by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the latest statement by a high-ranking European official warning of a possible war with Russia.  We next review a range of other foreign and US developments with the potential to affect the financial markets, including a new EU plan to finance weapons and ammunition for Ukraine in a way that could further bolster gold prices and another big subsidy to a major semiconductor firm to help it fund new factories and expansion projects here in the US.

European Union-Russia:  In an opinion piece in top European newspapers, European Council President Charles Michel added his voice to those warning that Western Europe is on the road to war with Russia.  In his article, Michel argues that no matter what territorial gains Russian dictator Vladimir Putin achieves in Ukraine, he will not stop there. Rather, he will continue trying to grab territory in Eastern Europe. Since the US may not come to Europe’s aid, despite its obvious interest in doing so, Michel argues that Europe must prepare to defend itself.

• According to Michel, “If we do not get the EU’s response right and do not give Ukraine enough support to stop Russia, we are next. If we want peace, we must prepare for war.”
• More to the point, Michel argued that Europe must rapidly shift to a “war economy” to deter further Russian aggression and prepare for hostilities.
• We agree that Putin’s apparent goal of re-establishing the Russian Empire would imply additional territorial grabs in Europe. So long as Ukraine continues to resist Moscow’s invasion, the Russian military is likely to have its hands full and may not directly threaten targets in Western Europe.  The threat to the West would likely come when and if Ukraine stops fighting.  At that point, the Russian military is likely to regroup and prepare for a renewed assault on Ukraine and/or Western Europe.
  • With the Russian military preoccupied and largely depleted as an offensive force in Ukraine, a future Russian assault on Western Europe may not involve a broad, multi-front attack on numerous countries simultaneously.
  • Rather, a near-term Russian offensive may well focus on specific, bite-sized territorial objectives, just as Nazi Germany initially focused on remilitarizing the Rhineland in March 1936, acquiring Austria in the Anschluss of March 1938, and then demanding and receiving the Sudetenland region of Czechoslovakia in September 1938.
• Initial Russian territorial claims following a victory in Ukraine might include taking control over Moldova and/or Georgia, where the Kremlin already has troops. Russia might also seek to take control over areas of Eastern Europe where the population has a lot of Russian speakers, or where Putin perceives European military vulnerabilities.

European Union-Russia-Ukraine:  The European Commission today unveiled a plan to help buy weapons for Ukraine by using the earnings on seized Russian assets.  Under the plan, 90% of the earnings on those assets would be diverted to the European Peace Facility, the main EU fund used to supply Ukraine with weapons, equipment, and ammunition.  The remaining 10% of earnings would go to the general EU budget to help Ukraine rebuild and expand its defense industry.  To come into effect, the plan will have to be approved by all EU member countries.

• If approved and implemented, the plan is expected to channel about 3 billion EUR ($3.25 billion) to Ukraine in 2024.
• US officials have supported using Russian assets seized as punishment for Moscow’s invasion, likely enticed by the poetic justice of making Russia itself pay for the damage it has caused. The risk, however, is that the US and EU moves to seize their adversaries’ sovereign assets will likely further fracture the global financial system, encouraging potential adversaries (especially countries in the China/Russia geopolitical bloc) to cut their use of the dollar or other Western currencies.
• In response to US seizures of Afghan and Russian assets in recent years, we think potential adversary governments are already directing their central banks to reduce their exposure to the greenback. One reflection of that is the recent jump in central bank gold purchases, which our analysis suggests is a key reason why gold prices have recently hit record highs.  If the new EU program is implemented, potential adversary governments will likely order their central banks to buy even more gold, boosting gold prices further.

Eurozone:  European Central Bank President Lagarde today said the ECB could cut its benchmark interest rate as early as June, but it can’t commit to a specific path of future rate cuts.  According to Lagarde, continued price pressures for services mean the central bank will have to stay flexible and data dependent as it loosens monetary policy going forward.  The statement suggests that both the Federal Reserve and the ECB want to maintain their room to maneuver and keep investors guessing as they cut rates in the coming months.

China:  Not only is the European Union shifting its economy to a war footing, but new research by the Center for Strategic and International Studies shows China has already shifted its economy to essentially the same status.  For example, the study shows that Chinese shipbuilding capacity is now approximately 230x current US capacity.  In contrast, the study assesses that the US defense industrial base is still operating at a peacetime pace.

US Monetary Policy:  The Federal Reserve’s policymaking committee wraps up its latest meeting today, with its decision and new economic projections due at 2:00 PM EDT.  The committee is widely expected to hold the benchmark fed funds interest-rate target at 5.25% to 5.50%.  The first cut is now expected in June.  Nevertheless, the policymakers could signal an earlier or later date for their first cut and may also announce an end to their quantitative tightening policy or other changes in their approach to policy.

US Military:  The Wall Street Journal carries a video today explaining the challenges faced by the US military as it replaces its Minuteman III strategic nuclear missiles with a more modern arsenal.  The video is a nice complement to our Bi-Weekly Geopolitical Report from March 11, in which we explored the US’s overall effort to modernize its nuclear deterrent and what the program means for investors. (Clearly, we at Confluence remain a step or two ahead of the Journal!)

US Semiconductor Industry:  The Commerce Department said it has awarded $8.5 billion to microprocessor giant Intel to help fund new computer chip plants and expansion projects in Arizona, Oregon, New Mexico, and Ohio.  The award is part of the roughly $50 billion provided for in the CHIPS and Science Act of 2022 to help bring more chip manufacturing back to the US and ensure secure supplies of the products.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment opens with confirmation that today the Bank of Japan ended its many years of negative interest rates.  We next review a range of other international and US developments with the potential to affect the financial markets, including reports that the European Union is preparing to impose punitive tariffs on grain and grain products from Russia and Belarus, and a preview of the Federal Reserve’s latest policy meeting starting today.

Japan:  As flagged in our Comment yesterday, the Bank of Japan today ended its eight-year policy of negative interest rates, dismantled its yield curve controls, and scrapped most other emergency policies it had adopted to fight the country’s past economic stagnation and deflation.  It set the new target for benchmark short-term interest rates at 0.0% to 0.1%.  Just as important, the central bank said it will stop setting a yield target for 10-year Japanese government bonds and cease buying stocks, real estate investment trusts, and other unorthodox investments.

• Despite taking the momentous step of ending their negative interest-rate era, the policymakers insisted that overall monetary policy will remain accommodative for the time being in order to support economic growth. Indeed, the policymakers said they would continue buying Japanese government bonds.
• Since the move was well telegraphed over the last several months, today’s announcement has had little impact on financial markets. Japanese stocks today appreciated modestly, and the yen (JPY) weakened 0.9% to 150.44 per dollar.

China-Hong Kong:  The Hong Kong municipal government today unanimously passed a controversial new national security law to supplement the security law imposed by Beijing on the territory in 2020 and align the city’s security rules with those of mainland China.  Among the tough new provisions in the law, treason could be punished by life in prison, and sedition could be punished by two to seven years in jail.

• Stealing or disclosing “state secrets” could be punished by up to 10 years in jail.
• Importantly, the law broadens the definition of state secrets to include information about the economic, technological, or scientific development of Hong Kong or mainland China.
• The new law has therefore struck fear in the hearts of foreigners working in Hong Kong, who now worry that they could more easily be arrested merely for handling business data. Those concerns are likely to make the new law another point of tension between China and the West and make Hong Kong a less attractive place to do business.

European Union-Russia-Belarus:  The European Commission is reportedly preparing to impose punitive tariffs on Russian and Belarusian grain and grain products for the first time.  The plans reportedly call for tariffs of 95 EUR per ton on the affected grains, which would raise their price by about 50% and effectively push them out of the EU market.  The move would in large part be punishment for Russia’s invasion of Ukraine and its repression at home.

• Nevertheless, the move is also apparently an effort to respond to Europe’s restive farmers, who have been complaining not only about EU regulations but also about surging imports from the east amid the disruptions of the war in Ukraine.
• Even though Russian grain and grain products only account for about 1% of the EU market, the tariffs can be presented as protection for farmers’ economic interests.

European Defense Industry:  In a report last week, the North Atlantic Treaty Organization said 11 of the alliance’s current 32 members met the NATO standard of spending at least 2% of gross domestic product on defense in 2023.  As a group, the European NATO members met the 2% standard, helped by especially high defense spending in countries like Poland and Greece.  The report also said two-thirds of the NATO countries should achieve the 2% standard in 2024.

• The total European NATO defense spending of $470 billion in 2023 helps explain the strong performance of European defense stocks over the last year, which we mentioned in our Comment
• To help illustrate the recent strong performance of European defense stocks, the chart below shows that they have actually outperformed the US’s vaunted Magnificent 7 large-cap technology stocks so far in 2024.

US Monetary Policy:  The Federal Reserve’s policymaking committee begins its latest meeting today, with its decision due on Wednesday at 2:00 PM EDT.  The Federal Open Market Committee is widely expected to hold the benchmark fed funds interest-rate target at its current range from 5.25% to 5.50%.  The first cut is now expected in June.  Nevertheless, the policymakers could signal an earlier or later date for their first cut and may also announce an end to their quantitative tightening policy or other changes in their approach to policy,

US Fiscal Policy:  The White House and Congressional negotiators last night resolved a last-minute dispute over border enforcement spending, setting the stage for Congress to pass the remaining six appropriations bills for the remainder of the federal fiscal year before the current stop-gap spending bill runs out on Friday.  The process of getting those bills passed and signed into law could still lead to a partial shutdown of the government, but it appears any shutdown would last at most a few days and would not be very disruptive.

US Artificial Intelligence Industry:  Reports yesterday said technology giants Apple and Google are in talks to include Google’s generative AI system Gemini into Apple’s iPhones.  The news sparked significant increases in each company’s stock price yesterday, based on hopes that such a deal would reinvigorate Apple’s iPhone franchise and give Google added scale in the evolving AI “arms race.”  Nevertheless, we note that such an outcome assumes that regulators approve any such deal.

• Separately, AI chipmaker Nvidia also saw its stock price jump as it prepared to announce a new generation of AI processors that will be much faster and bigger than its current blockbuster H100 series.
• The new chips from Nvidia are expected to be available later this year, helping ease the current shortage of H100 chips.

US Nuclear Energy Industry:  TerraPower, a company started by Microsoft founder Bill Gates, said it will begin building the nation’s first liquid-sodium cooled nuclear reactor by June, with expectations that it will only cost half as much as a conventional water-cooled reactor and be generating electricity by 2030.  The announcement shows how the US is trying to compete in building a new generation of cheaper, more efficient nuclear generating plants using innovative cooling technologies and small, modular designs to cut costs and shorten construction periods.

US Auto Industry:  The United Auto Workers filed a petition yesterday with the National Labor Relations Board requesting a unionization vote of the 4,000 or so workers at Volkswagen’s car factory in Chattanooga, Tennessee.  According to the UAW, a “supermajority” of workers at the plant have signed a petition expressing an interest in joining the union.  If the unionization effort is successful, it would mark the first organization of a US auto plant not affiliated with one of the Detroit Three automakers.

US Defense Industry:  As the US struggles to boost its output of nuclear-powered submarines to counter rising threats from the China/Russia geopolitical bloc, Newport News Shipbuilding, a unit of defense giant Huntington Ingalls, has announced that it is trying to hire 3,000 skilled tradesmen this year and 19,000 within the next decade.  Meanwhile, the Hampton Roads Workforce Council warned that the Virginia region’s maritime shipbuilding vacancies could rise to 40,000 by 2030 if more workers can’t be drawn into the market.

• The Newport News announcement highlights the US’s rising demand for skilled tradespeople, such as welders and pipefitters. The rise in demand reflects factors such as near-shoring production within the US, increased factory construction, and rising defense budgets.
• In contrast, the decades-long advantage of college-educated workers continues to be eroded. The result is likely to be a rebalancing of opportunities in the labor market, with skilled tradesmen now enjoying more demand vis-á-vis the college educated.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the Bank of Japan’s likely abandonment of negative interest rates this week.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including news that even Beijing-friendly emerging markets are starting to push back against China’s surging exports and big changes coming in the US commercial and residential real estate markets.

Japan:  Sources say the Bank of Japan finally plans to end its negative interest rate policy at its two-day policy meeting that begins today, based on its assessment that the economy has at last achieved a virtuous cycle of moderate wage gains and modest price inflation. The revised policy rate of 0.0% or more would mark Japan’s first non-negative interest rate since 2016. Nevertheless, BOJ policymakers have signaled that they will still keep their benchmark rate accommodative, probably in the range of 0.0% to 0.1%.

• One implication of higher (or at least non-negative) interest rates in Japan is that the country’s investors may be tempted to repatriate the enormous sums they’ve invested abroad in search of better yields. A new survey by Bloomberg shows that about 40% of investment managers think Japanese investors will be tempted to start bringing capital back home at the first rate hike.
• News reports on the Bloomberg story emphasized that “only” 40% of investment managers think the Japanese would be tempted to repatriate funds early. To us, 40% sounds like a significant slice.  In any case, large amounts of capital shifting back to Japan would likely boost the yen (JPY) and potentially take some of the wind out of US stocks and bonds.

China-Brazil:  New reporting says the Brazilian government has launched several anti-dumping investigations as imports of Chinese industrial products soar.  The probes target products ranging from steel and chemicals to tires and could ultimately result in the imposition of tariffs, as demanded by Brazilian industries.  However, to avoid antagonizing Beijing and to preserve Brazil’s access to the Chinese market for agricultural products, Brazilian President Lula da Silva will probably try to minimize any trade barriers against China.

• We have long argued that China will eventually adopt a neo-colonial relationship with the other members of its evolving geopolitical and economic bloc. To absorb its massive excess capacity and help pay the associated debts, Beijing will focus on exporting cheap, relatively advanced manufactured products to its friends, largely transforming them into mere commodity suppliers to China.  As in classic colonialism, the result would be big trade surpluses for China and trade deficits for its partners.
• In our analysis, Brazil is still a member of the China-leaning bloc. It is not quite a Chinese colony yet, and it still maintains a trade surplus with China.  As Lula faces the domestic political costs of the evolving China-Brazil trade relationship, a big question is whether he will accept those costs and be drawn closer into the China bloc or resist them and stay out of that camp.
• With China’s excess industrial capacity and debt prompting ever-increasing exports at predatory prices, we note that several other emerging markets have also recently taken steps to protect their domestic markets from the Chinese onslaught, as have some major developed countries. Both the threat to domestic manufacturers and the potential pushback against Chinese exporters will likely have big implications for global investors in the coming months.

China:  January-February industrial production was up a solid 7% year-over-year, beating expectations and marking the strongest annual growth in almost two years.  However, other data showed property investment was down 9% year-over-year in the same period, and new construction starts were down 30%.  The figures suggest manufacturers are seeing some benefit from the government’s modest stimulus measures, but with domestic demand weak, a lot of the new output will likely be exported at low, dumping-level prices.

India:  The Electoral Commission of India announced on Saturday that the next parliamentary elections will begin on April 19, with the voting staggered across the country’s various states and due to wrap up on June 1.  Prime Minister Modi and his Hindu nationalist Bharatiya Janata Party are widely expected to win the lower house of parliament, giving Modi a third five-year term.  A win by the pro-US, business-friendly Modi would likely be taken positively by investors.

Pakistan-Afghanistan:  The Pakistani military this morning launched airstrikes against Islamist militants in Afghanistan after accusing them of conducting attacks in Pakistan over the weekend.  The Taliban government in Kabul condemned the strikes as a violation of its territory.  However, given militants based in Afghanistan have increasingly launched attacks on Pakistan since the Taliban took power in 2021, the Pakistanis appear to have had enough and may now continue their airstrikes until the militant threat is reduced.

Russia:  In the presidential election completed yesterday, President Putin appears to be on track to win a new term in office that will allow him to rule until 2030.  With some 25% of the ballots counted, Putin was reportedly winning 88% of the votes.  Of course, with all potentially competitive opposition candidates barred from participating, the election is in no way free or fair.  Nevertheless, Putin is sure to trumpet the result as a mandate justifying his autocratic rule.

European Union:  The Wall Street Journal today carries an article explaining the continued rapid rise of European defense stocks as governments boost their purchases of ammunition, military equipment, and weapons.  The article notes that European governments are rapidly boosting their defense budgets not only in fear of Russian aggression but also in response to former President Trump’s hints that he might renege on US commitments under NATO’s mutual defense treaty.

• The article is consistent with our oft-written belief that defense spending is likely to rise around the world in the coming years, creating potential investment opportunities in defense companies and other firms that have a lot of defense business.
• Notably, European defense stocks outperformed those of the US over the last year, probably because of the Europeans’ greater urgency to rearm and the US’s continued fiscal squabbles.

Cuba:  Prompted by recent electricity blackouts and food shortages, hundreds of protesters took to the streets in two cities over the weekend.  In response, the government shut down mobile internet service, just as it did to short-circuit similar protests in July 2021.

Global Cocoa Market:  In bad news for chocolate lovers everywhere (doesn’t everyone love chocolate?), global cocoa prices late last week set a new record high for the first time since 1977.  The price of near cocoa futures rose $1,105 per metric ton on Thursday and Friday to reach $8,018 per ton, three times the price from one year ago.  Prices so far this morning have topped $8,400 per ton.  Cocoa prices are rising in response to bad weather in West Africa, where most of the world’s supply is grown.

(Source: Wall Street Journal)

US Monetary Policy:  In a Financial Times poll of academic economists, more than two-thirds of respondents thought the Federal Reserve would cut interest rates no more than two times in 2024, with the first cut coming in late summer.  Even though investors have begun to come around to the fact that the Fed is likely to hold rates higher for longer than anticipated, the poll suggests market participants may still be expecting too many rate cuts this year.

US Labor Market:  In what is likely to become a politically controversial position, economists at Goldman Sachs have released analysis suggesting that strong net immigration in 2023 was a key reason why the US economy and payrolls were able to rise so much but didn’t put further upward pressure on consumer price inflation.  Looking forward, the analysts think continued strong immigration will continue to boost the US’s potential economic growth in 2024 while also keeping a lid on wages and inflation.

US Commercial Real Estate Market:  New data from Kastle Systems shows that even on their peak occupancy days, office buildings in 10 major cities are still filled with only about 61.7% of the employees they had before the COVID-19 pandemic.  Moreover, the rate of improvement has slowed to a crawl.  The data suggests that office buildings and the debt that backs them will remain a significant financial risk in the coming months and years.

US Residential Real Estate Market:  The National Association of Realtors on Friday said it has reached a deal to settle the multiple lawsuits it has been fighting over its standard practice of charging home sellers a commission of about 6%, split between the seller’s and buyer’s agents.  Under the deal, commissions will now be negotiated between the seller and his/her agent, and between the buyer and his/her agent.  Total commissions are expected to fall to 3% to 4%, sharply reducing realtor income and leading to a mass exit from the industry.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are off to a so-so start as investors brace for next week’s FOMC meeting. In sports news, the Champions League matchups are set, with a highly anticipated clash between Real Madrid and Manchester City in the quarterfinals. Today’s Comment delves into our analysis of the recent inflation reports, examines the potential impact of overnight reverse repo rates on the FOMC’s policy deliberations, and provides an overview of the upcoming Russian elections scheduled for the weekend. We also include, as always, a roundup of domestic and international data.

Double Dose of Inflation Trouble: Despite a negative market reaction to the latest inflation report, a closer look at the data reveals a more nuanced picture.

• February’s faster-than-expected rise in wholesale prices is another indication that inflationary pressures remain stubbornly persistent. The producer price index (PPI) in February increased more than expected, jumping from 0.3% to 0.6%, according to the Bureau of Labor Statistics. This aligns with concerns about inflation after the consumer price index (CPI) also rose faster than anticipated earlier this week. Similar to the PPI, the CPI climbed from 0.3% in January to 0.4% in February. Following the PPI report, the 10-year Treasury yield rose 10 bps, while the stock market dipped with the S&P 500 and NASDAQ both falling about 0.7%.
• Concerns in the market about resurgent inflation might be exaggerated. Recent data suggests that inflationary pressures are mainly driven by temporary factors, most notably the significant increase in energy prices. In February, the PPI witnessed a 4.4% surge in energy prices while the CPI reported a 2.3% rise, highlighting the importance of this trend. Additionally, the rise in fuel prices also resulted in higher transportation costs, which further contributed to the unusual increase in both price indexes. In essence, the factors that inflated prices were largely one-time events and may not signal sustained price pressures.

• The hotter-than-expected inflation report likely strengthens the case for the Fed to delay a rate cut. Futures markets currently predict rate cuts in either June or July, which aligns somewhat with Atlanta Fed President Raphael Bostic’s recent comments. The upcoming FOMC meeting in April, with its updated economic projections, will provide a clearer picture of the committee’s policy path for the rest of the year. We expect them to either maintain their current forecast of three rate cuts this year or potentially revise it down to two.

Liquidity and the Stock Market: While a recent cash injection will bolster the financial system, it’s unlikely to prevent a potential liquidity crisis later in the year.

• The Federal Reserve’s overnight reverse repo (ON RRP) facility balance has surged to $521.7 billion. This increase is likely temporary, but it gives policymakers some breathing room to decide when to slow down quantitative tightening (QT). The surge reflects investors who are seeking safe, short-term parking for their cash due to a temporary pause in Treasury settlements. However, with more attractive options now available in other investments like money market fund repos, banks have been diverting funds away from the facility. At the current pace, it is expected that ON RRP will run out of cash by midyear.
• Overnight funding levels are a critical gauge of excess reserves in the banking system. A significant drop can signal potential market stress. As the chart below illustrates, the recent liquidity surge has likely buoyed risk assets. However, the FOMC is grappling with the optimal level of reserves, as it directly impacts the timing of QT unwinding. Governor Christopher Waller downplayed concerns about the zero-balance ON RRP, while Dallas Fed President Lorie Logan expressed anxieties about potential future liquidity issues.

• The Federal Reserve is expected to discuss winding down its QT program at its upcoming meeting, even before the ON RRP facility is drained completely. However, the specific details of this shift remain unclear. While the expectation is for rate hikes to end before QT stops altogether, there’s a possibility the meeting could lead to a slowdown in the pace of tightening from the current maximum of $60 billion in Treasuries and $35 billion in mortgage-backed securities per month. This slowdown could alleviate some market liquidity concerns and potentially boost stock prices.

Russian Elections: While Russia’s upcoming presidential election is likely a formality, the outcome could reveal the true impact of the war in Ukraine on Putin’s domestic standing.

• Russian President Vladimir Putin is poised to secure a fifth consecutive term without encountering significant challenges to his leadership, prompting the Kremlin to anticipate a resounding victory. Recent polls indicate a remarkable 86% approval rating for Putin, marking the highest level since 2016. However, despite his widespread popularity, there are concerns that some segments of the populace may seek to express discontent with the Russian leader. A common strategy among voters is to converge at the polls on Sunday and collectively support opposition candidates by casting their ballots simultaneously, aiming solely to spotlight their opposition stance.
• These elections occur amidst a critical juncture in the war in Ukraine. With potential territorial gains, Putin seems intent on exploiting his perceived advantage to solidify his position. Earlier this week, Putin hinted at a willingness to negotiate an end to the conflict in Ukraine in return for security assurances. Russia’s resilient economy is nonetheless being strained by the war’s escalating costs, particularly with declining oil revenues. This fiscal pressure likely explains the Kremlin’s consideration of tax hikes, in a move that could face pushback given the country’s already high borrowing costs and elevated inflation.

• Another electoral victory for Putin may not startle the markets, but his post-election decisions are expected to draw significant attention. In remarks made on Wednesday, Putin stated that while he currently views the deployment of tactical nuclear weapons as unnecessary, Russia maintains readiness to employ them if it senses a threat to its sovereignty. This highlights the growing importance of nuclear deterrence in national security, especially with recent calls for a stronger European defense in response to Russia. Consequently, we expect continued high demand for uranium and related materials in the coming years.

Other News:  China is looking to stimulate its economy by boosting its tourism sector. This move suggests the country may be seeking to improve relations with the West as it grapples with an economic slowdown. Supporters of free-market principles have backed Nippon Steel’s acquisition of US Steel, but the controversy surrounding the deal highlights growing populist sentiment in the United States. Senate Majority Leader Chuck Schumer (D-NY) has pushed for new elections in Israel, signaling mounting impatience in the US with Israeli President Benjamin Netanyahu’s management of the conflict.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities have pared early gains due to stronger-than-expected PPI data and subpar retail sales figures. Meanwhile, Purdue, UConn, Houston, and Tennessee were able to secure top seeds for the NCAA Tournament. Today’s Comment dives into our thoughts on central banks moving away from ultra-accommodative policy, the potential for broader social media scrutiny beyond TikTok, and how the IEA’s reversal on its oil demand forecast reinforces our concerns about future inflation volatility. As always, we’ll wrap up with a summary of key international and domestic data.

The Next Monetary Regime:  The European Central Bank and the Federal Reserve have signaled potential rate cuts, but this easing cycle could be unlike past ones.

• The European Central Bank (ECB) is poised to implement changes to its operational framework, granting lenders greater autonomy in managing liquidity within the financial system. This shift aims to gradually wean banks off their reliance on the ECB for cash and foster a more self-sufficient approach to liquidity distribution. Interestingly, the Federal Reserve may be following a similar path. The Fed’s recent closure of its Bank Term Funding Program and its encouragement for banks to utilize the discount window suggest a potential move toward a less interventionist approach to liquidity management.
• These central bank adjustments signal a potential departure from pre-pandemic monetary policy norms, which could include a more cautious approach to future interest rate cuts. The White House’s recent inclusion of higher interest rate expectations in its forecasts further reinforces this shift. The strategy to uphold elevated peaks and troughs in interest rates is driven by the imperative need to preserve central bank agility in striking a delicate equilibrium between sustaining price stability and fostering optimal employment levels. The overarching objective is to mitigate the likelihood of exhausting all available monetary instruments once the economy succumbs to recessionary pressures.

• The evolving approach to monetary policy signals a potential paradigm shift for investors. With the era of near or below zero interest rates likely coming to a close, investors will need to adapt their strategies. While central banks may not entirely abandon this tool, their use of it is expected to be more measured moving forward. This shift in preference suggests a new normal for interest rates — they will likely settle at higher points across the yield curve compared to what we’ve witnessed over the past decade and a half. This is likely to remain true not just for the US but for most other developed economies as well.

Election Meddling: With presumptive presidential nominees likely secured by both major parties, lawmakers are shifting their focus to the growing influence of social media, particularly in the age of advancing artificial intelligence.

• A bipartisan effort in the House recently passed a bill that could see TikTok banned in the US. The legislation requires the app’s Chinese owner, ByteDance, to sever ties with the platform or face a potential shutdown in the US. Citing national security concerns, lawmakers worry about the app’s ability to be used for propaganda or voter manipulation. President Biden reportedly supports the bill, but its fate now rests with the Senate. However, Senate Majority Leader Chuck Schumer hasn’t scheduled a vote yet, as concerns about potential free speech limitations and government overreach are expected to be debated.
• While TikTok faces intense scrutiny for potential national security risks, other platforms haven’t escaped criticism. Former President Donald Trump has repeatedly labeled Facebook “the enemy of the people,” alleging bias against conservative voices. On the other hand, New York Rep Alexandria Ocasio-Cortez (D-NY) described the decision of X, formerly known as Twitter, to alter its algorithm to promote or suppress free speech as a form of election interference. The potential of AI-generated deepfakes to spread disinformation on social media platforms is likely to put more pressure on lawmakers to rein in Big Tech.

• The growing pushback against tech giants is likely to extend beyond this year’s election cycle. Countries are grappling with the immense power wielded by these companies, and Europe has already implemented a regulatory framework to rein them in. US regulators are also taking a more aggressive stance. However, despite their high stock prices, this increasing regulatory scrutiny highlights the importance of diversification in investment portfolios, given the potential risks associated with tech’s high valuations.

Crude Oil Concerns: A brighter economic outlook in the US is raising concerns that crude oil demand will be significantly higher than the initial projections for 2024.

• The International Energy Agency (IEA) adjusted its oil forecast, predicting a shift from a surplus to a deficit due to reduced OPEC supply and robust US economic growth. This adjustment reflects the IEA’s expectation that OPEC will likely maintain production cuts throughout the year, even though the group previously aimed for these cuts to last only until mid-2024. The agency further amplified its oil demand forecast, raising its projection by 50% compared to its June 2023 estimate. This significant upward revision reflects an anticipated increase in bunker fuel consumption due to shipping route adjustments to bypass Red Sea conflict zones.
• The revised economic outlook is likely to further exacerbate the upward pressure on Brent crude prices, which have already surged 11% this year. Continued oil price hikes could significantly impact inflation. This connection is evident in the latest CPI report, where the increases in energy price heavily influenced the overall reading. Notably, even non-energy sectors like airline fares have experienced a recent surge, rising 15.2% at an annualized rate over the past three months. Rising price pressures could prompt the Fed to delay cutting interest rates to ensure that it doesn’t lead to a reacceleration of inflation.

• Inflation volatility, particularly due to swings in commodity prices, is a major concern for the committee. While oil prices have garnered significant attention, rising copper prices are also emerging as an issue. This volatility is amplified by the uncertainty surrounding geopolitical tensions. Despite recent low oil prices amidst the Middle East conflict, we lack confidence in their long-term stability. Our primary concern lies in the potential for countries to hoard and weaponize their resource exports as global political fractures widen, aiming to extract concessions from rivals. As a result, we remain skeptical that inflation will be able to remain, sustainably, under the Fed’s 2% target.

 Other News: The US has held secret talks with Iran about ending the violence in the Red Sea, and these discussions highlight efforts from both sides to prevent a broader conflict in the region. Donald Trump, the presumptive Republican presidential nominee, is eying John Paulson as Treasury Secretary, signaling a strategic move to populate his administration with trusted allies. Meanwhile, SpaceX, led by Elon Musk, is poised for its third launch, with ambitions to successfully land a spacecraft on the moon. This endeavor underscores the increasing reliance of the United States on private enterprises for cutting-edge research and exploration.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment opens with a discussion of today’s expected congressional vote on forcing Chinese tech giant ByteDance to divest the US operations of TikTok.  We next review a range of other international and US developments with the potential to affect the financial markets today, including strong wage increases in Japan that could help prompt the central bank to end its negative-interest rate policy and more detail on the Biden administration’s proposed federal budget for the coming fiscal year.

US-China Espionage:  The House of Representatives is set to vote on a bill today that would force Chinese tech giant ByteDance to divest the US operations of its social media app TikTok or have the app banned in the US.  The move by the lawmakers stems from growing concern by intelligence officials that the app could be used to funnel data back to China for espionage or influence campaigns.  The House is widely expected to approve the bill, but its fate in the Senate is less certain.

• The renewed focus on reining in TikTok will surely add another source of friction between the US and China, raising the risk that China will try to force a major US technology firm to divest its operations in China. Obvious potential targets might be Tesla or Apple.
• More broadly, the anti-TikTok bill illustrates how big, influential technology firms are being forced to choose sides in the US-China rivalry. Both Washington and Beijing are now so distrustful that they don’t want their rival’s companies doing business on their home turf.  To the extent that they ban firms owned by their adversary from their home market, the result is basically “decoupling.”
• Major US technology firms are generally very globalized, and many count China among their most important markets or their top manufacturing base. Some may try to maintain their businesses in China, but they will run the risk of increasingly brutal pressure to pull out of that market.  Naturally, the resulting shift in addressable market will have a major impact on those companies’ sales, profits, and stock values.

US-China Trade:  New analysis shows Chinese solar panel makers have doubled their output capacity in just the last year to 1 trillion watts annually and now produce fully three times as many panels as there is global demand.  The resulting glut of panels has driven global prices down some 50%, and the surge of imports into the US is threatening to put US producers out of business despite the expansion subsidies they’ve been offered through the Inflation Reduction Act.  We therefore suspect solar panels will become another key point of US-China frictions.

China:  The central government has ordered a stop to a string of big, expensive infrastructure projects in several poorer, highly indebted provinces in the country’s interior.  The move marks an expansion of Beijing’s effort to rein in excess capacity and debt, which has tripped up the real estate development sector over the last couple of years.  Importantly, the clampdown on investment and debt will likely exacerbate the Chinese economy’s other structural headwinds and could make it difficult to meet the government’s target of 5% economic growth this year.

Japan:  In the annual “shunto” wage negotiations that mostly wrapped up today, major Japanese companies granted average pay hikes of 4% or more, marking an acceleration from last year’s 3.6% increase and the biggest wage increase since 1992.  The robust raise will likely help ensure that Japanese consumer prices will keep rising and encourage the Bank of Japan to finally lift its negative-interest rate policy as early as this month.

Russia-Ukraine War:  The Ukrainian military has reportedly launched drone strikes against at least three oil refineries deep in Russian territory near Moscow and St. Petersburg.  Sources say the strikes, which were designed to starve the invading Russian military of resources, caused “significant damage.”  However, we suspect that even knocking out three refineries temporarily would have only a limited impact on Russia’s warmaking capability and economy.

US Politics:  After winning primary elections in several states yesterday, both President Biden and former President Trump have locked up enough of their respective party convention delegates to win their nominations for president.  Given the candidates’ ages and other factors, there is probably still some chance that either or both could be replaced at the head of their party ticket before November, but for now, it’s a Biden-Trump race until we see if a third-party candidate emerges.

US Artificial Intelligence:  If you’re fascinated by the new Sora artificial intelligence tool for generating videos with simple prompts, the Wall Street Journal’s technology editor has a story today with new examples.  Like some of the Sora-generated videos already released publicly, the videos are fascinating by themselves.  In addition, they suggest how difficult it’s becoming to discern real videos from those that might be artificially generated to influence political opinions or defraud consumers.

US Fiscal Policy:  While yesterday’s Comment discussed President Biden’s overall proposed budget for the fiscal year starting October 1, today we give more detail on the proposed budget for defense, since one of our key theses is that global defense spending is likely to rise in the coming years.  The proposed budget calls for total defense spending of $926.8 billion, up just 2.1% from FY 2024 because of a deal between the White House and Congress to cap spending.  That marks a big slowdown from the estimate’s rise of 10.7% in defense spending this year.

• Since the nominal 2.1% rise in defense spending is below the expected rise in prices, the proposed budget actually represents a small decline in the military’s purchasing power.
• The main savings in the proposed defense budget comes in weapons procurement and research, development, testing, and evaluation. Spending on those items will fall even in nominal terms.
• In contrast, the proposal calls for a 4.5% increase in troop pay, partially offset by a small decline in troop counts and shifting more of the force from active duty to reserves.
• In any case, increasing US-China geopolitical tensions and healthy Congressional support for the military will likely result in a bigger increase in funding than in the proposed budget.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a Nigerian government crackdown on cryptocurrencies and their use to avoid the country’s currency controls.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a worrisome spike in attempted terrorist attacks in Europe and a potential new US probe into unfair Chinese trading practices.

Nigeria-Cryptocurrencies:  Highlighting how governments around the world likely see cryptocurrencies as a threat to their sovereignty, Nigerian authorities have detained two high-level employees of crypto exchange operator Binance, apparently for facilitating Nigerian citizens’ use of stablecoins to skirt central bank exchange-rate controls.

• Such transactions are a risk to Nigeria’s currency controls because cryptocurrencies have become prevalent in the country. Nigeria now has the world’s second-highest rate of cryptocurrency adoption, after India.  Nigerian cryptocurrency transactions in the year ended June 2023 totaled almost $60 billion.
• The ability of citizens to skirt government financial and currency controls using crypto assets is one reason why countries may increasingly clamp down on their use, as China has already done. As we have written before, many central banks are instead studying the possibility of issuing their own digital currencies.

Argentina:  Radical libertarian President Milei is facing a scandal today after opposition Peronist legislators revealed that he signed a decree giving himself a 50% pay raise last month.  In response, Milei has fired his labor secretary and argued that he inadvertently signed the decree because it was an automatic inflation adjustment instituted by the previous Peronist government.  The scandal could become another headwind for Milei’s effort to rein in Argentina’s government spending, reduce bureaucracy, spark faster economic growth, and stabilize the currency.

Russia-Ukraine-NATO:  Following on French President Macron’s statement last month that the North Atlantic Treaty Organization shouldn’t rule out sending troops to Ukraine, the Polish foreign minister on Friday told his parliament that it “is not unthinkable” that NATO forces could be deployed there.  The statement from the foreign minister, which contradicts the view of Polish Prime Minister Tusk, shows how Russia’s new momentum in Ukraine is increasingly scaring Western European leaders and forcing them to consider previously unthinkable actions.

European Union:  Authorities in multiple European countries have recently arrested a number of terrorists who were planning attacks on EU soil against Jewish and Israeli-connected targets, apparently in sympathy with Palestinians suffering from the Israel-Hamas war in the Gaza Strip.  The terrorists, at least some of whom have posed as refugees, are being directed in part by Iran and its militant Islamist proxies in the Middle East, including Hamas and Hezbollah.  The news suggests there is a rising risk of a successful attack that could undermine market confidence.

Israel-Hamas Conflict:  In its annual threat assessment report yesterday, the US intelligence community warned that Israeli Prime Minister Netanyahu’s grip on power is “in jeopardy” because of the Hamas attacks on Israel last October 7 and the government’s continued war against Hamas in Gaza.  If that leads to new elections in Israel, the assessment argues that voters could elect a more moderate government than Netanyahu’s.

• Separately, Israel and Hezbollah fighters in southern Lebanon have sharply escalated their attacks on each other over the last day. Israel has even launched airstrikes deep into Lebanese territory.
• The intensified fighting in southern Lebanon is a reminder that Israel’s fighting with the Palestinians and Iran-backed militant groups still has the potential to spark a broader conflict that could be deeply concerning for financial markets.

China:  Moody’s has downgraded the debt of Vanke, the China’s second-largest real estate developer, to below-investment grade status and warned of further downgrades in the future as the company struggles with declining contracted sales.  The downgrade illustrates the ongoing challenges facing the country’s enormous real estate sector as the government leans on it to cut excess capacity and debt, which in turn has prompted lower prices and falling demand.

United States-China:  In case you thought you could read a Comment from us that doesn’t include a new US-China friction, think again.  The United Steel Workers union will file a petition today with the US Trade Representative alleging that China uses discriminatory practices in shipbuilding and maritime logistics to undermine US producers.  The petition will ask the government to launch an investigation into the matter, which could eventually result in further tariffs or other trade barriers against Chinese products or services.

• Ultimately, pushing back against China’s dominance in global shipbuilding aims to help revive the once-thriving US shipbuilding industry. That could have important implications for both private industry and the US Navy, which is constrained by limited domestic shipyards.  However, any potential revival of the US industry would be a very long-term project.
• In any case, any new investigation into Chinese unfair trading practices or punitive trade barriers would exacerbate the spiraling tensions between the West and China, further fracturing the global economy and presenting risks for investors.

United States-Philippines:  As the Biden administration keeps trying to solidify US alliances to protect against Chinese aggression, Commerce Secretary Raimondo has urged US technology firms to at least double their investment in Philippine facilities that handle a key part of the info-tech supply chain:  assembling, testing, and packaging computer chips produced in the US or elsewhere.  Raimondo’s call is an example of US “friend shoring,” or trying to shift more of its critical supply chains to friendly countries, both to shore up those allies and boost resilience.

US Fiscal Policy:  The Biden administration yesterday released its proposed federal budget for fiscal year 2025, which starts on October 1. The plan calls for total outlays to rise 4.7% to a total of $7.265 trillion, largely because of Social Security, Medicare, Medicaid, and other entitlements passed by Congress in previous years.  The plan calls for receipts to rise 7.9% to $5.485 trillion, reflecting both economic growth and proposed tax increases on higher-income people.

• The deficit of $1.781 trillion would be modestly lower than the estimated $1.859 trillion in FY 2024.
• The plan also calls for a number of sweeteners designed to help the Democratic Party in the November election. For example, it calls for a new mortgage tax credit and subsidy for home sales.
• Nevertheless, because of the fractured Congress, the proposed budget is seen as highly unlikely to pass in anything resembling its current form. Rather, the proposal will serve as a key reference point for Biden’s re-election campaign.

US Labor Market:  Port operators on the East Coast and Gulf Coast are starting negotiations with the International Longshoremen’s Association for a new, multi-year labor contract to follow the current one when it expires on September 30.  However, the dockworkers are already threatening to strike if they don’t get the concessions that they’re demanding.  If the negotiations fail and a strike occurs, it will likely happen at the peak of the delivery season for holiday imports, potentially causing important disruptions to the economy and pushing prices higher.

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