by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some trends in the little-followed monthly report on construction spending.  The data suggests that the re-industrialization of the U.S. economy, which we have long expected, is now showing up in the statistical data.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest evidence of worsening U.S.-China tensions and new developments relating to artificial intelligence.

U.S. Re-Industrialization:  In a little-noticed report last week, April construction spending was shown to be up 6.1% from one year earlier, but private nonresidential construction spending was up 30.2%.  That marked the fourth straight month in which private nonresidential construction, a proxy for commercial construction, rose more than 20.0% on a year-over-year basis.  In contrast, private residential construction spending in April was down 9.7% on the year, and public works expenditure was up just 15.1%.

• The strength in commercial construction may seem surprising given today’s high vacancies and pessimism regarding properties such as office buildings and shopping malls. The details in the report, however, showed that the jump in commercial construction came largely from new factory construction, especially manufacturing facilities for electronics and information processing goods.
• The frenzy for building new electronics factories provides some of the first statistical evidence of U.S. re-industrialization, i.e., the rebuilding of the nation’s manufacturing, construction, and mining sectors as companies shift production back home from Asia or elsewhere. We suspect that a lot of the new factory construction reflects the recently announced, high-profile projects for electric-vehicle batteries, semiconductors, and other green-energy or information-processing goods.
• Importantly, we doubt that the recent spending uptick includes much of the hundreds of billions of dollars in subsidies provided by last year’s Inflation Reduction Act or the CHIPS and Science Act. Slow bureaucratic and administrative procedures would suggest that most of those subsidies will kick in later.  In addition, higher military budgets have not yet had their full impact on the defense industrial base.  The recent increase in commercial construction, therefore, is probably only the beginning of a much larger, longer-lasting uptrend.
• As we have been arguing, re-industrialization will likely make the U.S. more resilient to external supply shocks and provide more opportunities for workers without a four-year college degree. Nevertheless, these new facilities and the shortened supply chains they represent will be less efficient than under the extreme globalization of the last few decades.  The result will likely be higher costs, greater inflation, elevated interest rates, and prolonged downward pressure on bond prices.

China-United States:  Of course, the fracturing of the world into relatively separate geopolitical and economic blocs, and the resulting adjustments to supply chains and U.S. re-industrialization, stem mostly from the worsening tensions between the U.S. and China.  In the latest example of that, a U.S. Navy destroyer transiting the Taiwan Strait in international waters on Saturday was forced to slow to avoid hitting a Chinese navy ship that crossed its path, apparently deliberately.  Meanwhile, at the weekend’s Shangri-La Dialogue security conference in Singapore, in response to U.S. Defense Secretary Austin’s call for better U.S.-China military communication and the avoidance of such near misses, Chinese Defense Minister Li Shangfu essentially told the U.S. to butt out, saying, “The best way to prevent this from happening is that military vessels and aircraft [should] not come close to our waters and airspace. What does this have to do with your security? Watch your own territorial waters and airspace, then there will not be any problems.”

• Li’s statement implied that China’s territorial waters cover the entire Taiwan Strait, which they do not. In any case, his statement shows how China is becoming increasingly confident about its ability to compete with the U.S. and intimidate U.S. forces from entering the international waters along China’s coast.  As we have stated before, China’s growing military power and aggressiveness will likely spur further efforts by the U.S. to boost its deterrent forces, leading to a prolonged period of higher defense spending.
• Increasing tensions between China and the West also continue to put investors at risk. Dutch investment firm APG, which manages about €532 billion of pension fund assets, reports that its clients are increasingly reluctant to put their money to work in China because of the growing geopolitical risks.

Global Oil Market:  In a meeting yesterday, the Organization of the Petroleum Exporting Countries and its Russian-led allies struck a deal in which Saudi Arabia will cut its production by one million barrels per day beginning in July to support prices as global economic growth and energy demand weakens.  The move has boosted global oil prices so far this morning, pushing Brent up 1.8% to trade at $77.52.  Nevertheless, it’s not clear whether the cut will be enough to keep buoying prices as Chinese economic growth falters and the U.S. economy remains poised to enter recession in the coming months.

Russia-Ukraine War:  Ukrainian officials continue to signal they are close to launching their much-anticipated counteroffensive against the Russian forces occupying eastern and southern Ukraine.  Nevertheless, it’s important to remember that the Ukrainians may be deliberately drawing out their preparations to encourage the Russians to further deplete their resources by launching pre-emptive missile and drone strikes (sometimes against Ukrainian decoys).  In the meantime, the recent small-scale Ukrainian attacks on Russia itself and on areas of occupied Ukraine probably aim to drive the Russian forces to spread themselves too thin, spark disarray within the Russian leadership, and bring the war home to the Russian people.

• On those latter points, the owner and leader of Russia’s Wagner Group mercenary force, Yevgeniy Prigozhin, in recent days lambasted the Ministry of Defense for its inability to prevent Ukrainian attacks on Russia’s border regions and threatened to move his forces there to do the job even without waiting for permission.
• If Prigozhin follows through on his threat and sends his forces to the Russian border regions, he could potentially spark internecine, civil conflict in Russia itself, creating an existential threat to President Putin’s regime.
  • In Putin’s view, the presence of a large, battle-hardened military force on Russian soil and outside the direct control of the Kremlin or the Ministry of Defense would likely be intolerable.
  • Prigozhin has already accused the Ministry of Defense of mining transportation corridors used by the Wagner forces. Prigozhin’s rhetoric suggests that outright conflict between Wagner mercenaries and official Russian troops is plausible.

Turkey:  Fresh off his re-election, President Erdoğan has installed Mehmet Şimşek as his new finance minister.  Şimşek, a former deputy prime minister and finance minister, has made all the right statements so far to calm foreign investors, saying, “Transparency, consistency, predictability and compliance with international norms will be our basic principles . . . We will prioritize macro financial stability.”  However, it is not yet clear if Erdoğan will really allow him to change to the kind of orthodox policies that would probably be needed to bring down Turkey’s sky-high consumer price inflation and boost the currency again.

Mexico:  Mining industry association Camimex says sweeping new regulations passed this spring are forcing foreign producers of silver, copper, zinc, and other minerals to reconsider their investment plans in the country.  According to Camimex, the legal reforms could jeopardize some $9 billion of investment in the next two years while stymying the development of Mexico’s vast resources for clean energy technology.

U.S. Artificial Intelligence:  According to a U.S. Air Force officer, an AI-enabled drone trained to destroy enemy air defense systems failed a recent simulated test when it unexpectedly turned on its own operator and killed him.  The drone was trained by giving it “points” for taking out enemy surface-to-air missiles.  When the operator ordered the drone to hold off an attack, its drive for points was so strong that it fired its missiles at the operator himself to overcome the order.  When the drone’s programming was changed to stop it from attacking its own pilot, it tried to overcome the hold-off order by firing at the pilot’s communication equipment.

• We think the drone incident is a good example of the risks involved in using AI in military operations.
• Of course, researchers and policymakers are also scrambling to contain the risk of AI in civilian activities. Congress is working on various bills to regulate AI use, and one Democrat is preparing a bill that would require all output from generative AI systems to carry the message, “Disclaimer: this output has been generated by artificial intelligence.”

U.S. Technology Industry:  Despite the excitement over generative AI, the recent pullback by technology firms that over-expanded during the pandemic is now starting to have broader economic implications.  Reflecting the large layoffs by multiple West Coast tech giants, in April California had the nation’s second-highest state unemployment rate at 4.5%, compared with the national rate of 3.4%.  Washington tied for third with a jobless rate of 4.3%, and Oregon was close behind at 4%.

U.S. Media Industry:  The major Hollywood movie studios and the Directors’ Guild of America have reached a tentative deal on a new work contract.  The new contract will avert a strike by directors that would have come on top of the ongoing writers’ strike.  Reflecting the strong bargaining power that workers have in today’s tight labor market, the contract dramatically boosts directors’ royalties for streamed programs.  It also specifically precludes studios from using generative AI to do the work of directors.

U.S. Banking Industry:  According to the Wall Street Journal, bank regulators as early as this month will propose new rules requiring bigger banks to boost their capital by 20% on average.  Banks that are heavily reliant on fee income will face especially large capital requirements.  The expected new rules are largely in response to the regional bank crisis this spring.  Separately, the Financial Times says that many banks plan to unload even their performing commercial real estate loans in a rush to reduce exposure to the sector.

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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 the reasons we remain cautious about recent market optimism. We then explain why the Bank of Japan’s move away from yield curve control could hurt bond prices. Finally, we discuss the impact the U.S.-China rivalry has had on countries in Southeast Asia.

 Will It Last? Investor sentiment surged on Thursday as the possibility of a soft landing increased, and the U.S. government moved closer to averting a debt default.

• The debt ceiling bill passed through the Senate on Thursday. This crucial legislation ensures that the government can continue to meet its financial obligations. The bill curtails spending until 2024 and extends the legal debt limit until January 2025. Additionally, the Congressional Budget Office estimates that the bill will yield substantial savings of $975 billion in government spending over the next decade. The legislation is now en route to President Joe Biden’s desk, where it is expected to be signed over the weekend. This comprehensive debt-ceiling package will avert potential default but will be a fiscal drag on the economy.
• Additionally, remarks from two prominent Fed officials appear to support a pause in rate hikes in June. During an event for the National Association of Business Economists, Philadelphia Fed President Patrick Harker mentioned that he would like to leave rates unchanged at the next FOMC meeting. At the same time, a post on the regional bank’s website from Saint Louis Fed President James Bullard, a hawk, suggested that rates are now within the sufficiently restrictive zone. Unlike Harker, Bullard is not a voting member this year; however, his remarks suggest that other hawks, such as Fed Governor Chris Waller, may also support a pause at the next meeting.

• • Bullard uses the chart above, based on the Taylor rule, as a guide to where policy should be. It shows that the current policy rate has surpassed the lower level of the recommended range.
• The sudden optimism in the market is likely temporary as the economy still appears to be headed toward recession. Elevated interest rates could possibly deter consumption and investments. Similarly, a reduction in government spending should also weigh on economic activity. The recent surge in the payroll numbers suggests the labor market may be strong but keep in mind that responses for the Current Employment Survey have been on the decline since the pandemic. Hence, the data may not completely represent employment conditions across the country. As a result, it is still too soon to tell whether a downturn is actually around the corner.

Ueda’s Time: Bank of Japan (BOJ) Governor Kazuo Ueda’s impending move to end the central bank’s ultra-loose monetary policy has investors uncomfortable, as the shift is likely to cause a ripple throughout the financial system

• Earlier this week, the BOJ Governor hinted that he is ready to follow other central banks and raise rates. His remarks have added to speculation that the BOJ is preparing to end its policy accommodation. An April survey showed that around two-thirds of economists expect Ueda to lift rates by July. Meanwhile, market pricing suggests that investors believe the BOJ is unlikely to make any major changes to its policy over the coming months. The differing views have added to market jitters as investors don’t want to be caught off guard again when the central bank does decide to tighten policy.
• The lingering uncertainty surrounding the timing of policy changes has made governments nervous. One of the main concerns is that Japanese investors may decrease their purchases of foreign bonds if the central bank abandons yield curve control (YCC), which caps the yield on 10-year Japanese government bonds at 0.5%. This potential shift in investor behavior has prompted the European Central Bank to warn that BOJ normalization could potentially lead to strains in the international financial system. The BOJ is currently studying the matter, and its review is expected to last at least a year. However, Ueda, a former academic, has made it clear that he believes the era of low interest rates is over.

• • The chart above compares Japanese purchases to the yields on the 10-year Treasuries. The two variables have been inversely correlated since the Bank of Japan began YCC back in 2016.
• The upward movement in Japanese government bond yields will capture the attention of both domestic and international investors, which could position the Japanese Government bonds as a genuine competitor to the U.S. Treasury, especially for investors looking to diversify their portfolios. This changing dynamic will likely play a significant role in the ongoing secular decline in bond prices, further shaping the landscape of the global financial system. Close monitoring of these developments is crucial for understanding the potential implications for market participants and stakeholders.

Uncertainty in Southeast Asia: The U.S.-China rivalry is expected to loom over the Asia security summit this weekend, as both countries look to steer clear of one another.

• On Friday, defense chiefs from China and the United States met with Singapore leaders to discuss security concerns. Although not much was disclosed regarding talks besides the usual pleasantries, Singapore announced that it agreed to establish a hotline with China for high-level communications. The agreement comes as tensions continue to escalate between the two major powers. Last week, a Chinese fighter jet intercepted a U.S. spy plane. Although there were no casualties, the incident shows the contentious relationship between the U.S. and China. The hotline will likely ensure that U.S. allies have the ability to maintain communications with both sides in the event of a dispute.
• However, the escalating tensions between the two dominant superpowers have significantly unsettled countries in the Asia-Pacific region. Numerous nations have expressed their apprehensions regarding the increasing hostility between these global powers. The former Malaysian foreign minister, for instance, has openly expressed concerns about the potential for a conflict over Taiwan. Similarly, Singapore’s Deputy Prime Minister has characterized the rift between the United States and China as insurmountable. Southeast Asian countries find themselves in a challenging position, as they are reluctant to align themselves with either side. Their primary objective is to maintain access to the vast Chinese markets while ensuring the security offered by the United States. Striking a delicate balance between these two priorities is of paramount importance to these nations as they navigate through this complex geopolitical landscape.

     Source: Bloomberg

• The intensifying rivalry between the United States and China is anticipated to have adverse consequences for countries across Asia. As depicted in the chart above, governments in the region are projected to witness a significant surge in their military spending. This substantial increase in defense expenditures indicates a growing demand for advanced weaponry, technology, and infrastructure as countries look to prepare for a potential conflict. As a result, we suspect that aerospace and defense companies are poised to benefit from this trend and remain an attractive space for investment.

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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 ongoing debate as to whether the Federal Reserve should hike or pause at its next meeting. Next, we explain why the European Union has taken a vested interest in the Western Balkans. Lastly, we discuss why uncertainty in China has unnerved both investors and businesses.

A Fed Divided: Much to the bewilderment of markets, Fed officials can’t seem to get their story straight regarding the path of future rate hikes.

• Federal Reserve Governors Michelle Bowman and Phillip Jefferson offered seemingly different interest rate outlooks on Thursday. During a “Fed Listens” event in Boston, Bowman implied that higher interest rates had not done enough to pull down housing inflation. Meanwhile, Jefferson warned that higher interest rates could “exacerbate stress” across the banking sector. The opposing viewpoints highlight the disagreements among policymakers as they struggle to articulate a path forward. As a result, investors have not been able to confidently gauge where interest rates will be set at the June meeting as exemplified by the CME FedWatch Tool which swung widely on Thursday. The model initially predicted a 70% likelihood of a 25 bps hike during mid-day, but it later revised its forecast to a 70% probability of a pause by market close.
• Mixed economic data partially explains why Fed officials are having trouble establishing a consensus on the future path of interest rates. The unexpected surge in the number of job openings bolstered investor sentiment regarding the labor market’s tightness, strengthening the belief that the central bank should raise rates. However, later that same day, the release of the Federal Reserve Beige Book supported a more moderate policy approach as firms expressed a decrease in hiring activity and waning inflation pressure. The conflicting business cycle indicators will complicate the efforts of the Fed to communicate a path forward for interest rates.
  • The strong JOLTS report led to a rapid sell-off in equities that nearly wiped out gains made in the S&P 500 in May.

• Despite the disagreements evident within the Federal Open Market Committee (FOMC), it is highly likely that there will be no dissents at the next meeting. While members hold differing views on when to cease rate hikes, most are hesitant to signal the definitive end of the tightening cycle. Therefore, a plausible scenario is that the FOMC may indicate a hike every other meeting, a strategy often referred to as a hawkish pause. This policy adjustment will still be perceived as a form of moderation; however, the market’s response could be negative as investors generally prefer interest rates to decrease by year’s end or before a recession.

Sharing is Caring: As the war in the Ukraine rages on, the European Union is poised to broaden its reach in Eastern Europe.

• The EU countries have softened their stance with prospective members. Brussels announced that it would offer some single-market benefits to countries within the Western Balkans to prevent the region from destabilizing. The move comes amidst ethnic tensions in northern Kosovo which led to a clash between protesters and NATO peacekeepers. The measure would grant access to the bloc’s digital single market in areas such as ecommerce and cybersecurity. Additionally, the EU would also increase pre-accession funding. The decision to further integrate Western Balkan countries into the EU is meant to reduce Russia’s influence and prevent another war from breaking out in Eastern Europe.
  • Last year, The EU drastically increased humanitarian aid to countries in Eastern Europe.

   (Source: European Commission)

• Additionally, the EU is doubling its support for Ukraine. Brussels is working on a four-year financial plan to support the embattled nation. The additional funding will allow Kyiv to manage its budget while it tries to repel Russian forces from its borders. Similarly, French President Emmanuel Macron signaled that he would back a path for Ukraine to join NATO. Ukraine considers membership in the military alliance as key to its future defense and security. However, Kyiv has yet to receive full support from members due to fears that adding war-fighting countries would set a dangerous precedent.
• Europe needs to pursue greater involvement within the Western Balkans to prevent Moscow from destabilizing the region. Since the beginning of the conflict, Russia has sought to broaden its war campaign by stirring up conflict in the Western Balkans. Currently, Russia is using its deep cultural and historical ties with the Serbs to help stir unrest in Bosnia-Herzegovina and Kosovo. To prevent a crisis from spiraling out of control, the EU will have to offer additional aid to prevent these countries from leaving its orbit. At this time, we suspect the greater EU involvement should be enough to prevent disputes within the Western Balkans from turning into major conflicts.

Not Yet! Prominent American CEOs want the government to cool it on talks about the U.S. decoupling from China.

• JP Morgan chief executive Jamie Dimon along with several other corporate executives warned American and Chinese lawmakers against the further exacerbating of tensions. During a summit in Shanghai, Dimon argued that the conflict between the two major powers had hurt investor confidence. His comments mirrored remarks made by Tesla CEO Elon Musk who described the U.S. and China as being conjoined twins. The sentiment expressed by the business leaders broadly reflects the unease companies have about a possible decoupling of the world’s two largest economies. As a result, we expect business leaders will try to lobby governments to resume trade talks.
  • The U.S.-Taiwan trade deal reached on Wednesday will further escalate tensions as Beijing insists that any direct talks with the sovereign province is an encroachment on Chinese sovereignty.
• The recent surge in equities across Japan, Korea, and Taiwan can be attributed to investors hedging against the possibility of a decoupling between the United States and China, as well as concerns over a potential slowdown in the Chinese economic recovery. This strategic shift in portfolio allocations reflect investors’ eagerness to explore alternative opportunities within Asia. Moreover, apart from its ongoing rivalry with the United States, China’s reopening process has been characterized by fragility and unevenness, making it challenging for investors to accurately assess the country’s growth potential.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some unexpectedly soft economic figures out of China, which are weighing on global stock markets so far today.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new sources of tension between China, the U.S., and India and the latest on the deal to raise the U.S. government’s debt limit.

China:  The National Bureau of Statistics said the country’s May purchasing managers’ index for manufacturing fell to 48.8, well short of the expected reading of 49.5 and even lower than the April figure of 49.2.  In contrast, the official PMI for nonmanufacturing industries only fell to 54.5 in May, compared with 56.4 in the previous month.  China’s official PMIs, like most such indexes, are designed so that readings over 50 indicate expansion.

• At their current levels, the PMIs provide more evidence that the economic rebound after the government lifted its draconian Zero-COVID policy is already petering out. Factory activity is shrinking further, and now even the services sector is suffering from slower growth.
• Stagnating demand in China has the potential to drag on economic activity around the world, pushing down commodity prices and weighing on stock markets. Chinese stocks are now in a bear market.

China-United States:  The Department of Defense revealed that on Friday, a Chinese fighter jet flew dangerously close to a U.S. reconnaissance plane flying in international airspace over the South China Sea.  In what the U.S. called an “unnecessarily aggressive maneuver,” the fighter jet crossed the path of the recon plane just 400 feet in front of its nose, forcing the U.S. plane to fly through its turbulence.  The incident shows that U.S.-China tensions continue to spiral, creating greater risks of outright conflict and potentially causing collateral damage to investors.

China-India:  New reports say Beijing has recently ejected the last remaining Indian journalists from its country, while New Delhi has evicted the last Chinese journalists from India.  The evictions reflect a further worsening of bilateral tensions over border disputes in the Himalayan mountains and other issues.  While our analysis puts India in the China-leaning bloc of countries, the ongoing tensions suggest New Delhi is actually “in play” and will likely continue to increase its security cooperation with the U.S.

Japan:  If you’re a seasonal allergy sufferer and have always wondered what would give you real relief, the Japanese might have an answer for you.  The government yesterday proposed a program that would cut down 20% of the country’s cedar forests over the next decade, with the goal of cutting average pollen counts by half over the next 30 years.  The plan will expand the acreage of artificially planted cedars subject to logging, promote the use of domestic wood, and allow more foreign lumberjacks to immigrate.

Eurozone:  Similar to yesterday’s report of moderating price growth in Spain, a report today showed France’s May consumer price index was up just 6.0% from the same month one year earlier, marking a significant cooling from the rise of 6.9% in the year to April and coming in lower than the expected increase of 6.4%.

• Moderating inflation in the eurozone has prompted speculation that the European Central Bank could stop its interest-rate hikes as early as July.
• In turn, that prospect is weighing on the EUR today. As of this writing, the single currency is trading at $1.0686, down 0.5% for the day.

United Kingdom:  The country’s summer of strikes continues, with the U.K.’s main train drivers’ union walking off the job today.  The action has paralyzed most of England’s mainline railroads, heaping more headaches on Prime Minister Sunak and illustrating how inflation and wage demands remain potent issues in the U.K.

Russia-Ukraine War:  According to the Wall Street Journal, Ukraine and its Western European allies are planning a July summit of global leaders (excluding Russia’s) to promote Kyiv’s peace proposal.  European leaders such as French President Macron have reportedly been lobbying for participation by countries that have sided with Russia or have declined to take a position on the war, such as Saudi Arabia and Brazil.  News of the planned summit suggests that Kyiv is operating under a broad, comprehensive plan to win the war by quickly following its expected battlefield counteroffensive with a powerful political operation supporting its own peace plan over China’s rival plan, all the while leaving Russia isolated.

U.S. Fiscal Policy:  New analysis of the preliminary deal to lift the federal debt limit indicates it will ensure that student loan payments and interest accruals will restart no later than August 30, with no further extensions to the pandemic-era pause.  The need for former students to start making loan payments again could noticeably undermine consumer spending and help give the economy a final push into recession.

• The House Rules Committee approved the debt-limit legislation yesterday and sent it for a final vote of the full House which could occur as early as today.
• The vote in the Rules Committee relied on votes from both moderate Republicans and Democrats, illustrating how passage of the bill in the full House will likely require the cooperation of centrists on both sides of the aisle.

U.S. Monetary Policy:  In an interview with the Financial Times, Cleveland FRB President Mester said she sees no compelling reason to pause the Federal Reserve’s interest-rate hikes as long as inflation pressures remain high.  Essentially, Mester argued that the risk involved with hiking rates too little was higher than the risk involved with hiking too much.  Her hawkish statement feeds into growing expectations that the policymakers will lift their benchmark fed funds rate further at their upcoming meeting in June.

U.S. Labor Market:  Goldman Sachs (GS, $330.83) is reportedly planning another round of layoffs, which would be its third since last September.  This round will evidently be focused on employees in its investment banking group.  Financial dealmaking has been crimped over the last year as the Fed hiked interest rates and, more recently, as regional banks ran into trouble.

• The layoffs underscore how the Fed’s rate-hiking campaign has had the biggest negative impacts, so far, on sectors such as housing, commercial real estate, mortgage finance, and investment banking.
• This Wall Street Journal article provides a useful overview of how the Fed’s rate hikes have tightened conditions in various credit sectors.

U.S. Oil Market:  Starting tomorrow, the crude oil transactions used to calculate the Brent benchmark price will include purchases and sales of U.S. oil.  As output from the North Sea’s Brent field has fallen, the basket of prices that go into the Brent average has been gradually broadened in recent years.  The inclusion of U.S. prices reflects the growing heft of U.S. producers in the global oil market.  However, note that the U.S. oil to be included in Brent is not West Texas Intermediate, which is widely referred to as “U.S. crude.”

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the weekend’s preliminary deal to lift the federal debt limit until 2025.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the re-election of Turkey’s president and indications that quantitatively driven investment funds have been a key reason why U.S. stocks have been moving upward this year despite expectations of a recession.

U.S. Fiscal Policy:  For those who were truly “off the grid” over the Memorial Day weekend, on Saturday President Biden and House Speaker McCarthy reached a deal in principle to lift the federal debt limit.  The agreement would make sure the government can keep covering its debt service and other bills past June 5, which is Treasury Secretary Yellen’s new estimate of when the government will run out of cash.  The challenge over the coming days will be for Biden and McCarthy to whip up enough support in their respective parties to pass the bill into law.  On the Democratic side, many progressives are angry about compromises that will cap government spending and ease permitting for energy projects.  On the Republican side, many right-wing legislators are mad that spending wasn’t cut even more.  Nevertheless, we continue to believe the legislation will ultimately be passed into law in time to avoid a financial crisis.

• Key provisions of the deal include:
  • The debt limit would be suspended until January 1, 2025, well after the upcoming federal elections. By that time, the Treasury will have rebuilt its financial flexibility and its ability to use “extraordinary measures” to pay its bills.  That means any new debt crisis could probably be pushed off into mid-2025.
  • Federal discretionary spending will be capped for the next two years. In the upcoming fiscal year, discretionary defense outlays would be allowed to rise by a nominal 3%, while discretionary nondefense outlays would be frozen at current levels.
  • Some $30 billion in unused pandemic relief funds will be clawed back from dozens of programs.
  • Work requirements to be eligible for SNAP nutrition benefits (i.e., food stamps) would be extended to those up to age 54, compared with 49 currently.
  • Federal permitting procedures for energy projects would be accelerated by requiring a decision within one or two years.
• Rising prospects for the deal gave a boost to the stock market in recent trading sessions. However, it’s important to remember that if the deal is passed into law, the Treasury will need to rebuild its cash balances at the Federal Reserve, which will likely mean drawing hundreds of billions of dollars out of the economy in the coming weeks.  That will amount to significant fiscal tightening that could pull stocks down again.

Russia-Ukraine War:  As Ukraine endured another big wave of air attacks last night, officials in Russia today blamed Kyiv for a number of drone attacks on residential areas of Moscow.  If confirmed as an attack by Ukrainian forces, the incident would mark the first such attack on Russian civilian targets, although it seems just as likely that the attack was carried out by Ukrainian sympathizers or partisans, perhaps the same who staged an attack on Russia’s border region last week.

• In any case, the notable attack on Moscow probably aimed to unsettle Russian citizens and undermine their support for Moscow’s invasion. Bringing the war home to the Russian people may be one of the “shaping operations” that the Ukrainians are carrying out to prepare for their expected counteroffensive.
• A key risk is that it could also encourage China or other Russian allies to step up their support for Russia.

Turkey:  In Sunday’s run-off presidential election, right-wing nationalist President Erdoğan defeated opposition leader Kemal Kılıçdaroğlu by 52.2% to 47.8%.  Our analysis suggests that Turkey will remain in the U.S. geopolitical and economic bloc, reflecting its membership in NATO and its tight trade ties to the U.S., but the victory by Erdoğan means he will likely continue trying to play the U.S. off China and its evolving bloc.  Erdoğan is also likely to continue his unorthodox economic policies, such as holding down interest rates in the face of high inflation and a depreciating currency.  The news of Erdoğan’s victory has, therefore, weighed on the Turkish lira (TRY) yesterday and today.

Spain:  In regional and municipal elections on Sunday, the conservative People’s Party led by Alberto Núñez Feijóo roundly beat the ruling Socialist Party of Prime Minister Pedro Sánchez.  Counting so far shows support for the People’s Party surged to 31.5%, up 9% from the elections in 2019, while support for the Socialists was nearly stagnant at 28.1%.  Nevertheless, Sánchez gambled and called a snap national election for July 23 in order to keep some initiative in his hands and stem any momentum of the People’s Party and its far-right ally, the Vox Party.

• Spain’s relatively good economic environment may be one reason the prime minister was willing to gamble on new national elections.
• The country’s statistical agency today said its April consumer price index was up just 2.9% from the same month one year earlier, far better than the rise of 3.8% in the year to March and even below the expected inflation rate of 3.4%. Excluding the volatile food and energy components, the April core CPI was up 6.1%, down from 6.6% in the previous month.

Serbia-Kosovo:  After boycotting recent local elections in northern Kosovo, Serbian protestors on Monday tried to prevent the ethnic Albanian mayoral winners from entering city halls and taking office.  The resulting violence injured more than a dozen NATO peacekeepers, sparking condemnation by Western leaders.  The new violence risks undermining a March peace deal between Serbia and Kosovo.

China:  Now that the unemployment rate for young adults has risen to a record above 20%, officials report a surge in applications for programs that put young college graduates to work in the country’s vast, underdeveloped rural areas.  While many college graduates continue trying to hold out for better-paying jobs in urban areas, the trend reflects the extent to which slowing economic growth has reduced attractive opportunities for young people—a problem that could eventually undermine political support for the Communist Party.

• Not only has China’s economy matured to the point where it can’t grow as fast as it did in past decades, but its recovery from Beijing’s draconian Zero-COVID policies is petering out much earlier than anticipated.
• Reflecting that, Chinese stocks trading in Hong Kong today temporarily dipped into bear market territory, down more than 20% from their peak in January before rallying to close above that marker.

China-United States:  Stephanie Hui, the chief of Asia-Pacific private and growth equity for Goldman Sachs (GS, $332.01), said geopolitical tensions between Washington and Beijing have sapped U.S. investors’ interest in her funds, prompting her to stop trying to raise money in the country.  Instead, Hui said she is now focused on raising money in places like the Middle East and Southeast Asia.  Separately, Beijing has reportedly refused a request by Washington for U.S. Defense Secretary Austin to meet Chinese Defense Minister Li Shangfu at a security conference in Singapore this week.  Taken together, these developments offer even more signs of the worsening estrangement between the U.S. and China.

U.S. Stock Market:  New analysis from Wall Street indicates that the rise in U.S. stock values and the relative calm in the market so far this year can be ascribed to quantitatively driven funds.  The data suggests their buying has been more than enough to offset the pullback in investing by individuals and other discretionary investors.  Of course, a risk is that the quantitative models could start to flash sell signals, which presumably would drive market values down again.

Global Gold Market:  A new survey by the World Gold Council shows that 24% of global central banks plan to increase their gold holdings in 2023.  The survey indicates that the central bank buying plans, which were especially prevalent among emerging market institutions, are being driven by concerns ranging from geopolitical tensions to consumer price inflation.  That’s entirely consistent with our oft-stated belief that aggressive sanctions by the U.S. and its allies against Russia and other authoritarian states will prompt countries to rely more on the yellow metal.  We therefore remain bullish on gold prices in the coming years.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with our thoughts about the potential benefits and risks associated with generative artificial intelligence (AI). Next, we examine the impact that a German recession would have on the European Central Bank’s policy rate decision. Finally, we discuss the Turkish election and what it may mean for markets.

More Chips: As investors clamor for AI-related stocks, regulators are seeking to contain risks associated with the technology.

• Chipmakers are confident that they can capitalize on the generative AI craze. Semiconductor producer Nvidia (NVDA, $379.80) projected second-quarter sales of $11 billion. Nvidia’s strong guidance and positive earnings report boosted sentiment in the tech sector, sending the company’s share price up 24.37% on the day. Meanwhile, the tech-heavy NASDAQ surged 1.7% on Thursday, and the S&P 500 closed up 0.9%. Optimism that the sector will revolutionize the way companies generate profits has outweighed concerns regarding regulatory risks and potential geopolitical disruptions.
• Government authorities are finding it difficult to balance the interests of shareholders with national security concerns. European regulators have proposed new rules that would limit AI companies’ abilities to use copyrighted material and to make critical decisions such as granting loans and hiring. Additionally, friction between the U.S. and China continues to pave the way for tit-for-tat restrictions on chips. Earlier this week, Beijing banned some Chinese companies from purchasing chips from semiconductor company Micron (MU, $69.61). The move is likely in retaliation for U.S. export restrictions of advanced chips to the country and may lead to a response from the Biden administration.

• Concerns over regulation and geopolitical tensions is not likely to sway investors from buying tech shares. This is best seen in the performance of Micron Technology. Despite the company’s shares plunging more than 4% following the news of the ban, its stock price is now trading at its highest level in almost a year. This is likely not a one-off. The fear of missing out may encourage investors to overlook many of the risks associated with AI and semiconductors. That said, we suspect many of the dangers associated with the AI boom will likely play out over time and should not lead to the overall change in outlook for the industry in the short- and medium-term.

Recession or Not: The European Central Bank is expected to raise interest rates at its next meeting, despite data showing that the eurozone’s largest economy is in a recession.

• Germany’s economy shrank 0.3% in the first quarter of 2023, driven by weak consumer spending and a slowdown in exports. This was the second consecutive quarter of contraction; thus, it meets the formal definition of a recession. The lack of growth is related to shoppers reining in their spending to cope with rising inflation. Household final consumption expenditure fell 1.2% in the first three months of 2023. Meanwhile, the overall price level of goods and services has risen 7.1% since April 2022. Despite the recession, the European Central Bank is expected to raise interest rates at its next meeting in June.
• Inflation concerns have kept European Central Bank officials hawkish as they look to restore price stability. Hours after German GDP figures were released, ECB Vice President Luis de Guindos advocated for central bank officials to maintain their fight against inflation. Later that day, Dutch Governing Council member Klaas Knot argued that interest rates should increase until at least July and stay there for some time. Central bankers’ insistence on maintaining policy tightening will make it difficult for countries to recover from a downturn. However, we suspect that hawkish ECB policy may offer support for the EUR, especially if the Federal Reserve holds its interest rates steady at its next meeting as expected.

• If history serves as a guide, the ECB will be less aggressive in easing policy than its American counterpart. As the chart above shows, the ECB did not raise interest rates as fast as the Federal Reserve, but it was also much slower to cut. Overnight index swaps show that traders expect European interest rates to rise by 50 bps and American rates to fall by 25 bps by the end of the year. The narrowing of interest rate differentials should allow the EUR to appreciate against the USD, making European assets relatively more attractive.

Final Round: Markets are worried that another five years of Recep Tayyip Erdoğan as President will be damaging to the Turkish economy.

• After months of speculation about the potential end of his reign, Erdoğan is currently poised as the frontrunner to win the upcoming presidential run-off on Sunday. However, the backlash from victims of the devastating earthquakes combined with the mismanagement of the country’s economy could still hurt his chances of securing a victory. Interestingly, prior to emerging as the top vote-getter in the first round of the election, Erdoğan was trailing behind his rival Kemal Kılıçdaroğlu, with opinion polls indicating a gap of 43.7% to 49.3%. However, with the recent endorsement from the third-place candidate Sinan Oğan, Erdoğan now enjoys increased support and is heavily favored to win, much to the disappointment of investors.
• The market is bracing for another Erdoğan presidency, and as a result, it is expecting the Turkish lira (TRY) to decline in value after the election. Market participants are concerned that Erdoğan will continue to steer the country in a negative direction. Mounting inflation, a burdensome debt load, and sluggish economic growth weighed on investor sentiment. The iShares MSCI Turkey ETF has already fallen by 12% since the first round of elections. As a result, Turkey will need to undergo a significant and comprehensive transformation in order to rebuild the trust of investors.

• However, it is important to acknowledge that Turkish equities have demonstrated the ability to defy expectations in the past. This is evidenced by the remarkable 110% surge in dollar terms of the Borsa Istanbul 100 index last year, compared to a 20% decline in the S&P 500. Although some of those gains have been retracted, this rally highlights the possibility that investors may not always adhere strictly to conventional wisdom. From our perspective, Turkey’s strategic geographic location, robust military capabilities, and growing industrial base position it as an enticing prospect, provided the country manages to address its internal challenges. Only time will reveal if Turkey can fulfill its potential and capitalize on these advantages.

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