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 Ukraine’s new counteroffensive to push the Russians out of the southern city of Kherson.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a potentially dangerous new commitment by Taiwan to defend itself against Chinese military incursions.  We wrap up with a few additional words on the stock market’s reaction to Federal Reserve Chair Powell’s hawkish speech last Friday in Jackson Hole.

Russia-Ukraine:  The Ukrainian counteroffensive to push the Russians out of the southern Ukrainian city of Kherson continues with ground forces pushing against the Russians’ front lines and long-range missiles and artillery attacking their ammunition depots, troop concentrations, and lines of communication far behind the lines.  Meanwhile, the Russians are trying to reinforce their most vulnerable defensive positions by ratcheting down their offensives in the northeastern Donbas region and redeploying their best and most experienced troops southward toward the Kherson battlefield.  We believe it is far too early to gauge the success and likely outcome of the Ukrainians’ counterattack.  Indeed, their methodical approach to the offensive so far suggests it could play out over an extended period.  We may not know the true outcome of the offensive for several weeks.

• Retaking Kherson would provide major military, economic, and political benefits to Kyiv.  For example, seizing the city and pushing the Russians out of the region would reduce the Kremlin’s control over Ukraine’s coastline and could help reopen Ukraine’s trade flows through the Black Sea.  A victory would also help convince Western governments to keep supporting Ukraine in the fight.
• Separately, U.S. officials stated that Russia has picked up the first shipments of what could be dozens of Iranian drones designed to attack radars, artillery pieces, and other military targets.  The drones are part of a recent deal to help Russia in its war with Ukraine.  However, Russian tests have reportedly discovered that the drones malfunction frequently and may not be very effective in Ukraine’s congested battle space in which Ukraine is fielding many modern, sophisticated weapons provided by the West.
• Finally, as anticipated, Russia has once again shut off natural gas shipments through its Nord Stream 1 pipeline to Western Europe, ostensibly for “maintenance.”  European officials remain in the dark as to whether the shipments will truly resume on Saturday as the Russians say.  The move has boosted European gas prices by another 5.5% so far this morning.

Russia:  Mikhail Gorbachev, the former leader of the Soviet Union whose efforts to reform the Communist state led to its dissolution, died yesterday in Moscow at the age of 91.  Although Gorbachev was instrumental in ending the Cold War and bringing down the USSR peacefully, he remained vilified by many in Russia because of the economic chaos the breakup caused in the early 1990s.

European Bond Market:  Based on the Bloomberg Pan-European Aggregate Total Return Index, Europe’s market for high-grade government and corporate debt was down 5.3% for the month through yesterday, putting it on track to post its worst month since 1999.  As in the U.S., bonds in Europe have been hammered by rapid consumer price inflation, aggressive interest-rate hikes by central banks, and fears of impending recessions.

• Coupled with the downtrend in stock values so far this year, the fall in bond values has illustrated how the traditional portfolio benchmark of 60% stocks and 40% bonds can falter in a period of high inflation and rising interest rates.  Better performance this year would have come from a portfolio putting less emphasis on bonds and more on commodities, as many of our asset allocation strategies do.
• Illustrating the continuing challenging environment in Europe, the Eurozone’s August consumer price index was up 9.1% year-over-year, marking the region’s highest inflation rate since records began in 1997 and accelerating from the gain of 8.9% in the year to July.

China:  At long last, Communist Party leaders have decided their 20^th National Congress will begin on October 16.  The meeting will likely be historic, given that President Xi is expected to use it to cement his grip on power by being named to a third consecutive term.

• Xi will also use the meeting to announce major new initiatives in international relations, economics, and social policy.
• In the run up to the meeting over the next six weeks, we suspect Chinese officials will pull out all the stops to make the economy look stable and robust, producing positive vibes for Xi.  At the same time, officials are likely to crack down hard on any sign of political unrest that could mar the proceeding.

China-Taiwan:  Today, in a development that could dramatically raise the risk of a military clash, Taiwan warned that it will defend itself and strike back as China ramps up its military incursions in the island’s territorial airspace and waters.  Taiwan has also reportedly begun targeting Chinese drones overflying its outlying islands.  The more assertive approach suggests Taipei is trying to balance the risk of sparking outright conflict against its desire to block China from demonstrating effective control over nearby waters and airspace or even Taiwanese territory.

• The risk is that continued shooting at Chinese drones, or destroying one, could invite retaliation in kind from the Chinese.
• The development is a reminder that China-Taiwanese relations remain a major geopolitical risk for investors, especially as any conflict would likely draw in the U.S., Japan, and other Western allies.

China-Solomon Islands-United States:  After the Solomon Islands recently refused to allow a U.S. Coastguard ship to dock for supplies, President Sogavare said his government will temporarily bar ships from all foreign navies while it reviews its approval processes.  The move deepens concerns that China is now firmly pulling the international policy strings within the Solomon Islands government.  Sogavare struck a secretive new security deal with Beijing earlier this year, presumably in return for Beijing’s support in keeping him in power.

U.S. Monetary Policy:  Yesterday, New York FRB President Williams warned that with the economic momentum still strong and the labor market tight, the Fed will not only need to boost interest rates into restrictive territory, but it will also have to hold them there for some time in order to bring inflation back to the policymakers’ target of 2%.

• Investors now seem to accept that the Fed plans to keep ratcheting up interest rates for the time being, but the statement from Williams may be designed to show that the policymakers also aren’t likely to pivot to rate cuts nearly as soon as some investors think.
• As investors re-price the likely trajectory of interest rates, stocks and other risk assets, along with bonds, continue to depreciate.

U.S. Labor Market:  With companies still faced with labor shortages despite the Fed’s effort to slow economic growth, some are trying to lure workers with what could be a relatively low-cost perk.  Some manufacturers, hotels, warehouses, and restaurants are allowing new hires to work just a few days a week, take on four-hour shifts, or even choose new hours daily using phone apps.  In other words, on-site workers are starting to gain the same flexibility enjoyed by remote workers.

U.S. Stock Market:  Finally, now that investors have been able to digest Fed Chair Powell’s hawkish speech at Jackson Hole last Friday, we thought it would be helpful to provide some perspective on where monetary policy and the stock market are probably headed.  The overall picture that we see is that the market had become way too optimistic that the monetary policymakers would stop hiking interest rates and even pivot to rate cuts at the slightest sign of economic weakness.  We suspect there is something of a consensus that the incoming economic data will show significant weakness around the end of the year or in the first quarter of 2023.  Prior to Friday, that weak data would have suggested the hoped-for pivot was at hand.  It would have been a classic case of thinking that “bad news is bullish.”  Now, however, Powell’s commitment to hiking rates further has sunk in, and investors over the last few days have adopted the view that “good news is bearish,” and “bad news is just as bearish.”

• A case in point was yesterday’s JOLTS report showing a strengthening labor market.  That good data sparked yet another sell-off in equities as investors mulled over the implications now that the “Fed put” is gone.
• We would note that a range of technical indicators are also pointing to further weakness in the market.  For example, the S&P 500 price index is now trading below its 20-, 50-, and 200-day moving averages.  The index is now also threatening to fall below a key support level at approximately 3,920.  Momentum indicators on the index are also weakening.
• All in all, we would say Powell has succeeded in convincing investors that the Fed won’t come riding to the rescue if the economy falters.  Indeed, to re-establish the Fed’s inflation-fighting bona fides, Powell may actually need a recession so he can show just how much pain he’s willing to inflict.  He may even need to let the recession reach a certain level of severity, perhaps to the point of risking a financial crisis.  After all, the issue isn’t just bringing down the inflation number, but rebuilding the Fed’s credibility.
• The implication is that monetary headwinds to the stock market are likely to intensify and continue longer than investors previously thought.  It is probably far too early to get bullish on stocks at this point.

View PDF

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 key news is Ukraine’s official announcement that it has launched its long-awaited counteroffensive to retake the southern city of Kherson from its Russian occupiers.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, many of which are focused on political and economic turmoil in the emerging markets.

Russia-Ukraine:  In what could be one of the key moments in the war so far, Ukrainian officials announced the beginning of their big counteroffensive to retake the southern Ukrainian city of Kherson.  Although Kyiv has been taking preparatory steps for that attack for many weeks, it has been unclear whether the signaled counteroffensive was really going to happen, or whether it was just a feint.  In any case, Ukrainian forces have reportedly pushed the Russians out of a number of villages west, northwest, and northeast of Kherson and continue to pressure Russian lines elsewhere in the region.  Despite the Ukrainian counteroffensive in the south, Russian forces continue to launch missile and artillery strikes against both civilian and military targets throughout Ukraine.

• Meanwhile, the International Atomic Energy Agency said its mission to assess the safety and condition of the Zaporizhzhia Nuclear Power Plant in eastern Ukraine has now departed.  It is not known when the team will actually be able to visit the plant, and how completely it will be able to examine its status.
• On the energy front, European Commission President von der Leyen said the EU will soon announce emergency measures that will decouple end-user energy prices from the Continent’s soaring natural gas prices.  She also stated that the EU will later introduce a range of longer-term structural reforms to the EU’s energy market.
  • Separately, Russian gas giant Gazprom said it will further cut deliveries to major French utility Engie (ENGIY, $12.27) over an alleged contract dispute.  The new cut in deliveries is due to take effect today.
  • Russia also plans to shut down its Nord Stream 1 gas pipeline to Europe again tomorrow for what it calls maintenance. The shutdown is due to last until Saturday, although European officials fear Russia could keep it in place for longer in order to further ratchet up the pressure on Europe.
  • The cutoffs underscore Russia’s continued willingness to weaponize its energy exports and highlights Europe’s vulnerabilities, even in countries that rely relatively little on Russia, like France.

Eurozone:  ECB Chief Economist Philip Lane said the central bank should strive to hike interest rates in steady, small increments.  His statement suggests he may push back against some ECB officials’ calls for a big 75 bps hike at their policy meeting next week.

China:  Officials have discovered a new coronavirus subvariant, BF.15, in multiple people in the southern Chinese technology hub of Shenzhen, prompting the city to close subway stations, ban restaurant dining, and lock down shopping malls.  Local officials promise the shutdowns won’t become worse, but the outbreak raises new fears of an important new lockdown under President Xi’s Zero-COVID policy.

Iraq:  After ten months of failed negotiations to form a new government, influential Muslim cleric Muqtada al-Sadr said he will quit politics; however, the announcement sparked rioting by his supporters, resulting in dozens of deaths in Baghdad yesterday.  The incident suggests Iraq will continue to face political violence and instability for the near term.

Pakistan:  As predicted in our Comment yesterday, the IMF has approved the resuming of lending to Pakistan under an existing $7 billion deal that had been stalled because of the government’s reluctance to implement austerity policies.  Securing the new funding means Islamabad has now pushed off the threat of a near-term default, although it still faces financial risks in the medium term because of issues like its fractious political dynamics and recent flooding.

Sri Lanka:  Amid Sri Lanka’s ongoing negotiations for a bailout loan from the IMF following its default in May, President Wickremesinghe announced plans for further austerity measures to secure a deal.  The plans would further increase taxes (including hiking the value added tax from 12% to 15%), strengthen central bank independence, and reallocate government funds toward relief programs.

Colombia-Venezuela:  Colombia’s new leftist president, Gustavo Petro, has re-established diplomatic relations between his country and Venezuela.  The move leaves the U.S., Canada, and Brazil as the only large countries in the hemisphere that no longer recognize Venezuela’s authoritarian government.

U.S. Financial Payments System:  Yesterday, Federal Reserve Vice Chair Brainard said the central bank’s new “FedNow” system for faster payments will be live by next summer.  The new system will allow bill payments, paychecks, and other common consumer or business transfers to be available quickly and around-the-clock, versus the existing system that is closed on weekends and can, at times, take several days before funds become available.

U.S. Manufacturing:  Spurred by recent legislation that provides a range of incentives and subsidies for renewable energy, top U.S. solar panel maker First Solar (FSLR, $121.69) said it will spend as much as $1.2 billion to boost its domestic manufacturing capacity by around 75%.  The new capital investment will be targeted toward a new facility in the Southeast and upgrading an existing facility in Ohio.

View PDF

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 a key focus is now on the risks to a major nuclear energy plant in eastern Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a few additional words on Federal Reserve Chair Powell’s speech at the Jackson Hole symposium on Friday.

Russia-Ukraine:  Depleted and combat-weary forces from both Russia and Ukraine continue to make only the most minimal territorial advances along their front lines, although both sides continue to use long-range missile and artillery strikes to weaken the other side.  Notably, shelling continues in the area around the Zaporizhzhia nuclear power plant, with both sides accusing the other of putting the plant in danger.  Meanwhile, media reports say a newly formed 3^rd Army Corps composed of recent volunteers from around Russia is now ready to deploy to Ukraine with highly advanced weaponry, although analysts are doubtful that the quickly trained troops will be competent enough to turn the tide of the war.

• Today, the UN’s International Atomic Energy Agency is due to send a team to the Zaporizhzhia nuclear plant to assess its condition.  Led by IAEA Chief Rafael Grossi, the team will also check safety and security systems and evaluate staff conditions.
• On the energy front, the CEO of Shell (SHEL, $54.88) warned that Europe’s energy crisis will last several years at least, even if it gets through this winter.  According to the executive, “It may well be that we have a number of winters where we have to somehow find solutions through efficiency savings, through rationing, and a very, very quick buildout of alternatives.”
  • With Europe facing extremely high energy prices, rationing, and increased interest rates, investors continue to push down the euro.  Investors also continue to bet on further depreciation in the common currency, with net short positions against the euro now at their highest level since the start of the coronavirus pandemic in early 2020.
  • The euro is staging a very modest rebound so far this morning, but it remains below par with the dollar at just $0.9996.

China-Solomon Islands-United States:  Earlier this month, The U.S. Coast Guard said the Solomon Islands failed to respond to an official request for one of its cutters to make a routine port call for replenishment, forcing the vessel to make its port call in Papua New Guinea.

• The refusal to grant permission to dock could be related to a secretive new security agreement struck between China and the Solomon Islands earlier this year.
• The incident suggests China may be requiring the Solomon’s government to distance itself from the U.S.  In return, China could support Solomon’s President Sogavare in his effort to delay his country’s next elections and stay in power.
• In any case, the matter illustrates how the South Pacific islands are becoming a key theater in the U.S.-China rivalry.  It also highlights how countries around the world are being pressured to ally themselves with either the U.S. or China.

United Kingdom:  In the race to succeed Boris Johnson as Conservative Party leader and prime minister, front-runner Liz Truss, the current foreign minister, is coming under increased pressure to outline her plan to support British families facing enormous energy bills this winter.  Truss has tried to hold the line against providing new cash “handouts,” preferring to provide tax cuts instead, but the opposition Labor Party is hammering her for the way that plan could provide outsized benefits to upper-income Brits.

Serbia-Kosovo:  Over the weekend, Serbia and Kosovo reached a deal to resolve administrative hurdles both sides had slapped on their neighbor’s citizens or threatened to do so.  Serbia agreed to abolish entry/exit documents for Kosovo ID holders and Kosovo agreed not to introduce them for Serbian ID holders.  The deal diffuses a flashpoint that could have spiraled into violence just as Europe is already dealing with the war in Ukraine.

Pakistan:  The Pakistani government says it has now secured the $37 billion in loans and investments needed to secure an additional $4 billion loan from the IMF to cover its budget shortfall for the current fiscal year.  IMF officials today will vote on approving the deal.  Securing the new funding means Islamabad now has pushed off the threat of a near-term default, although it still faces financial risks in the medium term because of issues like its fractious political dynamics and recent flooding.

Brazil:  Last night, current right-wing populist President Bolsonaro and leftist former President Lula da Silva squared off in their first debate ahead of this fall’s presidential elections, along with four minor candidates.  Bolsonaro has recently been trailing da Silva badly in the polls, but press reports suggest he landed a few blows by painting the former president as corrupt.  Meanwhile, da Silva stressed how good Brazil’s economy had been under his administration.

U.S. Monetary Policy:  In his keynote address at the Kansas City FRB’s annual conference in Jackson Hole, Wyoming, on Friday, Fed Chair Powell poured buckets of cold water on the idea that U.S. monetary officials would pivot to easier policy anytime soon.  Powell not only signaled that the Fed will keep raising rates until they are high enough to restrain economic growth but will hold them there until inflation pressures come down significantly, even at the risk of pushing the economy into recession.  Isabel Schnabel, the German member of the European Central Bank’s executive board, drove home the point in her speech on Saturday.  According to Schnabel, the cost of inflation is so high that central banks must act decisively to stop it, without fear of causing a recession.

• The speech sparked a sizable pullback in risk assets on Friday, and we suspect it could continue to weigh on stock prices in the near term.
• Indeed, stock futures are down approximately 1% at this writing, and the 10-year Treasury note has risen to a two-month high of 3.116%.

U.S. Energy Policy:  The California legislature this week is set to vote on whether to extend the life of the state’s sole remaining nuclear generating station beyond its planned closure in 2025.  Governor Newsome has recently reversed course and called for extending the life of the plant amid rising electricity demand and reduced availability of electricity from other sources, such as hydroelectric.  A vote in favor of keeping the plant open would add to the recent momentum toward nuclear power not only in the U.S. but globally.

U.S. Space Program:  Earlier today, NASA was forced to temporarily scrub the planned launch of its Artemis I rocket for a trip to the moon, based on unresolved problems with the rocket’s engines.  Getting the program back on track would help ensure the continuance of the program, along with hefty revenue streams to its major aerospace contractors, even though it has been criticized for its cost.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment examines why Thursday’s economic data could encourage the Fed to raise rates more aggressively. Next, we explain how elections in Russia could impact its war with Ukraine. We conclude the report by discussing the U.S.-China rivalry and how it could impact Asia.

More Hikes? The positive Gross Domestic Income (GDI) report for Q2 could overshadow the negative Gross Domestic Product (GDP) numbers and pave the way for more Fed tightening.

• An alternative measure of economic output has bolstered the Federal Reserve’s claim that GDP might not reflect the underlying fundamentals of the economy. In the second quarter, GDI, adjusted for inflation, rose at an annualized rate of 1.4% from the previous period. The number contradicts the GDP reading of a 0.6% drop in economic activity in the same period and suggests that the economy may not have contracted at all this year. In an ideal world, the two numbers should be identical, as total spending should equal total income. However, statistical differences between the two variables have widened to levels never before seen in the series history.

• A strong labor market might be responsible for the divergence between the real GDP and real GDI. While GDP is the sum of the total market value of all the final goods and services produced, GDI is the aggregate income earned and cost incurred during production. In theory, the latter should reflect the underlying labor market strength. Although the initial claims have risen over the last few months, many workers that reentered the workforce were able to find jobs quickly. As a result, the tight labor market may have shielded the economy from the negative impacts of monetary tightening.
• The positive GDI number could push the Fed to raise interest rates aggressively over its next few meetings. St. Louis Fed President James Bullard has insisted that the central bank should lift its policy rate to 4.0%. Kansas City President Esther George has advocated that the bank should go even further. Assuming that the FOMC follows Bullard’s lead, it would suggest that they could raise rates by 50 bps in each of its next three sessions. Hence, financial conditions could tighten significantly throughout the rest of the year and possibly worsen in 2023.

The market will be on pins and needles when Fed Chair Jerome Powell gives the keynote address at the Jackson Hole Symposium. Over the last two days, investors have purchased more than    $1 billion in short-term bond ETFs and have pulled over $2 billion from ETFs attached to the S&P 500. So far, it is speculated that Powell will make hawkish comments during his speech; however, a dovish tone could lead to a strong rally.

Russia-Ukraine: The Kremlin is ramping up pressure in Ukraine to solidify gains before election season for Russia begins in September.

• Russian President Vladimir Putin signed an order to boost the Russian troop total by 137,000 to 1.15 million. It was the first time that Putin had expanded the military headcount in over five years. The new decree has added to speculation that Russia believes that the war will be protracted. However, there is also the possibility that the order could be a bluff. Russia has not been able to take over Ukraine as swiftly as it initially implied it would. In short, Putin likely has a credibility problem. The war has lasted six months despite assurances from Putin that the conflict would only be a few weeks. Additionally, the government was forced to delay annexation referendums in Donbas due to its inability to secure the region properly. Thus, the Kremlin’s decision to increase the number of troops could be a way to signal to its population that the Russian military is still determined to win.
• The Moscow exchange plans to allow evening trading next month. Stock trading was halted for a month after the conflict began as the government attempted to hide the financial damage of the war. The government then began to allow limited securities trading in the morning sessions. The Russian Central Bank has maintained that regulators will block investors from “unfriendly” countries from trading on the exchange. The move to open the market for a full day reflects the government’s attempt to show a return to normalization after the invasion of Ukraine.
• Ukrainian President Volodymyr Zelensky has stated that the world narrowly avoided a radiation disaster. On Thursday, Ukraine’s largest power plant was forced to disconnect after fires damaged a transmission line. The incident has heightened concerns that the war could lead to a major nuclear disaster as Russian forces continue to use the power plant as a shield against attacks from Ukrainian troops. In addition, there was a mass power outage in areas nearby. A nuclear accident in Ukraine could lead to a global crisis and possibly slow the global push to use nuclear energy in other countries.

Elections are essential, even for authoritarian governments. Regional elections will take place on September 11, and this will be the first time Russian constituents are able to showcase their level of satisfaction with the government. A low turnout would suggest that the war has dented sentiment in the country. It could also force Putin to take more extreme measures to end the war as he prepares to run for reelection in early 2024.

Asia Risks: Friction between the U.S. and China remains the top risk in Asia.

• Regulators in the U.S. and China achieved a breakthrough in negotiations to keep Chinese firms listed on American exchanges. Chinese regulators have requested major accounting firms to bring relevant audit documents of Chinese firms to the U.S Public Company Accounting Oversight Board. The order will prevent Chinese companies from being delisted from American exchanges. Although this is a positive development, it does not change the trajectory of the U.S.-China relationship.
• Tensions between the U.S. and China continue to escalate as U.S. lawmakers continue to travel to Taiwan. Senator Marsha Blackburn (R-TN) is the third politician to travel to the self-governing island this month. House Speaker Nancy Pelosi (D-CA) and Senator Ed Markey (D-MA) also made the trip. China responded to the Pelosi trip by holding military exercises near Taiwan. Thus, Blackburn’s trip could also have a similar response. The big takeaway is that American lawmakers believe it is politically beneficial to poke China in its eye over Taiwan. Although China’s reaction has been mild, relative to its threat to the U.S. “not to play with fire,” their response to such provocation could escalate after President Xi is sworn in for a third term. Therefore, we still believe the risk of conflict between the U.S. and China remains elevated.
  • Additionally, China has urged the U.S. not to engage India in planned military drills along the two countries’ shared border, referred to as the Line of Actual Control (LAC). China believes that such exercises would violate the Beijing-New Delhi accords.
• China’s assertiveness has finally pushed Japan to ramp up its defense budget drastically. The Japanese government will double its defense spending over the next five years to address national security threats. In June, the government released a report showing the country’s concern about the Russia-Ukraine war, China’s intimidation of Taiwan, and their vulnerable supply chain technology. Behind only the U.S. and China, Japan will have the third largest military budget in the world.

The rivalry between the U.S. and China could lead to a broader war in the Indo-Pacific. Many countries in the region fear China’s rise as a military power and look to expand their capabilities in the event of a conflict. Although we do not expect tensions to rise significantly over the next few months, we do believe that the Chinese will become more assertive after the National Party Congress in the fall. The increase in defense spending likely favors our analysis that defense industries are positioned to benefit from increased global tensions.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with an explanation as to why traders believe that central banks will become more hawkish over the next few months. Next, we review the ramifications of President Biden’s student loan forgiveness program. Lastly, we will give our thoughts as to whether the U.S. should intervene in Ukraine to protect the country’s nuclear power plant and what it could mean for financial markets.

 A Hawkish World: Market participants have placed bets that major central banks will raise rates aggressively in their next meetings.

• A day before Federal Reserve Chair Jerome Powell is set to speak at Jackson Hole, investors have dampened expectations that the central bank will alter its policy path. There has been speculation that the Fed will stop tightening late this year or early next year due to the poor economic data and a reduction in inflation. However, recent comments from Fed officials have tapered down those expectations. For example, Kansas City Fed President and voting member Esther George advocated that the Fed should discuss the pace of future rate hikes but continue to raise rates until inflation is firmly under control.
  • Investors have already baked in the possibility of a pause in 2023. Thus, Powell’s remarks stating the contrary could lead to a violent reaction from markets. In the chart below, the green line represents the implied three-month LIBOR rate from the two-year deferred Eurodollar futures, and the red line shows the fed funds target rate. The Fed usually begins to cut rates once the two lines cross. Although the model does not signal an imminent rate cut, the finish line is clearly in sight.

• In Europe, elevated inflation has led money market funds to place bets that the European Central Bank will raise rates by 100 bps by its October meeting. That would put the central bank’s key rate at 1.00%, the highest level in over a decade. The bank has faced pressure to become more hawkish after inflation in the Euro area outpaced the U.S. in July for the first time since the pandemic. Additionally, the increase in energy prices due to the Russia-Ukraine war still threatens to worsen European inflation in the winter. If the ECB raises its policy rate, the rise in borrowing costs will likely hurt riskier southern European economies disproportionately. In other words, investors will demand an additional risk premium to lend to those countries due to their high debt burdens and relatively weak economies.
• • Investors have piled onto bets that Italian bonds will fall. The total value of Italian bonds that traders have wagered against has hit its highest level since the financial crisis. The prospect of higher European interest rates and a return of right-wing populists to power has added to investor concerns that the country may struggle to repay its debts.
• Chinese regulators have pressured banks not to sell the yuan in order to prevent further devaluation of the currency. The slowdown of the Chinese economy coupled with hawkish U.S. monetary policy have pushed the yuan down against the dollar. Currency depreciation, especially for commodity importers, can add to inflationary pressures because most goods are priced in dollars. As a result, if the currency continues to drop against the dollar, the People’s Bank of China could be forced to remove monetary accommodation, which would lead to slower GDP growth for China and could hurt the global economy.

The strong dollar poses a significant threat to international equities, particularly as oil and gas prices remain elevated. Because Fed tightening has contributed to the dollar surge throughout the year, a reversal could provide a tailwind for struggling economies. That said, Fed officials have made it clear over the last few weeks that it would like inflation to drop before it decides to reverse course. As a result, we maintain our position that the current investing environment does not favor international equities.

Student Loan Debt Relief: President Biden announced student loan forgiveness of up to $10,000 for students making under $125,000 a year.

• The debt forgiveness program will likely have minimal impact on financial markets. Only 13.5% of the population has student loan debt, therefore, it does not impact many people. So far, economists have not been able to show any significant economic effects. Bloomberg estimates show that the executive order could add up to 0.2% to annual inflation. However, there is a possibility that consumer confidence could receive a temporary lift. Thus, from an economic standpoint, the order is fairly insignificant.
• There is speculation that the student loan forgiveness program could provide some relief for the housing market. Although the recent home-price surge has disproportionately hurt young adults, most of the proposed debt relief will not go to low-income households. As a result, the financial positions of the most vulnerable potential homebuyers will not change significantly because of this executive order.

(Source: Strategas)

• The program could impact President Biden’s reelection ambitions if he decides to run again in 2024 but will likely not change the outcome of mid-term elections in the fall. Millennial and Gen Z voters make up a vital block for Democrats; however, recent polling has shown that these groups’ enthusiasm has dipped significantly since the 2020 election. Although President Biden has seen a recent surge in popularity, the Democrats are still heavily favored to lose the House and are only slightly favored to maintain the Senate.

The recent decision by the President to forgive student loans will have political ramifications. Essentially, Biden has decided to show favoritism to a critical voting bloc. Although this is not unusual for a president, especially when elections are near, it does raise the likelihood of a potential voter backlash during mid-term elections in November. Generally speaking, a deadlocked Congress is favorable to equities because it means that laws will be unlikely to change significantly. Hence, a Republican takeover of either or both houses in Congress should be viewed favorably by markets.

Russia-Ukraine Update: Russia has raised the stakes of its invasion of Ukraine with its seizure of the Zaporizhzhia nuclear plant.

• Russian forces have occupied the Zaporizhzhia nuclear plant for six months. The power plant is the largest in Europe and contains six of Ukraine’s 15 functional reactors. The country has relied on nuclear power for its energy needs to reduce its dependence on Russia. Thus, Russia’s occupation of the area poses a severe risk to Ukraine’s power supply. If the Kremlin decides to take the plant offline, citizens would be forced into a virtual blackout. Although this scenario has yet to bear fruit, there is speculation that Russia could attempt this in the winter.
• President Biden has received calls for the U.S. to aid Ukraine in its effort to remove Russian troops from the power plant. Ukrainian and former U.S. government officials have urged the White House to send military personnel to secure the site and protect the International Atomic Energy Agency inspectors.

A nuclear disaster at the power plant could disrupt the global supply chains, hinder food production, and make energy problems much worse. Although it is unlikely that the U.S. would send military to help secure the area, President Biden will likely be forced to step in if the situation deteriorates into a global crisis. A potential nuclear disaster could have a seismic impact on financial equities. We will continue to monitor this situation closely.

View PDF