by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the expected surge in COVID-19 infections in China after it relaxed its pandemic regulations.  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 in the Russia-Ukraine war and the beginnings of a wave of strikes in the U.K.  We discuss today’s U.S. inflation data in the “U.S. Economic Releases” section below.

China: Following the government’s recent relaxation of its COVID testing and quarantine policies, a range of indicators suggests the disease is now ripping through the country.  Hospitals and clinics are reportedly facing a surge in cases, although it is still a bit too early for deaths to be rising dramatically.

• Experts predict the new wave will peak in one to three months, with some 60% of the population infected—probably enough to ensure significant economic disruptions as people self-quarantine and businesses face mass absenteeism.
• Those trends are likely to weigh heavily on China’s economy and financial markets, which in turn is likely to present headwinds for the global economy and financial markets.

China-United States: The Chinese Commerce Ministry yesterday filed a complaint with the World Trade Organization against the massive new U.S. restrictions on selling advanced computer chips, chipmaking equipment, and related components and services to China.  The filing comes just days after the WTO ruled against the Trump administration’s imposition of steel and aluminum tariffs against China and other countries based on national security concerns.

• The Biden administration’s restrictions, issued in October, essentially amount to a blockade of advanced information technology going to China in order to suppress the country’s military and economic development.
• In each case, however, the WTO ruling is unlikely to have legal effects because its Appellate Body has been suspended over disagreements among the WTO’s member states. The new U.S. restrictions will likely remain a key source of friction between the U.S. and China and will probably limit China’s technological development going forward.

China-India: Chinese and Indian troops have once again skirmished along the China-India frontier high in the Himalaya mountains.  In contrast with the big 2020 skirmish that killed approximately two dozen, the latest fight only produced minor injuries and was apparently very short-lived.  Nevertheless, the incident serves as a reminder of the geopolitical risks involved as the two countries jockey to maintain control over their frontiers in the Himalaya region.

European Union: Ambassadors from the EU’s member states last night reached a deal with Hungary that will allow the EU to implement a new minimum corporate income tax of 12% and provide some €18 billion in support for Ukraine.  In return, the EU committed to approve Hungary’s €5.8 billion COVID-19 recovery plan, which has been held up since last year because of EU concerns about rule-of-law policies in Hungary.

• In a separate deal today between EU national governments and the European Parliament, officials agreed to impose a tax on imports based on the greenhouse gases emitted to make them, inserting climate regulation for the first time into the rules of global trade.
• The “carbon border adjustment mechanism” has angered a number of EU trading partners, especially some emerging markets that emit relatively large amounts of greenhouse gases when producing goods for the EU market.

Russia-Ukraine War: Heavy fighting continues along the frontlines in eastern and southern Ukraine, with the Russians continuing to mount air, missile, and drone strikes against Ukrainian civilian energy infrastructure throughout the country.  Meanwhile, the Ukrainians launched yet another attack on a key bridge in the Russian-occupied city of Melitopol and put it out of action.  That attack demonstrates Ukraine’s ability to strike Russian forces deep inside occupied territory.  It also shows their intention to keep attacking throughout the winter to prevent the Russians from regrouping.

• President Putin has signed a law allocating over nine trillion rubles (about $143 billion) to defense, security, and law enforcement for Russia’s federal budget in 2023.
  • That amount is about 8% of Russia’s 2021 gross domestic product, and probably an even greater proportion of Russia’s 2022 and 2023 GDP. It also implies that Russia’s defense burden is now more than twice that of the U.S., and several times more than the defense burden in many European countries.
  • The U.K. Ministry of Defense has also assessed that as Russia’s defense spending has significantly increased, it will now represent over 30% of Russia’s entire 2023 budget. This suggests that in order to pay for the war, Putin will have to defund many civilian budget accounts, thereby further undermining the economy.
• Illustrating President Putin’s worsening domestic political position, the Kremlin announced that his annual marathon news conference, in which he takes questions from the public, has been cancelled for the first time in a decade.

Turkey-Greece: As the latest spat in a decades-long series of bilateral disputes, Turkish President Erdogan warned that his country has developed a new medium-range missile that could be fired at Athens if Greece continues to build up its military forces on the Aegean Sea islands close to Turkey.  Although disputes like this have gone on for decades, Erdogan’s assertiveness has raised the risk of a destabilizing conflict between two key NATO members.

United Kingdom: Railroad workers have begun the first of four days of strikes this week in their dispute over pay levels, job security, and working conditions.  The strikes are already snarling transportation throughout the country, but that’s just the first blow for the government as a range of public employees are also set to strike in the coming weeks, including nurses, ambulance drivers, postal workers, border and customs officers, and highway workers.  The wide range of strikes will likely be an additional headwind for the British economy and stocks as the country struggles to deal with its winter energy crisis.

U.S. Monetary Policy: The Fed today begins its latest two-day policy meeting, with the decision due to be released on Wednesday afternoon.  Policymakers are widely expected to hike their benchmark fed funds interest rate by just 0.5%, to a range of 4.25% to 4.50%, after four straight hikes of 0.75%.  They will also release their updated forecasts for key economic indicators and the path of interest rates going forward.

U.S. Fiscal Policy: As congressional leaders scramble to avoid a partial government shutdown when the current funding law expires on Friday night, Senate Majority Leader Schumer said negotiations over the weekend were successful enough to warrant a one-week extension in order to finalize a funding deal for the rest of the fiscal year.  Senate Minority Leader McConnell also signaled that an omnibus spending bill remained a viable option, but he said that Democrats needed to meet Republican conditions.  In any case, the statements suggest Congress will avoid the threat of a government shutdown, which would probably push down financial markets.

U.S. Stock Market: The SEC will vote tomorrow on four proposals aimed at lowering costs for small investors.  The new rules would effectively curtail “payment for order flow” and force brokers and market-making firms to execute deals at the best price available.  For example, the new rules would require brokers to auction customers’ orders and publish detailed data showing how orders were carried out.

U.S. Cryptocurrency Market: Sam Bankman-Fried, founder and CEO of now-bankrupt crypto exchange FTX, was arrested yesterday in the Bahamas after the U.S. Justice Department filed criminal charges against him related to the exchange’s collapse.  The indictment against Bankman-Fried is due to be unsealed this morning.  Also this morning, the U.S. Securities and Exchange Commission sued Bankman-Fried for securities fraud.

• Bankman-Fried had been expected to testify before Congress today regarding the collapse of FTX, but now that will not happen. However, current FTX chief executive and workout specialist John Ray III will testify.
  • Ray will likely unveil even more damning evidence of how poorly FTX was run as he already has during his short tenure at the company.
  • In his prepared testimony for today, Ray will say that FTX’s collapse “appears to stem from the absolute concentration of control in the hands of a very small group of grossly inexperienced and unsophisticated individuals” who failed to implement the controls “that are necessary for a company that is entrusted with other people’s money or assets.”
• The latest developments in the FTX saga, in conjunction with the many other crypto bankruptcies this year, will likely continue to be a black eye on the industry and make it even harder for crypto assets to regain their previous high valuations, at least in the near term.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a major scientific success that could help improve energy supplies in the coming years.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a scandal over Qatar’s effort to buy influence in the European Parliament.  We also provide a preview of this week’s Federal Reserve policy meeting and the looming deadline to prevent a partial shutdown of the federal government.

Global Energy Supply:  U.S. government scientists have reportedly achieved a net energy gain in a nuclear fusion reaction for the first time ever.  Although industrial-scale fusion is still probably decades away, this breakthrough boosts hope for a future in which energy supply is virtually limitless, emits no carbon, and produces no harmful wastes.

European Union-Qatar:  Over the weekend, Belgian police launched a series of raids on EU politicians’ homes, arrested a member of the European Parliament, and seized €600,000 in cash as part of an international investigation into an attempt by Qatar to buy influence in the bloc’s legislature.  The scandal has already triggered official resignations and the suspension of a parliamentary vote, due next week, which would have granted Qatari nationals visa-free travel to the bloc.

Eurozone:  The European Central Bank has warned that the Eurozone’s banking system is at risk of mounting bad loans and is having a funding squeeze due to rising interest rates, high inflation, and a likely recession.  The ECB therefore plans more frequent inspections of bank offices and will carry out more “targeted reviews” of the largest lenders in the zone in order to push them to address those risks.  Even though the European economy has recently been holding up better than many observers expected, the ECB statement is a reminder that the zone’s banking system faces both economic and regulatory risk in the near term.

Russia-Ukraine War:  Heavy ground fighting continues in northeastern Ukraine along the borders of the Donbas region, while the Russians used an apparently replenished supply of missiles and drones to cripple more of the Ukrainians’ energy infrastructure.  Meanwhile, a Ukrainian artillery strike reportedly killed dozens of Russian troops barracked in a hotel complex in Ukraine’s southeastern city of Melitopol.  The successful attack, which targeted Russia’s mercenary Wagner Group, illustrated how the Ukrainians are continuing to make highly effective use of advanced weapons provided by the West to inflict high casualties on the Russians.

Iran:  In a continued effort to stamp out the recent anti-government protests raging throughout the country, the government hanged a second protestor this morning after he was convicted of stabbing two security force members to death and injuring four others in the holy city of Mashhad.  With at least ten other protestors now on death row, the government may hang more protestors in an attempt to intimidate the opposition but doing so could also risk enflaming opponents of the government.

China:  New research indicates that China has not only lent some $1 trillion to less-developed countries around the world as part of its Belt and Road Initiative (BRI), but the People’s Bank of China has also loaned hundreds of billions in foreign reserves to those countries via currency swaps.  In contrast to the highly transparent, conditional, short-term swaps provided by the Federal Reserve to key U.S. trade partners, the PBOC swaps are highly opaque and often rolled over continuously, making them tantamount to a bailout for countries that have often defaulted on their debts or are likely to have trouble repaying their BRI loans.

• Researchers estimate that the average interest rate on the swaps is about 6%, making them more expensive than the swaps provided by the Fed to other central banks to swap their currencies for dollars. The swaps would also be more expensive than the typical International Monetary Fund loans to poor countries.
• As the world fractures into relatively separate geopolitical and economic blocs, the PBOC swaps illustrate how China’s approach to its evolving bloc is likely to be much more coercive than the U.S.’s traditional cooperative approach to its allies. As the Chinese-led bloc evolves, we suspect Beijing will essentially take a neo-colonial or even neo-imperialist approach to its bloc.

U.S. Monetary Policy:  The Fed will hold its latest policy-setting meeting this week, with their decision due to be released on Wednesday afternoon.  The policymakers are widely expected to hike their benchmark fed funds interest rate by just 0.5%, to a range of 4.25% to 4.50%, after four straight hikes of 0.75%.  They will also release their updated forecasts for key economic indicators and the path of interest rates going forward.

• If the Fed begins hiking rates more slowly, as anticipated, it will confirm a looming divergence between U.S. and European interest rates. Since inflation is expected to be stickier in Europe, its major central banks may well keep hiking their benchmark rates aggressively even as the U.S. central bank hikes begin to slow.
• That prospect probably goes far toward explaining the recent weakening in the dollar versus European currencies. The weakening of the dollar is likely to continue giving a boost to European stocks.

U.S. Fiscal Policy:  Congressional leaders will be scrambling this week to reach a deal on a full-year spending bill or to pass a short-term funding measure to avoid a partial government shutdown when the current funding law expires on Friday.  Any sign of serious struggles to reach a deal or any display of brinksmanship could well push markets lower before the issue is resolved.

U.S. Energy Policy:  In an interview with the Financial Times, top White House energy advisor Amos Hochstein said that Wall Street’s pressure on energy companies to funnel this year’s high profits back to investors rather than investing in new production is “un-American” and hurts U.S. families.  However, the interview will do little to reverse energy companies’ complaints about mixed messages from the Biden administration, as Hochstein also argued that firms should eventually help shift the economy away from its dependence on oil and gas.

U.S. Winter Storm:  A major winter storm that pummeled California with heavy rain and snow over the weekend is now moving eastward and is expected to create difficult winter conditions throughout the central Great Plains and Midwest in the coming days.  While the storm may have helped ease California’s long drought, it is expected to disrupt transportation and other economic activity across much of the country.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equity prices have tanked, and the U.S. dollar surged following the hotter-than-expected Producer Price Index report. Today’s Comment begins with discussing the effectiveness of price caps in deterring Russia’s war effort. Next, we examine some possible changes to inflation and how these could impact Fed policy in 2023. We end with a talk about the risks China’s reopening poses to the global economy and markets.

Price Cap, So Far: The EU limit on the price of Russian oil is already causing unintended consequences, but it isn’t clear whether Moscow’s war aims will be affected.

• Confusion over insurance papers have led to a backlog of oil tankers in the Turkish Strait. There are currently 28 tankers carrying more than 23 million barrels of oil being held up because of paperwork. Although Western countries have agreed to ban shipping service providers like insurance companies from delivering Russian oil above the price cap, many of the stuck ships contain Kazakh oil. Turkish and Western officials are working to resolve the matter, but there is still a chance of future problems given the complicated nature of enforcing sanctions. Oil prices were little affected by the event.
• Despite the hassle, there is no guarantee that the price cap will work. The $60 price level is below the $70 a barrel outlined in Russia’s latest budget proposal. Although the limit is beneath the Kremlin’s desired level,  the difference can be made up through borrowing or increased spending from the wealth fund. Russia’s ability to fund the war despite the price caps suggests that the West will have to look for other ways to punish Moscow. Currently, the EU is working on a cap for natural gas prices, but countries appear to be far apart on a deal. That said, the limits on Russian natural gas mean that the EU will need to import large volumes of the product to make up for the resulting shortfall.
• There is still no sign of war de-escalation, but an end in 2023 isn’t out of the question. Although Russian President Vladimir Putin insists that the war will likely be long, he downplayed the possibility of another mobilization. His hesitancy to call up new soldiers is likely related to concerns of public outcry over the war. Over 370k Russians fled the country within two weeks of the first mobilization. The large-scale departures highlighted the level of dissatisfaction within the country concerning the escalation of the war. Given that Putin stands for reelection in March 2024, he may be swayed to support a temporary resolution next year if he can spin it as a victory.
  • A possible end to the conflict in Ukraine would be favorable to financial assets and reduce volatility in commodity markets.

Inflation Easing: Although the annual change in the Consumer Price Index is well above the Fed’s 2% target, there are signs that price pressures are easing.

• An increase in inventories has led to a slowing of price increases in various sectors. Used car prices, which were a major contributor to inflation in 2021, are finally started to decline from record highs. Meanwhile, an increase in property developments has reduced demand for rentals. Although these are anecdotal evidence of a decline in prices, the recent Purchasing Manager Index data suggests that supply chain issues that prevented firms from getting needed material are much improved from the previous year. As a result, it is likely that inflation will continue its downward trend throughout 2023.
• That said, wage pressure and regulations will likely prevent inflation from hitting the Fed’s 2% target in the coming year. Nominal hourly earnings have remained stubbornly high even as inflationary pressures have eased. Meanwhile, new climate regulations also present a risk to consumers as businesses offset costs through price hikes. Input inflation data collected by the Bureau of Labor Statistics show that trade services, which measure wholesale and retail margins, are well above their pre-pandemic levels and remain one of the primary drivers of supplier price pressures. The November figures indicate that margins are holding up even as the economy slows. As a result, firms have no incentive to shoulder unexpected cost increases due to new regulations.

• Although price pressures are easing, it isn’t clear what inflation rate the Fed will seek before it decides to pause or pivot. Federal Reserve Chair Jerome Powell maintains that the bank needs to see clear progress that inflation has turned a corner before the Fed will change course. The lack of clarity shows that the Fed may not have a consensus. If this is true, there will likely be more dissents after the FOMC meetings, especially as the economy falls into recession. As a result, investors should pay closer attention next year to Fed speeches of voting members for clues on future policy.

COVID Uncertainty: China is expected to relax many of its Zero-COVID policies; however, the impact on the global economy may be more complex than investors realize.

• The removal of restrictions is expected to lead to a massive jump in infections. Although the transition will be slow, it is predicted that the next wave could lead to a total death range between 1.3 and 2.1 million. The rise in infections will likely prevent many workers from returning to their jobs due to fears of contagion. As a result, factories may not be able to produce at very high levels. Additionally, a lack of restrictions could cause infections to spread into neighboring countries.
• As Chinese consumers re-enter the market, the demand for commodities such as oil will likely rise. It is estimated that crude prices could surge above $100 a barrel next year following China’s reopening. This is unwelcome news for the rest of the world, as the recent decline in energy pressures helped push down global inflation. Thus, the rise in commodity prices may make it difficult for major central banks to ease monetary policy. Additionally, it could worsen the energy crisis in Europe and lead to a more severe recession on the continent.
• The impact that the end of Zero-COVID will have on equity markets will likely be revealed over the next several months. If Beijing can ramp up the number of vaccinations, it should save many lives. Additionally, if people decide to isolate themselves while the infections spread, demand for energy products will not be as pronounced. The best-case scenario for markets is for China to take a moderate approach. If they do reduce Zero-COVID restrictions slowly enough for investors to adjust and adapt, the overall impact may be positive for the global markets; however, a hastened approach could lead to disaster.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with our thoughts about the deepening yield curve inversion and who stands to benefit. Next, we explain why we think major powers will look to make friends with commodity-rich countries. We end our report with a discussion on the impact that global fracturing will have on tech stocks.

Breaking news: WNBA player Brittney Griner was freed in a prisoner swap for an arms dealer. 

Inversion deepens:  In recent weeks, we have seen a general decline in U.S. Treasury yields.  However, the bulk of the declines have occurred in the longer duration segment of the yield curve, causing a deeper inversion. Interestingly enough, the decline in interest rates has supported international equities.

• Recession fears and doubts about the Fed’s willingness to further tighten policy have led to a decline in both the short and long end of the yield curve. The two-year Treasury has dropped 40 bps from a month ago, but the ten-year Treasury has fallen even more, at 70 bps over the same period. As a result, the yield curve inversion is at its lowest point in over 40 years. The depth of the yield curve inversion has added to concerns that the recession could be worse than the market anticipates; however, the decline in interest rates has some unexpected beneficiaries.

• The decline in U.S. Treasury yields has made riskier assets more attractive. Despite being down nearly 9% on the year, the Euro Stoxx 50 index is up more than 18% on the quarter. The rally in European equities is related to optimism that inflation is close to peaking, the dollar is in decline, and the situation in Ukraine won’t markedly deteriorate. Although Europe is still expected to fall into recession next year, it seems that the market is starting to believe it won’t be as bad as originally thought.
• Although the market has been pricing in a U.S. recession over the last several months, investors are still unclear as to whether the downturn will be severe. There are likely three scenarios that will lead to a deep recession: a financial collapse, a housing market crash, and a major geopolitical event. At this time, any of these events could occur. In fact, the National Association of Home Builders suggests that the housing market is already in recession. Meanwhile, deteriorating financial conditions and the ongoing war in Ukraine are also current risks. Investors have likely discounted most of these risks, but there may still be more room for equities to drop. In the event of a crisis, the Fed could be swayed to cut rates drastically; thus, next year could lead to a strong rally.

An Uncertain World: Commodity-producing countries present a major risk to the global economy.

• Peruvian President Pedro Castillo was replaced by Dina Boluarte after his failed attempt to change the constitution in order to avoid impeachment. Boluarte will be the country’s sixth president in less than five years. All things considered, the transition of power went rather smoothly, but Boluarte will likely be plagued by the same corruption scandals as her predecessor. At the same time, her not being elected to office will likely encourage the opposition to push for new elections. Political turmoil in a resource-rich country like Peru has the ability to cause volatility in commodity prices such as copper, gold, and zinc.
• Meanwhile, U.S. officials are fretting over how the Chinese reopening will impact the price caps on Russian oil. Hopes of an increase in Chinese demand have boosted crude prices after four sessions of declines. Russian Urals crude oil trades at about a $20 discount to benchmark crude prices, suggesting a price of around $57 per barrel as of this morning. Although the cap is set at $60 per barrel, there are concerns that if the market price for the Urals rises above that limit, Russia will stop supplying oil to certain countries. Although the agreement to establish price caps allows for readjustment every two months, a limit set above $60 per barrel would undermine this effort to punish Moscow for the war.
  • Although price caps remain above the Russian production cost, estimated to be $40 per barrel, it is still below the $70 per barrel needed for Russia to maintain its fiscal budget.
• Securing commodities within these countries will likely worsen as the world forms into blocs. As a result, leaders of the groups, who we assume will be China and the U.S., will have to increase their engagement in other parts of the world to ensure that the commodity markets remain stable. This new reality likely explains why the U.S. is relaxing tensions with Venezuela, and why China is building closer ties with Saudi Arabia. As a result, commodity-rich countries could become major investment targets as the U.S. and China vie for their interests.
  • Saudi Arabia and China are expected to sign an investment agreement and discuss the possibility of pricing oil in CNY.

Tech Pushback: Government restrictions and political scrutiny are leading to headwinds for the tech sector.

• The West is attempting to block China from securing advanced chips for defense purposes. The Netherlands is working with the U.S. on plans to curb the export of semiconductors to China. The decision comes as the U.S. and EU team up to reduce China’s ability to impose its influence worldwide. China is heavily dependent on chip imports, and it is estimated that the country spends more on semiconductors than it does on oil (see following chart). As a result, foreign suppliers to China will take a revenue hit, while domestic chipmakers could see a boost in investment.

• Meanwhile, social media giants are also being caught in regulatory crosshairs. The Biden administration is pushing the Supreme Court to hold social media companies liable for hate speech promoted on their platforms. Similarly, the push to ban TikTok is gaining momentum after South Dakota barred the use of the app for state agencies over national security concerns. Social media sites generate much of their revenue based on clicks and the data collection of their users; thus, limits on either would hurt the profitability of these firms. As a result, social media sites’ abilities to generate money is likely to be constrained by government regulations.
• The tech sector thrives in a globalized world, and therefore, regional fracturing would significantly disrupt the industry. Tech has the highest exposure to foreign markets when compared to its peers (see the following chart). Its vulnerability to foreign markets means that restrictions will likely have an adverse effect on the industry’s ability to generate revenue. As a result, we believe that investors should be hesitant to pile into tech stocks without a deep understanding of these companies’ susceptibility to regulatory risks. Hence, a Fed pivot should not be the only factor when investing in tech stocks.

Source: Globalxefts

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning, on this 81^st anniversary of the surprise attack on Pearl Harbor.  Only a few surviving servicemen will visit this site today, a reflection of the aging of the WWII generation.  A 17-year-old serviceman in 1941 would be 98 today. In the markets it is another rather quiet morning.  Earlier this morning, U.S. equity futures and oil were lower but have turned higher in the past hour while the dollar is mixed.

In today’s Comment, our coverage begins with China news.  International news comes next, and our update on the war in Ukraine follows.  Coverage of economic and market news is next in line, and we close with a roundup of U.S. news.

China News:  China is moving rapidly to ease COVID restrictions and there is some evidence of a thaw in U.S./China tech relations.

• So far, there has been no national announcement of an end to Zero-COVID policies, but we are seeing a rapid dismantling of the restrictions. Here are some of the changes:
  • The Beijing Capital Airport has dropped its negative test requirement to enter terminals. If this becomes adopted broadly, it should dramatically ease air travel in China.
  • Instead of sending infected patients to quarantine centers, those afflicted can now convalesce at home. Unfortunately, because there have been no national guidelines issued, local government reactions have been varied.  Some podcasts we monitor on China report that local officials sometimes weld rebar on doors to ensure that those with the virus don’t venture out.  In other areas, citizens are self-policing.
  • Testing requirements are ending in most areas.
• An important element of the adjustment to policy is expanded vaccinations. A key worry is the low level of immunizations found among the elderly, who are especially vulnerable to COVID.  China is facing strong resistance to vaccination among its older population.
• This opening brings risks with some models suggesting up to one million deaths could result. But with rising social unrest and a soft economy, Beijing likely feels it has little option but to ease restrictions.  As we noted yesterday, the narrative around the Omicron variant is that it isn’t as deadly as earlier strains.  Although there is some data to support that idea, it is also true that in the West, by the time Omicron was circulating, vaccinations and widespread infections were already in place and resistance was therefore elevated.  In China, with fewer vaccinations and infections, the fast-spreading variant could be a problem.
• A surge in infections could not just overburden the health system, it could expose health workers to the virus.
• The recent actions to thwart China’s efforts to acquire advanced semiconductor chips and the tools to build them is leading to some adjustments. Corporate America is generally opposing the turn against China and their lobbying efforts are leading Congress to ease restrictions.  On China’s side, Beijing is allowing U.S. officials to enforce export controls to ensure that chips don’t end up in the hands of the military.  We don’t think these measures will change the trajectory of policy, but it does show how hard it is to enforce economic restrictions on a country like China, who is deeply enmeshed in the global economy.
  • Another sign of the thaw are moves by Chinese regulators to allow real estate firms to service foreign debt. Throughout the real estate crisis, China has focused on domestic interests, mostly allowing foreigners to bear the brunt of the adjustment.  However, it appears that Chinese officials have concluded that harming foreign investors may weaken their economy in the long run.
• TikTok continues to be a problem for U.S. security officials. The government remains worried that China will use the platform not only to collect data but to execute influence operations.

International News:  Germany uncovers a right-wing coup plot, and Argentina’s vice-president has been found guilty of fraud.

• Twenty-five people were arrested from three countries on suspicion of a coup to overthrow the German government. Among those detained is a former AfD lawmaker, and a member of Germany’s special forces.  It isn’t obvious if the plot was gaining traction or close to operational capacity.  Some members did contact Russian intelligence, but there isn’t any evidence that the Russians were involved.  Germany has a neo-Nazi undercurrent that resurfaces on occasion.  During the 1970s, left-wing groups associated with communist factions, such as the Baader-Meinhof Gang, were prevalent.  None, so far, have seriously threatened the government.
• Cristina Fernández de Kirchner, the current vice-president, a former president, and the wife of a late president, was convicted of fraud by an Argentine court. She was sentenced to six-years in prison and barred from public office for steering public works funding to a family associate while she was president and first lady.  In the short run, nothing will change.  She will appeal her conviction and during the appeal process, she will remain in office.  Her term ends next December, so it is likely she will leave office without the case being resolved.  The Kirchners are polarizing figures in Argentina; though, if the conviction sticks, it may mean the end of her family’s influence in the country.
• The U.K. is facing a wave of labor discontent. PM Sunak is considering anti-strike legislation to stem the tide.

War in Ukraine:  More on the Ukraine strikes inside Russia, and Hungary blocks aid.

• The recent drone attacks (apparently on three airfields) carried out by Ukraine have put the U.S. in a delicate position. Washington does not want to see this war escalate, and thus, isn’t supportive of these attacks.  However, it is also aware that Russia has been attacking Ukrainian infrastructure, so it can’t really tell Kyiv not to attack Russia proper.  One goal of Ukraine was to force Russia to expend resources to defend these airfields.  That goal has apparently been met.
• The EU and Hungary have been at loggerheads over a number of issues, including immigration and social policy. In response, the EU has blocked funds to Hungary, and this decision led Hungary to veto aid to Ukraine.  The EU is looking for ways to circumvent the veto.
• Although there have been steady calls for peace talks, the head of NATO suggests conditions for those talks are “not there now.”

Markets, Economics and Policy:  Lumber futures rise, and supply chain issues slow arms sales.

• Lumber prices soared during the pandemic, as there was a lift in housing and remodeling. However, the rally failed as time passed, and prices slid.  Although prices remain well below pandemic highs, prices jumped to their daily futures limit on reports that Canfor (CFPZF, $17.20) has cut mill output due to the falling demand.
• Arms demand is elevated due to the war in Ukraine and the general rebuilding of defense. However, supply chain issues and rising costs have cut sales over the past few months.

U.S. News:  Part of North Carolina remains without power, and the Georgia Senate seat remains with Democrats.

• Utilities are struggling to fix the sabotaged substations in North Carolina. It is still uncertain who was behind the attacks, but the event highlights the need for redundancies.  It would be prohibitively expensive to defend all infrastructure, but holding inventory of critical parts would likely speed recovery.  Of course, inventory costs money and reduces efficiency.
• Raphael Warnock (D-GA) won a new six-year term by defeating Hershel Walker. This gives the Democrats a 51-49 advantage in the Senate.
• Rackspace Technology (RXT, $3.95) reported a massive ransomware attack. The company hosts emails and cloud computing, mostly for business.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning on the Feast of St. Nicholas!  It’s actually a rather quiet morning after yesterday’s risk-off day.  U.S. equity futures have been vacillating this morning, mostly trading inverse the dollar.  Gold is higher this morning, but oil is trading lower.  Equities have been taking on a tone of bad news is good news.  Yesterday’s ISM services index, coming in well above the expansion line of 50, raised fears that monetary policy won’t be as easy as hoped.  We note that the WSJ’s latest “Fed whisperer,” Nick Timiraos, published an article yesterday reiterating Chair Powell’s recent comments about moving to slower rate hikes but also signaling that tightening was far from over.  Last week, when that speech occurred, the financial markets viewed the talk as dovish.  The Timiraos article suggests that isn’t the narrative that the FOMC preferred.

In today’s Comment, our coverage begins with China news.  Economics and policy are up next, and an update on the North Carolina substation attack follows.  Our war in Ukraine briefing comes next, and we close with the international roundup.

China News:  The state funeral for Jiang Zemin has begun, as the CPC does its best to project unity.  We also update the COVID situation.

• It is becoming clear that China’s Zero-COVID policy is evolving, but we hesitate to call it a full reopening. Instead, policymakers seem to be moving along three tracks.
  • There appears to be a concerted effort to change the narrative on the disease from something to be feared into more of an inconvenience. COVID has exhibited a wide array of effects with most people seeming to survive it just fine, but it is clearly a risk to the elderly and to those with several preexisting conditions.  Also, the mystery of “long COVID” remains an issue.  Most nations have generally developed a strategy of trying to open as much as possible while simultaneously protecting the most vulnerable.  Finding that balance can be tricky.
  • As part of this narrative change, public health authorities are said to be close to announcing less strict quarantine and testing measures.
  • Expanding immunizations is also being promoted. Unfortunately, Beijing doesn’t want to accept Western vaccines, which have proven to be more effective.  Thus, immunizations may have only a limited effect on reducing risk.
  • Opening is risky, and the use of substandard vaccines coupled with a population that hasn’t had much exposure to the virus further raises the risk that a bout of infection could strain the medical system. However, it has become clear, for economic and social reasons, that the Zero-COVID policy can’t be maintained.  Beijing is adjusting, but it isn’t completely certain how well this will work out.
• The fiscal response by the U.S. to COVID was extraordinary, and the speed that policy stimulus was deployed opened the potential for abuse. Reports of identity theft when applying for unemployment insurance and the abuses of PPP payments were widespread.  Turns out the abuses were also international in nature—the Secret Service reports that Chinese hackers clipped at least $20 million of COVID relief payments.
• As General Secretary Xi starts his third term among expectations of market-unfriendly policies expanding, we are beginning to see reports of capital flight as wealthy Chinese citizens begin moving funds offshore. Singapore appears to be the most prominent beneficiary.  The city-state has a large ex-pat population and is a natural destination for such funds.
• Canada is joining other G-7 nations in conducting freedom of navigation operations in the Taiwan Strait.

Markets, Economics and Policy:  The economic picture is mixed.  Business leaders are worried but still see a soft landing.  Supply chains are improving, but layoffs are rising.

• Recent CEO surveys suggest that business leaders are becoming more concerned about the economy, but still expect a soft landing. It’s not obvious if these leaders have a great track record on forecasting the economy (to be fair, no one else is all that good either) but their attitudes likely reflect present business activity.  Thus, we see it as confirmation that we are not currently in a recession.
• At long last, supply chains appear to be improving. Freight rates have been easing, and we note that in the recent ISM data, there is growing evidence of improvement.

• The number of purchasing managers reporting faster deliveries is rising rapidly, although history would suggest some of this improvement is likely coming from slower economic activity.
• Taiwan Semiconductor (TMSC, $81.62) announced it is increasing its investment in its Arizona facility.
• Pepsico (PEP, $183.12) announced layoffs from its corporate headquarters.
• For years, tech firms have been news aggregators as they give users the ability to find articles and, for a long time, avoid paying subscriptions. Clearly, this content model can’t work indefinitely.  If the content providers can’t get paid, they will eventually stop providing the content.  Congress is apparently working on legislation that would facilitate the providers’ abilities to negotiate fees from the tech firms.  Facebook (META, $122.43) announced it may stop providing news feeds on its platform if the legislation passes.
• Commercial property private REITs are seeing redemption notices.
• Influenza hospitalizations are rising rapidly. The spike in infections may be a hangover from the COVID restrictions, which also reduced flu infections but have lowered resistance.
• The head of the PBOC is making the argument that the dollar has peaked. Although we are not sure that we won’t see one more recovery in the greenback, (especially if Nick Timiraos is right) we do think that we are in the very late innings of this dollar bull market.

North Carolina:  Although authorities are not calling the weekend attack on substations in North Carolina domestic terrorism, the actions were clearly targeted, suggesting that it wasn’t just a random attack.  Utilities are steadily bringing power back online, but it probably won’t be until Thursday before power is fully restored.  Our worry is that if similar attacks become common, not only will it cause disruptions, but mitigation efforts (backup generators, diesel stocks, extra food, etc.) will tend to be costly and could boost inflation.

War in Ukraine:  Ukraine strikes inside Russia which could expose divergences in goals among allies.

• Although Kyiv hasn’t fully accepted responsibility, it appears that Ukrainian drones attacked three Russian airfields inside of Russia proper, including one that houses some of Russia’s strategic air assets[1]. A drone also hit a Russian oil depot.  Ukraine’s ability to strike inside Russia is a new development, and one that the U.S probably isn’t pleased about.  We note that the U.S. “modified” its HIMARS systems given to Ukraine to reduce its range and lessen the likelihood that Ukraine could strike within Russia.
  • This development could mark a serious escalation of the war. First, if Ukraine now has the ability to strike targets deep inside Russia, then Putin’s conduct of the war will come under further scrutiny.  Second, Ukraine’s Western allies are mostly willing to support this war as long as it stays contained, since the West has no interest in seeing this conflict expand.  Attacking Russia proper changes the nature of the war and could prompt Russia to take more aggressive steps, such as engaging tactical nuclear weapons.
  • We will wait to see the U.S./allied response. Since the drones appear to be of Ukrainian origin, the U.S. and its allies can argue that it wasn’t Western arms that attacked Russia.  We doubt the Kremlin will accept this argument.  We look for the West to restrict weapons sales further to discourage this development.
• Meanwhile, polls show some reduction in support among Americans for “indefinite” aid to Ukraine. And Germany is balking on sending the arms it promised earlier.
• As the war continues, the Kremlin is increasing its commandeering of private companies to support the war effort. This action will tend to reduce available supply; if money supply isn’t restricted, then inflation will worsen.

International News:  The EU awakens to the change in U.S. policy.

• The Inflation Reduction Act, in IOHO, is the opening salvo in U.S. industrial policy designed to kick start the reindustrialization of America, but at the expense of our trading partners, mostly Europe. For the Europeans, who have maintained export promotion far beyond just the recovery from WWII, this is a massive threat.  When French President Macron was in Washington recently, he warned that the new law could “fragment the West.”  Perhaps, but given that Europe can’t defend itself, it probably is better described as the U.S. subjugating Europe.  The EU is expected to react, and there is talk of it creating its own energy subsidies and maybe giving up on free trade as a policy[2].  However, we don’t expect the U.S. to change its policies all that much, and if anything, we expect more of the same.
• Although Turkey has thrust itself into global geopolitics in a robust fashion, and is getting some economic benefits, it still faces an ugly inflation problem.
• South Africa’s President Ramaphosa is facing a corruption scandal, but it appears he will escape impeachment.
• Not so for Peru’s President Castillo, who is facing a third attempt to remove him from office.
• Mount Semeru has erupted in Indonesia. The volcano is situated on Java, where, at the other end of the island, sits the city of Jakarta.  Major volcanic eruptions can cool the earth for a time, as volcanic ash spews into the upper atmosphere.
• Papua New Guinea may have underestimated its population by half.

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[1] In other words, it houses an element of its nuclear weapons delivery.

[2] Which is a bit rich, given that numerous policies, such as regulations on food, are clearly protectionist.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a long discussion of several key developments today in the global energy markets, including the implementation of several sanctions against Russia’s oil and natural gas due to its invasion of Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Global Energy Market:  This week could be momentous for global energy markets, with the European Union and U.K. set to implement a ban on Russian oil imports, the broader group of industrialized countries set to impose a price cap on Russian oil exports, and Chinese President Xi set to visit Saudi Arabia.  These developments illustrate how the increased friction between the evolving U.S. and China-led geopolitical blocs has sparked a new era of intense economic warfare around the world, creating both headwinds and opportunities for investors.

• As previewed in our Comment on Friday, the Group of Seven (G7) countries and their allies, representing much of the world’s richest and most advanced democracies, approved a plan to cap the price of Russian oil exports beginning today. To cut the revenues available to Russia for its war against Ukraine, the cap will ban Western companies from insuring, financing, or shipping Russian oil unless it is sold for less than $60 per barrel.
  • Russian officials have said they will not send any oil to countries that implement the price cap.
  • There are differences of opinion regarding the impact of the price cap on global oil prices. Oil prices are up so far this morning, but that could primarily be because of looser COVID-19 restrictions in China (see below).
• Separately, today the EU and the U.K. will implement its ban on importing Russian oil, which was approved earlier this year. They will also implement a ban on Russian refined products beginning in early February.
• Yesterday, the Organization of the Petroleum Exporting Countries and its Russia-led partners said that they will stand by their October decision to cut oil production by two million barrels per day, rather than the proposals last month ranging from an output cut to an output increase. The decision will give the OPEC+ group more time to assess the impact of the EU ban on Russian imports and the broader price cap on Russian oil exports.
• Of course, oil isn’t the only front in the energy war. Data from commodity analytics firm ICIS shows that the EU’s demand for natural gas in October and November was 24% lower than its five-year average.  The figures suggest that the EU has made significant progress in finding energy efficiencies and implementing conservation measures, although they were also helped by the relatively warm weather in early autumn.
• Spooked by the energy supply disruptions from the war in Ukraine, the Japanese government has launched a plan to develop a strategic reserve of liquified natural gas. The program would require importing an additional 840,000 tons of LNG per year, consistent with our view that the geopolitical fracturing of the world will not only threaten energy supplies, but will also encourage hoarding behavior, all of which will tend to buoy commodity prices.

Russia-Ukraine War:  As heavy fighting continues primarily in the Donbas region of northeastern Ukraine, and Russian forces continue to launch air, missile, and kamikaze drone attacks against Ukrainian infrastructure, explosions were reported at two air bases deep inside Russia.  The explosions reportedly damaged or destroyed several Russian military aircraft.  They are also consistent with a number of other explosions in Russian territory throughout the war that were likely carried out by Ukraine, although the Ukrainian authorities have not formally acknowledged any role in the attacks.

China:  Following the previous week’s big protests against the government’s Zero-COVID policies and repressions of freedom, we are seeing increasing reports that local government officials are gradually ratcheting back some pandemic restrictions.  The rollbacks include lifting some curbs on residents’ movements, such as by ending mandatory COVID testing for people who want to use public transport, enter parks, or visit other public spaces.  The authorities are also stepping up their efforts to vaccinate vulnerable citizens, especially the elderly, probably in an attempt to shield the population and healthcare system in case looser pandemic rules lead to higher infection rates.

• The modest loosening of COVID restrictions may have helped eliminate the recent protests, but a heavy police presence and surveillance around potential protest sites probably played the bigger role.
• The apparent easing in COVID rules have given a big boost to Chinese stocks and the CNY so far this morning. However, we continue to think the government’s COVID policies will weigh on the economy.  Much of China’s economy is still on lockdown, and even if the pandemic rules are loosened, the lack of herd immunity and weaknesses in the healthcare system mean big new outbreaks of infection will likely hold back activity.  That will also continue to create headwinds for the broader global economy and financial markets.

Iran:  After weeks of anti-government protests touched off by anger at the country’s Islamic “morality police,” the Iranian government said it is dismantling the organization and may roll back some rules such as the requirement that women wear the hijab in public.  However, protests continued over the weekend, signaling that the small grant of freedom may not be enough to relieve the political pressure on the government.  Instability in Iran, a major oil producer, may therefore continue in the near term.

Eurozone:  October retail sales fell by a seasonally adjusted 1.8%, even worse than expected and the biggest drop since last December.  Sales in October were also down 2.7% from the same month one year earlier.  The data supports the view that the Eurozone economy is now falling into recession.

United States-European Union:  In the latest sign that new U.S. subsidies and “buy-American” rules will prompt Europe to respond in kind, European Commission President von der Leyen said that the EU must “simplify and adapt” its rules on state aid to allow similar protectionist policies.  U.S. and EU officials are due to meet today to discuss the issue.

• The Biden administration has not strongly pushed back against insinuations that the EU could respond with its own protectionist policies. Indeed, U.S. Trade Representative Tai recently proposed that the EU adopt similar policies, probably aimed at a reduction in EU trade with China.
• In his meeting with French President Macron last week, Biden also suggested that the U.S. could adjust its rules to address European concerns.
• The Europeans remain quite irritated and concerned about the new U.S. industrial support, which is focused largely on green technology, but President Biden’s conciliatory stance suggests that a trade war is not necessarily set in stone.

United States:  Two electrical substations in rural North Carolina were attacked by gunfire on Saturday evening, leading to power outages that could last for days for over 33,000 customers.  Although the outage is relatively small, the apparently deliberate attack has raised concern about follow-on attacks and the overall vulnerability of the nation’s electrical supply.

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