by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with our thoughts about global central banking. Next, we discuss why political uncertainty in the U.K. and the U.S. may impact investment decisions within these countries. Lastly, we review the challenges companies may face when navigating in a less globalized world.

Monetary Moderation: Although financial conditions will likely remain tight around the world, interest rates may peak later this year.

• The Federal Reserve wants investors to know that it is not ready to take its foot off the pedal in the fight against inflation. The Federal Open Market Committee (FOMC) meeting minutes released on Wednesday showed that policymakers are concerned that financial markets are prematurely pricing in an interest rate cut. As a result, the FOMC emphasized that policy easing would not start until inflation fell to its 2% target. Additionally, it warned that unwarranted easing in financial conditions could complicate the bank’s efforts to restore price stability. That said, policymakers seem inclined to keep their next few hikes at 50 bps or lower in their upcoming meetings.
  • Although policymakers support keeping the policy rate in restrictive territory, some members are open to a pause. Minneapolis Fed President and notable hawk Neel Kashkari said that he would like rates to rise another 100 bps before the central bank halts its hiking cycle. Based on the market projection of rate increases, this could mean that the Fed could be finished with its hiking cycle in July at the latest.
• China’s central bank reiterated its commitment to maintaining a relatively loose monetary policy in order to promote economic growth. The People’s Bank of China will use its monetary tools to ensure ample liquidity as the economy transitions from Zero-COVID. The country is determined to stimulate growth, and it has already loosened restrictions on property lending and is considering fiscal stimulus. So far, the monetary easing has not boosted household consumption, as consumers are still reluctant to engage in service activities while COVID spreads. Although the country’s latest inflation reports showed CPI rising 1.5% from the previous year, the additional stimulus may prop up inflation down the road.
• Meanwhile, a sharp deceleration in inflation has helped push down bond yields for European countries. The yield on 10-year German bonds fell for the fourth consecutive day on Wednesday, its longest streak since November. Italian bonds also performed well with the yield gap between German and Italian debt, a gauge for financial stress within the Eurozone, narrowed to its lowest level in three weeks. Although the decline in inflation will not prevent the European Central Bank from hiking rates in its next meeting, it does signal that the central bank will not need to be as aggressive to tame inflation as policymakers originally thought.

Populist Uncertainty: The U.S. and U.K. are finding it increasingly difficult to form a government that can satisfy the needs of all the varying party coalitions.

• The U.S. House of Representatives failed to select a new Speaker for the sixth consecutive vote. Although Republicans have a majority, a few holdouts have refrained from choosing Congressman Kevin McCarthy for the position. The constant jockeying from the far-right politicians for more influence within the party may be a bad omen for worse things to come later in the year. For example, if the Republicans can’t agree on something as simple as the Speaker, how are they supposed to agree on a budget? Although situations like this should make reaching across the aisle more appealing, political polarization makes that option costly for lawmakers, and therefore unlikely to happen. As a result, debt default due to a refusal to raise the debt ceiling cannot be ruled out.
• In the U.K., Prime Minister Rishi Sunak has come under scrutiny for not articulating a clear vision for the country going forward. The country is currently undergoing several crises, from rising work stoppages to crumbling National Health Services, as well as an imminent recession. To address these concerns, Sunak has made a five-point pledge he outlined as the peoples’ priorities. The pledge includes: a cut in inflation by the end of the year, growth in the economy with a decrease in the national debt by the end of the current parliament, a cut to the NHS waitlist, and the passage of stringent immigration laws. If Sunak were to fail to make good on these promises, his premiership could be in jeopardy.
  • Although many of the goals are achievable, the first two could be difficult to accomplish. Inflation is expected to be more persistent in the U.K. than in other countries and it is expected that the next recession will be worse than the pandemic downturn.
• The political divergence reflects the toll of the growing polarization within these countries. The last time that the U.S. failed to elect a Speaker of the House was in 1823, and the event served as a prelude to the Civil War. Meanwhile, Brexit still divides the U.K. as the country has yet to figure out its identity going forward. Although it is unlikely that populist elements will be able to take firm root within these governments any time soon, political disruptions are likely to become normal. As a result, investors should pay closer attention to regulatory threats that immigration, free trade, and tech will pose to their investment portfolios within these countries.

Great Powers at Play: As the war rages on in Ukraine, companies are beginning to adjust to a world divided by blocs.

• Despite the recent success of Ukraine, there are still concerns that Russia could stage a comeback. NATO Secretary-General Jens Stoltenberg has warned members not to underestimate Russia. Meanwhile, a possible new mobilization push by Russia has led Ukrainian President Volodymyr Zelensky to ask for more military assistance from the West. The rise in concern has led allies to pledge to send more military equipment. However, the additional aid for Ukraine increases the likelihood of a prolonged war.
  • In an attempt to end the conflict, Turkish President Recep Tayyip Erdoğan has urged Putin to declare a ceasefire to pave the way for peace talks.
• Additionally, companies are starting to diversify their supply chains in order to adapt to a less predictable world. Apple (AAPL, $126.36) has already shifted some of its operations out of China in favor of India and Vietnam. The trend was also reflected in a 2022 survey that revealed that the ratio of executives expressing concern about the political risk in China had jumped to 20-1, compared to 2-1 two years prior. As companies look to rearrange their supply chains, it could lead to higher global inflation but could benefit countries that don’t align with either bloc.
• MSCI Asia ex-Japan is trading near a four-month high and is set for its fourth straight day of gains. Although much of the growth is related to China’s relaxing of its Zero-COVID restrictions, we suspect that other countries within the index could also benefit in 2023 as companies look to reshore their operations in nearby countries. The size of India’s labor force and its neutral status could make it an investment target, and therefore, bears watching. Indonesia could be another country of interest due to its natural resources.

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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 news from Europe, where year-over-year price inflation looks like it may be moderating.  The news has raised hopes of lower inflation and interest rates even beyond Europe, giving a boost to the stock and bond markets as well.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the Russia-Ukraine war and an update on the historic challenges that the U.S. House of Representatives is having in selecting a new Speaker.

France:  The December Consumer Price Index (CPI) was up just 6.7% in the year ending in December, coming in cooler than expected and marking a slight improvement from the annual gains of 7.1% in each of the previous two months.  Much of the slowdown in inflation reflected falling energy prices—the result of both warm weather across the Northern Hemisphere that has helped bring down global natural gas prices and government efforts to cap prices.

• Excluding energy and unprocessed food, the December core CPI accelerated to an annual rise of 5.3%, compared with a rise of 5.0% in the year to November.
• Despite the acceleration in core inflation, the decline in the headline number has sparked optimism about slowing inflation and lower interest rates throughout Europe and beyond. In turn, that has buoyed stock and bond prices in multiple markets so far this morning.

United Kingdom:  Because of Europe’s recent warm weather and reduced global prices for natural gas, analysts now believe British household energy bills in 2023 will be lower than previously anticipated, dropping below the level of the government’s price guarantee in the second half of the year.  The resulting fall in the cost of living would not only be politically positive for the government, but it would also limit the fiscal cost of its programs to shield households from high inflation.

Russia-Ukraine War:  As heavy fighting continues along the front lines and Russia keeps launching air strikes against Ukraine’s infrastructure, Russian oligarch Yevgeny Prigozhin has admitted that his Wagner Group mercenaries have stalled in their effort to seize control of the eastern Ukrainian city of Bakhmut.  Other reporting suggests that Russian forces have shifted their focus to the smaller city of Soledar, just to the north of Bakhmut.  In any case, Prigozhin’s admission may be laying the groundwork for further criticism of the Russian Ministry of Defense, which Prigozhin is using to implicitly establish himself as a more effective leader who is ready to take power.

European Union-China:  With COVID-19 cases continuing to rip across China following the sudden end of the government’s Zero-COVID policies, the European Union today is expected to finalize a requirement that Chinese travelers must test negative for the disease before boarding flights to the EU.  The move would come as France, Spain, and Italy have already imposed such testing rules, but a bloc-wide requirement would further embarrass and anger Beijing and feed into the global fracturing that we so often write about.

U.S. Congress:  Yesterday’s voting for the new Speaker of the House proved to be inconclusive, after Republican Kevin McCarthy failed to secure a majority even after three rounds of voting.  It was the first time the House hasn’t been able to select a Speaker on the first ballot since 1923.  The voting will continue today.

• The conservatives’ disciplined opposition to McCarthy may be a good example of the “vetocracy” engendered by polarized politics and strong interest groups, as described by Sarah Quinn in her book American Bonds.
• McCarthy has vowed to take as many votes as necessary to win the position, aiming to wear down his right-wing opposition, so it is not clear when the balloting will be complete and when a new Speaker will be selected.

U.S. Labor Market:  Workers at videogame firm ZeniMax, a unit of Microsoft (MSFT, $239.58), have voted to form a union, marking the latest example of labor organization within the largely non-union information technology industry.  The vote illustrates how today’s labor shortages have shifted economic power towards workers and away from managers and owners.

U.S. Weather:  Beginning today, the West Coast will be facing its third major rain and snow storm since Christmas.  The National Weather Service has already warned of flooding, especially in northern California, which implies the risk of meaningful economic disruptions, although the storms could potentially help end California’s recent drought.

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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 all the key global developments over the holiday period, including the latest on China’s new COVID-19 wave and how it’s affecting international relations.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an update on Brazil’s new president and today’s election in the U.S. Congress for Speaker of the House.

China COVID Crisis:  Over the holiday weekend, additional major developed countries imposed COVID-19 testing requirements on travelers from China due to its recent relaxed pandemic controls which have caused a surge in infections.  The rules generally require travelers on flights originating in China to submit a negative test no more than two days before boarding.

• The list of countries requiring tests now includes the U.S., Canada, Japan, the U.K., France, Spain, and Italy. Although the new rules were probably spurred by legitimate concerns about importing new COVID-19 cases from China, it’s notable that the countries imposing the tests are all important members of the evolving U.S.-led geopolitical and economic bloc.
• Even if the testing rules are short-lived, as planned, they have angered the Chinese government and will likely prove to be yet another brick in the wall being erected between the U.S. and Chinese blocs. This geopolitical and economic wall has, thus far, been focused on impeding trade, technology, and capital flows, but the new COVID-19 testing rules show that the wall can also limit human travel and migration.

China-European Union:  Today, the European Commission announced that it has offered China free doses of the West’s highly effective, variant-adapted vaccines, but Beijing immediately rejected the offer, citing the “strengthening clinical efficacy” of its “ample” domestic shots.

• China’s prompt rejection of the EU’s offer illustrates how strongly politics plays into Beijing’s pandemic policy. In Beijing’s eyes, accepting the EU’s offer would legitimize Western vaccines and highlight the relatively low effectiveness of China’s domestic shots, and would run counter to Beijing’s “East is rising, West is falling” political mantra.
• The relatively low vaccination rates in China, especially among its elderly population, is a key reason for the new wave of infections following the lifting of President Xi’s draconian Zero-COVID policies.

China-United States:  Faced with the U.S.’s aggressive new restrictions on exporting advanced computer chip technology to China, an official at the China Semiconductor Industry Association stated that his country will likely shift its strategy toward making incremental improvements in its current, relatively basic capabilities, rather than building new, cutting-edge technologies.  The revamped approach would put more resources into areas where China already has an advantage and where the U.S. is less likely to impose export curbs, such as mature process technologies.

• Even though the U.S. is still working to bring key allies onboard with its full export restrictions, the CSIA official’s statement shows that the new rules are already proving effective in changing China’s behavior and suppressing its technological and economic prospects. Over time, such technology headwinds will likely weigh on the Chinese military, economy, and financial markets.
• We suspect that many Western observers still don’t fully appreciate how aggressive the new U.S. technology restrictions are.
  • The rules essentially aim to clamp down on exports of advanced U.S. semiconductors, semiconductor technologies, computer chip components, chip-making machines, and even chip-related services to China.
  • If similar rules were being enforced by the U.S. Navy somewhere in the South China Sea, it would amount to a partial naval blockade, i.e., an act of war.

Eurozone:  As the European Central Bank continues to hike interest rates aggressively and cut back on its bond purchases, nine out of 10 economists polled by the Financial Times said that Italy is the Eurozone country most at risk of an out-sized sell off of its government bonds in 2023.  Despite Italian Prime Minister Meloni’s plans to rein in her country’s budget deficit, investors are focused on the fact that Italy’s total government debt burden remains one of the biggest in Europe, at about 145% of gross domestic product.

United Kingdom:  The country continues to face waves of strikes as the new year begins, with railway workers set to walk out on Tuesday, Wednesday, Friday, and Saturday this week in a dispute over pay, job security, and changes to working practices. Train drivers represented by a separate union will walk out on Thursday in a dispute over pay, completing five days of travel misery for passengers.  The strikes, in multiple industries, are creating political challenges for Prime Minister Sunak and further disrupting British economic growth.

European Union-United Kingdom:  Irish Prime Minister Leo Varadkar has admitted that the trading arrangements imposed pursuant to the post-Brexit trade deal between the EU and the U.K. are being applied too strictly.  Importantly, he admitted that the deal’s Northern Ireland Protocol, which creates a trade barrier between Great Britain and Northern Ireland, had made unionists in Northern Ireland feel less British.

• Varadkar’s conciliatory statement raises hopes that the EU and the U.K. may come to an agreement to adjust the protocol in the coming months.
• Adjusting the protocol could ease EU-U.K. tensions and potentially boost British economic growth by restoring some U.K. trading links with the EU.

Russia-Ukraine War:  Heavy fighting continues along the front lines running from eastern to southern Ukraine, although it appears neither side is making significant headway at the moment.  Meanwhile, the Russians continue to launch missile and kamikaze drone attacks against Ukrainian infrastructure, but the Ukrainians claim that they are now able to shoot down virtually all the Iranian-made drones sent against them.  If that claim is accurate, it could potentially mean that Russia will eventually give up on the tactic or escalate to the use of Iranian-supplied ballistic missiles.  Meanwhile, poor operational security apparently allowed the Ukrainians to kill dozens of recently mobilized Russian troops with a U.S.-provided missile system over the holiday weekend, prompting a new round of criticism from Russian ultra-nationalists and creating more political headaches for President Putin.

Brazil:  Former President Luiz Inácio Lula da Silva was inaugurated again on Sunday, but without the traditional passing of the presidential sash meant to symbolize the peaceful transfer of power.  That was precluded because President Bolsonaro had fled to Florida on Friday in an apparent attempt to shield himself from the new government’s corruption investigations.  Among Lula’s first acts under his new presidential mandate to move Brazil’s economic and social policy to the left, he has:

• Reiterated his intention to abandon Brazil’s constitutional cap on public spending to increase outlays on his preferred social programs.
• Revoked an eleventh-hour decree from the Bolsonaro administration that gave a tax break to large companies.
• Ordered his ministers to end studies on privatizing energy group Petrobras and the national post service Correios.
• Revoked a decree that allowed for “artisanal” gold mining on indigenous land.
• Revoked a decree that made it easier to buy guns.

Uruguay:  Allegations that a personal bodyguard to President Luis Lacalle Pou was selling fake passports, potentially to Russians trying to flee their country after its invasion of Ukraine, have now ballooned into a wide-ranging corruption scandal.  The scandal threatens to undermine Uruguay’s reputation as one of South America’s more stable and well governed countries.

U.S. Congressional Politics:  In the race to become the new Speaker of the House, Republican Kevin McCarthy’s bid remains up in the air due to opposition from his party’s right wing.  McCarthy has acquiesced on requested rules changes that give rank-and-file members more power, including making it easier to oust the speaker, but it’s not clear whether that will be enough to win the gavel when the voting takes place at midday.

U.S. Labor Market:  New analysis from the Atlanta FRB shows that wages for workers who stayed at their jobs were up 5.5% in November from a year earlier, averaged over 12 months.  That marked the biggest annual wage gain in the 25 years of available data.  Moreover, the report showed that workers who changed companies, job duties or occupations saw even greater wage gains of 7.7% year-over-year.

• The wage gains are likely contributing to today’s elevated inflation rates as companies boost prices to cover their higher labor costs.
• All the same, the wage gains haven’t necessarily been enough to offset the higher costs that workers are facing. Data from the Labor Department shows that after accounting for price inflation, wages for all private-sector workers were down 1.9% from the same month one year earlier.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Note to readers: the Daily Comment will go on holiday after today’s Comment and will return on January 3, 2022. From all of us at Confluence Investment Management, have a Merry Christmas and a Happy New Year!

Our Comment today opens with a surprising monetary tightening in Japan that has had a significant impact on global markets 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 the release of a new U.S. spending bill for 2023 that should eliminate the risk of a partial shutdown of the federal government when the current spending authorization runs out at the end of the week.

Japan:  In its latest policy decision, the Bank of Japan kept its benchmark short-term interest rate unchanged at -0.5%, but then surprised investors with a hawkish change to its yield-curve-control policy.  The BOJ said that it would now allow the yield on 10-year government bonds to rise as high as 0.50%, from a limit of 0.25% previously.  BOJ Governor Kuroda insisted that the change was aimed only to improve the functioning of Japan’s bond market, but the move is being taken as a sign that the central bank has finally been forced to respond to rising inflation and the weak JPY.

• The decision has driven important moves in several key markets so far this morning:
  • Japanese 10-year government bond yields jumped to approximately 0.40% immediately after the decision, pushing up government bond yields in many other countries as well.
  • More importantly, the JPY so far this morning has strengthened some 3.1% to 132.59 per dollar, from about 137.00 per dollar before the decision.
  • Japanese stock values fell approximately 2.5% on the prospect of a stronger JPY and higher borrowing rates.
• It remains to be seen whether and how aggressively Japanese monetary policy will continue to tighten. Nevertheless, the reactions to today’s BOJ move illustrate how sharply markets can move in response to a sudden unhinging of policy.  For example, the market reaction suggests a similar big impact on the dollar if the Federal Reserve were to lift its target inflation rate above the current 2.0%.

China:  After abandoning President Xi’s Zero-COVID policy and with a new wave of COVID-19 infections sweeping across the country and disrupting the economy, Chinese state media has taken to describing this “exit wave” as well planned and temporary.  A report in the state-run China Daily today promises “normalcy by spring.”

China-Hong Kong:  Securities regulators in China and Hong Kong have agreed to expand the scope of their “Stock Connect” program, under which investors can access mainland stock markets through the Hong Kong bourse.  Northbound investments can now include stocks that have a market capitalization exceeding about $717 million or that meet certain liquidity criteria. Southbound investments can now include stocks of primary-listed foreign companies that are constituents of Hang Seng composite indices.

• The move will boost the number of mainland stocks eligible for trading via the northbound link to about 2,516, up from the current 1,458.
• Nevertheless, despite other recent signs that the Chinese government wants to ease tensions with the West in order to support its economy, we still believe the long-term geopolitical competition between China and the West will make it riskier and more difficult for U.S. investors to invest in China.

Russia-Ukraine War:  Fighting continues along the front lines running from northeastern to southern Ukraine, while yesterday the Russians launched a new swarm of Iranian kamikaze drones against Kyiv.  Ukrainian military officials believe that the Russians should only be able to launch three or four more rounds of missiles into Ukraine before they will deplete their available inventory, after which they will need to procure Iranian ballistic missiles, which Ukraine would have trouble defending against.  Meanwhile, Russian President Putin traveled to Minsk yesterday but apparently failed to get President Lukashenko’s agreement to deepen Belarus’s participation in the war.

European Union:  As we previewed in our Comment yesterday, EU energy ministers agreed to impose a price cap if month-ahead prices remain above €180 per megawatt hour on the bloc’s main trading hub for three consecutive days. Prices must also be at least €35 higher than a reference level for global LNG during the same period.  The new rule goes into effect on February 15.  One key risk with the policy is that it could prompt shippers to divert natural gas shipments to Asia or other locales where prices may be unregulated and much higher.

United States-European Union:  Facing strong pushback from the EU against its new subsidies for U.S.-made green technology, the Biden administration yesterday delayed its proposed rules for new tax incentives related to electric vehicles.  Details on the battery-sourcing requirements that electric vehicles must meet in order to qualify for up to $7,500 in tax credit will now be released in March, instead of by the end of this year as earlier planned.

• The delay suggests that the administration is showing some alliance-building sensitivity to EU leaders, who worry that the U.S. subsidies will hurt the EU’s green technology sector. Indeed, German Economy Minister Habeck and French Finance Minister Le Maire today issued a joint paper arguing that the U.S. and EU have a mutual interest in swiftly finding common ground on the controversy.
• All the same, it’s important to remember that the U.S. administration has encouraged the EU to adopt similar subsidies as a way to reduce their economic dependence on China.

United States-Congo-Zambia:  Last week, the U.S. signed a memorandum of understanding with the Democratic Republic of Congo and Zambia to provide them with the funding and technical expertise to develop their supply chains for minerals related to electric-vehicle batteries.  The move shows how the U.S. is working to reverse its disadvantage in the supply of exotic minerals needed for the electrified economy of the future.

• Importantly, the U.S. move also has important geopolitical considerations. We assess that the Congo is currently a member of the evolving China-led geopolitical bloc, while Zambia is in the “leaning China” bloc.
• The U.S. move illustrates how the U.S. and China are likely to work feverishly to peel countries out of their adversary’s blocs in order to ensure access to critical mineral supplies.

U.S. Fiscal Policy:  Earlier today, congressional leaders unveiled an agreed spending bill for the remainder of the 2023 fiscal year.  The bill, which must be passed and signed into law by the end of the week to avoid a partial government shutdown, includes $858 billion in military spending, or $45 billion more than President Biden had requested and up about 10% from $782 billion the prior year. It also reportedly includes $773 billion in nondefense discretionary spending, up almost 6% from $730 billion from the prior year.

U.S. Retirement Policy:  The spending bill expected to be signed into law in the coming days also includes several important changes to the laws related to retirement savings.  For example:

• The bill raises the age at which people are required to start withdrawing money from tax-deferred retirement accounts from 72 today to 73 beginning in 2023 and to 75 in 2033
• It also increases the catch-up contributions older workers are allowed to make to their 401(k)-style retirement accounts. In 2023, people 50 and older will be able to contribute an extra $7,500 a year to these accounts. The bill would also raise the catch-up amount to at least $11,250 a year for people 60 to 63 beginning in 2025.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a review of Japan’s new defense strategy, which was released at the end of last week, and illustrates how Japan intends to become a much more powerful military force and a more potent ally as the U.S.-China geopolitical rivalry worsens.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new developments in the massive COVID-19 surge in China and the wave of pre-Christmas strikes sweeping across the U.K.

Japan:  In its updated military strategy, the Japanese government stated that China has now become its main security challenge and that meeting that challenge will require the country to double its defense spending to 2% of gross domestic product by 2027.  Based on current GDP, this would bring Japan’s annual military budget to around $80 billion, putting Japan third in the world behind the U.S. and China.  Importantly, the new strategy says that much of that spending will be on “counter-strike” missiles that could be used to attack military bases outside of Japan.

• The new military strategy shows how Japan has woken up to the threat it faces from China, Russia, and North Korea. The commitment to boosting its defense capability also illustrates how Japan will be a critical ally in the evolving U.S.-led geopolitical bloc as it seeks to defend itself from the aggressiveness of the evolving China-led bloc.
• Pacifists have complained that the counter-strike missile capability may violate Japan’s exclusively defense-oriented posture under the Constitution’s war-renouncing Article 9. However, the government has long viewed the capability as constitutional so long as three conditions for the use of force are met:
  • An armed attack has occurred or is imminent;
  • There is no other way to halt an attack; and
  • The use of force is limited to the minimum necessary.
• The planned increase in Japan’s defense budget also illustrates the big increases in military spending that we expect to see across the globe in the coming years. In our view, those increases will create enticing investment opportunities in the traditional defense industry, software and cybersecurity, and other related industries, especially in the U.S.
  • Japan’s new counter-strike capabilities will ultimately be achieved by extending the range of its homegrown Type 12 stand-off missile.
  • However, in the first five years or so until that modification can be made, Japan will be buying hundreds of U.S.-made Tomahawk missiles.

Russia-Ukraine War:  Although fighting continues along the entire front from northeastern to southern Ukraine, the bulk of the violence remains centered on the eastern city of Bakhmut, which Russian mercenaries have been trying to capture for months.  Meanwhile, Russian President Putin will visit Belarus today to confer with its president, probably in part to signal that Belarus could enter the war in support of Russia and pin down significant numbers of Ukrainian troops in the northwest as a precaution.  Separately, a missile attack on the Russian region of Belgorod suggests the Ukrainians continue to get bolder about bringing the war home to Russia, although the Ukrainian officials, as usual, have not taken credit for the attack.  Finally, Ukrainian officials say that Russia has procured another batch of Iranian drones for use in its continuing campaign to destroy Ukraine’s energy infrastructure and freeze the Ukrainians into surrender.

• Contrary to what some observers think, new reporting indicates that the Russian defense industry remains capable of producing at least basic, relatively low-tech artillery shells and missiles despite Western sanctions. The problem for the Russians is that they are firing those shells and missiles much faster than they can produce them.
  • For example, the analyses show that in June, the Russians were firing 60,000 shells and missiles per day. The rate has recently fallen to about 20,000 per day, but that’s still far more than Russian industry can replace.  An analysis by the Jamestown Foundation indicates that the Russian military has fired so many shells and rockets since it invaded in late February that it would cost roughly $92.74 billion to replace the entire range of munitions that have been used.
  • As a result, the U.S. Defense Department believes that, in early 2023, Russia will need to begin using old, less reliable shells and missiles that were stockpiled decades ago.
• In a separate issue, Israeli defense officials warned that Iran isn’t just providing drones and missiles to Russia for the war, but, in return, it is asking Russia to provide it with ships to build up its navy. The Iranian navy is reportedly keen to increase its operations in waters as distant as the Indian, Pacific, and Atlantic oceans.
  • Iran had previously been hoping to acquire Chinese-made combat ships, but Beijing has proven reluctant to share its military technology.
  • Russia’s reliance on Iranian drones and missiles suggest it could be more amenable to helping Iran acquire ships and related equipment.

European Union-Qatar:  As EU officials continue to investigate an apparent Qatari effort to buy influence in the European Parliament, Qatari officials warned that the investigation would endanger negotiations for Qatar to help replace some of Russia’s energy supplies to Europe.

• Since Russia’s invasion of Ukraine, Qatar has emerged as one of Europe’s best hopes for weaning itself off Russian natural gas. Germany, France, Belgium, and Italy have been in talks with Qatar to buy LNG on a long-term basis.
• If Qatar acts on its threat to ratchet back energy supplies to the EU, even as supplies from Russia remain largely cut off, it could undermine the recent improvement in sentiment about EU economic prospects and have a negative impact on European stocks.
• On a closely related note, EU energy ministers today are expected to agree on a price cap of €188/MWh for natural gas in an attempt to stabilize and push down energy prices for consumers. However, some large EU countries are still pushing back on the idea out of fears that the price cap could remove the incentive to economize on use and send some gas shipments abroad.

United Kingdom:  Prime Minister Sunak is convening a cabinet meeting today to develop a plan for dealing with the massive wave of pre-Christmas strikes rolling across the country.  Nurses, ambulance drivers, customs and immigration staff, postal staff, and rail workers will all walk out in the coming days, leaving the government with a growing logistical and political headache.

• Public support for the strikes remains relatively strong, prompting many even in Sunak’s own Conservative Party to urge him to sign off on pay raises, particularly for nurses.
• Of course, doing so would further worsen the government’s finances. In any case, the strikes could also weigh on the British economy and stock market, on top of the recent energy crisis.

China:  As expected, the country’s recent abandonment of its Zero-COVID policies has left the disease running rampant in major cities, causing widespread business disruption as staffing shortages threaten to close down factory production lines and transportation workers fall ill.  Companies have reportedly been left with no direction on how to handle the sudden surge in cases, after they had formerly been operating under strict guidelines handed down by local governments.  As we have previously predicted, the disruptions are likely to weigh on the Chinese and global economies in the coming months until the new “exit wave” runs its course.

China-Australia:  China’s foreign ministry has invited Australian Foreign Minister Penny Wong to attend a renewed Australia-China Foreign and Strategic Dialogue this week, restarting a series that has been on ice since 2018 because of worsening geopolitical tensions between the countries. Just as concerns about China’s economic growth likely played a major role in its abandonment of its Zero-COVID policies, those same concerns appear to be driving China to improve relations with several countries in the evolving U.S.-led geopolitical bloc.

U.S. Energy Policy:  New data suggests that this year’s emergency releases from the U.S. Strategic Petroleum Reserve have left the federal government about $4 billion ahead.  With the sales set to end this month, Washington has sold 180 million barrels of crude at an average of $96.25 a piece, well above the recent market price of $74.29.  Unfortunately, that paper gain may not materialize if prices rebound ahead of any efforts to replenish the reserves.

U.S. Economic Performance:  In a new poll by the Wall Street Journal, a majority of respondents said that they expect the U.S. economy to be worse in 2023 than it was this year, despite the recent cooling in inflation.  The finding is consistent with our view that a recession is likely to begin in the first half of 2023.  Of course, the pessimism could also become self-fulfilling if it means consumers pull back on spending to build a financial cushion for tough times ahead.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Today’s Comment begins with our thoughts about European fragmentation. Next, we discuss how countries within blocs may prioritize their own self-interests over others within their group. Lastly, we review signs that the global economy may enter a recession in 2023.

 Fragmentation Returns: The bond market is unsettled with the European Central Bank’s plan to wind down its balance sheets and accelerate rate hikes

• The ECB is poised to ramp up its tightening cycle in 2023 as it looks to combat inflation. On Thursday, ECB president Christine Lagarde announced that the central bank planned to raise interest rates higher than the market anticipated and wind down its balance sheets starting in March. The bank plans to hike rates in 50 bps increments and reduce its balance sheet by 15 million euros per month, on average, until the end of the second quarter of 2023. When explaining the need for the aggressive decision, Lagarde argued that the ECB has more ground to cover to catch up with the Fed.
• The market responded negatively to the ECB’s hawkish tone. The Euro Stoxx 50 closed down 2.6% on Thursday. Meanwhile, the 10-year yield on Italian bonds jumped 25 bps, pushing its risk premium above the German 10-year bond by 207 bps. The market reaction suggests that investors would like to receive more yield from retaining riskier assets. That said, the central bank’s tough talk did help boost the EUR. The currency peaked at $1.0737, its highest level since June 9, as investors believe that the ECB is prepared to take on inflation.
• At this time, the ECB may not actually be able to tighten policy as much as it claims. Tightening monetary policy aggressively creates diverging borrowing costs among eurozone countries. Differing interest rates will make it harder for the European financial system to operate as a single entity. Although the ECB has developed anti-fragmentation instruments to address these issues, committee members are reluctant to use those tools. As a result, it is more likely that if bond spreads get too out of whack, the ECB could moderate its policy stance.

Friend or Foe? Inter-bloc rivalries may undermine efforts to form regional blocs and could lead countries to become isolationist.

• The U.S. and the European Union are still at loggerheads over the “made-in-America” provision in the Inflation Reduction Act. The law allows U.S.- based firms to receive a tax break if they source materials from American suppliers for parts used to make goods such as electric vehicles. France believes that the regulation will disadvantage European companies. Meanwhile, American think tanks posit that the bill will help the U.S. compete with China. The dispute could turn into a trade war between the U.S. and Europe and undermine efforts to integrate economic and foreign policies.
• Things are not any better in the potential Chinese-led bloc. India has purchased Russian oil under the G-7 price cap. Before the cap was established, Russia insisted that it would not supply countries who complied with the rule. Additionally, China has banned the sale of military-grade processors to Moscow in order to comply with U.S. sanctions. The decision by India and China to follow western sanctions on Russia suggests that countries may not be loyal to their bloc if it goes against their respective interests.
  • This could potentially have geopolitical implications as smaller blocs may form within larger blocs. For example, OPEC countries (who are generally aligned with China) could respond by reducing production, thereby harming other members of the China-led bloc.
• The interwar period between World War I and World War II was the last time countries were truly deglobalized. Although there were military alliances, the lack of a definitive reserve currency made it difficult for countries to maintain trade blocs. As a result, countries were very centralized, and global trade was relatively limited when compared to pre-WWI. As the U.S. withdraws from its position as a global hegemon, other countries may seek to also disengage from the rest of the world. This scenario could lead to higher inflation, which should benefit commodities. As the chart below shows, commodities generally perform well relative to stocks in an inflationary environment.

(Source: Longtermtrends.com)

Warning Signs: There are mounting signs that the global economy may have a rough ride in 2023.

• U.S. economic data shows that the world’s largest economy is slowing down as retail sales and manufacturing dropped in November. The weak economic data shows that consumption and production are waning, adding to woes that the U.S. may be headed toward recession over the next few months. Additionally, firms are becoming wary of the number of workers on their payrolls, and even government agencies are feeling the pinch. As a result, unemployment numbers may rise next year as firms adapt to a decline in demand.
• The COVID spread in China also poses a risk to the global economy. As Beijing slowly starts to reduce its Zero-COVID restrictions, the death toll is beginning to surge. The spread of the virus will make it difficult for the world’s second-biggest economy to purchase global goods and could further complicate supply-chain flows. As a result, international firms could take a hit in revenue and see an uptick in their input costs. Although the drop in Chinese demand could weigh on global inflation, it is also possible that it would make it harder for countries reliant on exports to grow their economies.
• Lastly, there is still rising uncertainty about how major central banks will adjust monetary policy during a recession. Although it is tempting to assume that they will abandon tightening when the economy weakens, the central banks are mandated to reduce inflation to around 2%. Given that these banks aim to maintain unemployment and price stability, it wouldn’t be unreasonable for them to keep rates elevated even when the economy is in recession. As a result, we advise that investors be strategic in their allocations and pay closer attention to shorter-duration assets until the Fed signals that it is prepared to ease monetary policy.

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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 the Federal Reserve’s rate decision from Wednesday. Next, we provide an overview of both the European Central Bank and Bank of England’s decision to tighten monetary policy. Lastly, we give our thoughts about the latest chapter in the fight against global inflation.

 The Fed Presses On: Fed Chair Jerome Powell insists that the Fed will tighten policy until it makes noticeable improvements toward its 2% inflation objective; however, the market is not convinced.

• The Federal Reserve reduced the size of its rate hike but warned markets that peak interest rates would be higher than it had previously anticipated. On Wednesday, the Federal Open Market Committee raised its benchmark rate by 50 bps to a target range of 4.25% to 4.50%. During a press conference, Powell stuck to the Fed statement and maintained that the central bank’s fight against inflation is not over. The latest dot plot shows that the overwhelming majority of Fed officials support peak fed funds above 5.0% in 2023, while the following year shows a sizeable dispersion around a median range of 4.1% (See chart below). As of this morning, Eurodollar futures signaled terminal fed funds of 4.9% in 2023 and 3.4% the year after.
  • Despite his hawkish talk, Powell let slip that the Fed could reexamine its 2% inflation target at some point in the distant future, signaling that the Fed could become significantly more dovish over the next few years.

• The market reaction was mixed. Equities appeared to have accepted that the Fed will raise rates higher than initially anticipated. Although the S&P 500 fluctuated following the announcement, it ultimately closed down 0.6% from the previous trading day. The dollar and bond market had a somewhat muted response to Powell. The U.S. dollar index closed down 0.12% from the prior day. Meanwhile, the spread between the 2- and 10-year Treasury narrowed to a paltry 3 bps lower in the same period. The lack of a reaction suggests that fixed-income and currency traders believe that the Fed will not tighten policy in a downturn. If they are right, the U.S. dollar could weaken in 2023.
• A strong economy and a tight labor market will likely allow the Fed to raise rates without much hassle. However, an economic downturn could complicate matters. The latest summary of economic projections shows that the median forecast for GDP growth will be 0.5% for 2023, with some officials predicting a contraction. A recession could lead the Fed to discontinue hiking rates and, if it is severe enough, could force the central bank to cut rates. An inflation rate of less than 3% could also lead to a Fed pivot, but this is more fantasy than anything. At this time, it appears that the Fed would like to either hike or pause depending on the economic data.

 Other Central Bank News: The European Central Bank and the Bank of England followed the Federal Reserve’s lead but are likely less committed to raising interest rates in 2023.

• The ECB and BOE have both decided to raise interest rates by 50 bps. The two central banks have elected to downshift their hikes to accommodate for a slowdown in inflation and economic growth. The BOE lifted its bank rate from 3.0% to 3.5%, while the ECB pushed its deposit rate from 1.5% to 2.0%. Although the banks maintained that their peaks are likely higher, it appears that both are paying attention to the economic ramifications of continuing to tighten policy. Unlike the Fed, the BOE and ECB are both predicting recessions for 2023.
  • There was a stronger-than-expected consensus at the BOE. Six of the nine members voted for a 50 bps hike, one for a 75 bps hike, and the other two members wanted policy to remain unchanged. This suggests that the BOE has become more dovish.
• The ECB is signaling that it would like to tighten policy more aggressively, but it is unclear if it has the policy flexibility to do so. In its statement, the ECB announced plans to wind down its €5 trillion balance sheet in March 2023. The move comes as the financial stress, as measured by the spread between 10-year German and Italian bonds, has declined more than 50 bps since September. That said, as interest rates rise it will likely worsen European fragmentation. Additionally, ECB President Christine Lagarde stated that the bank could continue hiking rates in 50 bps intervals. Tightening policy during a recession will likely be politically unpopular, and, as a result, the ECB may be more assertive in the short-term to maneuver its policy rate into restrictive territory before it begins receiving pushback.
  • Another sign that they may not raise rates throughout 2023, is that it appears that these is not a strong consensus among council members.
• The tighter monetary policy within these countries may not be as long-lived as these banks are implying. Both the Eurozone and the U.K. are either in or headed toward contraction. As a result, these countries risk harming their economy with higher rate hikes. Although this does not mean that these central banks will cut rates in 2023, it does signal that they are close to finishing their tightening cycle. Assuming that the U.S. does not enter a deep recession, this outcome should be supportive of the dollar as it will likely mean that European inflation will be a persistent problem.

 A New World: Central Bankers are unlikely to be as hawkish in 2023.

• Unlike the U.S., there may not be policy space for other central banks to tighten more than needed. In Europe, governments are becoming more comfortable in dealing with the problem through subsidies and price ceilings. The U.K. and Germany have funded payments to households and businesses to offset rising energy costs. Meanwhile, the Netherlands will implement rental caps to deal with shelter shortages. The government interventions should help reduce inflationary pressures and allow the central banks to become more measured in how they raise rates; however, there is an additional risk of higher inflation volatility in the future once these caps are removed.
• That said, there are many headwinds that could prevent banks from abandoning rate hikes altogether. The major unknown is how China’s reopening will impact global price pressures. China’s recent decision to accept western medicine to help contain the COVID virus shows how eager the government is to reopen. Although there has been much discussion about the future demand for commodities, there is also the possibility of an improvement in supply chains due to the lessening of restrictions. Additionally, rising union power and the war in Ukraine are also likely to boost price pressures as the potential rise in wages and raw materials could force firms to push cost adjustments onto consumers.
• Major central banks are entering a new phase of their tightening cycle. Monetary policymakers will begin to look for signs that they should moderate policy rather than continue to tighten it. Assuming that prices continue to fall globally, we expect the ECB and BOE to be the first of the five major five central banks (which include the Swiss Central Bank, the Federal Reserve, and the Bank of Japan) to signal a pause in tightening. This should make equities within these countries relatively more attractive when compared to the U.S.

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