by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with multiple reports out of Asia.  Even though China is largely shut down this week because of the Lunar New Year holiday, several news items today reflect how its growing military strength and aggressiveness are having an impact on other countries in the region.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including growing signs that the U.S. labor market is softening as the economy heads into a likely recession.

China:  Although news flow from China will be limited this week because of the Lunar New Year holiday, we are seeing reports that the massive new wave of COVID-19 infections sweeping across the country is now slamming rural areas.  The infections have reportedly peaked in China’s major cities, but the rural healthcare system is now under extreme strain.

Japan:  The country’s parliament, the National Diet, opens its 150^th regular session today, with contentious debate expected over increased defense spending, policies aimed at children, and extending the life of nuclear reactors.  Especially heated will be Prime Minister Kishida’s call for increased taxes to pay for a massive hike in defense spending, which has split his party and thrown his leadership into question.

Australia:  Last week, the Australian government announced that it will replace its European-made Taipan military helicopters, a decade earlier than planned, with U.S.-made Black Hawk choppers from Lockheed Martin (LMT, $443.28).  The 40 Taipans, made by EU aerospace champ Airbus (EADSY, $32.29), have had quality and maintenance issues for years.

• The decision to replace them with Black Hawks illustrates how the developing boom in global defense budgets is likely to disproportionately benefit U.S. defense firms, given their technological leadership, proven quality, and production capacity availability.
• For those reasons, we continue to overweight U.S. defense firms in our updated asset allocations strategies this quarter.

New Zealand:  The ruling Labor Party has named Chris Hipkins, the former education minister, as the country’s new prime minister after Jacinda Ardern announced her resignation from the position last week.

• So far, Hipkins has not outlined a detailed policy program, but he has indicated that the cabinet reshuffle announced earlier by Ardern would go forward, which includes keeping Finance Minister Grant Robertson in his role.
• That would indicate that there will be policy stability and continuity in New Zealand in the near term, which investors will appreciate. However, the Labor Party is still polling poorly and is at risk of losing power in the October elections.

Sri Lanka:  Yesterday, the government said it had received assurances from Chinese officials on the board of the International Monetary Fund that they would approve the country’s proposed debt restructuring, meaning China has fallen in line with previous assurances from India and Japan.  If approved by the IMF board, the restructuring would unlock some $2.9 billion in loans from the institution to help Sri Lanka through its current debt crisis, which includes a default on its debt last May.

United Kingdom:  The Bank of England today said 16 top life insurers passed a recent stress test examining how they would manage with mass credit downgrades and greater client longevity.  However, the institution warned that the insurers may be overly optimistic about their ability to sell down assets in a financial crisis, especially as other financial companies may be trying to sell assets at the same time.

Russia-Ukraine:  Russian forces are reportedly making new progress in pushing the Ukrainians back from the front lines in the southern part of the country, especially in the region around Zaporizhzhia.  The new push suggests that President Putin’s autumn mobilization of hundreds of thousands of fresh conscripts may be helping renew Russian combat power.  On a related note, the Ukrainian government said that it will mobilize fresh reservists to give its front-line fighters a rest.

• Separately, after seeing his political star rise to the point where he could openly disparage the Ministry of Defense and, by implication, Putin himself, financier Yevgeny Prigozhin has reportedly begun to lose influence in the Kremlin because of his Wagner Group mercenaries’ failure to capture the eastern Ukrainian city of Bakhmut. Making matters worse, Prigozhin’s ally General Sergey Surovikin was unable to turn his strategy of bombarding Ukraine’s civilian infrastructure into tangible military gains and last week was demoted to deputy commander of the war.
  • Prigozhin’s waning star could remove a political threat to Putin and ensure that he will retain power at least in the near term.
  • That could reinvigorate Putin’s effort to rebuild and strengthen Russia’s conventional military forces over time.
• In terms of Western support for Ukraine, German Foreign Minister Baerbock signaled yesterday that Berlin “would not stand in the way” if Poland wanted to transfer its German-made Leopard tanks to Ukraine. To test whether Chancellor Scholz has really acquiesced in the idea, Poland said it will formally request German approval for the transfer, as required by its purchase contract for the heavy tanks.  If Germany approves, it could unlock additional Leopard transfers from countries such as Finland, Sweden, Denmark, and Portugal.

Brazil-Argentina:  At a summit this week, the leaders of Brazil and Argentina plan to approve the launching of preparations for a new common currency designed to facilitate trade between the two countries and reduce their dependence on the U.S. dollar.  The “sur” would take many years to develop, and it would initially be used in conjunction with the current Brazilian real and Argentine peso.  Only then could it replace the real and the peso and potentially be adopted by other regional countries.

• Nevertheless, despite the uncertain and long-term nature of the project, the initiative shows how some countries, especially those with deep economic or political ties to China, are looking for ways to reduce their exposure to the greenback.
• As a reminder, our analysis indicates that both Brazil and Argentina will belong to the evolving “Leaning-China” geopolitical bloc, based largely on their exports to China. If China eventually succeeds in developing a digital, commodity-backed form of its yuan to serve as the reserve currency for its geopolitical bloc, as we think it could, the sur could be a secondary reserve currency for that bloc or even be subsumed into the Chinese reserve currency.

U.S.-China Military Competition:  In a webinar with the Council on Foreign Relations last week, U.S. Air Force Secretary Frank Kendall said that he has shifted his service’s focus heavily toward defending against China simply because China in recent years has shifted its focus toward defeating the U.S.  As examples, Kendall cited how the Chinese military has shrunk its army to free up resources for its air force and navy.  He also cited China’s decision to make its Strategic Rocket Forces a separate service, which has a focus on developing long-range precision missiles that could attack U.S. military bases and aircraft carriers in the Asia Pacific region.

• On a more positive note, Kendall also noted that the new Chinese military is still unproven and may not perform that well in real-world operations. He also noted that the U.S. has developed a number of secret capabilities for which the Chinese probably haven’t prepared.
• All the same, Kendall’s discussion suggests that China is preparing to challenge the U.S. in the Asia Pacific region much more aggressively than most Americans probably realize. It’s encouraging that the various U.S. services are responding comprehensively, but Kendall’s statements underline how the risk of conflict with China is rising.

U.S. Executive Branch:  Following reports that White House Chief of Staff Ron Klain will resign, President Biden is expected to name his former pandemic advisor, Jeff Zients, to the position.  Respected more for his organizational skill than his political instincts, Zients also served as former President Obama’s director of the National Economic Council and as supervisor of an operation to fix bugs on the government’s health insurance website.  He has also twice served as acting director of the Office of Management and Budget.

U.S. Labor Market: Spotify (SPOT, $97.91) said today that it will lay off 6% of its global workforce, becoming the latest information technology company to retrench after over-expanding during the halcyon days of the COVID-19 pandemic.

• Recent layoffs have been concentrated in the technology, real estate, and financial services industries, but there is growing evidence that the layoffs are creating a broader softening in labor demand.
• For example, recent data shows that in December, about 826,000 unemployed workers in the U.S. had been out of a job for about three and a half to six months, up from 526,000 in April 2022.

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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 how investors’ expectations of the Fed’s rate hikes are impacted by a possible recession. Next, we give our thoughts about U.S. foreign and domestic policy. Finally, we review the latest developments from China.

Economy in Focus: Fresh data on Wednesday dented hopes of a soft landing, much to the chagrin of markets.

• A tightening labor market and a slowdown in residential construction have added to concerns that the market has not fully bottomed. The number of first-time claims for unemployment insurance fell unexpectedly to a four-month low in the week ending January 14. The sharp decline in benefits suggests that the Fed’s attempts to cool the labor market by raising rates have not been effective. Meanwhile, building permits rose at a slower pace than housing starts for the second consecutive month in December, signifying a possible decline in future U.S. economic activity.

• The market responded negatively to these reports as investors weighed the possibility that the Fed could raise interest rates while the U.S. heads into a recession. The S&P 500 and the Dow Jones both fell 0.8% on Thursday. Meanwhile, the two- and 10-year Treasury yields remained below the fed funds rate, indicating that the market anticipates that the central bank may be looking to cut rates soon. Although the latest Atlanta GDPNow forecast shows that GDP expanded at an annualized rate of 3.5% in Q4 of 2022, last month’s data suggests that the economy quickly ran out of steam toward the end of the year.
• Despite tough talks by officials, investors do not believe that the Fed will be able to push rates above 5% this year. On Thursday, Fed Governor Lael Brainard and Boston Fed President Susan Collins joined the chorus of policymakers warning markets that the Federal Reserve will continue to hike rates to combat inflation. However, investors are skeptical as to whether these officials will hold true to their word. Futures and options flow activities suggest that traders believe the Fed will be done with its hiking cycle after its March meetings. This optimism may partially explain why equity futures are slightly up this morning. If the Fed shocks markets by raising rates during a recession, U.S. equities will be negatively impacted.

Looking For a Fight? While lawmakers in Congress are debating whether to raise the debt ceiling, Washington is trying to rally its allies to take on Russia and China.

• The U.S. Treasury was forced to take extraordinary measures to prevent the government from breaching its debt limit. The stalemate in Congress over whether to increase the government borrowing cap threatens to push the country into default which could have disastrous consequences on the U.S. financial system. Although Senate Majority Leader Mitch McConnell offered assurances that the debt ceiling would be raised, there does not seem to be a path toward agreement anytime soon between the two sides. Republicans are pushing for spending cuts, while Democrats want to raise the ceiling without any strings attached. If history serves as a guide, talks will likely go down to the wire as the two groups hold out for leverage.
• On the foreign policy front, the U.S. and Germany are in a dispute over delivering military vehicles to Ukraine. The Germans do not want to send any of their own tanks unless the U.S. sends theirs first. The row over who should send tanks exemplifies Germany’s reluctance to help Ukraine in its war efforts and threatens to undermine Western unity. As we have mentioned in previous reports, the war in Ukraine could cause fractures within the European Union and the North Atlantic Treaty Organization (NATO). Although the issue does not pose short-term risks to financial markets, the situation may accelerate efforts to deglobalize.
• Additionally, the U.S. and its allies are working together to hinder China’s ability to develop advanced military technology. Washington would like to hobble its Indo-Pacific rival by restricting access to semiconductors used for weaponry. Major chip-producing countries Japan and the Netherlands are expected to agree to limit the sales of their technology to China by the end of the month. Beijing views semiconductors as crucial to its endeavor to surpass the U.S. economically and militarily. However, previous investment schemes have not yielded satisfactory results. As a result, there is growing speculation that China may seek to invade Taiwan in order to have access to the nation’s chips.
  • Because of this, U.K. Prime Minister Rishi Sunak would like his country to develop its own chip industry so that it is not dependent on Taiwan for semiconductors.

Energy Rises: As China’s COVID wave approaches its peak, there are growing concerns that the return of Chinese demand may lift inflation overseas.

• The Chinese economy may be poised to come roaring back as COVID cases begin to ease. Vice Premier Sun Chunlan says infections have fallen to a “relatively low level.” The announcement indicates that the Chinese government is prepared to further reduce restrictions to help provide a boost to the economy. As the country prepares to celebrate the Lunar New Year, Chinese travelers are expected to receive extra scrutiny in other countries. As a result, tourists may stay home during the holiday which should be supportive of domestic spending.
• China’s reopening is already having an impact on commodity prices. The price for materials such as copper and aluminum have surged 12% and 11%, respectively, to begin the year. Meanwhile, crude oil demand is expected to jump to an all-time high by the second half of the year. The pick-up in commodity prices is related to concerns that the end of COVID restrictions will make it easier for manufacturers to ramp up production and encourage spending from consumers.
• The potential rise in commodity prices will complicate efforts by central banks to combat rising inflation. Energy prices represent a heavy component within consumer price indexes. Thus, a sharp increase in prices could cause a major setback in the central banks’ abilities to contain rising inflation. The inflationary threat posed by China’s reopening may explain why policymakers have been reluctant to end policy tightening. That said, China’s reopening does have some winners. The rise in commodity prices should boost the stock markets of export-producing countries such as Brazil and Canada.

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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 the market’s reaction to Wednesday’s economic data. Next, we discuss why central banks are now pushing for smaller rate hikes. We end the report with our thoughts about the recent developments in tech and crypto.

A Softish Landing: Poor economic data and hawkish Fed comments led to a sell-off in equities.

• Retail sales figures showed that consumer spending declined for the third consecutive month in December. Meanwhile, industrial production data showed that manufacturing activity also waned over that period. The weak figures show that the Fed may not be able to lower rates before the economy enters recession, which would have been known as a “soft landing.” On Wednesday, Cleveland Fed President Loretta Mester and St. Louis Fed President James Bullard stated that the Federal Reserve was not finished raising rates and would need to keep rates tight for some time to bring down inflation. Therefore, the likelihood that the Fed will keep rates higher, even during a downturn, is elevated.
• The weak economic data spooked investors who previously believed that the economy may have averted a recession. As a result, the market responded negatively to the dimmer outlook for the economy. The S&P 500 closed down 1.6% from the prior day. Meanwhile, bond prices jumped, and the 10-year Treasury yield plunged to a 4-month low of 3.368%.  The market reaction was likely a combination of investors looking to lock in early 2023 gains and secure bonds while interest rates remain relatively high.
• In our view, equity investors and bondholders have two opposing views on the Fed. Stock traders believe that Fed Chair Jerome Powell will cave once the economy starts to sputter. Meanwhile, bond traders are convinced that Powell will keep rates elevated even as the country falls into recession. Although it isn’t clear who’s right, the difference will likely dictate how the market performs throughout the year. If equity traders are right, stocks should have strong performance as the market has likely priced in the worst of a recession. However, if bondholders are correct, the slump in equity prices could worsen. At this time, we believe that investors should take a wait-and-see approach before making major adjustments to their portfolios.

The Central Bank Shuffle: Although the Fed insists that it will continue to raise rates, there are growing expectations that it will decrease the size of its hike at its next meeting.

• Dallas Federal President Lorie Logan, a voting member, added to the chorus of calls for a downshift in rate hikes beginning at the Federal Open Market Committee meeting next month. On Wednesday, she argued that a slower pace of hikes could reduce interest rate uncertainty, which should alleviate financial conditions. Although she later added that the Fed should ultimately settle rates at a higher level than originally anticipated, her comments did seem to fall in line with market expectations of a 25 bps hike at the Fed’s February meeting. The CME FedWatch tool shows that there is a 95% chance that the central bank will raise its target range from 4.25%-4.50% to 4.50%-4.75%.
• Talk of a possible moderation in Fed tightening has helped support foreign currencies and has provided other central banks with more flexibility to set rates. After hitting parity in 2022, the GBP and the EUR have rallied strongly against the USD.  Meanwhile, the JPY has skyrocketed following the Bank of Japan’s decision to lift its yield cap on 10-year Japanese government bonds. The three currencies are hovering near seven-month highs, which reduced pressure on these countries’ respective central banks to tighten aggressively in order to defend against a strengthening dollar.
  • Despite being one of the strongest-performing assets last year, the USD, as tracked by the DXY index, is down 1.3% to begin the year, which is worse than the poorest-performing asset class in the S&P 500.
• Other central banks are now following the Fed’s lead in moderating their tightening. Despite guidance from European Central Bank President Christine Lagarde that borrowing costs will be lifted in 50 bps increments over its next two meetings, there is talk that the ECB could slow hikes as soon as March. Meanwhile, the Bank of Japan’s decision to defy market expectations and not alter its policy on Wednesday has also added to speculation as to whether it plans to tighten policy anytime soon. The dovish shift from central banks should be beneficial to equities as it will prevent a further slowing of the global economy. However, we would like to caution that the mood may change if inflation returns due to China’s reopening.

Tech and Crypto Risk: As investors increase their appetite for risk, tech companies and crypto platforms struggle to find a path forward.

• The tech sector is headed for a reset as companies adapt to a higher interest rate environment. Microsoft (MSFT, $235.81) and Amazon (AMZN, $95.46) announced a combined 28,000 job cuts on Wednesday. The huge cutback in their workforce is related to the industry looking to reposition itself after years of robust growth. After suffering its worst yearly performance since the Great Financial Crisis, NASDAQ is now up 5.5% on the year, nearly twice that of the S&P 500. The rebalance in tech could position the sector for stronger growth when economic growth starts to pick back up.
• Meanwhile, the fallout from crypto continues to spread. On Wednesday, digital currency platform Coinbase (COIN, $50.21) announced that it was halting operations in Japan. Additionally, reports claim that crypto lender Genesis is preparing to file for bankruptcy. The negative developments in crypto reflect the growing uncertainty surrounding digital assets and suggest that the currency still has many risks. Bitcoin dropped below $21,000 following the development but still remains up 25% on the year.
• The end of zero-interest rates monetary policy has forced tech companies and crypto to restructure their businesses. This should make firms leaner and more profitable as well as create a more viable digital currency market in the long run. However, the recent turmoil suggests that there is still some market skittishness toward riskier financial assets. Investors should remember that despite speculation of a soft landing, there is still time for things to turn awry. As a result, investors should remain cautious and complete their due diligence before investing in riskier elements of the market.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an upward revision in the International Energy Agency’s forecast for global oil demand this year, which is giving a boost to oil prices so far this morning.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an unexpected decision by the Bank of Japan that has given a boost to Japanese stocks but has driven down the JPY.

Global Oil Market:  In its monthly forecast, the IEA stated that the end of China’s strict pandemic shutdowns should lead to a further rise in oil demand this year, even though the COVID-19 infections sweeping through China right now are causing widespread economic disruptions at the moment.  With U.S. and European oil usage also looking firmer this year, the agency therefore predicted total global oil demand in 2023 will rise to a record-high average of 101.7 million barrels per day, up 1.9 mbpd from 2022.

• The news is helping to give global oil prices a further boost so far this morning.
• Brent crude oil futures are currently up approximately 1.6% to $87.30 per barrel.

China:  In another sign that China is easing up on its economic restrictions and trying to ease tensions with the West, the country’s censors have reportedly cleared two Marvel superhero movies from The Walt Disney Company (DIS, $99.91).  That marks the first Chinese clearances for Marvel movies since 2019, and the films will be allowed to be shown in China next month.

Japan:  The BOJ today kept its monetary policy unchanged, with a yield target of -0.1% for short-term obligations and a cap of 0.5% for 10-year notes.  The decision to hold steady came after a surprise tightening last month.  That disappointed many investors who had bet on a further hike in the 10-year yield and a potential end to the BOJ’s long experiment with yield- curve control.  In response, Japanese bond yields have declined sharply so far today, pushing down the JPY and boosting Japanese equity markets.

European Union:  In her address at Davos yesterday, European Commission President von der Leyen said that the EU will respond to the recent U.S. subsidies for green technologies by easing its restrictions on state aid to industry and pumping cash into strategic climate-friendly businesses.  However, her proposed program would still need a unanimous buy-in across all EU countries, and some national leaders believe a better way to keep investment in the EU is to boost the bloc’s productivity, increase research spending, and bring down energy prices.

• EU leaders believe the $369 billion in green subsidies under the Inflation Reduction Act will likely draw massive amounts of investment out of Europe and toward the U.S., and they worry that EU countries don’t have the fiscal space to compete with the U.S.
• However, the Biden administration continues to argue that the EU should adopt similar “complementary” subsidies that would strengthen the EU as a member of the evolving U.S. geopolitical bloc and reduce the EU’s dependence on China and the countries in its bloc.

United Kingdom:  The December Consumer Price Index (CPI) was up 10.5% year-over-year, marking a modest cooling in inflation after the index rose 10.7% for the year to November.  However, excluding the volatile food and energy components, the December Core CPI was still up 6.3%, unchanged from the inflation rate in November.

• Overall British inflation has now slowed for two straight months, but only modestly, and the wave of strikes now sweeping across the country threaten to buoy wage costs and inflation for months to come.
• The Bank of England is, therefore, still expected to keep hiking interest rates at its next policy meeting in February.

Russia:  Defense Minister Shoigu outlined a long-term expansion of the country’s military in which total personnel would rise to 1.50 million in 2026 from the current 1.15 million.  The plan would also include the creation of new military districts centered on Moscow and St. Petersburg and the establishment of an army corps in the exclave of Karelia.

• The expansion of the country’s military will coincide with a likely pullback in economic activity because of factors such as Western sanctions and mass emigration.
• As a result, Russia is likely edging closer to the day when its defense spending exceeds 10% of gross domestic product – a “defense burden” that has historically created headwinds for economic growth.

Turkey:  President Erdoğan announced that the country’s next presidential and parliamentary elections would be pulled forward by one month to May 14.  Erdoğan’s support in public opinion polls is currently at rock bottom because of soaring inflation, high unemployment, and a currency crisis.  However, he appears to be gambling that a recent spate of public spending programs and his aggressive foreign policy will help him eke out a win and stay in power.

U.S. Labor Market:  As early as today, Microsoft (MSFT, $240.35) is expected to announce another round of layoffs, making it one more in a string of high-profile information technology firms that are shedding workers.  Besides technology, it also appears that rising interest rates and the implosion of the housing market have prompted significant layoffs in the real estate and financial services industries.

• Nevertheless, with the economy facing an overall shortage of workers, many of those being laid off appear to be finding other jobs quickly. That’s evident in the weekly data on initial jobless claims, which haven’t increased appreciably despite the technology and real estate layoffs.
• Indeed, one benefit to the layoffs is that the released workers become available to other industries that are growing but have had trouble finding workers, such as defense.

U.S. Bank Regulation:  Acting Comptroller of the Currency Michael Hsu warned that a bank is probably too big to manage effectively and should be broken up if it repeatedly fails to resolve longstanding deficiencies despite reprimands from its regulators and onerous restrictions such as caps on its growth.  The statement highlights the increased regulatory and antitrust risk facing many industries under the Biden administration.

U.S. Investment Strategy:  An interesting article in the Wall Street Journal describes how financial firms are currently in intense disagreement over the future of the “60/40” portfolio, in which 60% of assets are allocated to stocks and 40% to bonds.  Although the 60/40 portfolio largely failed to protect its investors from big negative returns in 2022, its adherents maintain that it was a rare, one-off occurrence.  Others believe a fundamental change may be in order, a viewpoint which we share, given the likelihood of a secular bear market in bonds and unusually good prospects for gold and other commodities.  For example, a decent standard asset allocation going forward may allocate almost half the previous bond allocation of 40% to gold and commodities.

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