by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a slew of reports related to China and its recent shift toward supporting domestic economic growth and easing tensions with the West.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including similarly important shifts in the economic policies of Japan and Europe.

Chinese Real Estate Industry:  In the latest sign that Beijing has reversed its previous clamp down on the residential real estate industry, the government has reportedly drafted a 21-point action plan to aid embattled developers with 450 billion CPY ($67 billion) in financing.  The plan would also include “reasonable debt extensions” for “high-quality developers.”  The government hasn’t indicated which firms are eligible, but it appears the support will focus on large, nationally active, systemically important firms.

• The new support programs for real estate developers suggest that China’s traditional growth-oriented, pro-Western policymakers have firmly taken control of the government apparatus. Other recent signs pointing in that direction include the dramatic relaxation of COVID-19 restrictions and conciliatory moves toward the West.
• The reversal from the formerly hardline, ideological policies will likely lead to a temporary easing of U.S.-China tensions, a surge in optimism regarding China, and possibly a rebound in Chinese equity markets. The policy easing could also help rekindle Chinese economic growth, which came in at a very weak 3.0% in 2022, according to official statistics released today.  We still believe U.S.-China relations will worsen over time, but the current reversal in Beijing’s policies could produce a short-term, investible pop in the value of Chinese risk assets.

Chinese Information Technology Industry:  Despite the step-back from tough restrictions on the real estate industry and acerbic diplomacy against the West, other reporting indicates that the government has expanded its longstanding practice of taking 1% equity positions in key private firms as a way to exercise ongoing influence over them.  These “special management shares” or “golden shares” typically come with a seat on the private firm’s board of directors and the right to control certain company decisions.  This allows the government to wield power over it outside the regulatory regime.

• A unit of the Cyberspace Administration of China has reportedly taken golden shares in a digital media unit of Alibaba (BABA, $117.01), along with a seat on its board, and it is reportedly preparing to take similar golden shares in Tencent (TCEHY, $47.79). Other Chinese tech firms that already have such golden shares include Weibo (WB, $20.69) and TikTok owner Bytedance (unlisted).
• China’s shift from heavy-handed regulations and fines against its technology industry may look positive at first glance, but the increasing use of golden shares suggests that the step back from regulation is only a tactical adjustment. What we are probably seeing is that Beijing wants to take a kinder, gentler approach to its key real estate and technology industries, but without really losing control over them.  Except for those who feel comfortable investing alongside the Chinese Communist Party, investors are likely to see that as a negative for these companies in the long run.

Chinese Population Growth:  Today, the National Statistics Bureau said that the country’s population fell by 850,000 in 2022, marking its first decline in decades.  That left China’s official population last year at 1.412 billion people.

• Like many countries around the world, China’s extremely low birth rate is expected to lead to further headcount declines and worsening population aging in the future. Among the key implications, that means China’s workforce and available military manpower will also continue to decline.
• Some countries are in relatively better shape, including India. In fact, India is expected to overtake China as the world’s most populous country later this year.

U.S.-China Geopolitical Competition:  Swedish state-owned mining company LKAB announced that it has discovered a deposit of more than 1 million tons of rare earth oxides in the country’s far north.  If confirmed, it would be the largest such deposit in Europe.

• Rare earth minerals are essential to advanced technology products, and China and its evolving geopolitical bloc currently account for the big majority of the world’s proved reserves, production, and refining capacity.
• When the Swedish deposit is eventually mined in a decade or so, it could help reduce the evolving U.S. bloc’s current dependence on China.

Global Automobile Market:  Data providers LMC Automotive and EV-Volumes.com reported that global sales of fully electric vehicles surged to 7.8 million units last year, giving them at least a 10% market share for the first time.  Fully electric vehicles made up 19% of all car sales in China, 11% in Europe, and less than 6% in the U.S.  The rapid growth in the market underlies the rising demand for lithium, cobalt, and other exotic minerals that are especially important in the batteries of electric vehicles.

Japan:  The Bank of Japan has begun its latest policy meeting, prompting concern that it could decide on a further loosening of its yield-curve control policy, as it did in December when it decided to let the yield on 10-year Japanese government bonds rise to 0.50%.  So far this morning, 10-year JGB yields have moved slightly above that limit, pushing the JPY higher.

European Union:  In another sign that the EU is taking up the mantle of industrial policy and the subsidization of its key industries, Competition Chief Vestager has sent a letter to EU finance ministers asking them to consider a new “temporary crisis and transition framework,” which would simplify state aid rules for green projects and renewable energy technologies.  The new framework would be designed to compete with the $369 billion in new U.S. subsidies for green energy technology included in the Biden administration’s recent Inflation Reduction Act.  European Council President Charles Michel has echoed the call for new EU industry support.

United Kingdom:  The British train conductors’ union has voted to hold two more days of strikes early next month, prolonging the long wave of work stoppages among transportation and public services workers.  Besides being disruptive to the economy, the wave of strikes continues to weaken the political position of Prime Minister Sunak and his Conservative Party.

World Economic Forum in Davos:  The WEF is kicking off its winter conference today in Davos, Switzerland.  After two years in which the in-person forum was canceled because of COVID-19, the event will be attended by hundreds of top political and business leaders from around the world.  The forum typically produces a lot of interesting political, economic, and business news and commentary.

Russia-Ukraine War:  Late last week, the Russian government stated that President Putin has named Gen. Valery Gerasimov as commander of the Russian forces in Ukraine, demoting the previous commander, Gen. Sergei Surovikin to the position of deputy commander.  Since Gerasimov was probably heavily involved in overseeing the invasion, the decision is likely to have little appreciable effect on the war.  In large part, naming Gerasimov as commander is likely meant to signal that the Kremlin has the war well in hand, despite financier Yevgeny Prigozhin’s effort to claim credit for the recent capture of Soledar, via his Wagner Group mercenaries.  Prigozhin continues to disparage the Ministry of Defense and, by implication, Putin himself, likely in an effort to build political support for a potential future challenge to Putin.

• Separately, the British government late last week confirmed that it will provide Challenger 2 battle tanks to Ukraine, marking one of the first commitments to send heavy armor to the Ukrainians.
• The announcement is important because it is likely to encourage other NATO allies to provide main battle tanks to the Ukrainians, potentially providing a significant boost to the country’s ability to push out the invading Russians.

Peru:  Protests against President Dina Boluarte and the ouster of former President Castillo continue to spread around the country.  Indeed, the protests are intensifying and becoming more violent, prompting the government to declare a state of emergency in the capital Lima and several other regions.

U.S. Fiscal Policy:  On Sunday, newly elected Speaker of the House McCarthy said he would negotiate with President Biden over raising the federal debt ceiling of roughly $31 trillion, which the government is expected to hit this week, but he insisted that the talks include spending cuts.  With Democrats insisting that federal programs continue to be funded at least at current levels, the statement illustrates the risk of an impasse, potentially leading to a partial government shutdown or even a debt default, as the government runs out of work-around measures later this year.

U.S. Winter Storms:  California was hit by yet another big round of rain and snow storms on Monday, and a smaller set of storms in the middle of this week is now expected to mark the end of a period of intense precipitation.  Although the storms have caused widespread death and destruction, they have also helped alleviate the state’s recent intense drought.  That could potentially be a boon for California’s important agriculture sector, help bring down produce prices, and modestly reduce inflation pressures.

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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 on whether the Fed is close to ending its rate-hiking cycle. Next, we explain why changes to Japan’s controversial yield-curve-control policy pose a risk to the international financial system. The report ends with our thoughts on the state of the global economy.

 Is the Fed Finished? Investors and policymakers are growing confident that inflation is on the right path; however, the two groups disagree about when tightening will end.

• The latest CPI data showed that inflation is continuing to decelerate. Consumer prices rose 6.5% from the prior year, the slowest increase since October 2021. The easing of price pressures has added to the speculation that the Fed will reduce the size of its rate hike to 25 bps at its next meeting in February, with some investors pricing in a pause for March. That said, Fed officials insist that the central bank is not finished. St. Louis Fed President James Bullard insists that the Fed quickly raise rates above 5%, while Richmond Fed President Thomas Barkin urged the central bank to be deliberate in its next rate increases.
• The market responses to the data were relatively mixed. U.S. Equities whipsawed but ultimately closed higher. Meanwhile, the U.S. dollar index dipped, and the ten- and 2-year bond-yield spread narrowed. The overall mood of investors appeared to be bullish for stocks as traders now believe that the Fed is nearing the end of its tightening cycle. After the report, swaps signaled less than 50 bps of tightening over the next two FOMC meetings, a sign that investors believe the next hike could be the last one.
• It is unlikely that the Federal Reserve will pause rate hikes before lifting its policy rate above 5%. If 2022 serves as a guide, the Fed will lift rates whether markets like it or not. Recent comments from Fed Chair Jerome Powell reinforce this belief. On Tuesday, he warned that the central bank is prepared to raise rates despite political pressures to stop. We suspect that the Fed views the tight labor market as evidence that it can raise rates even during a recession. Thus, market bets of an imminent pause may be short-sighted while inflation remains well above the Fed’s 2% target.

JGB Headaches: The Bank of Japan continues to deal with the fallout after it widened the target range for yields on 10-year bonds.

• The announcement that the BOJ will review the side effects of its ultra-loose monetary policy has led to speculation that it could end yield-curve control (YCC). On Friday, the central bank vowed to intervene in markets after traders pushed the yield on the 10-year JGB above the 0.50% target. The jolt in yields was related to a Citigroup report which predicted that the bank could abandon YCC as soon as next week. The added pressure for the BOJ to pivot away from its ultra-loose accommodative policy has boosted the JPY. The currency has now surged more than 3% against the dollar since January 11.
• Although the BOJ has consistently maintained that its decision to widen the target range on 10-year bonds was to improve market functionality, traders have interpreted the move as a sign that it was preparing to tighten policy to address rising inflation. As a result, the bank may be forced to delay ending YCC until markets are calmer.
• The market rout in Japan poses a risk to the global financial system. The country’s low-interest rates and cheap currency have made it attractive for investors to generate arbitrage profits, known as the yen carry trade. In this situation, investors borrow in one currency and invest the money into high-yielding assets in another currency. As a result of the JPY’s relative weakness against the dollar, it was used as the go-to funding source for cross-border lending, and, therefore, a sharp appreciation in the currency will make it more expensive for borrowers to make debt payments.

• The fight against inflation has made the market very sensitive to changes in monetary policy. Hence, central banks and governments must be mindful of major policy changes as they could create a financial crisis. The international financial system narrowly avoided a blowup last year following the release of former U.K. Prime Minister Liz Truss’s disastrous mini-budget.
  • As previous reports mentioned, we suspect a U.S. recession is imminent but will likely be of the garden variety. However, a financial crisis, housing market crash, or major geopolitical event could cause a severe downturn.

Recession Receding: There is growing optimism that the global economy is positioned to bounce back from its slowdown.

• The IMF believes that the global economy may have averted a recession but has warned that the situation is still fragile. Warmer-than-expected weather helped cushion Europe from the worst of the effects from the war in Ukraine. The better temperatures have meant that EU countries have not needed to use much of their energy inventory through the winter thus far. As a result, Europe has been able to avoid a possible energy crisis. The U.K. also appears to be on better footing. The latest GDP figure showed that the economy grew in November, suggesting that the U.K. avoided a recession toward the end of 2022.
• China still poses a risk to the global economy. The latest trade figures from the country showed that exports fell 9.9% in dollar terms from the previous year, while imports fell 7.5% in the same period. The sharp drop in foreign and domestic sales reflects the devastating impact that Zero-COVID has had on demand and production within the country. Although there is much optimism that the country’s reopening will help lift world GDP growth, the chaotic transition away from these restrictions threatens to undermine the confidence of the Chinese consumer, which could crimp future spending.
  • Chinese Lunar New Year should provide insight into the psychological impact that the transition has had on consumers. A jump in spending will be a positive sign for the global economy.
• Despite the upbeat outlook on the global economy, it is important to remember that many countries will likely face economic contractions this year. The length and severity of the downturns depend on the cause of the contraction. A major unknown is whether central banks will tighten during this period. Policymakers from the European Central Bank, Federal Reserve, and the Bank of England have held steadfast to the idea that increasing rates in a downturn is not out of the question. However, markets have doubts as to whether these officials are serious. As a result, investors should still be vigilant of sudden market changes.

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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 Consumer Price Index report and its implications for Fed policy. Next, we discuss the impact that China’s reopening is having on markets. The report concludes with our thoughts on Germany’s response to the U.S. climate-change subsidy initiative.

Inflation Nation: The CPI report will bolster expectations that the Fed will moderate monetary policy this year.

• The December inflation report has bolstered expectations that the Fed will reduce the size of its rate hike at its next meeting. Last month, headline CPI rose 6.5% from the prior year. The increase was in line with expectations and below the previous month’s report of 7.1%. The cooling of inflation will give the Fed some flexibility if it decides to slow the pace of interest rate hikes. On Wednesday, Boston Fed President Susan Collins, a voting member, mentioned that she favored a 25 bps hike in February. Meanwhile, Fed Chair Jerome Powell’s lack of clarity on rate policy reinforced investor sentiment that he may favor a downshift in rate rises.
• Although the Fed is considering moderation in its policy, other central banks are hesitant to follow suit. European central bank official Olli Rehn insisted that the ECB needs to raise rates significantly in its next meeting to contain inflation. His French counterpart Francois Villeroy also mentioned the importance of raising rates into restrictive territory. In Japan, a review of the central bank’s ultra-easy monetary policy has led to speculation that the Bank of Japan could make another adjustment to its yield-curve-control ban. The reluctance to moderate policy in Europe is related to inflation being well above U.S. levels; meanwhile, rising inflation in Japan may force the bank to tighten.
  • The combination of BOJ tightening speculation and Fed moderation has led to a strong uptick in the JPY.
• A moderation in the Fed’s monetary tightening will allow other central banks in the developed world to close the interest gap with the U.S. The rise in rates in Europe and possibly Japan will put downward pressure on the greenback. If true, international equities could provide attractive opportunities. Additionally, a consistent deceleration in inflation suggests that the Fed may be able to pull off the elusive soft landing.

China’s Back: There is much anticipation regarding the reopening of the Chinese economy, but the lack of COVID data may be a problem for markets.

• Commodity prices are surging due to expectations that the end of China’s Zero-COVID restrictions will boost global demand for materials. On Wednesday, copper prices soared to $9000 a ton, its highest level since June 2022. The rampant rise in the metal is due to hopes that the increase in economic activity in China will boost global growth. Oil prices had a similar bounce as the price of crude jumped 3% on Wednesday, despite a strong build-up in U.S. inventories. It is now expected that Brent could hit $110 a barrel by the third quarter when China and other Asian economies fully reopen.
  • The optimism has boosted Chinese equities. Year-over-year performance of the MSCI China Price Index has now surpassed the S&P 500.

• Despite the improvement in market sentiment, the lack of infection data from China is troubling. Beijing has not updated its daily COVID reports for three days. Although the reduction of tests rendered the data mostly meaningless, the lack of transparency is feeding concerns that the spread of the virus may be worse than the government originally anticipated. One hospital in China reported that half of its 2000 workers were infected with the virus. Meanwhile, local officials in Henan, the country’s third most populous province, revealed that over 90% of the region had been infected. The mystery behind the scale of the spread has led neighboring countries to push for more testing for tourists leaving China.
• A severe outbreak is potentially detrimental to the global economy. A major unknown is how the recent rise in infections could impact consumer psychology. Although it is tempting to believe that things will return to normal after the recent wave, there is also the possibility that people will be much more cautious, particularly when it comes to services. Hence, the recovery may not be as robust as the current market pricing suggests. Spending during the Lunar New Year will likely provide insight as it is one of the year’s biggest shopping periods for China. A sharp increase in sales should boost optimism about China’s recovery.

Berlin Shrugs: Germany may be more open to allowing the U.S. to implement its climate-change subsidies than its comments suggest.

• The European Union is moving to compete against the U.S. in the green energy race. German Chancellor Olaf Scholz is pushing for the EU to create financial instruments to make it easier for countries to provide incentives for green investment. Although Scholz did not explicitly call for EU bonds, he did advocate for joint financing instruments to help budget-strapped countries. The call was in response to the U.S. act that gives tax credits to consumers who buy electric cars made in North America. If the EU were to follow through on the initiative, it could pave the way for stimulus throughout the bloc.
• The possibility of a joint EU venture reinforced investor optimism that a recession within the region will not be as severe as originally thought. The gap between Italian and German 10-year bonds, a gauge of European financial stress, has shrunk by 53 bps to start the year. Meanwhile, the EUR has surged to parity with the CHF and has been able to hold its value against the USD. The improved outlook has encouraged investors to pour in half a trillion dollars to purchase European bonds, suggesting strong demand for more European assets. However, despite Scholz’s tough talk, we are not confident that he is serious about a push for EU-wide investment.
• Although Scholz’s proposal suggests that he supports a pro-European stimulus package, it isn’t clear if it is a genuine plan. In theory, Germany could implement a similar policy unilaterally without EU consent as it did with its controversial energy subsidy. Its unwillingness to do so suggests that it is ambivalent toward the U.S. incentive program. If true, this may disappoint the Biden administration as we suspect it wants the EU to implement a stimulus program supporting European firms. In our view, Washington believes that with increased state action, the EU could become less dependent on China.
  • That said, if Scholz follows through on the proposal, the EU will likely create a plan that favors lending and subsidizing firms. This scenario would benefit European equities; however, such a plan could take months or maybe years to implement.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where a key Russian blogger has broken taboo and directly criticized President Putin for his management of the invasion.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including some welcome signs of increased investments in U.S. manufacturing and energy production.

Russia-Ukraine War:  Reports indicate that Aleksandr Lapin, the former commander of the Central Military District forces that allowed the Ukrainians to recapture huge swaths of territory in eastern Ukraine last summer, has been reassigned to take over as chief of staff of the Russian ground forces.  In response, influential Russian military blogger and former rebel commander Igor Girkin published a criticism of President Putin for appointing and refusing to remove Russian military leaders who oversee frequent and disastrous military failures.  The criticism marks one of the first times an influential nationalist has directly criticized Putin for his management of the war.  It therefore signals how the disastrous invasion continues to undermine Putin’s political position within Russia.

Saudi Arabia-Pakistan:  The Saudi government said yesterday that it is considering offering some $11 billion in aid to Pakistan to help it avoid a threatened default on its foreign debt.  Along with earlier offers of aid from the United Arab Emirates and Qatar, the major Middle East oil producers have now said they may provide up to $22 billion to Pakistan.

• The support could strengthen Pakistan’s hand in negotiating a restart to a stalled bailout from the International Monetary Fund.
• Pakistan has so far been unwilling to agree to the IMF’s terms for a deal, which include raising electricity and gasoline prices and increasing taxes.

Egypt:  As part of its negotiations for a $3-billion bailout from the IMF, the Egyptian government has reportedly agreed to reduce the role of the military in the country’s economy, including via the privatization of military-owned businesses.  The military’s economic activity has spread through the economy since President Abdel Fattah al-Sisi took power in a coup in 2013, reducing opportunities for private business owners.

Brazil:   As prosecutors in Brazil continue to investigate last weekend’s capital rioting by supporters of Former President Bolsonaro, the former leader said he will leave the U.S. and return to Brazil within a few weeks.  Bolsonaro’s return to Brazil would likely be welcomed by the White House, which has come under pressure from some Democrats to expel him.

Peru:  At least 17 people have been killed in political protests this week, as the demonstrations intensify against last month’s removal and detention of Former President Castillo.  According to the country’s independent human rights office, 39 civilians have been killed in the unrest since Castillo’s arrest, while the defense ministry says 75 police officers have been injured.  The continued violence could threaten production at Peru’s globally important mines producing copper and other key minerals.

United States-China-Taiwan:  A series of 24 war games held by the Center for Strategic and International Studies found that an alliance of the U.S., Japan, and Taiwan would likely be able to repel a full-scale Chinese invasion of the self-governing island, but at the high cost of dozens of navy ships, hundreds of aircraft, and tens of thousands of troops over three to four weeks of fighting.  The report recommends that the U.S. improve its effort to increase deterrence against the Chinese by raising the expected costs that they would pay for an invasion.

U.S. Demographics:  A new study from the Aspen Economic Strategy Group finds that falling birth rates, declining population growth, and population aging are among the biggest risks for the future U.S. economy.  To address the threat, the study recommends that the U.S. adopt policies to increase fertility and boost immigration.

U.S. Monetary Policy:  At an event with other central bankers in Sweden yesterday, Federal Reserve Chair Powell said that he remains strongly committed to lowering inflation by restraining economic growth through interest-rate increases, even if doing so fuels political blowback.  In fact, he stressed that preserving the Fed’s ability to make tough economic calls without political interference would require it to avoid straying into issues that aren’t directly related to its economic-management objectives, such as climate change.

U.S. Industrial Policy:  South Korean conglomerate Hanwha Group (000.880.KS, KRW, 27,200) said that it will invest $2.5 billion to expand the production of solar panels and components at a facility in Georgia.  The commitment would reportedly be the biggest foreign direct investment in U.S. solar manufacturing ever.

• The South Korean plan is also a sign that the big green-energy subsidies in the recently passed Inflation Reduction Act are already drawing increased investment to the U.S. that otherwise may have gone to other countries.
• That risk has already generated pushback from the European Union, prompting some limited concessions from the U.S. We suspect that the U.S. subsidies will continue to spur concerns by other countries as more investment is redirected toward the U.S.  The U.S. program will also likely spur calls for similar subsidies in other countries.

U.S. Oil and Gas Industry:  Despite popular perceptions that U.S. oil and gas drilling is at a standstill, the Wall Street Journal has an interesting article today showing that activity in at least some regions is actually beginning to boom again, especially in natural gas fields.  We still suspect that environmental regulations, the rise of green energy, and investor demands for capital discipline will slow new energy investment and contribute to higher energy prices in the future, but today’s article points to at least some new activity after a long period where high prices failed to prompt the usual supply response.

U.S. Air Travel Industry: This morning, the Federal Aviation Administration halted all domestic air departures until at least 9:00 am ET due to an outage of its computer system that alerts pilots to advisories and other flight information.  The halt has reportedly produced numerous flight delays, pushing airline stocks lower.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the news of a potential mine shutdown that would affect global copper supplies and the increased tensions between China, Japan, and South Korea.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs that Pakistan is getting closer to defaulting on its foreign debts, and more indications that the Federal Reserve could soon slow its interest-rate hikes to just 25 basis points per meeting.

Global Copper Market:  Canadian miner First Quantum Minerals Ltd. (FQVLF, $23.19) said that it will shut down its vast copper mine in Panama, which produces about 1.4% of the world’s copper supply, if it can’t resolve a tax dispute with the Panamanian government.  Global copper prices remain in retreat, in large part because of the threat of recession in the West and lower demand from China as it deals with its latest COVID-19 wave.  Nevertheless, any outage at the FQM mine could help put a floor under prices or even give them a boost.

China-Japan-South Korea:  Today, the Chinese government suspended visa issuance to travelers from Japan and South Korea, marking its first formal retaliation for the COVID-19 testing rules those countries and others have imposed on travelers from China because of its massive new wave of infections.

• The move illustrates how willing China is to wield its massive economic power as a source of coercion or consensus-building to influence other countries’ behavior.
• As we wrote in our latest Bi-Weekly Geopolitical Report, published yesterday, China will probably grant or deny access to its vast market and capital flows in order to eventually establish a neo-colonial relationship with the countries in its evolving geopolitical bloc.

Russia-Ukraine War:  After weeks in which the front lines from eastern to southern Ukraine were largely static, Russian forces have reportedly been able to capture most of the town of Soledar, just to the northeast of the embattled city of Bakhmut.  That gives Russia a rare but mostly symbolic victory and will make it more difficult for Ukraine to hold Bakhmut, although the city isn’t expected to immediately fall.  The Russian move also comes as reports indicate that the country’s government will soon announce the mobilization of 500,000 more troops in another special draft.

• Separately, after several countries last week agreed to send light tanks or armored vehicles to Ukraine, British officials said they have been discussing sending their Challenger 2 main battle tanks.
• Poland, Finland, and other European countries are also considering sending heavily armored, powerful tanks, which in sufficient numbers could provide a major boost to Ukraine’s military power.

Brazil:  Following the weekend’s capital rioting by supporters of right-wing Former President Bolsonaro, the country’s supreme court yesterday ordered the suspension of the federal district’s governor, a Bolsonaro ally.  The move is likely to further anger Bolsonaro’s supporters and could exacerbate the country’s political polarization.  Separately, some Brazilian politicians who accuse Bolsonaro of inciting the unrest have demanded he be extradited from the U.S., where he has been for the last two weeks.  Some prominent U.S. Democrats have echoed that call.  However, the White House has merely said that it would treat any extradition request seriously.

Pakistan:  Facing dwindling currency reserves and a high risk of default on its foreign debts, yesterday the Pakistani government begged the International Monetary Fund to ease the harsh conditions on its funding program for the country in order to unleash billions of dollars of additional loans.  The IMF officials made no commitment to easing the terms.

Canada:  The Canadian government announced yesterday that it will buy 88 advanced F-35 fighter jets from Lockheed Martin (LMT, $458.99) to modernize its air combat capabilities.  The total cost of the purchase will be approximately $14 billion.  The purchase illustrates how much the West’s increasing defense budgets and military modernization efforts are likely to benefit U.S. defense firms, given their cutting-edge technologies and production capacity.

U.S. Monetary Policy:  San Francisco FRB President Daly said yesterday that because of the lags before changes in monetary policy affect the economy, it might make sense for the Fed to slow its interest-rate hikes to just 25 basis points beginning at its next policy meeting.  According to Daly, that would give the policymakers more time to assess how their previous aggressive rate hikes are affecting economic activity.  Meanwhile, Atlanta FRB President Bostic yesterday stated he would consider a 25-bps hike more seriously if Thursday’s inflation report shows that the consumer price index is slowing in line with other recent data releases.  The statements place a spotlight on Fed Chairman Powell’s remarks later today when he may weigh in on the issue.

U.S. Student Loan Market:  Today, the Department of Education released a proposed rule that would make it easier for student loan borrowers to use income-driven repayment plans and get out of their debt sooner.  For example, the minimum amount of monthly discretionary income that would have to be paid on their loans would be cut to 5% from the current 10%.  Borrower loan balances wouldn’t grow as long as they make their payments, which basically would amount to loan forgiveness for the borrowers with the lowest incomes.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an update on the post-pandemic landscape in China, where the relaxation of pandemic lockdowns continues to reverberate throughout the domestic, regional, and global economies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the weekend’s big capital riot in Brazil and the election of Kevin McCarthy as Speaker of the House.

China Reopening:  As of Sunday, the Chinese government has removed most of its COVID-19 restrictions on international travel, prompting tens of thousands of air arrivals and departures.  The move could eventually help the tourism industry in countries that had become dependent on Chinese visitors before the pandemic, especially in Asia, but outbound Chinese tourism won’t immediately rise to its pre-pandemic levels given that many foreign countries have slapped testing requirements on them to keep China’s surging infections from spreading.  It may also take the airlines some time to re-orient their fleets toward China again.

• Separately, the reopening of the economy appears to be boosting global oil prices today, even though the relaxation of pandemic lockdowns has led to a current surge in infections and is actually crimping current economic activity.
• So far this morning, front-month Brent crude oil futures are trading up some 2.9% at $80.82 per barrel.

China Regulatory Policy:  The China Securities Regulatory Commission is reportedly preparing to cease allowing local companies in certain sectors to list on the Shanghai or Shenzhen stock exchanges so that the government can channel funding into strategic industries.  The sectors to be “red lighted” will reportedly include food and beverage chains and COVID-19 testing firms.  The CSRC will also name a number of “yellow light” sectors, such as apparel and furniture, where initial public offering requests could come under heavy scrutiny if their growth relies heavily on debt for expansion.

• Over the last few years, the government has clamped down hard on big economic sectors that leaders felt had become too powerful, wasteful, or simply at odds with President Xi’s vision of good communist values. The real estate development, information technology, and on-line tutoring industries were prime targets, and their investors paid a heavy price.
• The new red-light and yellow-light rules mark a further blow to China’s free markets. In turn, they will likely contribute to rising investor skepticism about China and could potentially drive more foreign investors elsewhere.

Russia-Ukraine War:  Fighting continues along the front lines running from eastern to southern Ukraine, with the Russian military continuing to stage air attacks against critical Ukrainian energy infrastructure.  To sustain its air attacks even as it has depleted much of its own conventional and advanced missiles and artillery, Russian officials say they are about to begin domestic production of Iranian-designed kamikaze drones.

• Separately, a new Atlantic Council survey found that 46% of the 167 foreign policy analysts polled thought that Russia could become a failed state or break up by 2033.
• Also in the survey, 40% pointed to Russia as a country they expected to break up for reasons including “revolution, civil war or political disintegration” over that time.

NATO Expansion:  Swedish Prime Minister Kristersson warned that his government can’t meet some of the demands Turkey is making before it would lift its veto over Sweden entering the North Atlantic Treaty Organization.  Turkey’s demands focus on Sweden’s alleged ties to Kurdish separatists in Turkey.  It is not clear whether Ankara will finally acquiesce to Sweden and Finland joining NATO after Turkey’s presidential elections sometime in the coming months.

France:  After abandoning his first effort to reform the country’s pension system due to the COVID-19 pandemic, tomorrow President Macron plans to propose a new reform that would increase the minimum pension but raise the age at which retirees can get the full benefit.  The aim is to cut the massive fiscal cost of the country’s pension system and boost the incentive to work.  However, most French voters object to the proposed reforms, and labor leaders have threatened a series of strikes to oppose them.

United Kingdom:  As the country continues to reel from economically damaging work stoppages across the railroad and healthcare sectors, Prime Minister Sunak’s government is planning to meet union leaders today in an effort to avert further strikes.  Of great importance is a threatened teachers’ strike.  Since the beginning of the year, Sunak has somewhat moderated his stance toward the strikers, although he still insists he will keep any resolution of the strikes from overly burdening the government’s budget or further boosting inflation.

Brazil:  Thousands of supporters of the country’s right-wing former president, Jair Bolsonaro, stormed the presidential palace, national parliament, and supreme court buildings yesterday and demanded that the military remove newly inaugurated leftist President Lula da Silva, who beat Bolsonaro in the October presidential elections by 51% to 49%.  Bolsonaro has refused to concede defeat in the elections, but the military, so far, has not shown signs that it supports his argument that the elections were marred by fraud.

• Bolsonaro has decamped to Florida, as has his former justice minister, who had been named as the federal district’s public security chief.
• The presence of both Bolsonaro and the federal district’s public security chief in Florida will likely raise concerns that the storming of the capitol was preplanned and that the two men left the country in an effort to distance themselves from the action. However, Bolsonaro eventually condemned the rioting and claimed no connection with it.
• In any case, the storming will likely raise concern about the resilience of Brazil’s democracy. Investors certainly have concerns about the leftist president’s economic policies, but political instability would add to the headwinds for Brazil’s stock market.

U.S. Congressional Politics:  The new Republican majority in the House of Representatives finally elected Rep. Kevin McCarthy as Speaker of the House early Saturday morning, but only after he made a series of concessions to far-right wing members of his party that will leave him severely weakened.  The 15 rounds of voting needed to elect McCarthy as well as his compromises are widely being panned as another sign that political polarization is leaving the U.S. ungovernable.

U.S. Monetary Policy:  At a conference on Friday, Richmond FRB President Barkin warned that the Federal Reserve is likely to continue raising interest rates because its mandate to control inflation will trump the risk of causing a recession.  The statement marks a further Fed effort to keep business leaders cautious even though some investors and analysts are already looking for a potential monetary loosening.

U.S. Weather and Drought:  California is preparing for yet another major rain and snow storm today, but scientists warn that the recent torrents aren’t nearly enough to end the state’s drought.  Continued water-use restrictions are therefore likely to continue weighing on California’s economy.

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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 Fed officials’ speeches and the U.S. jobs numbers. Up next, we review how rising inflation in the developed world impacts investing in emerging markets. We end the report by focusing on Russia and China’s ability to use state power to generate growth as their economies cope with headwinds.

All About Timing: Some investors are positioning themselves for a Fed Pivot, despite monetary policymakers’ insistence that they are not finished tightening.

• Fed officials reaffirmed the central bank’s commitment to tightening policy until inflation falls to its 2% target. Atlanta Fed President Raphael Bostic argued that inflation is the biggest headwind to the U.S. economy, and in an interview with CNBC, his colleague from Kansas, Esther George, added that she would like the Fed’s policy rate to rise above 5% and have it held there until 2024. Meanwhile, St. Louis Fed President James Bullard struck a moderate tone suggesting that interest rates are almost high enough to bring down inflation.
• The labor market remains too hot for the Fed. According to the Bureau of Labor Statistics, the economy added 233k jobs in December, while the unemployment rate fell from 3.7% to 3.5%. Although job creation has eased in recent months, the Fed has made it known that it would like the unemployment rate to increase before it reverses course on policy. As a result of the data, the S&P 500 dropped, and bonds rallied as it added to evidence that the Fed will need to continue tightening.

• Data suggests that the rise in hourly wages may be a side effect of elevated margins from firms. The chart above looks at the annual change in trade services, a measure of retail and wholesale margins, and average hourly wages. If we are correct, a profit margin decline should contain wage growth, relieving some inflationary pressure.

• The Federal Reserve is in a difficult position as it decides what will be the appropriate policy going forward. Although it is clear that the central bank will be ready to pause rate increases later this year, the Fed is reluctant to commit due to concerns that it might be caught flat-footed by inflation. The anticipation of the conclusion of the Fed’s hiking cycle has led investors to position themselves to take advantage of any positive surprises within the data. This behavior may have the Fed worried that financial markets are assuming that it will cut rates aggressively if the economy falls into recession. As a result, we expect policymakers to stress that a pause is not the same as monetary easing.

The Saver’s Rush: The fight against inflation in the developed world may deter overly sensitive investors from allocating capital to emerging markets.

• Inflation in the Eurozone returned to single-digit territory in December, but concern remains about persisting price pressures. The overall consumer price index rose 9.2% from the prior year, below the previous month’s increase of 10.1%. The dip in the index is related to the slide in energy prices. That said, excluding volatile elements, the index rose 5.2% from last year, a jump from the prior month’s report of a 5.0% increase. Price pressures in core components of the index will motivate the European Central Bank to raise rates by at least 50 bps at its next meeting.
• Meanwhile, in another part of Europe, deceleration in inflation has led to a decline in equity prices. Several days after the Turkish CPI fell by more than 2000 bps, the country’s BIST 100 Composite Index sank by more than 8%. The sharp drop in the index is especially notable, given its strong performance in 2022, when Turkish equities more than doubled. Although much of the decline is related to investors locking in gains from their investments, it also reflects the tendency for investors to pull out of risky countries at the first sign of trouble.

• A lesson can be taken from the situation in Turkey. In this case, we learned that investing can be more about circumstances than solid fundamentals. As the chart above shows, the rise in the BIST 100 in 2022 was largely driven by domestic savers trying to protect the purchasing power of their holdings. Argentina’s stock market, which also performed well in 2022, is another place where this may be happening. The reason for these investments is that equities serve as a form of value storage in countries where inflation is uncontrolled. Hence, high-inflation countries may present short-term opportunities for investors looking to earn capital gains abroad. That said, as global yields begin to rise in the developed world, these countries could face financial outflows as investors become more risk averse.

Return of the State: China and Russia’s governments are intervening in their own economies to prevent backsliding.

• Beijing is pulling out all the stops to help restore faith in its economy. Chinese regulators are considering relaxing the country’s “Three Red Lines” property rules to incentivize more real estate investment. They are also exploring the possibility of raising borrowing caps and delaying the grace period for meeting debt targets. These moves are controversial as China has not fully recovered from the fallout of its property meltdown. However, these measures have added to investor confidence that Beijing will get its economy back on track after ending its draconian Zero-COVID policy.
  •  As a result of Beijing’s actions over the last few months, the off-shore CNY has surged 7% since October 25, when it hit the weakest level on record, and is currently trading above its 200-day moving average.
• Meanwhile, Moscow has ramped up the pressure on state-owned firms to help fund its war efforts in Ukraine. The government has called for “revenue mobilization,” in which state enterprises pay higher dividends and one-time payments to help improve the country’s fiscal budget. The order could be harmful to its coal-producing sector, which has recently returned to near high levels after Europe loosened transportation restrictions. The Russian government’s pressure on companies signals that the West’s sanctions are working to starve Moscow of the funds needed to maintain its war efforts. However, it also shows that the war is still disruptive to the commodity market.
• Recent moves by China and Russia suggest that as the world becomes more polarized, governments will look to have greater economic control. In the short term, this could benefit international equity markets as stimulus will increase domestic demand and make it easier for firms to boost production. However, as blocs and countries become isolated, firms could struggle to find the opportunities to widen their customer base. Thus, we may be headed to a world that is more favorable to real assets, such as commodities, rather than financial assets.

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