by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion about concerns regarding bank lending. Next, we explain why stubborn inflation has led to greater scrutiny of the central banks. Lastly, we give our thoughts on supply chain efficiencies and the performance of the U.S. dollar as tensions between the U.S. and China continue to escalate.

Lending Sentiment Sours: The latest earnings report has added to concerns that a credit crunch is imminent.

• Despite the four largest banks showing strong earnings in the first quarter of 2023, there are still concerns about the financial system. On Wednesday, Morgan Stanley (MS, $90.25) announced an increase in the company’s provision of credit losses to $234 million, up from $57 million a year ago. The upward revision in its loss expectations is related to concerns about commercial real estate and the overall economy. Goldman Sachs (GS, $335.91) announced that its profits fell 18% in the year’s first three months due to a slump in dealmaking and bond trading. Additionally, Zions Bank (ZION, $32.72), US Bancorp (USB, $36.01), and Citizens Financial Group (CFB, $30.50) each reported declines in deposits, primarily from their wealthier clients.
  • On a positive note, Western Alliance (WAL, $40.35) had an unexpected rebound in deposits.
• Lenders were already tightening their lending standards before March’s SVB debacle. In February, a Fed survey showed that senior loan officers were restricting the amount of credit due to worries about demand weakness and deteriorating loan quality in the final quarter of 2022. The report showed that the net percentage of respondents tightening standards has risen to its highest level since the pandemic. Although the next report on senior loan officer sentiment will not be released until May, the latest Beige Book shows that banks are increasingly reluctant to issue credit given the recent banking crisis. 

• Tightening credit conditions raises the likelihood of a hard landing. The Federal Reserve is expected to raise its target range for interest rates to 5.00%-5.25% in May. The Fed’s decision to increase borrowing costs will raise transaction expenses for bank dealmaking and reduce the value of bond holdings, thus weighing on the profitability of financial institutions. The Fed’s new emergency facility did relieve pressure on the regional banks from needing to lift rates in order to keep borrowers, but banks may still be reluctant to lend due to interest rate uncertainty. As a result, businesses and consumers may be unable to obtain loans when they need them as the economy slows.

It’s Getting Sticky: Stubborn inflation adds to concerns that the central banks are not finished tightening monetary policy.

• The lack of progress toward price stability has hurt the credibility of the central banks. The current board of the Reserve Bank of Australia is set to lose responsibility for setting interest rates because it has come under scrutiny for its poor guidance. The task will be given to a separate board within the RBA that will specialize in managing monetary policy. Several months before it started its most aggressive tightening cycle in three decades, the RBA had stated that a rate hike was unlikely before 2024. Additionally, its inflation forecast failed to detect the acceleration in price pressures. The revamp of the central bank is expected to take place in July of this year after the RBA Act is amended.
• Australia is not the only country with a central bank currently under pressure. The Bank of England, the European Central Bank, and the Fed have all moderated expectations of a pause due to higher-than-expected inflation. Their inability to succeed in reining in price pressures may be related to demand-side inflation. The chart below breaks down inflation by demand, supply, and ambiguous contributors, as determined by the U.S. personal consumption expenditure price index. The series suggests that improvements in the supply chain are the primary drivers in the recent decline of price pressures.
  • The chart may reflect issues with containing service-related inflation figures.

• A tight labor market and a resilient economy have given central banks more leeway to increase benchmark interest rates. The Federal Reserve Beige Book, which provides anecdotal information on economic conditions within regional Fed districts, showed that the country is not currently in a recession. Meanwhile, better-than-expected growth from China has boosted confidence that a global recession is not imminent. These positive signs have forced market participants to push back their expectations of a shift in central bank policy. The latest CME FedWatch Tool now forecasts a Fed pause or cut in interest rates to take place at the September meeting, a month later than investors were predicting last week. Overnight index swaps for the EUR and GBP have also shown a similar trend.
  • That said, we believe that many central banks will be finished hiking rates by the third quarter.

 The Great Decoupling: Supply chain efficiency and the dominance of the U.S. dollar may be casualties as the world splits into separate blocs.

• Companies are accepting that they may have to prioritize supply chain resiliency over efficiency as a way to hedge against geopolitical risks from rising U.S.-China tensions. India appears to be an attractive destination target. A day after opening its first store in India, Apple (AAPL, $167.63) CEO Tim Cook met with Indian Prime Minister Narendra Modi to discuss plans for future investment in the country. The iPhone maker is expected to double or triple its investment expenditure in Asia’s second-biggest economy which could pave the way for more companies to follow suit.
• The decision to broaden supply chains comes amidst heightened rhetoric from the U.S. regarding China. Treasury Secretary Janet Yellen is expected to warn Beijing of a U.S. response if it continues unfair trade practices. Her remarks will reinforce the notion that China and the U.S. are headed for a divorce as the two sides grapple with disagreements over human rights, support for Russia, and accusations of industrial espionage. Although U.S.-China trade increased to an all-time high last year, it is now showing signs of slowing.

Source: Investors.com

• Frictions between the U.S. and China will lead to a decline in the usage of the dollar for global trade. Beijing has already gotten a head start in this process as its foreign exchange reserves have declined from nearly $4 trillion in 2014 to slightly above $3 trillion as of March of this year. Meanwhile, Brazilian President Lula has called on emerging economy countries to reduce their reliance on the U.S. greenback for trade. We suspect countries that align with China will be persuaded to use other currencies for trade, especially if they want access to the world’s second-largest economy. If we are correct, the U.S. dollar should be headed toward a secular decline against other global currencies.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several new initiatives in European economic policy, including subsidies for semiconductor manufacturing and a tax on imports tied to greenhouse gas emissions.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including a report on consumer price inflation in Britain that has raised concerns about more interest-rate hikes in the advanced countries.

EU Industrial Policy:  The European Commission formally unveiled its proposed “EU Chips Act” yesterday, which would provide some €43 billion ($47 billion) in subsidies and other assistance for semiconductor manufacturers operating in the EU.  The support represents an attempt to compete with the subsidies in last year’s U.S. Chips Act and could make the EU more self-sufficient in both commoditized and advanced computer chips.  The proposed program also illustrates how it has become more acceptable for governments to use active “industrial policy” to offer protections and backing for certain industries.

EU Environmental Regulation:  The EU parliament approved a first-of-its-kind law yesterday that will tax imports into the bloc based on the greenhouse gases emitted to make them.  The new legislation is designed to make sure that EU manufactured goods are not put at a competitive disadvantage by imports from countries with looser, less costly environmental regulations.

Eurozone Bank Health:  Concerns are growing ahead of the late-June expiration of the European Central Bank’s pandemic bank-support program known as “targeted longer-term refinancing operations,” or TLTROs.  Expiration of the program will require banks in the Eurozone to repay hundreds of billions of euros back to the ECB, replacing them with more costly sources of funding.  Many banks, especially some in Italy, may find it challenging to raise the required liquidity.

United Kingdom:  The March consumer price index came in 10.1% higher than in the same month one year earlier, marking a modest deceleration from the 10.4% rise in the year to February but dashing expectations that inflation would finally fall into single digits.  Excluding the volatile food and energy components, the core CPI in March was up 6.2% on the year, just as it was in February.  The report has rekindled concerns about continued high inflation and additional interest-rate hikes throughout the advanced countries in the coming months, which are weighing on global stock markets so far this morning.

Turkey:  An in-depth article in the Wall Street Journal yesterday linked the massive devastation and loss of life from the country’s February earthquakes to a systemic weakening of building regulations as President Erdoğan relied on construction to goose the economy and boost his political support over the last two decades.

• The article shows that the government’s deliberate easing of building rules and failure to prosecute rule-breaking likely resulted in tens of thousands of building collapses and deaths during the quakes.
• Since Erdoğan is now so closely identified with the construction boom of the last two decades, the scandal about building regulations is a key threat to his re-election prospects when the nation goes to the polls on May 14.

India:  The United Nations Population Division released new data today showing that India has now overtaken China as the world’s most populous country.  Reflecting its higher birth rate, India’s estimated population now stands at 1.428 billion, while China, with its low birth rate, has an estimated population of 1.425 billion.  Meanwhile, technology giant Apple (AAPL, $166.47) opened its first retail store in India yesterday, further expanding its commitment to the country after its recent opening of manufacturing facilities there.  The population data and the move by Apple are being taken as further validation of India’s increasingly attractive investment prospects compared with China.

Mexico:  The Supreme Court invalidated part of a law pushed by President Andrés Manuel López Obrador last year that put the country’s national guard under the military’s control.  The ruling is a strong rebuke to the president’s penchant for putting more government functions under the control of the military and means that the national guard must now remain under civilian control.  While the president argues correctly that the Mexican military is one of the country’s most efficient and competent institutions, putting more government functions in its control raises concerns about transparency and whether the military is being given jobs for which it is poorly equipped, including local policing.

China-Taiwan-United States:  Admiral John Aquilino, the head of U.S. Indo-Pacific command, said in testimony before Congress yesterday that he would not join his fellow top military officials in speculating about when China might try to seize control of Taiwan and spark a war with the U.S.  However, Aquilino did say the Defense Department and defense industry need to accelerate their efforts to boost U.S. military power in order to deter China.  We continue to believe that increased geopolitical frictions will boost global defense spending in the coming years, presenting attractive opportunities for investors, but Aquilino’s statement matches our concern that the U.S. military buildup still appears to lack urgency.

U.S. Financial Regulation:  In testimony before the House Financial Services Committee yesterday, Securities and Exchange Commissioner Gensler was heavily criticized by Republicans for his efforts to crack down on the cryptocurrency markets.  In response, Gensler stated that crypto companies flout regulations worse than any firms he has ever seen.  The exchange points to continued muddled enforcement efforts by the SEC and prolonged political pushback in Congress.

U.S. Media Industry:  Yesterday, Fox Corporation (FOX, $31.20) agreed to pay $787.5 million to settle its legal conflict with Dominion Voting Systems just before the start of a trial on the voting-machine company’s allegations that it was defamed by Fox News after the 2020 presidential election.  The settlement avoids a court case that could have ultimately clarified and tightened the legal responsibilities of media companies in potential defamation cases.  All the same, the big payment to settle the case is a shot over the bow of media firms and could make them more cautious about how they report on political news going forward.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a couple of big-picture views on the global economy and a key commodity market.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including stronger-than-expected economic growth in China and a range of developments in U.S. economic policy.

Global Fracturing and Inflation:  European Central Bank President Lagarde warned in a speech yesterday that if the world continues to fracture into relatively separate geopolitical and economic blocs, global consumer prices would be boosted by about 5% in the short run and about 1% over the long term due to less efficient supply chains.  She also warned that global fracturing would threaten the position of the U.S. dollar as the world’s key reserve currency.

• Clearly, Lagarde has been reading the many analyses Confluence has been publishing on this topic. Her analysis is consistent with our view that as the world breaks into U.S.-led and China-led blocs, shortened supply chains and increased geopolitical tensions will lead to higher costs, increased inflation, and rising interest rates.
• The evolving U.S.-led bloc is likely to look much like today’s group of rich, advanced, highly industrialized countries with a few closely related emerging markets but will have more manufacturing “brought home” to that bloc from China and its bloc. We suspect companies will eventually adjust to this new world, meaning equities and commodities are likely to remain attractive.  However, higher inflation and interest rates will likely contribute to the beginnings of a long-lasting bear market in bonds.

Global Copper Market:  At this week’s World Copper Conference in Santiago, Chile, a key topic of discussion is the worsening outlook for the metal’s supply/demand balance.  Driven by new construction and soaring use in green technologies such as electric vehicles, global demand for copper is expected to rise to 36.6 million metric tons per year by 2031.  However, because of lackluster investment at the present time, which is driven in part by restrictions in South America, global output is expected to grow slowly to just 30.1 million metric tons per year.

• Analysts expect the supply shortfall to drive prices much higher over the coming years.
• We agree that tepid investment today is likely to boost prices for a range of commodities in the coming years. We think geopolitical tensions and the fracturing of the world into relatively separate blocs will also tend to drive values higher.  We therefore continue to believe commodities will offer attractive returns in the coming years, once we get through any short-term softness due to the impending recession in the U.S.

China:  As we flagged in our Comment yesterday, first-quarter gross domestic product was up a relatively healthy 4.5% from the same period one year earlier, beating expectations and marking a strong acceleration from the growth of 2.2% in the year ending in the fourth quarter of 2022.  The acceleration in the first quarter came largely from stronger consumption spending as the economy continues to recover from its previous Zero-COVID restrictions, but it also benefited from increased government infrastructure investment and rebounding exports.

• China’s growth in the first quarter puts it on track to meet the government’s target of having GDP expand about 5% in 2023.
• The rebound in Chinese GDP growth will likely give a boost to global economic activity and commodity prices, at least to the extent that it relies on investment and imports. However, some economists are concerned that rebounding consumption spending, especially on services, will mute the benefit of economic growth outside of China.

Germany:  The country’s last three nuclear electricity plants were shut off over the weekend pursuant to a law passed two decades ago and strong anti-nuclear protests over the last decade.  The shutdowns come despite an energy crunch touched off by Russia’s invasion of Ukraine last year.  The shutdowns are expected to leave German and European energy supplies more volatile and precarious going into the future.

Saudi Arabia-Iran-Israel:  Reflecting the recent China-facilitated rapprochement between Iran and Saudi Arabia, the Iranian government said it has invited Saudi King Salman bin Abdulaziz to visit the country in the near future.  The invitation comes as Iranian President Ebrahim Raisi has already accepted an invitation to visit Saudi Arabia, although no date has been set for his visit.  Meanwhile, senior Saudi officials on Sunday met with leaders of the Palestinian militant group Hamas, which is backed by Iran, to discuss renewing their ties for the first time since they were put on ice in 2007.

• The rapprochement with Iran threatens Israel’s strategy of strengthening ties with the Saudis and other Sunni Muslim states to form a bulwark against Shiite Muslim Iran in the Persian Gulf region.
• Saudi Arabia’s renewed ties with Hamas also threaten to unleash new terrorist attacks directly on Israel.

Ecuador:  In an interview, conservative President Guillermo Lasso said he would dissolve the country’s congress and call new elections if the leftist-dominated legislature tries to impeach him on what he called trumped-up corruption charges.  However, opinion polls indicate Lasso only has the support of about 22% of the population, and it appears his days in office are numbered.  The result could be a constitutional crisis and lead to further political instability in Ecuador, potentially leaving it as yet another major Latin American commodity producer taken over by the left.

China-United States:  Yesterday, U.S. prosecutors charged dozens of Chinese security officers and their associates in absentia for running thousands of fake social-media personas to discredit U.S. policies.  They also arrested and charged two ethnic Chinese for setting up a secret Chinese police station in New York City to harass Chinese dissidents.  Along with last week’s revelation that a former U.S. Navy sailor helped disseminate classified documents posted online by an Air National Guardsman, yesterday’s charges highlight how rogue-state officials and their domestic sympathizers are active in U.S. cyberspace and on U.S. territory.  Reports today indicate the FBI is investigating the Navy sailor involved in the further dissemination of the leaked intel documents.

• Naturally, that realization is likely to further worsen U.S. relations with China and Russia.
• It could also potentially spark moves to root out any domestic “fifth column” of China and Russia sympathizers.

U.S. Fiscal Policy:  Even though House Speaker McCarthy hasn’t gotten the Republicans he leads to agree on a budget proposal for the upcoming federal fiscal year, he said in a speech yesterday that the party would soon pass legislation linking a rise in the federal debt limit to cuts in spending.  According to McCarthy, the majority of Republicans would only agree to a rise in the debt limit if it were linked to a limit on federal spending, a claw back of COVID-19 aid, and a requirement that people work to receive federal benefits.

• President Biden has signaled that he is willing to negotiate on federal spending levels, but he rejects linking those talks to the debt limit.
• McCarthy’s speech is a reminder that federal fiscal policy and the risk of a default remain a risk for the financial markets, even if the most likely scenario is a last-minute compromise.

U.S. Environmental Policy:  The Treasury Department yesterday released an updated list of electric vehicle models that qualify for tax credits under last year’s Inflation Reduction Act.  Because of tightened rules on pricing and the country of origin for key components, the list now includes just 16 models from U.S. brands.  The pared down list illustrates the impact of the law’s preference for North American-made vehicles and technology, which has strained relations between the U.S. and some of its allies.

U.S. Banking Regulation:  New research drawing on public filings indicates that most U.S. banks haven’t been hedging their exposure to rising interest rates.  For example, the research shows that only about 6% of bank assets have recently been hedged with interest-rate swaps.  The findings suggest that the rise in interest rates that helped bring down two key banks last month could have also left other institutions at risk.  We continue to watch carefully for signs that other banks could be in trouble or that financial stresses will crimp bank lending and help push the economy into recession.

U.S. Labor Market:  Privately held consulting giants McKinsey & Co. and Bain & Co. are reportedly delaying the start dates for new MBA hires to as late as April 2024, in some cases paying them thousands of dollars to work for a charity for a few months before starting their consulting jobs.

• The actions by McKinsey and Bain reflect concerns about an impending recession and slowdown in business. They also serve as a reminder that as recession nears, demand will likely soften even for expensive workers in business services.
• Separately, UPS (UPS, $193.29) and the Teamsters union begin negotiations this week for a new five-year contract covering some 330,000 employees before the current contract expires on July 31. Because the number of covered employees is so large, the negotiations and resulting contract could have significant implications for overall U.S. wage rates and labor market conditions.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an apparent assassination attempt against Japanese Prime Minister Kishida.  Although Kishida escaped unharmed, the security failure raises concerns for leaders attending the Group of Seven summit in Japan next month.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs that China’s first-quarter economic growth will come in healthy when it’s released tomorrow and new evidence suggesting the U.S. is about to experience a rebound in manufacturing activity.

Japan:  Prime Minister Kishida was apparently the target of an attempted explosives attack as he prepared to deliver a stump speech for a local by-election near the southwestern city of Osaka on Saturday.  The assailant’s pipe bomb landed just feet from Kishida, but security personnel whisked him away before it exploded, and the prime minister was not injured.

• Coming just nine months after Former Prime Minister Abe was assassinated by an assailant with a homemade gun, the incident on Saturday points to continuing gaps in the security for Japanese leaders.
• Moreover, the incident raises questions about the security environment for the global leaders who will attend a G7 summit in Hiroshima next month.

China:  Numerous signs indicate that tomorrow’s report on first-quarter gross domestic product will be in line with the government’s goal of 5% growth this year.  New data today showed that March new home prices were up 0.5% month-over-month, accelerating from a rise of 0.3% in February and marking their strongest increase in almost two years.  The People’s Bank of China also kept its one-year medium-term lending facility interest rate unchanged at 2.75% today rather than cutting it, and last week the government announced better-than-expected export growth.  Continued economic recovery from China’s pandemic lockdowns will likely be positive for global stocks and commodity prices, at least in the near term.

Turkey:  National oil champ Turkish Petroleum will begin shipments this week from its new Sakarya gas field, just three years after discovering the deposit.  According to President Erdoğan, supplies from the new gas field will help slash energy costs for Turkish consumers and businesses.  The timing of the announcement was probably driven by President Erdoğan, who is at risk of losing his bid for a new term in office in the May 14 elections.

• Erdoğan’s electoral strategy is to tout his achievements in completing key economic projects and making Turkey a stronger player in global politics.
• Last week, Erdoğan also presided at a ribbon-cutting for the Turkish navy’s new flagship, the TCG Anadolu.  The landing ship, which can carry helicopters and armed drones, is Turkey’s largest ever naval ship.

Poland-Hungary-Ukraine:  Faced with a glut of imports from Ukraine due to the European Union’s policies to help the country deal with the Russian invasion, the Polish and Hungarian governments have announced a temporary ban on Ukrainian grain despite EU warnings that they could be violating the bloc’s trade policy.  The grain shipments were supposed to be re-exported to the Middle East and Africa but have been bottled up in Poland and Hungary due to a lack of truck and train capacity.

Russia-Ukraine War:  Reports indicate a Russian power station in the southern border region of Belgorod was knocked off line by an apparent Ukrainian drone strike.  Ukraine has staged numerous attacks on military sites within Russia, but today’s strike seems to mark an expansion of its attacks.  By shutting off power to Russian citizens, it broadens the impact of the attacks, potentially undermining Russian citizens’ confidence in the war effort and perhaps sparking stronger retaliation by the Russian military.

United Kingdom:  As the West continues to worry about China’s stranglehold on the rare minerals needed for future energy technologies, British geologists have identified eight sites in the U.K. that have the right geology to potentially yield 18 key metals and minerals, including cobalt and lithium.  The mapping marks the first time the U.K. has systematically identified geological potential for the resources needed to produce electric car batteries, semiconductors, and wind turbines.  The sites will still need to be explored, and any commercially viable deposits would probably take more than a decade to develop.

Sudan:  Over the weekend, military forces led by two rival generals began attacking each other in the capital Khartoum and elsewhere in the country, dashing hopes that the country could continue its transition to democracy after the country’s armed forces toppled its dictator in a 2019 coup.  Continued political instability opens the country to further interference from Russia and other countries that would want to take advantage of its strategic location in northeastern Africa.

U.S. Intelligence Leak:  New reporting indicates the classified U.S. intelligence documents posted by Air National Guardsman Jack Teixeira in his chat room were further disseminated by a pro-Russian blogger who had been in the U.S. Navy until late last year.  The revelation adds to concerns that the U.S. military could be infiltrated with Russia sympathizers who are willing to undermine the U.S. and potentially put U.S. military and government personnel at risk.  Such concerns could encourage even stronger U.S. government action against authoritarian states such as China, Russia, and Iran.

U.S. Industrial Policy:  New research by the Financial Times suggests the U.S. is about to enjoy a manufacturing boom sparked by the $400 billion or so in subsidies provided in last year’s Inflation Reduction Act and CHIPS Act.  The research identifies more than 75 large-scale factory commitments that will take advantage of the laws, which will create about 82,000 jobs.

• The research is consistent with our view that deglobalization, increased defense spending, and Washington’s new embrace of industrial policy will prompt significant re-industrialization in the U.S., creating new investment opportunities while also imposing such costs as higher interest rates and the risk of malinvestment.
• Even though Republicans largely opposed the two industrial policy measures and continue to criticize them, the analysis indicates more than 75% of the investments identified so far will be in Republican-held congressional districts, where they will create some 58,000 jobs. If true, that could eventually boost Republican support for the laws and ensure they have political support going forward.

U.S. Bank Regulation:  According to officials attending the International Monetary Fund’s annual meeting last week, the banking crises last month in the U.S. and Europe could prompt the Basel Committee on Banking Supervision to try enforcing its strictest regulations on small and mid-sized U.S. banks that are currently exempt.  The possible change would expand the Basel Committee’s reach beyond those that are just “internationally active” to those that are “internationally relevant.”  Such a move could impose greater compliance costs on smaller banks and reduce their profitability and lending activity.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with the market’s reactions to the reduction of supplier price pressures in March and last week’s jump in unemployment claims. Next, we give our thoughts on commercial real estate and its potential threat to the economy. Finally, we focus on why we believe investors should look toward neutral countries that may not align with either the U.S. or China-led blocs.

Is It Over? The market responded positively to the mixed economic data that was released on Tuesday.

• A sharp decline in producer inflation and a steady increase in jobless claims have increased speculation that the Fed may soon pause rate hikes. The prices paid by suppliers for goods and services decelerated in March from 4.9% to 2.7%. The steep declines in trade services, transportation, and warehouse prices were the primary drivers of the slowdown. Additionally, initial jobless claims rose by 11,000 to 239,000 in the week ending April 8, the highest level since January 2022. The increase in the weekly applications for benefits could be a signal that the labor market is cooling. The combination of easing price pressures and increased layoffs could pressure the Fed to rethink its interest rate strategy.
• Investors were surprised by the economic reports released on Thursday, and equity holders responded by piling into risk assets. The S&P 500 rose 1.3% from the previous day, while the NASDAQ Composite gained 1.9% in the same period. At the same time, yield-curve inversion deepened as the data reinforced fears of an imminent recession. The yield on two-year Treasuries fell by 5 bps from 4.75% to 4.70%, while the 10-year Treasury yield dropped 21 bps from 4.50% to 4.19%.
• The latest economic releases may not be enough to convince the Fed to pause in May, but they may deter policymakers from hiking in later meetings. Although PPI is highly correlated with the consumer price index, it is unlikely that the next report will show a similar decline. The unemployment data has a similar problem. Initial claims remain too close to pre-pandemic lows to justify a shift in Fed policy. As a result, it is still highly probable that the Fed will raise its benchmark interest rate by 25 bps at its next meeting.

No Need to Fear: The regional bank crisis has fueled speculation that commercial real estate (CRE) loans may pose a risk to the overall economy; however, we have a different perspective.

• The CRE sector is risky for lenders looking to maintain healthy balance sheets following the recent bank turmoil. Bank of America reported that clients pulled $451 million from real estate stock due to concerns about the commercial property market. The massive withdrawal comes as the sector faces a series of headwinds from higher borrowing costs, work-from-home trends, and a possible recession. Other sources of liquidity, such as commercial mortgage-backed securities, may not provide much help as bond issuance is down 82% from the prior year.
• With over $1.5 trillion worth of U.S. commercial real estate debt due by 2025, the CRE sector has limited financing options. Mortgages on office spaces are particularly vulnerable as nearly a quarter of the loans are set to expire in 2023. Shadow lenders are positioning themselves to fill the void left by prudent banks. Private credit providers typically offer smaller loans at higher spreads than traditional lenders. A syndicated loan fetches about 4.5% over the secured financing overnight rate, while direct lenders receive close to 6.0%. Therefore, commercial property owners’ bottom lines will be pressured due to the increase in borrowing costs.
• The risk that CRE loans pose to the economy, though, may not be as critical as reports suggest. Regional banks do indeed provide 70% of the loans to the CRE sector, but this does not mean the sector is in imminent danger. Private lenders have the liquidity necessary to help struggling firms and may be better suited than traditional banks to take them over in the event of default. Unlike regional banks, debt funds typically have experts that understand how these companies operate. Additionally, the lack of regulation may give these lenders more flexibility to offer support for struggling property firms. The CRE sector may be poorly positioned, but its unwinding is unlikely to be as detrimental to the U.S. economy as is currently being speculated.

Nonalignment Flex: Countries that are capable of managing relationships with both the U.S. and China-led blocs may offer investment opportunities.

• Lula’s refusal to expand the U.S. ties created by his predecessor shows how Brazil can sway between blocs. On Friday, Brazilian President Luiz Inácio Lula da Silva advocated for developing countries to abandon the use of USD for trade. Latin America’s largest country by population and economy could assist in U.S. foreign policy efforts to rein in Beijing’s ambitions, as China relies on the two countries for grain exports. However, it seems Lula has no interest in antagonizing Beijing. Since his inauguration, Brazil has been pushed closer to China, much to the dismay of Washington.
• Meanwhile, India and Turkey have been able to exercise strategic ambiguity between the two blocs. Despite being a member of the North Atlantic Treaty Organization, document leaks revealed that Turkish officials had met with mercenaries from the Wagner Group to discuss weapons sales. Although no arrangement was made, the discussions show how Turkey has dual aims in this conflict. Meanwhile, India continues taking advantage of the war in Ukraine to access cheap oil. Russia’s discounted crude prices have allowed New Delhi to pressure other suppliers to slash their prices. India and Turkey’s ability to work with Russia without significant consequences from the U.S. exemplifies these countries’ viability in a fractured world.
• Neutral countries will likely be targets for foreign direct investments as the two major powers compete for influence. The strategic importance of these countries will give them greater flexibility to maintain trade ties with both blocs. Additionally, the neutral countries will likely have a much greater voice in negotiating favorable bilateral agreements as it can always threaten cooperation with the other bloc as leverage. As a result, we believe that countries capable of resisting both the U.S. and China may be attractive destinations for investments.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion on why monetary policymakers are reluctant to articulate a coherent message on future policy. Next, we give our thoughts about a potential credit crunch. Lastly, we review the latest headlines coming out of Asia.

Is Tightening Over? Sticky inflation and slowing economic growth have central bankers divided on future rate hikes.

• The failures of Silicon Valley Bank (SIVBQ, $0.57) and Signature Bank (SBNY, $0.15) in March have prompted several Fed officials to push for a rate pause. Minutes from the central bank’s March 21-22 meeting showed that policymakers were concerned that the banking turmoil could spread throughout the economy. Despite Federal Reserve officials having confidence that the banking system was sound and resilient, Fed staff predicted that the crisis could lead to a recession in late 2023. That said, the committee still voted unanimously to raise rates by 25 bps as members concluded that the emergency lending program sufficiently solved the bank run problem.
• The U.S. banking crisis and the collapse of Credit Suisse (CS, $0.92) led several European Central Bank policymakers to rethink the need to raise rates further. ECB Vice President Luis de Guindos and Governing Council Member Pablo Hernández de Cos have insisted that rates need to rise to help get inflation to its 2% target. However, both policymakers were unsure whether the ECB should raise its benchmark rate at its next meeting. The central bank’s reluctance to commit to further rate hikes reflects the hesitancy of policymakers in a time of heightened uncertainty.
• There is still palpable fear that the financial system has not fully recovered. The indecisiveness regarding the path of future hikes suggests that officials are close to implementing a pause. That doesn’t necessarily mean that the central banks will stop anytime soon. Austrian Central Bank Chief Robert Holzmann is pushing for the ECB to raise rates by 50 bps. Meanwhile, St. Louis Fed President James Bullard insists that the Fed should keep raising rates while the labor market remains strong. Overnight index swaps for the EUR and the USD show that the market expects central banks to raise rates at least one more time this year.
  • On a related note, new Bank of Japan Governor Kazuo Ueda has stated that he is in no rush to tighten policy. Meanwhile, the Bank of Canada paused rates in its latest meeting but may raise in the future.

Credit Crunch: Signs of a credit crunch have led the government to develop more safeguards to protect the public from any financial fallout.

• There is a growing debate about whether the drop in bank lending reflects tightening lending standards. Fed data showed that U.S. commercial bank lending fell by $105 billion in the two weeks ending March 29. Analysts at Goldman Sachs and Treasury Secretary Janet Yellen attributed the decline to the transfer of assets from failed banks Silicon Valley Bank and Signature Bank. In contrast, Lael Brainard, head of the National Economic Council, stated that she is seeing signs of banks pulling back credit. The discussion over lending has added to worries that the banking system may still need assistance.
• The lack of lending may be related to financial institutions preparing for extra scrutiny of their lending practices. European regulators are working on a plan that would complicate government efforts to inject liquidity into struggling banks. In the U.S., a recent survey showed that there is bipartisan support in favor of restoring bank regulations that were repealed in 2018. At the same time, Bank of England Governor Andrew Bailey warned that potential reforms to increase guaranteed deposits will have cost implications for banks.
• Investors are worried about potential hangover effects from the banking crisis. Despite the rebound in investment grade bonds, investors are wary of junk bonds. The lack of risk appetite reflects growing fears of an incoming recession, particularly in the U.S. Although a downturn is widely expected in the Eurozone and U.S., factory output data suggests that the EU may be better positioned. When combined with a weakening dollar, we suspect that there may be attractive opportunities outside the U.S. So far this year, the Euro Stoxx 50 has outperformed the S&P 500, 12.95% to 7.05%.

Asia in Focus: There are new risks developing in the Indo-Pacific region, but we remain optimistic.

• Several Asian countries have reported a substantial jump in COVID infections; however, this outbreak remains contained at this time. Singapore, India, Indonesia, and Vietnam have all reported yearly highs in their number of cases. The latest strand, known as the Kraken variant or XBB.1.5, is viewed as a highly transmissible omicron strain but with relatively mild side effects. Hospitals have been able to manage the caseloads so far, but governments are still looking to take more preventive measures. For now, we do not expect this new wave to lead to major supply chain disruptions, but it is something we will be monitoring.
• North Korea fired a new type of intercontinental ballistic missile on Thursday. The launch triggered a scare in northern Japan as residents were told to take shelter. There were no casualties, but the launch reflects North Korea’s improvement in its weapons capabilities and its growing assertiveness. Additionally, the provocative act will put pressure on Japan to ramp up its defense expenditures as it looks to protect itself from rivals. The Japanese government plans to double its military budget within the next five years and may be encouraged to increase it even further. The new military spending should benefit U.S. aerospace and defense industries as Tokyo may seek to collaborate with Washington to meet its ambitious target.

• On a positive note, China’s need for economic growth may lead it to moderate tensions with the U.S. On Thursday, Beijing announced that it would scale back its no fly-zone over Taiwan to 27 minutes, after initially notifying Taipei that it was planned to last from April 16-18. Although the Taiwan protests helped, the move may reflect a temporary thaw in U.S.-China tensions. Recently, government officials from Washington and Beijing have made comments in favor of the two countries maintaining ties. Although the relationship between the two countries will continue to be rocky, we believe that China may be a desirable investment destination for risk tolerant investors in the short to medium term.
  • The recent surge in Chinese exports (see previous chart) reflects its need to bolster its GDP after it lifted its COVID restrictions.

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