by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

With last week’s events in Israel serving as a reminder of how the world is becoming more violent and chaotic as the post-Cold War era comes to an end, today’s Comment opens with an update on the all-important risk of a Chinese move to take control over Taiwan.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more signs that the Bank of Japan may soon intervene to support the yen (JPY) and the latest developments in the U.S. labor market.

China-Taiwan:  Kyodo News recently carried a nice summary of the strategy options Beijing is likely considering to eventually achieve its long-held goal of taking control over Taiwan.  Consistent with our view, the article discounts the likelihood that the People’s Liberation Army would launch an amphibious invasion of the island.  Rather, the PLA’s recent exercises suggest it would establish a naval, air, and missile “quarantine” around Taiwan to cut the island off from needed supplies and pressure its government to submit to Chinese authority.

• Rather than calling the operation a “blockade,” which is an act of war against a foreign country, Beijing would say it is merely controlling access to its own territory. That assertion would aim to make it politically difficult for the U.S., Japan, South Korea, and their allies to intervene.
  • Beijing could also start off with only occasional or targeted quarantine actions, perhaps using coast guard forces on ostensibly “law enforcement” missions.
  • The goal for such actions would be to raise shipping insurance costs and otherwise discourage maritime traffic to the island without necessarily sparking a military response from the U.S. and its allies.
• A major risk for Beijing is that a quarantine strategy would allow the U.S. and its allies time to build up their forces in the region and develop a strategy to defeat the quarantine. Nevertheless, given China’s much closer proximity to Taiwan, it would find it much easier to sustain itself in a long stand-off.
  • Even if the U.S. and its allies rapidly build up their forces and use their superior technology to sink the PLA Navy and down the PLA Air Force, China’s trump card is probably its enormous missile arsenal.
  • Even after losing many ships and aircraft, China could saturate Taiwan and its nearby shipping corridors with ground-attack and anti-ship missiles to keep the quarantine in place. Chinese missiles could also threaten U.S. and allied military bases in places like Okinawa, the Philippines, and Guam.  Taking out those missiles would require a U.S. or allied attack on Chinese territory, potentially sparking a nuclear war.
• In sum, Beijing has big strategic and tactical advantages around Taiwan, along with regional military superiority. If Washington wants to meet its security commitment to the island, maintain the U.S. alliance structure, and protect U.S. interests, the U.S. and allied militaries will have to be rebuild to a scale sufficient to deter China from throwing its military weight around.
  • As we have noted before, Western defense spending will likely rise for years, and domestic reindustrialization will probably continue.
  • That will likely create important new investment opportunities in the industrial and defense-related technology sectors.

United States-China:  White House officials say President Biden will issue new rules this week to further limit the sale of advanced semiconductors and related equipment to China.  The new rules will supplement the draconian controls issued by the administration in October 2022 and in August 2023, which aim to keep Beijing from gaining a military edge from artificial intelligence and other advanced information technologies.

• The Biden administration’s technology controls also supplement the tariffs and other broad trade barriers against China that were imposed by the Trump administration and largely remain in place.
• As we have written so many times before, the clampdown on bilateral trade, investment, and technology flows are symptoms of the worsening tensions between the U.S. geopolitical bloc and the China/Russia bloc. Those tensions, and the potential for new bilateral restrictions, continue to pose risks for investors.

Japan-China:  In a sign the Japanese government is becoming more concerned about Chinese aggression in the near term, Defense Minister Kihara said Japan will start buying the U.S.’s advanced Tomahawk cruise missiles in its fiscal year starting March 2025, one year earlier than previously planned.  To further underscore Japan’s urgency to get the missiles sooner rather than later, the earlier acquisition date requires Japan to accept certain compromises in capabilities.  The FY 2025 purchase means the first 200 missiles bought will be current Tomahawk models, while only the remaining 200 missiles, to be bought in FY 2028 and later, will be the latest Block 4 model.

Japan:  At a Group of 20 meeting on Friday, Finance Minister Suzuki warned that Tokyo may need to intervene to support the yen (JPY) as tightening monetary policy around the world continues to drive the currency lower.  The statement, which followed a separate warning earlier this month, came as the JPY depreciated anew to close the week at 149.56 per dollar ($0.00669), very close to the rate of 150.00 per dollar ($0.00667) that has long been seen as the point at which Japan would step in to support the currency.

New Zealand:  In parliamentary elections over the weekend, the center-right National Party came in first with about 39% of the vote, followed by its preferred coalition partner, the ACT Party, with 9%.  That should allow NP leader and former business executive Christopher Luxon to become prime minister as head of a government consisting of NP, ACT, and possibly the populist New Zealand First Party.

• The new right-wing government would replace the center-left Labor Party that has ruled since 2020.
• In his campaign, Luxon said his government would emphasize fighting crime, reducing road congestion, and increasing personal responsibility.

Saudi Arabia-Israel:  Sources say Saudi Arabia has now formally notified the U.S. that it will suspend its negotiations with Israel for normalizing ties between the two countries.  The notification came as Israel continued to prepare for a massive ground attack on Gaza and its Hamas government to retaliate for the big Hamas terrorist attack on Israel last week.  The Saudis’ suspension of normalization talks was probably a top goal for Hamas.

• Separately, Iran warned Israel over the weekend that while it doesn’t want to see further escalation of the conflict between Israel and Hamas, it will intervene if Israel proceeds with a major ground attack on Gaza. Reports also say Iranian-backed Hezbollah fighters in southern Lebanon have stepped up their missile and artillery strikes on Israel in recent days.
• The developments underscore the continuing risk that the conflict will spread. The worst-case scenario would be a regional conflict involving several states, which would likely be very negative for risk assets but positive for the dollar and crude oil.

Poland:  In elections yesterday, the ruling right-wing Law and Justice Party (PiS) came in first with almost 37% of the vote, but that may not provide enough seats in parliament to stay in power, even in coalition with the country’s far-right parties.  If that is borne out in the final count, it would open the door for former Prime Minister Donald Tusk and his Civic Platform Party to return to power.  Since Tusk is known to be business-friendly and pro-European Union, Polish stock prices have surged so far today, as has the Polish currency.

Ecuador:  In a run-off election over the weekend, center-right businessman Daniel Noboa won the presidency with approximately 52% of the vote, beating his leftist rival Luisa González.  Noboa, who is only 35 years old, campaigned on a platform of encouraging foreign investment and creating better employment opportunities for younger workers.

U.S. Monetary Policy:  In an interview with the Financial Times, Chicago FRB President Goolsbee insisted that U.S. price pressures are on a sustainable downtrend, despite fluctuations in the inflation data.  He also said Federal Reserve policymakers are “rapidly approaching” the point where they will shift from discussing the need to raise interest rates further to discussing how long to hold rates at their current high levels.  That is consistent with our view that the Fed’s monetary policy is almost as tight as it will get, but that it may remain tight for some time.

U.S. Labor Market:  Healthcare giant Kaiser Permanente and its striking unions late last week reached a tentative deal on a new labor contract.  We have yet to see details on the agreement, but we note that the workers had been demanding not only higher wages, but also improved staffing at Kaiser’s facilities to improve work conditions.

• Although demand continues to outstrip supply for relatively lesser-skilled workers, hiring for “knowledge workers” in areas like technology, finance, and consulting has fallen.
• As a result, an unusually large proportion of second-year MBA students are still without job offers and are starting to look for positions in other industries.

U.S. Defense Stocks:  The Wall Street Journal today carries a nice summary of the current challenges and future opportunities in defense stocks.  Despite some current headwinds, such as uncertain funding amid the political polarization in Washington, the article echoes our view that longer-term trends toward a more chaotic, tension-filled world will likely be positive for defense stocks going forward (although we think the new, fractured, tension-filled world will also be positive for firms in defense-related technology, energy, mining, and commodities).

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are up slightly, and the Atlanta Braves are out of the playoffs. Today’s Comment starts with our thoughts on the inflation report. We then follow with discussions on rising global borrowing costs, the Polish Parliamentary elections, and provide an update on Hamas/Israel. As usual, our report also provides an overview of the latest domestic and international data releases.

Inflation Losing Momentum? September’s CPI report spooked investors, raising concerns that stubborn price pressures could persist.

• Consumer prices rose 3.7% in September, unchanged from August and above expectations. Treasury yields rose sharply following the report, with the 10-year yield increasing 11 basis points to 4.71% on Thursday. The S&P 500 and Nasdaq Composite fell roughly 1% on the day. The sell-off in financial assets reflects investors’ concerns that the Federal Reserve will continue to tighten monetary policy to combat inflation. The CME FedWatch Tool now projects a 30% chance of another rate hike before the end of the year, up from 25% the day before.
• Despite the market’s negative reaction, the CPI report offers some grounds for optimism about inflation. The surprise increase in shelter prices, which spiked 0.6% last month, was a key contributor to the overall rise in inflation. However, we are skeptical that this trend will continue into next year. The core CPI, which excludes volatile food and energy prices, continued its downward trend, with the year-over-year change falling from 4.3% in August to 4.1% in September. Additionally, if the trend of the past six months continues, inflation is likely to fall below its five-year average within the next few months.

• The Federal Reserve is likely to face turbulence as it works to move core inflation below 4%, which is expected to happen this year. Fed officials are aware of this and will likely plan to hold rates steady before gradually reducing them over time. However, the decision to hike rates again could change if the October and/or November job reports continue to show that the labor market remains strong. As a result, the latest CPI report is unlikely to be enough to shift the sentiment of policymakers, and another rate hike cannot be completely ruled out.

 Global Credit Squeeze: The lack of available liquidity is starting to impact major economies.

• Countries are struggling to cope with rising global interest rates. UBS (UBS, $24.50) warned on Friday that the rapid increase in unsecured personal loans in India raises the likelihood of a rise in defaults. Bank of England Governor Andrew Bailey has warned that U.K. interest rates have risen to “restrictive” levels and that he will be closely monitoring how policy impacts the country’s mortgage market. Meanwhile, Italian bond yields have surged over the last few weeks, raising concerns that the European Central Bank may need to scale back plans to shrink its balance sheet to prevent financial fragmentation.
• Although the largest economies have avoided recession so far, there are signs of growing financial stress. S&P Global projects that the U.S. junk bond default rates will jump from 3.2% to as high as 6.5% by June 2024, while European junk bond defaults may jump to 5.5% next year from the current 3.1%. This unexpected surge in charge-offs assumes that interest rates remain relatively high, and that economic growth decelerates in the coming months. However, the doomsday scenario may be avoided if central banks are able to act quickly enough.

• One of the biggest mysteries since central banks began tightening monetary policy is how policymakers will react if inflation remains high and the economy falls into recession. Adding to the uncertainty is the expectation that refinancing activity will surge in 2024 to compensate for the loans that are expected to come due that year. Data collected by Bloomberg suggests that firms are in for a rude awakening if rates remain elevated. So far, policymakers have consistently denied that they are considering pivoting away from their current hawkish stance and have only signaled the possibility of a pause in rate hikes. However, their tone may change if economies start to fall into recession.

Polish Elections: Parliamentary elections will happen this weekend in Poland, in what could be the most divisive election since the fall of communism.

• Poland’s upcoming parliamentary election will be a clash of two opposing ideologies: the right-wing, populist Law and Justice (PiS) party and the centrist, pro-European Civic Platform (PO) party. A win for the former could see the country slide further away from democracy, while a win for the latter would likely bring it back in line with European norms. Neither party is expected to win an outright majority, so the outcome of the election is likely to depend on the performance of smaller parties.
• Dethroning the PiS will likely be a difficult task, but it will be necessary for Poland to regain access to much-needed EU funding. In 2019, Poland passed laws that undermined the independence of its Supreme Court, drawing the ire of the European Commission. These laws prevent judges from assessing each other’s compliance with EU standards and questioning the composition of a tribunal, and they give the disciplinary chamber of the Supreme Court the power to penalize judicial officials for the content of their verdicts. Warsaw claims that the changes were necessary to prevent the return of communism, but the European Court of Justice has ruled against it and has fined the Polish government.

• Despite its relatively small size, Poland has the fifth-largest economy in the European Union, and its GDP per capita is expected to overtake that of the U.K. in a little over a decade. However, if it continues on its current path toward authoritarianism, it may become the second country to leave the bloc, and the first to be forced out. An exit of Poland could further undermine the bloc’s legitimacy, as the decline in membership will raise questions about whether it can remain together. Additionally, having a potentially hostile country outside the bloc will likely need to be addressed. As a result, a victory by the PiS could negatively impact the euro.

Israel/Hamas Update: Israel has told people to leave Gaza as tensions rise in the region. The announcement reflects escalating tensions in the Middle East and raises the likelihood of a broader conflict. Iran and Saudi Arabia are in constant communication to prevent miscalculation by either side. Meanwhile, Jordan has cautioned Palestinians from going to Egypt.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are off to a great start and the Dodgers are out of the playoffs. Today’s Comment begins with a discussion of the increased scrutiny facing social media companies, our analysis of the latest FOMC meeting minutes, and an update on ongoing bank woes. As usual, our report also provides an overview of the latest domestic and international data releases.

Silicon Valley Headaches: Sovereign states are once again warning companies to crack down on the spread of disinformation, a hot topic that is only becoming more pressing as the conflict between Israel and Hamas continues.

• European Commissioner Thierry Breton has warned social media giants Meta (META, $327.82) and X (formerly Twitter), to crack down on disinformation surrounding the Israeli-Hamas conflict. His warning reflects the growing concern over the spread of false and inflammatory content, such as clips from video games, older videos of conflict, and extreme rhetoric from posters looking to stir tensions between the two sides. The controversy surrounding these posts has revived the debate over the responsibility of tech firms to moderate content on their platforms, especially as hate crimes are on the rise and deepfakes are becoming more prevalent.

• The scrutiny of social media firms poses a threat to tech earnings as governments around the world look to curb controversial speech. Tech firms in the U.S. have been able to shield themselves from legal liability for user-generated content under Section 230 of the Communications Decency Act. However, this loophole may come under renewed scrutiny if Israeli-Hamas misinformation leads to an increase in the harassment of underrepresented groups. Meanwhile, the European Union has already threatened to fine these companies under its Digital Services Act for not taking down certain content. On Wednesday, EU regulators gave X and Meta 24 hours to remove terroristic content from their platform to avoid a penalty.

• The pressure on social media companies to find a balance between free speech and content moderation is likely to grow in the coming year, when both the European Union parliamentary elections and the U.S. presidential election are scheduled to take place. Failure to meet these standards could pose a threat to companies’ earnings, as they may be forced to pay fines or face litigation over posts. While the probability of this severely impacting the trajectory of the sector over the next few months is low, it does reflect the regulatory risks that social media firms face in the future as governments become increasingly skeptical of their influence over the public.

 Policy is Different: Although the Fed minutes showed that policymakers favored at least one more rate hike, the market remained unconvinced.

• Minutes from the September 19-20 Federal Open Market Committee (FOMC) meeting showed that a majority of policymakers agreed that another rate hike would be needed before the end of the year to keep inflation on a downward trajectory. While all FOMC members agreed that rates should remain at a restrictive level, they also stressed the need to proceed cautiously and be data-dependent over the next few meetings. This shift in central bank thinking reflects that policymakers are now more focused on when to stop hiking rates instead of how high to raise rates.
• The market largely shrugged off the FOMC minutes, as investors seem to believe that the economic environment has changed since the group last met. Following Friday’s job report, which showed the economy added over 300,000 jobs in September, interest rates on long-duration Treasury bonds rose to a near two-decade high, leading some central bankers to argue that further rate hikes may not be necessary. Additionally, the risk of a broad Middle Eastern conflict has raised concerns that the economy could be susceptible to an oil price shock. As a result, the latest forecast from fed futures contracts shows that investors still believe that there is a more than 70% chance that policymakers are finished hiking, remaining relatively unchanged from the previous day.

• That said, we suspect that the Fed’s talk of “higher for longer” may be less hawkish than some investors fear. Depending on how neutrality is measured, the restrictive rate could vary depending on the model used to gauge policy tightness. Former St. Louis Fed President James Bullard’s model suggests that restrictive territory may be closer to 5.0%, while current San Francisco Fed President Mary Daly, a voter on next year’s committee, estimates that the range is likely above 3.0%. This suggests that investors should not rule out the possibility that the Fed could cut rates next year by more than the forecasted 50 bps outlined in the latest Fed dot plots.

Banks Woes: Financial institutions are starting to feel the squeeze of higher interest rates as credit quality deteriorates.

• The four biggest banks are expected to write off more loans in the third quarter than any other period since the start of the pandemic. According to data collected by Bloomberg, the banks, which are scheduled to release their earnings reports starting on Friday, are expected to write off nearly $5.3 billion in loans. The increase in net charge-offs is due to concerns that higher interest rates will make it more difficult for banks to find qualified borrowers. Citigroup (C, $41.33) CEO Jane Fraser said that higher interest rates have been particularly burdensome for borrowers with weak credit scores and shrinking savings.
• Rising interest rates are making it more expensive for banks to attract and retain deposits, as savers seek out higher yields elsewhere. While deposits have stabilized in recent months, they remain below pre-March regional bank turmoil levels, according to Federal Reserve data. To attract and retain savers, banks have been forced to sacrifice some of their net interest margin by raising deposit rates. This adjustment has hurt financial institutions, as they were not prepared for a rapid increase in borrowing costs, having purchased long-dated Treasuries when rates were low. Some of the major banks, despite their greater sophistication, were also caught off guard by the rapid rise in interest rates.

• Despite challenges within the banking sector, there is still little evidence of an imminent crisis. In March, the Federal Reserve showed its willingness to provide banks with as much liquidity as needed to stay afloat, reducing the likelihood of another 2008 event. Additionally, government regulations have forced banks to have contingency plans in case of a possible run. However, policymakers are closely monitoring the rise in charge-offs, as the Fed may be forced to act if default rates start to spread throughout the economy. The chances of this happening this year are not great, but they will increase as long as the central bank keeps interest rates high.

Update on the Israeli-Hamas Conflict: National security officials are increasingly concerned that the war in Israel could expand, with Iran potentially targeting U.S. troops. At the same time, border clashes have led to speculation that Hezbollah may join the conflict. The U.S. has sent officials over to help mitigate the risk of a broader conflict. While we remain optimistic that the conflict will be contained, we acknowledge that the risk of a wider war is elevated.

Other News: House Republicans have nominated Steve Scalise to take over as speaker; however, it is unclear if he has enough support in his party to take over the job. Congressional members’ inability to choose a leader boosts the chances of another government shutdown, which could hurt bond prices. Additionally, it appears that Hollywood actors and studios are struggling to come to an agreement on a new contract. The ongoing discussion reflects a broad trend in labor relations and shows how firms may struggle to increase profit margins without increasing their prices.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a warning from the International Monetary Fund about global public finances.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the Israel-Hamas war, a potentially important corruption scandal at a Chinese electric vehicle firm, and some thoughts on the U.S. bond market.

Global Fiscal Policy:  In its latest Fiscal Monitor report, the International Monetary Fund warned that governments around the world must take steps to address their worsening fiscal deficits and burgeoning debt.  According to the IMF, government leaders seeking to tackle those problems should consider both revenue increases and spending cuts.  While painful, the organization said taking the medicine would help preserve financial stability and reduce the need for central banks to keep hiking interest rates.

Israel-Hamas-United States:  President Biden yesterday confirmed that more than a dozen U.S. citizens were killed in the Hamas attack on Israel over the last several days.  According to the White House, 20 or more U.S. citizens are also missing, suggesting that some or all of them could be among the hostages that Hamas has taken back to the Gaza Strip.  The announcement likely ensures that the U.S. will have to get more involved in the conflict as it plays out in the coming days, weeks, and potentially months.

Japan-China:  In a recent opinion poll conducted in both Japan and China, fully 92% of surveyed Japanese said their impression of China was “not good,” up from 87% last year and the second-highest since the annual survey began in 2005.  In contrast, only about 63% of Chinese respondents said they had a negative view of Japan, almost the same as last year.  The results help rationalize the Japanese government’s recent ratcheting up of rhetoric against China and its increased investment in military capabilities.

China-Australia:  The Chinese government today released an Australian citizen it had been holding for three years on suspicion of disclosing state secrets.  The release of journalist Cheng Lei is another step in the ongoing easing of tensions between China and Australia, which has already led to reduced Chinese barriers to some Australian exports.  If the cooling of tensions continues, a broader range of Australian companies could regain access to the Chinese market.

China:  Fast-growing electric vehicle firm Xpeng (XPEV, $16.94) said it has suspended its vice president of supply chain procurement on suspicion of corruption.  Xpeng is seen as a potential threat to Tesla (TSLA, $263.62) and BYD (BYDDY,$ 61.75), so it is a high-profile firm in China.  The accusation raises concerns that the government may be turning its anti-corruption sights to the rapidly advancing EV industry.

• China’s EV industry seems poised to take the world by storm with its inexpensive, high-quality vehicles, at least if the European Union and other markets don’t impose trade restrictions to protect domestic jobs.
• All the same, it’s important to remember that President Xi’s past anti-corruption initiatives have seriously tripped up other key sectors. If the Xpeng move is only the tip of an anti-corruption iceberg, it would be a further red flag for Chinese economic growth going forward.

Finland-Estonia:  Authorities in Helsinki and Tallin said they suspect sabotage after discovering damage to a key natural gas pipeline and communications cables running between the countries under the Baltic Sea.  If the damage did result from deliberate sabotage, a likely suspect would be Russia, which probably wants to punish Finland for recently joining the North Atlantic Treaty Organization and Estonia for the support it has rendered to Ukraine as that country seeks to fight off Russia’s invasion.

Canada-India:  The Indian government’s deadline for Canada to slash its diplomatic presence in New Delhi expired yesterday with the two countries still negotiating on how to deal with the crisis sparked by Canada’s accusation that India helped assassinate a Canadian citizen and Sikh separatist leader in British Columbia in June.  Although it isn’t yet clear how the negotiations will go, the fact that the two sides are hashing things out could be a welcome sign that they are trying to halt the downward spiral in their relations.

Canada:  The Unifor auto workers’ strike against General Motors (GM, $30.99), which we mentioned in yesterday’s Comment, ended abruptly last night after the union and the company tentatively agreed on a new labor contract that would boost wage rates by as much as 25% over three years and also increase the company’s pension contributions.  The quick capitulation suggests GM wants to avoid a “two-front war” while it also faces the strike by the United Auto Workers in the U.S.  Since one target of the Canadian strike was GM’s lucrative pickup products, it also suggests that the UAW would have greater leverage if it extends the strike in the U.S. to those types of factories.

U.S. Politics:  As of this writing, Republicans in the House of Representatives still plan to vote on a new Speaker today, choosing between current Majority Leader Scalise and Judiciary Committee Chair Jordan.  However, it appears that neither Scalise nor Jordan has locked up the votes needed to win, raising the distinct possibility that the issue won’t be resolved today.

U.S. Bond Market:  New analysis suggests that part of the recent weakness in the bond market may reflect the cumulative impact of reduced buying by the Federal Reserve, China, and Japan.  The Fed’s policy of allowing Treasury obligations on its balance sheet to mature without replacing them has reduced its holdings of Treasury bonds by about $650 billion over the last year.  China and Japan have also reduced their holdings as they periodically try to support their currencies.  And, of course, China continues trying to diversify its foreign reserves away from the greenback.

U.S. Regulatory Policy:  Today, the Federal Trade Commission and the Consumer Financial Protection Bureau jointly proposed a set of new rules to clamp down on junk fees that are poorly disclosed or sprung on consumers at checkout.  The proposed rules will now begin a 60-day public comment period before they can be formally adopted.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the situation in Israel, where the country’s military is poised to launch a ground attack on Hamas fighters in the Gaza Strip and all eyes are watching for a potential widening of the conflict.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a likely new anti-subsidy investigation by the EU against China and the latest on U.S. labor market unrest.

Israel-Hamas:  In response to the weekend attack by the Hamas government in the Gaza Strip, the Israeli government yesterday announced a “complete siege” of the territory, vowing to stop any food, water, electricity or other supplies from entering.  After mobilizing some 300,000 reservists, the military also looks set to launch a full-scale ground invasion of Gaza, likely in an effort to destroy Hamas.  Meanwhile, Hamas threatened to kill one of its estimated 100 or so civilian hostages for every unannounced Israeli airstrike on the territory.

• Naturally, a key concern is whether the conflict will spread. So far, reports indicate there have only been sporadic sympathy attacks by the Iranian-backed Hezbollah militants in southern Lebanon, but that could change as the Israelis commit more forces to a ground incursion in Gaza.
• Meanwhile, the U.S. is reportedly sending a surge of ammunition and other military equipment and supplies to the Israelis. The U.S. has also deployed its aircraft carrier USS Gerald R. Ford and its battle group to the eastern Mediterranean Sea and has sent additional military aircraft to land bases in the region.  This morning, Chair of the Joint Chiefs of Staff CQ Brown explicitly said the deployments aim to deter Iran from getting involved in the conflict and warned Tehran to keep its distance.  The U.S. and European leaders also continue to voice their support for Israel, but China still has not condemned the Hamas attack.
  • Separately, Saudi Arabia’s Crown Prince Mohammed bin Salman said his kingdom stands by the Palestinians in the crisis.
  • That suggests Iran has had some success in achieving what was likely one of its goals in helping Hamas with its attack, i.e., scuttling the budding U.S.-brokered deal in which the Saudis would have recognized Israel.
• Yesterday, U.S. and other financial markets initially responded as would be expected in such a crisis: Investors sold off equities and piled into safe havens like bonds, oil, and gold.  By day’s end, however, investors had reversed much of those moves, and equities ended with impressive gains.
  • Such a turnaround is common in these types of crises. The initial selling clears out the weak longs, and once they’re out of the market, the selling stops.  That allows for a rebound in stocks, but we wouldn’t count on it to last.

• • Some of the late-day buying yesterday probably also stemmed from hopes that the crisis would convince the Federal Reserve to stop hiking interest rates and start easing policy. For example, the CME’s fed funds target-rate probability gauge now shows that investors see only about a 25% chance that the Fed will hike rates further by the end of the year.  That may prove prescient if the policymakers only focus on the ongoing slowdown in economic growth and cooling current inflation.  Keep in mind, though, that they could just as easily keep hiking if they focus more on continuing threats, like the big federal budget deficit.

Russia-Ukraine-North Korea:  In the world’s other major war, new satellite imagery suggests Russia has begun taking delivery of additional military supplies via railroad from North Korea.  The imagery shows a huge increase in freight-car traffic at the Tumangang Rail Facility on the Russian-North Korean border.  The cars are also carefully covered, further suggesting they are carrying sensitive equipment.  The evidence of new shipments comes after Russian President Putin met with North Korean leader Kim Jong Un last month to request help with replenishing the ammunition and supplies that Russia has depleted in its continued invasion of Ukraine.

China:  New data shows consumer spending and home sales were weaker than expected during the Golden Week holiday that ended on Friday.  Golden Week is typically one of the country’s top periods for spending and home transactions, but the data shows tourism outlays were only 1.5% higher than in the pre-pandemic year of 2019, representing a decline after stripping out price inflation.  The amount of residential floor space sold was also lower than in 2019.  The figures are further evidence that China’s economic growth is being held back by issues such as weak consumer demand, high debt levels, poor demographics, and de-coupling from the West.

• As further evidence of China’s economic problems, the major real estate developer Country Garden (CTRYY, $2.71) failed to make one of its international loan payments for the first time. It also warned that it doesn’t expect to make upcoming payments to its foreign bond holders.
• Country Garden’s troubles began after its apartment sales plunged in recent months, as the government’s crackdown on highly indebted developers sparked a liquidity crisis and weighed on sales.

European Union-China:  The EU is expected to launch an anti-subsidy investigation against Chinese steel producers later this month.  The probe would be part of a new, U.S.-led “Global Arrangement on Sustainable Steel and Aluminum” aimed at China’s dumping of cheap, subsidized metal products to the detriment of developed-country producers.  Countries including Japan and the U.K. would also be invited into the group if they agree to impose punitive tariffs on China’s dumped metal products.

• The EU’s move comes just weeks after it announced an anti-subsidy probe into Chinese electric vehicles, and shortly before it is expected to announce a separate probe into Chinese wind turbines.
• The initiatives by Brussels are sure to worsen EU-China relations and contribute further to the fracturing of the world into relatively separate geopolitical and economic blocs, as we have frequently described.

Argentina:  The peso (ARS) dropped 7.4% against the U.S. dollar on the black market yesterday as right-wing firebrand Javier Milei, who is leading the opinion polls ahead of the October 22 presidential election, warned again that he plans to dollarize the economy if he wins.  In a radio interview, Milei warned that Argentines shouldn’t keep any investments denominated in ARS.

Canada:  The Unifor auto workers’ union today has launched a strike against U.S. automaker General Motors (GM, $30.99) after the workers and the company failed to agree on a new labor contract.  The strike illustrates how tight labor markets have emboldened workers in Canada just as they have in the U.S.  The work stoppage also piles pressure on GM, which is already dealing with the United Auto Workers strike in the U.S.

U.S. Labor Market:  The 75,000 healthcare workers who launched a three-day strike against Kaiser Permanente last week have now gone back to work, and negotiations on a new labor contract with the firm are set to begin again on Thursday.  The union has warned that the workers will go out on strike again in November if they can’t strike a deal for higher pay and increased staffing at Kaiser’s facilities.

U.S. Education System:  An intriguing story in the New York Times notes that schools run by the Defense Department on U.S. military bases have begun to substantially out-perform typical public schools.  The article ascribes their outperformance to a range of factors, including higher teacher pay, higher standards, stronger discipline, and quicker reopening after the coronavirus pandemic.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning.  Financial markets have been roiled by events in the Middle East, which we will discuss.  We are seeing market reactions typical with such geopolitical events, such as a stronger dollar, higher oil prices, a surge in gold, and a decline in equities.  However, we have seen most of these markets correct since their most extreme levels of the overnight session.  As a reminder, this is a bank holiday, so cash Treasury trading is closed and there won’t be any government data releases.

In today’s Comment, we start our coverage with the Hamas attack and our take on the event.  Up next is our international overview, and then we look at economic news.

The Second Yom Kippur War:  Nearly fifty years ago, Egypt and Syria, along with other Arab states, launched a surprise attack on Israel.  After initial successes, Israel halted the Arab offensive and counterattacked.  However, the war did nearly bring the U.S. and USSR into a direct confrontation, and a major side effect of the conflict was the first unveiling of the Arab OPEC oil weapon.

This attack was a surprise as well.  Hamas fighters launched a multipronged attack on several towns surrounding the Gaza Strip.  The attack appeared to catch Israel completely off guard.  Although the situation remains fluid, it appears that over 100 Israelis are being held hostage and over 600 Israelis have died in the assault, with the total death toll exceeding 1,000.  It is reported that Americans and Europeans are also being held or have died in the assault.  Israel appears to be preparing for a major assault on Hamas as it has called up 300k reservists.  The towns captured by Hamas are being retaken.  The Gaza Strip is under siege, and their utilities have been cut off.  Given that the situation is continuing to evolve, we won’t try to report the latest news, but instead, we will note our observations of the event.

A failure of intelligence:  Israel’s model of managing the Palestinian areas was to isolate them with walls and checkpoints, regulate the economies of the Palestinian controlled West Bank and Gaza Strip, and use a deep intelligence network to snuff out unrest and potential attacks.  The Israeli government had mostly given up on occupation, as occupying Gaza was difficult, and so isolating and controlling was seen as a better solution.  This attack was broad and sophisticated.  Not only were there a large number of Hamas fighters involved, but there were also large caches of weapons that had been accumulated and stored.  The fact that Hamas was able to put this offensive together without losing operational security is remarkable.  Coupled with this intelligence failure was the relatively slow response to the attack by the military and the government.  How did Hamas pull this off?  It seems to have done so by persistently signaling that the Hamas leadership had no interest in any sort of confrontation with Israel.  Essentially, Israeli intelligence fell victim to “narrative capture,” which is when analysts become so convinced of a narrative that they ignore evidence that contradicts the accepted wisdom.

Israel and the U.S. respond:  PM Netanyahu has declared a state of war on Hamas and the Israeli government has approved “significant military steps.”  The U.S. announced that the USS Gerald Ford carrier group will move to the Eastern Mediterranean.  The group was already conducting exercises with the Italian Navy.  The U.S. is reviewing the sending of additional assistance to Israel.  The large number of hostages taken by Hamas will be difficult to manage.

The conflict could widen:  There have been reports of rocket attacks in northern Israel, likely carried out by Hezbollah.  As the U.S. moves to support Israel, we will be watching to see if Iran or other regional powers, such as Turkey, try to resupply Hamas.  While a regional conflict is a low-probability event, when something like this occurs, there is still a chance for expansion.  For example, we note that China is now calling for a Palestinian state, and although we doubt Beijing has the ability to project power into the region, a broader proxy conflict could emerge if outside powers begin taking sides.  At the same time, China’s tone-deaf response to the Hamas attack on Israeli civilians will likely fall flat with parties in the region.  In addition, given that Iran benefits from this conflict (see next point), Israel may decide to directly retaliate against Tehran.

The role of Iran is a key to whether this conflict expands:  There appears to be broad evidence of Iranian involvement.  The WSJ is reporting that the Islamic Revolutionary Guard Corps was deeply involved in the planning of the attack and approved the operation.  Other sources corroborate this assertion.  Iran claims it was not involved.  We also note that the Biden administration is clearly trying to avoid tying the operation to Iran.  As we have discussed in our Weekly Energy Update, the Biden administration has been trying to resurrect the Iran nuclear agreement (JCPOA) since coming into office.  Its most recent decision to unfreeze Iranian assets for hostages will be politically difficult to manage.  SoS Blinken has indicated that the $6.0 billion of assets were not used for Hamas.  Although that might be technically true, the political optics are not favorable.  The ongoing investigation of Robert Malley raises concerns that Iran has penetrated the administration.  The initial reaction of the Biden administration appears to be to “slow walk” the issue of Iranian involvement.  However, that stance will be difficult to maintain, as there appears to be sufficient evidence to point to Iranian involvement, and thus, some sort of retaliation is likely.

The Israeli/Saudi normalization is in peril:  Saudi Arabia and Israel, supported by the U.S., have been in talks with the intent to normalize relations.  Riyadh’s stipulations are major (formal U.S. security guarantee, nuclear power transfer, peace in Palestine), which has made a deal difficult to achieve, but, as we have noted in our Weekly Energy Update, progress was being made.  However, a deal now looks unlikely.  Although we think the timing of this assault was to coincide with Yom Kippur, the fact that the hostilities will likely scuttle normalization is a major benefit for Iran.  Thus, the attack coming when talks were making progress suggests possible coordination with Iran.

Market ramifications:  Here is what we expect from markets:

Oil prices:  After running up to just over $95 per barrel, WTI has endured a stiff correction, likely on fears that rising interest rates would hurt the global economy and weaken demand.  However, there was also a chance that a successful Israeli/Saudi normalization could have encouraged Riyadh to boost production as part of the contribution to the deal with Washington.  Saudi Arabia has 2.0 mbpd of excess capacity, and therefore represents the most bearish factor to the market.  Since the attacks are likely to end or dramatically postpone normalization, we don’t see any other reason why the Saudis would lift output.  In fact, if Iran is implicated, we could see actions by the West to curtail Iranian oil flows.  In addition, given the fact that the U.S. SPR has already been aggressively tapped, it will be risky to authorize another drawdown.  If there is a crackdown on Iranian oil shipments, it is possible that the Saudis will offset those barrels, but, barring a significant economic slowdown, this event will likely put a floor under oil prices at a minimum and could lead to higher prices.

The dollar:  If we are right on oil prices, the dollar should rally too.  As we noted in our June 12 Bi-Weekly Geopolitical Report, as the U.S. has shifted from a petroleum importer to exporter, America’s terms of trade have flipped as well.  Higher oil prices lead to an improvement in the terms of trade and thus a stronger dollar.  In addition, when crises hit, it is normal for the dollar to appreciate.

Treasuries:  Usually, such events lead to the safety buying of Treasuries.  We are seeing some of that this morning, but given the other concerns surrounding this market, the rally is unlikely to persist.

Equities:  Equities are risk assets and events such as this raise risk perceptions. Thus, it’s a bearish factor for stocks, at least in the short term.

Economic Roundup:  Labor actions continue, Boomers support the economy, and we continue to watch the bond market.

• Health care workers in California have returned to work without a contract, but given the state of negotiations, labor action might return. On the other hand, the UAW is expanding its strike to Mack Trucks (VLVLY, $20.58) after workers rejected the company’s offer.
• One of the reasons consumption is holding up so well is due to the spending of older Americans. As the U.S. population ages, more households are living off their accumulated assets and Social Security.  This spending is less sensitive to the job market and is turning out to be a surprising source of support for the economy.
• In the 1980s, there were concerns about the size of deficits and the market’s ability to absorb the borrowing. The market did clear, but at rates much higher than what we have seen for the past two decades.  There are renewed fears that the market won’t easily absorb the wave of borrowing that the Treasury is planning, and these fears have been a factor behind the recent rise in longer-duration yields.
• Texas cities are reporting high numbers of office vacancies. It isn’t work-from-home that is the problem, but overbuilding.  Although this is bad news for real estate owners, it does indicate that a strong Texas economy won’t be adversely affected by rising rents.
• One of the surprises of this rate hiking cycle has been the tame behavior of credit spreads. Normally, tighter monetary policy leads to spikes in credit spreads.  What appears to be happening is that private credit has replaced bonds and bank loans for lending.  Since private credit spreads are not easily observable, problems in this area may not be observable either.
• Large company bankruptcies are on the rise. Higher interest rates are playing a role.
• The post pandemic labor market has exhibited an unusual characteristic—higher wage growth for less skilled workers.

• Recently, the premium for skill appears to have returned.  However, anecdotal evidence suggests that higher skilled workers are facing a sluggish job market.

International Roundup:  Russia moves to end its compliance with the nuclear test ban, the ruling coalition in Germany takes a drubbing in local elections, and there was an earthquake in Afghanistan.

• Russia claims it will end its compliance with the nuclear test ban treaty. Although this is making headlines, the treaty was never ratified by the U.S. and the agreement was never in force because too few nations agreed to it. But because the U.S. and Russia have abided by the terms, the announcement could lead to a resumption of testing.
  • Russia withdrew its Black Sea ships from Crimea due to Ukrainian drone attacks.
• Conservative parties in Germany scored major wins in local elections. The AfD, a populist right-wing party, did surprisingly well.  These wins are a signal to the ruling government that their policies are unpopular.
• Poland will hold elections later this week. This report details the parties and their leaders.
• There was a massive earthquake in Afghanistan with a death toll exceeding 2,400.
• The Maduro government in Venezuela has issued an arrest warrant for Juan Guaido, a major opposition leader. Guaido lives in the U.S, and he probably won’t be extradited, but given how the U.S. has eased sanctions on Venezuela, there is a chance Washington might send him off.

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