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, in which Russia has announced a mobilization of its reserves and has made new threats to use nuclear weapons.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an overview of today’s interest-rate decision by the Federal Reserve.

Russia-Ukraine:  As Ukrainian forces continue to press their counteroffensives in their northeastern region around Kharkiv and in their southern region around Kherson, ethnic-Russian separatists in occupied areas yesterday announced they will hold referendums on annexing themselves to Russia.  The sham referendums are likely aimed at strengthening President Putin’s narrative that the war is all about “liberating” Ukraine and bringing the ethnic Russians there under Moscow’s protection.  After such a sop to Russian nationalism, Putin may hope to encourage more Russian men to volunteer for the war.  Indeed, in a speech defining the war as an existential struggle for Russia’s survival against what he described as a hostile West, Putin today announced a “partial mobilization” of Russia’s reserve forces.  Defense Minister Shoigu later said that the mobilization would eventually provide about 300,000 fresh troops for the armed forces, although he emphasized that the measure would not involve mass conscription.  Finally, in a further reflection of Russia’s continued manpower shortcomings, the Duma yesterday rushed into place a new law that dramatically increases penalties for desertion, refusing conscription orders, and insubordination. It also criminalizes voluntary surrender and makes surrender a crime punishable by ten years in prison.

• Russia’s mobilization of reserves is unlikely to have much impact on the war in the near term, since the country’s wartime losses to date have depleted many of the officers, weapons, and supplies needed to train and equip any new troops. The mobilization, coupled with a new Russian threat to use nuclear weapons, is probably mostly geared toward intimidating the West and showing Chinese President Xi, Putin’s key patron, that Russia can turn the war around.  Another reassuring sign is Shoigu’s assurance that there would be no mass conscription, which suggests the government still fears the political consequences of a true mass mobilization.
• As a reminder, government readouts from their summit last week suggest that Xi raised tough questions for Putin regarding the war. However, it’s unclear whether the message was that the Russians need to stop fighting with one hand tied behind their backs, or that they need to start winding down the war.
  • Putin’s mobilization and the new nuclear threat today could signal that the message was the former. In that case, Russia could now throw its full weight into the war and create much more risk for global geopolitics and the global economy.
  • However, since the Chinese readout didn’t mention Ukraine, and since Indian Prime Minister Modi explicitly questioned the wisdom of the war, it may be that Putin’s most important patrons and enablers are telling him to look for a way out. In that case, Putin’s latest move could merely be a last gasp before starting to search for an eventual wind-down of the war, perhaps by simply settling for a Russian annexation of Ukraine’s Luhansk, Donetsk, and other occupied regions.

European Union-China:  The European Union Chamber of Commerce in China issued a report saying EU companies are being forced to “reduce, localize, and silo” operations in China because of President Xi’s regulatory crackdowns on previously booming industries and his draconian Zero-COVID policies.

• The bleak report also warns that because of those and other problems, China is losing its attractiveness as an investment destination.
• The report is consistent with our view that the world is fracturing and regionalizing, with countries breaking up into relatively separate geopolitical and economic blocs. The result is likely to be less efficient production, higher costs, higher inflation, and lower profits.

European Union-United States:  In another example of how many key countries allied to the U.S. are coalescing into a U.S.-led bloc, companies in Europe that make steel, fertilizer, and other feedstocks of economic activity are shifting operations to the U.S., attracted by more stable energy prices and muscular government support.  The trend is likely positive for U.S. investment and employment going forward.

Germany:  The federal government announced it will nationalize the country’s largest electric utility Uniper (UNPRF, 4.27), after it was pushed to the brink of insolvency by Russia’s cutoff of energy supplies and soaring prices for natural gas.  The move is a fine example of how war and crises can lead to long-lasting increases in government power over the economy.

• The German government, which had already planned to take a 30% stake, will now completely buy out Uniper’s previous owner for €480 million.
• Berlin will also take on a €7.5 billion credit line from the previous owner.
• Finally, the government will recapitalize the struggling utility with €8 billion. That move comes on top of a €13 billion government credit line that the government already provided to Uniper earlier this year.

United Kingdom:  To help its businesses weather surging energy prices touched off by the war in Ukraine, yesterday the government said it will cut the wholesale price of energy for businesses and public organizations by more than half this winter.

• The move to subsidize business and government energy costs is the second half of Prime Minister Truss’s plan to get the U.K. through its expected energy crisis this winter.
• While helping to shield households and businesses from skyrocketing energy prices, the plan does little to produce new energy supplies. It is also expected to boost financial strains on the government into the future.  Rising interest rates are already boosting government interest payments and creating investor worries about the U.K.’s debt levels.

South Korea:  Even though the country’s currency is depreciating rapidly and is now at its lowest level against the dollar since 2009, the Bank of Korea has denied government suggestions that it will announce a currency swap arrangement with the Fed this week.  At 1,394.90 per dollar, the won is currently down 15.1% against the dollar so far this year, worse than any other major Asian currency except the Japanese yen.

Haiti:  In yet another sign of how high global prices for food, energy, and other commodities are feeding political unrest in developing countries, a government plan to cut fuel subsidies has sparked large protests throughout Haiti.  Demonstrators across the country are calling on Prime Minister Ariel Henry to resign, saying he failed to address a spiraling economic and security crisis that has destabilized the Western Hemisphere’s poorest country.

U.S. Monetary Policy:  Today, Fed officials will wrap up their latest two-day policy meeting, with their interest-rate decision and updated economic projections due out at 2:00 pm ET.  Investors are broadly expecting that the officials will again hike their benchmark fed funds interest rate by an aggressive 75 bps.  We’ll also be watching with keen interest to see what their new economic and interest-rate forecasts say about the path of monetary policy going forward.

• As we mentioned yesterday, there has been some whispering among observers that the rate hike could be a full percentage point as the officials try to re-establish their inflation-fighting credibility amid continuing fast price hikes.
• Investors in late summer seemed too complacent about the Fed’s rate-hiking program. While many investors thought the policymakers would quickly pivot to steady or falling rates, we think there is a high chance they will keep hiking and spark a recession.  Indeed, market indicators suggest investors are currently coming around to that view, not just for the Fed, but also for other major central banks.  The prospect for unexpectedly high interest rates will likely continue to challenge stocks, bonds, commodities, and foreign currencies in the near term.

Hurricane Fiona:  After battering Puerto Rico earlier this week, Hurricane Fiona has now strengthened to a Category 4 storm and is moving north-northwest through the Caribbean Sea.  The hurricane is expected to slam into Bermuda later this week.

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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 a near miss yesterday when a Russian missile almost struck a Ukrainian nuclear power plant.  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 the Federal Reserve’s latest policymaking meeting which begins today.

Russia-Ukraine:  Ukrainian forces continue to consolidate and extend their gains in the northeastern region around Kharkiv and the southern area of operations near Kherson.  Although the gains have slowed since last week, Russian nationalist bloggers and influencers seem to be panicking to the point where they are urging the government to annex the ethnic-Russian provinces of Luhansk and Donetsk, despite the fact that Russian forces only control a portion of those two regions.

• Highlighting the risk that Ukraine’s nuclear power plants could be damaged in the fighting, a Russian missile yesterday struck just 300 meters from the Pivdennoukrainsk nuclear power plant in the Mykolayiv region. The explosion caused no damage to the reactors, but it could well have caused a disaster if it had scored a direct hit.
• Despite the recent Turkey-Russia-Ukraine deal easing exports of Ukrainian agricultural commodities, world food supplies remain tight. In fact, executives at major agriculture companies now say at least two more years of good harvests in North and South America are needed to ease the pressure.  Because of a wet spring followed by drought and intense heat in the Great Plains and Midwest, it now appears that the U.S. grain crop this year will be below last year’s, putting further upward pressure on prices.

European Union:  In what could be a major political development for Europe, EU affairs ministers from across the bloc are meeting today in Brussels to discuss ways to scrap or limit the unanimity rule for foreign affairs.  Under that rule, any one EU country has a veto over the bloc’s foreign affairs initiatives, such as Hungary’s recent veto of tighter sanctions on Russia.

• Officials from major countries such as Germany and France believe the move can be accomplished via current treaty provisions, which allow shifting from unanimity to “qualified voting” in certain circumstances.
• If that isn’t possible, the move would likely require a change in EU treaties, which would be highly unlikely in the near term.

 Sweden:  The Riksbank today hiked its benchmark short-term interest rate by a whopping 1.0%, marking its biggest rate rise in three decades and lifting the rate to 1.75%.  As with other major central banks, the Riksbank is belatedly fighting to get control over a surge in consumer prices.  Sweden’s August consumer price index was up 9.8% year-over-year.

Iran:  Anti-government riots have broken out across the country in response to the death of a young woman in police custody who had been arrested for not wearing a headscarf as prescribed by the country’s “morality police.”  The government is cracking down hard on the protests, but the situation reveals increased unhappiness with Iran’s religious leaders and potential political instability in one of the world’s key oil producers.

China-Ecuador:  Yesterday, the government of Ecuador said it had secured a deal in which China Development Bank and the Export-Import Bank of China (Eximbank) will provide debt relief worth $1.4 billion and $1.8 billion, respectively. Consistent with China’s reluctance to write down any principal on its problem loans, the deals will extend the loans’ maturity, reduce interest rates, and slow amortization.

• The deal will allow Ecuador to keep up public spending in order to diffuse recent public protests over rising food and fuel prices.
• The deal also demonstrates how Ecuador has become a Chinese toehold in South America. Not only has it provided major financial assistance to Ecuador, which alone would boost its influence, but it is also negotiating a free-trade deal with the country that could be finalized as early as December.

Brazil:  Ahead of the first round of presidential elections on October 2, supporters of conservative President Bolsonaro have murdered at least two prominent supporters of leftist Former President Lula da Silva, the frontrunner.  The Lula campaign has also been hit with bombings and other political violence.  The incidents raise concerns about broader clashes as the election nears, or if President Bolsonaro refuses to accept the results of the election.  Naturally, such destabilization would be negative for Brazilian equities.

Mexico:  An earthquake registering at least 7.6 on the Richter scale hit the southwestern state of Michoacán yesterday, killing at least one person and damaging several buildings.  So far, the quake doesn’t appear to have caused any significant damage to the country’s economy or financial markets.

United States-United Kingdom:  In an interview on her way to the United Nations General Assembly, British Prime Minister Truss admitted that a U.S.-U.K. free trade deal is not in the cards anytime soon.  The admission belies Brexit supporters’ insistence that a major benefit of the U.K. leaving the EU would the opportunity to strike a major deal with the U.S.  Without such a deal, Brexit will leave the U.K. with a much more difficult trade relationship with the EU, adding to the U.K.’s economic problems and probably weighing on its financial markets.

U.S. Monetary Policy:  Today, Fed officials begin their latest two-day policy meeting, with their interest-rate decision and updated economic projections due out on Wednesday afternoon.  Investors are broadly expecting that the officials will again hike their benchmark fed funds interest rate by an aggressive 75 bps.

• However, there has been some whispering among observers that the rate hike could be a full percentage point as the officials try to re-establish their inflation-fighting credibility amid continuing fast price hikes.
• As we have been warning, investors in late summer seemed too complacent about the Fed’s rate-hiking program. While many investors thought the policymakers would quickly pivot to steady or falling rates, we think there is a high chance they will keep hiking and spark a recession.  Indeed, market indicators suggest investors are currently coming around to that view, not just for the Fed, but also for other major central banks (see chart below).  The prospect for unexpectedly high interest rates will likely continue to challenge stocks, bonds, commodities, and foreign currencies in the near term.

U.S. Labor Market:  Even though a major railroad strike was narrowly averted last week, workers emboldened by the tight labor market continue to make tough wage and benefit demands across industries.  It now appears that contract talks for 22,000 port workers on the West Coast have started to stall, raising the risk of a strike that would further impede international trade and snarl global supply chains.  Some isolated work stoppages have already occurred.

• The increase in labor action is likely boosting wage, salary, and benefit costs in a number of industries.

Those cost increases will probably exacerbate inflation, encourage the Fed to hike interest rates further, and weigh on corporate profits.  Any way you cut it, the increased labor activism is a threat to stock values going forward.

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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 the Ukrainians continue to make progress in their key counteroffensives.  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 this week’s Federal Reserve policy meeting and how it’s affecting the financial markets so far this morning.

Russia-Ukraine:  Ukrainian forces continue to press their counteroffensives both in the country’s northeast near the city of Kharkiv and in the south around the Russian-occupied city of Kherson.  The northeastern attacks have slowed somewhat as the Ukrainians focus on consolidating last week’s gains, although the Ukrainian military says it now controls the key eastern bank of the Oskil River.  The bulk of the Ukrainian effort now appears to be on the Kherson axis.  Meanwhile, Russian forces continue to cede ground and are struggling to establish new defensive lines, at least in part because they are mostly left with poorly trained, poorly motivated volunteers, and other irregular troops.  The Russians are progressively turning to rocket and missile attacks on Ukraine’s civilian energy and other infrastructure in an effort to break the Ukrainians’ will to fight.

• On the economic front, Russia’s effort to undermine the West’s will to support Ukraine by shutting off energy supplies is increasingly looking like it’s blowing back on Russia itself. The strategy will undoubtedly cause economic pain in Western Europe this winter but falling global prices and reduced exports have sharply curtailed the Russian government’s revenues.  As Western European countries quickly build infrastructure to import energy from the U.S. and elsewhere, Russia’s strategy will have even less impact on Western Europe while leading to ever-increasing budget deficits at home.
• Meanwhile, we continue to assess Russian President Putin’s meetings with Chinese President Xi and Indian Prime Minister Modi last week. The press read-outs from those meetings suggest China and India have stepped back from their support for Russia, whether it be tacit or otherwise.  A key question is whether Putin will respond by doubling down on his Ukrainian attacks in an effort to win the war quickly, or whether he will start looking for an excuse to start winding down the effort.
• Of course, another key consideration for Putin is that Russia’s recent failures in the war have prompted increased criticism of his government, and, by implication, himself.

Global Diplomacy:  Queen Elizabeth II’s funeral was held today in Westminster Abbey, with leaders from dozens of major countries in attendance.  With all those leaders rubbing shoulders, it would be no surprise if we see lots of market-impacting diplomatic news from the gathering.  Remarkably, many of those leaders will then head off to New York for this week’s opening of the United Nations General Assembly, so there will actually be several days of major diplomacy to wade through.

• One event we’re especially keen on is British Prime Minister Truss’s speech at the UN, in which she is expected to link domestic economic conditions to geopolitics and argue that the liberal democracies must reduce their dependence on commodities and other goods from authoritarian countries.
• That argument would dovetail with our belief that globalization is being replaced with regionalization, in which the world’s countries are fracturing into relatively separate geopolitical and economic blocs. As we’ve written before, this regionalization will probably lead to shorter supply chains, less efficient production, higher prices, and higher inflation going forward.

European Union:  Today, the European Commission proposed new legislation that would give it the power to force member states to stockpile key products and break contracts during a crisis such as the war in Ukraine or the coronavirus pandemic.

• The proposed law would give the Commission ample space to declare an emergency. It would then be able trigger a number of interventionist measures to ensure the availability of goods, for example, by facilitating the expansion or repurposing of production lines.
• The proposal is an example of how geopolitical frictions, war, and other crises often strengthen the state over the private sector.

European Union-Hungary:  The European Commission yesterday proposed freezing about €7.5 billion of EU “cohesion funds” earmarked for Hungary over corruption concerns, although it also opened the door for a compromise under which Hungary could get the cash if it addresses its corruption issues.  The move is the latest in the EU’s long-running battle with Hungary, which has chafed at many EU regulations and policies, including the EU’s support for Ukraine in its war with Russia.

Taiwan:  An earthquake measuring 6.8 on the Richter scale struck southeastern Taiwan and reverberated across the island yesterday, causing building damage, derailing a train, and triggering concerns of a tsunami.  As of this writing, however, there have been no reports of damage at the country’s globally-critical semiconductor production facilities.

United States-Taiwan-China:  In an interview yesterday, President Biden again said the U.S. would defend Taiwan “if in fact there was an unprecedented attack” on the island by China.  That marks at least the third time Biden has made the commitment, which suggests he has decided to deliberately shift the U.S. away from its previous “strategic ambiguity” policy toward the island.

• Under that policy, the U.S. left its commitment to the island unclear, both to discourage any Taiwanese independence moves and to deter China from getting too aggressive with the island.
• The administration’s decision to explicitly commit to a defense of Taiwan likely reflects concerns about China’s growing military strength and aggressiveness. The new U.S. commitment hasn’t been expressed formally, but it does suggest a tougher approach that will likely help keep U.S.-China tensions high and create more headwinds for Chinese stocks.

U.S. Monetary Policy:  Tomorrow, Fed officials begin their latest two-day policy meeting, with their decision due out on Wednesday afternoon.  Investors are broadly expecting that the officials will again hike their benchmark fed funds interest rate by an aggressive 75 bps.

• However, there has been some whispering among observers that the rate hike could be a full percentage point as the officials try to re-establish their inflation-fighting credibility amid continuing fast price hikes.
• As we have been warning, investors in late summer seemed too complacent about the Fed’s rate-hiking program. While many investors thought the policymakers would quickly pivot to steady or falling rates, we think there is a high chance they will over-shoot and spark a recession.  As more investors buy into our view, we are noting meaningful drops in the values of stocks, bonds, commodities, and foreign currencies so far today.

U.S. Petroleum Industry:  New reports indicate smaller private oil companies that helped boost the country’s oil output over the last couple of years have now begun to deplete their fracking opportunities and are starting to pull back from the market.  With publicly-traded companies still held under a tight leash by investors demanding capital discipline, that raises the prospect of further tightness in supply that could again give a boost to prices, and inflation, going forward.

• Separately, the continued rise in natural gas prices prompted by the war in Ukraine and supply shortages is pushing up electricity prices in the U.S.
• The rise in gas and electricity prices threatens to impose big costs on households as autumn turns to winter and heating demand rises.

Hurricane Fiona:  Over the weekend, Hurricane Fiona slammed into Puerto Rico, knocking out electricity for the entire island at times.  The island’s power company warned that fully restoring electricity service could take several days.

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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 update on the conflict in Ukraine, which includes a discussion about China and Russia’s relationship. Next, we review the dollar’s impact on the global economy. We conclude the report with an overview of U.S. efforts to adapt to a changing geopolitical landscape.

Ukraine Updates: The war shows no signs of ending soon, but Ukraine’s odds of retaking lost territory have drastically increased.

• The UN’s nuclear watchdog urged Moscow to remove its forces from the Zaporizhzhia Power Plant to avoid a potential catastrophe. Russian troops took over the area early in the war and used the region to launch attacks against Ukrainian forces. The call from the regulators for Russia to depart the site reflects the clear and present danger the conflict is having on the region. The plant’s strategic importance suggests that it is unlikely that the Russians will leave the area. Thus, the possibility of a nuclear disaster is elevated.
• Russian President Vladimir Putin admitted that China has concerns about the ongoing war in Ukraine. The rare acknowledgment of the two countries’ differences likely signals that Russia does not feel as if it has Beijing’s full support. If correct, this could potentially force Putin to take more decisive action in Ukraine to prevent further losses in the conflict. History shows that Russian leadership does not survive after the country loses a war. Therefore, we expect Putin to take more extreme action to change the tide of the conflict.
• Ukraine’s recent success in its war efforts has encouraged the West to provide the country with more military support. President Biden announced that the U.S. would provide Ukraine with $600 million in additional weaponry, while Germany said it would send two more rocket launchers and 50 armored vehicles. The increase in Western military aid shows that the war is far from over. As a result, Europe will likely not be able to avoid an energy-supply crunch in the winter.
  • In a related story, Germany seized refineries owned by Russian oil giant Rosneft as Berlin looks to take over its energy sector. The move is designed to prevent disruptions in German energy supply as the country weans itself from Russian gas. In addition to taking over Rosneft, the country plans to take over Uniper (UNPRF, $4.03) and two other gas importers.

Dollar takes off: The greenback’s rise against global currencies will prevent central banks from providing policy stimulus even as economies slow.

• The yuan surpassed 7 per dollar for the first time since 2020. This sharp decline in the yuan was driven by the deceleration in GDP growth and the rise of the U.S. dollar against global currencies. Although the depreciation of the yuan has typically led to a surge in capital flight to safer currencies, new regulation prevents this from happening. The decline in the yuan could prevent the People’s Bank of China from easing monetary policy while also pushing up the cost of imports. As a result, the depreciation of the yuan will likely add to a long list of economic woes in China, which already include COVID lockdowns, consumer pessimism, and slowing exports.
• Today, concerns over the U.K. economy have pushed the pound to its lowest level since 1985. The British currency fell to $1.137 after weak retail sales signaled a slowdown in consumer spending. In addition to the sales numbers, investor expectations of a jumbo rate hike from the Fed also weighed on the sterling. The currency’s depreciation will force the Bank of England to continue tightening, possibly even if the economy contracts. Hence, the currency’s weakness could trigger a long and deep recession.
• The U.S. Dollar Index, which tracks the greenback’s strength relative to global currencies, is up 14.5% year-to-date. For comparison, Energy is the only stock market sector with better performance. As a result, the dollar’s rise has pushed up import prices, making global inflation worse. This trend will likely continue as long as the Federal Reserve continues its currency policy path.

Geopolitical Shifts: The U.S. is adjusting to changes in the geopolitical landscape.

• S. policymakers cannot agree on whether they want to send military aid to Taiwan. The new legislation, the Taiwan Policy Act, is criticized for being too provocative toward China. The bill would grant the sovereign island $4.5 billion in aid over four years and includes extensive language on sanctions toward Beijing if it were to become more hostile toward the region. As we have mentioned in previous reports, there are many political benefits to getting tough with Beijing. A recent poll showed that 82% of Americans hold an unfavorable opinion toward China. This bravado could backfire at some point if China retaliates, but it is unlikely that Beijing will take aggressive actions before its National Party Congress on October 16. However, this will likely not be the case once the summit is over. Further provocation from the U.S. might lead to a direct conflict with China.
  • China has imposed sanctions on U.S. defense companies for selling arms to Taiwan. The measure is another example of Beijing’s sensitivity to the One China Policy in Taiwan.
• S. Secretary Tony Blinken has assumed a crucial role in ending military clashes between Armenia and Azerbaijan. The two sides began fighting on Tuesday over disputed territory. A previous cease-fire brokered by Moscow earlier this year failed as Russia was distracted by its invasion of Ukraine. The U.S. involvement in ending the conflict is a possible sign that Washington would like to fill the void left by Russia.
  • House Speaker Nancy Pelosi will visit Armenia during her trip to Europe for the G-7 Summit, another example of the increased U.S. interest in the region.

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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 implications of a more aggressive Federal Reserve. Next, we discuss the latest developments in the EU and U.S. fight against inflation, which includes an update on rail worker negotiations. The report concludes with a discussion on how sanctions are affecting Russia’s relationships with its allies.

Go Big or Go Home: Higher than expected inflation numbers have added to speculation that the Federal Reserve could be more aggressive in its tightening cycle. However, this does not mean it won’t cut rates.

• The market expects the Federal Reserve to go big at its next meeting. The CME FedWatch Tool shows that the Federal Reserve will raise rates by at least 75 bps in September and potentially push its benchmark policy rate up 100 bps. This change in the policy-rate forecast was related to disappointing CPI and PPI reports. In August core CPI accelerated unexpectedly, while core PPI failed to drop as much as the market anticipated. Higher fed funds expectations could lead to a choppy market over the next few days as the FOMC meeting approaches.
• The Fed’s next rate hike will be historic even if it raises the policy rate by only 25 bps. This next rate decision should lift the policy rate above the previous cycle’s peak for the first time since 1981. The milestone possibly reflects the central bank’s confidence in financial market conditions. The previous two economic downturns exposed the weaknesses in the financial system and forced the Fed to develop policy tools designed to prevent a crisis. Therefore, we may be heading into a new finance regime in which the Federal Reserve raises interest rates, but also maintains those rates for much longer. If we are correct, the tech sector’s dominance in the S&P 500 is likely over. However, the financial services industry could be on the ascent.

• The Fed’s new policy tools will be tested as the central bank ramps its balance sheet reduction and rate hikes over the next few months. Quantitative tightening is expected to cause financial strain as traders struggle to get deals done. The Bloomberg U.S. Government Securities Liquidity Index, a gauge of deviations in yield compared to a fair value model, dropped to its lowest level since March 2020. The deterioration in the index suggests that traders find it more challenging to exchange treasuries for cash and vice versa. If the problem worsens, the Fed will be forced to intervene. Although the financial system is withstanding monetary tightening now, we are still not sure that a financial mishap will not take place in the future. In the event of a blowup in the financial system, we expect the Fed to become more accommodative in its rate policy. As a result, we believe that the Fed could pause or cut rates by mid-2023 if financial conditions deteriorate significantly.

The West Needs a Break: The European Union and the U.S. are exploring ways to prevent further inflation within their respective regions.

• Vice President of the European Central Bank Luis de Guindos wants to anchor inflation expectations. In a speech to EU ministers, Guindos urged the central bank to prioritize price stability over growth. His comments are another example that the central bank could look to slow GDP growth in Europe to tame inflation. Higher European interest rates increase the likelihood that the region will fall into recession, leading to further fragmentation throughout the bloc. That said, a decline in gas prices could provide a tailwind for Europe, but we are not optimistic about that happening anytime soon.
• As energy woes continue in Europe, EU countries rolled out plans designed to protect households from big jumps in their utility bills. France plans to cap energy price increases at 15% for next year. Meanwhile, Germany is considering purchasing a controlling stake in gas import company Uniper (UNPRF, $4.08) to ensure the company does not fall into bankruptcy. These extreme actions by countries demonstrate the growing angst over energy security.
  • Italy might not be as vulnerable as initially thought. Energy company CEO Claudio Descalzi claimed that Italy could make it through the winter without Russia’s gas, assuming the temperatures are mild. Last year, the country imported nearly 40% of its gas from Russia.
  • On the other hand, Germany may not be so lucky. The country’s head energy regulator warned that Germany would run into gas shortages if the winter is gruesome.
• The U.S. rail workers reached a tentative agreement with rail companies to avert a strike on Wednesday. At the last minute, White House officials intervened on a deal that secured better pay and improved working conditions for workers. A shutdown would have prevented almost 30% of cargo shipments by weight from shipping in the U.S., potentially adding to already elevated inflationary pressure. The agreement ended a two-year negotiation and will be welcomed by markets.

Ukraine War and Russian Sanctions Update: As Ukrainian troops continue to progress in their counteroffensive, the West looks for new ways to punish Russia for the invasion.

• The West wants Turkey to stop helping Russia avoid sanctions. Although a NATO ally, Turkey has tried to remain neutral in the Ukraine conflict. It has supplied Ukraine with sophisticated military drones to help in its war efforts while deepening its trade ties with Russia. Turkey has received limited pushback from the U.S. and Europe up to this point. However, this may change soon. The West is considering slapping sanctions on Turkish banks that are integrated into Russia’s domestic payment system, known as MIR. The crackdown from the West suggests that it will become less conciliatory toward neutral countries that aid Russia in averting sanctions.
• Chinese President Xi and Russian President Putin met in Uzbekistan on Thursday at the Shanghai Cooperation Organization Summit. The two countries will discuss the ongoing war in Ukraine, with Russia hoping for additional support from China. Despite the two’s agreement that their relationship has no limits, Beijing has implicitly shown that it is unwilling to run afoul of U.S. sanctions. China’s position is unlikely to change as Russia’s inability to secure a quick invasion, as it initially promised, has made it look weak in the eyes of many within the Chinese leadership. Moreover, China’s lack of military support will likely make Russia’s losses from the war even greater.
  • Although there is some speculation that U.S. actions in Taiwan could lead China to ramp up its support for Russia, we are not so sure. In our view, Russia’s vulnerabilities may have encouraged the U.S. to take a greater interest in Taiwan as the sovereign island has much more geopolitical significance than Ukraine. Thus, there are likely factions within the Chinese Communist Party that are less inclined to support the additional backing to Russia.

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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 an update on how Russia is responding to Ukraine’s recent battlefield gains.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, along with some additional commentary on yesterday’s disappointing inflation data and the resulting big drop in stock prices.

Russia-Ukraine:  As Ukrainian forces continue to consolidate their hold on recently retaken territories in the northern Kharkiv region and around Kherson in the south, the Russian government finally acknowledged its defeat in those areas.  The acknowledgement has focused on failures by the Ministry of Defense and the uniformed military leadership, likely to deflect the blame from President Putin himself.  With the Kremlin’s propaganda machine in disarray, some politicians are calling for a formal declaration of war, a full mobilization, or even a partial mobilization, although we continue to believe a full mobilization would be hard to pull off and remains Putin’s last resort, given how politically risky it would be.  Finally, in new evidence of how Ukraine’s recent successes have impacted Russian resolve and morale, reports indicate that some Russian officials in occupied Crimea are sending their families back to Russia in case the Ukrainians are able to retake the peninsula.

• The Ukrainian success in recapturing northern transportation hubs like Izyum will likely prevent Russia from achieving its goal of seizing the entirety of Ukraine’s eastern Donbas region.  Meanwhile, Ukrainian forces continue to push eastward into the Donbas, even as they slow their advance to consolidate their control over the recently retaken territories.  In a telephone call yesterday, German Chancellor Scholz told President Putin his position in Ukraine was hopeless and urged him to withdraw his forces completely.
• Following on the summer’s Russia-Ukraine-Turkey deal to allow safe passage of Ukrainian grain shipments through the Black Sea, the UN is pressing for a similar deal that would allow the export of key fertilizer chemicals from Ukraine’s coast.  The deal would help erase the current global shortage of fertilizer, which has further weighed on food supplies and boosted agriculture commodity prices.
• We’ve mentioned before how Russia’s invasion has scared Western democracies into what is likely to be a multi-year effort to rebuild their defense capabilities and boost their defense spending.  One example is offered by the U.S.-supplied High-Mobility Artillery Rocket System (HIMARS) that Ukraine has used to such great effect in its recent counteroffensives.  Now that the system has proven so effective in real-life combat, the U.S. Army has asked defense contractors how they could produce up to 500 additional HIMARS over the next five years – an amount that would essentially double the number of existing HIMARS.  Other countries seeking to boost their HIMARS arsenals include Romania, Singapore, and Taiwan.

Global Oil Market:  In its monthly crude oil report, the International Energy Agency cut its forecast of global oil demand this year to 99.7 million barrels per day (bpd), largely because of slowing economic growth in the developed countries and continued COVID-19 lockdowns in China.

• The IEA’s reduced demand forecasts are consistent with the fall in energy prices since early summer.  If continued high inflation prompts the major central banks to keep hiking interest rates and China keeps imposing pandemic lockdowns, oil demand could skid further and put even more downward pressure on prices.
• The IEA now sees global oil demand only surpassing its pre-pandemic high next year when it is expected to total 101.8 million bpd.

European Union Energy Crisis:  European Commission President von der Leyen detailed her proposal for a windfall profit tax on electricity producers that don’t rely on natural gas.  With the Russian gas shutoff boosting prices for that fuel, the non-gas producers have been boosting prices in tandem and raking in profits.  Von der Leyen’s proposal would raise €140 billion from an EU-wide levy on those companies and use the funds to soften the blow of record high prices this winter on consumers and businesses.  EU member states will meet to discuss the proposal on September 30.

Armenia-Azerbaijan:  Yesterday, both Armenia and Azerbaijan claimed that the other side had fired on their border communities, sparking a crisis that could potentially reignite their 2020 war.  Moscow has already brokered a ceasefire, but the violence illustrates how Russia’s military failures and political isolation in the Ukraine war have weakened its sway over the countries in its region.

U.S. Inflation and Monetary Policy:  Following up on our initial take on the August consumer price index in our Comment yesterday, we think what was most disconcerting to the market was the unexpected acceleration in the “core” CPI, which excludes the often-volatile food and energy components of the overall CPI.  The August core CPI was up 0.6% from the previous month, which was double its rate of increase in July.  Much of that acceleration reflected faster cost increases for housing, but that wasn’t the whole story.  The acceleration in core inflation reflected faster price hikes in a wide range of non-energy and non-food products.

• The acceleration in prices for non-energy and non-food products suggests inflation pressures continue to broaden despite the Federal Reserve’s long string of aggressive rate hikes.  To date, the Fed’s rate hikes haven’t seemed to do much to tighten financial conditions and bring down inflation pressures.
• The continued broadening in inflation pressures undoubtedly will encourage the Fed to keep raising rates aggressively.  As we mentioned in our Comment yesterday, the August data probably guarantee at least a 75 bps hike in the benchmark fed funds interest rate at the Fed’s policy meeting next week.
• In addition, we note that the Fed’s accelerated quantitative tightening also seems to be putting strain on the market for U.S. Treasury securities.  Bid-ask spreads in that market have widened considerably, and price swings have expanded to levels unseen since the beginning of the pandemic in early 2020.  The market action is a reminder that the Fed’s tightened monetary policy could spark a crisis in some sector of the financial markets at some point.
• The prospect of continued aggressive rate hikes, tighter monetary policy, and a potentially deep recession goes far toward explaining the sharp drop in stock prices yesterday, in which the S&P 500 price index dropped 4.2%.  Meanwhile, gold prices fell 1.6% and crude oil prices fell 0.4%.  The yield on the 10-year Treasury note jumped to 3.422%, almost matching its cycle high in mid-June.
  • In turn, that gave an additional boost to the U.S. dollar, while driving down other major foreign currencies.
  • The Japanese yen fell approximately 2% to 144.95 per dollar, prompting the Bank of Japan to check in with traders on market conditions (a move that has often presaged a market intervention in the past).
• As investors price in further big interest-rate hikes, it would not be surprising to see these trends continue in the coming days.

U.S. Railroad Strike:  As the major railroads and their unions remain at an impasse in their contract negotiations, the risk of an economically damaging strike on Friday continues to increase.  The threat has prompted a number of major businesses to appeal to Congress to take action to prevent a shutdown.  The White House has also launched an effort to coordinate alternate transportation providers such as trucking firms and ship companies.

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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, and a discussion on the latest Ukrainian successes not only in northern Ukraine but also in the south.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including concerns about the possibility of major new strikes in the U.S. as early as Friday.

Russia-Ukraine:  Although media reports have focused on the Ukrainians’ routing Russian forces in the northern region around Kharkiv over the last week, the latest details suggest their counteroffensive to retake the southern city of Kherson is also progressing well.  Some observers have referred to the Ukrainians’ southern attack as merely a feint to draw Russian forces away from the north, but that’s probably overstating the situation.  More likely, the Ukrainians’ southern attack created an opportunity in the north that they then exploited.  As evidence of the new successes in the south, the latest reports indicate Russian forces have abandoned some of their positions to the northwest of Kherson.  We have also seen unconfirmed reports that Russian units in the area are negotiating a surrender to the Ukrainians.  Nevertheless, U.S. military officials warn that the war is far from over, and that the Ukrainians still have a tough fight in front of them.

• In a document shared with U.S. lawmakers and reviewed by the Wall Street Journal, Ukrainian officials are preparing to request a large number of new, advanced, “offensive” weapons to use as they seek to push the Russians out of their territory.  The requested weapons include the Army Tactical Missile System, or ATACMS, which has a range of about 190 miles. The wish list also includes modern tanks, drones, and artillery systems; more Harpoon anti-ship missiles; and 2,000 missiles for the High Mobility Artillery Rocket System, or HIMARS, which the U.S. began providing earlier this year.
  • Other reporting that we’ve seen suggests the Biden administration is getting more comfortable with the idea of sending more advanced weapons to the Ukrainians.
  • Along with other reports showing that the Western European nations are increasingly turning to U.S. defense firms to rebuild their military forces in response to the war, we continue to believe that the U.S. defense companies are in for a long period of strong orders.
• On the energy front, new Russian budget figures suggest falling global energy prices and Russia’s own cutoff of energy supplies to Western Europe are blowing back on Moscow.  While Russia recorded a budget surplus of almost 500 billion rubles in the first seven months of the year, the cumulative total fell to only 137 billion rubles last month, suggesting a big deficit in August which economists attributed to sharp declines in oil and gas revenues.  The deteriorating budget situation may add to the economic and political pressures on Russia, although it would probably take a while for them to reach a critical level.

Global Semiconductor Industry:  In another sign of deglobalization, shortening supply chains, and countries trying to ensure they can produce critical goods domestically, Indian industrial group Vedanta (VEDL.NS, INR, 277.55) and Taiwan technology company Foxconn (2354.TW, TWD, 49.80) said they will build an integrated computer chip and display production center in India’s province of Gujarat.  The government-backed project will cost almost $20 billion and comes on top of massive new semiconductor production capacity being planned in the U.S. and Europe.

Global Agriculture Industry:  EU officials are reportedly delaying implementation of the European Commission’s proposed “Sustainable Use of Pesticides” regulation out of fears that the required cut in pesticide use could push down crop yields and further boost food prices in the EU and globally.

• The regulation intends to reduce the amount of chemicals used in food production by 50% within the next seven years.
• The delay in implementing the rule could signal that officials around the world are now rethinking their approach to regulation as the world faces insufficient commodity supplies and surging prices.

Chinese COVID-19 Shutdowns:  Along with new Zero-COVID lockdowns elsewhere in the country, Beijing officials are taking especially stringent steps to contain their latest outbreak ahead of the Communist Party’s important 20^th National Congress next month.  The government suddenly announced yesterday that employees and students must show a negative COVID-19 test taken within the previous 48 hours to return to work and school today after the three-day Mid-Autumn Festival holiday.  The move led to chaos this morning when commuters found subway gates would not open because they could not verify their tests.  President Xi’s stringent Zero-COVID policies continue to weigh on Chinese economic activity and discourage new investment in the country, with negative implications for the global economy and financial markets.

Chinese Housing Market:  Massively indebted property developer Evergrande (EGRNY, $3.05) said it will resume construction work on all its remaining stalled projects by the end of this month and accelerate work on its other projects to a “normal” level.  The announcement likely reflects Beijing’s push to stabilize the country’s home construction market ahead of the 20^th National Congress next month.

Argentina:  In a meeting with IMF Managing Director Georgieva yesterday, Economy Minister Sergio Massa promised that Argentina would stick by its deal to reduce its fiscal deficit and trim energy subsidies in exchange for pushing back the debt payments to the IMF.

• Nevertheless, it’s important to remember that Massa is a leading figure in Argentine Peronism, which has been hostile to IMF-imposed austerity measures that could directly hurt its constituents.
• Given Argentina’s long history of breaking such deals, we suspect investors will continue to discount the country’s assets for the foreseeable future.

U.S. Labor Market:  With the massive U.S. labor shortage continuing to give leverage to employees, faltering contract negotiations are raising the risk of major strikes against the nation’s railroads and West Coast ports as early as Friday.  Key railroads have already warned they will restrict shipments of hazardous chemicals so they would not be left unattended in the event of a work stoppage.

• In addition, some 15,000 nurses in Minnesota launched a three-day strike yesterday as they push for a roughly 30% pay hike over three years.
• The potential railroad and port strikes could be especially damaging to the economy as they would further snarl the supply shortages that have been disrupting activity over the last year or more.  And of course, that would likely exacerbate the current high level of inflation.

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