by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Happy Veterans Day! Today’s Comment begins with our view on the market’s reaction to the positive CPI report. Next, we discuss how a moderation in Fed policy could impact the dollar. The report ends with a review of recent developments that may impact commodity markets.

 CPI Day: A deceleration in inflation has bolstered investor confidence that the Fed will end its tightening cycle.

• Markets rejoiced Thursday after the latest consumer price index report showed that inflation slowed more than expected in October. Last month, headline CPI rose 7.7% from the previous year, well below the September rise of 8.2%. Meanwhile, core CPI, which excludes food and energy prices, rose 6.3% from October 2021, down from 6.6% in the previous month’s report. The sharp decline in inflation was driven by a deceleration in energy and used car prices. The reaction from investors is likely the result of speculation that the Fed may pivot soon.
• The upbeat report helped boost equities and bond prices but weighed heavily on the dollar. On Thursday, the S&P 500 had its best performance in over two years as the index rose 5.5% from the previous day. Meanwhile, the yield on the 10-year Treasury, which is inversely correlated to bond prices, fell 28 bps to 3.86%. Hence, the robust market response from the inflation data suggests that there is still much optimism that the Fed will not raise rates much higher than their current levels. The latest CME Fedwatch tool shows that the market has priced in an 85.4% chance the Fed will raise rates by 25 bps in its next meeting.
• We have our doubts about a possible Fed pivot. The chart below shows the implied three-month LIBOR rate using two-year Eurodollar futures and compares it to the Fed Funds target rate. The blue line shows the spread between the two rates, and the black line shows where the Federal Reserve ended its tightening cycle. Assuming this trend holds, the latest spread numbers suggest that the Fed may stop hiking in early 2023. That said, this time may be different. The Fed has habitually disciplined markets whenever investors doubted the central bank’s commitment to fighting inflation.

Dollar’s Descent: As the Fed starts to ease off the accelerator, other central banks are looking to press on.

• Fed officials welcomed the positive inflation news but insisted that the central bank is not finished tightening. Philadelphia Fed President Patrick Harker signaled that in light of the CPI data, the Fed could raise rates by 50 bps. His colleagues Dallas Fed President Lorie Logan and San Francisco Fed President Mary Daly, mirrored his sentiment. The insistence by Fed officials that they will continue to raise rates is another example of the Fed’s relentless effort to reinforce its inflation fighting credential. As a result, the rally in equities may be short-lived as investors realize that financial conditions will likely get tighter going into 2023.
• Moderation in the Fed tightening cycle could allow other central banks to catch up. On Thursday, several European Central Bank officials stressed that interest rates must rise much further to control inflation. Meanwhile, the Bank of England announced that it was prepared to offload some of the bonds it purchased during its emergency action. Even the Bank of Japan has discussed the possibility of normalization! The move to tighten monetary policy in other parts of the world will put downward pressure on the dollar but also threatens global growth. As a result, the U.S. may be an attractive target for investment going into 2023.
• The strong CPI report may not be enough to sway the Fed to stop tightening, but it could threaten the greenback. There are two reasons that support a possible peak in the U.S dollar. 1) Inflation in Europe and the U.K. has yet to hit its peak, suggesting more tightening is needed. 2) Advanced economies have typically maintained a relatively tight place when the Fed has started cutting. That said, a global recession or a geopolitical conflict, such as a nuclear attack on Ukraine or an invasion of Taiwan by China, could trigger a flight-to-safety response from investors, pushing the dollar up even further. As a result, the currency’s continued decline is far from certain.

• Several European economies are showing signs of an impending recession. On Friday, economic reports showed that Spain, Germany, and the U.K. are in dangerous territory.

Commodity Challenges: Despite the warmer-than-expected winter so far, there is still a risk that commodity prices could begin to surge.

• The reopening of the Chinese economy could bolster demand for commodities. On Friday, Beijing eased some pandemic restrictions. Temporary bans on routes from countries with COVID outbreaks have been lifted, while regulators narrowed quarantine and mass testing requirements. Although China has not formally ended its controversial Zero-COVID policy, the recent measures suggest it is heading in that direction. As a result, crude oil prices jumped 3.3% so far today, as there are now expectations that demand will rise. We estimate that the price of Brent Crude could easily surpass $100 a barrel once China fully opens its economy.
• Meanwhile, Germans are reluctant to supply non-allied countries with their natural gas. On Friday, Germany sent diplomats to India to resolve a dispute over a cut in supplies. Their decision to reduce exports to India may be related to New Delhi’s continuing trade ties with Russia. Although India has not formally taken a side in the Russia-Ukraine war, its indifference on the matter could lead it to be shunned by western countries. That said, Germany’s hesitancy to sell its LNG to India will likely reduce its chance of facing an energy crunch later in the winter.
• Despite the Russian retreat in Kherson, the war in Ukraine is far from over. On Friday, the Kremlin announced that its soldiers had left the city. Although this may sound like good news, residents have stated that Russians remain in the country dressed in civilian clothing. The ongoing war in Ukraine remains the biggest threat to commodities. There is hope that Russia and Ukraine will come to terms on a new peace agreement; however, it does not appear that either side is ready to make steep concessions to get a deal done. The U.S. is rumored to be working on a way to get the two sides together, and if they are successful, we could see a drop in commodity prices.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a quick observation on the market action following the CPI data. Next is our take on the midterm election results. Then, we point out the recent slowdown in the movement toward deglobalization. Lastly, we give an update on the downfall of FTX.

What the CPI Data Tells Us: CPI data for October came in less than expected (see the data section in the pdf) triggering some sharp moves in the financial and commodity markets. The most violent moves occurred in equities, with S&P futures jumping 3.5%. Treasuries also rallied strongly, with the 2-year yield dropping over 20 bps. But perhaps the key market indicator is the dollar as the DXY plunged nearly 200 pips after the release. Gold, often thought to be an inflation hedge, revealed its true nature as prices popped nearly $30 per ounce on weaker than expected inflation. Gold, like bitcoin (which also rallied) is a debasement, not an inflation hedge.

As we note below, yearly CPI is still 7.7% higher than last year. The fact that we can see such violent moves in markets on a rather modest improvement in inflation suggests that (a) there is still ample liquidity available to move markets on “good” news and (b) the data is raising hopes that the FOMC will be done soon, as shown by the rally in the 2-year T-notes.

We have doubts about this market move because we are less optimistic this data will change the Fed’s policy trajectory all that much. Today, as we note in the data section, we have a full slate of Fed speakers so we should have some insight soon on how at least some of the members of the FOMC view the report. We would look for some “fade” after this early move, but today does suggest there is a lot of liquidity and more investors seem worried about missing out on the rally rather than protecting themselves from further weakness.

 The Red Ripple: Congress will likely narrowly split between the Democrats and Republicans, which should be favorable for equities.

• More results came in from Tuesday’s election. Currently, only three senate races have yet to be called. Georgia will head to a run-off; meanwhile, results for Arizona and Nevada are expected to be released later this week. In the House of Representatives, there are 33 races that have not been called, including 21 of the 53 most competitive races. Betting odds on Predictit.org show that the Democrats, as of the time of this writing, have an over 90% chance of winning the Senate, while Republicans are eight seats away from taking back the House. A split Congress came as a surprise to investors who were expecting a “red wave,” but in time this change should be viewed favorably by the market.
  • Off the heels of the Democrats’ better-than-expected performance, President Biden announced that he wants to run for a second term.
• The market reaction was slightly lower as investors awaited more results to be announced. The S&P 500 stocks closed down 2.1% on Wednesday. Meanwhile, the election uncertainty contributed to the choppy trading of U.S. bonds. The yield of the 10-year Treasury, which moves inversely to its price, rose 2.5 bps to 4.151% the day after polls closed. However, Wednesday’s trading showed investors are still a bit wary about the outcome, but we do not expect that feeling to last long.
• A divided legislative branch is a net positive for equities as it reduces the likelihood of policy changes. It will be more difficult for the Democrats to push through another round of fiscal stimulus as the Republicans will look to block it. It will also strengthen the hand of Democrats that favor Ukraine-Russia peace talks. Last month, House Minority Whip Kevin McCarthy warned that Ukraine would not be given a blank check to fight its war. The lack of stimulus and a possible end to the war in Ukraine should remove some inflationary pressure and make it easier for the Fed to ease up on policy tightening.
  • However, there is some downside risk. The lack of a solid Republican majority will allow fringe groups to potentially play party spoiler. As a result, the likelihood of a debt ceiling showdown is now elevated.

On Second Thought: There are signs that major countries are looking to slow the trend toward deglobalization.

• Moscow ordered its forces to leave the city of Kherson, an embarrassing setback for Vladimir Putin. Meanwhile, the U.S. is working behind the scenes to secure peace talks with Russia. The developments suggest that there is wavering support for the war in Ukraine; thus, there may be room for negotiations. Although we may point to Russian losses as the reason for the Kremlin wanting to start talks, Western support for restrictions, particularly on Russian energy, is far from solid. As a result, both groups have room to make concessions.
  • A possible solution to the war in Ukraine would be favorable for equities as it should lead to fewer supply chain disruptions and stable pricing for commodities.
• In the United Kingdom, Brexiteers are starting to loosen their opposition to immigration. On Thursday, Next plc (NXT.L, £5,528) boss Simon Wolfson urged the government to allow more foreign workers to enter the country. As a backer of the leave camp during the Brexit vote, Wolfson’s comments are noticeable given the group’s strong anti-immigration stance. Therefore, his reversal may reflect a growing sense of regret that the U.K. left the European Union. Although it is unlikely that the U.K. will apply to rejoin the EU within the next decade, it does suggest that populist policies are starting to lose some appeal as the country struggles to find labor and cope with higher levels of inflation.
• The shift toward deglobalization is going to take a lot of work. In a free trade world, countries had access to cheap labor and relatively stable commodity prices. That said, the cost of maintaining these benefits came at the expense of higher inequalities within countries. Although it would be foolhardy to believe that the latest developments could lead to a reversal in the trend toward deglobalization, the recent push by governments to prevent further decline of international ties suggests that the world is still a long time away from a complete fracture. Assuming we are correct, it would indicate that a more regionalized world is still far away.

 A Crypto Moment: FTX may be the digital currency version of Lehman Brothers.

• Major trading platform FTX is going bust. On Wednesday, Binance announced that it was pulling out of its deal to buy FTX. The breakdown in talks was related to the discovery of a big hole it found in FTX’s financial data. The platform has an $8 billion shortfall and needs $4 billion to remain solvent. The problem began when Coindesk reported that Almada Research, a trading desk for FTX, had more liabilities than assets and escalated when traders began offloading FTTs, the platform’s signature crypto tokens. The sell-off threatens to hurt other platforms that hold FTTs in their portfolio of crypto currencies.
  • In another twist, U.S. regulators are investigating FTX over how it has handled customer funds.
• The rapid decline in FTX has spilled over into other digital currencies and crypto institutions. For example, Bitcoin has fallen below $17,000, and shares in Silvergate Capital (SI, $34.69), a financial bank for digital currencies, declined more than 7% on Wednesday. Meanwhile, investors pulled $700 million out of Tether after the stablecoin fell below parity with the dollar for the first time since July. The fragility of crypto markets is related to the lack of users for digital assets. As a result, the market is susceptible to runs as investors look to liquidate at the first sign of trouble.
• The biggest unknown from this development is how the regulators will interpret the turmoil. Unlike money market funds, crypto is not deeply integrated into the financial system. That said, the recent market crash could lead policymakers to pass legislation restricting these assets’ use as leverage in financial transactions. At this time, the likelihood of a possible financial crisis related to the downturn is minimal. However, the shift away from digital assets reflects investor preference for shorter-duration assets since they can provide quick returns.
  • The crypto crisis is another example of how tightening financial conditions have negatively impacted risk assets. We expect these episodes to persist as long as the Federal Reserve continues to raise interest rates.

View PDF

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 some of the key air defense and cyberwarfare assistance that the U.S. has provided to Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an initial take on the U.S. mid-term elections, although it’s important to note that the votes are still being counted and the outcomes of many races are still up in the air.

Russia-Ukraine:  Ukrainian forces continue to make marginal gains in their counteroffensives in the northeastern Donbas region and in the southern region around Kherson.  Reports today indicate that the Ukrainians have entered a key city just north of Kherson.  Meanwhile, the Russians continue to strike back with air, missile, and kamikaze drone attacks.  Additional reporting shows that the Russians continue to struggle with depleted weapons inventories and difficulties with manufacturing replenishment weapons, in part due to Western sanctions.  They are therefore turning to other countries to buy weapons.  The most recent reports suggest Russian National Security Council Secretary Patrushev arrived in Tehran yesterday, probably to discuss the potential sale of Iranian ballistic missiles to Russia.

• Yesterday, the Ukrainian military announced it had received its first two U.S.-supplied National Advanced Surface-to-Air Missile Systems (NASAMS), which should improve the country’s air defense capabilities and reduce the damage to its civilian infrastructure from Russian air, missile, and drone attacks. The U.S. has pledged to provide six more NASAMS over the next year and a half.
  • One benefit of the NASAMS is their use of adapted air-to-air missiles known as Surface-Launched AMRAAMs. Newer NASAMS can also launch other air-to-air missiles, such as the AIM-9 Sidewinder.
  • That’s important because the U.S. and its allies have significant stocks of those types of missiles.
• U.S. Army Gen. Paul Nakasone, head of the National Security Agency, recently explained why Russia has launched only small, ineffective cyberattacks against Ukraine and its allies so far in the war. According to Nakasone, Russia’s cyber capabilities were seriously blunted by U.S. “hunt-forward” teams sent to Ukraine in late 2021.
  • The hunt-forward teams, consisting of U.S. cyber soldiers, conduct defensive and cooperative measures overseas at the invitation of a foreign government. The teams are a part of the U.S. military’s “persistent engagement strategy,” which centers on maintaining constant contact with cyber adversaries and ensuring that proactive, not reactive, moves are made.
  • According to Nakasone, U.S. hunt-forward teams have conducted dozens of operations abroad in recent years, including in Croatia, Estonia, Lithuania, Montenegro, and North Macedonia.

China:  As shown in the data section, the October producer price index was down 1.3% year-over-year, marking China’s first annual drop in wholesale prices since December 2020.  Along with the weak international trade data released earlier this week, the fall in the PPI provides clear evidence that China’s economy is losing momentum, which is likely to be a headwind for the global economy and global risk assets in the coming months.

• The October consumer price index was up just 2.1% year-over-year, below expectations and weak enough to suggest muted consumer demand.
• Amid weak foreign demand, unpredictable and disruptive COVID-19 lockdowns, government crackdowns on whole swaths of the private sector, and other challenges, the reports indicate waves of Chinese manufacturers are closing down or reducing operations, pushing many blue-collar workers into unemployment.

European Union:  The European Commission proposed a loosening of the bloc’s debt rules today that would give highly indebted governments more room to spend money. Until now, the bloc has required governments to keep the budget deficit below 3% of GDP and debt below 60% of GDP, with tight timelines for cutting above-target deficits and debt.  Those rules have been suspended for several years now, but the EU is proposing to replace them with country-specific action plans to cut deficits and debt over longer, more realistic time periods.

• We suspect some version of the proposed rules will be put into place, simply because the prior rules and timelines are unrealistic given that many EU countries have boosted their spending and debt so much in recent years.
• The new rules would likely trade austerity for higher debt, leaving many EU countries at economic risk. High debt among countries in the Eurozone could also lead to widening currency spreads that would complicate ECB policymaking and threaten the euro.

United Kingdom:  To help cut the U.K.’s yawning budget deficit, Chancellor Hunt is reportedly considering a proposal to reduce the income level at which the country’s top personal income tax rate of 45% kicks in.  The move would allow the government to avoid breaching the Conservative Party’s 2019 pledge not to increase tax rates.

U.S. Mid-Term Elections:  Based on the results available so far this morning, the key takeaway from the elections yesterday is that the “red wave” of massive Republican Party gains failed to materialize.  The Republicans are expected to regain control of the House of Representatives, but with a smaller majority than they had hoped and anticipated going into the polls.  The Senate remains up in the air, with votes in several key races still being counted.  At least one important Senate race, in Georgia, could result in a run-off election.

• In any case, the U.S. will now have a divided government again, with Democrats retaining the Executive Branch and Republicans controlling at least one chamber of the Legislative Branch.
• Historically, such divided government has actually been positive for investors. In addition, the U.S. stock market has historically tended to rally over the year following the mid-term elections.  U.S. stock futures are trading lower so far this morning, perhaps on investor disappointment that pro-business Republicans didn’t do better, but the election may have actually helped lay the groundwork for stronger stock markets once the U.S. economy gets through its impending recession.

U.S. Military Power:  Because of the military’s recent shortfalls in recruiting, the U.S. Navy said late last week that it is raising its maximum age for new sailors from 39 to 41.  The policy change means that the Navy is now accepting the oldest enlisted recruits of the four services.  The Air Force’s maximum enlistment age is now 40, and the Army’s maximum is 35, while the Marine Corps’ enlisted age limit is 28.

U.S. Semiconductor Industry:  Taiwanese computer chip giant Taiwan Semiconductor Manufacturing Company (TSM, $65.02) is reportedly preparing to build a second cutting-edge fabrication facility north of Phoenix, Arizona.  The scale of the investment is expected to be similar to the $12 billion or so the firm will spend on its first cutting-edge Arizona fab, announced in 2020.

• The development marks a welcome diversification of TSMC’s production capacity, which currently is heavily focused on Taiwan itself, making the firm’s critical output subject to disruption as China pushes Taiwan toward reunification with the mainland.
• The new plant also reflects the kind of shortened supply chains and “friend shoring” we expect to see as the world fractures into relatively separate geopolitical and economic blocs. Our studies indicate that Taiwan would end up as a key member of the evolving U.S. bloc.

U.S. Cryptocurrency Market:  After suffering a sudden liquidity crunch, major cryptocurrency exchange FTX agreed to be taken over by rival Binance.  The crypto world had already been shaken this year by rising interest rates, investors’ falling risk appetite, and a series of bankruptcies in which FTX founder Sam Bankman-Fried often rode to the financial rescue.  The takeover of FTX, therefore, marks a major power shift from FTX to Binance and a humbling comedown for Bankman-Fried.

• The news has also sparked a new round of weakness in crypto assets. So far this morning, Bitcoin has fallen approximately 4.6% to $17,859.99, while Ether is down 7.6% to $1,229.85.
• FTX’s own token, FTT, has lost some three-fourths of its value so far today.

View PDF

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 new statement by Ukrainian President Zelensky that he is open to peace talks with Russia, subject to tough conditions.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a series of speeches by policymakers at the European Central Bank that indicate they will continue to hike interest rates aggressively.

Russia-Ukraine:  The Ukrainians continue to slowly and methodically press their counteroffensives in the northeastern Donbas region and in the southern region around Kherson.  Meanwhile, the Russians increasingly look like they are preparing to defend Kherson, although perhaps with only a blocking force of minimally trained, recently mobilized troops.  The Russians also continue to attack civilian infrastructure targets throughout Ukraine using air, missile, and kamikaze drones.  However, Ukrainian intelligence officials say that Russia has now run through some 80% of their modern, high-precision missiles, which could mean their campaign against the Ukrainian infrastructure will soon slow enough for the Ukrainians to get much of their energy grid back into operation.

• President Zelensky stated that he was open to peace negotiations with Russia if they are focused on safeguarding Ukraine’s territorial integrity, compensating Kyiv, and bringing perpetrators of war crimes to justice. The U.S. and other allies have been pressuring Zelensky to say he is open to talks in order to firm up international support for Ukraine.  However, Russia is unlikely to accept Zelensky’s tough terms, at least for now.
• Separately, Zelensky said his government has used its wartime powers to temporarily take control of five “strategic” companies owned by the country’s oligarchs.
  • The nationalized companies include Ukraine’s top oil producer, its top oil refiner, and a key manufacturer of engines for airplanes and helicopters.
  • Importantly, some of the nationalized firms were previously owned by Igor Kolomoisky, an oligarch who backed Zelensky’s presidential bid in 2019 and who is now facing probes into the insolvency of PrivatBank, another of his previous businesses. That suggests that Zelensky may be using his wartime powers to carry out his program of weakening the country’s corrupt oligarchs.

Eurozone Monetary Policy:  Pushing back against politicians and investors hoping for a “dovish pivot” toward stabilizing or even falling interest rates soon, several senior policymakers at the ECB today insisted that the fight against price inflation will require them to keep hiking interest rates, even beyond the point at which they constrain demand and weaken growth.  The well-coordinated statements signal that the ECB will continue to hike rates aggressively, even as it tries to keep a lid on longer-term bond yields in the bloc’s weaker economies.

Pakistan:  Supporters of Former Prime Minister Imran Khan have blockaded roads around the capital of Islamabad in an effort to topple the government following an attempted assassination of Khan last week.  The protestors are angry at what they see as the government’s reluctance to investigate allegations that current Prime Minister Sharif and senior civilian and military officials conspired to kill Khan.

China:  The latest figures show that new COVID-19 infections nationwide have topped 5,400 cases per day for the first time since May.  Although there are now multiple conflicting reports about whether the government will end its disruptive Zero-COVID policies in the coming months, the current surge suggests that the government could impose new lockdowns in the coming days.  As we have discussed before, such lockdowns have been challenging for the Chinese economy, the broader global economy, and global financial markets.

United States-China:  In another example of how the world’s technology industry is finding work-arounds to the strict new U.S. restrictions on selling semiconductor technology, equipment, and services to China, Nvidia (NVDA, $143.01) announced it has developed a new graphics chip for advanced Chinese companies that can be exported to China without restriction.

• According to Nvidia, the new chip has the same computational performance but a narrower interconnect bandwidth, i.e., the capacity of the chip to send and receive data from other chips, which is crucial for training large-scale AI models or building supercomputers.
• Nvidia hopes the new chip will allow it to retain hundreds of millions of dollars of revenue from China that otherwise would be lost.
• Nevertheless, it appears that the new, restricted chip will help meet the U.S. goal of further suppressing the overall computational capacity of China and the Chinese military.

U.S. Labor Market-Impact of COVID-19:  Even though new COVID-19 infections have fallen sharply, pandemic restrictions are practically gone, and life in many respects is approaching normal, new research indicates that the disease continues to impede labor force participation and productivity growth.  In turn, the resulting labor shortages are contributing to upward pressure on wages and inflation.

• According to the new studies, the number of workers who missed at least one week of work because of illness in any given month is now up 630,000 from the average levels before the pandemic.
• At least 500,000 more workers have dropped out of the labor force because of the lingering effects of a previous COVID-19 infection.
• In a Census Bureau survey in October, 1.1 million people said they hadn’t worked the week before because they were concerned about contracting or spreading the virus.
• The pandemic’s lingering suppression of the labor force has forced many firms to keep payrolls higher than they otherwise would in order to ensure adequate personnel for operations. That means those firms are now operating less efficiently than they would have before the pandemic.  The resulting drop in productivity per worker hour has raised labor costs and fed into inflation.

U.S. Labor Market-Impact of Recession:   Recent layoff announcements by major employers suggest that middle managers may be particularly at risk as the economy slips into recession.  Skilled production workers and other non-supervisors are typically the first to be let go as firms trim their labor costs going into a downturn, but today’s massive shortage of such workers means firms will probably be loathe to let them go.  Rather, the economy may be slipping into a “white collar recession.”

U.S. Real Estate Market:  New data shows developers are slowing their major office projects already under way and shelving new projects as they face soaring interest rates and high office vacancy rates after the COVID-19 pandemic.

• Reduced office construction will help slow the economy and push it into recession, but it could eventually help bring the supply of office space down to the lower, post-pandemic level of demand. In time, that could help stabilize office rents.
• The boom-and-bust cycles in property development can be difficult for investors, but they also hold out the promise that excess space and low rents today can eventually reverse.

U.S. Elections:  Voters across the U.S. go to the polls today for mid-term elections in which all seats in the House of Representatives and one-third of the seats in the Senate will be contested.  The latest polls suggest that the summer swing of voting intentions toward the Democrats has now largely dissipated, raising the chance that the Republicans could take control of both chambers.

View PDF

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.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including multiple reports related to China.  Importantly, there are conflicting reports about China’s readiness to ease its Zero-COVID policies, which have done so much to impede Chinese and global economic activity.

Russia-Ukraine:  As Ukrainian forces continue to press their counteroffensives in the northeastern Donbas region and in the southern region around Kherson, Russian forces continue to strike back with air, missile, and kamikaze drone attacks against civilian infrastructure across Ukraine.  The Russians are also attempting to counterattack with ground forces, but reports indicate a contingent of their Pacific Fleet Marines took heavy casualties in the Donbas recently.  At the same time, Russian financier Yevgeny Prigozhin continues to throw his Wagner Group mercenaries against the Ukrainian city of Bakhmut in the Donbas region and is reportedly close to taking the city, albeit with significant casualties.  However, most Western observers that we follow believe that the capture of Bakhmut would give Russia little strategic advantage; rather, the Wagner Group attacks there appear to be designed to bolster Prigozhin’s leadership credentials, perhaps for his take over as Russian defense minister or for him to eventually seize power from President Putin.

• A report in the Wall Street Journal stated that U.S. National Security Advisor Sullivan, in recent months, has engaged in confidential discussions with high-level Russian officials to reduce the risk of a broader conflict over Ukraine and to warn Moscow against using nuclear or other weapons of mass destruction.
• Some Western analysts dismiss the possibility out-of-hand that Russia might take steps toward using a tactical nuclear weapon in its war with Ukraine, but as President Putin becomes increasingly backed into a corner, we would place the probability of such a move at around 25% or so.
  • Sullivan’s discussions with the Russian leadership confirm that the risk of such an event is not negligible.
  • In any case, Sullivan’s instinct to keep the lines of communication open reflects how many national security personnel in the U.S. administration are traditionalists and well-schooled in the imperatives of U.S.-Russian diplomacy and great-power rivalry.

United States-China:  Just one month after the U.S. imposed a series of tough, new restrictions on sending advanced semiconductor technology, goods, or services to China, reports show Chinese tech firms such as Alibaba (BABA, $69.81) have found at least one workaround as the firms are tweaking their most advanced chip designs to reduce processing speeds, allowing them to avoid U.S. sanctions when the chips are shipped back to China after being made in Taiwan.

• With the U.S.-China geopolitical rivalry intensifying, the U.S. restrictions aim to suppress China’s computing power and make it more difficult for the country to compete economically and militarily.
• China’s indigenous semiconductor plants are most likely decades away from producing cutting-edge chips such as those designed by Alibaba, so the move to deliberately cut their processing speeds is likely to have a noticeable impact on Chinese firms.

China-Solomon Islands-Australia:  Illustrating how some countries will likely try to play the evolving China-led geopolitical bloc against the U.S.-led bloc for their own advantage, last week the Solomon Islands took delivery of a Chinese domestic security aid package consisting of two water cannon trucks, 30 motorcycles, and 20 SUVs for its police force, just days after it took delivery from Australia of 60 short-barreled police rifles and 13 vehicles.

• In our recent study projecting which countries will end up in each of the evolving geopolitical blocs, we assigned the Solomon Islands to the “Neutral” camp. Our study projects that Australia will be a key member of the U.S.-led bloc.
• The competing Chinese and Australian donations come one year after the Solomons’ Prime Minister Sogavare put down a violent uprising stemming from his efforts to switch the country’s allegiance to China as he attempts to retain power.
• In the coming years, as the U.S. and Chinese blocs attempt to curry favor with other ostensibly neutral countries, such as Indonesia and Vietnam, we suspect many of the neutrals will try to play the two blocs off each other in order to take advantage of the situation and retain their room to maneuver.

Chinese COVID Policy:  In a Saturday press conference, government health officials said they will continue to enforce President Xi’s “dynamic Zero-COVID” policy, calling it “completely correct, most economical, and effective.”  Although the officials promised to continually refine the policy to minimize economic and social disruptions, the statement suggested that the Chinese economy and financial markets will continue to struggle with the economically painful policy.  However, reports based on insider accounts this morning indicate high-level officials are actually reconsidering the Zero-COVID policy but want to move slowly before abandoning it to limit any downside for public health and/or for the political position of the Communist Party.  The conflicting reports have whipsawed stock equity futures over the last day.

• The headwind from the Zero-COVID policy has added to China’s many other problems, such as the government’s crackdown on whole swaths of the private sector, foreign clampdowns on technology and capital flows into China, and weakening foreign demand for Chinese exports. Indeed, data this morning showed that Chinese exports in October were down 0.3% year-over-year, marking their first annual decline since May 2020.
• The Zero-COVID policy and new outbreaks of the disease have also presented challenges for U.S. firms currently active in China. Yesterday, Apple (AAPL, $138.38) said global shipments of its newest high-end iPhones will be delayed after the latest lockdowns caused havoc at a factory run by a main supplier, Hon Hai Precision Technology (HNHPF, $6.22).

Chinese Finance Sector:  The Communist Party announced that Fan Yifei, one of the six deputy governors of the People’s Bank of China, has been detained as part of an investigation into “suspected serious violations of discipline and law.”  Fan, a former high-level officer at China Construction Bank (CICHY, $10.98), is the latest in a series of financial officials who have been arrested on corruption charges over the past two years.

• Foreign investors are now quite attuned to President Xi’s value-destroying crackdowns on sectors such as technology and real estate development.
• Fan’s arrest is a reminder that China’s broader financial sector is also at risk of a regulatory crackdown. At the PBOC, Fan’s responsibilities included overseeing the country’s payment system and shepherding the central bank’s effort to create a digital currency.  His arrest signals that those two areas may now be a focus of the party’s corruption police.

United Kingdom:  When he releases his Autumn Statement at mid-month, Chancellor Hunt reportedly will call for tax increases and public spending cuts worth up to £54 billion per year to close the government’s yawning fiscal deficit.  Not only would the fiscal tightening reverse Former Prime Minister Truss’s plans, which sparked a massive selloff in U.K. government bonds, but it would also mark a return to growth-inhibiting austerity like that of the early 2010s.

U.S. Economy:  New polling suggests that almost three-quarters of U.S. consumers plan to seek less-expensive alternatives in this year’s holiday shopping season, driven largely by high inflation and concerns about an economic downturn.  The report is a reminder that the resilient labor market and continued high employment will not necessarily preclude a drop in consumer spending or a broader economic recession.  We continue to believe a recession is likely to begin in the next few quarters.

U.S. Elections:  Voters across the country will go to the polls tomorrow for mid-term elections in which all seats in the House of Representatives and one-third of the seats in the Senate will be contested.  The latest polling suggests that the summer swing of voting intentions toward the Democrats has now largely dissipated, raising the chance that the Republicans could take control of both chambers.

• For investors, perhaps the key thing to remember is that U.S. stock prices typically rebound once the mid-term elections are finished, perhaps reflecting greater clarity on which party will control policy.
• If that happens again this year, it would suggest stocks could rebound in the coming months and beyond. The chart below shows stock performance this cycle versus the average when a new party takes over the presidency (as happened in 2020).

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts on the impact higher interest rates will have on investor sentiment. Next, we discuss how the changing geopolitical landscape is forcing leaders to rethink their alliances. Lastly, we talk about both the positive and the negative developments internationally.

 Pay Now, Not Later: Expectations of higher interest rates are adding to investor woes about duration risk.

• Investors have reevaluated their estimates of rate hikes for 2023 in response to comments made by Fed Chair Jerome Powell. In a press conference, Powell stated that the central bank’s peak interest rates were likely higher than markets have currently priced in. As a result of this comment, investors have updated their peak interest rates to slightly above 5% by March 2023.
  • The chart below shows the market-implied Fed funds rate through 2023. Post-meeting data shows that investors have priced in a higher peak and have extended expectations of a Fed reversal.

• Investors have begun offloading some of their duration sensitive assets thanks to new interest rate expectations. The nominal total return for the 30-year Treasury is down more than 30% year-to-date. Meanwhile, the NASDAQ composite index is down nearly 26% for 2022. The sell-off in duration sensitive assets is related to investors demanding higher premiums for investments that cannot provide short-term returns. Hence, investors are now prioritizing stocks that can give them a return now rather than later.
• The combination of higher interest rates and inflation will encourage investors to demand higher premiums to hold on to riskier assets. As a result, investors are starting to prefer stocks with low multiples and high-dividend-paying potential. This dynamic partially explains why iShares ETF for value (IVE, $140.42) has outperformed its growth (IVW, $56.23) counterpart this year (-8.62% vs. -30.53%). It appears that investors are becoming increasingly uncomfortable with holding onto securities for long periods when there is uncertainty concerning inflation and borrowing costs. This trend will likely continue as long as the Fed continues to tighten the screws on its monetary policy.

A New Identity: As Europe adjusts to the new world order, leaders begin to show their true colors.

• The once Eurosceptic Giorgia Meloni has changed her tune since taking over as Prime Minister of Italy. On Thursday, Meloni met with Brussels to dispel notions that she was unwilling to work with officials to manage the country’s heavy debt burden. When Meloni was initially elected, there much skepticism about her readiness to make the reforms required for Italy to receive its total allocation of EU funds. So far, those concerns have been muted as Meloni has expressed an openness to working with Brussels.
  • The improved outlook on Italy explains why Italian bond yields have declined in the weeks following Meloni’s election victory. The interest rate on bonds has fallen nearly 30 bps since the Italian elections. Although rates still remain elevated, the decline shows that investors are willing to give Meloni a chance.

• Meanwhile, German Chancellor Olaf Scholz reminded the world that Berlin will always prioritize its own self-interest. Scholz is set to meet with Chinese officials on Friday to ensure that the ties between Beijing and Berlin remain tight. China is Germany’s third biggest trading partner behind the European Union and the U.S. The decision by Scholz angered some of his Western allies who then accused Germany of making the same mistake it did when it built close ties with Russia. Scholz’s gesture toward Beijing suggests that the world may not be split into two blocs but possibly three, with the U.S., EU, and China each leading their own blocs.
• It is not clear how an independent Europe could coexist with the U.S. However, if we are correct, companies could be caught in the crosshairs as governments may pressure firms to choose sides. We are already seeing the S pressure firms such as Intel (INTC, $27.39) to stop selling semiconductors to China. Additionally, the situation will likely play out slowly over the next ten years as governments adapt to this new normal. In the meantime, companies with domestic supply chains may be relatively more attractive because they are less susceptible to policy-related disruptions.

 

Brighter Outlook: There is finally some good news coming out of China; however, rising uncertainty persists in other parts of the world.

• The investing environment in China is showing signs of improvement. For example, on Thursday, Bloomberg News reported that Chinese authorities were looking for ways to ease the impact of their Zero-COVID policy. Officials plan to lift restrictions on flight suspensions to make it easier for the country to receive more travelers. Additionally, U.S. regulators are ahead of schedule on their audit of Chinese companies. So far, the developments have provided a reprieve for Chinese stocks the day after Beijing stamped out speculation that it was preparing to end its COVID restrictions.
• Despite the positive news out of Asia, Europe and the Middle East still look like a mess. The EU is considering using the assets it seized from the Russian Central Bank to help Ukraine rebuild. Tensions between the West and Russia will surely escalate if Moscow is forced to bankroll the development of Ukraine. Thus, there is an increased likelihood that the two sides will completely sever ties. In the Middle East, former Pakistani Prime Minister Imran Khan was nearly assassinated on Thursday during a protest. The shooting of Khan reflects the rising tensions within Pakistan as the country deals with a heavy debt burden, slow economic growth, and high inflation. A political crisis in Pakistan could spill over to China and India.
• There is much uncertainty around the world which could weigh on investor sentiment. However, that doesn’t mean that there are not opportunities internationally. The development in China suggests that Beijing is somewhat sensitive to the market’s perception of its policies. Meanwhile, the stories from Europe and the Middle East will not have an immediate market impact. Nevertheless, it is essential to remember that a broad understanding of what is happening worldwide will help investors improve their valuation process, which is why we make certain to provide the good, the bad and the ugly in all of our reports.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning. Today’s Comment begins with our thoughts on the Federal Reserve’s rate decision. Next, we discuss how the Fed indirectly pressures other central banks to tighten their own policy. Finally, we explain how an international push away from globalization will likely impact U.S. firms.

 The Fed Is Not Done: Bullish investors got whacked on Wednesday after Federal Reserve Chair Jerome Powell squashed pivot expectations.

• The Federal Reserve raised rates by 75 bps and signaled the possibility of a more moderate rate hike in its next meeting. Although the hike was widely expected, the Fed gave somewhat conflicting remarks about future increases. In the Fed statement, officials mentioned increasing interest rates until inflation returns to its 2% target while acknowledging that it will be monitoring the policy’s impact on the economy. The two statements led to confusion within markets as investors interpreted it as a signal that the Fed was nearing the end of its tightening cycle. However, Powell later clarified that the central bank is not ready to pause or pivot and has instead increased the ceiling of its interest rate target.
• Although the market initially responded favorably to the possibility of policy moderation, the mood changed after Powell spoke. The S&P 500 tanked 2.5% following the news as Powell’s comment dashed hopes of an imminent Fed reversal. Meanwhile, the dollar rose, and bond prices dropped as tighter financial conditions made cash more attractive. The market’s reaction suggests that many investors still hold risky assets in their portfolios, with hope that the Fed will change course. Hence, the market has not likely hit bottom yet.
• Clearly, the Fed would like investors to believe it is prepared to combat inflation at all costs; however, we have our doubts. The Federal Open Market Committee is unlikely to have unanimous support in favor of raising rates into a recession. In fact, the committee’s reference to a decrease in the size of the rate hikes and an increase in the peak of interest rates suggests that it will try to push up rates as high as it can while the economy remains relatively strong. Hence, the Fed may raise rates by 50 bps until either inflation falls or the economy contracts.
  • The increase in borrowing costs has pushed auto and mortgage rates to their highest levels in more than a decade. Thus, the rise in interest rates is already hurting growth as it suppresses durable goods consumption and investment spending.

 The More, The Scarier: Monetary policymakers in other countries feel compelled to follow the Fed’s lead, whether they like it or not.

• The Bank of England hiked its benchmark interest rates by 75 bps on Thursday, marking its biggest hike in 33 years.  The central bank was forced to raise rates aggressively after unfunded tax cuts from the Truss administration called into question the country’s ability to contain inflation. In its statement, the BOE specified that its interest rate peak would be lower than the market expects. The comment indicates that the bank is reluctant to continue to hike rates as the economy starts to slow. The two dissenters who voted for smaller hikes reflected this cautiousness. The lack of action suggests inflation in the U.K. could be higher for longer, and the pound may begin to weaken again.
• European Central Bank officials have also signaled that they are now more hawkish. ECB president Christine Lagarde stated that a recession would not be enough to bring down inflation. Meanwhile, Governing Council member Martins Kazaks went further and noted that the banks should raise rates “significantly” even with a recession on the horizon. The signaling from ECB officials indicates that the bank will raise rates by 75 bps in its next meeting and could continue to tighten for the foreseeable future.
  • The spread between the 10-year bonds for Italy and Germany, a gauge for financial distress in Europe, is well below its 2022 high. So far, European fragmentation is less of an issue than earlier in the year; however, this could change if the Eurozone falls into recession.

• It is unlikely that either the BOE or ECB feels comfortable becoming more hawkish. This fact explains why these banks have yet to close the door on their respective bond-purchasing programs completely. Their decision to follow the Fed’s lead reflects their need to save face in order to persuade investors not to sell off their respective currencies. Thus, it is unlikely that either central bank will continue with jumbo hikes when the Fed eventually decides to halt its tightening cycle. In the meantime, ubiquitous monetary tightening of financial conditions raises the likelihood of a severe global downturn.

A Darker World:  Globalization may run out of steam as the governments become more hostile and demagogues gain influence.

• Benjamin Netanyahu’s right-wing coalition will face resistance from other countries. The Biden administration has hinted that it is reluctant to work with Jewish supremacist politician Itamar Ben-Gvir. His history of making threats toward the Palestinians makes a relationship untenable. The controversial figure has risen in prominence due to the rise in popularity of ultra-right-wing candidates. His party, Religious Zionism, will be essential for Netanyahu to be able to form a government. The election in Israel reflects how nationalistic countries are becoming and provides further evidence that the world is moving away from multilateralism.
• U.S. rivals North Korea and Russia are becoming increasingly belligerent. Pyongyang tested its most powerful intercontinental ballistic missile (ICBM) on Thursday. Although the launch failed, it is clear that North Korea’s weapon capabilities are still improving. Meanwhile, Russian officials discussed when or how to use nuclear weapons in Ukraine. Although the U.S. will be unlikely to seek violent means to contain these threats, military action is not completely out of the question. That said, the risk of a continental war in Asia and Europe is elevated.
  • A recent report showed that North Korea sent artillery to Russia for war in Ukraine. The cooperation between the two countries suggests that they share policy interests.
• Globalization cannot survive in a hostile world. Companies’ reliance on supply chains depends solely on the belief that countries will remain stable. Thus, as governments become more nationalistic and assertive, firms will be forced to move their manufacturing production to safer countries or bring them back home. This outcome will lead firms to increase their capital expenditures and potentially increase prices as they adjust to a costlier world.
  • In addition to rising conflict, the lack of cooperation is also a headwind to the global economy. Today’s sell-off in China is a good example. Beijing’s unwillingness to seek help from the West has prolonged its COVID recovery. On Wednesday, Beijing reiterated its plans to adhere to Zero-Covid policy. The outcome could make a global recession more likely and weigh on commodity prices.

View PDF