by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with positive reports on the global gold market in 2022 and world economic growth in 2023.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs of better-than-expected economic growth in Europe and China, and news that the U.S. will officially end its COVID-19 emergency in May.

Global Gold Market:  The World Gold Council reported that global gold demand increased 18% last year to 4,741 tons, marking the strongest demand for the yellow metal since 2011.  According to the council, the increase was driven by a 55-year high in central bank purchases.  We continue to believe that factors such as loose monetary and fiscal policies, fear of currency debasement, geopolitical tensions, and the U.S.’s willingness to freeze foreign countries’ dollar reserves will all continue to bolster the demand for gold going forward, pushing up gold prices.

Global Economic Growth:  The International Monetary Fund said it now expects the global economy to grow 2.9% in 2023, an upgrade from its October forecast of 2.7%.  Coupled with unexpectedly strong economic data from Europe and China (see below), the report has given a modest boost to global equity markets so far this morning.

• In its report, the IMF ascribed the update to its 2023 forecast to unexpectedly resilient demand, falling inflation, and China’s economic reopening after its Zero-COVID pandemic lockdowns.
• On a more downbeat note, however, the institution slightly downgraded its forecast for 2024 to 3.1%, far below the average growth rate of 3.8% in the two decades prior to the pandemic.

Eurozone:  After stripping out price changes and seasonal factors, fourth-quarter gross domestic product increased 0.1% from the previous quarter, beating expectations for a fall of 0.1% even though Germany and Italy both posted contractions in the period.  The expansion means that the overall Eurozone economy managed to grow in each quarter of 2022, bringing its full-year increase to 3.5%.  It also means the bloc has been able to skirt the recession that was widely expected just a few months ago.  Since the news could embolden the European Central Bank to keep hiking interest rates aggressively, even as the Fed slows its rate hikes, it should be positive for the EUR.

France:  On a less positive note out of Europe today, France is facing its second major wave of strikes in two weeks as education, health, railway, and energy workers go out on strike to protest the Macron government’s proposed pension overhaul.

China:  The country’s official Purchasing Managers Index (PMI) for manufacturing rebounded sharply to 50.1 in December from 47.0 in November, while the PMI for the nonmanufacturing sector jumped to 54.4 from 41.6.  Like most major PMIs, China’s are designed so that readings over 50 indicate expanding activity.  Even though the December manufacturing index was slightly below expectations, the figures suggest that the overall Chinese economy has snapped back to growth after the government abandoned its strict pandemic testing and lockdown policies late last year.  The news is at least a short-term positive for global economic growth and stock prices.

Russia-Ukraine War:  Despite increasing pressures from the beleaguered Ukrainians and a coterie of Pentagon officials, yesterday President Biden appeared to rule out sending the F-16 fighter jets being requested.  On the other hand, yesterday French President Macron signaled that he would be open to sending such support.

• Given that the allies supporting Ukraine have continually expanded the list of weapons they’re willing to provide, it is possible that they will eventually send Kyiv some type of fourth-generation fighters, at least the European-made Tornado or Gripen.
• However, a key question is whether such weapons will be sent, in sufficient quantities, in time for the Ukrainians to counter an expected new Russian offensive in the spring.

Russia-Iran:  Russia and Iran have reportedly launched a system to provide standardized, secure banking messages between Russian and Iranian financial institutions.  The system is designed to help Russia and Iran get around Western sanctions barring them from the global SWIFT communications system.

• The effort to establish a rival system illustrates how countries in the evolving China-led geopolitical bloc are working to develop their own, independent financial relationships.
• Over time, we expect Beijing to focus on developing and controlling a bloc-wide financial system marked by its own bank messaging system, its own idiosyncratic financial rules, and probably some type of digital, commodity-backed CNY as the bloc’s reserve currency.

India:  Energy and infrastructure conglomerate Adani Enterprises (ADANIENT.NS, INR, 2,892.85) continues to face a massive sell-off and a falling stock price on the Indian market after a recent short-seller’s report accused the company of cooking its books.  Although Adani shares are not available to investors in the U.S., it’s important to remember that international investors have been known to sell a country’s wider stock market on the news that one of its bigger companies is facing issues.

Brazil:  Former President Bolsonaro has applied for a six-month tourist visa to remain in the U.S. while the new government in Brasilia investigates him for corruption and any role he might have played in this month’s rioting in the country’s capital.

U.S. COVID Policy:  President Biden reportedly plans to call for an end to the national emergency and public-health emergency declarations for COVID-19 on May 11.  Ending the emergency declarations would allow for the termination of certain pandemic measures, such as the suspension of eligibility renewal requirements for people on Medicaid.  That could mean that millions of beneficiaries lose coverage just as the economy is falling into recession.

U.S. Monetary Policy:  Fed officials begin their latest two-day monetary policy meeting today, with their decision due to be released tomorrow at 2:00 PM ET.  The officials are widely expected to slow their rate hikes at the meeting to just 25 basis points, bringing the benchmark fed funds rate to a range of 4.50% to 4.75%.  However, they are also expected to signal that they won’t be finished tightening policy until they make more progress in bringing down inflation.

• We continue to believe that the continued rate hikes will help push the U.S. economy into recession in the very near future. That suggests U.S. stock prices could well turn downward again, despite their rally in recent weeks.
• Meanwhile, the European Central Bank and the Bank of England will also hold policy meetings this week, but they are expected to keep hiking their benchmark interest rates by an aggressive 50 basis points. The narrowing differential between the U.S. and European benchmark rates will probably put continued downward pressure on the dollar.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with confirmation that the U.S. has secured the cooperation of Japan and the Netherlands in clamping down on key semiconductor technology transfers to China.  The move is designed to suppress China’s military technology development, but it will also feed the continued escalation of tensions between the West and China.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new, lower forecasts of future fossil fuel use and a preview of the Federal Reserve’s upcoming policy meeting this week.

United States-Japan-Netherlands-China:  As we flagged in our Comment earlier this month, the Biden administration reached a deal with Japan and the Netherlands on Friday under which they will restrict the exporting of certain advanced semiconductor manufacturing equipment to China.  The Japanese and Dutch restrictions will complement the aggressive new rules unveiled by the U.S. in October, which prohibit sending China certain advanced U.S. computer chips, chipmaking equipment, chip components and inputs, and even personal services related to those items.

• The new U.S. restrictions aim to suppress China’s ability to produce advanced military technology, including not only advanced computer chips but also artificial intelligence, supercomputing, and other technologies for modern warfare.
• With allies like Japan and the Netherlands signing up to enforce the restrictions as well, the new U.S. rules are likely to seriously impede China’s overall information technology development. On top of that, House Foreign Affairs Committee Chairman McFaul revealed last week that the Biden administration is planning to issue an executive order that would dramatically widen its clampdown on U.S. capital flows into China’s technology industry.  That order would prohibit U.S. investments in whole sectors, such as artificial intelligence, quantum computing, and cybersecurity.
  • In theory, China could still catch up to Western technology standards in the future, but the U.S.-led restrictions are likely to seriously slow the process and crimp U.S. investment opportunities in the country.
  • Of course, the U.S. clampdown on technology and capital flows will also anger Beijing and will almost certainly prompt retaliatory measures and increase friction between the two countries.

United States-China:  As U.S.-China tensions continue to escalate, U.S. Air Force General Mike Minihan, chief of the Air Mobility Command, reportedly ordered his officers last Friday to achieve “maximum combat readiness” this year, in preparation for a U.S.-China conflict that he believes will happen by 2025.  Minihan’s timeline for war is even earlier than the 2027 date predicted two years ago by Adm. Phil Davidson, then chief of the U.S. Indo-Pacific Command.

• A U.S.-China conflict is still not necessarily inevitable. Nevertheless, it appears that U.S. national security officials are becoming increasingly concerned about tensions boiling over in the near term.
• We continue to believe that increasing tensions with China and Russia’s aggression in Ukraine will spur more military spending and defense investment throughout the U.S.-led geopolitical bloc in the coming years. However, those increases are coming slowly, largely reflecting bureaucratic delays, resistance by both business elites and populists alike, and the lack of a modern-day Winston Churchill raising the alarm about China’s growing power and military aggressiveness.
  • The West’s defense industry should probably be moving closer to a war footing right now, which should include dramatically boosting its capacity and production. Although we have emphasized that global economic fracturing and shortened supply chains will prompt “re-industrialization” in the West, increased defense manufacturing could also be an important part of the story.  However, the West’s defense industry currently remains on a peacetime footing.
  • If U.S.-China tensions suddenly worsen, it could require a rapid expansion in the West’s defense industry. That kind of expansion could be chaotic, but it could also lead to great wealth creation for those in a position to benefit from defense contracts.

Russia-Ukraine War:  Russian forces, bolstered by recent conscripts, have reportedly changed their tactics and are now making progress in their efforts to surround the embattled city of Bakhmut in eastern Ukraine.  The new Russian progress comes as Western officials begin to worry that the Russians will have the advantage the longer the war of attrition lasts, due to their superior numbers of troops and equipment.  That calculus could well spur the West to speed its deliveries of advanced equipment to the Ukrainians, perhaps even to include jet fighters.

Israel-Iran:  Over the weekend, the Israeli military launched a drone strike on a military facility deep in Iran, in the city of Isfahan.  The strike, the first under Prime Minister Netanyahu’s new far-right government, came just days after the U.S. and Israel held their biggest-ever joint military exercise.  It also comes amid an escalating cycle of violence between Palestinians and Israeli security forces in Jerusalem and in the West Bank.

• Israel has been reluctant to directly help Ukraine defend itself against Russia’s invasion, given the Israel needs Russia’s acquiescence to attack its foes in Syria.
• However, the attack on an Iranian military supply depot may have been meant as much to degrade Iran’s ability to support Russia in its invasion as to damage Iran’s own defense capabilities.

European Union:  Figures today showed that Germany’s gross domestic product unexpectedly declined 0.2% in the fourth quarter of 2022, largely reflecting reduced household consumption because of high energy prices.  The contraction in the EU’s largest economy means the bloc’s overall GDP could also show a small contraction in the fourth quarter when the report is released tomorrow.  If that’s the case, the EU’s GDP would have fallen for two straight quarters and would, therefore, have met the standard definition of a recession, although the downturn would still have been much less severe than was widely feared last year.

United Kingdom:  Yesterday, Prime Minister Sunak sacked Cabinet Office Secretary and Conservative Party Chairman Nadhim Zahawi over a simmering scandal revolving around his late tax payments.  That means Sunak has now lost two Cabinet ministers in the last three months, even as a third is under investigation and is likely to resign soon.  The scandals have greatly wounded Sunak politically, even as he struggles to deal with Britain’s high inflation, economic slowdown, massive strikes, and worsening public finances.

Global Energy Market:  In its annual energy outlook publication, BP, plc (BP, $36.32) has reduced its forecasts of global fossil fuel demand to reflect how countries around the world are accelerating their transition to renewable energy in response to Russia’s invasion of Ukraine.

• In its forecast for 2035, for example, BP now expects global oil demand to fall to just 93 million barrels per day, about 5% lower than what was forecast last year.
• Despite the expected decline in demand, we continue to believe that oil, gas, and many other key commodities will be richly priced in the coming years, largely reflecting factors like the U.S.-China geopolitical tensions, potential supply shortfalls, and a weaker dollar.

U.S. Banking Industry:  Regional banks and lenders with big credit-card businesses say they are tightening credit standards ahead of an expected recession.  Some lenders also say they are boosting their financial reserves to prepare for a continued increase in delinquencies.  Although consumer delinquencies remain historically low, they have begun rising in recent months.

U.S. Fiscal Policy:  President Biden and House Speaker McCarthy are due to meet on Wednesday to discuss a range of issues and, most importantly, begin negotiating on a deal to raise the federal debt ceiling.  Plans for the meeting may ease concerns about a bitter political fight that could lead to a U.S. default, but a lack of results could rekindle concerns and undermine the financial markets later in the week.

U.S. Monetary Policy:  Fed officials will begin their latest two-day monetary policy meeting tomorrow, with the decision due to be announced on Wednesday at 2:00 PM ET.  The officials are widely expected to slow their rate hikes at the meeting to just 25 basis points, bringing the benchmark fed funds rate to a range of 4.50% to 4.75%, but they are also expected to signal that they won’t be finished tightening policy until they make more progress in bringing down inflation.

• We continue to believe that the persistent rate hikes will help push the U.S. economy into recession in the very near future. That means U.S. stock prices may well turn downward again, despite their rally in recent weeks.
• Meanwhile, the European Central Bank and the Bank of England will also hold policy meetings this week, but they are expected to keep hiking their benchmark interest rates by an aggressive 50 basis points. The narrowing differential between the U.S. and European benchmark rates will probably put continued downward pressure on the dollar.

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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 latest Gross Domestic Product data and what it may say about the economy. Next, we explain why the global bond rally has not eased concerns over government debt management. The report ends with our views on the latest earnings figures from various companies.

A Second Look: The market responded positively to the preliminary GDP data; however, a deeper dive shows signs of potential trouble.

• The economy expanded at a faster-than-expected pace in the fourth quarter. According to the Bureau of Economic Analysis, GDP rose at an annual pace of 2.9% in the final three months of 2022. The reading was well above expectations of 2.6%. The strong report boosted investor confidence that the country may avoid a downturn. As a result, investors showed an increased appetite for risk, leading to a 1.1% high in the S&P 500 and a 2.0% peak in the NASDAQ. That said, the excitement may be temporary as the overall GDP number overshadowed problems within the underlying data.
• Much of the GDP growth in the fourth quarter came from volatile elements of the report. Inventories accounted for nearly half of the rise in economic output, while a sharp decline in imports also boosted economic activity. Excluding trade, government spending, and inventory data, the economy only grew at a paltry 0.25% in the final quarter of 2022. The figure, referred to as final sales to private domestic consumers, shows that the country may be experiencing a slowdown. Thus, the market may have interpreted the headline figure as evidence that the Fed may achieve a soft landing, but a deep dive into the report shows that the economy is holding on by a mere thread.
• This may be a make-or-break moment for the Fed. It had signaled for several weeks that it was committed to raising its benchmark interest rate to 5.0% and above to help bring down inflation. However, this talk was under the belief that a tight labor market reflected a strong U.S. economy. Although policymakers have consistently pointed to the tight labor market as evidence that it has room to tighten, the GDP figures show that the economy may be on the verge of recession. Therefore, Powell may be forced to explain whether the Fed will raise rates into a downturn like officials have suggested or listen to markets and implement a pause.
  • Further proof of the wonkiness in the data is that construction activity, as by housing starts, shows that homebuilders continue to hire workers at a steady pace despite taking on fewer projects.

Debt Problems: Governments have struggled to manage their debts even as the demand for global bonds have surged.

• The debt-ceiling fight could push the Fed to end its quantitative tightening earlier than expected. The U.S. Treasury is expected to limit the number of treasury bill issuances in the second quarter since the government reached its statutory debt limit earlier this month. The lack of bond offerings will likely cause problems within the financial system as financial institutions, such as money market funds and pension plans, must hold ultra-safe assets on their balance sheets. A lack of available debt could lead to bidding up for collateral within the repo market. The lack of quality capital may force these funds to withhold assets in the short-term lending facility; thus, causing the Fed to prematurely end the shrinking of its bond portfolio in order to prevent a potential crisis .
• Although European debt sales surged in January, the European Union is having trouble finding takers for its bonds as it considers expanding the bloc’s lending capacity. Interest rates on joint EU bonds are higher than those of many of its members, such as France and Germany. The lack of demand has less to do with the creditworthiness of the region and more to do with its lack of liquidity. Investors view resistance to the bond’s creation as a sign that these bonds can’t be relied upon as safe-haven assets in the future. Therefore, the EU may be limited in its ability to raise the funds needed to compete with the subsidies offered in the U.S. Inflation Reduction Act.

• The Bank of Japan is facing increased pressures to abandon its yield-curve control program to help improve financial conditions within Japan. On Thursday, the International Monetary Fund advised the BOJ to be more flexible in setting long-term yields and communicate clearly if it aims to tighten policy to control rising inflation. The successor to BOJ Governor Kuroda Haruhiko is expected to phase out yield-curve control after he takes over in April. Speculation over when the central bank will abandon its policy has forced the BOJ to take action to keep interest rates in check.
  • This shift is expected to raise the country’s heavy debt burden, which is the highest amongst advanced economies. A 100 bps increase in the 10-year yield could raise the Japanese government debt-to-GDP ratio by 3% by 2025, according to the Fitch Ratings Agency.

Earnings Slowdown: The GDP shows that consumption helped save the economy from contracting in December, but more firms are expressing doubts about whether this will last.

• Major firms are forecasting a steep slowdown in sales for the coming year. Microsoft (MSFT, $248.00 ) and Intel (INTC, $30.09) both reported weak PC sales in their latest earnings reports. Meanwhile, Tesla (TSLA, $160.70) slashed the prices of its vehicles to maintain its market share. The deteriorating earnings outlook suggests that the firms may start to feel margin pressure as the economy begins to slow, and thus, it is possible that the market may not have reached its bottom yet.
• As input prices continue to rise, firms will likely have little room to maneuver to ensure profitability. Higher costs mean that firms depend on consumers to spend more to remain in the black. This feat may be harder to achieve, given the possibility of a looming recession. The negative earnings news on Thursday reversed some of the equity gains from the GDP report and is contributing to weakness in premarket trading. The S&P 500 rose above 1% yesterday but closed only 0.5% up from the previous trading day.
• The Chinese reopening and strong labor market data have boosted investor confidence that sales will be strong, even during a U.S. recession. However, that sentiment may be more sector dependent. For example, firms that offer more expensive and discretionary products could see a mild tapering of sales as consumption begins to cool. Though, this trend may not be consistent for all industries. Walmart’s (WMT, $142.21) decision to increase pay to all employees and Chipotle’s (CMG, $1,606.29) move to hire an additional 15,000 workers is evidence that not all firms are feeling a profit crunch.

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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 whether central banks will continue to raise rates. Next, we explain why investors have varying opinions about the state of the global economy. We end the report with our thoughts about rising friction within the U.S.-led geopolitical bloc.

 Are They Done? Moderating inflation data and fears of a recession have led to calls for central banks to stop tightening; however, policymakers have pushed back.

• Most of the G-7 central banks have resisted pressure from markets to change tack and stop hiking. After a report stated that policymakers were considering slowing hikes after their March meeting, European Central Bank officials decided instead to double down on the need to raise interest rates by 50 bps increments. Governing Council members Gediminas Šimkus and Joachim Nagel argued that the ECB should continue to raise rates in half-point increments throughout the year in order to contain inflation. Meanwhile, Fed policymakers, in the days leading up to the central banks’ one-week silence period, have urged markets to reconsider bets that the Fed could stop hiking as soon as June.
• Global credit conditions are beginning to ease despite the rhetoric from central bank officials. The spread between the 10-year Italian and German bonds, a gauge for financial distress, has narrowed by almost 60 bps from its 2022 peak in October. At the same time, the average 30-year U.S. fixed-mortgage rate has fallen almost 100 bps within a similar period. The relaxation of borrowing costs partially reflects investor expectations that the lending environment may improve in the future.
• The Bank of Canada’s decision to pause rate hikes after Wednesday’s 25 bps increase adds to speculation that central banks could be almost done tightening. It was the first of the G-7 countries to announce at least a temporary reprieve from its hiking cycle. This may force the Federal Reserve and the ECB, who are meeting on back-to-back days, to give more details about their policy path going forward. Equities could take a hit if policymakers signal that they are prepared to lift rates during a downturn. However, anything short of that may be favorable toward shorter-duration equities.

The Recession Debate: Warmer-than-expected weather, China’s reopening, and faster-than-expected U.S. GDP growth have made investors optimistic that a recession may be averted; however, there is still room for cautiousness.

• The improved economic outlook has helped boost investor appetite for equities, particularly in Europe. So far this year, MSCI Europe ex-U.K. UCITS  has outpaced MSCI USA UCITS as the indexes have risen 8.23% and 2.54%, respectively, within that period. Positive economic data and a weaker dollar have driven this preference for European stocks. Earlier this week, the preliminary Purchasing Manager Index (PMI) and Euro Area Consumer Confidence report figures showed that economic activity was gaining steam in Europe. Meanwhile,  December pending home sales showed the first monthly purchase rise in 14 months, a rare win for U.S. real estate that has been hampered as of late.
• Despite the glimpses of sunshine, there still remains much gloom. The U.K. has had a rocky start to the year as rising energy costs in December hurt the country’s manufacturing sector and households, and forced the government to take out more debt to fund energy subsidies. The U.S. has also faced some bad news. Retail sales were weak in December, while the industrial sector may already be in contraction. The deteriorating economic conditions within the two countries partially explain why the GBP is expected to underperform the EUR in 2023, and the USD has depreciated against many of its trade partners so far this year.
• In short, many unknowns remain regarding where equities will peak and bottom this year. Those that are pessimistic about growth in the U.S. and abroad have forecasted a possible low in the S&P 500 of around 3300, while optimists foresee the index rising to 4500. The wide range in forecasts shows the vast amount of uncertainty within the market. As a result of these jitters, many investors have piled into global money market funds, which are now having their best four-week run since May 2020.
  • The winner of these three groups (optimist, pessimist, and the jitters) will depend on the scale of the downturn and the Fed’s response. If the recession is mild and the Fed moderates its policy, participants on the sidelines could miss out on a decent opportunity as many stocks have discounted the possibility of a recession.

 Bloc Battle: Rivalries are brewing between and within blocs as governments prepare for a less globalized world.

• The United States, European Union, and the United Kingdom plan to offer subsidies to support semiconductor production. The push to develop semiconductors locally is related to concerns that the bloc may be cut off from vital chips if China invades Taiwan. The increase in state investment should be a boon for chip developers looking to set up shop in the West. However, the cost of relocation and the increase in labor costs may lead to more expensive chips.
• Despite their coordination over semiconductors, there seems to be tensions brewing between the U.S. and EU over clean energy subsidies. European companies are being pressured to move operations to the U.S. to take advantage of the tax incentives granted in the Inflation Reduction Act. Although there seems to be reluctance among some members of the EU to take up similar initiatives, it does appear that the European Commission is preparing for a response. The EU is considering loosening stimulus rules to help facilitate more lending to member countries. The action could help support European firms but will likely face resistance from fiscally prudent countries.
• That said, the group maintained a united military and trade front in its stance against the China-Russia bloc. On Tuesday, Germany and the U.S. agreed to send tanks to help Ukraine fight the Russians. Dutch officials are traveling to Washington to discuss export controls on China after ASML (ASML, $681.53) urged lawmakers for “sensible” restrictions. Additionally, Politico reported that the EU is preparing to take on China in the Middle East and Africa by offering an alternative to the Belt and Road Initiative. Even with their differences, Brussels and Washington will likely have similar trade and foreign policies going forward. As a result, the two sides may be more prone to work out their issues.
  • On Wednesday, it was revealed that Washington could include European firms in the subsidies offered in the Inflation Reduction Act in exchange for access to the region’s critical minerals and raw materials. Earlier this month, the largest European deposit of rare earth elements was discovered in Sweden.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an apparent agreement between the U.S. and Germany that will unlock the transfer of advanced tanks to Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including some thoughts on how the Biden administration may be hoping to leverage its green energy subsidies from last year’s Inflation Reduction Act.

Russia-Ukraine War:  As we previewed in our Comment yesterday, the U.S. and Germany are set to announce a deal in which the U.S. would reverse its earlier position and donate about 30 of its best-in-class Abrams tanks to Ukraine, while Germany would send a smaller number of its own advanced Leopard 2 tanks and authorize other European countries to send many more.  To get the deal done, President Biden reportedly overruled Pentagon concerns that the Abrams would be too costly and difficult for the Ukrainians to use effectively.

• The Ukrainians reportedly hope to build an entirely new tank division around the donated Abrams and Leopards. Having those tanks would enhance Ukraine’s firepower and help it defend against a new Russian offensive expected in the coming months.
• The Abrams and Leopards could also help Ukraine recapture more territory from the Russians. However, they wouldn’t necessarily guarantee a Ukrainian victory in the war.

Russia-U.S. Arms Control:  The new Republican leaders of the House armed services, foreign affairs, and intelligence committees have requested that the Biden administration formally confirm whether Russia is complying with the New Start nuclear arms control treaty.  That treaty, which governs the number of strategic nuclear weapons Russia and the U.S. can have, is the only remaining arms-control treaty in force that traces its origins back to the Cold War period.

• The congressional concern was triggered by Russia’s decision last November to suspend New Start inspections and its subsequent refusal to participate in the consultations required under the treaty to support its implementation. President Putin’s veiled threats to use nuclear weapons in the war in Ukraine have also raised concerns about Russia’s intentions.
• If the administration determines that Russia has abrogated the treaty, and if no resolution is reached with Russia, it would free the U.S. to respond to the new geopolitical reality in which it will soon have to deter two major nuclear powers, both Russia and China, given that China is so rapidly building up its force of strategic nuclear weapons. The result could be a global arms race, consistent with our view that the world is embarking on a prolonged period of rising military spending.

United Kingdom:  Not only is the country continuing to deal with strikes across its transport and public sectors, but now workers at an Amazon (AMZN, $96.32) facility in Coventry said they will walk off the job in a dispute over pay.  Leaders of the Amazon union said they plan to widen the strike to other Amazon facilities as well.

Italy:  Gasoline station owners across the country are turning off their pumps for two days to protest government pressure on them to hold down prices following the expiration of a subsidy program at the end of last year.  When the subsidies ended, gas prices jumped, prompting the government to require stations to post average prices along with their own at the pumps.

• The pump owners’ strike may cause some disruption to the Italian economy and create political headaches for Prime Minister Meloni.
• On the other hand, some outside observers have praised her for the fiscal discipline she has shown with ending the subsidies after the retreat in energy prices late last year.

U.S.-EU Energy Policy:  Sen. Joe Manchin (D-WV) said he will introduce a bill requiring the Treasury Department to delay issuing its rules governing the $7,500 tax credit for purchasers of an electric vehicle under last year’s Inflation Reduction Act.  Separately, even as top EU leaders float the idea of establishing their own big subsidies to spur investment in European green energy, Dutch Prime Minister Rutte said he would oppose issuing new, common EU debt to fund the effort.  Financing limits could keep the EU subsidies too small to compete with the $369 billion or so of U.S. subsidies available under the law.

• Responding to European protests against the law’s requirement that eligible vehicles must get at least 40% of their value from countries that have a free-trade deal with the U.S., the Treasury Department tweaked its rules to make it easier for some foreign automakers to qualify for subsidies in December.
• Manchin is now arguing that the Treasury’s action undermines the aim of the law, which he said was squarely to promote domestic manufacturing and energy security. Manchin’s bill is currently given little likelihood of passage, but it does reflect how nationalist populism is strengthening in both major U.S. political parties.
• Nevertheless, a final interesting wrinkle is that Treasury Secretary Yellen has revealed that the administration may be planning to use the law’s subsidies as leverage to entice U.S. allies into limited free-trade agreements focused on critical technologies and minerals, such as semiconductors and lithium. U.S. Trade Representative Tai has also suggested that the U.S. wants the EU to adopt aggressive industrial policies to strengthen its economy and reduce its dependence on China.  It appears that the administration’s goal is to create a common, integrated industrial policy for key technologies and natural resources across the entire U.S.-led bloc.  The goal may be to keep the free trade and capital flows associated with the policy limited enough to avoid antagonizing the nationalist populists, but still sufficiently meaningful to strengthen the U.S.-led bloc for its geopolitical competition with China and its bloc.

U.S. Antitrust Regulation:  The Justice Department and eight states yesterday sued Google, a subsidiary of Alphabet (GOOG, $99.21), for abusing what they call monopoly power over the internet ad industry.  The suit alleges that Google’s behavior hurts web publishers and advertisers and seeks to force Google to unwind “uncompetitive” acquisitions such as its 2008 purchase of DoubleClick.  The lawsuit illustrates the Biden administration’s more aggressive antitrust enforcement and the increased regulatory risks faced by the technology sector.

U.S. Labor Market:  Walmart (WMT, $143.02) stated that it will hike its minimum wage to $14 per hour, from $12 per hour currently, beginning in February.  The company said that should boost its average hourly wage to about $17.50 from the current $17.00, helping it compete for workers with rivals that pay even more.  The move points to a continued tight labor market, despite some recent signs of cooling demand for workers.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with some positive economic news out of Europe where the January flash composite PMI unexpectedly swung above the level of 50, indicating a return to growth.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a report that Japan and the Netherlands will join in the U.S. clampdown on sending advanced semiconductor technology to China, and new indications of a broader softening in the U.S. labor market.

Eurozone:  S&P Global said its flash composite Purchasing Managers Index for the Eurozone rose to a seasonally adjusted 50.2, beating the expected reading of 49.8 and the final December reading of 49.3.  The index has now risen for three consecutive months after it reached its most recent low in October.

• As with most major PMIs, this one is designed so that readings over 50 signify expanding activity. At its current level, the figure suggests that the Eurozone economy is already expanding again despite the war in Ukraine, energy shortages, and sky-high inflation.
• In turn, that has bolstered recent hopes that the European economy may have dodged the recession that was widely expected just a few months ago.

Russia-Ukraine War:  As we flagged in our Comment yesterday, the Polish government has formally requested permission from Berlin to send its German-made Leopard 2 tanks to Ukraine.  The move raises the pressure on Germany to finally relent and give its required permission.  However, it’s too early to know if Chancellor Scholz will acquiesce, especially since the Russian government has now warned him that granting such permission would sour future German-Russian relations.

• As a reminder, Poland earlier this week vowed to send the tanks to help Ukraine even if Germany doesn’t approve. Once Poland sends its Leopards, it would probably clear the way for a range of other European countries to send their own Leopards to Ukraine.
• Scholz is concerned that if Ukraine ends up with a nearly entirely German-made tank force, his country will look like the major power backing Ukraine. He and some other officials in Germany are wary about drawing Russia’s ire because of Germany’s past economic links to Russia and Germany’s lack of any nuclear deterrence to defend itself.
  • That’s why Scholz has said that Germany wouldn’t allow shipping the Leopards to Ukraine unless other countries send their advanced tanks, especially the U.S. Abrams tank.
  • However, the turbine-powered Abrams may not be appropriate for the Ukrainians, given the long time needed to train on it, its immense fuel usage, and its need for extensive maintenance capabilities.
• Having dozens of Leopards would enhance Ukraine’s firepower and help it defend against a new Russian offensive expected in the coming months. The Leopards could also help Ukraine recapture more territory from the Russians.  However, they wouldn’t necessarily guarantee a Ukrainian victory in the war.

NATO Expansion:  In a new setback for Sweden and Finland as they work to join NATO, a far-right politician burned a copy of the Quran and denounced Muslims outside the Turkish Embassy in Stockholm over the weekend.  The incident prompted Turkish President Erdoğan to again threaten to veto the Swedish and Finnish applications to join the military alliance.  There is some speculation that Erdoğan is simply playing the strong nationalist card ahead of Turkey’s May elections.  Even if that’s true, however, it would suggest Sweden and Finland can’t move forward in their applications to join NATO for at least several more months.

France:  In its new six-year defense plan, the French government plans to spend some €400 billion (approximately $433.4 billion) to transform its military into a more responsive force that can quickly respond to contingencies around the globe, particularly around French territories in the Indo-Pacific region.

• The spending would represent a 35% increase over the previous six-year plan. The new spending will include a new aircraft carrier, big new investments in drones and undersea warfare equipment, and a massive increase in France’s intelligence and surveillance capabilities.
• The spending increase is consistent with our view that threats from revisionist, authoritarian powers like China and Russia have touched off what will likely be a multi-year boom in global defense spending, much of which will benefit U.S. defense firms.

Brazil:  President Lula da Silva has replaced the country’s top army commander, Gen. Julio Cesar de Arruda, because of what Defense Minister Mucio called a “fracturing of trust” after the riots at Brazil’s capital on January 8 which aimed to prevent Lula from taking power despite his win in the October elections.  Since those riots, Lula has accused many officials in the Brazilian military and security forces of conspiring to let the violence proceed unimpeded.

Japan:  Yesterday, the Bank of Japan held its first bond auction under an expanded bank lending program designed to ease pressure on its yield-curve control policy.  The successful auction and the broader program are expected to boost bank liquidity and improve the demand for Japanese government bonds, helping keep 10-Year JGB yields at the BOJ ceiling of 0.50%.  However, it is not yet certain how long the BOJ will be able to maintain its yield-curve control in the future.

United States-Japan-Netherlands-China:  The Japanese and Dutch governments are reportedly ready to join the U.S. in imposing stringent new restrictions on sending advanced semiconductor technologies to China.  The Japanese and Dutch restrictions could be announced by the end of January.

• The U.S. restrictions, announced last October, aim to suppress China’s ability to develop advanced weapons that could threaten the U.S. and its allies.
  • The rules essentially cut China off from acquiring advanced semiconductors, semiconductor manufacturing equipment, semiconductor manufacturing components and other inputs, and even semiconductor support services that are based on U.S. technology.
  • The pending Japanese and Dutch restrictions appear to be focused more narrowly on exports of advanced semiconductor manufacturing equipment and inputs.
• In any case, having the U.S., Japan, and the Netherlands all restricting advanced semiconductor technology will likely knee-cap China’s effort to build its own advanced computer chip capabilities and impede its development of some military technologies.
  • As the world continues to fracture into at least a U.S.-led geopolitical bloc and a rival China-led bloc, it’s important to remember that there will still probably be a lot of trade and travel between the two camps.
  • However, the competing governments will likely be quite aggressive in limiting the transfer of critical, high-value goods and technologies, as we’ve already seen over the last few years. Importantly, that will likely crimp China’s technological development going forward.

U.S. Labor Market:  On top of the layoffs in the information technology and real estate industries that we’ve been flagging, new reports today hint that labor demand may be starting to wane more broadly.  First, industrial conglomerate 3M (MMM, $122.62) said that it is cutting some 2,500 manufacturing positions globally due to a softening in demand for its products that took hold late last year.  Separately, economists have begun to note a consistent fall in temporary employment over the same period.  Falling temp jobs often signal a broader decline in the labor market.

U.S. Energy Industry:  After years of paltry investment in new oil and gas drilling, offshore drilling in the Gulf of Mexico and elsewhere around the world is quietly growing again.  According to data provider Westwood Global Energy Group, about 90% of the 600 leasable offshore drilling rigs available worldwide were working or under contract to do so in December, versus just 63% five years ago.  The increase in drilling suggests today’s high energy prices and growing energy demand have begun to produce a supply response, despite the prior hurdles like investor demand for capital discipline and social and regulatory preferences for green energy.

U.S. Cryptocurrency Industry:  New reporting indicates that tougher scrutiny by the Securities and Exchange Commission has hindered a number of cryptocurrency companies from going public over the last year.  As we had warned would happen, the regulatory crackdown appears to stem from the wave of bankruptcies and financial problems in the industry.

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