by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equity futures have moderated as investors await a reaction to the May inflation data from Federal Reserve officials. In sports news, the Florida Panthers have taken a commanding 3-0 lead against the Edmonton Oilers in the NHL Finals. Today’s Comment will delve into the potential impact of letting the Saudi Arabia-US petrodollar agreement lapse, discuss what the latest PPI data tells us about consumer inflation, and examine why investors are reluctant to hold the Mexican peso. As usual, the report concludes with a summary of international and domestic economic releases.

End of the Petrodollar?: Saudi Arabia allowed the agreement with the US to price its oil exclusively in dollars lapse last Friday as the two sides work on a new defense pact.

• The decline of the petrodollar system likely signals a shift away from the dollar-based global financial regime. The agreement was the result of then President Richard Nixon’s controversial decision to suspend the gold window in 1971. Upset by this move, Saudi Arabia considered pegging the price of oil to a basket of currencies, effectively severing the link to the dollar.  In 1974, the US agreed to provide Saudi Arabia with military aid and weapon sales, in exchange for Riyadh’s commitment to recycling its excess dollars back into the US Treasury market.
• Saudi Arabia’s recent move regarding the petrodollar system can be seen as another sign of a shifting global landscape. By avoiding a definitive stance on ending the dollar’s dominance in the oil trade, the kingdom appears to be strategically navigating the growing tensions between the US and China. China’s rise as a major oil importer for Saudi Arabia, coupled with the US shale industry’s emergence as a competitor in Europe, suggests that economic realities are driving Saudi Arabia’s cautious approach. After all, China is now Saudi Arabia’s second-largest customer after Russia and has shown a preference for diversifying away from holding excessive US dollars and toward holding more gold.

• The potential end of the petrodollar system may be more calculated than it initially appeared. Earlier this year, Saudi Arabia delayed its BRICS membership bid while negotiating a potentially transformative security pact with the US. This pact, if finalized, would be more comprehensive than the previous agreement and reportedly could include a stronger US commitment to Saudi Arabia’s defense. While progress has been made, details remain under discussion, but it does feel as if both sides are close to an agreement. This strategic maneuvering suggests the petrodollar’s demise might be premature, as the US-Saudi relationship remains a key factor.

Another Inflation Surprise: Wholesale price inflation gave investors another reason to be optimistic that the Fed will cut more than once this year.

• Producer prices unexpectedly declined in May, marking their largest monthly drop since October 2023. The Bureau of Labor Statistics reported that the overall producer price index (PPI) fell by 0.2%, significantly lower than consensus estimates of a 0.1% increase. This decline was widespread, with core PPI, which excludes volatile food and energy prices, holding steady compared to the previous month. Additionally, the cost of processed goods used in production, a measure of input costs, dropped 1.5%, suggesting that businesses are seeing lower costs to build their inventory.
• Following the release of the report, the 10-year Treasury yield dropped below 4.3%, as investors believe a September cut is still possible. The report provided confidence that factors within the PPI index that contribute to the Personal Consumption Expenditures (PCE) price index, the Fed’s preferred inflation gauge, were relatively tame. This evidence suggests that core inflation may not reaccelerate this year as members of the Fed expect. In April, the PCE price index rose by 2.75% compared to the previous year, which was below the Fed’s year-end expectation of 2.8%.

• The latest CPI and PPI reports provide evidence that inflation is on the right track. However, investors may want to wait for the latest Fed speeches before pricing in bets for additional rate cuts. The latest Fed dot plot showed that the range of rate expectations narrowed significantly from March to June, with no policymakers supporting more than three rate cuts before the end of the year, despite that being the median estimate in the previous two meetings. Any signal that current voters on the Federal Open Market Committee have become more dovish will likely be viewed favorably by markets.

Demise of the Super Peso: Mexico’s currency plunged after a surprise landslide election victory, raising investor concerns about the country’s economic future.

• The weakness in the currency arises from concerns that the next administration will pursue judicial reforms aimed at removing checks on the ruling Morena party. Following her victory earlier this month, President-elect Claudia Sheinbaum stated that the government should focus on reforms that would replace appointed Supreme Court judges with popularly elected ones, a move likely to undermine potential challenges to the party’s agenda. While Sheinbaum mentioned that the matter should be discussed with law schools and judiciary workers, her predecessor President Andrés Manuel López Obrador (AMLO), who still holds significant influence in the party, doubled down on the necessity of this change.
• Investor uneasiness reflects concerns that the Morena party is trying to circumvent the judicial system to pass controversial legislation. Most recently, Mexico’s Supreme Court struck down a proposal that would have given the state-owned electric company an unfair advantage over private competitors. The court ruled that the proposal violated constitutional guarantees of fair competition in the power sector. Additionally, the High Court clashed with AMLO by overriding legislation that aimed to restrict the power of the National Electoral Institute. This independent body safeguards elections by enforcing rules on political campaigning by public officials.

• The recent drop in the peso (MXN) suggests investors are losing faith in Mexico’s ability to maintain stability. During his six-year term, AMLO did well at keeping spending in check, even as many countries were ramping up debt during the pandemic. Nevertheless, reforms favoring state-owned firms over foreign competition could create new tensions with their Western counterparts, especially if the government pursues the nationalization of key parts of its energy sector, which is a growing concern. That said, the country will likely remain a good investment opportunity as long as the High Court remains independent of the ruling party’s influence.

In Other News: The Bank of Japan maintained policy rates at its latest meeting but stated that it will reduce the amount of its bond purchases in a sign that the central bank is moving closer to policy normalization. Concerns over snap elections in France continue to weigh on stocks, as investors remain nervous about a potential victory for far-right candidates. Russian President Vladimir Putin proposed conditions for a possible truce, but they were rejected because they included demands for Ukrainian territory Russia doesn’t currently control. Nevertheless, this proposal shows a beginning to discussions about ending the conflict.

PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Investors are looking past the recent Federal Open Market Committee meeting after a bullish PPI report boosted rate cut hopes. On the sports front, the US Men’s National Soccer Team secured a draw against Brazil in their Copa América warmup. Today’s Comment will analyze the FOMC meeting, explore why the CPI report offers hope of a policy shift for the Fed, and delve into the significance of the French elections. We’ll also provide our usual roundup of domestic and international news.

Fed Raises Doubts: The latest FOMC move suggests that it is unlikely to feel confident enough to cut rates before the election.

• The central bank held its benchmark interest rate steady at a target range of 5.25% to 5.50%. However, it lowered its projected number of rate cuts for the year from three to one. This shift surprised market participants, as recent declines shown in the CPI and PCE reports suggested progress toward the central bank’s inflation target. A recent surge in the nonfarm payroll data, though, appears to have influenced this hawkish stance. During the press conference, the Federal Reserve Chair reassured markets that the Fed remains prepared to act if job growth weakens unexpectedly in the coming months.
• Job data has become paramount in the Fed’s monetary policy decisions. Fed officials have recently signaled that a significant weakening of the labor market could prompt them to ease policy. However, recent data suggests that the labor market remains tight. Since the last Fed meeting, the unemployment rate has edged up slightly, from 3.8% to 4.0%, while nonfarm payroll jobs averaged a strong 200,000. Elevated wage pressures also remain a concern. Hourly earnings remain stubbornly above 4% annually, exceeding the level policymakers view as a sustainable long-term path, which is closer to 2.5%.

• The hawkish pivot may be related to concerns about political favoritism. Recent setbacks in inflation, as evidenced by the CPI reports during the first quarter, coupled with a relatively tight labor market, have led many commentators to question the need for any rate cuts at all. This criticism may have influenced the FOMC’s decision to revise its terminal fed funds rate upward, particularly as the election nears. However, the central bank remains open to a dovish shift if labor market conditions deteriorate. Should the unemployment rate remain above the year-end projection of 4.0% (which is the current rate), it could prompt Fed officials to reassess the number of rate cuts planned for the year.

Calling the Fed’s Bluff? Despite concerns from some Fed officials, inflation is rising at its slowest pace since monetary tightening began in 2022.

• Inflation eased to a three-year low in May, according to the Bureau of Labor Statistics. Consumer prices rose just 3.4% year-over-year, down from 3.6% in April. Core inflation, a more stable measure excluding food and energy, also slowed slightly to 3.3% from 3.4%. This moderation was driven by monthly price drops in airline fares, auto insurance, and new cars. Further supporting this trend, housing costs, the index’s largest component, held steady for the fourth consecutive month. This cooler-than-expected report suggests that despite Fed concerns, policy rates are still helping relieve inflationary pressures.
• The 10-year Treasury yield plunged 9 basis points on the day, as the market cheered the CPI results and shrugged off the FOMC meeting. The market’s reaction suggests that bond investors may be discounting the Fed’s projection of a single rate cut this year, instead believing policymakers submitted their estimates prior to the release of the latest CPI figures. Data from the first five months of the year shows that non-seasonalized inflation, which is never revised, is rising at a much slower pace than in 2022 and 2023. The latest report provided even more optimism that inflation may be falling closer to its four-year average recorded before the pandemic.

• Fed officials have consistently emphasized the need for greater confidence in falling inflation before considering rate cuts this year. The next three months, which typically see lower core CPI readings, will be a critical test for the central bank. If inflation remains below 2023 levels during this period, it would be seen as evidence of easing price pressures. The bond market’s reaction reflects optimism that this will happen. However, the scenario is not without risks. A disappointing CPI report could trigger a sharp rise in bond yields in the coming months and a rethink as to whether policy rates are restrictive enough to bring down inflation.

Macron’s Gamble: The French president is hoping that the market can help spook voters into reconsidering their support for far-right parties.

• The latest opinion polls indicate that the far-right conservative party is poised to make significant gains in the upcoming election on June 30. Projections suggest that the National Rally (RN) is expected to secure between 235 and 265 seats in the 577-member National Assembly. Although this would constitute a substantial increase, they are likely to fall short of achieving an outright majority. While there have been discussions about RN aligning with the center-right Republicans, significant internal opposition within both parties hinders such a partnership. Meanwhile, far-left parties are also working on forming a united front.
• The upcoming election is likely to thrust the country’s ballooning deficit into the spotlight. Post-pandemic efforts to control the national debt have been unsuccessful. In 2023, the debt-to-GDP ratio remained at 6%, significantly exceeding the 3% threshold mandated by EU fiscal rules. Bond yields surged after the snap election announcement. Investors fear a potential RN victory could lead to higher government borrowing rather than debt reduction. Marine Le Pen, the party’s leader, has unnerved investors with her proposed sales tax cuts and push to lower the retirement age. As a result, the spread between French and German 10-year bonds widened.

• Although RN gained momentum from the recent European parliamentary elections, its success in the upcoming elections remains uncertain. Its surge over the weekend was driven primarily by frustrated voters who were more motivated to participate in an election widely regarded as inconsequential. Voter turnout for the parliamentary election was only 50%, compared to 80% in the general election. Nonetheless, a potential defeat for RN could increase pressure on Emmanuel Macron to step down, as it would be seen as a sign that the country has lost faith in his leadership. Although a leadership change in France is not our base-case scenario, it is something we will be paying close attention to.

In Other News: In a sign that conflict in Europe will likely continue, the G-7 struck a deal to offer additional funding to Ukraine for its war efforts. South Africa inches closer to a coalition government as the African National Congress Party negotiates a power-sharing deal with the pro-business Democratic Alliance.

PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with a new medium-term forecast of global oil supply and demand from the International Energy Agency. We next review several other international and US developments with the potential to affect the financial markets today, including a risky decision by the European Union to impose steep antidumping tariffs on Chinese electric vehicles and a proposed new US rule that would keep medical bills out of credit reports.

Global Oil Market: The IEA, in its closely watched medium-term outlook, has forecast that the world’s capacity to produce oil will far exceed demand by the end of this decade. The forecast is based on expectations of further fast supply growth in the US and elsewhere in the Americas, coupled with waning oil demand as green energy becomes more prevalent. The implication is that the supply/demand mismatch will drive down oil prices.

• The IEA now expects global oil production capacity to rise to 113.8 million barrels per day by 2029, but it expects demand to peak in that year at about 105.4 million bpd.
• Of course, the IEA forecasts are highly dependent on a continued transition to non-fossil fuels. Recent political trends and weaker-than-expected demand for electric vehicles suggests that the transition going forward may not be as significant as the IEA expects.

Global Shipping Market: Global shipping and logistics firms suffered big declines in their stock prices yesterday, reflecting the possibility of a ceasefire in the Israel-Hamas conflict. After the UN Security Council approved a US-proposed ceasefire plan late Monday and both Israel and Hamas showed signs that they are inching toward accepting the deal, hopes are rising that the Houthi rebels in Yemen would stop their sympathy attacks on shipping in the Red Sea.

• Of course, the complex interplay of various actors surrounding the Israel-Hamas conflict means it could still expand to a wider, regional war. For example, Iran-backed Hezbollah militants in southern Lebanon fired a barrage of missiles today into northern Israel to retaliate for an Israeli strike that killed one of the group’s commanders.
• In any case, if the US peace deal is eventually put into place and allows the Red Sea to reopen, ships would no longer have to be re-routed around Africa, global capacity would be freed up, and freight rates would be driven lower.
• While lower freight rates would undermine shippers’ profits, they could also help bring down consumer price inflation around the world.

European Union-China: Risking a trade war, the European Union today said its antidumping probe into Chinese electric vehicles found that they are heavily subsidized and present “a threat of clearly foreseeable and imminent injury to EU industry.” In response, the EU said it will impose antidumping tariffs on Chinese EVs, on top of the current 10% tariff. The move will bring total EU tariffs on Chinese EVs from 20% to almost 50%, depending on the brand and how much the producer cooperated with the EU probe. The new tariff will apply starting on July 4.

• The EU’s move aims to protect the region’s large auto and auto parts sector, which employs a large share of the EU workforce. Nevertheless, the new tariffs are opposed by European automakers, who fear Chinese retaliation against their exports to China. Those automakers themselves also make a lot of the Chinese EVs and import them to the EU under their own brands.
• The EU’s move brings it into closer alignment with the tougher US approach to China’s geopolitical and economic challenge. That raises the prospect that China might indeed retaliate against the EU, imposing its own tariffs and other trade barriers against European goods and services.
• In sum, the EU’s new tariffs and any Chinese retaliation fits in with our often-stated view that the world is fracturing into relatively separate geopolitical and economic blocs. A few key results are likely to be higher and more volatile inflation and interest rates going forward.

China: The global fear of Chinese dumping these days stems largely from a new surge of investment in Chinese factories, leading to excess capacity, falling domestic prices, and firms exporting at fire-sale prices. Illustrating that the problem isn’t just in EVs, the chair of the Asian Photovoltaic Industry Association says China’s solar panel industry is dealing with a severe glut and falling prices, to the point where it is in an “ice age.” The official called on the Chinese government to intervene to bring supply back into balance with demand.

• Separately, China’s May consumer price index was up just 0.3% from the same month one year earlier, as anticipated. May factory-gate prices were down 1.4% year-over-year.
• The price data is consistent with continued weak domestic demand and broad excess capacity in the factory sector.

France: Ahead of the country’s snap parliamentary election on June 30, Finance Minister Bruno Le Maire has warned that a victory by the far-right National Rally could spark a debt crisis like the UK suffered during the short-lived government of Liz Truss. Le Maire’s warning smacks of scaremongering to discredit his political rivals, but market action does reflect investor concern that the surging NR’s populist program could lead to a blow-out in France’s budget deficit and debt levels. Some French debt is now trading at yields above Portugal’s.

Canada: Yesterday, the government and the Public Service Alliance representing about 9,000 of the country’s border agents reached a tentative deal on a new labor contract, averting a threatened “work to rule” strike that could have substantially disrupted US-Canadian trade starting on Friday.

US Monetary Policy: The Federal Reserve wraps up its latest policy meeting today, with its decision due at 2:00 PM ET. With price pressures still high, the policymakers are expected to keep their benchmark fed funds interest rate unchanged at 5.25% to 5.50%. They will also release their updated economic projections, including their “dot plot” of expected rate changes going forward.

• Based on interest-rate futures pricing, investors currently look for the Fed’s first rate cut to be in the autumn. The biggest uncertainty is whether the policymakers will implement further cuts later in the year.
• Because of today’s sticky inflation, we continue to believe the policymakers could keep rates “higher for longer” than investors currently believe.

US Regulatory Policy: The Consumer Financial Protection Bureau yesterday proposed a rule barring medical bills from credit reports. According to the CFPB, the rule would keep debt collectors from harassing consumers for inaccurate or false medical bills. The bureau also said its internal research shows medical bills on credit reports have “little or no value” in predicting whether consumers would repay their other debts. The CFPB said removing medical bills from a report would raise the relevant credit score by about 20 points.

PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with notes on eurozone monetary policy and further details on the weekend elections for the European Parliament. We next review several other international and US developments with the potential to affect the financial markets today, including a knife attack on four US teachers in China and signs of a potential dockworker strike against the US’s major East Coast and Gulf Coast ports later this year.

Eurozone: In a joint interview with European newspapers, European Central Bank President Lagarde warned that her institution may not necessarily keep cutting its benchmark interest rate after doing so last week. According to Lagarde, “We are not following a pre-determined path . . . There could also be phases in which we leave interest rates unchanged.” The statement is a reminder that persistent price inflation and the Fed’s “higher for longer” policy will limit how much the ECB can ease policy to bolster economic growth.

Germany: In another sign that Russia’s invasion of Ukraine has prompted European leaders to start seriously preparing for war, the German government has updated its wartime mobilization and civil defense plan for the first time since the Cold War. Among other measures, the “Framework Directive for Overall Defense” calls for reinstating conscription into the armed forces, forcing skilled laborers and professionals to work in certain defense-related roles, rationing food and fuel, and transforming subway tunnels into bomb shelters.

France: Following up our discussion in yesterday’s Comment about the European Parliament elections and French President Macron’s decision to call snap elections in response, we want to clarify that Macron himself will not be on the ballot, as his presidential term runs to 2027. The elections, starting June 30, will only be for the national parliament. Initial press reports suggested that the centrist-liberal Macron called the election as a reluctant response to the surging popularity of France’s hard-right National Rally party, but we see another possibility.

• National Rally won some 32% of the European Parliament votes in France, more than twice the tally for Macron’s party. However, the European Parliament has relatively limited power in European Union governance, so many French voters may have seen the balloting as a chance to register dissatisfaction without much practical impact. Macron is probably betting that French voters in the runup to the election will have to face up to National Rally’s actual agenda, potentially eroding its support and making it lose.
• Macron is probably also calculating that if National Rally wins the election and installs its leader, Jordan Bardella, as prime minister in a “cohabitation” relationship with Macron, the hard-right party for the first time will face potential voter backlash for its actual policies.
• In sum, it appears that the wily Macron is gambling that even if he can’t make National Rally lose the parliamentary election, two years of hard-right control over parliament will undermine it and ensure that it doesn’t win the powerful presidency in 2027. Of course, the risk is that the hard right doesn’t fall on its face in the campaign or in parliament, leaving it even stronger in 2027.
• Amid this risky political backdrop, French stocks and bonds continue to sell off so far today. More broadly, the euro (EUR) today is trading down another 0.3% to $1.0730.

(Source: Wall Street Journal)

Belgium: The European Parliament elections also shed further light on Belgium, which is often seen (by outsiders) as ripe for disintegration into its Flemish north and culturally French south. The center-right New Flemish Alliance retained its position as the country’s biggest party, with 25.6% of Flemish votes, while the separatist Vlaams Belang party only increased its support to 21.8%. In response, Prime Minister Alexander De Croo resigned, setting the stage for a new government that will probably be inclined to give more autonomy to Belgium’s regions.

United Kingdom: Including bonuses, average weekly wages in the three months ended in April were up 5.9% from the same period one year earlier, matching both the expected increase and the increase in the three months to March. With wage growth elevated, inflation pressures still high, and the Fed holding rates high for longer than anticipated, it remains to be seen whether the Bank of England will start cutting its benchmark interest rate in August, as many investors expect.

Australia: The May NAB business confidence index fell to a seasonally adjusted -3, compared with +1 in April, while the business conditions index fell to +6 from +7. Importantly, several price indicators in the report pointed to accelerating cost growth, despite Australia’s current weak economic growth. The report suggests that price inflation remains an issue worldwide, potentially discouraging a range of central banks from cutting interest rates.

United States-China: Four US teachers on an exchange program in the northeastern Chinese city of Jilin were stabbed in a knife attack in a public park yesterday. Video footage indicated that at least three of the teachers were seriously wounded. The incident appears to be an isolated crime, but with US-China tensions so high, we can’t discount the possibility that it will become a new issue poisoning the relationship and creating further risks for investors.

US Monetary Policy: The Federal Reserve begins its latest policy meeting today, with its decision due tomorrow at 2:00 PM ET. With price pressures still high, the policymakers are expected to keep the benchmark fed funds interest rate unchanged at 5.25% to 5.50%. Just as important, the officials will also release their updated economic projections, including their “dot plot” of expected rate changes going forward.

• Based on interest-rate futures pricing, investors currently look for the Fed’s first rate cut in the autumn. The biggest uncertainty is whether the policymakers will implement further cuts later in the year.
• Because of today’s sticky inflation, we continue to believe the policymakers could keep rates “higher for longer” than investors currently believe.

US Corporate Governance: Data from ISS-Corporate shows that through the first five months of 2024, shareholders in S&P 500 companies have forced 70 votes on measures against traditional environmental, social, and governance (ESG) initiatives, up from 30 such votes in the first five months of 2022 and just 7 in 2020. Anti-ESG moves are now the fastest growing type of proxy proposal. However, most of the anti-ESG proposals have received support from less than 2% of shares voted, and none have passed.

US Shipping Industry: The International Longshoremen’s Association has canceled talks on a new labor contract covering dock workers at the nation’s East Coast and Gulf Coast ports to protest the expanding use of automated machinery at some facilities. Canceling the negotiations with the ports raises the risk of a strike when the current contract runs out on September 30. Such a strike would disrupt the supply of many goods sold during the holiday season, boost prices, and buoy consumer price inflation.

• Separately, the Port of Baltimore’s main channel fully reopened yesterday, once again allowing full operations at one of the biggest East Coast ports.
• The reopening came 11 weeks after a container ship slammed into the Francis Scott Key Bridge, bringing it down and blocking the passageway.

PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the initial results from the European Parliament elections over the weekend, which suggest that surging support for right-wing parties will produce big changes in the European Union’s economic and social policies. We next review several other international and US developments with the potential to affect the financial markets today, including an update on China’s effort to rescue its residential real estate market and some notes on US fiscal policy.

European Union: In weekend elections for the European Parliament, centrist parties kept their majority, but far-right parties did better than in the 2019 elections and appear to have won almost 180 of the 720 seats in the body. Support for the right grew strongly in Germany and France, prompting French President Macron to call snap elections on June 30 and driving down EU stocks and the euro so far today. The new parliament will likely shift European Union policies in a more anti-immigration direction and roll back the EU’s climate stabilization policies.

• Results so far suggest the center-right European People’s Party (EPP) alone will have 186 seats, making it the biggest party in the parliament. The center-left Socialists and Democrats (S&D) are projected to have 134 seats, while the center-left Renew party is on track to end up with 79 seats.
• The hard-right European Conservatives and Reformists (ECR) are expected to have 73 seats, and the hard-right Identity and Democracy (ID) group will have 58 seats. Along with smaller parties that share their ideology, the hard right will have almost one-fifth of the seats.
• The environmentalist-leftist Greens are expected to have only 53 seats.

Israel: Centrist politician and former general Benny Gantz said he is resigning from Prime Minister Netanyahu’s emergency cabinet to protest what he called Netanyahu’s mistakes in prosecuting Israel’s war against the terrorist Hamas government in Gaza. Gantz also called for early elections. Netanyahu’s conservative party and its right-wing allies retain a majority in parliament even without Gantz’s support, so the move doesn’t immediately topple Netanyahu. However, Gantz’s move adds to the destabilizing political uncertainty in Israel.

China:  Major residential real estate developers Country Garden, Vanke, and Shimao have now all reported significantly higher home sales in May than in April. The firms’ sales are still down dramatically from year-earlier levels, but the reports suggest the government’s new plan to rescue the sector is having at least some success. However, we remain skeptical that the sector can regain its former luster merely based on the plan’s eased mortgage standards and financial incentives for local governments to buy up excess properties.

Iran: Ahead of the presidential election later this month, the Guardian Council has approved a list of candidates consisting almost entirely of hardline conservatives. The Council, made up of clerics charged with defending the nation’s theocracy, banned two prominent reformers who had called for more moderate religious policies and rapprochement with the US. The Council’s decision helps ensure that tensions between Tehran and the West will continue to present risks to global investors in the coming years.

Chile: New reporting shows that a powerful and dangerous criminal gang from Venezuela has rapidly built a presence in Chile, boosting the incidence of extortion, kidnapping, murder, and other crimes. Although Chile retains its reputation as one of Latin America’s most developed and safest investment locations, the new spike in violence and the inequality protests that ushered in a leftist president in 2021 continue to raise investor concerns.

US Monetary Policy: The Federal Reserve holds its latest policy meeting this week, with its decision due on Wednesday at 2:00 PM EDT. With price pressures stubbornly high, the policymakers are widely expected to keep the benchmark fed funds interest rate unchanged at 5.25% to 5.50%. Just as important, the officials will also release their updated economic projections, including their “dot plot” of expected rate changes going forward.

• Based on interest-rate futures pricing, investors currently look for the Fed’s first rate cut in the autumn. The biggest uncertainty is whether the policymakers will implement further cuts later in the year.
• Because of today’s sticky inflation, we continue to believe the policymakers could keep rates “higher for longer” than investors currently believe.

US Fiscal Policy: In an interview with the Financial Times, the International Monetary Fund’s second-ranking official argued the US has “ample” resources to bring down its fiscal deficit to more sustainable levels. In the interview, First Deputy Managing Director Gita Gopinath said that US policymakers should consider boosting taxes on high-income individuals. She also said that in the US, as in all advanced economies, there is “no way of getting around” the fact that population aging will require fundamental reforms to pension systems and medical spending.

• The volume of individual income taxes, Social Security and Medicare taxes, and corporate income taxes has certainly risen over the last decade, as shown in the chart below. However, the increase has been much smaller than it would have been without the tax cuts of 2017.
• Importantly, the rise in tax revenues hasn’t been nearly enough to cover the rise in spending. The biggest increases in spending have come from Social Security, Medicare, Medicaid and other healthcare, and net interest.

PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities futures are down after strong employment data suggests that the economy remains robust. In sports news, the US Cricket team was able to score an upset victory over top contender Pakistan as it prepares for the World Cup. Today’s Comment dives into the European Central Bank’s latest rate decision, the recent flight to safety in the 10-year Treasury, and the ongoing investor uncertainty surrounding elections. As always, we’ll wrap up with a look at key domestic and international data releases.

European Central Bank: The ECB decided to lower its benchmark policy rate on Thursday but was mum on future hikes until data provided support.

• The ECB lowered its key interest rate by 0.25% on Thursday, signaling a cautious approach to future reductions. The move was widely expected and followed weeks of hints from policymakers about their willingness to ease borrowing costs. While most council members supported the cut, there was one dissenter. Robert Holzmann, head of Austria’s central bank, believed the ECB acted too hastily given recent CPI data, which suggested a pick-up in price and wage pressures across the eurozone. Consequently, there’s uncertainty about whether another rate cut will occur this year.
• The central bank’s recent rate cut raises questions about the effectiveness of its tightening measures. Policymakers boosted inflation forecasts for 2024 and 2025 but held steady for 2026. The economic outlook has brightened with upwardly revised GDP for 2024 as the region recovers from the near recession of 2023. Despite a recent uptick in core CPI, which rose from 2.80% to 2.83% last month, the ECB remains confident that inflation will eventually decline. This confidence rests on its belief that the effects of past interest rate hikes are still filtering through the economy.

• The recent ECB rate cut could be a response to market pressures, following strong hints of a reduction in the weeks leading up to the meeting. This may lead the ECB to adopt a more cautious approach as they look to avoid boxing themselves in, or worse, be forced to make a U-turn to prevent a reacceleration in inflation. Wage pressures are in focus as they have been a key driver of service-sector inflation. However, leading economic indicators suggest a cooling labor market, potentially paving the way for one more cut later this year, as markets have anticipated. September or later seems to be the most likely timeframe.

US Treasurys: Subpar economic data has recently driven the yield on the 10-year Treasury to its lowest level in three months.

• US worker productivity rose by a modest 0.3% from the previous quarter, marking the slowest pace since early 2023. While exceeding expectations slightly, the increase reflects a broader slowdown in economic activity. This follows a string of concerning reports, particularly disappointing retail sales, job openings, and home prices. However, a glimmer of hope emerged in May. Both ISM and S&P Global PMI surveys reported a pick-up in service activity, while consumer confidence took a surprising leap. Despite these signs, the overall market sentiment leans toward slowing US GDP growth.
• Weak economic data is driving a dovish shift in investor sentiment. The 10-year Treasury yield has plunged nearly 30 bps in 10 days, reflecting hopes that the Fed can achieve a soft landing. Recent inflation reports, including April’s CPI and PCE price index, showed a welcome deceleration in price pressures, suggesting inflation may be nearing the Fed’s 2% target. In addition, labor’s share of economic output has fallen significantly from its peak of 59% to 55%, reaching its lowest level in almost a decade. This suggests that wage pressure on inflation should continue to subside over the next few months.

• The Federal Reserve’s policy undeniably shapes long-term bond yields. However, investors shouldn’t overlook the impact of geopolitical changes. Since the Great Financial Crisis, US foreign demand for Treasury bonds has fallen considerably. This loss represents a critical source of buyers who are less sensitive to interest rate fluctuations. Additionally, US reliance on imports, a major disinflationary force, has also been disrupted. Rising deficits coupled with growing trade tensions suggest a potential opportunity for investors to sell 10-year Treasurys before interest rates rise again.

Global Elections: At nearly the halfway point of the year, elections continue to present surprises, potentially causing trouble for investors.

• A notable trend has been the unexpected pushback against establishment candidates. Last week in India’s elections, the Bharatiya Janata Party (BJP) was widely expected to increase its majority, but it instead suffered an embarrassing setback and was forced to form a coalition. Meanwhile, in Mexico, the overwhelming dominance of Morena also caught investors off guard. This trend is expected to carry over to Europe and the US, with elections likely to show major victories for far-right candidates, including Marine Le Pen’s National Rally Party in France and the gaining popularity for former US President Donald Trump.
• The rise of less conventional candidates has yielded mixed results for emerging markets, as investors grapple with the uncertainty surrounding policy impacts. Argentine President Javier Milei initially received a positive response from markets following his victory in December, but sentiment shifted once the challenges of implementing his proposed changes became evident. India had the opposite impact as investors believed that the BJP may still be able to push its agenda despite losing seats. South African and Mexican markets have yet to recover from their recent elections, as investor pessimism persists due to a lack of clear policy direction.

• Europe casts its first ballots this weekend, with parliamentary elections kicking off a wave of voting across the Atlantic. The UK follows next month, and the United States rounds out the year with its national elections in November. A common thread runs through these elections: anxieties over immigration, debt, and inflation. Early exit polls indicate a narrow victory for the left-wing parties in the Netherlands, with far-right candidate Geert Wilders making significant gains. Meanwhile, UK polls suggest that the Labour Party is poised to easily defeat the Tories. In the US, election polls show former President Trump leading in November, while other prediction markets show a dead heat.

In Other News: A record heat wave in the western states could potentially weigh on economic activity in June. China is cracking down on mutual funds with large-scale audits as it continues to scrutinize the financial sector.

PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equity futures are off to a modest start as investors eye Friday’s jobs data. In sports news, the Lakers are looking at hiring UConn Coach Dan Hurley to take over the team. Today’s Comment explains the potential reasons other central banks may be waiting on the Federal Reserve before making future rate decisions. We also explore whether Nvidia can sustain its current momentum and discuss the implications of the disappointing election results for Modi’s new government. As always, our report will include a roundup of international and domestic data releases.

Rate Cuts in the West: Despite policy pivots by the European Central Bank (ECB) and Bank of Canada, the dollar’s strength against major currencies may persist in the near term as other central banks await Fed action.

• The ECB became the latest central bank to cut interest rates, lowering them for the first time since 2019. This move aims to stimulate the eurozone economy, which has seen a series of quarters with subpar growth. The ECB’s decision comes as annual inflation has dipped from a peak of nearly 6% in 2023 to under 3% a year later, suggesting a need to balance GDP growth and price stability. The ECB follows similar recent rate cuts by the Bank of Canada and the Swiss National Bank.
• Central banks are likely to tread carefully on further rate cuts despite the market’s positive reaction. A wider gap between their policy rates and the Fed’s rate could strengthen the dollar, making imports more expensive, especially for dollar-priced commodities. While there is optimism that the Fed might cut rates later this year, it’s far from certain. Before their blackout period, several Fed officials emphasized the need for more data before easing monetary policy. Adding to the complexity, the euro area is also experiencing a rise in price and wage pressures.

• Central bank flexibility hinges on the Fed’s ability to deliver on its planned rate cuts this year. Next Wednesday’s release of the Summary of Economic Projections will be a key indicator. Recent data weakness suggests a high likelihood of 1-2 cuts, aligning with market expectations. If the Fed delivers, other central banks are likely to follow suit with similar cuts to maintain parity, potentially easing pressure on the US dollar. However, a Fed decision to hold rates steady could see other banks stand pat, lending support to the dollar.

Nvidia Takes Over: The biggest mover of the Magnificent Seven is soaring, but its rapid rise could be masking a hidden weakness.

• So far in 2024, US chip designer Nvidia has surged to become the world’s second-most valuable company, boasting a market valuation exceeding $3 trillion and surpassing Apple. This remarkable rise follows a period of strong demand for their graphics processing units (GPU), particularly after the company strategically pivoted to develop advanced artificial intelligence (AI) capabilities. While Nvidia faces competition from Intel and AMD, its dominance in AI is undeniable. The company holds a staggering 70% to 95% market share for AI accelerators, solidifying its position as a leader in this rapidly growing field. This strategic shift toward AI has fueled consistent, impressive earnings reports, making Nvidia a major driver of growth within the S&P 500.
• Despite its dominance in AI and high-performance computing, some analysts view Nvidia’s valuation as riskier compared to the established Magnificent Seven tech giants. While the AI market holds immense potential, its relative youth raises questions about Nvidia’s long-term sustainability if the AI boom falters. Unlike its more diversified peers, it’s heavy reliance on AI could expose it to a significant correction if market demand cools. This lack of diversification is a familiar concern for companies reliant on a single hot trend. Tesla exemplifies this as their recent stock price decline has coincided with a slowdown in electric vehicle demand.

• Nvidia’s momentum could be amplified by its upcoming stock split on June 7. The lower share price might attract more retail investors, potentially mirroring past trends. Historically, Bank of America research suggests companies outperform the market over the next year (25% vs. 12%) following a stock split. However, it’s crucial to remember that past performance doesn’t guarantee future results. Investors should consider both Nvidia’s long-term prospects and its ability to meet current market expectations. Focusing on the company’s valuation fundamentals alongside short-term momentum can be a wise approach for building a well-rounded portfolio.

The New India: Prime Minister Narendra Modi failed to attain a demanding victory in the election, calling into question his longer-term ambitions.

• Modi was formally named the Prime Minister of India for the third consecutive time on Wednesday despite his party’s disappointing performance at the polls. The ruling Bharatiya Janata Party (BJP) won 240 out of the 543 seats in parliament, falling short of a majority and necessitating a coalition to maintain power. This result signifies a weaker mandate for Modi. Throughout his tenure, Modi has been a strong advocate for Hindu nationalism and has sought to amend the country’s secular constitution, a move that would require approval from two-thirds of the parliament.
• Modi’s hold on power, albeit with a reduced majority, has reassured investors by signaling continuity in market reforms. Throughout his tenure, Modi has set an ambitious agenda, aiming to propel India to developed nation status by 2047. In pursuit of this goal, his party has pushed pro-market reforms to enhance India’s attractiveness to investors and boost its overall competitiveness. He’s expected to leverage his new term to address labor and land regulations, which have faced significant resistance. Notably, farmer protests in 2022 forced the government to repeal three laws intended to deregulate the agricultural sector.

• One source of concern is that Modi, who is 73, is widely believed to be considering retirement in a couple of years. Although his party has downplayed this speculation, retiring at that age would be consistent with previous Indian leaders. His successor is widely expected to be his right-hand man, Amit Shah, whose views are highly nationalist. Given the likely negative impact Hindu nationalism had on the outcome of this election, the party could face significant challenges if Modi decides to step down. While optimism prevails due to recent reforms in India, we’ll be closely monitoring any political developments.

In Other News: The Federal Trade Commission has opened an investigation into the Microsoft AI deal, in another demonstration of the regulatory risks facing Big Tech. Boeing Starliner reached orbit in a sign that the company is looking to take on Musk’s SpaceX in the space race.

PDF