by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

The Daily Comment will go on hiatus beginning Wednesday, November 23, and will return on Monday, November 28. 

Our Comment today opens with an update on the Russia-Ukraine war, where it appears that the Russian forces recently pushed out of the southern city of Kherson are now being redeployed to other parts of the front line and are digging in for a stronger defense.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a welcome upward revision to economists’ expectations for the Eurozone’s economy this winter.

Russia-Ukraine:  Now that the Ukrainian military has pushed the Russian occupiers out of the southern city of Kherson and its environs, various reports indicate that the Russians are redeploying their withdrawn forces to other fronts, with an emphasis on the northeastern Donbas region.  The latest news suggests that they are also prioritizing the building of new defensive lines to limit Ukraine’s ability to make further gains.  Meanwhile, the Russians continue to pummel Ukraine’s civilian infrastructure with air, missile, and kamikaze drone attacks.  As winter takes hold in Ukraine, we suspect that the Ukrainians will prioritize keeping the pressure on the Russian forces in order to complicate their efforts to reconstitute and regain their combat strength.

• Despite the Kremlin’s on-going propaganda efforts regarding its invasion, new polling suggests that Russian citizens are becoming increasingly anxious about the war. This indicates that President Putin’s political position is becoming increasingly at risk even among the broader public.
• Meanwhile, demonstrations against Western support for Ukraine are continuing and even spreading into Europe. The demonstrations, organized by both the far left and the far right, raise the risk that Western governments could eventually be forced to reduce their support for Kyiv which would give Russia a freer hand in the war.

Eurozone:  Despite the continuing war in Ukraine, economists have recently boosted their forecasts for the Eurozone’s near-term economic growth and now believe its downturn this winter will be much milder than earlier thought.  Greater fiscal support from governments, lower gas prices, and a mild autumn have all helped to improve the bloc’s outlook, with many economists now expecting the Eurozone’s economic output to decline just 0.5% in the fourth quarter and 0.1% in the first quarter of 2023.

• Importantly, a mild autumn and success in building up huge stocks of natural gas have left the Eurozone in a relatively good position to avoid the massive energy crunch previously expected to result from Russia’s cut-off of energy exports to the bloc.
• If the Eurozone’s economic performance comes in as now expected, it would likely give a boost to the bloc’s stock markets and help U.S. firms that conduct business there.
  • Of course, U.S. investors might also see some benefit from the weakening dollar, which tends to boost their returns from foreign stocks and increases the value of U.S. firms’ foreign revenues.
  • The U.S. dollar index is now down approximately 5.5% from its most recent peak in late September, and it has fallen some 4% in November alone.

Turkey:  Over the weekend, in response to last week’s terrorist bombing in Istanbul, the Turkish military launched air strikes against Kurdish militant’s bases and other sites in Syria and Iraq.  The ministry also said it had destroyed 89 targets, including shelters and ammunition depots, and that senior members of the PKK “were among those neutralized.”  Such a large series of strikes raises the risk of new instability in the region.

China:  The broad new wave of COVID-19 infections continued unabated over the weekend, with daily new infections remaining above 24,000.  In addition, the country reported its first fatalities from the disease since late May.  Separately, Hong Kong’s chief executive has tested positive for COVID-19 just days after interacting with his boss, President Xi Jinping, at the Asia Pacific Economic Cooperation forum in Bangkok.  Xi is therefore at risk of coming down with the disease, increasing the likelihood that he will be in quarantine for some time after returning from his trip.

• Even though Beijing has ordered that the country’s previous Zero-COVID policy be watered down to reduce the negative impact on the economy and people’s social lives, the new infection wave means that there is some risk that the government will backtrack and impose new lockdowns in the future. Besides, with so many Chinese residents still unvaccinated, millions of people could begin to self-quarantine to keep from being infected.
• In either case, the new wave threatens to become another headwind for the Chinese economy in the coming weeks and months. And of course, that would imply new headwinds for the global economy and financial markets.  For example, China’s torturous exit from Zero-COVID lockdowns has helped push global crude oil prices down below $80 per barrel last week.

Indonesia:  An earthquake struck the island of Java early today, leaving at least 56 people dead, around 700 injured, and hundreds of buildings damaged.  The quake registered 5.6 on the Richter scale, making it a rather moderate temblor despite the damage and loss of life.

Democratic Republic of Congo:  Ethnic tensions have erupted into the most intense clashes in a decade, with the M23 rebel group advancing to within 12 miles of the city of Goma and pushing United Nations-backed Congolese government forces from several surrounding towns.  The advance raises the prospect that M23 and its foreign allies could dominate a region that produces important minerals, including tin, gold, tantalum, and coltan.

Colombia:  Even though recently inaugurated leftist President Gustavo Petro had pledged to stop new oil and gas exploration projects in Colombia, his finance minister signaled in a recent interview that the government will first review existing contracts to see if any modifications are necessary.  Stepping back from Petro’s plan to end Colombian fossil fuel exports could help buoy the economy and reverse a steep fall in the peso.

COP27 Climate Summit:  As the global summit conference to address climate change ended over the weekend, negotiators reached a deal in which large, rich, developed countries would set up a special fund to help the poorest less-developed countries manage the cost and damage of global warming.  In return, the developing countries agreed to support the current targeted cuts in global greenhouse gas emissions.  However, the size, structure, and mechanics of the fund were left to be hashed out sometime in the future.

U.S. Consumer Demand:  As the holiday shopping season kicks off in earnest this week, new data and polling suggest that headwinds such as high inflation and rising interest rates will push down spending on gifts this year.  The polling indicates that people will buy less presents and spend marginally less than they did on presents last year.

U.S. Energy Sector:  Although it now looks like Europe could skirt the big energy crisis it was previously expected to face this winter, the massive energy exports to Europe and other issues are pushing heating costs dramatically higher in the U.S. Northeast this winter.  The New England regional grid operator has said that it will be able to cope under normal weather conditions this winter but warned that a prolonged period of particularly cold temperatures could force it to ration electricity supply, potentially through rolling blackouts that could negatively affect the region’s economy.

U.S. Cryptocurrency Market:  As part of its bankruptcy process, crypto exchange FTX and its linked companies filed a list of their 50 largest creditors on Sunday, and the filing showed that all of those creditors were customers which are owed more than $20 million.  Two of those are due over $200 million.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

The Daily Comment will go on hiatus beginning Wednesday, November 23, and will return on Monday, November 28. 

Guten Morgen! Today’s Comment begins with our thoughts about the growing financial stress within the international banking system. Next, we discuss how the dollar is faring against countries with opposing monetary policies. We end this report with a discussion about the easing of geopolitical tensions and its impact on financial markets.

 Global Liquidity: As international financial conditions weaken, there are growing concerns that banks are struggling to meet short-term obligations.

• Financial stress is on the rise in major economies across the world. Rising interest rates in China (one-year note yields jumped nearly 25 bps this week) have triggered investor withdrawals from fixed-income products, as investors fear rising rates will lead to principal losses. Regulators have made unscheduled inquiries of Chinese banks to check their ability to meet these withdrawals. The areas of concern are “wealth management products” which seem to be similar to Western ETFs. They offer higher yields compared to bank deposits, but also offer daily liquidity. However, they are also “mark-to-market” products, meaning that their prices fall as rates rise. We expect the PBOC to prevent runs, but the snap rise in yields is revealing some fragility in China’s financial system.
• At the same time, a financial stability review conducted by the European Central Bank showed that investment funds are lacking the sufficient liquid assets needed during a financial crisis. Meanwhile, the lack of demand for U.S. Treasuries, especially in the off-the-run coupons, has led to volatility in bond prices. The issues with the international financial system are in part due to global monetary tightening.
• Although our base case is that the upcoming recession will likely be “garden variety,” a financial crisis could worsen a downturn. It is unclear how the financial system will cope if Fed officials follow through on their plan to raise rates to between 5% and 7%, but the unusually high level will likely add to the ongoing woes. Although central bankers have consistently argued that this time will be different, history shows us that overconfidence leads to blind spots. The shadow banking system is likely a pain point as these institutions sometimes operate with leverage and little transparency. That said, the Federal Reserve reassured markets that it has the tools needed to prevent a liquidity crunch from causing a panic. Unfortunately, the current market structure may be inadequate given the size of government and private sector debt. Without reforms (e.g., clearinghouses for Treasuries, and expansion of market makers) the current system is prone to “freezing,” meaning that bond holders may find it difficult to liquidate holdings.

Different Directions: While most advanced economies aim to tame inflation through tight monetary policy, Japan is determined to keep policy accommodation in place.

• Japanese inflation accelerated to its fastest pace in over 40 years. Both headline and core CPI rose above the Bank of Japan’s 2% target, increasing to 3.6% and 2.5% from the prior year, respectively. Despite the disappointing report, the central bank has blamed price increases on factors beyond its control. Its position isn’t a surprise. The bank’s insistence on maintaining low-interest rates is likely related to it not wanting to increase the cost of government. Keep in mind that Japan’s government debt to GDP ratio is higher than Greece’s and almost twice the size of Italy’s. Japan has been selling Treasuries to prevent further JPY weakness, exacerbating the problem described above.
• While Japan is going one way, the Eurozone wants investors to believe it is going in the opposite direction. According to European Central Bank President Christine Lagarde, Eurozone interest rates may need to be lifted to levels that hinder growth in order to tame inflation. Additionally, she emphasized that the central bank must also reduce the size of its balance sheet if it wants to get inflation under control. Her remarks reinforce our view that the central banks are more focused on restoring price stability rather than increasing economic activity. As a result, we suspect that central bank tightening during a recession will prolong a downturn within the bloc.
  • Despite tough talk from Lagarde, we have doubts about how aggressive the ECB is willing to get in order to tame inflation. Earlier this year, the central bank expressed concerns about the possibility of fragmentation, a problem that only worsens as monetary policy tightens. Thus, her comments may be related to propping up the EUR rather than a genuine commitment to fighting inflation.
• So far, the JPY and EUR have not been adversely impacted by the recent developments despite offering their opposing commitment to price stability. In fact, the DXY index, which compares the USD to peer currencies, is down 0.1% as of this writing. The limited movement in currencies may reflect investors’ hopes that, despite recent Fed comments, the central bank is almost done with its hiking cycle. As mentioned in our previous reports, central banks in advanced economies typically keep rates elevated for longer periods than the Fed. Possible de-escalation of geopolitical tensions is also another potential source of relief. In short, the USD’s rise may be facing some resistance from wary investors.

 Cooler Heads: Western governments have taken a noticeably somber tone toward their rivals as winter quickly approaches.

• Leaders in the West are paving the way for de-escalation. French President Emmanuel Macron applauded China’s effort to rein in Russia in an attempt to prevent further escalation in the war. Although Beijing is sympathetic to Moscow’s need to defend itself from NATO expansion, it has also come out against the possible use of nuclear weapons during the conflict. Meanwhile, the Biden administration is pushing for Saudi Arabia’s Crown Prince, Mohammed bin Salman, to be granted immunity in a case involving the killing of journalist Jamal Khashoggi. The move will likely lead to better relations between the U.S. and Saudi Arabia. Lastly, President Biden rebuffed Ukraine’s claims that the missile that landed in Poland came from Russia.
• The change in tactics may be related to concerns over commodity supplies. Although the West has ample inventory to cover its needs so far, there are concerns that this may not be the case next year. Restrictions on Russian energy and the reopening of the Chinese economy threaten to cause a surge in demand and a lack of supply for energy alternatives. The International Energy Agency warned that Europe could enter a deficit of 30 billion cubic meters (bcm) of natural gas in 2023 in a worst-case scenario. As a result, Western governments may be looking to exhaust all options before implementing some of their more extensive penalties against Moscow due to its war in Ukraine.
• If successful in reducing tensions, Western gestures could support equities and weigh on the dollar and commodity prices. Throughout the year, geopolitical tensions have contributed heavily to investor uncertainty. That said, fears of a possible war spilling over into broader Europe and a direct conflict between the U.S. and China have dissipated over the last week. If this continues, the outlook for international equities will improve drastically as a weaker greenback and cheaper energy sources should help bring down global inflation. Although it is too soon to say whether this will carry over into 2023, signs are generally positive.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion about why countries are ok with tight fiscal and monetary policy even when their economies are barreling toward recession. Next, we review what a possible reprieve in geopolitical tensions could mean for commodities. Finally, we provide our latest take on the FTX collapse and what it may say about risk assets.

 No More Cake: The prospect of recession has not encouraged policymakers to push through measures to stimulate the economy.

• Chancellor Jeremy Hunt revealed a budget proposal to raise over £55 billion through tax increases and spending cuts on Thursday. The plan includes increasing windfall taxes, pushing more people into the top tax band, and cutting household energy subsidies. Hunt’s heavy-handed proposal will reassure the market that the government is serious about maintaining sound fiscal policy as the country copes with elevated inflation. In his speech, Hunt admitted that the U.K. economy would shrink next year. As of this moment, the British sterling is down 0.7% against the dollar as investors are now concerned about the economy’s viability.
• In the U.S., equities are trading lower following comments by Fed officials suggesting that the central bank is not prepared to pause. After the October CPI report showed that inflation was falling faster than most anticipated, investors began pricing in the possibility of a Fed pause for early 2023. Fed Governor Christopher Waller has challenged this sentiment by emphasizing that one report does not make a trend, dismissing the possibility of an end to hikes. Fed tightening could make it more difficult for the economy to grow, and thus, raise the likelihood of a recession.
• These developments reinforce the view that governments are more focused on taming inflation than they are on promoting growth. A possible reason for this preference can be related to the low unemployment numbers. As demonstrated with the Phillips curve, there is a general trade-off between inflation and the unemployment rate. Theoretically, higher price levels allow firms to hire and maintain a larger workforce. As a result of higher employment levels, a recession may be less politically costly for policymakers, thus paving the way for hawkish policies. Although this could mean more monetary and fiscal responsibility among policymakers, it will also deny financial assets of additional stimulus. Hence, the easy money days may not be back for a long-time.

Remain Calm: Geopolitical tensions among major powers have cooled much to the relief of markets.

• China and Russia are relatively more sanguine, as both appear open to de-escalation while the global economy begins to slow. On Thursday, Moscow agreed to extend the grain deal with Ukraine. Meanwhile, Chinese President Xi Jinping was somewhat restrained in his comments during the G-20 gathering. However, he did chastise Canadian Prime Minister Justin Trudeau for leaking their discussions to the press. The latest developments have made investors more confident that tensions are easing. Equities sustained a brief rally following remarks from Xi and President Biden at the G-20, while grain prices fell following the announcement of the wheat deal. That said, it is unlikely that this optimism will last for long.
• The shift in these countries’ sentiments is likely related to the slowing global economy. On Thursday, economic data revealed that Russia fell into recession. New data showed that its GDP shrank by 4% from the prior year for the second consecutive quarter. At the same time, onerous COVID restrictions and a property market crash have made China more reliant on export promotion for growth. The weakness in their respective economies may have forced them to modify their stances. In the long run, these countries would like to become self-reliant, but they would like to do so at a moderate pace to avoid outraging the public. As a result, the path toward deglobalization is likely to be done at a plodding pace.
• Russia and China’s calmness won’t fool anyone. Western countries are determined to contain the two. On Thursday, Germany and France greenlit a project to develop fighter jets. The increased military spending reinforces our view that the aerospace and defense industries may have attractive investment opportunities, particularly for international firms. Yet, despite the West being undeterred, commodities appear to behave as if tensions have declined. One reason crude prices have softened is due to an increase in optimism among traders that geopolitical tensions are easing. If this trend continues, the drop in commodity prices should boost the global economy and reduce inflationary pressures.

 FTX Saga Continues: The fallout from the collapse of FTX has spilled over to other areas of the crypto market.

• Several crypto platforms have announced new restrictions on trading after FTX filed for bankruptcy. On Wednesday, Gemini exchange paused withdrawals from its interest-bearing Earn accounts; meanwhile, Genesis Capital Management halted new loan originations and redemptions. Crypto firms implemented these new limits to prevent a run on assets; hence, the move suggests a broader panic throughout the market. These stringent measures will undermine outsiders’ already shaky confidence in cryptocurrencies. As a result, cryptocurrencies will struggle to find newcomers, therefore making these digital assets less useful for portfolio diversification purposes.
• There are growing calls for more regulation and oversight of cryptocurrencies as the ongoing crisis has drawn comparisons to the fall of Lehman Brothers. The Security and Exchange Commission and the Commodity Futures Trading Commission are both vying for jurisdiction over the crypto market. The new legislation pushed by Senator Elizabeth Warren (D- Mass) would allow regulators to consider consumer protection, anti-money laundering, and protection of the climate from crypto mining. Although the concerns are not new, the crisis appears to give crypto regulation new life.
  • There is also talk about a potential crypto central bank run by Binance, though that may lead to other complications.
• There are no signs that the crypto meltdown will bleed into the broader financial system. However, the crisis shows how new asset classes created by ultra-low interest rates can lead to market bubbles. Central banks’ decisions to drop rates to rock-bottom levels meant market participants had to invest in risky assets in order to find yield. As a result, institutions created new financial products like crypto for investors looking to gain a positive return on their excess cash. When central banks began raising rates to fight inflation, investor returns moved away from risky assets and into safe havens. Thus, the recent market rout exemplifies how these innovations can struggle to survive in a normalized world. Although we are not expecting an imminent financial crisis, we do believe there is an elevated risk while the Fed continues its tightening cycle.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning.  Recently, the dollar has been the key indicator of the direction of financial and commodity markets.  A stronger dollar usually signals weaker financial and commodity markets, while dollar weakness indicates the opposite.  This morning, the dollar is weaker but there isn’t much follow through in other markets.  Equities are mostly steady, energy prices, in front of today’s weekly DOE data, are weaker too, and interest rates are mostly steady.  We may be seeing some early position squaring in front of Thanksgiving week and, as we note below, there is a lot of economic data today that may be dampening trading.  There is one area of the market doing rather well this morning, which is precious metals, which are likely reacting to dollar weakness.

In today’s Comment, we begin with Ukraine and the latest on the missile strike in Poland.  China news is up next, where we add color to yesterday’s Biden/Xi meeting.  Crypto bats third as trouble in that space continues.  Batting cleanup is economic and policy news, and after are comments on Mexico.  We close with odds and ends.

War in Ukraine:  The latest on the situation in Poland (quick take: de-escalation).

• Yesterday afternoon, a missile hit Przewodów in Poland, a small town of about 400 people, which appears to be about five miles from the Ukraine/Polish border. Russia had fired a series of missiles at civilian targets in Ukraine following Ukrainian President Zelensky’s terms for talks.  It appears that at least one missile crossed into Poland, killing two people.  Russia has denied any responsibility for the strike.
• The Polish government held an emergency security meeting and has called for consultations with NATO. Poland is a NATO member, and attacking a member could trigger an Article 5 collective defense event, which would pull NATO into the war in Ukraine.  The Polish Army was put on alert after the event.  Pictures said to be from the site suggest a sizable blast.  The G-7 also held an emergency meeting.  Late yesterday, President Biden indicated that the missile didn’t appear to have come from Russian soil.
• Most recent news suggests a de-escalation. This morning, Polish President Duda said that the explosion was an “unfortunate accident” and was not done intentionally.  The missile does appear to be Russian made, but Ukraine, being a part of the former Soviet Union, uses Russian and Soviet-era munitions.  It is possible that the missile was part of an anti-air strike by Ukraine; after all, Russia did unleash a wide missile strike.  Or it could have been an errant missile fired by Russia.  The bottom line is that NATO clearly does not want to turn this into an Article 5 incident.  The fact that Poland is calling the incident an accident suggests that this is not likely to escalate.
• What this situation does remind us of is that whenever an ordnance is in the air, accidents can happen. If the U.S. and NATO wanted to create a pretext for a broader war, they could have used this event for that purpose.  The Gulf of Tonkin incident triggered broader U.S. involvement in Vietnam, for example.  Russia is increasingly using “dumb” bombs and missiles due to its lack of semiconductors to build “smart” ones.  These “dumb” bombs and missiles are less precise and more likely to strike unintended targets.  Thus, there is a risk that the conflict could widen beyond Ukraine.  So far, the reaction of NATO is that they won’t be quick to escalate.  Perhaps the next worry should be that Russia, observing this reaction from NATO, becomes reckless, or perhaps assumes it can attack the periphery around Ukraine to disrupt weapons flow and training areas without repercussions.  For now, though, this situation appears under control, but there is a risk of a broadening of the conflict if Russia views the response as weakness.

China News:  What we see after Biden/Xi[1] and the unwinding of Zero-COVID.

• The Biden/Xi meeting looks like an attempt to stabilize relations, but likely nothing more. Fundamentally, both sides have diametrically opposed policy goals that are probably not reconcilable.
  • China is uncomfortable with a world breaking into blocs.[2] We note direct opposition to the concept in the CPC’s media mouthpieces.  President Xi met with the Dutch PM in a straightforward attempt to get AMSL (AMSL, $597.47) to reject U.S. policy which prevents China from acquiring the company’s semiconductor-etching machinery.  China’s economy is dependent on exports.  If the U.S. creates conditions where some markets are restricted, it will have a negative effect on China’s economy.  Beijing would prefer a world arranged bilaterally, whereas the U.S. would not.
  • Highlighting this issue are reports that China’s semiconductor output posted its largest monthly decline in October.
  • China is dealing with some serious economic issues. Its real estate sector is under great pressure and unwinding that problem will be costly.  Losing export business while addressing domestic issues would be damaging.
  • Treasury Secretary Yellen met with PBOC Governor Yi yesterday. It doesn’t appear that new ground was broken, but at least the two sides are talking.
• It is looking increasingly likely that the Zero-COVID policy is slowly unwinding. Although reported infection rates are rising, we are not seeing widespread lockdowns.  Instead, curbs are being relaxed despite the surges.  Why the change?  In part, it looks like Chinese citizens have had enough of the lockdowns.  Protests against them are increasing, forcing local officials to ease constraints.  We don’t think we will see an official, nationwide relaxation of restrictions but the local easing will likely boost economic activity in the coming year at the potential cost of rising infections.
• At the G-20 meeting, China rejected the term “war” when discussing the war in Ukraine, taking Russia’s narrative on the conflict. Western leaders at the meeting were pushing for China to reject Russia’s nuclear threats.
• U.S. and China are restarting military talks, but we note that on the Chinese side, Wei Fenghe, the current defense minister, will be replaced by Li Shangfu, who is under U.S. sanction for buying Russian arms. It’s not obvious how this will be resolved.
• The FBI is “extremely concerned” about China’s ability to influence social media via TikTok.

Crypto:  Here’s the latest on the continuing crisis in crypto.

• As Sam Bankman-Fried makes a last ditch effort to raise money, U.S. regulators are circling, increasing the odds that he could be facing prosecution. Part of the attractiveness of crypto is the absence of regulation.  Turns out, it’s a downside too.  The U.S. operated with a free banking system from the end of the Second Bank of the United States to the creation of the Federal Reserve (1836-1913).  In this period, banks would issue their own currency, and bank runs were common. Even under a gold standard, financial instability was the norm.  The evolution of regulation was an attempt to stabilize finance.  There is a cost, as an actor can’t do everything they want.  Watching crypto looks a lot like the free banking period since the issuance of money by individual financial institutions is an element of the earlier period.
• Contagion is occurring in the wake of FTX’s collapse. The crypto lender BlockFi has paused withdraws and restricted activity and is preparing for a bankruptcy filing.  BlockFi was rescued by FTX this summer when the plunge in cryptocurrencies threatened insolvency.  It was using FTT, FTX’s own coin, to extend credit.  With the collapse of FTX, BlockFi’s assets are likely worth much less, making the company vulnerable to a run.
  • Although the FTX situation continues to weaken the crypto space, so far, the traditional financial system has not shown signs of trouble. The Fed is working with banks on the crypto custody issue.
• Major players in the crypto industry are turning on Bankman-Fried.
• Binance is proposing an industry recovery fund, most likely to head off further contagion and to fend off the regulators.
• On a related note, the NY FRB is testing a digital dollar.

 Markets, Economics and Policy:  George warns on the economy and childcare remains a problem.

• KC FRB President George noted that it is likely impossible to lower inflation without triggering a recession. We would agree.  George is a traditional hawk but has been an unexpected voice of moderation in this tightening cycle.
• The lack of childcare may be a major reason why the labor markets remain tight. The BLS estimates that 104k members of the labor force were not working due to childcare issues.  These may include problems due to illness or the lack of affordable care.
• Home equity lines of credit are expanding. Collectively, homeowners are still sitting on large amounts of net equity and may not want to buy a new home due to current mortgage rates and weak affordability.  Tapping home equity is a way to acquire funds.  However, if nominal home prices fall, those lines could be at risk.
• As we note below, U.K. inflation hit a 41 year high of 11.1%.
• A bill to limit companies’ use of non-disclosure agreements looks like it will pass soon.

On the international front, Mexico’s President Andrés Manuel López Obrador (AMLO) is facing increasing unrest, with protesters opposing his increasingly heavy-handed rule.  The latest problem is his plan to “reform” Mexico’s election system.  Critics argue it will make his party dominant, creating conditions similar to the PRI’s dominance after the Mexican Revolution.  For years, the PRI operated a single party state.  AMLO seems to want to return to that period and this latest effort is part of that plan.  If AMLO is thwarted, his party is likely to lose influence.

Odds and Ends:  Odd news items that caught our attention this morning.

• In the early days of online purchasing and banking, older friends and family members argued that such transactions couldn’t be safe, and that they would continue to write checks. Turns out that the latest hot criminal scam involves paper checks.  Thieves are rifling through the mail to get checks, which they then add their own names or others in the scam to pull funds from checking accounts by using a chemical processes to erase the original payee and amount.
• Running a marathon is a hard; doing it while chain smoking is even harder.

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[1] See what we did there?!

[2] See our bloc analysis in the BWGR section.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning to all those eight billion out there (that are growing older, btw)!  Equities are trending higher this morning, interest rates are falling, and the dollar is lower.  The driving factor behind the rally is primarily the meeting between President Biden and President Xi (although the better-than-expected PPI data gave another leg up to the rally), which will head up our Comment this morning.  Up next is broader China news.  Ukraine comes next, followed by our take on economics and policy.  An update on the crypto situation is the next item, and we close with international news.

Biden-Xi:  The leaders of China and the U.S. met yesterday for the first time since Biden has been in office.  Although unusually late for the leaders of the two largest economies on earth to delay a meeting, President Xi has mostly stayed home during China’s Zero-COVID policy.  Expectations about the meeting were low, and for the most part, these expectations were met.  The first clue that no new ground was broken was that there was no joint statement as both sides issued their own statements.

So, if the outcome was so pedestrian, why are markets surging?  Mainly because relations have become so difficult, even this outcome looks quite positive.  China’s official media was downright gushing.  Here are the key takeaways from our perspective:

• The meeting does appear to stabilize relations, which seemed to be on a downward spiral. Xi and Biden have a positive history as they met several times when both were second in command in previous administrations.  The meeting does suggest that at least the two sides can begin talking.
• Our take is that China needed stabilization more than the U.S. did. China is attempting to deal with a property bubble (see next section), and its Zero-COVID policy is hurting its economy.  We suspect that Beijing thought that after Trump’s loss, U.S. policy to China would ease, but that didn’t happen.  In fact, it may have become harsher.  Beijing was avoiding contact with Washington for a host of reasons, but a big one may have been to wait until after Xi was given his third term as general secretary.  China’s economy is still dependent on exports, and it needs to trade with the U.S.  Thus, cooling tensions makes sense.
• It appears that contact will continue. Secretary of State Blinken is scheduled to visit his counterparts as a follow up.  Even Australia is trying to mend relations.
• At the G-20, China also signaled it wasn’t happy with the war in Ukraine. China’s English language readout didn’t include the quote below, but it was in the Chinese readout (translation courtesy of Bill Bishop of Sinocism).

The two heads of state also exchanged views on issues such as the Ukraine crisis. Xi Jinping pointed out that China is highly concerned about the current situation in Ukraine. After the crisis broke out, I put forward the “four should,” and not long ago I put forward the “four commons.” In the face of a global and complex crisis such as the Ukraine crisis, there are several points that deserve serious consideration: first, there are no winners in conflicts and wars; second, there is no simple solution to complex problems; third, major power confrontation must be avoided. China has always stood on the side of peace and will continue to promote peace talks. It supports and looks forward to the resumption of peace talks between Russia and Ukraine. At the same time, China hopes that the United States, NATO, and the European Union will conduct comprehensive dialogues with Russia.

• At the same time, very large differences remain. The U.S. is more than happy to maintain the status quo in Taiwan as Washington supports a quasi-independent state without full independence.  For China, this is unacceptable, but it doesn’t really have a path to unify the island without setting off a war.  Biden is not fully in control of policy towards China and Taiwan, as Congress is becoming increasingly hawkish toward Beijing and toward supporting Taipei.  The actions taken on semiconductors have been viewed as a major step in a costly “cold war” with China, and it would be hard to pull back politically.  Much like U.S. administrations found in the Cold War, appearing “soft on communism” was a loser in elections.  Thus, we would not expect a major change in policy from the U.S. side.

Overall, it’s good news that the two sides are talking, but it’s important not to view this meeting as some sort of turning point.  The differences between the U.S. and China are great.  China is envisioning a world where it is a regional hegemon and expects the U.S. to acquiesce to its role and allow that to occur.  We don’t see Washington ceding that outcome without a fight.  The meeting does stabilize conditions, but we would not expect the U.S. to adjust its policy on trade or semiconductors.  But at least with both sides talking, the risk of miscommunication is lessened.

China News:  China moves to bolster its economy by easing COVID-19 restrictions and helping the real estate sector.

• Although the Zero-COVID policy remains officially in place, in practice restrictions are easing despite a steady rise in infections. Quarantine rules are being relaxed.  Tracking and investigation of reported cases are being eased.  Testing rules are becoming less stringent.  We would not expect a major announcement from the government in rolling back rules, but at the provincial level, Beijing is allowing local governments to ease up.  Although it may take a while for citizens to return to pre-pandemic behavior, this easing should boost economic activity.
• Banks are being instructed to extend deadlines, and regulations on how real estate firms handle escrow accounts are being eased. These measures are helpful, but there is increasing evidence that the sentiment towards real estate has fundamentally changed.  Before, real estate was seen as a safe investment.  In a country that restricted capital flows, real estate was one area where households could have a chance at a positive real return on savings.  That idea is now widely seen as outdated, and real estate is seen as risky, as household saving shows signs of building.
• Global investors are shunning China bonds.

War in Ukraine:  Discussions of peace talks are rising, but Russia and Ukraine appear to be in no hurry to begin serious discussions.

• One of the truisms of nuclear weapons is that a nation possessing them can never be forced into unconditional surrender. That doesn’t mean nuclear powers can’t lose wars, but that loss is a choice.  Essentially, a nuclear power loses a war when it concludes that the costs of continuing the conflict exceed the benefits.  For example, the U.S. and U.S.S.R. both lost wars in Afghanistan.  They both left not because they couldn’t win, but because they decided winning wasn’t worth the trouble.
  • Ukraine can’t force a surrender on Russia, since, as Moscow has warned, it can use nuclear weapons to avoid defeat. Thus, this conflict will end with some sort of negotiated settlement.  At this juncture, Ukraine sees little reason to talk as it is enjoying battlefield success.  And Russia expects Ukraine’s allies to tire of the conflict and thus sees every reason to continue to war, regardless of losses, hoping that the deprivations caused by the war will lead NATO to reduce its support of Ukraine.
  • And so, allies of the combatants are making comments about talks. General Milley recently suggested that a “window” for talks could emerge this winter.  The administration has “clarified” these remarks by saying it’s up to the Ukrainians to decide to talk, but the reality is that if the U.S. reduces its support, Ukraine will be forced to make a deal.
  • As noted above, China’s displeasure with Russia over the war could lead Beijing to pressure the Kremlin to sue for peace.
  • At this point, we don’t expect a rapid resolution to the conflict, but the war won’t go on indefinitely. Outside pressure on both Russia and Ukraine can likely force some sort of ceasefire.  We are not there yet as the U.S. sees value in degrading Russia’s military.  But the loss of Russian energy is a major problem for the EU, and China is clearly displeased with the course of the war.  So, by next summer, we could see some moves toward talks.
• The U.S. is warning Russia against the use of nuclear weapons. The U.S. has also added additional sanctions on Russia.

Markets, Economics and Policy:  Vice-Chair Brainard bolsters the case for slowing rate hikes, and student debt relief is in limbo.

• Although we don’t expect the FOMC to stop tightening anytime soon, the pace of hikes looks poised to slow. Vice-Chair Brainard suggested she would support a slowing in the pace of tightening, worried about the lagged effects of rising rates.
• The plan to offer student debt relief has been put on hold by the Eighth Circuit Court of Appeals. It is unclear when or if the plan will be revived.  In its place, the Biden administration is considering extending the current payment suspension.
• One area of concern is residential real estate. The spread between mortgage rates and Treasuries is widening, mostly because the buyers of mortgages are stepping away from the market.
• Layoff announcements are building rapidly, with tech and transportation leading the way.
• Railroad unions are continuing to reject the recent tentative agreement, raising the odds of a nationwide strike.
• Industrial metals are recovering on hopes of a China reopening.
• Martin Gruenberg will be nominated to run the FDIC; he has been acting director for several months.

Crypto:  The FTX debacle continues.

• An investigation by the Financial Times reveals that FTX had less than $1.0 billion in liquid assets backing $9.0 billion of liabilities. It has become clear that the company funded a large number of dubious crypto assets with little oversight, leading to lots of illiquid “assets.”
• The FTX bankruptcy is in chaos, and the company could have up to one million creditors.
• The collapse of FTX has affected the regulatory agenda regarding crypto as those advocating a light touch are retreating, and it is likely that policymakers will develop a restrictive regulatory stance.
• Although there is the potential for systemic risks to the financial system, so far, we haven’t seen signs of major stress.

A deal in Europe:  The U.K. and France have a new arrangement to deal with migrants attempting to move to the U.K.  Westminster will pay Paris $75 million to manage the migrant flows, an increase of $10 million from earlier agreements.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including a discussion of what comes next following Ukraine’s dramatic recapture of the southern city of Kherson late last week.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, much of which is focused on developments in China and in U.S.-China relations.

Russia-Ukraine:  Now that Russian forces have abandoned the southern Ukrainian region around Kherson, they appear to be redeploying their forces northward to launch new offensives in the province of Donetsk.  That will likely force the Ukrainians to reinforce their units in that area, but they are also expected to send some troops from Kherson northward to bolster their offensive in the northeastern Luhansk region.  In any event, it appears that Ukraine’s recapture of Kherson has set the stage for intensified fighting, rather than less fighting, in the coming months.

• Following the Ukrainian military’s dramatic recapture of Kherson, President Zelensky not only took the aggressive step of visiting the city in person, but he also claimed that the recapture “is the beginning of the end of the war.”
• Despite Ukraine’s victory in Kherson, it is still struggling to repair the damage Russian air strikes have caused the country’s civilian infrastructure. Because of that and the danger of booby traps left by the retreating Russians, the Ukrainian government today asked Kherson citizens who had fled not to return to the city quite yet.
• The Ukrainian victory in Kherson also hasn’t been enough to convince U.S. officials that Kyiv can keep taking back territory as winter approaches. Some U.S. officials are therefore working to nudge President Zelensky toward peace talks, while taking care to emphasize that any decision on talks remains in the hands of the Ukrainians.
• U.S. Treasury Secretary Yellen has said that some sanctions on Russia could remain in place even after any eventual peace agreement with Ukraine, raising the prospect of a long-term U.S. effort to squeeze Russia’s economy.
  • Such a move would be consistent with the fracturing of the world into relatively separate geopolitical and economic blocs, as we have recently been arguing.
  • In our analysis, we would expect Russia to end up as a junior partner in the evolving China-led bloc. As the U.S. and its bloc works to compete against China and the Chinese bloc, it would make sense for the U.S. to retain a range of military, economic, and diplomatic restrictions on both China and Russia.

Turkey:  An apparent terrorist bombing in central Istanbul killed six people yesterday, prompting the government to vow vengeance on the Kurdish militants that it suspects planted the device.  Because of U.S. support for Kurdish rebels in Syria, the attack and any Turkish retaliation is likely to worsen U.S.-Turkish relations.  Potentially, that could mean that Turkey will become even less cooperative in supporting Ukraine as it tries to defend itself against Russia’s invasion.  It could also prompt Turkey to dig in its heels against Sweden and Finland joining NATO.

United Kingdom-France:  Today, negotiators from the U.K. and France struck a deal in which the U.K. will provide additional resources to France so it can halt additional migrants from illegally crossing the English Channel to the U.K.  The agreement is an early sign that Prime Minister Sunak’s government may be able to work more constructively with France and the rest of the EU than other recent Conservative governments.

China COVID Policy:  The Communist Party has ordered that the country’s Zero-COVID policy be “optimized and adjusted” to minimize its impact on economic growth, people’s lives, and foreigners’ ability to visit China.  Along with the news of easing inflation in the U.S., the announcement helped give a big boost to stocks in China and Hong Kong on Friday.

• However, it’s important to note that the order didn’t change the overarching policy goal of completely stamping out COVID-19. Many Western observers assessed the move to be merely fine-tuning, rather than easing, the Zero-COVID policy.
• That’s especially the case given that new infections in China have now surged to more than 10,000 per day, marking their highest level since Shanghai was forced to shut down its economy in March. Since so many Chinese citizens remain unvaccinated or vaccinated only with China’s relatively less effective indigenous vaccines, especially among the elderly, a large breakout of new infections could spark a big increase in deaths.  In turn, that would probably prompt the government to tighten restrictions again, with negative implications for the Chinese economy and financial markets.

China Real Estate Policy:  In the country’s second major move to accelerate economic growth, the People’s Bank of China and the China Banking and Insurance Regulatory Commission released a broad support program for the real estate industry on Friday.  One of the biggest policy changes in the notice is to allow a “temporary” easing of restrictions on bank lending to real estate developers.  In addition, developers’ outstanding bank loans and trust borrowings due within the next six months could be extended for a year, while repayment on their bonds may also be extended or swapped through negotiations.  To reduce the risk of popular unrest over developers’ failure to deliver finished homes after buyers made down payments, the new policy also calls on banks to negotiate with homebuyers on extending mortgage repayment and emphasized that buyers’ credit scores should be protected.

• The regulatory adjustments for the real estate market come on top of other, more limited measures issued in recent months, including cutting interest rates, urging major banks to extend 1 trillion yuan ($140 billion) of financing in the final months of the year, and offering special loans through policy banks to ensure property projects are delivered.
• The eased property restrictions probably also fed into the surge in Chinese stocks on Friday. However, it is important to remember that the regulatory easing flies in the face of President Xi’s desire to rein in real estate developers’ debt, so it’s not entirely clear how far the measures will be taken.  It therefore remains to be seen whether Chinese stocks will continue to rebound.

United States-China:  President Biden and Chinese President Xi held their first in-person meeting as national leaders today on the sidelines of the Group of 20 summit in Indonesia.  According to U.S. National Security Advisor Sullivan, Biden used the occasion to warn China about U.S. red lines as the two countries’ rivalry intensifies.  He also suggested that Xi should help rein in North Korea’s belligerent nuclear missile program.

U.S. Mid-Term Elections:  Based on updated vote tallies released over the weekend, Nevada Senator Catherine Cortez Masto now appears to have won re-election, ensuring the Democratic Party will retain control of the upper house of Congress with Vice President Harris’s tie-breaking vote.  If the Democrats win Georgia’s senatorial run-off vote on December 6, they will improve their position in the Senate to an outright majority of 51-49.

• Nevertheless, for investors, the key story is simply that the Republicans have probably taken control of the House of Representatives.
• If confirmed by final vote tallies in the coming days, Republican control of the House means that the federal government will again be split between the parties. Historically, that has been a positive environment for U.S. stocks.

U.S. Monetary Policy:   At an event in Australia today, Federal Reserve board member Christopher Waller warned that investors shouldn’t be lulled by last week’s report showing cooler inflation.  According to Waller, the monetary policymakers “have a ways to go yet” to boost interest rates high enough to get inflation truly under control.  The statement should be a reminder that the Fed is still desperately keen to rebuild its inflation-fighting credentials, so it is likely to keep raising interest rates in the near term even if doing so pushes the economy into recession, as we expect.

U.S. Economy:  The freight unit of FedEx (FDX, $175.61) said it is furloughing some workers in select U.S. markets in response to slowing demand.  Since transportation services can often be a bellwether for the overall economy, the action provides concrete evidence that U.S. economic activity is slowing sharply, consistent with our view that it will slip into recession sometime in the first half of 2023.

• Because of slowing demand and purchasing mistakes amid the pandemic’s disruptions, many retailers have already started offering big “Black Friday” discounts to clear out excess inventories. The drop in prices could help bring down inflation but will probably also weigh on retailers’ profits and stock prices.
• In other potential good news for inflation, wetter weather in Brazil and Indonesia is promising to bolster coffee supplies which will prompt a big decline in prices. Futures prices for the Arabica variety have fallen approximately 22% in just the last month.

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