by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with some notes on Vice President Harris’s big economic speech on Friday, which appears to have fallen rather flat. (We also note that the Democratic Party opens its national convention in Chicago today.) We next review several other international and US developments with the potential to affect the financial markets today, including another move by China to weaponize its rare-earth mineral resources and a new statement by a Federal Reserve policymaker pointing to only cautious interest-rate cuts starting in September.

US Economic Policy: In a speech on Friday laying out her economic agenda if she were to win the presidency, Vice President Harris proposed several populist measures aimed at cutting taxes and reducing living costs for working-class families. As with her proposal the previous week to make tips to service and hospitality workers tax-exempt, some of her proposals echoed the populist goals of the Republican ticket. As we’ve noted before, it appears the two sides are in a potentially expensive bidding war for working-class voters.

• Harris’s proposals include re-instating the expanded child tax credit from the pandemic era, but she would raise it to $6,000 until the child’s first birthday. That echoes a recent proposal by Sen. JD Vance, the Republican’s vice presidential candidate, to hike the child tax credit to $5,000.
• To help bring down housing costs, Harris proposed tax incentives and subsidies aimed at encouraging homebuilders to construct more affordable homes. She laid out a goal of having three million new housing units built by the end of her term.
• Harris also proposed a series of regulatory actions to bring down prices, including moves to stop alleged “price gouging” by companies and negotiating lower prices for more drugs bought by the Medicare and Medicaid programs.
• In energy policy, Harris has adopted an ambiguous approach, even though she has stepped back from the idea of banning hydraulic fracturing to search for oil and gas on federal lands, which she had proposed in her 2019 run for president as she made a play for the progressive wing of the Democratic Party.
• Finally, in international trade policy, Harris criticized former President Trump’s proposal for massive tariffs of 60% against imports from China and across-the-board tariffs of 10% or more on imports from other countries, saying those moves would raise prices for US consumers.
• Of course, even if Harris is elected, her ability to pass these economic ideas would largely depend on whether the Democrats or the Republicans control Congress. Nevertheless, the overall populist tenor of the two parties’ proposals is consistent with our expectation that the US budget deficit, consumer price inflation, and interest rates will be higher in the coming years than over the last couple of decades.

China-United States: The government last week said it will impose export controls on rare antimony metals, ores, and oxides, as well as equipment for processing superhard materials, starting September 15. Since antimony is critical to producing many advanced technologies, including armor-piercing ammunition, the new restrictions are being seen as retaliation for the recent US moves to block Chinese imports and investments and restrict China’s access to advanced US technologies.

• Given that the world continues to fracture into relatively separate geopolitical and economic blocs, a key question is whether China’s action will seriously crimp US access to antimony. As shown in the chart below, most of the world’s antimony reserves and output are in China’s bloc, meaning Beijing’s new measures could have a serious impact on the US and its allies.
• In our analysis of global fracturing, we have long expected the China bloc to weaponize its extensive commodity holdings to retaliate for the US’s recent trade, investment, and technology barriers. Besides antimony, Beijing and Russia (its junior partner) have already clamped down on natural gas and rare earths exports. Going forward, we believe the resulting risk to supplies will tend to boost commodity prices generally.

China-Philippines: According to Manila, Chinese coast guard ships rammed at least two Philippine coast guard vessels this morning near a disputed shoal in the South China Sea. The incidents caused significant damage to the Philippine vessels, but they apparently caused no injuries. Nevertheless, as we’ve noted before, the new tensions around Sabina Shoal show there is still some risk of a conflict developing between China and the Philippines, despite a deal the two countries recently struck to ease tensions around a separate shoal in the area.

• The tensions between Beijing and Manila are especially dangerous because of the US-Philippine mutual defense treaty. In the event of a Chinese attack on the Philippines or Philippine vessels, the US could be obligated to come to Manila’s defense.
• The Philippine government has said that a key red line would be if aggressive Chinese action killed a Philippine citizen.

Thailand: King Maha Vajiralongkorn yesterday endorsed Paetongtarn Shinawatra as Thailand’s new prime minister, following her election by parliament last week. Paetongtarn is now the third member of the billionaire Shinawatra family to lead Thailand. Her elevation follows yet another power play by the country’s conservative monarchists and their allies on the top court, which recently banned a key reformist party and forced out the previous prime minister. The incident shows that political instability remains an investment risk in Thailand.

Germany-Ukraine-Russia: Finance Minister Lindner, a member of the fiscally conservative Free Democrats Party, has reportedly sent a letter to the German ministries of foreign affairs and defense saying he won’t approve any new requests to send military aid to Ukraine unless new funding is identified to pay for it. Lindner was reportedly urged to write the letter by Chancellor Scholz, the leader of the center-left Social Democratic Party (SPD) who has been pressured by pacifists in his party to reduce involvement in the Russia-Ukraine war.

• To date, Germany has been the second-biggest donor of military aid to Ukraine, after the US. Any cut-off of German aid could have a significant impact on Kyiv’s ability to keep fending off the invading Russians.
• Lindner’s letter brings to light the fractious nature of Germany’s ruling three-party coalition. In contrast with the Free Democrats and SPD, the Greens have been more supportive of Ukraine and the need to boost defense spending. Panning Lindner’s letter, a Green lawmaker quipped, “One has the impression that it is about sacrificing peace and freedom, but remaining debt-free.”
• More broadly, we continue to believe that growing tensions between the China/Russia geopolitical bloc and the US bloc will keep driving defense budgets higher over time. Being closer to the Russian threat and not facing the toxic budget politics of the US, the Europeans have made much progress in that direction, giving European defense stocks a big boost. However, the news of Lindner’s letter has driven those stocks sharply lower so far today.

United Kingdom: Now that Prime Minister Starmer’s new government has offered generous pay hikes to striking doctors and train drivers, unions representing other healthcare and transport workers are reportedly considering going on strike to see what they can get. If the new strikes and pay hikes materialize, it would put further pressure on the UK’s big budget deficit and may tempt Starmer’s government to call for even bigger tax hikes than expected.

US Monetary Policy: In an interview with the Financial Times, San Francisco FRB President Daly said recent economic data has given her more confidence that inflation is coming under control, but she said the Fed should still be “prudent” and cut interest rates only gradually to make sure price pressures don’t increase again. Coming just days before the Fed opens its annual Jackson Hole monetary policy conference, the statement helps confirm that investors had gotten ahead of themselves in recent weeks as they began to expect an aggressive rate cut in September.

US Art Market: New reporting shows auction prices for paintings and other artworks have plunged over the last year, especially for the output of young, up-and-coming artists. The values of some celebrated paintings have plunged as much as 90% from their peak. Even though the art market was at a record high just a few years ago, prices are now dropping in response to higher interest rates and moderating economic growth.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good Morning! Investors are reacting to the strong economic data released on Thursday. In sports news, New York Yankee Aaron Judge became the player to hit 300 home runs the fastest in MLB history. Today’s Comment will delve into the market’s newfound optimism surrounding positive economic data, examine the factors driving gold’s strong performance this year, and provide a comprehensive overview of global monetary policy. As always, the report will include a summary of key domestic and international economic indicators.

September Take Off? While a rate cut at next month’s FOMC meeting appears likely, a strong economy has dampened expectations of a mega cut.

• More members of the Federal Reserve are backing a September rate cut. St. Louis Fed President Alberto Musalem reinforced this view on Thursday, endorsing a modest rate reduction as recent data suggests the economy is regaining balance. This marks a significant shift from his June stance, where he argued that rate cuts were appropriate only after several quarters, not months, of solid data. Musalem now aligns with Federal Reserve officials like Chicago and Atlanta Fed presidents Austan Goolsbee and Raphael Bostic, who also support a rate cut at the upcoming meeting.
• Strong retail sales and Walmart’s upbeat outlook eased concerns that consumer demand was slowing. In July, retail sales surged at their fastest pace since January 2023, according to the Commerce Department. While the rebound in auto purchases following a crippling software attack on dealerships contributed significantly to the overall sales surge, broad-based spending growth was evident across most retail sectors. Walmart reinforced this positive trend by reporting increased spending, particularly among high-income households looking for bargains, and subsequently upgraded its company outlook for earnings.

• As September nears, market attention will likely transition from the question of whether the Fed will pivot to the timing and pace of rate cuts. A sustained period of robust economic data will probably induce a gradual approach to monetary easing from the Fed, which will be aimed at preventing a resurgence of inflation and the need for policy tightening. Conversely, signs of economic weakness, particularly a rising unemployment rate, could prompt a more aggressive easing cycle.

Gold Bulls Are Back! Bullion prices have soared to record levels as investors seek refuge in the commodity amid escalating geopolitical tensions and currency debasement.

• Gold has outperformed the S&P 500 year-to-date, surging 20.3% compared to the index’s 16.8% gain. While Chinese gold purchases contributed to the metal’s early-year rally, the recent price surge has been fueled by a broader range of factors. Soaring geopolitical tensions, exemplified by the assassination of leaders associated with the war in Gaza and Ukraine’s incursion into Russia, have intensified safe-haven demand for gold. Moreover, concerns over currency debasement, driven by nations grappling with high debt loads and potential interest rate cuts, have fueled substantial gold purchases.
• Gold has increasingly supplanted 10-year Treasury notes as the preferred safe-haven asset. This decoupling intensified in 2022 as government spending soared and the Federal Reserve rapidly tightened monetary policy. The correlation between the two assets has weakened from a strong 88% to a more modest 75% over the past two years, primarily driven by an oversupply of Treasury bonds relative to demand. While redirecting Treasury issuance towards shorter maturities has mitigated some imbalances, the fundamental relationship between gold and 10-year Treasurys appears to be broken.

• We anticipate the negative correlation between gold and Treasury yields to persist due to escalating geopolitical tensions and the diminishing appeal of US dollar-denominated assets. As the global order fractures, a declining pool of interest rate insensitive Treasury buyers will likely contribute to higher and more volatile interest rates. While potential Treasury and emergency Federal Reserve interventions could temper extreme rate spikes, we anticipate a new interest rate environment over the next few years with persistently higher levels compared to the pre-pandemic era.

Global Rate Cut Angst: There is growing concern that central banks may not be able to continue cutting rates following setbacks in inflation.

• Central banks are adopting a more cautious tone despite a wave of policy pivots this year. Brazil, one of the first major economies to cut rates, is now considering a reversal due to a worsening inflation outlook. Meanwhile, an unexpected surge in German wages has prompted calls for the European Central Bank to exercise caution before implementing another rate cut next month. In contrast, recent market turbulence has led the Bank of Japan to reconsider its tightening plans to prevent further volatility.
• Central banks face a complex landscape as they navigate persistent global labor shortages and the US dollar’s strength. While service sector inflation has eased, tight labor markets continue to fuel wage pressures. As the chart below shows, the unemployment rates remain notably below pre-pandemic levels. Moreover, exchange rate volatility has been a major problem, especially for countries dependent on dollar-denominated imports. The Bank of Japan’s surprise rate hike last month, partly attributed to yen weakness, underscores the challenges posed by currency fluctuations.

• As the global economy transitions towards policy normalization, investors should anticipate a more gradual process compared to previous cycles. Central banks are navigating an unprecedented post-pandemic landscape characterized by heightened geopolitical tensions and reduced global interconnectedness. These complexities will challenge policymakers to maintain consistent policy rate paths in either direction. Barring a catastrophic event, policy normalization is likely to proceed, albeit at a slower pace and in a more restrictive manner than the market currently anticipates.

In Other News: The Nigerian government claims diplomatic immunity after a French court ordered the seizure of three of its jets in a dispute with a Chinese company. The case is a test of tolerance for multilateralism in an increasingly fractured world. Democratic presidential candidate Kamala Harris has announced a plan to give first-time home buyers a $25,000 home tax credit. Saudi Arabia’s holdings of US Treasurys rose to the highest level in history, which is another sign that the demand for Treasurys is still there for foreigners looking to play both sides of the US-China rivalry.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Markets are in a risk-on mode today after yesterday’s robust inflation data. In sports news, Real Madrid kicked off their 2024/25 season with a triumphant UEFA Super Cup victory, and now set their sights on defending both their Champions League and La Liga titles. Today’s Comment examines the Fed’s challenges in taming lingering inflation, the mounting regulatory pressures on tech companies, and the evolving Chinese economic landscape. As always, we conclude with a comprehensive overview of domestic and international news.

Inflation Pressures Ease: The July CPI report fueled optimism among investors that the Federal Reserve will lower interest rates in September, but questions persist regarding the size of the cut.

• Inflation eased to a three-year low last month, according to the Bureau of Labor Statistics. The headline Consumer Price Index (CPI) decelerated from 3.0% to 2.9%, while the core CPI, which excludes volatile food and energy prices, softened to 3.2% from 3.3%. These figures aligned with market forecasts and increased expectations for a potential interest rate cut in September. However, despite the positive report, market expectations for a rate cut have moderated, with odds of a 25 basis-point reduction now favored over a 50 basis-point cut, according to the CME FedWatch Tool.
• A primary driver of the shift in market expectations was the unexpected resurgence of housing inflation. Shelter costs accelerated from a month-over-month increase of 0.2% to 0.4%, challenging the notion that housing inflation, especially rental prices, had begun to cool. Fed officials have long anticipated the incorporation of market rent data into CPI figures, but technical issues, such as the timing of pandemic-related eviction moratorium expirations, have complicated the pass-through effects.

• With one CPI and one PCE price report to go before the next Fed meeting, the central bank is likely to lean toward a rate cut if inflation continues on its current trajectory. However, the size of any potential rate cut will hinge primarily on the upcoming jobs report. Several Fed officials have signaled that an unexpected increase in unemployment could pave the way for Fed action. Given the Fed’s most recent projections with the most pessimistic scenario forecasting a 4.4% unemployment rate by year-end, any reading above this level would likely necessitate a more aggressive policy response.

Trust Busting?: Tech giants are increasingly resembling the monopolistic power of Standard Oil as governments intensify scrutiny of their market dominance.

• A federal court ruling has found Google guilty of illegally monopolizing the search engine and search text ad markets. As a result, the Department of Justice (DOJ) is considering breaking up the tech giant. The court determined that Google’s $26 billion payments to make its search engine the default on smartphones and web browsers effectively blocked competition. While Google plans to appeal the decision, the judge has ordered both parties to explore remedies to restore competition. Potential consequences of a breakup include the divestiture of Alphabet’s Android, AdWords, and Chrome.
• The recent ruling against Google is part of a broader global effort to curb the power of tech giants. The DOJ is also targeting Apple for alleged anti-competitive behavior in the smartphone market. Simultaneously, the Federal Trade Commission (FTC) is challenging Amazon’s practices that restrict sellers from offering lower prices on other platforms. Overseas, European regulators have accused Meta of violating the bloc’s Digital Markets Act with its pay or consent advertising model. The decision to go after major tech companies has occurred as the equity market has become more concentrated.

• It’s important to note that despite regulatory pressures, tech companies have yet to be forced to break up their businesses. In fact, the last major company breakup occurred in the 1980s with AT&T, but a similar attempt to dismantle Microsoft in 2001 was unsuccessful. Despite these challenges, tech giants may be forced to relinquish some of their market dominance as they look to appease regulators. The increased competition and diminished pricing power of these firms will erode their profitability, leading to a broader market concentration over the next decade.

China’s Economic Woes Continue: China’s economic slowdown, exacerbated by trade disputes and debt, casts a long shadow over the global economy.

• New economic data has led to concerns about the current state of the Chinese economy. China’s industrial output slowed to its weakest pace in four months in July, expanding at a rate below expectations. Meanwhile, the unemployment rate edged up from 5.0% to 5.2%. The real estate market remains a significant concern for policymakers, with the home price index falling even deeper into contraction territory. Home prices dropped 4.9% year-over-year in July, compared to a decrease of 4.5% in the previous month.
• Weak economic indicators are likely to increase pressure on Beijing to bolster growth. The government has been cautious about deploying significant fiscal stimulus due to mounting debt concerns. Unlike its major economic peers, which have sought to stabilize their debt levels, China has continued to accumulate debt. Its total debt-to-GDP ratio, comprising household, corporate, and government liabilities, has exceeded 300% and is on course to outstrip the US’s ratio within the next few quarters. This rapid debt accumulation has intensified fears of a debt trap as China strives to maintain its growth trajectory.

• While elevated debt levels pose risks to economic expansion, a prudent approach to debt management can strengthen investor confidence. By carefully calibrating stimulus measures and avoiding fiscal excess, the government can sustain growth while gradually addressing its debt burden. Although this strategy may not swiftly resolve the debt challenge, it can mitigate the risk of a severe economic downturn. Consequently, while we don’t expect growth to be strong, we still see a lot of investable opportunities in the region.

In Other News: Google reports that members of the Trump, Biden, and Harris teams were all targets of a phishing campaign from Iran. The hack highlights the growing prevalence of cyberwarfare. Vice presidential candidate Tim Walz agreed to debate JD Vance on October 1. The showdown will likely be used to win over swing voters in the Rust Belt.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! S&P 500 futures are trading sideways as investors process the latest CPI figures. In sports news, the St. Louis Blues made a significant move by submitting offer sheets to Edmonton Oilers’ prospects Broberg and Holloway. Today’s Comment will discuss why the Fed may be hesitant to cut rates despite market expectations, why we remain skeptical of chip companies, and why the latest developments in the war in Ukraine could lead to a broader conflict. As always, we’ll conclude with a roundup of key economic indicators.

Market is Moving Too Fast: Fed officials continue to push back against market expectations of imminent rate cuts, even as price pressures show signs of easing.

• While market anxieties center on a potential recession, Federal Reserve officials remain steadfast in their focus on taming inflation. Atlanta Fed President Raphael Bostic offered a tempered view of the recent surge in the unemployment rate on Tuesday, suggesting that an influx of new workers, rather than a weakening labor market, accounted for much of the increase. Despite acknowledging progress in the fight against inflation, Bostic indicated a desire for more concrete evidence of its sustained decline before considering a policy shift. Nevertheless, he maintained his stance on favoring a rate cut later this year.
• The ease in supplier inflation has likely boosted sentiment. The July PPI report released on Tuesday indicated a deceleration in price pressures. Trade services, which measure the margin charged by wholesalers, were the biggest drag on the index, suggesting firms are losing pricing power. Notably, the components that feed into the Fed’s preferred inflation gauge (the PCE price index), such as financial services, airline fares, and healthcare, were all relatively tame. This positive data encouraged bond investors, leading to a rally in 10-year Treasury bonds and a pick-up in equities prices.

• The CME FedWatch Tool projects a 70% probability of at least a 100 basis-point decline in the fed funds rate, but that seems overly optimistic. The robust economy, as indicated by the Atlanta Fed’s GDPNow forecast of 2.9% growth this quarter, suggests that the economy is still resilient. Moreover, the Fed will likely seek confirmation of sustained inflation stability over the next two months before committing to more than one rate cut. Consequently, we anticipate a 25-bps rate reduction in September, with the potential for additional cuts contingent upon supportive economic data.

Chipmakers Bounce: A benchmark for semiconductor companies rallied on Tuesday, but skepticism remains about the sustainability of this momentum.

• The PHLX Semiconductor Sector Index surged 4.15% on Tuesday, significantly outperforming both the S&P 500 and the Bloomberg Magnificent 7 Index. Nvidia led the rally after announcing a less severe delay for its Blackwell B200 AI processor. Additionally, Intel contributed to the gains following its announcement of a restructuring plan to bolster its competitiveness. While other chipmakers benefited from improved investor sentiment fueled by positive inflation data, concerns about the industry’s long-term outlook remain prevalent.
• The semiconductor sector is likely to encounter significant headwinds in the coming months. The index, comprising roughly 30 companies, has heavily relied on Nvidia’s performance, which has surged nearly 141% year-to-date and disproportionately contributes to the sector’s earnings. Nvidia’s upcoming report is expected to face intense scrutiny after many peers failed to meet investor expectations for future sales. While Nvidia’s biggest clients have plowed ahead with investments in AI capabilities, they also face investor pressure to deliver profits, which could impact the demand for chips.

 

• Despite the recent rally in tech stocks, we maintain a cautious outlook due to overvaluation concerns. Many of the sector’s leading companies have already priced in substantial growth over the next several years, limiting potential upside. Furthermore, the sector’s heavy reliance on Nvidia’s performance poses risks, as the company’s ability to consistently deliver earnings surprises is unlikely to persist. We believe smaller companies with solid fundamentals offer more attractive growth prospects, particularly if the Fed successfully engineers a soft landing.

 Ukraine Gambit: Kyiv’s decision to move into Russian territory may have won it early gains, but it is also likely to ramp up the risks of a broader war in Europe.

• A week-long Ukrainian offensive into Kursk province has compelled Russia to redirect some troops from Ukraine to bolster its own defenses. While the scale of the troop withdrawal remains unclear, this strategic adjustment signals a significant re-evaluation of Moscow’s military campaign. Ukrainian forces have, thus far, seized approximately 390 miles, an area comparable to San Antonio, Texas. Moscow has struggled to give an adequate response to the incursion and is now considering broadening out its campaign.
• Ukraine’s invasion of Russia was a high-stakes gamble with an uncertain outcome. Despite initial territorial gains, holding these positions will prove difficult as Russia mobilizes a larger force through renewed conscription. Ukraine may have calculated that seizing Russian territory would strengthen its bargaining position in potential peace negotiations. However, Russia has rescinded its original peace proposal, which demanded a ceasefire in exchange for retaining occupied Ukrainian territory and permanently blocking Ukraine’s NATO membership.

(Source: ISW)

•  The incursion could heighten the risk of miscalculation, particularly from Russia. Since the conflict began, Moscow has repeatedly alluded to the potential use of strategic nuclear weapons. Moreover, there has been speculation about a possible Russian attack on Poland. While the consequences of employing tactical nuclear weapons remain uncertain, an attack on a NATO member state could directly involve the United States. Although a broader European conflict remains unlikely, the risk has escalated significantly in recent weeks.

In Other News: Japan’s Prime Minister Fumio Kishida is expected to step down next month in a move that would usher in new leadership and potentially delay parts of his pro-growth agenda. Meanwhile, US President Joe Biden has expressed confidence that Iran will refrain from aggression if a ceasefire is reached in Gaza, a development that could help prevent the conflict in the Middle East from escalating further. Additionally, the US Department of Justice may pursue action to break up Google following a court ruling that deemed the company to have monopolistic power.

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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 forecasts for global oil demand from the Organization of the Petroleum Exporting Countries. We next review several other international and US developments with the potential to affect the financial markets today, including news of a new, advanced artificial-intelligence chip from Chinese tech giant Huawei, data showing plummeting economic optimism in Europe, and new US regulatory initiatives from the Biden administration.

Global Oil Market: The Organization of the Petroleum Exporting Countries yesterday cut its forecasts of global oil demand in 2024 and 2025, largely because of the ongoing slowdown in Chinese economic growth and the risk that high interest rates could kick the US economy into recession. The cartel now sees demand rising by 2.11 million barrels per day this year, versus its previous growth estimate of 2.25 mbpd. The new growth forecasts put total global demand at 104.3 mbpd in 2024.

• Global oil demand continues to grow faster than right before the coronavirus pandemic, but it is rapidly normalizing.
• The slowdown in demand continues to keep a lid on prices, although geopolitical tensions and the risk of supply disruptions in Eastern Europe and the Middle East have kept oil prices higher than they otherwise would be.

China: Technology giant Huawei has reportedly developed a new artificial intelligence chip to replace the advanced Nvidia chips now barred by the US government from being exported to China. The new Huawei chip, the Ascend 910C, has reportedly been provided to top Chinese internet and communications firms for testing.

• Huawei has apparently had production problems with the Ascend 910C, and it could face more such problems as the US clamps down further on exporting advanced chipmaking equipment and services to China.
• Nevertheless, the new chip illustrates how aggressively Beijing is pushing to develop China’s own independent technologies, both for its own security and to dominate key global markets of the future.
• Beijing’s push to develop advanced technologies such as semiconductors, solar panels, and electric vehicles (which it collectively calls “new quality productive forces”) probably would have happened even without the US’s recent export controls. Now that the effort is in full swing, it will likely feed into the spiral of geopolitical and economic tensions between the Beijing and Washington, presenting risks for investors.

Vietnam-China: The Washington Post reports Hanoi has dramatically accelerated its program to expand islands it claims in the South China Sea, putting it on track to add some 1,000 acres this year through dredging and land reclamation on existing islands and shoals. The program, which aims to thwart China’s territorial claims in the area, mimics the island-building tactics that China itself used about a decade ago to assert its sovereignty in the South China Sea.

• Vietnam’s effort to do the same now could worsen Chinese-Vietnamese tensions, potentially leading to conflict and/or disruptions in the area’s vital shipping lanes.
• As we noted in our Bi-Weekly Geopolitical Report from June 3, 2024, the South China Sea is marked by multiple territorial disputes, many of which are worsening.

Germany-China: Data from the Bundesbank shows German firms’ direct investment in China totaled 7.3 billion EUR in the first half of 2024, compared with 6.5 billion EUR in all of 2023. Much of the rise in foreign direct investment represented the re-investment of profits earned in China, but the acceleration this year also reflects German companies’ new strategy of investing in China to serve the Chinese market, rather than for export. The figures raise concerns that German firms are again discounting geopolitical risks, as they previously did by relying on Russian energy.

Eurozone: The ZEW Economic Sentiment Indicator for the eurozone plummeted by a seasonally adjusted 25.8 points in August to just 17.9, marking its biggest drop since early in the coronavirus pandemic. The indicator for Germany alone fell 22.6 points in a month to 19.2, for its biggest decline in two years. The drops apparently reflect the European Central Bank’s continued high interest rates, concerns about the US economy, and the risk of escalating war in the Middle East. They also raise the likelihood of further ECB rate cuts in the coming months.

Mexico: The government is bracing for a retaliatory war between two branches of the powerful Sinaloa drug cartel after its patriarch, Ismael “El Mayo” Zambada, last month was kidnapped and turned over to US authorities by the son of a longtime associate, Joaquín “El Chapo” Guzmán. To prepare for the conflict between the Zambada and Guzmán families, the government has deployed hundreds of special forces soldiers to the cartel’s home city of Culiacán, but reports say the two families are stockpiling weapons and preparing to fight each other.

• Significant new intra-cartel violence would further worsen Mexico’s reputation for insecurity. Even though Mexico is well placed to benefit from global fracturing and the “near shoring” of production closer to the US, weak rule of law and other factors have blemished Mexico’s investment environment and probably reduced how much it has benefited from current global economic trends.
• Importantly, increased intra-cartel fighting could also spill over into the US, given that the cartels have operatives north of the border.

US Regulatory Policy: As part of its “war on junk fees,” the Biden administration yesterday proposed several rule changes aimed at making it easier for consumers to cancel services and subscriptions. For example, a proposed rule from the Federal Trade Commission would require companies to make canceling a service or subscription as easy as signing up for one. While the proposals might play well politically, they could weigh on the profitability of some firms that rely on “sticky” client relationships.

US Stock Market: The Wall Street Journal today carries an interesting article on the strong outperformance of stocks recently kicked out of the S&P 500. According to new research by investment gurus Rob Arnott and Forrest Henslee, such stocks lose value quickly in the year before they are kicked out of the index, in part because of forced selling by index funds or index mimickers when their looming exit is announced. After they are out and that selling pressure dissipates, however, the stocks often outperform for about five years.

• As might be expected, Arnott and Henslee this week are launching a new index based on the strategy.
• Appropriately, the index will be called the NIXT.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with several items on China’s international relations and domestic economy. We next review several other international and US developments with the potential to affect the financial markets today, including a statement by a British monetary policymaker calling for continued high interest rates and new data showing a recovery in US trucking demand.

China-Philippines: Manila has accused the Chinese air force of harassing a Philippine military transport plane on routine patrol in Philippine airspace near the disputed Scarborough Shoal last Thursday. The Chinese harassment comes despite the recent deal between Beijing and Manila to diffuse tensions over a Philippine military outpost on Second Thomas Shoal, another disputed outcrop in the South China Sea. The new incident suggests dangerous Chinese-Philippine tensions in the disputed waters are likely to continue, despite one-off deals or lulls.

China-Estonia-Finland: On a more positive note, the Chinese government has admitted that a Chinese-owned ship severed an important natural gas pipeline and damaged communication cables in the Baltic Sea last October. As long suspected, the damage was caused by the Chinese ship dragging its anchor along the seabed. However, Beijing insists the incident was an accident caused by bad weather.

• The incident, which affected a pipeline and communications cables running between Finland and Estonia, had raised fears that it was a sabotage operation to punish Helsinki and Tallin for their opposition to Russia’s invasion of Ukraine. Once investigators tied the incident to the Chinese ship, it also raised concern that Beijing might be cooperating in Russian sabotage.
• Of course, the new admission by Beijing won’t necessarily end the concern about China helping Russia politically and militarily; however, it may help ease that concern in the near term.

China: The country’s fourth-largest mutual fund company, Harvest Fund Management, on Friday said its chairman has resigned due to a corruption investigation. The resignation is probably related to Beijing’s new effort to make China a “financial superpower,” in part by cleaning the sector up and purging corrupt officials. Cutting corruption is a laudable goal, but the sector will likely be challenged by other aspects of Beijing’s program, such as capping pay for financial professionals.

• Separately, multiple Western companies have said in their latest quarterly earnings reports that they are seeing steep declines in their sales in China, reflecting both weak consumer demand and a growing preference for Chinese brands.
• The statements are consistent with our view that the US and Chinese geopolitical blocs will continue to decouple. In addition to growing government-imposed trade barriers between the blocs, we think China’s cooling economic growth and reduced appetite for foreign goods and services will increasingly weigh on foreign investment in the country, especially from the US bloc.

United Kingdom: Catherine Mann, an external member of the Bank of England’s monetary policy committee, has warned that consumer price inflation in the UK will likely reaccelerate. According to Mann, who dissented from the central bank’s decision to cut interest rates earlier this month, business surveys show companies plan to continue hiking wages and prices, which will boost inflation again and require continued tight monetary policy.

Russia-Ukraine: The Ukrainian military’s surprise incursion into Russia’s Kursk region last week is apparently continuing. The Ukrainians have now advanced as much as 20 miles into Russia, and reports today say they have tried to open up a new incursion into the Belgorod region, farther south. The Russian military has had to respond by stitching together several inexperienced, poorly prepared, under-strength units, and those units still have not been able to push the Ukrainians back over the border.

• The aim of the incursions may be to force the Kremlin to redeploy troops and other military assets away from the frontlines in Ukraine, easing pressure on Kyiv’s troops.
• Even though Kyiv’s goal may be rather limited, the incursion is embarrassing for Russian President Putin and his military officials. If it continues, it could become a more serious political problem.
• Because of that, it’s important to remember that if the fighting on Russian soil continues, Putin could unleash a bigger-than-expected assault to crush the Ukrainian forces, even if it means temporarily pulling resources off the frontlines in Ukraine.

US Politics: At a campaign rally in Las Vegas over the weekend, Vice President Harris said that along with hiking the federal minimum wage, she would seek to eliminate income taxes on tips for service and hospitality workers. The proposal on tips echoes a recent promise by former President Trump and signals that Harris may try to meet or exceed any populist economic ideas espoused by her rival between now and the November election.

• Exempting tips from taxes would probably have only a small impact on federal revenues. After all, many service and hospitality workers have such low income that they aren’t liable for taxes. Those that are liable for taxes are often in the lowest tax bracket.
• Nevertheless, if the two candidates get into a bidding war for the populist vote, they could begin to promise more costly proposals, such as big spending increases or broader tax cuts for favored groups.

US Industrial Policy: New research by the Financial Times shows that about 40% of the factory investments announced in the first year of the CHIPS Act and Inflation Reduction Act have been delayed or paused. While it isn’t clear whether that rate is unusually small or large for similar unsubsidized project, the data is likely to be a black eye for the Biden administration. On a more positive note, the slow progress on some projects may also reduce or slow their draw on the federal budget, lowering their negative impact on the budget deficit in the near term.

US Trucking Industry:  New data from logistics data firm FreightWaves shows that trucking shipment orders in the second quarter were up 9% year-over-year, while tender rejections (a measure of capacity tightness) rose 1.3%. The figures suggest trucking demand is now rebounding again, even if pricing remains in the doldrums due to issues such as excess fleet size. In turn, stronger trucking demand could point to a rebound in the US industrial sector and help calm fears about a recession in the US economy.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! The S&P 500 is off to a slow start today as investors shrug off yesterday’s rally. In sports news, the US Men’s Basketball team was able to mount a comeback against Serbia in its quest for Olympic gold. Today’s Comment will examine the factors driving investors back to large-cap stocks after the recent market downturn. We’ll also delve into the reasons behind the surge in equity and bond volatility and provide an update on the conflict in the Middle East. As usual, the report will conclude with a summary of key economic indicators.

Market Rotation Trade: A week into the market meltdown, investors have reverted to old habits seeking reassurance.

• The market rallied after initial jobless claims posted their largest weekly decline since January 2023. This drop helped reassure investors that the labor market was cooling more slowly than anticipated, bolstering hopes for a Fed-engineered soft landing. Major tech companies, led by the Magnificent 7, outperformed the S&P 500 by a significant margin, rising 3.0% compared to the index’s 2.0% gain. This sharp increase suggests investors are cautiously re-entering the market and are eager to gauge the sustainability of the improved sentiment.
• The S&P 500 rally may be poised to broaden beyond the tech sector, echoing a pattern observed in the weeks preceding the market downturn. While Yardeni Research indicates a slowdown in earnings growth for the Magnificent 7 in the second quarter, the remaining S&P 500 components have collectively returned to profitability. This strong performance has challenged the notion that the S&P 500 has grown over-reliant on tech companies to drive earnings and reinforce the view that mega-tech companies are running out of steam.

• Don’t be misled by the recent surge in tech stocks. While it’s tempting to get caught up in the excitement, it’s crucial to remember why investors initially exited the sector. Doubts persist about tech companies’ ability to justify their lofty valuations, prompting us to maintain our optimism for other S&P 500 sectors. The prospect of a rate cut has buoyed undervalued sectors like real estate and financials, while the potential for increased power consumption in AI has lifted utility stocks. As a result, we are confident that the market will broaden out once more, replicating the pattern that was seen before the recent sell-off.

Volatility Is Back: The unwinding of the carry trade highlights the unusually low equity volatility of recent months in comparison to bonds.

• For the first time in a significant period, both the VIX and MOVE indexes are signaling heightened market risk. While the MOVE index, a measure of bond market volatility, has persistently exceeded its long-term average of 95 since the Fed’s 2022 rate hikes began, the VIX had remained relatively subdued, generally below its fear threshold of 20, despite prevalent inflation and recession concerns. Contrary to the prevailing view that investor sentiment explains the VIX-MOVE divergence, we believe the discrepancy is linked to carry-trade dynamics, which has artificially held down equity market volatility.
• The global trend to push interest rates higher has encouraged investors to employ leveraged carry trades. This strategy involves borrowing funds in a low-interest-rate environment, such as Japan, and investing in higher-yielding assets in countries like Mexico, Brazil, or the US. Such trades typically thrive in liquid markets that facilitate easy entry and exit and a stable currency. However, these strategies become vulnerable to sudden market disruptions, such as an unexpected interest rate hike from the Bank of Japan or fears of an imminent US recession.

• The recent VIX spike has been partially attributed to the unwinding of carry trades as investors reevaluate positions in light of the yen’s strength and the narrowing US-Japan interest rate differentials. As these positions unwind, equity volatility should gradually subside, though it will likely remain sensitive to shifts in US growth expectations. In contrast, the MOVE index, which is sensitive to interest rate expectations, is likely to remain elevated as long as the Fed remains noncommittal on the path of interest rates. This index should fall if inflation continues on its downward trajectory.

Conflict in the Middle East: Israel and its allies are preparing for a retaliatory attack from Iran and Hezbollah in the coming days, which may impact supply chains.

• Tehran is expected to retaliate for the assassinations of a Hezbollah leader in Lebanon and a top Hamas official visiting Iran. Israel has already intercepted an Iranian aerial attack but faces growing concerns about the sustainability of its defenses. The Israeli government has advised citizens to stockpile food as it prepares for potential defensive and offensive campaigns to deter future attacks. This development could escalate the conflict, drawing in additional nations and undermining recent ceasefire discussions.
• The conflict is likely to exacerbate supply chain uncertainties, potentially disrupting goods transportation through the Red Sea. Retailers have already begun stockpiling merchandise in anticipation of shipping disruptions, while Brent crude prices have increased nearly 3% over the last five days as investors assess potential repercussions. Furthermore, ocean freight costs have surged to their highest levels since 2022 as shippers bolster security measures to safeguard cargo delivery.

• The likelihood of a major Middle East conflict with significant global economic repercussions remains low, though not nonexistent. Iran has indicated a desire for retaliation without triggering a broader conflict. The US is maintaining backchannel communications to minimize the risk of unintended escalation. Presently, we remain optimistic about tensions de-escalating within the next few weeks. However, if our assessment proves incorrect, there is a realistic possibility of direct US involvement in the war. Nevertheless, this scenario remains unlikely.

In Other News: Russian President Vladimir Putin has legalized bitcoin and crypto mining, signaling the country’s intent to leverage its low-cost energy to attract investors in the burgeoning digital market. If elected in November, Republican presidential nominee Donald Trump asserts that he should have a greater say in Federal Reserve policy rate decisions. His statement is likely to fuel concerns about potential threats to the Fed’s independence. UK riots have shown signs of subsiding following days of protests against immigration policies.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! S&P 500 futures are off to a strong start to the day as data reassured investors that the country is not in recession. In sports news, US Men’s Track and Field athlete Quincy Hall staged a comeback in the 400m to take gold. Today’s Comment will discuss the market reaction to poor performance in the Treasury auctions, review the growing signs that consumption is waning, and examine Europe’s decision to target the ultra-wealthy for its budgetary challenges. As usual, our report will conclude with a round up international and domestic data releases.

Auction Failure: Uncertainty over the path of interest rates continue to weigh on the equity market.

• The S&P 500’s early gains evaporated Wednesday, with the index closing down 0.6% amid weak Treasury auction results. A $42 billion sale of 10-year notes was met with tepid demand and ended with a yield of 3.960%, which is 3 bps higher than what investors were anticipating. While lower than the previous auction’s 4.276% yield, the result highlights investors’ ongoing aversion to current bond yields. The miss triggered a sell-off in equities as investors remain concerned that the Fed will fail to implement rate cuts in time to avert a hard landing.
• Treasury bond auctions have struggled since the Fed embarked on its rate-hiking campaign in 2022. The chart below illustrates escalating auction tails, signaling weak demand, which peaked in late 2023 amid expectations of an imminent shift in monetary policy. While shifting Treasury issuance towards shorter maturities has eased some pressure, it has exacerbated challenges in the five-year sector. Recent narrowing of auction tails for both 10-year and five-year Treasury bonds suggests growing investor discomfort with holding mid and long-term bonds.

• The surge in failed bond auctions indicates that the market’s capacity to absorb Treasury issuance has been overwhelmed. While a potential Fed rate cut could offer temporary relief, the underlying issue is excessive government spending. The burgeoning US debt burden will be a formidable challenge for the next administration. Despite vague campaign promises of tax increases or Social Security reform, neither candidate has offered concrete plans to address the growing deficit. Consequently, a return of bond yields to pre-pandemic levels appears unlikely in the near term.

Households Holding Back: Although consumption figures remain positive, a rising chorus of corporate voices warns of potential reductions in consumer spending.

• Earnings reports continue to allude to a consumer pullback in spending. The travel and leisure industry, including key players like Airbnb and Disney, has been hit hard. Airbnb reported delayed bookings and shorter stays, suggesting a shift towards more spontaneous travel plans. Disney blamed declining consumer spending for its bleak outlook. These challenges are mirrored in the fast-food sector, with companies such as McDonald’s and Domino’s also reporting weaker-than-expected results. The pessimism has led shares of these stocks to fall as investors fear a broader economic slowdown.
• Economic indicators point to growing household financial strain. Auto and credit card delinquency rates have soared to levels not seen since the COVID-19 pandemic, according to the New York Fed, signaling mounting pressures on household balance sheets. Moreover, a sharp $1.7 billion decline in consumer debt — the largest since early 2021 — suggests consumers are tightening their belts amid economic challenges. This sudden weakness in the data comes nearly a week after the breach of the Sahm rule.

• While concerns of a looming recession persist, current economic indicators suggest a different trajectory. The Atlanta Fed’s GDPNow forecast predicts a 2.9% annualized growth rate for the third quarter, an acceleration from the previous quarter’s 2.8%. Historically, significant economic downturns in the past three decades were recognized following exogenous shocks like the global pandemic, the collapse of Lehman Brothers, the 9/11 attacks, or the Gulf War. In the absence of such disruptive events, like a major financial crisis or widespread conflict, the economy is likely to continue expanding.

Italy Getting Tough: Italian Prime Minister Giorgia Meloni faces the challenge of balancing the nation’s need for fiscal restraint with her campaign pledge to support struggling families.

• To shield middle-class households from higher taxes, Meloni has focused on the ultra-wealthy and financial institutions. On Wednesday, her cabinet endorsed a plan to double the flat tax on foreign income for new residents from $100,000 to $200,000. Additionally, it was revealed last week that her administration has begun revisiting plans to tax banks and insurers that profited from higher interest rates. Last year, her administration was forced to walk back plans for a 40% windfall tax on excessive financial institution profits after the proposal triggered a market sell-off.
• The move underscores a growing European populist trend targeting the wealthy as countries look to balance their budget. This trend is underscored by the UK’s decision to end non-domiciled tax status and the growing support for France’s Left Alliance, which has promised higher taxes on billionaires and which may revive the wealth tax. This decision stems from the pressure these governments face to address their budget deficits without harming the middle class. France and Italy are currently in breach of the EU’s 3% deficit limit, while the UK is struggling to meet its debt reduction target set in 2020.

• While targeting the wealthy to address budget deficits might be politically expedient, historical evidence suggests that it’s an ineffective strategy. Not only can high-net-worth individuals easily transfer assets offshore, but those in positions of power often possess the means to shape legislation in their favor. Therefore, we predict that a Robin Hood-style fiscal policy will be unsustainable in the long term. As budgetary pressures intensify, governments are likely to resort to more conventional measures, such as pension and social program reforms.

In Other News: Ukraine’s surprise attack on Russia has intensified the ongoing conflict, and it shows no signs of de-escalation. Meanwhile, global economic concerns are mounting as Asian chipmakers face pressure from weakening AI demand. Adding to the uncertainty, a major earthquake struck southwest Japan, triggering tsunami fears and potentially impacting Japanese equities.

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