by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with more signs that major countries and companies are shoring up their alliances and operations to counter China’s increasing geopolitical aggressiveness.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new data suggesting the German economy may finally be slipping into recession and the latest on the U.S. political standoff over the federal government’s debt limit.

Japan-South Korea: Japanese Prime Minister Kishida yesterday visited Seoul for a summit with South Korean President Yoon, marking the first visit by a Japanese leader in 12 years.  The meeting, which led to several bilateral agreements, illustrates the two countries’ rapid rapprochement as they both begin to focus on the growing geopolitical threat from China.

• The recent rapprochement comes after more than three years of estrangement over Japan’s behavior in Korea before and during World War II.
  • Illustrating just how far Japan was willing to go to solidify its relationship with Seoul, Kishida expressed his “unwavering” commitment to the 1998 joint declaration that expressed Japan’s “deep remorse and heartfelt apology” for its wartime aggressions.
  • According to Kishida, “My heart aches as many people went through very difficult and sad experiences in the harsh environment at that time.”
• Kishida’s remarks could give Yoon space to maneuver amid domestic political opposition to a closer relationship with Japan without a fresh apology.

China-Singapore: FedEx (FDX, $229.30) confirmed it will move its regional headquarters for Asia Pacific, the Middle East, and Africa from Hong Kong to Singapore, including about 15% of office jobs.  The firm insisted the move simply aims to connect the regional headquarters and its operational units “with greater speed and agility,” but we suspect it really aims to protect FedEx workers from the draconian security law that China imposed on Hong Kong in 2019.  If so, the move is another example of global fracturing and the way U.S. firms are “friend-shoring” investment into the U.S.-led bloc and away from the China-led bloc.

Russia-Ukraine War: Ukraine has still not launched its much-anticipated counteroffensive against the Kremlin’s invasion forces, but it continues to stage drone attacks against Russian logistics facilities behind the front lines in an apparent effort to soften up Russian forces.  Meanwhile, the Russian forces today launched what local officials said was the biggest wave of drone and missile strikes against Kyiv since the war started.  The Russian attacks came as Yevgeny Prigozhin, the leader of Russia’s Wagner Group of mercenaries, backtracked on threats to withdraw his forces from the embattled city of Bakhmut because of insufficient ammunition and supplies from the Russian Ministry of Defense.  Reports suggest Prigozhin may have been assuaged after former invasion commander Gen. Sergei Surovikin was named as liaison between the Defense Ministry and the Wagner forces.

• Separately, the Kremlin has hiked taxes on Russian oil producers to help make up for the loss of revenue due to Western sanctions on the country’s energy exports. Analysts expect the move to further crimp the producers’ ability to invest in future production.
• The European Union has proposed sanctions on Chinese companies supporting the Russian military for the first time since the Ukraine war began. The move is likely to further heighten tensions between Brussels and Beijing, hastening the EU’s economic decoupling from China.

Arab League-Syria: In an emergency session in Cairo, national leaders of the Arab League decided to readmit Syria after more than a decade of isolation over its brutal tactics in its civil war.  The move is being seen as a sign of waning U.S. influence in the Middle East as it will complicate U.S. efforts to isolate Syrian President Bashar al-Assad.

Germany: March industrial production fell by a seasonally adjusted 3.4%, much worse than expected and enough to mark its biggest monthly drop in a year.  Along with other recent data showing March declines in factory orders, retail sales, and exports, the data suggests that Germany, the EU’s biggest economy, may have slipped into recession in the first quarter.

U.S. Fiscal Policy: Treasury Secretary Yellen yesterday warned that if Congress refuses to pass an increase in the federal debt limit by June 1, the administration would consider invoking the Constitution’s 14^th Amendment to continue paying the government’s bills, including its debt service.  However, Yellen called the potential move a “not good option” that would likely cause a constitutional crisis as scholars dispute whether the amendment could be used in such a way.

• Separately, President Biden and members of his administration plan to meet tomorrow with House Speaker McCarthy and other congressional leaders to discuss a way out of the impasse.
• We continue to believe that brinksmanship surrounding the debt ceiling could prompt elevated volatility in the financial markets as we approach the June 1 deadline by which Yellen has warned that the government could no longer pay its bills.

U.S. Labor Market: The monthly labor report, released on Friday, showed the unemployment rate for Black Americans fell to a record-low of just 4.7% in April.  In tight labor markets, workers who have historically been underemployed are typically drawn into jobs over time.  The longer those workers remain in their jobs, the greater the chance they will build valuable skills, become more productive, and be better able to ease the growing shortage of labor in the economy.

U.S. Manufacturing Sector: Organizers said this year’s SelectUSA summit in Washington, where state and local governments woo foreign investors, had record attendance.  Reports say the hundreds of billions of dollars in federal subsidies for new manufacturing facilities in last year’s Inflation Reduction Act and CHIPS Act have sparked a massive competition by state and local governments to draw in foreign investors.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with our thoughts about the recent changes to monetary policy in Europe and the U.S. Next, we explain why safe-haven assets have become more attractive over the last few days. Finally, the report ends with a discussion about why the rivalry between the U.S. and China has spilled over into Africa.

Next Stage? Global monetary tightening may be heading toward a close as central bankers focus their attention on a potential downturn.

• Investors are not convinced that the Federal Reserve and the European Central Bank are willing to continue to raise interest rates until inflation is tamed. A day after the Fed removed mention of “additional policy firming” from its statement, ECB President Christine Lagarde tried to reassure markets that the ECB was not going to halt its hiking cycle anytime soon. However, investors fear that the banking turmoil in the U.S. could force most central banks to rethink future policy decisions. Despite hawkish rhetoric from Lagarde, the EUR fell 0.41% to $1.1018 on Thursday.
• The market expects the ECB and Fed to cut rates later this year, regardless of their comments that they won’t. The latest Euro Area Bank Lending Survey for Q1 2023 showed that the net percentage of financial institutions restricting credit has risen to its highest level since the European Sovereign Debt Crisis. At the same time, the Federal Reserve’s Senior Loan Officer Opinion Survey is expected to show similar results on Monday. Expectations of a lending slowdown have added to concerns that policymakers will need to pivot to prevent a severe recession. The CME FedWatch Tool predicts that the Fed will continue to raise rates until November, at the latest. Meanwhile, Euribor future prices suggest that the ECB will take its foot off the pedal this fall.

• Although a recession will likely force the ECB and the Fed to prematurely end their hiking cycle, we expect EU policymakers to be less aggressive. European banks are relatively healthy when compared to their American counterparts. This is mostly because there are fewer banks for depositors to choose from. Additionally, European banks are required to regularly mark to market their securities holdings. Hence, they are unlikely to have the same maturity mismatch problems that plagued Silicon Valley Bank (SIVBQ, $0.41) and First Republic Bank (FRCB, $0.32). The differences between the American and European banking systems will likely mean that the banking turmoil will have less of an impact on ECB policy which should be bullish for the EUR and supportive of European equities.

• • Additionally, the ECB has typically been slower to cut rates than the Fed, as the previous chart shows.

Risk Aversion: Uncertainty over the state of the economy and the future path of U.S. interest rates have investors retreating to safety.

• Investors are still worried that problems within the regional banking system will spill over to the broader economy. On Thursday, several regional lenders ran into financial trouble. PacWest (PACW, $3.17) shares tanked after it confirmed that it was exploring strategic options including a possible sale. Meanwhile, Western Alliance’s (WAL, $18.20) stock took a hit following a now debunked report stating that it was considering a sale. At the same time, a deal for TD Bank (TD, $60.33) to take over First Horizon (FHN, $10.06) collapsed. This overall weakness in the regional banks has led to a steep drop in the sector’s benchmark KBW index.
• Wary investors have sought comfort in traditional safe-haven assets in response to the higher volatility. The recent bank fiasco helped push gold prices close to their all-time high on Thursday, while yields on the two-year Treasury fell 15 bps in the same period. The flight-to-safety response comes amidst rising uncertainty after a week of subpar economic data which led investors to question the health of the economy. The number of workers applying for initial jobless claims hit a six-week high last week; meanwhile, labor productivity was shown to have contracted in the first three months of the year. On Thursday, concerns about the economy helped push the VIX  index past the critical level of 20.

• The shift away from riskier assets reflects overall concerns about an imminent downturn. Luckily, these worries have yet to fully materialize in the data. The latest nowcast model from the Federal Reserve Bank of Atlanta estimates a 2.7% annualized rise in GDP for Q2. Additionally, April’s jobs report shows that the economy is still adding 200k+ jobs a month. As a result, the Federal Reserve may be more inclined to hike rates at its next meeting than the market realizes. That said, safe-haven investments, particularly in precious metals, may be a way to protect against a sharp reversal in economic activity.

African Spotlight: Influence over the commodity-rich continent is becoming increasingly important as the U.S.- and China-led blocs search for additional resources to fuel their economies.

• After years of neglect, the West is now looking to reengage African countries. German Chancellor Olaf Scholz started his three-day trip across the continent earlier this week and is expected to push for deeper Western integration. Meanwhile, Japanese Prime Minister Fumio Kishida told African leaders that G-7 countries are prepared to cooperate to help resolve the conflict in Sudan and would like to invest more in the region. The new attention on African nations is meant to offset the inroads made by China and Russia as the major blocs look to secure access to the continent’s energy commodities and growing market.
• However, the West has a long way to go before it is able to catch up to China. Beijing’s Belt and Road Initiative has invested over $155 billion in the continent over the span of two decades. In comparison, the U.S. has financed roughly $14 billion worth of projects from 2007 to 2020. The funding gap has led to concerns that the West may not be able to convince African governments to join the U.S.-led bloc. For example, it was reported that South Africa allowed a sanctioned Russian aircraft to land on one of its bases earlier this week.
• Africa may not have many investment opportunities at this time, but it still has much potential. The continent’s population is expected to account for 20% of the world by 2030 and could reach 25% in 2050. The massive jump in people will help fuel GDP growth in a region that has largely been ignored by market participants. As the world breaks into regional blocs, we suspect commodity firms in Africa may be attractive for investors looking to broaden their exposure to emerging markets.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning!  In the wake of the FOMC, it’s mostly a risk off day so far this morning.  Treasury yields were lower overnight, but have reversed higher, the dollar and equities are lower, oil is modestly higher after a hard sell off, and gold is higher.

In today’s Comment, we lead off with a recap of the Fed meeting.  The ECB meets today, so we offer our first impressions from that meeting too.  The ongoing banking crisis is up next, followed by an update on the debt ceiling situation.  In the market section, we cover the changes coming to the southern U.S. border and then close with a look at the world: China, Ukraine, and general international news.

The FOMC Recap:  As expected, the Fed raised rates 25 bps and signaled a pause.  Here is the official statement and our take:

• The key difference between the May and March statement is the pause signal:
  • March: The Committee will closely monitor incoming information and assess the implications for monetary policy. The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.
  • May: The Committee will closely monitor incoming information and assess the implications for monetary policy. In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.
• Note that the bolded sentence from the March statement is missing in the May statement. The committee has left itself some leeway to raise rates if necessary, but the markets are signaling a near certainty of steady policy at the June 14 meeting.  Current market projections for the July 26 meeting suggest a near even chance of steady policy or a rate cut.  The market is starting to anticipate rate cuts as, even if it’s a bit early, the September 20 meeting is projecting an +80% chance of a rate cut.
• So far, the White House has backed Fed policy tightening, but left-leaning members of Congress are increasing their criticism of monetary policy. A group of Senators and Representatives sent an official letter to Chair Powell, calling on the committee to pause its rate hikes.  Although the signers of the missive are not surprising, a case can be made that a slowing economy and stress in the banking system support a cautious approach to policy tightening.  The Fed has a dual mandate for price stability and full employment, and the signers of this letter tend to focus on the latter mandate.
• Surprisingly, the FOMC statement took a rather sanguine view of banking stress. The turmoil we have seen in the banking system has raised fears of restricted credit—the so-called “credit crunch.”  In looking at the Senior Loan Officer Survey, which is the current reading regarding commercial and industrial loans for large and medium firms, we are at levels that tend to signal recession over the next year.  It also suggests, which shouldn’t be a shock, that unemployment is rising.

This chart shows the survey and the unemployment rate.  The lags are not consistent, but it’s rather clear that readings above 40% increase the odds of a recession.

• Market reactions were interesting. The initial reactions suggested the markets took the statements as dovish.  For example, the dollar weakened, and gold jumped to $2045 per ounce.  Equities rallied and Treasury yields fell.  During the press conference, the chair made it clear that a pause was not a signal of easing, notwithstanding expectations noted above.  In addition, he said that, in his opinion, he expects inflation to fall slowly.  Since he also noted that he doesn’t expect a recession, his outlook on inflation is consistent.  FWIW, we think a recession is more likely than the chair does, and thus inflation will also fall much more quickly than he expects.  However, on Powell’s comments, the equity market fell off rather sharply, and the other markets mostly moved to areas seen prior to the statement.
• To a great extent, we are now at a critical crossroads. If the economy heads into recession, inflation will fall and the FOMC will cut rates.  This is what the financial markets appear to be discounting.  Powell may genuinely believe that a recession isn’t likely, despite the fact that his staff expects one.  Or it may simply not be politically possible for the chair to signal that a recession is likely; after all, if that is what the FOMC members expect, they should be cutting now.  Paradoxically, if the political problem is why Powell doesn’t expect a recession, his position’s impact on markets raises the odds that we will have a recession.

 The ECB:  As expected, the ECB raised rates by 25 bps.  This was widely expected, but the tone of the statement was rather hawkish.  The bank indicated that policy would remain tight because inflation remains sticky.  Similar to what we are seeing in the U.S., European banks are tightening credit.  And, as we are seeing in the U.S., corporate market power is boosting inflation as firms pass along higher costs to consumers to maintain their profit margins.  The press conference was underway as we were writing this report, but market reaction appears to suggest that market participants were wanting more aggressive tightening; we are seeing the EUR weaken in the aftermath of the release.

The Banking Crisis continues:  As the coronation of King Charles III looms, in deference to another Queen, yet another regional bank looks like it’s in deep trouble.  After the Powell press conference yesterday, PacWest Bank (PACW, $6.42) announced it was in talks with investors about strategic alternatives, which likely means it will need to be sold.  Its shares plunged in afterhours trading.  Overall, mid-sized banks continue to lose ground.

• As we note above, the FOMC seems rather unconcerned about the banking situation. We believe this is because they think that stopping the bank run was sufficient.  As we have stated on numerous occasions, the problem isn’t just the bank run situation, it’s disintermediation.  Banks can’t offer market yields on deposits since their assets were purchased in the ZIRP era and doing so would lead to insolvency.  This situation is very similar to the S&L problems of the 1980s.  There is probably only one solution to this problem—the Fed must lower rates to protect the asset bases of these banks.
• Meanwhile, we are starting to see increasing evidence of a credit crunch. Bank lending fell towards the end of March and it’s likely the slump will continue.  Slowing lending will act as a brake on the economy and increase the odds of recession.
• Adding to problems was the announcement that Toronto-Dominion Bank (TD, $59.76) was terminating an agreement to purchase First Horizon Bank (FHN, $15.05), citing regulatory constraints. Toronto-Dominion Bank will pay First Horizon around $225 million for ending the deal.  First Horizon shares fell sharply overnight.

 The Debt Ceiling:  Treasury Secretary Yellen’s recent signal that the Treasury would “run out of cash” by as early as June 1 has increased the tension on Congress to avoid a debt default or a government shutdown.  Speaker McCarthy is expected to meet President Biden on May 9, but there is little evidence that either the president or speaker are prepared to make concessions.  The president simply wants an increase in the debt ceiling—a “clean bill.”  McCarthy, fresh off his budget vote, wants to use his legislation as the basis for negotiations.  We doubt these meetings will accomplish much.  Meanwhile, there are various tactics and ideas being considered.

• Democrats are crafting a discharge petition, which would force a vote on increasing or suspending the debt ceiling. The petition would put the bill on the floor for a vote over the Speaker’s objections, and given the narrow GOP majority, only a few defections could lead to a clean debt ceiling resolution, which would likely pass the Senate.  If five GOP reps defect, this bill could reach the floor.  However, getting five will still be difficult.
• Whenever the debt ceiling becomes a problem, the argument emerges that the 14^th Amendment makes defaulting unconstitutional. The key clause is as follows:

     The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion,       shall not be questioned…

This clause was designed to prevent Southern Congressmen from attempting to repudiate the Federal debt accumulated to fight the Civil War.  The fear was that the southern states, with voter rolls bolstered by free slaves, could legislate to avoid servicing the war debt.  The 14^th Amendment was designed to prevent that outcome.  Some legal scholars believe the clause could be used to skirt the debt ceiling issue.  Of course, this clause conflicts with Congress’s “power of the purse,” so a unilateral action by the executive branch to keep spending and borrowing would eventually be decided by the courts.  However, it should be noted that it is unclear who exactly could sue.  The Supreme Court ruled in 1997 that individual lawmakers lack standing, but Congress as a whole might.  Given the risks involved, previous administrations have avoided this outcome.  But, it is being considered, apparently.

• Another possibility is Congress could agree to extend the deadline by either raising the debt ceiling by an amount estimated by legislators to be a few week’s or month’s worth in order to negotiate further or suspend the limit while negotiations are going on. This idea may be gaining some traction.  It should be noted that, due to recesses scheduled in both houses, the House is only in session 12 days and the Senate 15 days this month.  Complicating matters further, President Biden will be out of the country this month, visiting Japan and Australia.  At the same time, “kicking the can” doesn’t really resolve the issue and without the deadline looming, it’s unlikely progress will be made.
• Other more arcane solutions have come up in these debates. A favorite of Joe Wiesenthal of Bloomberg (and co-host of the Odd Lots podcast) is the $1.0 trillion platinum coin.
• Another odd twist to the deadline is that the IRS has improved its efficiency in sending refund checks. Because it is sending checks faster, the Treasury General Account is draining faster too.

Markets, Economics and Policy:  The strike in Hollywood continues, and the border crisis is increasing.

• The writers have gone on strike in Hollywood. Late night talk shows tend to be affected first, as the hosts lose their joke pipeline.  Taped shows are usually done a few weeks in advance, so it may be a month or so before TV dramas and sitcoms go to reruns.  Usually, we wouldn’t see this issue as market moving.  But the decision to strike, the first in 15 years, is due to the accelerating shift away from broadcasting to streaming.  Writers are finding that the new environment is turning them into “gig” workers with little job security.  Often, the streaming firms make content that is short-term in nature and is hiring writers for short term projects.  The network broadcast model was designed to put a team of writers on a drama or sitcom which generated steady work.  Breaking work into small segments and hiring workers for only those jobs is a factor across the economy; organized labor is trying to respond.  We note this is a factor in the delivery industry as well.
• Title 42, which has allowed immigration officials to turn away potential immigrants and asylum seekers due to the pandemic, will expire on May 11. The government is moving 1500 troops to assist processers and help secure the border.  The expiry is expected to increase flows to the border and is not just a political problem for the White House, but it will also affect the southwestern border states as they cope with the increased flow.
• Drought is reducing the water levels of the Panama Canal, forcing vessels to reduce their cargo to transverse the waterway.

 China News:  We are monitoring recent changes to China’s national security laws which are affecting Western firms.  And Florida is joining other states in restricting the foreign purchasing of real estate.

• Governments have multiple policy goals. In particular, there can be a tension between economic growth and national security which is especially evident in foreign investment.  In our Weekly Energy Update, we have regularly reported on such tensions rising as Chinese EV battery firms look to make investments in the U.S.  Given China’s lead in this area, it makes economic sense to use their technology.  However, given national security concerns, we should avoid such endeavors.  Recently, China issued a new national security law, effective July 1, which is so broad and vague that just about anything (perhaps even reporting on the economy) could be seen as violating the law.  We will have more to say on this in the coming weeks, but in the meantime, there are reports suggesting that incoming foreign direct investment into China is waning and this decline may be tied to these new regulations.
• When a nation runs current account deficits, it must fund them via a capital account surplus. The dollar’s reserve currency status essentially requires the U.S. to run a current account deficit, which means foreigners have dollars they need to invest in the U.S.  Most of the time, those dollars flow into Treasuries,[1] but, foreigners sometimes prefer other investments.  Real estate is popular for numerous reasons.  Wealthy foreigners may want a place in the U.S. if they need to move quickly.  U.S. farmland has attracted foreign buyers.[2]  Florida has introduced legislation to restrict and regulate “hostile nations” from purchasing real estate in the Sunshine State.  Florida has been a popular destination for foreign capital flight, especially from South America.  There are concerns the legislation may to too broad and introduce unnecessary restrictions.

 International News:  We update the Ukraine War, we have a new head of the World Bank, and England holds local elections.

• The day after an apparent drone attack on the Kremlin, we still aren’t sure who is responsible. Russia is blaming Ukraine for the attack, calling it an assassination attempt.  President Zelensky denies the claim.  If Ukraine was behind the attack, it didn’t signal the action to the U.S.  If Ukraine was responsible, it was ill-advised as it is unlikely that such an attack would be successful, and it would open the possibility for Russia to retaliate in kind.  This is why some analysts are arguing it was a “false flag” operation, made by the Russians themselves.  Or, it could have been elements within Russia, either trying to eliminate Putin, or making the feeble attack to trigger a massive, and perhaps unconventional response.  We will continue to monitor the situation, but we do doubt it was a Ukrainian operation.
• NATO is warning members that Russia may be targeting undersea pipelines and cables. Intelligence officials say Russia is actively mapping these assets.
• An op-ed in the Atlantic makes the case for overwhelming support of the upcoming Ukraine offensive. We note the U.S. announced additional support.
• Zelensky is visiting the Hague
• Ajay Banga has been confirmed as the president of the World Bank.
• England holds local elections today, the first major test for PM Sunak.
• The civil conflict in Sudan is clearly a tragedy. Wars often expose wider vulnerabilities.  It turns out that the country is the world’s primary supplier of gum arabic, which is used as a thickener and stabilizer in numerous food products.  Currently, suppliers are using current inventories but if the conflict continues, it could become a problem.

---

[1] Which is one of the reasons why a debt ceiling default is so risky.

[2] Chinese buyers of Missouri farmland has been a “hot button” issue, for example.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a word on global oil supplies and prices, where a new tanker seizure by Iran would seemingly boost crude oil prices but growing concerns over recession have pushed those prices sharply lower so far today.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an apparent Ukrainian drone strike against the Kremlin and a preview of today’s Federal Reserve decision on U.S. interest rates.

Global Oil Market – Iran:  The U.S. Navy announced that Iran has again seized an oil tanker in the Persian Gulf region, marking the second such incident in a week.  Tehran has justified the harassment by saying the tankers violated maritime regulations, but the real reason is likely to retaliate for the ongoing U.S. sanctions against Iran and to undermine the U.S. security presence.

• If they continue, the tanker seizures could boost crude oil prices beyond what they otherwise would be.
• All the same, global prices for oil and other key commodities are trading sharply lower today on increasing concerns about the impending recession in the U.S. Front-month futures prices for WTI are currently down 3.0% to $69.57, while prices for Brent are down 2.7% to $73.29.

Russia-Ukraine War:  Russia is dealing with another wave of what appear to be Ukrainian drone attacks today.  In one key incident, two Ukrainian drones were downed by Russian electronic warfare systems and crashed into the Kremlin in central Moscow, prompting Russian accusations that Ukraine was trying to assassinate President Putin.  The Russians also threatened to retaliate in kind against the Ukrainian government, but we would note that Ukraine may have been emboldened to launch the strike against the Kremlin because the capital of Kyiv is now protected by sophisticated air defense systems like U.S. Patriot missiles.  Other attacks apparently made by Ukraine today included a strike against a major fuel depot, a strike on an airport, and the derailment of a fuel train in southern Russia.  By disrupting Russian logistics, these attacks could signal that Ukraine is nearly finished preparing for its expected counteroffensive.

• Separately, the Turkish government announced that the deputy defense ministers of Turkey, Russia, and Ukraine will meet on Friday to discuss extending the agreement that unblocked some of Ukraine’s Black Sea grain exports last year.
  • Russia has signaled that it expects sanctions relief before it would agree to extend the deal.
  • If the deal isn’t extended and Ukrainian grain exports are again shut in, it could lead to another round of higher global food inflation.
• There is also new information on the explosions last September that damaged the Nord Stream 1 and 2 natural gas pipelines that run from Russia to Western Europe. Four Nordic media outlets have discovered that several Russian military ships, including a tug capable of launching mini-submarines, were spotted in the area just days before the explosions.  Indeed, the Russians could have had several motives for the attack. They may have meant to punish the European countries for lending support to Ukraine or to test the West’s security for undersea infrastructure in the region.

European Union:  The EU’s single-market commissioner, Thierry Breton, will announce his plan to ramp up the bloc’s production of ammunition and missiles in response to Russia’s aggression against Ukraine.  Breton’s “Act in Support of Ammunition Production” (ASAP) would pour some €500 million from the EU budget into European defense industry factories to boost weapons manufacturing.  The plan is the third leg of the EU’s program to boost its defense capabilities after many years of muted efforts.

Chile:  Leftist President Gabriel Boric is making good on his plan for the government to take at least a 51% stake in key lithium-mining operations.  In an interview with the Financial Times, the official charged with negotiating for the stakes revealed that he wants to complete the purchases by the end of this year.  The process has spooked investors and driven down the value of Chilean mining firms.  The move is also expected to shift investment toward other producers such as Australia, Argentina, and Africa.

U.S. Monetary Policy:  The Fed’s policy making committee will wrap up its latest meeting today, with its decision due to be announced at 2:00 PM EDT.  The policymakers are widely expected to hike their benchmark fed funds interest rate by another 0.25%, to a 16-year high of 5.00% to 5.25%.  However, the focus for investors will likely be the post-meeting statement and comments by Fed Chair Powell to see if they provide any hints that the rate hikes are finished.  Given the damage inflicted on the economy from the current rate-hiking cycle, we continue to believe that any hint of a pause could give a boost to equities.

U.S. Fiscal Policy:  Democrats in the House of Representatives launched a “discharge petition” aimed at bringing a vote to the floor for a “clean” bill which would raise the federal debt limit with no associated spending cuts.  The discharge petition would require the support of five Republicans, so it’s considered a longshot, but it does suggest at least some in Congress are increasingly concerned about the economic damage that could be caused by brinksmanship around the debt limit or an outright default.

U.S. Artificial Intelligence:  Arvind Krishna, the chief executive of IBM (IBM, $125.16), said in an interview that his company will pause all hiring of back-office positions that could be done with artificial intelligence.  Going forward, Krishna suggested that about 7,800 positions at the company could eventually be replaced by AI and automation.  The statement will likely fuel concerns that the rapid rollout of AI could boost unemployment.

• In another example of AI disruption, education technology firm Chegg (CHGG, $9.08) yesterday warned that popular AI chatbot ChatGPT is already starting to hurt its sales of on-line study guides.
• Chegg’s stock plunged 48.4% on the news.

U.S. Labor Market:  In yesterday’s JOLTS report on the labor market, total job openings fell in March to a seasonally adjusted 9.59 million, marking their lowest level in almost two years.  In addition, March layoffs rose to 1.81 million, reaching their highest level in over two years.  The figures point to a worse-than-expected softening in labor demand and add to other recent evidence that the economy could be slipping into recession even now, although we still think the recession will hit a bit later in the year.  In any case, the weak JOLTS report helped push equities and other risk assets sharply lower yesterday.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a report showing an acceleration in the Eurozone’s consumer price inflation.  While the acceleration was modest, it could still encourage a more aggressive interest-rate hike by the European Central Bank at its policy meeting on Thursday.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an unexpected resumption of rate hikes in Australia and a warning by U.S. Treasury Secretary Yellen that the federal government could be unable to pay its bills by June 1 if Congress doesn’t act to raise the federal debt limit.

Eurozone:  The April consumer price index was up 7.0% from the same month one year earlier, dashing expectations that annual inflation would be unchanged at 6.9%.  The acceleration in headline price growth could encourage the European Central Bank to again hike its benchmark short-term interest rate aggressively at its policy meeting on Thursday.  That’s especially the case given that a separate key measure of inflation also remains worrying.  Excluding the volatile components of food and energy and the government-influenced prices for alcohol and tobacco, the April core CPI was up 5.6% on the year.  That marks somewhat cooler core inflation than in March, when the core CPI was up 5.7%, but it was no cooler than the 5.6% increase in the year to February.

Italy:  The right-wing populist government of Prime Minister Meloni has issued a decree aimed at making it easier for companies to hire new workers.  The decree will reduce the country’s “basic income” support for people who can work and ease regulations to make it easier to hire short-term workers.  In a modest effort to encourage more births, the policy also includes a cut in payroll and benefit taxes for workers with children.  None of the changes are revolutionary, but they could have a small impact on Italy’s labor market, and they could signal further, more substantial moves by Meloni later, despite opposition by labor groups.

Russia-Ukraine War:  The U.S. released a new, unclassified estimate that Russian forces fighting in Ukraine have suffered approximately 100,000 total casualties since December, including about 20,000 killed in action.  According to the report, about half the fatalities were members of the Wagner mercenary group with half of those being prisoners who had been enticed to join up in return for their freedom if they survived a six-month tour of duty.  The enormous losses show how the Russians’ strategy has caused a depletion in their combat strength just as the Ukrainians look set to launch a new counteroffensive.

Australia:  The Reserve Bank of Australia (RBA) unexpectedly resumed its monetary tightening cycle by boosting its benchmark short-term rate 0.25% to 3.85% to help bring consumer price inflation back down to target.  The hike by the RBA was its first since a similarly sized increase in March.

• The RBA’s rate hike underscores that many major central banks remain committed to monetary tightening despite nascent signs that inflation is cooling. The rate hike is a signal that investors should be prepared for the possibility that rates could go higher than anticipated, and possibly stay there, in key countries around the world.
• As a result of the RBA hike today, Australian bonds have sold off, boosting the yield on 10-year government obligations to 3.456%. In contrast, the Australian dollar (AUD) has jumped 1.01% to $0.6697.

Canada:  The Canadian government and its main public-employee union yesterday reached an agreement on a new labor contract that will end the workers’ strike.  Under the deal, the government will boost wage rates by 12% over four years and provide a one-time, lump-sum payment equal to 3.7% of annual pay.  The agreement hewed close to what the unions initially demanded, reflecting the bargaining power they had amid the country’s tight labor market.

U.S. Labor Market:  As we warned in our Comment yesterday, Hollywood screen writers failed to strike a deal for a new labor contract last night with the major networks and studios, prompting them to announce a strike.  As the 11,500 members of the Writers Guild of America walk off the job, late-night and variety shows are likely to be the first affected.  The strike reflects both concerns about the impact of streaming technology on writers, and the increased bargaining power workers have in today’s tight labor market.

U.S. Monetary Policy:  The Fed’s policy making committee will begin its latest meeting today, with its decision due tomorrow afternoon at 2:00 pm ET.  The policymakers are widely expected to hike their benchmark fed funds interest rate by another 0.25%, to a 16-year high of 5.00% to 5.25%.  However, as we mentioned in our Comment yesterday, the focus for investors will likely be on the post-meeting statement and comments by Fed Chair Powell to see if they provide any hints that the rate hikes are finished.

• Given the damage inflicted on the economy from the current rate-hiking cycle, any hint of a pause could give a boost to equities.
• Also, any strong signal of a pause in U.S. interest rates would likely be a further negative for the dollar. Factors such as slowing U.S. economic growth and the prospect of continued interest-rate hikes abroad have now pushed the greenback lower by 8.6% from its most recent peak last September.

U.S. Fiscal Policy:  Yesterday, Treasury Secretary Yellen warned that the federal government could be unable to pay all its obligations, including Treasury debt service, as early as June 1 if Congress doesn’t raise the debt limit.  In addition, the bipartisan Congressional Budget Office brought forward its deadline of when the government could default, saying lower-than-expected tax receipts this spring could leave the government unable to pay its bills by early June.

• The new forecasts raise the risk of a near-term default on government debt, which would likely be a significant negative for U.S. asset values.
• President Biden later invited the Republican and Democratic leaders of Congress to meet next week to discuss a way forward.

U.S. Bank Regulation:  Responding to the recent U.S. bank failures, the Federal Deposit Insurance Corporation yesterday recommended a boost in the business deposit amount that would be insured as one way to help prevent bank runs.  According to the FDIC, a targeted rise in deposit insurance for businesses’ everyday operating accounts would be more cost-effective and less likely to promote risky behavior by bank bosses than just eliminating the $250,000 cap in place on deposit insurance.

• The FDIC didn’t specify how much the coverage cap should be raised for business transaction accounts.
• However, it did calculate that raising the insurance cap to $2.5 million would likely cover what most small and medium-sized companies need to keep in their accounts to cover payroll.
• In any case, any such change in the deposit amount covered by insurance would require approval by Congress.

U.S. Defense Industry:  As major U.S. defense contractors released their quarterly reports over the last couple of weeks, some company officials said on their earnings calls that they are facing far fewer supply chain problems than they did over the last two years.  Greg Hayes, the CEO of Raytheon (RTX, $100.33), even gushed that, “It’s getting a hell of a lot better.”

• The officials noted that defense supply chains are still not back to normal, but the situation is far better than it was, and revenue growth now looks set to accelerate sharply.
• We continue to believe that increasing geopolitical tensions will drive military budgets higher around the world. Due to issues like bureaucratic lethargy, labor shortages, and supply chain disruptions, the expected growth in revenues and profits will probably only become notable in the next couple of years.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several notes on the U.S. economy, including a new federal bank seizure and sale, and the risk of a writer’s strike in Hollywood.  We next review a wide range of other U.S. and international developments with the potential to affect the financial markets today, including big new labor union actions in France and Belgium, and important purchasing managers’ indexes in China.

U.S. Banking Industry:  Over the weekend, major banks including JPMorgan (JPM, $138.24) and PNC (PNC, $130.25) placed bids to take over ailing First Republic (FRC, $3.51), the latest mid-sized bank to face falling asset values and deposit flight connected to the Federal Reserve’s interest-rate hikes.  JPMorgan ultimately won the day, giving it control of about $200 billion of First Republic’s assets and all of the bank’s $100 billion in deposits.  As part of the deal, the FDIC will provide JPMorgan with about $50 billion in fixed-rate term financing and share potential losses on First Republic’s loans.

• At least so far, it appears that the First Republic takeover could close the chapter on this spring’s bank crisis. As of right now, we’ve seen no major ripple effects elsewhere in the financial markets, which suggests the federal regulators have managed to contain the idiosyncratic problems at Silicon Valley Bank, Signature Bank, and now First Republic.
• However, we continue to be concerned about longer-term “disintermediation” risks in the banking sector, as high short-term interest rates prompt savers to move deposits out of banks and into investments such as mutual funds and Treasury bills. The loss of deposits could force banks to pull back further on lending and make the impending recession worse than it otherwise would be.

U.S. Construction Industry:  Investors continue to look for signs the economy is cooling enough to bring down inflation and allow the Fed to stop hiking interest rates, but we’re starting to focus more on a factor that could delay the slowdown:  construction spending.  Non-residential commercial construction has grown smartly over the last year and looks set to continue growing in the very near term, in part because of federal fiscal stimulus.  Indeed, spending on new factories has recently reached a record high, more than offsetting the decline in residential building.  We still think the economy is likely to slip into recession soon, but the momentum in construction spending could be one reason it’s taking so long for the data to show it.

• Even as some firms get cautious about underlying demand and pull back on investment, and even as the ongoing bank crisis threatens to prompt a sharper pullback in lending, those forces will be at least partially offset by:
  • Increased investment in defense industry facilities as the military budget rises;
  • Higher investment in semiconductor factories because of the subsidies in last year’s CHIPS Act; and,
  • New investment in battery plants and other green-technology factories because of the subsidies in last year’s Inflation Reduction Act.
• Although the Fed’s rate hikes pushed residential construction sharply lower over the last year or so, the decline came entirely in the single-family sector. Construction in the multi-family sector has held up well as residential firms try to meet the increased demand for apartments.

U.S. Labor Market:  Hollywood screenwriters are expected to go out on strike if they can’t agree on a new contract with the major networks and studios by their deadline later today.  In part, the potential walkout reflects the country’s current tight employment market, which has given workers increased bargaining power.  However, it also reflects the concern among writers that they’re being shortchanged by new streaming models.

U.S. Monetary Policy:  The Fed’s policy making committee will begin its latest meeting tomorrow, with its decision due on Wednesday afternoon at 2:00 pm ET.  The policymakers are widely expected to hike their benchmark fed funds interest rate by another 0.25%, to a 16-year high of 5.00% to 5.25%.  However, the focus for investors will likely be the post-meeting statement and comments by Fed Chair Powell to see if they provide any hints that the rate hikes are finished.

• Given the damage inflicted on the economy from the current rate-hiking cycle, any hint of a pause could give a boost to equities.
• Any strong signal of a pause in U.S. interest rates would likely be a further negative for the dollar. Factors such as slowing U.S. economic growth and the prospect of continued interest-rate hikes abroad have now pushed the greenback lower by 8.6% from its most recent peak last September.

European Union:  Today, May 1, is the Labor Day holiday in much of the world, including the EU.  In addition to the holiday festivities, however, the day will be marked by a number of labor protests, including yet another round of demonstrations against President Macron’s pension reform in France and even a wide-ranging set of labor protests in Belgium.

Russia-Ukraine War:  The Ukrainian defense minister said his country is close to completing its preparations for a spring counteroffensive, and that it is generally ready to launch the operation.  The statement is consistent with a range of signs that the Ukrainians will soon launch a high-stakes attack to push the Russian occupiers back.  If successful, the counteroffensive could help shore up Western support for the Ukrainians and reduce political pressure for negotiations.

• Meanwhile, NATO’s top commander, Army Gen. Christopher Cavoli, has told the House and Senate armed services committees that the number of Russian forces in Ukraine has now surpassed the number from when Russia first invaded last year.
• While Russia has the resources to keep fighting in Ukraine for another year, Cavoli said the country’s forces remain vulnerable to Ukrainian weapons, ingenuity, and resolve.

China:  The official purchasing managers’ index for manufacturing fell to a seasonally adjusted 49.2 in April, short of expectations and far below the 51.9 reading in March.  The April PMI for the service sector also fell, but only to 56.4 from 58.2 in the previous month.  Like most PMIs, China’s are designed so that readings above 50 indicate expanding activity.  The figures suggest the Chinese service sector continues to recover from the government’s strict pandemic lockdowns, but the factory sector still faces challenges, in part because of weak demand overseas.

Iran:  The government’s statistical bureau has now failed to publish any data on consumer prices for two straight months, leading to speculation that the annual inflation rate has surged to a new record high of more than 49%.  Driven in part by U.S. sanctions on Iran because of its nuclear program, the inflation surge risks undermining political stability in the country.

View PDF