by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! U.S. equities appear subdued ahead of the weekend, while Inter Miami’s new game plan is clear — feed Messi! Today’s Comment kicks off with an analysis of the potential risks of Western allies’ joint action against Houthi rebels, followed by a deep dive into why traders remain confident in a March Fed rate cut. We also unpack the latest Japanese monetary policy decisions and bring you up to speed on key domestic and international data releases.

Broadening Conflict: The U.S. and U.K. launched joint airstrikes against Houthi rebels in Yemen, heightening tensions in the Middle East.

• The U.S. and U.K. launched joint airstrikes against Houthi rebel targets in Yemen, responding to their recent attacks on commercial ships in the Red Sea. They were joined by Australia, Bahrain, Canada, and the Netherlands in this operation. The coalition used precision-guided missiles to hit more than 60 targets in 16 locations in Yemen. This coordinated effort comes days after the U.S. and its allies warned Houthi rebels that continued attacks on vessels would lead to a military response. The coordinated offensive raises the likelihood of a broader conflict in the Middle East. In response to the attack, the Houthis have vowed to retaliate. 
• Fighting in the region is likely to lead to volatility in oil prices. The International Association of Independent Tank Owners, a trade group representing 70% of globally traded petrochemicals, has advised its members to stay away from the highly contested Bab-el-Mandab strait. The warning comes a day after Iran seized a ship with Iraqi crude that was headed for Turkey in the Gulf of Oman. Uncertainty regarding how the next few days will play out has led to a surge in oil prices, which have risen 4% over the past two days as traders price in the potential for supply disruptions. Despite the uncertainty, oil prices remain below the previous year’s levels.

• Red Sea tensions underscore the U.S.’s critical role in safeguarding economic stability through ensuring free passage in key shipping lanes. Though oil prices have been affected, swift containment of the situation should prevent long-term trade disruptions. Yet, a wider conflict which escalates military action could trigger a more sustained price shock and heighten recessionary risks, potentially sparking financial market panic due to geopolitical uncertainty. Although we remain optimistic that this will not turn into an all-out war in the Middle East, we acknowledge that risks remain elevated.

Traders Unconvinced: Market bets of rate cuts surprisingly increased even after hotter-than-expected inflation data and a reiterated commitment from Fed officials to maintaining restrictive policy.

• Central bank officials pushed back on speculation of March rate cuts but stopped short of ruling them out entirely. Hawk Loretta Mester, president of the Cleveland Fed, insisted it’s too early for such a move. However, she pointed out that December’s inflation uptick doesn’t mean that progress has stalled. Meanwhile, both Richmond and Chicago Fed Presidents Thomas Barkin and Austan Goolsbee, refused to rule out a March rate cut, adding to the uncertainty. The lack of clarity from Fed officials prompted markets to boost their March pivot prediction by five percentage points, raising the expectation of a rate cut next spring to 70%.
• Mixed economic data fuels uncertainty around the Fed’s March policy stance. December inflation hit 3.4%, exceeding both forecasts and November’s reading, raising concerns about a potentiation return of price pressures. Conversely, a surprisingly strong December job market, which added 216,000 positions, suggests ongoing economic momentum. While headline figures mask nuanced trends, like a downward shift in monthly inflation and a steady increase in the number of unemployed workers throughout the year, the Fed’s muted reaction indicates they’re prioritizing different factors or possible embracing ambiguity. With conflicting signals and hidden depths, predicting their next move is like peering into a foggy crystal ball — a gamble fraught with uncertainty.

• Pent-up anticipation of a Fed pivot to easier policy has fueled risk appetite, with traders betting on six aggressive rate cuts this year. While this expectation reflects the perceived historical tendency of the Fed to cut rates faster than it raises them, we believe the actual easing cycle will be later and shallower than the market anticipates. If policymakers prove less dovish, the recent bond rally could face a sharp reversal. Nevertheless, even in that scenario, fixed-income securities should fare better than last year. The upcoming FOMC meeting will likely serve as the key turning point, testing market expectations and setting the tone for the year ahead.

What’s Next for BOJ? The Nikkei 225 continues to rally in 2024 as investors grow concerned that the Bank of Japan won’t be able to shift away from its aggressive monetary easing.

• The strength of Japan’s benchmark stock index comes amid signs that nominal wage growth slowed sharply in the final months of 2023. The annual change in nominal wage growth slowed to 0.2% in November, down considerably from the previous month’s rise of 1.5%. The slowdown raises concerns that BOJ Governor Ueda will see it as a sign of weak inflationary pressures, and will delay his planned pivot away from aggressive monetary easing. The wage slowdown points to firms’ continued reluctance to increase labor earnings, likely due to concerns about hurting profit margins if they cannot readily pass on the costs to consumers.
• While optimism has fueled a surge in popularity for Japanese equities since 2023, concerns linger about the sustainability of the rally. The Nikkei’s RSI climbed above the overbought threshold of 70, suggesting a potential loss of momentum in the coming months. Price pressures also provide a headwind. November’s CPI data showed a welcome decline in annual inflation to 2.5%, down from 3.2% in October. However, government forecasts predict inflation will struggle to fall below that threshold throughout 2024, exceeding the central bank’s 2% target.

• Many economists and market analysts anticipate that the Bank of Japan will eventually pivot away from its ultra-accommodative policy, but the timing largely hinges on the outcome of the annual wage negotiations in March, known as Shunto. If labor unions secure significant wage increases, the central bank may feel compelled to finally raise interest rates or adjust its yield curve control policy, potentially leading to a stronger yen (JPY). This may hurt Japanese businesses due to higher borrowing costs and a less competitive currency, but we suspect the fallout could spread into global financial markets due to the preponderance of yen carry trades that are outstanding.

Other news: Taiwan’s presidential elections take place this weekend, and China has issued another strong warning against any moves towards formal independence, raising concerns about a potential increase in regional tensions.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Risk assets are off to a rough start as CPI failed to reinforce rate cut expectations. On the bright side, Real Madrid secured a nail-biting win over their city rivals Atlético Madrid in extra time, keeping their Supercopa dreams alive. Today’s Comment starts with our thoughts on the resurgence of demand for fixed-income securities. We then discuss the SEC’s approval of a bitcoin ETF and provide an update on the conflict in the Red Sea. As always, our report also includes an overview of the latest domestic and international data releases.

Bond Rush! Anticipation of central bank rate cuts has led investors to flock to fixed-income securities; however, policymakers continue to play their cards close to their chest.

• G-7 central bankers are hinting at the end of rate hikes, but they’re staying mum on potential cuts. While New York Fed President John Williams believes current rates can tame inflation, he emphasizes the need for continued evidence of a sustained cooldown before considering any easing. The European Central Bank’s Isabel Schnabel and Bank of England Governor Andrew Bailey both echoed this cautious stance by warning against premature speculation due to persistently high inflation exceeding their 2% target. Although inflation has eased notably over the past year, growing concerns from economists and analysts suggest that inflation may struggle to reach the 2% target within the year due to geopolitical and supply chain risks.
• Ignoring central bank warnings of steady rates, investors drove European bond sales to a record high of 118 billion EUR ($108 billion) this week. Supranational organizations and sovereign governments fueled the surge, seeking to lock in lower rates and fund annual expenditures. This borrowing spree wasn’t limited to Europe. Emerging market governments and corporations also jumped in, raising $50 billion in the first half of January to capitalize on the temporary dip in rates. This global borrowing spree reflects investor optimism in the wake of easing rate pressures, signaling potential financial relief across markets after a period of hawkish policy.

• While falling rate expectations eased borrowing costs and boosted liquidity, a long lasting ease in financial conditions will likely require actual policy changes from central banks. Despite isolated suggestions like Fed Governor Waller’s hint at a March cut, no clear evidence points to an imminent pivot. Thus, the risk remains real, similar to 2023, that the current bond rally may fizzle out before it gains firm footing, revealing more risk in long-duration bonds than current pricing suggests. We recommend that investors cautiously approach the prospect of rate cuts as a deceleration in inflationary pressure may prompt policymakers to maintain current rates beyond market expectations.

SEC Approves: Crypto traders achieved a crucial victory as the Security and Exchange Commission approved the first spot Bitcoin ETFs.

• After years of regulatory limbo, 10 crypto ETFs secured approval, marking a significant step forward for the industry. This green light follows a decade-long legal battle that culminated in the federal courts forcing the SEC to review Grayscale’s Bitcoin ETF application. Despite the SEC’s concerns about potential manipulation and fraud in digital assets, this decision clears the way for the first crypto ETFs to begin trading as soon as this morning. This opens the door for both retail and institutional investors to gain regulated exposure to digital assets for the first time, a move that could significantly boost adoption and legitimize the crypto market.
• Following the announcement, Bitcoin, the most widely traded currency, rose as high as 2% on the day and volume jumped to a 10-month high. This surge reflects investor excitement over the potential domino effect, paving the way for broader adoption of other digital assets. While crypto’s mainstream appeal remains debatable, its dedicated fanbase is undeniable. A recent Crypto Council for Innovation survey revealed that a whopping 83% of holders favor clear regulatory guidelines from the next president, hoping they will nurture the industry’s growth. Crypto may not swing elections, but its rising influence is becoming clearer.

• Although the ruling improves crypto’s attractiveness, the market remains rife with regulatory uncertainty and elevated volatility. Bitcoin’s $47,000 price tag faces a bumpy road ahead, with analysts predicting declines towards $28,000 by year-end, countered by some optimistic forecasts eyeing a climb above $100,000. This stark contrast underscores the inherent volatility of the asset. As a result, unless a divine power comes down to meet us at Mt. Sinai to tell us otherwise, we will remain steadfast in our belief that crypto is not a safe choice for risk-averse investors.

Conflict in the Red Sea: The Iranian-backed Houthis have continued to escalate tensions with the West by launching attacks on commercial ships entering the Red Sea.

• Frustration mounts as leaders from the United States and its allies issue stern warnings of military action in response to ongoing Houthi rebel attacks on shipping vessels in the Red Sea. This escalation comes after a recent barrage of attacks by the Houthis, which involved 18 drones, two anti-ship cruise missiles, and one anti-ship missile aimed at commercial ships traversing the crucial global trade route. The Houthis have linked their actions to the ongoing conflict between Israel and Hamas by vowing to continue their attacks until Israeli forces withdraw from Gaza. This raises concerns of a wider regional conflict.
• Houthi attacks on Red Sea shipping are worrying, but their inflationary impact remains elusive. Violence in the Red Sea has spiked freight costs, as shippers are forced to pay higher shipping costs through insurance and take longer shipping routes to transport their goods. That said, freight costs remain well below pandemic levels. Meanwhile, overall global trade dipped 1.3% in December suggesting that countries are still being impacted. The European Union, specifically, saw a sharp drop in trade with imports falling by 3% and exports declining by 2%. However, there are still no signs that the shipping problem will impact inflation.

• Weak confidence and elevated rates, which dampen demand, largely shield consumers from the conflict’s immediate sting. This trend is likely to hold in the next three to six months assuming that the conflict in the Middle East remains relatively contained. We foresee a broader conflict significantly impacting European inflation, more so than the U.S., while proving bullish for commodities like oil and metals. However, Western intervention remains a major headwind for financial markets as it could lead to a renewed war effort, but this remains a low probability.

Other News: With Chris Christie suspending his presidential bid, Donald Trump is now closer to facing a one-on-one fight for the Republican nomination. While he still appears to be the frontrunner, we can’t rule out an upset. China has gestured toward more cooperative U.S. ties days before Taiwan’s elections, potentially reducing the risk of miscalculation regarding an island takeover if its preferred candidate loses. Alphabet Inc.’s Google (GOOG, $143,80) plans to lay off hundreds, in a sign that tech may be trying to meet earnings expectations through a smaller workforce.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a warning about high government debt levels from the Institute of International Finance.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a dramatic example of violence in Ecuador and the latest on fiscal policy negotiations in the U.S.

Global Government Debt:  The Institute of International Finance has issued a report warning that the “unmoored” level of public debt around the world is raising the risk of a bond-market backlash.  The report indicates that government debt isn’t just a problem in the U.S., the U.K., and other developed countries, but is also a problem in many emerging markets.

• Our analysis suggests much of the problem in the U.S. can be traced to the lingering effects of the COVID-19 pandemic, which pushed legions of baby boomers into retirement (replacing Social Security contributions with Social Security withdrawals), boosted price inflation, and prompted generous new entitlement benefits.
• In theory, policymakers could attack some of those issues, say by bringing down inflation and curtailing benefits. On the other hand, other issues will generate continued spending pressures, such as further population aging and new geopolitical tensions that will require higher defense budgets.

Eurozone:  Luis de Guindos, vice president of the European Central Bank, warned in a speech today that even though the eurozone economy is likely to enter another downturn this year, persistent inflation pressures could keep the monetary policymakers from cutting interest rates as aggressively as market participants expect.  The statement illustrates how bond investors in Europe are probably too optimistic about near-term interest rate cuts, just as they are in the U.S.

United Kingdom:  Former defense officials have gone public with complaints that the Ministry of Defense is trying to cover up data showing a serious shortfall in skilled personnel for the armed forces.  The lack of skilled sailors has reportedly prompted the early retirement of at least two navy vessels.  Meanwhile, The Telegraph reports that total U.K. armed forces personnel has fallen to 184,865, the lowest number since the end of the Napoleonic Wars in 1815.

Ecuador:  Armed gang members yesterday staged attacks across the country, including breaking into a public television station and temporarily interrupting a live show while they brandished guns and grenades.  The gang violence appeared to be a warning against President Noboa’s plan to crack down on the gangs and bring them under control.  The violence highlights the growing power and violence of drug cartels, which threatens to destabilize governments, imped investment, and drive more migrants to the U.S.

United States-China:  As more evidence that the U.S. military is preparing for a potential future conflict with China, an important Air Force intelligence unit is reportedly urging its Arabic- and Pashto-speaking cryptologic linguists to learn Mandarin.  The move by the 70^th Intelligence, Surveillance, and Reconnaissance Wing comes as the U.S. Marine Corp is completely restructuring to fight a war in the Indo-Pacific region, while the U.S. Army has reinstituted jungle warfare training, and the U.S. Navy is broadening its submarine efforts with Australia.

U.S. Fiscal Policy:  Even though lawmakers have reached an agreement on the top-line budget parameters for the current fiscal year, Senate Minority Leader Mitchell yesterday advised that there won’t be enough time to pass all the specific appropriations bills needed to finance the government when the current stopgap funding law expires beginning in about two weeks.  In other words, Congress may have to pass yet another stopgap to avoid a partial government shutdown until the appropriations bills are finished.  Stay tuned for more budget chaos.

• Separately, lawmakers who are working on separate tax legislation are reportedly considering curbing the controversial pandemic-era Employee Retention Credit (ERC). That law, passed in 2020, gives employers a lucrative tax break for retaining employees during the pandemic shutdowns, but it has been wracked by fraud and an overly long availability until 2025.
• Curbing the eligibility for that credit or cracking down on spurious claims could help generate funds for other priorities the lawmakers are discussing, such as reversing the requirement in the Trump tax package of 2017 that corporate research deductions be spread out over five years instead of being expensed immediately.

U.S. Energy Market:  A new outlook from the Energy Information Administration forecasts that U.S. oil production will rise further from the record high of 12.9 million barrels per day in 2023 to further new record highs of 13.2 million bpd in 2024 and 13.4 million bpd in 2025.  The agency also projects that U.S. output of natural gas will also rise to new records this year and next year.  The figures underscore how the U.S. has become an energy powerhouse since the arrival of new technologies such as hydraulic fracturing and horizontal drilling.

• While “green” policies and investor demands for capital discipline did discourage new exploration and development for much of the last decade, drillers more recently have boosted output.
• Along with weakening demand growth in China and other markets, the surge in U.S. energy output has helped push down prices in recent months, helping bring down the overall rate of consumer price inflation.
• If the U.S. economy slows too much and slips into recession, the further loss of demand would likely weigh even more heavily on global oil and gas prices.
• Nevertheless, we think the hesitant drilling in recent years and increased geopolitical tension will buoy oil and gas prices again over the longer term.

U.S. Cryptocurrency Market:  Bitcoin (BTC, $45,108.20) and other cryptocurrencies swung wildly in price yesterday after a hacker took control of the Securities and Exchange Commission’s social media account and falsely announced that the agency had approved the U.S.’s first-ever cryptocurrency ETFs.  Crypto prices surged, only to fall sharply within minutes when the SEC disclaimed the report.  Nevertheless, the SEC is widely expected to announce its official decision on crypto ETFs either today or tomorrow.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an observation from a high-profile investment manager about renewable energy as one element of energy security.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a surprise fall in the eurozone’s unemployment rate and further indications that the Federal Reserve is pivoting toward looser monetary policy (although still probably not as fast as many investors think).

Global Energy Market:  In a short interview carried by the Wall Street Journal yesterday, a managing partner at infrastructure investor Brookfield Asset Management (BAM, $38.84) argued that last year’s slump in many renewable energy stocks was “very overdone” and that investment and capacity growth in renewable energy continues to surprise on the upside.  Importantly, the manager tied the outlook for renewables not only to a desire for clean energy and growing opposition to fossil fuels but also as a source of secure, domestic energy.

• The comment came from Jehangir Vevaina, a managing partner in Brookfield’s renewable power and transition group. Vevaina touches on a theme we’re seeing more often these days:  With geopolitical tensions raising the risk of disruptions in global energy flows, one advantage of solar, wind, hydroelectric, and other renewables is that they can provide secure, domestically produced energy.
• Clearly, the current push for “Green Technology” has become very politicized and polarizing. The green technology push will likely lead to lots of malinvestment and underinvestment in fossil fuels.  On the other hand, looking at renewables as one way to improve energy security suggests that the industry could still have a bright future even if today’s environmentally driven push for renewables comes to an end.

Eurozone:  The November unemployment rate fell to a seasonally adjusted 6.4%, beating expectations that it would remain at October’s rate of 6.5%.  With the decline in joblessness in November, the region’s unemployment rate is now once again at a record low, despite a recent slowdown in economic activity due to high interest rates and other factors.  In turn, the continued strong demand for labor and rising wages could encourage the European Central Bank to keep interest rates high for longer than investors expect.

France:  President Macron has named his recently appointed 34-year-old, charismatic education minister, Gabriel Attal, to be his new prime minister following the resignation of Élisabeth Borne on Monday.  The popular Attal will be France’s youngest-ever prime minister, suggesting Macron was looking for a dramatic nominee who could breathe new life into his administration.  Nevertheless, Macron’s lack of a majority in parliament means he will still struggle to push his agenda forward.

Russia:  According to British intelligence, the Kremlin has re-established the Stalinist counterintelligence organization known as SMERSH, an acronym for “death to spies.”  Made famous in Ian Fleming’s James Bond spy novels, the unit aims to root out traitors and spies within the Russian government.  Coming hot on the heels of increased counterintelligence efforts in China, the move may be a reaction to increased human intelligence successes by Western services that have unsettled President Putin and General Secretary Xi.

Israel-Hamas Conflict:  In separate incidents yesterday, the Israeli military killed a senior figure of the Iran-backed Hezbollah militant group in southern Lebanon and another top Hamas commander in Syria.  The increasingly brazen Israeli assassinations outside of the conflict zone in the Gaza Strip are keeping alive the risk that the war will broaden regionally.

China:  The China Passenger Car Association today said the number of Chinese-made autos that were exported abroad rose to a record 5.26 million in 2023, putting China on track to be the world’s top vehicle exporter.  When Japan, the previous top exporter, reports its data in the coming weeks, it is expected to have sold less than 4.50 million vehicles abroad.

• China’s surging auto exports reflect both its strong competitiveness in electric vehicles and its surging sales to Russia after that country was sanctioned by the West for its invasion of Ukraine.
• Since China’s rising auto exports will threaten domestic carmakers around the world, they are likely to spur further protectionist policies, especially in Europe. In turn, efforts to hold back the Chinese export tide will likely further exacerbate today’s tensions between China and the members of the U.S.-led geopolitical bloc.

China-Taiwan:  Just days before the presidential election on Saturday, independence-leaning frontrunner Lai Ching-te of the ruling Democratic Progressive Party has accused China of trying to undermine his campaign.  According to Lai, Beijing has used the full gamut of interference tactics, from propaganda and military intimidation to “cognitive warfare” and fake news to scare voters into casting their ballot for his opponents, especially the China-friendly Kuomintang Party’s Hou Yu-ih.

• A victory by Lai could immediately raise tensions between China and Taiwan, potentially drawing in the U.S., Japan, and other Taiwan supporters.
• This portends rocky trading in the world’s financial markets early next week, assuming the current opinion polls are accurate (see the latest chart by the Economist below).

(Source: The Economist)

China-Argentina:  The Chinese government yesterday said it would cut import tariffs or extend tariff reductions on 143 different products from Argentina, ranging from dried sweetcorn to infant formula and plywood.  The move is being seen as an effort to curry favor with Argentina’s new, radical libertarian president, Javier Milei, who has vowed to shift his country’s orientation back to the U.S. and away from China.

• Our objective, quantitative methodology for predicting which geopolitical bloc a country will end up in currently places Argentina in the “Leaning China” camp, based in large part on Argentina’s strong commodity exports to China.
• Nevertheless, we think the U.S. and China will actively work to draw “Leaning” countries closer and away from their rival. With Milei threatening to reorient Argentina toward the U.S., it’s no surprise that Beijing has taken steps to curry favor with Milei.
• Going forward, many countries, especially those in the “Leaning” blocs, will likely be in a position to play the U.S. and China off against each other. To the extent that they can garner concessions from either of the big powers, those countries could see improved economic prospects and better stock returns.

U.S. Economic Growth:  New analysis cautions that the recent strong financial results at big companies may not be indicative of the overall corporate sector.  Indeed, the analysis notes that while big firms’ earnings before interest, taxes, depreciation, and amortization (EBITDA) soared 18% from 2019 to the end of 2022, “middle market” companies with annual revenues between $100 million and $750 million saw their EBITDA fall 24% in the same period.  That’s important because middle market companies account for a huge chunk of the U.S. economy and workforce.

• A range of other measures also reflect big advantages for big firms and tough challenges for smaller ones. For example, the advantages to size also show up in disparate EBITDA margins and differing trajectories for corporate profits versus sole proprietorships (see chart below).
• The tougher challenges for smaller firms could eventually prompt them to cool hiring, cap wage rates, and reduce investment, leading to stronger headwinds for the economy and financial markets.

U.S. Monetary Policy:  In a further sign that the Fed has pivoted toward loosening monetary policy relatively soon, Dallas FRB President Logan in recent days delivered a speech calling for the Fed to slow its quantitative tightening program.  We still think bond investors have gotten ahead of themselves in expecting sharply looser policy in the very near term, and we still think there is a risk that bond yields will rebound at least temporarily in the coming weeks and months.  Nevertheless, the signs are starting to point more strongly to looser policy later in 2024.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a discussion of how the Houthi threat to shipping in the Red Sea is disrupting global supply chains and threatening to push up inflation again.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a cut in Saudi Arabia’s oil export price and a budget agreement in the U.S. Congress that could avert another partial government shutdown or the need for another stopgap funding measure when the current one starts to run out later this month.

Global Supply Chains:  As Houthi rebels in Yemen continue to attack commercial shipping in the Red Sea, shippers are increasingly worried that China won’t have enough shipping containers for its future exports.  When firms carrying goods from China to Europe divert their ships away from the Red Sea and Suez Canal to the longer route around the Cape of Good Hope or shift to the overland China-Europe rail route (see map below), the delivery delay of up to two weeks means the return of half-empty containers to China will also be delayed.

• Any shortage of containers could stymie Chinese exports, further weighing on the country’s economic growth. Separately, Chinese electric vehicle makers are struggling to send their EVs to Europe because of an unrelated shortage of car-carrying ships.
• A surge of aggressively priced Chinese exports has been a key reason for the recent decline in consumer price inflation in the U.S. and the rest of the developed countries. Constricted Chinese exports and rising container leasing rates would therefore threaten to boost developed-country inflation again, complicating the major central banks’ calculus on when they could start cutting interest rates.

Global Oil Market:  Today, Saudi Arabia cut the official selling price for its February oil exports.  The cut reflects both rising U.S. oil production and slowing global energy demand because of factors such as China’s weak economic growth and high interest rates in many countries.

• We continue to believe that the outlook for oil is bullish over the longer term, but prices are likely to remain under pressure in the short term as global economic growth slows.
• In response to the Saudi price cut, oil prices have fallen approximately 3.3% so far this morning, with Brent currently trading at $76.19 per barrel.

Emerging Market Debt:  In a new report, Fitch Ratings warns that higher global temperatures, rising sea levels, and increased flooding could lead to lower credit ratings for developing countries in the Asia-Pacific region that don’t adapt.  The only country that Fitch identifies as safe is Singapore.  The report warns that most other countries in Asia and South Asia will have trouble finding the resources to mitigate the risks.

Japan:  Prosecutors have made their first arrests in the illegal political fundraising scandal that’s been dogging the administration of Prime Minister Kishida.  Those arrested included Yoshitaka Ikeda of the ruling Liberal Democratic Party and one of his aides.  Kishida announced that the party has expelled Ikeda, but the scandal nevertheless continues to weigh on the prime minister’s approval ratings and threatens his political power.

China:  Now that Chinese home prices are no longer providing the strong investment returns that they used to, younger Chinese consumers are reportedly investing more in gold jewelry.  Because of their enormous populations, India and China are already the world’s top consumers of gold jewelry.  If Chinese demand accelerates further, it could conceivably give a further boost to global gold prices, just as recent purchasing by key central banks has done.

United Kingdom-China:  The Chinese Ministry of State Security has accused the British secret intelligence service MI6 of recruiting a private-sector consultant from a third country to repeatedly enter the country, collect information, and try to recruit sources of information.  The Chinese government has already cracked down on other Western data and due diligence firms, leading to some arrests.  The new accusation is likely to further scare off Western professionals and prompt more Western companies to reconsider doing business in China.

United States-China:  The top Republican and Democrat on the House Select Committee on the Chinese Communist Party have released a letter they sent to President Biden urging him to take stronger action to stem China’s growing dominance in the global market for older, less-advanced semiconductors, rather than just constraining China’s access to the most advanced chips, as the administration has already done.  The lawmakers warn that the U.S. economy is becoming too dependent on workhorse chips from China.

• As we’ve discussed in the past, the worsening U.S.-China rivalry is driving a continued fracturing in global supply chains. Government and business leaders are likely to keep driving to cut dependence on critical, high-value goods from China, although many less important, low-value products are likely to continue being sourced from that country.
• The widening scope of the restrictions will continue to be a risk for companies that rely on Chinese inputs or sell to China.

U.S. Military:  On Friday, the Pentagon announced that Defense Secretary Austin had been hospitalized in intensive care since New Year’s Day to deal with complications from an unspecified elective surgery.  However, the incident created a scandal when it emerged that President Biden wasn’t informed about Austin’s hospitalization for three days, and that key members of Congress weren’t informed for four days.

• Deputy Defense Secretary Kathleen Hicks reportedly took on Austin’s duties while he was incapacitated, but only via secure communication links from her temporary location in Puerto Rico, rather than returning to Washington.
• The scandal is likely to raise pressure on Austin and lead to increased calls for his replacement. In any case, the scandal has the potential to disrupt the U.S. military’s on-going restructuring and adjustments to meet the rising challenge from China.

U.S. Fiscal Policy:  Congressional leaders reached a deal yesterday on overall budget spending for the current fiscal year, potentially averting another partial government shutdown or stopgap spending bill when the current stopgap bill starts to run out later this month.  The challenge now will be for Congress to pass the many individual appropriation bills that will turn the budget into law.  Republican conservatives in particular are expected to oppose the spending total and demand riders that implement their preferred conservative policies.

U.S. Commercial Real Estate Market:  New data shows that a record 19.6% of office space in major markets was unleased in the fourth quarter, up from 18.8% one year earlier and slightly above the previous record of 19.3% in 1986 and 1991.  The high vacancies reflect both previous overbuilding and the pandemic-inspired “work from home” movement.  In any case, high vacancies coupled with high interest rates means the office sector remains an economic risk.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! December jobs bury the bull market’s hopes, while Crosby and Bedard steal the NHL All-Star spotlight. In today’s Comment, we dive deep into the mysteries of the January Barometer, explore why the Magnificent Seven’s reign may be nearing its end, and analyze how Ukraine war fatigue might pave the way for de-escalation in Europe. As always, our comprehensive report encompasses the latest domestic and international data releases.

January Gloom: Equity prices are on track to finish the week down in a bad omen for financial markets.

• The weak start to January raises concerns about the rest of the year. Data from 1954 to 2023 reveals an unsettling pattern — in 11 out of the last 17 occurrences when January saw declines in both the first week and month as a whole, the S&P 500 finished the year lower. Rising interest rate concerns, fueled by mixed economic data, are driving this bearish sentiment. While the latest JOLTS report signaled that firms are slowing their hiring, both initial claims and ADP’s private payroll data suggest workers are having no trouble finding new work. Fueling anxieties further are the ongoing conflicts in the Middle East that threaten to disrupt energy supplies and exacerbate pre-existing inflationary pressures.
• This early-year phenomenon likely reflects investors’ tendencies to anchor expectations to limited data, seeking early signs for dominant themes. While the S&P 500 started 2023 with a decline in its first week, Microsoft’s (MSFT, $367.94) extended partnership with OpenAI, a leading artificial intelligence (AI) company, buoyed the index to a 6.3% gain by month’s end. Hopes for monetary easing have gripped investors since the last Fed meeting in December, where officials hinted at potential rate cuts in 2024, but these hopes have faced a sharp reality check. Investor expectations of a March rate reduction have drastically contracted, with the CME FedWatch Tool probability plummeting from 73.4% a week ago to 60.9% today.

• Just like in the lead-up to the climax of the classic romantic comedy When Harry Met Sally, investors will spend 2024 analyzing every move of the FOMC, trying to decipher the next step in their rate-cut tango. Will it be a graceful glide to lower rates or a clumsy stumble into recession? Prepare for a comedy full of “mumbling with great incoherence,” with investors caught between hope and frustration as the Fed navigates the economic tightrope. But remember, while monetary policy takes center stage, don’t forget the political circus happening backstage. Half of the world will be voting, and these elections could redraw the global economic map, which is also likely to have a major impact on financial markets.

Tech Rally Over? Lower rates threaten the Magnificent Seven’s market dominance. Prepare for a changing of the guard.

• In an environment of high-interest rates and cautious investor sentiment, firms with significant growth potential and limited downside risk became particularly attractive investment targets. Large companies with exposure to AI technology, a field perceived to hold immense future potential, were among the most sought-after. Investors were drawn to these companies because the firms have the ability to grab market share in an industry that is expected to play a significant role in reshaping the economy. Consequently, the excitement over AI has led investors to neglect other sectors offering opportunities.
• The prospect of lower rates has helped shift investor attention toward stocks with a better value proposition. With a hefty P/E above 20, the S&P 500 looms large over its smaller rivals. Mid-cap companies, long overshadowed by big-name hype, finally saw their alluring P/E ratios attract renewed investor attention. Though initially buffeted by a 6.5% headwind in the first 10 months of 2023, the S&P 400 Mid Cap Index roared back with a vengeance, finishing the year an impressive 11.5% higher. At the same time, small-cap companies have had a similar performance, rising 13.9% to the end of the year.

• Market fundamentals favor a potential shift from large caps to smaller peers, but unforeseen headwinds like recession or rising rates could slam the brakes on the trend, dampening risk appetite and prompting caution. So far, all signs suggest that the Fed will be able to navigate a soft landing. The Atlanta GDPNow forecasts continued economic resilience with the economy expected to expand at a 2.5% annual rate in the fourth quarter. At the same time, Cleveland Fed data suggests the year-over-year change in core PCE inflation could dip below 3% this month, offering a glimmer of hope for risk-averse investors and potentially accelerating the shift towards smaller companies.

Fresh Ukraine Worries: The growing difficulty in supplying Ukraine with military equipment has fueled anxieties among Eastern European nations bordering Russia, who fear it could leave them more vulnerable to Russian aggression.

• Amidst the ongoing war in Ukraine, Latvian Foreign Minister Krišjānis Kariņš sounded the alarm, warning that Russia’s ambitions likely extend beyond Ukrainian borders and could pose a broader threat to Eastern European nations. He is pushing for the West to develop a longer-term strategy that will contain the ostracized country.  His concerns come on the same day that the Pentagon stated that it had no funds left to replace weapons sent to Ukraine. Although there was $4.2 billion left for aid, it warned that the lack of additional funding may force the U.S. to pause its support
• With brutal new bombardments engulfing Ukrainian cities and Ukrainian counteroffensives pushing outwards, the need for further aid hangs precariously in the balance, shrouded in the uncertainty of allied agreement on a new spending package. The ongoing Congressional debate in the U.S., balancing domestic security concerns with foreign commitments, further clouds the picture. Meanwhile, Europe gropes anxiously for alternative solutions that don’t hinge on Hungarian approval, adding another layer of complexity to the already precarious situation. Ukraine’s stark assertion that no plan B exists beyond securing Western funding underscores the gravity of the situation and amplifies the pressure on allies to reach a decision.

• Though further Western aid for Ukraine does seem likely, its long-term sustainability remains on shaky ground, influenced by rising American anxieties about both securing their own borders and the escalating tensions in the Middle East. While America’s foreign policy focus is sharply rising, with four in 10 now saying it should be a top government priority — double the sentiment from a year ago — this change in attitude doesn’t translate directly to unwavering support for Ukraine. In fact, America’s focus on the war has dipped slightly from 6% to 5%. This shift in priorities could potentially make the West more receptive to a quicker peace deal.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Global markets hum with cautious optimism as investors dissect the latest FOMC minutes, while the European football world holds its breath for Kylian Mbappé’s blockbuster transfer decision. In today’s Comment, we delve into the Fed’s policy signals, why Europe’s central bank deserves a closer look, and the escalating tensions in the Red Sea. As always, our comprehensive report equips you with the latest domestic and international data releases.

 Pivot or Not? While some investors anticipate swift rate cuts, FOMC minutes suggest a more gradual and data-dependent approach, prompting concerns about unrealistic expectations in the market.

• Wednesday’s minutes revealed that policymakers acknowledged potential 2024 rate cuts while stressing ongoing restrictive policy for now. Inflation progress toward the 2% target was noted, but officials demanded further proof of easing pressures before declaring victory. However, optimism was tempered by concerns from others within the committee. They flagged potential risks to inflation from global energy/food prices, geopolitical developments, a potential rebound in core goods, and effects of nearshoring. While some saw the labor market’s cooling, which was further buttressed by the JOLTS report’s low job vacancy figures, as evidence for dovishness, others remained cautious, emphasizing the need for comprehensive data before changing course.
• Beyond conventional economic gauges, Fed officials highlighted a potentially disruptive factor influencing their policy decisions — the looming commercial real estate debt wall. Over $117 billion of office building loans in the U.S. face maturity in 2024, according to the Mortgage Bankers Association. Issued during an era of low rates, these loans now burden properties whose value has fallen, raising concerns about potential losses and limited lender capacity for extensions. The ongoing crisis in CRE markets adds a layer of complexity to the Fed’s decision-making process, as they must weigh not just inflation and employment risks but also financial stability concerns.

• The 2019 mid-cycle adjustment by the Federal Reserve serves as a reminder that an outright recession isn’t always necessary for them to cut rates. Following a series of hikes to normalize monetary policy during that period, Fed Chair Jerome Powell explained the policy shift as a tactical move to mitigate the dampening effects of international developments on U.S. growth, manage downside risks to the economy, and support a symmetrical return to the Fed’s 2% inflation target. However, complications within the repo market emerged as a key driving force behind the decision. With inflation exceeding its target, the central bank is likely to prioritize price stability over short-term growth concerns, potentially leading to less aggressive rate cuts than the market anticipates.

ECB Bluffing? After pulling back on bets for U.S. rate cuts, investors should consider revising their expectations for the European Central Bank as well.

• Growth expectations have taken center stage in shaping rate expectations for the European Central Bank (ECB). After a promising first half of 2023, the eurozone economy stumbled in the third quarter, with GDP contracting at an annualized rate of 0.1%. This slowdown was further underscored by the recent Purchasing Manager’s Index (PMI) reading of 47.6, dipping below the 50 threshold that indicates a contraction in private sector activity. These indicators have significantly increased the possibility of the eurozone slipping into a technical recession, defined as two consecutive quarters of negative GDP growth. As a result, bets for rate hikes have faded, and speculation about potential easing measures is rising.
• Investors dismissing the ECB’s commitment to a tight policy may be overlooking a hidden weapon — the lingering Pandemic Emergency Purchase Programme (PEPP). While the bank has hiked rates to record highs and started shrinking its balance sheet, PEPP’s ongoing reinvestments of maturing securities suggest it hasn’t fully embraced monetary tightening.  Even though net purchases ceased in 2022, PEPP has continued to reinvest maturing securities. Despite its initial aim of preventing fragmentation, PEPP’s ongoing presence has inadvertently provided the eurozone with a buffer against the potential negative impacts of tighter policy on its financial system.

(Source: Bloomberg)

• While the eurozone’s financial system is better equipped to handle rising rates compared to the U.S., a looming debt maturity wall in their junk bond market could still force cuts. The share of lower-rated firms facing debt repayments within the next three years has risen to its highest level since 2015, particularly in high-yield debt for telecom, consumer staples, and real estate. This significant vulnerability could lead policymakers to rethink monetary policy stance. As a result, we maintain that aggressive rate cuts as soon as the market expects are unlikely in the near term. However, we acknowledge that conditions may change in the future.

 Middle East Uncertainty: Houthi rebel attacks on commercial vessels in the Red Sea have spooked markets, raising fears of a wider Middle Eastern conflict.

• The U.S. and its allies have threatened military action against the Houthi rebels if the group continues its attack on vessels traveling through the Red Sea. The warning comes after the Yemen-based military group carried out at least 23 attacks since the fighting broke out between Israel and Hamas. In addition to warning the rebels, the U.S. also aimed criticism toward Iran, viewed as the Houthis’ primary financial backer, by warning of repercussions if Iran continues to support these attacks. Prior to the warning, the U.S. Navy was forced to use self-defense against rebel boats, killing 10 Houthis in the process.
• Simmering tensions in the Red Sea threaten a vital global trade route, raising concerns about supply disruptions and potential inflationary pressures. The vital Bab el-Mandeb Strait, nestled between the Arabian Peninsula and Africa, funnels 12% of global trade, including containerized goods and oil, towards the crucial Suez Canal. Recent attacks on shipping have forced rerouting, causing over $1 million in extra fuel costs, rising insurance premiums, and delaying deliveries. While below the chaos of the pandemic, these disruptions are no less worrying. Increased shipping costs and delays ripple through supply chains, potentially translating into higher consumer prices.

• While current oil prices and consumer spending trends haven’t fueled a major inflation hike due to the conflict in the Red Sea, escalating tensions could quickly disrupt supply chains or amplify energy market volatility, triggering a more pronounced surge in price pressures. Although crude oil has seen a 6% increase recently, it remains below $80 a barrel, and slowing global demand, evident in the economic slowdown in Europe and China, could provide some downward pressure on global prices. However, the conflict’s unpredictable nature keeps the inflation threat on the table, requiring close monitoring of its potential economic fallout.

Other news: Former President Donald Trump faces a crucial legal hurdle as he pushes the Supreme Court to decide if Colorado can remove his name from its presidential ballot. The dispute reinforces our view that the outcome of this year’s presidential election will be less predictable than previous contests. Meanwhile, economic cracks widen in China as the world’s second-largest economy grapples with a property market slump and declining exports. Chinese provinces have been forced to pump billions into their fragile banking system, raising concerns about a prolonged slowdown and its global ripple effects.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with recent reports suggesting U.S. and European leaders are shifting their focus from helping Ukraine expel the invading Russians to simply helping it defend the territory it still holds.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including an Israeli strike on a Hamas leader in Lebanon that raises the risk of escalation and new private-sector data confirming the recent slowdown in U.S. labor demand.

Russia-Ukraine War:  Now that Russian and Ukrainian forces have fought to an apparent draw and many U.S. and European politicians staunchly oppose further aid to Kyiv, President Biden and allied leaders have reportedly begun to shift their focus toward bolstering Ukraine’s ability to defend the territory it still holds, rather than pushing the Russians out of the country.  Their aim is to bolster Kyiv’s bargaining position when peace negotiations eventually come about.

• In our view, the U.S. and European resistance to further aid for Ukraine is essentially political and strategic, rather than economic.
  • The officials who support Ukraine are often traditional center-left or center-right establishment elites. Those who oppose more aid to Ukraine are often on the far left or the far right.  U.S. and European far-right populists have been especially energized by working class anger over post-Cold War globalization, migration, de-industrialization, and income and wealth inequality.  Those populist isolationists are often strongly opposed to more assistance for Ukraine.
  • Some of international relations theorists also argue that while the U.S. and Europe might face an existential threat if Ukraine lost its independence to Russia, the West wouldn’t face much additional risk if Russia merely holds on to the territory it has already conquered.
• In contrast with the very real political pushback and strategic disagreements, the U.S. and European aid to Ukraine so far in the war is small from an economic standpoint. For example, the U.S.’s total assistance of $75.4 billion to date equals:
  • About 0.16% of the estimated $46.116 trillion in U.S. gross domestic product from the start of Russia’s invasion until late 2023;
  • Roughly 0.65% of the U.S. government’s total spending of about $11.689 trillion over the same period;
  • About 5.1% of the U.S.’s defense spending of $1.491 trillion over that period; or
  • Approximately the same amount that the U.S. spent on health research in that period, and well below what it spent on disaster relief.
• For investors, the longer-term strategic implications of reduced Western aid for Ukraine may be most important.
  • Recent research from the Institute for the Study of War notes that if the conflict is frozen with Russia retaining the almost 20% of Ukrainian territory it now holds in the east and south, President Putin would almost certainly use the freeze to rebuild his forces for a new invasion in the future.
  • That would likely require the U.S. and NATO to drastically bulk up their defenses in Europe, further bolstering our thesis of higher future defense spending and new investment opportunities in the defense sector.

Israel-Hamas Conflict:  In an apparent Israeli drone strike, a top Hamas political leader and at least two of the group’s military commanders were killed in an explosion in the suburbs of Beirut yesterday.  Since the assassinations took place in an area dominated by the Iran-backed Hezbollah militant group, which previously warned against any Israeli strikes in Lebanon, the incident further ratchets up the risk of the conflict spreading beyond the Gaza Strip.

• Separately, the Turkish government yesterday arrested nearly three dozen people on suspicion of helping Israel’s intelligence services target Palestinians living in Turkey for assassination.
• If true, it would be just the latest in a rash of aggressive — and risky — extraterritorial assassination programs carried out by countries ranging from Russia to India.

European Union:  José Manuel Campa, head of the European Banking Authority, said in an interview that the regulator is launching an investigation into the relationship between banks and non-bank financial institutions (NBFIs) such as hedge funds, private equity firms, and cryptocurrency groups.  The goal is to determine if there is any risk that financial stress in the NBFIs could spread to banks.  Importantly, the initiative may encourage similar scrutiny in the U.S., with the possibility of new regulations down the road.

United Kingdom:  According to a union leader representing the junior physicians who yesterday launched a planned seven-day strike against the National Health Service, the doctors would accept a 35% pay hike spread over several years, rather than all at once.  The statement could potentially diffuse the strike, which would be the longest in NHS history.  It could also help bring an end to the U.K.’s year-long labor unrest.

• Meanwhile, research firm Kantar estimated that British grocery prices have softened considerably in recent months. The firm said December grocery prices in the U.K. were up just 6.7% year-over-year, compared with 9.1% in November.
• Easing inflation could not only take the wind out of union wage demands, but it could also prompt an eventual cut in the Bank of England’s benchmark interest rate.

United States-Netherlands-China:  ASML (ASML, $716.92), the world’s top manufacturer of fabricating equipment for advanced semiconductors, yesterday said the Dutch government has revoked some of its licenses to export deep ultraviolet lithography systems to China.  Under U.S. pressure to help constrain China’s ability to make advanced chips, the Dutch government already bans ASML from selling its top-of-the-line extreme ultraviolet lithography systems to China.  Revoking the licenses for less advanced systems shows the U.S.-China tech war is expanding.

• The U.S.-China geopolitical rivalry, and especially the U.S. clampdown on technology flows that could help China’s military, continue to present risks for investors who own Chinese assets or have positions in companies that depend on Chinese capital or markets.
• As proof of that, ASML’s depository receipts in the U.S. fell 5.3% yesterday, as the loss of DUV export licenses convinced investors that even more of the company’s China revenue could be at risk.

United States-China:  Reflecting China’s growing competitiveness in making electric vehicles, Shenzhen-based BYD (BYDDY, $53.70) for the first time delivered more all-electric cars than U.S. rival Tesla (TSLA, $248.42) in the fourth quarter of 2023.  While China still lags in some advanced technology industries, in part because of Western restrictions, it continues to come on strong in EVs.  As Chinese EV exports increasingly threaten other countries’ auto industries, the question is whether, when, and how those countries might clamp down on the Chinese cars.

• On a related note, the Financial Times this morning carries an article in which top officials from General Motors (GM, $36.05) and Nissan (NSANY, $7.80) warn against former President Trump’s plan to gut the Inflation Reduction Act’s subsidies for EVs made substantially in the U.S.
• The officials warn that if the subsidies are revoked, the recent U.S. investment boom in EV-related factories will end, inward foreign investment will weaken, and consumers will be tempted to buy vehicles from China and elsewhere.

U.S. Energy Regulation:  Oil giant Chevron (CVX, $149.48) yesterday warned that it will book impairment charges of $3.5 billion to $4.0 billion in the fourth quarter, in part to reflect the impact of tough regulations in California.  The California issue is a reminder of the regulatory drag that can hit energy firms operating in the U.S.  In addition, Chevron said the charges would also reflect hiccups in the disposal of certain assets in the Gulf of Mexico.

U.S. Labor Market:  Recruitment site Indeed has released data showing that its total job postings at the end of 2023 were down 15% from one year earlier.  However, the data shows that the pace of decline slowed in the second half of the year, and that overall postings remain more than one-quarter higher than before the pandemic.  In sum, the report helps confirm that labor demand slowed markedly in 2023, especially early in the year.  As we argued in our outlook, slowing momentum will leave the economy more susceptible to a recession in 2024.

U.S. Stock Market:  On the year’s first day of trading yesterday, the NASDAQ Composite price index dropped 1.6%, as some large, growthy technology stocks sold off sharply.  The stodgier Dow Industrials rose marginally to a new record high of 37,715.04.  In fact, the Dow has now risen for nine straight weeks.

• Of course, one day does not make a trend. Nevertheless, we note that recent action and yesterday’s trading in particular were consistent with the arguments we made in our recent Outlook for 2024.
• In our Outlook, we argued that the run-up in large-cap tech and artificial intelligence stocks last year has left them richly priced. Going into the new year, we think investors are likely to see better opportunities in value and small-cap equities.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a discussion of what some observers are starting to describe as a Stalinist purge by General Secretary Xi.  We note that Xi’s firing of military officers and defense industry officials may not be for corruption, but for real or imagined susceptibility to being recruited by the CIA.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more attacks on Red Sea shipping and a range of new labor laws in the U.S.

China:  The country’s top legislative body, the National People’s Congress, said on Friday that it has kicked out nine People’s Liberation Army generals, including five from the scandal-ridden PLA Rocket Force, two working on weapons procurement at the Central Military Commission, and one each from the PLA Air Force and the PLA Navy.  Also late last week, the Chinese People’s Political Consultative Conference, a prestigious government advisory body, said it has removed three top-level defense industry leaders from its membership.

• The sackings come three months after the mysterious firings of former Defense Minister Li Shangfu, who had previously been involved with procurement at the CMC, and former Foreign Minister Qin Gang, who was rumored to have had an affair that led to the birth of a child in the U.S. Prior to that, several top PLARF leaders were fired and put under investigation in July, sparking a scandal that has now reportedly caught up more than 70 officials.
• At first glance, the common thread linking most of these firings is that the officials were involved with developing and procuring equipment for the military. That suggests the officials were involved with kickbacks or other types of financial corruption, and that’s how most press reports seem to be describing the story.  That alone would point to some organizational weakness and lack of loyalty in the Chinese military.  However, we think there may be a more profound implication for U.S. security and global investors:
  • China’s widespread corruption among government and business leaders is usually described as a political challenge or economic risk, but it has also been a key source of leverage for Western spies to recruit Chinese sources.
  • Like other intelligence services, the Central Intelligence Agency knows that the way to convince a Chinese citizen to sell Beijing’s secrets is to use MICE: Money, Ideology, Compromise, or Ego.  Corrupt officials or lower-ranking workers are already susceptible to being bought with money.  If the CIA threatens to expose their corruption, they can also be susceptible to compromise.
• What many people don’t realize is that the CIA had leveraged Chinese corruption to build an extensive and effective network of human intelligence sources within China in the first decade of this century, but it was compromised and destroyed by the Chinese Ministry of State Security from 2010 to 2012, just as General Secretary Xi was coming to power. Discovery of the CIA’s network in China was reportedly a key factor in sensitizing Xi to the threat from Western spies and corruption in his own ranks.
  • CIA Director Burns has recently said his agency is successfully rebuilding its network in China. If so, it’s probably doing so by leveraging corruption again, and the corrupt Chinese officials with some of the most valuable secrets would be those associated with procuring weapons — especially the PLARF missiles that threaten U.S. forces in the Western Pacific Ocean and even the U.S. mainland.
  • In sum, the U.S.-China intelligence war is already in full swing, so the true import of Beijing’s military corruption scandal is that it suggests large numbers of Chinese military and defense industry personnel are susceptible to being turned by the CIA. We suspect that will exacerbate Xi’s security concerns, prompting further aggressive moves against the U.S. geopolitical bloc and even more of the global fracturing that is creating risks for investors.

China-Philippines:  Responding to Manila’s stated plan to build permanent civilian facilities on a disputed shoal in the South China Sea, Beijing on Friday warned that such an action would “seriously impinge on China’s sovereignty” and prompt it to “respond resolutely.”  The warning shows how the increasingly acrimonious territorial dispute between China and the Philippines could spark a conflict.  Given that the U.S. and the Philippines have a mutual defense treaty, any such conflict could potentially lead to a U.S.-China conflict.

China-Mexico:  Late last week, the Mexican government imposed an anti-dumping tariff of almost 80% on some types of steel imported from China.  The action came in response to complaints by Mexican producers that Chinese steelmakers have been disposing of their excess output abroad at artificially low prices.

• One little noticed aspect of China’s economic rise over the last two decades is that the country’s state-supported, low-cost producers have often undercut budding manufacturers in other so-called emerging markets around the world. Waves of cheap Chinese goods have often put domestic producers in Latin America, Africa, and South Asia out of business, short-circuiting their governments’ economic development strategy of boosting manufacturing and forcing them to stick with low-value added commodity production.
• Under pressure from imports, domestic steel production in Latin America is expected to cover just 83% of the region’s needs in 2023.
• More broadly, various reports suggest that China’s current economic slowdown is prompting many of its manufacturers in multiple industries to dump goods at low prices on world markets. In turn, that’s pushing down import prices and helping push down consumer price inflation in the U.S. and elsewhere.

Taiwan:  As campaigning ramps up for the presidential election on January 13, front-runner Lai Ching-te of the ruling Democratic Progressive Party has come under fire for the government’s 2019 decision to slash readings of classical Chinese literature in school curricula.  The DPP has long leaned toward independence from China, but Lai’s opponents are casting the curriculum change as an example of anti-Chinese extremism that could prompt Beijing to attack if the DPP stays in power.  It’s still unclear if the controversy could throw the election to the China-friendly KMT.

Japan:  An earthquake registering 7.6 on the Richter scale hit the western coast of Japan yesterday, causing widespread damage and prompting a tsunami warning.  At this point, it appears the quake has produced relatively limited casualties and damage, probably because it struck a sparsely populated area on the coast.

South Korea:  Lee Jae-myung, head of the opposition Democratic Party, was attacked and stabbed in the neck today by an assailant at a public event in Busan.  His injuries are considered serious but not life threatening.  Nevertheless, the incident is a reminder of the potential political volatility we could see in 2024 as countries ranging from South Korea and Taiwan to Mexico and the U.S. hold important elections.  South Korea holds legislative elections in April.

United Kingdom:  Although many of the strikes the country faced last year have died down, some labor actions continue.  Today, junior physicians are launching a six-day strike against the National Health Service for better pay and working conditions, in what may turn out to be one of the most disruptive labor actions to date.  Continued labor unrest is feeding into the sense of economic malaise gripping the U.K. as it deals with challenges like high interest rates, slow growth, continuing trade lethargy due to Brexit, and the uncertainty of upcoming elections.

Israel-Hamas Conflict:  As Iran-backed Houthi rebels in Yemen continue to aggressively attack commercial shipping in the Red Sea in sympathy with the Hamas government in Gaza, the U.S. Navy sank three Houthi vessels over the weekend that were attacking a private container ship.  With the threat of the Israeli-Hamas conflict now escalating again, global oil prices so far this morning have risen about 2%, with Brent trading at $78.58 per barrel.

U.S. Labor Market:  Even though the federal minimum wage remains at the same $7.25/hour rate that it’s been at since 2009, 22 states lifted their minimum rate starting yesterday.  The highest minimum wage in 2024 will be in the state of Washington, where it will stand at $16.28, up 3.4% from the previous rate of $15.74.  However, a new analysis by the Wall Street Journal suggests the minimum wage is becoming increasingly irrelevant, as even the lowest-paid workers in most states typically make almost 50% more than their state’s wage floor.

• In an interesting new law going into effect in Alabama, any employee hours in excess of 40 per week will be exempt from state income taxes.
• Essentially, the law will exempt overtime from state taxation. The law could therefore help incentivize overtime work, effectively increasing the labor supply.

U.S. Business and the Elections:  As mentioned above in the paragraph on South Korea, business leaders around the world are looking warily at the large number of countries holding key elections in 2024.  In the U.S., a new survey indicates that senior executives and risk managers now see escalating political polarization as their second-most important emerging risk, right after generative artificial intelligence.  The report shows many leaders are starting to prepare for the possibility that political protests could disrupt their companies’ operations.

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