by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with a discussion about central banks around the world becoming more hawkish. Next, we give an overview of rising geopolitical tensions in Central Asia and Europe. We conclude the report with thoughts on how U.S. moves are impacting global financial markets.

Central Bank Worries: Monetary policymakers continue to dig in their heels as price stability remains their top priority even as output falls.

• European Central Bank officials are worried that an economic slowdown will not be enough to meaningfully bring down inflation. According to the ECB’s September meeting minutes, central bankers expressed concerns that a weaker euro and fiscal stimulus have made inflation resilient. The comments suggest the bank will opt for a jumbo rate hike in its next meeting on October 27. The market has priced in a 66% chance of a 75 bps rate hike and a 34% chance of a 100 bps rate hike.
• Fed officials keep throwing water on the possibility of a slowdown in rate hikes. Five officials on Thursday reiterated the central bank’s desire to bring down inflation at all costs. In her first remarks since taking over as Fed governor, Lisa Cook argued that the Fed needs to push rates higher until the data shows that inflation is moving toward the bank’s 2% target. In a separate statement, Fed Governor Christopher Waller shot down the possibility that financial instability could force the bank to pivot. If Waller is correct and the Fed maintains rate hikes during a financial crisis, a recession could be more profound than most investors expect.
  • In the event of financial market turmoil, we suspect the Fed will use the emergency tools developed during the pandemic. Accordingly, we may see some cash injections from the Fed to relieve some of the stress in the banking system.
• Global liquidity is drying up as central banks tighten monetary policy and the world economy slows. The U.S. banking system appears to be ground zero for financial distress. Treasury market liquidity, as tracked by the Bloomberg U.S. Government Securities Liquidity Index, rose to its highest level since the 2020 pandemic. The lack of demand for government bonds is driven by high inflation and large deficits. As a result, if left unchecked, the Treasury build-up could lead to the financial system getting clogged again and the Fed might be forced to end quantitative tightening prematurely.

Rising Global Frictions: As everyone focuses on Russia, there are signs that frozen conflicts are starting to thaw in other parts of the world.

• Turkish President Recep Tayyip Erdogan threatened to invade the Greek islands on Thursday. Erdogan accused Greece of militarizing the Aegean Islands in violation of the 1923 and 1947 treaties. The U.S. did not welcome the comments as it believes the countries should focus their attention on Russia. Greece has been helpful in the transfer of weapons to Ukraine, while Turkish drones were pivotal in fending off Russian troops at the start of the invasion. A conflict between the Mediterranean rivals threatens to divide NATO and calls into question the military alliance’s unity.
  • Erdogan’s comments are another example of his split allegiance between the West and Russia in the war in Ukraine.
• A deal to formally end a dispute between Israel and Lebanon is in jeopardy. The sides were close to an agreement that would allow Israel to start drawing gas from the Karish gasfield, but Lebanon has demanded last-minute changes to the deal. The hiccup in talks will prolong negotiations as Israel prepares for elections next month. Assuming the deal is not resolved, the outcome will prevent an additional supply of natural gas from entering the market. Renewed threats from Lebanon against Israel also raise the likelihood of a war between the countries.
• Lastly, squabbles among Central Asian countries are becoming more common as Russia focuses its attention on Ukraine. Kyrgyzstan’s President Sadyr Japarov skipped the Commonwealth of Independent States (CIS) summit in St. Petersburg on Friday due to anger at home over Moscow’s inability to prevent Tajik forces from invading Kyrgyz territory in September. His lack of attendance is viewed as a slight to Putin, who is celebrating his 70th birthday at the event. We suspect that Russian losses in Ukraine have led countries within Central Asia to question Moscow’s security commitment. Thus, there is the possibility for violent outbreaks in an area that holds 10.6% of the world’s oil reserves.

The U.S. Leads the Dance: American foreign and monetary policy decisions continue to rattle markets as the world waits to see how the U.S. will respond to Russia and rising inflation.

• President Biden warned that Russia’s threat of a strategic nuke was not a bluff. In a speech at a New York fundraiser, Biden acknowledged that his administration is seeking an off-ramp for Putin following a series of Russian losses in Ukraine. The comment from Biden suggests that his administration is looking for ways to get Putin to the negotiating table. The possibility of nuclear conflict could lead to a broader war in Europe and would be detrimental to risk assets.
  • We do not believe it is probable that Putin will use a nuke at this time, but we think the risk is to the upside.
• A strengthening dollar has contributed to a substantial decline in foreign exchange reserves in Japan and China. The rise in the greenback has forced countries to enter exchange rate markets to prevent their currencies from devaluing. Japan’s reserve drop resulted from the Bank of Japan’s decision to sell off U.S. Treasuries. In China, the decline in reserves was driven by a reduction in gold holdings. These moves show the level of pressure governments are under to preserve their respective currency’s value.
• The world waits as the U.S. pressures OPEC to back off its decision to cut its output target by 2 million barrels per day. On Thursday, the Biden administration expressed that all measures are being considered to prevent rising oil prices from putting upward pressure on gas prices and inflation. In addition, the U.S. is considering offloading some of its strategic reserves as well as a potential export ban. Depending on what it decides, it could have slightly beneficial or disastrous effects on global energy prices.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion about the Federal Reserve’s insistence on raising its benchmark interest rate despite the global outcry. Next, we discuss the impact that Ukraine’s successes in the south have had on Russian sentiment. We end the report with an overview of how foreign governments are looking to calm discontent within their countries.

 The Fed Marches On: Despite calls for the central bank to rethink its policy stance, the Federal Reserve is poised to keep raising rates until it sees trouble.

• The Fed may not be finished tightening, but officials are looking toward the horizon for a potential end date. On Wednesday, San Francisco Fed President Mary Daly pushed back against the suggestion that the Fed will wait until something breaks before it acts. During an interview on BloombergTV, Daly hinted that central bank officials are monitoring economic signals that would suggest it had gone too far. Her remarks indicated that some Fed officials are uncomfortable raising rates in a recession.
• A possible end to the interest rate hikes explains the rise in gold and equity prices throughout the week. The ISM Supplier Delivery Index, a proxy tool to gauge supply chain efficiency, fell to a post-pandemic low. The improvement in manufacturing deliveries suggests that supply-driven inflation may be on the decline, paving the way for a possible Fed pivot. Investors responded to the report by piling into gold which is now hovering around $1700 an ounce. Additionally, equities mounted a two-day rally that ended after a positive jobs report from ADP signaled that the labor market remains tight.

• At this time, the Fed is on track to continue raising rates until inflation slows to the central bank’s 2% target. The latest CME FedWatch Tool forecast shows a 67.3% chance that the Fed will raise its benchmark interest-rate range of 3.75% to 4.00% and a 32.7% chance of an interest-hike range of 3.50% to 3.75%. The recent movement in the market indicates that many investors believe that the Fed will not be able to keep raising rates for much longer without triggering a recession. As a result, many market participants likely have yet to offload some of their poor-performing financial assets. This scenario suggests that the market may still have a ways to go before it hits bottom if the Fed proceeds with its tightening cycle.

 Ukraine update: As Russian losses continue to pile up, Moscow learns to accept some hard truths.

• This war is becoming increasingly unpopular. After Putin’s call for “partial mobilization,” Russian protests have become louder and more widespread. Although most of the pushback initially came from major cities such as St. Petersburg and Moscow, there are now signs of resistance in poorer areas such as Dagestan. The sustainability of this war hinges on the Kremlin’s ability to maintain popular support. Unfortunately for Putin, time may not be on his side as he would like to secure a decisive victory in Ukraine before he begins his presidential campaign late next year. Putin is unlikely to lose any election, but the lack of turnout could dent his political clout. Although we are not forecasting his ousting, we would like to remind our readers that his exit would likely be sudden.
  • The removal of Putin would lead to much uncertainty as it is unclear who would be his replacement. Additionally, his transition from power may not be peaceful as Putin has many supporters in the military. As a result, Putin’s removal could lead to a rush toward safe-haven assets in the short run as events played out.
• Low morale among Russian troops is a core reason why Ukraine has been so effective in their campaigns. The Ukrainian offensive in the southern part of the country has led to a series of Russian retreats, and although the mobilization effort will likely provide the army with more manpower, it also has the potential to lead to more disobedience. The lack of support among Russian soldiers may have contributed to Putin’s decision to promote the controversial Chechen leader Ramzan Kadyrov to Colonel Leader on Wednesday. Additionally, Russia could look to push for Belarus to become involved in the war. As Ukraine’s forces continue to stack up successes in the south, Russia is likely to take more extreme actions.
• The longer the war rages on, the more isolated Russia will become from Europe. In 2021, the EU accounted for 36.5% of its imports and 37.9% of its exports. Its deep trade ties with Russia have made the two sides somewhat dependent on each other for critical resources and revenue. However, this dynamic is on the verge of changing following Russia’s invasion of Ukraine. On Thursday, U.S. exporter of LNG Venture Global signed a contract to provide Germany with liquified natural gas. This is the only deal thus far between Germany and the U.S., but it is unlikely to be the last.
  • The disentanglement between Europe and Russia will likely favor Western energy companies as countries look to prioritize the security of resources over convenience.

Global discontent: The slowdown in growth and inflation has led to political backlash worldwide, and governments are starting to respond.

• China has ramped up its corruption crackdowns in the run-up to the country’s Communist Party Congress later this month. Although Chinese President Xi Jinping has made fighting corruption a central theme of his leadership, some of these investigations appear to target mainly potential rivals and critics. We suspect that the crackdowns are a way to make it easier for Xi to push through policies that may not be growth friendly. This shift is designed to help China decouple from the West and become more self-sufficient. As a result, investment opportunities in China may not be as plentiful in the future.
• The White House is preparing to punish OPEC+ for its decision to cut its oil output by 2 mbpd. The Biden administration is working with Congress on legislation reducing the oil cartel’s control over energy prices. Introduced in May, the aptly named NOPEC bill seeks to expose countries to anti-trust lawsuits from the U.S. government. However, it is unclear how the U.S. could enforce a ruling against a foreign country. These countries’ dependency on the American financial system could be a target. If we are correct, the weaponization of the dollar will likely encourage countries to diversify their currency holdings away from the U.S dollar.
• Prime Minister Liz Truss failed to quell criticism of her tax policies from fellow Tories. Truss was heckled at the Conservative Party Conference after members were displeased with her bold fiscal plan that rattled markets and temporarily tanked the British pound. Although she vowed to plow ahead with her agenda, the conference showed that she might be losing support from members of her party. The latest polls show that the Labour Party would win if elections were held today. Although elections are not until January 23, 2025, Labour’s lead is not a good sign for the Tory leadership. Hence, Truss could be pushed out if she cannot regain support for her policies.

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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, where there is increasing evidence that the Russian army is collapsing, at least in some specific areas.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a preview of an important OPEC+ meeting and a discussion of yesterday’s JOLTS report in the U.S.

Russia-Ukraine:  Ukrainian forces continue to recapture significant swaths of territory in Ukraine’s northeastern Kharkiv and Luhansk provinces and in the southern region around Kherson, in part by utilizing tanks and other equipment recently captured from the retreating Russians.  At the same time, the Russians are continuing to stage unsuccessful ground attacks in the northeastern region of Donetsk, while also continuing to conduct artillery and missile strikes against civilian infrastructure throughout Ukraine.  Ukraine’s advances and Russia’s poorly executed mobilization of reservists (discussed below) are now generating increased disputes and disagreements among key supporters of President Putin, putting him in a difficult political spot.  On top of that, reports indicate that the new call-up of troops is depleting the nation’s police and security forces, making it more difficult to control popular unrest.

• At least one Russian source says that the Russian army around Kherson is collapsing catastrophically after Ukrainian forces broke through their lines and ran all the way to the coast, cutting off thousands of Russian troops with no hope of receiving reinforcements or supplies. If true, that event would likely cause even greater criticism of Putin.
• Meanwhile, Defense Minister Shoigu announced that Russia has already mobilized 200,000 of the 300,000 new troops it called up in late September. However, even if that figure were accurate, multiple sources say the call-up continues to suffer from a range of problems, including an acute shortage of officers to train and lead the new troops.
• On the energy front, EU officials are reportedly preparing to implement the G-7’s proposed cap on Russian oil prices in two stages. The officials are preparing legislation needed to implement the measure, but they will hold off approving it until the rest of the G-7 is ready to move forward.  The plan reflects the difficult politics involved in imposing any sort of trade restrictions on Russian energy.

Global Oil Market:  The Organization of the Petroleum Exporting Countries and their Russia-led partners are meeting in-person today for the first time in years to discuss a production cut of up to 1.5 million barrels per day.  Not all the members are supporting the cut, but now that the UAE has thrown its backing behind Saudi Arabia and Russia in supporting the idea, it appears that a significant reduction in output is likely.  That could help boost energy prices again, with negative impacts for consumer price inflation and the electoral prospects of Democrats in next month’s mid-term elections in the U.S.

• Meanwhile, the chief of Saudi Arabia’s state oil company, Saudi Aramco (2222.SR, SAR, 35.95) warned that the world is too focused on the near-term demand impact of a possible recession rather than the limitations of supply.
• The official said that the global oil market remains extraordinarily tight, in large part because of under-investment in new supply in recent years, and that prices could skyrocket in response to a demand shock like a stronger-than-expected rebound in the Chinese economy.

Germany-Poland:  Yesterday, the Polish government signed an official note to Germany requesting the payment of $1.3 trillion in reparations for the damage incurred by occupying Nazi Germans during World War II.  The Polish foreign minister also asked that Germany solve the issue of looted Polish artworks, archives, and bank deposits.  In our view, the demands are further evidence of the fracturing of political ties in Europe, especially after Germany’s recent actions to give itself a competitive advantage in the evolving European energy crisis.

United Kingdom:  Just as Continental Europe’s industrial base has been impacted by the war in Ukraine, thousands of British businesses are now closing or retrenching in response to skyrocketing energy prices, rising interest rates, and falling demand.  The reports confirm that U.K. stocks may be among the most vulnerable as Europe’s energy crisis continues to worsen this winter.

Japan-South Korea:  Japanese Prime Minister Kishida and South Korean President Yoon plan to talk by telephone on Thursday to discuss North Korea’s recent provocative missile tests, one of which overflew Japan.  The call not only illustrates how Japan and South Korea are beginning to coordinate more closely on national security issues, including against China, but it also shows that Kishida and Yoon remain committed to rapprochement after many years of tensions between Japan and South Korea.

Brazil:  As results from Sunday’s elections are finalized, it appears that both left-wing and right-wing parties have gained seats in the country’s parliament, but neither has won enough to dominate the body.  That’s good news for investors, as it will require alliances to pass legislation, and therefore will reduce the chance of radical new policies, no matter who wins the upcoming presidential run-off election.

Uganda:  Over the last two weeks, officials have counted more than three dozen cases of the Sudan strain of Ebola, for which there are no proven vaccines or antiviral treatments and which can’t be detected by rapid tests.  Officials fear there are many more unknown cases, including in areas frequented by Western tourists.

U.S. Economy:  The monthly JOLTS report yesterday showed employers’ total job openings fell 10% in August to a seasonally adjusted 10.1 million from 11.2 million the month before.  The apparent drop in labor demand was taken as an important sign that the Federal Reserve’s interest-rate hikes are having their intended effect, boosting hopes that inflation will soon fall and reduce the need for further rate hikes.

• The report was key to sparking yesterday’s big rebound in the stock market, which pushed the S&P 500 price index up 2.6% to 3,774.75.
• We would note, however, that the JOLTS report was all positive. The report also showed that quits and layoffs in August were little changed.

U.S. Monetary Policy:  Despite the economic slowdown evident in the JOLTS report and some other economic indicators, yesterday Fed board member Philip Jefferson warned that bringing consumer price inflation down to acceptable levels will take time and require a bigger slowdown in economic growth and labor demand.  Importantly, he said that the labor market remains very tight, suggesting that he would support continued increases in interest rates despite the market’s hope for a reprieve in the near term.

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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, where Ukrainian forces continue to make surprising progress in the counteroffensives in northeastern and southern Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a new controversy over energy policy in the European Union and a discussion of what has been driving the rebound in the U.S. stock market yesterday and today.

Russia-Ukraine:  The latest reporting indicates that Ukrainian forces continue to recapture significant amounts of territory not only in the northeastern Donbas region but also in the south around Kherson.  Notably, these gains have come at the expense of units that were considered to be among Russia’s finest before the war, which indicates that even Russia’s finest military units are now seriously degraded and have only limited combat forces available to them.

• Ukraine’s reaccelerating military advances are risky, in that Ukrainian forces could over-extend themselves and outrun their supply lines.  However, Kyiv has apparently accepted that as a calculated risk in order to make fast progress while Russia hits snafus and other obstacles with its recent mobilization order.
• As we’ve mentioned before, Russia’s losses have the potential to push President Putin toward playing his nuclear card, most likely by detonating a relatively low-yield tactical nuclear weapon over Ukraine, the Black Sea, or perhaps the Baltic Sea.  Less noted is that Putin could also be subtly threatening to use strategic weapons.  For example, press reports indicate a Russian submarine designed to deliver a nuclear-armed drone has mysteriously left its normal operating area in the White Sea.  We’ve seen other reports of unusual deployments of Russian strategic bombers.

European Union:  The chief technical officer of German electricity grid operator Amprion warned yesterday that Germany may have to reduce or temporarily halt power exports to France and other countries this winter to prevent bottlenecks and shortages across its power grid.  The alert shows that the energy crisis touched off by Russia’s invasion of Ukraine has reached the point where it is more seriously threatening the bloc’s unity.

• Germany has already been criticized for its recently announced €200 billion plan to provide energy subsidies to domestic businesses and households.
• Other EU states worry Germany’s energy subsidies will give it an unfair competitive advantage in the bloc’s marketplace because many countries can’t afford to give their firms and consumers similar help.

United Kingdom:  Just a day after being forced to back down on her plan to cut income taxes for the U.K.’s richest citizens, Prime Minister Truss is facing a new rebellion from her own Conservative Party over her plan to boost social benefits next year by less than consumer price inflation currently about 10%.  Instead, she wants to hike those benefits only in line with average wage growth, or about 5%, in order to reduce public spending.

• The Truss proposal has already prompted pushback by at least one cabinet member and several members of parliament.
• As with the plan to cut taxes for the U.K. elites, the pushback against reining in pensions and other social benefits illustrates how populist policies are now ascendant in Britain’s Conservative Party, as they are in many right-wing and left-wing parties around the world.  Those populist priorities are often unfriendly to the interests of capital holders.

Japan-North Korea:  Today, the North Korean military launched a ballistic missile directly over Japan for the first time since 2017.  The overflight forced Tokyo to issue a rare public alert for people to take cover and prompted condemnation from Japan and other countries.  North Korea’s recent missile launches are likely designed to draw the U.S. and its allies into new negotiations for security and economic concessions.  For investors, the provocations could raise risk premiums for Asian assets.

China-Taiwan-United States:  In an interview Sunday, U.S. Defense Secretary Austin said that the U.S. will help Taiwan “develop the capability to defend itself” against a Chinese invasion.  Austin stopped short of repeating President Biden’s recent vow to send U.S. troops to help Taiwan resist an invasion, but he still seemed to strike a more bellicose stance than officials have typically done under the U.S. “strategic ambiguity” policy.  That fits the pattern of an increasingly fractious U.S.-China relationship that threatens to catch investors in the crossfire.

United States-China:  A bipartisan group of 15 senators is planning to introduce legislation to create a “China Grand Strategy Commission,” which will be given two years to develop a whole-of-government approach guiding Washington’s relationship with Beijing.  The goal will be to formulate a U.S. “grand strategy” on China that could avoid conflict while allowing the U.S. to continue pursuing its interests.

U.S. Economy:  The Institute for Supply Management yesterday said its September ISM Manufacturing Index fell to a seasonally adjusted 50.9, compared with 52.8 in each of the previous two months.  The ISM indexes are designed so that a reading over 50 points to expanding activity, and therefore the report suggests that the U.S. factory sector is still growing, only slowly.  That is likely the kind of data the Federal Reserve policymakers want to see to be sure inflation pressures are coming down, even though New York FRB President Williams yesterday said price pressures are likely to remain sticky and will require a long period of high interest rates to combat them.

• Indeed, the September subindex on supplier deliveries fell to its lowest level since December 2019, suggesting that supply bottlenecks have now eased considerably.  The September subindex on prices fell to its lowest level since June 2020.
• The indication of cooling demand and moderating inflation was probably key to the stock market’s big jump yesterday.  Just as important, investors bid up bonds again, driving the yield on the benchmark 10-year Treasury note down to 3.650%.

U.S. Supply Chains:  Apple (AAPL, $142.45) this week released data showing that 48 of its more than 180 suppliers had manufacturing sites in the U.S. as of September 2021, which is up from just 25 a year earlier.  The figures illustrate how U.S. firms are “re-shoring” or “near-shoring” production back to the U.S. to ensure stable supplies as the world fractures into relatively separate geopolitical and economic blocs.  As we’ve written many times before, such shortened supply chains will likely be costlier and less efficient than fully globalized supply chains, raising inflation and interest rates going forward.

• The U.S. government is also continuing to cut technology exports to China.  Reports indicate that the Biden administration is currently preparing new export controls on semiconductors and the machines to make them.
• The new export controls could be announced as early as this week.

U.S. Retail Real Estate:  Recent data suggests retail real estate is now performing strongly again for the first time in years, or even decades.  According to Cushman & Wakefield, U.S. retail vacancy fell to 6.1% in the second quarter, the lowest level in at least 15 years, while asking rents for U.S. shopping centers in the quarter were 16% higher than five years ago.  A separate analysis shows more stores opened than closed in the U.S. last year for the first time since 1995.  The improvements reflect a rebalancing of supply and demand after poor returns and high vacancies discouraged new building in recent years.

U.S. Cryptocurrency Regulation:  Yesterday, the Financial Stability Oversight Council, chaired by Treasury Secretary Yellen issued a report saying that while the crypto industry remains small compared with the overall financial system, that could change quickly and exacerbate potential systemic risks.  Illustrating the growing regulatory risk for crypto assets, the report called on Congress to write rules covering the crypto industry in areas that don’t currently fall under regulation.

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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 that Ukraine has retaken more land with its counteroffensives in the northeast and south of the country.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a dramatic U-turn in the U.K. government’s big tax-cutting proposal.

Russia-Ukraine:  Over the weekend, Ukrainian forces recaptured the important transportation hub of Lyman in Ukraine’s northeastern Donbas region, and the Russian military admitted it had withdrawn its troops to avoid their encirclement.  The loss touched off another round of angry recriminations by ultra-nationalist Russian bloggers and military commentators, who castigated Russia’s military leadership and demanded stronger performance from commanders on the ground.  Importantly, it appears that the Russian military failed to reinforce its position in and around Lyman, probably because President Putin has prioritized holding the southern region around Kherson and Zaporizhzhia against the Ukrainian counteroffensive there in order to preserve Russia’s land bridge to its illegally annexed region of Crimea.

• Ukrainian forces continue to push eastward into the Russian-held province of Luhansk, further pressuring Russian forces and further raising the risk that President Putin will feel so backed into a corner that he would contemplate detonation of a tactical nuclear weapon to try to reverse his fortunes.
  • It’s important to remember that NATO and the U.S. have had decades to refine their surveillance, monitoring, and intelligence capabilities regarding the all-important threat of Russian nuclear weapons. Since Russian tactical warheads are stored in specific bunkers and not married with artillery or missile systems until just before they’re used, our best sources suggest NATO and the U.S. would be able to see their preparation “as the process unfolds.”
  • Of course, President Putin might want that to be the case anyway, since his greatest leverage would come with the threat, rather than the use of such weapons. There is probably a growing chance that Putin will at some point order the initial steps toward using tactical nukes in order to send an even stronger warning to the West, hoping it will split the allies or convince them to back off and let him have Ukraine.
• In a television interview yesterday, NATO General Secretary Stoltenberg warned that any use of nuclear weapons in Ukraine would “change the nature” of the conflict and would result in “severe consequences” for Russia.

OPEC+ Oil Cartel:  Press reports indicate that the Organization of the Petroleum Exporting Countries (OPEC) and its Russia-led partners are planning to cut crude oil production by as much as 1 million barrels per day when they meet on Wednesday.  The reports also suggest that Saudi Arabia, the key country in the group, wants to lower output both to prop up prices and to keep some production capacity in reserve in case Western sanctions lead to a drop in Russian output later this year.  Russia, the other key producer in the group, also wants to prop up prices to help pay for its invasion of Ukraine.

• A question to be resolved is whether OPEC+ members will reduce actual production, their quotas, or a mixture of the two. The group is already 3.5 mbpd short of its target, as Nigeria, Angola, Russia, and others struggle to churn out the barrels they have committed to on paper.
• If implemented as output cuts, the deal could push energy prices up again, exacerbating inflation in the developed countries and complicating the Democrats’ chances in November’s U.S. mid-term elections.
• Indeed, Brent crude futures are up 3.9% to $88.48 per barrel so far this morning.

United Kingdom:  After ten days of financial market turmoil touched off by her massive tax cut proposals, Prime Minister Truss has abandoned her plan to cut the top personal income tax rate from 45% to 40%.  The decision came as Truss faced a revolt by her own Conservative Party members of parliament, which raised the risk that the provision wouldn’t pass the legislature.

• Abandoning the tax cut for Britain’s richest citizens has important political implications in Britain and beyond. The pushback against cutting taxes for elites reflects the enduring power of populism among right-wing parties today.  Truss’s U-turn will likely be a signal to politicians worldwide about the danger in proposing elitist policies over populist ones.
  • Having retreated on the top income tax rate, Truss could now come under pressure to reverse other proposed unfunded tax cuts that have blown a hole in the U.K.’s public finances. Examples include the £13-billion reduction in national insurance contributions, which gives the biggest benefit to better-off voters, and the £17 billion plan to reverse a previously-planned hike in corporate income taxes — a policy that business leaders have said is not a priority.
  • Of course, the mess also seriously damages Truss and her government, raising the chance that she will be pushed out of power relatively soon.
• Abandoning the tax cut only marginally reduces the cost of Truss’s program, but financial markets so far this morning are taking the news positively. The yield on 10-year gilts fell modestly to 4.02%, down from approximately 4.60% at the height of the market turmoil last week, while the pound edged up in value to $1.1212.

European Union:  The European Commission plans to propose a major reform of its “Growth and Stability” fiscal rules this month in order to give EU member countries more time to cut their debts and make space for public investment.  Under the proposal, the EU and national capitals would work out multiyear, country-specific plans for getting their debt burdens under control.  The plan aims to simplify the EU’s hugely complex fiscal rules while also tightening enforcement.

China – National Day Holiday:  Marking China’s National Day on Saturday, President Xi said in an article that the country “has never been closer” to achieving its great national rejuvenation, but that the last mile would be full of perils and challenges.  He urged Communist Party members to press on even as they face major challenges, risks, barriers, and contradictions in the coming years.

• In the run-up to the party’s 20th National Congress later this month, Xi’s article shows that he remains fully committed to his program of strengthening China and eventually displacing the U.S. as the world’s most powerful nation.
• Because of the National Day holiday, China’s stock markets and most business and government activities will be shut down all this week.

Turkey:  The September consumer price index was up 83.5% from the same month one year earlier, accelerating from the rise of 80.2% in the year to August and marking Turkey’s highest inflation rate since July 1998.  Despite the accelerating inflation, President Erdoğan continues to insist on further interest-rate cuts, pushing the value of the lira even lower.  Against the U.S. dollar, the currency is now down approximately 27% year-to-date.

Brazil:  In the first round of Brazil’s presidential election yesterday, leftist Former President Luiz Inácio Lula da Silva led with 48.4% of the vote, beating incumbent President Bolsonaro with 43.2% of the vote.  However, Bolsonaro’s tally was significantly stronger than expected, setting up what could be a close vote in the run-off election on October 30.

• Public opinion polling had long predicted a very strong majority for Lula, prompting fears of a hard swing to the left in Brazilian economic policies and undermining Brazilian stock prices.
• Bolsanaro’s better-than-expected showing in the first round is likely to generate at least a short-term rebound in Brazilian stocks. Indeed, Brazilian stocks are up well over 5% in the U.S. this morning.

China – Real Estate Market:  Ahead of the holiday on Friday, regulators announced a series of policy changes to support the contracting real estate development and housing industries.  The moves include special interest-rate cuts for first-time home buyers and a tax cut for a broader group of home buyers.  The moves prompted a jump in the Hong Kong-listed shares of major Chinese property developers today.

United States-China:  The top Republicans on the House Agriculture and Oversight committees asked the Government Accountability Office to conduct a study examining foreign countries’ acquisition of U.S. farmland and its impact on national security, food security, and trade.

• The lawmakers, along with many Democrats, are especially interested in whether Chinese acquisitions, in particular, could pose a national-security threat.
• Naturally, the requested GAO study could be the first step in a legislative push to further restrict Chinese acquisitions of U.S. assets. That move would likely exacerbate U.S.-China tensions and accelerate the fracturing of the world economy into a U.S.-led bloc and a Chinese-led bloc, as we have often predicted.

U.S. Housing Market:  As rising interest rates push more families out of the market for new homes, builders are reportedly cold-calling investment buyers and offering them discounts of as much as 20% from the price they would charge to individual buyers.

• The phenomenon illustrates the dramatic slowdown in housing demand in response to the Federal Reserve’s interest-rate hikes.
• Of course, that slowdown in demand is also likely to weigh on U.S. economic growth and could help push the economy into recession.

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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 an overview of the upcoming Brazilian elections on Sunday. Next, we discuss how other countries are looking to fight inflation while generating economic growth. We end the report with a summary of the ongoing troubles in Europe.

 Brazil Election: Sunday’s election has sparked concerns of a potential coup and a return to left-wing policies.

• Brazil will hold its presidential elections on October 2. Former President Lula da Silva and current President Jair Bolsonaro are favored make it out of the first round that has 11 candidates competing to lead the country. Lula is heavily favored to win the election and is predicted to take an outright majority in the first round. Assuming he does not win a majority, a run-off will occur on October 30. The return of Lula will not be viewed favorably by markets as his party has a reputation of being fiscally irresponsible.
  • His campaign promises include increasing cash transfers, expanding social housing, and imposing debt forgiveness.
• A Bolsonaro loss may lead to a military coup. In the run-up to the election, Bolsonaro consistently blamed his potential defeat on electoral fraud. Given the country’s history of right-wing dictatorship from 1964-1985, the risk of political violence following the election is elevated. Although members of Bolsonaro’s political teams have stated that they would seek legal remedies if Lula won, they also mentioned the possibility of national protests and strikes. A military coup could lead to Latin America’s fourth largest economy being targeted by Western sanctions. For now, it does not appear that the military is interested in running the country.
• The next president of Brazil will have to deal with the “Centrão” to pass meaningful legislation. The group contains an established bloc of politicians likely to oppose left-wing policies. Currently, the economy is on pace to grow 2.5% for the year, and the latest CPI report shows that inflation is falling. As a result, Lula is unlikely to have the political clout needed to reverse many of the pro-business laws put in place by his predecessor. Therefore, a Lula victory is unlikely to change investor sentiment about Brazil and should not impact the country’s currency much.

The Fed Speaks: As the Federal Reserve looks to continue tightening its monetary policy, other countries are looking at fiscal stimulus as a way to reduce inflation.

• Fed officials insisted that the central bank will continue to raise interest rates to tame inflation. St. Louis Fed President James Bullard claimed that markets are right about the Fed’s rate intentions going into 2023. Meanwhile, Cleveland President Loretta Mester mirrored the sentiment but added that the bank could increase its policy rate above the Fed’s dot-plot median target rate. Although remarks by officials indicate rates will increase by another 125 bps before the end of the year, the level of hikes for each of the remaining meetings is still unknown. The latest CME FedWatch Tool suggests a 44.8% chance of a 50 bps increase and a 55.2% chance of a 75 bps increase.
  • The next meeting is on November 2; thus, the October CPI report released in two weeks will likely give us insight into how aggressively the Fed will tighten monetary policy.
• In a surprise, revised data showed that economic activity in Britain grew in the second quarter. The latest report showed that output increased by 0.2% from April to June, slightly above the original estimate of a 0.1% decrease. Despite the upward revision, concerns about the British economy remain. The figures reveal that consumption and investment have declined in that period, and this situation likely worsened in Q3 as the country adjusted to higher inflation and borrowing costs. The Truss administration’s stimulus plan may provide some economic reprieve but probably not enough to avoid a recession later this year and could make inflation worse.
  • The U.K. Prime Minister Liz Truss and Chancellor Kwasi Kwarteng are looking for solutions to stem concerns over its controversial tax plan. They will hold an emergency meeting with the Office of Budget Responsibility on Friday. The agency is expected to release the budget estimate on November 23. The meeting most likely explains the recent rebound in the pound.
• Japanese Prime Minister Fumio Kishida instructed the government to develop a budget that will tackle inflation and support a stronger yen. The move comes as the country looks for alternatives to ending its monetary policy accommodation to reduce price pressures. The next budget is expected to add to the country’s burdensome debt load and will probably weigh on future economic growth.

More Problems for Europe: Europe is struggling to cope with rising inflation and lack of energy resources as it looks to punish Russia for its invasion of Ukraine.

• Russia announced that it annexed four of Ukraine’s regions on Friday, a sign that tensions on the European continent are rising. The annexations are controversial because Russian forces do not fully control these areas, and many residents vehemently oppose Moscow. As a result, maintaining stability in the region will likely be difficult and expensive for a country struggling with economic sanctions. That said, the annexations could give Russia a pretext to use more dangerous weapons.
  • The biggest takeaway from the annexation is that Russia is prepared to go all out in this war. Therefore, we believe that, barring an overthrow of Vladimir Putin, the battle is likely to be prolonged. This outcome suggests that the European energy supply crunch could extend into next year and even worsen.
• Eurozone inflation jumped 10.1% from the previous year in September, a new record. The latest CPI report showed that price pressure is becoming more broadly based. Core inflation rose 4.8% from the prior year, higher than August’s reading of 4.3%. Persistently higher inflation could pressure the European Central Bank to increase its policy rate more aggressively in its October meeting. The market has priced in a 75 bps hike at its next meeting; however, we cannot completely rule out a more aggressive move.
  • Diverging borrowing costs among eurozone members may force the ECB to intervene in bond markets if it decides to raise rates. The spread between the Italian and German ten-year bonds is approaching its yearly high, thus increasing the likelihood of European fragmentation.
• The European Union will levy windfall taxes on energy companies in a move designed to pay for subsidies for households. The EU is now expected to focus on implementing a price cap on Russian oil. The moves suggest that the bloc will find it difficult to expand production and may worsen the energy problem.

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