than a month ahead of the elections for the European Parliament, new polling shows the once-surging, right-wing populist Alternative for Germany (AfD) party is rapidly losing support following revelations that Chinese and Russian spies have been working in its ranks. The reports suggest Chinese and Russian agents have infiltrated populist, anti-establishment political parties and media outlets throughout the West. In turn, any further revelations of the type could slow populist gains in other countries as well.
Japan: Masato Kanda, the vice minister of finance in charge of currency policy, declined today to confirm reports that the government had intervened in the market yesterday to prop up the yen (JPY). Nevertheless, he noted that the recent depreciation in the currency was hurting vulnerable people by raising the prices of imported goods. He stressed that the government would therefore respond firmly to excessive movements in the currency market, in what amounts to a virtual admission of the intervention yesterday.
Taken together, Kanda’s statement and the intervention yesterday suggest the government’s red line on the yen’s value is now about 160 per dollar ($0.00625). If the currency looks set to depreciate below that level going forward, the government is likely to intervene again.
So far this morning, the yen is trading at approximately 156.92 per dollar ($0.00637).
Australia: March retail sales unexpectedly fell by a seasonally adjusted 0.4%, wiping out the revised 0.2% gain in February. The culprit? In part, it was Taylor Swift, whose multiple sold-out concerts in February had boosted ticket sales, travel, and other types of consumer spending. Now that the Swifties have gotten back to normal life, the data shows that Australian consumers are in a funk, with retail sales in March up just 1.3% year-over-year.
China: The official purchasing managers’ index for manufacturing fell in April to a seasonally adjusted 50.4, beating expectations but still down from 50.8 in March. The nonmanufacturing PMI fell to 51.2 from 53.0. Like most major PMIs, these are designed so that readings over 50 indicate expanding activity. The April data therefore suggests the Chinese economy is still growing again after a period of weakness, but because of challenges such as the continued decline in real estate development, the recovery remains modest and could fizzle out.
Faced with the risk of the current recovery petering out, the Communist Party Politburo today issued a statement hinting at new economic stimulus measures.
The statement suggests the People’s Bank of China could soon launch a new set of interest-rate cuts, while the government provides new support for the housing market.
China-Solomon Islands-United States: The Solomon Islands’ pro-China prime minister, Manasseh Sogavare, yesterday said he would not stand for a new term when lawmakers vote this week for a new prime minister. Rather, ex-Foreign Minister Jeremiah Manele will represent his party. By stepping down, Sogavare insists his party will cobble together 28 of the 50 seats in parliament to retain power, but a coalition of key opposition parties has 20 seats locked up and could convince enough smaller parties and independents to join it and take power.
If Sogavare’s party loses the parliament vote, it could reflect popular dissatisfaction over his 2022 security deal with Beijing, which has brought Chinese police to the Solomon Islands and drawn the Solomons away from the US.
Parliament’s vote for the prime minister is due to be held on Thursday.
US Monetary Policy: The Fed begins its latest policy meeting today, with its decision due at 2:00 PM EDT tomorrow. Given the continued momentum in US economic growth and persistent price pressures, the policymakers are widely expected to hold the benchmark fed funds interest-rate target unchanged at a range of 5.25% to 5.50%. Based on interest-rate futures trading, it now appears investors expect the first rate cut — perhaps the only rate cut this year — to come around the end of summer.
As we’ve noted before, continued high interest rates will likely put stress on certain banks, commercial real estate owners, and other players in the financial markets.
Despite the economy’s current positive momentum, high interest rates probably remain a risk for the economy and financial markets.
Our Comment today opens with a discussion of the latest US bank to be seized and sold by regulators as a result of today’s high interest rates. We next review a range of other international and US developments with the potential to affect the financial markets today, including a UK proposal to cut long-term disability benefits due to their spiraling fiscal costs and a proposed tax increase on the wealthy in Russia to help fund its invasion of Ukraine. We also include a preview of this week’s Federal Reserve policy meeting.
US Banking System: On Friday afternoon, state and federal regulators seized Philadelphia-based Republic First Bancorp and sold it to fellow regional lender Fulton Financial. Reports say the bank faced challenges similar to Silicon Valley Bank and the two other lenders that had to be seized last year: a steep drop in the value of its bond holdings as interest rates rose, along with a wave of withdrawals as large depositors sought greater security and higher yields elsewhere. Nevertheless, the seizure hasn’t seemed to spark too much investor concern so far.
The muted market reaction probably reflects the fact that Republic First had total assets of only about $6 billion at the end of 2023 and a stock-market capitalization that was closer to zero than anything else. The bank’s small size, well understood problems, and orderly seizure could minimize the risk of contagion to other financial institutions.
Nevertheless, the development underscores how continued high interest rates in the US are stressing particular firms in the financial sector and related industries, such as commercial real estate.
Despite the economy’s current positive momentum, an unexpected crisis for a big firm could still undermine confidence, spark financial contagion, and potentially put the economy into reverse. We therefore think high interest rates remain a risk for the economy and financial markets.
Japan: Continued high rates in the US also keep buoying the dollar, especially as foreign central banks hesitate to hike their rates or prepare to cut. Exemplifying the trend, the Japanese yen (JPY) today continued to depreciate, almost reaching 160 per dollar ($0.00625), a new multi-decade low. Reports indicate that the government then intervened in the market to lift the currency. As of this writing, the yen is trading at 156.26 per dollar ($0.00640).
United Kingdom: Faced with surging payments for long-term disability benefits, largely driven by mental health issues, the UK government will release proposed rules today to tighten eligibility and cut costs. The proposed rules mark a rare instance in which a Western government has been willing to suggest benefit cuts to a politically popular program as its costs increase in the face of population aging and worsening mental health conditions.
Russia: In a speech last week, President Putin said his government is exploring options for hiking taxes on wealthy companies and individuals. According to Putin, the aim is to make the tax system more progressive, with richer taxpayers obliged to pay a higher rate to fund social programs and channel more resources to the poor. Such a move would also disproportionately hit taxpayers in the rich, vibrant, liberal-leaning cities of Moscow and St. Petersburg, basically forcing them to pay more to support Russia’s expensive invasion of Ukraine.
Sources say the government is considering hiking the top corporate income-tax rate to 25% from its current rate of 20%.
For the individual income tax, the government is mulling a boost in the top rate to 20%, versus 15% today, for those with incomes over about $54,300 per year and an increase to 15% from 13% for those with incomes over about $10,860. Individuals with incomes below that level would continue to enjoy the flat 13% rate put into place early in Putin’s reign.
The dumping probe is widely expected to confirm that Chinese EV makers are exporting to the EU at subsidized, unfairly low prices. According to Rhodium, EU policymakers are likely to respond by imposing anti-dumping tariffs of 15% to 30%, despite the risk of angering Beijing and potentially prompting it to retaliate against European exports.
Nevertheless, the Rhodium analysts believe many Chinese EV makers would still earn a comfortable profit at the EU’s contemplated tariffs. The analysis suggests it would take tariffs of 50% or even more to make the EU market unattractive to Chinese producers.
Of course, tariffs that high would be even more likely to anger Beijing and prompt retaliation against the EU. All the same, now that EU leaders have joined US leaders in realizing that Chinese dumping could be a mortal threat to their domestic industries, the EU is becoming increasingly aggressive in erecting barriers to Chinese trade.
China-United States: Admiral John Aquilino, the outgoing commander of all US military forces in the Indo-Pacific, has warned that China is pursuing a “boiling frog” strategy in the region. In Aquilino’s analysis, Beijing is actively boosting its military strength and adopting more aggressive military behavior in the Indo-Pacific, but it is doing it so gradually that the US and its allies may not see the danger until it’s too late to reverse it.
Aquilino’s analysis, which is consistent with our view of Chinese strategy, points to even more tensions or a potential crisis in the region in the future.
As we often warn, the spiral of tensions and the potential for a future crisis will produce continued risks for investors going forward.
US Monetary Policy: The Fed holds its latest policy meeting starting tomorrow, with its decision due at 2:00 PM EDT on Wednesday. Given the continued momentum in US economic growth and persistent price pressures, the policymakers are widely expected to hold the benchmark fed funds interest-rate target unchanged at a range of 5.25% to 5.50%. Indeed, interest-rate futures trading suggests investors now expect the first rate cut — and potentially the only rate cut this year — to come around the end of summer.
As noted above, continued high interest rates will likely put stress on certain banks, commercial real estate owners, and other players in the financial markets.
Despite the economy’s current positive momentum, high interest rates probably remain a risk for the economy and financial markets.
Danish Prime Minister Mette Frederiksen recently castigated the European governments that slashed their defense spending at the end of the Cold War and then remained far too complacent about the growing threat from Russia in recent years. According to Frederiksen, hiking their defense budgets as is now necessary will require countries to reverse the tax cuts and welfare spending hikes they have been funding with their post-Cold War defense reductions. The United States may be in the same position since it also spent its post-Cold War “peace dividend” on civilian programs. This report looks at these fiscal dynamics and what future fiscal and monetary policy might really look like.
As our regular readers know, we at Confluence believe the intensifying rivalry between the US geopolitical bloc and the China/Russia bloc will lead to bigger future defense budgets in many countries. Western nations that cut their defense spending dramatically after the Cold War and spent the resulting peace dividend on civilian programs will soon be under great pressure to reverse course. We have also argued that growing geopolitical tensions will likely lead to stronger government intervention in Western economies. Frederiksen is one of the first Western leaders to state the trade-offs so clearly: Hiking defense budgets as required now may well require tax hikes and/or civilian spending cuts.
To scope out the prospects, we compared today’s US federal budget to the budgets of the late years of the Cold War. In the chart below, we show the Office of Management and Budget’s estimated fiscal year 2023 federal receipts and outlays as a share of gross domestic product and compare them to their average shares from 1985 to 1989. The chart shows the US has cut its defense spending by about 2.7% of GDP since the late Cold War. However, it also boosted its outlays on Medicare, Medicaid, other healthcare, and Social Security retirement benefits by a total of 5.1% of GDP. (In large part, those spending hikes probably reflect the aging of the US population and rampant healthcare price inflation.) The excess of new spending over the peace dividend is mostly explained by a small rise in tax receipts and a major expansion in the budget deficit.
Comparable data for European countries is hard to come by, likely because of relatively bigger economic, financial, and political changes after the Cold War. Nevertheless, a review of government outlays in the United Kingdom suggests European countries spent their peace dividend in roughly the same way that the US did. As shown in the chart below, the UK cut its defense spending by 1.9% of GDP and then hiked healthcare, social security, and other civilian spending by a total of about 8.1% of GDP. It would not be a surprise if other Western nations shifted their budget spending in similar ways.
This reorientation of the West’s public spending will have enormous political and financial implications in the coming years. Of course, much of the increased social security and healthcare spending has benefited politically powerful senior citizens. We think those seniors would thwart any substantial cuts to that spending to fund higher defense budgets. For example, if US leaders now wanted to boost the defense budget back to the late-Cold War average of 5.8% of GDP from today’s 3.1% of GDP, not much of the required $708 billion in new military spending would likely come from cuts to Social Security, Medicare, and Medicaid outlays. Other civilian outlays today are not much higher (as a share of GDP) than they were in President Reagan’s second term. Therefore, even if those programs were cut to their share of GDP in 1985-1989, the savings would cover less than half of the targeted boost in defense spending. The shortfall could theoretically be made up with new revenues, but we think today’s strong political opposition to taxes means the required tax hike of about $400 billion would be a nonstarter in Congress.
If political realities mean defense rebuilding can’t be fully funded by cutting civilian spending or hiking taxes, what will Western governments do? We think the likely answer would be even bigger budget deficits coupled with financial repression. In other words, Western governments would likely fund higher defense spending largely by borrowing. To limit the resulting interest costs, agencies such as the US Treasury and central banks such as the Federal Reserve would probably adopt policies to keep bond yields artificially low, such as by forcing banks to buy and hold more Treasury bonds. The central banks could also adopt yield curve control, in which a central bank, such as the Fed, caps long-term yields by buying up Treasurys. While this may seem implausible to many investors, it’s important to remember that there is a precedent for this policy. Indeed, financial repression was used in the decades right after World War II to help the US government weather the debt overhang left after the war ended. The implication for bond investors is that the yields on their future government bonds may not keep up with consumer price inflation, and their purchasing power may slowly erode over time.
Note: there will not be an accompanying podcast for this report.
Good morning! Equities are off to a slow start today as inflation concerns linger for investors. But on a brighter note, the Florida Panthers are surging ahead with a commanding 3-0 series lead over the Tampa Bay Lightning. Today’s Comment explores the importance of central bank independence, analyzes investor anxieties surrounding the latest economic growth data, and delves into the reasoning behind Argentina’s recent surge in attention. As always, we conclude with a summary of key domestic and international economic releases.
Fed Independence Under Attack: Some speculate that if former President Donald Trump is reelected, he might seek to exert greater influence over the Federal Reserve.
A proposal is gaining traction among allies of the former president that could weaken the Federal Reserve’s independence. According to the Wall Street Journal, a group of former officials and supporters drafted a 10-page document advocating for increased presidential influence on the Fed. The proposal reportedly requires the Fed to consult the president before making rate decisions and empowers the Treasury Department to act as a check on the Fed’s authority. Additionally, it would seek a way to help push Fed Chair Jerome Powell out of power before the end of his term in 2026.
The Federal Reserve’s independence has been a cornerstone of price and currency stability since the collapse of the Bretton Woods system. This was particularly evident in the late 1970s when then-Fed Chair Paul Volcker’s decisive action to raise interest rates, despite short-term economic pain, reassured markets of the US’s commitment to tackling inflation. This bold move restored credibility to the dollar, making US Treasury securities more attractive to foreign investors and fueling a subsequent bond bull market over the next three decades.
While former President Trump’s responsiveness to market fluctuations should temper fears of aggressive action to weaken Fed independence, the very discussion raises concerns. Investor and central bank confidence in the Fed’s autonomy is crucial. A loss of faith could trigger a flight from Treasurys, a favoring of hard assets like gold, and a push toward a bear scenario with rising yields for the bond market, similar to periods of high government spending in the post-WWII era. This could likely have spillover effects into equities as investors may be less comfortable investing in risky assets. Investors should continue to monitor this situation closely.
Worse Fears: The Gross Domestic Product (GDP) report didn’t give investors anything to smile about as it showed the economy was slowing, and inflation was accelerating.
The US economy grew at a sluggish 1.6% annualized rate in the first quarter of 2024, falling short of analysts’ predictions of 3.4% and the prior quarter’s 2.5% growth. This weaker-than-anticipated report was primarily driven by a slowdown in consumer spending, which dipped from 3.3% to 2.5%. While some investors might see this as a positive sign indicating a potential cool-down in the economy, a key inflation measure — the core PCE price index — painted a contrasting picture. This index rose from 2.0% to 3.7% in the first quarter, suggesting inflationary pressures are actually intensifying.
Slowing growth coupled with persistent service sector inflation raises the specter of a stagnant economy with high prices. The surge in price pressures was driven by increases in services, particularly shelter and financial services, which have risen at an annualized rate of 5.7% and 15.9% in the first quarter, respectively. The massive acceleration sent shockwaves through markets, with the S&P 500 dropping 0.5% on the day and the 10-year Treasury yield rising 5 basis points. Investors are now re-evaluating their expectations, with some abandoning hopes for rate cuts and a growing number pricing in the possibility of another rate hike later this year.
Despite a disappointing Q1 2024 GDP report, a bright spot emerged. Final sales to private domestic purchasers, a key metric of core economic activity, remained stable at an annualized growth rate exceeding 3%. This excludes factors like inventories, net exports, and government spending, suggesting businesses and consumers are still on solid ground. However, the PCE Price Index’s jump highlights ongoing inflationary pressures driven by the tight labor market. The next quarter’s GDP report could see a rebound, but inflationary concerns remain.
The Argentine Paradox: Argentina’s new market-friendly policies, which were praised by investors, have sparked protests from some citizens, echoing a recurring pattern in the country’s history.
Despite the social unrest, investors have started to take Argentina seriously again. Over the last three months, Argentina’s parallel currency has outperformed its peers surging 25%, despite the ARS being down nearly 10% on the year in what is known as the blue-chip swap. The strong currency performance has also helped boost returns for foreign investors as the Argentine stock market has emerged as one of the best performing in the world this year, up 26.7%, driven primarily by the energy and financial sectors.
Although economic changes are likely something to cheer about, it is important to remember that investors have been down this road before in Argentina. The country has often gone through waves of leaders that favor market-friendly policies only to have them thrown out of office and replaced with leaders that favor social goals instead. This pattern has led to significant fluctuations in the stock market, creating an environment where investors should view Argentina more as a trade opportunity rather than a stable long-term investment.
Our forecast does not include a recession during the three-year period.
The US economy is expected to be relatively strong throughout the forecast period.
We expect heightened geopolitical tensions to persist as the deglobalization trend continues.
Inflation is likely to remain higher due to structural forces such as tight labor market conditions and shortened supply chains caused by deglobalization.
Monetary policy is expected to remain tighter for longer given elevated inflation and low unemployment rates. While hikes are unlikely, monetary easing may be pushed out further and the terminal rate will likely be higher than observed in previous easing cycles.
Our fixed income focus is on the intermediate segment in expectation of a positively sloped yield curve, albeit one that is relatively flat compared to recent cycles.
Our sector and industry outlook favor a Value bias as well as quality factors.
International developed equities present an attractive risk/return opportunity.
Gold and silver exposures were maintained.
ECONOMIC VIEWPOINTS
The US presidential election season is starting to take over the airwaves and usually brings concern over the general direction of politics and the economy. Given that this important part of the democratic process involves intense emotions among voters, one might expect the election’s outcome to significantly influence market sentiment and performance. Yet, historical data contradicts this statement. Instead, markets have typically shown a tendency to remain flat in the first half of the election year and rally in the months just before the election. Importantly, markets are good at discounting expected outcomes, but they do not handle uncertainty and rapid change well. Congress is expected to remain divided with slim margins, thus major changes in overall legislative action is unlikely.
We will focus more on the election in the coming quarters, but for now, we continue to closely watch inflation, labor markets, and fundamental valuations of each asset class. Inflation remains front of mind as the Federal Reserve’s communication moves from “transitory” to “speed bump” inflation. As we’ve written before, we see structural forces positioned to keep inflation higher than pre-pandemic levels. Factors contributing to higher inflation include supply chain rearrangement with reshoring and friend-shoring of industrial capacity, elevated geopolitical tensions, and developed world aging demographics.
Labor markets have remained surprisingly strong with the unemployment rate currently at 3.8%. While wage growth rate has slowed, the most recent median wage level grew 4.7% year-over-year. Technological advancements, most notably AI, could change labor’s significance, but we believe there will be minimal impact during our forecast period. On the other hand, the aging workforce and uncertainty of immigration numbers will have more impact on whether the labor markets remain tight.
Inflation, labor markets, and economic growth are important indicators in their own right, but their combined effect is amplified by the monetary policy response. As higher-than-expected inflation and the strong labor market continues, our expectation is for the fed funds rate to stay higher for longer. While our forecast does not include policy tightening, we believe that the easing timeline and magnitude have been delayed. We don’t expect the FOMC to lower rates to the levels seen in recent easing cycles. We also expect the Fed to hold policy steady through the election cycle.
STOCK MARKET OUTLOOK
We anticipate a compelling economic backdrop over the forecast period. In turn, this will be supportive for risk assets. Our expectation is for the domestic market rally to broaden across market capitalizations. The large cap rally is already widening beyond the Magnificent 7, whose stocks are off their recent highs. We are not forecasting a breakdown in the largest stocks, but rather a measured and sustainable broadening of valuations that more accurately reflect business fundamentals. This glide-path should be supported by the high levels of cash currently held on the sidelines.
We continue to favor a Value style bias across all market capitalizations. Value equities still offer appealing fundamental valuations compared to historical averages, stable earnings growth, and less exposure to sectors we consider overvalued. Independent of whether an ETF is categorized as Value or Growth, our analysis focuses on the ETF’s underlying holdings to determine which ETF we anticipate will perform in line with our forecast. Within large caps, we maintain an overweight position in Energy due to geopolitical tensions in the Middle East and sustainable energy transition policies, thereby creating an opportunity within the sector. Additionally, we maintain our factor exposure to the military-industrial complex through two positions in military hardware and cyber defense. The deglobalization seismic shift continues to fuel additional conflicts that had been controlled through soft power over the past few decades of global economic growth and collaboration.
We still view valuations of small and mid-cap stocks as attractive, coupled with respectable earnings power. However, the recent mid-cap price appreciation has led us to dampen our prior overweight to the asset class. Separately, with our expectation for monetary policy to remain tighter for longer, small cap equities might face steeper financing conditions, introducing further volatility in the asset class that we do not view as appropriate for the more conservatively oriented portfolios. For the more risk-accepting portfolios, to mitigate this risk, we maintain our quality factor exposures within the mid-cap and small cap allocations, which screen for indicators such as profitability, leverage, and cash flow.
We maintain our allocation to Uranium Miners, bolstered by ongoing global initiatives to develop and utilize nuclear energy. The evolving landscape of baseload energy production, coupled with policy shifts, have highlighted nuclear energy as a key player in the energy transition. Ambitious green energy policies are driving substantial goals for reducing fossil fuel usage, yet the current green energy technologies face challenges in generating energy at the required scale and consistency. Furthermore, a persistent supply constraint of uranium over the last decade underscores a compelling supply/demand imbalance. This scenario presents a significant opportunity for strategic exposure to the uranium sector, aligning with our long-term investment outlook.
International developed equities remain constructive given relative valuations. Most equities in the developed world ETF are large global market leaders that possess competitive advantages, yet these companies are trading at valuation discounts to domestic large cap companies. Given the attractive valuations and high dividend yields, we have added international developed in the lower-risk portfolios. We maintain a country-specific exposure to Japan as shareholder-friendly reforms continue to take effect and as capital flows continue moving into Japan, which could potentially lead to multiple expansion.
BOND MARKET OUTLOOK
We anticipate that the path to a positively sloped, though relatively flat, Treasury curve by the end of the forecast period may be uneven given our expectations of heightened inflation volatility. In the near term, with inflation above the Fed’s preferred 2% level, tight labor markets, a data-dependent Fed, upcoming domestic elections, and the US Treasury’s need for heavy issuance of debt, we concur with the market’s assessment that the Fed will be content to leave its fed funds rate higher for longer. These influences alone portend a volatile period for bonds, especially among longer maturities.
As with last quarter, an inverted yield curve leads us to emphasize the intermediate segment of the curve due to its modest rate stability and resultant limited market risk and opportunity costs.
(Source: Federal Reserve Economic Data)
Among sectors, we find advantages in mortgage-backed securities (MBS), particularly highly seasoned pools with lower coupons, relative to Treasurys. Extension risk is more limited in these pools and recent spreads are attractive from a historical perspective. By contrast, investment-grade corporates are currently trading at historically tight spreads of less than 100 bps to Treasurys, approaching the record from 1998. Accordingly, we employ corporate bonds more liberally in the short-term segment and maintain our overweight to MBS in the intermediate-term bond sleeve of the strategies.
Looking at speculative-grade bonds, while spreads have tightened post-COVID, they remain above historically tight levels and still offer attractive yields. Although caution is appropriate in the broader speculative bond segment, we find continued advantage in the higher-rated BB segment given that credit fundamentals remain relatively healthy and the vast majority of bonds in this segment are trading at discounts to par.
OTHER MARKETS
Among commodities, we retain the position in gold as both a hedge against elevated geopolitical risks and an opportunity given increased price-insensitive purchasing by international central banks. In the current deglobalization environment, international central banks are seeking to buy gold as a reserve asset in fear of the weaponization of the dollar. Silver is maintained in the more risk-tolerant portfolios for its low price relative to gold. Real estate remains absent in all strategies as demand is still in flux and REITs continue to face a difficult financing environment.
The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
The Confluence Diffusion Index receded from the previous month, in a sign that the economy is still fragile. The March report showed that seven out of 11 benchmarks are in contraction territory. Last month, the diffusion index slipped from -0.0909 to -0.1515, slightly below the recovery signal of -0.1000.
Investors’ dimming hopes for a June rate cut have caused a mild tightening of financial conditions.
Sinking housing starts signal a potential slowdown in construction activity.
Payroll data appears positive, but pockets of weakness remain in the job market.
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is in recovery. The diffusion index currently provides about six months of lead time for a contraction and five months of lead time for recovery. Continue reading for an in-depth understanding of how the indicators are performing. At the end of the report, the Glossary of Charts describes each chart and its measures. In addition, a chart title listed in red indicates that the index is signaling recession.
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