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 some notes on Ukraine’s devastating victories over Russian forces since late last week.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an important election in Sweden and new research on how COVID-19 continues to hold down the U.S. labor force.

Russia-Ukraine:  Over the weekend, Ukrainian forces continued to rout the Russians in the northern region of Kharkiv and make new territorial gains with their counteroffensive to retake the occupied city of Kherson in the south.  Ukrainian military officials indicate Kyiv has now retaken an area roughly the size of Rhode Island since the beginning of the month.  All reports indicate the Russian retreat is disorganized and desperate.  Nevertheless, the Ukrainians are already slowing their advance this morning in order to consolidate their hold on the recaptured territories and prepare for a possible Russian counterattack.  It is still much too early to expect a full Ukrainian victory or a complete withdrawal by the Russians, but the Ukrainian successes over the last week could mark a turning point that boosts the country’s confidence, encourages further military and other support from the West, and worsens the Russia’s shortfalls in morale, manpower, and equipment.  The Ukrainian military is also likely to benefit greatly from the equipment and ammunition the Russians have abandoned in their retreat, as well as from the intelligence to be gleaned from the Russians’ abandoned command posts.

• Importantly, the rout of Russian forces in Ukraine is generating intense criticism of the Ministry of Defense, although there is less discernable criticism of President Putin himself.  Indeed, Putin may be to the point where he wants the MOD to take the criticism to deflect blame from himself.  The Kremlin has even announced that Putin has postponed all his meetings with the leadership of the MOD and representatives of the Russian defense industry, which is a bizarre decision in the face of the military operational and defense industrial crisis facing Russia.
• On the energy front, Russia’s nearly complete cutoff of natural gas supplies is now idling more and more of Western Europe’s industrial capacity, from steel and aluminum to cars, glass, ceramics, sugar, and toilet-paper makers. Some industries, such as the energy-intensive metals sector, are shutting factories that analysts and executives say might never reopen, imperiling thousands of jobs.  The shutdowns illustrate how important it is for Ukraine to continue showing battlefield successes as a way to hold out hope that the economic costs to Western Europe will be short-lived.

United Kingdom:  Queen Elizabeth II’s funeral has now been set for Monday, September 19, in Westminster Abbey.  Importantly, all indications are that leaders from across the world will descend on London for the event, making it a major unscheduled diplomatic meeting.  Confirmed attendees so far include U.S. President Biden, European Commission President von der Leyen, Japanese Emperor Naruhito, and New Zealand Prime Minister Ardern.  We would not be surprised if the funeral ends up spawning several important meetings and initiatives.

United Kingdom-European Union:  To take advantage of the U.K. leadership change last week, Chief EU Brexit Negotiator Maroš Šefčovič has offered an idea to resolve the EU-U.K. dispute over customs checks for goods going from the British mainland to Northern Ireland.  Under his proposal, the U.K. would share data on the shipments with the EU in real time, and physical checks would only be required in rare instances in which there was a suspicion of smuggling or other issues.

• We have not seen a firm response to the idea from the British government so far, and it isn’t clear whether the idea would mollify those in Northern Ireland who most oppose any arrangement that interferes with its connection to the mainland.
• All the same, the idea could potentially help resolve one of the main sources of tension between the U.K. and the EU.

Sweden:  In parliamentary elections yesterday, preliminary results showed a center-right bloc of parties with a slim majority over a center-left bloc, but the real news was that the right-wing nationalist Sweden Democrats took their biggest-ever share of votes in a general ballot. Final results are not due for several days, but it appears that the Sweden Democrats will be the largest party in the right-wing bloc and the second-largest party overall.  If the right wing takes power, one important implication is that they are likely to push more reliance on nuclear electricity generation in Sweden, further bolstering a global trend.

Colombia:  In an interview with the Financial Times, Environment Minister Susana Muhamad said the government of leftist President Gustavo Petro will, for the first time, require environmental licenses for mining exploration as part of a wider overhaul of the process for awarding concessions.  The move likely signals the kinds of new regulations that will be put in place as left-wing leaders take control of more governments in Latin America.

U.S. Dollar:  Ahead of tomorrow’s release of the August Consumer Price Index (CPI), the dollar is weakening substantially against all major currencies except the yen.  The softening in the greenback partly reflects expectations that CPI inflation will slow, potentially setting the stage for the Federal Reserve to slow its interest-rate hikes down the road.  In addition, investors may still be digesting the European Central Bank’s aggressive 75 bps hike in its benchmark interest rate last week.

• At this writing, the euro is trading up approximately 1.1% against the dollar, at a value of $1.0152.
• At the same time, the pound is up 0.9% to $1.1694.

U.S. Labor Market:  New research by economists at Stanford University indicates that illnesses caused by COVID-19 have reduced the U.S. labor force by about 500,000 from what it would otherwise be.  Retirements and other social impacts from the pandemic probably account for a greater share of today’s workforce shortfall, but the research still illustrates the ongoing cost of not reducing infections further.  The shortfall in the labor force from what it would be otherwise has likely contributed to labor shortages, spiking wage rates, and higher inflation.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a discussion about the raging energy crisis in Europe. Next, we give an overview of stories that show that the world is still adapting to a new normal. We end the report with our thoughts on the latest central bank developments.

Russia’s Energy, Europe’s Problem: The risk of a deep European recession remains elevated as countries grapple with finding alternatives for Russian energy.

• Some countries have ignored calls for price caps and cooperation as governments struggle to compensate for Russian energy loss. The latest threat from Moscow to halt shipments has made the situation worse. Vulnerable countries such as Germany and Austria admitted that they were reluctant to back the price caps due to their dependence on Russian energy. Germany attempted to reduce its reliance on Russia by securing gas-sharing agreements. However, neighboring Belgium, Luxembourg, the Netherlands, and Poland failed to sign off on the arrangement. The lack of coordination among countries undermines European unity and may cause fractures within the bloc.
• The White House’s plan to supply Europe with gas angered U.S. lawmakers. The Energy Information Administration forecasts the natural-gas spot-price will be $9/MMBtu this winter. Although the cost is cheap for European buyers, it will drastically increase energy bills for U.S. households. Governors of northeastern states have informed the Biden administration that they would prefer that the U.S. keep its gas domestically as the country copes with elevated inflation. The rising politicization of gas shipments in the U.S. could exacerbate the energy crisis in Europe.
• As energy markets brace for a supply crunch in the winter, financial instability remains a risk. An ECB review of bank vulnerabilities to a potential surge of company defaults is underway over concerns that gas stoppage could strain the financial system. Earlier this year, the central bank warned traders that it would not provide emergency funding to bail them out in a crisis. The lack of support threatens the financial system because utility companies reliant on energy futures will be desperate for cash to cover shorts and meet margin calls. As a result, exchanges are now demanding more collateral to protect against a possible default. Although a potential cap on prices could help relieve some of this pressure, the ECB and governments may still need to get involved in ensuring that financial institutions remain liquid. As a result, we think the chance of a financial crisis in Europe remains a distinct possibility if immediate action is not taken to address ongoing issues.

 A Whole New World: The post-pandemic world is still taking shape as countries work out the best pathway forward.

• After 70 years on the throne, Queen Elizabeth II passed away on Thursday and will be succeeded by Prince Charles of Wales. The country will spend the next ten days mourning the death of its oldest and longest-serving monarch. Her death will likely delay the new government’s effort to implement its energy agenda.
  • Additionally, with the country distracted, the Truss administration might use the time to clean house. U.K. Treasury official Tom Scholars was sacked as the new Truss administration looks to refocus the finance ministry away from financial prudence and toward economic growth. The overhaul will likely pave the way for Truss to implement her new policies that lower taxes and push through her £150 billion energy plan.
• Wheat prices jumped over concerns that Turkey and Russia might scrap their grain deal. Turkish President Tayyip Erdoğan and Russian President Vladimir Putin have criticized the arrangement as benefiting wealthy nations and not developing countries. The leaders have advocated that Russia should be allowed to export its grains. Although food sales have been exempted from sanctions, many shippers and bankers are reluctant to do business with Russia. As a result, the wheat export has benefited Ukraine at Russia’s expense. The deal is set for 120 days, and markets are sensitive to any news that the agreement could collapse.
• Firms are forced to choose between the U.S. and China as politicians are determined to force a decoupling. On Thursday, Apple (AAPL, $154.46) faced scrutiny from republican lawmakers over its decision to use Chinese-made semiconductors for its new iPhone 14. The attack on Apple reflects the growing animosity among U.S. lawmakers toward companies doing business with China. This political pressure will dissuade many companies from setting up supply chains in rival countries and accelerate a push toward deglobalization.

Central Bank News: Stocks rallied, and bond prices dropped after the Fed Chair’s hawkish comments and the European Central Bank’s historic rate hike.

• Stocks closed higher on Thursday despite hawkish Fed rhetoric. On Thursday, Federal Reserve Chair Jerome Powell reiterated the central bank’s intention to raise interest rates until inflation drops to the bank’s 2% His comments reaffirmed expectations that the Fed will raise rates to 3.25% at its next meeting. Surprisingly, equities rebounded following Powell’s perceivably bearish comments. The rally was related to short-covering as investors grew confident that the market had already priced in a 75 bps hike. So far, the market anticipates that the Fed will lift rates to 4.00% by the end of the year.
• There was a sell-off in Eurozone bonds after the ECB raised rates by a record 75 bps. The rate hike pushed German two-year bond yields to 1.37%, its highest level since 2011. The spike in yields reflects European interest rate expectations, hence the market believes the ECB is far from finished. During Thursday’s press conference, ECB president Christine Lagarde acknowledged that the benchmark rate’s jump signaled to markets that the bank was committed to the inflation fight and hinted that another jumbo hike could happen at its next meeting.
  • The yield spread between the Italian and German 10-year bonds, a measure of European financial stress, narrowed after the rate hike. The decline in the yield gaps suggests that investors are confident that the bank is prepared to intervene in bond markets in an emergency.
• In China, data from the People’s Bank of China showed that financial institutions are not lending. Although demand rebounded from a low in August, credit growth remains anemic as households are cautious about taking out new loans. This lack of credit circulation throughout the real economy, even with easy monetary policy, has added to concerns that the country is in the midst of a liquidity trap. If correct, this could mean that China will struggle to achieve robust GDP growth over the next few years.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will begin with a discussion concerning the European Central Bank’s rate decision. Afterward, we will discuss the impact monetary tightening has had on the global economy. Lastly, we review the latest moves by major powers to expand their influence in other countries.

 The Euro Bounce: The euro is strengthening following the European Central Bank’s decision to raise rates. Meanwhile, rising inflation and slowing growth remains a risk for Europe.

• As expected, the ECB lifted its main refinancing rate by a record 75 bps. The massive jump in interest rates comes as the Eurozone combats unusually high inflation. The bank’s statement shows that it projects inflation to remain elevated but does not forecast a recession. During the press conference, ECB President Christine Lagarde emphasized that future rate decisions will be data dependent and be made on a meeting-to-meeting basis. She also added that the bank will continue to raise rates to 2.3% by end of the year and will proceed with its rate cycle if inflation remains a problem.
  • That the ECB decided to downplay recession concerns suggests that it is less focused on growth and more on inflation. As a result, we suspect that the banks could consider large rate hikes in the future.
• Gas prices retreated on Thursday as investors brace for new emergency measures to help offset rising energy costs. European Union Ministers are scheduled to meet on Friday to discuss ways to curtail energy demand. The group is expected to discuss five moves to help bring down energy demand. Potential plans include the redistribution of some windfall energy profits, a price cap on Russian gas, mandatory targets during peak hours, and other measures. The decision to constrain energy usage is a response to concerns that Russia will halt the supply of gas to the region in the coming months. Limits on energy will worsen the impact of a European recession and disproportionately hurt industrialized countries such as Germany.
  • That said, members will not share the pain equally. Spain, which has already filled its gas capacity to the critical 80 percent level, has been able to export some of its excess to neighboring France.
• Despite measures to curb energy demand, countries are likely to ease household pain through government intervention. For example, on Thursday, U.K. Prime Minister Liz Truss unveiled a £150B energy plan. The plan will cap annual household bills to £2,500 over the next two years. In Germany, the government has vowed to offer pandemic-era funds to companies struggling with the surge in energy costs. The increase in fiscal stimulus will likely prevent a worst-case scenario in Europe but will not stop the continent from falling into recession.

The Fed Strikes: Global currencies suffer as the Fed continues to tighten monetary policy; however, there are positive signs that inflation may be on a steady downward path.

• Market confidence that the Federal Reserve will lift rates by 75 bps skyrocketed this month. Over the last several weeks, Fed officials dismissed assumptions that the central bank could reverse course in response to weakening economic data. On Wednesday, Cleveland Fed President Loretta Mester and Fed Governor Lael Brainard affirmed that the Fed still needed to raise rates to contain inflation. The latest projection from the CME FedWatch Tool suggests a 76% likelihood that the Fed will lift its policy rate to 3.25% in its next meeting.

• • The newest Federal Beige Book showed that the economic outlook remained weak as business contacts expressed skepticism over future demand over the next six to 12 months. Although survey respondents reported moderation in price pressure and labor availability, firms still view inflation and hiring as an issue. The report suggests that the economy may head into a recession within the next few months.
• Hawkish Fed policy continues to push up the dollar’s value against its global peers. On Thursday, the British pound fell to its lowest against the dollar since 1985. Meanwhile, the Japanese yen slipped to a 24-year low. Out of the top three major currency pairs, the euro bucked the trend as anticipation of an ECB rate hike helped give it a slight boost against the greenback. As the dollar continues to gain in value, we expect other central banks to raise rates. Hence, global financial conditions will likely tighten over 6 to twelve months. Firms with U.S. dollar exposure are very attractive in this environment.
  • Japan’s Chief Foreign Exchange Minister Masato Kanda signaled that the bank would consider all options to halt the yen’s slide but emphasized that the bank’s position has not changed. In addition, the Bank of Japan may purchase yen in the open market to help bring down the currency’s value. Traders expect that the BOJ could intervene when the yen breaches ¥147.
• Rent and home prices may be close to their respective peaks. According to data collected by Zillow, rental prices slowed for three consecutive months. Meanwhile, potential home buyers surveyed by Fannie Mae expressed optimism that home prices would decline over the next few months. If valid, the deceleration will affect the overall Consumer Price Index as shelter prices represent nearly a third of its weight. The Zillow index lags the CPI by about 6-9 months, and as a result, we suspect that category to rollover around March of next year.

The Great Power Tussle: The U.S. and China blocs continue to battle over global influence, while the war in Ukraine shows no signs of ending.

• In a speech, Russian President Vladimir Putin stated that his country was winning the war in Ukraine and vowed to proceed with the invasion in Ukraine. His remarks highlight the pressure of progress in the war as the country heads into regional elections over the weekend. Although the outcome is likely to be favorable for the Kremlin, low turnout would signal that the government is losing support. Although Putin insists that he feels no pressure to end the conflict, a potential voter backlash could force him to rethink the invasion, especially as he plans to run for reelection in early 2024.
  • Ukrainian President Volodymyr Zelensky revealed that Ukrainian troops were able to retake territory lost to Russian troops.
• The U.S. will meet with 13 Asian countries to discuss an economic framework that limits China’s influence in the region. The deal has been low on details but appears to be focused on limiting tariffs in exchange for market access for exporters. It is not clear when an agreement will be reached, but we believe that it should be beneficial to firms which conduct business in Asia.
• President Putin is scheduled to meet with Chinese President Xi Jinping at the Shanghai Cooperation Organization summit in Uzbekistan next week. The two leaders will discuss the ongoing developments of the war as well as improvements in trade relations. Although it has maintained its neutrality in the war, China has allied with Russia. That said, the relationship still has its flaws. Thus, the meeting could give insights as to whether China still plans on expanding its support for Moscow.
  • China’s reluctance to provide Russia with weapons has forced Moscow to look to pariah nations such as Iran and North Korea for its needs. Additionally, China has used the Ukraine war to expand its influence in Eurasia as earlier this month Beijing urged Russia to stop blocking oil exports from Kazakhstan.

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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 the latest on the Ukrainian counteroffensive to retake Kherson and an apparent new counteroffensive in the country’s north.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, with a particular emphasis on the energy and economic challenges in China and Europe.

Russia-Ukraine:  Ukrainian forces continue to press their counteroffensive to retake the Russian-occupied city of Kherson in the country’s south, although with an emphasis on surgical missile and artillery strikes against logistics nodes, communication lines, and command centers rather than massed attacks to seize large swaths of territory.  The Ukrainian counteroffensive appears to be progressing methodically around Kherson, but it is also creating opportunities for the Ukrainians elsewhere.  As Russia redeploys its forces from occupied areas in the north and east of the country, the Ukrainians have made some gains against the remaining troops in those areas.  For example, reports indicate that yesterday the Ukrainians seized some territory north of Kharkiv.

• Separately, Russian President Putin has threatened to curtail the export of grain from Ukraine again, falsely charging that the West has been deceiving the developing world by largely keeping the Ukrainian grain exports set in motion by a recent Turkish-brokered deal for itself.  So far, the statement has had little discernible effect on global grain markets.  However, trading on those markets could turn volatile again if it begins to look like Russia will follow through on Putin’s threats.
• While the war has been devastating to much of Ukraine’s industrial base, one industry is benefiting from the country’s unexpected success in standing up to the Russian military.  New reports say Ukraine’s defense industry is enjoying a spike in demand from foreign customers interested in securing weapons proven in combat against Russia’s invasion.  The Ukrainian weapons being exported include the very successful “Skif” man-portable anti-tank missile and the Corsar light portable missile system.

European Energy Crisis:  As part of its effort to manage Russia’s cutoff of natural gas supplies and spiking energy prices, the European Commission plans to recommend that EU governments impose a windfall levy on revenues generated by non-gas electricity producers when market prices exceed €200 per MWh, less than half the current market price. The funds raised by the levy would then be redistributed to help companies and households deal with the crisis.

• EU leaders hope the threshold price is high enough to incentivize further investment in alternative energy sources and encourage energy conservation by businesses and households, while also limiting the politically dangerous price hikes for end users.
• Channeling the funds raised by the levy may be especially important for Europe’s industrial users, as we continue to see reports of production facilities being shut down because of the high cost of energy.

United Kingdom:  In contrast with the EU’s approach, newly minted Prime Minister Truss said in her first parliamentary question-and-answer session that she continues to oppose additional windfall taxes and promised that her government would unveil its energy support package this week.  Truss’s plan is expected to involve a cap on household energy bills of around £2,500 and include some sort of mechanism for the government to make up the difference for energy producers.

Chinese COVID-19 Lockdowns:  To give a sense of how extensive China’s latest COVID-19 lockdowns have become, the country’s media is reporting that 33 cities and an estimated 65 million people were under some sort of lockdown as of Saturday, making this the broadest outbreak since early 2020.

• The new lockdown is also likely to intensify ahead of the Communist Party’s pivotal 20^th National Congress starting in early October.  In all likelihood, the restrictions will further weigh on Chinese economic growth, presenting additional headwinds for the global economy.
• The prospect of weaker demand in China continues to weigh on global commodity prices, along with the impact of rising interest rates and the strong dollar.

Chinese Trade:  The August trade surplus narrowed to just $79.4 billion, far short of the expected surplus of $92.7 billion and down from a surplus of $101.3 billion in July.  Exports in August were up just 7.1% year-over-year, slowing markedly from their gain of 18.0% in the year to July and illustrating how weak demand overseas is weighing on the Chinese economy.  Perhaps more importantly, imports in August were up just 0.3% year-over-year, reflecting how factors like constant COVID-19 shutdowns and government clampdowns on sectors like technology and real estate are sapping the country’s own domestic demand.

Japan:  The yen continues to depreciate rapidly so far this morning, with the currency down some 1.9% from its close yesterday to trade at 144.77 per dollar.  If sustained, the drop in the yen today will be its biggest since June and will leave the currency down 19.8% year-to-date.  As long as the Federal Reserve and other major central banks continue to hike interest rates while the Bank of Japan holds rates steady, the yen could keep losing value.

U.S. Monetary Policy:  In an interview with the Financial Times, Richmond FRB President Barkin insisted that the Fed must lift interest rates to a level that restrains economic activity and keep them there until policymakers are convinced that inflation is subsiding.  Barkin’s statement underlines the message in Chair Powell’s recent speech at Jackson Hole.

• Barkin’s statement suggests investors should not discount the possibility that U.S. interest rates will be hiked much further and stay at high levels longer than many observers expect.
• Indeed, it is looking increasingly likely that the policymakers will implement another 75 bps rate hike at their next policy meeting occurring September 20-21.

U.S. Health Policy:  The federal government plans to recommend that people get COVID-19 boosters once a year, starting with the new shots that are rolling out right now.  The new guidance is a shift from the government’s current practice of issuing new advice every several months.  Authorities hope that coordinating COVID-19 shots with people’s annual flu shots will boost the number of people getting boosters.

U.S. Travel Industry:  According to the Transportation Security Administration, Labor Day 2022 was the first post-pandemic holiday in which airline travel surpassed its pre-pandemic high.  The TSA said 8.76 million travelers went through its checkpoints between Friday, September 2 and Monday, September 5, compared with 8.62 million passengers over the long holiday weekend in 2019.  The figures underscore how the travel industry in particular, and the service sector in general, continue to recover well on the back of pent-up demand.

U.S. Oil Industry:  In a public letter, conservative activist investor Vivek Ramaswamy has urged Chevron (CVX, $157.12) to be less beholden to ESG sentiment, slow its transition to renewable energy, and pump more oil to take advantage of today’s high prices.  Despite the influence Ramaswamy wields, it’s not clear whether Chevron or any other oil company will heed his call.  Nevertheless, it will be interesting to see if his call marks the beginning of stronger pushback against ESG investing orthodoxy.

U.S. Electricity Industry:  California Governor Newsome has warned that the state’s current heatwave is taxing the electricity grid and could lead to rolling blackouts.  According to Newsome, the state will maintain a number of emergency measures to reduce demand.  He also called on consumers to continue conserving electricity, a move that could have some negative impact on California’s economy this month.

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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, with a focus on Ukraine’s ongoing counteroffensive in the south of the country and the latest fallout for the world’s energy markets.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine:  Ukrainian forces continue to press their counteroffensive to retake the Russian-occupied city of Kherson in the country’s south, although their focus is still on degrading Russian logistics points and command centers with precision missile and artillery strikes rather than trying to seize large swaths of territory.  This carefully calibrated strategy appears to be working so far, although it’s still not clear how far it can take the Ukrainians.  In the meantime, Russian President Putin yesterday expressed his frustration with the war as he heaped praise on the ethnic Russian sympathizers who make up the forces raised in the Donbas provinces of Luhansk and Donetsk themselves, suggesting they were fighting better than Russia’s own forces.  At the same time, new reporting suggests the Russians are desperately seeking ways to import advanced computer chips to replenish their stockpiles of military equipment, after many more than anticipated have been destroyed in the war.

• In another sign of Ukraine’s success in its southern counteroffensive so far, Russia-allied separatists in occupied Kherson said they would delay their sham referendum on having the region join Russia due to the new fighting to retake the territory.  However, the officials have not provided a specific date when the vote will be held.
• Kremlin Press Secretary Dmitry Peskov said Russia will not resume natural gas shipments to Western Europe through the Nord Stream 1 pipeline until the “collective West” lifts its sanctions on Russia due to its invasion of Ukraine.  The statement confirms what many political leaders and analysts have long suspected, i.e., that the recent “maintenance” shutdowns of the pipeline have been a ruse to put pressure on the West and force it to acquiesce to the invasion.
• To deal with the shut-off of Russian gas supplies and the resulting price spike, the European Commission is set to propose an emergency cap on wholesale gas prices in the EU, with two potential options for implementing it.  One option involves putting a limit on what can be paid for gas imported from Russia. The second would introduce a capping system that would differ from country to country depending on their energy mix.
• To provide for backup energy supplies in case of a crunch this winter, the German government said two of the country’s three remaining nuclear generating plants will be kept on standby through April, rather than being shut down permanently at the end of the year as previously planned.  The decision highlights the rebounding global interest in nuclear power due to the war and the associated high energy prices around the world.
• In yet another response to Europe’s impending energy crunch as winter approaches, a number of major European utility firms have secured big state-backed credit lines to help them weather the crisis.

Global Oil Supply:  The Organization of the Petroleum Exporting Countries and its Russia-led partners yesterday agreed to cut their collective oil production by 100,000 barrels per day beginning next month, reversing an increase President Biden secured last month in a visit to Saudi Arabia.  Although the cut is small compared with the overall global scale of the oil market, it nevertheless represents a potent political statement that OPEC+ is willing to thwart U.S. preferences in order to buoy oil prices and push back against the West’s sanctions on Russia.

• Nevertheless, global oil prices continue to soften today, largely on concerns about yet another wave of coronavirus lockdowns in major cities in China.  Of course, broader concerns about rising interest rates and recessions in the major developed countries also continue to weigh on oil prices.
• At this writing, Brent crude is trading down approximately 2.6% on the day at $93.43 per barrel.  Prices also continue to soften for a range of other industrial commodities on concerns about Chinese lockdowns and recession in major developed countries.

United Kingdom:  Over the long weekend, Foreign Minister Liz Truss was finally declared the winner of the race to succeed Boris Johnson as Conservative Party leader, setting her to become prime minister today.  After naming her cabinet, Truss’s first order of business will be to finalize a plan to shield households and businesses from a doubling of energy prices in October if current rules remain in place.

• At a cost of almost £100 billion, the energy-price relief plan would freeze gas and electricity bills at the current typical annual cost of £1,971, while other measures would aim to protect businesses from catastrophic price rises.
• The rest of Truss’s economic agenda focuses on tax cuts and deregulation aimed at unleashing more energy development and industrial investment.
• In foreign policy, Truss has struck a tough position on Russia and vowed to stand up to Brussels in a row over post-Brexit trading arrangements in Northern Ireland.

Japan:  The yen’s recent weakness has accelerated sharply today, as the currency plunged 1.0% to a 24-year low of about 141.99 per dollar.  Traders ascribe today’s drop to an aggressive interest-rate hike by the Reserve Bank of Australia.  While the RBA and other major central banks hike interest rates to combat inflation, the Bank of Japan remains the outlier in its insistence on holding its policy extremely loose.

• Since the yen’s current weakening phase took hold in early 2021, the currency has lost approximately 26.9% of its value against the U.S. dollar.  The yen’s decline in 2022 to date now amounts to 19.8%
• As long as the Fed and other major central banks are hiking rates and the BoJ is holding its policy steady, the yen will remain at risk of further depreciation.

China:  An earthquake rating 6.8 on the Richter scale struck the southwestern province of Sichuan today, killing dozens and injuring hundreds.  The quake will compound the economic challenges facing Sichuan as it continues to deal with a major heatwave, drought, energy shortages, and COVID-19 lockdowns.

Chile:  Over the weekend, voters overwhelmingly rejected the country’s proposed new leftist constitution, with 62% voting against the law and 38% voting in favor of it.  The result is likely to buoy Chilean stocks in the near term, although left-wing President Boric has vowed to make a new effort at re-writing the constitution.

U.S. Bond Market:  According to Fitch Ratings, defaults on leveraged loans to below-investment-grade companies spiked to $6 billion in August, reaching their highest level since the midst of the pandemic in October 2020.  Since interest rates on the loans typically fluctuate with the market, the spike in defaults suggests that the Fed’s rate-hiking crusade is beginning to have a noticeable negative effect on junk issuers.  As the Fed continues to hike rates, we remain concerned that it will spark a bigger and broader bout of defaults among junk issuers.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Note: the markets and our office are closed on Monday, September 5, in observance of the Labor Day holiday. Our next report will be published on Tuesday, September 6.

Today’s Comment begins with a focus on how hawkish Fed policy has pushed the value of the dollar higher. Next, we review the latest developments in the Russia-Ukraine conflict, which includes our thoughts on a possible price cap on Russian commodities. The report concludes with an examination of China related risk and its potential impact on the global economy.

Strong Dollar: A possible 75 bps rate hike by the Federal Reserve at its next meeting has pushed the dollar to a 20-year high against global currencies.

• Fed officials this week hinted that the Fed would raise interest rates even if the country falls into recession. Cleveland Fed President and voting FOMC member Loretta Mester said that she expects rates to rise above 4% and stay at the level throughout 2023. On Thursday, Atlanta Fed President Raphael Bostic mirrored Mester’s sentiment and alluded to the bank possibly offloading mortgage-backed securities from its balance sheets. As the Fed continues to fight inflation, other central banks will face pressure to follow its lead.
• The yen sank below 140 for the first time in a quarter century. The currency’s drop against the dollar adds to speculation that the Bank of Japan will eventually tighten monetary policy. The currency’s depreciation against the dollar has contributed to the surge in Japan’s cost of living expenses due to the country’s heavy reliance on imports. Despite investors’ concerns, BOJ Governor Haruhiko Kuroda has not indicated that he is ready to reverse course on central bank policy. His reluctance is likely related to the country’s heavy government debt burden. Japan’s government debt is 266% of GDP and is the highest among developed countries. The lack of BOJ action suggests that the yen will continue to drop against the dollar, especially as the Fed raises rates.
• Slow economic activity and tighter U.S. monetary policy have also tumbled the pound. The currency has depreciated 14% against the U.S. dollar this year and dipped below $1.15 for the first time since March 2020. We predict that the depreciation in the currency will continue as the economy heads into recession. It is unclear as to whether it will continue to raise rates in a downturn, but the recent comments from the Bank of England suggest it might. On Thursday, the BOE announced that it intends to cap yields on its bonds to prevent financial market disruptions and likely to prevent surging borrowing costs. By restricting the interest rate on the long duration while it already has control over its short end through its policy rate, the bank would effectively embrace yield curve control. The move to control yields would mean that the bank would have less control over its exchange rates, therefore leading to further depreciation. As a result, we agree with Capital Economics’ forecast that the pound will fall to $1.05 by the middle of 2023.
  • The country’s spat with the European Union also threatens the currency. The two sides are at loggerheads over the Northern Ireland Protocol. On Thursday, Brussels warned U.K. Foreign Secretary and prime minister frontrunner Liz Truss that the EU will not engage in Brexit negotiations unless it removes a bill allowing London to scrap the NI protocol unilaterally. Although a complete break between the EU and U.K. will hurt both parties, the latter will feel the brunt of the damage.

 Russia- Ukraine Update: The war in Ukraine continues to show that the world is starting to form regional blocs.

• G-7 countries have moved one step closer to a formal agreement to cap Russian oil The deal is designed to keep oil available while also slashing Russia’s export revenue. That said, there is still a hurdle which the group needs to overcome before the agreement is official. The EU would have to amend its sixth round of sanctions prohibiting oil purchases after December 5. In response to the deal, Russia has vowed not to sell its commodities to countries that impose price controls. Assuming Russia does not stop oil deliveries, the agreement should be bearish for commodity prices as it would expand the oil supply.
  • European Commission president Ursula von der Leyen has hinted that Europe could also entertain a price cap on Russian gas.
• Russia is exploring the purchase of $70 billion in yuan and other “friendly” currencies to prevent the ruble’s appreciation. The surge in the currency’s value was fueled by government measures to limit its sales and the increased demand for Russian commodities. The currency’s recent strength has been a double-edged sword. It has provided some price stability while making Russian exports relatively more expensive. The war in Ukraine has shown how dangerous it is for rival countries to hold U.S. dollars as foreign reserves. Thus, we expect more countries will follow Russia’s lead and begin to diversify their respective holdings of FX reserves.

• Despite concerns of a nuclear catastrophe, fighting continues to occur near the Zaporizhzhia nuclear power plant. The UN nuclear agency chief warned that the physical integrity of the site was violated due to frequent attacks around the area. Russia has controlled the site since March, but both sides have accused the other of possibly triggering a nuclear disaster in Europe. A potential accident at the power plant is a significant global risk as it could threaten the food supply, contaminate water, and lead to many civilian deaths.

 China Risks: New lockdowns and friction with the West will make the China a difficult place to invest.

• The lockdown in Chengdu has sparked concerns that the Chinese economy will weigh on global growth. The lockdown in a city of over 21 million has led to a panic in nearby areas. In Shenzhen, there were reports of frantic buying as locals feared their city could be next. Despite reassurances from government officials in Shenzhen that it will not impose a lockdown, the rise in cases has already led to new restrictions. Additional COVID restrictions will likely weigh on the Chinese economy and make it more difficult for companies to sell to consumers within the country.
• S. Senators have proposed a bill that will make it harder for Chinese firms to raise capital on American exchanges. The proposal would target Variable Interest Entities (VEI) used by Chinese companies to list abroad. If passed, the bill would be the latest salvo launched at American investors that fund Chinese companies and would reinforce our view that the two major economies are decoupling. The lack of U.S. investment suggests that Chinese firms could struggle to find outside financing, which may prevent its economy from growing. Although it is unclear how much support the bill has in Congress, the legislation does support our thesis that U.S. policymakers are becoming more hawkish toward China. Hence, companies with exposure to the region may be less attractive.
• American support for Taiwan is another example of this decoupling trend continuing. On Thursday, China sent 23 military aircraft across the median line of the Taiwan Strait. Chinese intimidation tactics suggest that Beijing is less tolerant of the West’s interaction with the island democracy. We believe that China will likely take a tougher stance against countries interacting with Taiwan after the National Congress of the Chinese Communist Party which begins on October 16.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion of the September effect. Next, we review possible headwinds in Europe. We end the report by examining the rivalry between the West, Russia, and China.

Wait, It Gets Worse? September is generally the worst month for equity performance. Known as the September effect, the S&P 500 has averaged a 1% seasonal loss for the month, dating back to 1928.

• There are many reasons for this decline but the theories most frequently cited are parents selling off financial assets to pay for their kids’ college tuition, investors adjusting portfolios after returning from vacation, and/or tax-loss harvesting from mutual funds. Despite the historical record, it is essential to note that this average is biased as September has been a harbinger of adverse market events. For example, the fall of Lehman Brothers, the collapse of Long-Term Capital Management, and the terrorist attack on the World Trade Center all happened in September. These events suggest that the historical average might not accurately reflect the month’s performance. In our view, the median provides the best picture of the long-term seasonal performance. In this instance the S&P 500 median performance for September (1.02%) outperforms both February (0.76%) and May (0.49%). That said, there are still several headwinds that investors should consider for this month.
• Hawkish monetary policy remains a threat to equity performance. The European Central Bank is scheduled to meet on September 8, while the Federal Reserve is set to meet a few weeks later. The central bank officials are expected to make substantial hikes in their benchmark rates at their respective meetings. Persistently low unemployment rates and stubbornly high inflation in both the U.S. and the euro area fuel the need for decisive central bank action. However, the more these institutions tighten, the higher the likelihood that these countries will fall into recession. The sell-off in August will likely soften the blow of the interest hikes from both banks.
• Another significant headwind comes from China. The country has implemented a new lockdown in Chengdu. The city’s new restrictions suggest that global demand and production could slow in September as the world’s second largest economy struggles to contain COVID.
  • The latest PMI for China showed that manufacturing output contracted after the index fell to 49.4 from 50.2 in July.

 Financial markets are full of smoke and mirrors, and therefore, what can look like a historical trend could be an illusion. Although there are plenty of reasons to be skeptical, we believe investment decisions should be based on facts rather than market myths.

 European Risks: Headwinds in Europe will persist as business conditions in the region deteriorate due to tight monetary policy and elevated inflation.

• Traders ratcheted up their bets that the European Central Bank will be more aggressive after yesterday’s Consumer Price Index (CPI) report showed inflation hitting a new high in August. The latest CPI report for the eurozone showed that headline inflation jumped 9.1% from the previous year, while core inflation rose 4.3%. The price statistics suggest that inflation has spread into other sectors of the economy outside of energy and food. The yield spread on German and Italian bonds, a gauge for financial stress within the eurozone, has widened to 2.33%, closing in on this year’s peak of 2.42%.
  • The strong CPI report places more pressure on the ECB to take aggressive actions to curb inflation. On Friday, Fed Chair Jerome Powell asserted that the Fed would keep rates elevated for longer. His statement led to a surge in the Euro Overnight Indexed Swaps due to concerns that the ECB would have to follow suit. Euro Overnight Indexed Swaps show that investors predict that the ECB will support a 75 bps hike in October.
• The European Union proposed new regulations on smartphone production to curb tech waste. Suppliers of smartphones will be required to provide at least 15 different parts for a minimum of five years after a phone is released. Additionally, the EU will require batteries to last through at least 500 full charges without deteriorating below 83% of their capacity. The new directive will hurt the profits of electronics firms as it will reduce the need for consumers to purchase new phones and make it more difficult for firms to profit from repairs. The new rules created by the EU will likely pave the way for a global benchmark and could force tech companies to change their business models.
• Elevated energy prices continue to slow down the European economy. German firms have begun cutting production to cope with costlier energy, and French manufacturers fear they could be next, barring assistance from the EU. Energy prices in Europe have risen 300% in 2022, and a sustained slowdown in manufacturing production threatens to push the region into recession.
  • The latest Purchase Manager Index report for the eurozone showed that the contraction in factory output worsened in August after it slipped to 49.6 from 49.8 in the previous month.

2022 has not been kind to Europe, and we do not think this will change anytime soon. Tight monetary policy, elevated inflation, and the war in Ukraine will make it difficult for the region to avoid recession. As a result, we suggest that investors should be very tactical if they plan to invest in the area.

Tit-For-Tat: The back and forth between the West and its rivals continue to support our view that the world economy is moving away from global markets.

• The deterioration in the EU-Russia relationship remains a prominent risk. On Wednesday, the EU tightened visa restrictions on Russians, and there was even discussion about an outright ban. Although there is much resistance to a visa embargo, the move suggests that EU restrictions could target ordinary Russians. However, assuming this trend continues, we expect Moscow to ramp up its nationalistic rhetoric as it portrays the war as a Western attack on Russia. There is also evidence that talks about punishing Russia over its invasion within the EU could lead to more infighting.
• Ukrainian forces have taken a more creative approach in their counter-offensive against Russia. Although Russian troops have portrayed Ukraine’s new line of attacks as failing instantly, analysts theorized that those perceived failures might be strategic feints and misdirection to exploit Russian weaknesses If analysts are correct, the tactics will make it difficult to discern legitimate Ukrainian failures. It seems that Russia might also be suspicious. Moscow has asked media outlets not to report on the counter-offensive. Therefore, it will take some time before we can discern whether the new counterattack was a success.
• In addition to Europe and Russia escalation, the U.S. also made moves to target Beijing. On Wednesday, the U.S. ordered software company Nvidia (NVDA, $150.24) not to sell its AI semiconductors to China. The decision is another example of how the U.S. plans to contain the growth of its Indo-Pacific rival through export controls. These restrictions on U.S. exports will encourage Beijing to invest in its domestic industries while denying American firms a vast export market. Nvidia warned that the new rules would cost it millions in revenue.
  • On an unrelated note, Taiwan has shot down a Chinese drone over the Kinmen Islands. Although there is no sign that China will retaliate, we suspect the shooting of drones may serve as a pretext for escalation in the future.

Rivalries among major powers pose the most considerable long-term risk. The last time we saw similar developments was in the run-up to WWI. Although we are not forecasting a large-scale war, we believe that global tensions could force countries to accelerate the trend away from globalization.

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