by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with some ideas we picked up on the world’s geopolitical trends from our reading over the holiday weekend.  We next review a range of recent international and U.S. developments with the potential to affect the financial markets today, including a potential new financial crisis in China, a landslide victory for a far-right candidate in last week’s Dutch elections, and an early take on U.S. consumer spending on Black Friday.

United States-China:  We often write about the intensifying U.S.-China geopolitical rivalry since it’s key to understanding the world’s future economic and financial market environment.  Based on our reading over the Thanksgiving holiday, which included The Strategy of Denial, by Eldridge Colby, lead author of the U.S. government’s 2018 National Defense Strategy, we want to refine one assertion we’ve often made about how the U.S. established and maintained its position as global hegemon in the decades since World War II.

• As Colby notes, the great lesson of the 20^th century was that the U.S. can’t rely on the Pacific and Atlantic oceans to protect its territorial integrity, political freedom, or prosperity. Concentrated economic wealth—and therefore potential military power—in Asia, Europe, and the Middle East means the U.S. can only be secure by blocking the emergence of regional hegemons in those territories.
• While we’ve often said that one step in establishing U.S. hegemony was to “freeze” past conflicts in those regions, it’s more precise to say the U.S. used its predominant military, economic, and diplomatic power after World War II to hold down the historic hegemonic aspirants in those regions: Japan in Asia, Germany in Europe, and potentially Russia in the Middle East.  This is consistent with Colby’s analysis of U.S. strategy.
• But importantly, Colby notes that the U.S. can’t just exercise its own power to hold down those want-to-be hegemons. To safely contain aspiring regional hegemons, the U.S. actively developed regional anti-hegemonic coalitions to help keep the peace, such as the North Atlantic Treaty Organization in Europe and various bilateral alliances in Asia and the Middle East.
  • President Trump’s error was casting these alliances as relationships in which the U.S. benevolently provides security for Asia, Europe, and the Middle East.
  • Actually, the U.S. enlists countries in these regions to help protect U.S. national security. While “free rider” problems exist in all such alliances, they’re the price the U.S. pays for these regions to cooperate in protecting U.S. security.
    • By allowing us to maintain military bases on their soil, our allies enable the U.S. to practice an extraordinarily deep “forward defense.”
      • Rather than having a western defense perimeter along our own Pacific coast, we’ve pushed it more than 5,000 miles away to the “First Island Chain” running from Japan and Taiwan through the Philippines, Guam, and Malaysia, as shown in the map below.
      • Rather than an eastern defense line along our own Atlantic coast, we’ve pushed it more than 4,000 miles away to the eastern frontiers Finland, the Baltics, Poland, Romania, Turkey, Jordan, Israel, and Saudi Arabia.
    • Just as important, the U.S.’s preponderant military spending and power give us the leadership role in coordinating and agglomerating our allies’ power in ways that serve U.S. interests as well as their own, especially in managing the coalition to deny China’s bid for regional hegemony.
  • Colby’s book is pretty theoretical, almost like a primer on game theory, but it’s a useful guide to the geopolitical dynamics we’re likely to see between the U.S. and China in the coming years. For investors, the key is that the U.S.’s efforts to build and maintain anti-hegemonic coalitions in Asia and Europe will surely exacerbate the global fracturing that we’ve been writing about, with results ranging from higher inflation and interest rates to potential investment opportunities in short-duration, dividend-paying industrial stocks and commodities.

(Source:  Hudson Institute, 2023)

China:  The government in recent days has been scrambling to avert a meltdown of shadow-banking giant Zhongzhi Enterprise, which last week announced it was insolvent and had at least $31 billion more liabilities than assets.  If the company collapses, it would be one of China’s biggest corporate failures in many years and would likely further sour investors on the country.  In addition, investors in products offered by the company have begun to stage demonstrations demanding their money back, which could lead to broader political unrest.

• Separately, the Financial Times today has a fascinating article on the Chinese government’s ongoing campaign to repress Muslim influence, not just in Xinjiang but throughout the country.
• Using satellite photos, the article shows how the government has torn down or refurbished mosques and other buildings to eliminate their Arabic features, and in some cases replaced them with traditional Chinese elements.

Taiwan:  The opposition Kuomintang and Taiwan People’s Party have scuttled their effort to present a unified ticket in the January 13 presidential election, while Terry Gou, the founder of giant contract electronics manufacturer Foxconn (HNHPF, $6.29), withdrew from the race.

• The moves will probably further boost the prospects of the ruling Democratic Progressive Party under Vice President Lai Ching-te.
• Since the poll-leading DPP favors greater independence from China, the opposition’s collapse will raise the risk of China launching provocative military, economic, or diplomatic moves against Taiwan in the coming weeks.

Malaysia:  The government of Prime Minister Ibrahim has unexpectedly extended the license for Australian mining firm Lynas (LYSDY, $4.38) to run its rare earths processing facility in Pahang state, despite opposition from residents wary of environmental pollution.  Renewing the license to operate the plant, which is the world’s largest such facility outside China, is a signal that Ibrahim will push forward with his plan to make Malaysia a key player in the mining and processing of rare earths, which are critical to the highly electrified economy of the future.

• Ibrahim’s government believes Malaysia holds some $173 billion of rare earth reserves, which it believes should be exploited to boost foreign investment, economic growth, and Malaysian wealth (the chart below shows how Malaysian per-capita gross domestic product has grown in recent decades).
• As the U.S. and its evolving geopolitical bloc work to cut their dependence on Chinese rare earths, they would likely be a ready market for anything Malaysia can produce. In turn, that would likely help draw Malaysia closer to the U.S. bloc.  Our analysis currently places Malaysia in the “Leaning U.S.” camp.

Netherlands:  In parliamentary elections on Wednesday, the far-right populist Freedom Party led by anti-Islam and Euroskeptic firebrand Geert Wilders came in first with 23.7% of the vote, well ahead of the Labour-Green Alliance of Frans Timmermans and its 15.6%.  That gives the Freedom Party 37 of the 150 seats in parliament, versus 25 for the Labour-Green Alliance, 24 for the ruling center-right Freedom and Democracy Party (VVD), and 20 for the centrist New Social Contract Party (NSC).  Because of the fractured results and the reluctance of other parties to associate with Wilders, it is not yet clear if he will be able to form a coalition that would have a majority in parliament, despite his unexpected landslide victory.

Turkey:  As the government continues to normalize economic policy after President Erdoğan’s recent re-election, the central bank on Thursday hiked its benchmark short-term interest rate to 40%, boosting the rate from 35% previously and marking its sixth straight rate hike.  Still, the benchmark rate remains far below Turkey’s consumer price inflation, currently over 61%.  The lira (TRY) has therefore continued to weaken, trading on Friday at 28.8656 per dollar ($0.0346), down 35.2% for the year-to-date.

Russia-Ukraine War:  With Russian and Ukrainian forces largely at a stalemate along the front lines in eastern and southern Ukraine, Russia launched big new waves of kamikaze drones against Kyiv and other Ukrainian cities over the weekend.  After rebuilding its missile and drone stocks over the summer, Russia now appears to be repeating last winter’s tactic of attacking Ukraine’s civilian power and heating infrastructure to undermine the country’s will to fight and force it to divert its air defense systems away from the front lines.  To warn off the Kremlin, the Ukrainian military retaliated by striking a power plant in Russian-occupied eastern Ukraine, cutting electricity to several cities and towns.

Israel-Hamas Conflict:  Over the holiday weekend, Israel and Hamas continued to honor a ceasefire and release of Hamas hostages and Israeli-held prisoners.  The released hostages include several Thais, a dual Israeli-Russian citizen, and at least one U.S. citizen.  Nevertheless, Palestinian-Israeli violence continues in the West Bank, and Iran-backed militants elsewhere in the region keep attacking U.S. military forces, keeping alive the possibility that the conflict will expand into a regional conflagration.

U.S. Income Tax System:  The Internal Revenue Service said it will delay several new tax rules mandated by Congress.  The rules, which will be delayed for two years, touch on reporting requirements for e-commerce sales and cryptocurrency transactions, and on catch-up contributions to retirement accounts.

U.S. Labor Market:  New analysis from Glassdoor shows that Generation Z workers (those born from 1997 to 2012) are about to overtake baby boomers in terms of their share in the U.S. labor force.  The baby boomers’ share in the labor force has long been falling as more and more of the cohort retired, faced health problems, or died, and as younger generations started working.  The coronavirus pandemic greatly accelerated the process, just as the Great Financial Crisis did a decade and a half ago.  The mass withdrawal of baby boomers during the pandemic not only helped create today’s labor shortages and rising wage rates, but it also made it that much easier for Gen Z workers to overtake the baby boomers’ share in the labor force.

U.S. Consumer Finances:  Among the nation’s top five credit card issuers, new analysis shows the share of their lending portfolios delinquent by 30 days or more is continuing to surge.  The rise in delinquencies and associated charge-offs likely reflects factors such as the consumer price inflation of recent years, the Federal Reserve’s aggressive interest-rate hikes, and the fact that some households have now spent all their excess savings from the pandemic years.  Rising delinquencies and charge-offs serve as a reminder that the economy remains at risk of recession going into 2024.

U.S. Consumer Spending:  As the holiday spending season swung into high gear over the Thanksgiving weekend, the data so far suggests retailers saw a modest increase in store traffic and sales compared with last year.  Data from Mastercard SpendingPulse™ showed Black Friday sales in stores and on-line were up 2.5% year-over-year.  Data from RetailNext showed foot traffic in stores was up 2.1%.  Nevertheless, it is still too early to gauge just how successful the holiday selling season will be when all is said and done.

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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 recent cooling in U.S.-China tensions seems to be worrying Russia.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including what is likely to be a painful government spending freeze in Germany, a report showing cooler price inflation in Canada, and an overview of a key U.S. earnings report due out after market close today.

China-Russia-United States:  At an international cultural forum in St. Petersburg last week, Russian President Putin went to extraordinary lengths to tout current China-Russia relations, claiming the relationship has progressed to the point where it is now “truly unique” and had “never reached such a height and quality in the history of our states.”

• According to experts in China-Russia relations, Putin’s obsequious remarks (technically known as “brown nosing”) were probably an effort to curry favor with Beijing and remind Chinese leaders of Russia’s value as a geopolitical partner, even as President Xi works to cool tensions with the U.S.
• If so, Putin’s insecurity reflects how dependent Russia has become on China as the junior member of the evolving China/Russia geopolitical bloc. Putin’s insecurity underscores that Russia has much to lose if U.S.-China relations improve.

China-Saudi Arabia:  The People’s Bank of China and the Saudi Central Bank yesterday said they have agreed on a three-year currency swap program totaling up to $7 billion.  The swap facility will support Beijing’s effort to internationalize the renminbi (CNY) and reduce the two countries’ dependence on the dollar for bilateral trade and investment.  In the long run, such efforts may contribute to the ongoing gradual decline in global demand for the greenback.  In the near term, however, our research suggests the dollar will be buoyed by other factors, such as the U.S.’s current innovation and capital investment cycle.

China:  The National Data Administration proposed by Beijing early this year has now been established as a unit of the National Development and Reform Commission.  Taking over some of the responsibilities of the Cyberspace Administration of China, the NDA is expected to play a key role in China’s future digital development.  Its responsibilities include drawing up development plans, establishing common standards for data storage and sharing, regulating digital industries, and promoting the digitalization of public services.

• Establishment of the NDA shows how China is working feverishly to advance its digital industries and leapfrog the U.S in technology.
• Nevertheless, based on the Chinese government’s recent record, the NDA is probably just as likely to over-regulate as it is to promote China’s digital economy. If the NDA tightens regulation and state control too much, it could stymie Chinese firms’ innovation.  Greater state control over China’s digital industries could also invite further U.S. limits on bilateral data and technology flows.

Taiwan:  Yesterday, Vice President Lai Ching-te, the current front-runner in January’s presidential election, named the island’s envoy to the U.S. as his running mate.  The move probably helps consolidate Lai’s advantage in the race, especially since the opposition Kuomintang and Taiwan People’s Party have hit a roadblock in their effort to form a joint ticket to better challenge Lai.  Even though the Kuomintang and the TPP last week agreed to explore a joint ticket, they failed over the weekend to agree on which party would get to field their candidate.

Japan:  Early indications suggest corporations will again boost their pay rates in 2024, largely matching the big raises they offered in 2023.  The planned wage hikes reflect both labor shortages and workers’ demand for increased income to compensate for continued high price inflation.  If companies follow through with the planned hikes, the Bank of Japan would be more likely to abandon its longstanding loose monetary policy.

Germany:  The government has announced it will freeze spending for the rest of the year in response to a recent court ruling that the constitutional “debt brake” prevents transferring unused emergency pandemic funds to finance the government’s big green energy program.

• Chancellor Scholz and his government are now working feverishly to decide how much of the green energy program to retain and whether to fund it by tax hikes, spending cuts elsewhere, or both.
• In any case, the spending freeze will probably be a further headwind for the German economy, on top of other factors such as high energy prices, high interest rates, weakening global demand for German exports, and poor demographics.
• Given the huge size of Germany’s economy, its slowing growth will likely be an important drag on the overall European economy in the near term.

Netherlands:  Ahead of tomorrow’s parliamentary elections, new public opinion polling shows far-right, anti-Islam firebrand Geert Wilders and his Freedom Party are now tied for first place with the liberal VVD party of outgoing Prime Minister Mark Rutte.  Under the Dutch electoral system, the polling suggests the most likely outcome of the election will be a right-wing coalition government.

United Kingdom:  Treasury Secretary Trott confirmed that Chancellor Hunt will propose cutting both corporate and personal income taxes when he delivers his “Autumn Budget Statement” on Wednesday.  Although justified as a reasonable move to promote economic growth now that British inflation has come down sharply, the tax cuts are widely seen as an effort to boost the Conservative Party’s lagging support in public opinion polls.  Given the planned rise in other levies, many voters will still likely see their overall tax burden increase in the coming years.

Canada:  Consistent with recent trends in other key developed countries, the October consumer price index was up just 3.1% from the same month one year earlier, slowing from the gains of 3.8% in the year to September and 4.0% in the year to August.  Excluding the volatile food and energy components, the October Core CPI was up 3.4% year-over-year.  That marked a slight acceleration from the previous month’s core inflation; the average of the Bank of Canada’s preferred trimmed mean and weighted median measures for underlying core inflation was 3.55% in the year to October, decelerating from 3.8% the month before.

United States-Israel-Hamas:  Illustrating how there is still a risk that the Israel-Hamas conflict could widen, the Israel Defense Forces and many Israeli citizens are increasingly agitating for Prime Minister Netanyahu to approve stronger attacks on the Iran-backed Hezbollah militants who are launching harassment fire into northern Israel from southern Lebanon.  Meanwhile, in the U.S., the Defense Department and some Congressional leaders are pressuring President Biden to retaliate more strongly against other Iran-backed militants in the region, who have now launched 61 separate attacks on U.S. military bases since the Israel-Hamas conflict began on October 7, injuring dozens of U.S. personnel.

• If intensifying political pressures in the U.S. or Israel lead to stronger military attacks against the various Iran-backed militants in the region, the militants and potentially even Iran could respond with even stronger attacks.
• As the U.S. presidential election draws closer, Biden may be especially vulnerable to domestic political pressure. His administration is already gaining a reputation for being excessively cautious in foreign policy, so he may feel compelled to unleash the U.S. military to avoid looking “soft on defense.”

U.S. Artificial Intelligence Industry:  In a continuation of the chaos at artificial intelligence darling OpenAI, virtually all the remaining employees of the for-profit AI unit have warned they will resign and seek to follow former CEO Sam Altman to Microsoft (MSFT, $369.84) unless the nonprofit governing board resigns en masse and brings Altman back.  The employees’ threat underscores how the for-profit AI unit’s brash, risk-on approach to the technology clashed with the nonprofit board’s much more cautious approach.  In broader terms, how societies handle the clashing visions between rapid AI development and cautious regulation could profoundly affect the technology’s progression over the coming years.

• Meanwhile, major U.S. stock price indexes weighted by market capitalization may be heavily influenced today and tomorrow by AI chip giant and “Magnificent Seven” member Nvidia (NVDA, $504.09), as investors look ahead and then respond to its latest quarterly earnings report, due out after market close today.
• Wall Street analysts currently expect Nvidia to report quarterly sales of $16.2 billion, almost triple its $5.9 billion in sales for the same quarter last year. The analysts expect the company’s quarterly profit to come in at $7.2 billion, more than 10 times its profit of $680 million one year ago.
• Despite those projections, it’s important to remember that Nvidia has beat expectations in 19 of the last 20 quarters.  If the firm fails to beat this time around, or if it fails to confirm the market’s rosy long-term expectations, the stock could fall and pull down the indexes.

The Daily Comment will go on hiatus beginning Wednesday, November 22, and will return on Monday, November 27. 

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with indications of a potential cooling of Japan-China tensions as Beijing looks to bolster Chinese economic growth.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a mysterious disappearance by North Korean paramount leader Kim Jong Un, a radical shift in Argentina’s political leadership in yesterday’s election, and big changes in the U.S. artificial intelligence industry.

China-Japan:  Following their summit at the Asia-Pacific Economic Cooperation meeting last week, Japanese Prime Minister Kishida said Chinese President Xi agreed to support expert-level talks on the safety of Japanese food products.  The announcement came three months after Beijing banned imports of Japanese seafood in response to Tokyo’s decision to release treated wastewater from the stricken Fukushima nuclear reactor.  Coupled with Xi’s recent effort to ease tensions with the U.S. and Australia, the news from Kishida suggests Xi is intent on an even broader détente with the U.S. geopolitical bloc as a way to revive China’s faltering economic growth.

China-South Africa-United States:  Reports say South Africa has now sent its first-ever bulk shipment of soybeans to China, illustrating how Beijing is trying to diversify its food and feed security by boosting its buying from Africa and Latin America.  The Chinese move to “de-risk” its food supply could dash hopes for a return to normal U.S.-China agricultural trade after the disruptions of the Trump years.

North Korea:  The new Missile Industry Day holiday, announced earlier this month to mark the launch last year of North Korea’s most powerful nuclear-capable missile, mysteriously passed on Saturday without any mention in state media.  Moreover, Saturday marked the 29^th straight day in which paramount leader Kim Jong Un was not seen in public or in the country’s press.

• The media’s failure to mention the new holiday and Kim’s unusually long absence could suggest he is facing some kind of internal political challenge or health issue.
• Such a prospect would raise concerns about instability in North Korea. Given the country’s tight political ties with China and Russia, and its growing missile arsenal, any such instability in North Korea would be of grave concern to countries and investors around the world.

Italy:  In a scheduled update after markets closed on Friday, Moody’s (MCO, $356.67) affirmed its investment-grade rating on Italian sovereign debt and raised its debt outlook from negative to stable.  As its basis for the move, Moody’s cited “stabilization of prospects for the country’s economic strength, the health of its banking sector, and the government’s debt dynamics.”

• In response, investors are bidding up Italian government bonds this morning, pushing the yield on the benchmark 10-year obligation down to a two-month low of 4.32%.
• The spread between Italian and German 10-year government bond yields has fallen to just over 1.7%, also its lowest in about two months.

Argentina:  Radical libertarian economist and first-term congressman Javier Milei won yesterday’s run-off presidential election, defeating Economy Minister Sergio Massa of the ruling left-wing populist Peronist Party by approximately 56% to 44%.  Milei’s decisive win suggests Argentines have become fed up with the excessive government spending, high regulation, rampant inflation, and frequent debt defaults and currency crises under the Peronists.

• Milei, who will be inaugurated on December 10, has promised a swift lurch to right-wing policies such as slashing government spending and replacing the Argentine peso with the U.S. dollar to bring down inflation. Milei has also signaled that he will shift Argentina’s foreign policy back toward friendship with the U.S. and away from China.
• Milei has no executive experience, and his La Libertad Avanza (LLA) coalition, founded in 2021, will hold only a small number of seats in the lower and upper chambers of the legislature. Therefore, it isn’t clear whether Milei will be able to push through his proposed reforms.
  • Dollarizing the economy will be especially difficult, as the central bank holds few greenbacks at present.
  • Besides that, Argentina is still largely frozen out of the global credit markets, making it unclear where it could get more dollars to exchange for the peso.
• Nevertheless, optimism about a change in direction within Argentina is driving up the value of Argentine stocks and sovereign bonds so far today. The value of many Argentine stocks trading in the U.S. has climbed by double-digit percentages so far today.

United States-Israel-Hamas:  Amid signs of a potential ceasefire and a freeing of hostages in the Israel-Hamas conflict, President Biden on Saturday warned that the U.S. may sanction Israeli settlers who have been attacking Palestinians in the West Bank.  The attacks and killings of West Bank Palestinians by Israeli troops and settlers haven’t been well reported since the conflict was sparked by Gaza-based Hamas militants’ October 7 attacks on Israel, but Biden has privately raised concerns with Israeli Prime Minister Netanyahu that they could broaden the conflict.  Biden’s warning of sanctions shows the administration is still concerned about that happening.

• Separately, satellite imagery studied by the Financial Times indicates that more than half the buildings in northern Gaza have been destroyed or seriously damaged by the Israeli airstrikes and other attacks aimed at rooting out Hamas fighters in the enclave.
• As we noted in a Comment last week, there is an apparent disconnect between the extent of the physical damage in Gaza and the number of casualties reported by Hamas. Most recently, Hamas medical authorities have reported that about 12,000 residents of Gaza have been killed in the Israeli attacks, with many more than that injured.  In contrast, the FT analysis suggests that at least 60,000 buildings in all of Gaza have been destroyed or seriously damaged.
  • That implies that, on average, “only” one Palestinian has been killed for every five buildings hit.
  • While the Palestinian casualties are still horrific and tragic, the low ratio of deaths to buildings lost suggests Hamas is seriously undercounting Gaza’s casualties, the Israel Defense Forces are being more discriminating and careful than is suggested in the global press, or both.

United States-India:  Despite the sharp drop in Chinese citizens studying in the U.S., which we noted in a recent Comment, new data shows the total number of international students studying in the U.S. jumped 12% to more than 1 million in the 2022-2023 academic year.  The increase was driven in large part by a 35% jump in the number of Indians coming to the U.S. to study.  The overall number of foreign students in the U.S. is now only slightly below pre-pandemic levels, but the number of foreign graduate students in the country has reached a record high.

• The rebound in international student enrollments is probably a relief to colleges and universities since foreign students often pay the full list price to enroll and help subsidize the cost to U.S. students.
• Many Indian students in the U.S. are gifted in the sciences, technology, engineering, and math, so their rising representation at U.S. colleges and universities is likely to bolster the nation’s advantages in research and innovation.
  • To the extent that Indian students are allowed to work before or after graduation, they could also contribute to the U.S. economy with less of the security concerns surrounding students from Communist China.
  • Even those who return to India could end up working directly for a U.S. firm, since more multinational companies have begun setting up their own back-office technology departments in India. These “global capability centers” focus on cybersecurity, artificial intelligence, and even human resources and accounting tasks that had previously been handed to Indian outsourcing companies such as Infosys (INFY, $17.51).
• The jump in Indian students in the U.S. is not only helping offset the drop in Chinese students, but it could also help peel India away from the China/Russia geopolitical bloc and draw New Delhi closer to Washington.

U.S. Artificial Intelligence Industry:  Speaking of U.S. technology innovation, the board of privately held artificial intelligence darling OpenAI on Friday unexpectedly ousted CEO and founder Sam Altman, apparently for poor communication about technological risks rather than any malfeasance or management shortcomings.  Over the weekend, top investors in the company were reportedly working to bring him back, but the deal fell through.  This morning, reports say Microsoft (MSFT, $369.84), a major investor in OpenAI, will hire Altman and his president and co-founder, Greg Brockman, to head a new advanced AI research team at Microsoft.

• Although it’s unclear whether Altman and Brockman can replicate the success of OpenAI at Microsoft, their move could have profound implications for both companies and for the future development of the industry.
• In any case, the boardroom drama highlights how AI, which is widely expected to have profound effects on the global economy, could be hindered or tripped up by disagreements about its risks and how to manage or regulate it.

U.S. ESG Investing:  And speaking of another recent investment craze, new research from Morningstar (MORN, $271.04) shows the third quarter was the first period in which more environmental, social, and governance (ESG) funds liquidated or removed their ESG investing criteria than were added.  Net withdrawals from the funds have totaled $14 billion in the year to date.  The pullback from ESG investing reflects multiple factors, including high interest rates that have drawn money into other products, a regulatory clampdown requiring tighter ESG criteria, and political attacks.

U.S. Labor Market:  Amid extensive labor shortages following the mass retirement of baby boomers during the coronavirus pandemic, workers continue to feel empowered, and unions continue to flex their muscles.  Now, workers at two branches of Wells Fargo (WFC, $42.96) have begun agitating for union representation.  The development confirms that unions aren’t just striking for better pay and conditions in industries that have traditionally been unionized.  Workers are also boosting their efforts to unionize in industries that traditionally have not had to deal with organized labor, including technology, retail coffee chains, and now banking.

The Daily Comment will go on hiatus beginning Wednesday, November 22, and will return on Monday, November 27. 

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Oil prices fell into bear market territory on Friday due to a jump in U.S. inventories and demand pessimism. In other news, Shohei Ohtani, formerly of the Angels, and the Braves’ Ronald Acuna Jr. were named the most valuable players in their respective leagues. Today’s Comment begins with our thoughts about holiday spending this year. We then discuss why governments are struggling to find ways to fund initiatives, and then detail Argentina’s run-off election to be held Sunday. As always, our report includes a summary of the latest domestic and international data releases.

Holiday Cheers? Major retailers are concerned that Christmas spending may slow this year.

• This week several major retailers reported higher profit margins with tighter inventory but lower revenue. The decline in sales mirrors the impact of rising prices on consumer spending. Walmart’s (WMT, $156.04) report further underscored this trend, indicating a “softening” and “uneven sales” pattern since October. Shares of the company stock plummeted 8% on Wednesday due to the pessimistic outlook. At the same time, Target (TGT, $129.94) indicated that it believes consumers are delaying purchases until the last minute, while Macy’s (M, $13.33) results demonstrated that consumers may be receptive to purchases if prices are reduced. 
• Recent economic data provides some clues about how holiday spending might unfold. October retail receipts indicate a significant slowdown in consumer spending compared to its peak in 2021. When adjusted for inflation, the data shows a year-over-year decline of 0.73%. This decline is likely attributed to a confluence of factors, including rising prices and high-interest rates dampening consumer spending. The trend is expected to persist as more households resort to increasingly expensive credit cards to finance purchases. The data indicates that real spending has not yet declined significantly enough to raise major concerns about the economy, but time will tell whether this will hold up over the next few months.

• The upcoming holiday season will serve as a critical test of consumer sentiment and spending patterns. Stronger-than-expected sales would provide reassurance that consumption remains resilient heading into 2024. Conversely, a weaker-than-expected performance would likely raise further concerns about the economy and could lead to more predictions of a downturn. In an effort to boost sales, firms may consider decreasing prices, which could offer a potential double benefit of stronger sales and lower inflation. However, it is important to acknowledge that price reductions may carry the risk of further cooling in the labor market. At this time, we remain optimistic that consumption will continue to be an engine of economic growth.

Fiscal Deficits: Governments are struggling to find a way to meet their spending plans without exacerbating their growing deficits.

• In the absence of a comprehensive spending bill, the Pentagon faces a potential $82 billion budget cut over the next two fiscal years. This mandate stems from a provision embedded in June’s debt limit legislation, which requires all federal departments and agencies to trim their budgets by 1% from 2023 levels for the subsequent two fiscal periods if no funding agreement is reached before the new year. The potential budget cut could hamper Washington’s efforts to bolster its presence and influence in the Indo-Pacific region, where it seeks to counter China’s growing dominance.
• Similarly, Germany’s top court has struck down a plan to fund climate change initiatives using off-budget funds, jeopardizing about 770 billion euros ($837 billion) in spending plans. The ruling, which comes as a blow to the country’s three-party coalition government, means that the government will have to find alternative ways to finance its ambitious climate goals. While the government has vowed to find a solution, there will likely be some bickering among members of the coalition. German Finance Minister Christian Lindner has said that it is possible to fund the budget without using additional debt or raising taxes; however, the climate fund has been frozen in the meantime.

• The pandemic’s burden on government finances, coupled with escalating geopolitical tensions, will necessitate further defense spending while potentially curtailing other initiatives. Climate change initiatives face heightened scrutiny as households hesitate to embrace costly transitions to a low-carbon economy. Governments are unlikely to completely abandon their commitment to climate change mitigation, but they may be forced to postpone some deadlines in the face of budgetary constraints. Defense spending is likely to remain strong as there appears to be a consensus that the world is becoming a more dangerous place. Hence, we do not view the budget tightening as a potential threat to portfolio positions within Aerospace and Defense.

Where Will Argentina Swing? Investors will be closely watching the Argentine elections on Sunday to gauge the political climate in South America.

• The two candidates represent opposing ends of the political spectrum, with Javier Milei’s campaign drawing comparisons to former U.S. President Donald Trump and former Brazilian President Jair Bolsonaro due to his skepticism of central banks and his focus on law and order. Conversely, his opponent, Sergio Massa, despite being considered “the least Peronist of the Peronists,” has emphasized his party’s legacy of welfare spending and subsidies and is expected to seek support from radical leftists. The outcome is considered close, but Massa is favored to win given his strong performance in the general election.
• Geopolitical considerations also loom over this election, as China seeks to strengthen ties with Argentina to safeguard its access to the country’s resources. Last month, the People’s Bank of China extended a $6.5 billion currency swap line to Argentina, enabling Buenos Aires to intervene in currency markets and settle imports in yuan (CNY) rather than dollars, which will prevent it from falling into arears with the International Monetary Fund. This move was widely perceived as a political favor for Sergio Massa, the current finance minister, as he seeks to convince voters of his ability to steer the country away from the brink of collapse.

• The outcome of the election will shape the trajectory of a country grappling with persistently high inflation and an ever-growing debt burden. A Massa victory is likely to be favored by markets, as he is expected to pursue more conventional economic policies than his opponent. Conversely, a Milei win could potentially align with U.S. efforts to maintain regional influence, as he has shown that he is less willing to cooperate with China. Although the election may not have major impact on markets, it may provide further signs as to how the world is breaking into geopolitical blocs as the world moves away from globalization and towards regionalization.

Other News: Iran maintains that it does not want the Israel and Hamas conflict to spread but has warned that it may take action if the assault on Gaza continues. The message is a positive sign that there is a communication between Washington and Tehran, which should reduce the chance of miscalculation. Spanish Prime Minister Pedro Sánchez won another term after securing an amnesty deal with the Catalan separatists. It is unclear how long he will be able to maintain his coalition as there has been public outcry following the appeasement of the separatists. Powell’s firm grip on the Fed is further evidenced by his exceptionally low dissent rate. Our analysis reveals that Powell has had the fewest dissents per meeting of any Fed chair since Thomas B. McCabe.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Gold prices are rising as investors eagerly await the Federal Reserve’s next policy decision, while Gerrit Cole has been named the American League Cy Young Award winner. Today’s Comment delves into the reasons behind the surge in investor risk taking being fueled by optimism over a possible end to interest rate hikes, the potential easing of commodity inflation next year, and Xi Jinping’s softening stance towards certain adversaries. As always, our comprehensive report summarizes the latest domestic and international data releases.

Monetary Inflection Point? Risk appetite has started to pick up as investors are growing confident that monetary tightening is over.

• Recent economic data suggests that central banks are making progress towards their inflation targets. The Bureau of Labor Statistics (BLS) released data earlier this week showing that producer prices (PPI) rose 1.4% since October 2022, while consumer prices (CPI) increased 3.2% in the same period. This trend is also evident in other countries, with the eurozone and the U.K. both making headway toward achieving their respective 2% inflation targets. While policymakers have not ruled out further rate hikes, fed funds futures contracts indicate a 97.3% probability that the central bank will hold rates steady at its next meeting and an 81% likelihood of a rate cut by June 2024.
• Expectations of a Fed pivot have led investors to diversify away from safe assets. The Bloomberg indexes for global bond and dollar performances have also reflected the recent shift in risk sentiment. The investment-grade debt index from a multitude of countries has surged 3.1% in the past two weeks, recouping half of the losses it had incurred since mid-July. This impressive rally aligns with the Bloomberg Dollar Index, which indicates a similar resurgence of global currencies against the greenback within the same period. While this market response to economic data is encouraging, some investors remain cautious, recognizing that underlying uncertainties may reverse the present trend.

• In the near term, this shift might provide some respite for investors who have endured losses in riskier assets earlier this year. Notably, the weakening U.S. dollar should uplift emerging market equities. However, the sustainability of this trend remains uncertain. Much of the performance of the dollar and risk assets has been driven by expectations of central banks halting their tightening cycle, which may or may not materialize. Nevertheless, investors should also be mindful that as monetary policy concerns recede, attention may shift back to GDP growth, which could favor U.S.-denominated assets due to the country’s robust economic outlook.

Commodity Price Pressures: Increased supply and weakening demand are expected to put downward pressure on food and other commodity prices going into 2024.

• Global food prices are expected to fall next year, according to agribusiness lender Rabobank’s annual outlook. A key factor driving this downward trend is the surge in production resulting from firms seeking to capitalize on higher prices. Prices for sugar, coffee, corn, and soybeans are all expected to be impacted by the projected increase in supply. Conversely, China’s anticipated growth in copper output is likely to keep metal prices below 2022 levels in 2024. S&P Global Market Intelligence expects the London Metal Exchange’s three-month price per metric ton to hit $8602 in 2024, below its $8784 from two years prior and roughly in line with this year’s estimated price of $8596. However, copper prices are expected to spike in 2025 and onwards.
• On the demand side, there are also indications that commodity prices may face resistance. Rabobank forecasts that slower economic growth due to higher interest rates and elevated prices could dampen demand. Several major economies are already teetering on the brink of recession. The German economy is projected to contract by 0.3% in 2023. Meanwhile, China’s economic woes are expected to persist into the following year. The lack of growth across the globe could make it more challenging for commodities to sustain their current price levels.

• The moderation in commodity prices offers a glimmer of hope amidst the looming threat of a global economic downturn. The anticipated easing of food inflation should provide a much-needed boost for emerging markets, where high food prices have historically been linked to social unrest. Moreover, the relaxation of commodity pressures is likely to contribute to global efforts to curb inflation. If these supply and demand dynamics persist, the improvement in commodity prices could facilitate economic growth for non-commodity producers, even in the face of a potential recession.

Xi’s Delicate Dance: The Chinese president faces difficulties in fostering cordial relations with his Indo-Pacific rivals.

• President Biden’s seemingly impromptu remark calling Xi Jinping a “dictator” during a post-meeting Q&A session likely altered the tone of their discussions. Prior to this comment, the two leaders had reportedly engaged in productive talks, agreeing to collaborate on combating fentanyl trafficking and reestablishing military communication channels. Following his meeting with Biden, Xi is expected to meet with Japanese Prime Minister Fumio Kishida on Thursday. The two will likely discuss the recent detaining of well-known Japanese businessman Hiroshi Nishiyama on suspicion of espionage. His imprisonment has raised concerns about China’s recent crackdowns on foreign workers.
• Xi Jinping’s recent efforts to cultivate stronger ties with the international community underscore his determination to revitalize China’s economy, which has encountered hurdles following its stringent pandemic lockdowns. While investment spending has traditionally been a cornerstone of China’s growth, its aversion to accumulating debt necessitates a diversification of growth strategies. Trade emerges as an appealing option as it would allow the country to preserve its manufacturing base while alleviating deflationary concerns. In October, headline CPI dipped 0.1% year-over-year, while core CPI increased by 0.7%. A possible reset in relations with China and its rivals may help lead to an increase in its net exports which have been a drag on growth.

• Xi’s recent overture should not be misinterpreted as a change of heart. He has offered no indication that he is prepared to retract his willingness to decouple from the U.S. or remove his country’s backing of Russia. Therefore, the thaw in intentions is likely a tacit acknowledgment that he does not desire an abrupt end to relations with the world’s largest economy. However, this does imply that he may be more focused on addressing domestic challenges rather than settling historical scores such as the reunification of Taiwan, suggesting that the risk of conflict between the two largest economies may be diminishing.

Other News: West Virginia Senator Joe Manchin announced that he is contemplating a presidential bid. His inclusion adds another layer of complexity to an already crowded field, further clouding the outlook for the 2024 election. The GM-UAW contract is expected to be approved, thus reducing the chance of another strike. The Senate approved the stopgap spending bill to keep the government funded into 2024. This sets up another fight in two months but should calm nerves about disruption to governmental operations.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with new impediments to U.S. investments in China.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the Israel-Hamas conflict, new signs of economic weakness and falling inflation pressure in Europe, and House passage of a new stopgap funding bill for the U.S. government.

United States-China:  The U.S.-China Economic and Security Review Commission, an advisory panel on China policy, issued a recommendation yesterday that Congress pass a law forcing U.S. publicly traded companies to disclose how their investors are exposed to risks related to China.  For example, the commissioners recommended that the companies disclose the percentage of their total assets in China, their joint ventures with Chinese firms, the amount and nature of research and development they undertake in China, and the influence of any employee associated with the Chinese Communist Party in corporate decision-making.

• If passed, the disclosure requirement would be yet another impediment to U.S.-China capital flows.
• Separately, the Federal Retirement Thrift Investment Board, which oversees approximately $771 billion of retirement savings for federal workers, said today that it will change the benchmark index for its international fund to avoid exposure to stocks listed in China or Hong Kong, citing increased U.S.-China geopolitical tensions.
• Finally, we note that President Biden and President Xi plan to meet for four hours today at the Asia-Pacific Economic Cooperation summit in San Francisco. At the end of the meeting, Biden and Xi are expected to announce a number of smaller-scale agreements.  More broadly, the summit may help slow the current downward spiral in U.S.-China relations.

Taiwan:  The country’s top two opposition parties, the China-friendly Kuomintang and the Taiwan People’s Party, have struck a deal to field a joint ticket in January’s presidential election.  The deal aims to help the opposition compete better against Vice President Lai Ching-te, the leading candidate of the ruling Democratic Progressive Party, which has forged tighter ties with the U.S. and is currently leading in the polls.

Israel-Hamas Conflict:  Hours after the U.S. officially backed Israeli assertions that the Hamas government in Gaza places military command posts in hospitals, the Israel Defense Forces said they launched a targeted strike against Hamas personnel in the territory’s besieged Al-Shifa Hospital.  The IDF says the raid turned up weapons and other “concrete evidence” that the facility was being used as a Hamas command post.  The IDF says that evidence will be shared publicly in the near future.

• Meanwhile, Hamas authorities say Israel’s airstrikes and other attacks on Gaza during the conflict have now killed about 11,000 people, many of them noncombatant women and children. If that figure is accurate at all, it is certainly brutal and horrifying, and it reflects an apparent policy decision by the Israeli government to defang Hamas no matter what the cost to civilians or to Israel’s own reputation and political support.
• Still, given that Gaza had a population of about 2.0 million at the start of the conflict, 11,000 dead (and perhaps tens of thousands injured) seems low enough to suggest that the IDF really is taking some care to avoid hurting civilians. Besides, other reports suggest that up to 50% of all the structures in Gaza have been destroyed or severely damaged by Israel’s attacks.  If that translates to 11,000 structures hit, it suggests “only” one death and perhaps several other injuries for each structure targeted.

European Union:  In a new sign that the European economy is failing to keep up with activity in the U.S., the European Commission today cut its 2023 growth forecasts for both the broad EU and the eurozone.  In each region, the commission now forecasts that gross domestic product this year will expand just 0.6%, compared with a forecast of 0.8% in September.  The faltering growth reflects a range of problems, from high inflation and interest rates to weaker global demand for European exports.

United Kingdom:  In another sign that inflation pressures are easing worldwide, the U.K.’s October consumer price index was up just 4.6% from the same month one year earlier, less than expected and much less than the 6.7% increase in the year to September.  Excluding food, energy, and other volatile categories, the October core CPI was up an annual 5.7%, versus 6.1% in the year to September.  Signs of cooling inflation have boosted hopes that the Bank of England can forego further interest-rate hikes and may even start to cut rates in 2024.

Russia-Ukraine War:  The Ukrainian government has struck a deal with major insurers to provide war-risk coverage for ships carrying grain and other foodstuffs out of Ukrainian ports.  After Russia withdrew from a safe-passage deal with Ukraine over the summer, Kyiv has managed to get several ships moving out of its ports, but the new deal could further boost the country’s agricultural shipments, bolstering global supplies and helping hold down prices.

• Separately, EU officials are looking for new ways to clamp down on Russian oil revenues following recent reports that Moscow is largely circumventing the West’s $60-per-barrel cap on its exports.
• One proposal would have Denmark stop, inspect, and potentially impound tankers carrying Russian oil through Danish waters without Western insurance, under laws permitting states to check vessels they fear pose environmental threats.
• If implemented, the plan would naturally be high risk, potentially producing serious naval tensions in the Baltic region.

U.S. Fiscal Policy:  The House of Representatives yesterday passed Speaker Johnson’s two-step stopgap funding measure to keep some federal departments operating until mid-January and others until early February.  Since many of Johnson’s own Republican Party voted against the bill because it lacked spending cuts and other positions favored by the far right, passage of the measure required the votes of many Democrats.

• The “continuing resolution” now moves to the Senate, where prospects appear to be good that it will pass and be sent to President Biden to be signed into law.
• Nevertheless, even if the bill passes and averts a partial government shutdown this weekend, there will still be the chance of a fresh impasse and potential shutdown when the new bill expires early in 2024.

U.S. Labor Market:  Despite the national sigh of relief when the United Auto Workers and the major U.S. automakers struck a tentative deal on a new labor contract, workers at several plants run by General Motors (GM, $28.20) have voted to reject the deal.  That puts the GM tally to date at about 50%, with voting set to continue for another week or two.  In contrast, the proposed deals at Ford (F, $9.86) and Stellantis (STLA, $20.25) are on track to be approved by comfortable margins.  The neck-and-neck voting at GM is a further reflection of just how empowered workers feel in the midst of today’s labor shortages.

U.S. Consumer Price Inflation:  In the interest of acknowledging contrarian viewpoints, we note that the Wall Street Journal today carries an interview with Cathy Wood, the founder of ARK Investment Management and a major technology-stock cheerleader, in which she argues that new technologies and falling commodity prices will lead to a future of deflation rather than inflation.  Of course, this could simply be an instance of Wood “talking her book,” since lower inflation implies lower interest rates and higher valuations for long-duration stocks like technology start-ups.  We continue to believe that consumer price inflation in the coming decades will be higher and more volatile than in the post-Cold War period of relative peace and globalization over the last three decades.

• It’s difficult to forecast inflation rates over such a long period, but we would not be surprised if they average between 3.0% and 4.0% between now and mid-century, versus the average of 2.5% over the last 30 years (see chart below).
• While technology advancements will help bring down some costs, we think that will be offset by factors such as:
  • The global economy’s fracturing into relatively separate blocs;
  • The shift to less efficient global supply chains;
  • The relocation of production back to relatively expensive countries in the West;
  • Increased corporate and government investment spending to support those shifts;
  • Higher commodity prices because of recent under-investment and the expected weaponization of supplies by the China/Russia bloc;
  • Population aging and its associated labor shortages; and
  • Potential increases in consumer spending as lower-skilled workers gain a bigger part of national income.

U.S. Financial Markets:  After driving stock and bond prices sharply higher yesterday, the euphoria over yesterday’s report of falling inflation as measured by the consumer price index appears set to continue today.  After the S&P 500 stock price index surged 1.7% yesterday, it and all the other main U.S. equity indexes are pointing to a higher open at the moment.  Precious metals are also a bit firmer today, but longer-maturity bonds have given back some of yesterday’s rally, pushing yields up modestly so far this morning.

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