by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the latest on the Silicon Valley Bank crisis.  Although the U.S. banking system appeared to be stabilizing yesterday, the jitters touched off by SVB have now sparked concerns about major European banks.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including several reports touching on economic and political instability in key emerging markets.

U.S. Banking System:  Yesterday brought additional evidence that the crisis touched off by the failure of Silicon Valley Bank (SIVB, $106.04) could be easing, at least domestically.  We have seen no reports of widespread bank runs in the U.S., and the regional banks with relatively high proportions of uninsured deposits saw their stock and bond prices partially recover yesterday from Monday’s selloffs.  However, Swiss banking giant Credit Suisse (CS, $2.51) is suffering enormous declines in the value of its stock and bonds today as the jitters touched off by SVB appear to be spreading to Europe (see next section).

• As the U.S. financial system stabilizes, attention is turning to the longer-term fallout of the crisis. Importantly, many investors still expect the Federal Reserve to slow, stop, or even reverse part of its ongoing interest-rate hikes when it holds its next policy meeting next week.  We agree that the policymakers might slow their pace of rate hikes, but only temporarily.  After all, even though they’re probably close to the end of their tightening cycle, the policymakers haven’t yet gotten inflation back under control.
  • For investors who assume the Fed will cut rates because of the SVB crisis, we would remind them that the central bank now has a separate tool to address that issue: its new “Bank Term Funding Program (BTFP).” This program allows banks to borrow unlimited amounts from the Fed at the par value of any Treasury, Agency, or mortgage-backed securities they have available to pledge as collateral.
  • Since the BTFP backstop appears to be working to stop widespread bank runs here in the U.S., at least so far, the Fed is likely to feel it can keep hiking interest rates to bring inflation down.
• Over the longer term, the crisis is likely to spur increased regulation of the banking system. In particular, federal banking regulators are expected to apply their most stringent capital and reporting rules to relatively smaller banks, including those with assets ranging from $100 billion to $250 billion.  Those banks were spared the additional rules in a deregulation measure in 2018, but now they are likely to be re-regulated.  Fed officials have also indicated that they will investigate the downfall of SVB for any criminal behavior.

European Banking System:  As mentioned above, shares of Credit Suisse (CS, $2.51) have dropped some 20% so far this morning.  The bank’s problems are not a direct result of the SVB crisis in the U.S., as the institution has been struggling for years with enormous losses, scandals, management turnover, accounting issues, and other problems unique to itself.  Today’s sell-off was triggered by news that its largest shareholder, Saudi National Bank (1180, SAR, 42.75), has refused to provide any more capital to the bank.  All the same, the concern is that global depositors and investors have now become more suspicious about banks in general, raising the risk of bank runs despite the apparent stabilization we saw in the U.S. yesterday.

• The stock sell-off in Europe has not been limited to Credit Suisse. Many other major European bank stocks are also selling off sharply so far this morning.
• As in the U.S., the volatility is generating calls for the region’s central banks to slow, stop, or even reverse their recent campaigns to hike interest rates to fight inflation. The European Central Bank holds its next policy meeting tomorrow, and that potentially sets investors up for disappointment if the ECB decides to stick with its plan for continued aggressive rate hikes.

China:  Retail sales in January and February combined were up 3.5% from the same period one year earlier, reversing the 1.8% annual decline in sales registered in December.  Separately, January-February industrial production was up 2.4% on the year, accelerating from a rise of 1.3% in the year to December.  The figures suggest the economy continues to recover modestly following the end of President Xi’s draconian COVID-19 lockdowns late last year.  That’s a welcome sign for global demand as the U.S. still seems likely to slip into recession later this year and global banking systems are suffering a loss of confidence.

China-Honduras-Taiwan:  Honduran President Xiomara Castro today announced that her country will switch to recognizing China instead of Taiwan, granting a political victory for Beijing’s effort to isolate the island and eventually bring it under its control.  Beijing has recently been luring away more of Taiwan’s allies with promises of trade and investment opportunities, leaving just 13 mostly small island countries that still recognize Taiwan.

Pakistan:  Protests have broken out across the country in response to an attempt by police yesterday to arrest opposition leader Imran Khan on charges of corruption stemming from when he served as prime minister.  The attempted arrest occurred after several months of Khan being locked in a bitter political stand-off with the government of current Prime Minister Sharif.  The political instability comes as Pakistan is dealing with a deep financial crisis brought on by domestic mismanagement, high inflation, and soaring commodity prices.

Argentina:  The consumer price index in February was up 102.5% year-over-year, marking the country’s highest inflation rate since 1991.  Argentina’s soaring prices have largely been attributed to central bank money-printing, as well as the Russian invasion of Ukraine. The amount of money in public circulation has quadrupled during President Fernández’s first three years in office.

Bolivia:  As the country’s foreign-currency reserves shrink and the central bank has stopped publishing reserve figures, Fitch yesterday downgraded Bolivia’s debt deeper into junk territory, assigning it a B- rating with a negative outlook.  As citizens begin to panic about the boliviano’s (BOB) peg to the U.S. dollar, they have been mobbing the offices of the central bank in a desperate effort to buy greenbacks.

United States-Russia:  Yesterday, a Russian fighter jet collided with a U.S. drone flying over the Black Sea, forcing the drone to crash land into international waters.  According to the Pentagon, two Russian Su-27 fighters followed and harassed the spy drone for about 30 minutes, after which one of the fighters dropped fuel on it before speeding away.  The other fighter then tried to do the same, but it came into contact with the drone’s propeller.  Both Russian fighters then landed in Russian-held Crimea.

U.S. Regulatory Policy:  The Environmental Protection Agency proposed a new rule this week that would limit the amount of so-called “forever chemicals” in public drinking water supplies.  The EPA is proposing maximum allowable levels for two compounds in a class of chemicals known as perfluoroalkyl and polyfluoroalkyl substances, or PFAS, which take a very long time to break down.  If finally adopted, the rule is expected to impose costs of billions of dollars on water utilities around the country.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Silicon Valley Bank crisis and how it appears to be calming down, at least for now.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including further signs of economic decoupling between the West and China and new moves to lower prices in the U.S. healthcare market.

U.S. Banking System:  Yesterday, in the first full day of trading after Silicon Valley Bank (SIVB, $106.04) was taken over by regulators, it appeared that the government’s response to the crisis prevented serious contagion to other financial institutions.  There have been reports that bigger banks, which are perceived to be safer, are now seeing an influx of new deposits from the customers of smaller, relatively riskier banks, but we’ve seen little indication of widespread, debilitating bank runs.  That makes sense given the aggressive structure of the government’s crisis response and the fact that SVB was arguably a unique institution.  Because of its focus on venture capital and technology customers, and its decision to invest much of its portfolio in long-maturity bonds, SVB was especially susceptible to problems.  We’re optimistic that the financial system has dodged a destabilizing contagion situation, but some banks remain weakened, so it’s probably too early to send the all-clear signal.

• Multiple regional banks with a high proportion of uninsured deposits suffered steep stock and bond sell offs For example, San Francisco-based First Republic Bank (FRC, $31.21) closed 62% down.  Many of those smaller banks’ stocks look set to rally today, but their decline yesterday serves as a reminder that some smaller, tech-focused institutions could still have problems like SVB did.
• Overnight, it appeared that a number of foreign banks were also hit with big stock and bond selloffs related to concerns about their holdings of longer-term U.S. Treasury securities. Those concerns could continue to weigh on those banks’ stock and bond values for a while yet.
• Meanwhile, the Federal Deposit Insurance Corporation told Congress yesterday that they plan to take another swing at auctioning off SVB after failing to find a buyer over the weekend. Since the regulators have now deemed the bank to be “systemic,” the FDIC said it could offer deal sweeteners such as loss-sharing agreements.
• A key remaining issue is whether the crisis will convince the Federal Reserve to slow, stop, or even begin reversing its campaign of interest-rate hikes. Traders have certainly shown that they now expect the Fed to at least moderate future rate hikes, but any unexpected reacceleration in inflation could force the policymakers into making the tough call to keep hiking rates aggressively.  Such a move would boost volatility in the financial markets.

Eurozone Monetary Policy:  Naturally, the SVB crisis has also prompted speculation that the European Central Bank could slow its recent aggressive monetary tightening.  ECB policymakers have already signaled they will hike their benchmark short-term interest rate by 50 basis points at their next policy meeting on Thursday, and that is unlikely to change.  After that, however, the SVB crisis and the fear of “breaking something” in Europe could lead to slower rate hikes.

European Union Trade Policy:  In an interview with the Financial Times, European Commission Trade Chief Dombrovskis revealed that Brussels is exploring ways to police EU companies’ investments in foreign production facilities to circumvent bans on technology exports to China and other rivals.  The revelation provides more evidence that the EU is now getting behind Washington’s effort to clamp down on advanced technology transfers to China in order to suppress its military development.

Global Oil Market:  In its monthly oil market forecast, the Organization of the Petroleum Exporting Countries said it still expects global demand to grow to 101.90 million barrels per day this year, up 2.3 million bpd from last year.  The forecast is essentially unchanged from the previous month.  While OPEC now believes Asian demand will be higher than it originally thought, largely due to China’s abandonment of its strict COVID-19 lockdowns, the organization believes the increase will be offset by weaker demand growth in the developed Western economies.

China:  Industry sources say the Chinese government has begun to impede projects to lay and maintain subsea internet cables through the South China Sea, as Beijing seeks to exert more control over the infrastructure transmitting the world’s data.  According to the reports, long approval delays and stricter Chinese requirements, including permits for work conducted outside its internationally recognized territorial waters, have pushed companies to design routes that now avoid the South China Sea.

• The Chinese measures are at least in part a response to recent U.S. moves to exclude China from international cable consortiums and block direct U.S.-China connections.
• Taken together, the moves are another example of U.S.-China decoupling in the information technology and infrastructure arenas.

United States-United Kingdom-Australia:  President Biden, Australian Prime Minister Albanese, and British Prime Minister Sunak signed a deal yesterday to operationalize their countries’ “AUKUS” defense cooperation deal that was announced in 2021.  Under the deal, Australia would acquire at least eight nuclear-powered submarines in an arrangement that is intended to preserve the West’s lead over China in undersea military systems and cement the alliance between Australia, the U.S., and Britain.

• Under the deal, the U.S. will gain additional submarine basing rights in Australia, boosting its ability to deal with China’s increasing military aggressiveness in the region.
  • Repairing and rotating attack subs through a base near Perth will also give the Australians experience with operating and maintaining advanced vessels.
  • The expanded basing rights are consistent with the U.S. strategy of widely disbursing its Indo-Pacific forces to better protect them from a potential Chinese attack.
• Australia will purchase up to five Virginia class attack subs from the U.S. to improve its sub fleet in the 2030s. Virginia class subs are nuclear-powered, making them quieter than Australia’s current subs and therefore more survivable.  They can also patrol much farther without refueling.  They are not armed with nuclear weapons.
• By the 2040s, Australia will shift to buying a new class of subs that the U.K. will design using advanced U.S. technology. Those subs will be made in Britain and Australia.  As part of the deal, Australia will spend billions of dollars to improve its Perth naval base and expand the submarine industrial bases in the U.S., the U.K., and Australia.

United States-Canada:  Volkswagen AG (VWAGY, $18.33) said it will build its new electric-vehicle battery plant in Canada to take advantage of the clean-technology subsidies from the U.S. in last year’s Inflation Reduction Act.  As we reported in our Comment last week, the company was lured into making its investment in North America by the prospect of billions of dollars in subsidies from the IRA.  It has put plans for a European battery plant on hold to see if the EU comes up with similar subsidies.

U.S. Military Power:  In a move little noticed by the press, last week President Biden invoked the Defense Production Act to authorize a Defense Department program aimed at accelerating the rebuilding and expansion of the U.S. hypersonics industrial base.  The authorization allows the Defense Department to establish incentives for companies to increase production capacity or quality within critical technology areas that the president deems critical to national defense.

• China and Russia remain far ahead of the U.S. in fielding sophisticated hypersonic missiles, which can fly at several times the speed of sound and be maneuvered to dodge anti-missile defenses.
• After several failed tests, the U.S. finally scored some successful tests of its hypersonic technology last year. The new DPA authority suggests the Defense Department is preparing to mass produce the new weapons in order to better compete with China and Russia’s militaries.

U.S. Healthcare Industry:  Novo Nordisk (NVO, $140.54) said it will cut the U.S. list prices of several of its insulin drugs by up to 75% beginning in January 2024.  In addition, the company will cut prices for its unbranded insulin products to match the reduced price of its corresponding brands.  Novo Nordisk’s move follows a similar price cut by Eli Lilly (LLY, $324.49) earlier this month.  The price cuts, made under pressure from the Biden administration, will primarily benefit uninsured people, as insured patients often pay fixed co-pays for their insulin.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a discussion of the U.S. banking system, which has now seen the collapse of several sizable banks in the last week.  Over the weekend, federal regulators put a plan into place that appears to have removed the fear of massive bank runs, but that plan does nothing to shield bank stockholders and bondholders.  Bank shares and bonds remain under pressure 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 the latest from the Chinese government’s “two sessions” meetings.

U.S. Banking System:  Following Friday’s collapse of Silicon Valley Bank (SVIB, $106.04) and its takeover by regulators, Signature Bank (SBNY, $70.00), a key depository institution for cryptocurrency firms, collapsed on Sunday and was taken over by regulators.  To avoid a widespread loss of faith in the nation’s banks and their deposit insurance backstop, the Treasury Department, the Federal Deposit Insurance Corporation, and the Federal Reserve declared the two institutions to be a systemic risk to the country’s financial system.  This gave the regulators special powers to guarantee the banks’ uninsured deposits and establish a broad “Bank Term Funding Program” of one-year, collateralized loans to help banks cover their customers’ withdrawals.  The regulators said Silicon Valley’s depositors will have access to all of their funds by Monday.

• The critical issue in this crisis is contagion. Anytime a bank fails, it raises the risk of a widespread run on banks.  Fortunately, Silicon Valley was unusual in that so many of its deposits were bigger than the $250,000 insured by the FDIC.  In addition, under the government’s rescue scheme, the FDIC will cover 100% of the deposits at Silicon Valley and Signature, rather than the standard $250,000.  Federal regulators said any losses to the FDIC would be recovered in a special assessment on banks, and that the U.S. taxpayers wouldn’t bear any losses.  The banks’ equity and bond holders will not be made whole.
• In a statement Sunday night, the Fed said it was closely monitoring conditions in the nation’s financial markets and would use its “full range of tools to support households and businesses” as appropriate.
• The regulators launched their rescue plan after failing to find a buyer for Silicon Valley over the weekend. If their plan is seen as credible, it could restore confidence in the banking system and prompt a rebound in stock prices today following the rout on Friday.  However, the crisis could also spark a reversal of the bank deregulation of recent years and, if it’s seen as a bailout at the public’s expense, it could also be a political black eye for the Fed and the Biden administration.
• We have long warned that the Fed’s aggressive interest-rate hikes had the potential to “break something” in the financial system, and it now appears that the “something” was medium-sized, technology-dependent banks. It was reassuring that last year’s many bankruptcies and financial shenanigans in the cryptocurrency industry appeared to have little impact on the broader financial system.  However, it now appears that the Fed’s rapid rate hikes dried up financial flows into venture capital funds and technology startups, forcing them to withdraw funds from tech-focused banks even as those banks faced falling values for their bond holdings.
  • Fortunately, it appears so far that Silicon Valley and Signature represent relatively rare special cases. Some other smaller, regionally focused banks are facing pressure this morning, but it appears that the regulators’ emergency program will be able to contain the crisis and prevent broader contagion.
    • Another asset class that could come under pressure in the near future is mortgage REITs.
    • If Silicon Valley has to dump large amounts of its $50-billion portfolio as it is cleaned up, then the mortgage-backed securities could face losses.
  • Going forward, the crisis could well prompt the Fed to slow its rate hikes to assess any further stress in the financial system.
  • Reflecting the chance for slower rate hikes, investors today are bidding up bonds, pushing their yields down. The yield on the benchmark 10-year Treasury note has fallen to 3.505% so far this morning.

Chinese Politics:  In the latest developments from the government’s “two sessions” over the last few days, the National People’s Congress (NPC) gave Xi Jinping a precedent-breaking third five-year term as president to go with his October success in garnering a third term as general secretary of the Communist Party of China (CPC).  The vote, which positions Xi to become president for life, was 2,952 to 0.  Xi was also named head of the Central Military Commission, which leads the People’s Liberation Army, for a third term.

• The NPC on Saturday also named Li Qiang as China’s premier, the government’s #2 official. As powerful as that sounds, the role has come to be seen mostly as that of an implementer of the president’s policies, especially in the economic sphere.
• The NPC yesterday also kept Yi Gang as the head of the People’s Bank of China and Liu Kun as finance minister, in an apparent effort to reassure investors by leaving familiar faces at the central bank and finance ministry. However, given that the legislature has also approved Xi’s steps to again give the CPC the lead in setting policy, leaving Yi and Liu in their positions does not necessarily mean policy continuity.

Chinese Mining Industry:  New analysis from a British cobalt trader estimates that China will account for 50% of global cobalt production within the next five years, up from approximately 44% currently.  The increase will come despite Western efforts to gain control over supply chains for critical minerals such as cobalt, lithium, and nickel, which are essential for making EV batteries.  We continue to believe that China and its evolving geopolitical bloc may crimp global supplies of the critical minerals they control as tensions with the West continue to worsen.

China-Saudi Arabia-Iran:  Over the weekend, additional details came out regarding the Friday deal, brokered by China, in which Saudi Arabia and Iran agreed to reestablish diplomatic relations.  Besides Saudi Arabia and Iran agreeing to reopen each other’s embassy and restart normal diplomatic operations within two months, key elements of the deal and interests for the three participants are as follows:

• Saudi Arabia agreed to tone down the critical coverage of Iran by Iran International, a Farsi-language satellite news channel funded by Saudi businesspeople. Iranian officials believe Iran International has been instrumental in encouraging the recent popular protests against Iran’s government.
• In return, Iran agreed to stop encouraging cross-border attacks on Saudi Arabia from Yemen by Iranian-backed Houthi rebels.
• By brokering the deal, China gained the ability to present itself as an independent, influential power broker in the Middle East. China was also able to leverage its growing economic heft and its position as a key buyer of Middle Eastern oil.  For example, it appears that China has promised to help Iran deal with its current currency crisis and other economic woes so long as Iran improves its behavior vis a vis other Chinese friends in the region.  China probably also offered economic incentives to Saudi Arabia to come to a deal.  In any case, the agreement helps deter Saudi Arabia, which we assess to be in the developing “lean-China” geopolitical bloc, from getting too close to Israel and the rest of the U.S. bloc as it seeks protection from Iran’s expansionist policies in the region.  Indeed, it may be that China pushed through the Saudi-Iranian deal to scuttle a potential Saudi-Israeli normalization deal that the U.S. has been pushing.
  • As Israel becomes increasingly alarmed about Iran’s rapidly advancing nuclear program, the deal will probably constrain any plans it may have for a surprise military strike on the country.
  • Such a strike would probably require cooperation from Saudi Arabia, such as allowing Israeli jets to use its airspace. After working with China to reestablish ties with Iran, Saudi Arabia now would probably be more reluctant to allow that.

China-Russia-Ukraine:  In a sign that China may be trying to build on its recent diplomatic successes, the Wall Street Journal has scooped that Chinese President Xi will finally speak with Ukrainian President Zelensky for the first time since Russia’s invasion of Ukraine.  Xi’s call to Zelensky is expected to come after Xi visits Moscow next week to meet with Russian President Vladimir Putin.  It wouldn’t be surprising if Xi fleshes out his recent peace proposal for the Russia-Ukraine conflict, which was widely panned as nothing more than general principles.

Japan:  Investors are complaining that upcoming revisions to the rules Japan applies to companies’ anti-takeover defenses could deter domestic takeover bids, foreign buyers, and shareholder activists.  If so, it would exacerbate Japan’s longstanding reputation as a country where companies don’t prioritize investors and shareholder value.

United Kingdom:  The country continues to deal with continuing waves of strikes by transportation and public-sector workers.  Today, junior doctors in England’s National Health Service will begin a three-day walkout for higher pay.  This week will also bring additional strikes by teachers and other public employees seeking higher wages.

U.S. Military Power:  The nation’s newest aircraft carrier, the USS Gerald R. Ford (CVN 78), has embarked on her first deployment with a full air wing.  The vessel is the lead ship in the Navy’s new Ford class of carriers, incorporating multiple improvements over the previous Nimitz class.  After the Ford’s short deployment last year with a partial complement of aircraft, the current deployment is designed to refine how her crew and the rest of her task group will operate with her new technologies.  Once that is completed, the ship can finally be certified for a regular deployment, some six years after she was commissioned in 2017.

• Among their new features, the Ford-class ships utilize powerful electromagnetic catapults to get aircraft airborne, rather than the older steam-catapult technology. The ships also have advanced new elevators to move aircraft and armaments between the deck and hangers below.  Compared with Nimitz-class carriers, Ford-class vessels have their “islands,” i.e., control towers, farther aft to free up deck space and make deck operations more efficient.
• The six-year period between the Ford’s commissioning and first regular deployment illustrates some of the challenges faced by the U.S. defense industry as the West ramps up its defense spending to push back against authoritarian aggressor states like China and Russia. Part of Ford’s delay came from mechanical problems associated with her new technologies.  Even excluding that issue, however, current Western military procurement processes can be extremely slow and inefficient.

U.S. Fiscal Policy:  Late last week, President Biden released his proposed federal budget for the fiscal year starting October 1.  The proposal envisions total outlays of $6.883 trillion, or 25.3% of forecasted gross domestic product, compared with the current fiscal year’s projected outlays of $6.372 billion, or 24.2% of GDP.  Receipts would total $5.036 trillion, or 18.5% of GDP, compared with this year’s $4.802 trillion, or 18.2% of GDP.  That would leave the coming year’s federal deficit at $1.846 trillion, equal to 6.8% of GDP.  The proposal calls for cutting the deficit in future years by hiking taxes on corporations and individuals with very high incomes.  However, since the Republicans control the House of Representatives, the proposal is unlikely to pass and whatever budget emerges is likely to look far different.

U.S. Environmental Policy:  As the Biden administration prepares to approve the big “Willow” oil-drilling project in the Alaskan Arctic and anger environmentalists, he is also preparing to offer them a sop in the form of a ban on future oil and gas leasing in U.S. Arctic waters.  The ban would make about 2.8 million acres in the Arctic’s Beaufort Sea off limits to future oil and gas leasing indefinitely.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with our thoughts on the sudden sell-off in equities yesterday. Next, we go over the latest developments in the Middle East and Asia. Finally, we discuss why we are not confident that Haruhiko Kuroda’s exit from the Bank of Japan will lead to a quick end to yield curve control.

Trouble Lurking: Huge sell-offs in major banks yesterday have led to concerns that the Fed may be unable to maintain rates at its current level.

• The four largest U.S. banks lost a combined $52.4 billion in market value on Thursday. The sell-off was related to concerns that banks may be sitting on unrealized losses in their security portfolios. The fear was sparked after Silicon Valley Bank (SIVB, $106.04), a small technology focused lender, revealed that it had lost $1.8 billion following the sale of portfolio securities completed to address a decline in customer deposits. The sale of the company’s stock was halted after it fell 68% following the report. The company is now scrambling to raise new capital elsewhere.
• This current problem within the financial system is related to bank bond portfolios. During the pandemic, these banks invested the influx of deposits, mostly from pandemic stimulus, into long-dated securities such as Treasuries. The value of the holdings has plummeted as the Fed rate hikes have encouraged investors to reallocate their portfolios toward shorter-duration assets. Meanwhile, depositors have responded to higher rates by moving their holdings into higher yield money market funds. Equity holders of bank stocks are unsure as to whether these institutions have reflected the bond losses on their balance sheets.
• Although the Fed’s mandate of maintaining price stability and full employment is well publicized, it is frequently forgotten that the central bank was originally established to stabilize the banking system. Thus, the Fed’s 2% target may take a back seat if the Fed believes the banks are in trouble. Movements within the swaps market reinforced this view. The latest CME FedWatch Tool shows that investors expect the markets’ reactions to impact Fed policy. Thirty-day fed futures contracts now signal that the Fed may be less inclined to raise rates by 50 bps in its March meeting, with some contracts showing that the Fed could end the year with rates lower than they are today. We will continue to monitor this situation closely.

Major Power Games: While the U.S. is building closer ties to the Middle East and Indo-Pacific, Russia is working to maintain influence within Eastern Europe.

• Saudi Arabia is playing the U.S. and China against each other as the two look to reshape the Middle East. On Thursday, Saudi Arabia requested several items from Washington including security guarantees, support for building its civilian nuclear program, and fewer restrictions on arms sales in exchange for normalizing relations with Israel. At the same time, China brokered an agreement to restore diplomatic relations between Saudi Arabia and Iran. Since Iran and Israel are bitter rivals, we suspect that the OPEC leader could use the arrangement to promote itself as the dominant powerbroker within the region.
• The U.S. and India’s economies are becoming more integrated. White House representatives traveled to India this week to work out the details of supply chain coordination for semiconductors. This effort reflects the U.S.’s broader goal of decoupling from China. The growing population and improving infrastructure in India have made it a target of American foreign direct investment. Apple’s (AAPL,$150.04 ) decision to set up a production plant in India exemplifies this trend. The decoupling from China will force many companies to reshore their factories in other countries as the world breaks into regional blocs. India is one country that will gain from this shift while other possible beneficiaries include Indonesia, Mexico, and Brazil.
• Russia is losing its grip on allied countries within Eastern Europe. Protests forced the Georgian government to withdraw a bill that would have limited outside media influence in its politics. Meanwhile, Hungarian President and Putin ally Viktor Orbán warned that his country might have to distance itself from Russia due to its conflict in Ukraine. The souring of relations between Russia and some of its allies comes amidst concerns that Moscow may look to expand the conflict into other countries to turn the tides of the war. So far, the Georgian and Hungarian people seem uninterested in participating in the conflict.

 The New BOJ: Outgoing Bank of Japan Governor Haruhiko kept policy unchanged at his last meeting; however, his successor is slated to welcome in a new period of Japanese monetary policy.

• Kazuo Ueda will assume command the Bank of Japan in April and is expected to begin a new policy era. The new head of the BOJ will take over an economy replete with rising inflation and an eroding bond market. Japanese inflation has accelerated to a 41-year high, and the country’s yield curve is kinked. Ending yield curve control should alleviate these issues, although the country’s heavy debt burden will complicate the move. Even if the economy expands at a modest pace of 3% over the next 10 years, the country’s debt could climb to 1,100 trillion JPY ($8.5 trillion).
• The possible hawkish shift in Japan’s monetary policy could lead the JPY to outperform the dollar. According to Deutsche Bank, a combination of policy normalization and  easing by the Fed could push the JPY up about 60% against the greenback. The analysis assumes that 10-year Japanese bond yields settle at around 1.5% to 1.6% once the BOJ ends its policy intervention. A stronger JPY should be supportive of Japanese equities for dollar-based investors since it has a strong reputation for being a hedge against dollar devaluation and U.S. recessions.
• That said, Ueda’s taking office is not a guarantee that yield curve control will immediately cease. The International Monetary Fund has warned the Bank of Japan that an abrupt end to its policy will have a “meaningful spillover” effect on global financial markets and could lead to a liquidity crunch for potential borrowers profiting from arbitrage trading. Additionally, the latest GDP figures showed that weak consumption and investment almost pushed the country into recession last year. In short, the decision to end yield curve control is not an easy choice and is not likely not be as smooth as many investors are anticipating.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion about the growing appeal of the U.S. dollar. Next, we examine what the potential impact could be for companies as governments move away from neoliberal policies. Finally, we review why the recent decline in commodity indexes should not dampen investor outlook on the sector.

The Dollars Back: Hawkish talk from Federal Reserve Chair Jerome Powell has investors piling back into the greenback.

• The ICE U.S. Dollar Index surged to its highest level since November 2022 after Powell signaled that recent economic data could encourage the Fed to set rates even higher than it outlined in its latest dot plots. Powell attempted to calm markets by stating that the Fed has not yet made a final decision. However, the 30-day fed funds futures market is now forecasting a 46% chance that the central bank could raise rates an additional 125 bps by the end of July. Doubts about whether other central banks will follow suit have also supported the dollar.

• The European Central Bank is expected to raise rates by 50 bps in its next meeting later this month, but it isn’t clear where policy will go after that. Head of the Italian Central Bank Ignazio Visco criticized members of the ECB’s rate-setting governing council for pushing for additional rate hikes despite agreements that policy would be determined meeting-by-meeting. The uncertainty for the future of ECB policy raises the likelihood of a greater depreciation of the euro. The currency has fallen 1.5% against the dollar over the last three days, and it accounts for about 58% of the dollar index.
• Meanwhile, speculation that the Bank of Japan will maintain its accommodative monetary policy at its next meeting has also put pressure on the yen. The central bank is set to meet today and is expected to leave policy unchanged while the central bank transitions to its new leadership in April. By keeping policy loose, especially while the Fed tightens, the BOJ will make the yen less attractive to international investors which would add upward pressure on the greenback. This trend may conclude if incoming BOJ chief Kazuo Ueda signals a policy shift or if current central bank head Haruhiko Kuroda surprises markets by widening the band around the 10-year yield target like he did in December.

 The Biden Shuffle: The White House has begun to shift from neoliberal economic policy to a world that favors equity.

• U.S. President Joe Biden is set to unveil his budget proposal on Thursday. The plan likely has no chance of becoming law but will provide a platform for the president to lay out his policy initiatives as he prepares for reelection. His proposal calls for increased taxes for the wealthy and corporations, incentives to boost domestic manufacturing jobs, and protections for elderly healthcare. The White House estimates that the plan could generate $3 trillion in deficit reductions. His bill appears to be aimed at making his Republican counterparts look out of touch as they prepare a budget proposal that includes changes to the social safety net.
• The Inflation Reduction Act continues to attract more foreign businesses to the U.S. Volkswagen announced that it has put its plan to build a battery plant in Eastern Europe on hold as it analyzes the European Union’s counteroffer. The car manufacturer estimates that the American initiative could net the company between €9 and €10 billion in subsidies and loans when it builds its battery plant in the U.S. The EU’s decision to offer similar subsidies reaffirms our belief that Washington wants Europe to invest domestically to reduce dependence on Chinese manufacturing. In our view, the Inflation Reduction Act aims to have the U.S. and EU make greater investments in climate change technology to help the West close the gap with market leader and rival China.
• Increased state involvement within the economy in the U.S. and Europe will support domestic incomes but squeeze profit margins in the long-term. On the bright side, the reshoring of manufacturing jobs should lift household earnings. However, higher taxes on corporations will make it harder for firms to be profitable, while the development of national champions may encourage governments to implement trade barriers. In short, the move away from neoliberal policies toward populist initiatives is not favorable for companies with a lot of foreign exposure.
  • President Biden’s push for export curbs on semiconductor parts and China’s protection of its climate technology may offer a taste of what the future might hold in a less globalized world.

It’s Complicated: Uncertainty of supply and demand for commodities has made it difficult to gauge the bottom of the market, but the long-run outlook for the sector remains favorable.

• The Chinese economy has still not fully recovered from its COVID lockdowns. While generally seen as a net importer of metals, China is expected to export some of its excess inventory of copper. The decision to offload some of its holdings comes amidst signs that manufacturing and construction activity have not returned to maximum levels. Additionally, there are fears that lockdowns may return as a Chinese city has backed a plan to use lockdown measures to help contain influenza outbreaks. This situation suggests that China is still not fully on its feet and consumer confidence may struggle to return to pre-pandemic levels.
• Supply does not seem to be on the upswing either. At the annual CERAWeek conference, U.S. shale producers admitted that they couldn’t challenge OPEC’s pricing power. They have argued that the industry has lost ground to foreign rivals due to a lack of investment. Oil firms have been pressured to limit spending in order to boost higher returns for shareholders. The lack of U.S. production should provide upward prices as declining rig counts prevent firms from producing more oil.

• The Bloomberg Commodity Total Return Index dropped 11% from its peak in May last year. The decline in the index was related to a drop in Chinese demand, concerns about a possible global recession, and a strengthening of the U.S. dollar. Despite its recent fall from grace, the index has been known to be a hedge against inflation, especially in a less globalized world. Uncertainty within the Middle East and Europe will likely support the assets for the foreseeable future; meanwhile, Chinese demand is still expected to return over the coming months. As a result, we believe there is still much upside for the sector.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with energy industry warnings about insufficient oil supplies in the coming years, which is consistent with our positive outlook for commodity prices once the economy gets past the impending recession.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an overview of Federal Reserve Chair Powell’s testimony before the Senate Banking Committee yesterday.  Powell continues his semi-annual testimony today at 10:00 AM EST before the House Financial Services Committee.

Global Oil Supplies:  Energy industry leaders attending the annual CERAWeek conference in Houston have been warning that rising exploration and production costs and investor pressure to return cash to shareholders will crimp the growth of future shale oil supplies, leading to higher oil prices in the future.  The assessment is consistent with our view that commodities, in general, and mineral fuels, in particular, are likely entering a period of elevated prices and good returns due to geopolitical frictions, deglobalization, and insufficient investment.

Russia-Ukraine War:  After U.S. and German media reports suggested that a “pro-Ukrainian” group was responsible for last September’s bombing of the Nord Stream 1 and 2 natural gas pipelines under the Baltic Sea, a top Ukrainian official denied that his government had any involvement in the attack.  Nevertheless, German officials today detailed some aspects of their investigation that seem to point in the same direction as the media reports.

• All the same, the media reports do sound plausible, given that the pipelines running from Russia to Western Europe were key to building Europe’s dependence on Russian energy. Putting the pipelines out of commission has helped accelerate the Continent’s rapid shift away from Russian energy sources and arguably helped buttress Western Europe’s ability to support Ukraine in its defense against Russia’s invasion.  The bombings were, therefore, certainly in Ukraine’s interest.
• An important question remaining is whether Ukrainian special forces or intelligence operatives had the expertise and equipment needed to carry out the attacks without being detected. A further question would be whether they had any help from the U.S. or other countries.

Georgia:  Mass protests and rioting have broken out in the capital of Tbilisi after the government’s proposed “foreign agent” law passed its first reading in parliament.  The draft law is modelled on Russian President Putin’s restrictive regime for media and non-governmental organizations.  For example, it would deem any Georgian media organization or NGO receiving more than 20% of its funding from foreign sources as a “foreign agent” and would subject it to undefined “monitoring.”  The controversy will further sour relations between Georgia and the EU, making it more difficult for Georgia to eventually become a member of the bloc.

United Kingdom:  Prime Minister Sunak has unveiled a proposed new law that would significantly toughen the U.K.’s approach to illegal migration into the country.  The legislation would impose a legal duty on the home secretary to remove irregular migrants to a “safe” third country or to their country of origin.  It would also bar any migrant deemed to have entered the U.K. illegally from ever claiming asylum in the future.  Although British officials insist the legislation would be consistent with international law, the fact that it contravenes European standards means it could worsen U.K.-EU tensions again, despite Sunak’s apparent success in renegotiating the Brexit treaty’s Northern Ireland Protocol.

China:  At the Chinese government’s big “two sessions” meetings yesterday, President Xi presented a major bureaucratic reorganization aimed at solidifying the Communist Party’s control over the agencies of state power and accelerating the country’s technological and financial development.  Among other initiatives, the plan would:

• Cut the government’s workforce by 5% across the board;
• Shift some responsibilities of the Ministry of Science and Technology to other agencies in order to make the ministry more focused on spurring scientific and technological innovation;
• Establish a national data bureau to regulate the control and use of information, which is expected to be the lifeblood of China’s evolving artificial-intelligence driven economy;
• Consolidate the existing banking and insurance regulatory bodies into a new State Administration for Financial Supervision and Administration which would also absorb some functions from other agencies, such as the central bank’s oversight powers over financial holding companies and the securities regulator’s investor protection duties;
• Resurrect the Communist Party’s Central Financial Work Commission to oversee the government’s financial regulation effort and ensure it conforms to Party priorities.

U.S. Monetary Policy:  In the first day of his semi-annual testimony before Congress, Fed Chair Powell told the Senate Banking Committee yesterday that since recent data on demand, employment, and inflation had come in hotter than expected, monetary officials would likely hike interest rates further than previously anticipated.  Even more concerning for the financial markets, Powell said that “If the totality of the [upcoming] data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”

• In other words, Powell was signaling that the policymakers could return to hiking rates at an aggressive pace of 50 basis points per policy meeting, as they had been doing over much of the last year before slowing the pace to 25 bps at the last meeting.
• Investors quickly repriced a range of financial assets to reflect the more aggressive policy tightening. The target-rate probability tool from CME Group (CME, $182.22) quickly shifted to show that investors now see about a 75% chance that the Fed will hike its benchmark fed funds rate by 50 bps at its March 21-22 meeting, versus just a 31% chance prior to Powell’s testimony (see chart below).  Equities sold off sharply in response.
• The renewed signals of even tighter monetary policy appear to be worrying officials at the White House. Asked about the Fed’s plans yesterday, a top official insisted that the Biden administration wouldn’t try to interfere with the monetary policymakers but suggested they take a longer look at the data before hiking rates more aggressively.

U.S. Industrial Policy:  Illustrating the impact of the green-technology subsidies provided in last year’s Inflation Reduction Act (IRA), Volkswagen AG (VWAGY, $18.81) stated that it will prioritize its plan to build an electric-vehicle battery plant somewhere in North America.  According to Volkswagen, the company should expect to receive more than $10 billion in incentives from the IRA and other U.S. laws over the lifetime of the plant.  In contrast, the company said it will put a similar battery plant planned for eastern Europe on hold until the EU clarifies what support it is willing to provide.

• The news will likely exacerbate EU leaders’ irritation over the IRA subsidies, which they fear will draw billions of dollars of investment toward the U.S. and away from Europe.
• On the other hand, U.S. officials have encouraged the EU to adopt similar industrial policies to support its manufacturing base, and the competitive threat from the U.S. will probably convince the EU to do just that in the future.

U.S. Antitrust Regulation:  The Justice Department filed a lawsuit yesterday to block the proposed merger between JetBlue Airways (JBLU, $8.16) and Spirit Airlines (SAVE, $17.13) on grounds that the linkup would stifle competition and boost airfares for travelers.  The two companies vowed to fight the lawsuit.  Nevertheless, the Justice Department’s action illustrates the Biden administration’s stepped-up antitrust regulations.

U.S. Labor Market:  An analysis of recent employment data shows that more women than men have gained jobs over the last four months, pushing the female share of nonfarm payrolls to 49.8%.  As recently as 2019, women represented more than half of all nonfarm payrolls, but that changed with the COVID-19 pandemic, when women lost 12 million jobs and men only lost 10 million.  The surge of women coming back into the labor force could help unshackle the economy and could potentially hold down excessive wage increases.

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