by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with new data suggesting Russia is now almost completely getting around the West’s $60 price cap on its oil exports, potentially setting up new Western efforts to clamp down.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a slowdown in British wage growth that could help ease consumer price inflation in the U.K. and the latest on efforts in the U.S. Congress to avoid a partial shutdown of the federal government, which could begin this weekend.

Global Oil Supplies:  New analysis shows virtually all of Russia’s seaborne oil exports are now selling for more than the $60-per-barrel cap that Western nations have tried to enforce as a way to limit Russian revenues for its invasion of Ukraine.  The Group of Seven countries and Australia had some initial success when they tried to enforce the cap by banning insurance and other services for shipments priced above $60 per barrel, but now it appears the Russians have learned to circumvent the ban with tactics such as buying up and using old tankers without Western insurance and falsifying price certifications.

• It should be no surprise that the $60 cap has been circumvented. From time immemorial, government efforts to control trade have been undermined by smugglers and sanctions busters.
• Nevertheless, the West’s restrictions on trade have probably imposed additional costs on Russian oil exports. Even if the oil is sold at prices above $60, the profitability of that oil and the revenues it provides to the Kremlin have probably been reduced.
• In any case, the wide circumvention of the ban has prompted Western officials to start discussing ways to tighten the cap. If such tightening happens, it could potentially reduce global oil supplies and help buoy energy prices.

China-Taiwan:  The Central Election Commission of Taiwan has certified the independent candidacy of Terry Gou, the founder of Foxconn (HNHPF, $5.93), for the presidential election coming up on January 13.  Although Gou is currently trailing the three main candidates in opinion polls, Beijing is concerned that he will drain support from its preferred candidate, the Kuomintang Party’s Hou Yu-ih.

• The Chinese government has recently opened a large-scale investigation into Foxconn’s tax and land-use practices in China, in a move that has been widely interpreted as an effort to pressure Gou to drop out of the race. Company officials say they are bracing for additional such measures from China.
• Foxconn is best known as a supplier to Apple (AAPL, $184.80), and it is the key assembler of the company’s flagship iPhone. Additional Chinese pressure on Foxconn to force Gou out of the Taiwanese race could therefore potentially have an impact on Apple.

United States-Asia-China:  After launching its Indo-Pacific Economic Forum last year to promote trade between the U.S. and the rest of the region and to loosen countries’ economic ties to China, the Biden administration has unexpectedly withdrawn its support for IPEF measures designed to ease cross-border data flows and coordinate labor standards.  The retreat on free data flows apparently stemmed from administration efforts to tighten regulations over U.S. technology firms, while the retreat from labor standards came at the request of at least one U.S. lawmaker facing a tough election.

• Because of domestic political opposition, the U.S. is currently precluded from offering traditional tariff cuts and reduced import barriers to tease Indo-Pacific countries away from China’s economic pull. The administration, therefore, hoped that IPEF’s non-tariff measures would be attractive enough.
• Without the promise of free data flows and common labor standards, the IPEF deal will lean heavily on less attractive features, such as initiatives related to supply chains, clean energy, anti-corruption measures, and taxation.
• Perhaps most significant, the pullback from free data flows suggests the U.S. may soon adopt Chinese-style restrictions on data transfers. If so, it’s a sign that the fracturing of the world into relatively separate geopolitical and economic blocs, which we’ve been writing about so much, will disrupt not only trade, capital, and technology flows between the U.S. bloc and the China/Russia bloc, but it will also disrupt data flows.

United States-China Travel:  New research by the Institute for International Education shows the number of U.S. citizens studying in China fell from more than 11,000 in the 2018-2019 academic year to just 211 in 2021-2022.  The figures suggest many U.S. students have been put off by the Chinese government’s draconian pandemic shutdowns and aggressive law enforcement actions.  Although the number of Chinese students in the U.S. remains about 290,000, the study illustrates how global fracturing is disrupting human travel and migration, just as it’s disrupting inter-bloc trade, capital, technology, and data flows.

United States-China Summit:  When President Biden and General Secretary Xi meet tomorrow at the Asia-Pacific Economic Cooperation summit in San Francisco, they will reportedly announce a deal under which China will clamp down on companies exporting the precursor chemicals for fentanyl, the synthetic opioid that has spread addiction and death throughout the U.S.  They are also expected to announce a deal to reopen military communication channels that Beijing shut after then-U.S. House Speaker Pelosi visited Taiwan in August 2022.

European Union:  Recent data indicates the EU’s labor market is softening much more dramatically than the U.S.’s, especially in the industrial powerhouse of Germany and other northern countries.  Much of the problem can be traced to weakening demand overseas and high energy costs.  Higher unemployment will likely impose new fiscal burdens on EU governments but could also weaken inflation pressures, discourage further interest-rate hikes, and hold down the value of the euro.

United Kingdom:  Average wages in July through September, excluding bonuses, were up 7.7% from the same period one year earlier, marking a modest deceleration from the year-over-year increase of 7.9% in May through July.  Total pay was up 7.9% on the year, versus 8.5% in the prior period.  The figures point to a modest cooling in wage pressures, which could help bring down consumer price inflation in the U.K. and allow the Bank of England to hold off on further interest-rate hikes.

U.S. Fiscal Policy:  In the House of Representatives, at least half a dozen Republican lawmakers have come out against Speaker Johnson’s proposed two-part stopgap funding bill, which aims to avoid a partial government shutdown when the current stopgap expires on Friday.  Since the Republicans only control 221 seats in the chamber, while the Democrats have 213, the defections from Johnson’s own party mean his measure would likely need the support of at least some Democrats to advance the bill to the Senate, where its prospects seem better.  At this point, prospects for a partial government shutdown this weekend appear to be too close to call.

U.S. Labor Market:  Industry groups say the demand for seasonal workers during the upcoming holidays will be much cooler than in recent years, with public advertisements for such workers at the lowest level in a decade and hiring intentions down about 40% from their recent high in 2021.  Individual companies are also reporting relatively modest hiring plans.  Weaker demand for seasonal workers suggests the overall labor market is softening, which is likely to contribute to slower wage growth and weaker economic growth.

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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 West’s slowing demand for electric vehicles.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an easing of data regulations in China and a proposal by House Speaker Johnson for a two-step stopgap funding bill to keep the federal government functioning after the current stopgap expires on Friday.

Global Electric Vehicle Industry:  As incoming data continues to point to a slowdown in the West’s demand for electric vehicles, new research by HSBC (HSBC, $37.03) indicates dealers in key markets now have to offer discounts from the vehicles’ suggested retail price.  For example, the average discount in October was 11% in the U.K., 10% in the U.S., and 7% in Germany.

• The slowdown in demand reflects a range of factors, from the high price for EVs, rising interest rates, concerns about recharging and safety, and political attacks.
• If it continues, the slowdown threatens to undermine what has been seen by some as a promising new investment sector and a source of new economic growth.
• Nevertheless, at least some companies are continuing to invest in the sector. In news this morning, oil giant Exxon (XOM, $103.75) announced it is starting to drill for lithium in Arkansas and aims to become a major U.S. supplier for makers of EV batteries by 2030.

United States-China:  When President Biden and General Secretary Xi meet on Wednesday at the Asia-Pacific Economic Cooperation summit in San Francisco, they will reportedly announce an agreement not to incorporate artificial intelligence into autonomous weapons, such as drones, or into the command and control of nuclear weapons.  We haven’t seen any details on the deal, but if it is substantive, it would suggest that U.S. and Chinese diplomats have been able to make more progress on cooling bilateral tensions than earlier expected.

• On the other hand, any ban on military AI announced at the meeting could be much less than meets the eye. One big hurdle to such a ban is that verification might be difficult.  If neither side can verify with confidence that the other side isn’t deploying military AI, the deal could have little practical effect.
• Moreover, it is questionable whether Beijing would countenance or abide by such restrictions. Chinese military doctrine and official statements make clear that the People’s Liberation Army not only intends to bulk up to the point where it can compete with the U.S., but also intends to fully leverage AI and other technologies to bolster its warfighting capabilities.

China:  Information provider Qichacha announced that the Cyberspace Administration of China has approved its data export security plan, which will allow the company to offer databases of Chinese corporate information in other countries.  The approval of Qichacha’s plan is a sign that Beijing may be easing its recent draconian limits on providing Chinese information to foreigners.

• Coupled with a range of other government intrusions into business operations, the data export limits have helped sour foreign businesses on China, likely contributing to the recent sharp drop in foreign direct investment into China.
• Easing up on the data export rules and other regulations may be an effort by Beijing to reattract foreign capital and reverse China’s ongoing slowdown in economic growth.

Spain:  Over the weekend, tens of thousands of protestors marched in cities across the country to register their anger at Prime Minister Sánchez’s gambit to win parliamentary support for his Socialist Party government by offering amnesty to Catalan separatists.  The move has sparked especially strong condemnation by right-wing populists, who accuse the prime minister of allowing the Catalan separatists, who held an illegal referendum on independence in 2017, to achieve a “coup.”  The political crisis could potentially weigh on Spanish assets despite the country’s relatively good economic performance recently.

United Kingdom:  Prime Minister Sunak today replaced Home Secretary Suella Braverman, a controversial right-wing firebrand, with Foreign Secretary James Cleverly.  He also named former Prime Minister David Cameron, a moderate who campaigned against Brexit and resigned when the measure passed in 2016, to take over the foreign ministry.

• The moves apparently aim to drag the Conservative Party back toward the political center and close its massive polling gap with the Labor Party ahead of the next election.
• Nevertheless, they could spark increased chaos in the Conservative Party, as Braverman now seems likely to launch a bid to replace Sunak as prime minister.

Israel-Hamas Conflict:  Illustrating many of issues involved in the fighting, the Israel Defense Forces are focusing much of their invasion force on Gaza’s Al-Shifa hospital to destroy what they say is a Hamas command post located in the facility and in tunnels underneath it.  The IDF has demanded that Hamas abandon the hospital, but the militants have refused.  Meanwhile, the hospital has virtually run out of fuel, electricity, food, and medical supplies.

• The IDF claims it delivered supplies to a location about 1,000 feet from the hospital, but they were not retrieved. Hospital officials say the fighting has been too intense to collect the supplies, but it isn’t clear whether Hamas actually prevented them from doing so.
• Separately, a key foreign policy advisor to the president of the United Arab Emirates warned that Israel’s “unparalleled” and “disproportionate” attacks on civilians threaten to spark increased radicalization in the region.
• Indeed, Iran-backed Hezbollah fighters and other Islamist groups continue to attack Israel from the north, keeping alive the risk that the conflict will spread regionally.

U.S. Military:  The Air Force’s future heavy bomber, the B-21 “Raider,” made its first test flight on Friday, about two years later than initially planned.  The sixth-generation bomber, with its flying-wing design and advanced capability to network with other platforms, is designed to replace the aging B-1 and B-2 starting later this decade.  Its mission will be to deliver either strategic-nuclear or conventional weapons around the world to deter U.S. adversaries such as China, Russia, Iran, and the rest of Beijing’s geopolitical bloc.

• The Air Force currently plans to buy at least 100 units of the B-21, at a projected cost of about $750 million each.
• The Defense Department continues struggling to ramp up the output of weapons, ammunition, and supplies as geopolitical tensions rise, but the launch of the B-21 is a reminder that it is making some progress. Other ongoing programs to modernize the U.S. strategic deterrent force include replacing the Air Force’s Minuteman III intercontinental ballistic missile with a new “Sentinel” missile and replacing the Navy’s Ohio-class ballistic missile submarines with new “Columbia-class” subs.

U.S. Fiscal Policy:  As Congress continues to bicker over fiscal policy ahead of this Friday’s expiration of the current stopgap spending authorization, Moody’s (MCO, $344.57) at the end of last week cut its outlook on U.S. Treasury debt from “stable” to “negative.”  Moody’s remains the last of the major credit-scoring firms to give the Treasury its top debt rating, but it warned that the outlook is worsening because of political polarization, expanding federal budget deficits, and worsening debt sustainability.

• With federal spending rising rapidly while tax revenues wither, the widening budget shortfall was probably a contributing factor to the run-up in longer-maturity bond yields over the last couple of months.
• With the current stopgap funding bill set to expire on Friday, newly installed Speaker of the House Mike Johnson has proposed a “laddered” new stopgap measure that would keep the government funded at current levels until early 2024. Under the proposal, some departments would be funded at their current levels until late January, while others would be funded at their current levels until early February.
  • The new continuing resolutions would give lawmakers more time to come up with a deal on funding for the rest of the fiscal year, which runs to September 30.
  • A vote on Johnson’s proposal could come as early as Tuesday.

U.S. Labor Market:  New analysis by the Federal Reserve Bank of Atlanta shows lower-skilled workers are now seeing much more moderate wage growth than in the first two years of the post-pandemic period.  For example, average hourly earnings for workers in the bottom quartile of the wage distribution were up just 5.9% in the year to October, versus a 7.2% rise in the year to January.

• The end of out-sized wage gains for lower-skilled workers suggests the economy is continuing to normalize from the pandemic era’s disruptions.
• Nevertheless, their exceptionally large previous wage gains mean that those workers are now capturing a larger share of total wage income, potentially reducing wage inequality and allowing them to consume more in the coming years.

U.S. Commercial Real Estate Market:  New analysis by the Wall Street Journal shows that lenders this year have issued a record number of foreclosure notices on mezzanine loans and similarly risky loans connected with commercial properties.  Mezzanine loans, similar to second mortgages, can be foreclosed much more quickly than first mortgages, so the rapidly rising number of foreclosures provides a more real-time view into the financial stresses caused by rising vacancies and higher interest rates.  As the Federal Reserve raises interest rates or keeps them higher for longer, the commercial real estate and/or private debt sectors are probably the most likely domestic source of financial crisis or a recession.

 

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Gold has retreated on Powell’s monetary policy comments, and the National Women’s Soccer League has signed major TV deals. Today’s Comment begins with our thoughts on declining demand for U.S. government bonds. We then discuss the impact of geopolitical competition on the semiconductor industry, and the political ramifications of Senator Joe Manchin’s (D-WV) decision not to run for re-election. As always, our report includes a summary of the latest domestic and international data releases.

Auction Flop: A Treasury bond auction drew weaker-than-expected demand, raising concerns about the path of interest rates.

• Thursday’s auction of 30-year government bonds yielded 4.769%, 5 basis points higher than the start of pre-auction trading, reflecting investors’ reluctance to buy long-duration debt. Wednesday’s Treasury auction also underwhelmed expectations. This poor performance has raised concerns that the bond market may be struggling to absorb new U.S. debt issuance. Following the auction, the S&P 500 sank 0.8% and the NASDAQ fell 0.9%, ending the duo’s longest winning streaks in almost two decades. The market reaction suggests that investors are concerned about the Federal deficit and the lack of participation from the Federal Reserve in the bond market.
• Treasury auctions have become more important than employment data in recent months, according to research from Citi Global Markets. After analyzing 22 Treasury auctions, the bank found that equity sales have fluctuated more after Treasury auctions than on the day the jobs data is released. This may explain why the stock market rallied earlier this month after the Treasury announced that it would sell $112 billion in fixed-income securities, less than the $114 billion primary dealers had expected. The growing importance of Treasury sales underscores concerns that bondholders’ appetite for U.S. debt is waning.

• The scarcity of bond buyers is likely to push up interest rates and tighten financial conditions, as investors demand higher yields to compensate for the liquidity risk. This trend will persist unless policymakers take steps to control the federal deficit, or the Fed expands its balance sheet. Policy rate cuts may also relieve some of this pressure on long-duration securities by discouraging investors from purchasing shorter-duration bonds. Uncertainty about high interest rates will likely lead to increased scrutiny of risky assets, as investors assess the potential impact of higher borrowing costs on corporate earnings. However, the lack of demand for Treasury issuance reduces the chance of another rate hike from the Federal Reserve.

Semiconductor Slump: Despite a strong start to the year fueled by excitement about AI, chipmakers’ profits have slipped due to weak demand and a growing supply of semiconductors.

• The PHLX Semiconductor Sector Index has plummeted 11% from its peak in August 2023, drastically outpacing the 3% decline in the S&P 500 from the same period. This is driven by a pessimistic outlook after last year’s chip shortage turned into a glut. However, recent earnings reports from Samsung Electronics Co.(005930.KS, KRW, 70,500) and Taiwan Semiconductor Manufacturing Co.(TSM, $91.62) have offered a glimmer of hope for a reversal, as both companies suspect that the market is inching closer to balancing. Meanwhile, Chinese chipmaker Semiconductor Manufacturing International Corp. (SMIC) has voiced concerns that growing geopolitical competition within the space could lead to overcapacity.
• SMIC’s concerns appear to be a veiled criticism of U.S. efforts to stifle China’s advancement in chipmaking. The Biden administration has imposed export controls that make it more difficult for China to develop chips for military technology. Additionally, the U.S. has allocated resources to build its own domestic chip fabs to reduce its reliance on Taiwan, a major chipmaking hub. China has responded by increasing its spending on semiconductor production. This increased competition has led to a surge in investment in semiconductor production, as both countries seek to insulate themselves from possible supply chain disruptions.

• The easing of tensions between the United States and China is unlikely to improve the outlook for the semiconductor industry, as both sides are seeking to reduce their reliance on the other. As a result, chipmakers are likely to face increased competition, as the massive investments in semiconductors should lead to a battle for market share. This could make technology more affordable in the long term, as firms struggle to maintain market power in an environment where new entrants are likely to emerge. However, the lack of market dominance could also make it difficult for firms to maintain healthy profit margins.

Senate Majority in Danger? West Virginia Senator Joe Manchin’s decision not to seek reelection in 2024 gives Republicans a prime opportunity to flip a Senate seat.

• Manchin’s decision not to seek reelection in 2024 jeopardizes the Democratic Party’s control of the U.S. Senate. The party will struggle to find a replacement for the moderate Manchin, as there is no apparent frontrunner in the race. West Virginia has a long history of favoring Republican candidates, and former President Donald Trump won the state by a nearly 40% margin in 2020. If the Democrats lose Manchin’s seat, the Senate will likely fall into Republican hands. The seat is favored to switch to Conservative West Virginia Governor Jim Justice, and it isn’t clear whether the Democrats will look to save it.
• Senator Manchin’s decision not to run for re-election may be related to the growing demand for a third-party challenger in the 2024 presidential election. He has long been associated with the bipartisan No Labels political party, and in his announcement, he mentioned a desire to test the level of support for a candidate who could bring the middle together. So far, several challengers have thrown their hats in the ring, including Harvard Professor Cornel West, environmentalist Jill Stein, and environmental lawyer Robert Kennedy. While third-party candidates are often seen as spoilers, it is unclear whether any of these candidates can swing the election.

• The entrance of third-party candidates increases the likelihood of a contingent election, in which no candidate wins the 270 electoral votes required to win the presidency outright, which has not occurred since 1877. In this case, the Constitution requires the House of Representatives to choose from the top three candidates who received the most electoral votes. Each state gets one delegate, and a candidate needs to receive at least 26 delegates to secure the nomination. The last time this happened, the Democratic and Republican candidates agreed to give the presidency to Republican Rutherford B. Hayes in exchange for the end of Reconstruction in the South. Markets would likely react poorly to this outcome, as it would call the legitimacy of the government into question.

Other News: China is investigating a ransomware attack on the U.S. unit of the Industrial and Commercial Bank of China. The attack on U.S. Treasuries disrupted trading and reflects the ongoing battle to develop the cyber infrastructure needed to prevent hackers from accessing sensitive information. Israel is concerned over a possible war with Hezbollah, in another example of the risk of a spreading Middle East conflict. Cleveland Fed President Lorretta Mester is set to resign in 2024, and she will likely be replaced by another policy hawk. Fed Chair Jerome Powell has warned that Fed officials may look beyond data when determining whether inflation is improving.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equity markets are treading cautiously ahead of Fed Chair Jerome Powell’s speech, while Real Madrid advances to the Champions League knockout stages for the 27^th consecutive year. Today’s Comment begins with why investors should remain cautiously optimistic about the shift in central bank sentiment. We then give our thoughts on the potential impact of proposed bank regulation changes, and how the Republican debate may hint at future foreign policy direction. As always, our report includes a summary of the latest domestic and international data releases.

Policy Sentiment Shift: Bond investors are convinced that rates have already peaked. However, policymakers seem less certain.

• After reaching their October highs, global bond yields have embarked on a downward trajectory. The 10-year Treasury yield has plummeted nearly 50 basis points since its peak two weeks ago, mirroring the retreat observed in its British and German counterparts, which have shed 40 and 30 basis points, respectively, during the same period. This surge in bond demand has extended to mortgage rates, with the average 30-year fixed-rate mortgage experiencing a 25 basis point decline in a week, settling at 7.61%. The collective pause adopted by central banks has fueled investor speculation about a potential bond rally, leading to a renewed interest in fixed-income securities.
• While investors appear to believe that central banks have concluded their rate-hike cycle, central bankers themselves remain more cautious. Bank of England Governor Andrew Bailey has decisively dismissed speculation of a policy easing in mid-2024, underscoring the ongoing struggle against inflation. Echoing this sentiment, Bank of Canada Governor Tiff Macklem has warned that the lingering effects of energy price shocks could hinder inflation control efforts. Reinforcing this cautious outlook, Federal Reserve Governor Michelle Bowman and Minneapolis Fed President Neel Kashkari have hinted at the possibility of further interest rate increases to ensure inflation’s return to the 2% target.

• The future course of monetary policy will largely hinge on expectations for economic growth. While concerns about a potential recession in 2024 are mounting, similar worries were prevalent at the beginning of this year. One encouraging aspect is the continued resilience of the labor market across the developed world. Even Canada, which experienced a technical recession in the third quarter, boasts an unemployment rate of 5.7%, below its historical average of 7.6%. Most evidence suggests that even if there is a downturn, it is likely to be mild. Hence, a recession may not be enough to pivot policy, especially if inflation returns.

Regional Banks: Several months after endangering the financial system, small to midsize lenders may begin another chapter.

• Regulators want to limit bank access to funds from Federal Home Loan Banks (FHLB). The decision comes after lenders relied heavily on the $1.3 trillion system meant to encourage mortgage loans to meet their short-term funding needs after the fall of Silicon Valley Bank. Several months after the March banking turmoil, FHLB had over $880 billion in outstanding loans to U.S. banks and credit unions. The Federal Housing Finance Agency (FHFA) has proposed requiring banks to hold 10% of their assets in mortgage loans, establishing new safeguards for lending to struggling banks, and implementing stricter stress tests.
• The new rules are designed to help FHLB return to their original mission of supporting banks in providing loans to potential homebuyers, but banks argue that the regulators are overreaching. The banking industry has rejected claims that its problems were due to a lack of regulation and instead are blaming the Federal Reserve’s lack of guidance. JPMorgan CEO Jamie Dimon has ridiculed policymakers for being “dead wrong” on inflation and pleaded for the Fed to show greater humility, given its proposal for more capital requirements. The pushback suggests that regulators may not be able to implement all the changes they want to protect the banking system.

(Source: Federal Reserve)

• New capital restrictions would complicate banks’ efforts to lend across the country. The latest Senior Loan Officer Opinion Survey (SLOOS) shows that banks are already tightening their lending standards, particularly for non-government-backed and non-residential loans. If these rules are implemented, they could dampen the potential stimulative impact of a pivot in Fed policy, which is likely to be less aggressive than in previous easing cycles. This may mean that when the Fed does decide to make the policy change, it might be less successful in generating demand than in previous easing cycles, especially if the rate cuts are modest as we would expect.

Rethinking Defense: Although all Republican presidential candidates have voiced support for Israel in its fight against Hamas, they have taken a more Jeffersonian stance on other foreign policy issues.

• During the debate, most candidates expressed skepticism about further funding for Ukraine. Former UN Ambassador Nikki Haley said the U.S. should support Ukraine by sending weapons, not aid. Entrepreneur Vivek Ramaswamy argued that Ukraine’s occupied areas should remain with Moscow. Republican Gov. Ron DeSantis of Florida and Sen. Tim Scott of South Carolina both expressed concerns about how the money is being spent. In contrast, former New Jersey Gov. Chris Christie was the only candidate to show restraint, warning that the cost was warranted to prevent another world war.
• Their wariness regarding Ukraine comes as Americans are voicing more concern about deteriorating law and order in the United States. A recent Gallup poll showed that Americans’ perception of safety has fallen to its lowest level in five years. The most frequently proposed solution to the rising crime problem discussed on the debate stage was to increase security along the U.S.-Mexico border. Candidates also proposed finishing the border wall and possibly designating drug cartels as foreign terrorist organizations. China was also mentioned, with Haley vowing to stop all trade with the world’s second-largest economy until it prevents fentanyl from entering the U.S.

• The candidates’ notable tone on the debate stage suggests that a sizeable Republican base may now prefer a more Jeffersonian approach to foreign policy, with a focus on domestic issues over global affairs. While the United States may not completely abandon its leadership role in the world, it may need to redefine that role to be more palatable to a populace that has grown tired of its hegemonic status. This could involve off-budget spending programs similar to the Lend-Lease Act or aid packages with strings attached akin to the Marshall Plan.

Other News: Bank of Japan Governor Kazuo Ueda has stated that the central bank will proceed cautiously as it moves away from its ultra-accommodative policy. His remarks suggest that Japanese policymakers may be averse to significant changes in policy. Hollywood actors and studios have reached a tentative agreement to end the 118-day strike, with new restrictions on the use of artificial intelligence technology. The agreement reflects labor concerns about the threat that AI poses. Spanish Prime Minister Pedro Sánchez and the Catalan separatist Junts have reached an agreement that could pave the way for a new government.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning.  Equity markets are mostly treading water this morning, and Chair Powell will speak later today.  Interest rates are also mostly steady, but commodities are mixed as oil and gold are lower while grains are higher.

In today’s Comment, we start our coverage with a recap of yesterday’s state and local elections.  Next is our update on the situation in Gaza.  A roundup of economic and financial news follows.  China is next on the docket, and we close with our international overview.

Elections:  Democrats generally did well last night.  Meanwhile, budgets and AI are background issues.

• Going into last night’s elections, there was a general level of concern among Democrats due to recent adverse polling. However, for the most part, the party outperformed expectations.
  • Abortion continues to bring out voters for Democrats. Ohio voters chose to put abortion access into the state’s constitution, for example.
  • Governor Beshear was re-elected in Kentucky, a deeply red state.
  • In Pennsylvania, voters supported Democrats in local elections despite weak poll numbers in that state for President Biden.
  • In Virginia, Democrats gained control of the statehouse, thwarting Governor Youngkin’s goal of a Republican takeover. This loss may dim his national aspirations.
• The House GOP can’t seem to agree on a plan of action to deal with the fiscal budget. One idea being floated is a series of continuing resolutions, essentially creating a series of “fiscal cliffs.”  To some extent, the budget talks have an air of “rearranging the deck chairs on the Titanic” in that the deficit is spiraling in an unsustainable path, and there is little evidence either party is paying attention.
• We are about a year away from presidential elections, and there are reports that AI generated videos are becoming indistinguishable from real ones, which means that video disinformation may become just about impossible to control. Not only does this create conditions where political operatives can generate mayhem, but it also gives foreign actors outsized influence.  We have been monitoring this issue for some time, and the speed of development has been surprising.  It is unclear how this will affect elections next year, but this factor adds to an already unsettling political environment.

Gaza:  IDF has entered Gaza city, and the U.S. is warning Israel against taking control of Gaza.

• According to reports, Israeli forces have entered Gaza City. This battle will be difficult for the Israelis, since in general terms, defense is easier than offense.  Complicating matters further is that urban warfare is difficult, and Hamas is well prepared for this attack with a well-established tunnel system.  We would expect the conflict to become bogged down from this point forward.
• The U.S. is warning Israel that it probably isn’t a good idea to occupy Gaza. Given how rapidly this situation is evolving (it was a month ago that Hamas attacked Israel), it appears that the Netanyahu government hasn’t sorted out what its plans are.  We note that SoS Blinken downplayed the notion of occupation.  The fact of the matter is that there are no good solutions to this situation which is why the government is struggling with a plan.
• Arab states are increasing their calls for a ceasefire. China and Russia are echoing these calls in a bid to improve their status in the region.
• The EU is facing an increase in terrorist violence, likely in response to the conflict in Gaza. Extremist activity in the U.K., Belgium, Germany, and France has been reported.  The violence appears to be having an impact on immigration policy (see below in International Roundup).
• One of the factors that may have triggered Hamas’s attack was normalization between Israel and Saudi Arabia. The Abraham Accords, for the most part, ignored the Palestinian situation and the fact that Arab states signed on suggests that the Palestinians were not a key factor in relations.  Initially, Riyadh backed away from normalization talks.  However, there are reports the Saudis are still interested in making a deal.  If talks go forward, it suggests that the Palestinians have very little leverage in the region.

Economic and Financial News:  The NY FRB’s household debt data was released yesterday, showing an uptick in borrowing.  Commodities are mixed: oil is lower, while beef and grain prices are rising.

• The NY FRB household debt data showed a modest rise in Q3. The debt balance per capita is just above $60k.

• Company reports are hinting that consumer spending may be slowing down. If so, economic activity will likely also decline.
• Oil prices have declined to the levels last seen before the Gaza event. Although there are worries that the conflict will spread, every day that passes with the war staying in Gaza, the fears clearly dissipate.
• Last summer was dry and hot in the central U.S. These conditions create a problem for ranchers, as it forces them to buy hay to feed their animals instead of using grass, and the hay costs rise due to drought.  The bottom line is that beef costs are slated to rise further.  The CPI for beef was up 7% in September.
• China is increasing its purchases of U.S. soybeans; this buying is boosting soybean prices.

China Update:  The IMF upgrades its forecasts for China’s economic growth while raising concerns over its real estate situation.  Beijing is putting additional controls on the exporting of rare earths.

• The IMF raised its forecasts for this year’s growth to 5.4% from 5.0% and lifted next year’s forecast GDP to 4.6% from 4.2%. At the same time, the IMF warned that China’s housing sector remains a risk to the economy. China has boosted infrastructure spending to lift growth.  We view this action as problematic, but the spending is likely better than allowing for a downturn.
• China announced new measures to control exports of rare earths, along with other major commodities such as oil and iron ore. China has been aggressively building oil stockpiles in recent months.  Some of this rebuilding is taking advantage of sanctions on Russia and Iran, which have depressed prices for their crude oil.  Adding controls is consistent with China’s functioning in a multipolar world.
• China is building its stockpile of semiconductor equipment prior to U.S./EU restrictions.
• Polling in China suggests some softening in hostility towards the U.S. This change may reflect the impact of recent meetings.

International Roundup:  NATO and the U.S. are suspending a 1990 treaty that limited conventional forces in Europe.  Portugal’s PM is out, and we include a note on immigration.

• The U.S. and NATO have formally suspended their participation in a treaty that limited conventional forces in Europe, effective December 7. This action follows Russia’s withdrawal from the treaty.  The treaty was a landmark at the time, signaling a formal end to the Cold War.  The pact limited troop levels and armor that could be held by NATO and the Warsaw Pact states.  It also forced both parties to inform the other where troops were deployed.  However, Russia suspended the treaty in 2007, and it’s unclear why NATO and the U.S. waited so long to retaliate.  The slow response is an indication of policymakers’ denial of Russia’s intentions.
• PM Costa of Portugal resigned yesterday after police raided his residence as part of a corruption investigation. The president of Portugal will either need to appoint a new PM or call for elections.  The probe concerns how EU funds were spent on green investments.
• Immigration has been a “hot button” issue in the EU for some time.  Much of the immigration is coming from Northern Africa and the Middle East.  These immigrants, mostly Muslim, have struggled with integrating into Europe and the social disruption has caused political upheaval in the EU, elevating right-wing parties.  Part of the problem is that Europe is facing a demographic deficit and needs immigrants, but worries about cultural disruptions remain unsolved.  As tensions have risen, individual nations in Europe are taking action, making a EU-wide policy difficult to implement.  The fear is that individual states will try to force the costs of immigration onto other nations, creating fissures within the EU.  At this point, we don’t see how Brussels can contain this trend, meaning that the immigration issue will likely worsen.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning.  It’s a risk-off day in the markets.  As we noted above, global equities are mostly lower.  Commodities are weaker as well on fears of weaker economic growth.  We are seeing a rally in Treasuries in light of broader market weakness.  It’s election day in the U.S.  Although today’s elections are local, political analysts will be looking hard at the results for any insights into next year’s presidential race.

In today’s Comment, we start our coverage with an update on the situation in Gaza.  China is up next, economic and finance news follows, and we close with our international overview.

Gaza:  Netanyahu claims Israel will take “indefinite” control over the Gaza Strip, and the death toll is mounting.

• The Israeli PM indicated overnight that Israel would take control over Gaza to prevent Hamas from retaking power. For Israel, this is a “back to the future” moment, as Israel held control over the area until 2005, when PM Sharon concluded it would make more sense to leave Gaza to the Palestinians and create a hard border around the area.  Returning to Gaza means re-occupation, which is difficult.  However, it is now clear that a Hamas-controlled Gaza is a major threat to Israeli security, thus leaving Netanyahu with little choice.
• According to the health ministry in Gaza, 10k Palestinians have died in Gaza and 25k have been injured.
• U.S. continues to press Israel for a pause. So far, the Israeli government has refused any significant ceasefires without the release of hostages, although it has allowed for some relief supplies to enter the area from Egypt.
• The Israeli military has surrounded Gaza City, essentially cutting the area into two parts.

China Update:  Australia is improving relations with Beijing, the U.S. and China are setting up meetings, as are EU officials, and China’s exports remain weak.

• Relations between Australia and China deteriorated during the pandemic when Canberra called for an international inquiry into the origins of COVID-19. This week, Australian PM Albanese concluded trade meetings with Beijing which apparently have eased Chinese restrictions on Australian products.  General Secretary Xi spoke glowingly of the improving relations between the two nations, suggesting ties are now on the “right path.”  What Albanese is trying to do is what many nations in the region are also attempting, which is to have economic ties to China while also building security relations to contain Beijing.  We note the Australian PM remains cautious about China.
  • Interestingly enough, as trade relations between Australia and China improve, Australia’s talks with the EU have “collapsed.” It may be difficult to maintain security relations when economic activity is stunted.
• Australia isn’t alone in trying to improve relations with Beijing. The Biden administration has been actively arranging talks all year.  There are expectations that Xi and Biden will meet in San Francisco at the APEC summit later this month.  Meanwhile, Treasury Secretary Yellen and Vice-Premier He are scheduled to meet November 9 and 10.
  • Invitations were sent to U.S. business leaders to meet with Xi and Biden during the APEC summit.
  • There are reports the U.S. and China will discuss nuclear weapons in the near future. China has been rapidly expanding its nuclear weapons arsenal recently.
• The EU is also planning talks with China in December. EC President von der Leyen is planning on traveling to Beijing for meetings, although the initial tone appears rather hawkish.
• China is increasingly harassing Western surveillance flights that are looking to see if nations are breaking sanctions on North Korea.
• On the economic and finance front, there were several interesting developments:
  • Gallup is leaving China because the government views its surveys as a “tool” to discredit the regime.
  • The CPC has banned party members from owning private equity. Concerns about corruption led to the decision.
  • Chinese tech mogul Chen Shaojie has been arrested. It is unclear with what he has been charged.
  • China’s exports fell again in October.
  • Slumping pork prices could lead to a negative print on China’s CPI.
  • China’s #2 property developer, Vanke (000002, CNY, 11.93), appears to be in trouble, prompting local governments to step up their support. There is evidence that Beijing is responding to the property crisis by moving to support other industries and through the expansion of central government spending.
  • China has created a network of ports as part of its maritime Belt and Road Initiative. This network could become a major military asset.  The Belt and Road projects have become notorious for pushing nations into debt; China has become a major source of aid that may be designed to support its collection efforts as well.

Economic Roundup:  The Senior Loan Officers Survey was released yesterday; we offer details.

• The Senior Loan Officer Survey was released yesterday afternoon. For the most part, credit standards remain tight but have loosened somewhat.

Demand also showed signs of improvement.

The willingness to make consumer loans was mostly steady.

However, demand from consumers remains soft.

Overall, the survey suggests financing conditions are not getting much worse, but overall, lending standards remain tight.

• Higher interest rates and dollar strength are taking their toll on emerging markets.
• As commercial banks face increasing capital restrictions, they are developing novel ways to distribute lending risks. Banks are increasingly using synthetic risk transfer products, which allow banks to reduce their capital charges on loans.  In return, buyers of these instruments receive high returns.
• In general, funding for any asset can come from either debt or equity. The attractiveness of either method depends on the cost of the funding.  As mortgage rates hit 8%, homebuyers are being offered instruments which are essentially equity participation in the home-buying process.  The firms providing the equity are then creating bonds to sell to investors.

International Roundup:  Germany is struggling to deal with the Alternative for Germany party (AfD), and the incumbent in El Salvador can run again.

• A close advisor to the head of Ukraine’s armed forces was killed yesterday by a bomb hidden in a birthday gift. Major Gennadiy Chastyakov, an aide to General Zaluzhny, died when the package exploded.
• In democracies, there are situations where, if power is closely balanced, individuals can have an outsized impact on policy. In the U.S., such situations are uncommon because a two-party system tends to overwhelm its dissidents.[1]  Multiparty systems, such as those seen in continental Europe, are much more prone to minority parties having significant power.  Major parties rarely win a majority outright, and thus, must court minor parties to form governments.  This means that if the lesser parties become unhappy, they can bring down governments.  We are seeing something like this in Germany.  The AfD has seen its power rise in recent local elections.  The major parties are trying to avoid a situation where they need the AfD to form a government.  What’s driving the AfD’s success is  German’s anger over immigration and energy policy.  Sometimes, minor parties in government can force the larger parties into policies that are unpopular.  If that occurs, as we are seeing in Germany now, it can lead to political tensions.
• In El Salvador, an election tribunal decided to allow Nayib Bukele to run for a third term, in contradiction of the nation’s constitution. Bukele is very popular but was being prevented from running again due to legal restrictions.  Now that those are out of the way, he will likely win; elections will be held in February 2024.

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[1] Although uncommon, it isn’t unprecedented.  The power of Sen. Manchin and Sen. Sinema was in evidence from 2020-22.  And, the power of the Freedom Caucus has had an impact on the House of Representatives.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an update on the Israel-Hamas conflict, where we continue to see a risk that the fighting could expand regionally and potentially even draw in the U.S.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a new ban on short selling in South Korea and additional signs of softer labor demand in the U.S.

Israel-Hamas Conflict:  The Israel Defense Forces continue to attack Hamas forces in the Gaza Strip, with a focus on stand-off attacks against the entry and exit points of the extensive tunnel network the terrorist government has built throughout the enclave.  The strikes have reportedly trapped many Hamas fighters in the tunnels with no electricity, light, or air conditioning.  Meanwhile, Iranian-backed groups in the region continue to launch drone, missile, and air attacks against Israel and U.S. forces in the region (see map below).  In an effort to reassure allies that the U.S. will carefully calibrate its response to those attacks, Secretary of State Blinken made a surprise trip to several regional capitols over the weekend.

• The IDF reportedly plans to continue its strikes on the tunnel network until at least 65% of its entry and exit points have been destroyed. Outside analysts currently estimate about 50% have been destroyed.
• The continuing rise in reported civilian casualties suggests that Hamas has built many of those entry and exit points under residential and commercial buildings. The IDF insists that it gives fair warning for civilians to evacuate before each strike, but many civilians with no place to go still die in the airstrikes or artillery and tank fire.
• The mounting civilian casualties and growing anger at Israel around the world will probably raise the risk of retaliation, against both Israel and the U.S., by Iranian-backed Islamist groups such as Hezbollah in southern Lebanon. If they continue, they could potentially even prompt attacks on Israel by regional states, including Iran.  In other words, there is still a risk that the conflict will expand into a dangerous regional war that could crimp global oil supplies and drive-up energy prices.

Israel:  As we have warned, the fight against Hamas is now starting to have palpable negative effects for Israeli businesses, with firms struggling to deal with plummeting demand, the loss of workers called up for reserve duty, and consumers in border areas fearful to go out on shopping trips.  Prime Minister Netanyahu has promised vast, pandemic-style cash transfers to affected firms and workers, but the aid package is already being criticized as too small.

Japan:  Now that the Bank of Japan has softened its yield curve control policy and signaled it will let longer-term yields rise, several major Japanese banks have raised the (still miniscule) interest rates they offer on time deposits.  For example, Sumitomo Mitsui Trust Bank, a unit of Sumitomo Group (SSUMY, $21.11) said it will hike the annual interest paid on five-year noncancelable deposits to 0.10% from 0.01% previously.  (So far, we have seen no reports of Japanese depositors dancing for joy in the streets.)

South Korea:  The Financial Services Commission today issued a blanket ban on short selling listed stocks until June 2024.  In a statement, the Commission claimed the ban was necessary to ensure “fair price formation in the domestic market” following “repeated illegal naked short selling by global institutional investors.”  Nevertheless, the move is being seen as a sop to retail investors ahead of next year’s parliamentary elections.  In response, Korean stock-price indexes today have surged as much as 6%.

China-Russia:  On Friday, the Commercial Aircraft Corp. of China, otherwise known as Comac, gave an update on the development progress of its long-delayed widebody jet, the C929, without mentioning its Russian joint-venture partner, United Aircraft Corp. (UAC).  That marks the second time in two months that Comac has given an update without mentioning the Russian firm, which suggests UAC has dropped out of the project.

• If the Russian firm has indeed dropped out of the C929 project, it could signal that the firm is a casualty of the Western sanctions on Russia for its invasion of Ukraine.
• After similarly long delays, Comac’s single-aisle C919 aircraft, designed to compete with the 737 from Boeing (BA, $195.05), began flying commercially only in May.
• Despite China’s successful industrial policies to develop products such as electric vehicles and mid-range semiconductors, it continues to struggle with large civilian airliners. For now, that suggests the global market for such aircraft will remain a duopoly between Boeing and Europe’s Airbus (EADSY, $34.59).

China:  New analysis of Chinese data suggests foreign companies pulled more than $160 billion of earnings out of the country over the six successive quarters ended in September.  Reflecting that, net foreign direct investment in China in the third quarter of 2023 turned negative for the first time in a quarter-century, and the value of the yuan (CNY) fell to its lowest level in a decade.

• The withdrawal of foreigners’ earnings reflects a range of factors, such as rising interest rates in the West, slowing growth as the Chinese economy matures, and headwinds from poor consumer demand, high debt levels, bad demographics, and disincentives arising from the government’s increasingly intrusive control over business.
• In addition, the economy is slowing from foreign decoupling, i.e., new barriers to trade, capital, and technology flows with China. In other words, the pull-out of earnings is also another example of how the world is fracturing into relatively separate geopolitical and economic blocs, as we’ve written about in depth.

European Union:  In an interview with the Financial Times, EU Transportation Commissioner Adina Vălean said Brussels has launched an investigation into the big fare increases of 30% or more that European airlines imposed during the summer.  The European Commission has no authority to regulate airfares, but the probe is a useful reminder that governments around the world may not rely solely on tight monetary policy to fight inflation.  Executive and legislative branches of government can also put regulatory pressure on firms, perhaps including price caps.

Germany:  Tesla (TSLA, $219.96) last week reportedly announced big pay increases for the workers at its “Gigafactory” near Berlin.  Chief executive Elon Musk also promised the workers that they will build the firm’s next-generation electric vehicle.  The moves come as Tesla is trying to fend off an organization effort at the plant by Germany’s powerful IG Metall union.  If the plant is successfully unionized, it would likely encourage efforts to organize other Tesla facilities around the world.

Sweden:  Separate from the German situation, the IF Metall trade union that launched a strike against Tesla in late October claims the company will open talks with it today.  Although Tesla doesn’t manufacture autos in heavily unionized Sweden, it does employ about 120 mechanics at its service centers there, and those workers have been agitating for a union.  If the company ultimately acquiesces to the mechanics’ demands, it could also potentially encourage further unionization efforts elsewhere.

U.S. Labor Market:  In contrast with the post-pandemic “Great Resignation,” when employers reported big jumps in voluntary quits, the softening white-collar labor market has now pushed turnover down steeply.  The latest JOLTS report from the Labor Department shows the quits rate is now back down to where it was just before the pandemic.  As a result, some businesses are over-staffed, which will heighten the risk of bigger layoffs as the economy slows.

• In a further sign of softer demand for white-collar workers, major consulting firms such as McKinsey and Bain & Co. say they are freezing starting pay for new graduates they will hire in 2024.
• Nevertheless, the firms continue to pay rich salaries to new employees. McKinsey, for example, offers a base pay of $192,000 per year for fresh MBA graduates.

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