by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! S&P 500 futures are off to a modest start. In sports news, Caitlin Clark broke the WNBA assist record. Today’s Comment will discuss the recent massive tech outage, the overperformance of small caps relative to large caps, and our thoughts on China’s Third Plenum. As usual, our report ends with a roundup of international and domestic economic releases.

Cybersecurity Concerns: A seemingly innocuous software update exposed serious vulnerabilities in our critical infrastructure.

• On Thursday, a massive tech outage caused IT systems around the world to shut down. The system failure impacted companies across many industries, including airlines, banks, and emergency services. The source of the disruption appears to be related to a system update by cybersecurity software company CrowdStrike. The company has since found a fix for the problem, and users of macOS and Linux were not affected. However, it is unclear when all systems will return to normal following the outage.
• Despite CrowdStrike’s assurances that the outage wasn’t caused by cyberwarfare, the event highlights vulnerabilities to cyberattacks. The recent surge in attacks, which picked up around 2020, has shown no signs of slowing down. The hacking of auto software provider CDK Global serves as a stark example of this growing threat. The global cost of cybercrime is expected to surge from $8.15 trillion in 2023 to over $13.8 trillion by 2028. The increase is likely to be shared by governments as they look to prepare for the new form of war that relies less on direct combat and more on sabotage.

• Building on our previous analysis, we expect US government spending to increase regardless of the outcome of the 2024 election. Although Republican presidential candidate Donald Trump has mentioned cuts to foreign aid if he wins, he has consistently advocated for improving US defense spending. We anticipate that his administration could reallocate funds to provide more support for the US Department of Homeland Security. Consequently, defense companies, particularly those specializing in cybersecurity, may have significant upside potential in the coming years.

Shifting Gears: Investors are moving into small caps as the market continues to price in the possibility of a rate cut in September.

• While the S&P 500 has declined 1.0% over the last five days, the S&P SmallCap 600 Index has risen nearly 3.0%. This shift into small-cap stocks reflects investors favoring smaller companies amid expectations of a Fed pivot. Since the Fed started hiking interest rates in March 2022, investors have sought refuge in large companies because of their profitability, pricing power, and ability to absorb large changes in interest rates. Now that it appears that those rates may be moving downwards, investors are ready to go bargain hunting.
• While our views on small caps are bearing out, our concerns now rest with the longevity of the rally. The strong correlation between the S&P 600 and 10-year Treasury rates in the second half of 2023 demonstrates that even though stocks rallied during the period of lower rates, they were unable to maintain momentum when rates reversed course. Therefore, while recent economic data has drawn investors back to small caps, their optimism likely hinges on the Fed maintaining a dovish stance on future rate policy in the form of multiple rate cuts this year.

• While monetary policy uncertainty due to high inflation presents challenges, small-cap stocks still offer attractive opportunities for investors. Our research consistently shows that value investing remains a long-term driver of performance. Since small caps boast lower P/E ratios compared to their mid- and large-cap counterparts, they possess significant upside potential relative to their peers. However, to mitigate risks, we recommend screening for quality factors like profitability, leverage, and solvency.

China’s New Way: The final day of the widely expected meeting ended with a thud as the final statement failed to reassure investors that the worst was behind.

• In short, Beijing plans to continue with its state-driven economic model that focuses on balancing economic development with domestic security. Notably, the statement maintains its ambitious 5% growth target and preference toward long-term investments in technology as it looks to make itself less dependent on the West for resources. There was also a mention of the need to ensure the long-term growth by addressing potential risks associated with the property sector, local government debt, and small and mid-sized financial institutions.
• The market’s reaction to the readout was negative, interpreting it as a sign of the government’s reluctance to intervene and stimulate growth. While China’s economy did manage a 4.7% year-over-year growth rate, this masks a concerning slowdown in domestic consumption. Retail sales have dipped modestly over the past few months and are on course to contract 1% by year-end. At the same time, consumer confidence remains near its pandemic lows, with ongoing market volatility leading households to prioritize saving over making discretionary purchases.

• China’s recent remarks solidify our belief that the nation will continue to grapple with several challenges, often referred to as the five D’s: weak consumer demand, excess capacity and high debt, poor demographics, economic disincentives from the Communist Party’s intervention in the markets, and Western decoupling from trade, technology, and capital flows. These factors will likely make it difficult to identify investment opportunities in China; however, a focus on companies that cater primarily to the domestic market and align with China’s strategic goal could have long-term benefits.

In Other News: Israel is considering transferring control of the Rafah border to the EU, in a sign that the conflict is close to coming to an end. An ECB survey suggests that investors are growing confident that rate setters could lower rates again in September. Also, Ursula von der Leyen easily secured a second term as president of the European Commission, further cementing centrist party control over European affairs[1].

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[1] Yesterday’s Comment mistakenly stated that von der Leyen was the president of the European Parliament.

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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 improved from yesterday following TSMC’s outlook. In sports news, Team USA crushed Serbia in an exhibition game, just 11 days before their Olympic opener. Today’s Comment dives into three key topics: the growing rivalry between the West and China over semiconductors, the market’s growing belief in a Federal Reserve policy shift, and the enduring power of centrist parties in the EU. We’ll also cover the usual roundup of international and domestic data releases.

Chip War to Trade War: Semiconductors are a flashpoint in the technological rivalry between the West and China, as both powers vie for supremacy in this critical industry.

• The US is looking for ways to undermine China’s semiconductor industry. Earlier this week, the Biden administration announced that it might implement the Foreign Direct Product Rule to prevent companies from selling chip-related technology to China. This rule allows the US to control foreign-made goods containing even minimal American technology. The clampdown is not only limited to sales, as the US has also pushed a top Dutch technical university into not accepting Chinese students.
• The European Union has also taken steps to counter China’s semiconductor industry. On Tuesday, it launched an anti-dumping investigation into imports of low-tech chips (also called legacy chips) from China. EU regulators suspect Beijing of unfairly undercutting prices to gain an advantage in the European automotive market. The investigation comes amidst concerns that China could use its overcapacity to flood foreign markets to the detriment of its competitors. The probe will likely open the door for tariffs, which is likely to further strain the EU trade relationship with Beijing.

• The US and Europe’s recent moves, though in early stages, signal a growing trend of coordinated action to counter rivals in the chip industry. This will likely intensify regulatory scrutiny for chip companies as Western regulators look to close ranks. While TSMC’s latest revenue outlook suggests that firms are confident that they can navigate these headwinds, investors may turn their focus to whether Nvidia can maintain its streak of exceeding earnings expectations. In general, the current lofty valuations of chip companies, especially when compared to peers, suggests that the market rally for chip companies may lose momentum over the coming months.

Fed Soft Landing Near? A potential rate cut appears more likely, with the latest Beige Book and Fed comments offering some dovish hints.

• The July 17  Beige Book, a summary of economic conditions across the Fed’s 12 districts, indicates a slowdown in the economy. According to the report, five districts are experiencing muted or declining economic activity, an increase of three compared to the previous report. This is likely to strengthen the Fed’s case that inflation is cooling, and that it should shift its focus toward protecting economic growth. On Wednesday, Richmond Fed President Thomas Barkin hinted that Fed officials may drop their assessment that inflation is elevated and suggested that a 25 bp cut may be inconsequential.
• Investors are betting heavily on a September rate cut, with the CME FedWatch Tool indicating a near-certain likelihood at 99%. However, the prospect of additional cuts remains unclear. While the latest economic projections suggest that the Fed will only cut its policy rate once this year, it appears that the estimate was heavily influenced by the acceleration in inflation in the first quarter. In contrast, traders project that the recent rise in the unemployment rate and persistent disinflationary pressures may persuade Fed officials to cut rates 2-3 times this year.

• There has been a significant shift in the expectations for rate cuts following the Fed’s hawkish turn at its June 11-12 meeting. The implied policy rate curve, which tracks expectations for up to three years ahead, now suggests that the Fed could lower rates to as low as 3.5% by 2026. This level implies policymakers are expected to bring interest rates down to a neutral zone, neither tightening nor loosening the economic grip. If this holds true, it suggests the market, despite recessionary fears, remains confident in a soft landing. This bodes well for value stocks, which should outperform in such a scenario.

European Centrists Fight On: As right-wing populists gain ground, European centrists still have the edge in gaining power.

• Today, the European Commission is set to hold a vote on who will lead as president. The front-runner appears to be current head Ursula von der Leyen, and there does not seem to be anyone standing in her way. However, because the vote is done in secret, it gives party members the ability to vote against party lines. She has attempted to mediate tensions by appealing across party lines and vowing to push prosperity and security throughout the bloc. She will need 361 of 720 votes to win another five-year term.
• Her potential victory would likely be viewed as a triumph for centrist parties after the recent parliamentary elections. Earlier this month, far-right parties saw a major increase in seats, with their share growing from 14.8% to 26.0%. However, they were unable to secure enough seats to take power. Recent elections in France also suggest that these groups are not necessarily making significant inroads domestically. Despite their growing influence, their lack of success suggests they will struggle to enact meaningful changes to European policies.

• That said, even though the far right doesn’t sit in the driver’s seat, they still have a hand on the wheel. This victory will likely give these groups a larger platform to voice their concerns, which could potentially lessen some of the anti-establishment resentment. Roberta Metsola’s landslide victory for president of the European People’s Party illustrates the continued dominance of centrist forces in the European Parliament. As a result, this could lead to a somewhat more favorable environment for investment in Europe, particularly since centrists seem likely to retain control.

In Other News: The Democratic National Convention’s decision to delay the procedural roll call for the party nominee is yet another indication that the party apparatus is losing confidence in President Biden’s ability to win in November. The European Central Bank opted to hold interest rates steady at its recent meeting, a cautious move reflecting its concern about lingering inflationary pressures. Meanwhile, UK Chancellor Rachel Reeves hinted at tough choices ahead, suggesting the country is gearing up for debt control measures.

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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 slow start as investors look for more confidence in the data. In sports news, the players of the American League were able to beat the National League in the MLB All-Star game. Today’s Comment starts with a summary of how former President Donald Trump and incumbent President Joe Biden are strategizing to win over supporters. We follow with discussions on the bitcoin and gold rivalry and the potential shift in US foreign policy. As always, the report concludes with a roundup of domestic and international news.

Political Re-Brand: Republican presidential candidate Donald Trump seems to be moving toward the center, while President Joe Biden has shifted further toward the left.

• During an interview with Bloomberg Businessweek, Trump outlined his vision for a second term. He made concessions such as allowing Fed Chair Jerome Powell to complete his term, despite previous reports suggesting he might challenge the Federal Reserve’s legal independence. Additionally, he is reportedly considering Jamie Dimon for Treasury Secretary, a position Dimon declined in 2016 but may be open to taking now that he is mulling retirement. Another newsworthy announcement was Trump’s expectations that his unreleased economic agenda would be implemented quickly after his victory.
• Meanwhile, President Biden has sought support from progressives as he looks to beat back calls to drop out of the election. In an effort to address concerns about inflation impacting everyday households, he unveiled a list of re-election promises on Tuesday. These include capping rent hikes for large landlords at no more than 5%, forgiving medical debt, and raising the minimum wage. Shelter prices and costs associated with healthcare have been significant drivers of inflation throughout his term, and these proposals aim to directly target those areas.

• Less than four months away from the election, betting markets show that former President Donald Trump has about a 67% chance of winning. These odds are likely to fluctuate in the coming months. While Trump’s current lead is significant, he may encounter resistance from his opponents, especially if Biden unexpectedly withdraws from the race. A major point of concern is Trump’s lack of a detailed economic plan, which is likely to make investors nervous given some of his positions. The uncertainty could introduce volatility into financial markets leading up to the November election.

New vs. Old School Hedges: Investor confidence in a potential Trump victory has driven a surge in gold and bitcoin prices over the past few days.

• Gold prices have skyrocketed 4% over the past week, while bitcoin has surged an even more impressive 12%. The surge in demand for these assets reflects investor concerns about the US Treasury’s safe-haven status. They fear the potential deregulation of cryptocurrencies and rising government spending, leading to ballooning deficits, could weaken the attractiveness of US dollar-denominated assets. Trump recently added to those concerns after he complained that the US dollar remains too strong compared to the Japanese yen (JPY) and Chinese yuan (CNY).
• A second Trump term is likely to ramp up the competition between precious metals and cryptocurrencies. Gold’s established reputation makes it a go-to for traditional investors, but younger generations are drawn to bitcoin’s potential. This digital asset’s allure stems partly from its innovative technology, which streamlines trading and purchases. However, its significant price swings raise concerns about its viability as a long-term store of value. As the chart illustrates, bitcoin’s volatility is roughly four times higher than gold’s, potentially making it a riskier option for long-term investment strategies.

• The coming years could see high-risk investors experiment with bitcoin, but for most, gold remains a more reliable choice. Central banks’ preference for gold diversification will likely bolster its value, especially as the world breaks into blocs. While bitcoin offers the potential for higher returns, its lower trading volume makes it a more volatile investment. We recommend gold for most investors due to its stability. However, bitcoin’s popularity may rise as the cryptocurrency market matures. Thorough research is essential before investors enter this market.

No More Mr. Nice Guy: The Republican populist wing appears to advocate a more transactional approach to foreign policy as it looks to pivot inward.

• There are growing signals that President Trump could dramatically shake up US foreign policy in his second term. In a letter to the European Council president, Hungarian Prime Minister Viktor Orbán claimed that if reelected, Trump would force Ukraine to accept a peace deal with Russia. The comment comes after Viktor Orbán held separate in-person meetings with Russian President Vladimir Putin and Trump earlier this month to discuss the matter. In that same vein, Trump also mentioned that Taiwan should pay the US for protection in a sign that he may not be willing to deter a Chinese invasion.
• The abrupt shift in stance regarding security assistance likely represents a significant reversal in American foreign policy. Traditionally, the US has advocated shielding allies from threats posed by Russia and China; however, now it appears that these countries will have to protect themselves. This newfound hesitation to provide security guarantees, specifically to smaller allies, comes amid growing anxieties that the US needs to do more to provide security domestically. This was shown as both Trump and his running mate J.D. Vance criticized US efforts to prioritize aid to foreign conflicts over securing the southern border.

• If Trump wins the office, one of the most intriguing developments will be how he handles defense spending. Although US defense spending is at an all-time high, its share of GDP has dramatically decreased from the levels seen during the late Cold War. That said, while we expect that he will likely favor less spending abroad, we remain confident that overall spending for national security will stay at current levels or could even increase. This is due to the US’s need to develop deterrents to foreign threats and enforce strict immigration policies. As a result, we believe that defense companies could perform well under his leadership.

In Other News: China’s suspension of nuclear arms talks with the US further strains their already tense relationship. Meanwhile, a ceasefire agreement remains elusive in the Israel-Hamas conflict, despite hints of willingness from both sides. Additionally, there are concerns in Japan that its intervention in currency markets is becoming less effective, in a sign that the central bank may be forced hike rates soon.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with a note on the recent plunge in global cotton prices, which has been driven by surging output in Brazil. We next review several other international and US developments with the potential to affect the financial markets today, including a major new tax reform in Turkey and a few words on US political developments.

Global Commodity Market: Global cotton prices have plunged to about $0.69 per pound so far in July, reaching their lowest levels since October 2020 and less than half their 10-year peak in May 2022. The decline largely reflects surging exports from top-producer Brazil, where low corn prices have pushed farmers to plant cotton instead. The drop in cotton prices will hurt farm incomes in other major cotton-producing countries, but it could also help boost margins for clothing manufacturers.

China: The Communist Party yesterday opened its latest “Third Plenum” meeting, which takes place every five years and often focuses on new economic reforms. Reports in state media say General Secretary Xi will use the meeting to push China’s “self-confidence and self-reliance,” in part by supporting the development of “new productive forces,” such as the increased production and export of advanced technologies like electric vehicles and solar panels.

South Korea: New polling shows 66% of South Koreans now support or strongly support their country developing its own nuclear weapons, up from 60% in a poll from last year. Prime Minister Han Duck-soo recently said the government isn’t in a position to develop nukes “for now,” but Seoul’s conservative mayor, Oh Se-hoon, who is seen as a likely presidential candidate in 2027, last week called for South Korea to go nuclear immediately.

• The developments are consistent with our view that rising geopolitical tensions and foreign doubts about US security commitments could spark a new nuclear arms race around the world.
• Our Bi-Weekly Geopolitical Report from February 12, 2024, provides a detailed discussion of this possibility.

France: As politicians keep jockeying for power after this month’s inconclusive parliamentary elections, the left-wing New Popular Front alliance that came in first is being riven by infighting. Its most radical faction, the far-left France Unbowed, has pulled out of the alliance’s negotiations on a candidate for prime minister after its leader, anti-capitalist firebrand Jean-Luc Mélenchon, was blocked by the Socialists.

• If the leftists within New Popular Front can’t agree on a candidate, it raises the chance that President Macron’s centrists could retain the prime minister’s post.
• That would likely be a relief to investors, as it would probably ensure at least some continuity with Macron’s pro-business policies, but the fractured nature of the new parliament would still leave French politics unstable in the near term.

Turkey: President Erdoğan’s government is reportedly prepping a major tax reform aimed at broadening the tax base, cooling economic growth, and helping reduce consumer price inflation. Among other measures, the reform would introduce a minimum corporate tax rate of 10% and toughen tax audits. The moves would complement last year’s hike in the value-added tax and cuts in fuel subsidies, as well as the central bank’s recent boost to interest rates. Those moves have yet to rein in Turkey’s big post-election surge in prices.

Canada: In a release yesterday, the Bank of Canada’s quarterly business-outlook survey showed many businesses expect softer demand and reduced cost pressures going forward. The survey results have increased expectations that the central bank will cut interest rates again at its policy meeting on July 24, despite recent data showing a re-acceleration in consumer price inflation in May. The renewed expectations for a rate cut have put pressure on the Canadian dollar, which is now trading at about 1.37 per greenback, a depreciation of 0.7% from one week ago.

US Politics: Former President Trump, the presumptive Republican nominee for president in the November elections, chose Senator J. D. Vance of Ohio as his running mate yesterday. Vance, who will turn 40 in August, is expected to shore up Trump’s support among younger white males, especially in the industrial Midwest, who are a critical group supporting Trump-style populism.

• The politically savvy move is likely to further cement expectations that Trump will win in November. It will also probably increase expectations that the Republicans will win added seats in the Senate and the House of Representatives.
• In turn, that will likely add to the revived “Trump trade,” which is reflected in falling bond prices, higher bond yields, increased prices for many equities, and stronger valuations for bitcoin and other cryptocurrencies.

US Monetary Policy: At an event in Washington yesterday, Fed Chair Powell said recent economic data “do add somewhat to confidence” that inflation will return to the Fed’s target after price pressures remained elevated earlier in the year. However, he declined to provide any hint as to when the monetary policymakers will start to cut interest rates. We continue to expect the Fed will start cutting rates at its September policy meeting, potentially following that with one more rate cut later in the year.

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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 aftermath of the attempted assassination of former President Trump, although we caution that it is still too early to really understand how the incident could affect US politics and policy. We next review several other international and US developments with the potential to affect the financial markets today, including more news about China’s worsening trade relations with the West and a note on the US apartment market.

US Politics: Law enforcement officials continue to investigate Saturday evening’s attempted assassination of former President Trump. At the same time, investors and commentators are trying to gauge the impact on November’s elections. At this early moment, a key consideration is whether the event will increase the probability of a Trump win in the presidential contest and the probability of Republican gains in the Senate and House of Representatives. Early signs suggest that the incident has, indeed, boosted support for Trump and the Republicans so far.

• For a time earlier this month, increased expectations for a Trump win prompted a clear “Trump trade” based on the idea that his policy proposals (such as less independence for the Federal Reserve, a dramatic hike in import tariffs, and tax cuts) would be inflationary. For example, those concerns temporarily pushed Treasury yields higher.
• Such concerns had diminished in the face of economic data pointing to moderating economic growth and lower inflation. Going forward, more such data could well continue to offset concerns about inflationary policies under a new Trump administration. All the same, we caution that these are early days in this crisis, and the full implications for investors are still to be seen.

China: New data today shows gross domestic product rose by a seasonally adjusted 0.7% in the second quarter, short of expectations and much weaker than the 1.5% gain in the first quarter. As a result, second-quarter GDP was up just 4.7% from the same period one year earlier, also short of expectations and weaker than the 5.3% increase in the year ended in the first quarter. Details in the data showed most of the growth in the second quarter came from new factory investment and exports, while weak consumer demand and residential investment pulled down growth.

• The expansion in factory investment and exports is consistent with the government’s plan to rekindle growth by supporting the production and foreign sales of advanced technology goods, such as electric vehicles and solar panels. However, a key problem with that strategy is that it is generating pushback and protectionist measures by countries fearful of having their domestic industries devastated by cheap Chinese goods.
• The continued weak economic data will keep alive hopes for added stimulus measures from the government.
• The weak figures will also likely inform the discussions at this week’s Third Plenum, in which top Communist Party officials will work on new long-range economic reforms.

China-Global Rare Earths Market: In one example of how excess Chinese production can drive down prices and undermine other countries’ producers, new data reveals that surging Chinese output has pushed the price of certain rare earth minerals down almost 20% this year. China already dominates the reserves, production, and refining of these minerals, which are important to the electrified economy of the future. A likely reason for China’s overproduction of them is to short-circuit the effort by Western countries to develop their own independent sources.

Canada-China: Canadian Deputy Prime Minister Freeland, who is also the country’s finance minister, warned for the first time that Ottawa may impose protectionist tariffs against a broad range of Chinese imports. Previewing the government’s upcoming consultation with businesses about potential tariffs on Chinese electric vehicles, Freeland forcefully argued that world leaders for too long have accepted the unfair trading advantages arising from China’s communist economy.

• Given Canada’s enormous trade relationship with the US, policymakers in Ottawa have a strong incentive to be aligned with US trading policies against China. The US is also likely pressuring Ottawa to ensure Chinese EVs don’t reach the US via Canada to skirt the new US tariffs against them.
• In any case, Freeland’s warning is another sign of how the US geopolitical and economic bloc is closing ranks and erecting broad new protectionist measures against Chinese exports. Of course, that will further worsen tensions between the West and China.

France: As politicians keep trying to form a government after no party gained a majority in the country’s recent parliamentary elections, the state financial watchdog Cour des Comptes has issued a report suggesting that continued big budget deficits and high debt have left the government “dangerously exposed” to a fresh economic crisis. The audit report warns that in the event of a new crisis, the government may not have the financial capacity to respond appropriately.

Italy: Prime Minister Meloni’s right-wing government said it will propose new legislation to bring small, modular nuclear reactors into the country’s energy mix, almost 35 years after Italy closed its last nuclear power plant. The new policy would complement Meloni’s moves to restrict the further development of solar power and other renewables. More broadly, the policy is another example of the increased interest in nuclear power around the world, which has driven up spot uranium prices.

US Apartment Industry: Although average renter eviction rates nationwide are now back down to their pre-pandemic levels, new data shows that the rates remain high in several cities in the Sunbelt and elsewhere that experienced a surge in population and rent rates. The high eviction rates suggest landlords may be coming to the end of their ability to keep hiking rents. If so, stabilizing rent rates could help hold down consumer price inflation in the coming months and quarters, helping convince the Federal Reserve to cut interest rates.

(Source: Wall Street Journal)

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equities are relatively muted as investors await earnings reports. In sports news, the USMNT is looking to hire Jürgen Klopp as head coach. Today’s Comment will begin with a discussion of the latest CPI report, then will explore why small caps are showing signs of life, and we will wrap up with a look at the challenges Russia faces in navigating a smooth exit from the war. As always, our report will include a roundup of international and domestic data releases.

Inflation Inflection Point? The cooler-than-expected CPI report fueled market optimism for a potential Fed rate cut in September.

• June marked the first time in nearly four years that inflation has dipped. Consumer prices fell 0.1% month-over-month, according to the Bureau of Labor Statistics. This slowdown brought the annual inflation rate down to 3.0% in June, a decrease from 3.3% in May. While energy prices led the monthly decline, the slowdown was more widespread. Core inflation, which excludes volatile food and energy, held steady at 0.1% for the month. However, annual core inflation slipped to 3.3%, a slight improvement from the previous month’s increase of 3.4%.
• The recent slowdown in price increases is likely to be welcomed by Federal Reserve officials. However, it may not be sufficient to prompt a rate cut at their next meeting. St. Louis Fed President Alberto Musalem commented that while the CPI data is encouraging, more evidence is needed before the central bank decides to lower interest rates. Financial markets seem to agree, pricing in only a 7% chance of a cut this month, but a much higher 94% chance by September. This cautious stance reflects concerns about overreacting to a single month of positive data.

• The coming months are critical for the Fed to build confidence in delivering multiple rate cuts this year. As the chart above shows, inflation has expanded at a slower pace than it has in the previous two years, with the latest reading falling below levels that were normal even prior to the pandemic. We will be paying particular attention to the shelter component. If it holds steady at June’s 0.2% pace or declines further, inflation is likely to continue its downward trend. This could lead to two rate cuts, with a possibility of even three.

Small Cap Has Its Moment: Thursday’s inflation surprise triggered a risk-on mood among investors, fueled by renewed confidence in a soft landing.

• Investors initially sought refuge in the S&P 500 after inflation data emerged. However, the trading day witnessed a significant rotation towards mid- and small-cap stocks. The large-cap index climbed as high as 1.0% midday but ultimately closed down 0.8%. Meanwhile, the S&P MidCap 400 and S&P SmallCap 600 indexes surged, gaining 2.45% and 3.31% respectively. Their strong outperformance relative to large cap was driven by investors looking for bargains as they prepare for the possibility of rate cuts.
• Our latest Bi-Weekly Asset Allocation Report underscores the potential for small-cap stocks to outperform in a scenario where interest rates are cut. This optimistic outlook hinges on two key factors. First, small-cap companies tend to hold a greater share of floating-rate debt, making them more responsive to interest rate reductions that directly translate to improved profitability. Second, the valuation gap between small and large caps has widened to near-historic levels. Historically, such a spread has triggered mean reversion, where undervalued assets experience a surge to close the gap.

• Momentum undeniably fueled returns in 2024, but value investing holds a proven track record for long-term outperformance. As the chart illustrates, value stocks recovered from an initial pandemic dip to become the strongest driver of returns compared to other factors. This trend should persist as long as the economy is not in recession, inflation approaches the 2% target, and the Fed implements multiple rate cuts over the next three years. While we’re confident in these conditions prevailing, a worsening geopolitical climate could disrupt this scenario.

Moscow’s Poker Face: While NATO continues to demonstrate its commitment to backing Ukraine’s war effort, Moscow may not be in a rush to end the conflict.

• NATO leaders solidified a united front at their summit on Thursday, emphasizing shared concerns over territorial disputes with China and Russia. The deepening Sino-Russian relations particularly alarmed the leaders, who viewed them as a potential challenge to the established international order. Discussions also addressed accusations of China’s covert support for Russia’s actions in Ukraine, despite Beijing’s claims of neutrality. Western leaders further warned China that its actions could force a choice between aligning with them or with Russia.
• Despite the West’s commitment to Ukraine, it appears that Moscow is in the fight for the long haul. Russia’s economy is performing well, as the country has mobilized to sustain its war efforts. The unemployment rate is at a 30-year low, and strong domestic consumption has pushed GDP growth, outpacing most countries within the eurozone. However, there does seem to be a problem under the surface. Russia’s historically heavy reliance on exporting commodities to Europe, now restricted by sanctions, could pose a significant long-term economic threat.

• While a desire to conclude the war might exist on both sides, ending the conflict in Ukraine appears immensely challenging. Rebuilding the country into a fully functioning state will be a long and arduous process, potentially taking decades. Even if Russia aimed to claim all or part of Ukraine, it’s unlikely they possess the resources or capacity to handle such a reconstruction alone. China’s own economic challenges also limit its ability to help in the transition. Faced with Western isolation and the immense challenges of rebuilding Ukraine, Russia is likely to adopt a more calculated approach in its search for an exit strategy.

Other news: President Biden failed to win over supporters after making several blunders during his speech at the NATO summit, raising the likelihood that he may be forced to drop out of the race. Also, US intelligence reportedly thwarted a Russian assassination attempt against the CEO of Rheinmetall, a major German arms supplier to Ukraine. This suggests Russia might be willing to escalate the conflict beyond Ukraine’s borders. Meanwhile, Saudi Arabia’s budget constraints have forced it to pause spending on some projects.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Please note: Due to the Fourth of July holiday, we will not publish a Daily Comment on Friday, July 5. We will resume publication on Monday, July 8. Have a Happy Fourth!

Our Comment today opens with some good news on the dangerous Chinese-Philippine tensions in the South China Sea. At last, the two sides have held talks aimed at diffusing the situation. We next review several other international and US developments with the potential to affect the financial markets today, including the latest on the French elections, a preview of tomorrow’s elections in the United Kingdom, and a new effort by the US government to block a proposed merger on competition concerns.

China-Philippines: Beijing and Manila yesterday held emergency talks aimed at reducing tensions over their conflicting territorial claims in the South China Sea. According to Philippine officials, the two sides made “substantial progress” in cooling the situation. However, the officials also stressed Manila’s intention to remain “relentless” in protecting its sovereignty over the disputed areas. With China emboldened by its recent activities in the area, that suggests to us that the situation remains dangerous.

European Union-China: According to insiders, the European Commission will soon propose scrapping its €150 threshold under which items can be imported duty free. The move will be aimed mostly at Chinese purveyors of cheap goods, such as Temu, AliExpress, and Shein. We suspect Beijing will see the move as another form of trade protectionism aimed against China, on top of the EU’s new tariffs against Chinese electric vehicles. As a result, the move could further worsen EU-China trade tensions.

• Cheap e-commerce imports into the EU below the duty-free threshold reportedly topped 2.3 billion items last year. They are on pace to double this year to about two deliveries per every household in the EU.
• Because of the EU’s subsidized postage rates, Chinese firms find it cost effective to export to the region, but the shipments impose a cost on the EU.

France: In their effort to deny the far-right National Rally (RN) a parliamentary majority in Sunday’s run-off elections, cooperating far-left and centrist parties pulled their weakest candidate from more than 200 constituencies where they otherwise would have split the anti-RN vote. In those districts, a single far-left or centrist candidate will now compete, increasing the odds of beating the RN candidate and keeping the far-right party from an outright majority.

• However, all signs suggest RN will still win the largest number of seats in parliament, which would give it unprecedented power in France.
• Besides, RN has now said it is open to forming a coalition government, which would help ensure it has increased influence in French government going forward.
• Another key risk is that France could end up with a “hung” parliament, in which no party or group of parties can form a majority. That would leave France in political limbo, potentially for a long time.

United Kingdom: In other European political news, Britain will hold parliamentary elections tomorrow, with the opposition Labour Party still looking set to win in a landslide. According to the latest polls, support for Labour remains about 20 percentage points above the support for the ruling Conservative Party.

• Even though Labour leader Sir Keir Starmer has managed to moderate the party’s past “tax, spend, and regulate” policies, investors are increasingly concerned about how they would be treated under a new government.
• Recent reports say rich Britons are already dumping stocks and real estate in anticipation that Labour will raise the capital gains tax.

Turkey: The June consumer price index was up 71.6% from the same month one year earlier. As bad as that was, the increase was less than expected, and it marked a welcome deceleration from the 75.5% rise in the year to May. The data also marked the first slowing in consumer price inflation in eight months, raising hopes that the government’s pivot away from President Erdogan’s unorthodox economic policies a year ago may finally be bearing fruit.

Jamaica: As noted in our weather section below, Hurricane Beryl continues to “barrel” through the Caribbean and is expected to hit or skirt Jamaica later this afternoon. After becoming the earliest-ever Category 5 storm, Beryl has now been downgraded to Category 4. Nevertheless, it has already caused extensive damage in Grenada and other Caribbean islands, and it could still cause extensive damage in Mexico later this week.

US Politics: Democratic lawmakers, party leaders, and donors are reportedly becoming increasingly angry at President Biden and the White House staff for not addressing their concerns about the president’s age and weak performance in his first debate against former President Trump in June. Now that several Democratic lawmakers have publicly called for Biden to give up his re-election bid, we see an increasing chance that the president could ultimately capitulate, prompting the Democrats to scramble to choose a replacement candidate.

• Ironically, Democratic leaders say the issue now is more about the White House stonewalling their demand for answers and lack of concern for the impact on congressional candidates, rather than the signs that Biden’s age is catching up to him.
• As we have noted previously, both Biden and Trump are old enough and have other issues that it would not be a surprise if either or both were not on the ballot by November. For now, the odds still seem to favor Trump in the election, but anything could still happen.

US Antitrust Policy: The Federal Trade Commission yesterday voted unanimously to file a lawsuit against mattress maker Tempur Sealy’s proposed acquisition of giant bedding retailer Mattress Firm. According to the FTC, the combination would allow Tempur Sealy to restrict rivals’ access to an important retail chain, allowing it to boost prices. The lawsuit shows how the FTC has become much more aggressive in challenging potentially anticompetitive behavior.

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