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 details on the shooting of newly mobilized troops at a training camp in Russia and signs that Russian oligarch Yevgeny Prigozhin may be positioning himself to eventually push President Putin aside.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including several items related to China and a discussion of the evolving energy crisis in Europe.

Russia-Ukraine:  Russian forces, which are now on the defensive in Ukraine’s northeastern Donbas region and in the southern region around Kherson, continue to launch missile, artillery and drone strikes on residential areas and critical infrastructure across Ukraine.  The strikes appear to have very little direct military value, as they are apparently geared more toward terrorizing the population and undermining Ukrainian morale.  As one example, the strikes have been focused heavily on destroying Ukrainian energy infrastructure ahead of winter.

• New details are emerging about an incident over the weekend in which three recently mobilized Muslim men opened fire in a Russian training camp, killing many. The shooting apparently was sparked by Muslim inductees complaining that they should not be fighting Russia’s war, to which the camp’s commander said it was a “holy war” and called Allah a coward.  The Muslims opened fire to avenge the insult to Allah.  The incident highlights the tensions arising as the Kremlin continues trying to force ethnic minorities to shoulder the bulk of the burden of the war.
• Separately, Yevgeny Prigozhin, the leader of Russia’s mercenary company known as the Wagner Group, continues to openly disparage the established Russian military for its ineffectiveness in the war.  According to Prigozhin, the well-funded Wagner fighters are in a class far above the regular Russian troops, suggesting that he may be positioning himself as an alternative for president if Putin continues to be embarrassed by the war effort.

Global Commodity Markets:  Anglo-Australian mining giant Rio Tinto (RIO, $55.18) warned that prices for iron ore and other key commodities are likely to keep falling in the near term as the U.S. and European economies fall into recession and Chinese housing construction continues to fall back.  We still think today’s geopolitical frictions will buoy commodity prices in the coming years, but the warning from Rio Tinto is a reminder that the asset class could still pull back sharply in recessionary periods.

European Energy Crisis:  German Chancellor Scholz said his government will now allow the country’s three remaining nuclear generating plants to keep producing electricity until mid-2023 to help get Germany through Europe’s winter energy crisis.  Longstanding plans had called for the plants to be shut down permanently at the end of 2022.  The decision essentially reflects a major backdown by the German Greens, one of the three parties in Scholz’s coalition.  The decision is also further evidence that nuclear energy is getting a second look now that many countries are facing energy shortages because of the war in Ukraine and other geopolitical frictions.

• Separately, amid spreading unrest over high inflation, some 21 countries in the EU have now raised their minimum wages in order to help their lowest-earning citizens deal with higher prices for energy and other goods and services.
• However, in most of those countries, the minimum wage hike has not been enough to offset overall consumer price inflation, leaving real minimum wages lower than before, as shown in the following chart. The decline in minimum wage earners’ purchasing power will contribute to the impending recession in the EU.

United Kingdom:  Although British financial markets have calmed considerably since Prime Minister Truss’s government backed away from its massive, debt-funded tax cuts, new reports suggest that the Bank of England will further delay its planned sale of billions of pounds of government debt beyond its current start date of October 31.  According to the reports, the central bank officials worry that the market for Gilts is still too unstable to launch the quantitative tightening program.

China-United Kingdom:  Yesterday, British Prime Minister Truss  expressed concern after a video emerged that appeared to show a Hong Kong activist being dragged inside the Chinese consulate in Manchester and beaten during a protest.  The aggressive behavior by the Chinese diplomats will likely further strain China-U.K. relations.

China:  As we receive more detail on the Communist Party’s 20^th National Congress, one thing that strikes us is that President Xi in his opening speech Sunday called on the country’s military to develop faster so that it can win “regional wars.”  That marked a departure from recent years, when Xi typically called on the military to fight and win “wars,” with no reference to their scale.  Reverting to China’s customary emphasis on regional wars may simply aim to focus the military on the potential conflict around Taiwan, but it could also be a tacit admission that China cannot yet hope to vanquish the U.S. and its allies in a broader conflict.

United States-China:  Apple (AAPL, $142.41) has reportedly suspended plans to use memory chips made by China’s largest memory chip maker, Yangtze Memory Technologies Company, even though Yangtze had already completed the months-long verification process for Apple to use the chips in its newest iPhones.  The decision illustrates the impact of the new U.S restrictions on the involvement of U.S. persons in developing chip facilities in China, and on equipment and materials shipped to Chinese wafer fabricators that produce NAND flash-memory chips with 128 layers or more.

• The decision by Apple is a body blow to China’s dreams of building a more competitive memory-chip industry.
• As such, the new U.S. technology restrictions are likely to ratchet up tensions between the U.S. and China. As we have recently written, China’s likely response over time will probably include efforts to restrict key mineral commodity exports to the U.S. and its allies.

U.S. Hurricane Damage:  Reinsurer Swiss Re (SSREY, $18.35) said it expects approximately $1.3 billion in claims from Hurricane Ian after it struck Florida last month.  The company also estimated that the storm caused total insured losses of between $50 billion and $65 billion, making it the second-most expensive storm in U.S. history after Hurricane Katrina in 2005.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including news of further progress with Ukraine’s counteroffensive to retake the Russian-held city of Kherson in the country’s south.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an ominous delay in China’s release of its third-quarter economic data.

Russia-Ukraine:  The Ukrainian counteroffensive in the country’s northeastern Donbas region has now slowed considerably, but the latest reports indicate that the Ukrainians are launching significant new attacks in the southern region around the Russian-occupied city of Kherson.  Meanwhile, Russian forces continue to launch missile, artillery, and drone strikes at military and civilian targets across Ukraine.  Reports also suggest that the first of Russia’s newly-mobilized troops have been killed in combat in Ukraine. Often, these troops have received only a few days of training.  That news is reportedly sparking increased popular anger in Russia, although it still appears that the government has control over the situation.

• Meanwhile, thousands of Russian troops were deployed to Belarus over the weekend to join Belarussian forces arrayed on the border with Ukraine, ostensibly to help Belarus deter a purported Ukrainian attack. Even though some reports suggest the new Russian troops arrived without artillery or vehicles, the deployment is being seen largely as a Russian effort to further threaten Ukraine and force it to shift troops to the Belarussian border and away from its successful counteroffensives in the northeast and south.
• Also, more than a dozen missile and artillery strikes hit the Russian province of Belgorod, on the border with Ukraine, on Sunday alone. The strikes almost surely were launched by the Ukrainian military and were meant to bring the reality of the war to Russian citizens.
• Responding to reports that Russia’s latest attacks have relied heavily on Iranian-supplied Shahed 136 kamikaze drones, European Union foreign ministers have warned that they could impose new economic sanctions on Tehran if it continues to offer Russia such support.

China:  The Chinese Communist Party opened its week-long 20^th National Congress yesterday, during which President Xi is expected to win a precedent-breaking third term in power with a revamped Politburo to support him.

• In his opening speech, Xi defended his foreign policy as a series of successes in fending off Western “bullying” and protectionism, but his praise was coupled with a somber warning that the nation must stand united behind the party to cope with a world he depicted as increasingly turbulent and hostile.
• In domestic policy, Xi declined to back down from his tough, restrictive “Zero-COVID” policies. With recent data pointing to new waves of infection, a new round of tough social-distancing restrictions is likely to be imposed soon, causing yet another pullback in Chinese economic activity.
• In an ominous sign for China’s latest economic data, the government delayed publication of its report on third-quarter gross domestic product at the last minute. This suggests to us that the growth rate is uncomfortably low, to the point where it would distract from the positive tenor that Xi is trying to strike in the Congress.  Continued economic weakness in China is likely to be a headwind for global economic growth and world financial markets.

European Union:  Yesterday, EU commissioners agreed on a preliminary proposal to set a maximum “dynamic price” at which natural gas transactions can take place in the bloc over the next three months.  The aim is to empower the EU to intervene in cases of extreme natural gas prices while not hurting the security of supply or encouraging consumption.  The proposal will be debated by EU national leaders on Thursday and Friday before being finalized.

United Kingdom:  Newly-appointed Chancellor Hunt today said that the government will reverse nearly all of Prime Minister Truss’s proposed tax cuts and slash her planned energy subsidies to restore fiscal credibility.  Hunt also warned that there will be “more difficult decisions” on taxes and spending in the future.  Meanwhile, the Bank of England confirmed that, as planned, it had ended the emergency bond buying it put in place two weeks ago to calm the markets following the initial release of Truss’s tax-cutting plans.

• U.K. markets improved on the news that the government is apparently getting its fiscal house in order. Benchmark 30-year Gilt prices rose, pushing their yield down to 4.36%.  The pound also rallied, and it is currently changing hands at about $1.1303.
• Despite the U-turn, Truss is now just barely hanging onto power. Over the weekend, more Conservative Party members of parliament said that the prime minister’s position is increasingly untenable.  Most of those officials appear to expect Truss can survive only a few days to a few weeks.

Japan:  With the yen weakening further this morning to ¥148.60, close to the psychologically important level of ¥150.00, Finance Minister Suzuki warned that the government would take bold action against any “speculative” foreign exchange moves.  The statement has left currency traders on the lookout for any intervention to support the yen, similar to what the government implemented last month.

Iran:  Anti-government protests continued over the weekend, spreading to a notorious prison for political dissidents and foreigners.  Although the Islamic regime doesn’t appear to be threatened by the protests just yet, the widening unrest does pose a longer-term threat to the government.

Brazil:  In their first one-on-one debate ahead of their presidential run-off election, conservative President Bolsonaro apparently scored several body blows against leftist Former President Luiz Inácio Lula da Silva over corruption and his ties to left-wing autocrats in the region.  The latest polling suggests Lula’s lead over Bolsonaro has narrowed to just 5%.  If Bolsonaro continues to make progress against Lula, we suspect the prospect of a continuing conservative government in Brasilia would be positive for Brazilian stocks.

U.S. Economy:  In the Wall Street Journal’s latest quarterly survey of economists, 63% fully expect that the U.S. economy to fall into recession within the next 12 months, up from 49% in July.  The surveyed economists now expect the economy to contract in both the first and second quarters of next year.  Based on our own analyses, we agree that the economy is more likely than not to be in a recession sometime in the coming year.

• The recession risk is driven in part by high inflation, especially for energy products. The Energy Information Administration currently estimates it will cost $931 to warm the typical home that is heated with natural gas between October and March, up 28% from a year earlier.
• If it gets colder than federal weather forecasters expect, heating bills could be 51% more than last year for homes with gas-fueled furnaces and boilers.

U.S. Energy Market:  Utilities in New England are warning that they could face challenges in delivering electricity this winter if a surge in natural-gas demand abroad threatens to reduce the supplies they need to generate power. New England relies on natural-gas imports to bridge winter supply gaps, so it is now competing with European countries for shipments of liquefied natural gas.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning. Today’s Comment begins with our thoughts on yesterday’s CPI report. Next, we discuss significant policy shifts in some of the most influential countries. Finally, we discuss how Russia’s nuclear threat has encouraged other countries to become more pugnacious.

The Market Reacts: A possible short-covering rally lifted equity prices on Thursday as investors digested the latest Consumer Price Index (CPI) report.

• The horrible September inflation report raised the likelihood of another jumbo hike from the Fed in its next meeting in November. Although headline CPI decelerated from 8.3% to 8.2% last month, core CPI jumped from 6.1% to 6.3%. Much of the disappointment in the CPI report came from accelerating rent, transportation, and airline prices. The stronger-than-expected inflation report means that the Fed will raise its benchmark interest rate by at least 75 bps and possibly 100 bps next month.
• Initially, the market viewed the report negatively, but sentiment began to change once investors dismissed the chance of a soft landing. All 11 of the S&P 500 sectors rose while bond prices fell due to concerns that the Fed will have to lift rates higher. Several theories exist for the equity rally, including short-covering, inflation peak expectations, and a possible Fed pivot. Whatever the reason for optimism, we do not expect it to last much longer as the economy continues to show signs of slowing. Although it’s easy to assume that the Fed could rein in its tightening if the country falls into recession, there are Fed officials who are for additional hikes even during a downturn. In short, we are not convinced that the stock market has hit its bottom quite yet.
• It isn’t all bad when you look at the monthly data. Core goods prices were unchanged from the previous month thanks to a sharp drop in used autos and apparel prices. Meanwhile, food and energy prices are showing consistent signs of deceleration. Hence, much of the rise in the year-over-year change in inflation was due to base changes as opposed to renewed inflationary pressures. In fact, we suspect that the October CPI report could surprise to the downside. If we are correct, it will likely encourage Fed officials to signal a pause in 2023.

Big Changes: Major countries are beginning to make sudden shifts in their economic and foreign policy agenda to cope with the challenging environment.

• In a shock, U.K. Prime Minister Liz Truss sacked Chancellor Kwasi Kwarteng on Friday. The move comes after Truss was forced to make an embarrassing U-turn on major parts of her flagship tax plan. The new budget will eliminate the £18 billion corporate tax cut. Following the news of the budgetary changes on Thursday, U.K. government bonds and the British pound rallied. Although Truss’s policy reversal will relieve the financial stress caused by her tax plan, there is no guarantee that the market turmoil will end after the BOE ends the bond purchasing program today. Additionally, there is still concern that Truss’s leadership may be in jeopardy.
• China will host its 20^th National Party Congress on Sunday. The convention will formally instate Xi Jinping as President for the third consecutive time and will outline the country’s plan for the next five years. Although the remarks have not been released, we expect Xi will emphasize that the country should shift its focus away from constant growth and toward self-dependency. The Chinese economy is facing one of the rockiest economic periods in recent history. It has struggled to contain a faltering real estate market, persistent COVID outbreaks, and isolation from the U.S. An inward-focus economy will benefit domestic industries, particularly in tech, and the country looks to aid their development through stimulus.
• The European Central Bank officials intend to unwind the bank’s balance sheet in 2023. As opposed to selling the bonds, members of the Governing Council prefer to let the bonds mature. If the bank follows through on this plan, it could lead to more financial stress in European Bond markets, especially as the central bank raises its policy rate.

Missiles, Missiles, Missiles: Speculations of a Russian nuclear strike in Ukraine have forced other countries to flex their might.

• The chance of a nuclear Armageddon is rising. EU foreign policy chief Josep Borrell warned Moscow that NATO countries would “annihilate” Russian forces if Putin decides to use nuclear weapons in Ukraine. Both Russian and NATO forces have planned nuclear drills. The escalation in rhetoric has led to concerns that there is a possibility of miscalculation. In order to mitigate that risk, French President Macron clarified that his country would not respond in kind in the event of a nuclear attack on Ukraine. Financial markets are the least of your concerns in the event of nuclear war; however, in the build-up, commodities will benefit from the rising uncertainty.
• Not wanting to be left out, North Korea reminded the world that it also has weapons. Earlier today,  it launched two ballistic missiles and sent fighter jets close to the border of its southern neighbor. South Korea responded to the provocative acts by scrambling its jets and slapping unilateral sanctions on Pyongyang. The escalation of tension on the Korean peninsula has flown under the radar due to the war in Ukraine. A fight between North and South Korea could lead to an intercontinental war in Asia as Japan, the U.S., and China all have vested interests in the outcome of the conflict. As a result, we think investors should be cautious when looking at international equities as geopolitical risks are still quite elevated.
• The U.S. now believes it is battling nuclear threats in both Europe and Asia. The Biden administration’s new National Security Strategy stated that Russia was an imminent concern, and that China was a long-term threat. The focus on these two countries comes amidst heightened tensions over Ukraine and Taiwan. The document states that the U.S. will not allow these countries to achieve their foreign policy objective by use of force. This posturing by the U.S. signals that it is prepared to invest more in its defense to take on its foreign challengers. The resulting increase in military spending should favor more aerospace and defense industries.
  • China has an estimated 350 warheads, and the Pentagon believes that number could ratchet up to 1000 by 2030.
  • The rising China threat has made Japanese citizens more open to U.S. military bases in their country.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning and happy CPI day!  U.S. equity futures were moving higher in front of the report, and we will cover the CPI numbers in detail below, but in short, they were bad, leading to a sharp reversal in equity futures.  Our coverage begins with economics and financial news, with a deep dive into the Fed Minutes.  Up next is China news as the U.S. is cracking down on technology transfers.  War coverage follows and we close with the international news roundup.

Economics and Finance:  The Fed Minutes offer some insight into the bank’s thinking.

• The September FOMC minutes revealed that the Federal Reserve favors hefty rate hikes, but we are starting to see some concern emerging about overdoing it. Although the report showed that supply chains are improving, officials are worried that the pace of increases in goods prices is still elevated. The persistent pick up in goods inflation has led some members of the committee to take a look at firms’ profits. Wholesale and retail margins, referred to as trade services below, is the largest contributor to producer services inflation.

• Central bankers across the world are plowing ahead with tight monetary policy regardless of the economic impact. Minnesota Fed President Neel Kashkari warned against bets in favor of a Fed pivot, stating that the bar is very high given the level of inflation. In the U.K., officials from the Bank of England signaled that rates are likely to rise sharply and announced plans to end its bond-buying program on Friday. Lastly, the European Central Bank President Christine Lagarde dismissed speculation that the EU is in recession in a sign that the bank plans to forge through with additional rate hikes. Tightening financial conditions will hurt risk assets and slow the global economy.
• One of the complicating factors for the Fed is that labor markets remain tight. A factor driving this situation could be a condition called “labor hoarding.”  For the past four decades, firms treated workers as expendable; the entire gig working industry is essentially built on an idea that a firm can call on labor only when needed.  As the labor force growth slows, firms are finding that it has become difficult to fill positions, leading companies to hold on to workers even as economic activity slows.  If the Fed doesn’t take this situation into account, it may lead the FOMC to overestimate the economy’s strength and overtighten.
  • One way to resolve the lack of labor force growth is through immigration. We note that the U.S. is planning to issue the maximum legal level of H-2B visas.
• Hawkish central banks have added to the debt burden of emerging market countries. Most emerging markets rely on foreign debt due to their favorable interest rates. However, as the central banks have raised their benchmark interest rates, investors are pushing up borrowing costs to compensate for the additional risk. The problem will likely get worse as the global economy begins to slow. To prevent an emerging market debt crisis, the International Monetary Fund is trying to rework the debt for developing countries, but it would like China to participate in the restructuring. The risk of an emerging market debt crisis is elevated especially as Beijing continues to drag its feet on negotiations.

• Tomorrow, the BOE says it will halt its bond buying, which has led pension funds to increase selling to build liquidity. As we noted earlier in the week, central banks are facing the Tinbergen problem of not having enough policy tools for the problems they face.  Specifically, if central bankers prioritize financial stability, then inflation will rise while if they instead fight inflation, then financial risks increase.  We note that there are rumors that the Truss government is considering backing away from some of its fiscal expansion policy, which may be enough to give the BOE some room.
• The IMF warns that there is a 10% risk of negative global GDP growth next year.
• Although we will cover the information in more detail in tomorrow’s Weekly Energy Update, OPEC+ has cut its global demand forecast for oil, which is probably why it made its controversial output cuts. In its monthly report, the IEA warned that OPEC+’s actions could trigger a global recession.
• Japan’s bond market traded today for the first time in five days. Yield-curve control has made actual trading just about non-existent.
• Florida’s orange crop is set to be the smallest since WWII. Hurricane Ian contributed to the small crop.

 The Ukraine War: Sensing weakness, NATO ramps up its support for Ukraine against Russia, while Moscow gets a needed break on oil.

• Western countries pledged more military equipment to Ukraine and new penalties to curtail Russia’s revenue generation. The new ammunition will allow Ukraine to defend itself from retaliatory attacks from Russia. New reports suggested that Russia has targeted 40 Ukrainian cities with missiles. Meanwhile, the new penalties will likely be an alternative way to punish Russia after OPEC+ cuts have put price caps at risk.
  • The latest developments in Ukraine suggest that the war is not close to being over; however, there does seem to be hope for de-escalation. Russian President Vladimir Putin offered to resume gas supplies through Nord-Stream 2. The plan was quickly denied by Berlin, who fears that the move would come at the expense of Ukraine.

• The IMF warned that Ukraine would need $3 billion a month in 2023 to fund its debt obligation. The war-torn country has not been able to run its government without additional aid from the West.
• Putin is pressing Belarus to join the war. We doubt President Lukashenko wants to join this war and it isn’t obvious if Belarusian troops would be effective, but, it may draw some Ukrainian forces to guard its northern border.
• Winter offensives are difficult. Cold weather complicates armor operations and soldiers must fight both the weather and the enemy.  Thus, there have been expectations that the pace of operations will slow as winter sets in.  However, Lloyd Austin, the U.S. Secretary of Defense, indicated that the offensive would continue through the winter.
• Russia has formally blamed Ukraine for the Crimea bridge attack.

China News:  The U.S. increases pressure on China’s semiconductor industry.

• In the wake of new U.S. restrictions on semiconductor equipment sales to China, the chip toolmakers announced the suspension of equipment sales. There have been some exemptions granted, but only for a year.  We also note that the FCC is likely to ban all new sales of Huawei (002502, CNY, 3.10) and ZTE (ZTCOF, $1.79) equipment in the U.S.  Although complete isolation isn’t likely possible, supply chain disruption is clearly underway.
• After a long delay, the Biden administration did issue its National Security Strategy. The document makes it clear that China and Russia are its main focus.

International Roundup:  There is flooding in Nigeria, and Orbán gets shunned.

• Massive flooding in southern Nigeria has killed at least 500 and displaced 1.4 million people. Disruptions to agriculture and energy production are likely.
• Germany made it clear it isn’t pleased with Hungary’s actions.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning.  Markets are higher this morning, with U.S. equity futures moving higher before the PPI data.  The PPI data came in “hotter” than expected, taking equity futures off their earlier highs.  The dollar is mixed, with the GBP modestly higher while the JPY is lower (and in the area that has triggered intervention recently).  We expect a mixed trade today in front of tomorrow’s CPI data.

In today’s Comment, we begin with economic and finance news by trying to answer the question: what on earth is Andrew Bailey trying to do?  The Ukraine War update follows, China news comes next, and we close with the international roundup.

Markets, Economics and Policy:  BOE Governor Andrew Bailey has rocked the financial markets with inconsistent statements, so we will attempt to parse out what is going on with the U.K. central bank.  The IMF is meeting, and its forecast is dour.

• Yesterday, in an interview, BOE Governor Bailey surprised the markets by indicating that the emergency funding for the Gilt market would end on Friday, full stop. He warned the markets that they had “three days left.”  This declaration contradicted earlier statements suggesting that support would be extended.  Financial markets reacted immediately as the GBP plunged, equities sold off, and long-duration yields, not just on Gilts but Treasuries too, rose.
• And yet today, Bailey apparently signaled that the BOE will probably continue to support the Gilt market.
• So, how do we make sense of this?
  • First, a quick recap of how we got here. The U.K. was facing higher inflation.  Then PM Truss issued her fiscal plans, which included what was essentially a large fiscal spending program.  Gilt yields jumped.
  • Whenever interest rates rise sharply, financial stability is at risk. And, in our experience, where the “cracks” appear is often a surprise.  In the U.K.’s case, the initial stress emerged in the pension market.  Pension funds have long-term liabilities since members will age in a few decades and so the funds try to match that liability with a similar long-dated asset.  When interest rates fell to zero, meeting these long-term liabilities became a challenge.  And so, to offset this risk, the funds engaged in derivatives which would pay them if interest rates fell further.  For this to work, of course, leverage was employed.
  • When interest rates rose, it was actually good news for the pension funds, because it became easier to fund their long-dated liabilities. However, these derivatives, which, to remind, protected from falling rates, were triggering margin calls as rates rose.  This situation is what we call the “hedger’s dilemma.”  The long term cash position in an adverse market action actually improves, but in the short run, the derivative demands for immediate cash must be maintained to continue to hold the hedge position.  So, to provide cash to meet margin calls, pension funds started dumping Gilts, sending their yields higher and essentially creating a “doom loop.”
  • Here is where the BOE enters the picture. To stabilize the Gilt market, Governor Bailey offers a short-term buying plan to provide a market to break the doom loop.
• However, the pension crisis has created a policy dilemma for Bailey. He is facing the “Tinbergen problem.”  Jan Tinbergen[1] postulated that policy makers need an equal number of policy tools for an equal number of policy problems.  Otherwise, the policymaker is forced to choose which problem to resolve and let the other go untouched.  Bailey needs to simultaneously address an inflation problem which demands higher rates and also a financial stability problem, which requires easier policy.  So, this is how he is trying to manage this dilemma:
  • The BOE has offered to buy Gilts, but the offer doesn’t have a set price. If a pension fund wants to sell Gilts to the BOE, it makes an offer, but the bank can refuse to buy at that price.  What Bailey is trying to avoid by this policy is a resumption of QE.  This is why so few bonds have actually been sold.  The deal being offered isn’t that attractive to pension managers mostly because they have no transparency on whether or not they can actually get liquidity.  Thus, most of the transactions are occurring in the market.
  • Essentially, what the BOE is trying to do is protect the functioning of the Gilt markets without signaling to the Truss government that the bank is monetizing her spending. It’s a bold strategy…
• The BOE’s problem is a cautionary tale for all central bankers. In an inflationary environment coupled with excessive leverage, a byproduct of years of ZIRP, central bankers will almost certainly be facing similar problems in the future.  The whole talk of the “Fed pivot” is mostly based on this dilemma.  The pivot argument rests on the notion that when faced with combatting inflation or financial instability, the Fed will choose the latter, flooding the markets with liquidity and leading to rallies in risk assets.  We see two issues with the pivot argument.  The first is that the Fed (or other central banks) may not choose stability; in that case, the downside in risk assets could be much more severe.[2]  The second is that the flooding of liquidity may not lead to the rally in risk assets, but a currency crisis (as we are seeing with the strength in the dollar).  Thus, the BOE situation is a cautionary tale that is almost certain to be repeated elsewhere.
• The IMF offered a downbeat forecast for the global economy that actually reflects what is occurring in the U.K.’s Policy tightening, China’s Zero-COVID policy, and the Ukraine War are creating a toxic mix that will depress economic growth, trigger higher prices, and raise financial stress.
• The Biden administration has proposed rule changes to “gig workers” that, if accepted, could undermine the business models of companies that provide platforms for such workers. Essentially, the rules would turn more of these workers into employees, forcing firms to provide benefits that they currently don’t offer.  Shares in such companies slid on the news.
• Railroad workers rejected a tentative agreement, brokered by the Biden administration, increasing the chances of a national rail strike. The railroad industry has become increasingly concentrated in the past decades, leading to stronger profit margins but also making the system more vulnerable to labor action.  A nationwide strike will put the administration in a difficult spot.  If they support the unions, it could paralyze the economy and lead to higher inflation from panic buying, but if it steps in and forces the workers back on the job, they could lose political support from the unions.
• High frequency data suggests imports plunged in September. This may reflect production problems in China but may also be tied to falling American consumption.  One of the signals of recession is falling imports.
• Inflation expectations survey data from the NY FRB suggests that inflation is expected to moderate over the next year, but the three-year expectation did tick modestly higher.
• The federal deficit fell by $1.4 trillion in fiscal year 2022 (which runs from November to October) as pandemic spending eased and tax revenue increased. This drop is actually fiscal tightening, one of the overlooked bearish factors for the economy.
• As the dollar rises, the JPY is once again at similar levels to where the BOJ had decided to intervene last month. The strong dollar is also creating a boon for Americans traveling abroad.
• One of the problems with regulation is a process called “regulatory capture.” The longer a regulatory body exists, the greater the odds that the group being regulated comes to dominate the regulator.  This occurs for a couple of reasons.  First, all the data to regulate the industry comes from the companies in that industry, and so to obtain the necessary information, the regulatory body must have good relations with the firms.  Second, if a regulator wants a job in the private sector at some point, they will almost certainly go to work with a firm they have regulated.  This problem is known as the “revolving door.”  Recent investigations, however, suggest the problem runs even deeper since regulators are often investing in the firms they regulate, further leading them to side with the companies they are supposed to be monitoring.
• Apartment demand is falling rapidly as rents rise.
• BNY Mellon (BK, $38.48) is now offering custody services for crypto.

Ukraine War:  Russia continues its attacks on civilian infrastructure in Ukraine.

• For the second day, Russia is hitting infrastructure targets in Ukraine. As these attacks continue, NATO is mulling over whether it should provide more sophisticated air defense systems to Ukraine.  If these are provided, it will be part of a steady broadening of the war effort.
  • Sanctions on technology appear to be undermining Russia’s ability to build smart weapons. The lack of precision weaponry is leading Russia to rely on less sophisticated weapons, which is leading to indiscriminate damage.
• As the war continues to go badly for Russia, Putin has appointed another general to lead the effort. Sergei Surovikin is considered a hardline professional soldier who conducted the Syrian campaign.  It remains to be seen if he can fix the Russian military’s problems in Ukraine.
• Putin and Turkish President Erdoğan met in Kazakhstan today. Turkey has supported both sides in the Ukraine war, and so Erdoğan has suggested he could act as a broker between the two sides.

China News:  The news is quiet in front of next week’s Party Congress.

• As the Party Congress prepares to meet next week, the party is increasing security to ensure a smooth “coronation” for General Secretary Xi.
• Chinese universities are rising in world rankings, while U.S. universities retreat.
• Utah is becoming a virtual marriage destination for Chinese LGBTQ couples.

 International Roundup:  Japan reviews its defense posture.

• Japan’s PM Kishida is preparing for an extensive review of Japan’s security. Since the end of WWII, Japan has relied on the U.S. for security, but facing a more uncertain future, it appears that Tokyo is moving to expand its power projection.
• We are covering the tensions between Saudi Arabia and the U.S. in our Weekly Energy Update, which will be published Friday.

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[1] A Dutch economist who was the first to win a Nobel prize.

[2] When the Fed faced this issue in 1929, it opted to address the inflation/asset bubble instead.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

In today’s Comment, we begin with economic and finance news as the BOE had to rush support to the Gilt market after rates jumped on fears that the bank would withdraw support from the market.  War news comes next, with a look at Putin’s retaliation.  China news follows and we close with the international news roundup.

Markets, Economics and Policy:  The U.K. is facing increased financial system stress and U.S. retailers are pushing Christmas forward.

• The BOE offered plans to scale back its support of the Gilt market by the end of the week. When market volatility threatened to upend the pension system at the end of September, the BOE rushed to announce bond purchases for a two-week period.  As that emergency period ended, the bank suggested yesterday it would provide backstops but that direct purchases would end.  Oh well…best laid plans sometimes fail.  Overnight, the BOE announced it would expand its buying to include inflation-indexed bonds as well.  As the market prepared for less support, yields spiked yesterday, again raising fears of systemic risk.
• So, at present, we have three major central banks—the BOE, BOJ, and the ECB engaged in some form of yield-curve control. The BOE is trying to prevent rapid increases in long duration debt to prevent systemic risk.  The BOJ is simply fixing the long rate to near zero, and the ECB is actively preventing the sovereign spreads between northern and southern Europe from widening.  So, out of the G-7 nations, only the U.S. and Canada are not setting rates in long-duration sovereign bonds.
  • What is happening here? It looks to us that due to high levels of debt, central banks can’t let long-duration bond yields rise to their normal level without triggering financial stress.  For context, the long-term ex-post real U.S. 10-year yield is 2%; in English, this means that with U.S. CPI at 8.3%, the 10-year yield “should” be 10.3%.  It’s rather difficult to fathom how the financial system would deal with that level of rates.  So far, market participants believe the Fed will bring down inflation[1] and so are “looking through” the current inflation to project lower price growth.  This position isn’t unreasonable, but the longer it takes for inflation to fall, the more likely rate raises will follow.  This is why, we think, the FOMC has been so hawkish:  the members fear a loss of confidence that could lead to a buyers’ strike in bonds.
  • We have to wonder if we aren’t seeing something akin to nations leaving or maintaining the gold standard in the 1930s. As the U.S. refrains from fixing the long end (and in fact is doing QT), the dollar is rallying because it is becoming increasingly alone in this position.  At some point, it may become impossible for central banks not to engage in yield-curve control for the sake of financial stability.  If that situation arrives, real assets may be the best refuge.
  • So, when does the Fed “blink?” Yesterday, Fed Vice-Chair Brainard and Chicago FRB President Evans suggested some degree of caution on the drive to lift the policy rate.  Perhaps the best gauge of when the Fed might at least pause is any one of the financial conditions indices.  We prefer the Chicago FRB’s variation.

When this index moves above zero, stress levels are a concern.  We are slowly rising toward that level, which may coincide with Brainard and Evans’ warnings.  However, we also caution that the Fed really didn’t have to worry about inflation for the past 30 years, and so we don’t know how it will react if there is a financial accident under conditions of elevated price levels.  It is notable that the VIX futures curve has moved above 30, suggesting that elevated volatility is expected to continue for the foreseeable future.

• On the inflation front, we note that general retailer inventories remain stubbornly elevated.

Stores are beginning Christmas promotions before Halloween this year, likely in an attempt to work off excess stocks.  Although inflation remains elevated, news such as this does offer the possibility of slower price increases.

• Germany has faced criticism for its plans to subsidize energy consumption. Other nations in the EU fear that German buying, bolstered by these subsidies, will create shortages for their own citizens.  In response, the German government is backing joint EU debt, a further extension of EU-wide borrowing that began during the pandemic.  If this debt becomes securitized and backed by the entire EU or the Eurozone, it will be further progress on creating a unified debt structure.
• The Quebec pension fund is writing off $150 million of bad investments in crypto.
• The U.S./Mexican border has always been a gateway for immigration to the U.S. For years, it was mostly Mexicans looking to enter the U.S., sometimes legally, sometimes not.  But in recent years, the immigrant flows have become increasingly diverse.  But we were surprised to see Indians looking to cross this border.

Ukraine War:  Putin retaliates for the bridge attack.  This link shows the current war map.

• Yesterday, Russia launched missile strikes against civilian targets in Ukraine in response to the attack on the Kerch Strait Bridge. Putin indicated that if attacks on Russian infrastructure continued, he would respond as he did yesterday.
  • Ukraine has been asking for more sophisticated air defense systems, and yesterday’s attack may help in this effort. Bolstering Ukraine’s military hardware is becoming increasingly difficult for Europe’s defense industry.  One of our expectations is that defense spending will soar globally in the coming years.
  • The G-7 is meeting in response to the missile attacks.
  • We note that Russian-based hackers disrupted several U.S. airport websites. Killnet took responsibility for the attacks.
• There is a growing backlog of wheat freighters as inspectors struggle with the shipping activity. As part of the deal, Russia demanded extensive inspections at the Istanbul monitoring center to prevent the vessels from shipping arms to Ukraine.  The delays will tend to boost grain prices.
• In response to Russia’s annexation of areas of eastern Ukraine, Ukrainian President Zelensky has signed a decree ruling out negotiations with Russia.

China News:  A rash of COVID infections is leading to wider lockdowns.

• As China’s early October holiday season winds down, reports of COVID-19 infections are rising. Shanxi province and Inner Mongolian cities are restricting traffic and increasing testing, and there are also reports that Shanghai may soon implement measures.  These lockdown measures continue to throttle China’s economic growth.
• Why does China persist in its Zero-COVID policy despite the economic damage it causes? There are a several reasons:
  • Zero-COVID is a key policy of President Xi and so backing down is tantamount to admitting failure. Although he may relent after winning a third term, we wouldn’t count on it.
  • China’s domestically developed vaccines don’t offer much protection but to avoid admitting failure, Beijing won’t import the more effective mRNA vaccines that were developed in the West.
  • The problem of lockdowns is that it prevents infections; although that’s a goal, the lack of infections also prevents the development of immunity. China celebrated its discipline compared to Western nations, who faced higher rates of infection.  But now, China has a large population of unexposed, under, or unvaccinated citizens that would trigger a potential crisis if the virus were to spread without restrictions.  And given China’s older population, this outcome could be catastrophic.  Thus, without importing vaccines, China appears stuck with the Zero-COVID policy.
  • If so, that means that China’s economy will continue to struggle.
• German Chancellor Scholz will travel to China in early November.
• In a speech, the head of the U.K. GCHQ warned about China’s expanding security state and the risk is poses to the West.

 International Roundup:  Poland is about to get EU funds and Iran faces further stress.

• Poland has been unable to garner emergency aid from the EU due to disputes over Poland’s domestic political situation. But it appears that an agreement is now close.
• For nearly four weeks, Iran has seen significant unrest that followed the death of a young Kurdish woman at the hands of morality police. Now demonstrations have spread to the oil industry as workers are striking in sympathy.

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[1] If one observes the “real” rate from the TIPS spread relative to the ex-post rate (nominal yield less the yearly change in CPI) it is clear that investors think inflation won’t last.

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