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 as risk sentiment improves. In sports news, Team USA’s basketball team dominated Brazil, securing their spot in the semifinals against Serbia. Today’s Comment will explore why the market has stabilized since Monday’s sell-off, share our thoughts on carry trades, and provide an update on the UK budget situation. As usual, our report includes a summary of international and domestic data releases.

All Calm on the Market Front: Equities staged a recovery from Monday’s sharp decline, yet investors remain cautious about potential future turbulence.

• The S&P 500 surged 1.7% on Tuesday, rebounding from a global sell-off ignited by recession concerns. Despite these fears, recent economic indicators point to a resilient economy. Wednesday’s S&P Global and ISM Purchasing Managers Indexes not only confirmed continued expansion but also surpassed market forecasts. Moreover, the Senior Loan Officer Opinion Survey revealed that while banks have tightened lending standards overall, the net share of lenders which have tightened conditions has decreased from the previous quarter, signaling potential optimism in the lending market.
• While the market has experienced a slight reprieve, underlying uncertainty persists. The CBOE Volatility Index (VIX) declined from 32.38 to 27.71 on Tuesday, though it remains significantly elevated above the 20 level, indicating continued market anxiety. This elevated reading reflects investors’ continued uncertainty about the Federal Reserve’s interest rate trajectory. While policymakers have indicated that recent events won’t prompt an immediate rate cut, market participants still anticipate potential adjustments to the rate cut outlook beyond the previously projected single reduction this year.

• The market will closely watch economic data in the coming weeks as investors anticipate the Federal Open Market Committee’s next move on September 18. Two additional CPI reports and another employment report will be released prior to the meeting and will likely influence market reactions. While a September rate cut is still expected if inflation continues its downward trajectory, the magnitude of the cut will hinge on labor market conditions. A rise in the unemployment rate to 4.4% could increase the odds of a substantial 50-basis-point reduction.

More than Japan: While the Japanese yen (JPY) dominated market attention, other currencies were also adversely affected by the downturn in the broader market.

• Emerging market currencies were battered by the market turmoil as carry trades unwound since the start of the week, with the Mexican peso (MXN) plunging below the critical 20 level against the dollar, marking its weakest point in two years. The Chinese yuan (CNY) also declined against the dollar. In contrast, the Swiss franc (CHF), a safe haven currency, soared to a six-month high, prompting some Swiss National Bank policymakers to consider currency intervention to curb its appreciation. Ironically, the dollar’s value has remained relatively stable amid these volatile currency movements.
• This turmoil was ignited by the JPY’s sharp appreciation following the Bank of Japan’s (BOJ) surprise rate hike and weak US economic data. Although the BOJ has subsequently indicated no plans for further tightening, which has offered some relief, currencies continue to fluctuate amid growing recession fears in the United States. J.P. Morgan’s one-month volatility index indicates persistent uncertainty in currency markets as the duration of the current unwind remains unclear. By one estimate, the carry trade unwind is somewhere between 50%-60% complete.

• The unwinding of carry trades continues to threaten the equity market, particularly the tech sector, due to its heavy reliance on this funding. While recent market stability is encouraging, normalization is expected in the coming days. Following the BOJ’s announcement, European and Asian stocks rallied this morning, a trend we anticipate will continue. Despite our optimistic outlook, we remain vigilant for signs of significant market disruption, especially if US recession fears intensify.

Labor Party Plan: A month after their decisive victory in the UK Parliament, the Labour Party is finally unveiling its plan to address the government budget deficit.

• UK Chancellor Rachel Reeves is expected to push for higher taxes and pension reform as she seeks to submit her budget by October 30. During a Bloomberg TV appearance this week, she announced plans to strike a balance on taxes and hinted that an increase in the capital gains tax could be on the table. Separately, rumors circulated on Wednesday about her exploring a public pension overhaul modeled after Canada’s system. This could involve consolidating local government pension plans to channel funds to infrastructure projects while also reducing costs and fees.
• Concerns about the new government’s fiscal policy have intensified following the revelation of a 22 billion GBP ($28 billion) public spending overrun last week. This deficit compounds the nation’s efforts to curb spending, as the Office for Budget Responsibility has reported that borrowing has exceeded its March forecast by 3 billion GPB ($3.8 billion) year-to-date. While a surprising first-quarter economic uptick has mitigated some of these costs, there are fears that the Labour Party may need to implement austerity measures unless growth accelerates significantly.

• While the UK’s market influence has diminished since its 2020 departure from the European Union, it remains a key country to monitor. The infamous Truss mini-budget and its subsequent financial market turmoil underscore the UK’s capacity to impact global markets. Unlike Truss’s administration, which triggered market instability with its unfunded tax cuts, the current government has been more measured in its fiscal policy, avoiding lofty spending pledges that could erode investor confidence. If the Labour Party can present a viable budget plan in October, it should support UK assets.

In Other News: Kamala Harris, Democratic presidential nominee, has selected Minnesota Governor Tim Walz as her vice-presidential running mate, a strategic choice aimed at enhancing her appeal among voters in the Rust Belt. Rioting continues in Bangladesh after the prime minister resigned following widespread protests. The country is a significant hub for garment manufacturers supplying US retailers.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with a recap of the wild market swoon around the world on Monday. So far today, the markets have calmed down considerably, and the Japanese equity market regained most of the 12% decline it suffered yesterday. We next review several other international and US developments with the potential to affect the financial markets today, including a potential new point of conflict between China and the Philippines and an antitrust ruling against technology giant Google.

Global Financial Markets: The global rout in risk markets yesterday ultimately drove large-cap US stock prices down about 3.0%, with previously high-flying technology stocks and small-cap stocks faring even worse. All the same, our close read of the markets and our second look at recent economic data still suggest that the culprits were largely what we tagged in yesterday’s Comment: an overreaction to the weak July employment report on Friday, rising Japanese interest rates, and an unwinding of yen carry trades.

• Multiple US data series suggest lower-income consumers continue to struggle with the high price inflation of recent years. Those consumers have been especially whipsawed by the way tax brackets are indexed to inflation only with a lag. Many responded by borrowing more, only to be hit with higher interest charges. On top of that, higher interest rates have cooled parts of the production sector, such as apartment developers. Weaker consumer demand and cooler business investment is now hurting the labor market.
• As we noted in our Economic and Financial Market Outlook for 2024, which we titled “The Slow-Bicycle Economy,” slower economic growth will make the US economy more susceptible to recession, especially if there is an exogenous shock to the system. At this point, however, such an exogenous shock is not readily apparent. It is entirely possible that the US will merely experience a period of slower growth or perhaps a mild, short recession. The silver lining is that such a situation would imply lower interest rates.
• Looking ahead to the coming days, the unwinding of yen carry trades and continued concerns about the US economy could keep the markets volatile. This volatility will likely prompt investors to reassess their expectations and valuations for certain sectors, potentially leading to a longer-lasting rotation away from recent high-flyers to down-trodden assets that may benefit from lower interest rates, such as real estate and bonds.
• In the Japanese stock market, which dropped 12.4% yesterday to get the rout going, indexes closed up about 10.4% today.

Global Oil Market: Saudi Aramco, Saudi Arabia’s largely state-owned oil company and the world’s biggest producer, confirmed it will pay out $124 billion in dividends this year, dwarfing the $32 billion in dividends and share buybacks expected from US oil giant ExxonMobil. More broadly, the firm warned that global oil demand is much stronger than investors realize.

• According to CEO Amin Nasser, global oil demand is “robust,” especially in China, despite its economic slowdown and the broader global transition to green energy.
• If Nasser is correct, it would suggest the US and global economies are still in decent shape. In turn, that could point to ongoing upward pressure on oil prices.

China-Philippines: Yesterday’s South China Morning Post said Manila has deployed a coast guard vessel to a new area of the South China Sea claimed by both China and the Philippines. The Philippine vessel, the Teresa Magbanua, has reportedly been blocking Chinese coast guard ships from interfering with boats from the Philippine Bureau of Fisheries and Aquatic Resources, which have been refueling fishing boats in the area. According to the article, Beijing has accused Manila of intentionally grounding the Teresa Magbanua on the disputed Sabina Shoal.

• The report comes just days after Beijing and Manila reached a deal to defuse tensions around a Philippine naval vessel, the Sierra Madre, which was intentionally grounded in 1999 on the disputed Second Thomas Shoal, also in the South China Sea. The Sierra Madre is now an outpost for Philippine marines, helping assert Philippine sovereignty over the area.
• Since the old, rusting Sierra Madre is now in danger of breaking up, Beijing has been pressuring Manila to stop shoring it up. Once the Sierra Madre breaks up and the Philippine marines have to abandon her, Chinese forces would be free to seize the Second Thomas Shoal and assert Beijing’s sovereignty over the area.
• If Manila really has grounded the Teresa Magbanua on Sabina Shoal, right after promising not to shore up the Sierra Madre any further, it would mark a stunning and aggressive sleight of hand by Philippine President Ferdinand Marcos, Jr. The result would be to keep alive the increasing territorial tensions between Beijing and Manila, which could potentially draw in the US and lead to conflict in the South China Sea.

Australia: The Reserve Bank of Australia (RBA) today held its benchmark short-term interest rate unchanged at 4.35%, right where it has been since November. In its statement, the central bank said underlying inflation pressures remain too high and probably won’t come down enough to support a rate cut anytime soon. That puts the RBA at odds with most other developed-country central banks, many of which have started cutting rates or are preparing to do so.

European Union-Mercosur: According to the Financial Times, European and South American officials have said they recently resolved some sticking points in the 20-year negotiations over an EU-Mercosur free-trade deal and could have the pact signed by the end of 2024. If signed and approved by a majority of the EU’s 27 member states, the deal is expected to save EU businesses more than 4 billion EUR per year in tariffs, while opening new markets in Europe for the five Mercosur nations of Brazil, Argentina, Uruguay, Paraguay, and Bolivia.

Mexico: For the first time, Defense Secretary Gen. Luis Cresencio Sandoval has admitted that the country’s drug cartels have killed some Mexican soldiers with bomb-dropping drones like those being used in the Russia-Ukraine war. In our view, the cartels’ successful use of the drones illustrates why they are revolutionizing modern warfare: The drones are highly effective at killing and destroying equipment, while they are also cheap and relatively easy to use.

US Monetary Policy: After yesterday’s global market selloff, as discussed above, Chicago FRB President Goolsbee vowed the Fed would “fix” any deterioration in the US economy. Separately, San Francisco FRB President Daly said the policymakers “will do what it takes” to meet their price stability and employment goals.

• The statements are far from any commitment to implement an interim interest-rate cut, a 50-basis point cut in September, or even a 25-basis point cut that month.
• However, the statements do confirm that yesterday’s market action and recent soft economic data have gotten the Fed’s attention, raising the probability that they will ease monetary policy this autumn more aggressively than previously planned.

US Antitrust Policy: In a ruling yesterday, a federal judge said Google violated US antitrust law by spending billions of dollars on exclusive deals to maintain a monopoly on internet searches. The judge is still deciding what remedies to impose, and the company said it plans to appeal the ruling in any case. Still, the ruling illustrates the federal government’s increased focus on uncompetitive behavior by big technology firms. The question is how much that focus will hurt those firms’ revenues and profitability going forward.

US Artificial Intelligence Industry: New reports say AI chip darling Nvidia and manufacturing partner Taiwan Semiconductor have suffered production snags on Nvidia’s new Blackwell data center chip. The snags reportedly could delay shipments of Nvidia’s key new product scheduled for later this year. The news could take further wind out of Nvidia’s high-flying stock price.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with an overview of the sharp declines in global financial markets today. Given the recent weak economic data out of the US and the surging value of the yen, the volatility could stay with us in the near term. We next review several other international and US developments with the potential to affect the financial markets today, including new signs that Iran is about to launch an attack on Israel and additional notes on Friday’s weak US labor market report.

Japan: Responding to Friday’s weak US labor market data, rising Japanese interest rates, and the surging yen (JPY), the country’s benchmark Nikkei stock market index plunged 12.4% today, for its worst decline since 1987. The plunging Japanese market pulled down stock values across the region, with the South Korean and Taiwanese markets both falling more than 8%. European equities are also weaker today, and as noted above, current futures trading suggests US stock prices will fall sharply at the open.

• The weak US employment data on Friday has rattled investors worldwide. To complement the quick first take that we provided in our Comment on Friday, we provide a bit more detail later in today’s publication. We also note that today’s upcoming business-sector data from S&P Global and ISM could help calm the markets if they are strong enough.
• The Bank of Japan’s shift toward higher interest rates has also upset the years-long habit among some investors to borrow at ultra-low Japanese rates to fund aggressive bets around the world. With Japanese rates now rising, investors have begun to unwind those trades, taking air out of many high-flying stocks and pushing the JPY higher as they bring their funds back home. The resulting upward pressure on the yen then prompts even more unwinding.
• After weakening some 12.2% against the dollar in the first half of 2024, the yen has reversed almost all of that change in just the last five weeks. As of this writing, the currency is trading at 142.68 per dollar ($0.00701), down just 1.3% from the exchange rate of 140.85 ($0.00710) at the end of 2023. If the JPY continues to strengthen, the global market volatility seen today could continue for a while yet.

Japan-Philippines: In another sign that key US allies in the Indo-Pacific region are increasingly cooperating to thwart Chinese geopolitical aggressiveness, Japan and the Philippines held their first-ever joint naval exercise in the South China Sea on Friday. The drill came just weeks after Tokyo and Manila signed a deal allowing them to deploy troops on each other’s territory in time of conflict. Separately, the German and Philippine defense ministers met yesterday to work on a new defense cooperation deal expected to be signed later this year.

China: The Wall Street Journal on Saturday carried an interesting article on the enormous scale of Beijing’s support for Chinese manufacturers. For example, the article says Beijing channels almost 5% of national income to support the factory sector, six times the share provided by the second-biggest spender, South Korea. Just as important, the article notes that 99% of China’s publicly listed companies report some kind of direct government subsidy. In 2023, the top recipient was battery maker CATL, which got about $790 million.

• The Chinese Communist Party has long maintained an investment-driven economic model marked by high spending on infrastructure, housing, and factories. Since the prior emphasis on housing left that sector with enormous excess capacity and debt, the party is now emphasizing factory investment and competitiveness.
• Along with the outright cash subsidies, Chinese manufacturers receive tax breaks, cheap loans from state-owned banks, low-priced land from provincial and local governments, preferential pricing for raw materials and energy from state-owned producers, and even inexpensive equity financing by government-run investment companies. Beijing also provides valuable non-monetary support, such as discriminatory rules against foreign firms operating in the country and low regulation on Chinese firms.
• Within China’s domestic economy, channeling so many resources to manufacturers leaves much less available for service firms and consumers. Even when Beijing vows to boost consumer spending, the strategy is often underwhelming. Over the weekend, for example, the State Council released a plan to boost consumer spending by increasing support for nursing care and “low altitude tourism,” i.e., hot air balloons.
• Internationally, the resulting excess capacity and low domestic prices have prompted Chinese manufacturers to dramatically ramp up their exports, which threatens to hurt manufacturers and manufacturing workers in the US, other developed countries, and even many emerging markets. As a result, we expect those countries to continue slapping Chinese firms with anti-dumping tariffs and other trade barriers, which will further worsen China-Western tensions.

Malaysia: Government officials, academics, and business managers say the number of Chinese citizens moving to Malaysia has surged in response to China’s slowing economic growth and oppressive Communist Party intrusions. According to the report, the surge is driven largely by students and investors. The number of Chinese citizens living in Malaysia may now be as high as 200,000, up from just 82,000 in 2022. The influx may help goose the Malaysian economy and stocks, although it could also spark social tensions.

European Union: Even though Ursula von der Leyen secured a second term as president of the European Commission earlier this summer, with support from both the EU member states and the European Parliament, she has faced an embarrassing threat to her authority as she works to fill the 27 commissioner posts in the EU’s executive body. For each country that is not just renominating its existing commissioner, von der Leyen has requested both a male and a female nominee. However, at least six countries have simply nominated a man.

• Under EU law, each member state has the right to nominate one commissioner. Then, von der Leyen gets to decide which portfolio each commissioner gets.
• Von der Leyen has promised to build a gender-balanced college of commissioners, but she has no authority to require both a male and a female nominee from each member state. Most returning commissioners are likely to be men, so without more female nominees, the new college of commissioners will likely be male dominated.

United Kingdom: Rioting by far-right activists spread to more cities over the weekend, as a follow-on to the anti-immigrant riots sparked last week by a stabbing attack that killed three children in the city of Southport. Prime Minister Starmer held an emergency meeting with his top ministers on Saturday and declared the government’s full support for police trying to control the violence. Nevertheless, the rioting threatens to disrupt economic activity and tarnish the UK’s reputation as a safe place for business and investment.

Iran-Israel: Tehran today issued a warning for pilots and aviation authorities to consider Iranian airspace off-limits, in what is likely an indication that it will soon launch its expected strike on Israel. Meanwhile, US Secretary of State Blinken yesterday told the Group of 7’s foreign ministers that he expects Iran to attack in the next 24 to 48 hours. Given that world financial markets are already facing economic jitters, an unexpectedly large, dangerous attack that threatens escalation could spark additional market volatility.

United States-Vietnam: In an annual review, the US Commerce Department on Friday unexpectedly maintained its designation of Vietnam as a “non-market economy,” keeping it in the same category as countries like China and Russia. The designation means Vietnamese imports into the US will continue to face special anti-dumping and anti-subsidy scrutiny and higher tariffs.

• The US decision comes despite Hanoi’s recent economic reforms and increased US investment in Vietnam. At first glance, it also seems inconsistent with the US’s recent pressure on Western firms to shift production from China to other countries in the region.
• On the other hand, it’s important to remember that Chinese companies have been looking to set up shop in Vietnam, Mexico, and other countries to get around US tariffs on Chinese products. Keeping Hanoi’s non-market designation may give the US more leeway to impede Chinese goods being routed through Vietnam.

US Defense Policy: Faced with growing threats from China, Russia, and North Korea, a senior Defense Department official said at a conference last week that the military’s current strategic review is exploring an increase in the US arsenal of nuclear weapons and launchers. The statement suggests the Biden administration may already be stepping back from its 2022 Nuclear Posture Review, which some defense analysts considered too dovish. If so, it could portend even more pressure to increase the US defense budget in the coming years.

US Labor Market: Finally, as a follow-up to our quick take on the weak July employment report in our Comment on Friday, we note that much of the issue was that new job creation finally fell sharply below the number of new entrants into the labor market. Our analysis shows most of the weakness came in the private sector, where the net employment gain in July was just 97,000, down 42.3% from the monthly average of 168,000 over the previous year. In the public sector, the jobs gain was 17,000, down 63.9% from 47,000 over the prior year.

• In the private goods-producing sector, net hiring in July was a bit stronger than in the prior year. The problem was in the private services sector, where net hiring weakened to 77,000, down 51.8% from the average of 149,000 in the previous year. In large part, that reflected weaker hiring in ambulatory healthcare offices and professional services, along with payroll declines in industries such as publishing and other information services.
• In the public sector, the weak hiring primarily reflected employment declines in state and local governments outside of education.
• While we’re still working to deeply understand what’s going on in the labor market, the weak labor demand in professional and information services may mean firms over-hired in those areas in the post-pandemic boom. Potentially, it could also point to some shifts related to artificial intelligence. Finally, the weakness in governments’ non-education hiring could reflect continued strong retirements in that relatively older sector.
• In any case, if the weak July figures aren’t reversed in the August report, the Fed policymakers certainly could become more amenable to a 50-basis point cut in the benchmark fed funds rate in September, as many investors now expect.

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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 poor start today as investors fret over a possible recession. In sports news, US gymnast Simone Biles has claimed another individual all-around Olympic gold medal. Today’s Comment will examine investor concerns over rising capital expenditures, explain how labor costs could contribute to the Fed’s inflation target, and discuss China’s recent decision to expand its nuclear arsenal. As usual, we will conclude with a roundup of domestic and international economic data.

The Great Reset: AI woes and Fed uncertainty keep the market on edge, with investors bracing for September’s rate decision.

• The tech sector’s heavy focus on AI is increasingly frustrating investors seeking immediate returns. Amazon’s stock price plunged by as much as 5% on Thursday after the company issued disappointing Q3 guidance and announced plans to escalate capital expenditures on AI. Given current valuations, investors are concerned that tech companies’ AI ventures may not generate profits as quickly or significantly as anticipated. The market exhibited similar reactions to comparable strategies adopted by Alphabet, Microsoft, and Meta.
• Investor enthusiasm for highly valued tech stocks has cooled as the market anticipates interest rate cuts and analysts grow increasingly skeptical of companies prioritizing capital spending over immediate profits. Tech giants previously thrived as investors sought higher potential returns in a rising interest rate environment. However, with the prospect of declining borrowing costs, the market’s focus is shifting toward sectors like Real Estate and Utilities. This market rotation has allowed the S&P 500 Equal Weight Index to gain ground on its market-cap-weighted counterpart this year.

• The S&P 500’s three consecutive daily swings of over 1% this week, a level of volatility unseen since January, underscore the market’s fickle nature. As the Fed continues to tease a potential rate cut, we could see a shift in investor focus from growth to value stocks, which would emphasize current profitability over future earnings potential. However, investors must remain vigilant for a potential hawkish pivot by the Fed, especially if inflation unexpectedly resurges. This could cause investors to rethink their previous strategies and create even more volatility in markets.

Labor Costs and Inflation: Declining unit labor costs coupled with increased productivity further indicate easing inflationary pressures.

• Productivity, as measured by output per hour, surged in the second quarter, while labor costs remained relatively stable. According to the Bureau of Labor Statistics, nonfarm productivity rose at an annualized pace of 2.3% in the second quarter. This was an improvement from the previous quarter’s rise of 0.4%. Conversely, unit labor costs decelerated noticeably, declining from an annualized pace of 3.8% to 0.4% in the same period. This is the lowest reading in 2.5 years.
• Significant productivity gains are likely to bolster the Fed’s confidence in engineering a soft landing. This sharp increase indicates the economy can sustain growth without igniting inflationary pressures. Last quarter’s accelerated GDP growth from 1.4% to 2.5% coincided with a notable decline in price pressures, as evidenced by the GDP deflator falling from 3.1% to 2.3%. Moreover, moderating wage growth will be instrumental in keeping inflation on track toward the 2% target. As the chart below illustrates, the Fed’s core services index is highly correlated with employment costs.

• The Fed is confronted with the challenge of curbing inflation without precipitating a recession. Despite recent GDP growth, indicators point to a potential economic slowdown. Corporate reports of waning consumer price tolerance and a near high for the year in jobless claims amplify these concerns. While we do not share the market’s pessimistic recessionary outlook, we acknowledge the possibility of economic deceleration. Notably, the current economic landscape echoes that of 2023, characterized by a summer surge in initial jobless claims followed by a subsequent normalization.

Nuclear Proliferation: China seeks to rewrite the rules of nuclear buildup as it looks to catch up to the US.

• Beijing has proposed a pledge among the five permanent UN Security Council members to refrain from using nuclear weapons first. As the sole council member to make such a proposal, China appears to be seeking a tactical advantage in the ongoing nuclear disarmament debate. This move comes in response to US-led efforts to reduce nuclear arsenals globally. Notably, China has accused the US of violating the Non-Proliferation Treaty due to its pledge to defend European allies in the event of a nuclear attack.
• Despite criticism, the motives behind China’s nuclear buildup remain a subject of debate. Projections indicate that China could possess over 1,000 nuclear warheads by 2030, a substantial increase from the 200 it held in 2019. However, this pales in comparison to the US and Russia, with each estimated to have over 5,000 warheads. Due to this significant disparity, some analysts theorize that China’s goal is not to achieve nuclear parity with its rivals but rather to deter potential aggression.

(Source: Financial Times)

• We are moving toward a more hostile world. As global geopolitical tensions rise, other nations may pursue their own nuclear deterrents. Iran and North Korea have already expanded their nuclear capabilities. Additionally, countries aligned with the US could potentially follow suit, especially if US security guarantees are perceived to have weakened. This increased demand for uranium, coupled with production constraints, could drive up uranium prices significantly over the next decade. Additionally, the potential increase in nuclear ability may raise the possibility of a miscalculation that leads to a major conflict.

In Other News: The US has secured the largest prisoner exchange in the post-Soviet era as the president seeks to reassure critics of his administration’s effectiveness. Additionally, the tech sell-off has spread to other markets, particularly Japan, as investors reassess portfolio allocations in light of shifting interest rate expectations.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with an overview of the Federal Reserve’s latest monetary policy decision yesterday, in which it set the stage to potentially cut interest rates in September. We next review several other international and US developments with the potential to affect the financial markets today, including a rate cut by the Bank of England and signs that global and US climate-change spending is starting to shift from prevention to adaptation.

US Monetary Policy: Wrapping up their latest policy meeting yesterday, Fed officials held their benchmark fed funds interest rate unchanged at 5.25% to 5.50%, as widely expected. Just as important, their policy statement downgraded their assessment of consumer price inflation from “elevated” to “somewhat elevated” and said the risks of high inflation versus a weak labor market have “continued to move into better balance.” In his press conference, Chair Powell also stressed that he doesn’t want to see any “material further cooling in the labor market.”

• Even though Powell stressed that the policymakers aren’t ready to cut interest rates just yet, the statements point to a possible cut in September. All the same, the statement and press conference were probably a bit less dovish than initial press reports suggested. Both held far back from any commitment to cut rates at the next meeting in about six weeks, giving the policymakers some wiggle room if the inflation data turns against them.
• Powell’s statement about avoiding further deterioration in the labor market seems warranted. Multiple indicators suggest labor demand has softened considerably. To avoid the risk of further deterioration, it does seem likely that the Fed will finally cut interest rates in September, marking its first election-year rate cut since 2008.
• The chart below shows how the world’s major central banks have shifted their benchmark interest rates in recent years.

UK Monetary Policy: The BOE today cut its benchmark interest rate from 5.25% to 5.00%, but the vote to do so was extremely close. While five members of the policy committee voted to cut rates, four voted to hold them steady. Following the announcement, BOE Governor Bailey also cautioned that the officials must be careful “not to cut interest rates too quickly or by too much.” In sum, the tenor of the action was cautious, suggesting the BOE may continue to cut rates only slowly or sporadically.

• In response to the Fed’s decision yesterday and today’s initial rate cut by the BOE, the pound (GBP) is trading down about 0.6% to $1.2782.
• The rate cut has also given a boost to the UK’s two-year government bonds, pushing their yield down to 3.76%.

UK Public Security: During a vigil on Tuesday night for three children killed in a knife attack earlier this week, right-wing protestors attacked a mosque, rioted, and scuffled with police in the northern England city of Southport. The violence has now spread to other cities as well, including London. The rioting, which has injured dozens of police, arose despite investigators’ insistence that the 17-year-old attacker was a native-born Briton, and that they have found no sign of an Islamist motive so far.

• It appears the protestors were largely inspired by misinformation and conspiracy theories on social media, including by Russian state-controlled media.
• The violence illustrates the risk that rapidly spreading misinformation and scapegoating could spark disruptive, destabilizing violence even in stable developed countries.

European Union-United Kingdom: Responding to British Prime Minister Starmer’s overtures for improved EU-UK cooperation in international security and trade, the European Commission has issued a list of eight demands it wants London to meet as a sign of good faith. The demands center on measures to fully implement the Brexit deal under which the UK left the EU, including UK commitments related to Northern Ireland and the rights of EU citizens living in the UK. The demands suggest it may be harder to repair EU-UK relations than Starmer expected.

European Union-Hungary-Venezuela: As world leaders continue criticizing Venezuelan President Maduro’s apparently false declaration that he won re-election in last weekend’s balloting, Hungary’s right-wing populist government has vetoed any official condemnation by the EU. The European Commission’s foreign affairs chief, Josep Borrell, has issued a personal condemnation, but Budapest’s veto signals that Hungarian Prime Minister Orbán intends to keep undermining democratic values in favor of authoritarianism around the globe.

Russia-Ukraine: New public opinion polls show a majority of Ukrainians still opposes ceding any territory to Russia to end its invasion of their country, but the share willing to consider such a concession has grown to as much as 45%. The shift in public opinion comes as top government officials begin to show more openness to negotiation in their statements and diplomatic activity.

• If the Ukrainians really are becoming more open to territorial concessions in return for peace, it likely stems from general war weariness, the armed forces’ inability to stop Russia’s slow advances, and skepticism about continued support from the West.
• We have long expected that the most likely outcome of the war is a negotiated settlement, once both sides are sufficiently exhausted. That point hasn’t yet been reached, but it does appear to be coming closer.
• In any case, we continue to believe that any negotiated settlement could merely provide a temporary peace. With the support of his like-minded authoritarian revisionists in places like Beijing and Pyongyang, Russian President Putin would likely use any truce to rebuild his military and prepare for new assaults against Ukraine and potentially other countries in the future.
• Because of that possibility, we suspect Western European nations will continue working to rebuild their defense capabilities even after a Russia-Ukraine peace deal. That would likely lead to continued growth in Western European defense budgets and good prospects for the region’s defense contractors.

China: According to data provider Preqin, private capital fundraising in the second quarter fell to a record low of $3.4 billion, less than one-tenth the average quarterly fundraising of roughly $45 billion from 2019 through 2021. The weak second-quarter fundraising figure — which includes all funds raised for private equity, venture capital, private debt, real estate, and infrastructure — reflects both China’s worsening economic growth and weaker prospects for profitable exits in the future.

US Climate Policy: The Wall Street Journal today carries an interesting article claiming the $1.3 trillion or so spent globally and in the US to address global warming is gradually shifting away from prevention (reducing emissions, etc.) toward mitigation (shoring up infrastructure, etc.). According to the article, only about 5% of total climate spending is now on mitigation, but that share is rising. If the trend continues, an entirely new set of companies could be the beneficiaries, beyond today’s solar cell makers, electric vehicle manufacturers, and the like.

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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 higher this morning as investors await the Fed’s rate decision. In sports news, Simone Biles led the US women’s gymnastics team to gold at the Olympics. Today’s Comment will delve into the Federal Reserve’s interest rate decision, examine the cooling AI hype, and analyze the Bank of Japan’s latest policy move. We will conclude with a review of key domestic and international economic data.

Is it Pivot Time? The FOMC is set to conclude its two-day meeting today, with investors eagerly awaiting clues about potential rate cuts.

• Federal Reserve policymakers are expected to announce a shift in their focus away from inflation and toward employment to achieve greater economic balance. Concerns are growing amid four consecutive months of rising unemployment, which could trigger the Sahm Rule if the trend persists in July. This rapid labor market deterioration has prompted prominent economists, including former New York Fed President William Dudley and former PIMCO CEO Mohamed El-Erian, to push for an immediate rate reduction within the next two Fed meetings in order to avert a policy mistake.
• While Fed officials have signaled increased confidence in inflation’s downward trajectory, concerns persist about the potential resurgence of price pressures. Richmond Fed President Thomas Barkin recently expressed skepticism about the current restrictive nature of interest rates, noting that inflation, though improved, remains above pre-pandemic levels. The core PCE price index rose 1.6% in the first half of 2024, a deceleration from the 2.0% pace in the same period of 2023 but still significantly higher than the 0.9% average seen in the three years preceding the pandemic.

• Despite mounting pressures for an immediate rate cut, the Fed is expected to maintain its current policy stance at today’s meeting. The central bank is likely wary of potential inflationary pressures during the typically quiet summer months, which would delay any rate reduction until September or beyond. Although unemployment has risen sharply, it remains within a range typically associated with economic growth. As a result, the Fed is expected to adopt a cautious approach, potentially keeping rates unchanged for an extended period. If this occurs, it could impact the rotation trade.

Magnificent 7 in Focus: Microsoft is the latest tech company to disappoint investors following its earnings reports, as investors start to question AI profit expectations.

• While Microsoft surpassed overall earnings expectations, its Intelligent Cloud division fell short. Revenue for the highly touted segment climbed 19% to $28.5 billion but missed estimates by $200 million. The company attributed the shortfall to a weak European market and capacity constraints, as it struggles to keep pace with surging AI demand. These challenges coincide with recent service outages, including CrowdStrike’s software failure and a cyberattack yesterday, which will now lead to concerns about the company’s overall technical infrastructure.
• Microsoft is the third of the Magnificent 7 to disappoint investors this month, following in the footsteps of Alphabet and Tesla. Their bleak outlooks have contributed to a broader tech sell-off, as investors seek more attractive valuations in other equity sectors. The S&P 500 is down 0.7% so far this month, while the NASDAQ 100 has plummeted over 5%. Hardware companies have taken the brunt of the downturn as investor are not sure whether these stocks have any more room to grow from their current valuations.

• Four Magnificent 7 companies remain, and Nvidia’s August 28 report will serve as a crucial test for the AI rally. The chipmaker’s triple-digit revenue growth and earnings beat have made it the index’s sole standout. A disappointing result could dampen investor enthusiasm for AI and accelerate a market shift towards smaller companies, especially if the Fed maintains a dovish stance today. AMD’s recent earnings report, boasting strong sales and a bullish outlook, suggests sustained spending on AI chips. This could bode well for Nvidia given the similar landscape.

Hawkish BOJ: The Bank of Japan unexpectedly raised interest rates in a sign that the central bank is looking to normalize policy after decades of policy accommodation.

• The Bank of Japan (BOJ) has raised its benchmark interest rate to 0.25%, its highest level in over 25 years, from a previous target range of 0-0.1%. This move is intended to bolster the weakening yen (JPY) and stimulate economic growth by mitigating inflationary pressures from rising import costs. Additionally, the central bank revealed that it would gradually reduce its bond purchase program by half to 3 trillion JPY a month by early 2026, or the equivalent of about $20 billion.
• The Bank of Japan’s recent policy adjustments signal a determined effort to normalize monetary policy and strengthen the yen. Prior to its latest meeting, concerns mounted over Japan’s economic slowdown, with GDP failing to surpass its Q2 2023 peak. Governor Ueda defended the policy shift, arguing that a stronger yen could invigorate growth by fostering consumer confidence through stable import prices. Although Japan’s inflation rate has peaked, it remains a persistent issue. Headline CPI, which includes volatile energy and food costs, continues to exceed the 2% target, amplified by the impact of dollar-denominated commodities.

• Assuming interest rate expectations remain stable, the recent policy shift is likely to contribute to dollar weakness. The Bloomberg Dollar Spot Index has already fallen by 0.4% in response to the decision by the BOJ. We anticipate a convergence of US interest rates with those of other G7 nations over the coming months. This shifting interest rate environment is expected to exert downward pressure on the dollar initially, although other factors will increasingly influence the currency’s strength going forward, which include GDP growth expectations and capital flows.

In Other News: An Israeli strike on Beirut reportedly killed a top Hezbollah commander, signaling a potential escalation of tensions in the Middle East. Meanwhile, China’s manufacturing sector contracted for the third consecutive month as the country grapples with declining industrial output.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with new data on economic growth in the eurozone and the prospects for more interest-rate cuts by the European Central Bank. We next review several other international and US developments with the potential to affect the financial markets today, including emergency spending cuts to bring down the UK’s budget deficit and a preview of the Federal Reserve’s latest policy meeting, which starts today.

Eurozone: In an initial estimate, second-quarter gross domestic product rose by a seasonally adjusted 0.3%, beating the expected increase of 0.2% and matching the first-quarter growth rate. That translates to an annualized growth rate of only about 1.2% in each quarter, and the region’s GDP in the second quarter was up just 0.6% from the same period one year earlier. The figures do reflect a modest improvement in the eurozone’s economy in 2024, but they remain weak enough to suggest the European Central Bank will continue to cut interest rates.

United Kingdom: The new Labour Party chancellor, Rachel Reeves, yesterday revealed a series of emergency spending cuts to help plug what she called an undisclosed 22-billion GBP budget hole left by the previous Conservative Party government. The spending cuts include measures to end winter fuel subsidies for higher-income pensioners and eliminate outlays on roads and hospitals. The measures are being seen as a prelude to tax hikes in the next fiscal year budget, due to be released on October 30.

Japan: Global investors continue to brace for the Bank of Japan’s latest policy decision tomorrow. After the central bank ended its previous policy of negative interest rates in March, market indicators now suggest investors see about a 40% chance that the BOJ will lift its benchmark short-term interest rate further to 0.25%. It is also expected to release a plan for starting to unload its $3.8 trillion in Japanese government bond holdings (JGB). (See our preview of the Fed’s Wednesday policy decision below.)

• Amid investor anticipation of the BOJ’s rate hike and bond sales, the yen (JPY) has appreciated and JGBs have depreciated sharply so far this month.
• Since the JPY is used globally as a funding currency, the recent currency moves and investor repositioning has also fed an increase in volatility in global markets over recent weeks.

China: At the Communist Party’s latest Politburo meeting yesterday, top officials reportedly decided to implement aggressive new economic measures to boost China’s consumer spending and corporate investment. However, the announcement in state media offered few specifics.

• Any new measures would supplement the central bank’s interest-rate cuts last week and a range of other modest measures implemented earlier, such as easier rules for home purchases and subsidized appliance trade-in programs.
• All the same, General Secretary Xi and his top officials have shown little inclination to adopt the wide-ranging, consumer-oriented reforms that many economists believe are necessary to reignite Chinese growth. Going forward, we suspect Chinese economic growth will continue to be held back by factors such as weak consumer demand, excess capacity and high debt, poor demographics, disincentives from the Communist Party’s interventions in the markets, and decoupling by the West.

China-Philippines: Following a recent deal by Beijing and Manila, the Philippine military has reportedly carried out a resupply mission for the marines it has stationed on an old, grounded naval vessel in an area of the South China Sea claimed by both countries. According to Beijing, the Philippines allowed China to inspect the shipment beforehand, but Manila denies it gave up its sovereignty in such a manner.

• Given that Philippine President Ferdinand Marcos Jr., is so politically skilled and probably intent on avoiding a conflict, it would not be surprising if he has secretly shown some flexibility with the Chinese demands for control over the situation. (For an in-depth discussion of Marcos’s background and character, see our Bi-Weekly Geopolitical Report from July 22, 2024.) Indeed, Manila has admitted to an “exchange of information” with the Chinese prior to carrying out the mission.
• All the same, to the extent that Manila is willing to overtly or secretly bow to China’s demands, it could potentially be a sign that the Philippines has lost some faith in the strength of its alliance with the US and the US’s commitment to its defense. If that is true, and if the sentiment spreads among other US allies, it would reflect a worrisome weakening of the US alliance system in the Indo-Pacific region.

Russia: President Putin has reportedly signed a decree allowing military equipment designers to utilize foreign intellectual property without the owner’s consent, bypassing traditional patent protections. At one level, the move highlights Russia’s desperate attempt to catch up to Western technological advances as it faces greater sanctions over its invasion of Ukraine. The move also shows how Russia has become a rogue state that no longer operates under accepted economic rules, which will likely further cut it off from Western trade and capital.

North Korea: In a report to lawmakers yesterday, South Korea’s intelligence service reportedly said North Korean Supreme Leader Kim Jong-un has chosen his pre-teen daughter, Ju-ae, to be his eventual successor. According to the intelligence service, the younger Kim is being educated specifically to take over the reins of power, although there is still some chance that a sibling could displace her.

Venezuela: A day after President Maduro claimed he won a third term in office in the weekend election, mass protests have broken out in Caracas and other cities across the country. The US, the European Union, and several Latin American nations also criticized the apparently fraudulent outcome, prompting the Maduro government to sever diplomatic ties with Argentina, Chile, Costa Rica, Peru, Panama, Uruguay, and the Dominican Republic.

• As we noted in our Comment yesterday, the apparently fraudulent outcome is likely to further isolate Venezuela. It could also lead to a snap back of economic sanctions on the country, including on its energy sector.
• On top of that, the size of the popular protests suggests Maduro could also face rising internal dissent and increased political instability. That could further harm the Venezuelan economy and push even more of its citizens to emigrate, including to the US.

US Monetary Policy: The Fed today begins its latest two-day policy meeting, with its decision due tomorrow at 2:00 PM ET. Despite growing calls from some observers to start cutting interest rates now, the more likely course is for the officials to signal an initial cut in September. Recent data has certainly shown the economy is cooling and price pressures have fallen, but the officials still say they want to see more evidence that those changes will be sustained, despite a risk that continued high rates could spark an economic downturn.

US Energy Industry: British energy giant BP today said it will start drilling a new oilfield in the Gulf of Mexico. The move is a reminder that the Gulf remains an important energy resource, despite the prolific expansion of onshore shale fields in places like the Permian Basin over the last two decades. The move also shows that traditional energy resources can remain attractive in an era of policy preferences for renewable energy, tough regulation, and shareholder demands for cash returns.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with a quick note on the renewed risk of a wider war between Israel and Iran-backed militants in Gaza and southern Lebanon. We next review several other international and US developments with the potential to affect the financial markets today, including a potential trade deal that the European Union might offer to former President Trump if he is re-elected in November and a preview of the Federal Reserve’s upcoming policy meeting this week.

Israel-Hezbollah: A rocket apparently fired from Lebanon by Iran-backed Hezbollah militants struck a soccer field in the Golan Heights on Saturday, killing a dozen Israeli children and teenagers. In response, the Israeli military launched airstrikes against militant positions across Lebanon yesterday. The retaliatory strikes by the Israelis have the potential to widen the continuing Israel-Hamas conflict into a regional war with bigger economic and security consequences for the world, as has long been feared.

European Union-United States: According to the Financial Times, European Union officials are planning a two-step, carrot-and-stick response if former President Trump is re-elected in November and imposes minimum 10% tariffs against all imports. Under the plan, the EU would approach Trump even before inauguration day to explore which US products the EU could import more of in order to forestall Trump’s tariffs. If no deal is reached, the EU would retaliate with tariffs of 50% or more against some US goods.

• EU officials reportedly estimate the minimum 10% tariffs floated by Trump would reduce EU exports by around 150 billion EUR annually.
• The EU plan clearly draws lessons from the so-called “Phase I” trade deal that the US and China sealed under Trump in 2020. Under that deal, China was supposed to dramatically boost its imports of certain US products, but ultimately fell far short, with few US complaints from either Republicans or Democrats.

France: Interior Minister Gérald Darmanin today said far-left radicals could have been behind the big sabotage attacks that disrupted high-speed rail service last week on the opening day of the Olympic Games in Paris. However, he also noted that the perpetrators could have been acting on behalf of other entities, keeping alive the possibility that the sabotage was ultimately inspired by Russia or its allies.

United Kingdom: In an effort to finally stop the periodic strikes by junior physicians in the National Health Service, the new Labour government of Prime Minister Starmer has offered them a pay hike of 22% over two years. That would still fall short of the 35% raise sought by the doctors, but it is much richer than what the previous Conservative government was willing to offer. Clearly, price inflation and labor shortages still have the potential to spark labor unrest and pay demands, even though the global surge of strikes has cooled over the last year or so.

Venezuela: With four-fifths of voting stations counted in yesterday’s election, the national electoral authority said President Maduro won with 51.2% of the vote. The authority said Edmundo González, the main opposition candidate, garnered only 44.2% of the vote, despite media reports saying he enjoyed strong, widespread support. There were also reports of voter intimidation and irregularities. The disputed results are likely to further isolate the Venezuelan government and possibly lead to new US sanctions, including on the national energy industry.

United States-Japan: In a new sign that the US and its allies are prepping for a possible conflict with China sometime in the future, the Pentagon yesterday said it will upgrade US Forces Japan to a joint force headquarters with expanded missions and operational responsibilities. With the change, the US’s roughly 55,000 personnel in Japan will be led locally, potentially by a four-star commander, rather than from the Indo-Pacific Command in Hawaii.

• Separately, US Secretary of State Blinken and Secretary of Defense Austin met with the Japanese cabinet to discuss measures clarifying the circumstances in which US nuclear forces could be used to deter a threat to Japan, from China or North Korea, for example.
• The officials also discussed further defense industrial cooperation, including having Japanese factories produce advanced US missiles to help get around the US’s current capacity shortfalls at home. The two sides also already have an agreement for Japanese firms to provide maintenance and repair services for US navy ships and aircraft.

US Monetary Policy: The Fed’s policy committee holds its latest meeting this week, with its decision due on Wednesday at 2:00 PM ET. Despite growing calls from some observers to start cutting interest rates at this meeting, we think the more likely course is for the officials to signal an initial cut in September. Recent data has certainly revealed that the economy is cooling and price pressures have fallen, but the officials still say they want to see more evidence that those changes will be sustained, despite a risk that continued high rates could spark an economic downturn.

• As investors anticipate rate cuts starting this fall, new reports show they have been pouring cash into exchange-traded funds focused on bonds.
• The data indicates that flows into bond ETFs and mutual funds accounted for almost 90% of all net fund inflows in the US in the first half of the year.

US Commercial Real Estate Industry: Data from MSCI shows lender portfolios of foreclosed and seized office buildings, apartments and other commercial property jumped 13% in just the second quarter, to a value of $20.5 billion. That marked the highest level of seized properties since 2015 and suggests many lenders have finally given up on those property owners struggling with high interest rates, weak demand, and low occupancy rates.

US Property Insurance Industry: New reports from rating firm AM Best indicate that property insurers in the US suffered a total net underwriting loss (premiums minus claims) of $15.2 billion on their homeowner polices last year. That marked their worst underwriting loss since at least 2000. The analysis shows the big losses stemmed from the increasing frequency and severity of weather events, rapid price increases for building materials, more people moving to disaster-prone areas, and regulators’ slow approvals for premium increases.

US Cryptocurrency Industry: In a speech at a bitcoin conference on Saturday, former President Trump made a strong pitch for cryptocurrency supporters. If re-elected, Trump vowed to sack Securities and Exchange Commission leader Gary Gensler over his efforts to restrict cryptocurrency investments. He also promised to end the Biden administration’s “persecution” of the industry. Meanwhile, reports say Vice President Harris’s advisors have reached out to key cryptocurrency leaders in an effort to reset relations.

• The Trump and Harris overtures show each side recognizes that younger voters have a more favorable view of cryptocurrencies and want to see the industry succeed.
• This suggests that the SEC’s current resistance to the industry will likely be dismantled following the election, no matter who wins the White House.

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