by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment focuses on three major themes: 1) Why mixed data shows that it is too soon to rule out the possibility of a recession; 2) How the GOP debates may be more important than people realize; and 3) Why Russian President Vladimir Putin will look to burnish his reputation going into the 2024 election.

Bad News Is Good News: Recent economic data has raised concerns about the possibility of a recession.

• Economic activity in the United States and Europe appears to be slowing, according to a preliminary survey. The August S&P Composite PMI for the United States came in at 50.2, just above the 50 threshold that separates expansion from contraction. The eurozone and the U.K. also saw their PMIs fall into contractionary territory, with readings of 47.0 and 47.9, respectively. While the manufacturing sector has seen the worst of the slowdown, there are also signs that the service sector is starting to feel the pinch.
• Surprisingly, the market responded positively to the disappointing results as it added to speculation that central banks will pause at their next meetings. The S&P 500 had its best day since June, closing the day higher by 1.1%. Meanwhile, the yield on the 10-year Treasury, which hit its highest level since 2007 earlier this week, fell 13 bps. The rise in optimism is related to investors’ beliefs that the central bank may not make matters worse by raising benchmark interest rates. The CME FedWatch Tool predicts that there is an almost 90% chance that the Federal Reserve will stand pat at its September meeting.

• It is not uncommon for a flurry of positive economic data to be released in the run-up to a recession. In fact, prior to the 2001 recession and the Great Financial Crisis, there was talk among experts that a downturn had been averted. Looking even further back, government data released before the Great Depression also did not provide much warning of the impending downturn. While we do not believe that the U.S. is currently in a recession, we are hesitant to say that the worst is over especially as central banks continue to raise interest rates.

First Face Off: GOP candidates had their first debate in Wisconsin on Wednesday in a test to see whom the new face of the party could be.

• The Republican presidential debate kicked off without much fanfare, as the candidates played it safe and avoided controversy. However, Nikki Haley stood out from the pack by highlighting her international experience and offering a different perspective on the country’s problems. In a surprising move, she blamed her own party for the inflation crisis and accused her rival Vivek Ramaswamy of being soft on China by supporting Russia. Former President Donald Trump, who was not in attendance, is likely to keep his front-runner status, as no candidate was willing to directly take him on in the debate.
• President Trump’s decision to skip the debate may not have been in his best interest. Debates are a chance for candidates to shape the national conversation on important issues, connect with voters, and defend their records. By not attending, Trump missed an opportunity to control the political narrative and shape the conversation on issues such as U.S. economic policy and border security. Trump has been a vocal critic of U.S. interventionism and is unlikely to support fiscal reforms that would disproportionately burden his voter base. As a result, President Trump may be forced to play defense when he finally enters the political arena.

(Source: New York Times)

• One of the most pressing issues facing the next U.S. president will be how to deal with the global shift towards regional blocs. At the recent BRICS summit, Beijing and other members of the bloc pushed for emerging markets to join their group as a counter to the G7. In addition to dealing with China, the next U.S. president will also need to address the issue of how to navigate toward an economy built around resiliency as opposed to efficiency. The 2024 U.S. presidential election is still a long way off; therefore, investors have not priced in its potential outcome. If the candidates are perceived as being more hawkish towards China, or less committed to free trade, then financial markets could become more volatile.

 Putin’s Positioning: Russian President Vladimir Putin is seeking to position himself as a capable and decisive leader as he prepares for reelection in March 2024.

• Yevgeny Prigozhin, a potential rival to Russian President Vladimir Putin, died in a plane crash on Wednesday. Prigozhin was the leader of the mercenary Wagner Group that launched a failed mutiny in June. He was also formerly a close ally of Putin. The plane crash occurred as Prigozhin was traveling from Moscow to St. Petersburg. The cause of the crash is still under investigation, but it is believed that a Russian anti-aircraft defense system may have shot down the plane. Prigozhin’s death is a significant development as he was seen as a potential threat to Putin’s leadership.
• However, Putin still has a lot to worry about as he looks to boost his leadership credentials. The Russian economy is in freefall, with the ruble (RUB) down nearly 30% against the dollar since the start of the war in Ukraine. Also, Russia’s current account balance has deteriorated considerably, and interest rates have surged. The country’s oil and gas revenues have kept the country afloat, but they have shrunk by almost 50% in the first six months of the year. These poor economic indicators are likely to dampen sentiment among the Russian populace, especially as the pain of economic sanctions continues to hurt households. Putin will need to find ways to address these economic challenges if he wants to maintain his high approval ratings.

• In the face of a prolonged war effort, an attempted coup, and increasingly challenging economic conditions, Russian President Vladimir Putin appears poised to secure a fifth term in office come March 2024. Yet, lingering uncertainties persist regarding the extent of his support within the military ranks. Approaching the upcoming election, Putin is likely to adopt a more daring approach to reaffirm his strongman image, taking calculated risks to fortify his credentials. This dynamic environment introduces the potential for trade disruptions as the conflict continues to unfold, posing a significant risk to regional stability and economic activities.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning from a blistering hot St. Louis!  It’s the “dog days” of August, and as we noted above, U.S. equity futures are pointing to a higher open.  Unfortunately, we have been experiencing this pattern recently, where we see stronger futures overnight only to see the gains fade as the day wears on.  Overall, August has been a tough month for equity investors as global stocks are having the worst month so far in over a year.  Meanwhile, the early signs of the political season are upon us—tonight is the first GOP debate.  The leading candidate, Donald Trump, is sitting this one out.

In today’s Comment, we open with a recap of the BRICS meetings being held in South Africa.  Up next is a quick look at the upcoming Jackson Hole conference.  A roundup of economic news follows, including a look at the U.S. housing market. The China update is next as the U.S. Commerce Secretary makes her way to Beijing.  We close with the international roundup and a look at the critical Suwałki Gap.

BRICS Meeting:  The five official nations of the BRICS—Brazil, Russia, India, China, and South Africa—are considering expanding the group.  China’s President Xi, who caused a bit of a stir when he failed to show up at a business meeting, met with South African President Ramaphosa to discuss expanding the group.  Xi’s vision for BRICS is to create a counterweight to the G-7.  Although China wants to expand the group (with Iran and Indonesia expressing interest in joining), India and Brazil are more cautious, worried that additional members will dilute their influence.  We suspect that Xi’s support for expanding the body is designed to enhance China’s clout.

Perhaps the biggest concern comes from rumblings that BRICS will create an alternative to the dollar system.  The body has ties to the New Development Bank, which is lending in local currencies to members.  Although there has been talk of creating a BRICS currency, the idea it would emerge from these meetings was mostly scotched by President Ramaphosa, who flatly stated that there would be no discussions about a common currency.  All members have expressed interest in trading in their own currencies, which makes sense.  The problem is that without a reserve asset to hold surpluses, the utility for the exporter to hold the local currency of another country is rather low.  A classic example is that Russia, who is selling oil to India, is now holding billions of INR that it can’t do much with, since it doesn’t want imports from India, and India restricts capital inflows.  There has also been talk of using gold as the reserve asset.  Although this might work (and could be profoundly bullish for gold), a gold standard is inflexible and thus tends to lose its allure for trade.

Our take is that there will be more talking, but we are not likely to see the membership group expand yet.  Also, the expectation of a BRICS currency is probably premature.

Jackson Hole:  Later this week, the KC FRB annual meetings in Jackson Hole will be held, with Chair Powell’s speech due on Friday.  Last year, Powell ditched his prepared remarks and kept it simple—expect higher rates and get used to them.  We don’t expect a repeat this year.  If anything, he will likely be non-committal on further increases, and will probably signal that a rapid decline in the policy rate is unlikely.  The contours of the debate are framed between two poles.  On the one side is that the economy is too strong and inflation too hot so the policy rate needs to rise further.  In his first interview since leaving the St. Louis FRB, Jim Bullard laid out the case that the state of the economy warrants higher rates.  The other side was discussed by the current “Fed whisperer” Nick Timiraos of the WSJ, who begged the question…is the 2% target worth the pain necessary to get there?  We suspect this is what Powell will need to address on Friday.

Economic Roundup:  Housing woes continue, labor unrest does too, and the Biden administration looks to help student loan borrowers.

• Later today, we will get new home sales data, with a modest rise expected. Yesterday, existing home sales came in weaker than expected.  Compared to last year, sales are down 16.3% for single family homes.  However, despite weak sales, prices for existing single family homes rose 1.6% from last year.  In our affordability study, which measures how many weeks a worker earning the median wage for non-supervisory workers to service a mortgage at the prevailing wage, median home price, and mortgage rate, the level reached nearly 2.8 weeks, the highest level since 1985.

• So far, this development hasn’t hurt the economy because most existing home borrowers are simply not selling their homes, reducing supply.  We expect to see new home sales rise relative to existing homes when the data comes out later this morning.
• United Parcel Service (UPS, $166.86) workers, represented by the Teamsters Union, announced the two parties had come to an agreement, averting a strike. Terms suggest about a $7 per hour jump in the average hourly pay.  Next up is the UAW, which is trying to claw back earlier concessions.  Meanwhile, the labor market news is somewhat mixed.  Pay for new hires is reportedly stabilizing after rising rapidly in recent years.  At the same time, tech layoffs are falling, suggesting an improvement for those workers.  Later today, we get benchmark revisions to the payroll data which could result in about a 600k reduction in reported jobs.
• The Biden administration has launched the SAVE Plan which is designed to scale student loan payments to incomes and cap interest costs. The courts struck down earlier efforts to cancel some student loans, so the administration is taking another path, essentially reducing debt service costs.  There have been concerns that when households with outstanding student debt begin paying on these loans in the fall, the economy would suffer.  This plan will likely blunt some of that negative pressure.
• Margin protection has been an element in keeping inflation elevated. There is evidence we have reached the end of that protection as firms are signaling that they probably won’t be able to pass along further cost increases.  However, there is no evidence to suggest a rollback in prices is likely.
• On the battered commercial real estate side, it’s a “good news, bad news” story. The good news is that office tenants are renewing their leases, but the bad news is that they are doing so while taking less space.
• The Bank for International Settlements warns that cryptocurrencies seem to be increasing financial fragility in emerging markets.

China update:  Gina Raimondo is off to China where the economy continues to struggle.

• Commerce Secretary Raimondo is on her way to China, part of a parade of administration officials trying to at least stabilize U.S./China relations. As part of the trip, the U.S. has eased come controls, removing 27 Chinese entities from the “unverified list.”  We doubt this action will make much of a difference.  We note that National Security Director Sullivan warned China to be more “transparent” about its economic data, reacting to news that Beijing won’t publish youth unemployment data anymore.
• Due to concerns about the Chinese financial system, policymakers are moving cautiously on potentially reducing rates, likely worried that aggressive cuts will trigger capital flight and a rout of the CNY. Unfortunately, without stimulus, the Chinese economy will continue to struggle.
• As geopolitical tensions rise between China and the U.S., American financial firms are seeing reduced opportunities in China.

 International Roundup:  Here are other news items of note.

• There are reports of local fuel shortages in Russia. Between the reconfiguring of supply chains, resources being diverted for the war effort, and sanctions, the domestic economy is bound to have periodic supply issues.  What remains uncertain is if these outages will result in a drop in production or civil unrest.  So far, there isn’t much evidence of either.
• The State Department has warned Americans in Belarus to “leave immediately.” The government notes that the presence of Russian troops is rising in the country and local law enforcement can be “arbitrary.”  The department also notes that European nations bordering Belarus have been closing borders.  Last week, Lithuania closed two border crossings, and Poland and Latvia are considering closing crossings as well.  Direct flights out of Belarus are limited.
  • There is a growing concern that Russia might forcibly take the Suwałki Gap which separates Belarus from Russian-controlled Kaliningrad.

 (Source:  The Baltic Times)

• • If this gap were seized, there would be no land bridge between NATO and the Baltic state, making their defense difficult.  The vulnerability of this area isn’t anything new, but the reported build-up of Russian troops in Belarus has raised alarms.  The State Department’s warning adds to this concern.
• We also note that Russia has reportedly placed nuclear weapons in Belarus. In the context of the increasing threat to the Suwałki Gap, this is a further Russian provocation.
• Russia may be considering annexing the regions in Georgia it seized in 2008.
• It’s settled—Srettha Thavisin will be the next PM of Thailand. Thailand has been under a caretaker government since March.
• Spain’s king has asked the conservative party leadership to form a government. Given that the coalition isn’t a majority, this effort will likely fail and so new elections later this year are increasingly likely.
• Azerbaijan is essentially blockading the disputed region of Nagorno-Karabakh. The region, which has an Armenian majority, is beginning to see shortages of essential items develop.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment opens with a curtain-raiser for the BRICS summit starting today in South Africa.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including news of growing trade ties between China and Russia, a vote for a new prime minister in Thailand, and the latest developments in the U.S. labor market.

Brazil-Russia-India-China-South Africa:  The latest summit of the BRICS countries will start today in Johannesburg, with appearances by top leaders ranging from Chinese President Xi to Indian Prime Minister Modi.  Leaders from a number of other emerging markets will also be attending, although Russian President Putin will not.

• One key agenda item is Xi’s push to expand the group to countries such as Indonesia and Iran. However, Modi and Brazilian President Luiz Inácio Lula da Silva are resisting that move out of fear it would give Xi too much power and dilute their influence.
• The leaders reportedly also plan to discuss how the countries can reduce their reliance on the U.S. dollar, especially after seeing how Washington and its allies were able to freeze hundreds of billions of dollars of Russia’s foreign reserves following its invasion of Ukraine.
  • Some observers think the summit will also discuss the creation of a new BRICS currency to replace the dollar, sparking fears of a sudden weakening in the greenback. However, other reporting suggests an alternative currency will not formally be on the agenda.
  • In any case, even though the greenback’s dominance in international trade and foreign reserves has been falling gradually for years, we and other observers doubt the renminbi (CNY) or any other proposed alternative could suddenly and sharply displace it. At least for now, we think there are big political, economic, financial, and technical hurdles that would likely preclude the BRICS countries from a wholesale abandonment of the dollar.

China-Russia:  New data shows that total trade between China and Russia in the first seven months of 2023 jumped to $134 billion, up 36% from the same period one year earlier, putting Russia just behind Australia and Taiwan in the list of China’s largest trading partners.  The figures illustrate how Russia’s invasion of Ukraine and the resulting Western sanctions have pushed China and Russia closer together economically, helping coalesce the evolving China/Russia geopolitical bloc.  We think the continued war and the continued common interest of the two countries will lead to a further coalescing of the bloc in the coming years, making it even more difficult for U.S. investors wanting to invest in the members of the bloc.

• While China’s overall exports from January through July were down 5% on the year, its exports to Russia were up 73%. That means China now accounts for almost half of all Russian imports.  Importantly, China appears to be sending Russia many products with dual military/civilian uses that could help support Moscow’s invasion Ukraine, such as semiconductors and heavy equipment.
• Russia’s exports to China in the same period were up 17% on the year, boosting Russia’s share of China’s imports to 4.8%

China-United States:  For the second time this month, the Chinese Ministry of State Security reported that it has arrested a Chinese citizen on charges of spying for the Central Intelligence Agency.  The announcement came just a month after CIA Director William Burns said his agency was making progress in rebuilding its spy network in China.  That suggests the MSS statements may be as much public relations as anything else.

• In any case, the CIA evidently recruited both spies while they were studying abroad, one in Japan and the other in Italy.
• To do so, it appears that the CIA borrowed the very same techniques the MSS has used to recruit U.S. citizens to spy for China, i.e., it buttered them up with compliments, dinners, gifts, and offers to pay for written “research.” (We think that’s hilarious.)

Japan:  The government stated today that on Thursday it will start releasing tritium-laced water from the Fukushima No. 1 nuclear power plant that is being decommissioned following its inundation and nuclear accident due to a tsunami in 2011.  Release of the stored radioactive water is opposed not only by local residents and fishers, but also by a number of neighboring countries.  Importantly, some countries have threatened to ban imports of Japanese seafood because of concerns about radioactivity.

Thailand:  Today, parliament picked real-estate tycoon Srettha Thavisin as the country’s next prime minister, marking a modest democratic advance after almost a decade of military rule.  Even though Thavisin had to rely on military-backed parties to be elected, the return of civilian rule and the fact that Thavisin is seen as pro-democracy will likely help the U.S. strengthen ties with Thailand again after it had drifted closer to China in recent years.

U.S. Labor Market:  Unionized pilots at American Airlines (AAL, $15.16) ratified a new labor contract that will boost wages by more than 40% over its four-year term.  The eye-popping wage increase reflects not only today’s general post-pandemic labor shortage, but also a shortfall in the number of available aviators and surging demand for leisure travel.  Such lucrative new labor contracts will likely keep investors concerned about continuing inflation pressures and the likelihood that the Federal Reserve will keep interest rates “higher for longer.”

• All the same, other signs point to some cooling in labor demand. For example, new data from ZipRecruiter (ZIP, $16.66) shows that most of the postings for some 20,000 different job titles on its site are offering less pay than just one year ago.
• The biggest drops have been in technology, transportation, and other sectors that had hiring frenzies in 2021 and early 2022.

U.S. Bond Market:  The rare “bear steepening” in the Treasury yield curve has continued this week, with the yield on the 10-year Treasury note rising yesterday to a 16-year high of 4.339% while the yield on the two-year obligation rose to 4.990%.  The difference between the two has now narrowed to just 65 basis points, compared with 93 basis points as recently as the end of July.  We believe the rise in longer-term yields primarily reflects a realization that the Fed is not likely to cut interest rates in the near term.  Since the yield curve’s inversion remains quite large, we think there is plenty of room for longer-term yields to keep rising.

• Meanwhile, new data shows that the average interest rate on a 30-year, fixed-rate mortgage has jumped to 7.48%, reaching its highest level since November 2000.
• That will likely continue to discourage current homeowners with ultralow mortgage interest rates from putting their homes on the market. That could make the supply of existing homes even tighter and push their prices higher, while also creating further incentives for new home construction.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a discussion of the important U.S.-Japan-South Korea summit on Friday and what it means for the global national security environment.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including further interest rate cuts in China, elections in Latin America, and real estate and weather news here at home.

United States-Japan-South Korea: President Biden, Japanese Prime Minister Kishida, and South Korean President Yoon on Friday formalized an important new series of trilateral commitments on diplomatic, economic, and military cooperation at a Camp David summit.  For example, the military agreements include a multi-year plan for joint exercises, deeper coordination on ballistic missile defense, and a new crisis-communication hotline.  The agreements don’t include any mutual defense commitments like those of the North Atlantic Treaty Organization, but they do mark a stepped-up effort at unity and coordination as the democracies face rising geopolitical challenges from Beijing’s evolving geopolitical bloc, which includes countries ranging from China and Russia to North Korea, Iran, and Cuba.

• The summit illustrates how the rising geopolitical threat from the China/Russia bloc has forced the U.S. and its allies to coalesce and overcome some of their past divisions, such as the longstanding enmity between Tokyo and Seoul over Japan’s brutal behavior on the Korean peninsula before and during World War II.
• The rising geopolitical threats have also generated a renewed bipartisan commitment to U.S. hegemony among centrist Republicans and Democrats. The Biden administration has relied heavily on their support as it tries to rebuild U.S. global leadership and rally allies to defend against the threat.  However, it’s important to remember that the overall trend over at least the last decade was for many U.S. voters to question the costs of maintaining global dominance.  Strong populist forces remain on both the left and the right of the political spectrum, and they could still ultimately derail the U.S.’s new globalist approach and push policy back toward isolationism.

China-Africa: New reporting shows the Chinese Communist Party has started to offer training in authoritarian governance to the ruling parties in key African countries.  The training is offered through a “leadership school” that focuses on topics such as party governance, party discipline, anti-corruption methods, “Xi Jinping Thought,” and poverty alleviation.

• The development suggests Beijing is becoming more comfortable with explicitly exporting its authoritarian political model.
• Since many of the targeted countries are important suppliers of key mineral resources, it appears the effort is partly aimed at locking up those resources to benefit China.

China: Following up the central bank’s interest rate cut last week, the nation’s banks today cut their one-year prime lending rate slightly to 3.45% compared with 3.55% previously.  Observers had expected the five-year prime rate to be cut as well, but it was left unchanged at 4.20%.

• The rate cuts are an effort to rebuild economic momentum in China, but the limited nature of the cuts also illustrates policymakers’ reluctance to implement big changes.
• China continues to struggle with what some economists are calling the “four Ds”: Demand weakness, Debt overhang, Demographic decline, and De-coupling in international trade, investment, and technology flows.
• With policymakers reluctant to revert to China’s traditional countercyclical strategy of increased debt and infrastructure investment to offset those trends, investors are becoming increasingly pessimistic about Chinese assets. That’s especially the case now that another major real estate developer is apparently facing liquidity problems and property-sector debt issues are starting to affect the broader financial system.  Chinese stocks trading on the mainland and in Hong Kong are trading lower so far this morning, and the renminbi has weakened to about 7.33 per dollar, near a record low.

European Union: Reports last week said the EU’s natural gas storage facilities have been almost completely filled, well ahead of the winter heating season, helping drive down the continent’s gas prices.  Nevertheless, new data from the Bruegel think tank suggests weak underlying demand is also putting downward pressure on prices.

• The slowdown in demand partly reflects Europe’s slowing economic growth and slow passthrough of wholesale price cuts to consumers.
• Perhaps more interesting, the think tank says weaker gas demand is also being driven by surging investment in alternative heating technologies, such as electric heat pumps and solar panels.

Russia-Ukraine War: Officials in Ukraine are reportedly negotiating a risk-sharing deal with global insurers so that the firms could cover up to 30 grain ships traveling from the country’s southeastern ports.  Now that Russia has pulled out of the previous deal allowing Ukraine to export grain, such a deal could potentially help ensure that Ukrainian grain can get to world markets, which would likely help hold down future prices.

Turkey: The government and central bank yesterday announced a series of moves aimed at discouraging savers and businesses from using foreign currency-protected savings accounts.  Those accounts, which reimburse their owners at government expense when the lira weakens against the dollar and euro, were implemented in late 2021 to encourage people to keep holding lira.  Along with recent interest rate hikes and import restrictions, the move signals that the government continues to shift toward more orthodox economic policies now that President Erdogan has been re-elected.  Over the summer, that shift has given a significant boost to both the lira and Turkish stocks.

Cyprus: Ethnic Turks on Friday violently pushed back United Nations peacekeepers who were trying to block the construction of an unauthorized road in the buffer zone separating the recognized Turkish Cypriot territory from the Greek Cypriot territory.  The road would link the Turkish Cypriot territory to what the UN says is an illegal military outpost in the buffer zone.  The incident could signal aggressive new moves by Turkish Cypriots to expand their area of control on the island, which would likely generate increased tensions with Greece.

Guatemala: In a run-off presidential election yesterday, center-left sociologist and corruption fighter Bernardo Arévalo won 58% of the vote, handily beating former first lady Sandra Torres, the conservative establishment candidate.  Arévalo campaigned on promises to rejuvenate the country’s democracy, stamp out corruption, reduce crime, and improve the public health and education systems.  If he can overcome Guatemala’s vested interests and make progress on those issues, there is a chance he could eventually reduce the high numbers of Guatemalans trying to emigrate to the U.S.

Ecuador: In the other major Latin American presidential election yesterday, leftist former lawmaker Luisa González won 33% of the vote, and center-right businessman Daniel Noboa won 24%.  They will now face each other in a run-off election on October 15, with the winner likely to be determined by the candidate voters think can re-establish social order and end the country’s current out-of-control violence and crime.  For U.S. investors, the key issues are probably how the eventual winner will manage Ecuador’s extensive mineral resources and whether he or she can reduce crime enough to stem the flow of migrants to the U.S.

U.S. Commercial Real Estate Industry: Despite the challenges in commercial real estate sectors such as office buildings and regional malls, new data suggests demand remains high for free-standing retail buildings and open-air malls.  The good supply and demand dynamics in those areas partly reflect the dearth of building after the Great Financial Crisis, which allowed the market to absorb excess properties.

U.S. Weather: After being downgraded from hurricane status, Tropical Storm Hilary roared into Southern California yesterday afternoon and evening, but the resulting rains, winds, flooding, and power outages were less severe than feared.  Even a series of small earthquakes that happened at the same time weren’t enough to cause major damage.  Nevertheless, public facilities such as schools and the Death Valley and Joshua Tree national parks have been closed as a precautionary measure.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment covers three main themes: 1) The impact of better-than-expected growth on global interest rates; 2) How China’s economic troubles are not going away anytime soon; 3) Why investors will be paying close attention to gatherings in South Africa and Jackson Hole, Wyoming, next week.

 Party’s Over? Stronger-than-expected economic growth has kept central banks from cutting interest rates, leading to tighter financial conditions.

• Global bond yields have surged to their highest level since 2008 as investors price in additional rate hikes. The IMF had previously forecast that there was a 90% chance of a U.S. and European recession by the end of 2023. However, after two consecutive quarters of expansion, both economies seem on track to finish 2023 in expansion. Additionally, stubbornly high inflation rates suggest that banks may need to keep interest rates in restrictive territory for longer. These higher rates are likely to put a strain on the global financial system, which could spill over into bond markets.
• This higher-for-longer sentiment has weighed on investor appetite for risk, sending the S&P 500 down 2.0% and the NASDAQ 100 down 3.2% since Monday. The major shift away from riskier assets is related to the growing attractiveness of higher-yielding safe assets, such as inflation-adjusted U.S. 10-year Treasuries, which surged to a 14-year high of 1.89%. The rise in yields has also impacted mortgage rates. According to the Mortgage Banker Association, the average 30-year mortgage rate has risen to its highest level since 2002 at 7.09%.

• Despite the economy being more resilient than investors thought at the start of the year, the strong economic performance is not likely to persist indefinitely. One of the primary reasons for the economy’s good run over the last few quarters is that fiscal and monetary policies have likely made households less sensitive to changes in interest rates. Over 60% of homeowners have mortgage rates below 4%, and firms were able to take advantage of favorable credit conditions to extend the duration of their loans before interest rates rose to their current levels. According to the Fed Small Business Credit Survey, over 58% of firms applied for new financing in 2022, which reduced their need for new loans.

China Worries Spreads: There is mounting evidence that China is still facing a severe property crisis.

• The Chinese financial system is coming under scrutiny after several institutions were unable to repay their debts. Zhongrong International Trust Co., which considerable real estate exposure, has missed payments on several products and currently has no immediate plan to make creditors whole. The situation has led to a spate of protests as clients look to hold the trust accountable. At the same time, China Evergrande Group filed for bankruptcy in New York and is currently working on restructuring its debt in Hong Kong. The ongoing turmoil shows that China’s property problems are likely worsening.
• The situation is likely to exacerbate China’s economic woes. Earlier this month, it was revealed that Chinese exports had fallen by the largest amount since the start of the pandemic. Meanwhile, consumer confidence remains near all-time lows. Additionally, Beijing’s resistance to providing additional stimulus is also likely to hamper the country’s economic growth and investor sentiment. The ongoing troubles have led to increasing calls for the People’s Bank of China (PBOC) to provide more aggressive policy easing to address these issues. The PBOC has already cut policy rates twice in three months and may offer more easing if the economic situation continues to deteriorate.

• The financial instability in China is currently isolated from the rest of the world. However, the global markets may still feel the spillover effects. Much of the domestic demand is expected to decline as China deals with its debt burdens. This problem could become more acute if Beijing forces households to absorb the losses from the property fallout. As a result, this could have a negative impact on international trade, as the lack of Chinese demand will weigh on commodity prices and make the country’s exports relatively cheap. This could help to reduce global inflation.

 A New Chapter: Next week, two major conventions will take place, one in South Africa and the other in the United States.

• The 15^th BRICS summit will take place in Johannesburg, South Africa on August 22-24, 2023. Leaders are expected to discuss the development of a new common currency backed by the commodities of the group members. There is also speculation that the bloc may be expanding to include more countries. While the group has denied that it is trying to create a rival to Western dominance in international trade, it is clear that they are at least interested in providing an alternative to the current order. As a result, the event will be closely watched by the global community.
• Meanwhile, central bankers from around the world will be gathering in Jackson Hole, Wyoming, for the annual meeting of the Federal Reserve Bank of Kansas City. The meeting is traditionally a forum for central bankers to share their views on the global economy and monetary policy. This year’s meeting is likely to be particularly important as policymakers grapple with the challenge of tightening monetary policy without triggering a recession. Federal Reserve Chair Jerome Powell is set to speak at the summit, and his remarks will be closely watched for clues about the Fed’s future policy plans.

• The upcoming BRICS summit and the Jackson Hole Economic Policy Symposium may have major ramifications for interest rate expectations. The potential for BRICS to issue bonds backed by a non-U.S. currency could sap future demand for U.S. Treasuries, making it more expensive for the U.S. government to borrow money. Although this is unlikely to happen, it is a risk that investors will be watching closely. Powell’s speech at Jackson Hole is also likely to be closely scrutinized by investors. While he is widely expected to remain vague about the Federal Open Market Committee’s next rate decision, he could give investors some insight into the inner thinking of policymakers. Any hints about the direction of future rate hikes could have a significant impact on financial markets.

Odds and Ends: President Trumps said that he would not reappoint Powell if reelected. There are over 2.2 trillion options set to expire today.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will cover three key themes: what the latest FOMC meeting minutes could mean for monetary policy going forward, an update on the latest complaints regarding artificial intelligence, and why the upcoming Argentine election in October has investors on edge.

Is the Fed Done? The hawkish Fed minutes weighed on market sentiment as investors pulled back on bets of a Fed pause.

• The minutes of the Federal Open Market Committee’s (FOMC) July 25-26 meeting revealed that most members believed that there was a significant upside risk to inflation, which could warrant additional rate hikes. This hawkish tone suggests that, despite the progress made in bringing down inflation, policymakers are not yet confident that inflation has peaked and are willing to take a more aggressive approach in tightening monetary policy. However, there were also a few more optimistic members of the FOMC. Two officials favored leaving rates unchanged or “could have supported such a proposal.” Although there were no dissenting votes, it is clear that not all policymakers are on the same page.
• Investor sentiment soured following the release of the FOMC minutes, as the market could not rule out the possibility of a hard landing. The S&P 500 closed yesterday down nearly 0.8%, while the U.S. Dollar Index (DXY) rallied. Despite the disappointing news, investors did not severely change their rate expectations. The yield on the 10-year Treasury rose a paltry 5 basis points, and the CME FedWatch Tool’s expectation of a September hike increased only modestly from 10% to 12.5%. This suggests that investors still believe that the Fed is near the end of its hiking cycle.

• Despite the market’s reaction, it is too soon to rule out another rate hike this year. As the chart above shows, the economy is projected to accelerate in the third quarter, making it difficult for the Fed to justify easing policy any time soon. This may explain why investors sold off after the report, as they may have wanted to lock in their gains from earlier this year. However, we will be paying close attention to Fed Chair Jerome Powell’s speech at Jackson Hole next week for any hints as to how the Fed is leaning. Our expectation is that Powell will likely keep his options open.

AI Presence Expanding: Generative artificial intelligence (AI) is receiving flak after author Jane Friedman found books generated by the technology that were claimed to have been written by her.

• The rise of AI-generated content has sparked controversy with some people concerned that it will displace human workers. This is because AI models are trained on massive datasets of text and code, including the work of authors. Without proper attribution, this can lead to accusations of plagiarism and copyright infringement. A survey by the Authors Guild found that 90% of writers believe they should be compensated for their work used to train AI models. Others argue that the rising popularity of AI-generated content threatens to crowd out quality work from human writers.
• Generative AI content-generating applications are at the heart of the Hollywood writers’ and actors’ strikes, and their concerns could easily spread to other industries. The strike has gone on for over 100 days, and it appears that studios have already made some concessions, such as crediting writers for work used by the models and using more human-generated content. However, it remains to be seen whether these concessions will be enough to satisfy the picketers. Regardless of the outcome of the strikes, it is clear that AI is here to stay in Hollywood. A recent survey found that over 96% of media executives plan to increase their spending on AI technology.

• The ongoing dispute between Hollywood writers and actors is an example of how workers are concerned about the potential for technology to displace low-skill and middle-skill white-collar workers, particularly among young people. Without adequate regulations in place, the growing ubiquity of AI could lead to a knowledge gap and inequality in the workforce. As a result, we suspect that the technology will likely face increased scrutiny in the coming months as concerns about its disruptive potential enter the national conversation. Investors should be aware of the uncertain regulatory landscape for the technology and how this may impact company earnings in the future.

Argentina in the Spotlight:  The presidential front-runner in Argentina unveiled controversial proposals to overhaul the Argentine economy that have left many investors worried.

• Libertarian presidential candidate Javier Milei has proposed a sweeping set of free-market policies to jumpstart the Argentine economy. In a two-hour interview, he promised to slash government spending by at least 13% of GDP by 2025, shutter the country’s central bank, and replace the national currency with the U.S. dollar. These policies are designed to help rebrand Argentina as a stable and attractive destination for investment, following years of economic turmoil. Argentina narrowly avoided default earlier this year after it was able to restructure nearly $22 billion of domestic debt, extending the maturity into 2024 and 2025. The event led S&P to slash Argentina’s national rating to SD from raCCC+.
• In addition to radically reforming the economy, the new leader vowed to distance Argentina from socialist countries, including its two largest trading partners: Brazil and China. According to the Observatory of Economic Complexity, these two countries imported more than $17 billion worth of Argentine goods in 2021, which is more than the next three countries combined. Milei’s remarks are likely to be a major shift in the country’s trade policy as it has often relied on China for exports and debt relief. Growing uncertainty regarding the impact of his policies led to a steep decline in the Argentine peso (ARS).

• The rise of Javier Milei is a reminder of how volatile Latin American politics can be. The region has typically swung between left-wing and right-wing governments, each promising to bring about a better future. However, as the world moves towards regional blocs, we see the same volatility in foreign and trade policy. For example, Brazil’s relationship with China was very contentious before Lula took over the presidency, since former President Jair Bolsonaro had blamed China for the pandemic. As a result, investors should keep in mind that these blocs will be fluid, especially as the world moves away from globalization.

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