by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equity markets are off to a sluggish start as investors await Friday’s inflation data. In sports news, the Atlanta Hawks chose Zaccharie Risacher with the first overall pick in the NBA draft. Today’s Comment will delve into the impact that immigration may have on monetary policy, our thoughts on the latest Fed stress tests, and a summary of the attempted coup in Bolivia. As usual, our report includes a roundup of international and domestic data releases.

The Immigration Conundrum: Foreign workers have played a pivotal role in filling job vacancies and easing inflationary pressures; however, the broader public wants fewer of them.

• Switzerland is set to address immigration concerns through a constitutional amendment that would require government action if the number of permanent residents surpasses 9.5 million. It would also impose a cap of 10 million on the total number of permanent residents. This vote coincides with Switzerland’s negotiations for an updated agreement with the European Union, where disagreements over wages and immigration persist. Businesses, especially in hospitality, share these concerns, highlighting their reliance on foreign workers to fill vacancies. The sentiment reflects a broader trend of rising skepticism towards immigration in Western countries.
• The debate over immigration intensifies as central bankers grapple with the pandemic’s impact on labor markets and inflation. A recent report by French economist Olivier Blanchard and former Fed Chair Ben Bernanke warns that persistent wage pressures — a key driver of inflation — are making it difficult for central banks to achieve their goals. Immigration has offered some relief by easing labor shortages. However, policy changes could undermine this progress, potentially forcing central banks to take stronger measures like rate hikes. As Fed Governor Michelle Bowman noted, stricter immigration policies could put upward pressure on inflation.

• The recent rise in anti-immigration sentiment could eventually influence monetary policy discussions. While increased immigration has helped address labor shortages and ease wage pressures, its impact is not one directional. Despite Fed Governor Bowman’s acknowledgement that the influx of foreign workers has helped alleviate inflationary pressures, she also suggested that it may have also contributed to rising rents due to the group’s housing needs. This mixed effect means immigration may become a factor that central banks consider, but it is unlikely to be the sole driver of policy decisions.

Is This Time Different? Major US banks all passed the Fed’s annual stress test this year, but there are still concerns that a financial crisis could hurt the economy.

• The stress test results indicate that these firms can withstand a major loss during a recession and still maintain sufficient capital to meet their obligations. According to the report, the group of banks would incur approximately $685 billion in losses, lower than the previous year’s figure and still within the acceptable range established by recent stress tests. While the success of these firms, as a whole, allows for more generous payouts through dividends and stock buybacks, the results did vary by individual firm. In the first, quarter, banks repurchased $14 billion worth of shares.
• The health of the financial system has been a major concern for investors ever since the Federal Reserve began raising rates in 2022. This concern is heightened by the FDIC’s latest quarterly report, which estimates that banks are currently holding a staggering $525 billion of unrealized losses on their balance sheets — a figure about seven times higher than what was recorded during the financial crisis. While banks can avoid recognizing these losses as long as they maintain sufficient liquidity, a liquidity crunch similar to the one that forced Silicon Valley Bank’s collapse in 2023 could trigger a wave of bank losses.

• The Federal Reserve, keenly aware of the financial system’s vulnerabilities, has been implementing measures to mitigate crisis risks. These include requiring banks to hold more collateral and making the standing repo facility permanent in July 2021. However, unforeseen geopolitical or financial events could still trigger a crisis, forcing the Fed to take more drastic actions. While there are currently no signs of an imminent crisis, the risk remains elevated as long as the Fed maintains restrictive interest rates. That said, any signs of a pivot should benefit these firms, especially small to mid-sized banks.

Bolivia Unrest: One of the largest producers of lithium narrowly avoided a coup on Thursday, highlighting the political uncertainty in small resource-rich countries.

• Bolivia narrowly avoided a coup attempt on Wednesday. Soldiers led by dismissed army chief Juan José Zúñiga stormed the presidential palace in an attempt to remove socialist President Luis Arce. Luckily, Arce was able to rally public support and regain control later that day. The motive behind the uprising remains unclear, but it may be linked to Arce’s recent efforts to reconcile with his predecessor, Evo Morales, ahead of upcoming elections. Notably, Zúñiga had been fired earlier this week for expressing opposition to Morales’ return to office.
• The recent coup attempt in Bolivia throws a wrench into South America’s efforts for regional integration. Last year, Brazilian President Lula da Silva spearheaded efforts, alongside other leftist leaders, to reunite President Arce and his exiled predecessor, Evo Morales, in the run-up to elections. Bolivia’s economy has sputtered since Morales’ departure in 2019, but the discovery of vast lithium reserves in July 2023 has offered a glimmer of hope. Last year, the country narrowly avoided a financial crisis after draining its gold reserves to sustain spending.

• Bolivia has a long history of coups with 23 attempts since 1950, 12 of which failed. In fact, the previous coup took place only five years ago. Unfortunately, political instability has long plagued emerging markets, particularly those reliant on resource exports. This trend is likely to worsen in a deglobalizing world and will likely have an impact on global commodity prices. As a result, investors should expect energy prices to become volatile over the next few years as countries look to form into regional blocs. Additionally, this fragmentation could potentially lead to higher global inflation due to persistent supply disruptions.

In Other News: Bulgaria and Romania failed to meet the economic requirements needed to adopt the euro. Their failure is a reminder of the difficulty in joining the economic bloc, particularly for Ukraine. A census report has shown that Hispanics fueled the US population boom in 2023, signaling their growing political influence.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with the latest on the simmering China-Philippines tensions in the South China Sea. We next review several other international and US developments with the potential to affect the financial markets today, including a new down-leg in the value of the Japanese yen, a bad inflation report in Australia, and, on a more positive note, signs of continued strong demand for junk-rated debt in the US.

China-Philippines: In an interview with the Financial Times, the Philippine Ambassador to the US warned that the China-Philippines dispute over the South China Sea’s Second Thomas Shoal has now reached an incendiary phase in which it could suddenly expand into a major conflict, much as the assassination of Austrian Archduke Franz Ferdinand sparked World War I. However, according to Ambassador Jose Manuel Romualdez, this conflict would be more dangerous because it could draw in countries with nuclear weapons.

• As a reminder, our new Mid-Year Geopolitical Outlook identifies the China-Philippines territorial dispute in the South China Sea as the world’s most dangerous geopolitical risk in the second half of 2024.
• While Beijing has deployed its coast guard and marine militia to quarantine a Philippine military outpost on the Second Thomas Shoal, using aggressive tactics to thwart resupply missions, Manila has also used provocative tactics to fight back, including by cutting Chinese fishing nets in the area and secretly delivering construction materials to shore up the outpost.
• What isn’t clear is the extent to which Washington and Manila are coordinating. One concern we have is that Philippine President Ferdinand Marcos, Jr., may be trying to force the US into backing his country’s sovereignty claim more forcefully.
• Since the US and the Philippines have a mutual defense treaty, which the Biden administration has repeatedly pledged to honor, Marcos may be trying to goad China into a violent action that would force the US military to make a show of force in the area. Ambassador Romualdez’s interview may also be aimed at prompting the US into action. Of course, the risk is that bringing US and Chinese military forces into closer proximity in the area could push them into conflict, even if accidentally.
• With our extraordinary focus on geopolitical risks here at Confluence, we are actively considering how we can adjust our investment strategies to hedge against such risks or take advantage of any resulting opportunities.

China-United States: In a new sign that the US is military is preparing for a potential conflict with China, the Marine Corps earlier this month recertified the airstrip on the Western Pacific island of Peleliu. In a major battle during World War II, the US sent 50,000 Marines and Army soldiers to pry the island and its airstrip from 10,000 Japanese defenders, resulting in tens of thousands of casualties. As discussed in our new Mid-Year Geopolitical Outlook, the US is now strengthening its presence across the Indo-Pacific region in an attempt to deter further Chinese aggression.

Japan: The value of the yen (JPY) today fell to 160.36 per dollar ($0.0062), reaching its weakest level since 1986. The currency has now lost some 12.2% of its value so far this year, as investors continue to be disappointed by the Bank of Japan’s slow pace of interest-rate hikes while the Federal Reserve and other major central banks keep their rates high. The new yen weakness will likely raise expectations that the Japanese government will again intervene in the currency markets to slow the currency’s slide.

Australia: The May consumer price index was up 4.0% from the same month one year earlier, well above both the expected increase of 3.8% and the April rise of 3.6%. A measure of core inflation rose to 4.4%. Coming just one week before a cut in income taxes and government payments to individuals to help offset the rise in the cost of living, the data has boosted expectations that the Reserve Bank of Australia will be forced to hike interest rates again. In turn, that prospect is weighing heavily on Australian stock and bond prices so far today.

North Atlantic Treaty Organization: In other security news, NATO’s member states today officially approved outgoing Dutch Prime Minister Mark Rutte as the alliance’s next secretary general. Rutte is seen as a strong trans-Atlanticist who can manage NATO relations with both the US and Russia. However, he has been criticized for the Netherlands’ failure to reach the NATO target of spending at least 2% of gross domestic product on defense throughout his time as prime minister. Rutte will take over the leadership of NATO on October 1.

Eurozone: The European Commission and European Central Bank today jointly announced that Bulgaria and Romania have failed to meet the economic criteria to join the eurozone, as widely expected. The countries’ key shortcomings included excessively high consumer price inflation and concerns that their institutions were too saddled with corruption and money laundering. The decision means that the eurozone will continue to encompass 20 countries; the last of which to join was Croatia at the beginning of 2023.

Kenya: The mass protests against the government’s new tax hikes, which we described in yesterday’s Comment, have now turned deadly, as police opened fire yesterday on protestors who had broken into parliament. According to local rights groups and activists, at least five protesters and first responders were killed and scores were injured in the incident. The violence threatens both the political and economic stability of a major African country.

Canada: The Wall Street Journal today carries an interesting article on Canadian oil sand companies and their recent outperformance. After years in which the firms were held back by high costs and limited export-pipeline capacity, they have now largely completed their expensive facility build-outs and are discovering improved operating practices to cut production costs. The May 1 opening of a new export pipeline to Canada’s west coast has also removed export bottlenecks. The resulting higher profits have pushed the firms’ stock prices sharply upward.

US Financial Conditions: New research from Goldman Sachs shows firms with low credit ratings have repriced some $391 billion in leveraged loans into lower-interest debt so far this year, a new record for the period. According to Goldman, the benefit from the repricing has been equivalent to a 0.50% cut in the Federal Reserve’s benchmark fed funds rate.

• The ability of the firms to roll their debt over into lower-interest loans stems from high investor demand for investment products that package the loans into securities.
• As illustrated by the rollover activity, burgeoning private credit funds, and the current low spreads for junk bond funds, high investor demand for yield is probably one reason today’s high interest rates haven’t sparked a broad financial crisis or thrown the economy into recession.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with further details on how Canada is considering antidumping tariffs against Chinese electric vehicles, as we flagged in a short blurb late last week. We next review several other international and US developments with the potential to affect the financial markets today, including another EU antitrust complaint against a major US technology firm and a statement by a Federal Reserve governor saying she would be open to raising interest rates if consumer price inflation doesn’t keep falling.

Canada-China: Following up on an item we flagged without detail late last week, the Canadian government is seeking public opinion on whether to impose antidumping tariffs or other barriers against Chinese EVs. Starting July 2, citizens will have 30 days to register their opinion, after which the government can decide on what it believes will be the optimal path.

• To justify the action, Ottawa cited “unfair competition from China’s intentional, state-directed policy of overcapacity and lack of rigorous labor and environmental standards.”
• More interesting, Ottawa said its goal is not only “to protect Canada’s auto workers and its growing EV industry” but also to “prevent trade diversion resulting from recent action taken by Canadian trading partners.” In other words, it is worried that the new US and EU tariffs against Chinese EVs will divert them toward Canada, where they likely would be sold at fire-sale prices.

European Union-United States: One day after accusing US tech giant Apple of using its app store to snuff out online competition, the European Commission today accused Microsoft of uncompetitive practices for the way it bundles its Teams collaboration tool with its Office products. The move appears to be another use of the EU’s new Digital Markets Act, signaling it will be applied aggressively and could trip up other US tech firms. If found guilty under the DMA, a firm could face a fine of 10% to 20% of its global annual revenue.

European Union-Ukraine-Moldova: EU officials today will meet with Ukrainian and Moldovan officials in Luxembourg to begin talks on their accession to the bloc. At the meetings, the EU will outline the reforms and legislation each country needs to adopt before being deemed ready to join. However, both Ukraine and Moldova are likely to need several years to meet the EU’s standards, so joining is by no means imminent.

• In large part, the talks will be symbolic, since they are merely aimed at getting the ball rolling before Ukraine-skeptic Hungary takes over the six-month rotating presidency of the Council of the European Union on July 1.
• Our next Bi-Weekly Geopolitical Report, to be published on Monday, will provide a full explanation of what that Council is and how it fits into the EU’s decision making.

France: With polls showing the far-right National Rally could win the parliamentary elections starting on Sunday, leader Jordan Bardella yesterday held a press conference to unveil new details on the party’s economic, immigration, and foreign policies. To counter concerns that the party’s populist bent would lead to tax cuts and spending hikes, blowing out the French budget deficit, Bardella vowed that National Rally would actually bring the deficit back down to the European Union limit of 3.0% of gross domestic product by 2027, versus 5.5% of GDP last year.

• Besides vowing “reasonable” fiscal policies, Bardella also outlined an economic program that largely echoed President Macron’s mainstream goals of strengthening the French industrial base, boosting employment, and cutting regulation. The main difference was that Bardella said National Rally would reverse Macron’s pension reform, which raised the national retirement age from 62 to 64 years.
• Bardella’s economic proposals illustrate how many of Europe’s populist, far-right parties have moderated their policies once they attained power. One example of that has been Italian Prime Minister Giorgia Meloni and her Brothers of Italy party.
• If that turns out to be the case in France, the recent sell-off in French stocks and bonds could well be an attractive buying opportunity.

Israel: The Israeli Supreme Court today ruled that ultra-orthodox Jewish students cannot be legally exempted from military conscription. It also ruled that those students aren’t entitled to government funding if they don’t have a valid conscription exemption. While it remains unclear when the ruling will be implemented, it will eventually end a controversial practice that many Israelis see as unfairly benefiting ultra-conservative citizens. It could also weaken the cohesion of Prime Minister Netanyahu’s right-wing coalition government.

Kenya: Protestors have launched nationwide demonstrations against a new set of tax hikes the government hopes will raise some $2.1 billion and help cut the budget deficit from the current 5.7% of GDP to 3.3% of GDP next year. The tax hikes are required under Kenya’s most recent bailout deal with the International Monetary Fund. The protests have already turned violent, threatening political and economic instability in the country.

US Monetary Policy: In a speech today, Fed board member Michelle Bowman said she would be willing to raise the benchmark fed funds rate again if progress on lowering consumer price inflation stalls or reverses. According to Bowman, one key upside risk for inflation is the large federal budget deficit, which reflects factors such as weak tax revenue, higher interest costs, and increased outlays on Social Security, Medicare, and other programs. She also said high immigration could drive up the price of housing, even if it helps hold down wage rates.

US Manufacturing Sector: Danish pharmaceutical giant Novo-Nordisk yesterday said it will invest $4.1 billion to build a new factory in Raleigh, North Carolina and expand production of its blockbuster weight-loss drugs Wegovy and Ozempic. The move will likely put pressure on US drug giant Eli Lilly to expand output of its rival drugs Zepbound and Mounjaro. The investments would add to the current boom in US factory construction, which to date has been driven more by manufacturing facilities for electronic goods such as electric cars and semiconductors.

US Artificial Intelligence Industry: The Recording Industry Association of America has filed copyright infringement suits against two AI startups developing products that allow users to generate new music using text prompts. The suits, brought on behalf of major music companies, allege that the startups used copyrighted works scraped from the internet to train their models.

• The suits illustrate the legal challenges that have to be sorted out for the AI industry to continue growing.
• One likely result of such suits is that specialized data sets that are useful for training AI models will become increasingly valuable. Those data sets will be guarded furiously, potentially to the point where specialized, focused AI models will proliferate and become even more important to the economy than the general AI models getting so much attention today.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with a new antitrust suit by the European Union against US tech giant Apple. The suit suggests major US tech firms will be in the crosshairs of the EU’s new Digital Markets Act going forward. We next review several other international and US developments with the potential to affect the financial markets today, including new polling showing that the far right and far left are likely to dominate France’s parliamentary elections this Sunday and details on an ongoing cyberattack affecting US auto dealerships.

European Union-United States: The European Commission has accused US technology giant Apple of stifling competition on its App Store. The action marks the first major application of the EU’s Digital Markets Act, which went into effect in March and aims to keep big, powerful online platforms such as Apple’s from squashing competition from start-ups. If found guilty, Apple could face a fine of 10% to 20% of its global annual revenue, or tens of billions of dollars.

European Union-China: European and Chinese officials over the weekend confirmed that the EU and China have agreed to start talks over the growth of Chinese electric vehicles in the bloc, which EU officials fear will put legions of Europeans out of work. The talks aim to diffuse the EU’s planned antidumping tariffs against Chinese EVs, which are due to come into effect in July. At this point, however, we see no reason to think the talks could head off those tariffs.

France: Ahead of the snap parliamentary elections next Sunday, a new Financial Times poll shows 35.5% of voters intend to cast their ballot for the far-right populist National Rally, while 29.5% intend to vote for the new far-left alliance called New Popular Front. President Macron’s centrist Ensemble alliance, including his own Renaissance liberals, has the support of only 19.5%. As of right now, the figures suggest the runoff election on July 7 could pit the far right against the far left, guaranteeing a major change in France’s domestic policies.

Philippines-China: Satellite imagery shows the Philippine government has begun building an anti-ship missile base on the west coast of Luzon island, facing the South China Sea. The new base is aimed at deterring Chinese aggression against disputed islands and shoals in the area, including the Second Thomas Shoal, which we think is a particularly dangerous source of friction between China and the Philippines.

Russia-Germany: According to Western security officials, communication intercepts show that a fire last month at a Berlin factory owned by defense contractor Diehl was set by Russian saboteurs trying to disrupt shipments of critical arms and ammunition to Ukraine. Confirmation that the fire was an act of sabotage has prompted a call for similar incidents to be re-investigated for any link to Russia. Of course, such aggressive Russian attacks on NATO soil run the risk of worsening NATO-Russia tensions going forward.

Russia: Terrorists yesterday attacked a synagogue, two churches, and a police station in the restive North Caucasus republic of Dagestan, killing four civilians and 15 police officers. The attacks suggest Islamist militants could be taking advantage as the Kremlin shifts its attention and resources to the war in Ukraine and the fight to control political dissent.

US Cybersecurity: The cyberattack on auto dealership software provider CDK Global that started last week continued through the weekend, disrupting dealership business. Statements from CDK Global suggest the attack involved ransomware, in which the attackers shut down a system until a ransom is paid. The attack illustrates how specialized software for particular types of businesses have the potential to shut down large swaths of an industry.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equity futures are holding steady as investors wait for fresh economic data to guide their next move. On the sports front, Argentina emerged victorious against Canada with a 2-0 win, setting the stage for the Copa América. Today’s Comment dives into three key topics: the persistently low bond yields, the recent restrictions on Chinese electric vehicle imports, and the performance of banks. We’ll wrap up the report with a look ahead to today’s domestic and international data releases.

Bonds are Back: Bond investors continue to doubt whether the Fed will hold rates steady as the economy continues to show signs of slowing.

• The yield on the 10-year US Treasury note remains stubbornly low, closing below 4.3% for the tenth consecutive day on Thursday. This defies expectations given several headwinds: the Fed’s recent shift towards fewer rate cuts, stubbornly high inflation, and a ballooning Treasury supply. Investor demand for bonds seems fueled by a confluence of factors. One is the hope that inflation will continue to cool in the coming months. Additionally, economic uncertainty is driving a flight to safety, pushing investors towards the perceived security of Treasurys. Finally, a string of weak economic data has reinforced the cautious market sentiment.
• The Fed’s recent slowdown in quantitative tightening, from $60 billion to $25 billion a month, might also be contributing to the decline in bond yields. This shift in policy suggests a less aggressive approach to draining liquidity from the financial system, potentially making long-duration assets more attractive to investors. While the two-year quantitative tightening program nears its final phase, the Fed plans to use the reduced pace of balance sheet reduction to ensure a smooth transition from abundant liquidity to ample liquidity. Phasing out this program will likely ease pressure on bond yields and provide support for stocks.

• However, further declines in Treasury yields are unlikely in the short term without clear signs of inflation subsiding. The Fed’s May decision to accelerate balance sheet reduction reflects its confidence in remaining patient as inflation pressures ease. Notably, the core PCE price index, the Fed’s preferred inflation measure, has shown a slower pace of increase in the first four months of this year compared to 2022 and 2023. For sustained confidence in inflation’s retreat, the index should continue this trend and align with pre-pandemic levels over the next three months.

The West’s EV Problem: Tensions escalate in the West-China trade dispute as Canada joins the fray.

• Canada is considering raising tariffs on electric vehicles (EVs) imported from China. This move aligns with similar actions taken by its allies such as the United States and the European Union. The concern is that China’s rapid growth in EV production could harm domestic auto industries. Earlier in 2024, the US significantly increased tariffs on Chinese EVs to 102.5%, while the EU implemented tariffs as high as 38% on specific vehicles. Canada, with its current 6% tariff, is exploring raising it to match the approach of its partners. However, a final decision on Canadian tariffs remains pending.
• The proposed tariff increase on Chinese electric vehicles comes as the Western green industry faces challenges. Weak domestic demand is hindering growth, as evidenced by EV startup Fisker’s recent bankruptcy after halting production. At the same, Tesla’s stock price also reflects these difficulties, dropping nearly 27% this year following its announcement of a tough industry outlook. Europe shares these struggles, with a particularly sharp decline in Germany. Last month, EV sales in the Continent’s largest economy plunged by 30%, while the broader European market saw a 12.5% drop.

• The fight for leadership in green technology shows no signs of slowing down, even though Western nations face challenges in attracting consumers to some eco-friendly products. Affordability appears to be the biggest hurdle, with electric vehicles remaining out of reach for many households and governments becoming more selective when offering subsidies. Tariffs on Chinese EVs might not be the silver bullet. While they could limit Western sales, they might also boost demand in emerging markets. In the meantime, Western governments may need to acknowledge that consumers are not yet fully prepared to abandon their gas-powered vehicles.

Higher-for-Longer and Banks: Banks in the US and abroad are facing headwinds as they struggle to attract deposits and protect their balance sheets, but there are no signs of a crisis.

• Japan’s regional banks are facing increased scrutiny as interest rates rise. Moody’s rating agency warned last month that higher rates could lead to capital flight, potentially harming these banks. Similarly, S&P Global expressed concerns earlier this month that rising rates could pressure the capital ratios of regional banks, especially those with high buffers. This isn’t a solely Japanese issue. US banks are also under the microscope. Moody’s recently placed several American banks on watch for downgrades due to their exposure to the potentially risky commercial real estate market.
• The threat to bank profitability appears likely to persist as long as interest rates remain high. This current rate cycle has negatively impacted bank balance sheets, putting pressure on some major institutions. For example, Norinchukin Bank, a Japanese agricultural lender, announced it would unload $63 billion in low-yielding US and European government bonds. This move aims to stem losses following an unsuccessful gamble on falling interest rates. In contrast, US banks have been increasing their holdings of short-term, floating-rate collateralized mortgage obligations (CMO) backed by Ginnie Mae. This strategy aims to protect themselves from potential deposit flight if interest rates continue to rise, but exposes the banks if rates fall significantly as it could lead to a wave of refinancing.

• While rising interest rates pose challenges for the financial system, there aren’t immediate signs of a crisis. This can be maintained if central banks prioritize clear and open communication about their interest rate expectations. Additionally, banks must avoid excessive risk by not over-committing to specific forecasts on Federal Reserve decisions. The pandemic highlighted the dangers of banks relying too heavily on, or outright contradicting, Fed guidance. This approach may be viable in a stable environment, but it becomes riskier during periods of high inflation volatility and geopolitical uncertainty.

In Other News: Purchasing Managers Index (PMI) surveys suggest European economies are not as robust as previously thought. This could fuel expectations of further rate cuts from the ECB. US car companies face challenges from cyberattacks, highlighting the need for further investment in cybersecurity. The Philippines’ undisclosed reinforcement of a ship in the South China Sea could lead to heightened tensions with China.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equities are starting the day strong despite another round of disappointing economic data. In sports, Texas A&M dominated Florida, bringing them closer to clinching the College World Series title. Today’s Comment will explore why Nvidia’s momentum may wane, discuss the renewed investor interest in the US dollar, and explain the latest rate decision from the Bank of England. As always, we conclude with a roundup of international and domestic news.

Hype Keeps Growing: Nvidia’s stock price keeps climbing, but there’s growing worry that the current enthusiasm might not be sustainable.

• The US chip designer overtook Microsoft as the world’s most valuable company on Tuesday. This rise is fueled by the ongoing excitement surrounding artificial intelligence (AI), which continues to captivate investors. The company’s recent strong performance is partly due to its decision to split its stock 10-to-1. This move made the shares more affordable for retail investors, increasing their accessibility. Nvidia sits at the forefront of the AI revolution, controlling an estimated 80% of the market for AI-specific chips. This takeover marks a historic shift, with the top spot last held by a non-Microsoft or Apple company being claimed by Cisco in 2000.
• While Nvidia’s stock soars, the momentum has not carried over to other AI-related stocks. Nearly 60% of the companies within the S&P 500 have seen gains this year, while more than half the stocks in Citi’s “AI Winners Basket” have seen a decline. The problem may be related to valuation. The “Magnificent Seven,” a group of prominent tech companies, trade at a significant premium compared to their large-cap peers. Their average price-to-equity ratio is a hefty 36.6, compared to 21.6 for the S&P 500 when those seven stocks are excluded.

• AI’s rising popularity is being met with increasing regulatory hurdles. The US is taking further steps to curb China’s chipmaking capabilities by limiting access to advanced chips. This week, a White House official will meet with counterparts from Japan and the Netherlands to discuss stricter chip export restrictions to China. Domestically, US antitrust watchdog and FTC Chair Lina Khan has announced her intentions to prevent large tech firms, particularly in the AI space, from further expansion. Earlier this year, she blocked the proposed Nvidia-ARM merger, which would have been the largest ever in the semiconductor industry, citing concerns that it would stifle innovation.

The Dollar Comeback: The Bloomberg Dollar Spot Index is on the verge of setting a new high for the year as investors view the US currency as being safer than its European counterpart.

• The US dollar has risen sharply since May. Investors are seeking the greenback due to rising uncertainty in the eurozone. Earlier this month, the European Central Bank cut its benchmark policy rates by 25 basis points, despite signs that inflation might be about to resurge. Meanwhile, the Federal Reserve surprised markets with a hawkish turn, despite evidence suggesting that inflationary pressures are easing. These contrasting policy moves have widened interest rate differentials, as investors rotate out of European bonds and into US Treasurys, in a sign that they are growing confident in America’s ability to control inflation.
• Political uncertainty has bolstered the US dollar, with French elections set to take place in 10 days. There is widespread concern that populist parties will win a significant number of seats, which is fueled by the rising popularity of the National Rally party and a potential coalition of left-wing populist movements that could gain control of parliament. Although French President Emmanuel Macron’s position is not on the ballot, the election may act as a referendum on his presidency, potentially rendering him a lame duck if his party suffers a serious defeat. A populist victory could see a slowdown or even a reversal of some of his pro-market reforms.

• Although the dollar has some momentum, concerns over US growth could prevent it from a breakout. The latest retail sales data suggests that consumers are starting to become price sensitive, while the labor market has shown signs of cooling. This weakness may lead investors to price in another rate cut for the year, rather than just the one that the Fed outlined in its summary of economic projections. Additionally, a less disruptive than expected election outcome could entice investors back to European markets. Consequently, the dollar may enter a holding pattern in the coming weeks as investors seek greater clarity.

No Action in the UK: The Bank of England held rates steady at its latest meeting despite inflation falling to target in May.

• The BOE kept its key policy rate at a 16-year high of 5.25%. The decision not to move was not unanimous, as two members of the committee voted in favor of a cut. While inflation did return to 2% in May, policymakers signaled concerns that service inflation and wage pressures remained a problem and could hinder the central bank’s target of maintaining price stability, while others showed that elevated components of the reports were likely temporary. That said, the committee seems to be satisfied with the level of inflation progress.
• The BOE’s cautious approach mirrors the Fed’s latest decision from earlier this month. Both central banks expressed concerns about a potential resurgence of inflation in the second half of the year during their explanations for their recent actions. The BOE’s meeting minutes stated that they believe price pressures may rise later in the year as energy prices stop acting as a drag on the inflation index. Meanwhile, Fed Chair Jerome Powell argued that the rollover impact of the core PCE price index could also cause the Fed’s preferred inflation measure to increase due to these temporary effects. However, both central banks maintained that a cut is still likely this year.

• The possibility of rate cuts in late summer or early fall remains on the table for both the BOE and the Fed. The chart above shows that when inflation is adjusted for comparison with other countries (harmonized inflation), UK inflation is roughly in line with US inflation. However, it’s important to note that recent declines are largely due to falling energy prices, which may not reflect the underlying trend in other parts of the economy. Reflecting this concern, the Bank of England may consider a cut in August, while the Federal Reserve will likely wait for data releases, particularly inflation reports from July and August, before deciding on a September rate cut.

In Other News: In a move to counter isolation by the US, Russia signed a mutual defense treaty with North Korea. This highlights Russia’s efforts to forge alliances with countries opposing the West, potentially to bolster its war effort in Ukraine. Meanwhile, Dutch Prime Minister Mark Rutte was selected as the new head of NATO, and his seamless transition will likely help the military alliance maintain unity as it looks to take on threats from Russia and China.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Note: There will be no Daily Comment tomorrow due to the holiday.

Our Comment today opens with a new World Gold Council survey showing global central banks are likely to keep buying large amounts of gold, supporting prices for the yellow metal. We next review several other international and US developments with the potential to affect the financial markets today, including unexpected business support for the far-right party ahead of France’s June 30 parliamentary election and several notes on US political and economic developments.

Global Gold Market: According to a new World Gold Council survey, 81% of central bankers think reserve managers will continue to increase their gold holdings in the coming year. That share is the highest since the group’s 2019 survey and reflects growing interest in gold reserves as a hedge against geopolitical and economic risks and as a source of good investment performance. The figures are consistent with our positive outlook on gold and our view that central bank buying is more than offsetting the headwinds from high interest rates.

China: In its latest review of global nuclear arsenals, the Stockholm International Peace Research Institute (SIPRI) highlighted how China is now expanding its arsenal of nuclear weapons faster than any other country. According to SIPRI, China built some 90 new nuclear warheads last year, bringing its total arsenal to 500. It is also rapidly expanding its fleet of intercontinental ballistic missiles to deliver those warheads, and it may have started deploying its weapons at a higher state of readiness.

• The SIPRI figures regarding China’s growing arsenal are consistent with the estimates we made in our Bi-Weekly Asset Allocation Report from April 15, 2024, where we attempted to calculate the incremental global demand for uranium related to weapons.
• Not only is China’s rapid nuclear buildup an unheralded reason for the recent jump in spot uranium prices, but it is also likely to intensify tensions between China and the West. As more Western leaders and voters come to appreciate the growing nuclear threat from China, we think there is a good chance that they will push for stronger defense spending.

China-Philippines: The Chinese government yesterday accused the Philippines of trying to deliver construction materials to the Sierra Madre, a Philippine navy ship grounded on a disputed shoal in the South China Sea to assert Manila’s claims to the area. In turn, Manila denied the accusation and said a Chinese coast guard ship rammed a Philippine vessel during the incident. The worsening Chinese-Philippine tensions remain a key risk for investors, as discussed in our Mid-Year Geopolitical Outlook, published yesterday.

France: As the June 30 parliamentary elections draw closer, business leaders are racing to embrace the surging far-right National Rally (RN), both to express their support and to influence the party. The development is a reaction against the far-left New Popular Front (NFP), which has issued a radical tax-and-spend agenda and is RN’s main competitor in the race.

US Foreign Policy: In a new poll by the Ronald Reagan Institute, 54% of respondents said US leaders should be more involved in international affairs, up from only about 40% in each of the previous three years. The share saying the US should be less engaged internationally remained at 33%, close to where it has been for the last several years.

• We continue to believe US voters have become weary of the costs of global hegemony over the last decade and a half, leading to increased populism, isolationism, and “America First” attitudes. One key question is whether those attitudes will continue to strengthen and ultimately force the US to give up its global leadership role, or whether the resulting challenge from China/Russia geopolitical bloc will spur a recommitment to international engagement.
• Now that US hesitation on the global stage has encouraged the authoritarian states of the China/Russia bloc to become more assertive, the Reagan Institute poll suggests US voters may indeed be embracing a stronger international stance again. If so, it will likely lead to even more tensions between the US bloc and the China/Russia bloc, as well as continued increases in US defense spending.

US Immigration Policy: President Biden has announced a new program that will give legal status to the spouses of US citizens who are in the country illegally, provided that they have been in the US for at least a decade and meet other criteria. The program is expected to help up to several hundred thousand people get work permits, deportation protection, and a path to citizenship. The announcement comes just two weeks after the president imposed a blanket ban on illegal immigrants claiming asylum after crossing the southern border.

• The apparently contradictory goals of the spousal program and the blanket asylum ban reflect the contradictory political and economic environment for immigration policy.
• Politically, large numbers of Americans want the government to clamp down on the flow of new immigrants and the lack of control over migration at the southern border, but there are still many in Biden’s Democratic Party base who prioritize immigrant rights and the ability of immigrants to bring family members to the US.
• Economically, as we mentioned in our Bi-Weekly Geopolitical Report from May 20, 2024, the post-pandemic labor shortages, especially in lower-skilled jobs, have been an important driver of consumer price inflation. Giving more immigrants the right to work would likely help fill those labor shortages and cap wage rates, bringing down price pressures.

US Apartment Market: While overall apartment rental rates in the US are nearly unchanged from the previous year, new data shows a surprising upswing in rents outside the Sunbelt. Brokers and property owners say the rent hikes in places such as Kansas City and Washington, DC, reflect a dearth of new supply and renters’ inability to buy a home because of sky-high prices and elevated interest rates.

• The figures suggest US rents have already reached a bottom and may be turning up again. Since apartment rents have a big weight in the key gauges of consumer price inflation, any upswing in rents could keep inflation from falling to the Federal Reserve’s target.
• In turn, that would likely force the Fed to keep interest rates higher for longer.

US Electric Vehicle Market: The number of US electric-vehicle startups that have filed for bankruptcy has now risen to three after Fisker threw in the towel yesterday. Fisker’s filing follows the earlier bankruptcies of truck maker Lordstown Motors and bus maker Arrival. While press reports indicate the failures stemmed largely from operational and financial problems specific to the failed companies, they also reflect unexpectedly soft demand for EVs in the US market.

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