by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several notes on China’s worsening relations with the U.S. and other members of the U.S. geopolitical and economic bloc.  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 an inconclusive election in Spain, growing protests against a judicial reform in Israel, and a blockbuster weekend at the movies in the U.S.

China-United States:  The Chinese government has opened an anti-dumping investigation into U.S. propionic acid, an important preservative for products ranging from foods to medicines.  The probe will last for one year, but it could be extended to as late as January 2025, at which point the government could take steps to block or reduce U.S. sales of the chemical in China.

• The anti-dumping investigation follows fast on the heels of the government’s recent move to require a license for the export of gallium and germanium, key metals for the production of high-technology goods such as semiconductors. It also follows an enforcement action that limited the Chinese sale of products from U.S. technology firm Micron Technology (MU, $65.65).
• Along with those actions, the anti-dumping probe appears to be retaliation for last year’s U.S. clamp down on sending advanced semiconductor technology to China.
• In any case, the Chinese move is just the latest evidence that U.S.-China tensions continue to worsen, presenting challenges and risks for investors.

China-Canada:  The Canadian government on Friday charged a retired Royal Canadian Mounted Police officer with foreign interference, saying he helped China “identify and intimidate” someone in Canada at the behest of the Chinese government.  The case appears to be another example of China trying to secretly extend its policing power and Communist Party discipline against Chinese people living abroad, sometimes through secret foreign police stations.

• Just as China’s Ministry of State Security often pressures ethnic Chinese abroad to spy for it, the latest Canadian case also involved an ethnic Chinese.
• The charged RCMP officer reportedly emigrated to Canada from Hong Kong.

China-Taiwan:  New satellite imagery of Chinese military bases and defense industry factories shows the country has been rapidly replacing its short-range missile arsenal on the southeastern coast facing Taiwan with much more capable medium-range missiles.  The new missiles being deployed include the DF-17 and DF-24, which can not only travel more than 1,000 miles, but are also fitted with hypersonic glide vehicles that could evade U.S. air defense systems.

• If the Chinese military launches an effort to take control of Taiwan, analysts suspect its first step will be to send waves of these missiles to take out U.S. and allied bases in places like Guam and Japan. The missiles could also be used to take out capital warships, such as aircraft carriers.
• The reports also indicate the new medium-range missiles are sometimes being deployed in close proximity to China’s strategic nuclear bases. That likely aims at discouraging the U.S. from any effort to destroy the missiles preemptively, since any such attack might damage Chinese strategic forces and increase the risk of a counterattack against the U.S.
• As with China’s aggressive build-up of its inter-continental ballistic missile force, which looks set to give China as many strategic nuclear weapons as the U.S., the roll-out of more medium-range missiles is likely to increase the bipartisan U.S. effort to address China’s growing military threat.

Russia-Ukraine War:  Following fast on Russia’s withdrawal last week from the deal allowing Ukraine to export grain from its southern ports, Russian forces have redoubled their missile attacks on Ukraine’s grain storage and export facilities.  The Russian strikes today hit a key terminal close to the border with NATO member Romania, raising the risk of escalation.  Meanwhile, the Ukrainians apparently launched a number of drone strikes against targets in central Moscow and in Crimea.  So far this morning, the result has been a further boost to global grain prices.  At this writing, U.S. wheat prices are up 5.2% to $7.34 per bushel.  Corn prices are up 4.0% to $5.56 per bushel.

European Union:  Hamburg Commercial Bank said its “flash” HCOB purchasing managers’ index for the eurozone fell to an eight-month low of 48.9, well below the expected reading of 49.7 and the June reading of 49.9.  Like all major PMIs, the HCOB index is designed so that readings below 50 indicate contracting activity.  Today’s release showed that the main weakness in the eurozone is in the manufacturing sector.  The subindex on factory activity fell all the way to a 38-month low of 42.7.

• The reading points to worsening recessionary conditions in the eurozone in the coming months. In turn, that could convince the European Central Bank to halt or pause its interest-rate hikes following an expected 25-basis point increase this Thursday.
• Reflecting that, European bond yields are dropping today, and the value of the euro has declined 0.3% to $1.1088.

Spain:  In elections yesterday, Alberto Núñez Feijóo and his center-right People’s Party won the most seats in parliament, but not enough to give it a clear shot at forming a governing coalition even if it teams up with the far-right Vox Party.  In contrast, Prime Minister Pedro Sánchez and his Socialist Party out-performed expectations and won enough seats to give it a fighting chance at a forming a majority grouping.  The results are an unexpected setback for right-wing populism in Europe and will set the stage for a period of inter-party wrangling and potential new elections in Spain.

Israel:  Prime Minister Netanyahu and his right-wing coalition in parliament will press ahead with a vote on a controversial judicial reform today.  The renewed push to limit the supreme court’s power to nix legislation has sparked mass protests and strikes.  The potential for political unrest and economic disruptions could weigh on Israeli assets in the coming days and weeks.

U.S. Monetary Policy:  Officials at the Federal Reserve will hold their latest two-day policy meeting this week, with their decision due to be released at 2:00 PM EDT on Wednesday.  Along with most other analysts, we suspect that continued strong wage gains and price pressures will prompt them to hike the benchmark fed funds interest rate further after pausing last month.  All the same, some other analysts think recent signs of modest economic slowing could convince them to hold rates steady again and simply signal the potential for more rate hikes later.

U.S. Stock Market:  After an 18-month drought in initial public offerings, a wildly successful IPO last week is raising hopes for a revival of deals in the coming months.  Based on last week’s strong performance of Oddity Tech (ODD, $52.56), the parent of direct-to-consumer beauty brand Il Makiage, it appears that investor demand for new companies is strong.  Moreover, the group of companies looking to come to market appears to be stronger than usual, since the hiatus in deals allowed many small firms to focus on consolidating their business and cutting costs.

U.S. Movie Theater Industry:  Despite ongoing concerns that the movie theater industry may never recover from the pandemic, the latest data suggests Barbie generated gross revenues of $155 million and Oppenheimer grossed $80 million over the weekend.  That would mark the first time in history that a three-day weekend has seen one movie open to $100 million or more and another to $50 million or more. It would also mark the fourth-biggest weekend of all time at the domestic box office.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with an explanation of why today could be a rocky day for markets. Next, we will discuss two major developments that may reshape international finance. Finally, we will share our thoughts on the Spanish elections occurring on Sunday.

Triple the Effect: A trifecta of events will weigh on market activity on Friday: a reshuffling of a popular tech index, the expiration of option contracts, and the release of corporate earnings.

• The tech-heavy Nasdaq 100 index is undergoing a special rebalance today to address concerns about the weighting of mega tech companies. The index is typically rebalanced quarterly, but an exception was made earlier this month due to the growing dominance of these companies. Boosted by the excitement of artificial intelligence, the top five tech companies now account for over 50% of the index, significantly higher than the 40% cap typically preferred by the providers. The special rebalance will reduce the weightings of these companies and increase the influence of smaller companies. This will likely lead to increased volatility in the market as investors adjust their portfolios accordingly.
• In addition to the Nasdaq 100 rebalance, an estimated $2.4 trillion worth of options tied to stocks and indexes are set to mature. The expiration of these contracts will likely impact trading activity as investors decide whether they would like to roll over existing positions or start new ones. July has been the slowest month of trading in two years, and there is speculation that investors may be sitting on the sidelines until there is more clarity about the future direction of monetary policy. If investors do decide to roll over their options, it could lead to a surge in trading volume and volatility. However, if investors decide to start new positions, it could lead to more sustained performance.

• Finally, the day is likely to be heavily influenced by corporate earnings releases. Several companies are expected to report their results, including regional lenders Comerica (CMA, $52.93) and Regions (RF, $20.35), as well as credit card company American Express (AXP, $177.11). Comerica and Regions are expected to give insights into the deposit market, important information given the fears of disintermediation. At the same time, American Express’s earnings will provide information on the discretionary spending habits of consumers. The results could have a significant impact on the direction of the market in the coming weeks as it may give investors a better sense of the state of the economy.

Institutional Shifts: The World Bank and the Federal Reserve have made major announcements that suggest both organizations are looking to modernize.

• The Chinese-backed Asian Infrastructure Investment Bank (AIIB) has joined forces with the World Bank. The deal with the AIIB will help alleviate the World Bank’s financial constraints. However, this new partnership is likely to raise eyebrows, as it comes weeks after reports that members of the Chinese Communist Party infiltrated the bank. Suspicions of Chinese involvement in the World Bank led Canada to withdraw its membership from the multilateral organization. The move also comes as the two supranational financial institutions look to restructure the debt of emerging market companies.
• The Federal Reserve in the United States has upgraded its payment system to make it easier for Americans to transfer money. FedNow is a much-needed shift in a banking system where people still rely on paper checks and cash to send payments through Automated Clearing House (ACH) transfers, which can take several days to process. Although banks still need to sign up for the new system, its implementation is expected to lead to some disruption. The real-time payment system network should increase competition among credit card companies and offer new opportunities for fintech companies.

• These two developments show how the world is slowly adapting to a new normal. China is one of the world’s largest creditors, and its partnership with the World Bank makes sense given its influence in developing countries. Meanwhile, the U.S.’s current payment system is antiquated and needed to be improved to keep up with the demands of a world that is increasingly dominated by digital transactions. Taken together, these reports reflect how difficult it is for the financial system to keep up with changing trends as one could argue that both events should have happened much earlier.

¿A La Derecha? The upcoming Spanish election is widely expected to result in a rightward shift in the country’s political landscape.

• Recent polls suggest that the Popular Party (PP), led by Alberto Núñez Feijóo, is poised to win the most votes in the upcoming Spanish election taking place on Sunday. This would put the PP in a strong position to form a government. However, there is speculation that Feijóo may seek to form a coalition with the controversial Vox party. The far-right group has been accused of racism, xenophobia, and Islamophobia. If Feijóo were to form a coalition with Vox, it would be a significant shift in Spanish politics, as it would give a far-right party a seat in parliament for the first time since the end of Francisco Franco’s rule in 1975.
• The rise of populist parties in the European Union is linked to the bloc’s encouragement of unpopular reforms. In Spain, for example, the government barely passed a labor reform in order to unlock pandemic funds last year. Similarly, pressure to push through reforms in Italy helped lead to the ouster of Mario Draghi from the premiership. Meanwhile, French President Emmanuel Macron’s controversial pension reforms have boosted support for his political rival, Marine Le Pen. This situation will likely worsen as the European Central Bank plows ahead with rate increases despite signs that inflation is slowing, and the region narrowly avoided a technical recession in Q2 of 2023.

• The European Union’s inability to adapt to each country’s individual needs is a major weakness that could undermine the bloc’s ability to function in the future. This is evident in the fact that Spain will be subject to tighter monetary policy despite the fact that it is making better progress in its inflation fight than other countries. This lack of flexibility could lead to more populist leaders being elected in the EU, who would likely look to protect their countries’ interests, even if it means going against the bloc. As a result, if this trend continues, it could lead to a much weaker euro in the future.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our concerns about the banking sector. We then discuss how the war in Ukraine and El Niño could impact Fed policy. Finally, we explain why the recent improvement in U.S.-China relations may be short-lived.

Deposit Flight: While banks have mostly recovered from the March fiasco, disintermediation remains a challenge.

• Three of the country’s biggest banks by assets were able to beat expectations in the second quarter. JP Morgan (JPM, $154.25), Citigroup (C, $47.52), and Wells Fargo (WFC, $46.26) made a combined profit of $22.3 billion going into the year’s second half, thanks in part to hawkish Fed policy. The surge in interest rates have benefited banks in two ways. First, they were able to charge more for loans, which increased their net interest income. Second, the banking crisis in March led to an increase in deposits at major banks as savers fled regional banks. This surge in new clients made it easier for banks to lend out capital. However, it is unclear whether this trend will continue into the third quarter.
• Several major headwinds are expected to plague banks over the next few months. First, as interest rates rise, customers are pushing for more compensation for their deposits. In fact, institutional depositors are already moving their savings to higher-yielding accounts. Second, the prospect of new regulations and loan losses from commercial real estate is forcing banks to shore up their balance sheets. For example, U.S. Bancorp (USB, $38.68) announced that it has increased its Common Equity Tier 1 (CET1) by 60 basis points, offloaded assets, and securitized auto loans in order to reduce its balance sheet exposure. On top of that, banks have noticed that households are holding back on spending, and credit card losses are increasing.

• The good news is that deposits at commercial banks have stabilized since the fall of Silicon Valley Bank. However, these holdings will be under threat as long as the Fed keeps raising rates. Regional lenders are the most sensitive to interest rate changes, as evidenced by the deposit outflows reported by U.S. Bancorp, Citizens (CFG, $31.06), M&T Bank (MTB, $138.08), and Charles Schwab (SCHW, $66.00) in the second quarter. Even Bank of America (BAC, $31.40), the second-largest bank by assets, saw a deposit flight. If bankers are forced to pay more on deposits, it could lead to even higher borrowing costs and further weigh on consumer spending. As a result, we are still paying close attention to the banking system.

It’s Hot in Here: Adverse weather conditions and the war in Ukraine could complicate Fed efforts to ease monetary policy.

• Temperatures in the United States, Europe, and Asia have reached record highs this year, driven by relatively strong El Niño conditions. Global ocean temperatures have exceeded the 20^th-century average by 1.89 F, according to the National Oceanic and Atmospheric Administration. The unusually hot weather has pushed up energy consumption in the United States, with power demand in Texas and Arizona expected to set records. The unprecedented heatwave has also led to wildfires in Greece and Canada. Additionally, there are concerns that poor conditions could hurt crop yields.

• At the same time, the war in Ukraine is also leading to uncertainty regarding food prices. On Wednesday, Russia announced it would consider all vessels headed to Ukrainian ports to be military threats. The declaration comes a week after Moscow pulled out of the Black Sea grain deal. Wheat futures surged 8% following the report as investors expect grain supply to fall. So far, grain prices remain lower than at the start of the year; however, they could rise if shipments are disrupted or become more expensive to insure. This may lead to an increase in food inflation just as cost pressures were trending downward.

• Adverse weather conditions and the war in Ukraine are likely to dissuade talks of policy cuts. Central banks appear to be indifferent as to whether inflation is supply- or demand-driven. They are instead focused on containing price pressures, regardless of the source. As the chart above shows, most of the progress made in U.S. inflation has come from supply-side factors. Hence, supply disruptions could reverse some of the gains made in the inflation fight. While this does not necessarily mean that they will continue to raise interest rates, they are less likely to consider a cut if there is a chance of inflation accelerating.

There Is a Glimmer: Despite ongoing friction between the two global superpowers, there are signs that both sides are willing to de-escalate and avoid direct conflict.

• The U.S. and China are taking tentative steps to improve relations while trying to avoid actions that could provoke the other side. On Thursday, Washington officials rebuked Taiwanese presidential frontrunner Lai Ching-te’s assertion that his country’s political goal is to “enter the White House.” The “One China” policy prohibits top Taiwanese officials from making official visits to Washington. Meanwhile, Beijing has finally started holding diplomatic talks with U.S. representatives. Special Presidential Envoy John Kerry agreed with his Chinese counterpart to continue to hold discussions about climate change goals. Additionally, Chinese President Xi Jinping met with former Secretary of State Henry Kissinger to discuss warmer U.S.-China ties.

• That said, the two largest economies in the world will continue to take steps to protect their own interests. On Wednesday, China’s envoy to Washington warned that his country would respond if the U.S. proceeds with pushing through laws that hurt China’s advancement in military technology. The threat comes amidst speculation that the Biden administration is considering limiting investment into companies linked to the Chinese defense industry. Although White House officials maintain that the restrictions will be limited in scope, it is possible that the measure could pave the way for more discussion regarding the topic, especially going into the 2024 election.

• A deceleration in the global economy is likely to slow the pace of the decoupling between the United States and China, but it is unlikely to disrupt it entirely. The two countries are deeply interconnected, and both would suffer if there were a complete break in economic ties. China’s economic recovery will receive a boost from an increase in exports to the United States and maintaining access to China’s supply chains and materials will help the United States with its green energy transition and prevent trade disruptions. However, trade between the two countries is unlikely to return to its pre-pandemic pace anytime soon.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with good news on consumer price inflation in the United Kingdom, which has helped push down bond yields so far this morning.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including news that Russian President Putin is handing control of expropriated Western assets to his cronies and a discussion of new antitrust policies issued yesterday in the U.S.

United Kingdom:  The June consumer price index was up just 7.9% from the same month one year earlier, much cooler than expected after the rise of 8.7% in the year to May.  Obviously, the U.K. inflation rate remains very high, but it now appears it could be on the verge of falling more rapidly, as the U.S. inflation rate has.

• The moderation in inflation has sparked hopes that the Bank of England might respond by slowing or stopping its aggressive interest rate hikes.
• That hope has sparked a furious rally in U.K. government bond prices so far today, driving yields lower. Currently, the yield on the benchmark two-year Gilt has fallen sharply to 4.858%, while the yield on the 10-year Gilt has declined to 4.185%.  The yield on 10-year U.S. Treasury notes has fallen only modestly to 3.763%.
• The sharp decline in U.K. yields has also pushed down the value of the pound so far today. At this writing, the GBP is trading down 1.0% versus the dollar, to $1.2910.

Japan:  In contrast with the pound’s fall today, the yen (JPY) continues to rally in response to investor expectations that the Bank of Japan will soon loosen its policy of yield curve control and allow longer-term bond yields to rise.  So far this morning, the JPY is trading up 0.8% to 139.94 per dollar ($0.0071 per JPY).  That translates to an increase of approximately 4.0% just in July.

China:  Foreign Minister Qin Gang has not been seen in public now for almost a full month, and with government spokesmen unable to give a consistent explanation of his whereabouts, rumors are swirling about what might have happened.  The rumors range from a health issue to the possibility that he has been caught up in some kind of scandal.

• Of course, Communist Party Foreign Affairs Chief Wang Yi remains very much in the public’s view. Therefore, no matter what has happened to Qin, it wouldn’t necessarily mean a substantial change in China’s foreign policy.
• All the same, Qin’s mysterious absence raises questions about Chinese leadership politics and policy disputes.

Russia:  Days after the government “temporarily” seized the Russian assets of French dairy firm Danone (DANOY, $12.42) and Danish brewer Carlsberg (CABGY, $30.63), new reporting says President Putin ordered the expropriations after businessmen close to the Kremlin expressed an interest in the businesses.  The key allies of Putin were named to lead the companies yesterday.  The transfers are being widely seen as a sign that other seized Western assets in Russia will be transferred to Putin loyalists.

Thailand:  The constitutional court yesterday temporarily suspended the parliamentary duties of Pita Limjaroenrat, leader of the progressive Move Forward Party that won May’s elections.  The suspension gave conservatives in the senate an opening to declare Pita ineligible to serve as prime minister, adding to their moves against his premiership last week.

• The maneuvers involving the constitutional court and senate illustrate how Thailand’s conservative establishment of generals, oligarchs, and royal officials are determined to keep Pita out of power.
• Some of Pita’s supporters have called for mass protests in the streets, creating a risk of political instability in what we consider a member of the evolving U.S. geopolitical and economic bloc. Indeed, Thailand has been benefiting as global businesses and investors shift away from the China/Russia bloc.

Kenya:  Opposition leaders, including the former prime minister and five-time presidential candidate Raila Odinga, have called for three days of mass protests against new taxes signed into law last month by President William Ruto.  Previous violent demonstrations in recent weeks have already killed dozens, despite widespread beliefs that the conflict is really a personal feud fed by Odinga’s frustration at never having won the presidency.

United States-North Korea:  A low-ranking U.S. soldier stationed in South Korea yesterday crossed into North Korea and was taken into custody, apparently in a willful effort to escape prosecution for an assault charge south of the border.  The soldier is now the only known U.S. citizen in North Korean custody, potentially creating more tensions between the two countries.

U.S. Antitrust Policy:  In an announcement yesterday, the Justice Department and the Federal Trade Commission jointly issued draft guidelines on how they will police proposed mergers.  According to the agencies, the new guidelines have been designed to reflect current business practices and recent court rulings on company combinations.

• For the first time, the guidelines explicitly address problems that can result from deals involving dominant technology companies and private-equity firms.
• In another first, the guidelines say the agencies will examine whether a merger will leave the combined company so dominant in a local labor market that it reduces the competition for workers, potentially pushing down their wages.

U.S. Stock Market:  New research from S&P Global (SPGI, $421.85) found that nonfinancial investment-grade companies in the S&P 500 stock index cut their total operating expenses by 5.3% in the first quarter.  The figures illustrate the way firms turned their attention to cost cutting as wages and interest rates rose and sales growth slowed in the period.  Nevertheless, the cost cuts were mostly offset by a 3.9% fall in sales, leaving only a small rise in operating profits.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news that the U.S. is sending more military forces to the Middle East to counter Iranian mischief there.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a warning from the International Energy Agency that Europe remains vulnerable to energy shortages and price hikes, and news of a deal that will postpone the day when U.S. companies will face higher taxes from the OECD-brokered agreement on minimum corporate tax rates.

United States-Iran:  As Iranian forces ramp up their harassment of ships in the Persian Gulf, the U.S. has decided to deploy advanced F-35 fighter jets, additional F-16 fighter jets, and an additional Navy destroyer to the region.  While the move is likely to help deter Iran from trying to seize more foreign tankers, it will also raise the risk of an accidental confrontation that would boost energy prices and slow economic growth around the world.

• Iran’s recent aggressive harassment in the region is partly a result of the U.S.’s effort to shift its military power out of the region and to focus more on Great Powers like China and Russia.
• It also reflects the shortage of U.S. Navy ships available to deploy to the Middle East. Throughout the War on Terror and its immediate aftermath, the Navy’s combat force, currently at about 294 ships, has been only a fraction of its size during the Cold War.

China-Russia:  The Chinese and Russian navies this week are holding joint exercises in the waters that separate Japan from Russia and South Korea.  The maneuvers are further evidence that the countries are increasing their military cooperation to bolster their ability to project power internationally.  Even though Russia’s ground forces are still mired in their disastrous invasion of Ukraine, the country’s naval forces remain quite capable and can offer synergies to the world-leading Chinese navy.  As the China-Russia bloc increases its effort to project power globally, tensions with the West are unlikely to ease significantly.

China:  In recent days, Zhejiang province has cleared its website of recent data which showed a jump in cremations after President Xi ended his strict Zero-COVID lockdowns late last year.  The data had shown that cremations in the province jumped to 171,000 in the first quarter of 2023, compared with first-quarter readings of just 99,000 in 2022 and 91,000 in 2021.  The figures had been widely discussed on social media as evidence that lifting the pandemic restrictions so suddenly caused a surge in excess deaths.

• It appears that the data was wiped off Zhejiang’s website because the implied jump in deaths is an embarrassment to the government.
• The move is also a reminder that rising deaths and sickness from the coronavirus could be adding to the other headwinds that are slowing China’s economic recovery, including weak exports, high corporate debt, worsening government intrusion into the economy, and consumers trying to rebuild their finances after the pandemic lockdowns.

Russia-Ukraine War:  The Saudi and Turkish governments are reportedly trying to broker a deal to repatriate Ukrainian children taken to Russia and held in children’s homes or adopted by Russian families.  According to the reports, officials in Kyiv and Moscow are compiling lists of the thousands of children moved to Russia since President Putin’s invasion of Ukraine, as part of the mediation process.  That points to at least some measure of cooperation and raises hopes for a return of the seized children.

European Union:  The International Energy Agency warned that even if Western Europe’s natural gas storage facilities are 100% by this winter, the agency’s modeling shows the region could still face shortages and price spikes if the winter is cold and Russia shuts off its remaining exports.  The EU’s gas storage currently stands above 80% of capacity, nearly 20% above the previous five-year average.

United Kingdom:  Sticky consumer price inflation and the likelihood of further interest-rate hikes by the Bank of England have pushed U.K. government bond yields well above those of other major developed economies.  At this writing, 10-year Gilts today are trading to yield 4.370%, versus 3.977% for Australian obligations, 3.774% for U.S. Treasurys, and 2.405% for German bonds.  The surge in U.K. yields illustrates the risk in longer-maturity U.S. bonds, which could be repriced lower if investors swing around to the idea that U.S. inflation will be higher and more volatile in the future.

U.S. Corporate Tax Policy:  The Treasury Department yesterday struck a deal with the Organization for Economic Cooperation and Development that will give U.S. companies an extra year, until 2026, before they will face higher foreign taxes under the OECD-brokered global agreement on minimum corporate taxes.  The deal also preserves favorable treatment for U.S. tax credits.

U.S. Telecommunications Industry:  The Wall Street Journal’s recent series on the telecom industry’s use of lead-sheathed cables helped crush the shares of major incumbents such as AT&T (T, $13,53) and Verizon (VZ, $31.46) yesterday.  Those two companies and several smaller firms suffered sharp declines in their stock price as Congress looks set to get involved and investors begin to expect major regulatory issues and mitigation costs.  The firms’ stock prices have also been hurt by their high debt levels in the face of rising interest rates, the slowing real estate market, and the end of the 5G technology roll-out.

U.S. Consumer Spending:  Despite today’s data showing a rise in June retail sales, new analysis from Bank of America (BAC, $29.40) shows that renters have been pulling back their spending on credit cards, even as home owners are still slightly increasing theirs.  The figures suggest that renters are reacting to the rent inflation of the last couple of years, while the many homeowners who have locked in low mortgage rates are still able to boost their spending.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several items related to China.  As usual, the trend remains negative.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including further efforts by the Turkish government to improve its economic policy and a discussion of the unexpectedly low yields on longer-term U.S. bonds.

United States-China:  At a Group of 20 meeting of finance ministers, U.S. Treasury Secretary Yellen warned it would be premature to relax the tariffs imposed on Chinese imports by President Trump in 2018, despite the Biden administration’s current effort to cool tensions.

• According to Yellen, “The tariffs were put in place because we had concern with unfair trade practices on China’s side, and our concerns with those practices remain. They really have not been addressed, and China put in place retaliatory tariffs of its own.”
• Yellen’s statement underscores our view that U.S.-China relations remain on a downward trajectory, even if there are temporary efforts to slow the descent from time to time. The result will be continued risks for investors.

Taiwan-China:  Taiwanese Vice President Lai Ching-teh, the ruling party candidate in January’s presidential elections, announced he plans to make two stops in the U.S. on a trip to South America next month.  Such visits by high-level Taiwanese politicians to the U.S. typically spark sharp anger and retaliatory measures by Beijing, so we would expect the trip to further worsen U.S.-China tensions.

Japan-China:  Japan’s deepening defense alliance with the U.S. remains the main source of today’s Japan-China tensions, but Tokyo’s plan to release treated radioactive wastewater from the disabled Fukushima nuclear reactor into the ocean has become another simmering feud.  Over the weekend, high-level Japanese officials were forced to cancel their plans to visit China at the last minute.  Even though the International Atomic Energy Agency has approved the water release as safe, some Chinese officials have even called for boycotting Japanese seafood.

China:  Data today showed China’s second-quarter gross domestic product was up just 0.8% from the previous quarter, decelerating sharply from the 2.2% increase in the first quarter.  A separate report today showed that tepid hiring in the face of the economic slowdown helped push youth unemployment to a new record high of 21.3% in June.  Still another report over the weekend showed June resale home prices in major cities were down 0.7% from the prior month, after a slide of 0.4% in May and an increase of 0.2% in April.  The report showed similar depreciation for newly built homes and for housing units in lower-tier cities.

• Taken together, the reports illustrate just how badly China’s economic growth is faltering these days, due to factors ranging from weakening export growth, excessive debt, and government intrusion into the economy. The reports are weighing on global risk assets so far this morning.
• The reports will likely bolster expectations for more fiscal and monetary stimulus from the government.
• All the same, those expectations could be dashed because of President Xi’s apparent desire to de-emphasize economic growth and rein in China’s problematic excess capacity and high debt levels.

Russia-Ukraine War:  The Russian government today said it would no longer honor its deal allowing Ukraine to keep exporting grain through its southern ports.  The Russians said they would once again allow safe passage of Ukrainian grain through the Black Sea if Western countries would facilitate Russia’s own exports of food and fertilizers, but that appears to be unlikely.  Now that Ukrainian exports are again at risk because of the war, grain prices are rising so far this morning, with nearby corn futures up 1.0% to $5.19 per bushel and wheat up 2.9% to $6.81 per bushel.

• Separately, the Kremlin announced that it has taken “temporary” control of the Russian subsidiaries of French dairy firm Danone (DANOY, $12.52) and the Danish brewer Carlsberg (CABGY, $31.22). The announcement gave no details, but the government in the past has described such takeovers as retaliation for Western seizures of Russian assets.
• On the battlefield, it is now clear that the Ukrainian military has adjusted its counteroffensive plans to de-emphasize big, massed armor strikes in favor of careful, limited attacks aimed at attrition of the Russian forces. Not only could that gradually wear down the Russians, but it could also lay the groundwork for more dissention and insubordination to percolate up within the Russian chain of command.  As shown by the mutiny of Yevgeniy Prigozhin and his Wagner Group mercenaries at the end of June, that dissention and insubordination has become a big problem for the Russian military.

Turkey:  The government yesterday tripled its tax on gasoline and also hiked duties on other key fuels.  The tax hikes were an apparent effort to cover the cost of the government’s huge giveaways ahead of May’s election and to fund the $100-billion reconstruction bill from February’s devastating earthquake.  President Erdoğan’s new, post-election economic team has also hiked the country’s value-added tax and taken other steps to bring policy into balance.  Taken together, the policies mark at least a partial return to economic orthodoxy, although they could exacerbate inflation and weigh on economic growth.

U.S. Bond Market:  New analysis shows that long-term bond yields are currently trading with a “term premium” of -0.75%, far below the average premium of +1.50% since 1961.  The figures suggest investors are demanding an unusually low yield premium to hold longer-maturity obligations (i.e., they’re valuing long bonds too richly).  The analysis is consistent with our often-expressed concern that long yields are too low, and that those investors who own long bonds are at risk as worries about long-lasting inflation and high interest rates spread.

U.S. Weather Disruptions:  Heavy rains continue in the Northeast.  In addition to causing mass floods that have killed multiple people, the rains have prompted the cancellation of at least 1,000 airline flights, which will probably require several days to unsnarl.  The worst-hit airport has been Newark Liberty International in New Jersey.

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