by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with updated oil demand and supply forecasts from the International Energy Agency.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more signs of faltering Western investment in China and a preview of today’s Federal Reserve decision on interest rates.

Global Oil Market:  In its monthly report, the International Energy Agency raised its 2023 forecast for global crude oil demand to 102.2 million barrels per day, an increase of 2.4 mbpd from 2022.  The organization also raised its 2023 supply forecast to 101.3 mbpd, suggesting a tight market that could mitigate some of the downward pressure on oil prices as the U.S. and other major economies post weaker economic growth or look set to enter recession.  So far this morning, Brent crude is trading up approximately 0.7% to $74.80, but that remains far below the level of almost $120 per barrel one year ago.

China – Inbound Portfolio Investment:  In the latest sign that Western investors are losing their appetite for Chinese assets, U.S. investment banks such as Goldman Sachs (GS, $342.50) have reportedly been pulling out of initial public offering deals involving companies based in China.  Even when the investment banks take part in a Chinese IPO, reports indicate they are sometimes having trouble selling the deals.  As we have often argued, geopolitical tensions between China and the West, along with slowing Chinese economic growth, have raised the risks involved with investing in China.  It is now becoming increasingly clear that investors are responding to those risks.

China – Monetary Policy:  The People’s Bank of China cut another set of policy interest rates yesterday, following its earlier cut in its seven-day reverse repo operations.  This time, the central bank cut the rate on its overnight Standing Lending Facility to 2.75% from the previous 2.85%.  The institution also cut its SLF rate for other maturities.  The rate cuts have spurred expectations of more monetary easing in the coming weeks.

• Separately, top officials are also reportedly considering a broad economic stimulus program that would help areas such as personal consumption and real estate.
• Nevertheless, it is not clear if President Xi would be willing to abandon his plans to rein in debt and other economic imbalances engendered by the government’s past stimulus programs.

European Union:  The European Commission today issued fresh antitrust charges against Google (GOOG, $124.43), alleging that the company illegally distorts competition in the bloc’s advertising technology sector.  The document includes a call for Google to divest some of its online advertising business.  The charges illustrate how major U.S. technology firms continue to face heightened regulatory risks, both in the U.S. and in Europe.

• Separately, the European Parliament today advanced a draft law called the AI Act that aims to impose the West’s first comprehensive regulation of artificial intelligence. If passed into law, the legislation would:
  • Regulate how companies train their AI models to ensure the models don’t create illegal content.
  • Require companies to publish summaries of the copyrighted data used to train their models, potentially giving content creators a way to share in their profits.
  • Require companies to disclose when content is generated using AI.

North Atlantic Treaty Organization:  Members of the NATO military alliance are struggling to agree on a successor to Secretary General Jens Stoltenberg when his term ends in October.  As a result, the members are leaning toward extending the former Norwegian prime minister’s mandate for a fourth time.  That would not only allow more time for the NATO members to agree on a new leader, but it would also allow for some continuity in the midst of Russia’s invasion of Ukraine.

• Separately, reports indicate the U.S., the U.K., Germany, and France are drafting a multilateral political declaration that would allow individual countries to provide bilateral security assurances to Ukraine in lieu of NATO membership.
• However, neither the framework document nor the bilateral agreements would have the status of legal treaties. They also would not involve any formal NATO commitments.

Russia-Ukraine War:  Speaking of the war, yesterday Russian President Putin publicly backed Defense Minister Shoigu’s demand that the Wagner Group of mercenaries be brought under central control.  Wagner chief Yevgeniy Prigozhin has so far refused to do so, but Putin said formalizing Wagner’s relationship to the Defense Ministry would be necessary to ensure veterans’ benefits for the mercenaries—an argument that likely aims to undermine Prigozhin’s popularity with his troops and short-circuit his political ambitions.

United States-Iran:  Reports today say the Biden administration has quietly restarted indirect talks with the Iranian government in a bid to ease tensions.  After giving up last November on its effort to reinstate the international agreement limiting Tehran’s nuclear program, the administration now appears to be seeking better behavior from Iran through talks and the easing of some international financial flows that had been frozen by U.S. sanctions.

U.S. Monetary Policy:  Officials at the Fed today wrap up their latest policy meeting, with their decision due to be released promptly at 2:00 PM EDT.  Market indicators suggest investors now expect the policymakers to pause their interest-rate hikes and keep the benchmark fed funds rate steady within a range of 5.00% to 5.25%.  The officials are also expected to signal an option to resume their rate hikes in the future if consumer price inflation doesn’t moderate as expected.

U.S. Military Leadership:  In a surprise move, Defense Secretary Austin has recommended U.S. Pacific Fleet Commander Samuel Paparo to be the new Chief of Naval Operations.  The move was a surprise because Austin had been widely expected to name the current Vice CNO, Admiral Lisa Franchetti, to be the Navy’s top officer.  President Biden will have final word on the matter, but Austin’s support for Paparo suggests that growing U.S.-China tensions have put a premium on top-level experience in the Pacific theater, even if that means missing a chance to name the first female leader of the Navy and the first female member of the Joint Chiefs of Staff.

U.S. Defense Industry:  Defense giant Lockheed Martin (LMT, $452.37) and semiconductor maker GlobalFoundries (GFS, $62.89) announced a deal that will secure the supply of computer chips used in Lockheed’s weapons in return for investments in new GlobalFoundries production capacity.  The agreement will also help make GlobalFoundries eligible for capacity funding from last year’s CHIPS and Science Act.  The deal serves as a reminder that the legislation aims to spur domestic production of not only advanced computer chips, but also the less-advanced chips used in military equipment.

U.S. Labor Market:  Officials in the Biden administration have started trying to ease tensions between the West Coast dockworkers’ union and port employers, who have been struggling to agree on a new labor contract for the last year.  With patience wearing thin on both sides, the dockworkers have reportedly begun to stage informal work slowdowns, raising the risk of broader disruptions or even an outright strike that would snarl supply chains and potentially boost inflation again.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with plenty of China news, including signs of an investor exodus from the country and efforts by the central bank to boost economic growth.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs of re-industrialization in the European Union and an overview of the latest Federal Reserve policymaking meeting, which begins today.

China – Inbound Portfolio Investment:  Major asset managers around the world report they are being deluged by client requests for “Asia Ex-China” products, as global investors react to China’s slowing economic growth and increasing geopolitical tensions with the West.  As a corollary, the fund managers say they’ve seen an uptick in requests for “Asian ally” products that would invest in Asian countries that are friendly toward the U.S., such as Japan and South Korea.  Some clients are also requesting funds that would invest in Asia excluding both China and Japan.

• As we have been arguing for some time now, worsening geopolitical tensions are likely to prompt both the U.S. and China to clamp down on investment flows between the two countries. Tightened rules could come from out of the blue at any time, leading to losses for investors.
• We continue to believe that a safer approach may be for U.S. investors to focus their exposure on the evolving U.S. geopolitical bloc, which will likely consist mainly of today’s rich, highly advanced industrialized countries that are liberal democracies and provide good protections for property rights. The U.S. bloc will also include a number of tightly related emerging markets, such as Taiwan, South Korea, and Mexico.

China – Monetary Policy:  Today, in a sign that officials now feel they must address the economy’s slowing growth, the People’s Bank of China unexpectedly cut the interest rate it charges on seven-day reverse repo operations to 1.9%, versus 2.0% previously.  The central bank also injected 2 billion CNY ($280 million) into the banking system at the new, lower rate.  Analysts expect that China’s other key lending rates will also be cut soon.  Nevertheless, faltering confidence by businesses and consumers and weak loan demand mean the policy easing may have little positive effect on growth.

China – Military Policy:  According to a recently declassified Intelligence Community report, China’s actual military spending is now equivalent to about $700 billion per year, even more than the $516.1 billion that we estimated in our recent report on Chinese military power and almost three times that of China’s official defense budget.  As the Soviets did during the Cold War, the Chinese use a range of budgetary shenanigans to under-report their actual defense spending.

• The Chinese spending of $700 billion still doesn’t match the U.S. defense budget of $824.4 billion in 2022, but China’s spending is concentrated on only about one-quarter of the earth’s surface, whereas the U.S., as the global hegemon, must spread its budget over virtually the entire world.
  • With total actual military expenditure of $700 billion per year, China would be spending about $14,200 for every square mile of its core defense sphere (basically, the eastern half of the Northern Hemisphere).
  • In contrast, the U.S. defense budget equates to just $4,302 for every square mile of the Earth’s surface excluding Antarctica (which is supposedly neutral).
• Along with China’s aggressive military operations and intensive investment in its weapons arsenal, the lack of transparency in its defense spending should be a major concern for Western defense officials and will likely be an argument against the cooling of tensions being advocated by Western business elites seeking to protect their commercial interests.

European Union:  On top of the recent construction data indicating a massive jump in U.S. factory construction, new data suggests re-industrialization is also happening in Europe.  The data shows global businesses acquired or leased 9.6 million square feet of industrial space in the region in 2022, marking a 29% increase over the previous year.  The uptake of factory buildings comes even as weak consumer growth in the region pushes down contracts for retail and warehousing space.

• Re-industrialization in Europe is probably being driven by many of the same forces as in the U.S. Faced with slower growth in China and the risk that geopolitical tensions will sever their critical global supply chains, firms are cutting their risks by “near shoring” production.
• Nevertheless, the Europeans are probably still not seeing the level of re-industrialization that they could have if they adopted U.S.-style subsidies for green technology, advanced semiconductors, and other key industries. As in the U.S., the EU also probably hasn’t yet seen the full impact of defense spending increases, which will require a build-out of the region’s defense industrial base.
  • Illustrating the allure of the new U.S. industrial policy, German semiconductor firm Infineon (IFNNY, $40.84) said it may start producing more of its products in the U.S. so that they would be eligible for subsidies included in last year’s Inflation Reduction Act.
  • Infineon is the world’s largest producer of semiconductors for the auto industry.

United Kingdom:  The unemployment rate in February through April fell to a seasonally adjusted average of 3.8%, rather than rising to 4.0% as anticipated.  That means joblessness declined further from the 3.9% rate in January through March.  Even more alarming for the Bank of England, average weekly earnings in April were up 7.2% year-over-year, surpassing the expected increase of 7.0% and accelerating from the rise of 6.7% in the previous month.

• The strong labor market data suggests the central bank will be even more inclined to keep hiking interest rates.
• In response, U.K. bonds are slumping so far this morning, driving yields higher. The yield on two-year Gilts has now reached its highest level since 2008.

Global Oil Market:  In its monthly market report, the Organization of the Petroleum Exporting Countries said their producers as a whole cut oil production by 464,000 barrels per day in May, down to a total level of 28.07 million bpd.  Although the cuts were largely concentrated among a few of OPEC’s biggest producers, the figures suggest the organization is following through with its “voluntary” effort to boost prices by restricting supply.  Nevertheless, output increases by some OPEC members will likely mute the impact on global supplies, especially as demand falters in the face of slowing economic growth.

• So far this morning, Brent crude is trading up 2.5% at about $73.60 per barrel.
• All the same, that is sharply lower than the price of $120 per barrel one year ago.

Nigeria:  In a sign that he will continue to shift economic policy in a more orthodox direction, newly elected President Bola Tinubu has suspended central bank chief Godwin Emefiele, who had spent billions of dollars of the country’s foreign reserves to prop up the currency.  Tinubu has also ended a program of fuel subsidies that cost Nigeria some $10 billion per year.  The moves have given a significant boost to Nigerian bonds.

U.S. Monetary Policy:  Officials at the Fed begin their latest two-day policy meeting today, with their decision to be released tomorrow at 2:00 PM EDT.  Market indicators suggest investors now expect the policymakers to pause their interest-rate hikes and keep the benchmark fed funds rate steady within a range of 5.00% to 5.25%.  The officials are also expected to signal an option to resume their rate hikes in the future if consumer price inflation doesn’t moderate as expected.

• On a related note, new data shows U.S. junk-loan defaults are surging as more financially challenged companies with floating loan rates find they can’t meet their debt payments.
• The data shows 18 such defaults in January through May, for a total of $21 billion. That’s more than in the full-years of 2021 and 2022 combined.

U.S. Apartment Market:  New figures from rental-listing and property-data companies show that asking rents for new leases have hit a plateau and in some cases are declining.  That marks a big slowdown from the double-digit increases one year ago.  Of course, the slowdown in asking rents is a positive for apartment dwellers and could soon start pushing down overall consumer price inflation.  Nevertheless, weaker-than-expected rent rates could also cause problems for building owners, potentially making the apartment sector another source of concern in the commercial real estate market.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a couple of quick notes on the war in Ukraine and Russia’s relationship with the United States.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the death of Italian right-wing firebrand Silvio Berlusconi and a preview of this week’s policy meeting at the Federal Reserve.

Russia-Ukraine War:  The latest reporting suggests the Ukrainian counteroffensive remains in its probing and feinting phase, with some thrusts being stopped but others managing to gain some territory.  So far, it appears that Ukraine’s losses have been moderate for this type of operation, including the loss of some advanced Western tanks and other equipment.

Russia-United States:  Moscow police have arrested a U.S. citizen living in Russia and charged him with dealing illegal drugs.  Travis Leake, a 51-year-old musician, has been living in Russia since 2010 and had refused to leave despite State Department warnings that U.S. citizens should get out of the country.  His arrest will probably be a new point of friction between Russia and the U.S. and could morph into another prisoner exchange like the one in December that freed WNBA star Brittney Griner.

Italy:  Former Prime Minister Silvio Berlusconi died today, creating a leadership vacuum in his conservative Forza Italia Party and likely taking some of the energy out of Italy’s right-wing political forces.  The most immediate issue is who will take over Forza Italia, which is a member of current Prime Minister Meloni’s three-party coalition.  More broadly, since Berlusconi was sympathetic to President Putin, his death could help ensure that Meloni’s government has a free hand to keep supporting Ukraine as it tries to defend against Russia’s invasion.

United Kingdom:  Former Conservative Party Prime Minister Boris Johnson resigned from his seat in parliament on Friday after seeing a new Privileges Committee report that accuses him of lying to the Commons about holding illegal parties during his government’s pandemic lockdown.  At least two of Johnson’s allies have also resigned, setting the stage for three by-elections that will be a challenge for current Prime Minister Sunak’s government to defend.  As a result, political instability looks set to continue in the U.K. in the near term.

• Separately, former Scottish First Minister Nicola Sturgeon, who resigned in February, was arrested yesterday by police officers investigating the finances of her Scottish National Party (SNP).
• The SNP’s focus is gaining independence for Scotland. The arrest of Sturgeon and the investigation into the SNP will likely take the wind out of that effort for the near term.

Turkey:  Late last week, newly re-elected President Erdoğan named Hafize Gaye Erkan as the new chief of the central bank.  Erkan, a Princeton-educated economist who used to be a banker at Goldman Sachs (GS, $336.02), is a specialist in building complex financial models to uncover the risk in bank balance sheets.  That classical skillset suggests she will take a traditionalist approach to policy, much as Erdoğan’s new finance minister seems to be doing.

• Taken together, the appointment of the two officials suggests Erdoğan will tone down his loose, unorthodox economic policies now that he has been safely re-elected.
• If monetary and fiscal policy do shift toward a more orthodox stance, it would likely be a positive for Turkish assets going forward.

China-South Korea:  The South Korean government has arrested a former executive of Samsung Electronics (005930.KS, KRW, 71,000.00) on charges that he illegally stole the chipmaker’s manufacturing technology with the intentions of building an entire copycat factory in China.  We suspect the near miss will force South Korean officials to confront the risk that the country’s most important technology secrets could flow to China, or be acquired by China, which would eventually harm South Korea’s leading tech companies.  In turn, that will likely force a clampdown on trade, investment, and technology flows with China, bringing South Korea more in line with the policies of the U.S. and the rest of the evolving U.S. geopolitical bloc.

United States-China:  The Biden administration has requested that the U.S. be reinstated as a member of the United Nations Educational, Scientific, and Cultural Organization (UNESCO) so that it can start pushing back against China’s dominance of the group which began after President Trump’s withdrawal in 2017.  Reinstatement would require the U.S. to pay several hundred million dollars in arrears on its membership dues, but the administration sees that price as worth it to reduce Beijing’s impact on UNESCO’s work on issues ranging from press freedoms to artificial intelligence.

U.S. Monetary Policy:  Officials at the Fed begin their latest two-day policy meeting tomorrow, with their decision due to be released on Wednesday at 2:00 PM EDT.  Market indicators suggest investors now expect the policymakers to pause their interest-rate hikes and keep the benchmark fed funds rate steady within a range of 5.00% to 5.25%.  The officials are also expected to signal an option to resume their rate hikes in the future if consumer price inflation doesn’t moderate as expected.

• In a Financial Times opinion piece today, former PIMCO bond guru Mohamed El-Erian argued that the more prudent course would be to hike rates again this week, since pausing until July wouldn’t give the Fed much additional data on the impact of previous hikes and since recent economic data has been strong enough to justify a June hike.
• On the other hand, El-Erian argues that a pause, potentially followed by cuts, could be in order if the global supply side of the economy has changed to the point where the Fed’s 2.0% inflation target is too low. Such a pause could also help reduce the risk of more financial instability like the bank crisis this spring.

U.S. Military:  As China’s military buildup and increasing aggressiveness create a need to beef up U.S. deterrence, independent auditors at the Government Accountability Office said the Navy’s submarine contractors can’t find enough workers to meet their planned schedule of building one Columbia-class ballistic missile submarine and two Virginia-class fast attack submarines each year.  According to the report, staffing for the attack subs is about 25% below what would be necessary to meet the planned schedule.  The staffing problems and construction delays are expected to produce significant cost increases for the new subs.

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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 thoughts on the future path of interest rates and why we still believe that the hype surrounding artificial intelligence is far from over. Next, we examine the struggles of the West to address the growing cost of climate change. Finally, we review the ongoing tensions between the U.S. and China and discuss how the rift may impact future diplomatic talks.

More to Come: Investors are anxious about central bank meetings which has weighed on equities.

• A surprise rate hike by the Bank of Canada on Wednesday has contributed to concerns that other central banks are not finished hiking rates. Earlier this week, European Central Bank officials insisted that the bank will continue to raise interest rates throughout the year. Meanwhile, members of the Federal Open Market Committee have signaled that they may not be ready to pause hikes indefinitely. Economists expected the ECB to raise rates over the next two meetings and pause for the remainder of the year. Meanwhile, the latest CME FedWatch Tool prediction of a rate cut by December is at 39.1%, much lower than the 98.9% that was forecast a month ago.
• Investors are hesitant to purchase risky assets due to the uncertainty regarding future borrowing costs. Higher interest rates are likely to exacerbate recession risks, especially as government data suggests that economic growth is slowing. According to data collected by EPFR, tech funds saw $1.2 billion in outflows in the week ending June 7; its first weekly loss in 8 weeks. The withdrawal comes amidst concerns that the Federal Reserve will not be able to navigate a soft landing. On Thursday, jobless claims surged to their highest level since October 2021. Thus, adding to evidence that the labor market is starting to cool and the economy is losing steam.

AI Losing Momentum?: While the market has recently become wary of tech stocks, we believe the AI boom is likely not over yet. The technology is still in its infancy stage and is expected to grow more prominent in the next few years. In recent months, more businesses have been trying to integrate generative AI into their business processes, with some even hiring consultants to help with the transition. It is speculated that the technology will be capable of automating about 40% of available service jobs within the next decade. While it is premature to say that the disruptive nature of the technology will lead to an equal amount of job displacement, we believe that AI will drastically improve efficiency and cut costs.

Smoke Spreads: The recent wildfires in Canada have caused widespread air pollution in a sure sign that the West needs to do more to combat climate change. However, it is not clear whether the West has the resources needed to do it alone.

• Canadian smog has entered states along the East Coast, will soon be moving south, and is expected to last until next Monday or Tuesday. This is the worst wildfire season in Canada’s history, which typically runs from May through October, and has led to flight cancellations and school closures. The cause of the fires has been attributed to lightning, which tends to be more prevalent when the weather is dry and hot. However, world leaders have also blamed climate change. President Joe Biden and Canadian Prime Minister Justin Trudeau have argued that more needs to be done to reduce carbon emissions.
• Making matters worse, the return of El Niño is expected to bring extreme weather conditions throughout the year. After remaining dormant for four years, the climate pattern has now resurfaced. Forecasters give it a 56% chance of being strong and an 84% chance of exceeding “moderate” strength. A strong El Niño typically brings cold and dry winters to northern Europe and more precipitation to southern Europe. These conditions will likely lead to higher energy demand due to an increase in household consumption. On a positive note, European countries are better positioned to deal with these challenges now than they were before the invasion of Ukraine.

• Western governments will likely be forced to make uncomfortable decisions if they want to follow through on their climate change goals. Neither North America nor Europe has the ability to produce enough electric vehicles to meet projected targets. In order to accelerate the development of clean technologies, both regions have offered subsidies for companies to build manufacturing facilities. This new investment will likely help expand production, but it does not appear to be on pace to meet future demand. In fact, without imports of cheap renewable energy technology from China, these regions will likely be unable to meet many of their targets. As a result, the West will have to choose between easing its targets or becoming more friendly with China.

Bloc Rivalry: The United States and China are engaging in increasingly provocative behavior, even as the two countries make plans to hold talks.

• There is more evidence that Beijing is expanding its efforts to spy on the United States. On Thursday, it was reported that Cuba has agreed to allow China to build a spy facility on the island. The facility could allow Beijing to eavesdrop on electronic communications across the southeastern section of the U.S. The Pentagon learned of the plan to build the surveillance facility a few weeks ago, but it is not yet clear whether construction has begun. The report comes two weeks after Microsoft (MSFT, $325.25) accused China of hacking critical U.S. infrastructure, and a couple of months after a Chinese spy balloon was found in U.S. airspace.
• At the same time, the United States is looking to bolster its military presence in the Indo-Pacific region in response to China’s growing military threat. Japan and Taiwan have agreed to improve intelligence sharing with the US military and will begin exchanging real-time data from naval reconnaissance drones. South Korea also announced this week that it had upgraded its alliance with the U.S. to a nuclear-based relationship. The two countries have discussed nuclear planning to create deterrence on the Korean Peninsula, but no final agreement has been reached on the deployment of U.S. weapons.
• Rising tensions between the major powers have cast doubts on the chances of a thaw in relations between the U.S. and China. However, Secretary of State Antony Blinken is still expected to travel to China next week in an attempt to restore high-level diplomatic and military ties. During the visit, Blinken will seek to address a range of issues, including trade, human rights, and security. Although it is unlikely that the two countries will become best friends, there is a growing recognition that both sides have a stake in de-escalating tensions. China’s economic recovery has struggled to take off, and U.S. businesses have urged the White House to reconsider its strategy of decoupling from the Chinese economy. Therefore, a positive breakthrough in U.S.-China relations would likely be welcomed by markets.

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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 thoughts on the reasons that central bankers may have for not being finished with rate hikes. Next, we explain the possible liquidity issue in international markets. Lastly, we discuss why a possible BRICS currency is not a threat to U.S. dollar hegemony.

A Canadian Surprise: An unexpected rate hike from the Bank of Canada (BOC) adds to concerns that other central banks may follow suit.

• Canadian monetary policymakers raised rates by 25 bps to 4.75% on Wednesday, defying market expectations of a continued pause. Although central bank officials warned that another rate rise is possible, only one in five economists surveyed by Bloomberg predicted the outcome. In a rare statement, the central bank mentioned that “excess demand in the economy” drove the decision. This policy reversal comes a week after a GDP report showed that the Canadian economy rose at a 3.1% annualized rate in the first quarter of the year, after contracting 0.15% in the previous quarter.
• The U-turn from the BOC has led many investors to modify their expectations of a rate cut by the end of the year. Global bond prices slumped on Wednesday as investors begrudgingly accepted that other central banks, such as the Federal Reserve and the European Central Bank, may not be finished hiking rates. For example, there are members of the Fed that believe that the bank should not lower rates until 2024. Similarly, European Central Bank head Christine Lagarde has argued that the bank should continue to hike rates until inflation is under control. The insistence on tightening comes amidst expectations that growth in the United States and Europe has accelerated during Q2, despite the persistent rate hikes, thus reinforcing the view that central bankers may need to tighten further to bring down demand-driven inflation.

• • Demand-driven inflation has not made much progress since the Federal Reserve started its hiking cycle, according to the San Francisco Fed.

• The Bank of Canada’s (BOC) decision to hike rates following the report of a rebound in its GDP suggests that other central bankers are going to be mindful of recession risks as they decide on policy. This is not to say policymakers will not consider raising rates if economic growth contracts. However, it does suggest that future rate hikes may be less predictable, especially if inflation begins to accelerate. The Bank of Canada’s decision provides further evidence that market bets of a potential 2023 rate cut from the Fed and ECB are possibly misguided.

Global Liquidity Drying Up? Banks are struggling to attract capital due to the U.S. government’s demand for new funds and central banks’ removal of stimulus.

• The race to refill the U.S. Treasury coffers will cause a strain on the American banking system. It is estimated that the government will need to borrow $1.1 trillion in short-dated Treasury bills by the end of 2023, with $850 billion in net over the next four months. The increased demand for cash will suck out liquidity from the financial system and put more pressure on U.S. banks to raise rates in order to attract savers. Additionally, the lack of available money in circulation may have an adverse effect on equity markets as investors can place their cash into safer assets.
• Additionally, European banks are set to make their first payment at the end of the month to the European Central Bank for loans it took out during the pandemic. The nearly €500 billion repayment of funds borrowed from targeted longer-term refinancing operations (TLTRO) could hurt fragile eurozone banks. The end of the program will force banks to survive on their own as the era of easy money concludes. Strategists at Bank of America suggest that banks may be forced to rely on alternative funding such as money markets for capital. If true, the increased competition could push up interest rates in Europe right at a time when the economy is expected to be in recession.

     Source: Wall Street Journal

• Italy will garner the most attention as the country was heavily reliant on ECB capital during the pandemic.

• Out of the top five central banks by total assets, only the People’s Bank of China and the Bank of Japan are anticipated to inject stimulus into the financial system throughout the year. The remaining three, the Federal Reserve, Bank of England, and Swiss National Bank, are expected to wind down their balance sheets as they look to control inflation. The lack of flows will be a temporary headwind for financial markets, but we expect the situation to improve once central banks start to normalize policy, which could happen as soon as this year. In the meantime, we think investors should expect more market volatility.

Dollar Is King: The greenback is likely to keep its throne as the global reserve currency, despite what critics may think.

• Led by China and Russia, there is a growing bloc of countries willing to create a currency to challenge the U.S. dollar’s dominance. Last week, foreign ministers from each of the BRICS countries, as well as representatives from Saudi Arabia, the United Arab Emirates, and Kazakhstan, met in South Africa. The countries gathered to discuss establishing a shared currency to avoid having to use the U.S. financial system to facilitate trade. The meeting was a precursor to a summit in Johannesburg, South Africa that is set to take place in late August but also serves as a reminder of the ongoing frictions between regional blocs.

• The American greenback is an attractive currency for countries to hold, especially in times of uncertainty. This is due to the deep financial market and open consumer market in the United States. Argentina’s presidential candidate, Javier Milei, has advocated for the country to abandon the peso in favor of using the dollar as its official currency. Although it is unclear whether Milei will succeed in his push to change the country’s currency, his proposal reflects foreigners’ faith in the U.S. dollar. However, unlike the U.S. dollar, the currencies of BRICS countries do not have the same level of liquidity and depth in the global market. This lack of market breadth and capital flexibility will make it difficult for other countries to use the currencies of the BRICS countries for international trade and investment.

• The chart above shows the percentage of foreign holdings of U.S. dollars relative to other currencies in use. The dollar is the dominant currency, but its popularity is declining. While the threat of a competing BRICS currency is unlikely to dethrone the U.S. dollar, we expect countries to diversify their currency holdings as the world splits into blocs. If this happens, the greenback could depreciate against other currencies, providing a boost to investors looking to invest abroad. Additionally, the new currency regime may lead U.S. policymakers to adopt more hawkish policies to prevent a weaker dollar from inflating the price of imported goods and services, and thus, contributing to inflationary pressures.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with new, upgraded forecasts for global economic growth from the World Bank.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a big slide today in the Turkish lira (TRY) as the country’s new finance minister begins shifting polices and the prospect for another big labor action in the U.S.

Global Economy:  In its latest Global Economic Prospects report, the World Bank said it now expects global economic output to increase an inflation-adjusted 2.1% in 2023, up from its forecast of 1.7% in January but still weaker than the 3.1% expansion last year.  Nevertheless, it also cut its forecast for 2024 to 2.4%, versus its January estimate of 2.7%.

• The revised forecasts essentially reflect how the U.S. and other key countries have maintained their economic momentum better than anticipated at the start of the year, which will likely push much of their slowdown or recession into next year.
• Prolonged economic momentum may be good for labor demand, but the institution warned that the resulting interest-rate hikes by the Federal Reserve and other central banks are causing increasing strains on many less-developed countries.

China:  Despite the World Bank’s upwardly revised growth forecasts for 2023, the faltering recovery in China remains a concern for global investors.  New analyses suggest the government may be fudging its export data upward to show national growth is better than it really is.  The analyses show discrepancies between China’s official export data and a range of other export indicators.  Faltering demand growth in China would likely be a major headwind for overall global growth and the financial markets.

• In official data released today, China’s May exports were down 7.5% year-over-year, after a rise of 8.5% in the year to April. The reported decline for May was much worse than analysts anticipated, but that won’t necessarily stop the concerns about inaccurate reporting to make the economy look better than it really is.
• Meanwhile, May imports were reportedly down 4.5% on the year, after a fall of 7.9% in the year to April. Falling imports also point to weakening demand in China.

China-United States:  In a sign that bilateral relations could be stabilizing, U.S. Secretary of State Blinken will reportedly visit China later this month.  That would mark a rescheduling of the meeting Blinken planned to make in February before it was derailed by that month’s Chinese spy balloon incident over the U.S.  Any resumption of high-level contact between U.S. and Chinese leaders could help ease the acrimony between the countries, but we believe the overall rivalry will continue to sharpen over time and drive further global fracturing, re-industrialization in the U.S., shortened global supply chains, and higher inflation and interest rates.

United Kingdom:  Mortgage lender Halifax said the average British home price in May was down 1.0% from one year earlier, marking the first year-over-year decline since 2012.  The decline in home values comes as the Bank of England reports that the country’s average mortgage interest rate has topped 4.5% for the first time since the Great Financial Crisis, with more hikes by the central bank expected in the coming months.

Turkey:  The Turkish lira (TRY) is down approximately 7% against the U.S. dollar so far this morning, recently trading at around 23 per greenback.  In contrast with the currency’s previous sharp drops, this one doesn’t appear to stem from concern about new, unorthodox economic policies or the threat of a financial crisis.  On the contrary, today’s decline appears to reflect a move toward better economic policies by newly installed Finance Minister Şimşek.  Specifically, today’s fall appears to reflect the government reducing its support for the currency and letting it trade more freely.

U.S. Fiscal Policy:  Investors are becoming increasingly worried that the Treasury Department will have to auction as much as $850 billion in bills between now and September to replenish its coffers and make up for the months when it was constrained by the recent standoff over a new debt limit.  As we’ve warned before, massive make-up issuance will drain liquidity out of the financial markets, potentially pushing down asset prices at least in the near term.

• Separately, some defense hawks in Congress are unhappy with the military budget’s minimal 3.3% increase under the deal to lift the debt limit. Hawks in both the House and the Senate have floated the idea of an immediate supplemental appropriation bill to boost defense spending further in the coming fiscal year.
• However, House Speaker McCarthy threw cold water on that idea earlier this week. It remains to be seen whether he will be able to hold the line on the defense budget as Congress gets to work on its appropriation bills in the coming weeks.

U.S. Retailing Industry:  While we continue to believe that global geopolitical fracturing will make re-industrialization of the U.S. economy a key trend in the coming years, as discussed in our Comment on Monday, new reporting suggests it will also lead to changes in U.S. retailing.  As foreign retailers become more wary about investing in China and its bloc, many that have only a small presence in the U.S. right now are reportedly planning to open large numbers of new stores here in the coming years.  Besides creating new competition for U.S. retailers, the expansion could help those foreign firms make up for lost opportunities in the China bloc.

U.S. Labor Market:  Teamsters President Sean O’Brien warned that his union will take a highly demanding, “militant approach” to negotiations with employers, including the upcoming talks for a new contract with UPS (UPS, $167.59).  That contract expires on July 31, and O’Brien specifically warned that he would take the union out on strike if the company doesn’t agree to universal pay rises, the end of an existing two-tier pay system, the installation of air conditioning into trucks, and other demands.

• The contract between the Teamsters and UPS is the country’s biggest labor deal, covering some 340,000 drivers and package handlers.
• A strike at UPS could therefore have a significant impact on the economy, not only by disrupting activity for businesses and individuals, but also by further signaling to workers their improved bargaining power amid today’s labor shortages.

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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 a major venture-capital business, Sequoia Capital, is splitting up into components that largely reflect the global fracturing that we’ve been talking about for so long.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the destruction of a major dam and power station amid the war in Ukraine and new U.S. lawsuits against major cryptocurrency businesses.

Global Fracturing:  Venture-capital giant Sequoia announced that it will split into three separate geographically focused partnerships that will be distinct firms with separate brands.  The firm’s U.S. and European venture-capital business will retain the name Sequoia Capital, while its Chinese business will split off and change its name from Sequoia China to HongShan, as it’s currently referred to in Mandarin.  Sequoia’s business in India and Southeast Asia will separate and be renamed Peak XV Partners.

• We have been writing extensively about the way the world is fracturing into relatively separate geopolitical and economic blocs. The Sequoia split-up illustrates how this fracturing will have a profound impact on businesses.
  • Under Sequoia’s new structure, the U.S. and European venture-capital business will largely focus on what we call the evolving U.S.-led bloc.
  • The new HongShan will cover the dominant country in what we refer to as the China-led bloc.
  • The new Peak XV Partners looks like it will cover many of the countries we believe will end up in either the China-leaning, neutral, or U.S.-leaning bloc.
• As with overall global economic production and relationships, Sequoia’s split-up will likely reduce some of the firm’s efficiency, synergy, and innovation capacity. On the other hand, it will make each entity more resilient and independent as U.S.-China geopolitical tensions threaten to sever cross-bloc trades and investment.  Many other important firms are facing similar tough decisions, as shown by the grilling recently faced by the chairman of Taiwan Semiconductor Manufacturing (TSM, $98.05).

China-Hong Kong-United States:  A former California-based executive of ByteDance claims in a wrongful dismissal lawsuit that the Chinese Communist Party accessed user data from the company’s hit TikTok app in order to identify democracy protesters in Hong Kong during its political unrest in 2018.  The accusation is likely to intensify U.S. government efforts to rein in TikTok or perhaps even ban it from the U.S. market.  More broadly, it will probably also heighten concerns about U.S. users’ data security on Chinese apps or devices, further worsening U.S.-China tensions.

Russia-Ukraine War:  Shelling overnight has destroyed a major dam and power station in southeastern Ukraine, causing massive flooding and putting the large Zaporizhzhia nuclear power station at risk.  The Russian and Ukrainian governments have accused each other of destroying the facility, but at this point, there appears to be a good chance that the destruction was a desperate attempt by Russia to complicate Ukraine’s planned counteroffensive.  Even though the flooding has reportedly washed away many of Russia’s trenches and other defensive works in the region and will cause water shortages in Russia-controlled Crimea, the water and soaked ground could preclude any Ukrainian attack in that vector, allowing Russia to shift more troops to other parts of the front lines.

U.S. Cryptocurrency Regulation:  Yesterday, the Securities and Exchange Commission sued leading cryptocurrency exchange Binance for running an illegal trading platform in the U.S., misusing customer funds, and placing those funds with affiliates that had a conflict of interest.  The SEC action adds to the legal attacks on Binance that have been launched by the Commodity Futures Trading Commission and the Justice Department.  In response, key cryptocurrencies and related firms fell sharply yesterday, with Bitcoin (BTC-USD, 25,647.03) ending down 5.2%.

• In late-breaking news this morning, the SEC has also sued major crypto exchange Coinbase (COIN, $58.71) for not properly registering as an exchange.
• At the moment, it looks like Coinbase stock will fall some 15% at the open, based on current pre-market activity.

U.S. Artificial Intelligence:  The U.S. Air Force has stepped back from the story we mentioned in our Comment yesterday, in which an official said a drone enabled by artificial intelligence turned on its operator to retaliate for being told to hold off an attack on an enemy air defense installation.  The Air Force now says the official’s comments were “taken out of context and were meant to be anecdotal.”  Evidently, the story not only touches on some of the risks involved in using AI in military operations, but it also reflects how the hype around AI is encouraging over-the-top claims about the technology.

U.S. Commercial Real Estate Industry:  New analysis from data provider Trepp shows that almost $1.5 trillion of commercial real estate mortgages are maturing over the next three years, the majority of which will likely be interest-only loans.  Those loans will be difficult for borrowers to refinance because banks are currently focused on reducing their exposure to commercial real estate, especially office buildings.  The analysis further clarifies the looming risks in the financial sector as the Federal Reserve continues to hike interest rates.

U.S. Labor Market:  Reflecting today’s tight labor markets and the way bargaining power has shifted towards workers, members of the Screen Actors Guild have voted to authorize the union to call a strike if its upcoming negotiations for a new work contract with Hollywood studios falls through.  Those negotiations begin tomorrow.  A strike by SAG would add to the current work stoppage by the writers’ union and the recent deal with directors that boosted their take of royalties and limited the threat that they could be replaced by artificial intelligence.

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