by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are down as investors await the Federal Reserve’s policy decision. In sports news, Real Madrid showed their fighting spirit again, securing a draw against Bayern Munich in a thrilling Champions League match. Today’s Comment examines our views on monetary policy, where we believe the market should be less focused on rate cuts and more on balance sheet reduction. We also discuss how investors are paying closer attention to earnings and whether China may look to stimulate its economy over the next few months. The report concludes with a summary of domestic and international data releases.

No Cut, No Problem: The market anticipates a hawkish stance from the Federal Open Market Committee (FOMC) after its meeting, but the Fed’s balance sheet plans shouldn’t be overlooked.

• Strong economic data has cast doubts on the Federal Reserve’s plan to cut rates three times this year, as initially outlined in their economic projections. The CME FedWatch Tool now reflects a more cautious approach, suggesting one or two cuts are more likely. This shift aligns with the Fed’s wait for clearer signs of inflation subsiding. Tuesday’s employment cost index, showing a jump in wages and benefits from 0.9% to 1.2% in Q1, is a prime example. The data highlights persistent wage pressures, particularly for unionized workers whose compensation rose 6.3% compared to 4.1% for non-union workers.
• Despite the economic data, the Fed might prioritize easing financial conditions through other means. Minutes from the March FOMC meeting showed that a majority of policymakers favored a measured slowdown in quantitative tightening (QT), specifically by reducing the pace of US Treasury drawdown while maintaining the current pace of runoff of mortgage-backed securities. The FOMC minutes didn’t provide a specific timeframe, but policymakers expressed a preference for a “fairly soon” implementation, likely indicating this summer or even this month. This move could help anchor Treasury yields and alleviate the risk of funding pressures in the repo market.

• While a rate cut delivers a more direct economic boost, slowing the pace of QT could still offer some market relief. Unlike rate cuts, a measured slowdown in balance sheet reduction is unlikely to significantly impact consumer spending. This signals the Fed’s consideration of a less restrictive policy stance. However, we don’t expect it to completely rule out rate cuts in 2024. Instead, it will likely signal less confidence in its ability to lower rates moving forward. Given persistent inflation, our current forecast is for a maximum of two rate cuts this year, with a strong possibility of none at all.

Investors Not Deterred: Investors have shifted their focus to corporate earnings, scrutinizing the ability of companies to maintain profitability amidst tightening financial conditions.

• Early signs from earnings season are positive. Over 80% of the nearly 300 companies that have reported have exceeded analyst expectations, defying concerns as the country continues to experience strong consumer spending growth. The S&P 500 has seen earnings growth of 5.6%, handily surpassing Bloomberg’s estimate of 3.8%. This strong performance is broad-based, with some companies reporting positive surprises exceeding 8% in earnings growth. This robust corporate performance appears to be a bright spot in the market as investors adjust to the possibility of fewer rate cuts from the Fed.
• The focus of tech earnings this week shifts to the “Magnificent Seven,” a group of high-valuation tech companies. Investors are eager to see if these companies can justify their lofty stock prices. So far, the tech sector has shown mixed results. Disappointing outlooks from Meta and weak sales from Apple have dampened investor enthusiasm. However, a surprise dividend from Alphabet and robust cloud performances by Amazon and Microsoft have offered some relief. A strong earnings report from Nvidia later this month could give the Magnificent Seven a much-needed boost. However, considering the recent reports from fellow chipmakers AMD and Supermicro, such a performance might be unlikely.

• Maintaining their stellar start to the year is proving difficult for major tech companies, suggesting much of their potential for growth is already reflected in their stock prices. This could explain the recent dividend announcements from companies like Meta and Alphabet, potentially aimed at appeasing investors seeking returns to offset the higher risks associated with tech stocks. However, such payouts are unlikely to become the norm, as tech companies prioritize reinvesting most of their earnings into research for the competitive AI landscape. This shift in focus could benefit less-favored sectors, particularly mid and small caps, which often boast stronger fundamentals.

China on the Move: Beijing is expected to announce new measures to help improve the country’s economic situation, while it struggles to deal with a struggling currency and slow growth.

• The Politburo met on Tuesday and set a date in July 2024 for the long-delayed Third Plenum. The postponement of the meeting, originally expected in late 2023 (a year after President Xi Jinping secured an unprecedented third term), has sparked speculation about internal discussions within the party leadership regarding China’s economic challenges. The focus of the July Plenum is expected to be economic reforms aimed at modernizing the country. Additionally, the Politburo indicated a willingness to support the struggling economy through measures such as bolstering the property market and potentially reducing interest rates.
• China’s rising yuan (CNY) is raising concerns about export competitiveness. While the yuan is loosely pegged to the dollar, it has appreciated against other Asian currencies — 6% against the Japanese yen (JPY) and nearly 3% against the Korean won (KRW) — sparking speculation of a devaluation. Although a weaker yuan might boost exports, it could also trigger capital flight, similar to what happened after the 2015 devaluation. This could harm financial assets and erode investor confidence. Despite these drawbacks, the People’s Bank of China’s ongoing warnings against speculators suggest currency intervention remains a possibility.

• The delay of China’s Third Plenum sparks questions, but it could also indicate that the government believes there is a modestly improved economic situation when compared to a few months ago. The lead-up to the meeting may buoy Chinese stock markets as the government highlights the country’s growth prospects. While a currency devaluation is a lingering concern, it’s unlikely unless China faces significant economic pressure. However, despite tentative signs of progress, investors should remain cautious due to persistent geopolitical and regulatory risks.

In Other News: The Department of Justice’s plan to reclassify marijuana as a less dangerous drug has led to a surge in the WEED ETF. The US Senate passed legislation banning the import of enriched uranium from Russia in another sign that the ties between the country remain severed.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with growing concern among top Israeli officials that they could be indicted for war crimes over their conduct of the war against Hamas. We next review a wide range of other international and US developments with the potential to affect the financial markets today, including several key economic statistics and a preview of the Federal Reserve’s latest policy meeting, which starts today.

Israel-Hamas Conflict: New reporting says Israeli Prime Minister Netanyahu has become increasingly concerned that he and other top Israeli officials could be indicted for war crimes by the International Criminal Court, which has been investigating Israeli and Palestinian conduct against each other over the last decade. The reports say Netanyahu is so concerned that he asked President Biden over the weekend to intervene to make sure the ICC doesn’t issue arrest warrants against him or his national security officials.

• A spokesman for the US National Security Council issued a statement saying that the ICC has no jurisdiction over the Israel-Hamas conflict and that the White House does not support its investigations.
• In any case, Netanyahu’s concern illustrates the risk that Israel is becoming increasingly isolated and is suffering significant reputational damage over its battle against Hamas in the Gaza Strip. As a result, the Israeli stock market, which had become an investor darling in recent years, could face years of headwinds.

Eurozone: Excluding price changes and seasonal effects, first-quarter gross domestic product rose 0.3%, beating expectations and easily reversing the revised 0.1% decline in the fourth quarter of 2023. The growth rate in January through March was the region’s strongest since the third quarter of 2022. Much of the growth reflected a renewed expansion in the German economy, which benefited from stronger investment and exports. Excluding the volatile food and energy categories, the core GDP price index was up just 2.7% year-over-year.

Germany: Little more than a month ahead of the elections for the European Parliament, new polling shows the once-surging, right-wing populist Alternative for Germany (AfD) party is rapidly losing support following revelations that Chinese and Russian spies have been working in its ranks. The reports suggest Chinese and Russian agents have infiltrated populist, anti-establishment political parties and media outlets throughout the West. In turn, any further revelations of the type could slow populist gains in other countries as well.

Japan: Masato Kanda, the vice minister of finance in charge of currency policy, declined today to confirm reports that the government had intervened in the market yesterday to prop up the yen (JPY). Nevertheless, he noted that the recent depreciation in the currency was hurting vulnerable people by raising the prices of imported goods. He stressed that the government would therefore respond firmly to excessive movements in the currency market, in what amounts to a virtual admission of the intervention yesterday.

• Taken together, Kanda’s statement and the intervention yesterday suggest the government’s red line on the yen’s value is now about 160 per dollar ($0.00625). If the currency looks set to depreciate below that level going forward, the government is likely to intervene again.
• So far this morning, the yen is trading at approximately 156.92 per dollar ($0.00637).

Australia: March retail sales unexpectedly fell by a seasonally adjusted 0.4%, wiping out the revised 0.2% gain in February. The culprit? In part, it was Taylor Swift, whose multiple sold-out concerts in February had boosted ticket sales, travel, and other types of consumer spending. Now that the Swifties have gotten back to normal life, the data shows that Australian consumers are in a funk, with retail sales in March up just 1.3% year-over-year.

China: The official purchasing managers’ index for manufacturing fell in April to a seasonally adjusted 50.4, beating expectations but still down from 50.8 in March. The nonmanufacturing PMI fell to 51.2 from 53.0. Like most major PMIs, these are designed so that readings over 50 indicate expanding activity. The April data therefore suggests the Chinese economy is still growing again after a period of weakness, but because of challenges such as the continued decline in real estate development, the recovery remains modest and could fizzle out.

• Faced with the risk of the current recovery petering out, the Communist Party Politburo today issued a statement hinting at new economic stimulus measures.
• The statement suggests the People’s Bank of China could soon launch a new set of interest-rate cuts, while the government provides new support for the housing market.

China-Solomon Islands-United States: The Solomon Islands’ pro-China prime minister, Manasseh Sogavare, yesterday said he would not stand for a new term when lawmakers vote this week for a new prime minister. Rather, ex-Foreign Minister Jeremiah Manele will represent his party. By stepping down, Sogavare insists his party will cobble together 28 of the 50 seats in parliament to retain power, but a coalition of key opposition parties has 20 seats locked up and could convince enough smaller parties and independents to join it and take power.

• If Sogavare’s party loses the parliament vote, it could reflect popular dissatisfaction over his 2022 security deal with Beijing, which has brought Chinese police to the Solomon Islands and drawn the Solomons away from the US.
• Parliament’s vote for the prime minister is due to be held on Thursday.

US Monetary Policy: The Fed begins its latest policy meeting today, with its decision due at 2:00 PM EDT tomorrow. Given the continued momentum in US economic growth and persistent price pressures, the policymakers are widely expected to hold the benchmark fed funds interest-rate target unchanged at a range of 5.25% to 5.50%. Based on interest-rate futures trading, it now appears investors expect the first rate cut — perhaps the only rate cut this year — to come around the end of summer.

• As we’ve noted before, continued high interest rates will likely put stress on certain banks, commercial real estate owners, and other players in the financial markets.
• Despite the economy’s current positive momentum, high interest rates probably remain a risk for the economy and financial markets.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a discussion of the latest US bank to be seized and sold by regulators as a result of today’s high interest rates. We next review a range of other international and US developments with the potential to affect the financial markets today, including a UK proposal to cut long-term disability benefits due to their spiraling fiscal costs and a proposed tax increase on the wealthy in Russia to help fund its invasion of Ukraine. We also include a preview of this week’s Federal Reserve policy meeting.

US Banking System: On Friday afternoon, state and federal regulators seized Philadelphia-based Republic First Bancorp and sold it to fellow regional lender Fulton Financial. Reports say the bank faced challenges similar to Silicon Valley Bank and the two other lenders that had to be seized last year: a steep drop in the value of its bond holdings as interest rates rose, along with a wave of withdrawals as large depositors sought greater security and higher yields elsewhere. Nevertheless, the seizure hasn’t seemed to spark too much investor concern so far.

• The muted market reaction probably reflects the fact that Republic First had total assets of only about $6 billion at the end of 2023 and a stock-market capitalization that was closer to zero than anything else. The bank’s small size, well understood problems, and orderly seizure could minimize the risk of contagion to other financial institutions.
• Nevertheless, the development underscores how continued high interest rates in the US are stressing particular firms in the financial sector and related industries, such as commercial real estate.
• Despite the economy’s current positive momentum, an unexpected crisis for a big firm could still undermine confidence, spark financial contagion, and potentially put the economy into reverse. We therefore think high interest rates remain a risk for the economy and financial markets.

Japan: Continued high rates in the US also keep buoying the dollar, especially as foreign central banks hesitate to hike their rates or prepare to cut. Exemplifying the trend, the Japanese yen (JPY) today continued to depreciate, almost reaching 160 per dollar ($0.00625), a new multi-decade low. Reports indicate that the government then intervened in the market to lift the currency. As of this writing, the yen is trading at 156.26 per dollar ($0.00640).

United Kingdom: Faced with surging payments for long-term disability benefits, largely driven by mental health issues, the UK government will release proposed rules today to tighten eligibility and cut costs. The proposed rules mark a rare instance in which a Western government has been willing to suggest benefit cuts to a politically popular program as its costs increase in the face of population aging and worsening mental health conditions.

Russia: In a speech last week, President Putin said his government is exploring options for hiking taxes on wealthy companies and individuals. According to Putin, the aim is to make the tax system more progressive, with richer taxpayers obliged to pay a higher rate to fund social programs and channel more resources to the poor. Such a move would also disproportionately hit taxpayers in the rich, vibrant, liberal-leaning cities of Moscow and St. Petersburg, basically forcing them to pay more to support Russia’s expensive invasion of Ukraine.

• Sources say the government is considering hiking the top corporate income-tax rate to 25% from its current rate of 20%.
• For the individual income tax, the government is mulling a boost in the top rate to 20%, versus 15% today, for those with incomes over about $54,300 per year and an increase to 15% from 13% for those with incomes over about $10,860. Individuals with incomes below that level would continue to enjoy the flat 13% rate put into place early in Putin’s reign.

China-European Union: As China continues to boost its electric vehicle industry, leading to excess capacity and surging exports of ultra-low cost Chinese EVs, new research from the Rhodium Group suggests the EU would have to impose tariffs of about 50% to stem the tide and protect domestic EU producers. The report comes as Brussels continues its formal investigation into possible unfair dumping by Chinese EV firms.

• The dumping probe is widely expected to confirm that Chinese EV makers are exporting to the EU at subsidized, unfairly low prices. According to Rhodium, EU policymakers are likely to respond by imposing anti-dumping tariffs of 15% to 30%, despite the risk of angering Beijing and potentially prompting it to retaliate against European exports.
• Nevertheless, the Rhodium analysts believe many Chinese EV makers would still earn a comfortable profit at the EU’s contemplated tariffs. The analysis suggests it would take tariffs of 50% or even more to make the EU market unattractive to Chinese producers.
• Of course, tariffs that high would be even more likely to anger Beijing and prompt retaliation against the EU. All the same, now that EU leaders have joined US leaders in realizing that Chinese dumping could be a mortal threat to their domestic industries, the EU is becoming increasingly aggressive in erecting barriers to Chinese trade.

China-United States: Admiral John Aquilino, the outgoing commander of all US military forces in the Indo-Pacific, has warned that China is pursuing a “boiling frog” strategy in the region. In Aquilino’s analysis, Beijing is actively boosting its military strength and adopting more aggressive military behavior in the Indo-Pacific, but it is doing it so gradually that the US and its allies may not see the danger until it’s too late to reverse it.

• Aquilino’s analysis, which is consistent with our view of Chinese strategy, points to even more tensions or a potential crisis in the region in the future.
• As we often warn, the spiral of tensions and the potential for a future crisis will produce continued risks for investors going forward.

US Monetary Policy: The Fed holds its latest policy meeting starting tomorrow, with its decision due at 2:00 PM EDT on Wednesday. Given the continued momentum in US economic growth and persistent price pressures, the policymakers are widely expected to hold the benchmark fed funds interest-rate target unchanged at a range of 5.25% to 5.50%. Indeed, interest-rate futures trading suggests investors now expect the first rate cut — and potentially the only rate cut this year — to come around the end of summer.

• As noted above, continued high interest rates will likely put stress on certain banks, commercial real estate owners, and other players in the financial markets.
• Despite the economy’s current positive momentum, high interest rates probably remain a risk for the economy and financial markets.

US Electric Vehicle Industry: Tesla has reportedly won Beijing’s tentative approval to release its “full self-driving” software in vehicles sold in China. The company’s FSD software is considered key to reigniting its sales growth in major markets, so the news has boosted Tesla’s stock price by approximately 11% in pre-market trading. Nevertheless, given the Chinese government’s massive support for domestic EV makers, we suspect that excess capacity and falling prices will remain a big challenge for Tesla.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are off to a slow start today as inflation concerns linger for investors. But on a brighter note, the Florida Panthers are surging ahead with a commanding 3-0 series lead over the Tampa Bay Lightning. Today’s Comment explores the importance of central bank independence, analyzes investor anxieties surrounding the latest economic growth data, and delves into the reasoning behind Argentina’s recent surge in attention. As always, we conclude with a summary of key domestic and international economic releases.

Fed Independence Under Attack:  Some speculate that if former President Donald Trump is reelected, he might seek to exert greater influence over the Federal Reserve.

• A proposal is gaining traction among allies of the former president that could weaken the Federal Reserve’s independence. According to the Wall Street Journal, a group of former officials and supporters drafted a 10-page document advocating for increased presidential influence on the Fed. The proposal reportedly requires the Fed to consult the president before making rate decisions and empowers the Treasury Department to act as a check on the Fed’s authority. Additionally, it would seek a way to help push Fed Chair Jerome Powell out of power before the end of his term in 2026.
• The Federal Reserve’s independence has been a cornerstone of price and currency stability since the collapse of the Bretton Woods system. This was particularly evident in the late 1970s when then-Fed Chair Paul Volcker’s decisive action to raise interest rates, despite short-term economic pain, reassured markets of the US’s commitment to tackling inflation. This bold move restored credibility to the dollar, making US Treasury securities more attractive to foreign investors and fueling a subsequent bond bull market over the next three decades.

• While former President Trump’s responsiveness to market fluctuations should temper fears of aggressive action to weaken Fed independence, the very discussion raises concerns. Investor and central bank confidence in the Fed’s autonomy is crucial. A loss of faith could trigger a flight from Treasurys, a favoring of hard assets like gold, and a push toward a bear scenario with rising yields for the bond market, similar to periods of high government spending in the post-WWII era. This could likely have spillover effects into equities as investors may be less comfortable investing in risky assets. Investors should continue to monitor this situation closely.

Worse Fears: The Gross Domestic Product (GDP) report didn’t give investors anything to smile about as it showed the economy was slowing, and inflation was accelerating.

• The US economy grew at a sluggish 1.6% annualized rate in the first quarter of 2024, falling short of analysts’ predictions of 3.4% and the prior quarter’s 2.5% growth. This weaker-than-anticipated report was primarily driven by a slowdown in consumer spending, which dipped from 3.3% to 2.5%. While some investors might see this as a positive sign indicating a potential cool-down in the economy, a key inflation measure — the core PCE price index — painted a contrasting picture. This index rose from 2.0% to 3.7% in the first quarter, suggesting inflationary pressures are actually intensifying.
• Slowing growth coupled with persistent service sector inflation raises the specter of a stagnant economy with high prices. The surge in price pressures was driven by increases in services, particularly shelter and financial services, which have risen at an annualized rate of 5.7% and 15.9% in the first quarter, respectively. The massive acceleration sent shockwaves through markets, with the S&P 500 dropping 0.5% on the day and the 10-year Treasury yield rising 5 basis points. Investors are now re-evaluating their expectations, with some abandoning hopes for rate cuts and a growing number pricing in the possibility of another rate hike later this year.

• Despite a disappointing Q1 2024 GDP report, a bright spot emerged. Final sales to private domestic purchasers, a key metric of core economic activity, remained stable at an annualized growth rate exceeding 3%. This excludes factors like inventories, net exports, and government spending, suggesting businesses and consumers are still on solid ground. However, the PCE Price Index’s jump highlights ongoing inflationary pressures driven by the tight labor market. The next quarter’s GDP report could see a rebound, but inflationary concerns remain.

The Argentine Paradox: Argentina’s new market-friendly policies, which were praised by investors, have sparked protests from some citizens, echoing a recurring pattern in the country’s history.

• President Javier Milei is facing mounting pressures following his pledge to curb public spending in Argentina. Thousands of protestors voiced their opposition to the government’s decision to forgo increased education spending, even though inflation has increased 80% over the last year. This demonstration serves as the first major test of Argentina’s willingness to accept austerity measures to rein in the ballooning budget deficit following Milei’s election victory in December. He is expected to implement a series of potentially unpopular measures, including a 50% devaluation of the Argentine peso (ARS), cuts to energy and transportation subsidies, and closures of government buildings.
• Despite the social unrest, investors have started to take Argentina seriously again. Over the last three months, Argentina’s parallel currency has outperformed its peers surging 25%, despite the ARS being down nearly 10% on the year in what is known as the blue-chip swap. The strong currency performance has also helped boost returns for foreign investors as the Argentine stock market has emerged as one of the best performing in the world this year, up 26.7%, driven primarily by the energy and financial sectors.

• Although economic changes are likely something to cheer about, it is important to remember that investors have been down this road before in Argentina. The country has often gone through waves of leaders that favor market-friendly policies only to have them thrown out of office and replaced with leaders that favor social goals instead. This pattern has led to significant fluctuations in the stock market, creating an environment where investors should view Argentina more as a trade opportunity rather than a stable long-term investment.

In Other News: Strong earnings reports from multiple tech companies, coupled with a surprise dividend from Alphabet, have fueled optimism that the tech sector remains a favorite among investors. The US is ramping up pressure on allies to tighten restrictions on semiconductor exports to China, aiming to hinder its technological progress in strategic sectors.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are taking a tumble early in the trading session as Meta’s earnings outlook dampens investor optimism. On the sports front, the Miami Heat have tied the series against the Boston Celtics. Today’s Comment explores why Treasury yields might face continued pressure despite recent strength. We also examine the role of US shale production in tempering oil price surges and analyze the escalating rivalry between the EU and China. As always, we’ll wrap up with a summary of important domestic and international data releases.

Appetite for Treasurys? Treasury allure persists despite oversupply fears and Fed unknowns, but its longevity is in question.

• Demand for U.S. Treasurys held steady even as the government sold a hefty $70 billion in 5-year notes on Wednesday. The auction yield came in at 4.659%, 4 basis points higher than anticipated. This follows strong investor interest in the previous day’s record $68 billion auction of 2-year notes, which yielded 4.898%, slightly below pre-auction yields, easing concerns of the yield topping 5.0%. The upcoming auction of 7-year notes on Thursday will be closely watched as a gauge of investor appetite for longer-term Treasurys given the uncertain outlook on interest rates.
• Investor appetite for Treasurys could face headwinds on Friday following the release of the personal consumption expenditure (PCE) price index. This inflation gauge is being closely watched by the Federal Reserve as it guides its interest rate decisions this year. Consensus forecasts predict a deceleration in the core index, from a year-over-year increase of 2.78% in February to 2.66% in the following month. A reading at or below expectations is unlikely to have a strong impact on rate cut expectations, which now show a terminal Fed Funds rate at a target range of 4.50% to 4.75%; however, a higher reading could boost expectations of no rate cuts at all this year.

• Fixed-income securities, particularly those with longer maturities, face heightened volatility for the remainder of the year. Investor uncertainty surrounding factors like policy rate changes, geopolitical conflicts, and widening budget deficits is driving this increased volatility. Intermediate-term bonds offer a potential hedge, balancing interest rate risk and price risk more effectively than bonds on either extreme of the yield curve. However, a hawkish shift in Fed policy expectations could lead to broad-based rate hikes across all maturities. Rising rates could dampen the momentum of already expensive equities, potentially benefiting previously overlooked stocks, especially if corporate earnings disappoint investors.

Swing Producer? US oil production has helped moderate oil prices in the face of geopolitical turmoil, but concerns linger about its long-term ability to continue doing so.

• Fears of a wider Middle Eastern conflict sent Brent crude prices surging past $90 a barrel. However, the oil market quickly rebounded as tensions eased, suggesting short-term resilience. This relative calm has alleviated concerns about supply disruptions, as previously delayed shipments are now reaching their destinations, thus reducing some of the market tightness. Iran’s reluctance to close the Strait of Hormuz coupled with U.S. hesitancy to enforce Iranian oil sanctions, suggests that supply will continue to make its way to global markets and could therefore limit the rise in oil prices.
• Soaring 16% this year, Brent crude prices face uncertainty due to continued robust market supply. However, the emergence of US shale production has been a key stabilizing force. This domestic resource has mitigated the impact of rising geopolitical tensions and OPEC production cuts, allowing American consumers to rely more on homegrown oil and reduce dependence on foreign imports. In 2023, the US shattered oil production records thanks to surging shale output, a feat unlikely to be surpassed anytime soon. Meanwhile, US oil consumption has remained relatively flat for the past two decades.

• The recent surge in shale production, though positive, might not be sustainable throughout the decade. A key constraint could be the declining number of operational rigs. Baker Hughes data shows a significant drop of 134 active rigs compared to April of last year, suggesting a potential plateau in production over the next few years. The world may need to turn to other suppliers like Brazil and Guyana to manage oil prices if there is a lull in production. That said, barring major geopolitical disruptions, Brent crude could face resistance around $90 per barrel and potentially dip below $80 by year’s end.

EU-China Rivalry: EU regulators are tightening scrutiny of Chinese firms, potentially aligning with the US approach of strategic competition with China.

• EU regulators raided the offices of Chinese security equipment company Nuctech in the Netherlands and Poland on Wednesday. They suspect Nuctech may have benefited from unfair foreign subsidies that distort competition in the market. Nuctech’s production of cargo, baggage, and body scanners used at airports and border points also raises concerns about potential national security risks, as the company could conceivably gain access to sensitive data on shipments. This raid follows the EU’s recent actions against Chinese companies, including accusations of unfair support for domestic medical device suppliers and an ongoing investigation into electric vehicle exports.
• Brussels’ recent assertiveness toward Chinese firms signals a strategic shift in response to the evolving dynamics with the world’s second-largest economy. Western concerns about recalibrating the relationship with China fuel heightened vigilance against potential market saturation by Chinese goods, particularly as Beijing seeks an export-driven escape from its economic slowdown. This hawkish shift is further reinforced by the EU’s strategic use of trade laws to address security risks posed by some Chinese companies. In 2023, the EU remained the largest importer of Chinese goods, accounting for 20.5% of all imports, while China only accounted for 8.8% of the EU’s exports.

• The escalating tensions between the EU and China highlight Western efforts to counter China’s excessive production capacity, aiming to safeguard their domestic manufacturing industries. This trend is likely to persist in the near future, with both upcoming EU parliamentary elections and the US presidential contest potentially favoring candidates who advocate for a firm stance on China. The new protectionist stance will likely complicate efforts of Beijing to bolster its economy and will make deflationary pressure within the country worse. Furthermore, it could potentially complicate efforts to stabilize the yuan (CNY), which has weakened significantly against the dollar.

In Other News: White-collar job growth has stalled in the US recently, with companies focusing on streamlining operations. French President Emmanuel Macron has called for a monetary policy overhaul to allow countries more flexibility to spend on defense. The Scottish government collapsed after a power-sharing agreement crumbled due to ideological differences.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Stocks are surging on good news from Tesla. In the NHL, the Florida Panthers stole another victory, extending their series lead to 2-0 against the Tampa Bay Lightning. Today’s Comment examines how rising labor power could complicate the Federal Reserve’s fight against inflation. We also explain why markets are reacting positively to the latest PMI data and discuss how global investors are keeping a close eye on upcoming elections in India. As usual, the report concludes with a round-up of international and domestic news releases.

US Labor Power:  Workers have scored a string of victories since the pandemic’s end, but these gains are now coming with drawbacks.

• The Federal Trade Commission has enacted a rule banning non-compete clauses used by employers. This change empowers 30 million workers to pursue opportunities at competing firms without fear of recourse, potentially boosting their wages and career mobility. Additionally, the Department of Labor also expanded overtime pay eligibility to salaried workers earning under $58,600 annually, significantly increasing the threshold from $35,500. These combined changes to labor rules will likely face resistance from businesses and advocacy groups through the court system, but also signal a potential shift in power dynamics, with workers gaining more leverage.
• Regulations enhancing workers’ bargaining power, coupled with an exceptionally tight labor market, pose a formidable challenge to the Federal Reserve’s efforts to curb inflation. The close correlation between the PCE core services index and the employment cost index is a critical indicator, suggesting a potential wage-price spiral. In this scenario, rising wages could be offset by price increases as businesses pass on higher labor costs to consumers. This dynamic explains why policymakers like Atlanta Fed President Raphael Bostic prefer restrictive-for-longer monetary policy as the economy continues to add jobs at a healthy clip.

• Stronger worker bargaining power could signal a shift in economic priorities, potentially favoring greater equity over pure efficiency. Historically, periods with stronger worker rights and income equality have often coincided with higher employment and inflation. While artificial intelligence may eventually ease some price pressures, its uneven adoption across sectors makes the timeline uncertain. This could lead the Federal Reserve to raise its neutral rate — the interest rate considered neither stimulative nor restrictive — to manage inflation. It may be close to around 3% to 4%, which is above the Fed’s long-term projection of 2.5% as outlined in its summary of economic projections.

US Loss is Europe’s Gain: The purchasing manager survey has boosted investor confidence, suggesting an improvement in market conditions for both the US and Europe, albeit for different reasons.

• Disappointing Purchasing Managers’ Index (PMI) data released on Tuesday revealed a sudden contraction in both the US services and manufacturing sectors. This is a significant shift from expectations of continued growth. The services PMI dropped from 51.7 to 50.9, and manufacturing fell to 49.9 from 51.9. Notably, the employment indicator also dipped for the first time since June 2020, raising concerns about a potential slowdown in job growth. Remember, readings below 50 in the PMI indicate a decline in private sector activity. The dollar fell following the report as it weakened the case for prolonged policy restrictions.
• However, a brighter picture emerges in Europe. Both the eurozone and UK PMI data indicated an acceleration in growth. The composite euro area index climbed from 50.3 to 51.4, while the UK composite index surged from 52.8 to 54.0. This robust upswing fuels hope that the worst of the economic downturn might be receding, especially as these countries prepare to cut policy rates sometime this summer. Despite the overall improvement in the index, manufacturing PMIs in both the eurozone and the UK remain in contraction territory.

• The contrasting economic picture could favor European equities, especially if it leads to a weaker dollar. A potential slowdown in the US might prompt the Fed to keep the door open for rate cuts this year as it aims to avoid a policy misstep. A disappointing GDP report tomorrow, although unlikely, could further encourage the Federal Open Market Committee to maintain a neutral-to-dovish stance at its meeting next week. Meanwhile, stronger GDP data in Europe and the UK could offer support for the euro (EUR) and pound (GBP) as these countries contemplate loosening monetary policy in the coming months.

Indian Elections: Prime Minister Narendra Modi looks to tighten the grip on his government as voters head to polls for the first of six phases of voting.

• Modi and his Hindu nationalist Bharatiya Janata Party (BJP) are widely anticipated to clinch victory in the election, with official results slated for release on June 4. Meanwhile, the opposition, spearheaded by the once-dominant Indian National Congress, seems to be grappling with internal discord, which has cast a shadow of doubt on whether the coalition can stay together to form a government if it wins. The weakness has given Modi an opportunity to attack his rivals over their welfare plan, suggesting it could lead to a redistribution of wealth to benefit minority groups, particularly Muslims.
• While the BJP is heavily favored, its goal of securing over 400 out of the 543 parliamentary seats — a milestone not achieved since 1984 — might be harder to achieve. A cornerstone of the group’s reelection bid lies in the robustness of the economy, consistently ranked among the world’s fastest growing. Nonetheless, criticism looms over the party’s approach, with concerns raised about economic growth being accompanied by widening income disparities, especially in rural areas. Additionally, the country’s unemployment rate remains a significant concern, standing at over 7% — a sharp increase from the sub-4% rate we saw nearly a decade ago.

• The reelection of Modi is poised to be welcomed by markets, with investors viewing him as instrumental in steering the country towards robust and sustainable growth. However, the election has proven to be more hostile than in previous years. Attacks on voting booths and allegations of vote rigging, especially in regions favoring the incumbent, have surfaced. As a result, there have been calls for a redo of voting in several areas. An extension of an already long electoral contest risks diminishing investor optimism. Although we expect the election to end in line with expectations, there is an elevated chance of unrest following the results.

In Other News: The US Senate passed a bill that could force a ban on TikTok, owned by Chinese company ByteDance. This move, while likely to face legal challenges, underscores the deepening tensions between the US and China. In Pennsylvania’s primary elections, both President Biden and former President Trump secured comfortable victories, but also saw a notable number of protest votes.

View PDF