by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with news that China is continuing to build out its electronic spying facilities in Cuba, which will likely further exacerbate tensions with the US. We next review several other international and US developments with the potential to affect the financial markets today, including a further slowdown in consumer price inflation in the eurozone and a discussion of yesterday’s rout in the US bond market.

China-Cuba-United States: Commercial satellite imagery analyzed by the Center for Strategic and International Studies shows China is continuing to expand its electronic eavesdropping facilities in Cuba, including a newly discovered site just 70 miles from the US military base at Guantanamo Bay. The facilities appear to be aimed mainly at spying on the US. The report is likely to add to the many geopolitical and economic tensions between the US and China, which continue to present risks for investors.

Russia: Reports say former Deputy Defense Minister Tatyana Shevtsova has defected to France, just weeks after she resigned her position as chief of the Defense Ministry’s financial directorate.  Shevtsova reportedly helped investigate corruption among high-level generals after Andrei Belousov took over as defense minister in May, but it appears she also came under suspicion because of some extremely expensive real estate she owns. As the wife of Russia’s energy minister, she also reportedly owns interests in at least two coal companies.

• If Shevtsova has really defected, she will likely be interrogated by France and other NATO countries for insights into how the Kremlin is financing its invasion against Ukraine.
• If Shevtsova reveals or confirms that China is providing more direct support to Russia than previously known, tensions between the West and Beijing could worsen further.

Eurozone: The June consumer price index was up just 2.5% from June 2023, matching expectations and decelerating from the 2.6% rise in the year to May. However, the core CPI inflation (excluding food, energy, and tobacco) was unchanged at 2.9%, largely reflecting sticky service prices. The elevated core inflation and likely price pressures from this month’s Paris Olympic Games are expected to discourage the European Central Bank from matching last month’s interest-rate cut with another in July. The next cut is now expected late in the summer.

Germany: According to an article in today’s Financial Times, many German companies are abandoning their long-held reluctance to produce military goods as they see growing defense orders across Europe. At least some of the firms have seen a big jump in their stock price after announcing a shift to military production.

• That’s consistent to our often-stated view that rising defense budgets in the West will likely benefit not only traditional military contractors, but also technology firms and other producers of dual-use goods and services.
• The expansion into defense production may be especially pronounced in Europe, where sluggish economic activity, weak demographics, and cooling exports mean defense is one of the relatively few growth opportunities.

France: As far-left parties and President Macron’s centrists continue trying to coordinate to head off a far-right win in Sunday’s run-off parliamentary elections, Marine Le Pen of the far-right National Rally (RN) today said her party would try to form a coalition government if it fails to win an outright majority. Previously, the party’s candidate for prime minister, Jordan Bardella, had insisted he would not rely on allies to govern. RN’s new openness to leading a coalition government likely increases the chance that it will take power in the Sunday vote.

• In last Sunday’s first-round voting for the 577 seats in parliament, RN came in first with 33% of the vote. The far-left New Popular Front (NFP) came in second with 28% and Macron’s centrist alliance came in third with 20%.
• But RN only achieved an outright majority in a relatively small number of constituencies. This coming Sunday, it will have to slug it out in a run-off against another party in hundreds of constituencies.
• In constituencies where French election rules would have sent three parties to a run-off (usually RN, NFP, and Macron’s centrists), NFP and Macron aim to drop their weakest candidate, increasing the odds that their remaining candidate could beat RN and lock it out of a majority.

Netherlands: In another example of increased far-right power in Europe, a coalition government that includes Geert Wilders’ nationalist, anti-Islam Freedom Party took office today. The government will be headed by Prime Minister Dick Schoof, a political novice and former intelligence agency chief. The far-right Freedom Party will head five of the 15 ministries, including the ministries for migration and trade.

US Bond Market: Investors yesterday dumped government bonds, pushing the yield on the benchmark 10-Year Treasury up to 4.479% by market close, versus only about 4.325% late last week. The action reportedly reflected investor reactions to last week’s debate and yesterday’s Supreme Court decision granting broad immunity to former President Trump for his official acts while in office.

• Those developments have increased the probability that Trump will be re-elected and have the chance to implement inflationary economic policies. The inflationary policies expected from Trump include big, across-the-board tariffs on imports, extension of the 2017 tax cuts, and populist spending programs.
• More generally, investors have become more concerned that Republicans will gain control of both the White House and Congress. Investors fear that having one party in control of both the executive and the legislative branches of government will lead to higher budget deficits.

US Technology Regulation: Also among the Supreme Court’s end-of-session decisions, the justices yesterday refused to rule on the validity of state laws in Texas and Florida that attempt to police social-media firms’ content moderation policies. The action suggests those policies can be protected by the First Amendment, but the justices sent the challenges back to lower courts for further argument and analysis.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with new details on why Philippine President Marcos is pushing back so strongly against Chinese territorial aggression in the South China Sea. We next review several other international and US developments with the potential to affect the financial markets today, including a new move by China to potentially weaponize its rare earth resources, a win by the far right in France’s first-round parliamentary elections, and additional signs of a potential economic slowdown in the US.

China-Philippines: As Chinese-Philippine tensions continue to worsen, a new article in the South China Morning Post provides a useful historical view on how the relationship soured. The article notes the key issue is Beijing’s multi-decade effort to assert its sovereignty over parts of the South China Sea claimed by Manila, which successive Philippine leaders have tried to stop with legal suits, appeasement, military investment, and alliance building — all to no avail. However, the article also emphasizes that Philippine citizens have become incensed at Chinese “Pogo” firms.

• Approved by the previous Duterte administration under its appeasement policy, the Pogos are lightly regulated, Chinese-owned gambling venues that have spread throughout the Philippines. Not only have the Pogos brought criminality, corruption, and illegal Chinese immigration, but recent police probes suggest they have also been used by Beijing to infiltrate secret Chinese intelligence and military operatives.
• Spurred on by China’s aggressiveness in the South China Sea and the revelations of the Pogo industry, almost 75% of Philippine citizens now favor the use of military force to maintain the country’s sovereignty over the disputed territories.
• The strong domestic political pressure on current President Ferdinand Marcos Jr. to take a hard line against Beijing is one reason we see today’s Chinese-Philippine tensions as an especially dangerous source of potential conflict. Because of the US-Philippine mutual defense treaty, any such conflict could also draw the US into a direct conflict with China.

China-Southeast Asia: As widely expected, the new US and EU tariffs on Chinese electric vehicles are starting to prompt Chinese EV makers to shift toward Southeast Asian markets. BYD (which Warren Buffet’s Berkshire Hathaway has invested in) and other Chinese EV makers are reportedly now spending billions of dollars to ramp up their sales and output in Indonesia, Thailand, and other countries in the region.

• Given that those countries are relatively poor, the move is expected to force the Chinese firms to cut prices, potentially weighing on their profitability.
• Of course, the invasion of Chinese EVs and any new Chinese EV factories could spark disruption in the region’s auto markets, potentially raising tensions between Beijing and regional capitals.

China-Global Rare Earths Market: On Saturday, China issued a package of new rules aimed at protecting its supply of rare earths, a class of exotic minerals critical to modern electrified technologies. Although China and its geopolitical and economic bloc already dominate the world’s supply and smelting of rare earths, the new rules emphasize that rare earth resources belong to the state and that the government will control the industry’s development. Importantly, the rules also establish a rare earth traceability system that could aid in embargoing rare earths.

• Beijing introduced restrictions last year on the export of germanium and gallium, which are critical to the manufacturing of semiconductors. It had also already banned the export of technologies for refining rare earths and making them into magnets.
• Under the new traceability system, Chinese firms involved in the mining, refining, or export of rare earths must establish a detailed product flow record and submit the data to the government.
• Of course, having detailed information on the flow of rare earth products would allow the government to fine-tune any restrictions it might want to place on their export. That’s consistent with our view that Beijing will likely try to weaponize its dominance of key mineral commodities as tensions between the US bloc and the China/Russia bloc continue to rise.

European Union-United States: The European Commission today charged US social-media giant Meta Platforms with violating the EU’s new Digital Markets Act, just as it issued charges against Apple and Microsoft last month. At issue is how Meta requires EU users of Facebook and Instagram to either pay a subscription fee or allow the firm to use their data for targeted ads. If found guilty of the infraction, Meta could be fined 10% to 20% of its global revenue. The action highlights the rising regulatory risks faced by US tech firms in the EU market.

European Union: The far-right government of Hungarian Prime Minister Viktor Orbán today takes over the presidency of the Council of the European Union, giving the nationalist firebrand a megaphone and opportunity to steer EU policy initiatives over the coming six months. Our new Bi-Weekly Geopolitical Report, to be published later today, explains how the Council fits into the EU’s governance structure.

France: In the first round of parliamentary elections on Sunday, preliminary results suggest the far-right National Rally (RN) party came in first with 33.2% of the vote, followed by the far-left National Popular Front (NFP) with 28.0% and President Macron’s centrist liberal alliance with 22.4% of the vote. That puts the far-right in position to potentially win an absolute majority in the National Assembly after the second-round voting on July 7.

• In such a situation, the far right would be in position to name the prime minister and force an uncomfortable “cohabitation” government with President Macron.
• However, the far-left NFP and Macron’s centrists are reportedly in emergency talks today to coordinate and block RN from gaining a majority. The parties are negotiating a plan to withdraw the weaker of their candidates in hundreds of constituencies, with the goal of limiting how many seats RN can win. The effort has given a modest boost to French stocks and the euro so far this morning.
• In any case, the results point to a sharp shift to the right in French politics, potentially leading to populist fiscal policies and a crackdown on immigration.

Iran: In Friday’s first-round presidential election, Masoud Pezeshkian, a reformist former health minister, came in first with 42% of the vote, followed by Saeed Jalili, an arch-conservative, with 38%. Since neither candidate won an absolute majority, the two will now face each other in a run-off election this coming Friday. Although the true power in Iran’s government lies with conservative clerics, a win by Pezeshkian could help nudge Iran toward better relations with the West and less belligerence toward Israel and other rivals in the Middle East.

US Regulatory Policy: In a decision Friday, the Supreme Court overturned its 40-year old “Chevron deference” doctrine, under which courts hearing challenges to regulations deferred to agency legal interpretations when the statutory language passed by Congress was unclear, as long as the interpretation was reasonable. Originally seen as a bulwark against excessive regulation, the doctrine more recently had been seen as giving regulators too much power. Now that the doctrine is overturned, it should be easier for firms to challenge regulations.

• When first laid down in 1984, in Chevron v. Natural Resources Defense Council, the doctrine aimed to recognize the expertise that federal regulators typically have in their area of responsibility. The decision on Friday turned in large part on the fact that while agencies have a lot of technical and policy expertise, they don’t necessarily have more legal expertise than the courts.
• Going forward, the decision means that a court hearing a challenge to a regulation won’t necessarily defer to the agency’s understanding of what it can or can’t do. That should tip the scale back in favor of businesses or property owners challenging a regulation.
• The decision illustrates how the US is now in the midst of a court-driven de-regulation phase. A key question is how far that de-regulation trend will go, especially given that today’s geopolitical tensions and political populism should tend to increase government power and lead to tougher regulation in some areas of the economy.

US Personal Income: In a little-noticed aspect of Friday’s report on May personal income and spending, the year-over-year growth in inflation-adjusted, per-capita disposable personal income (income after taxes) has slowed dramatically every month this year. In May, it was only up 0.5% year-over-year. The slowdown largely reflects the unusual jump in disposable income in early 2023, when tax brackets were adjusted for the high consumer price inflation in 2022.

• Real per-capita personal consumption expenditures have held up better, with the figure for May up 1.9% year-over-year.
• Still, the drop in real after-tax income threatens to weigh more on personal spending in the coming months. If so, that could lead to a more material slowdown in economic growth and greater pressure on the Federal Reserve to cut interest rates.

US Lumber Market: Near lumber futures on Friday fell approximately 3% to $452.50 per thousand board feet, bringing their drop to 27% since mid-March. The unusual decline in the middle of the prime homebuilding season suggests today’s high interest rates are finally starting to weigh on home construction and remodeling, despite continued high demand for new homes.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equity futures are off to a strong start thanks to a modest inflation report. In sports news, the Los Angeles Lakers “shocked the world” by drafting NCAA standout and USC star shooting guard Bronny James in the second round. Today’s Comment begins with a discussion about the first presidential debate, rising Treasury illiquidity, and the ongoing dispute between China and the Philippines. As usual, our report concludes with a roundup of domestic and international news.

First Presidential Debate: Although there was a clear victor in the debate, both candidates offered valuable insights into their visions for the next four years.

• Last night, both President Biden and former President Donald Trump presented their views on the state of the nation. Trump described the country as being in crisis due to rising immigration, elevated inflation, and increasing trade issues with China. In contrast, President Biden offered a more optimistic perspective, highlighting stronger job growth, progress in alleviating price pressures, and recent improvements in reducing border crossings. These contrasting viewpoints underscore how the two candidates will campaign in the coming months, each seeking to compare their records as president.
• Even though the national debt has become a pressing issue, neither candidate managed to clearly address how they plan to tackle it. While both mentioned raising revenue through tax increases, neither proposed significant spending cuts. President Trump focused on increasing tariffs, which raises the price that consumers pay for imported goods. On the other hand, President Biden advocated for raising taxes on high-income earners. Social Security benefits were a topic of discussion, but neither candidate presented a concrete plan to address the program’s long-term solvency. According to the Social Security Administration, the program’s assets that are available to pay benefits have been declining, while program costs are projected to rise.

• While it’s possible that neither candidate has a concrete plan yet, it’s more likely they’re focusing on popular policies without fully addressing the associated costs. The expiration of the 2017 tax cuts is likely to reignite debate on deficit reduction. We can expect differing approaches from the candidates. Trump will likely prioritize tax cuts and reduce spending, potentially targeting areas like climate change and social programs. Meanwhile, President Biden might advocate for letting the tax cuts expire to fund climate change initiatives.

Government Bond Liquidity: While the financial system appears stable, there are signs of financial stress bubbling beneath the surface.

• The Treasury market is flashing warning signs. Indicators like JP Morgan’s Liquidity Stress Dashboard and Bloomberg’s US Government Securities Liquidity Index are signaling a drying up of liquidity, particularly for bonds maturing within six years. This comes despite a seemingly strong bond market, with yields on the 10-year Treasury dropping 30 basis points in the past month. However, the turbulence in the Treasury market underscores growing concerns that the economy may not be able to absorb the high level of future Treasury issuance. It also casts doubts on the Federal Reserve’s ability to smoothly continue reducing its bond holdings.
• The decline in bond liquidity coincides with a shift in US debt ownership. As the Federal Reserve raises interest rates, foreign buyers, who are typically less concerned with price fluctuations (price insensitive), are reducing their purchases. This creates a gap that’s being filled by domestic households, who are more sensitive to interest rates and bond prices. The lack of interest rate-insensitive buyers of US debt is important because it raises concerns about whether the government debt could be attractive at lower price yields, particularly as inflation remains elevated.

• Shifting demand for US government bonds could prompt the Fed to adjust its balance sheet normalization plans. In June, the Fed opted to slow the pace of quantitative tightening (QT), a move likely aimed at easing pressure on bond liquidity, while also allowing the Fed to continue with its drawdown. Fed officials aim to reduce bank reserves from “abundant” to a more “ample” level, though they acknowledge the exact sweet spot remains elusive. However, if these Treasury liquidity indicators are truly signaling limitations, the Fed could ultimately decide to end QT prematurely, which would likely boost bond prices.

China-Philippines: Tensions between China and the Philippines continue to escalate in a spat that may lead to US intervention.

• In response to a recent clash in the South China Sea between the Philippines and the Chinese Coast Guard, the US reaffirmed its commitment to Philippine security on Thursday. The clash, which involved the sinking of a Philippine vessel and the alleged theft of firearms, has been seen as a hostile act by China. Following the incident, the US and the Philippines are set to continue with their pre-planned joint maritime exercises in the disputed waters, and they may include other countries such as Japan and Australia.
• The tense situation between China and the Philippines in the South China Sea has unnerved neighboring countries. Vietnam, Malaysia, and Indonesia also have territorial disputes with China in the region, raising concerns of a wider conflict. Despite seeking a peaceful resolution, the Philippines plans to send another supply mission to the Sierra Madre as early as next week. While the Philippine government has insisted that it can assert its sovereignty over the contested seas without the help of a US escort, the White House is already discussing potential responses to further Chinese aggression.

(Source: Wikipedia)

• The China-Philippines conflict in the South China Sea carries the risk of escalating into a black swan event. An attack on Philippine vessels by China could trigger the US-Philippines Mutual Defense Treaty, potentially leading to a direct military confrontation between the world’s two largest economies. This event would likely lead to a dramatic shift away from risk assets as investors look for safety until the situation resolves. This should benefit risk-free assets such as US Treasurys but could also be a boon for gold.

Other News: European Commission President Ursula von der Leyen was nominated for a second term, indicating that centrists still have significant influence in the European Union. French elections are set to take place next week, with polls showing that Macron’s party is likely to suffer a heavy defeat. Argentina’s President Javier Milei achieved a major victory after Congress passed his pro-business reforms, enabling the country to meet its fiscal targets.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equity markets are off to a sluggish start as investors await Friday’s inflation data. In sports news, the Atlanta Hawks chose Zaccharie Risacher with the first overall pick in the NBA draft. Today’s Comment will delve into the impact that immigration may have on monetary policy, our thoughts on the latest Fed stress tests, and a summary of the attempted coup in Bolivia. As usual, our report includes a roundup of international and domestic data releases.

The Immigration Conundrum: Foreign workers have played a pivotal role in filling job vacancies and easing inflationary pressures; however, the broader public wants fewer of them.

• Switzerland is set to address immigration concerns through a constitutional amendment that would require government action if the number of permanent residents surpasses 9.5 million. It would also impose a cap of 10 million on the total number of permanent residents. This vote coincides with Switzerland’s negotiations for an updated agreement with the European Union, where disagreements over wages and immigration persist. Businesses, especially in hospitality, share these concerns, highlighting their reliance on foreign workers to fill vacancies. The sentiment reflects a broader trend of rising skepticism towards immigration in Western countries.
• The debate over immigration intensifies as central bankers grapple with the pandemic’s impact on labor markets and inflation. A recent report by French economist Olivier Blanchard and former Fed Chair Ben Bernanke warns that persistent wage pressures — a key driver of inflation — are making it difficult for central banks to achieve their goals. Immigration has offered some relief by easing labor shortages. However, policy changes could undermine this progress, potentially forcing central banks to take stronger measures like rate hikes. As Fed Governor Michelle Bowman noted, stricter immigration policies could put upward pressure on inflation.

• The recent rise in anti-immigration sentiment could eventually influence monetary policy discussions. While increased immigration has helped address labor shortages and ease wage pressures, its impact is not one directional. Despite Fed Governor Bowman’s acknowledgement that the influx of foreign workers has helped alleviate inflationary pressures, she also suggested that it may have also contributed to rising rents due to the group’s housing needs. This mixed effect means immigration may become a factor that central banks consider, but it is unlikely to be the sole driver of policy decisions.

Is This Time Different? Major US banks all passed the Fed’s annual stress test this year, but there are still concerns that a financial crisis could hurt the economy.

• The stress test results indicate that these firms can withstand a major loss during a recession and still maintain sufficient capital to meet their obligations. According to the report, the group of banks would incur approximately $685 billion in losses, lower than the previous year’s figure and still within the acceptable range established by recent stress tests. While the success of these firms, as a whole, allows for more generous payouts through dividends and stock buybacks, the results did vary by individual firm. In the first, quarter, banks repurchased $14 billion worth of shares.
• The health of the financial system has been a major concern for investors ever since the Federal Reserve began raising rates in 2022. This concern is heightened by the FDIC’s latest quarterly report, which estimates that banks are currently holding a staggering $525 billion of unrealized losses on their balance sheets — a figure about seven times higher than what was recorded during the financial crisis. While banks can avoid recognizing these losses as long as they maintain sufficient liquidity, a liquidity crunch similar to the one that forced Silicon Valley Bank’s collapse in 2023 could trigger a wave of bank losses.

• The Federal Reserve, keenly aware of the financial system’s vulnerabilities, has been implementing measures to mitigate crisis risks. These include requiring banks to hold more collateral and making the standing repo facility permanent in July 2021. However, unforeseen geopolitical or financial events could still trigger a crisis, forcing the Fed to take more drastic actions. While there are currently no signs of an imminent crisis, the risk remains elevated as long as the Fed maintains restrictive interest rates. That said, any signs of a pivot should benefit these firms, especially small to mid-sized banks.

Bolivia Unrest: One of the largest producers of lithium narrowly avoided a coup on Thursday, highlighting the political uncertainty in small resource-rich countries.

• Bolivia narrowly avoided a coup attempt on Wednesday. Soldiers led by dismissed army chief Juan José Zúñiga stormed the presidential palace in an attempt to remove socialist President Luis Arce. Luckily, Arce was able to rally public support and regain control later that day. The motive behind the uprising remains unclear, but it may be linked to Arce’s recent efforts to reconcile with his predecessor, Evo Morales, ahead of upcoming elections. Notably, Zúñiga had been fired earlier this week for expressing opposition to Morales’ return to office.
• The recent coup attempt in Bolivia throws a wrench into South America’s efforts for regional integration. Last year, Brazilian President Lula da Silva spearheaded efforts, alongside other leftist leaders, to reunite President Arce and his exiled predecessor, Evo Morales, in the run-up to elections. Bolivia’s economy has sputtered since Morales’ departure in 2019, but the discovery of vast lithium reserves in July 2023 has offered a glimmer of hope. Last year, the country narrowly avoided a financial crisis after draining its gold reserves to sustain spending.

• Bolivia has a long history of coups with 23 attempts since 1950, 12 of which failed. In fact, the previous coup took place only five years ago. Unfortunately, political instability has long plagued emerging markets, particularly those reliant on resource exports. This trend is likely to worsen in a deglobalizing world and will likely have an impact on global commodity prices. As a result, investors should expect energy prices to become volatile over the next few years as countries look to form into regional blocs. Additionally, this fragmentation could potentially lead to higher global inflation due to persistent supply disruptions.

In Other News: Bulgaria and Romania failed to meet the economic requirements needed to adopt the euro. Their failure is a reminder of the difficulty in joining the economic bloc, particularly for Ukraine. A census report has shown that Hispanics fueled the US population boom in 2023, signaling their growing political influence.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with the latest on the simmering China-Philippines tensions in the South China Sea. We next review several other international and US developments with the potential to affect the financial markets today, including a new down-leg in the value of the Japanese yen, a bad inflation report in Australia, and, on a more positive note, signs of continued strong demand for junk-rated debt in the US.

China-Philippines: In an interview with the Financial Times, the Philippine Ambassador to the US warned that the China-Philippines dispute over the South China Sea’s Second Thomas Shoal has now reached an incendiary phase in which it could suddenly expand into a major conflict, much as the assassination of Austrian Archduke Franz Ferdinand sparked World War I. However, according to Ambassador Jose Manuel Romualdez, this conflict would be more dangerous because it could draw in countries with nuclear weapons.

• As a reminder, our new Mid-Year Geopolitical Outlook identifies the China-Philippines territorial dispute in the South China Sea as the world’s most dangerous geopolitical risk in the second half of 2024.
• While Beijing has deployed its coast guard and marine militia to quarantine a Philippine military outpost on the Second Thomas Shoal, using aggressive tactics to thwart resupply missions, Manila has also used provocative tactics to fight back, including by cutting Chinese fishing nets in the area and secretly delivering construction materials to shore up the outpost.
• What isn’t clear is the extent to which Washington and Manila are coordinating. One concern we have is that Philippine President Ferdinand Marcos, Jr., may be trying to force the US into backing his country’s sovereignty claim more forcefully.
• Since the US and the Philippines have a mutual defense treaty, which the Biden administration has repeatedly pledged to honor, Marcos may be trying to goad China into a violent action that would force the US military to make a show of force in the area. Ambassador Romualdez’s interview may also be aimed at prompting the US into action. Of course, the risk is that bringing US and Chinese military forces into closer proximity in the area could push them into conflict, even if accidentally.
• With our extraordinary focus on geopolitical risks here at Confluence, we are actively considering how we can adjust our investment strategies to hedge against such risks or take advantage of any resulting opportunities.

China-United States: In a new sign that the US is military is preparing for a potential conflict with China, the Marine Corps earlier this month recertified the airstrip on the Western Pacific island of Peleliu. In a major battle during World War II, the US sent 50,000 Marines and Army soldiers to pry the island and its airstrip from 10,000 Japanese defenders, resulting in tens of thousands of casualties. As discussed in our new Mid-Year Geopolitical Outlook, the US is now strengthening its presence across the Indo-Pacific region in an attempt to deter further Chinese aggression.

Japan: The value of the yen (JPY) today fell to 160.36 per dollar ($0.0062), reaching its weakest level since 1986. The currency has now lost some 12.2% of its value so far this year, as investors continue to be disappointed by the Bank of Japan’s slow pace of interest-rate hikes while the Federal Reserve and other major central banks keep their rates high. The new yen weakness will likely raise expectations that the Japanese government will again intervene in the currency markets to slow the currency’s slide.

Australia: The May consumer price index was up 4.0% from the same month one year earlier, well above both the expected increase of 3.8% and the April rise of 3.6%. A measure of core inflation rose to 4.4%. Coming just one week before a cut in income taxes and government payments to individuals to help offset the rise in the cost of living, the data has boosted expectations that the Reserve Bank of Australia will be forced to hike interest rates again. In turn, that prospect is weighing heavily on Australian stock and bond prices so far today.

North Atlantic Treaty Organization: In other security news, NATO’s member states today officially approved outgoing Dutch Prime Minister Mark Rutte as the alliance’s next secretary general. Rutte is seen as a strong trans-Atlanticist who can manage NATO relations with both the US and Russia. However, he has been criticized for the Netherlands’ failure to reach the NATO target of spending at least 2% of gross domestic product on defense throughout his time as prime minister. Rutte will take over the leadership of NATO on October 1.

Eurozone: The European Commission and European Central Bank today jointly announced that Bulgaria and Romania have failed to meet the economic criteria to join the eurozone, as widely expected. The countries’ key shortcomings included excessively high consumer price inflation and concerns that their institutions were too saddled with corruption and money laundering. The decision means that the eurozone will continue to encompass 20 countries; the last of which to join was Croatia at the beginning of 2023.

Kenya: The mass protests against the government’s new tax hikes, which we described in yesterday’s Comment, have now turned deadly, as police opened fire yesterday on protestors who had broken into parliament. According to local rights groups and activists, at least five protesters and first responders were killed and scores were injured in the incident. The violence threatens both the political and economic stability of a major African country.

Canada: The Wall Street Journal today carries an interesting article on Canadian oil sand companies and their recent outperformance. After years in which the firms were held back by high costs and limited export-pipeline capacity, they have now largely completed their expensive facility build-outs and are discovering improved operating practices to cut production costs. The May 1 opening of a new export pipeline to Canada’s west coast has also removed export bottlenecks. The resulting higher profits have pushed the firms’ stock prices sharply upward.

US Financial Conditions: New research from Goldman Sachs shows firms with low credit ratings have repriced some $391 billion in leveraged loans into lower-interest debt so far this year, a new record for the period. According to Goldman, the benefit from the repricing has been equivalent to a 0.50% cut in the Federal Reserve’s benchmark fed funds rate.

• The ability of the firms to roll their debt over into lower-interest loans stems from high investor demand for investment products that package the loans into securities.
• As illustrated by the rollover activity, burgeoning private credit funds, and the current low spreads for junk bond funds, high investor demand for yield is probably one reason today’s high interest rates haven’t sparked a broad financial crisis or thrown the economy into recession.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with further details on how Canada is considering antidumping tariffs against Chinese electric vehicles, as we flagged in a short blurb late last week. We next review several other international and US developments with the potential to affect the financial markets today, including another EU antitrust complaint against a major US technology firm and a statement by a Federal Reserve governor saying she would be open to raising interest rates if consumer price inflation doesn’t keep falling.

Canada-China: Following up on an item we flagged without detail late last week, the Canadian government is seeking public opinion on whether to impose antidumping tariffs or other barriers against Chinese EVs. Starting July 2, citizens will have 30 days to register their opinion, after which the government can decide on what it believes will be the optimal path.

• To justify the action, Ottawa cited “unfair competition from China’s intentional, state-directed policy of overcapacity and lack of rigorous labor and environmental standards.”
• More interesting, Ottawa said its goal is not only “to protect Canada’s auto workers and its growing EV industry” but also to “prevent trade diversion resulting from recent action taken by Canadian trading partners.” In other words, it is worried that the new US and EU tariffs against Chinese EVs will divert them toward Canada, where they likely would be sold at fire-sale prices.

European Union-United States: One day after accusing US tech giant Apple of using its app store to snuff out online competition, the European Commission today accused Microsoft of uncompetitive practices for the way it bundles its Teams collaboration tool with its Office products. The move appears to be another use of the EU’s new Digital Markets Act, signaling it will be applied aggressively and could trip up other US tech firms. If found guilty under the DMA, a firm could face a fine of 10% to 20% of its global annual revenue.

European Union-Ukraine-Moldova: EU officials today will meet with Ukrainian and Moldovan officials in Luxembourg to begin talks on their accession to the bloc. At the meetings, the EU will outline the reforms and legislation each country needs to adopt before being deemed ready to join. However, both Ukraine and Moldova are likely to need several years to meet the EU’s standards, so joining is by no means imminent.

• In large part, the talks will be symbolic, since they are merely aimed at getting the ball rolling before Ukraine-skeptic Hungary takes over the six-month rotating presidency of the Council of the European Union on July 1.
• Our next Bi-Weekly Geopolitical Report, to be published on Monday, will provide a full explanation of what that Council is and how it fits into the EU’s decision making.

France: With polls showing the far-right National Rally could win the parliamentary elections starting on Sunday, leader Jordan Bardella yesterday held a press conference to unveil new details on the party’s economic, immigration, and foreign policies. To counter concerns that the party’s populist bent would lead to tax cuts and spending hikes, blowing out the French budget deficit, Bardella vowed that National Rally would actually bring the deficit back down to the European Union limit of 3.0% of gross domestic product by 2027, versus 5.5% of GDP last year.

• Besides vowing “reasonable” fiscal policies, Bardella also outlined an economic program that largely echoed President Macron’s mainstream goals of strengthening the French industrial base, boosting employment, and cutting regulation. The main difference was that Bardella said National Rally would reverse Macron’s pension reform, which raised the national retirement age from 62 to 64 years.
• Bardella’s economic proposals illustrate how many of Europe’s populist, far-right parties have moderated their policies once they attained power. One example of that has been Italian Prime Minister Giorgia Meloni and her Brothers of Italy party.
• If that turns out to be the case in France, the recent sell-off in French stocks and bonds could well be an attractive buying opportunity.

Israel: The Israeli Supreme Court today ruled that ultra-orthodox Jewish students cannot be legally exempted from military conscription. It also ruled that those students aren’t entitled to government funding if they don’t have a valid conscription exemption. While it remains unclear when the ruling will be implemented, it will eventually end a controversial practice that many Israelis see as unfairly benefiting ultra-conservative citizens. It could also weaken the cohesion of Prime Minister Netanyahu’s right-wing coalition government.

Kenya: Protestors have launched nationwide demonstrations against a new set of tax hikes the government hopes will raise some $2.1 billion and help cut the budget deficit from the current 5.7% of GDP to 3.3% of GDP next year. The tax hikes are required under Kenya’s most recent bailout deal with the International Monetary Fund. The protests have already turned violent, threatening political and economic instability in the country.

US Monetary Policy: In a speech today, Fed board member Michelle Bowman said she would be willing to raise the benchmark fed funds rate again if progress on lowering consumer price inflation stalls or reverses. According to Bowman, one key upside risk for inflation is the large federal budget deficit, which reflects factors such as weak tax revenue, higher interest costs, and increased outlays on Social Security, Medicare, and other programs. She also said high immigration could drive up the price of housing, even if it helps hold down wage rates.

US Manufacturing Sector: Danish pharmaceutical giant Novo-Nordisk yesterday said it will invest $4.1 billion to build a new factory in Raleigh, North Carolina and expand production of its blockbuster weight-loss drugs Wegovy and Ozempic. The move will likely put pressure on US drug giant Eli Lilly to expand output of its rival drugs Zepbound and Mounjaro. The investments would add to the current boom in US factory construction, which to date has been driven more by manufacturing facilities for electronic goods such as electric cars and semiconductors.

US Artificial Intelligence Industry: The Recording Industry Association of America has filed copyright infringement suits against two AI startups developing products that allow users to generate new music using text prompts. The suits, brought on behalf of major music companies, allege that the startups used copyrighted works scraped from the internet to train their models.

• The suits illustrate the legal challenges that have to be sorted out for the AI industry to continue growing.
• One likely result of such suits is that specialized data sets that are useful for training AI models will become increasingly valuable. Those data sets will be guarded furiously, potentially to the point where specialized, focused AI models will proliferate and become even more important to the economy than the general AI models getting so much attention today.

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