by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with an update on the debt ceiling negotiations. Next, we argue that the Fed may pause this year but is not likely to pivot. We end the report with our thoughts about the rising likelihood of a hard split between the U.S. and China.

 Debt Ceiling: Ongoing talks between President Joe Biden and House Speaker Kevin McCarthy have yet to yield results, and investors are worried.

• American lawmakers are under pressure to reassure investors that they will raise the debt ceiling in a timely manner. The credit rating agency Fitch Ratings has placed the U.S. triple-A rating on watch for a possible downgrade due to concerns that political brinkmanship could prevent the government from honoring its debts. Despite progress made by negotiators, it is unclear when Congress will raise the debt limit to avoid a catastrophic default. The standoff is expected to continue today, but we are still confident that an agreement will be reached before the June 1 deadline. That said, the market may get a bit choppy as traders respond to the latest developments regarding negotiations.
• Uncertainty over lifting the debt cap has unnerved markets. The S&P 500 and Dow Jones Industrial Index are both trading lower this week (see chart below). At the same time, yields on Treasury bills expiring in the first eight days of June have risen above 7%. Anxiety over when the debt ceiling will be raised has led to a surge in market volatility. On Wednesday, the CBOE Volatility Index (VIX) surpassed 20 suggesting an unusual amount of fear amongst traders. The strong reaction highlights the significant risk a potential default will have on the U.S. economy.

• We are confident that an agreement will be reached with bipartisan votes but suspect that the deal will push the country closer to recession. Despite speculation that McCarthy will need to win unanimous support from his party to get a spending bill through Congress, there are Democrats willing to fill the gap if needed. However, the combination of a liquidity drain and spending cuts from the new deal will remove fiscal stimulus from the economy. As a result, we still believe a recession is likely to happen within the next few quarters, even if the U.S. avoids default.

 Hold Not Cut: The release of the latest Federal Open Market Committee meeting minutes has led investors to boost bets about a possible Fed pause.

• According to the May minutes, tighter financial conditions have led some Fed officials to question the need for additional rate hikes. The notes showed that central bank officials expressed a willingness to keep their options open as the committee determines whether it wants to raise rates further. The decision to maintain policy flexibility is related to concerns that inflation risks remain tilted to the upside. The latest staff projections for the annual change of personal consumption expenditure price index (PCE) were revised upward from 2.8% to 3.1% for 2023. That said, some policymakers argued that the committee should be patient before raising rates further.
• Recent speeches from officials suggest that the committee may be split between those favoring another hike and others preferring a pause. Earlier this month, Federal Reserve Governor Christopher Waller and Cleveland Fed President Loretta Mester advocated for additional rate hikes. Meanwhile, Chicago Fed President Austan Goolsbee and Federal Reserve Chair Jerome Powell expressed support for a pause at the June meeting. The conflicting reports have led traders to become less optimistic regarding a Fed pause. The latest CME FedWatch Tool now forecasts a 56.4% chance that the Fed will hold rates at their current levels at the time of this writing, much lower than the 90.1% prediction from three weeks ago.

• As the chart above shows, the Fed is still far away from achieving its 2% inflation target. The lack of progress in achieving price stability suggests that policymakers will likely keep rates higher for longer than the market anticipates. As a result, the risk of a hard landing is relatively elevated as Fed officials will likely not pivot anytime soon. That said, we still believe the central bank is close to ending its tightening cycle and is more likely to seek a potential off ramp as the country heads toward a recession.

Chinese Rivalry: From spying to resource hoarding, Beijing is leaving no stone unturned as it prepares for its eventual decoupling from the U.S.

• Chinese state-sponsored hackers have implanted malware on critical infrastructure in the U.S. and Guam, according to Microsoft (MSFT, $313.85). The breach was designed to disrupt communications links between America and Asian countries in the event of a potential conflict. Although spying between the two countries is routine, experts believe this was the widest Chinese espionage campaign ever against American infrastructure. This is the second time this year that Chinese spy attempts were discovered and will likely prevent a thaw in tensions between the major powers. Following the report, Chinese stocks erased gains made in 2023 as investors prepared for additional headwinds.
• On a related note, China is building relationships with authoritarian governments as it seeks to avoid being denied access to key resources. Chinese firms have spent $4.5 billion to acquire stakes in lithium mining firms in Latin America and Africa. Those investments are somewhat risky given the security threat within these countries. However, Chinese firms have little choice but to work with these authoritarian governments as Beijing attempts to dominate the electric vehicle market. Additionally, China’s decision to deepen ties with Russia is also evidence of the country’s willingness to work with authoritarian governments to guarantee that it has the commodities it needs to sustain economic growth.
• The rift between the two major powers continues to reinforce our view that the world is likely to split into regional blocs. Although China still offers some attractive opportunities, we believe that investors have options if they seek to maintain their exposure to the second-largest economy without having to invest directly in the country. For example, nations that have a lot of trade exposure to China, such as Japan and the countries of Europe, have had strong stock market rallies following the end of China’s Zero-COVID policies. That said, as the largest economies start to diverge, the need for diversification will likely be necessary to hedge against unexpected changes in the geopolitical landscape. Hence, investors should be wary of putting all of their eggs in one basket.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a few new developments in Russia’s invasion of Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new evidence of the threat from China’s hypersonic missiles and economic retaliation against other Western countries, plus a few items of note on the U.S. financial markets.

Russia-Ukraine War:  Two right-wing Russian militias that support Ukraine reportedly attacked and occupied at least one Russian village less than a mile from the Ukrainian border earlier this week.  The groups were then surrounded and destroyed by Russian forces yesterday.  Ukrainian officials acknowledged they were aware of the incursion but denied any involvement in it beyond “cooperating” with the groups.  All the same, reports yesterday said the groups had used U.S.-made military vehicles in the raid, including at least two M1224 MaxxPro armored vehicles and several Humvees.  The State Department responded to the allegation by reiterating that the U.S. doesn’t “enable or encourage” Ukrainian attacks on Russia itself.  The attack could marginally help the Ukrainians by diverting Russian military resources to the border area and undermining the Russians’ sense of security within their own country.  Nevertheless, we believe the use of U.S. equipment in the incident raises the risk of U.S.-Russian conflict.

• Separately, in an effort to bolster the U.S.’s commitment to aiding Ukraine, former British Prime Minister Boris Johnson gave a pro-Ukrainian speech on Monday to a group of prominent conservative politicians, donors, and business executives in Dallas. In his speech, Johnson said, “I just urge you all to stick with it . . . . It will pay off massively in the long run.”
• In another effort to address pushback against the U.S.’s support for Ukraine, a new media commentary directly addresses the controversy as to whether the U.S.’s aid to Kyiv is undermining its ability to deter China from seizing Taiwan.
  • The article notes that most of the U.S. military equipment sent to Ukraine so far was designed for a major ground war, leaving most of the naval and air assets needed to deter China in the Indo-Pacific region untouched.
  • The article argues that even if aid to Ukraine has depleted some of the U.S. arsenal, it may actually increase the country’s deterrence against China by signaling the U.S.’s resolve to protect fellow democracies from territorial aggression.

China-United States:  Speaking of a potential U.S.-China conflict, a Chinese technology magazine this month published details of a People’s Liberation Army war game in which just 24 hypersonic missiles were able to destroy a U.S. aircraft carrier and its strike group.  Using a complex three-way attack strategy, the missiles were reportedly able to sink the entire U.S. force in each of the 20 iterations of the game.  Of course, the report can’t be independently verified, and it may not be indicative of China’s true hypersonic capabilities.  Nevertheless, it does underscore China’s head start in hypersonic technology even as the U.S. continues to struggle with its program and with its decision whether to emphasize the hypersonic technology itself or just anti-hypersonic missile defense.

• Separately, the USS George Washington, one of the U.S. Navy’s 11 aircraft carriers, embarked on Monday for sea trials following a full six years out of service due to major maintenance.
• The vessel’s maintenance period was expected to be four years, but it was disrupted due to issues such as the COVID-19 pandemic, cannibalization of some systems for spare parts to be used on other carriers, a shortfall in maintenance funds, and its unexpectedly bad condition when it entered the maintenance period.
• Once the ship is back in service, it could help relieve the shortage in carrier availability as geopolitical threats continue to worsen. The table below shows the current status of all U.S. aircraft carriers.  (Note that none are anywhere close to the Persian Gulf and its critical oil supply lanes.)

Germany:  The latest trade statistics show German exports to China in January through April were down a whopping 11.3% from the same period one year earlier.  The drop reflects German automakers’ reduced market share in China, high costs for German chemical producers and other energy-intensive manufacturers, and the euro’s recent appreciation versus the dollar.

• However, the drop in Chinese demand could also reflect explicit or implicit retaliation for the European Union’s recent hawkishness against China.
• If so, it would provide more evidence that the world is indeed fracturing into relatively separate geopolitical and economic blocs, as we have been arguing.

United Kingdom:  In a speech today, Chancellor of the Exchequer Jeremy Hunt warned that persistently high inflation will prevent the government from cutting taxes anytime soon, based on concerns that tax cuts would provide extra stimulus to the economy and boost prices further.  The chancellor offered assurances that he wanted to cut the U.K.’s tax burden—currently the highest since World War II—but he first had to create economic conditions where it was safe to do so.

• Hunt’s speech came on the same day that the U.K. statistics agency issued its latest report on consumer price inflation. The April consumer price index was up 8.7% from the same month one year earlier, suggesting inflation cooled significantly from the 10.1% increase in the year to March.  However, the April CPI still overshot expectations, which had been that inflation would cool to 8.4%.
• The chancellor’s speech reflects how inflation is discouraging tax cuts in many developed countries; at the same time, politicians are loathe to use tax hikes to cool demand and bring down inflation.

Pakistan:  The country’s anti-terrorism court yesterday granted Former Prime Minister Khan bail on his corruption and terrorism charges, marking another step in the seesaw legal battle between Khan and the government.  The arrest of Khan and the government’s effort to prosecute him continue to rile the country’s politics, making it even more difficult to address Pakistan’s economic and financial crisis.

Mexico:  President Andrés Manuel López Obrador said his administration is considering buying retail bank Banamex, the country’s fourth-largest bank and a unit of Citigroup (C, $45.91) which the U.S. financial giant put up for sale last year.  A well-known Mexican businessman has already bid for Banamex, but the leftist-nationalist president indicated that if the private bid fell through, he would have the government buy it in a public-private partnership to make sure it stays in Mexican hands.

• Any such government purchase of Banamex would increase concerns about AMLO’s penchant for nationalizing businesses.
• That would likely be a further headwind for Mexican stocks, which otherwise would probably be benefiting more from the way global companies are “near-sourcing” production away from China.

U.S. Fiscal Policy:  Staff-level negotiators from the Biden administration and the office of House Speaker McCarthy met yesterday to hash out the details of a deal to raise the federal debt limit and avoid a potentially devastating default, but they reportedly made little, if any, progress.  Other reports this morning suggest Biden and McCarthy will talk later today.  Direct talks between Biden and McCarthy will likely be necessary to secure a deal before the apparent deadline of June 1, when the federal government may no longer be able to pay its bills without taking on new debt.

U.S. Stock Market:  Even though institutional and individual investors have cooled their stock purchases in the face of rising interest rates and recession fears, data from Birinyi Associates shows companies in the Russell 3000 have announced plans to buy back more than $600 billion of their own stock so far this year, matching last year’s record pace.  If actual purchases for the full year come in above $1 trillion, as the first-half pace implies, the buybacks could provide an important support for stock values despite the current headwinds in the market.

U.S. Banking Industry:  To hold on to large depositors with account balances well above the insured amount of $250,000, many regional banks have reportedly boosted their offerings of “reciprocal accounts.”  In these accounts, a customer’s large deposit balance is divvied up and shared among partner banks so that each carries just the insured amount.

• The goal is to keep the customers who were spooked by this spring’s bank failures from moving their money elsewhere.
• According to bank data firm BankRegData, deposits in reciprocal accounts soared to a new record high of $221 billion at the end of the first quarter, up from $158 billion at the end of 2022.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some key data showing how reduced demand for goods is slowing the global economy, even as post-pandemic demand for services continues to grow.  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 tension and decoupling between the West and China.

Global Economy:  Maritime research consultant Drewry has released data showing the world’s production of shipping containers has slumped dramatically in response to the falling demand for goods now that countries have eased their pandemic restrictions.  With consumers shifting their spending back to services instead of goods, shipping activity has declined, leaving a glut of containers around the globe.  Transportation dynamics often reflect the strength of economic activity, so the drop in container production helps confirm that the global economy is slowing.

Eurozone:  S&P Global said its May “flash” purchasing managers’ index for manufacturing fell to a 36-month low of 44.6, compared with 45.8 in April.  Like all major PMIs, this one is designed so that readings below 50.0 point to declining activity.

• The recent readings, therefore, indicate that the Eurozone’s factory output remains in a deep slump.
• On a more positive note, however, the May flash PMI for the service sector merely pulled back to 55.9 from 56.2 in the previous month. That illustrates how service activity in the bloc continues to grow smartly.
• The increased activity in the service sector is keeping the overall Eurozone economy growing despite the post-pandemic pullback in manufacturing. Illustrating that, the May flash composite PMI stood at 53.3, down only modestly from 54.1 in April.

United Kingdom:  The International Monetary Fund reported in an updated forecast that it no longer expects British economic activity to slip into recession this year.  The institution now expects gross domestic product to expand 0.4% in 2023 and 1.0% in 2024, reflecting stronger wage growth, more supportive fiscal policy, and an easing of global energy prices and supply chain blockages.  All the same, the IMF forecasters warned that consumer price inflation is likely to be elevated for some time to come.

Greece:  As we flagged in our Comment yesterday, conservative Prime Minister Mitsotakis called new parliamentary elections for June 25, rather than trying to form a coalition government after winning a plurality, but not a majority, in Sunday’s elections.  Because of how the seats in parliament will be allocated in the second election, Mitsotakis and his New Democracy Party will have a good shot at forming a government by themselves.

• Coupled with the economy’s rebounding tourism and transportation activity, Mitsotakis’ business-friendly policies have given a boost to Greek assets.
• Greek sovereign bonds rallied further yesterday on the election news, driving their yield to a record low against comparable Italian bonds.

Bulgaria:  After having five elections since 2021 that have ended inconclusively or resulted in short-lived governments, the country’s two main political parties have agreed to a power-sharing deal aimed at finally producing an effective government.  Under the deal, the two rival parties will form a coalition government with rotating prime ministers.  The agreement could help the country finally make progress on important issues like cutting inflation, clamping down on corruption, reducing economic dependency on Russia, and joining the Eurozone.

Japan-China:  Semiconductor manufacturers in China say they are worried that Japan’s new rules on selling advanced semiconductor-manufacturing equipment to the country could be tougher than the U.S. and Dutch restrictions.  If so, the executives said the restrictions could crimp China’s output of basic, relatively unsophisticated chips like those used in automobiles or kitchen appliances.  As we’ve warned many times before, investors remain at risk as the West and China try to decouple from each other economically and technologically.

United Kingdom-China:  In a member survey last month, the British Chamber of Commerce in China said only 8% of its members were pessimistic about their prospects in the country, down from 42% at the beginning of China’s post-pandemic opening last December.  However, fully 70% of the members said they were still taking a wait-and-see approach to new investments in the country because of continued regulatory uncertainty.  The survey shows how President Xi’s drive to bring the economy under stricter state control and clamp down on security risks is also playing into the decoupling phenomenon.

United States-China:  Several Chinese residents and a real estate firm filed a federal lawsuit to block a new Florida law restricting the sale of real estate to citizens of China, Russia, Iran, and other “countries of concern.”  The suit seeks to invalidate the law on grounds that it violates the Constitution’s equal protection clause and intrudes on the federal government’s right to manage national security, international affairs, and international commerce.

• The new Florida legislation was championed and recently signed into law by Governor Ron DeSantis, a prospective Republican presidential candidate.
• We think passage of the law illustrates how both Republicans and Democrats will likely compete to look toughest on China in the run-up to next year’s elections. If so, there could be a spiral of aggressive measures and proposals against China, which would likely make U.S.-China tensions even worse than they are at present.

U.S. Fiscal Policy:  In their latest face-to-face negotiation over raising the federal debt limit yesterday, President Biden and House Speaker McCarthy failed to reach an agreement, but McCarthy indicated the discussion was productive and that he expects to keep talking with Biden daily until they reach a deal.  The key sticking points now appear to be how much to raise the debt ceiling and at what level to cap federal spending in the upcoming fiscal year.  We continue to believe a deal will be reached and passed into law before the government loses its ability to pay its bills, but brinksmanship over the next couple of weeks could lead to heightened volatility in the financial markets.

U.S. Consumer Sentiment:  In the Federal Reserve’s annual survey of financial well-being, conducted last October, some 73% of U.S. adults said they were doing OK or living comfortably, down from 78% in 2021.  Importantly, a record 35% of the respondents said they were worse off financially than one year before, with more than half citing price inflation as a major challenge.  The survey underscores how the pain of rising prices was more than enough to offset the impact of low unemployment and rising wages last year.  It also reveals a likely reason why polls show that President Biden’s job approval ratings are so low despite high levels of employment.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a short recap of the Group of Seven (G7) summit in Japan, which finished over the weekend.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more Chinese retaliation against the U.S.’s clampdown on advanced technology flows and the latest on the negotiations over the U.S. federal debt limit.

G7 Summit:  Wrapping up their annual summit over the weekend, the G7 countries (the U.S., Japan, Germany, France, the U.K., Italy, and Canada) said they will work to insulate themselves from Chinese economic coercion and block the transfer of sensitive technology to China.  The statement reflects a growing realization of the way Beijing weaponizes other countries’ dependency on trade or capital flows with China, as we have described extensively in our various publications.

• Despite the tough communiques, however, President Biden said in a post-summit news conference that he wants more open lines of communication with China.
• Biden also predicted that U.S.-China relations would soon thaw, suggesting that there has been some sort of quiet diplomacy going on between the countries.

China-United States:  Although President Biden hinted at the G7 summit about an imminent thaw in U.S.-China relations, the Cyberspace Administration of China said yesterday that products made by U.S. memory chip maker Micron Technology (MU, $68.17) failed its network security review and that it would bar Chinese operators of key infrastructure from buying Micron’s chips.  The Chinese officials provided no details, and they didn’t say exactly which of the firm’s products would be affected.  In any case, Seoul said it didn’t plan to stop South Korea’s big memory chip makers from filling the gap left by Micron, in spite of U.S. entreaties.

• The Chinese move against Micron is widely believed to be retaliation for the U.S.’s draconian restrictions on the sale of advanced semiconductors and related goods and services, which were announced last October.
• Other suspected retaliatory measures include China’s recent clampdown on foreign consulting firms operating in China and the arrests of foreign business executives in the country.
• China’s belated retaliation for the U.S. technology clampdown illustrates the U.S.-China decoupling that is gathering force, at least in the realm of technology. As the U.S. begins to focus more on China’s increasing military threat, such decoupling is likely to expand, creating significant risks for U.S. investors.

European Union-United States:  Regulators in the EU imposed a record fine of $1.3 billion on Facebook parent Meta Platforms, Inc. (META, $245.64) for storing European user data in the U.S. in violation of the bloc’s privacy rules.  At issue is the regulators’ belief that European user data stored in the U.S. could be accessed by U.S. spy agencies with insufficient protections.  Meta said it would appeal the ruling, and the regulators said they would allow such data transfers if the EU and U.S. reach an accord on the protection of personal data.

United Kingdom:  Prime Minister Sunak is facing another headache after news was reported over the weekend that last summer Home Secretary Suella Braverman tried to use her then-position as attorney general to avoid standard penalties for a speeding ticket.  Sunak today will consult his independent adviser on ministerial ethics after being urged to investigate the matter.  The scandal comes as Sunak continues to battle high inflation, public-sector strikes, a controversial immigration proposal, and his Conservative Party’s poor results in recent local elections.

Greece:  In elections yesterday, the conservative New Democracy party of Prime Minister Mitsotakis won the most votes but not enough for a majority in parliament.  Since Mitsotakis then derided the possibility of negotiating a coalition deal to form a government, it appears Greece will face a new election sometime in the coming weeks.

• Given the way that parliamentary seats would be allocated in a second vote, Mitsotakis and New Democracy stand a better chance of winning a majority in parliament in that election.
• In anticipation that the business-friendly conservatives will win a new mandate, Greek assets are trading higher so far this morning.

India:  The Reserve Bank of India announced that it will take all of its largest denomination bills out of circulation by the end of September.  The move, which is reminiscent of a 2016 currency reform that eliminated smaller bills overnight, has sparked fear among consumers even though the central bank offered assurances that the bills would remain legal tender until September.  In fact, the large bills that are now subject to elimination were introduced amid the chaos touched off by the 2016 reform, which in turn was ostensibly aimed at undermining illicit activity.  The move appears to be weighing very slightly on the value of the rupee (INR) in foreign exchange trading so far today.

U.S. Fiscal Policy:  President Biden and House Speaker McCarthy have agreed to meet on Monday afternoon to try to overcome their impasse over raising the federal debt limit.  However, Treasury Secretary Yellen reiterated her view that the government would be unable to pay its bills by June 1 if there is no deal to raise the limit, saying the date is a “firm deadline.”  That underscores the risk that the government could default on its debt and leave many of its bills unpaid, potentially sparking economic havoc and calling into question the U.S.’s role as the foundation of the global financial system.

• All the same, we still suspect that the administration and Congress will reach a deal at the last moment and avert such an outcome.
• One key reason for optimism is that both Biden and McCarthy have already made some concessions to each other—a fact that’s easy to miss amid the political rhetoric.
  • Press reports say Biden, for example, has expressed his willingness to claw back unused pandemic relief funding, tighten work requirements for some social safety-net programs, reform permitting for energy infrastructure, and freeze spending in this year’s budget.
  • Meanwhile, McCarthy and his team haven’t pushed their earlier calls to undo provisions of last year’s Inflation Reduction Act and student debt relief. They also insist on increasing the budget for the armed forces, veterans, and border security.

U.S. Monetary Policy:  In a Friday interview with the Wall Street Journal, Minneapolis FRB President Kashkari said he would be open to holding the Fed’s benchmark fed funds interest rate steady in June to give officials more time to assess the effects of past rate increases and the inflation outlook.  Considering that other Fed officials have recently indicated they’re leaning toward at least one more rate hike in June, the statement by Kashkari illustrates how the June decision is basically too close to call at this time.

U.S. Oil Market:  In a new effort to refill the nation’s Strategic Petroleum Reserve after massive sales from it last year because of the Russia-Ukraine war, the Energy Department has revamped how it will accept bids from oil companies.  In contrast with its tender for fixed-price bids earlier this year, which failed because of the price risk it imposed on oil producers during the two weeks needed to evaluate the bids, the department will now request bids based on a less volatile measure of price spreads.

• If completed, the tender will result in the government purchasing about 3 million barrels of domestically produced sour crude, with more to be purchased later.
• Amid weakening demand and softer crude pricing as the economy slides toward recession, the purchases could provide some support for crude values.

U.S. Labor Market:  In its annual report on foreign-born workers, the Labor Department said immigrants made up 18.1% of the labor force in 2022, the highest level ever in records dating back to 1996.  Of the 164 million in the U.S. labor force (people working or looking for work), 29.8 million were born abroad, for an increase of 1.8 million from the previous year.  That means immigrants accounted for more than half the increase in the labor force last year.

• The analysis suggests the increased weight of foreign-born workers in the work force reflects both the pull of strong labor demand by companies and the high level of retirements and other withdrawals from work by native-born workers.
• Amid strong labor demand and company complaints about worker shortages, the influx of foreign-born workers probably helped hold down average wage rates, potentially helping to limit inflation pressures.  Nevertheless, many will likely see the rise in immigrant labor as competition for native-born workers, so the report could feed into the current backlash against immigration.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will start with our thoughts on the recent performance of European stocks. Next, we will give a broad overview of the limitations and controversy surrounding generative artificial intelligence. Lastly, we explain why emerging markets may not be keen to choose sides between the U.S.-led and China-led blocs.

The Renaissance: European equities have garnered attention from international investors as they continue to defy expectations of an economic slowdown.

• The market has been taken by surprise due to Europe’s resilience over the year since Russia invaded Ukraine. Initially, the conflict raised concerns about the Continent potentially slipping into a severe recession, mainly due to the potential blockade of Russian energy. However, as time passed, it became evident that Europe had not only managed to avoid a downturn, but gas prices have now dipped to their lowest level since 2021. Another positive factor was China’s reopening, which resulted in a surge in demand for European goods. This improved outlook has led investors to seek refuge in European assets. Buoyed by the prospect of Fed policy moderation, dollar-based investors have looked to Europe for portfolio diversification.
• This year, several European stock price indexes have risen to record highs, showcasing the strength of the market. Germany’s DAX stock index surpassed 16,272 points on Friday, marking a new record. At the same time, France’s CAC 40 index and Italy’s FTSE MIB index have also reached unprecedented levels in 2023. These exceptional gains in European equities have outpaced their U.S. counterparts. The chart below highlights Europe’s superior performance in recent months. The relative performance of MSCI United States compared to its European counterpart, declined from a multiple of 3.2 in August 2022 to slightly above 2.5 last month.

• The strong performance of European stocks is expected to continue in the coming months, but there are potential threats looming in the long term. The ongoing trade tensions between the U.S. and China may eventually compel countries within the EU to choose between the two superpowers. While it is likely that EU members will lean towards the U.S.-led bloc, countries like France and Germany might resist relinquishing their access to the world’s fastest-growing consumer market. Additionally, there is a possibility of Europe experiencing another energy crisis as supply constraints drive up commodity prices. Consequently, while performance is expected to remain positive in the foreseeable future, investors should remain vigilant and mindful of risks that may impact the market.

AI in Focus: Generative artificial intelligence (AI) has become the new buzzword as investors are optimistic about the technology’s earnings potential.

• Lawmakers and tech leaders convened on Capitol Hill to address growing concerns surrounding the rapid advancement of generative AI technology. During the hearing, OpenAI’s CEO Sam Altman emphasized the need for some form of regulation on this technology. Generative AI technology has faced criticism due to its potential for misuse, including the spread of misinformation, the creation of scams, and the exposure of company trade secrets. Furthermore, there have been talks about the potential revisions to Section 230 of the Communications Decency Act, which shields social media companies from liability for user-generated content. Altman’s testimony serves as an initial step by tech leaders to prevent lawmakers from imposing excessive regulations on AI. As aptly stated by IBM’s Christina Montgomery, “This cannot be the era of move fast and break things.”
• The release of OpenAI’s ChatGPT in partnership with Microsoft (MSFT, $318.52) has sparked a technological gold rush. Major tech companies such as Amazon (AMZN, $118.50), Alphabet (Googl, $123.55), and Meta (META, $246.85) have made major investments in this revolutionary technology as generative AI is seen as the future of business. These machine-learning algorithms are popular due to their ability to generate content. Although the tech is in its infancy stage, investors believe that over time companies will use the technology to improve their efficiency and boost productivity. Fear of the potential of generative AI has already sparked outrage among labor advocates who worry that the technology may be used to displace workers. The screenwriters’ union has been one of the most notable trade groups to speak out about the AI threat.

• While this new technology holds immense potential to reshape the world, its full impact is likely to take considerable time to materialize. To explore its capabilities, we tasked OpenAI with providing suggestions for recently released books about generative AI (see image below). The chatbot’s response revealed a significant flaw. Despite the authors being real individuals, a quick search on Google and Amazon shows that the book titles and reviews are not. Hence when it is faced with a difficult question, chatbots will generate responses that sound accurate but are ultimately incorrect. Such limitations are expected to diminish over time as AI models process larger volumes of data. Nevertheless, the flaw underscores the fact that the current state of the technology is not as advanced as sensational headlines may imply. Therefore, investors should exercise caution and not feel compelled to rush into this space prematurely.

Battle of Soft Power: As the West looks to improve ties within its own group, emerging market countries have decided to keep their options open for as long as possible. 

• On Friday, President Joe Biden will convene with other G-7 leaders in Hiroshima to address pressing global issues. The G-7 countries aim to strengthen their collaboration in the production of crucial components used in semiconductors, an essential industry for technological advancements. Moreover, the leaders seek to foster closer trade relations among themselves. Notably, Ukrainian President Volodymyr Zelensky is also scheduled to deliver a speech at the summit, during which he will most likely appeal to governments for increased assistance as Ukraine confronts the challenge of repelling Russian forces from its borders. The summit represents an important opportunity for these world leaders to address shared concerns and seek collective solutions.

• Meanwhile, leaders from African and Middle Eastern countries are actively asserting their neutral stance in the Ukraine conflict. Recent developments include Russian President Vladimir Putin and his Ukrainian counterpart agreeing to hold separate meetings with six African countries to explore potential peace plans. Additionally, Zelensky is visiting Saudi Arabia to participate in the Arab League Summit, where discussions will revolve around enhancing bilateral trade relationships and seeking a possible resolution to the ongoing war. Our analysis indicates that commodity-producing countries in the Middle East and Africa often align themselves with China and Russia based on bloc tendencies. These diplomatic efforts highlight the regional engagement and strategic considerations when addressing the Ukraine conflict.

• Currently, emerging market countries exhibit a greater reluctance compared to wealthier nations when it comes to aligning themselves with major blocs. Many countries within the bloc led by China and Russia rely significantly on the West for security and humanitarian aid, preventing them from fully severing ties with America. On the other hand, developed countries face fewer challenges in this regard. While countries like Germany and France have expressed their desire to maintain strategic autonomy, they have been hesitant to directly challenge U.S. foreign policy. Consequently, we anticipate that most emerging market countries will not rock the boat with the U.S.-led bloc. This pragmatic approach reflects the complex dynamics and considerations involved in balancing geopolitical relationships and economic interests among diverse nations.

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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 an update on the U.S. debt-ceiling discussion and an explanation as to why it may not be as bullish as some investors would expect. Next, we explain why calls for a Fed interest rate cut in September may be a bit premature. Finally, we end with our thoughts about how global fracturing may improve relations between governments and corporations.

The Debt Ceiling: Market sentiment was lifted on Thursday after President Biden reassured investors that the government would not default on its debts.

• President Joe Biden and House Speaker Kevin McCarthy announced that the two would meet to discuss the debt ceiling. Negotiations are expected to occur and include the potential for a deal on Sunday after President Biden returns from his trip to Japan. Talks between the two leaders will focus on possible budget cuts as the Republican party aims to reduce the deficit through spending decreases and Democrats look to increase government revenue. The two sides remain far apart on a potential agreement, but after weeks of posturing, there is now progress.
• Markets welcomed the announcement; however, there are still concerns about whether the two sides can reach an agreement by the June 1 deadline. On Wednesday, the S&P 500 closed 1.2% higher than the previous day, while the tech-heavy NASDAQ finished the day up 1.3%. The improvement in stocks is related to investors’ confidence that the U.S. government will avoid breaching the debt limit and triggering an unprecedented default. That said, government data released Monday showed that the Treasury’s cash balance fell below $100 billion, suggesting lawmakers are less than a month away from hitting the government’s spending cap.

  (Source: Haver Analytics, CIM)

• A lift in the cap will potentially lead to a knee-jerk reaction in the market, but we would not expect it to last. Over the last few weeks, policymakers have used the cash pile in the Treasury Government Account to keep the government afloat during the debt-ceiling showdown. Research from Strategas shows that the TGA spending has offset much of the impact of quantitative tightening, leading to an overall increase in net liquidity within the financial system. If the two sides agree by Monday, it may lead to a temporary bounce; however, the lack of cash injection would make it difficult for the market to sustain any rally.

Fed Speak: Policymakers have left the door open for an additional hike despite signs that the economy may be slowing.

• Investors have adjusted interest rate expectations after several Federal Reserve officials signaled support for another rate hike in June. The latest CME FedWatch Tool shows that the probability of a 25 bps rise in the Fed benchmark policy rate increased from 10.7% a week ago to 27.3% as of this morning. Earlier this week, Richmond Fed President Thomas Barkin and Cleveland Fed President Loretta Mester maintained that another interest rate increase is not off the table. Meanwhile, Atlanta Fed President Raphael Bostic emphasized that he prefers a Fed hike over a cut. The hawkish tone has added pressure on the dollar as traders are less confident that the central bank is ready to pivot.
• Fed officials’ preference toward higher rates comes amidst signs that financial conditions are tightening while household debt burdens are rising. A Fed survey of Senior Loan Officers showed that financial institutions have looked to tighten credit standards in response to economic uncertainty and concerns about funding costs and liquidity. Even buy now, pay later services have reduced or limited credit availability. The lack of credit will likely crimp consumption. Over the last few months, households have looked to fintech to purchase everyday essentials such as groceries. Additionally, the latest data from the New York Fed showed that consumer debt and delinquencies are currently still below dangerous levels but are on the rise.

• Despite investor expectations, it is unclear whether the Fed will cut rates during a recession. JP Morgan Asset Management stated that it supports the market view that the Fed will cut as soon as September. The remarks reflect previous Fed reactions to recessions where it cut aggressively to protect the labor market. However, this time may be different. As the chart above shows, aggressive interest rate increases have done little to reduce demand-driven price pressures. As a result, we suspect that the Fed may decide to keep rates higher for longer before it chooses to pivot. This scenario raises the likelihood of a prolonged recession.

Global Repositioning: State involvement in industry is becoming more prevalent as countries prepare to move into blocs.

• The U.S. push for its allies to provide more support for the green transition is starting to gain traction. On Thursday, the United Kingdom hinted that it might offer clean energy subsidies to firms in response to Joe Biden’s Inflation Reduction Act, despite rejecting the approach initially. The shift in sentiment is related to concerns that Brexit rules will prevent automakers from manufacturing electric vehicles in the U.K. Earlier this week, automaker Stellantis NV (STLA, $16.18) warned the U.K. government that it was becoming too expensive to assemble cars in Britain.
• At the same time, India is taking advantage of the uncertainty related to the ongoing rivalry between the U.S. and China to attract foreign investment. New Delhi announced plans to offer $2 billion in financial incentives to bring more tech production to India. Earlier this year, Apple (AAPL, $173.06) announced plans to build more of its iPhones in India, but it has yet to begin making its iPads and computers in the region. The new initiative will improve the level of foreign direct investment into the country, which is projected to increase modestly in the 2024 fiscal year. As the chart below shows, the current rate of FDI flows in India lags behind the previous year.

   (Source: Reuters)

• The fragmentation into global blocs will likely bring government and state interests closer. This dynamic will lead to greater cooperation between lawmakers and businesses that look to prioritize national strategic aims over wealth accumulation. A similar situation occurred during WWI when households loaded up on government bonds to show patriotism. Additionally, firms had friendlier relations with their workers during those times of war in order to maintain positive national sentiment. As a result, we suspect that firms that have close ties with the U.S. strategic aims like defense and aerospace should make suitable long-term investments.

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