by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with our thoughts on a troubling new approach to providing aid to Ukraine that Western policymakers are now considering.  We next review a range of other international and US developments with the potential to affect the financial markets today, including further weak industrial data out of Germany and a few thoughts about what the troubles at New York Community Bancorp might mean for the broader US financial system.

Russia-Ukraine War:  With far-right, populist politicians in the US and Europe opposing more military aid to Ukraine as it tries to fight off Russia’s invasion, one thing we’ve been watching closely is a proposal to channel frozen Russian assets in the West to Ukraine’s war effort.  The latest iteration of the idea is a proposal to use the frozen Russian assets as collateral for new allied borrowing to fund additional assistance to Ukraine.  Officials say the idea is now the leading option to provide further aid to Kyiv.

• The new proposal clearly stems from a perspective that enabling Ukraine to keep fighting off the Russians is so important that it offsets any negative effects from such a policy. However, we suspect that using frozen Russian assets as collateral for Western borrowing would dramatically increase tensions between the evolving US geopolitical bloc and the China/Russia bloc.  When push comes to shove, there would be a high likelihood that Western borrowers would renege on such debt, allowing creditors to confiscate the assets.
• As we’ve written before, tensions between the US bloc and the China/Russia bloc are in a self-reinforcing spiral. Unilaterally pledging Russian assets to Western creditors would almost certainly prompt Beijing, Moscow, and other governments in the China/Russia bloc to further sever their financial ties with the West.
• In such a scenario, we think China, Russia, Iran, and other members of Beijing’s bloc would accelerate their efforts to exit the dollar system and sell off their dollar holdings.
• If the world disintegrates into competing geopolitical, economic, and financial blocs as we think, the loss of efficiency and market competition would likely boost consumer price inflation and inflation volatility, as well as interest rates and interest-rate volatility. As we’ve written before, such an outcome would be especially negative for fixed-income assets.  In contrast, equities and commodities would probably provide higher total returns going forward.

China-South China Sea:  Illustrating the increasingly belligerent attitudes of some Chinese strategists and academics, a new article by maritime strategy expert Wu Shicun calls for Beijing to stop relying on “restraint and forbearance” in its territorial disputes in the South China Sea.  Instead, Wu calls for China to “show our swords when necessary,” essentially declaring that Beijing should threaten military force to counter any pushback against its expansive territorial ambitions.

China:  Following Tuesday’s government directive for the “national team” of major financial firms to buy Chinese stocks in an effort to buoy the market, trading prices and volumes continue to surge today.  The benchmark CSI index of large, liquid stocks is now up more than 4% for the month, after falling some 6% in January.  Separately, General Secretary Xi has replaced the chief of the China Securities Regulatory Commission, further signaling his intent to buoy the market.

Japan:  Workers’ nominal cash earnings in December were up 1.0% year-over-year, in part reflecting strong year-end bonuses.  That was weaker than the expected rise of 1.4%, but analysts considered it sufficiently strong to support the Bank of Japan’s plan to soon exit its longstanding policy of negative interest rates.

Germany:  December industrial production fell by a seasonally adjusted 1.6%, several times worse than the expected decline and far worse than the revised fall of 0.2% in November.  With the decline in December, Germany’s industrial output has now fallen for seven straight months, leaving it down 6.9% year-over-year.  The declines largely reflect Europe’s current high interest rates and German policies that have crimped energy supplies.  Since Germany is Europe’s manufacturing powerhouse, its industrial decline is a big hurdle for the region’s economy.

Argentina:  Radical libertarian President Javier Milei and his La Libertad Avanza coalition have pulled their big, omnibus economic reform bill from the floor of the lower house of Congress after accusing opposition lawmakers of reneging on plans to approve the bill.  With opposition support, the bill was approved on a first reading last week, but now opposition lawmakers have been voting down key sections in the second reading.  Since Milei’s coalition only has a small number of seats, the voting calls into question his ability to push through the reform program.

United States-Guyana-Venezuela:  With the Venezuelan government continuing to threaten military force to seize more than half the territory of Guyana, the US this week committed to sell the Guyanese additional fixed-wing aircraft, helicopters, drones, and radar systems.  As of this writing, the dollar value of the deal has not yet been made public.

US Monetary Policy:  At an event yesterday, Cleveland FRB President Mester said the strong headline numbers in last week’s January employment report masked other signs of moderation in the data and wouldn’t derail the Fed’s plans to cut interest rates gradually over the course of 2024.  Mester said she supported the policymakers’ expectations to cut rates three times, leaving the benchmark fed funds rate at 4.50% to 4.75% by year’s end.

• We agree that the details in the January report showed more moderation than suggested by the massive gain of 353,000 in nonfarm payrolls or the year-over-year rise of 4.5% in seasonally adjusted average hourly earnings.
• For example, we note that the standard approach of using seasonally adjusted figures for year-over-year calculations is prone to distortion, since both the current month’s figure and the year-earlier figure could have bad adjustments. Where possible, we prefer to use non-seasonally adjusted data for year-over-year comparisons.
  • Our approach suggests average hourly earnings in January were up just 3.9% on the year, moderating from a rise of 4.3% in the year to December.
  • Using our approach, annual wage growth is now at its weakest since last May.
• In addition, the report showed that the average workweek plunged to just 34.1 hours in January, down from 34.3 hours in December and 34.4 hours in November.

US Banking System:  Following New York Community Bancorp’s announcement last week of a surprisingly large loss, and in the wake of a dramatic selloff of its shares, Moody’s yesterday cut the firm’s debt to junk status.  Moody’s now rates NYCB’s debt at Ba2, versus Baa3 previously.  Nevertheless, it currently appears that the bank’s problem is limited to profitability, rather than the falling bond values and deposit flight that marked the banking crisis last spring.  For now, that suggests the situation at NYCB does not portend another crisis like last year.

• After acquiring Signature Bank during last year’s crisis and a separate bank in 2022, NYCB surpassed the $100 billion in assets that require greater regulatory scrutiny and higher capital standards. NYCB had noted that working through those acquisitions would require it to shore up its balance sheet, and its recent loan write-offs appear to be part of that effort.
• At the same time, NYCB has reported that its deposits have been largely stable, down just 2% during the fourth quarter of 2023. Its share of insured deposits is also much higher than the banks that saw deposit flight last year.
• On the New York Stock Exchange yesterday, NYCB closed at $4.20 per share, down 22.2% for the day and approximately 60% from its level just before the announced loss. Other regional bank stocks were also down yesterday, but not nearly as sharply as NYCB.

US Housing Market:  While some private data providers say overall apartment rents have stabilized or have even started to fall, new analysis from Yardi Matrix suggests the reversal in rent inflation has been mostly in the luxury segment, where most of the new supply has come. While overall rent costs grew by just 0.3% in 2023, Yardi says rents for lower- and middle-tier apartments rose 2.0%.  Continued increases in apartment rents may be one reason President Biden is struggling to retain the support of working-class voters as he campaigns for re-election.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a considerable rebound in the Chinese stock market after the government implemented a number of strong support policies.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including more signs of pushback against climate stabilization policies in Europe and encouraging forecasts of U.S. consumer price inflation from a key international research group.

Chinese Stock Market:  The Chinese government today seems to have finally gotten some traction in its effort to boost the country’s sliding stock market.  Following a series of actions by the stock market regulator, the country’s $1.2-trillion sovereign wealth fund, and General Secretary Xi, stock indexes on the mainland and in Hong Kong have jumped sharply today.  Nevertheless, it isn’t clear whether the upward momentum will continue going forward, especially considering that earlier efforts weren’t effective.  Included in the moves today:

• The China Securities Regulatory Commission said it will “coordinate and guide various institutional investors” into the stock market to prop up values, including making it easier for the sovereign wealth fund to buy shares;
• The CSRC also advised listed firms to take stronger steps to ensure investor confidence and market stability, including conducting share buybacks, boosting major shareholders’ stakes, and declaring regular dividends;
• Following the CSRC’s statement, sovereign wealth fund unit Central Huijin Investment said it would buy more exchange-traded funds, expand its holdings, and take steps to ensure “the stable operation of the capital market”; and
• Finally, news reports today say Xi will soon meet with market regulators to discuss market conditions and recent policy moves, indicating he will pressure them to ensure the stock market keeps rebounding.

Chinese Military:  As a reminder that both geopolitical tensions and economic headwinds have been weighing on Chinese asset values, on Sunday the New York Times published a detailed article on China’s massive program to expand its strategic nuclear weapons arsenal, which we have described in our past writings. Based on previously unavailable documents, the article shows that General Secretary Xi ordered the expansion just 19 days after assuming power in 2012, saying China needed a major arsenal to truly be a Great Power.

• Now, the article says, Chinese military strategists are looking at how to use the arsenal not only to deter U.S. attacks, but also to bully other nations.
• As more Western policymakers and voters come to realize the aggressiveness of China’s military buildup, we think they will demand pushback against Beijing and even stronger efforts to rebuild Western defenses. Tensions between China and the West are therefore likely to keep deteriorating over time.
• We continue to believe that spiraling geopolitical tensions, along with China’s own structural economic challenges, will continue to weigh on Chinese assets going forward.

Australia:  The Reserve Bank of Australia has cut its forecasts for economic growth in 2024 and 2025, citing slower demand growth from China and the impact of its own interest-rate hikes.  The central bank now sees Australian gross domestic product rising just 1.4% in 2024, versus its previous forecast of 1.8%.  Nevertheless, like many other major central bank chiefs, RBA Governor Michele Bullock is resisting calls for aggressive rate cuts in the near future.

• It’s important to remember that central banks outside the U.S. may have even greater incentives to resist near-term rate cuts than the Fed does.
• If the Fed slow-walks its rate cuts as we expect, leaving U.S. rates relatively high, any country whose central bank cuts rates aggressively would risk a sharp depreciation in its currency, potentially fueling a rebound in consumer price inflation.

European Union:  Faced with massive farmer protests across the EU, the European Commission has scrapped plans to implement a 30% reduction in agricultural greenhouse gas emissions by 2040.  Scrapping the planned cut probably reflects EU officials’ concern that farmer anger over EU agricultural policies might fuel further political gains for far-right populist parties ahead of the European Parliament elections in June.

Germany:  Siegfried Russwurm, head of Germany’s biggest industry association, has slammed the government’s climate policies as “more dogmatic than any other country I know.”  He especially complained about the government’s decision to phase out nuclear energy and coal and switch to renewables, saying the decision has put German firms at a disadvantage to those in other industrialized countries.  Russwurm’s strong statement is further evidence of growing pushback against climate stabilization policies in Europe.

Turkey:  After the resignation of central bank chief Hafize Gaye Erkan on Friday, President Erdoğan has named Fatih Karahan to be her successor.  Karahan is a former economist at the U.S. Federal Reserve, as well as a former deputy governor at Turkey’s central bank.  Finance Minister Mehmet Şimşek praised Karahan for his experience and knowledge, but his appointment nevertheless may prompt concern that Erdoğan is backing away from the more orthodox economic policies he has pursued since his re-election.

Mexico:  Ahead of the presidential and legislative elections this summer, President Andrés Manuel López Obrador has proposed almost two dozen major constitutional amendments that would dismantle many of the good-governance and free-market reforms of recent decades.  Although the president’s Morena Party doesn’t currently hold enough seats in Congress to pass the changes, the proposal allows Morena to set the terms of debate for the coming campaign.  If Morena wins enough seats, it could then pass the changes later.  The proposals include:

• Reducing the size of Congress;
• Directly electing the Supreme Court;
• Dismantling an agency that enforces government transparency;
• Outlawing hydraulic fracturing (fracking) in oil and gas production; and
• Giving workers a pension equal to their final salary.

U.S. Monetary Policy:  The Organization for Economic Cooperation and Development issued new forecasts showing the U.S. should have the second-lowest rate of consumer price inflation among major developed countries in 2025, at 2.2%, and the lowest rate in 2025, at 2.0%.  According to the OECD, the good progress on U.S. inflation could allow the Federal Reserve to start cutting interest rates as early as the second quarter of 2024.

• Nevertheless, we still think investors are expecting the Fed to cut rates more aggressively than it really will. Following Chair Powell’s interview over the weekend, in which he basically said the same thing, stock and bond values fell sharply yesterday.
• With the Fed likely to take its time cutting interest rates, and with economic growth relatively weaker in many other large, developed countries, the dollar in recent days has appreciated sharply. The U.S. Dollar Index now stands at its highest level since early December, having risen approximately 4% over the last five weeks.

U.S. Weather:  Southern California today continues to be battered by torrential rains resulting in extensive flooding, mudslides, disrupted business activity, and property damage.  Portions of downtown Los Angeles have already received 9 inches of rain, and outlying areas have received even more, with the downpours expected to continue until Thursday.  Besides the potential for a noticeable hit to economic activity in the country’s most populous state, we’re also watching for any future increases in insurance rates or insurer withdrawals from the market.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an artificial-intelligence leader’s expectation for a future marked by national AI systems.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including signs that biotechnology will be a new source of friction between the U.S. and China and a range of news items related to migration policy in North America.

Global AI Industry:  Nelson Huang, chief executive of artificial-intelligence darling Nvidia, said in an interview last Thursday that countries around the world should build their own “sovereign AI infrastructure.”  According to Huang, a country’s data should be considered its own natural resource, so it should be collected, controlled, and refined within the country’s borders.

• Of course, Huang could simply be “talking his book,” in the sense that building national AI computing systems in each of the more than 200 countries of the world would vastly increase the demand for Nvidia’s AI semiconductors.
• On the other hand, his statement also reflects the growing sense that data is extremely valuable, and that it becomes even more valuable when used to train a powerful AI system. Who owns that data and who can capture its value will be increasingly important questions going forward, especially when one country’s government or companies try to capture and exploit data from another country.

United States-China:  Signaling that biological engineering will be another technology of contention between the U.S. and China, the House Select Committee on the Chinese Communist Party has introduced a bill that would ban any entity receiving federal funds from buying equipment or services from companies in “adversary countries,” most notably China.  Similar legislation has been introduced in the Senate.  The goal of the legislation is to protect the U.S. biotech industry’s competitiveness in genomic sequencing, medicine development, and the like.

• One key target of the legislation is Chinese genomic-sequencing giant BGI Group, which has spawned concern because of its global genomic data collection efforts, its obligation under Chinese law to transfer data to the country’s government if requested, and its apparent links to the Chinese military.
• As with other advanced technologies such as 5G telecommunications and computer chips, it appears that the U.S.-China rivalry is about to lead to new restrictions in biotech trade, investment, and technology flows. As with those other technologies, the new restrictions will likely have big impacts on Western biotech firms that compete against the Chinese, rely on Chinese equipment or services, or hope to sell to the Chinese market.
• Of course, the U.S. has also clamped down on trade, investment, and technology flows with China in traditional industries as well. After former President Trump imposed punitive 25% tariffs on Chinese steel imports and 10% on Chinese aluminum imports, the Biden administration surprisingly maintained those duties. Over the weekend, Trump said that if he is elected again, he would impose tariffs of more than 60% on imports from China.

Philippines-China:  Today’s riskiest international dispute may be the overlapping territorial claims of China and the Philippines over certain islands and shoals in the South China Sea.  Nevertheless, a Philippine supply ship on Saturday successfully delivered fresh provisions to a grounded Philippine navy ship that serves as an outpost on the Second Thomas Shoal.  Previously, Chinese coast guard and maritime militia vessels had tried to stop such resupply missions by using water cannons against the Philippine vessels or even ramming them.

• China’s efforts to stop the resupply missions are dangerous because accidentally sinking a Philippine vessel or killing Philippine sailors could theoretically bring into force the U.S.-Philippine mutual defense treaty, bringing the U.S. into direct confrontation with Chinese forces.
• China’s restraint this time around suggests it is looking to cool tensions, in large part because of the severe economic headwinds it is now facing.

China:  As Chinese stock values continue to slide amid the geopolitical tensions mentioned above and the country’s current economic headwinds, the China Securities Regulatory Commission today vowed that it will implement several measures designed to buoy prices.  The proposed measures include cracking down on illegal trading and channeling more medium- and long-term capital into the market.  Nevertheless, mainland stock indexes fell sharply again today, bringing their year-over-year losses to more than 20%.

Israel-Hamas Conflict:  In the other major conflict that threatens a broader war, the U.S. bombed dozens of sites on Friday run by Iranian and Iran-backed forces in Syria and Iraq, and then continued striking Iran-backed Houthi militant sites in Yemen over the weekend.  While the targeted militant groups have themselves conducted dozens of attacks on U.S. ships and troops in sympathy with the Hamas government in Gaza that is now subject to retaliatory strikes by Israel, the attacks are keeping alive the risk that the Israeli-Hamas conflict will expand regionally.

Canada:  Reacting to concern that legions of international students are driving up housing costs, Ottawa is imposing a 35% cut in the number of foreign undergraduate students it will grant visas to in 2024 and 2025.  The cap, which will not apply to students seeking masters or doctorate degrees, will reduce the number of foreign students in Canada by about 210,000.

El Salvador:  Crime fighting President Nayib Bukele handily won re-election yesterday, setting the stage for him to continue aggressively incarcerating criminal gang members and cutting off their ability to communicate with enforcers outside of prison.  Bukele’s policies have reportedly led to a significant reduction in violent crime and a resurgence of commerce in some areas.  That could encourage similar policies elsewhere in the region, reducing the incentive for Central Americans to go to the U.S.

U.S. Immigration Policy:  As we flagged in our Comment last week, leaders in the Senate yesterday released their big immigration-and-foreign-aid bill that aims to tighten immigration restrictions at the southern border in return for additional military aid to Ukraine and Israel.  However, Republicans in the House have already declared the legislation dead on arrival, putting in limbo both new steps to deal with the surge of migrants at the border and additional assistance to Ukraine and Israel.

U.S. Monetary Policy:  In a CBS interview yesterday, Federal Reserve Chair Powell said “almost all” of the members of the rate-setting Federal Open Market Committee supported cutting the benchmark fed funds interest rate three times in 2024, for a total cut of 75 basis points.  However, he also stressed that economic conditions could lead the policymakers to cut rates more or less than currently planned.  In any case, Powell’s statement was consistent with our view that bond investors expect more aggressive rate cuts than the Fed is likely to deliver.

U.S. Higher Education:  In a post-pandemic first for the Ivy League, Dartmouth University said it will reinstate a requirement that applicants provide SAT or ACT scores starting next year.  According to the university, the scores provide the best indication of how students will perform in their freshman year.  Currently, providing the scores is optional at the school.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities slumped and Treasury yields are up following a really strong jobs number. In other news, the GOAT of Formula One, Lewis Hamilton, will be joining the iconic Ferrari team next year. In today’s Comment we dive into Thursday’s tech earnings bonanza, explore the surging popularity of leveraged loans, and unpack recent central bank policy decisions. As always, we’ll include a roundup of global and domestic economic releases.

The Train Keeps Moving: Tech giants pleasantly surprised investors with earnings that exceeded expectations, and yet the duration of this upbeat trend remains uncertain.

• Meta (META, $457.50) basked in the afterglow of stellar financial results and notched its highest quarterly revenue in over two years while tripling profits through strategic cost-cutting. To amplify the joy, it announced its first-ever dividend and a whopping $50 billion share buyback, grabbing headlines and investor attention. This wasn’t the only good news in the tech world. Both Amazon (AMZN, $169.39) and Apple (AAPL, $180.32) delivered positive surprises. Yesterday’s earnings report showed that Amazon is solidifying its dominance in cloud computing, demonstrating its significant revenue potential, while Apple defied naysayers with strong iPhone sales, proving the device’s enduring appeal.
• Despite continued strong financial performance, tech firms are facing significant headwinds from geopolitical and regulatory risks. The slowdown in China, a key growth market, will likely impact overseas profits, as Apple’s recent sales outlook demonstrates. Additionally, growing concerns about tech giants’ influence and limited accountability are fueling regulatory scrutiny. Lawmakers like Missouri Senator Josh Hawley have publicly criticized platforms like Facebook for failing to adequately protect children from harmful content. The growing adoption of AI by tech companies is raising concerns among governments who are looking for ways to mitigate potential risks to the public.

• Tech stocks currently outperform the market, but questions linger about the sustainability of their growth. The average P/E ratio of 38, while lower than the dotcom bubble peak, is still significantly higher than historical market averages, raising concerns about future valuations. Meeting current market expectations would require unprecedented revenue growth. Additionally, regulatory hurdles pose a major potential challenge. While navigating these hurdles successfully won’t guarantee smooth sailing, failing to do so could significantly impact performance and valuations. As a result, we still believe that investors could probably find better value in other places in the market.

Debt Wall Solution? As concerns rise about large amounts of maturing debt, companies are exploring options to restructure their obligations and avoid default.

• As companies grapple with maturing debt, many are turning to private credit funds for relief, seeking lower interest rates or longer maturities. Leveraged loans offer a potential solution, allowing them to refinance existing debt with lien debt. However, this comes at the cost of potentially higher interest rates and the risk of asset seizure in case of default. While this trend offers relief from elevated interest rates, it also raises concerns about potential risks to the broader market if economic conditions worsened.
• The record-breaking issuance of U.S. leveraged loans in January ($140.1 billion) highlights the growing global appeal of this financing option, while European debt issuance in this category surged by 20.1% in 2023. This increase in issuance reflects companies seeking to manage their existing debt in a challenging economic environment, but also raises concerns about increased refinancing risk for borrowers with higher risk profiles. Notably, refinancing activity reached a record high of $50.4 billion, while repricing (renegotiating loan terms) reached $78.7 billion, suggesting a strong focus on reducing debt payments through various strategies.

• Leveraged loans offer a double-edged sword in tackling the debt maturity wall. While they can ease debt pressure and potentially mitigate the broader economic impact of rising interest rates, concerns linger about their long-term stability. This stems from the subjective valuation of underlying collateral, particularly for loans backed by volatile assets like commercial real estate. The opaqueness of private credit funds, where some of these loans reside, further complicates matters, making it difficult for investors to conduct thorough due diligence. However, if the economy remains strong and default rates stay low, these loans may not pose a systemic risk.

The Dust Settles: With central banks in the U.S., Europe, and Japan all signaling that rates are unlikely to change, the market awaits the exact timing, which remains anyone’s guess.

• All G-7 rate-setting bodies opted to maintain their policy rates during their most recent meetings, affirming to the markets that they are embarking on a new phase of the monetary cycle. Among the four major central banks announcing their decisions, the Bank of Japan stood out as the sole institution contemplating a rate hike. Meanwhile, all the other institutions have signaled that interest rates will be cut sometime this year but likely not as soon as the market anticipates.
• Interest rate uncertainty could deter institutional investors from re-entering the stock market, despite the S&P 500’s current proximity to all-time highs. Bank of America strategist Jill Carey Hall’s research shows that institutional investors recently sold the most U.S. equities in nearly a decade, suggesting a shift towards safer assets due to economic uncertainty. The outflows were recorded in seven out of the 11 sectors, predominantly driven by sales in Technology, Consumer Discretionary, and Consumer Staples. This reluctance likely stems from a fear of being caught off guard if central banks reverse course on interest rates.

• Elevated interest rates may keep a significant amount of money parked in low-risk investments, but it could act as a potential tailwind for riskier assets once central banks start easing interest rates. This is evidenced by the record-breaking $6 trillion in U.S. money market assets. Although small and mid-cap stocks have not been able to grab headlines, these companies may be an attractive target for investors looking for a bargain. Valuations suggest that these firms provide investors with a lot of upside when risk sentiment changes.

Other News:  Fed Chair Jerome Powell will appear on 60 Minutes on Sunday, sparking speculation that he may aim to clarify recent remarks interpreted by the market in unexpected ways, or possibly to address concerns about the overall health of the financial system. Tensions are rising between China and the Philippines after Beijing criticized the latter’s congratulatory message to Taiwan’s newly elected president. This incident highlights China’s growing influence and its sensitivity towards its neighbors’ formal interactions with Taiwan. Hungary is looking to play ball with the West after finally approving an aid package for Ukraine and possibly approving Sweden’s NATO bid.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities are unfazed by Powell’s remarks this morning, while Caitlin Clark continues her dominant run in women’s college basketball. Today’s Comment dives into the latest Fed rate decision, explores renewed concerns about regional lenders, and examines the potential impact of China’s overcapacity on other nations. As always, we’ll wrap up with a summary of key international and domestic data releases.

Mission Not Accomplished: The Federal Reserve dashed hopes for a March rate cut, sending stocks plummeting and lifting bond yields from their intraday lows yesterday as investors recalibrated their expectations.

• The Federal Open Market Committee (FOMC) kept its benchmark interest rate unchanged at 5.25%-5.50% in its January meeting. While the decision was largely expected, the accompanying statement and Chair Powell’s comments offered valuable insights into the Fed’s future plans. The FOMC statement notably dropped any mention of further rate hikes and instead mentioned that it would consider “any adjustments” to its key policy rate. Chair Powell elaborated during the press conference, expressing the committee’s confidence in the trajectory of inflation toward the 2% target. However, he emphasized the necessity for additional evidence before contemplating rate cuts, suggesting such measures are unlikely to materialize by March.
• Stronger-than-expected economic data, including a robust December jobs report and resilient consumer spending, could be behind the Federal Reserve’s decision to delay rate cuts. The December jobs report smashed expectations, with the economy adding 216,000 jobs and far exceeding the forecast of 170,000. Additionally, personal consumption remains a key driver of GDP, with December discretionary spending accelerating from 6.2% to 6.5%, significantly outpacing the 10-year average of 5.0%. Despite robust data, inflation has remained largely unaffected, prompting some members of the committee to express concerns about economic conditions that could potentially hinder the attainment of the 2% inflation mandate.

• The Federal Reserve is expected to closely scrutinize economic data over the next few months, searching for signs that could justify a policy shift. Two key inflation and employment reports will be released before the Fed’s next meeting, and the upcoming revisions to the Consumer Price Index (CPI) on February 9 could provide further clarity on the central bank’s progress against inflation. While the Fed has ruled out interest rate cuts in March, a policy pivot within the first half of the year remains a possibility. The latest CME FedWatch Tool shows that there is a 90% chance that policymakers will vote to cut interest rates in May.

Regional Bank Worries? The surprise earnings loss reported by New York Community Bancorp fueled fears of instability in the U.S. financial system amidst fresh concerns about the U.S. commercial real estate market.

• Fourth-quarter earnings at New York Community Bancorp (NYCB, $6.47) sent shockwaves through the market with a staggering $252 million loss, primarily driven by loan losses. The bank was forced to slash its dividend by 70% and scrambled to bolster its capital reserves to comply with stricter regulations imposed on larger institutions. This news sent the stock price plummeting 37%, while the broader KBW regional bank index dipped 6% as investors feared similar challenges across the industry. The bank’s weak performance comes just under a year after its acquisition of New York Signature Bank, which ultimately collapsed due to deposit flight driven by the failure of Silicon Valley Bank.
• NYCB’s news ignited an initial sell-off, but deeper anxieties linger regarding broader financial health. Falling inflation has pushed real interest rates to their highest levels since the pandemic, squeezing banks’ margins as they compete to retain deposits with attractive rates. While deposit flight has subsided since March, fears persist that savers may flee to higher-yielding money market accounts if rates remain elevated. The Federal Reserve’s bank term lending facility, which addressed the deposit run problem in the short term, is scheduled to end in March, thus raising concerns about potential economic challenges if broader policy changes are not implemented.

• The Federal Open Market Committee (FOMC) omitted its prior statement about the banking system being “sound and resilient,” which raises concerns that policymakers are increasingly worried about financial conditions when compared to the previous meeting. While the impact of NYCB’s news on FOMC discussions surrounding the banking system remains unclear due to the absence of questions on the topic during Powell’s Q&A, his suggestion of initiating discussions on balance sheet reduction in March indicates potential measures to address liquidity risk. However, the specific form this reduction will take — whether tapering quantitative tightening or complete cessation — is yet to be determined.
• The fallout from NYCB spread to other banks around the world with Tokyo-based Aozora Bank and German bank DeustchBank both reporting losses on loans on U.S. commercial properties. Such issues in real estate could likely put more pressure on central bankers to loosen monetary policy.

 China’s Economic Fallout: There are fears that China’s economic slowdown could have spillover effects on the global economy, according to a business lobby group.

• The American Chamber of Commerce in China (AmCham China) sounded the alarm on persistent overcapacity woes, warning that Beijing’s credit shift from real estate to manufacturing could exacerbate the problem. This policy change, they say, raises the specter of “dumping” lower-priced goods into global markets, especially in strategically important sectors like electric vehicles. The report coincides with growing concerns that China might resort to increased state lending and industrial subsidies to prop up its flagging manufacturing sector.
• A potential glut of Chinese goods in the global market threatens to reignite Western concerns about unfair trade practices. The European Union is actively exploring measures to curb the influx of Chinese electric vehicles (EVs) within its borders, while the U.S. is pressuring companies to diversify their reliance on Chinese-made legacy chips for their devices. Pivoting exports towards developing countries within the Belt and Road Initiative might seem like a solution for China’s overcapacity woes, but the viability of this option is questionable. The global economic slowdown is expected to disproportionately impact these very countries, limiting their capacity to absorb significant amounts of additional imports.

• China’s bloated industrial capacity and escalating trade protectionism cast a long shadow over its fight against deindustrialization. Despite impressive recent growth, the country lacks concrete measures to unleash domestic consumption, a critical step needed to stabilize internal demand for its manufactured goods. Unfavorable demographic trends have further exacerbated this challenge and dampened consumption potential. While China’s economic resilience is undeniable, a strategic shift is necessary to navigate this complex crossroads and ensure sustainable, long-term growth.

Other News: The U.S. continues launching strikes against Houthi rebels in Yemen, escalating tensions in the region amid preparations for a response to the Jordan drone attack that killed three American service members. This escalating conflict in the Red Sea raises concerns about the potential for a broader war in the Middle East. U.S. regulators have targeted Chinese chipmakers over concerns that they aided AI firms with ties to the Chinese military. This crackdown on chip manufacturers reflects the intensifying competition between the two economic giants for dominance in the field of artificial intelligence.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the latest on the tensions in the Middle East, which still could expand into a broader regional conflict and disrupt key global oil supplies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more indications of weak Chinese economic growth and a preview of key U.S. monetary and fiscal policy announcements due out today.

Israel-Hamas Conflict:  Kataib Hezbollah, the Iran-backed militant group thought to be responsible for this week’s drone attack on U.S. forces in Jordan that killed three Americans, said yesterday that it will temporarily halt further attacks on the U.S.  Nevertheless, U.S. military officials said the announcement would not stop a planned retaliatory strike against the group, and President Biden said he has already decided how that strike will be carried out.

• Kataib Hezbollah’s stand-down could well reflect pressure from Iranian officials, who likely fear a U.S. strike and the prospect that the conflict sparked by the Hamas attacks on Israel on October 7 could expand to a regional war.
• Separately, Israeli forces continue their military operations against Hamas in Gaza; Prime Minister Netanyahu is still considering what kind of government should rule the territory when the fighting is over. Netanyahu remains under pressure from right-wing members of his governing coalition to eventually push Palestinians out of Gaza — a move that would likely be criticized around the world as ethnic cleansing and potentially spark further sympathy attacks by militant groups.
• In sum, the conflict remains a major source of global instability, especially if it widens and more seriously disrupts Middle Eastern energy supplies or Asian-European shipping.

China:  The National Bureau of Statistics said its January purchasing managers’ index for manufacturing rose to a seasonally adjusted 49.2, improving slightly from the December reading of 49.0.  The January PMI for services and construction rose to 50.7 from 50.4.  As with most major PMIs, the official Chinese gauge is designed so that readings over 50 indicate expanding activity.  At their current levels, the Chinese PMIs reflect the strong headwinds that are holding down growth, especially in manufacturing.

• Separately, the slowdown in Chinese growth continues to manifest itself in falling prices for Chinese real estate and stocks. Naturally, weak pricing in those two areas has forced Chinese investors to scramble for other ways to protect or build wealth.
• Recent reports indicate many Chinese investors have piled into domestic funds that invest in the U.S. or Japan. Those funds have recently provided good returns to the Chinese investors that own them, offsetting their losses from Chinese assets.
• Now, new data from the World Gold Council shows Chinese investors have also turned to buying gold as a way to protect themselves. Along with “blistering” demand from the world’s central banks, the WGC says strong Chinese purchases of gold jewelry and investment products were a key factor driving up gold prices in 2023.
• Based on our desire to hedge against today’s rising geopolitical risks and take advantage of the rising global demand for gold, we maintained our positions in the yellow metal across all our asset-allocation portfolios during our adjustments for the first quarter.

Hong Kong:  The municipal government has released a summary of the new national security law that it intends to add to its mini-constitution this year.  The proposed law, which is subject to popular discussion for 30 days, is intended to supplement the national security law imposed by Beijing in 2019.  Observers have already raised concerns about its provisions against sedition and the release of state secrets.  If passed, the law would likely further discourage foreign investment and travel to Hong Kong.

European Union-Russia:  The European Parliament has launched an investigation into allegations that Latvian lawmaker Tatjana Ždanoka has been spying for Russia for years.  The allegations were first published in a Russian investigative newspaper.  Ždanoka was one of just a dozen or so European Parliament lawmakers who voted against a resolution condemning Russia’s invasion of Ukraine in March 2022.

European Union-Mercosur:  French officials yesterday said the European Commission has stopped negotiating over a free-trade agreement between the EU and Mercosur, a trade bloc consisting of Brazil, Argentina, Uruguay, and Paraguay.  If true, it appears Brussels has caved to protesting farmers in France and elsewhere in the EU, who fear a surge of cheap South American food imports, despite the promise of greater EU industrial exports.  The end of talks over the deal also illustrates how politics has swung against free trade throughout the developed countries.

Eurozone:  French consumer prices in January were up just 3.4% from the same month one year earlier, compared with 4.1% in the year to December.  The good figures on price inflation have kindled new hopes that the European Central Bank could soon start to cut interest rates.  However, in an interview last night, ECB chief Lagarde warned that the monetary policymakers still want to see more data confirming that price pressures are easing.  Lagarde specifically cited a need to see easing wage growth.

U.S. Monetary Policy:  The Fed wraps up its latest policy meeting today, with its decision due at 2:00 PM EST.  The officials are expected to leave the benchmark fed funds interest-rate target unchanged at its current range of 5.25% to 5.50%.  Investors will focus on the decision statement and Chair Powell’s press conference, either of which could provide clues as to when the Fed will finally start cutting rates and reducing its balance sheet runoff.  Many investors expect those moves as early as March, but we continue to think they’ll come a bit later than that.

U.S. Fiscal Policy:  Today, the Treasury Department will release its borrowing plan for the coming quarter, including its planned debt issuance by maturity.  The quarterly refunding plan has recently been a market mover, and investors will be watching closely for any major change in the Treasury’s issuance of short-term obligations versus longer-term maturities.  If the plan shows larger-than-expected issuance of longer-term debt, it will likely drive down Treasury prices, boost yields, and potentially weigh on risk asset values as well.

U.S. Immigration Politics:  After Republicans in Congress pushed President Biden to accept tighter limits on immigration in return for new military aid to Ukraine, former President Trump has scuttled the deal to avoid giving Biden a win in the run-up to the election in November.  Meanwhile, Republicans on the House Homeland Security Committee have pushed through a measure calling for the impeachment of Homeland Security Secretary Mayorkas for failing to enforce the national immigration laws and stop the recent surge of illegal border crossings.

• The tussling over border policy signals that immigration reform and border security will be a big part of the presidential campaign leading up to November.
• Given that polling suggests voters are more supportive of the Republicans’ tougher restrictions, it’s probably no surprise that Biden tacked to the right on border security in his effort to win support for more aid to Ukraine. Now that the Republicans have apparently decided not to accept the win, a key question is whether voters will punish them for playing politics with an issue they previously called essential to national security.

U.S. Defense Industry:  As countries around the world work to rebuild their armed forces in response to worsening geopolitical challenges, new data shows U.S. defense companies recorded $81 billion in new foreign military sales in 2023, up 56% from 2022.  The figures are consistent with our view that increased geopolitical tensions have set the stage for years of increased sales and profits for traditional defense contractors and other industrial or technology firms producing defense-related goods and services.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a couple of notes on global oil supplies, including reduced capacity investment in Saudi Arabia but a new supply discovery in China.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, such as new data confirming Europe’s slow economic growth and a preview of key U.S. monetary and fiscal policy decisions due this week.

Global Oil Industry:  In Saudi Arabia, state-owned Saudi Aramco (2223.SR, SAR, 144.40) said it will comply with a request from the energy ministry to suspend a planned investment program that would have expanded its maximum sustainable production capacity from 12 million barrels per day to 13 million bpd by 2027.

• The energy ministry didn’t provide an explanation for its move, but other big oil producers in recent years have cut back investment because of profitability concerns and fears of falling future demand associated with the transition to green energy.
• Saudi Arabia and its OPEC+ partners have also been holding down current output in an effort to boost prices amid weakening global demand. Therefore, the energy ministry’s decision to limit new capacity investment could aim to help raise concerns about future supplies, thereby helping to boost prices.

China Oil Industry:  Officials yesterday announced the discovery of a large new oil field in central Henan province, saying the field could hold up to 732 million barrels of light crude.  That volume alone would amount to more than half of China’s current annual oil production.  The field, therefore, could help replace declining output elsewhere and modestly help reduce China’s dependence on foreign energy supplies, although the available volume probably isn’t enough to have a significant impact on global prices.

China Stock Market:  In yet another move to support China’s flagging stock market, the Chinese Securities Regulatory Commission and both major stock markets yesterday said strategic investors would be prohibited from lending out shares for short selling during specific lock-out periods.  The modest measure isn’t likely to help the stock market very much, but the drumbeat of new efforts to buoy the market show that the government is intent on at least arresting its recent decline.

China Military:  The Chinese People’s Political Consultative Conference has removed another high-ranking military official associated with missile development, meaning at least 16 such officials are now being investigated or disciplined for corruption or espionage.  As we’ve noted previously, the continued chaos surrounding the People’s Liberation Army Rocket Forces has likely unsettled General Secretary Xi, although we don’t necessarily subscribe to the theory that it has reduced Xi’s willingness to use military force if needed.

EU Regulation:  Amazon (AMZN, $161.26) and robotic vacuum maker iRobot (IRBT, $15.50) called off their proposed merger yesterday, largely because of pushback from antitrust regulators in the European Union and the U.K.  The deal’s scuttling shows how European officials have become much more aggressive than their U.S. counterparts when it comes to ensuring free-market competition and combating market concentration.  Going forward, large U.S. firms hoping to combine will probably continue to face high antitrust hurdles in the region.

EU Economic Growth:  The EU’s gross domestic product in the fourth quarter of 2023 was unchanged after a modest decline in the third quarter.  As a result, the region’s GDP in all of 2023 was up just 0.5%, much weaker than the U.S.’s growth of 2.5%.  The EU economy continues to struggle with elevated interest rates, high energy prices because of Russia’s invasion of Ukraine, and now broader supply disruptions because of the conflict in the Middle East.  As a result, EU stock values rose much less than U.S. stock values in 2023.

Germany:  A panel of outside advisors today issued a report saying the country’s constitutional “debt brake” is too rigid and should be broadly reformed to allow for more future-oriented fiscal spending.  Implemented in 2016, the rule limits the country’s structural budget deficit to 0.35% of GDP, adjusted for the economic cycle.  It was suspended at the outset of the COVID-19 pandemic, but it has nevertheless been criticized by left-wing and centrist politicians for slowing growth-enhancing public investment in infrastructure and green technology.

U.S. Monetary Policy:  The Fed today begins its latest policy meeting, with its decision due tomorrow at 2:00 PM EST.  The policymakers are widely expected to leave the benchmark fed funds interest-rate target unchanged at its current range of 5.25% to 5.50%.  We think investors will be focusing on the decision statement and Chair Powell’s press conference, either of which could provide clues as to when the Fed will finally start cutting rates and reducing its balance sheet runoff.  Many investors expect those moves as early as March, but we continue to think they’ll come a bit later than that.

• Separately, Elizabeth Warren and three other Democratic senators wrote a letter to Chair Powell over the weekend urging him to cut the current “astronomical rates” in order to bring down housing costs.
• Without doubt, the policymakers at the Fed are feeling a lot of political pressure to cut rates these days. Importantly, they’re likely feeling pressure from the Biden administration and from former President Trump, as well as Warren and her Democratic colleagues.  Nevertheless, we still believe Powell will try to delay easing policy a bit longer than investors currently expect in order to be sure inflation pressure is under control.

U.S. Fiscal Policy:  The Treasury Department will release its borrowing plan tomorrow for the coming quarter, including its planned debt issuance by maturity.  The quarterly refunding plan has recently been a market mover, and investors will be watching closely for any major change in the Treasury’s issuance of short-term obligations versus longer-term maturities.  If the plan shows larger-than-expected issuance of longer-term debt, it will likely drive down Treasury prices, boost yields, and potentially weigh on risk asset values as well.

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