by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with news related to China’s regulation of its technology sector.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, many of which also relate to China and its relationship with other countries.  We end today’s Comment with a few positive notes on U.S. inflation pressures.

China:  Technology-focused investment bank China Renaissance (1911, HKG, 7.10) said its founder and chairman, Bao Fan, dropped out of sight because he is “cooperating in an investigation carried out by certain authorities” in mainland China.  The news seems to confirm that Bao is the target of some kind of criminal or corruption probe.  If so, it would probably rekindle concerns that China’s technology sector is still being targeted for discipline, despite recent signs that the government was easing up on it.  That’s likely to be a headwind for Chinese technology shares in the near term.

China-United States:  New intelligence reports provided to Congress show that the U.S. Department of Energy, which runs several government labs, has now joined the FBI in concluding that the COVID-19 pandemic was caused by a Chinese laboratory mishap.  Although other components of the U.S. Intelligence Community still judge that the pandemic began through natural transmission, the new conclusion by the DOE will certainly anger the Chinese and potentially lead them to impose retaliatory measures against U.S. trade and investment.

China-Netherlands-United States:  The Dutch company ASML (ASML, $618.38) is virtually the sole supplier of the machines needed to make the world’s most advanced semiconductors.  It has reportedly found that a former China-based employee who was accused of stealing technology data from the firm appears to have ties to a Chinese state-sponsored entity which was previously linked to intellectual property theft.  The U.S. government is also investigating the incident as a potential case of Chinese industrial espionage.

• ASML is so critical to the production of the most advanced computer chips that it is certainly targeted by China for its technology secrets. Even if the West wasn’t trying to clamp down on technology transfers to China, we suspect Beijing would be trying to steal ASML’s technology so that it could share it with Chinese firms and eventually install a Chinese firm at the top of the global semiconductor equipment industry.
• If ASML’s technology data theft is confirmed to be linked to Beijing, it will further increase Western-Chinese tensions and put investors at an even greater risk of being caught in the crossfire.

China-Russia:  U.S. officials provided more details on their announcement last week that they have intelligence indicating that China is considering sending lethal aid to Russia for its invasion of Ukraine.  The officials stated that the aid China is contemplating sending could include drones, artillery, and possibly other weapons.  The U.S. revelation likely aims to expose China’s assistance to the aggressor even as it publicly paints itself as a neutral peacemaker and a champion of national sovereignty, independence, and territorial integrity.  The U.S.’s hope is that such a revelation will discourage Beijing from following through with sending the lethal aid to Russia.

• If China does follow through, then U.S. and European officials have warned that there would be severe consequences for China’s relationship with the West.
• It may seem that Western-Chinese relations are already as bad as possible, but the West’s recent moves to “decouple” from China have actually been relatively focused, mostly on the flow of advanced technology and critical resources. Overall, Western trades and investments with China have continued to grow.
• That suggests that any further worsening in the West’s relationship with China could lead again to restrictions on a broader range of goods, services, technologies, and capital flows that otherwise wouldn’t be considered sensitive.
• As we have warned many times before, worsening tensions with China have the potential to catch investors in the crossfire.

Russia-Ukraine War:  Russian forces have launched a new wave of drone attacks on Ukraine and continue their modest counteroffensives at various places on the front lines running from northeastern to southern Ukraine, but their gains appear to be minimal in the face of strong Ukrainian opposition.  Separately, Germany, France, and the U.K. have floated a plan under which the North Atlantic Treaty Organization would provide security guarantees to Ukraine as an incentive for it to begin peace talks with Russia.

Nigeria:  Although vote counting continues after Saturday’s presidential election, it appears that outsider Peter Obi of the Labour Party has won the state of Lagos, the country’s economic powerhouse and the home state of his main rival Bola Tinubu.  As the electoral authorities struggle with various complications in the country’s new voting system, it is unclear when the final election results will be known.  That raises the prospect of intensifying political violence in one of the world’s top oil producers.

Mexico:  Tens of thousands of protestors rallied in Mexico City yesterday against President Andrés Manuel López Obrador’s “reform” of the electoral system, which passed Congress last week.  The changes will slash funding for Mexico’s electoral authority, which is expected to lead to the dismissal of 85% of its professional staff and could potentially put the credibility of the country’s elections in doubt.  The protests are a welcome sign that significant numbers of Mexicans are willing to push back against the president’s growing authoritarianism.

European Union-United Kingdom:  Several weekend statements by Prime Minister Sunak and his ministers suggest the EU and the U.K. could announce a deal this week to restructure the controversial “Northern Ireland Protocol,” which is the part of the Brexit agreement that keeps shipments from the U.K. to Northern Ireland from flowing duty-free into the EU.  The very latest reporting indicates that Sunak could announce the deal as early as today.

• However, even if Sunak announces a deal, there is a strong chance that the far-right wing of his Conservative Party will oppose it on sovereignty and nationalism grounds.
• Such an event could destabilize the Sunak government, potentially prompting some of his ministers to resign and encouraging unionists in Northern Ireland to keep blocking the formation of a coalition government for the province.

United States-European Union:  In an important interview with the Wall Street Journal, European Commission Executive Vice President Vestager toned down her criticism of the new U.S. subsidies for green technology investments found in last year’s Inflation Reduction Act.  According to Vestager, a closer analysis of the subsidies suggests that the main threats to European competitiveness will be limited to a handful of sectors, and that even if some European companies may be incentivized to shift their capital investments to the U.S., the subsidies won’t necessarily be the deciding factor.

• Vestager’s comments indicate that the U.S. subsidies have become much less contentious, as we have long suggested they would. In part, that’s probably because the U.S. has been encouraging the Europeans to adopt similar industrial policies that would offer support for their own green technology industries over time.
• In any case, Vestager’s comments imply that the controversy over the U.S. subsidies will soon subside. That means they won’t be a serious threat to U.S.-European unity going forward.

U.S. Labor Market:  The Financial Times released an analysis of the latest corporate earnings reports showing that U.S. companies are now finding it “dramatically” easier to hire, despite recent data pointing to an extraordinarily tight labor market.  The report could help reassure the Federal Reserve that wage pressures will soon ease and that the policymakers can soon stop hiking interest rates to slow the economy.

U.S. Apartment Market:  Rental housing website Apartment List released data showing the average rental rate on new apartment leases fell in every major metropolitan area in the U.S. over the six months through January.  This, in part, likely reflects a spike in supply as newly built apartments become available.  According to the data, renters with new leases in January paid a median rent that was 3.5% lower than they would have paid last August.  Falling rent prices should eventually help bring down consumer price inflation, although their impact can be slow to show up in the data.

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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 about the potential for a bond rally in 2023. Next, we discuss how revisions to economic data may impact our timeline for a recession in both the U.S. and Europe. We end the report with our views on whether the U.S.-led bloc can remain united against Russia and China.

Will the Rally Return? Expectations of higher policy rates have called a potential rally in global bonds into question.

• Investors were convinced that a steady decline in inflation and an increased risk of a global recession would force major central banks to moderate their policy stance in 2023. After falling 16.2% in 2022, the Bloomberg EuroAgg Index, which tracks government and corporate bonds within the EU, has climbed 2.2% in the first month of the year. Meanwhile, the Vanguard Total Bond Market ETF, which tracks U.S. fixed-income assets, rose 4.1% in January after falling 13.4% the previous year. These assumptions were turned on their head after a relatively warm January led to stronger-than-expected economic data, and China’s reopening led to upward revisions for global growth.
• Hawkish comments from central bankers have led investors to ratchet up their interest rate expectations. Members of the Federal Reserve and the European Central Bank’s Governing Council have argued that strong January data provides evidence that central banks can raise policy rates further. A similar view is shared among members of the Bank of England’s Monetary Policy Committee. Meanwhile, there is speculation that the Bank of Japan is engaging in stealth tightening. Traders have not ignored these changes to central bank sentiment. Overnight index swap rates of four major banks have increased throughout February, suggesting that the market expects global financial conditions to tighten throughout the year.

• However, there is still a good chance that bonds could rally this year. Last year’s decline was so deep that any reversal in policy rates could lead to a disproportionate jump in bond demand. The market’s sensitivity to changes in interest rates can partially explain why the U.S. Treasury yield curve has remained inverted for so long. Investors don’t believe that the Fed will keep rates high for long enough to warrant a change in long-run borrowing costs. As a result, fixed-income assets, such as investment grade and government securities, will likely look more attractive as the central bank approaches the end of its hiking cycle.

Recession Fears Are Back: New economic data suggests that Gross Domestic Product growth was slower than investors initially thought in the final quarter of 2022.

• Revised figures showed that consumption was less robust than originally estimated, and fixed investment spending continued to be a drag on growth. Although the U.S. economy remained in expansion territory in Q4 2022, revisions have shown that Germany’s economy contracted toward the end of the year. The downward revision in the data suggests that businesses and households had been less active in the economy than sentiment surveys had indicated. Therefore, the risk of a hard landing is now elevated in the U.S. and Europe
• That said, all hope isn’t lost for central banks to navigate a soft landing. Governments have attempted to offset some of the negative impacts that rising energy prices and interest rates have had on the economy. In December, the German government approved gas and power subsidies to mitigate the impact of a potential energy crisis for households and firms. Meanwhile, the U.S. is looking at ways to reduce the cost of owning a home. The Biden administration plans to boost homebuying by reducing mortgage insurance costs for some new homeowners. These measures alone may not be enough to prevent a downturn, but they could help delay and/or moderate a future one.
• The U.S. and European economies are not deteriorating at the same pace. Downward revisions have not changed our forecast for when a potential U.S. recession could take place. We still suspect a downturn could happen in the second half of the year. A European recession could occur sooner, though, since the region’s higher inflation has caused a greater pullback in consumer spending, and it will be difficult for Europe to stimulate growth while also fighting inflation. It is too soon to tell whether central bank officials will factor in the slower growth in their next policy meetings; however, tighter monetary conditions may raise the likelihood of a deeper recession.

Anniversary of the War in Ukraine: The next year will offer a new durability test for the Western alliance.

• The coalition between the U.S. and Europe has held up much better than both Russia and China had anticipated. At the beginning of the war, there was much skepticism about whether the West could remain a united front against Moscow. Russian President Vladimir Putin believed that Europe’s dependency on Russian energy was a key vulnerability of the Western alliance. A multitude of sanctions and billions of dollars’ worth of military equipment proved his thesis wrong. The sanctions may have left much to be desired, but the weapons and equipment sent to Ukraine were critical in slowing Moscow’s territorial ambitions.
• China is still the elephant in the room. Although Europe has been willing to sever ties with Russia, they have been less willing to do the same with China. This is not only seen with Germany’s wooing of Beijing last year but also in the reluctance of Dutch chipmaker AMSL($638.09) to participate in U.S.-led export controls against China. Additionally, the reopening of the world’s second-largest economy has provided a major tailwind for Europe. China has noticed this weakness within the alliance and has been trying to play up its role as a peacekeeper to curry additional favor with Europe. Hence, we suspect the U.S. will have a difficult time convincing Europe to clamp down on Beijing without hard evidence of China’s involvement in the war in Ukraine.
• Make no mistake about it, there are major divisions within the U.S.-led bloc. However, these differences have not been able to prevent countries from working together to prevent Russia’s advancement in Ukraine. Confronting China will likely provide fresh challenges as the country remains a major export market for European countries. As a result, the U.S. may need to provide Europe with additional assistance if it wants to ensure that the Western alliance remains intact. We are confident that Europe offers many opportunities for investors looking for international exposure. However, this outlook may change if China supplies Russia with lethal weapons.

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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 about the minutes from the latest Federal Open Market Committee meeting. Next, we discuss changes and challenges in the tech sector and what they signal for investors. The report concludes with a discussion about the rising tensions between the U.S.-led and China-led blocs.

 Hawkish Minutes: The market has done away with bets for a pivot in June and now expects the Fed to raise rates at least until the start of the third quarter.

• According to a Fed statement, the overwhelming majority of Fed members supported slowing the pace of rate hikes. The latest meeting minutes showed that almost all participants favored a 25 bps hike in February, with few participants signaling a preference for a 50 bps hike. Despite the moderation in tightening, the minutes also revealed that all participants agreed that ongoing increases would be needed to help contain inflation. Although the committee acknowledged that inflation was on a downward trend, members insisted that there is still insufficient evidence that inflation is on a sustainable path toward the central bank’s 2% target.
• The minutes reinforced concerns from the market that the Fed was not yet prepared to end its hiking cycle. The S&P 500 closed down 0.2% on Wednesday as equity holders weighed the potential for further tightening. Meanwhile, the yield curve was only slightly affected as fixed-income investors had largely priced in the potential for more hikes. The yield on the 10-year Treasury fell 3 bps, while the 2-year yield was relatively unchanged.
• The market reaction indicates that investors have accepted that the Fed will at least meet the target rate outlined in its dot plot chart. Following the FOMC policy meeting on February 1, investors had assumed that the Fed was almost done hiking rates. However, this sentiment changed leading up to the release of the minutes as investors weighed hawkish comments from Fed officials. As the chart below shows, investors have drastically revised their expectations of future Fed rates. The change is similar to the level of St. Louis Fed President Bullard’s policy rate outlook. The increase in expectations suggests that financial conditions will likely get tighter throughout the year, and thus, could increase the likelihood of a severe recession.

Down But Not Out: Tech may have taken a beating as of late, but recent changes may make the sector more attractive down the road.

• FAANG stocks are down 6.6% over the last five days, despite starting the year strong. The underperformance of the high-tech growth sector is related to concerns that higher interest rates will continue to weigh on earnings. As a result, many of these firms will have to continue focusing on becoming more profitable and managing their expenses to bring more value to their investors. The pivot from tech firms partially explains why the market rallied at the beginning of the year when investors believed the Fed was set to end its hiking cycle.
• Tech firms have tightened their bootstraps over the last few months to offset rising interest rate costs. So far, much of the cost-cutting has come from layoffs. For example, Meta (META, $171.12), which fired 13% of its work staff in November, now plans to cut thousands more jobs across the company. Assuming that the job cuts in tech are mostly of inefficient workers, the trimming of the workforce should lead to more productivity and a boost to bottom lines. Therefore, the sector could be positioned for a strong rally when the Fed decides to cut rates.
• That said, the tech sector is also facing a litany of challenges that could prevent it from rallying to its full potential. Lawmakers have grown suspicious of the influence big tech firms have over the populace and would like to regulate their ability to collect and sell data. Advancements in artificial intelligence could be impacted as government officials fear that the technology will be misused. AI is an area that both Microsoft (MSFT, $251.51 ) and Amazon (AMZN, $95.79) view as having great revenue-generating potential, but it is also very expensive. Thus, attempts to restrict its use could slow investment in the area.
  • Similarly, some U.S. tech firms may face bans in other countries as foreign governments look to promote their own companies. For instance, China plans to restrict access to OpenAI’s ChatGPT service.

Taking Sides: Other countries continue to get caught in the middle of the major power struggle between the U.S. and China.

• Tensions between the U.S.-led and China-led blocs continue to ratchet up. Washington insists that Beijing is considering supplying lethal aid to help Russia with the war in Ukraine. The accusation has led to fresh tension between the two largest economies as such actions from China could open the country up to Western sanctions. Additionally, the U.S. plans to ramp up the number of troops it has deployed to Taiwan in the coming months. The move is designed to deter China from invading the autonomous island. Posturing from the U.S. suggests that a thaw in tensions between the two rivals is less likely to happen.
  • On a separate but related note, Russian, Chinese, and South African navies will participate in naval exercises off the South African coast later this week. The joint exercises show the growing military ties between Russia and China.
• The competition between the two powers has forced smaller countries to choose sides. Western governments are investigating whether a surge of exports from Central Asia included products under sanctions. If these countries are found to have aided Russia with sanctioned goods, they could be hit with penalties from the West. Meanwhile, G-20 host India does not want the word “war” used in any joint statement when referring to the conflict in Ukraine. The country considers itself to be a neutral party in the conflict and does not want the event to be stained by the bickering between rival diplomats. Although India remains a geopolitical ally of the U.S., the country wants to maintain ties with Moscow to preserve its access to Russian mineral resources.

• Rising geopolitical frictions between the U.S.-led and China-led blocs remain a prevalent risk for investors. The deep trade ties between the countries mean that any potential unraveling could be felt throughout the world. In the long-term, the decoupling should benefit countries along the periphery of the U.S. as near-shoring should lead to increased capital investment. However, this process will be costly and may force firms to push the adjustment onto consumers. If true, this will likely pose a long-term risk to inflation as less supply-chain diversification will make it more difficult for companies to rely on the lowest-cost producer to manufacture goods.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a few additional remarks on how the swaggering monetary policies of the major central banks have once again unsettled global stock markets.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including renewed threats to commodity supplies because of the war in Ukraine and evidence that global inflation is pushing up wages, even in Japan.

Global Monetary Policy:  This afternoon the Federal Reserve will release the minutes of its latest policy meeting, and investors are bracing for any additional signs that the policymakers are intent on continuing to raise interest rates further and keep them there for an extended period, as Chair Powell insists.  At the same time, yesterday’s surprisingly strong economic data in Europe has boosted expectations that the European Central Bank could hike its benchmark interest rate to a record high.  European swap markets now suggest investors are expecting the ECB to hike its key rate to 3.75% by September, up from 2.50% currently.

• In the U.S., the yield on 10-Year Treasury notes temporarily rose above 4.00% yesterday, surpassing their level from the end of 2022. The burgeoning concerns about surging interest rates drove U.S. stock prices sharply lower.
• European stocks yesterday fell less dramatically than in the U.S., although they continue to falter so far this morning.

Japan:  In an example of how global price inflation has dramatically changed economic trends,

Toyota Motor Corp. (TM, $139.18) said it had fully accepted its Japanese labor union’s wage demands and will give its employees their biggest pay increase in two decades.  The move by the bellwether manufacturer is likely to encourage other major Japanese employers to follow suit.

• In fact, Honda Motor Co Ltd (HMC, $25.90) also accepted its union demands in full to raise overall wages by about 5%, including base pay and seniority-based pay.
• Such moves in Japan and elsewhere are likely to keep concerns alive about a wage-price spiral that could keep inflation high for longer than investors currently expect.

China:  In recent days, there have been numerous reports that an influential Chinese technology investment banker, Bao Fan, has gone missing.  Bao and his investment bank have been instrumental in bringing many of China’s key technology companies to market.  His disappearance, which may indicate he is under investigation by the government, has raised fears that the country’s technology companies are about to face a new round of corruption and regulatory scrutiny despite recent hopes that Beijing was easing up on the sector.

Pakistan:  Former Prime Minister Khan plans to launch mass protests across the country today in a bid to topple incumbent Prime Minister Sharif, his arch rival, and force new elections.  The protests come as the government is struggling to convince the International Monetary Fund to release the next tranche of a $7 billion assistance package it needs to avoid defaulting on its foreign debts.

Russia-Ukraine War:  As Russian forces continue their underwhelming counteroffensive in the eastern Donbas region, the Ministry of Defense and the Wagner Group mercenaries owned by financier Yevgeny Prigozhin continue trying to undercut each other, exposing an important political rift within the Russian war effort.  To illustrate the damage, Prigozhin has even accused the MOD of withholding ammunition needed by his mercenaries.  For months Prigozhin has been trying to bolster his political power by highlighting the shortcomings of Russia’s official military organizations and demonstrating his mercenaries’ success, but it now appears that at least some officials in the Kremlin are trying to cut him down to size before he gets too powerful.

• Separately, reports indicate Ukrainian grain exports have been declining ahead of the March 19 expiration of the UN-brokered deal in which Russia has allowed Ukraine to export food products through its southern ports. The pullback in exports has already boosted world wheat prices by approximately 10% over the last month to about $8.00 per bushel.
• Similarly, new Western sanctions imposed this month on Russia’s refined crude oil products have refiners worried that they won’t have enough supply of an important input for gasoline. That raises the prospect that global gasoline prices could soon start rising again and keep global inflation from falling as much as it otherwise would.

U.S. Artificial Intelligence:  Microsoft (MSFT, $252.67) said yesterday that it will ease some of the caps it imposed just last week on users of its new artificial-intelligence search engine.  The company had limited the number of questions a user could ask the search engine each session after determining that long conversations confused it and led it to provide disturbing answers.  The company said it was easing the limits based on feedback from users.

• With interest in natural-language artificial intelligence systems growing rapidly, Microsoft’s decision to let everyday users essentially serve as testers has the potential to popularize the new technology even further.
• Workers in a range of industries have already started experimenting with the system, raising expectations that artificial intelligence could revolutionize many knowledge jobs in the future.

U.S. Cryptocurrency Regulation:  The Securities and Exchange Commission is reportedly investigating whether Paxos Trust’s stablecoin, BUSD, violates investor-protection laws.  If the SEC eventually brings a lawsuit and wins against Paxos, the agency could gain much broader authority to regulate the evolving cryptocurrency marketplace.  However, securities lawyers say the SEC faces an uphill climb to convince a court that stablecoins fall under its jurisdiction.

U.S. Winter Storm:  A major winter storm this week is causing heavy snowfall, high winds, and plummeting temperatures from the Rocky Mountains through the northern Great Plains and from the Midwest into New England.  The storm is expected to ground many airline flights and impede ground transportation for much of the nation, potentially causing temporary economic disruptions.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with more evidence that the European economy is growing much better than expected.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new tensions between the West and both Russia and China.  We also include a discussion of why investors should consider not just the central banks’ monetary policy but also the broader mix of economic policies when assessing the outlook for inflation.

Eurozone:  S&P Global reported that its flash composite Purchasing Managers’ Index for February jumped to 52.3, smashing both the expected reading of 50.6 and the final January reading of 50.3.  The unexpectedly strong reading in February mostly reflected a jump in the PMI for the services industries, since the PMI for manufacturing plateaued at just below 50.  As with most major PMIs, readings above 50 indicate expanding activity, so today’s report suggests the Eurozone’s economy has now expanded for two straight months and is currently growing at its best rate in nine months.

• On a related note, S&P Global said its flash composite PMI for the U.K. jumped to an eight-month high of 53.0 from 48.5 in the previous month.
• The reports are likely to be positive for European equities and currencies, although they will also probably encourage the major European central banks to keep hiking their benchmark interest rates aggressively.

Russia-Ukraine War:  President Biden made an unannounced visit yesterday to see Ukrainian President Zelensky in Kyiv and to signal the U.S.’s continuing support for the country as it fights to resist the Russian invasion.  Meanwhile, U.S. Secretary of State Blinken over the weekend said that he has evidence showing the Chinese government is preparing to expand its support for Russia to include lethal equipment.  Chinese officials have denied any such intention, but reports indicate that the U.S. administration has warned China that taking such a step would cross a red line and result in negative consequences for the U.S.-China relationship.  Ironically, Chinese Foreign Policy Chief Wang Yi said China would soon offer its own peace proposal to end the war.  European officials seem to be quite wary of the prospect.

Russia-United States:  In a speech to the national legislature today, President Putin stated that Russia will suspend its participation in the New START arms control treaty with the U.S., which limits the number of strategic nuclear weapons each side is allowed to deploy.

• The U.S. State Department had already formally notified Congress last month that Russia violated the treaty by refusing to allow on-site inspections and rebuffing Washington’s requests to discuss its compliance concerns. Putin’s announcement, therefore, breaks little new ground regarding the treaty’s operational effect.
• On the other hand, as China ramps up its inventory of nuclear weapons with no arms control constraints, the formal or informal demise of New START could free the U.S. to expand its nuclear forces to meet the new challenge of deterring both China and Russia simultaneously. Of course, that would likely entail a dangerous new nuclear arms race.

Iran:  Diplomatic sources say the International Atomic Energy Agency has detected that Iran has been enriching uranium to a purity of 84%, near the weapons-grade level of 90% and far above the 3.67% level it was capped at under the now-defunct limitation agreement of 2015.  If confirmed, the advancement could prompt a sharp reprisal from the international community and potentially lead to a military attack on Iran by Israel.

China-South Pacific Islands:  Illustrating its focus on building influence in the South Pacific region, the Chinese government named its first permanent special envoy to the region last week.  The new envoy will be Qian Bo, who has been China’s ambassador to Fiji since 2018.  The naming of the special envoy will likely cause alarm in the U.S. government and will serve to worsen the U.S.-China geopolitical rivalry, which we believe has the potential to hurt investors.

United States-China:  On the sidelines of the Munich Security Conference over the weekend, U.S. Secretary of State Blinken met with Chinese Foreign Policy Chief Wang and warned him that Beijing must “never again” repeat its “unacceptable” deployment of a surveillance balloon through U.S. airspace as it did late last month.  In its statement on the meeting, the Chinese government countered that the U.S. would “bear all the consequences” if Washington escalated the controversy.

• Overall, the Blinken-Wang meeting gave each side a chance to present their views on the balloon incident, and communication is probably a good thing.
• On the other hand, it is clear that the U.S. and China have diametrically opposed views of key world issues, and those differences are likely to keep U.S.-China tensions high and ensure that investors remain at risk as the relationship deteriorates.

U.S. Monetary Policy:  With the minutes from the Fed’s last policy meeting due to be released tomorrow, investors are worried that the U.S.’s recent strong economic data could push policymakers to hike interest rates even further and hold them there for a prolonged period.  We agree that it is a significant risk, and it is also a key reason why we continue to think that a recession will take hold later this year and that stock prices could fall substantially further before turning upward again.  However, it’s important to remember that such a scenario doesn’t depend on economic trends and monetary policymaking alone.  Another thing to keep in mind is the importance of policy coordination, or how monetary policy affects, and is affected by, other areas of economic policy.  Some strategists and investors should consider that the Fed’s rate hikes to tackle inflation may need to be more aggressive if they aren’t matched by anti-inflation measures in fiscal policy (including both tax policy and spending policy), regulatory policy, industrial policy, and perhaps even social policy (such as education and workforce policies).

• The Fed’s current rate-hiking program is clearly aimed at dampening demand to bring it back into balance with supply. That may get easier as supply chains continue to recover from the COVID-19 pandemic, but factors such as high wage growth and pandemic-era savings balances are still pushing up prices.
• Many other policies could also weaken demand and help boost supply. For example, tax hikes and government spending cuts can decrease demand.  Deregulation that reduces the cost of doing business can boost supply, and the same can be said for industrial policies that help expand particular industries so that they more quickly achieve economies of scale.  Education and workforce policies could boost the effective labor supply.
• The successful fight against U.S. inflation at the beginning of the 1980s illustrates how strategists and investors sometimes lose sight of the importance of policy coordination. The Fed and many other observers continue to believe that it was simply tight monetary policy that finally broke inflation’s back at the time.  In reality, we believe that deregulation and globalization were probably just as instrumental in bringing inflation down and re-establishing the dollar’s value.
• Looking out at the coming years, we expect inflation to moderate significantly, but we continue to believe it will settle at average rates that are higher than in the decades before the pandemic, in large part due to the type of policy mix we expect to hold sway. Regardless of the Fed’s monetary policy, supply is likely to be constrained and made more expensive by deglobalization (a form of re-regulation that cuts off efficiency gains from international trade) and near-shoring (a form of industrial policy that builds relatively more expensive, resilient supply networks closer to home).  Meanwhile, our read of political trends suggests there is no great move toward social policies that might significantly expand the labor force.  Populist tax policies might be targeted toward the wealthy, reducing their ability to invest to expand productive capacity, while the growth in Social Security and Medicare spending as the population ages will help keep demand higher than it otherwise would be.  In sum, investors may need to pay more attention to the thrust of the overall economic policy mix and policy coordination in order to understand where future inflation and interest rates are likely to end up.

U.S. Auto Loan Market:  New data indicates the share of subprime auto loans that were at least 30 days late reached 9.3% at the end of 2022, marking their highest delinquency rate since 2010.  The report suggests that even though the labor market remains strong, a significant number of consumers has been put into financial stress by last year’s spike in auto prices and high inflation for essential household goods.

• Many lower-income families will also soon face the end of their pandemic bump in food stamp benefits. Food stamp recipients in 35 states will lose at least $95 per month in benefits beginning in March.
• That’s consistent with our view, as we noted above, that the economy is still likely to fall into recession later this year.

U.S. Commercial Real Estate Loan Market:  On a related note, data provider Trepp reported that the delinquency rate for loans backed by office buildings in commercial mortgage-backed securities last month jumped to 1.83% from 1.58% previously.  Other reports point to higher delinquency rates and outright defaults for office building loans due to persistently high vacancies and rising interest rates.

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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 about the mixed signals coming from central bank policymakers concerning future rate decisions. Next, we explain how the transition away from COVID policies and restrictions will affect the West and China differently. Finally, we discuss how potential talks between the U.S. and China could impact the eventual disentanglement of the two economies.

Rate Hike Uncertainty: Future central bank policy is becoming harder to predict as policymakers and investors disagree on the best path forward.

• Monetary policymakers around the world are becoming more hawkish. Regional Fed Presidents James Bullard and Loretta Mester are entertaining the possibility of future 50 bps hikes. Although neither Fed member has a vote on the Federal Open Market Committee, investors have adjusted their estimate for a new peak in the Fed’s target range of its benchmark rate. Investors now expect rates to hit 5.2% by July, up from 4.9% two weeks ago. The S&P 500 fell 1.4% on Thursday following the comments as investors offloaded risk assets.
• European policymakers are sending conflicting messages about their potential policy path after their March meeting. Chief Economist Philip Lane, a noted dove, urged fellow policymakers to bear in mind that the increase in inflation has yet to be felt throughout the economy. Meanwhile, European Central Bank hawk Joachim Nagel insists that borrowing costs have not yet risen to a level that would injure the economy. The ECB is expected to raise interest rates by 50 bps in March and will then discuss future rate increases on a meeting-by-meeting basis. The rate uncertainty led to a 1% decline in the Stoxx Europe 600 and a 1.1% decline in the German DAX on Thursday.
• There is growing angst concerning when the Bank of Japan will pivot. With inflation above the central bank’s 2% target, the market anticipates that the BOJ will tighten policy this year. Newly nominated central bank governor Kazuo Ueda has publicly stated that he would like to maintain the bank’s ultra-accommodative policy. However, investors are betting that the BOJ will wind down its yield curve control by April or mid-July at the latest. In anticipation of the policy change, the JPY has rallied against the USD to start the year.
  • The bank plans to launch a pilot of its central bank digital currency beginning in April. The transition will give the central bank more flexibility when making policy decisions.

Pandemic Past: Countries are ending the last vestiges of COVID-19 policies as the pandemic enters a new phase.

• China has declared a “decisive victory” over the virus as the country continues to pivot away from its controversial Zero-COVID policies. Beijing claims, without supporting evidence, that the country’s death toll has dropped to the lowest in the world since the government ended many of its COVID restrictions. Officials cautioned that although the situation is improving, the virus is still circulating. Therefore, China still plans to continue its vaccination program. The self-proclaimed victory is another example of how the country is attempting to control the narrative surrounding its controversial policies as its moves to reopen its economy.
• In the U.S., Johns Hopkins University has ended its COVID tracker program. The initiative provided users with a simple and understandable interface for information on the pandemic. It was designed to make the data from the Centers for Disease Control and Prevention accessible and transparent to the masses. It was one of the most widely cited pandemic databases in the country, and thus, its end reflects how far the country has come since the pandemic began.
• Policy differences between the West and China will affect how they each transition toward a post-pandemic normal. An exodus of older workers has contributed to labor shortages in the U.S. and Europe, while the extensive COVID measures have led to a growing distrust of the government. These challenges have impacted fiscal and monetary decisions as government officials look to return their countries to the pre-pandemic normal. A tight labor market in the West has allowed central banks to maintain hawkish monetary policy to bring down inflation caused by the pandemic. China, on the other hand, has ramped up fiscal stimulus to help boost consumer confidence, which is near an all-time low.
  • The differences may mean that in the long run China may have an inflation problem, but until then, its markets should benefit. That said, hawkish policy in the West should make equity markets more resilient after inflation is under control.

 Another Attempt: Chinese and U.S. officials are scheduled to meet again as the two countries look to move past their row over spy balloons.

• Secretary of State Antony Blinken and his Chinese counterpart Wang Li will both attend the Munich Security Conference. Although there has been no formal announcement, there is speculation that the two will meet at the conference. The potential encounter would be the first high-level meeting between the two countries since the discovery of the spy balloon. Before that incident, the officials were scheduled to work on a thaw in relations between the two countries. Tensions between the major powers have simmered over the last two years due to concerns regarding Taiwan, Russia, and technology restrictions. A major breakthrough is not likely to take place, but we do believe that the meeting could lay the groundwork for future talks.
• The mutual antagonism will probably persist. The Pentagon announced that its top China defense minister arrived in Taiwan on Friday. The move will likely upset Beijing, which views military contact with Taipei as undermining the “One China Policy.” Moreover, China plans to respond to U.S. restrictions on semiconductors by limiting the U.S.’s access to its clean energy technology. China’s new technology czar acknowledged that his country might not be able to bypass U.S. controls on key chip technology but could still flex its muscles in other ways. Beijing’s decision to review the CATL-Ford deal to ensure that critical battery technology isn’t transferred is a prime example of the czar’s new strategy.
• The decoupling between the major powers will not be a smooth process. Trade ties between the two sides remain as strong as ever despite their growing mistrust. U.S. exports and imports with China remain near an all-time high, even as the countries attempt to reduce their dependence on one another. In other words, the talk has been cheap about a potential split over the last few years. What isn’t cheap, though, is the political landscape. There is a growing animosity among lawmakers within these countries. We suspect that the spy balloon may have been sent by Chinese officials to prevent a possible thaw in U.S.-China relations. Therefore, we believe the two are still on the path to divorce.

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