by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! It’s been a positive start for equities as inflation data meets expectations. Meanwhile, Dallas Mavericks’ star Luka Dončić celebrated his 25th birthday with a triple-double. Today’s Comment dives into three key topics: the impact of bitcoin on small indexes, the possibility of a June rate cut by the Federal Reserve and European Central Bank, and the ongoing influence of the war in Ukraine on defense and aerospace companies. As always, the report concludes with a summary of international and domestic data releases.

Crypto Powers Small Cap Growth: Fueled by bitcoin’s rally, the Russell 2000 Index has surged as investors seek growth opportunities beyond the established large-cap tech stocks.

• The combined market cap of cryptocurrency hit a record of $2 trillion earlier this week, fueled by the recent surge in popularity for bitcoin ETFs. Additionally, bitcoin surpassed $60,000 for the first time since November 2021. This rise followed the launch of Grayscale Bitcoin Trust last month and was further bolstered by several subsequent ETF launches, which are now attracting record inflows. Retail investors have been the primary driver of this popularity, eager to capitalize on bitcoin’s momentum. However, concerns are rising as early signs suggest leverage may be re-entering the market, potentially increasing volatility.
• Bitcoin’s surge has boosted small-cap stocks, particularly those with bitcoin exposure like MicroStrategy, Riot Platforms, and Marathon Digital Holdings. This shift may signal that investors are diversifying away from the AI craze that dominated the early part of the year. The Russell 2000 outpaced the S&P 500 over the last week, rising 2.2% compared to 1.7%. However, mirroring its large-cap counterpart, gains remain concentrated in a handful of companies. MicroStrategy fueled much of this growth, rising an impressive 43% and outperforming even media favorite Nvidia, which rose 15% in the same period.

• While current fundamentals raise concerns about the sustainability of this trend, it may reflect a broader shift as the business cycle nears maturity. The Russell 2000’s P/E ratio has soared from just above 30 to over 74 in just a week, highlighting the increasingly optimistic (but potentially risky) behavior of investors seeking growth opportunities in small-cap stocks. Historically, late-cycle expansions witness a transition from large-cap value to large-cap growth, followed by a shift into small-cap growth. If this pattern holds, investors’ growing risk tolerance could signal the need for portfolio caution. We remain optimistic but maintain vigilance for potential sentiment shifts.

June a Possibility? Policymakers in Europe and the US have unequivocally rejected the possibility of an interest rate cut this spring but have signaled the potential for a cut this summer.

• The Federal Open Market Committee (FOMC) signaled that interest rate cuts are likely this year, though the pace of easing will be less aggressive than in previous cycles. While a baseline scenario is three cuts, New York Fed President John Williams emphasized that economic data will guide the ultimate decision. Atlanta and Boston Fed Presidents Raphael Bostic and Susan Collins also support rate cuts, with a potential start as early as June. This hesitancy comes in response to strong employment data and a hot January CPI report, fueling concerns that the Fed’s fight against inflation is far from over.
• European policymakers remain committed to using economic data to guide interest rate decisions, but some are signaling a potential rate cut by summer. Members of the European Central Bank’s Governing Council, Gediminas Šimkus and Peter Kažimír, have warned that premature cuts could harm efforts to control inflation and have urged patience. However, Kažimír also expressed concern about Europe’s declining competitiveness and suggested that low-interest rates alone may not be enough to avert economic hardship. This concern is underscored by the euro area’s narrow avoidance of a technical recession in Q4, where output remained unchanged from the previous quarter. This stagnation may prompt policymakers to consider policy accommodation.

• Market expectations of a June rate cut seem largely accurate; however, the size remains uncertain. US policymakers have expressed concerns about reducing the size of the cut due to persistent economic growth and lingering inflationary pressures. Therefore, while the three cuts outlined in the latest projections are still likely, a smaller, Greenspan-style 50 basis point “maintenance” cut is also a possibility. Europe, on the other hand, may take a slightly more aggressive approach than the US to mitigate a worsening downturn. Consequently, a 100 bps rate reduction before year-end should not be ruled out.

Ukraine on the Brink? Russia’s perceived military success in Ukraine is raising concerns about the potential for escalation into a wider European conflict.

• Russian President Vladimir Putin issued a stark warning, cautioning that direct Western intervention in the Ukraine conflict could escalate into a nuclear confrontation. His statement follows recent remarks by French President Emmanuel Macron, who acknowledged discussions within NATO regarding potential troop deployment to support Ukrainian efforts. Despite Western officials firmly rejecting the possibility of direct NATO involvement in the war, Putin’s comments suggest that he is taking the perceived threat seriously, especially as Ukraine struggles to maintain its war efforts amid dwindling resources while it waits for additional aid from the West.
• Putin’s menacing rhetoric regarding nuclear warfare has surged in prominence as nations scramble to stymie Russian aggression, particularly in light of its potential spillover beyond Ukraine. Recently, US officials issued cautionary alerts, suggesting Moscow’s contemplation of deploying anti-satellite nuclear weaponry within the year. President Biden has conceded that such a launch wouldn’t directly imperil human lives; however, security experts fear that the launch may risk an accidental explosion in space. Nevertheless, this development further highlights the intensifying military competition between Western powers and their adversaries, likely contributing to the record-breaking global military spending witnessed in 2023.

(Source: Washington Post)

• Though the threat of nuclear warfare is sadly not new, Putin’s repeated threats underscore the increasingly perilous state of global security. Tensions continue to show signs of escalation between the West and its rival. Although a conflict is not imminent, the risk is becoming increasingly elevated. While NATO member states have demonstrated their commitment to developing collective defense capabilities, the specific response of the United States to an attack on its allies remains unclear. That said, the increased military spending should boost revenue for defense and aerospace companies.

Other News:  The House is expected to pass a temporary stopgap bill to avert a government shutdown, highlighting the struggles of a divided Congress to reach consensus on essential legislation. Meanwhile, the Supreme Court’s acceptance of former President Donald Trump’s appeal regarding presidential immunity, (still likely to lead to an unfavorable ruling) suggests further a delay in a potential trial until after the general election. Turkish tech stocks have been on a tear this year, as investors consider tech stocks in emerging markets.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with new restrictions on information flows within and between the US and China, which will likely further decouple the two economies and exacerbate tensions.  We next review a range of other international and US developments with the potential to affect the financial markets today, including signs of potential new British curbs on Chinese electric vehicle imports and a range of US political and policy news.

China:  The government yesterday passed amendments to its State Secrets Law that will expand the types of information that must be protected.  Importantly, the amendments establish a new category of “work secrets” at government and party bodies that aren’t considered state secrets but could “cause certain adverse effects if leaked,” adding a potentially broad new category of restricted information.  Other provisions will restrict travel and work by people who leave sensitive positions and impose new rules on private businesses exposed to state secrets.

• Implementing rules on the work secrets category are to come at a later date. The overall package of amendments is due to take effect on May 1.
• The toughened law is only the latest example of how General Secretary Xi is actively prioritizing national security over economic growth or Chinese “soft power.”
• The toughened provisions will likely add to the concerns of Western firms trying to do business in China, since they will put those companies and their employees at greater risk of running afoul of the law. In turn, that may further discourage Western investment in China, adding to the country’s economic headwinds.

United States-China:  In another development relating to information flows, President Biden will sign an executive order today limiting the sensitive personal data on US citizens that data brokers can sell to China and other adversarial countries.  The restrictions will apply to data such as genomic, biometric, personal health, geolocation, financial, and certain types of personal identifiers.  In large sets, those types of data could be used by adversaries for intelligence gathering and to facilitate illicit influence campaigns or computer hacking.

United Kingdom-China:  Reporting by Politico indicates the British government is considering launching an investigation into whether the Chinese government has subsidized its burgeoning electric vehicle exports in violation of global trade rules.  The probe would follow a similar action by the European Union last fall, which has angered Beijing and worsened China-EU relations.

• Now that Chinese EV makers have begun to make ultra-cheap, high-quality cars (aided by government subsidies and protection), their EV exports are rapidly rising and posing what could be an existential threat to automakers in the developed countries.
• With the threat of massive job losses in their auto sectors, the EU and the UK are therefore taking steps that will likely lead to tough restrictions against the Chinese. Along with the existing US restrictions on Chinese vehicles, that could eventually lead to excess capacity in China’s EV industry, which would further weigh on Chinese economic growth in the coming years.

Russia:  The Financial Times carries an article today describing what it says is a series of secret Russian military documents on the country’s policies for when it would use tactical nuclear weapons in a conflict.  The report suggests Russia’s threshold for using tactical nukes is lower than previously thought, including numerical standards such as the loss of 20% of its nuclear ballistic missile submarines.

• We are still analyzing the article, so our view on its implication may still evolve. Nevertheless, it appears that the documents’ scenarios for going nuclear are fundamentally defensive.  For example, one scenario is if an adversary has invaded Russian territory and Russian conventional forces are unable to stop it.
• Of course, it’s always useful to ask oneself: “Why is this being reported now?” It could well be that this is a leak designed to influence the current US and European debate over the future threat from Russia if it can consolidate its invasion of Ukraine.
• Regarding the war in Ukraine, we believe the stalemate that seemed to be evolving late last year is now shifting toward an advantage for the Russians. With Western aid to Kyiv faltering and Ukraine struggling to field the requisite manpower, equipment, and ammunition to fight effectively, it looks increasingly like Ukraine’s defenses are becoming brittle and could soon fail, allowing the Russians to sweep westward.

United States-European Union-Russia:  European Commission President von der Leyen today formally proposed that the Group of 7 countries use profits from the $300 billion or so of Russian foreign reserves that they have frozen to support Ukraine in fighting off Russia’s invasion.  The formal proposal, which is also supported by the US, comes despite a lack of consensus among the allies over the legality of doing so and how it could be done.

• Recent proposals have called for designating the frozen Russian assets as collateral to support G7 loans to Ukraine for its war effort and rebuilding, based on the idea that Russia will eventually owe reparations to Ukraine. The expected Ukrainian default would then result in the Russian assets being confiscated.
• Despite the machinations being considered, the confiscation of Russian assets at the end of the day would not only be a major provocation against Moscow, but it would likely accelerate the loss of the US dollar’s status as the world’s reserve currency. Countries in the China/Russia geopolitical bloc and any other nations worried about crossing the US would have an even greater incentive to reduce or end their use of the greenback, with unpredictable consequences for the world’s financial system.

US Politics:  In yesterday’s Michigan presidential primary elections, former President Trump handily beat former UN Ambassador Haley again in the Republican contest, and President Biden won the Democratic one, but the protest votes on each side were large.  In the Republican contest, Trump won 68.2% to Haley’s 26.5%.  In the Democratic ballot, Biden won 81.1% against an “uncommitted” vote of 13.3%.

• It increasingly looks like Trump and Biden will have a rematch in the November general election. Nevertheless, we still think that age and other potential issues could ultimately keep one or even both of the candidates off the ballot.  On top of that, a close race exacerbated by a potential third-party candidate could throw the election into Congress, with very unpredictable consequences.
• At the end of the day, this election season is looking unusually chaotic and hard to call. It would not be a surprise if the unpredictability at some point begins to weigh on the financial markets.

US Fiscal Policy:  After a meeting with President Biden at the White House yesterday, Republican and Democratic congressional leaders expressed confidence they would soon reach a new funding deal that would avert a partial shutdown of the federal government when the current stopgap law expires Friday night.  However, Senate Majority Leader Schumer, a Democrat, warned that the likely solution would be yet another short-term funding package designed to give the two parties time to agree on funding for the remainder of the fiscal year.

• Despite the optimism expressed by the lawmakers yesterday, neither a short-term nor a full-year deal can be assured, especially given the existence of a large body of Republican deficit hawks in the House who seem willing to torpedo any deal that doesn’t meet their aggressive goals for spending cuts.
• In any case, yet another stopgap measure and a further delay in passing funding for the rest of the fiscal year through September will impinge even more on the US military’s effort to rebuild and expand to meet the growing threat from the China/Russia geopolitical bloc.

US Antitrust Policy:  In another sign that the administration is trying to tighten antitrust policy, the Justice Department has reportedly opened an investigation into health insurance giant UnitedHealthcare.  The probe appears to be focused on the relationship between the company’s insurance operations and its Optum health-services operation.  It isn’t clear whether the probe will lead to an antitrust lawsuit.  As we mentioned in our Comment yesterday, the administration has had a mixed record in antitrust because of the prevailing Bork Standard in the courts.

US Economic Growth:  The National Association of Business Economists said its updated US economic forecasts now show gross domestic product growing 2.2% in 2024, up sharply from its December forecast of 1.3%.  The improved growth would reflect better-than-expected increases in personal consumption expenditures, corporate and residential investment, and government spending.  The forecasts also call for lower unemployment and price inflation, which should allow the Federal Reserve to start cutting interest rates in Q2.

US Cryptocurrency Market:  Just weeks after financial firms won regulatory approval to launch exchange-traded funds holding bitcoin, reports say about 10 companies have now filed applications to offer ETFs holding ether, the second-biggest cryptocurrency.  In response to the news, ether prices have surged approximately 42% so far this month.  That has given a further boost to bitcoin prices, which are now up about 33% in the month to date.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an assertion from French President Macron that European leaders have discussed sending Western ground troops to Ukraine to help rebuff Russia’s invasion of that country.  We next review a range of other international and US developments with the potential to affect the financial markets today, including a disappointing corporate governance reform in South Korea and an important new antitrust lawsuit in the US.

Russia-Ukraine War:  As Europe’s defense industry struggles to expand output enough to support the rebuilding of the Continent’s defenses and help Ukraine fend off Russia’s invasion, and as European leaders mull the prospect that the US might renege on its NATO mutual defense obligations, French President Macron said European leaders met yesterday to discuss sending Western troops to help the Ukrainians.  Macron said there was no consensus to send troops “in an official manner,” but he insisted all options must remain on the table.

• French support for the Ukrainians has so far been more about words than deeds, and Macron has often seemed to put European and French industrial interests ahead of Ukraine’s needs. The shift in his rhetoric after yesterday’s meeting was therefore notable.  Not only did Macron say that defeating Russia is essential to Western Europe’s security, but he acquiesced to Europe buying ammunition and equipment outside the region if necessary.
• Macron has long championed the idea that the countries of Western Europe should develop their own independent defense capability. Seeing Europe’s faltering defense industrial effort and slow military rebuilding, Macron may have sensed an opportunity for France to take the political lead on the Continent.  The proof will be whether France now takes concrete steps to boost the European defense effort and provide more aid to Ukraine.
• In any case, Macron’s statement about potentially sending Western troops to Ukraine has already sparked pushback from some corners of Europe, particularly Germany. Today, Germany’s Vice-Chancellor Habeck said there was “no chance” that Germany would send ground troops to Ukraine and noted things would be better if France would just send more weapons.

Sweden-North Atlantic Treaty Organization:  The Hungarian parliament yesterday gave final approval for Sweden to become the 32^nd member of NATO, providing the required unanimous consent of all current members and setting the stage for Sweden to formally join the alliance later this week.  The accession of Sweden into NATO is expected to strengthen the alliance’s northern flank and help transform the Baltic Sea into a NATO lake.  That could help contain any Russian territorial aggression in the area, bolstering both European and US security.

China:  It now appears that measures by Chinese authorities have successfully arrested the fall in the renminbi (CNY) this year.  The measures, such as delaying short-term interest rate cuts, have put a floor under the currency at around 7.2 per dollar.  The currency is still depreciating slowly, but not nearly as fast as in the first three weeks of the year.

Global Corporate Governance:  In a survey of business leaders across the Group of 20 major countries, three-quarters of respondents said the pressure to cut carbon emissions and invest in green energy is coming mostly from their own board of directors, rather than from regulators or customers.  Some 30% of the business leaders said the board pressure was “extreme,” while 47% said the pressure was “significant.”

• The survey results suggest the drive to transition to green energy is now deeply embedded in the viewpoint of those top investors, corporate leaders, academics, and former officials who make up so much of today’s corporate boards.
• All the same, with many consumers, farmers, and workers now starting to push back against the green-energy drive in many countries, it would appear that corporate directors pushing green policies could eventually face resistance in board elections, potentially creating disruption in some firms’ corporate governance.

South Korean Corporate Governance:  The government has released highlights of its plan to boost Korea’s perennially low stock valuations.  However, the “Corporate Value Up Program” was quickly panned as too weak, as it relies mostly on naming and shaming companies that don’t improve their governance.  One key problem is that the plan doesn’t include specific incentives for firms to reform their corporate structures to better protect small shareholders vis-á-vis large, controlling shareholders (who are often the company’s founding family).

• The Korean program was inspired by Japan’s corporate governance reforms under former Prime Minister Abe about a decade ago. Those reforms are considered one reason why Japanese stock values finally began to rally in recent years and finally reached new record highs in recent days, after decades of lethargic performance.
• The government said it plans to release a more detailed version of the plan in June. Nevertheless, disappointment over the initial release helped drive Korean stocks lower yesterday.

UK Antitrust Policy:  The Competition and Markets Authority has opened an investigation into possible illegal information sharing among eight British homebuilders.  With Britain facing a major housing shortage, homebuilders have come under fire for limiting their development efforts to projects where demand is high enough that they can build on spec and be assured of making high profits.  The new probe probably raises the regulatory risk for British homebuilders going forward.

US Antitrust Policy:  Yesterday, the Federal Trade Commission sued to block the proposed merger between grocery chains Kroger and Albertsons.  According to the FTC, the merger would lead to higher prices for US consumers and lower wages for the firms’ workers.  The FTC suit reflects the Biden administration’s effort to crack down on industry consolidation, but that effort has often run up against the prevailing “Bork Standard,” which requires a higher level of consumer harm before a merger can be blocked.

US Industrial Policy:  The Wall Street Journal carries an article today showing that the boom in US green-energy manufacturing and mining, partially touched off by the Biden administration’s industrial policy, is channeling the most investment into Republican-leaning regions of the country.  While Biden may be hoping that he’ll get credit from the new investment and gain politically in those areas, it seems just as likely that he won’t get much credit and will continue to struggle in public opinion polls because of public anger over consumer price inflation.

 (Source: Wall Street Journal)

US Politics:  Michigan holds its presidential primary elections today, in which former President Trump is expected to again trounce former UN Ambassador Haley on the Republican side.  Nevertheless, Haley remains defiant and has insisted she will stay in the race at least through Super Tuesday next month.

• Both Trump and President Biden face age, popularity, and other issues that could conceivably undercut them or force one or both off the ballot before November.
• Therefore, Haley may be positioning herself to inherit the Republican mantle or even pursue a third-party or independent candidacy.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the state of play between the US and China in the important new industry of generative artificial intelligence (AI).  We next review a range of other international and US news with the potential to affect the financial markets today, including developments touching on global nickel and natural gas markets and some notes on the US financial markets.

China:  Just a week after US generative AI firm OpenAI released its Sora text-to-video product, Chinese leaders and technology researchers are reportedly panicking over the realization that China has fallen years behind the US in the technology, rather than being the global leader as previously thought.  In a sign of the panic, the government has already ordered 10 state-owned firms to serve as “national champions” to push forward Chinese progress in generative AI, although it has not yet released the names of those firms.

• Chinese researchers had long thought that the country’s vast trove of available data, engineering talent, and government support would give it a leg up in developing the large language models that underlie generative AI.
• It now appears that Western firms also have sufficient data and talent to make strides in the technology. Perhaps just as important, reports suggest the US government’s clampdowns on selling advanced semiconductors and other technology tools to China for national security purposes have also been impeding Chinese progress.
• Beijing’s frustration at falling behind in the AI race and facing ever more restrictions on US technology will likely continue to fuel US-China geopolitical tensions, with negative long-term consequences for firms doing business in China or trying to sell to China.
• Nevertheless, the growing US clampdown on sending advanced technology to China is having a positive impact for some companies in the near term. As the US clampdown is expected to further crimp the sale of semiconductor manufacturing equipment to China, it appears that Chinese firms are ramping up their purchases of chipmaking machinery, driving strong revenue and profit growth at companies like Dutch giant ASML and Japan’s Tokyo Electron.

Indonesia:  The chief executive of French miner Eramet, Christel Bories, has warned that Indonesia’s low-cost nickel producers will wipe out their global rivals in the next few years, cementing the country as the world’s dominant producer of the metal, which is vital to electric car batteries.  Importantly, Bories said Indonesia’s low costs, which in part reflect government policies, will lead to mines elsewhere being shut down and/or governments having to offer subsidies to keep them open and ensure alternative supply sources.

Qatar:  Complementing recently announced investments aimed at increasing the country’s natural gas production, on Sunday the government announced new investments in its liquified natural gas export infrastructure.  Taken together, the government said the investments will boost Qatar’s total LNG output capacity by some 85% by the end of the decade.

• The new export capacity mostly aims to feed the growing Asian market, where countries are shifting away from coal for electricity generation because of environmental concerns.
• Amid signs the US may cap its LNG export potential to bottle up fuel supplies and keep domestic prices low, Qatar’s new capacity cut has positioned it to boost its global market share in the lucrative trade in the future.

Israel:  To fund the massive military spending associated with its war against Hamas in Gaza, the Israeli government has announced it will issue about $60 billion in sovereign bonds this year, freeze government hiring, and increase taxes.  However, those numbers assume that the 300,000 or so troops mobilized at the start of the war last year will continue to be demobilized and can return to their civilian jobs.  According to Finance Minister Rothenberg, the number of mobilized troops still serving has fallen to about 60,000 and should decline to 40,000 or less by late March.

• As we have argued frequently in the past, rising geopolitical tensions are likely to boost defense budgets around the world in the years to come. That process is already happening, albeit rather slowly.
• If tensions escalate further, as we think is possible, higher defense spending will require tradeoffs. For example, governments around the world will likely have to consider slashing civilian budget programs.  Israel’s increased borrowing, hiring freeze, and tax hikes suggest those kinds of initiatives are also likely to be considered in other countries.

European Union:  Thousands of farmers from Belgium and beyond have converged on Brussels today in a mass demonstration seeking more support from the EU.  The protests, which have included blocking major streets and roads with farm equipment, have gotten enough attention that European Commission ministers are recommending an increase in funding for the EU’s Common Agricultural Policy subsidy program, which already costs some 60 billion EUR per year.

US Politics:  In the Republicans’ South Carolina presidential primary election on Saturday, former President Trump handily beat former UN Ambassador and former South Carolina Governor Nikki Haley by approximately 60% to 40%.  Based on those results, Trump takes all the state’s delegates to the Republican National Convention in the summer.  Nevertheless, Haley vowed to stay in the race.  The next primary is in Michigan on Tuesday.

US Bond Market:  An article in the Wall Street Journal today highlights just how sharply financial companies have pulled back from parking overnight funds in the Federal Reserve’s reverse repo facility.  After hitting a peak of more than $2.5 trillion around the beginning of 2023, total positions have recently receded to only about $500 billion.  The volume of funds parked in reverse repo is considered a ready pool of money available to buy Treasury bills, so the decline in participation has raised concern about waning bill demand and rising interest rates.

US Stock Market:  As a reminder, Amazon.com joins the Dow Jones Industrial Average today, in a move precipitated by Walmart’s implementation of a 3:1 stock split to make its shares more accessible to small investors.  The Walmart stock split will also happen today.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities have simmered down since Thursday’s rally. Meanwhile, prospective college football players will not have to wait long to join their teams, as official signings will occur before title games. In today’s Comment, we delve into the reasons behind the markets’ resilience amidst Europe’s technical recession, explore the complexities surrounding commercial real estate issues, and offer insights into what US allies stand to gain from the ongoing chip war between the United States and China. As usual, we end our report with a summary of international and domestic releases.

What Recession? The Euro Stoxx 50 set a new record on Thursday as data showed that the regional economy is already starting to recover.

• While European economic data suggests a bumpy recovery is taking hold, the path varies across the continent. The eurozone’s composite purchasing manager index (PMI) rose from 47.9 to 48.9 in February, exceeding expectations of 48.5, according to S&P Global. However, the picture is more nuanced. France’s PMI saw a significant jump to 47.7 from 44.6, indicating expansion. Conversely, Germany’s PMI unexpectedly dipped to 46.1 from 47.1, falling below the expected 47.5 and suggesting contraction. This divergence highlights how the impact of the recent economic slowdown varies significantly across countries, with some weathering the storm better than others.
• Intriguingly, markets seem to be overlooking the recent weak economic data. Even though several European nations, including Germany, entered technical recessions earlier this year, stock markets have enjoyed a strong start. The Euro Stoxx 50 Index boasts an impressive gain of almost 8% so far this year, closely trailing the S&P 500 Top 50 Index’s rise of 9.5%. The apparent disconnect between economic data and European market performance is not unique to the region. Despite facing similar economic challenges, Japan’s Topix 100 Index has also seen a remarkable surge of over 15% in the first quarter of this year.

• Several global stock markets are experiencing a “top-heavy” trend, with large companies driving overall gains disproportionately. This investor preference for large-cap stocks stems from their perceived stability during economic uncertainty, further fueled by mixed signals from central banks on future interest rate cuts. The persistence of this trend depends on the severity of the anticipated downturn. If the expected shallow recession in Japan and Europe materializes, the current trend might continue. However, a deeper downturn could force investors to seek “safer havens” in government bonds, potentially leading to a shift away from large-cap stocks.

CRE Problem Persists:  Banks are racing against time to find solutions as hundreds of billions of dollars in office space loans approach maturity.

• January saw a dramatic surge in commercial real estate foreclosures, fueled by the brutal combination of high-interest rates and low occupancy rates. This “double whammy” squeezed borrowers, making it nearly impossible for many to keep up with payments, resulting in 635 foreclosures across the US. This spike highlights the significant challenges that lenders face in helping borrowers adapt to the harsh reality of higher interest rates, where the “extend and pretend” strategy is no longer viable. The increasing number of troubled CRE loans has raised concerns among regulators, with figures like Treasury Secretary Yellen and Fed Vice Chair Brainard closely monitoring the situation, fearing the potential spillover effects on the broader economy.
• A recent Barclays study revealed a significant link between bond spreads for regional banks and their risk profile. It found that 85% of the difference in bond spreads between regional banks can be explained by two factors — the weighted average rating factor (WARF), and their exposure to CRE as a percentage of their total capital. Despite their perceived stronger financial position compared to smaller banks, a recent report revealed that the bad property debts of larger banks now exceed their reserves for potential loan losses. This raises concerns about their ability to withstand potential shocks in the commercial real estate market.

• The Federal Reserve’s response to this financial challenge hinges on its assessment: Is it a liquidity squeeze or a broader refinancing issue? If the Fed perceives a liquidity shortage, it might use previous measures like temporary support to prevent bank runs. Alternatively, if it sees a wider refinancing challenge, lowering interest rates could improve the negotiating power of borrowers. However, both approaches present potential drawbacks. The most recent FOMC meeting minutes showed that policymakers believe that there are ample reserves in the financial system, suggesting a potential openness to rate cuts. However, Fed officials’ recent comments indicate that the committee does not plan to do so anytime soon.

Chip Wars: The US is showing that it would like to involve its allies as it battles China for AI supremacy.

• Following months of anticipation, the US government has begun allocating funds from the 2022 CHIPS and Science Act. On Thursday, South Korean semiconductor manufacturer SK Siltron secured a $544 million loan to expand its Michigan plant, marking a significant step in bolstering domestic chip production. The report comes several days after it was announced that GlobalFoundries received a $1.5 billion grant as it looks to help expand its facility in Malta, New York. It is widely expected that Taiwan Semiconductor Manufacturing Company and South Korea’s Samsung will also want to take part in the program.
• Increased government funding for critical industries, like advanced manufacturing, points to a potential shift toward prioritizing domestic production. This trend is bolstered by a significant surge in investments for building and upgrading manufacturing infrastructure in 2023, marking the highest contribution to economic growth in over a decade. This push isn’t limited to semiconductors; initiatives like the Inflation Reduction Act have fueled investments in electric vehicle manufacturing, further emphasizing the government’s preference for producing goods that are more forward-looking as it readies to take on China.

• Despite challenges in developing its domestic electric vehicle industry, the US holds a potential advantage in semiconductors due to its long history of designing advanced chips. Recent government initiatives leverage this strength to help the US maintain its global leadership and strengthen partnerships with allied nations. This could, in turn, benefit US-aligned technology firms through increased collaboration and trade opportunities. Notably, Japan is strategically positioning itself to capitalize on this trend, as evidenced by its recent partnerships with American companies like Rapidus and Micron, aiming to revitalize its own chipmaking capabilities.

Other News: The first commercial flight to the moon landed on Thursday. This mission not only signifies the United States’ triumphant return to the lunar surface after half a century, but also hints at the potential resurgence of another era of space exploration akin to a modern-day space race. The US and China are collaborating on addressing debt concerns in developing nations, showcasing a continued effort to manage tensions despite ongoing disagreements. Meanwhile, the South Carolina primary on Saturday could solidify former President Donald Trump’s lead in the Republican nomination race.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Markets are buoyant after a stellar earnings report from Nvidia, while Messi returns to action as the reigning Ballon d’Or winner. In today’s Comment, we discuss our reservations about the Magnificent Seven, give our reaction to the latest Fed minutes, and explain why Japan continues to capture the attention of investors. As usual, our report concludes with a summary of domestic and international data releases.

Magnificent Seven: Despite past solid performances, Big Tech valuations may face pressure as investors worry about their ability to sustain growth and meet audacious earnings targets.

• Chipmaker Nvidia reported stronger-than-expected earnings, indicating that AI hype still has momentum. The company announced that it made $22.1 billion revenue in the three month period ending in January. This surpassed estimates by $1.7 billion and sparked optimism for a $24-billion current quarter, driven by resurgent chip demand. The news comes after a stellar year with Nvidia’s stock surging 240% in 2023 and 40% year-to-date and is likely to buoy the broader tech sector as investors seek to avoid missing out on further gains made in the AI space.
• While the Magnificent Seven experienced strong overall growth to start the year, it wasn’t evenly distributed, potentially fueling investor concerns. Meta and Facebook surged the most, exceeding 30% growth in the first two months, while Apple and Tesla’s stock prices dipped during the same period. This disparity highlights investor skepticism towards stocks lacking robust earnings to justify their valuations. Currently, these Magnificent Seven stocks trade at a hefty 40.1 times earnings, nearly double the S&P 500 average. The high valuation suggests that these firms may not be able to sustain their current pace for the rest of the year.

• Investors may be drawn to companies with strong market positions and future growth potential, but these companies are possibly running out of steam. In the AI chip market, Nvidia holds a significant share with its H100 GPUs, and has even caused supply chain challenges for major players like Tesla, as reported by the company. However, concerns are rising about the ability of Big Tech, including Nvidia, to consistently deliver blockbuster earnings growth in the future especially given their rich valuations. This may explain why META has decided to pay out its first dividend. Nevertheless, we recommend keeping a close eye on the technology sector as broader economic factors and company-specific news could impact their valuations in the coming months.

Fed Speaks, Market Reacts: Markets have digested the Fed’s reluctance for aggressive rate cuts in 2024, but uncertainty lingers due to policymakers’ conflicting views on future monetary policy.

• Federal Reserve officials expressed hesitancy to cut interest rates soon unless they see more progress, according to the January 30-31 meeting minutes. While officials acknowledge inflation’s move toward the 2% target, concerns about persistent economic momentum and the risk of overly restrictive policy have divided the board. Additionally, there was a broad consensus that there are enough reserves to meet bank needs. On Wednesday, Richmond Fed President Thomas Barkin and Governor Michelle Bowman reiterated their concerns, urging patience as recent economic data showed that a lot of upside inflation risk remains.
• The Fed’s latest remarks significantly diminished the market’s expectation of a rate cut at the upcoming March meeting. At the start of the year, investors anticipated that policymakers could slash rates up to seven times, expecting the central bank to pivot to protect the economy from slowing down. However, sentiment began to change following the Federal Reserve’s January 30-31 meeting, during which Powell suggested that a rate cut in the upcoming meeting was unlikely. The latest swap rates suggest that investors believe that the Fed may cut three or four times this year, which is in line with the Fed’s median projection.

• Maintaining current interest rates for an extended period could complicate the Fed’s pursuit of a soft landing, as recent meeting minutes reveal. While policymakers expressed confidence in the overall economy, concerns emerged regarding the sustainability of recent growth, primarily driven by volatile factors like net exports and inventory investment. The minutes explicitly labeled these factors as “offering little signal for future growth,” highlighting their limitations as economic indicators. Further, rising bank loan-loss provisions suggest potential credit deterioration later in the year. Although we do not expect a recession this year, we believe that the risk is elevated.

Japan is Back!  The Nikkei 225 index hit a new high for the first time in over 34 years as investors begin to embrace the new normal.

• The recent resurgence of the Japanese stock market, once a global powerhouse in the 1980s, is fueled by a confluence of factors, including improvements in corporate governance, a shift from deflationary to moderate inflation, and a complex geopolitical landscape. The bounce began after the Tokyo Stock Exchange started its campaign to raise corporate valuations and was supported by the Bank of Japan, which has been reluctant to raise rates as a way of encouraging firms to test its pricing power. Furthermore, the lackluster performance of China’s stock market has led investors seeking regional alternatives to turn to Japan.
• Echoing 2023’s performance, Japan’s stock market has again outpaced many of its global counterparts in the first few months of 2024. However, uncertainty remains regarding the sustainability of this trend. The Nikkei 225 index currently boasts a 16% year-to-date gain, significantly exceeding the S&P 500’s 5.0% rise and even surpassing the broader MSCI World Index’s 3.6% increase. While foreign investors divesting from China may have fueled some of the initial gains, their return is uncertain and contingent on China’s rebound. Additionally, tepid results from upcoming union wage negotiations could challenge the narrative of Japan’s shift away from deflation, especially as the country flirts with recession.

• The stock market’s strong performance despite Japan’s economic downturn creates a puzzling disconnect, fueling concerns about market sustainability. Weakening consumer spending, a key factor in the slump, could complicate ongoing union negotiations. Companies might resist wage increases, challenging the optimistic narrative that Japan has finally escaped its multi-decade deflationary period. This could prompt investors to re-evaluate their bullish stance. However, a relatively cheap currency presents an opportunity for Japanese exporters. If leveraged effectively, it could boost earnings and support the export-driven growth strategy, potentially mitigating concerns about sustainability in the long run.

Other News: President Trump’s unveiling of his VP shortlist — comprising Tim Scott, Ron DeSantis, and Vivek Ramaswamy — underscores his mounting confidence as the frontrunner for the Republican nomination, signaling a potential rematch with President Biden. In a display of bipartisan unity, lawmakers engaged in discussions with Taiwan’s President-elect to reaffirm Washington’s steadfast support for the sovereign island. Meanwhile, the US government has committed billions of dollars to replace cargo cranes, previously manufactured by China, at ports — a significant indication of its strategic divergence from its Indo-Pacific rival.

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