by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Note to readers: the Daily Comment will go on holiday after today’s Comment and will return on January 2, 2024. From all of us at Confluence Investment Management, have a Merry Christmas and a Happy New Year!

Our Comment today opens with new research on the challenges facing emerging markets because of today’s high interest rates and strong dollar.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more signs of a potential future wind-down in the Israel-Hamas conflict and new data on U.S. population growth.

Global Emerging Markets:  According to the World Bank’s latest International Debt Report, the strong dollar and aggressive interest-rate hikes by advanced countries’ central banks have created severe financial distress among low- and middle-income countries.  For example, the report identifies 18 sovereign debt defaults by 10 different countries in the last three years, exceeding the total number in the previous two decades.

• Excluding China, the report says external debt among low- and middle-income nations now stands at 33% of gross national income, down a bit from the previous year but still much higher than the 26% of GNI one decade ago. Also excluding China, interest costs have risen to 1.06% of GNI from 0.94%, siphoning budget funds away from domestic uses and making it harder to service the debt.
• The report says that if the top central banks keep interest rates “higher for longer,” as we expect, more poorer countries will face default in the coming years.

Israel-Hamas Conflict:  The Wall Street Journal today reports that there is a growing rift between Hamas’s political leaders based in Qatar, who want to end the group’s war with Israel, and its administrative and military officials in Gaza, who want to keep fighting.  Importantly, the Hamas political leaders have been talking with other Palestinian factions in the broader Palestine Liberation Organization about postwar governance in Gaza.  The talks add to other evidence that the endgame of the war is coming closer.

China:  The province of Guangdong and two of its municipal governments have set up a new $1.5-billion fund to invest in the local semiconductor industry, just as Shanghai set up a similar fund in 2016.  Supplementing the central government’s “Big Fund,” the provincial funds illustrate how lower-level governments in China are encouraged to help achieve the goals set out by top leaders, including the rapid development, resilience, and self-reliance of the country’s advanced semiconductor industry.

European Union-China:  The European Commission announced today that it is launching an anti-dumping investigation into Chinese biodiesel imports.  According to the Commission, EU companies have submitted evidence that biodiesel imports from China are coming into the EU at artificially low prices that local companies can’t compete with.  The probe further illustrates how the EU is now taking a more skeptical, confrontational approach to China, aligning it more closely with the U.S.

India-United States:  In an interview with the Financial Times, Indian Prime Minister Modi for the first time responded to U.S. allegations that Indian agents tried to assassinate an expatriate Sikh separatist on U.S. soil.  However, Modi appeared to play down the allegation, promising that his government would “look into” any evidence the U.S. provided and insisting that relations between the U.S. and India will continue to strengthen despite “a few incidents.”

• Modi’s nonchalant response suggests he wants U.S.-India relations to keep strengthening as both sides seek to counter China’s increased geopolitical aggressiveness.
• For investors, closer relations between the U.S. and India will likely help open up opportunities in the Indian financial markets.

Colombia:  The central bank cut its benchmark short-term interest rate to 13.00% yesterday, after keeping it at a nearly quarter-century high of 13.25% since May.  According to Banco de la República Governor Leonardo Villar, he and five board members voted in favor of the rate cut, while two voted against.  With the rate cuts, Colombia now joins other South American countries, including Brazil and Peru, that have begun to ease monetary policy.

France:  The lower house of parliament yesterday approved President Macron’s proposed immigration reform, but only after he toughened its restrictions enough to attract the votes of right-wing populists.  The move sparked defections from scores of liberal legislators in Macron’s own coalition, potentially portending political instability in France in the coming months.

• The French bill increases the government’s power to deport foreigners and limits access to welfare and citizenship to dissuade asylum seekers from coming.
• More broadly, the U.K. and several other European countries are also tightening immigration restrictions as the region faces its biggest wave of migrant arrivals in years.
• Even in the U.S., right-wing populist Republicans have forced President Biden into negotiations to tighten refugee and immigrant rules as the price for his proposed bill providing more military aid to Ukraine and other U.S. allies.
• The tightened rules reflect the extent to which citizens in the developed Western countries are angry at the disruption and social change they perceive in times of mass immigration. Right-wing populists have responded to that anger throughout the West, forcing more traditional, centrist parties to tighten the rules.

United States-Mexico:  Citing the need to shift personnel to handle the current wave of migrants coming across the southern border, U.S. Customs and Border Protection closed the railway bridges this week at Eagle Pass and El Paso, Texas, which respectively rank as the second and fourth busiest freight rail crossings with Mexico.  Shippers and railroad industry groups warned the closures could disrupt more than one-third of U.S.-Mexican rail traffic, hitting industries from automobile manufacturing to farming.

U.S. Population Growth:  The Census Bureau has released an estimate that the U.S. population grew 0.5% this year, reaching 334.9 million as of June 30.  The growth this year marked a slight acceleration from the 0.4% increase registered in 2022.  That has helped keep the U.S. among the better-growing developed countries, many of which are seeing declines in their overall populations and work forces because of falling birth rates and higher average ages.

• Of course, the U.S. is also facing those challenges. As a result, there were only about 504,000 more births than deaths in the U.S. over the last year.
• The big difference for the U.S. is that it attracts so many immigrants. According to the Census Bureau, net migration into the U.S. came to 1.1 million over the last year.  That means immigration accounted for about 70% of U.S. population growth in 2023, versus about 40% a decade ago.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Note to readers: the Daily Comment will go on holiday after December 20, 2023, and will return on January 2, 2024. From all of us at Confluence Investment Management, have a Merry Christmas and a Happy New Year!

Our Comment today opens with a discussion of the potential fallout if the U.S. and its European allies stop providing military aid to Ukraine.  While some observers say there would be no impact, a new study argues that it would lead to much higher costs later on.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including a decision by the Bank of Japan to hold its monetary policy unchanged and a call by one Federal Reserve policymaker for multiple U.S. interest-rate cuts in 2024.

Russia-Ukraine-United States:  A new report by the Institute for the Study of War warns that if the U.S. and its European allies end their military aid to Ukraine, the country would be at risk of being overrun and conquered by Russian forces.  In such an event, the Kremlin’s battered but triumphant army would stand on NATO’s borders from the Black Sea to the Arctic Ocean, posing a major conventional military threat to NATO for the first time since the 1990s.

• The study finds that Russia’s current wartime defense industry expansion and large pool of potential military recruits would allow it to recover quickly from its steep equipment and troop losses in the Ukraine invasion to date. At the conclusion of fighting, the Russian army would also have a wealth of experienced officers and troops, effective tactics honed on the modern battlefield, and innovative new weapons.
  • The study argues that the second-worst scenario would be to freeze the conflict with Russia holding the 20% of so of Ukrainian territory it currently controls in the country’s east and south. President Putin would almost certainly use such a freeze to rebuild his forces and prep them for a new invasion in the future, but at least his forces would remain far from NATO’s southern frontier.
  • The best scenario for the U.S. and NATO would be to help Ukraine drive the Russians completely out of their territory. Putin would still likely respond by rebuilding his forces for a new future invasion, but those forces would then have to transverse all the territory of a potentially rebuilt Ukraine.
• If President Putin could deploy his rejuvenated army to positions along NATO’s entire eastern frontier, perhaps with Chinese approval and/or prodding, the study finds that the U.S. and its allies would need to invest enormous sums to rebuild the military strength needed to deter them, even as the allies are forced into an expensive defense buildup against China in the Indo-Pacific region. The study argues that the cost of this European defense buildup would far exceed the current cost of military aid to Kyiv.
  • Such a scenario would force the U.S. to make painful trade-offs between deploying deterrence forces to Europe or to Asia.
  • In other words, allowing Russia to win in Ukraine (either in full or in part) wouldn’t allow a full focus on Asia. Russia’s appetite for aggression would only increase, forcing the U.S. and its allies into an expensive two-front military buildup in both Europe and Asia.
• The ISW study is therefore consistent with our thesis that rising frictions between the U.S. geopolitical bloc and the China/Russia bloc will continue to fracture international relations, creating risks for investors but also creating opportunities in sectors such as broad industrials, defense companies, defense-focused technology firms, and mining and energy firms.

United States-NATO:  Speaking of NATO, one little-noticed provision of the National Defense Authorization Act passed by Congress last week prohibits any future U.S. president from pulling the country out of NATO without a two-thirds vote of approval in the Senate or separate legislation from Congress.

Israel-Hamas Conflict:  As Iran-backed Houthi rebels in Yemen continue to launch retaliatory missile and drone strikes on ships in the Red Sea, the U.S. and six of its allies yesterday agreed on an expanded naval task force to protect shipping in the region.  The task force will include ships from the U.S., the U.K., France, Bahrain, and several other countries to protect commercial ships and oil tankers in the region.

• Some 9 million barrels of crude oil are shipped through the Red Sea each day, representing almost one-tenth of global demand. After oil giant BP (BP, $35.12) said on Monday that it would pause its shipments through the Red Sea on security concerns, investors spooked by the prospect of supply disruptions bid up Brent oil to $77.95 per barrel, up 1.8% for the day.
• So far this morning, oil prices have given up a portion of yesterday’s gain, possibly reflecting satisfaction with the expanded naval task force.

Germany-Norway:  In a deal signed today, Norwegian energy giant Equinor (EQNR, $31.71) agreed to supply 129 billion cubic meters of natural gas to German state energy firm SEFE through 2039.  Worth about 50 billion EUR ($54.8 billion) at today’s prices, the long-term pipeline supply deal would reportedly be enough to cover one-third of Germany’s industrial gas demand over the period, helping replace the cheap Russian gas shut off after the Kremlin’s invasion of Ukraine.

• The deal will therefore be important in ensuring energy security for Germany, and for Europe in general, in the coming years.
• The deal is also an example of how global geopolitical fracturing will sometimes merely shift trade patterns, rather than end cross-border shipments.

United Kingdom:  Bank of England Deputy Governor Ben Broadbent yesterday warned that volatile, inconsistent data on wage growth will keep the central bank from making an early judgment on whether inflation pressures are easing, which in turn will discourage it from early interest-rate cuts.  The statement adds to the pushback from major central banks against investors betting on rate cuts in the near term.

• Responding to the risk that BOE policymakers could keep interest rates too high and prompt a big slowdown in the British economy next year, the chief investment officer of bond giant PIMCO said he is keeping his exposure to U.K. government bonds higher than he usually does.
• Other investors have apparently also been buying British bonds aggressively, pushing the yield on 10-year Gilts to about 3.673% recently, down approximately 100 basis points since late October.

Japan:  Dashing some investors’ hopes for policy normalization, the Bank of Japan today held its benchmark short-term interest rate at -0.1% and made no change to its “soft” ceiling on 10-year Japanese government bond yields.  In addition, BOJ chief Ueda said in his post-decision press conference that the policymakers want to see more evidence of sustained wage and price rises before ending their negative interest rates and yield curve control policies.  Without even a hint of monetary normalization, the yen (JPY) today has weakened by 1.1% to 144.34 per dollar ($0.0069).

U.S. Monetary Policy:  In contrast with the recent pushback against rate-cutting talk from other Fed policymakers, San Francisco FRB President Daly told the Wall Street Journal yesterday that cooling U.S. inflation in 2023 should prompt the policymakers to consider cutting interest rates several times in 2024.  As inflation cools, Daly said it makes sense for the Fed to make sure its high interest rates don’t disrupt the U.S. labor market.  The statement could potentially give a further boost to risk assets in trading today.

U.S. Air Travel Industry:  A recent report from the Federal Aviation Administration said the agency is struggling to find enough fully certified air-traffic controllers.  With nearly all FAA facilities facing controller shortfalls, the crisis is raising concerns that the agency might have to slow flight operations around the country.  Besides affecting airlines and air shippers, such a slowdown in air travel could disrupt supply chains, boost price pressures, and weigh on overall economic growth.

• The shortage of air-traffic controllers can be ascribed in part to mass retirements in recent years. At the same time, the tight labor market has made it harder to attract applicants.
• On a related note, the National Defense Authorization Act passed by Congress last week calls for U.S. active-duty military personnel to fall to 1.285 million by the end of fiscal 2024, down almost 64,000 from three years ago. As with the air-traffic controllers, the smaller target mostly reflects the difficulty of recruiting in a tight labor market, rather than a decline in the mission or responsibilities.

U.S. Political Dysfunction:  In yet another sign of how political tensions and disdain for compromise are affecting U.S. policymaking, new analysis shows that just 20 bills have passed both chambers of Congress and been signed into law this year, with another four awaiting President Biden’s signature.  Most of the bills that have become laws were uncontroversial measures like naming Veterans Affairs clinics.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Risk assets are down following stronger-than-expected jobs data. Meanwhile, the Los Angeles Lakers and Indiana Pacers have secured their spots in the NBA In-Season Tournament championship game. Today’s Comment kicks off with our insights on the latest craze in artificial intelligence followed by an analysis of why investors suspect the Bank of Japan may soon abandon negative interest rates and a discussion on Saudi Arabia, which continues to work with both the U.S. and Russia to achieve its aims. As always, our comprehensive report encompasses the latest domestic and international data releases.

AI’s Last Hoorah: Fear of missing out has led investors to pile into tech companies after each new development, but there are doubts about how long this can last.

• Alphabet subsidiary Google (GOOGL, $138.10) unveiled its highly anticipated answer to OpenAI’s technology on Wednesday. The company’s new artificial intelligence, dubbed Gemini, boasts capabilities exceeding anything currently available. Gemini can process information from audio, video, and text, which should expand the customer’s use. Additionally, it is believed to possess advanced reasoning and understanding abilities and was able to outperform the latest OpenAI on a range of industry benchmarks. So far, Gemini has been released in limited markets as Google would like to test the technology before releasing it early next year.
• Google’s answer to OpenAI is a reflection of the ongoing turf war for dominance in the AI space, which has also expanded to the chip market. Advanced Micro Devices Inc. (AMD, $127.69) unveiled its new MI300 accelerator chip, a direct challenge to Nvidia’s (NVDA, $464.22) dominance in the semiconductor market. This powerful new graphics processor boasts greater memory bandwidth and capacity compared to Nvidia’s H100 chip, positioning it as a compelling and potentially cheaper alternative. Major tech players, including Meta (META, $327.06), OpenAI, and Microsoft (MSFT, $370.75), have already expressed interest in acquiring the newly developed chip, indicating its potential to disrupt the current market landscape.
• 
• While the excitement surrounding AI technology continues, its path to widespread adoption faces significant challenges in 2024. Intense competition within the space threatens to squeeze profitability as companies engage in price wars, potentially hindering their ability to meet ambitious earnings targets and justify their high valuations. Furthermore, lingering regulatory uncertainty surrounding AI, fueled by concerns about privacy and societal risks expressed by policymakers, poses a further obstacle. As a result, investors should exercise caution and recognize that today’s industry leaders may not remain so in the future. Focusing on undervalued companies outside the AI sector may offer greater potential for long-term returns.

BOJ Regime Shift: The Japanese yen (JPY) has jumped following speculation that the Bank of Japan will move away from its ultra-accommodative monetary policy.

• BOJ Governor Kazuo Ueda hinted at potential policy adjustments in remarks to Japanese lawmakers on Thursday, stating that the central bank has “several options” available once short-term interest rates rise above zero. These comments followed Deputy Governor Ryozo Himino’s remarks the previous day, which suggested that a measured transition toward a more restrictive monetary policy could benefit the overall economy. The combined statements fueled speculation among traders that a significant policy announcement might be imminent at the BOJ’s upcoming meeting on December 18. This speculation contributed to a surge in the Japanese yen, reaching a peak of 4% appreciation against the dollar (141.71 yen per dollar) on Thursday, reflecting a decline in bearish sentiment toward the currency.
• The recent surge in price increases, driven by a departure from traditional corporate pricing and compensation strategies, suggests a significant shift in Japanese business culture. This has propelled inflation above the central bank’s 2% target for 19 consecutive months, boosting the BOJ’s confidence that deflation may be fading. However, a seamless transition to a hawkish monetary policy remains elusive. The latest GDP figures reveal a contraction of 2.9% in the third quarter of 2023 and a 2.5% decline in household spending since October 2022, suggesting the central bank’s tightening might not be as swift as investors anticipate.
• 
• Higher yields on Japanese government bonds (JGBs) may entice foreign investors, reversing the country’s sizable net outflows and transforming them into inflows. This could lead to capital appreciation for foreign investors with exposure to Japan, driven by a strengthening JPY. Additionally, global bond yields may rise as Japanese buyers, incentivized to hold more domestic debt, exert less downward pressure on international yields. However, the change could also lead to an increase in servicing costs for traders who profited from the yen carry trade. It shouldn’t be a problem as long as those traders are able to make payments on their loans. However, if they are unable to do so, it could lead to another financial crisis.

Saudi Arabia Weighs Its Options: The ongoing conflict between Israel and Hamas highlights Riyadh’s cautious approach to picking sides between regional rivals.

• Washington continues its efforts to facilitate the normalization of relations between Saudi Arabia and Israel. U.S. officials remain cautiously optimistic that both parties are receptive to restarting negotiations, which were paused following the escalation of violence between Israel and Hamas. While Saudi Arabia has not explicitly called for renewed talks, its recent appeals to the U.S. to exercise restraint in response to Houthi rebel attacks on ships in the Red Sea suggest a broader regional commitment to peace. Currently, there are no plans for the countries to engage in discussions while conflicts persist in Gaza.
• On a separate note, Saudi Arabia’s Crown Prince Mohammed bin Salman hosted Russian President Vladimir Putin in Riyadh for talks centered on oil production cuts. This meeting served as a stark reminder that Moscow retains significant influence in the Middle East, despite Western efforts to isolate it following the invasion of Ukraine. Putin, facing a looming re-election campaign and a struggling Russian economy heavily reliant on energy revenue, prioritized the meeting, demonstrating his deep concern about the impact of low oil prices. Following their discussion, both leaders called on other OPEC members to strictly adhere to the production targets set at the previous meeting. Notably, Iran, with whom Putin met on Thursday, remains the biggest holdout.
• 

• Despite being the world’s largest exporter of crude oil, Saudi Arabia is currently struggling to diversify its economy. Its attempts to branch out into different fields beyond energy have yielded weak results so far. On Thursday, the Kingdom announced a delay in its ambitious 2030 Vision due to concerns over growing budget deficits. The recent drop in oil prices, which has slowed down the global economy, has likely exacerbated these problems. To attract foreign investment, Saudi Arabia has announced a 30-year tax exemption for any company willing to relocate its headquarters to the country.

In Other News: The European Union is considering challenging U.S. steel tariffs with the World Trade Organization. The move highlights growing concerns that the Western alliance may be weakened following the next presidential election.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Risk assets are enjoying a lift as investors eagerly await tomorrow’s crucial jobs data. Meanwhile, former Padres’ outfielder Juan Soto is making his way to the Big Apple for his next adventure. Today’s Comment kicks off with our insights on the anticipated rate cuts for next year, then explores why banks are wary of the new Basel regulations, and finally delves into how China’s economic struggles might ultimately benefit the rest of the world. As always, our comprehensive report encompasses the latest domestic and international data releases.

Are Rate Cut Bets Overdone? Investors are having second thoughts on how aggressive the Fed will be when cutting rates next year.

• Despite rallying nearly 9% in November, the S&P 500 has been relatively sluggish in the first week of December. This lackluster performance can partially be attributed to market participants rethinking their expectations of a Federal Reserve policy shift. Projections based on fed funds contracts show that investors are predicting a 125 basis point cut in key interest rates, while economists have offered a more pessimistic view, predicting at most a 50 basis point cut in 2024. This divergence in views has led investors to seek protection against market volatility in the form of options.
• While concerns remain, expectations for a moderating interest rate environment are not entirely unfounded. Federal Reserve Board Governor Christopher Waller, a traditionally hawkish member, recently suggested that the central bank could cut rates as early as April if inflation continues to make significant progress towards the 2% target. Additionally, signs of a cooling labor market may further incentivize action from Fed officials. Last week, data from the Bureau of Labor Statistics revealed a two-year low in job postings for October, while the latest private payroll data from ADP indicated a reduction in new hires by firms. These developments suggest a potentially more dovish stance from the Fed in the near future.

• Although inflation remains significantly above the Federal Reserve’s 2% target, it is still too early to predict with certainty whether the Fed will cut rates or stand pat next year. Furthermore, aggressive cuts, as anticipated by the market, are highly unlikely without a major economic crisis. The Atlanta Fed’s latest forecast projects a modest 1.3% annualized growth for the final quarter of 2023. Therefore, if we assume there will be no recession or perhaps a mild one, then any potential rate cuts in the coming year will likely be moderate.

Wall Street Woes: CEOs from major banks gathered on Capitol Hill to express their concerns about new financial regulations.

• Implementation of new banking standards dubbed the “Basel III Endgame,” which are due to take effect in 2028, was the central topic of discussion. The chief executives argued that the proposed changes, which have not been finalized, are likely more burdensome than regulators realize. For example, the new capital requirements could make it harder for financial institutions to lend to households and small businesses, particularly those who already struggle to access credit. Additionally, the executives argued that the changes could push lending into less regulated sectors of the financial system. The banks’ concerns about the impact of the new regulations on lending come amid a significant rise in private credit lending, which has seen a dramatic increase in recent months.
• The new rules were announced in July in response to growing concerns about the weakness within the financial system. These rules will apply to banks with holding over $100 billion in assets, exempting smaller institutions. The aim is to compel banks to adopt a more conservative and standardized approach to risk measurement, effectively requiring them to hold more capital as a buffer against losses. Regulators estimate a 19% average capital increase for globally systemically important banks (G-Sibs), although industry groups believe the actual increase could be significantly higher. Nevertheless, the stricter rules should help bring U.S. banks into compliance with international standards.

• New rules often have a good purpose, but they typically come at a cost to the overall economy. The combination of higher interest rates and regulatory scrutiny has already weighed on lending. As the chart above shows, large banks have reduced the amount of credit issued compared to the year prior. However, the new Basel rules’ ability to prevent another crisis may not be as clear-cut as regulators may think, as it could lead to unforeseen consequences. For example, the rise of collateralized debt obligations (CDOs) was spawned by the first Basel Framework, highlighting the possibility of unintended side effects. That said, the proposed rules are still under development and open for public comment until January 16, 2024.

China Needs a Break: The country faces a growing number of obstacles as it seeks to expand its global reach and revitalize its struggling economy.

• China’s Belt and Road Initiative has suffered a significant setback with Italy’s formal withdrawal from the program. Though Italian Prime Minister Giorgia Meloni’s earlier criticism of the initiative foreshadowed the decision several months ago, it will likely strain relations with China. Italy’s 2019 participation in the BRI marked a historical first — the only G-7 member to join the program. However, this decision drew criticism from other EU countries and the United States, highlighting divisions within the Western alliance. Italy’s withdrawal may lead to some retaliation from Chinese consumers, but the decision to leave is a further indication of Beijing’s waning influence in Europe.
• U.S. ratings agency Moody’s ( MCO, $374.43) downgraded the outlook for eight Chinese banks, including the “Big Four” state-owned commercial banks (Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and China Construction Bank Corporation), from stable to negative. The negative outlook reflects Moody’s earlier downgrade of China’s sovereign debt rating, as the agency believes the government has less fiscal capacity to support struggling banks. Additionally, they signaled the potential downgrade of several government-backed entities supporting infrastructure. Fearing potential retaliation from the Chinese government, similar to surprise audits faced by Mintz Group, Bain & Co., and Capvision Partners earlier this year, Moody’s advised its staff to work from home following the downgrade.

• The country’s escalating economic problems will likely discourage Beijing from seeking major disruptions in its international relations in the near term. This is evidenced by Xi Jinping’s recent efforts to foster warmer ties with the United States, despite President Biden’s earlier remarks referring to him as a dictator. As the government seeks to manage its debt burden, promoting exports becomes an increasingly important strategy for generating growth and maintaining industrial production levels. This explains Xi Jinping’s recent trip to the EU, where he aimed to convince lawmakers not to place barriers on trade. In all, China’s shortcomings may lead to more stability as it may be too distracted to start a fight with the West.

Other News: Venezuelan President Nicolás Maduro recently unveiled a controversial map claiming Guyana’s Essequibo region as part of Venezuela. This action marks a significant escalation in Maduro’s ongoing efforts to assert control over the eastern region. President Biden suggested that there are Democrats who could possibly defeat Trump in an election, a possible sign that he may be weighing his options. Meanwhile, the Senate’s failure to pass legislation funding Ukraine due to demands for increased aid for U.S. border security highlights a growing trend of inward-focused politics as the nation grapples with its changing role in the global landscape.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the latest on the potential for a Venezuela-Guyana crisis.  We next review a wide range of other international and U.S. developments that could affect the financial markets today, including Italy’s widely expected decision to pull out of China’s controversial Belt and Road Initiative and several items related to U.S. monetary policy going into 2024.

Venezuela-Guyana:  It still appears that domestic electoral politics were the main reason President Maduro held last weekend’s referendum on taking control of the Essequibo territory of Guyana.  However, new steps that he called for yesterday appear much more concrete and menacing than mere political posturing.  If implemented, the steps requested by Maduro would likely lead to a serious case of territorial aggression in South America.

• The new steps called for by Maduro include the following:
  • Immediate legislative debate and approval of a bill creating a new Venezuelan state of “Guayana Esequiba” (Venezuela’s term for the Guyana territory).
  • Creation of a new High Commission for the Defense of Guayana Esequiba.
  • Creation of a Guayana Esequiba Comprehensive Defense Zone, with administrative and military headquarters in Tumeremo, a town in eastern Venezuela close to the border with Guyana.
  • Designation of Maj. Gen. Alexis Rodríguez Cabello as the Sole Authority of Guayana Esequiba, with administrative and military headquarters in Tumeremo.
  • Creation of a new Essequibo Division within state-owned oil company PDVSA and state-owned mining company CVG, with exclusive administrative and operational powers for the exploitation of natural resources in Guayana Esequiba.
  • Publication of a new official map of Venezuela, including Guayana Esequiba, and ensuring it is sent to all schools, high schools, and universities in the country.
  • Development of a comprehensive social plan for the inhabitants of Guayana Esequiba, including the provision of official Venezuelan identification cards.
  • Establishment of a three-month period for the withdrawal of foreign companies/unilateral concessions in Guayana Esequiba.
  • Creation of a Special Law for the protection of Guayana Esequiba.
• Besides seeking to boost his prospects in Venezuela’s planned 2024 elections, Maduro is likely hoping to wring more sanctions relief from the U.S. The Biden administration may indeed be tempted to further ease restrictions on U.S.-Venezuelan energy trade to avoid an invasion that would likely boost global energy prices ahead of the U.S. elections.
• On the other hand, if Maduro miscalculates and actually follows through on an attempt to seize Essequibo, we suspect the U.S., Brazil, and potentially other countries in the region would come to Guyana’s aid. Any such move by Maduro could therefore backfire on him, but even Venezuela would see some temporary fiscal benefit from the likely spike in oil prices that would result.

Guinea:  In another reminder of the mineral riches in less-developed regions like Latin America and Africa, mining giant Rio Tinto (RIO, $68.49) today said its single biggest investment over the next few years is likely to be a huge new iron ore mine in the West African country of Guinea.  In partnership with Guinea’s government and a Chinese firm, Rio expects to contribute about $6.2 billion to cover half the cost of developing the southern part of the projected Simandou mine, which some analysts think could eventually produce enough ore to drive down global iron and steel prices and take market share from today’s leading producers, Australia and Brazil.

Argentina:  Back in South America, Argentina’s newly elected president, populist libertarian Javier Milei, is making news by backing away from some of the radical economic policy changes that got him so much attention during his electoral campaign.  For example, he has fired some top economic advisers who were enlisted to help him kill the central bank and adopt the U.S. dollar as the national currency. He has also aligned with officials from a previous center-right government that he previously derided, and he has toned down his rhetoric against China.

• Ahead of his inauguration this coming Sunday, Milei is likely running head-on into the messy realities of governing, especially since some of his proposals would be socially disruptive and costly for many Argentines.
• Besides that, Milei’s party has only a modest number of seats in the country’s legislature, presenting challenges for getting his reforms passed into law.

European Union-United Kingdom:  As part of a deal to extend tariff-free trade in electric vehicles between the EU and the U.K., the European Commission proposed a program today offering 3 billion EUR ($3.2 billion) in subsidies to EV battery producers in the bloc.  The program would operate even as the EU continues its investigation into Chinese subsidies for its electric vehicles exported to the EU, which could ultimately lead to punitive EU tariffs against Chinese EVs.

• The EU program would pale in comparison with the big subsidies provided in the U.S. under the Biden administration’s Inflation Reduction Act.
• Nevertheless, the EU program is another reflection of how the world is fracturing into relatively separate geopolitical and economic blocs, and how industrial policy and more active government involvement in the economy is a part of that.

Italy-China:  The Italian government today said it has formally notified China that it is pulling out of President Xi’s signature Belt and Road Initiative.  Under that program, China has channeled more than $1 trillion to mostly underdeveloped countries around the world to build ports, railroads, and other infrastructure aimed at easing Chinese trade.

• The BRI has been criticized as a debt trap by many officials and economists in the West. The Chinese-led projects reportedly often come with opaque and onerous loan obligations.
• Italy’s move shows that the populist right-wing government of Prime Minister Meloni is now back in closer alignment with other states in the European Union, which have begun to push back against China’s rising geopolitical and economic aggressiveness.

U.S. Labor Market:  In a release yesterday, the monthly Job Openings and Labor Turnover report showed October job openings fell by 617,000 to a level of 8.7 million, well below the record high of 12.0 million in March 2022.  The number of quits and hires also remained well below the levels reached in early 2022.

• Coupled with the recent rise in the unemployment rate and an increase in the number of people drawing jobless benefits, the data points to continued gradual weakening in the labor market.
• That will probably help keep price inflation moderating and discourage the Fed from hiking interest rates further.

U.S. Energy Industry:  New data from the Energy Information Administration shows domestic oil production has now reached a new record high for the first time since the coronavirus pandemic hit.  In recent years, U.S. output was held back by a decline in new exploration and development, reflecting factors such as investor insistence that drillers focus more on profits and policymakers’ drive to impose new green regulations.  Now, domestic supply has rebounded enough that it is helping push energy prices downward.

• On the demand side, energy prices are also being cut by weak economic growth in China and some other major markets.
• Increased use of electric vehicles around the world may also be sapping petroleum demand to some extent.

U.S. Bond Market:  Reflecting the softening labor market, lower energy prices, and hopes that the Fed will cut interest rates soon, the yield on the 10-year Treasury note continues to decline.  In fact, we’ve noted that the 10-year yield’s 20-day moving average has now decisively slipped below its 50-day average.  Such a cross-over, when the 50-day average is still trending upward, is often a harbinger of further declines.  Nevertheless, we still think investors are overly optimistic about near-term rate cuts.

U.S. Monetary Policy:  Consistent with our view that many bond investors are too optimistic about near-term interest-rate cuts, a new poll of economists by the Financial Times found that almost two-thirds of the respondents think the Fed won’t start to cut rates until July 2024 or later.  About three-quarters of the respondents expect the Fed to cut the benchmark fed funds rate by half a percentage point or less by the end of 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 downgrade in the outlook for Chinese sovereign debt.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including reports of suspicious short-selling in Israeli stocks ahead of Hamas’s October 7 attacks on the country and new data on educational achievement for the future U.S. workforce.

China:  Moody’s (MCO, $373.94) today maintained its middling investment-grade rating of “A1” on China’s long-term sovereign debt, but in a surprise decision, the firm cut its outlook on the debt from “stable” to “negative.”  According to Moody’s, the cut in the outlook reflects a likelihood that Beijing will eventually need to bail out many of its highly indebted provincial and local governments.  It also cited China’s slowing economic growth in its reasoning.

• For comparison, rating firms Standard & Poor’s and Fitch both currently rate Chinese debt as A+, with a stable outlook.
• While China’s central government debt only amounts to about 21% of gross domestic product, total provincial and local government debt (including off-budget obligations) is estimated to be several times higher than that. Provincial and local governments are also highly dependent on land sales and other off-budget funds, which now are drying up because of Beijing’s clampdown on excessive property development.
• In sum, China continues to face economic headwinds from what we call the Five Ds: Weak consumer demand, high corporate and local government debt, poor demographics, economic disincentives from the Communist Party’s increasing intrusion into the economy, and decoupling as foreign countries shift their trade, investment, and technology flows away from China.

Japan:  As the country returns to consistent price inflation and the Bank of Japan prepares to let interest rates rise further, commercial banks are finding that decades of deflation and ultra-low interest rates have left their staffs unprepared for the new environment.  Major banks are having to retrain their staff to help them understand how to operate in an environment that is normal for most other countries!

Israel-Hamas Conflict:  A draft paper by law professors at NYU and Columbia flags suspicious short-selling in Israeli stocks right before the October 7 attacks by Hamas.  The professors posit that a trader or traders were informed about the planned attacks and sold Israeli stocks short in anticipation that they would decline sharply.  While that seems plausible enough, it also seems to contradict the narrative that the Hamas attacks were originally meant to be relatively small scale incursion but ended up being more much extensive and successful than anticipated.

• Meanwhile, reports today say the Israel Defense Forces’ retaliatory attack on Hamas in the Gaza Strip is close to encircling the last major group of Hamas fighters around the city of Khan Younis.
• Destroying that group could nearly end Hamas’s conventional military capability, but it wouldn’t necessarily lead to a quick end to all fighting in Gaza. Therefore, there is still a risk that the conflict could spread more broadly throughout the region.

Russia-Ukraine-NATO:  In another sign of how militarized Russia is becoming, President Putin has signed an order boosting the country’s total military personnel to 2.20 million, including 1.32 million troops.  That’s up from a total of 2.03 million, including 1.15 million troops, in the increase that was announced in August 2022.  The troop levels cited appear to encompass only active-duty troops, not reservists, so the figures imply that Russia will soon have 1.98% of its military-aged population (those aged 16 to 49) under arms.

• For comparison, active-duty troops only constitute about 0.90% of the U.S. military-aged population.
• Separately, the Stockholm International Peace Research Institute has estimated that revenue from military goods and services at the 100 global defense contractors it tracks actually fell by 3.5% in 2022, despite Western countries’ rush to rebuild their defenses following Russia’s invasion of Ukraine. Sales at the 42 U.S. defense firms tracked by SIPRI fell 7.9%.
  • According to SIPRI, the drop in revenues reflects problems ranging from labor shortages and soaring costs to supply chain disruptions.
  • The think tank believes Western defense firms will only see significant production, sales, and revenue increases in two or three years.
  • We continue to believe defense firms will see big, sustained increases in sales and profits over the coming decade or more as the U.S. and its allies work to rebuild their defenses, but we agree that those increases may not arrive for another couple of years.

 European Union-United States:  The CEO of Airbus (EADSY, $37.18) warned that the company’s multi-billion euro program for replacing its aging A320 family of jets could require “some support” from European governments.  The CEO may be trying to capitalize on Western governments’ recent openness to using taxpayer funds to support domestic manufacturers.  However, any new European support for Airbus would likely spark pushback from Boeing (BA, $234.87) and rekindle trade tensions with the U.S.

 European Union-Mercosur:  The Brazilian government has informed EU officials that the Mercosur trade group — Brazil, Argentina, Uruguay, and Paraguay — won’t be able to sign a proposed free trade deal with the EU this week as previously planned.  According to the Brazilians, the Argentines don’t want to move forward until the inauguration of their newly elected President Javier Milei, who has criticized Mercosur.  Coupled with resistance from France, the long-debated EU-Mercosur trade pact now looks like it could be postponed indefinitely.

United States-Cuba:  Victor Manuel Rocha, a former senior U.S. diplomat who served in U.S. embassies across Latin America, was arrested by the FBI yesterday on charges of spying for Cuba over the course of decades.  As bad as the case is, it likely pales in comparison to the enormous, highly aggressive espionage efforts that China continues to run against the U.S. and its allies.

U.S. Education System:  In a mixed message for the future labor force, the Organization for Economic Cooperation and Development said 15-year-olds in the U.S. lost less learning during the pandemic than most of the other OECD countries.  Based on tests administered under the organization’s Program for International Student Assessment, U.S. students’ average reading and science scores were essentially unchanged between 2018 and 2022.  As shown in the chart below, U.S. students’ average math score fell 13 points, versus an average decline of 15 points in the other countries tested.  Unfortunately, U.S. math scores remained far weaker than in other countries.

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