by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Risk assets are enjoying a lift as investors eagerly await tomorrow’s crucial jobs data. Meanwhile, former Padres’ outfielder Juan Soto is making his way to the Big Apple for his next adventure. Today’s Comment kicks off with our insights on the anticipated rate cuts for next year, then explores why banks are wary of the new Basel regulations, and finally delves into how China’s economic struggles might ultimately benefit the rest of the world. As always, our comprehensive report encompasses the latest domestic and international data releases.

Are Rate Cut Bets Overdone? Investors are having second thoughts on how aggressive the Fed will be when cutting rates next year.

• Despite rallying nearly 9% in November, the S&P 500 has been relatively sluggish in the first week of December. This lackluster performance can partially be attributed to market participants rethinking their expectations of a Federal Reserve policy shift. Projections based on fed funds contracts show that investors are predicting a 125 basis point cut in key interest rates, while economists have offered a more pessimistic view, predicting at most a 50 basis point cut in 2024. This divergence in views has led investors to seek protection against market volatility in the form of options.
• While concerns remain, expectations for a moderating interest rate environment are not entirely unfounded. Federal Reserve Board Governor Christopher Waller, a traditionally hawkish member, recently suggested that the central bank could cut rates as early as April if inflation continues to make significant progress towards the 2% target. Additionally, signs of a cooling labor market may further incentivize action from Fed officials. Last week, data from the Bureau of Labor Statistics revealed a two-year low in job postings for October, while the latest private payroll data from ADP indicated a reduction in new hires by firms. These developments suggest a potentially more dovish stance from the Fed in the near future.

• Although inflation remains significantly above the Federal Reserve’s 2% target, it is still too early to predict with certainty whether the Fed will cut rates or stand pat next year. Furthermore, aggressive cuts, as anticipated by the market, are highly unlikely without a major economic crisis. The Atlanta Fed’s latest forecast projects a modest 1.3% annualized growth for the final quarter of 2023. Therefore, if we assume there will be no recession or perhaps a mild one, then any potential rate cuts in the coming year will likely be moderate.

Wall Street Woes: CEOs from major banks gathered on Capitol Hill to express their concerns about new financial regulations.

• Implementation of new banking standards dubbed the “Basel III Endgame,” which are due to take effect in 2028, was the central topic of discussion. The chief executives argued that the proposed changes, which have not been finalized, are likely more burdensome than regulators realize. For example, the new capital requirements could make it harder for financial institutions to lend to households and small businesses, particularly those who already struggle to access credit. Additionally, the executives argued that the changes could push lending into less regulated sectors of the financial system. The banks’ concerns about the impact of the new regulations on lending come amid a significant rise in private credit lending, which has seen a dramatic increase in recent months.
• The new rules were announced in July in response to growing concerns about the weakness within the financial system. These rules will apply to banks with holding over $100 billion in assets, exempting smaller institutions. The aim is to compel banks to adopt a more conservative and standardized approach to risk measurement, effectively requiring them to hold more capital as a buffer against losses. Regulators estimate a 19% average capital increase for globally systemically important banks (G-Sibs), although industry groups believe the actual increase could be significantly higher. Nevertheless, the stricter rules should help bring U.S. banks into compliance with international standards.

• New rules often have a good purpose, but they typically come at a cost to the overall economy. The combination of higher interest rates and regulatory scrutiny has already weighed on lending. As the chart above shows, large banks have reduced the amount of credit issued compared to the year prior. However, the new Basel rules’ ability to prevent another crisis may not be as clear-cut as regulators may think, as it could lead to unforeseen consequences. For example, the rise of collateralized debt obligations (CDOs) was spawned by the first Basel Framework, highlighting the possibility of unintended side effects. That said, the proposed rules are still under development and open for public comment until January 16, 2024.

China Needs a Break: The country faces a growing number of obstacles as it seeks to expand its global reach and revitalize its struggling economy.

• China’s Belt and Road Initiative has suffered a significant setback with Italy’s formal withdrawal from the program. Though Italian Prime Minister Giorgia Meloni’s earlier criticism of the initiative foreshadowed the decision several months ago, it will likely strain relations with China. Italy’s 2019 participation in the BRI marked a historical first — the only G-7 member to join the program. However, this decision drew criticism from other EU countries and the United States, highlighting divisions within the Western alliance. Italy’s withdrawal may lead to some retaliation from Chinese consumers, but the decision to leave is a further indication of Beijing’s waning influence in Europe.
• U.S. ratings agency Moody’s ( MCO, $374.43) downgraded the outlook for eight Chinese banks, including the “Big Four” state-owned commercial banks (Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and China Construction Bank Corporation), from stable to negative. The negative outlook reflects Moody’s earlier downgrade of China’s sovereign debt rating, as the agency believes the government has less fiscal capacity to support struggling banks. Additionally, they signaled the potential downgrade of several government-backed entities supporting infrastructure. Fearing potential retaliation from the Chinese government, similar to surprise audits faced by Mintz Group, Bain & Co., and Capvision Partners earlier this year, Moody’s advised its staff to work from home following the downgrade.

• The country’s escalating economic problems will likely discourage Beijing from seeking major disruptions in its international relations in the near term. This is evidenced by Xi Jinping’s recent efforts to foster warmer ties with the United States, despite President Biden’s earlier remarks referring to him as a dictator. As the government seeks to manage its debt burden, promoting exports becomes an increasingly important strategy for generating growth and maintaining industrial production levels. This explains Xi Jinping’s recent trip to the EU, where he aimed to convince lawmakers not to place barriers on trade. In all, China’s shortcomings may lead to more stability as it may be too distracted to start a fight with the West.

Other News: Venezuelan President Nicolás Maduro recently unveiled a controversial map claiming Guyana’s Essequibo region as part of Venezuela. This action marks a significant escalation in Maduro’s ongoing efforts to assert control over the eastern region. President Biden suggested that there are Democrats who could possibly defeat Trump in an election, a possible sign that he may be weighing his options. Meanwhile, the Senate’s failure to pass legislation funding Ukraine due to demands for increased aid for U.S. border security highlights a growing trend of inward-focused politics as the nation grapples with its changing role in the global landscape.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the latest on the potential for a Venezuela-Guyana crisis.  We next review a wide range of other international and U.S. developments that could affect the financial markets today, including Italy’s widely expected decision to pull out of China’s controversial Belt and Road Initiative and several items related to U.S. monetary policy going into 2024.

Venezuela-Guyana:  It still appears that domestic electoral politics were the main reason President Maduro held last weekend’s referendum on taking control of the Essequibo territory of Guyana.  However, new steps that he called for yesterday appear much more concrete and menacing than mere political posturing.  If implemented, the steps requested by Maduro would likely lead to a serious case of territorial aggression in South America.

• The new steps called for by Maduro include the following:
  • Immediate legislative debate and approval of a bill creating a new Venezuelan state of “Guayana Esequiba” (Venezuela’s term for the Guyana territory).
  • Creation of a new High Commission for the Defense of Guayana Esequiba.
  • Creation of a Guayana Esequiba Comprehensive Defense Zone, with administrative and military headquarters in Tumeremo, a town in eastern Venezuela close to the border with Guyana.
  • Designation of Maj. Gen. Alexis Rodríguez Cabello as the Sole Authority of Guayana Esequiba, with administrative and military headquarters in Tumeremo.
  • Creation of a new Essequibo Division within state-owned oil company PDVSA and state-owned mining company CVG, with exclusive administrative and operational powers for the exploitation of natural resources in Guayana Esequiba.
  • Publication of a new official map of Venezuela, including Guayana Esequiba, and ensuring it is sent to all schools, high schools, and universities in the country.
  • Development of a comprehensive social plan for the inhabitants of Guayana Esequiba, including the provision of official Venezuelan identification cards.
  • Establishment of a three-month period for the withdrawal of foreign companies/unilateral concessions in Guayana Esequiba.
  • Creation of a Special Law for the protection of Guayana Esequiba.
• Besides seeking to boost his prospects in Venezuela’s planned 2024 elections, Maduro is likely hoping to wring more sanctions relief from the U.S. The Biden administration may indeed be tempted to further ease restrictions on U.S.-Venezuelan energy trade to avoid an invasion that would likely boost global energy prices ahead of the U.S. elections.
• On the other hand, if Maduro miscalculates and actually follows through on an attempt to seize Essequibo, we suspect the U.S., Brazil, and potentially other countries in the region would come to Guyana’s aid. Any such move by Maduro could therefore backfire on him, but even Venezuela would see some temporary fiscal benefit from the likely spike in oil prices that would result.

Guinea:  In another reminder of the mineral riches in less-developed regions like Latin America and Africa, mining giant Rio Tinto (RIO, $68.49) today said its single biggest investment over the next few years is likely to be a huge new iron ore mine in the West African country of Guinea.  In partnership with Guinea’s government and a Chinese firm, Rio expects to contribute about $6.2 billion to cover half the cost of developing the southern part of the projected Simandou mine, which some analysts think could eventually produce enough ore to drive down global iron and steel prices and take market share from today’s leading producers, Australia and Brazil.

Argentina:  Back in South America, Argentina’s newly elected president, populist libertarian Javier Milei, is making news by backing away from some of the radical economic policy changes that got him so much attention during his electoral campaign.  For example, he has fired some top economic advisers who were enlisted to help him kill the central bank and adopt the U.S. dollar as the national currency. He has also aligned with officials from a previous center-right government that he previously derided, and he has toned down his rhetoric against China.

• Ahead of his inauguration this coming Sunday, Milei is likely running head-on into the messy realities of governing, especially since some of his proposals would be socially disruptive and costly for many Argentines.
• Besides that, Milei’s party has only a modest number of seats in the country’s legislature, presenting challenges for getting his reforms passed into law.

European Union-United Kingdom:  As part of a deal to extend tariff-free trade in electric vehicles between the EU and the U.K., the European Commission proposed a program today offering 3 billion EUR ($3.2 billion) in subsidies to EV battery producers in the bloc.  The program would operate even as the EU continues its investigation into Chinese subsidies for its electric vehicles exported to the EU, which could ultimately lead to punitive EU tariffs against Chinese EVs.

• The EU program would pale in comparison with the big subsidies provided in the U.S. under the Biden administration’s Inflation Reduction Act.
• Nevertheless, the EU program is another reflection of how the world is fracturing into relatively separate geopolitical and economic blocs, and how industrial policy and more active government involvement in the economy is a part of that.

Italy-China:  The Italian government today said it has formally notified China that it is pulling out of President Xi’s signature Belt and Road Initiative.  Under that program, China has channeled more than $1 trillion to mostly underdeveloped countries around the world to build ports, railroads, and other infrastructure aimed at easing Chinese trade.

• The BRI has been criticized as a debt trap by many officials and economists in the West. The Chinese-led projects reportedly often come with opaque and onerous loan obligations.
• Italy’s move shows that the populist right-wing government of Prime Minister Meloni is now back in closer alignment with other states in the European Union, which have begun to push back against China’s rising geopolitical and economic aggressiveness.

U.S. Labor Market:  In a release yesterday, the monthly Job Openings and Labor Turnover report showed October job openings fell by 617,000 to a level of 8.7 million, well below the record high of 12.0 million in March 2022.  The number of quits and hires also remained well below the levels reached in early 2022.

• Coupled with the recent rise in the unemployment rate and an increase in the number of people drawing jobless benefits, the data points to continued gradual weakening in the labor market.
• That will probably help keep price inflation moderating and discourage the Fed from hiking interest rates further.

U.S. Energy Industry:  New data from the Energy Information Administration shows domestic oil production has now reached a new record high for the first time since the coronavirus pandemic hit.  In recent years, U.S. output was held back by a decline in new exploration and development, reflecting factors such as investor insistence that drillers focus more on profits and policymakers’ drive to impose new green regulations.  Now, domestic supply has rebounded enough that it is helping push energy prices downward.

• On the demand side, energy prices are also being cut by weak economic growth in China and some other major markets.
• Increased use of electric vehicles around the world may also be sapping petroleum demand to some extent.

U.S. Bond Market:  Reflecting the softening labor market, lower energy prices, and hopes that the Fed will cut interest rates soon, the yield on the 10-year Treasury note continues to decline.  In fact, we’ve noted that the 10-year yield’s 20-day moving average has now decisively slipped below its 50-day average.  Such a cross-over, when the 50-day average is still trending upward, is often a harbinger of further declines.  Nevertheless, we still think investors are overly optimistic about near-term rate cuts.

U.S. Monetary Policy:  Consistent with our view that many bond investors are too optimistic about near-term interest-rate cuts, a new poll of economists by the Financial Times found that almost two-thirds of the respondents think the Fed won’t start to cut rates until July 2024 or later.  About three-quarters of the respondents expect the Fed to cut the benchmark fed funds rate by half a percentage point or less by the end of 2024.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a downgrade in the outlook for Chinese sovereign debt.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including reports of suspicious short-selling in Israeli stocks ahead of Hamas’s October 7 attacks on the country and new data on educational achievement for the future U.S. workforce.

China:  Moody’s (MCO, $373.94) today maintained its middling investment-grade rating of “A1” on China’s long-term sovereign debt, but in a surprise decision, the firm cut its outlook on the debt from “stable” to “negative.”  According to Moody’s, the cut in the outlook reflects a likelihood that Beijing will eventually need to bail out many of its highly indebted provincial and local governments.  It also cited China’s slowing economic growth in its reasoning.

• For comparison, rating firms Standard & Poor’s and Fitch both currently rate Chinese debt as A+, with a stable outlook.
• While China’s central government debt only amounts to about 21% of gross domestic product, total provincial and local government debt (including off-budget obligations) is estimated to be several times higher than that. Provincial and local governments are also highly dependent on land sales and other off-budget funds, which now are drying up because of Beijing’s clampdown on excessive property development.
• In sum, China continues to face economic headwinds from what we call the Five Ds: Weak consumer demand, high corporate and local government debt, poor demographics, economic disincentives from the Communist Party’s increasing intrusion into the economy, and decoupling as foreign countries shift their trade, investment, and technology flows away from China.

Japan:  As the country returns to consistent price inflation and the Bank of Japan prepares to let interest rates rise further, commercial banks are finding that decades of deflation and ultra-low interest rates have left their staffs unprepared for the new environment.  Major banks are having to retrain their staff to help them understand how to operate in an environment that is normal for most other countries!

Israel-Hamas Conflict:  A draft paper by law professors at NYU and Columbia flags suspicious short-selling in Israeli stocks right before the October 7 attacks by Hamas.  The professors posit that a trader or traders were informed about the planned attacks and sold Israeli stocks short in anticipation that they would decline sharply.  While that seems plausible enough, it also seems to contradict the narrative that the Hamas attacks were originally meant to be relatively small scale incursion but ended up being more much extensive and successful than anticipated.

• Meanwhile, reports today say the Israel Defense Forces’ retaliatory attack on Hamas in the Gaza Strip is close to encircling the last major group of Hamas fighters around the city of Khan Younis.
• Destroying that group could nearly end Hamas’s conventional military capability, but it wouldn’t necessarily lead to a quick end to all fighting in Gaza. Therefore, there is still a risk that the conflict could spread more broadly throughout the region.

Russia-Ukraine-NATO:  In another sign of how militarized Russia is becoming, President Putin has signed an order boosting the country’s total military personnel to 2.20 million, including 1.32 million troops.  That’s up from a total of 2.03 million, including 1.15 million troops, in the increase that was announced in August 2022.  The troop levels cited appear to encompass only active-duty troops, not reservists, so the figures imply that Russia will soon have 1.98% of its military-aged population (those aged 16 to 49) under arms.

• For comparison, active-duty troops only constitute about 0.90% of the U.S. military-aged population.
• Separately, the Stockholm International Peace Research Institute has estimated that revenue from military goods and services at the 100 global defense contractors it tracks actually fell by 3.5% in 2022, despite Western countries’ rush to rebuild their defenses following Russia’s invasion of Ukraine. Sales at the 42 U.S. defense firms tracked by SIPRI fell 7.9%.
  • According to SIPRI, the drop in revenues reflects problems ranging from labor shortages and soaring costs to supply chain disruptions.
  • The think tank believes Western defense firms will only see significant production, sales, and revenue increases in two or three years.
  • We continue to believe defense firms will see big, sustained increases in sales and profits over the coming decade or more as the U.S. and its allies work to rebuild their defenses, but we agree that those increases may not arrive for another couple of years.

 European Union-United States:  The CEO of Airbus (EADSY, $37.18) warned that the company’s multi-billion euro program for replacing its aging A320 family of jets could require “some support” from European governments.  The CEO may be trying to capitalize on Western governments’ recent openness to using taxpayer funds to support domestic manufacturers.  However, any new European support for Airbus would likely spark pushback from Boeing (BA, $234.87) and rekindle trade tensions with the U.S.

 European Union-Mercosur:  The Brazilian government has informed EU officials that the Mercosur trade group — Brazil, Argentina, Uruguay, and Paraguay — won’t be able to sign a proposed free trade deal with the EU this week as previously planned.  According to the Brazilians, the Argentines don’t want to move forward until the inauguration of their newly elected President Javier Milei, who has criticized Mercosur.  Coupled with resistance from France, the long-debated EU-Mercosur trade pact now looks like it could be postponed indefinitely.

United States-Cuba:  Victor Manuel Rocha, a former senior U.S. diplomat who served in U.S. embassies across Latin America, was arrested by the FBI yesterday on charges of spying for Cuba over the course of decades.  As bad as the case is, it likely pales in comparison to the enormous, highly aggressive espionage efforts that China continues to run against the U.S. and its allies.

U.S. Education System:  In a mixed message for the future labor force, the Organization for Economic Cooperation and Development said 15-year-olds in the U.S. lost less learning during the pandemic than most of the other OECD countries.  Based on tests administered under the organization’s Program for International Student Assessment, U.S. students’ average reading and science scores were essentially unchanged between 2018 and 2022.  As shown in the chart below, U.S. students’ average math score fell 13 points, versus an average decline of 15 points in the other countries tested.  Unfortunately, U.S. math scores remained far weaker than in other countries.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with notes from the Ronald Reagan Presidential Institute’s annual National Defense Forum over the weekend.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including more risky Chinese moves in the South China Sea and a new intraday record high for gold prices.

United States-China:  At the Reagan Institute’s annual National Defense Forum over the weekend, Commerce Secretary Raimondo delivered a passionate, aggressive call for even stronger efforts to keep U.S. advanced technology from the Chinese military.  As we’ve noted before, many U.S. business elites continue to resist Washington’s new restrictions on trade, investment, and technology flows to China, including Raimondo’s move in October to clamp down on semiconductors with artificial intelligence capabilities.  However, Raimondo offered no apologies, saying, “I know there are CEOs of chip companies in this audience who were a little cranky with me when I did that, because you’re losing revenue. Such is life.  Protecting our national security matters more than short term revenue.”  Ouch!

• One of Raimondo’s goals is to boost the budget for her department’s Bureau of Industry and Security, which works to stop foreign threats to U.S. industry and national security. According to Raimondo, “I have a $200-million budget. It’s like the cost of a few fighter jets. Come on.  Let’s go fund this operation like it needs to be funded so we can . . . protect America.”
• As more U.S. officials and voters become aware of China’s military buildup and the U.S.’s lagging effort to match it, we see a rising chance that domestic political winds could suddenly shift toward something like the “Missile Gap” controversy of the 1950s and 1960s. The result could be a crash effort to hike U.S. defense spending and expand the military, with politicians who oppose the effort pilloried for being “soft on China.”  On that note, the latest Reagan National Defense Survey was released in conjunction with the weekend forum.  Some of its key findings include:
  • Fully 51% of respondents named China as the greatest threat to the U.S. (including 66% of Republicans and 40% of Democrats), up from 21% in 2018.
  • The increased concern about China mostly reflected worries about its military build-up, human rights abuses, and aggressive foreign policy. The survey now shows much less concern about China’s economic policies.
  • Despite concerns about China’s military, the respondents appeared overconfident in the U.S.’s military superiority over China. The respondents’ assessments suggest they still don’t appreciate how far China has developed its naval, air, missile, space, and cyber capabilities.
  • The survey suggests that if or when voters believe the U.S. is falling behind China’s military, they would be prepared to respond. About 77% of respondents support increased spending on the military (including 87% of Republicans and 71% of Democrats).  Fully 69% believe the U.S. needs to increase its defense industrial capacity.

(Source:  Ronald Reagan Institute, 2023)

China-Philippines:  As if to underscore China’s geopolitical aggressiveness, the Philippines yesterday said some 135 vessels from the quasi-military Chinese Maritime Militia are swarming a reef in the South China Sea that is recognized as Philippine territory under international law but is claimed by China.  The incident appears to be the biggest of its kind since the reef was deluged by some 200 Chinese vessels in 2021.  The swarming is particularly risky because the U.S. has a mutual defense treaty with Manila that could be invoked if Chinese forces attack the Philippines.

COP28 Climate Conference:  As the annual international meeting on climate change continues in Dubai, we’ve noted the following chart of global fossil fuel emissions.  The chart clearly shows how emission rates accelerated after China joined the World Trade Organization in 2001 and started its period of rapid economic expansion.  What few people are discussing is how emission growth slowed markedly in the last decade and a half, as Chinese economic growth slowed and much of the world was in a laggard recovery from the Great Financial Crisis of 2008.

• As the Chinese economy continues to slow and as developed countries continue to diversify their energy mix to include more renewable sources and nuclear energy, we wonder what would happen if emissions hit a plateau and even start to decline.
• Since many in the West are already pushing back against the “green transition,” we wonder if flattening or falling emissions could also sap some of the political support for green investment.

Israel-Hamas Conflict:  After restarting its attacks on the Gaza Strip on Friday, Israel now appears to be training its sights on the southern sections of the territory.  The renewed attacks and continued violence between Israelis and Palestinians in the West Bank mean there is still a risk that the conflict could widen.  Indeed, Iran-backed Houthi rebels in Yemen launched retaliatory missile and drone strikes over the weekend against commercial ships and a U.S. destroyer operating in the Red Sea.  At least two commercial ships were hit, while the destroyer shot down the drones sent against it.

Venezuela-Guyana:  In Venezuela’s “consultative” referendum yesterday, the government said more than 95% of the 10 million citizens who participated voted in favor of claiming sovereignty over Guyana’s oil-rich region of Essequibo.  Although it appears that authoritarian President Maduro has pushed the issue mostly to stoke nationalism and help his party in next year’s general election, the vote could potentially provide an excuse for more concrete steps to seize Guyana’s territory.  That risk could buoy oil prices to some extent in the coming months.

Japan:  As the U.S. and other developed countries deal with falling birth rates and population aging, Japan may offer lessons about how the labor market may evolve.  Now that Japan has faced those issues for decades, one new trend to deal with labor shortages is “spot workers,” who work during their free time, separate from their primary jobs and household responsibilities.  Unlike traditional gig workers or part-time workers, spot workers only work when they want to and have no on-going relationship with the employers.  They work for companies on a one-off basis, aided by apps that help them find openings, which offer streamlined on-boarding processes that allow them to get productive on an expedited basis.

U.S. Monetary Policy:  In a speech Friday before the blackout period ahead of the Fed’s next policy meeting, Chair Powell said interest rates are now “well into restrictive territory.”  He also said the policymakers would only hike rates further “if it becomes appropriate to do so.”  The statements suggest the Fed is unlikely to hike its benchmark fed funds rate further.  All the same, Powell also tried to dissuade investors from thinking the Fed would cut rates in the near term, saying it’s still too soon “to speculate on when policy might ease.”  We continue to think investors should believe the Fed policymakers when they say they intend to keep interest rates “higher for longer.”

• Nevertheless, many investors continue to have visions of rate cuts dancing in their heads. One result of that has been continuing downward pressure on the U.S. dollar.
• Earlier today, the prospect of falling U.S. interest rates and further dollar weakness boosted intraday gold prices to an all-time record of $2,135 per ounce before pulling back.
• Over the longer term, we also think gold is being buoyed by increased geopolitical tensions as the post-Cold War period of relative peace and globalization gives way to the new era of Great Power competition and U.S.-China rivalry.

U.S. Retirement Economics:  New analysis from Harvard University’s Joint Center for Housing Studies finds that nearly 70% of older people will eventually need long-term care services, but few will be able to afford it.  The study finds that more than half of older Americans live alone.  Among those living in metro areas, only 13% of adults 75+ could afford assisted living without diving into assets.  Only 14% could afford a daily visit from a home health aide along with their housing costs.

U.S. Momentum Investing:  New research suggests that momentum stock investing stopped performing well early this century in large part because of a change in the way rating firm Morningstar (MORN, $284.30) assigns “stars” to mutual funds.  Prior to 2002, Morningstar assigned its top 5-star rating to the funds posting the best recent returns versus all other stock funds.  The researchers believe that incited investors to pile into those funds, creating momentum.  Beginning in 2002, however, the firm started assigning stars based on how a fund performed against others using the same investment style.  The researchers believe that diluted the impact of performance chasing and took much of the wind out of momentum investing.

U.S. Quantum Computing:  We write a lot about artificial intelligence, autonomous vehicles, green energy, and other rapidly advancing technologies that have the potential to transform the global economy and create new opportunities for investors, but one technology we’ve neglected so far is quantum computing.  In a report today, IBM (IBM, $160.55) is expected to unveil 10 projects demonstrating how quantum calculations can be used to speed up scientific research and business decision-making.  The announcements aim to reassure investors that quantum computing still offers opportunities even if progress has come slower than anticipated.

• In a nutshell, quantum computing leverages the properties of sub-atomic particles that make it possible for them to be in many different states at the same time. This enables quantum machines to carry out large numbers of calculations simultaneously— potentially solving problems beyond the scope of traditional computers.
• One main challenge, however, is that the “qubits” on which the systems are based are unstable and only hold their quantum states for very short periods, introducing errors, or “noise,” into the calculations.  IBM is hoping to show progress in dealing with that problem.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities are trading lower as investors seek to liquidate some of their holdings ahead of Fed Chair Powell’s speech, and the Dallas Cowboys’ defense failed to live up to the hype on Thursday. Today’s Comment starts with our thoughts about changing interest rate expectations. We then examine the continued stability of oil prices and the potential challenges of providing military aid to other countries. As always, our comprehensive report encompasses the latest domestic and international data releases.

Inflation Cooling: While central bankers unanimously agree on the need for prolonged rate hikes, certain countries are better equipped to withstand the economic implications of this policy stance.

• Inflationary pressures remain pervasive across the developed world, yet price increases have moderated at a rate exceeding most analysts’ forecasts. The latest eurozone data indicates that headline inflation has climbed 2.4% since November 2022, substantially lower than the consensus forecast of 2.7%. Notably, Portugal and Italy have both reported annual price increases well below 2%. Concurrently, the Federal Reserve’s preferred inflation measure rose 3.4% from the prior year, well below consensus estimates of 3.5%. This progress has emboldened central bankers, who are now signaling their intent to maintain current interest rates while pursuing measures to address underlying price pressures.
• Despite concerns about a resurgence in inflation, several areas, including the eurozone, the U.K., and Canada, may find it untenable to maintain elevated interest rates without jeopardizing their economic growth prospects. These countries have all experienced economic contractions in the third quarter of 2023, highlighting the delicate balance between curbing inflation and fostering economic growth. In stark contrast, the U.S. economy surged at its fastest pace since 2021 from July to September. This divergence in growth prospects has fueled speculation among investors that other developed economies may be forced to loosen monetary policy ahead of the U.S.

• The chart depicted above showcases the shift in implied policy rates since August. Implied policy rates refer to market-derived forecasts of future interest rates. During this period, investors adjusted their anticipated policy rates downward for the U.K., Canada, and the eurozone for the next few years. Notably, the U.S. has bucked this trend, with investors revising their expectations for the upcoming year. This divergence in policy paths should be supportive of the U.S. dollar against its major counterparts.

Crude Prices Under Pressure:  Despite lingering supply concerns, oil prices have remained subdued, falling short of the previous year’s level.

• Oil producers’ efforts to achieve a sustainable rise in crude prices faced a setback due to supply cuts. In an attempt to bolster prices, OPEC+, which includes Russia, reached an agreement on Thursday to deepen production cuts by an additional 1 million barrels per day. While the agreement was nonbinding, it was meant to convey the oil-producing nations’ resolve to collaborate. Despite an initial surge, Brent crude prices closed the day lower, partly due to concerns that producers might not be able to implement the agreed-upon cuts fully. As a consequence, oil prices ended the day down 2%.
• The stability of oil prices has been partially attributed to weaker demand from China, which is grappling with internal economic challenges, and the looming threat of a global economic downturn. Notably, last year it was expected that oil demand would surge in 2023 as the lifting of China’s Zero-COVID policy was anticipated to increase energy consumption significantly. These expectations were dashed as the country’s low consumer confidence and industrial output have led to a sluggish economic recovery. Furthermore, the Organization for Economic Co-operation and Development (OECD) has forecast a slowdown in GDP growth for member countries to 1.4% in 2024, which will further contribute to weakened demand.

• This year, energy has been a major headwind for inflation. The base effects from last year’s energy price surge have largely dissipated, narrowing the gap between core inflation and headline inflation. The lack of drag from energy will put pressure on other components of inflation as central banks look to bring inflation back to their 2% target next year. Hence, a possible reversal of oil prices could force central banks to rethink the path of interest rates. If oil prices remain relatively stable in the coming year, policymakers may be encouraged to stand pat.

Wars Far From Over: Conflicts in Central Asia and the Middle East show no signs of waning, putting Washington in a difficult position.

• Ukrainian President Volodymyr Zelenskyy has pivoted strategically amidst the evolving conflict with Russia. Acknowledging the constraints of recent counteroffensives, Zelenskyy has redirected attention toward expediting the construction of robust military fortifications along the eastern front line. This shift in focus emphasizes a defensive stance aimed at fortifying Ukraine’s defenses against a potential resurgence of Russian aggression during the winter months. Additionally, there are concerns about Moscow’s preparations, including the accumulation of missiles, which could potentially target Ukraine’s power grids. The actions taken by both Ukraine and Russia signal a readiness to persist in the conflict, indicating that neither side is inclined to cease hostilities.
• At the same time, Israel has stated that it is preparing for a prolonged conflict with Hamas. The remarks come after a seven-day cease-fire ended and the two sides resumed fighting early Friday morning. Although the timing may vary, Israel is expected to maintain its ground offensive until at least early 2024. The objective of the attack will be to kill three of the top Hamas leaders—Yahya Sinwar, Mohammed Deif, and Marwan Issa—and dismantle the group’s capacity to govern effectively in Gaza. Israeli officials caution that the resolution of the conflict won’t be sudden, emphasizing their commitment to prevent the group from regaining influence.

• Facing mounting fiscal pressures, U.S. lawmakers will likely face heightened scrutiny when justifying foreign military aid, particularly for prolonged conflicts. While Americans generally support limited assistance to other nations, their tolerance may dwindle, especially when faced with persistent domestic challenges. These concerns likely explain the recent instances where lawmakers have conditioned military aid for Israel and Ukraine on the inclusion of funding for border security. Hence, we may be moving toward a world in which countries will be forced to be less reliant on the U.S. for protection. This scenario should lead to greater trade and supply chain uncertainty, which should favor commodity prices in the longer term.

Other News: Oil prices are also being impacted by the use of bot traders. This highlights technology’s growing influence on markets and raises questions about potential risks. In a separate event, Florida Governor Ron DeSantis’ one-on-one debate with California Governor Gavin Newsom fell short of expectations. While DeSantis hoped the debate would reinvigorate his campaign, he failed to clearly differentiate himself from Republican frontrunner Donald Trump.

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