by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the evolving relationship between the European Union and China.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including a short military operation in the Caucasus country of Azerbaijan that has apparently thwarted ethnic-Armenian separatists who had been supported by Russia, and a preview of the Federal Reserve’s interest-rate decision today.

China-European Union:  Jens Eskelund, president of the EU Chamber of Commerce in China,  issued a statement defending the European Commission’s decision last week to launch an anti-subsidy investigation into China’s exports of electric vehicles.  Because of the past experience when the EU’s solar panel industry was decimated by cheap Chinese imports, Eskelund said it should be “understandable” that the EU now wants to prevent the same thing from happening with EVs.

• Eskelund suggested the problem is excess EV manufacturing capacity in China, which the government should address by supporting domestic consumption.
• That’s consistent with the analysis of many economists, including us at Confluence, who believe the Chinese economy is riddled with excess capacity and high debt. In contrast, Chinese consumer spending remains weak, and savings rates are very high.
• All the same, Communist Party ideology and political habits find it difficult to countenance policies aimed at greater consumption and increased consumer choice. President Xi, therefore, is unlikely to give up on China’s export-led, neo-colonialist economic policies anytime soon.

China:  While China’s excess capacity in sectors such as EVs and residential real estate is widely recognized, the country also has a lot of excess office space.  Recent data shows office vacancies in 18 major Chinese cities reached almost 24.0% in June, even worse than the U.S. vacancy rate of 18.2%.  The difference is that China’s excess office space simply reflects massive over-building by developers and tepid uptake as economic growth slows.  The U.S. problem is more tied to the rapid shift toward employees working from home following the coronavirus pandemic.

European Union:  EU lawmakers this week will start negotiating over the final text of their proposed “Platform Work Directive,” a law that would designate gig workers as de facto employees.  In response, officials from ride-hailing giant Uber (UBER, $47.59) warned that if the law isn’t sufficiently flexible, it would force the company to pull out of many smaller cities in Europe and raise prices as much as 40%.

France:  The Rassemblement National Party, led by right-wing populist Marine Le Pen, announced that it has paid back the remaining 6 million euros ($6.4 million) or so that it owed to a Russian company.  The loan has been a political liability for the party since it was taken out in 2014, as it has raised concern that the party was under the influence of Russia and President Putin.  Paying off the loan, therefore, puts the party in a better position to contest future elections, especially as right-wing sentiment grows throughout Europe.

United Kingdom:  The August consumer price index was up 6.7% from the same month one year earlier, much better than the expected increase of 7.0% and down from 6.8% in July.  The August “core” CPI—which in the U.K. excludes food, energy, alcohol, and tobacco—was up just 6.2% year-over-year, beating expectations that it would be up 6.9%, just as it was in the year ended in July.

• The better-than-expected figures have boosted hopes that the Bank of England can pause its interest-rate hikes at its next policy meeting on Thursday.
• In turn, that has driven down British bond yields today, with the yield on the two-year Gilt falling to 4.84%.
  • That has given a boost to interest-sensitive sectors of the country’s stock market today, such as homebuilders and real estate firms.
  • The drop in bond yields has also driven down the attractiveness of the pound (GBP). At this writing, the GBP is trading at $1.2379, down about 0.1% for the day.

Russia-Ukraine War:  Two weeks after Ukrainian President Zelensky fired his former defense minister for corruption, the government sacked six deputy defense ministers who were apparently involved in the scandal.  The effort to clean house suggests Zelensky is intent on presenting the Ukrainian government in the best possible light as he works to maintain foreign military support from the U.S. and other allies and keep up domestic political support at home.

Azerbaijan-Armenia:  The former Soviet republic of Azerbaijan yesterday launched what it called “anti-terrorist” military strikes in its breakaway region of Nagorno-Karabakh, where the largely ethnic-Armenian population has long worked to join neighboring Armenia.  The strikes follow several weeks in which Azerbaijan carried out a military buildup on the region’s borders and imposed a blockade apparently aimed at forcing ethnic Armenians out.  With the Armenians’ Russian supporters distracted by the war in Ukraine, reports this morning say they have already capitulated, likely setting the stage for Nagorno-Karabakh to be re-integrated into Azerbaijan.

• In international political terms, Russia’s unwillingness or inability to protect the Armenians is a further blow to Moscow’s prestige and influence. That will also likely push the country of Armenia closer into the embrace of the U.S.
• The outcome is also probably a positive for Turkey, which has longstanding disputes with the Armenians and has supported Azerbaijan.

U.S. Monetary Policy:  The Federal Reserve will wrap up its latest policy meeting today, with its decision on interest rates due at 2:00 PM EDT.  The officials are widely expected to hold the benchmark fed funds rate steady at its current range of 5.25% to 5.50%.  The question is whether they’ll provide any guidance on future policy changes.  Many investors continue to look for rate cuts in the coming months, but we think they’ll be disappointed.  We think the Fed will try to keep policy tight for an extended period to make sure consumer price inflation is dead.

• As investors increasingly come around to the idea that the Fed will likely keep rates higher for longer, they continue to sell longer-maturity obligations.
• The yield on the benchmark 10-year Treasury note yesterday closed at 4.366%, reaching its highest level since 2007. The yield on the two-year Treasury rose to 5.109%, for its highest level since 2006.

U.S. Regulatory Policy:  Ahead of a new zero-emissions rule in California for commercial trucks that kicks in January 1, truckers are accelerating their shift to electric trucks and stocking up on diesel rigs they soon won’t be able to buy.  Since California’s market is so large, the buying activity could spur a noticeable increase in the national demand for electric trucks, charging stations, and even diesel rigs.

• Specifically, the rule will require that trucks purchased in 2024 and later can serve the state’s ports only if they are zero-emission vehicles.
• Diesel rigs won’t be able to serve California ports at all starting in 2035.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with updated forecasts for global economic growth from the Organization for Economic Cooperation and Development.  The OECD report also urged central banks to keep hiking interest rates and keep them high to snuff out consumer price inflation.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including an apparent assassination carried out by Indian agents in Canada and the prospect of tighter U.S. regulations on the naming of investment funds.

Global Economic Growth:  In its interim Outlook report, the OECD scaled back its forecasts for global economic growth to 3.0% in 2023 and 2.7% in 2024.  While the organization increased its forecasts for U.S. gross domestic product to show growth of 2.2% in 2023 and 1.3% in 2024, it cut its forecasts for other key economies.

• Importantly, the organization now sees much weaker growth in the eurozone, which will be held down by Germany and Italy in particular, and in China, where the economy is being held back by issues such as weak consumer demand, high debt levels, poor demographics, and decoupling policies in the West.
• Despite cutting its growth forecasts for many key economies, the OECD argued forcefully for central banks to raise interest rates further and keep them high for long enough to be sure consumer price inflation is vanquished.

United Nations General Assembly:  The annual meetings of the UN General Assembly began in New York this week, but the proceedings so far have been rather sleepy.  The top news to date is probably the announcement of a new “Partnership for Atlantic Cooperation” led by the U.S. and encompassing dozens of countries that touch the Atlantic Ocean in Europe, Africa, and the Americas.

• To wean countries from China’s embrace, the pact offers improved economic, environmental, and scientific ties among the signatories.
• The agreement also contains pledges to support territorial integrity and political independence, although it doesn’t include any security or military ties.

China-United States:  The American Chamber of Commerce in Shanghai said an annual survey of its members showed that only 58% were optimistic about their business prospects in China over the coming five years.  That marked the lowest level of optimism in the survey since it was launched in 1999.  As we have warned previously, companies that export to China or participate in its markets are likely to face headwinds because of issues like worsening U.S.-China tensions; clampdowns on trade, technology, and investment flows; and China’s own domestic economic challenges.

China-Germany:  The Chinese government on Sunday called in the German ambassador to complain about Foreign Minister Baerbock’s recent description of  President Xi as a dictator.  The incident highlights the increasingly frosty relationship between China and Germany as some German officials take a harder line on China while others keep trying to maintain good relations in the interest of trade and investment.  Ultimately, we suspect the hardliners in Germany will win the day, with negative consequences for the trade-dependent economy.

India-Canada:  In an emergency meeting with lawmakers, Canadian Prime Minister Trudeau said his government is investigating “credible allegations” that Indian agents may have helped kill an exiled Sikh leader near Vancouver in June.  The Sikh leader, Hardeep Singh Nijjar, was a Canadian citizen, prompting Trudeau to call the violation of Canadian sovereignty especially heinous.  In response, Ottawa yesterday expelled a senior Indian diplomat.

• The incident will further strain Indian-Canadian relations, with potential economic consequences. The Canadian government recently cancelled a trade mission to Mumbai set for October.
• If true, the incident also points to an ominous shift toward brazen, extraterritorial measures by Indian Prime Minister Modi, who many accuse of becoming increasingly authoritarian. If Modi really is adopting the extraterritorial “justice” practiced by authoritarian leaders such as Chinese President Xi, Russian President Putin, and Saudi Crown Prince Mohammed Bin Salman, it may become more politically difficult for the U.S. to embrace New Delhi as a partner in its geopolitical competition with China.

Poland:  Ahead of national elections next month, the ruling right-wing Law and Justice Party is reeling from a scandal in which officials are accused of selling Polish visas at foreign consulates despite the government’s assurances it is being tough on illegal immigration.  The political threat from the scandal is probably a reason why the government this week clamped down on Ukrainian food imports to bolster its largely rural voter base.  The Law and Justice Party is still leading the opinion polls, but if its support declines further and it falls out of power, Polish rule-of-law issues would probably no longer be a thorn in the side of the European Union.

Libya:  In the aftermath of last week’s floods, which killed thousands in the coastal city of Derna, hundreds of citizens yesterday participated in a violent demonstration demanding an investigation into who was responsible and why the government’s response has been so poor.  A key issue is why two nearby dams burst amid torrential rainfall.  Some reports say the dams hadn’t been maintained for 20 years, despite the provision of government appropriations.

• Derna lies in the territory controlled by Khalifa Haftar, a warlord who is supported by Russia and some Persian Gulf monarchies.
• At least for now, the demonstrators are focusing their ire on civilian authorities in the provincial government. However, if they start to target Haftar and his forces, they could spark a bloody crackdown and perhaps even international intervention.

U.S. Monetary Policy:  The Federal Reserve will begin its latest policy meeting today, with its decision on interest rates due tomorrow at 2:00 PM EDT.  The officials are widely expected to hold the benchmark fed funds rate steady at its current range of 5.25% to 5.50%.  The question is whether they’ll provide any guidance on future policy changes.  Many investors continue to look for rate cuts in the coming months, but we think they’ll be disappointed.  We believe the Fed will try to keep policy tight for an extended period to make sure consumer price inflation is really dead, as recommended by the OECD.

U.S. Regulatory Policy:  The Securities and Exchange Commission tomorrow will take up a proposal to tighten its “names rule” to crack down on deceptive fund descriptions.  The new truth-in-advertising rule would require that at least 80% of the assets held by mutual funds and other investment vehicles match the fund’s description as presented to investors.  Financial industry officials warn that the rule could discourage stock picking, violate free speech protections, and force funds to sell assets at a loss when markets are volatile.

U.S. Defense Industry:  At a conference last week, Defense Department Undersecretary for Acquisitions and Sustainment Bill LaPlante unexpectedly announced that the U.S. is now far ahead of schedule on the Pentagon’s goal of boosting production of 155-mm artillery shells.  According to LaPlante, output of the shells has already doubled versus just six months ago, to 28,000 shells per month.  Production is now expected to reach 57,000 per month next spring and 100,000 per month by fiscal year 2025, which begins next October.  The military’s original goal was 85,000 per month by fiscal 2028.

• The surge in production for 155-mm shells will help replenish U.S. stockpiles and allow for the continued support of Ukraine as it tries to defend itself against Russia’s invasion.
• Although the 155-mm shell is just one of many different types of ammunition and weapons systems that are important to the U.S. military, the surge in its output is welcome evidence that the U.S. defense industry may be able to generally boost production faster than previously thought. That would be a critical capability as the U.S. works to quickly rebuild its armed forces in response to China’s rapid military buildup and increased geopolitical aggressiveness.
• The surge in 155-mm shell output also helps confirm our view that we will see a bigger, re-invigorated industrial sector as companies bring production back home from China or elsewhere, and as U.S. and allied defense budgets are ratcheted upward. We continue to believe that industrial firms and defense contractors, in particular, will offer attractive investment opportunities in the coming years.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with signs that the Chinese government is working to prevent further financial market contagion related to its faltering real estate sector.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a desire by the U.K.’s opposition leader to improve relations with the EU and new warnings about debt-financed short positions in the market for short-term U.S. Treasury futures.

Chinese Real Estate Market:  Shadow-banking giant Zhongrong International Trust, which sparked concerns about a financial crisis when it missed payments on some of its trust products over the summer, said it has engaged two state-owned financial companies to help fix its operational problems.  The company insists that the arrangement isn’t a government bailout and that the two state-owned firms won’t have responsibility to make up the missed payments to investors.

• Nevertheless, the deal is likely to be interpreted as a bailout in all but name, with the government trying to quietly stem any contagion from the country’s faltering real estate market and failing developers.
• Chinese economic growth continues to struggle against what we call the Four Ds: Weak consumer demand, high debt levels, poor demographics, and de-coupling by foreign countries.  Massive excess production and high debts among the country’s major real estate developers are a particular problem.

Chinese Gold Market:  The central bank has lifted its temporary ban on gold imports into the country, which was imposed in August to reduce selling pressure on the renminbi (CNY).  We have recently been noting stronger central-bank purchases of gold around the world, and we believe those purchases have been instrumental in buoying the price of the yellow metal.  Stronger personal demand for gold in China could add to the upward pressure on gold prices.

India-China:  An India-based official of iPhone assembler Foxconn (HNHPF, $6.54) said the company aims to double its workforce, investment, and activity in India in the coming year, as part of its effort to diversify production out of China.  That would help keep the company on track to produce half of its iPhones in India by 2027.  The plan is a further reflection of how companies are increasingly trying to hedge their bets by moving production out of China amid worsening tensions between China and the West.  We believe India will be a prime beneficiary of that trend.

United Kingdom-European Union:  In a Financial Times interview, Keir Starmer, the leader of the U.K.’s opposition Labor Party, said he would seek a major re-write of the Brexit agreement between the UK and the EU if his party wins the next election.  According to Starmer, his goal in such a re-write would be to improve the U.K.’s economic relations with the EU as a way to boost economic growth.  For example, he would seek to improve the deal’s veterinary standards to ease U.K.-EU trade in animals and farm products.

U.S. Fiscal Policy:  Consistent with our latest Bi-Weekly Asset Allocation Report, more analysts are starting to focus on the end of the pandemic-era moratorium on student loan payments on October 1.  Over the weekend, an article in the Wall Street Journal estimated that re-starting student loan payments will cut overall consumer demand by about $100 billion in the coming year, as millions of consumers with student loans have to start paying $200 to $300 on their education debt again.  The drop in consumer demand has the potential to finally bring about the long-expected recession, with the associated negative implications for corporate earnings and stock values.

U.S. Monetary Policy:  The Federal Reserve will begin its latest policy meeting tomorrow, with its decision on interest rates due on Wednesday at 2:00 PM EDT.  The policymakers are widely expected to hold the benchmark fed funds rate steady at its current range of 5.25% to 5.50%.  The more important question is whether they will provide any guidance on future policy changes.  While many investors continue to look for outright rate cuts in the coming months, we continue to believe they will be disappointed.  We believe Chair Powell should be taken at his word when he says he will try to keep policy tight for an extended period to make sure consumer price inflation is really snuffed out.

U.S. Bond Market:  Against the backdrop of the Fed’s hawkish monetary policy, we’re seeing more official warnings about “basis trades” by hedge funds.  In its quarterly report today, the Bank for International Settlements said the associated buildup in debt-financed short positions on two-year U.S. Treasury futures could spark chaotic trading.  According to the BIS, “Margin deleveraging, if disorderly, has the potential to dislocate core fixed-income markets.”  We will continue to monitor the situation closely.

U.S. Labor Market:  Last week, the U.S. Army said it met its annual re-enlistment goal early, allowing it to suspend retention bonuses paid to re-enlisting troops at least until the end of the federal fiscal year on September 30.  The U.S. Navy said it will miss its recruiting goal by about 7,000 sailors, but that is actually better than the 13,000 shortfall it expected at the beginning of the fiscal year.

• Over the last couple of years, strong labor demand in the civilian economy has made it difficult for all the services to recruit new personnel or keep current troops from leaving.
• The better-than-expected re-enlistment and recruiting figures could reflect weakening in the civilian labor market, potentially leading to slower wage growth, reduced price pressures, and an end to the Federal Reserve’s long campaign of interest-rate hikes.

U.S. Auto Industry:  After launching their strike against the Big Three automakers last Friday, the United Auto Workers said it resumed negotiations for a new labor contract with each of the companies over the weekend.  The union suggested in a statement that it is making its best progress with Ford (F, $12.61).  However, in a test of the union’s novel tactic of simultaneously striking just one assembly plant at each of automakers, the firms began to warn that the strikes will force them to stop production and furlough workers at related plants.  We suspect the UAW would see that as an effort to “divide and conquer,” prompting the union to expand the strike.

U.S. Real Estate Industry:  Demand for office space in downtown San Francisco has reportedly started to recover from its deep plummet during the coronavirus pandemic.  The stronger leasing activity and renewed office-building sales stem partly from increased demand by firms in the fast-growing artificial intelligence space.  Nevertheless, some of the increased building sales also reflect the fact that some owners have capitulated on price, selling their properties at steep losses.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will be broken into three sections: 1) Why unions are starting to grow in popularity; 2) Why long-duration Treasury yields are likely to rise over the next few years; and 3) Why the market should be cautiously optimistic about the data coming out of China.

Labor Fights Back: Unions are back in fashion as more workers demand higher wages and better terms.

• The United Auto Workers (UAW) announced a strike against the Big Three automakers in one of the biggest labor disputes in recent memory. The strike could weigh on economic growth if it lasts long enough. The union rejected the carmakers’ last-minute bids to end the impasse, with the most significant sticking points being the UAW’s demands for defined-benefit pension plans, a 32-hour workweek, and other work incentives. The automakers have rejected these demands, believing that they would hurt business profitability. Ford (F, $12.62) estimates that the proposal could push it into bankruptcy.
• The long-simmering tension between unions and firms is likely to continue, as firms have been reluctant to share more of their profits with workers. Although most of the pushback against labor unions is coming from industries that are already unionized, there is growing support for labor unions overall. Recent Gallup polling data shows that approval ratings for labor unions have reached their highest point since 1965. This evolving sentiment is exemplified by the recent actions of basketball players at Dartmouth College, who have initiated proceedings to establish a local union. This shift in perspective comes amid a significant decline in labor’s share of economic output from its pandemic peak.

• Over the next thirty years, the bargaining power of unions is likely to weigh on company margins, as labor groups gain influence and extract more concessions from firms, such as higher wages, better benefits, and more job security. These concessions could reduce company efficiency, leading to lower productivity and greater inflation volatility. In this environment, large companies are typically better positioned to absorb losses and capitalize on technological substitutes such as artificial intelligence. However, the trend will likely be drawn out and bumpy, so there is no immediate cause for action.

Bond Bears Return: Long-term Treasury yields hit a post-GFC high as traders weigh hawkish Fed policy and government budget wrangling.

• Bond yields have risen due to uncertainty over fiscal and monetary policy. President Biden warned on Thursday that the government could shut down at the end of September if Congress doesn’t reach an agreement on a new budget. House Speaker Kevin McCarthy (R-CA) has struggled to convince fellow Republicans to keep the government funded. Meanwhile, stronger-than-expected retail sales data and a steady decline in jobless claims have added to speculation that the Federal Reserve may pursue a hawkish pause at its next meeting. The FOMC is expected to leave rates unchanged next week but signal its readiness to raise them further in the future.
• Ten-year Treasury yields have risen over 100 basis points since April, to levels not seen since 2006. This massive jump in interest rates reflects investor concerns about the Federal Reserve’s ability to maintain price stability and the government’s ability to meet its debt obligations. Although the recent CPI report showed signs of improvement in underlying price pressures, rising energy prices have raised concerns that some of this progress will be reversed. Additionally, growing partisanship prevents Congress from passing legislation to address the growing government deficit. As a result, investors are demanding higher yields to compensate for the increased risk.

• Long-duration bond prices are likely to face significant headwinds due to structural shifts in the global economy, particularly the transition from an economy that favors efficiency to one that favors resilience. This transition could lead to increased inflation volatility and supply chain disruptions, as the lack of imports makes it more difficult to meet domestic demand. Additionally, the growing government debt burden will continue to raise concerns about the sustainability of public finances. However, this transition will be uneven, with periods of fluctuating yields.

Chinese Surprise: Beijing received some welcome news, as economic data showed that the economy is starting to rebound.

• Industrial production and retail sales figures beat expectations in August, showing that the limited policy stimulus is having an impact on the economy. Factory output increased by 4.5% year-over-year, well above expectations of 3.9% and the previous month’s increase of 3.7%. Retail receipts jumped 4.6% year-over-year, well above the July increase of 2.5% and the consensus estimate of 3.0%. This progress is likely to boost optimism among investors who feared that the country was in a prolonged slump, which could persuade some that the worst is likely behind. As a result, the Chinese yuan (CNY) gained on the U.S. dollar.
• The positive economic reports show that China’s pro-growth initiatives are working. In recent weeks, Beijing has implemented measures to boost consumer and investor sentiment, including the People’s Bank of China’s most significant rate cut in three years, a slash in stamp duties on stock transactions, and a cut in the reserve requirement ratio to free up liquidity for lending. The measures follow statements made by Beijing officials in July that the government would provide stimulus to help support the economy following years of COVID restrictions. That said, there is still concern that Beijing’s work isn’t finished.

• It is never a good idea to read too deeply into a single month of economic data, and this is no different. China is still working its way through a property meltdown and a municipal debt problem. Additionally, not all of the economic data coming out of China is rosy. For example, the housing price index was down 0.1% from the prior year, and urban youth unemployment has risen above 21%. Thus, China is far from being out of the woods. However, if the growth in consumption does start to pick up, this should aid equities in countries with exposure to the second-largest economy.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment is split into three sections: 1) Why rising energy prices will complicate the Fed’s efforts to project future policy rates; 2) Why European policymakers may be finished with their hiking cycle; and 3) Why the green transition is leading governments to push for more domestic manufacturing.

Where Do They Stand? The disappointing consumer price index (CPI) report may lead to further divisions within the Federal Open Market Committee (FOMC).

• Rising energy prices pushed headline CPI above expectations in August, leading investors to adjust their interest rate expectations. Consumer prices rose 3.7% from the previous year, above economists’ expectations of 3.5% and July’s reading of 3.3%. The rise was driven by a 5.6% surge in petrol prices from the previous month, which accounted for more than half of the month-over-month increase. Energy prices have picked up following efforts by Saudi Arabia and Russia to prop up oil prices through production cuts. The sudden reversal of inflationary pressures has led to investors’ pricing in a near 50% chance of another hike by the end of the year.
• Despite the recent surge in headline inflation, there are some encouraging signs that underlying inflation pressures may be easing. The year-over-year change in core CPI, which excludes food and energy, fell from 4.7% to 4.3% in August. Meanwhile, the frequently cited core services inflation, which excludes goods and shelter, also eased in August, declining from 3.3% in July to 3.1%. Additionally, supercore inflation, which excludes food, shelter, and energy, rose by 2.2% in the same period but was modestly above its 20-year historical average of 1.9%. Therefore, there is still a case for the Fed to stand pat, at least for now.

• The latest CPI report is unlikely to have a significant impact on the FOMC’s decision of whether to keep interest rates unchanged during its next meeting on September 19-20. Although policymakers have not commented on how they would vote in the meeting, members have expressed concern regarding the level of tightness in the labor market. The committee is 25 bps shy of meeting its fed funds target outline in the latest dot plots. As a result, we will be paying close attention to the latest FOMC projection materials and Fed speeches for evidence of the committee’s thinking on future rate hikes.

Policy Pushback: Economic woes are prompting policymakers to reconsider rate hikes amid slowing output and lawmaker complaints.

• The European Central Bank (ECB) raised its benchmark policy rates by 25 bps on Thursday. The increase comes amidst signs that inflation is starting to return to normal but still remains well above the central bank’s 2% mandate. Despite the decision to tighten monetary policy, markets believe that the central bank is likely finished hiking rates. During the press conference, ECB president Christine Lagarde suggested that rates are currently in sufficiently restrictive territory but stopped short of ruling out an additional hike. As a result, the euro (EUR) fell against the USD and Japanese yen (JPY).
• Unlike the United States, the eurozone economy is more fragile, partly due to its greater reliance on exports, which are being hurt by China’s economic slowdown. European Central Bank officials downgraded their growth expectations for the next three years and hinted at the possibility of recession. At the same time, high interest rates have hurt manufacturing activity throughout the bloc, with industrial production falling 2.2% from the prior year in August. These troubles are not likely to go away anytime soon as the ECB projects that rates will likely stay above 3% in 2024, making it harder for them to justify rate cuts.

• Meanwhile, European governments have begun to express their frustration with the ECB’s tight monetary policy. Italian Prime Minister Giorgia Meloni has doubled down on a windfall tax on Italian banks (against the wishes of the ECB Governing Council) in a bid to prevent the banks from profiting at the expense of households due to monetary policy. A similar measure passed in Spain is currently being challenged in court. As the effects of the rate hikes start to work their way through the economy, policymakers will likely face political pressure to cut rates, thus leading to more downward pressure on the EUR.

Return of the Industrial State? Governments are becoming more assertive in protecting domestic industries as the world begins to fracture into blocs.

• The G-7 are increasingly becoming more protectionist as they look to prevent China from dominating the electric vehicle market. On Wednesday, European Commission President Ursula von der Leyen announced that the EU will launch an investigation into allegations of the Chinese dumping of electric vehicles. The probe paves the way for tariffs on foreign manufacturers that are in breach of trade rules. In the U.S., where there is already a 27.5% levy on Chinese made cars, regulators are considering a possible crackdown on EV battery imports from China, as lawmakers are trying to deter American carmakers from relying on China for the critical components of their vehicles.
• The pressure to reduce reliance on Chinese green technology is being driven by governments’ desire to avoid a repeat of the solar panel industry in the 2010s. During this period, Chinese companies backed by state aid undercut domestic producers, forcing many solar companies in the U.S. and Europe into insolvency. Given China’s dominance in EV batteries, automakers may be at risk of a similar outcome. China controls 76% of global battery cell production capacity and accounts for two-thirds of the world’s registered electric vehicles. Concerns over American supply chain exposure to China have led lawmakers to pressure Ford Motor Company (F, $12.64) to abandon its use of Chinese technology for its batteries.

(Source: Wikimedia Commons)

• Governments in advanced economies are likely to play a more active role in the economy than investors are used to, reflecting a long-term trend of supporting domestic firms to compete with foreign competitors. This is already evident in the Inflation Reduction Act, which uses tax subsidies to build domestic manufacturing in the U.S., and in similar incentives offered by the EU. While this shift may help businesses subsidize their research efforts, it could also lead to higher inflation and borrowing costs due to inefficiencies associated with firms being unable to use outside suppliers.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the latest news on souring relations between the West and China.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the Russia-Ukraine war and U.S. inflation and banking dynamics.

United States-China:  The House Select Committee on the Chinese Communist Party has been holding hearings and meetings on Wall Street this week to put further pressure on U.S. financial and business elites who have been reluctant to sever ties with China.  In a statement that we think investors should heed, the Republican chairman of the committee, Mike Gallagher of Wisconsin, and the Democratic vice-chairman, Raja Krishnamoorthi of Illinois, both said they favor new laws to restrict U.S. investment in publicly traded stocks and bonds of certain Chinese firms.

• The new legislation mentioned by Gallagher and Krishnamoorthi would go beyond the current U.S. restrictions on bilateral trade, investment, and technology flows, illustrating the risks to investors as U.S.-China geopolitical tensions worsen.
• As a reminder that China is also clamping down on bilateral business, the Chinese government today said it has “noticed reports” of “security incidents” related to iPhones made by U.S. technology giant Apple (AAPL, $176.30). The government emphasized that it is still committed to protecting the rights of foreign businesses and supporting free markets.  Nevertheless, since the statement followed so closely on Beijing’s recent directive which curbed the use of iPhones by certain government workers, it is being taken as a warning that China is prepared to undermine key U.S. economic interests to retaliate for the U.S. pushback.

European Union-China:  As advanced, low-cost electric vehicles from China start to flood Europe’s auto market, European Commission President von der Leyen today announced that she is launching an investigation into the subsidies paid to Chinese producers.  Complaining that European-made autos are often blocked from other markets, von der Leyen signaled Brussels will take a tough approach on subsidized Chinese EVs.

• The move is a reminder that von der Leyen and other leaders in Europe have swung behind the U.S. effort to push back against China’s growing geopolitical and economic aggressiveness.
• In response to von der Leyen’s speech, shares in high-flying Chinese EV companies have fallen sharply today, with Warren Buffett-invested BYD (BYDDY, $65.62) losing 2.8% of its value and rival Xpeng (XPEV, $18.65) losing about 2.5%.

United Kingdom-China:  Just days after British police said they had arrested two people, including a parliament researcher, on charges of spying for China, press reports say the authorities are preparing to arrest several more people in the coming months on charges that they have been secretly working to undermine Britain’s democracy under the direction of the Chinese government.  The news points to a further rupture in China-U.K. relations, which could potentially include new, U.S.-style restrictions on bilateral trade, investment, and technology flows.

Russia-North Korea-Ukraine:  Russian President Putin and North Korean Supreme Leader Kim met today at a Russian space-launch facility in Vladivostok, with both pledging to deepen their cooperation on security and economic issues.  The two leaders are widely expected to strike a deal under which North Korea will sell weaponry to Russia to help it continue its invasion of Ukraine.

• Separately, reports today say Ukrainian missiles struck a shipyard in Russian-occupied Crimea, heavily damaging or destroying two Russian navy vessels in drydock.
• The successful attack reflects how Ukraine’s military reach has been extended now that it has received long-range missiles from countries such as France and the U.K.

Sweden:  The center-right government this week proposed a 2024 budget that would hike military spending by approximately 28%.  The proposed budget would put Sweden on track to meet the North Atlantic Treaty Organization’s standard of spending at least 2% of gross domestic product on defense, even though the country is still waiting to be accepted into the alliance.

U.S. Military:  U.S. Air Force Secretary Kendall has announced that the service will miss its annual recruiting goal by about 10% when the fiscal year ends on September 30, marking the first such shortfall since 1999.  The deficit shows how most of the military is struggling to keep up troop levels because of factors such as the strong civilian job market, lingering disruptions from the coronavirus pandemic, and difficulties in finding enough young people who can meet today’s physical and intellectual standards.

U.S. On-Line Prices:  While investors today will focus on the headline Consumer Price Index (see U.S. Economic Releases below), a separate private index shows on-line prices are falling in year-over-year terms.  The Adobe Digital Price Index for August was down a full 3.2% from the same month one year earlier, including annual price declines of 7.3% for appliances, 7.0% for sporting goods, and 11.6% for electronics.

U.S. Banking Industry:  Incoming data shows net new bank lending has slowed to a crawl, with outstanding loans growing at an annualized, seasonally adjusted rate of just 3.6% so far in the third quarter, compared with average growth of about 7.0% over the long term.  Of course, part of the slowdown reflects weaker loan demand now that the Federal Reserve has hiked interest rates so aggressively since last year.  In addition, however, the slow growth reflects cautious lending as banks worry about rising deposit costs and asset values.  Importantly, slow lending could also help to finally push the economy into the recession that we’ve been expecting all year.

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