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.  Today is Ukraine’s national Independence Day and marks six months since the start of the war.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the European drought, tension in Brazil, and the latest student loan forgiveness program.

Russia-Ukraine:  Russian and Ukrainian forces continue to make only limited attacks and territorial gains against each other, but momentum continues to shift gradually toward the Ukrainians.  One piece of evidence in that regard is that Russia has reportedly been forced to transfer more national guard forces to the Russia-supporting province of Luhansk in eastern Ukraine to maintain order as more citizens there begin to oppose the war.  Separately, reports indicate that Russian President Putin has lost so much trust in Defense Minister Shoigu that he has taken direct control over many of the Russian units fighting in Ukraine.

• In an address today to mark Ukraine’s Independence Day, President Zelensky said the country had been reborn because of Russia’s invasion, and he defiantly vowed that Russian forces would be pushed out of all Ukrainian territory. As if to emphasize the point, Ukrainian forces destroyed another Russian ammunition dump in occupied territory in the country’s east.

European Drought:  A new report by an EU research center says about 47% of the EU is under drought warning conditions and 17% in drought “alert,” meaning vegetation and crops are being affected.  The report also warns that the drought is having a severe impact on hydroelectric production and is threatening the cooling systems of other energy facilities.  The report projects that the drought will persist until November, prolonging the risk of food production disruptions, high energy prices, and the associated economic headwinds.

United Kingdom:  As Foreign Minister Liz Truss and Former Chancellor Rishi Sunak continue to battle it out to succeed Boris Johnson as Conservative Party leader and prime minister, the prolonged mudslinging is starting to erode popular support for the party.  The latest polling shows support for the opposition Labor Party is currently 12 percentage points higher than the support for the Conservatives. However, although there is still some chance that the Conservatives could recover once their leadership race ends in a couple of weeks.

Japan:  Prime Minister Kishida reportedly plans to announce that Japan will not only restart several nuclear power plants shuttered after the 2011 meltdown at Fukushima but will also start studying the construction of new, modern plants.  The move would mark a major policy shift in Japan, which had virtually shut down its nuclear sector after the Fukushima disaster.  The move could also be a harbinger of a broader re-embrace of nuclear power globally.

China-Vietnam:  Sources say Apple (AAPL, $167.23) is in talks to produce its Apple Watches and MacBooks in Vietnam as it expands its effort to diversify production away from China.  Even though Apple is still reluctant to stray too far from China, its effort to move more production to Vietnam illustrates how Western countries are increasingly wary of putting all their eggs in the Chinese basket as U.S.-China tensions worsen.

Brazil:  In a major escalation of political tensions, Brazil’s electoral court ordered searches of the homes of several prominent businessmen over their alleged support for an undemocratic seizure of power if President Bolsonaro loses his re-election bid this autumn, as anticipated.

United States-Iran:  In the negotiations to restart the 2015 deal limiting Iran’s nuclear program, U.S. diplomats said “gaps” remain in Iran’s response to the EU’s “final draft” of a new deal, despite some progress being made.  Given that Iran evidently continues to make progress on its nuclear development, which would reduce the benefit of a new deal, it is looking increasingly unlikely that a substantive new agreement will be reached.

U.S. Monetary Policy:  At an event yesterday, Minneapolis FRB President Kashkari said that when consumer price inflation is as high as it is now, the Fed should err on the side of tighter monetary policy and not worry too much about putting the economy into recession.  Even though Kashkari isn’t a voting member of the Fed’s policymaking committee this year, his statement may reflect the sentiment of other policymakers.  His statement, therefore, adds to concerns that investors may be placing too much hope on a near-term Fed pivot toward lower interest rates.

• Meanwhile, the Kansas City FRB kicks off its conference in Jackson Hole, Wyoming, today, with Fed Chair Powell set to deliver his keynote address on Friday morning. Investors remain concerned that Powell will also push back on recent market expectations (hopes?) that the policymakers will soon pause their aggressive interest-rate hikes or even pivot to cuts.
• One important impact of the Fed’s rate hikes is that they’ve helped boost borrowing costs worldwide, including in less developed countries. Those countries are now burning through their foreign currency reserves as they deal with higher interest rates and higher prices for food and energy imports, potentially setting up more emerging market debt defaults.

U.S. Fiscal Policy:  President Biden today reportedly plans to announce a student loan forgiveness program that would cancel up to $10,000 of student debt for people making less than $125,000 per year or married couples making up to $250,000 per year.  The action is expected to eliminate student debt for about 15 million people, although the program is also likely to generate legal and political pushback, in part because of its impact on the federal budget deficit.

U.S. Energy Markets:  When we wrote our Comment early yesterday morning, we mentioned that natural gas prices at the time were surging on concern about another cutoff of Russian gas supplies to Europe.  Later yesterday, however, Freeport LNG announced that it would delay the restart of its LNG export facility in Texas, which has been shut down for repairs after a fire several months ago.  With U.S. gas exports now expected to be impeded for longer than previously thought, gas has fallen back below $10.00 per BTU and is currently trading at approximately $9.37.

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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 military operations remain relatively quiet.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more evidence of financial volatility and economic weakness in Europe.

Russia-Ukraine:  Russian forces continue to make only the most limited of territorial gains in Ukraine’s eastern Donbas region, and some observers suggest those gains have only been possible because the Ukrainians are thinning out their lines in the region in order to move more troops to the Kherson area.  The Ukrainians continue to suggest they will launch a counteroffensive to retake the city of Kherson and surrounding areas from their Russian occupiers, and in recent weeks they have taken some steps toward preparing for that counteroffensive.  Lately, however, we have seen very little sign of the counteroffensive ramping up in earnest, suggesting the Ukrainians may have changed their plans.

• Since tomorrow is Ukraine’s national Independence Day, the U.S. warned that Russia could use the occasion to increase its artillery and missile strikes against civilian areas.  Wednesday also marks the sixth month since the start of the war.
• Russia now says the assassin who killed nationalist commentator Daria Dugina in a car bombing over the weekend has fled to Estonia.  That accusation could be used as an excuse to threaten the Baltics, and there is probably some chance that the bombing was a false flag attack expressly for that purpose.  However, we suspect it could also reflect Russia’s own rough-and-tumble internal politics.
• As the U.S. and other Western allies continue to provide more advanced weapons to the Ukrainians, the momentum in the war appears to be shifting slightly in their favor.  We continue to see reporting that suggests that Western governments are secretly sending more advanced weaponry than they have publicly acknowledged.

Global Energy Markets:  Saudi Arabia Energy Minister Prince Abdulaziz bin Salman has warned that OPEC and its Russia-led allies may cut their crude oil production because of the recent volatility in futures markets.  In response, global oil prices have jumped almost 1.4% so far this morning, with Brent now trading at $97.82 per barrel.

• We would note that key members of the OPEC+ alliance haven’t been able to meet their production targets.  Most importantly, some analysts have questioned how much spare capacity Saudi Arabia really has.  An announced production cut might, therefore, have relatively little impact on actual supply.  The energy minister’s statement could well have been geared merely to reverse the recent softening in oil prices as investors grew more concerned about weakening economic growth across the globe.
• Meanwhile, Russia’s latest announced “maintenance” shutdown of the Nord Stream 1 natural gas pipeline to Europe and high demand for air conditioning in Europe’s heatwave continue to buoy gas prices.  U.S. natural gas futures have reached $10.00 per BTU, up some 20% over the last month and equal to their highest level in 14 years.
• Reflecting the difficulties and long lead-time likely required to secure Europe’s energy security, Belgium Prime Minister Alexander De Croo has warned that the Continent’s next “five to ten winters will be difficult.”

Eurozone Financial Markets:  While the major central banks’ monetary tightening has affected financial markets all over the world, there is increasing evidence that the ECB’s reduced bond buying has stoked volatility in the Eurozone’s bond market.  For example, German government bond yields have recently been more volatile than at any other time in the last decade, and spreads between German and Italian yields are reaching concerning levels again.  Fears of a looming recession and Europe’s usual summer trading lull have also sapped liquidity.

Eurozone Economy:  As shown in the Foreign Releases section in the pdf, S&P Global’s flash composite purchasing managers’ index for August fell to 49.2, as compared with 49.9 in July.  As with most major PMIs, the index is designed so that readings below 50 signal contracting economic activity.  Now that the index has been below that mark for two straight months, it’s becoming clearer that the European economy is indeed slowing and could be on the verge of the recession many analysts are already expecting.

• The news has helped push the euro down even farther so far this morning.
• The currency is currently trading at $0.9920, its lowest level in some 20 years.

Hong Kong:  The municipal government reported 6,617 new cases of COVID-19 yesterday, marking the sixth straight day in which the tally topped 6,000.  Officials have also said the city now has multiple transmission chains, raising the prospects of a sharp clampdown under President Xi’s Zero-COVID policy.

U.S. Labor Market:  Teachers at the Columbus School District, the largest in Ohio, have voted to strike over a wide range of issues including classroom sizes, teacher pay, caps on the number of class periods in the day, and heating and air conditioning availability in school buildings.  As we’ve noted before, falling labor force participation and fast economic growth have tightened labor markets in many countries, giving workers the leverage to demand better pay and working conditions.  If the wave of strikes drives up labor costs enough, it would help keep inflation high and erode corporate profit margins.

U.S. Apartment Market:  New details show that some 420,000 apartment units are due to be completed in the U.S. this year, marking the highest rate of completions in 50 years.  Initially, many of those new units will likely be snapped up by people shut out of the single-family home market by soaring prices and high interest rates.  Eventually, however, the new units could help bring down rents and inflation rates.

U.S. Military:  As we’ve mentioned previously, U.S. military forces have been facing huge challenges in recruiting new members, with the Army likely to end up with far fewer troops than planned in the next year or two.  Now, it turns out that applications to West Point and the other highly selective, prestigious service academies are down 10% to 30% from last year.  The shortfalls reflect problems ranging from the strong labor market, declining interest in the military after the long U.S. wars in Iraq and Afghanistan, and restrictions on in-person recruiting during much of the pandemic.

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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 very few new territorial gains are being made by either side, but the weekend assassination of a Russian nationalist influencer has sparked concern that Russia may now be forced to intensify its efforts.  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 words on this week’s Federal Reserve conference in Jackson Hole, Wyoming, where officials could well push back against the market’s recent optimism about a halt to interest-rate hikes.

Russia-Ukraine:  It now appears that Russia has exhausted its limited offensive capabilities of the last few months, and it is now making very few territorial gains in Ukraine’s eastern Donbas region.  Meanwhile, it continues to dig in against an expected Ukrainian counteroffensive against the areas Russia controls around the southern city of Kherson.  Russia continues to use aircraft, missiles, and long-range artillery to attack targets around Ukraine, but that constitutes most of the damage it’s inflicting for the moment.  At the same time, the Ukrainians continue to leverage precision, long-range artillery and other systems from the West to destroy Russian logistics nodes and troop concentrations.

• In an interview with the Financial Times, Russia’s permanent representative to the UN in Geneva said he sees no possibility of a diplomatic solution to end the war and expects a long conflict, mostly because of what he suggested was unwarranted support for Ukraine from the West.
• A car bombing near Moscow on Saturday killed Daria Dugina, a hawkish political commentator and daughter of philosopher Alexander Dugin, who has loudly called for a re-establishment of the Russian Empire and has urged the Kremlin to escalate its attack on Ukraine.  Officials in Kyiv denied that they had anything to do with the attack, but the killing of Dugina still could push President Putin to increase his efforts against Ukraine.
• In a move that could further galvanize or help rejuvenate support for Ukraine in the West,  the leader of a Russian-backed breakaway statelet in eastern Ukraine announced details of plans to put captured Ukrainian soldiers on trial in Mariupol.  Ukrainian President Zelensky warned any such trial would mean an end to all negotiations between Kyiv and Moscow.
• New data from China’s General Administration for Customs showed that Russia remained the country’s biggest supplier of crude oil for the third straight month in July.  The figures illustrate how the war has pushed China and Russia closer into each other’s arms, accelerating the fracturing of the world into relatively separate geopolitical and economic blocs.

United Kingdom:  If you thought U.S. consumer prices are rising fast, and even if you thought U.K. prices were rising even faster, you ain’t seen nothing yet!  Analysts at Citigroup (C, $52.61) predict Britain’s consumer price index in January will be up 18.6% year-over-year, mostly due to Europe’s soaring natural gas prices and the planned lifting of price caps on that gas.

• Such an inflation rate would likely push the U.K. economy deep into recession and force the Bank of England to keep raising interest rates aggressively.
• Rising energy prices are also putting pressure on Foreign Minister Truss and Former Chancellor Sunak to spell out policies to address the cost-of-living crisis as they continue to campaign to succeed Boris Johnson as Conservative Party leader and prime minister.
• In addition to rising energy costs, the U.K. is also facing a wave of strikes as workers leverage the tight labor market to demand higher pay and better working conditions.  Today, barristers in the country’s criminal court system voted to go on strike beginning September 5, joining transport and other workers who have staged walkouts.  If the strikes lead to higher wage costs, they will also contribute to rising price pressures.

China:  As is normal shortly after the People’s Bank of China cuts interest rates, as it did last week, commercial banks in China have implemented a series of modest prime-rate cuts on commercial and household loans.  The biggest cut was in the benchmark five-year mortgage rate, which was reduced from 4.45% to 4.30%.  However, the rate cuts are quite modest and are not expected to give any major boost to the economy.

• While China has reopened from the most recent COVID lockdowns, the economy is still facing serious headwinds from pandemic uncertainty, government crackdowns on property development and technology, and other factors.
• Southwestern China also continues to face a debilitating drought and heatwave, which has reduced hydroelectric production and prompted the government to impose energy conservation rules.

China-Taiwan-Japan:  Following a number of high-profile visits to Taiwan by U.S. lawmakers to show their support for the island democracy, a delegation of Japanese parliament members has begun a similar three-day trip to Taipei today.  The Japanese visit underscores how Tokyo has thrown its weight behind the U.S.’s effort to counter China’s growing geopolitical aggressiveness in the region.

Pakistan:  Former Prime Minister Khan has been charged with terrorism offenses after a weekend political rally in which he warned that his supporters “won’t spare” the officials from current Prime Minister Sharif’s government who were responsible for detaining Shahbaz Gill, one of his allies, earlier this month.  Khan’s supporters are seeing the charges as an attempt to silence Khan politically.  The rising tensions threaten to produce further political instability in Pakistan.

United States-South Korea:  Today, for the first time in four years, the U.S. and South Korea will begin more than a week of live military exercises together.  The joint drills will signal stronger cooperation between the two allies as the threats from China and North Korea increase, although they will also likely increase tensions with those two countries.

Canada:  Prime Minister Trudeau’s government is proposing that farmers cut their use of fertilizers in order to reduce their emissions 30% from 2020 levels by 2030, with those refusing to do so facing reduced eligibility for green investment incentives.  Although the government so far isn’t facing the intense backlash seen in the Netherlands when its government proposed new farming rules to reduce greenhouse gas emissions, farmers and farm-dependent provinces in Canada are pushing back strongly against the proposal.

U.S. Monetary Policy:  The Kansas City FRB opens its annual conference in Jackson Hole, Wyoming, starting on Wednesday, and investors are bracing for the possibility that Fed Chair Powell and other policymakers will push back against the recent market optimism over the possibility of a pivot toward interest-rate cuts.  Stock futures, bonds, cryptocurrencies, and a range of commodities are trading weaker this morning, while the dollar is up.  In addition, the euro has fallen back below parity, recently trading around $0.9900.

U.S. Education Policy:  In an interview yesterday, Education Secretary Cardona called on school districts to provide more competitive salaries to teachers, improve their working conditions, and give them a greater voice in school administrative decisions.  That follows on the Biden administration’s call for school districts to help alleviate the national teacher shortage by providing pay increases with part of the money they received last year from the administration’s pandemic relief program, although many Republicans want to alleviate the shortage by loosening teacher licensing standards.

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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 concerning central bank policies and how they may help foreign currencies to appreciate against the dollar. Next, we review whether the U.S. and China’s power struggle in Asia could benefit U.S. firms with domestic operations. We end the report with our thoughts about the latest developments in the Russia-Ukraine conflict.

Central Bank News: Mixed messages from the Fed regarding whether it will keep raising rates next year could allow foreign currencies to appreciate against the dollar.

• There is a split among Fed members about whether the central bank should raise rates until inflation is firmly under control or raise rates into restrictive territory and pause. In the former camp, Minneapolis Federal Reserve Bank President Neel Kashkari, the most hawkish member of the Fed, asserted that the central bank needs to urgently bring down inflation and has hinted that a recession may be necessary in order to restore price stability. Kansas City Fed President Esther George stated that the pace of hikes is debatable but that ending tightening before inflation has fallen is not. In the latter camp, San Francisco Fed President Mary Daly and St. Louis President James Bullard argued that the bank should raise rates but be cautious not to overdo it.
  • If the U.S. falls into a recession, the Fed could be pressured to back off on raising rates. As a result, some policymakers may be uncomfortable with committing to raising rates in 2023 for fear of political backlash.
• The Bank of Japan will maintain its ultra-loose monetary policy even as inflation rises above its target of 2 percent. In July, headline CPI rose 2.61% from the prior year, its fastest pace in almost eight years. The bank’s insistence on maintaining an accommodative policy is due to the country’s excessive debt burden. If it allowed rates to rise by lifting its yield cap, the government would have more difficulty servicing its interest payments. Additionally, the drop in energy prices has allowed the yen to slightly appreciate against the dollar from its yearly low in July. As a result, the central bank will likely not change its monetary stance anytime soon.
  • Despite the strong reading, inflation in Japan is still relatively low compared to the rest of the world. As the chart below indicates, Inflation rose 1.2% from the prior year when energy and food are excluded.

• Speculators predict that the policy rate of the Bank of England will surpass that of the Federal Reserve in one to three years. In July, U.K. headline CPI rose 10.1% from the prior year, while U.S. inflation was 8.6% in that same period. The increased inflation rate suggests that the BOE will need to become more hawkish in order to control inflation. The Bloomberg implied market rate shows that the BOE could lift its rate to 3.75% and cut after that.

The U.S. dollar value surged against other currencies throughout 2021 and 2022 due to the country’s relatively strong economic growth and hawkish monetary policy. This dollar strength could ease, however, as the American economy slows, and the Fed relaxes policy tightening. This outcome will benefit commodity-reliant countries like Japan and provide a tailwind for firms with significant foreign revenue exposure.

Asia News: The U.S. and China’s power struggle continues to play out in Asia.

• The U.S. and China continue to bicker over access to the Taiwan Strait. South Korea and the U.S. will participate in joint military exercises next week. During these activities, the countries will navigate their ships through the strait. China considers movement within the Taiwanese waters as a provocation, claiming the body of water represents Chinese territory. The dispute over transit routes is an example of escalating tensions between the two major powers. As a result, we suspect that the decoupling between the U.S. and China will continue and could be detrimental to U.S. firms with revenue and supply chain exposure in China and Taiwan.
• Against U.S. wishes, Russian President Vladimir Putin will attend the G-20 meeting in Bali. The White House has pushed Indonesia to exclude Russia due to its invasion of Ukraine. Indonesia’s decision to allow Putin to participate in the summit is another example of how countries are attempting to remain neutral in the rivalry between major powers. In the short term, the nonaligned countries may benefit from competition from major powers trying to win over their support. Indonesia, for example, recently secured wheat supply from Russia while maintaining U.S. military presence in the Pacific. However, this strategy isn’t perfect. During the cold war, nonaligned countries could not prevent proxy battles from breaking out in nearby regions. Therefore, the neutrality of countries could lead to more instability in Asia.
  • On an unrelated note, Indonesia is considering an export tax on nickel. The levy will weigh on automakers’ profit as the commodity is essential for EV batteries, and Indonesia is the largest producer of this metal. By imposing a tax, the government hopes to convince car companies to build factories in Indonesia.
• The U.S. warned North Korea against performing another nuclear test. The warning came soon after North Korea launched two cruise missiles off its west coast. The country’s rapid improvement in its military capabilities raises the prospect of a war on the Korean peninsula. Although China does not support the nuclearization of North Korea, it has improved its trade relationship with Pyongyang in light of recent weapons tests. The conflict in Korea is likely the second most significant geopolitical event in Asia and threatens to add to the global supply chain worries on the continent. We will be monitoring this situation closely.

Competition between the U.S. and China threatens firms’ ability to operate in Asia. As tensions continue to rise throughout the continent, firms could also struggle to find ways to make both sides happy. Although nonaligned countries appear to be a haven for firms looking to remain neutral, relocating to these areas will be risky. This outcome could benefit American companies with operations solely in the U.S.

Russia-Ukraine update: The cost of the war is rising, but a reshuffling in European governments could pave the way for an end to the war.

• Russian officials may shut down the main nuclear plant in Ukraine on Friday. Russia has warned that it needs to switch off the power plant to prevent a human-made disaster due to the war. However, Ukrainian officials argued that the plant shut down is related to Russia wanting to stage a large-scale provocation that could lead to a nuclear disaster. Such an incident could threaten to create an international crisis.
• Italians expect Russian interference in the upcoming parliamentary elections in September. Russian officials have urged Europeans to push out elected officials that support Ukrainian war efforts. The possibility of interference will likely undermine the election’s credibility and could lead people to stay home. That said, Italy’s right-wing bloc appears to be in a prime position to take over the government after the election. Although the leader of the most popular party, Giorgia Meloni, supports Ukraine, other parties within the right-wing bloc, such as the Forza Italia and the League, do not. As a result, it is possible that Italy could weaken its support for Ukraine after the election.
  • Ukraine needs the support of the West to maintain its war effort. If European countries begin to pull their support of Ukraine, it may be forced into accepting an unfavorable peace deal with Russia. The end of the war would be favorable to risk assets.

Wars are unpredictable and the conflict in Ukraine is no different. The potential of a nuclear disaster may force an international response and hurt global economic growth. The Chernobyl nuclear disaster not only impacted people but also contaminated forest and farmland and led to deformed livestock. That said, political shifts in Europe may help Russia change the tide of the war in its favor. At this time, we still view Europe to be a risky place to invest.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment is split into two sections. In the first half, we explain why speculation about a Fed pivot is premature. We briefly summarize the meeting minutes, show the market’s reaction, and discuss how the strong jobs market will affect the central bank’s decision to raise rates. In the second half, we review reports indicating that regional bloc formation can change over time. We discuss India’s military exercises with U.S. rivals China and Russia, Beijing’s reaction to the U.S. trade negotiations with Taiwan, and Turkey’s growing disenchantment with the West. After each section, we provide a synopsis of the stories covered and their possible ramifications.

 Central Bank News: Meeting minutes revealed the Fed’s openness to a pivot, but employment and inflation data suggest that monetary tightening is still needed.

• The Federal Reserve meeting minutes reinforced the market’s dovish perception of the central bank. Although Fed officials agreed unanimously to raise rates by 75 bps at the July 27 Federal Open Market Committee meeting, the minutes revealed that policymakers were also concerned about the economy. Fed officials noted that specific interest-rate-sensitive sectors, such as housing, were hurt by higher rates and warned the impact would spread into other areas of the economy. Additionally, it mentioned that some officials could support a pause once the rates reach the restrictive territory.
• Investor optimism that the Fed will end its tightening cycle before achieving its 2% target is misguided. On Wednesday, the S&P 500 pared back most of the day’s losses, Treasury yields dipped, and the dollar fell from the day’s high. The market’s reaction suggests that a recession will force the Fed to change its policy path. However, the minutes revealed the central bank is only focused on achieving its dual mandate of price stability and low unemployment.
• Prediction of policy moderations is overblown. The Fed would like the labor market to show tangible signs of deterioration before it ends its tightening cycle. The July employment payrolls report exceeded expectations, and the unemployment rate dropped from 3.6% to 3.5%. The Fed fears that an overly tight labor market leads to wage pressure, thus contributing to inflation. As a result, it is unlikely to stop raising rates as long as inflation remains high, and the unemployment rate is low.
  • Another reason for our skepticism of a Fed halt or reversal in its policy path is real fed funds. The Fed has never stopped tightening with a negative real Fed funds rate, which stands at -6.82% as of August 10. The Fed would need to raise rates almost 700 bps before the real Fed funds returned to positive territory.

The period of ultra-low inflation has likely passed, but it was good while it lasted. Although the Federal Reserve remains optimistic that slower economic growth will eventually resolve supply chain issues, we are not. Ongoing geopolitical tensions in Europe and Asia will make firms rethink their supply chains. Relatively safe countries that are friendly to the U.S. will be attractive destinations for firms looking to move their operations. That said, in the short run, labor will be able to extract higher wages from their employers, especially as the U.S. unemployment rate remains low. As a result, we believe investors should position themselves to adjust to a higher interest rate and inflation environment.

Geopolitical Tensions: Regional blocs are forming in ways that are hard to predict in the long run.

• U.S. ally India will join China, Russia, and Belarus for joint military exercises. India’s participation highlights the delicate balance countries are playing not to align with major power blocs. Its decision to play both sides isn’t without precedence. India was one of the founding members of the nonalignment movement during the cold war. The U.S. has recently turned a blind eye to India’s buying of Russian fuel and weapons. However, it isn’t clear if they will continue to do so indefinitely. The U.S. has built closer ties with India as a way to isolate China in the Indo-Pacific region. If it turns out that India is cozying up to China, the U.S. could back away and look for an alternative country to challenge China’s dominance within the region.
  • India has been a significant foreign direct investment target over the last two years. Firms have relocated manufacturing and service operations to the country due to its vast labor market and relatively low costs. If India’s relationship with the U.S. begins to sour, it could force firms to change tactics and look elsewhere.
• The U.S. continues to annoy China with its flirtation with Taiwanese recognition. The White House plans to hold trade discussions with Taiwan in the fall of this year. The talks have angered China, which views the gesture as another attempt to undermine its sovereign claim over the self-governing island. Although the negotiations are unlikely to lead to conflict, they may pave the way for further escalation. Hence, the possibility of a direct confrontation between the two major powers remains elevated. Firms with considerable revenue exposure or deep supply chains within China or Taiwan may be at risk.
  • Despite the dangers, European firms are still investing in China. Financial inflows from Europe increased 15% in the first half of  2022 compared to a year earlier. The increased investment suggests that firms are prioritizing short-term gains over long-term security.
• Internal rivalries within the Western military alliance threaten the group’s commitment to supporting Ukraine. To the annoyance of Ankara, Greece has played a central role in the U.S.’s ability to transport weapons to the Ukrainians. The Mediterranean nations have a long and heated rivalry, including conflict over Cyprus and other territorial disputes. Turkey fears its ties with the U.S. are threatened by Greece’s growing importance in the war. The growing closeness between the U.S. and Greece can partially explain why Turkey has built closer economic relations with Russia. The breakdown of the Western alliance will likely make it harder for Ukraine to maintain its war efforts and could pave the way for the war’s conclusion. Any end to the conflict will be taken positively by markets.
  • Turkish President Recep Tayyip Erdoğan will meet with Ukrainian President Volodymyr Zelensky to discuss steps to end the war.

The reshuffling of allies is not unusual during times of war. During World War II, Italy notoriously declared war on its former Axis partner Germany. Therefore, as regional blocs start to form, we do expect that certain countries could decide to switch sides or choose to fly solo. Over the last few weeks, we have been paying close attention to the European Union. Although it has historical and economic ties with the U.S., its reliance on Russian energy and its exposure to China shows its interests are not fully aligned with its American counterparts. We are not predicting a break of ties but rather that the two regions may push for separate aims. If we are correct, the lack of foreign policy cohesion between the U.S. and Europe could severely complicate firms’ ability to operate in different countries.

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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 Russians continue to face troop constraints and the Ukrainians continue to find success in attacking Russian troop concentrations and logistical nodes.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine:  Russian forces continue to make small, incremental territorial gains in the eastern Donbas region of Ukraine, but we are seeing more reports of conscripts from one ethnic Russian part of the region refusing to fight other ethnic Russian parts.  The reports are consistent with other signs that Moscow’s troop depletion and reliance on a hodgepodge of volunteers and other less-qualified troops have left it with a relatively ineffective fighting force.  Adding to morale problems, there are also reports that Moscow is failing to pay some Russian reservists and volunteers fighting in Ukraine.  Meanwhile, Ukrainian officials urged civilians around the Russian-occupied southern city of Kherson to evacuate so Kyiv’s forces could continue ramping up their counteroffensive to retake the area.

• Separately, it appears that the Ukrainians have exploded another of Russia’s large ammunition depots far from the front lines in occupied Crimea.  At least some of the successful attacks by the Ukrainians have involved precision, long-range artillery provided by the West, but some may also be the work of Ukrainian partisans or special operations forces.
• New official data from Turkey shows that the country’s exports to Russia from May to July were almost 50% higher than in the same period one year earlier.  The figures suggest that Turkey, ostensibly a U.S. ally and a member of NATO, has stepped into the breach to support Russia even as the rest of the West tries to punish it with sanctions.

European Energy Market:  As the EU looks for ways to cut its reliance on Russian energy, bloc officials are reportedly considering the possibility of lowering regulatory barriers to the mining and production of critical green energy materials such as lithium, cobalt, and graphite.  While it appears that any such deregulation of mining is still off in the future, even the consideration of such an idea seems to illustrate just how desperate EU leaders are to shore up their energy security.

Germany:  The ZEW Institute’s closely watched index of investor expectations fell to an 11-year low of -55.3, down from -53.8 last month.  Against the backdrop of the Ukraine war, surging energy costs, and rising inflation, the figures suggest investors are now more pessimistic about the German economy than they have been at any time since the Eurozone debt crisis more than a decade ago.

United Kingdom:  The Office of National Statistics reported that second quarter real wages fell by a seasonally adjusted 3.0%, marking their steepest decline in at least two decades.  According to the report, nominal pay rose 4.7% in the quarter, but that rise was more than wiped out by increased consumer prices.  As energy and other prices rise faster than wage gains, similar declines in real wages are being reported in countries across the globe.

China:  Property developers’ stocks have risen sharply today on rumors that the government will instruct state-owned institutions to guarantee their domestic bonds.  If true, the new government support would likely be targeted toward helping the developers complete homes that have already been paid for but not yet finished or delivered.  That could help stabilize China’s housing market and weaken one of the headwinds facing the Chinese economy, but the country and its financial markets would still face a range of challenges, such as unpredictable, draconian pandemic lockdowns, a regulatory crackdown on its technology industry, and fracturing trade and investment ties with the West.

Australia:  In what could be a major new scandal, Former Prime Minister Scott Morrison has been accused of secretly appointing himself as head of five separate ministries during the coronavirus pandemic.  Morrison has tried to defend himself by arguing that the moves were necessary to cut the risk of ministers contracting COVID-19 during the pandemic, but he is being widely pilloried for undermining democracy and government accountability, even by members of his own opposition Liberal Party.

Kenya:  Deputy President William Ruto has been declared the winner of last week’s presidential election with 50.5% of the vote, but his main rival’s supporters and some election commissioners are disputing the result.  The risk is that Kenya could be thrown into yet another round of political unrest and violence, adding to the overall instability sparked by rising commodity prices and high interest rates in many emerging markets.

U.S. Bond Market:  New analysis shows that just 6.2% of U.S. junk bonds are now trading at distressed levels, down from 11.6% as recently as early July.  The new study, which defines “distressed” bonds as those trading at a yield greater than 10.0% above comparable U.S. Treasury obligations, illustrates just how dramatically investors have jumped back into the junk bond market as they’ve come to expect the Fed will pivot to interest rate cuts as early as 2023.

U.S. Technology Trade:  In a potential scandal in the U.S., a new analysis shows that a Commerce Department-led process meant to review sensitive technology exports to China approves almost all requests and hasn’t stopped an increase in the sales of some particularly important technologies.  As a result, the U.S. continues to send to China an array of semiconductors, aerospace components, artificial-intelligence technology, and other items that could be used to advance Beijing’s military development.

• Given that being tough on China is now a political necessity for both Republicans and Democrats, it would not be a surprise if the news prompts tightened restrictions.
• The news therefore presents new regulatory risks for U.S. technology and aerospace firms that could be forced to cut their sales to China.

U.S. Agriculture Market:  Faced with a withering drought, cotton growers in the Southwest are abandoning up to 40% of the acres that they planted in spring, prompting forecasts for the weakest U.S. harvest in more than a decade and sending prices sharply higher.  Cotton futures prices rose some 13% in the last week, ending Monday at approximately $1.136 per pound.

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