by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Despite strong economic signs like positive durable goods orders, equity futures are paring back earlier gains. On a brighter note, the University of Iowa continues to dominate the Women’s NCAA tournament! Today’s Comment dives into why rising analyst forecasts for the S&P 500 shouldn’t lull investors into complacency. We’ll also explore how rising housing costs might impact the Fed’s policy decisions and analyze the likelihood of a slow US-China decoupling. Plus, we include our usual wrap-up of domestic and international data.

Equity Bulls on Tap: With the first quarter of 2024 nearing its close, several banks have already begun revising their year-end forecasts upwards.

• Oppenheimer Asset Management isn’t alone in its bullish outlook on the S&P 500. After a stellar first quarter, it has raised its year-end target from 5,200 to 5,500. This optimism is echoed by HSBC, UBS, and Bank of America, all revising their projections upwards to around 5,400 for the index by year’s end. Fueling this sentiment are the market’s strong gains and surprisingly positive corporate earnings reported in the final quarter of 2023. With the S&P 500 already up 10% year-to-date, further growth is anticipated if the Fed manages a soft landing.
• A cloud of uncertainty looms over the recent stock market optimism. Positive earnings surprises stemmed from analysts significantly lowering their Q4 2023 earnings per share (EPS) estimates ahead of reporting season, reflecting concerns about a potential economic slowdown later this year. Furthermore, liquidity in the financial system is expected to tighten in the coming months due to tax payments, ongoing quantitative tightening, reduced use of the overnight reverse repo facility, and interest rates remaining higher than market expectations. These conditions will likely prevent much of the cash being held in money market funds from returning to financial markets.

• The strength of the US economy bolsters optimism for equities, but hidden risks obscure the outlook. This is evident in the looming debt maturity wall. While leveraged loans offered companies a temporary lifeline, they’ve come at the cost of eroded profitability, potentially creating future solvency issues. There aren’t any glaring signs of an immediate crisis, but the lack of transparency in the private credit market remains a significant concern. Given these uncertainties, investors should exercise caution before taking on excessive risk, especially with policy rates hovering above 5%.

Fed Leaning Hawkish? Rising shelter costs are dampening the Federal Reserve’s optimism for three rate cuts this year, and the high home prices continue to fuel domestic inflation.

• Federal Reserve officials presented a divided front on future rate cuts this week. Voting member Raphael Bostic, President of the Atlanta Fed, pointed to stronger economic data and scaled back his forecast from two cuts to one. While Bostic expressed caution, Fed Governor Lisa Cook emphasized the potential hurdles on the path to price stability. In contrast, Chicago Fed President Austan Goolsbee held firm to his projection of three cuts, as outlined in the Fed’s latest Summary of Economic Projections (SEP). These divergent views highlight the complex interplay between robust employment data and higher-than-expected inflation on policymakers’ outlooks.
• Shelter costs remain a major hurdle for the Fed, delaying their shift on interest rates. While overall inflation shows signs of easing, housing prices act as a glaring outlier, driving a wedge in price trends. Excluding shelter, core CPI has held steady between 1.9% and 2.2% for the past seven months. This persistent rise in housing costs is often attributed to limited inventory and a slowdown in new construction. However, confusion clouds how this data is collected, with Fed Chair Jerome Powell himself acknowledging uncertainty about when the slowdown in housing prices will be reflected in inflation figures.

• Federal Reserve officials are signaling a cautious shift, with some openness to considering two rate cuts this year depending on economic data. While we expect the January and February inflation spikes to moderate, our confidence in the Fed achieving its target of 2% core PCE inflation by year-end has decreased. Stubbornly high shelter costs, a significant factor in inflation metrics, contribute to this hesitation. If inflation persists alongside a strong labor market, the Fed may postpone rate cuts until after the election.

Carrot and Stick Diplomacy: Despite China’s push for self-sufficiency in technology, it still seeks cooperation with US business leaders to temper U.S. hostility.

• On Wednesday, a select group of US corporate executives received an esteemed invitation to meet with Chinese President Xi Jinping. Following their participation in the high-profile China Development Forum, which wrapped up on Monday, these key players will convene for an exclusive gathering, aimed at providing insights into the nation’s burgeoning growth trajectory. The invitation arrives as US-China tensions escalate, fueled by policies targeting economic decoupling. With American businesses pulling back on investments in China, and Beijing planning to replace US technology, this high-level dialogue holds the key to shaping the future relationship between these economic giants.
• Despite recent tensions, a meeting between US CEOs and President Xi highlights the mutual dependence of the US and China. China’s manufacturing overcapacity strains its ability to sustain growth without access to US markets. This is particularly true for the electric vehicle industry, where China faces pushback from Western countries due to its surplus. However, US firms also rely on China’s vast consumer base for their own continued growth. Just look at Apple, whose sales of their flagship iPhone have dropped in China, prompting them to explore a partnership with Baidu to regain a foothold.

• High tensions simmer between the US and China, but a complete breakdown seems unlikely barring a major geopolitical crisis. Deep economic ties act as a safety net, minimizing supply chain disruptions and potentially creating space for a gradual thaw. Upcoming high-level visits, like Treasury Secretary Yellen’s expected trip to China next month, highlight the ongoing communication between the two countries. This trend is likely to continue, especially as China grapples with its economic slowdown. Nevertheless, we anticipate encountering occasional obstacles as both major economies strive to maintain their economic influence.

Other News: A major bridge in Baltimore collapsed late last night after a cargo ship collided with one of its supports. While there’s no indication of this being a deliberate act, authorities will likely conduct a thorough investigation in the coming months. Florida passed legislation to prevent minors under 14 from accessing social media, in another sign of the growing scrutiny of US tech companies.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a note on Congress’s passing of the last funding bills for the federal government on Friday and the resulting political clashes in the Republican Party.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including an aggressive new European Union antitrust probe into several top US technology firms and new data showing strong investor interest in US corporate bond funds.

US Politics:  On Saturday, the Senate passed the last of the bills funding the federal government through the end of the fiscal year on September 30, sending the bills to President Biden to sign into law to avoid a partial shutdown of the government.  Despite that victory, passage of the bills in the House on Friday with almost unanimous support from the Democrats and a minority of the Republicans has left the chamber in disarray.  As a result, the Republican majority in the chamber has narrowed to the point where the Democrats could take control.

• Far-right, hardline Republicans in the House are enraged that Speaker Johnson allowed a vote on the spending plan that was a compromise agreed to by President Biden and House leaders last spring. Republican Rep. Marjorie Taylor Greene of Georgia filed a motion to vacate the leadership, serving notice that Johnson could be ousted.
• Perhaps more important, Republican Rep. Mike Gallagher of Wisconsin announced he will leave Congress early in mid-April. That will leave the Republicans in the House with a majority of just one, meaning they could easily fail to push the Republican agenda in the chamber and could lose their majority if just one more Republican member leaves Congress early.
• To the extent that voters see the Republicans in the House as dysfunctional, the drama is a reminder that former President Trump does not necessarily have a lock on the November election, despite current polling showing that he has a slight advantage in public support. It remains too early to tell whom the next president will be.

European Union-United States:  The European Commission today announced it is launching official antitrust investigations into US technology giants Apple, Meta, and Google owner Alphabet. The probes are based on the EU’s new Digital Markets Act, which aims to limit the market power of big, on-line “gatekeeper” platforms. They will focus on whether the firms favor their own apps and how they use personal data for marketing. The probes will raise regulatory risks for a range of technology companies operating in the big European market.

Japan-United States:  The Financial Times said yesterday that the US and Japanese governments are preparing to make the biggest upgrade to their security relationship since their mutual defense treaty was signed in 1960.  The moves, which are aimed at more effectively fighting China in case of a conflict, will focus on giving US commanders in Japan greater operational authority to improve US-Japanese joint operations.

China-United States:  In yet another sign of economic decoupling brought on by US-China tensions, Beijing has issued new procurement guidelines that will phase out the use of foreign technology in government computers and servers.  For example, the new rules will outlaw computer chips from Intel and AMD, as well as operating and database software from Microsoft.  Instead, the government will seek to buy more Chinese-made technology, further limiting Chinese market opportunities for Western companies.

China:  In his keynote address to the China Development Forum yesterday, Premier Li Qiang tried to assure top foreign business leaders that the government is focused on removing obstacles to foreign investment in China.  Li specifically mentioned key issues such as fair market access, public contracts, and cross-border data flows.  Nevertheless, we suspect that the range of entrenched structural headwinds in China will continue to weigh on foreign investment in the coming years.

Russia:  The death toll from Friday evening’s attack by Islamic State on a crowded concert near Moscow has now surpassed 130.  Russia officials say they have arrested 11 people involved in the attack, including the attackers themselves.  Importantly, Russian officials continue to push a narrative that the Ukrainian government was involved, potentially with the intention to use the attacks to justify stepped-up aggression against Ukraine.

• Despite a laudable US effort to warn the Russians about the attacks ahead of time, we have seen little or no indication that the Kremlin respected the warnings or appreciated the US effort to avert civilian casualties.
• The fact that the attackers were able to carry out their plans despite the US warning to Russia suggests the Russian security services did not take the US warnings seriously and/or were incompetent in trying to stop the attacks.

Brazil:  New reporting shows left-wing populist President Lula da Silva is stepping up his interference in major companies.  For example, Lula reportedly forced partially state-owned oil giant Petrobras to backtrack on a plan to issue extraordinary dividends earlier this month.  The move helped push the company’s stock price by some 10% in a single day.  The moves are reviving concern that state intervention will eventually undermine Brazilian economic growth and prompt investors to flee the market.

US Bond Market:  New data from fund tracker EPFR shows investors have channeled about $22.8 billion into exchange-traded funds focused on corporate bonds so far this year, marking the first positive year-to-date inflows since 2019.  The inflows appear to reflect investors hoping to lock in high yields ahead of the Federal Reserve’s expected interest-rate cuts later this year.

US Media Industry:  Axios today carries an interesting article showing that the common news sources of the past have splintered into at least a dozen new information “bubbles” favored by different types of people.  For example, the report describes the “Instagrammers” bubble as consisting mostly of young to middle-aged women in college and the professional class.  In contrast, it describes the “Right-wing grandpas” bubble as mostly male older people who still watch Fox News, especially in prime time.

• It can be fun to read the article and ask yourself which bubble you fit into, or which bubble your family members or co-workers favor.
• On the other hand, the article illustrates the cleavages and mutually exclusive information sources that are driving political discussions these days. As people sink into their own bubble and keep themselves insulated from alternative viewpoints, the concern is that the new media landscape increases polarization and makes the country harder to govern.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Stocks have pulled back from their recent highs after the Federal Reserve meeting, while the University of Oakland is writing its Cinderella story after upsetting powerhouse University of Kentucky in the NCAA tournament. Today’s Comment examines why the recent global rate shift has us concerned about the market, how ongoing regulatory risks continue to impact big tech companies, and what the potential consequences of China’s economic struggles are for other countries. As always, we wrap up with a summary of international and domestic news.

Cuts Aren’t Guaranteed: All G-7 central banks have signaled a potential shift in monetary policy this year, but investors should remain patient before taking on risk.

• The Bank of Japan stands alone in its monetary policy. It recently raised rates but signaled a pause in tightening, aiming to keep rates accommodative. In contrast, all other major central banks are shifting towards looser policies. The Bank of England, European Central Bank, and Federal Reserve all hinted at potential rate cuts starting in June. Meanwhile, the Swiss National Bank took the most aggressive action, implementing its first rate cut in nearly a decade. The decision by rate-setters to adjust their policy language is likely to pave the way for looser financial conditions.
• Central banks’ dovish tilts have triggered a global decline in interest rates, paradoxically strengthening the US dollar. Expectations of a robust US economy and the Fed’s potential to maintain a tighter monetary policy stance are driving this rally compared to its peers. A strong dollar poses a challenge for foreign central banks, as it can lead to higher import prices, particularly for energy-related goods. Upward pressure on inflation could force them to choose between supporting their economies with lower rates or raising rates to combat inflation, potentially hindering growth.

• The recent global equity rally rests on a precarious tightrope — a soft landing for the US economy and a mild or brief recession in other developed economies. While policymakers and the market seem confident in a central bank pivot by June, a more cautious approach is warranted for investors. The US economy’s continued strength suggests the Fed may delay rate cuts until inflation shows clearer signs of abating. This, in turn, could lead other central banks to hesitate with aggressive rate reductions, potentially undermining the current market optimism. As a result, the recent rally may be short-lived.

Tech’s Boogie Man:  Recent lawsuits against Apple exemplify the significant regulatory risks facing the dominance of the Big Tech 7.

• Apple is facing mounting legal challenges. The US Department of Justice has filed an antitrust lawsuit, accusing the tech giant of stifling competition by restricting access to hardware and software features. This follows similar action from European regulators who charged Apple with non-compliance with the Digital Markets Act, alleging the company locks consumers into its service ecosystem. These legal battles, along with the potential for hefty fines and litigation costs, have weighed heavily on investor sentiment, contributing to an almost 8% year-to-date decline in Apple’s stock price.
• The legal challenges facing Apple exemplify a growing trend of government intervention in the tech sector. One contentious issue is the potential for governments to restrict sales of cutting-edge semiconductors to rival nations. The US, for instance, has implemented measures limiting the supply of such semiconductors to China, aiming to curb its technological advancement. Companies like Nvidia, which previously relied on China for a significant portion of its data center revenue, have had to reduce sales. Additionally, lawsuits regarding copyright infringement, such as those filed by the New York Times, could further dampen the enthusiasm of firms seeking to profit from generative AI.

• Tech giants facing legal scrutiny can weather initial skirmishes, but protracted legal battles lasting years loom large. Unfavorable rulings will likely trigger a flurry of appeals, further bogging down the process. Even absent a final verdict, these lawsuits can be a strategic nightmare, forcing companies to make temporary business adjustments that could erode their competitive edge. This is already playing out, with Apple recently lowering app sales commissions and allowing developers more payment flexibility in response to regulatory pressure. This trend is likely to continue and impact other major tech companies as well.

Yuan Breaks Threshold: A strengthening dollar and a production surplus could trigger heightened scrutiny of Chinese exports.

• The yuan (CNY) plunged to a four-month low after China’s central bank loosened its grip on the currency Friday, setting the dollar peg above 7.10 CNY. This move, likely driven by a strengthening dollar and soft data, weighed on the Chinese currency. The move fuels speculation of imminent stimulus to tackle slowing growth, partly caused by the property sector’s debt burden. The central government’s recent spending surge aligns with this, potentially aiming to alleviate pressure on local governments struggling with the ongoing property crisis. Finance Ministry data shows general public expenditure has surged 14% year-over-year, the fastest pace in over five years.
• China’s drive to boost growth is stoking fears of a wave of cheap exports, which may be particularly damaging to electric carmakers. Tesla underscored these concerns on Friday, announcing production cuts in China due to their inability to compete with lower-cost rivals. In response, both the EU and US are taking steps to shield their domestic industries. EU lawmakers are crafting legislation that could impose tariffs on Chinese electric vehicles (EV) by November. The US, already imposing a 27.5% import tax on Chinese EVs, is contemplating a significant increase, potentially reaching a staggering 125% of a vehicle’s value.

• China’s economic slowdown presents a multifaceted global challenge. While a surge in Chinese exports might provide temporary relief from inflationary pressures for some countries, it could trigger protectionist responses from others seeking to shield domestic industries and jobs. Furthermore, a significant portion of these exports are likely to be directed towards Belt and Road Initiative participant countries. BYD, for instance, has struggled in developed markets but remains the top choice for EVs in Brazil and Thailand. This suggests that China’s overproduction issue may continue to exert downward pressure on global prices, potentially harming Western companies indirectly.

Other News: Reddit’s IPO burned bright in a sign that investors are warming up to riskier bets. The recent decline in interest rates has fueled a tech spending spree, with companies taking advantage of cheap debt to refinance loans. Meanwhile, investors are actively acquiring corporate debt, seizing the opportunity for high yields before the Fed potentially cuts interest rates. This surge reflects a growing belief that rates have plateaued and are headed downward.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Stocks are rallying this morning as investors remain optimistic about the Fed achieving a soft landing. In sports news, March Madness tips off today, and we’re calling a win for the University of North Carolina. Today’s Comment dives into key issues: analyzing the latest FOMC meeting, exploring the budget debates among lawmakers, and examining the recent shift towards military assertiveness by US allies. As always, we’ll keep you informed with a roundup of international and domestic news.

Powell’s Punt: The Federal Open Market Committee’s (FOMC) decision paves the way for a potential rate cut in June; however, it may hinge on the strength of the labor market.

• Despite maintaining a cautious monetary policy, the FOMC signaled a brighter view of the US economy. In their latest decision, they opted to hold the target range for the federal funds rate between 5.25% and 5.50% and continue its balance sheet runoff. Nevertheless, a shift in their economic outlook is evident. FOMC projections show increased optimism, with GDP growth forecasts for 2024 revised upwards from 1.4% to 2.1%. Additionally, the unemployment rate is expected to dip slightly, from 4.1% to 4.0%. Notably, inflation projections remain unchanged, suggesting policymakers believe this economic uptick won’t significantly impact price pressures.
• The market initially welcomed the FOMC’s announcement, but a deeper analysis suggests a potentially hawkish undertone. Although the median dot plot remained flat at 4.625%, a rise in the weighted average from 4.70% to 4.80% signaled a slight shift among some policymakers. This could stem from concerns about the persistent tightness in the labor market, which might hinder progress toward the Fed’s 2% inflation target. Reinforcing this, Federal Reserve Chair Jerome Powell hinted during the press conference that persistently strong employment data could lead the central bank to hold interest rates higher for a longer period than currently anticipated by the market.

• The Fed’s decision on a June rate cut remains uncertain. While they haven’t committed to it, our baseline expectation is a cut if they aim to deliver on their projected three reductions this year. Thus, the strength of the employment data will be a key factor. If the US continues adding jobs at a solid pace, exceeding 180,000 per month, the Fed may delay easing policy, especially with inflation still above its target. However, to maintain political neutrality, the central bank might delay its first rate cut until July at the latest. This would keep them on track for three total reductions this year, with the other two likely occurring in the November and December meetings.

Slash Entitlements: Lawmakers are setting their sights on benefit programs as a potential area to address the government’s budget deficit.

• The Republican Study Committee (RSC), a conservative group within the Republican Party, has proposed a plan to ensure the long-term solvency of social programs. This proposal includes raising the Social Security retirement age, tightening work requirements for food stamps, and capping unemployment benefits based on prevailing wages, possibly around $15 per hour. While immediate passage seems unlikely, the RSC plan reflects a growing emphasis within the Republican Party on reforming entitlement programs. This aligns with recent comments by former President Trump, who called for streamlining Social Security to address potential inefficiencies. The Republican budget proposal is expected to reduce outlays by $14 trillion over the next decade.
• This plan addresses the challenge of the national debt’s sustainability through the implementation of rigorous spending controls, a matter both political parties are exploring alternative approaches to resolve. Democrats aim to reduce costs by allowing the expiration of the Trump tax cuts in 2025 and by increasing taxes on high-income individuals. President Biden has indicated his intention to raise taxes on individuals earning over $400k annually and to elevate corporate taxes from 21% to 28% should he be re-elected. This projection suggests Biden’s plan could generate nearly $5 trillion in additional revenue over the next decade.

• Austerity measures, including tax hikes and cuts to social programs, could free up resources to improve the fiscal balance. However, this approach faces significant hurdles. Public spending makes up a nearly a quarter of GDP, a substantial portion. Additionally, Social Security costs are projected to rise further by 2033, and these programs are essential for many voters. Tax increases are likely to encounter resistance from lobbyists representing groups who would shoulder the burden. While we remain optimistic that the government will take the necessary steps to stabilize government spending, we also acknowledge there may be bumps along the way. That said, we remain confident that defense spending will be fairly insulated.

Foreign Defense:  With growing concerns about international conflicts, key US allies are taking a harder look at their defense capabilities.

• The UK and Australia fortified their defense partnership on Thursday with a pact addressing China’s growing influence in the Indo-Pacific. This agreement streamlines troop deployments, further solidifying the ties established by the 2021 AUKUS defense pact. Meanwhile, in response to Russia’s escalating threat on the European continent, French President Emmanuel Macron has revived plans for EU defense bonds to bolster Europe’s military capabilities. However, this proposal faces an uphill battle as Germany remains staunchly opposed. Nonetheless, these moves reflect a broader Western trend of unease over rising threats from both Russia and China.
• The Ukraine invasion in 2022 marked a turning point for Western priorities. Previously, these nations prioritized domestic spending on social programs, often neglecting defense budgets. The war has triggered a significant shift. Western powers are now demonstrably reorienting their focus towards bolstering their own defenses and supporting allies in a climate of heightened security threats. This is evident in Europe’s recent surge in support for Ukraine, which has had a cascading effect, revitalizing the Continent’s defense industry. European defense stocks have surged 21% year-to-date, outperforming the US defense sector which has gained 5%.

• US allies, particularly in Europe, are investing in their own defense industries. Though, established US firms like Lockheed Martin, General Dynamics, and Northrop Grumman are well-positioned to remain key partners in the near future. These giants boast a proven track record of fulfilling allies’ growing demands for advanced weaponry. To capitalize on the expanding global defense market, they may look to expand through acquisitions and partnerships in other markets. This trend towards increased defense spending across the Western world bodes well for the industry as a whole.

Other News: Central banks in the West are taking a dovish turn, with the Bank of England signaling a potential rate cut later this year, and the Swiss National Bank taking a surprise step by lowering rates immediately. Yemen has told Russia and China that their ships will not be targeted; the move is further evidence of Iran’s growing influence on the conflict in the Red Sea. President Biden’s continued focus on reducing housing costs underscores the growing political importance of affordability.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the latest statement by a high-ranking European official warning of a possible war with Russia.  We next review a range of other foreign and US developments with the potential to affect the financial markets, including a new EU plan to finance weapons and ammunition for Ukraine in a way that could further bolster gold prices and another big subsidy to a major semiconductor firm to help it fund new factories and expansion projects here in the US.

European Union-Russia:  In an opinion piece in top European newspapers, European Council President Charles Michel added his voice to those warning that Western Europe is on the road to war with Russia.  In his article, Michel argues that no matter what territorial gains Russian dictator Vladimir Putin achieves in Ukraine, he will not stop there. Rather, he will continue trying to grab territory in Eastern Europe. Since the US may not come to Europe’s aid, despite its obvious interest in doing so, Michel argues that Europe must prepare to defend itself.

• According to Michel, “If we do not get the EU’s response right and do not give Ukraine enough support to stop Russia, we are next. If we want peace, we must prepare for war.”
• More to the point, Michel argued that Europe must rapidly shift to a “war economy” to deter further Russian aggression and prepare for hostilities.
• We agree that Putin’s apparent goal of re-establishing the Russian Empire would imply additional territorial grabs in Europe. So long as Ukraine continues to resist Moscow’s invasion, the Russian military is likely to have its hands full and may not directly threaten targets in Western Europe.  The threat to the West would likely come when and if Ukraine stops fighting.  At that point, the Russian military is likely to regroup and prepare for a renewed assault on Ukraine and/or Western Europe.
  • With the Russian military preoccupied and largely depleted as an offensive force in Ukraine, a future Russian assault on Western Europe may not involve a broad, multi-front attack on numerous countries simultaneously.
  • Rather, a near-term Russian offensive may well focus on specific, bite-sized territorial objectives, just as Nazi Germany initially focused on remilitarizing the Rhineland in March 1936, acquiring Austria in the Anschluss of March 1938, and then demanding and receiving the Sudetenland region of Czechoslovakia in September 1938.
• Initial Russian territorial claims following a victory in Ukraine might include taking control over Moldova and/or Georgia, where the Kremlin already has troops. Russia might also seek to take control over areas of Eastern Europe where the population has a lot of Russian speakers, or where Putin perceives European military vulnerabilities.

European Union-Russia-Ukraine:  The European Commission today unveiled a plan to help buy weapons for Ukraine by using the earnings on seized Russian assets.  Under the plan, 90% of the earnings on those assets would be diverted to the European Peace Facility, the main EU fund used to supply Ukraine with weapons, equipment, and ammunition.  The remaining 10% of earnings would go to the general EU budget to help Ukraine rebuild and expand its defense industry.  To come into effect, the plan will have to be approved by all EU member countries.

• If approved and implemented, the plan is expected to channel about 3 billion EUR ($3.25 billion) to Ukraine in 2024.
• US officials have supported using Russian assets seized as punishment for Moscow’s invasion, likely enticed by the poetic justice of making Russia itself pay for the damage it has caused. The risk, however, is that the US and EU moves to seize their adversaries’ sovereign assets will likely further fracture the global financial system, encouraging potential adversaries (especially countries in the China/Russia geopolitical bloc) to cut their use of the dollar or other Western currencies.
• In response to US seizures of Afghan and Russian assets in recent years, we think potential adversary governments are already directing their central banks to reduce their exposure to the greenback. One reflection of that is the recent jump in central bank gold purchases, which our analysis suggests is a key reason why gold prices have recently hit record highs.  If the new EU program is implemented, potential adversary governments will likely order their central banks to buy even more gold, boosting gold prices further.

Eurozone:  European Central Bank President Lagarde today said the ECB could cut its benchmark interest rate as early as June, but it can’t commit to a specific path of future rate cuts.  According to Lagarde, continued price pressures for services mean the central bank will have to stay flexible and data dependent as it loosens monetary policy going forward.  The statement suggests that both the Federal Reserve and the ECB want to maintain their room to maneuver and keep investors guessing as they cut rates in the coming months.

China:  Not only is the European Union shifting its economy to a war footing, but new research by the Center for Strategic and International Studies shows China has already shifted its economy to essentially the same status.  For example, the study shows that Chinese shipbuilding capacity is now approximately 230x current US capacity.  In contrast, the study assesses that the US defense industrial base is still operating at a peacetime pace.

US Monetary Policy:  The Federal Reserve’s policymaking committee wraps up its latest meeting today, with its decision and new economic projections due at 2:00 PM EDT.  The committee is widely expected to hold the benchmark fed funds interest-rate target at 5.25% to 5.50%.  The first cut is now expected in June.  Nevertheless, the policymakers could signal an earlier or later date for their first cut and may also announce an end to their quantitative tightening policy or other changes in their approach to policy.

US Military:  The Wall Street Journal carries a video today explaining the challenges faced by the US military as it replaces its Minuteman III strategic nuclear missiles with a more modern arsenal.  The video is a nice complement to our Bi-Weekly Geopolitical Report from March 11, in which we explored the US’s overall effort to modernize its nuclear deterrent and what the program means for investors. (Clearly, we at Confluence remain a step or two ahead of the Journal!)

US Semiconductor Industry:  The Commerce Department said it has awarded $8.5 billion to microprocessor giant Intel to help fund new computer chip plants and expansion projects in Arizona, Oregon, New Mexico, and Ohio.  The award is part of the roughly $50 billion provided for in the CHIPS and Science Act of 2022 to help bring more chip manufacturing back to the US and ensure secure supplies of the products.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment opens with confirmation that today the Bank of Japan ended its many years of negative interest rates.  We next review a range of other international and US developments with the potential to affect the financial markets, including reports that the European Union is preparing to impose punitive tariffs on grain and grain products from Russia and Belarus, and a preview of the Federal Reserve’s latest policy meeting starting today.

Japan:  As flagged in our Comment yesterday, the Bank of Japan today ended its eight-year policy of negative interest rates, dismantled its yield curve controls, and scrapped most other emergency policies it had adopted to fight the country’s past economic stagnation and deflation.  It set the new target for benchmark short-term interest rates at 0.0% to 0.1%.  Just as important, the central bank said it will stop setting a yield target for 10-year Japanese government bonds and cease buying stocks, real estate investment trusts, and other unorthodox investments.

• Despite taking the momentous step of ending their negative interest-rate era, the policymakers insisted that overall monetary policy will remain accommodative for the time being in order to support economic growth. Indeed, the policymakers said they would continue buying Japanese government bonds.
• Since the move was well telegraphed over the last several months, today’s announcement has had little impact on financial markets. Japanese stocks today appreciated modestly, and the yen (JPY) weakened 0.9% to 150.44 per dollar.

China-Hong Kong:  The Hong Kong municipal government today unanimously passed a controversial new national security law to supplement the security law imposed by Beijing on the territory in 2020 and align the city’s security rules with those of mainland China.  Among the tough new provisions in the law, treason could be punished by life in prison, and sedition could be punished by two to seven years in jail.

• Stealing or disclosing “state secrets” could be punished by up to 10 years in jail.
• Importantly, the law broadens the definition of state secrets to include information about the economic, technological, or scientific development of Hong Kong or mainland China.
• The new law has therefore struck fear in the hearts of foreigners working in Hong Kong, who now worry that they could more easily be arrested merely for handling business data. Those concerns are likely to make the new law another point of tension between China and the West and make Hong Kong a less attractive place to do business.

European Union-Russia-Belarus:  The European Commission is reportedly preparing to impose punitive tariffs on Russian and Belarusian grain and grain products for the first time.  The plans reportedly call for tariffs of 95 EUR per ton on the affected grains, which would raise their price by about 50% and effectively push them out of the EU market.  The move would in large part be punishment for Russia’s invasion of Ukraine and its repression at home.

• Nevertheless, the move is also apparently an effort to respond to Europe’s restive farmers, who have been complaining not only about EU regulations but also about surging imports from the east amid the disruptions of the war in Ukraine.
• Even though Russian grain and grain products only account for about 1% of the EU market, the tariffs can be presented as protection for farmers’ economic interests.

European Defense Industry:  In a report last week, the North Atlantic Treaty Organization said 11 of the alliance’s current 32 members met the NATO standard of spending at least 2% of gross domestic product on defense in 2023.  As a group, the European NATO members met the 2% standard, helped by especially high defense spending in countries like Poland and Greece.  The report also said two-thirds of the NATO countries should achieve the 2% standard in 2024.

• The total European NATO defense spending of $470 billion in 2023 helps explain the strong performance of European defense stocks over the last year, which we mentioned in our Comment
• To help illustrate the recent strong performance of European defense stocks, the chart below shows that they have actually outperformed the US’s vaunted Magnificent 7 large-cap technology stocks so far in 2024.

US Monetary Policy:  The Federal Reserve’s policymaking committee begins its latest meeting today, with its decision due on Wednesday at 2:00 PM EDT.  The Federal Open Market Committee is widely expected to hold the benchmark fed funds interest-rate target at its current range from 5.25% to 5.50%.  The first cut is now expected in June.  Nevertheless, the policymakers could signal an earlier or later date for their first cut and may also announce an end to their quantitative tightening policy or other changes in their approach to policy,

US Fiscal Policy:  The White House and Congressional negotiators last night resolved a last-minute dispute over border enforcement spending, setting the stage for Congress to pass the remaining six appropriations bills for the remainder of the federal fiscal year before the current stop-gap spending bill runs out on Friday.  The process of getting those bills passed and signed into law could still lead to a partial shutdown of the government, but it appears any shutdown would last at most a few days and would not be very disruptive.

US Artificial Intelligence Industry:  Reports yesterday said technology giants Apple and Google are in talks to include Google’s generative AI system Gemini into Apple’s iPhones.  The news sparked significant increases in each company’s stock price yesterday, based on hopes that such a deal would reinvigorate Apple’s iPhone franchise and give Google added scale in the evolving AI “arms race.”  Nevertheless, we note that such an outcome assumes that regulators approve any such deal.

• Separately, AI chipmaker Nvidia also saw its stock price jump as it prepared to announce a new generation of AI processors that will be much faster and bigger than its current blockbuster H100 series.
• The new chips from Nvidia are expected to be available later this year, helping ease the current shortage of H100 chips.

US Nuclear Energy Industry:  TerraPower, a company started by Microsoft founder Bill Gates, said it will begin building the nation’s first liquid-sodium cooled nuclear reactor by June, with expectations that it will only cost half as much as a conventional water-cooled reactor and be generating electricity by 2030.  The announcement shows how the US is trying to compete in building a new generation of cheaper, more efficient nuclear generating plants using innovative cooling technologies and small, modular designs to cut costs and shorten construction periods.

US Auto Industry:  The United Auto Workers filed a petition yesterday with the National Labor Relations Board requesting a unionization vote of the 4,000 or so workers at Volkswagen’s car factory in Chattanooga, Tennessee.  According to the UAW, a “supermajority” of workers at the plant have signed a petition expressing an interest in joining the union.  If the unionization effort is successful, it would mark the first organization of a US auto plant not affiliated with one of the Detroit Three automakers.

US Defense Industry:  As the US struggles to boost its output of nuclear-powered submarines to counter rising threats from the China/Russia geopolitical bloc, Newport News Shipbuilding, a unit of defense giant Huntington Ingalls, has announced that it is trying to hire 3,000 skilled tradesmen this year and 19,000 within the next decade.  Meanwhile, the Hampton Roads Workforce Council warned that the Virginia region’s maritime shipbuilding vacancies could rise to 40,000 by 2030 if more workers can’t be drawn into the market.

• The Newport News announcement highlights the US’s rising demand for skilled tradespeople, such as welders and pipefitters. The rise in demand reflects factors such as near-shoring production within the US, increased factory construction, and rising defense budgets.
• In contrast, the decades-long advantage of college-educated workers continues to be eroded. The result is likely to be a rebalancing of opportunities in the labor market, with skilled tradesmen now enjoying more demand vis-á-vis the college educated.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the Bank of Japan’s likely abandonment of negative interest rates this week.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including news that even Beijing-friendly emerging markets are starting to push back against China’s surging exports and big changes coming in the US commercial and residential real estate markets.

Japan:  Sources say the Bank of Japan finally plans to end its negative interest rate policy at its two-day policy meeting that begins today, based on its assessment that the economy has at last achieved a virtuous cycle of moderate wage gains and modest price inflation. The revised policy rate of 0.0% or more would mark Japan’s first non-negative interest rate since 2016. Nevertheless, BOJ policymakers have signaled that they will still keep their benchmark rate accommodative, probably in the range of 0.0% to 0.1%.

• One implication of higher (or at least non-negative) interest rates in Japan is that the country’s investors may be tempted to repatriate the enormous sums they’ve invested abroad in search of better yields. A new survey by Bloomberg shows that about 40% of investment managers think Japanese investors will be tempted to start bringing capital back home at the first rate hike.
• News reports on the Bloomberg story emphasized that “only” 40% of investment managers think the Japanese would be tempted to repatriate funds early. To us, 40% sounds like a significant slice.  In any case, large amounts of capital shifting back to Japan would likely boost the yen (JPY) and potentially take some of the wind out of US stocks and bonds.

China-Brazil:  New reporting says the Brazilian government has launched several anti-dumping investigations as imports of Chinese industrial products soar.  The probes target products ranging from steel and chemicals to tires and could ultimately result in the imposition of tariffs, as demanded by Brazilian industries.  However, to avoid antagonizing Beijing and to preserve Brazil’s access to the Chinese market for agricultural products, Brazilian President Lula da Silva will probably try to minimize any trade barriers against China.

• We have long argued that China will eventually adopt a neo-colonial relationship with the other members of its evolving geopolitical and economic bloc. To absorb its massive excess capacity and help pay the associated debts, Beijing will focus on exporting cheap, relatively advanced manufactured products to its friends, largely transforming them into mere commodity suppliers to China.  As in classic colonialism, the result would be big trade surpluses for China and trade deficits for its partners.
• In our analysis, Brazil is still a member of the China-leaning bloc. It is not quite a Chinese colony yet, and it still maintains a trade surplus with China.  As Lula faces the domestic political costs of the evolving China-Brazil trade relationship, a big question is whether he will accept those costs and be drawn closer into the China bloc or resist them and stay out of that camp.
• With China’s excess industrial capacity and debt prompting ever-increasing exports at predatory prices, we note that several other emerging markets have also recently taken steps to protect their domestic markets from the Chinese onslaught, as have some major developed countries. Both the threat to domestic manufacturers and the potential pushback against Chinese exporters will likely have big implications for global investors in the coming months.

China:  January-February industrial production was up a solid 7% year-over-year, beating expectations and marking the strongest annual growth in almost two years.  However, other data showed property investment was down 9% year-over-year in the same period, and new construction starts were down 30%.  The figures suggest manufacturers are seeing some benefit from the government’s modest stimulus measures, but with domestic demand weak, a lot of the new output will likely be exported at low, dumping-level prices.

India:  The Electoral Commission of India announced on Saturday that the next parliamentary elections will begin on April 19, with the voting staggered across the country’s various states and due to wrap up on June 1.  Prime Minister Modi and his Hindu nationalist Bharatiya Janata Party are widely expected to win the lower house of parliament, giving Modi a third five-year term.  A win by the pro-US, business-friendly Modi would likely be taken positively by investors.

Pakistan-Afghanistan:  The Pakistani military this morning launched airstrikes against Islamist militants in Afghanistan after accusing them of conducting attacks in Pakistan over the weekend.  The Taliban government in Kabul condemned the strikes as a violation of its territory.  However, given militants based in Afghanistan have increasingly launched attacks on Pakistan since the Taliban took power in 2021, the Pakistanis appear to have had enough and may now continue their airstrikes until the militant threat is reduced.

Russia:  In the presidential election completed yesterday, President Putin appears to be on track to win a new term in office that will allow him to rule until 2030.  With some 25% of the ballots counted, Putin was reportedly winning 88% of the votes.  Of course, with all potentially competitive opposition candidates barred from participating, the election is in no way free or fair.  Nevertheless, Putin is sure to trumpet the result as a mandate justifying his autocratic rule.

European Union:  The Wall Street Journal today carries an article explaining the continued rapid rise of European defense stocks as governments boost their purchases of ammunition, military equipment, and weapons.  The article notes that European governments are rapidly boosting their defense budgets not only in fear of Russian aggression but also in response to former President Trump’s hints that he might renege on US commitments under NATO’s mutual defense treaty.

• The article is consistent with our oft-written belief that defense spending is likely to rise around the world in the coming years, creating potential investment opportunities in defense companies and other firms that have a lot of defense business.
• Notably, European defense stocks outperformed those of the US over the last year, probably because of the Europeans’ greater urgency to rearm and the US’s continued fiscal squabbles.

Cuba:  Prompted by recent electricity blackouts and food shortages, hundreds of protesters took to the streets in two cities over the weekend.  In response, the government shut down mobile internet service, just as it did to short-circuit similar protests in July 2021.

Global Cocoa Market:  In bad news for chocolate lovers everywhere (doesn’t everyone love chocolate?), global cocoa prices late last week set a new record high for the first time since 1977.  The price of near cocoa futures rose $1,105 per metric ton on Thursday and Friday to reach $8,018 per ton, three times the price from one year ago.  Prices so far this morning have topped $8,400 per ton.  Cocoa prices are rising in response to bad weather in West Africa, where most of the world’s supply is grown.

(Source: Wall Street Journal)

US Monetary Policy:  In a Financial Times poll of academic economists, more than two-thirds of respondents thought the Federal Reserve would cut interest rates no more than two times in 2024, with the first cut coming in late summer.  Even though investors have begun to come around to the fact that the Fed is likely to hold rates higher for longer than anticipated, the poll suggests market participants may still be expecting too many rate cuts this year.

US Labor Market:  In what is likely to become a politically controversial position, economists at Goldman Sachs have released analysis suggesting that strong net immigration in 2023 was a key reason why the US economy and payrolls were able to rise so much but didn’t put further upward pressure on consumer price inflation.  Looking forward, the analysts think continued strong immigration will continue to boost the US’s potential economic growth in 2024 while also keeping a lid on wages and inflation.

US Commercial Real Estate Market:  New data from Kastle Systems shows that even on their peak occupancy days, office buildings in 10 major cities are still filled with only about 61.7% of the employees they had before the COVID-19 pandemic.  Moreover, the rate of improvement has slowed to a crawl.  The data suggests that office buildings and the debt that backs them will remain a significant financial risk in the coming months and years.

US Residential Real Estate Market:  The National Association of Realtors on Friday said it has reached a deal to settle the multiple lawsuits it has been fighting over its standard practice of charging home sellers a commission of about 6%, split between the seller’s and buyer’s agents.  Under the deal, commissions will now be negotiated between the seller and his/her agent, and between the buyer and his/her agent.  Total commissions are expected to fall to 3% to 4%, sharply reducing realtor income and leading to a mass exit from the industry.

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