by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment starts with a focus on the potential spillover effects of Russia’s invasion of Ukraine. Next, we examine policymakers’ dilemma of whether to promote growth or contain inflation. We conclude by discussing a possible rightward shift in U.S. policy.

Russia: The Ukraine war could potentially lead to new conflicts in other parts of Europe and the Middle East.

• NATO Secretary-General Jens Stoltenberg stated that the Ukraine war was the most dangerous moment in Europe since WWII and that Russia must not win it. He also suggested that NATO might act if Russia seeks to extend its military campaign into an allied country. His comments appear to be a veiled threat to Moscow not to provoke a NATO ally. Although the Kremlin has not directly mentioned another country, there are concerns that Russia could incite a war over Kosovo, a non-aligned country with NATO forces.
• Tensions in Eurasia pose a threat to the continent’s delicate commodity supply. Azerbaijan has reignited tensions with Armenia over the heavily contested Nagorno-Karabakh. On Thursday, Azerbaijan forces took over a strategic region in the disputed territory. While Moscow has forces stationed in the area to prevent clashes, the war in Ukraine has made Russia’s presence less effective. Thus, Azerbaijan’s advancement in Nagorno-Karabakh exemplifies how tensions between rival countries within Eurasia could heighten as war continues in Ukraine. Although many countries in Eurasia are typically ignored, disruptions in the region could make it harder for firms to secure natural resources. As a result, these conflicts could exacerbate the energy crisis in Europe.
  • It is estimated that the region contains over 31% of the world’s proven natural gas reserves, 17% of oil reserves, 23% of iron ore, 14% of gold, and 7% of copper.
• Vladimir Putin is expected to meet with Turkish President Recep Tayyip Erdoğan in Sochi on Friday. The two leaders will discuss the ongoing situation in Syria. Turkey would like to mount a military offensive against Kurdish fighters within Syria without worrying about a possible conflict with Russian troops stationed in the area. Because Turkey is a NATO ally, a conflict with the Russian military could lead to a broader conflict that includes other members of the security pact.

A broader war in Europe would rattle financial markets and could make commodity supply concerns deeply entrenched. As a result, we expect European firms may look to set up operations in areas that are resource-rich and relatively safe, like the U.S. and Canada.

Inflation worries: Around the world, governments struggle to determine whether they should prioritize inflation or GDP growth when creating new economic policy.

• Chinese Premier Li Keqiang implied that the government would tolerate GDP growth rates below its target as long as inflation and unemployment stay under 3.5% and 5.5%, respectively. Like the rest of the world, China is seeing an increase in consumer prices. In June, headline CPI rose 2.43% from the prior year, its highest jump in over a decade. Keqiang’s remarks suggest that Beijing is reluctant to inject fiscal stimulus into the economy due to concerns that it might worsen inflation. The lack of government support in China will weigh on global growth.
• In the U.K., Liz Truss, the frontrunner candidate for prime minister, directed her ire at the Bank of England and the Treasury for the country’s inflation problem. Although the BOE was the first major central bank to raise interest rates after the pandemic, Truss insists that it should have acted even sooner. Her criticism of the BOE suggests that she may favor eliminating the central bank’s independence. In a speech at a husting of Conservative party members, Truss hinted at changing the BOE’s mandate to align more closely with the other central banks. Her rebuke suggests that she will likely place the blame for inflation on the central bank in order to gain support for her tax cut proposal.
• In Europe, countries are looking to implement measures designed to combat rising inflation. For example, the French Parliament passed legislation on Thursday that would cap rent increases and extend fuel subsidies. Meanwhile, Ireland is considering imposing a windfall tax on energy profits. Government actions to rein in inflation will likely not be too effective because subsidies on fuel and windfall taxes on energy profits prevent consumers and suppliers from adjusting to the market. Fuel subsidies prevent demand destruction, while taxes on excess profits limit energy companies’ ability to expand investment in production capacity.

The decision to address inflation over GDP suggests that governments fear the public may be more sensitive to prices than the economy. This preference could mean countries will be reluctant to stimulate their economies as inflation remains elevated. The lack of financial support from the government during times of economic weakness suggests that any recovery from recession will likely be slow. Thus, we could be headed toward a sustained period of slow economic growth.

U.S. policy: The Democrats may be on the verge of passing another bill, but conservatives still strongly influence domestic and foreign policy.

• Senator Kyrsten Sinema (D-AZ) has agreed to support the climate and tax bill. Her support came after Democrats revised the legislation to eliminate a provision that would narrow a tax break for carried interest. Additionally, there were provisions to alter the 15% minimum corporate tax and add a 1% excise tax on stock buybacks. The tax changes in the bill may not have a significant impact on investors. Instead, they reflect a broader trend away from government spending as the country copes with rising inflation.
• The fallout continues following House Speaker Nancy Pelosi’s provocative trip to Taiwan. On Friday, China announced that it would impose sanctions on Pelosi and has halted cooperation with the U.S. in several areas, including talks on climate change and defense. Her visit to Taiwan has not only accelerated the decoupling between the U.S. and China but is also forcing firms to reconsider plans to invest in Taiwan.
  • Equities are already starting to see movement following the trip. Since Pelosi’s visit, stocks related to chipmakers have surged due to predictions that the U.S. and China will invest more in domestically made semiconductors.

There does seem to be relatively more support for conservative policies going into the midterm elections. Democrats who initially pushed for a bill that would have added to the deficit over 10 years are now backing a bill that reduces the deficit, suggesting the country is becoming fiscally cautious. Additionally, Pelosi’s trip reinforces our view that the country is becoming more skeptical of China. It is too soon to say whether this represents a broader trend, but it is something we are monitoring closely.

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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 on the central banks’ decision to raise rates despite slowing economic growth. Next, we examine how rising geopolitical risks make it more difficult for firms to rebuild their supply chains. We end the report with an update on the climate and drug bill.

 Monetary Policy: Central banks in the U.S., U.K. and the Eurozone appear to be plowing ahead with tighter monetary policy even as their economies slow.

• Fed officials downplayed expectations that the central bank was close to ending its tightening cycle. Despite the disappointing economic data, regional Fed Presidents Neel Kashkari and Thomas Barkin dismissed speculation that the Fed was finished raising rates and warned of a possible recession. Meanwhile, St. Louis Fed President James Bullard, a voting member, insisted that the central bank must front load big rate hikes to cool inflation. Additionally, he revealed his desire for the Fed’s policy rate to be between 3.75% and 4.00% by the end of the year.
• To keep pace with the Federal Reserve, the Bank of England raised its benchmark rate by 50 bps on Thursday. Although the increase is less than the Fed’s 75 bps hike in July, the rate rise was the country’s largest in 27 years. By increasing its policy rate, the BOE aims to prevents the pound from depreciating against the dollar and exacerbating the country’s inflation problem. The BOE warned that the country is expected to fall into a recession and that inflation could rise as high as 13%.
• The European Central Bank appears to have used funds from maturing bonds in the portfolio of its pandemic program to purchase the debt of southern European economies. The data showed that the bank’s net holdings of German, French, and Dutch bonds dropped by 18.9 billion euros in July. In the same month, statistics showed that the bank made 17.3 billion euros of net debt purchases from Italy, Spain, Portugal, and Greece. The central bank’s intervention suggests it will also aggressively raise rates in its next meeting.
  • Fitch Ratings Agency expects that the ECB’s new anti-fragmentation tool will allow the bank to raise rates while reducing debt sustainability risk. Fitch Ratings is one of the three most respected credit rating agencies. Thus, its analysis will likely help reassure investors that the ECB has a credible tool to fight fragmentation.

Strong U.S. economic growth and tight monetary policy have pushed the euro and British pound to near multi-decade lows against the dollar. The depreciation of the euro and pound have contributed to the inflation problem in their respective regions as it makes dollar-priced commodity imports more expensive. Unfortunately, neither the EU nor U.K. economies have expanded at the same rate as the U.S. since the pandemic started in 2020. As a result, they likely have less flexibility in raising rates. Although all three regions have elevated recession risks, the EU and U.K. are in a worse position than the U.S.

Geopolitical Risks: As the calls for a ceasefire in the Ukraine-Russia war become increasingly louder, conflicts in other parts of the world are becoming more noticeable, making it difficult for firms to return to pre-pandemic normalcy.

• European leaders are now pushing Ukraine to engage in ceasefire talks with Russia. On Wednesday, former German Chancellor Gerhard Schröder urged Kyiv to negotiate with Russia to end the conflict and modify its demands. Meanwhile, the Irish president and his wife stirred controversy after the first lady posted a letter on the presidential website pleading for world leaders to encourage ceasefire talks. The push by Putin’s allies within Europe is evidence that the conflict may be headed toward a pause. Ukrainian President Volodymyr Zelensky has also sought a meeting with Chinese President Xi Jinping to help negotiate an end to the contest. However, Xi has not replied to any of his requests to talk.
  • Although the possible end of the conflict is good news, it is foolhardy to assume that the relationship between Europe and Russia will return to normal. Russia’s weaponization of its natural resources will mean Europe will still need to reduce its dependence on Russia significantly. Meanwhile, Russia’s limited ability to deliver its natural gas to countries outside of Europe suggests it also needs to invest in building its pipeline capacity to new regions. Figuring out how to remove sanctions is another can of worms no one in the West wants to open. Although it is too early to determine whether the conflict will end soon, the path toward de-escalation is forming.
  • The U.S. and Italy has passed legislation that will allow Sweden and Finland to enter NATO.
• As the U.S. gears up for another round of nuclear talks, there is speculation that Iran might direct its proxies to attack American and partner targets in the region. Such an attack could lead to a crisis in the Middle East and push up the price of commodities like oil. Iran blames NATO for the recent unrest in Iraq. Over the weekend, protesters stormed the Iraqi parliament to demand new parliamentary elections. The rising tension between the West and Iran suggest that the Middle East remains politically unstable.
• China engaged in more military drills around the Taiwanese peninsula the day after U.S. Speaker of the House Nancy Pelosi visited the self-ruled island. In China’s most immense provocation in 16 years, its military launched several missiles into Taiwanese waters. The drills are expected to continue until Sunday. However, possible escalation cannot be ruled out. China is in a difficult bind. Pelosi’s visit undermines Beijing’s argument that the U.S. views it as a threat. Meanwhile, U.S. politicians on both sides of the aisle are pushing for Washington to take a tougher stance against China. As a result, we believe that the risk of possible miscalculation leading to direct conflict is elevated.
  • The White House is attempting to rein in Congress after Pelosi’s trip to Taiwan has encouraged politicians to flex their toughness on China’s credentials going into the mid-terms. The Senate is currently working on legislation that would designate the sovereign island as a major non-NATO ally.

One of the trends that we are noticing is that the world is becoming increasingly hostile. Rising global tensions will make it difficult to repair supply chains and could accelerate U.S. firms’ withdrawals from the rest of the world. This shift from relying on global supply chains in emerging markets will be expensive in the short term as firms look to adjust to this new normal.

Biden’s Agenda: The U.S. Senate is expected to pass the Inflation Reduction Act. The bill aims to raise corporate taxes and may negatively impact corporate earnings.

• Arizona Senator Kyrsten Sinema (D-AZ) is pushing for changes in the bill before backing it. She is a pivotal vote in getting the legislation through the Senate. She has concerns about the changes to the corporate minimum tax and has hinted at possible opposition to a carried interest tax. Additionally, she favors beefing up the amount of funding for the climate and energy portions of the bills.
• The Congressional Budget Office forecasts that the bill will reduce the deficit by a net $101.5 billion over the next decade. However, the CBO’s estimate did not include the $204 billion tax revenue gain from the increased Internal Revenue Service enforcement. The analysis is key to getting the bill passed as Democrats are trying to make themselves look more fiscally responsible after the initial stimulus package contributed to a surge in inflation.

The new bill from the Democrats is austerity disguised as fiscal stimulus. The trend of reducing the government deficit will likely be a central theme going into mid-terms and could continue afterward. The lack of government spending will lead to slower economic growth.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including a revelation that President Biden has personally threatened Chinese President Xi with trade restrictions if China helps Russia with its invasion.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, with a specific focus on House Speaker Pelosi’s now-completed trip to Taiwan and its impact on U.S.-China relations.

Russia-Ukraine: Russian forces continue to make small territorial gains around Ukraine’s northeastern Donbas region while shifting some troops to defend against the Ukrainians’ counteroffensive against the occupied southern city of Kherson.  Officials in Moscow have also ramped up their false claims of destroying multiple HIMARs systems and other weapons provided by the West, most likely in an effort to thwart rising exasperation from Russian military bloggers.  Not only have the Western weapons discouraged those bloggers and other Kremlin supporters, but Western intelligence analysis believe they are also causing significant casualties among Russian troops.  Other reports say Iran has provided its first batch of military drones to Russia for field testing.

• In a New York Times opinion article, foreign affairs author Thomas Friedman revealed that President Biden personally threatened Chinese President Xi with a ban on Chinese exports to the U.S. and Europe if China provided help to Russia in its invasion of Ukraine.  According to Friedman, the threat has been instrumental in preventing China from providing new arms or other assistance to Russia in the war.  However, he now fears that House Speaker Pelosi’s visit to Taiwan this week will prompt Beijing to help the Russians out of retaliation.
• On the economic front, German Chancellor Scholz endorsed the idea of extending the life of Germany’s last three nuclear-generating stations to help cushion the blow from Russia’s reduced energy exports to Western Europe.  The plants, which are scheduled to be retired at the end of 2022, produce only a small portion of the country’s electricity, but even that would be valuable to Russia-dependent Germany in the event of a fuller cut-off in Russian natural gas supplies.

United States-Taiwan-China: Undeterred by China’s threats and President Biden’s misgivings, yesterday House Speaker Pelosi landed in Taiwan on a trip designed to underscore the U.S.’s support for the island democracy.  Pelosi’s trip, which included a long, circuitous route from Kuala Lumpur across Borneo and around the Philippines to avoid flying over Chinese military facilities in the South China Sea, immediately spurred a series of protests by Beijing.  The Chinese government also sent more fighter aircraft into the Taiwan Strait and announced further live-fire military exercises in the six zones surrounding the island.  China also temporarily halted most food imports from Taiwan.

• As of this writing, China’s response to the Pelosi visit has been tough and high-profile, but not necessarily over-the-top.  However, the full extent of the retaliation may not be known for days or even weeks.  One concern is that China has told commercial ships and air carriers to stay out of its six military-exercise zones surrounding Taiwan.  If kept in place, those no-sail/no-fly zones could become a soft blockade on the island, potentially threatening to strangle it.
• On Pelosi’s side, we’ve noticed that there’s been little explanation as to why she chose to make such a provocative trip right now.  One obvious explanation would be to show the Democratic Party is just as tough on China as the Republican Party.  Thwarting China’s geopolitical aggressiveness is now a solidly bipartisan effort in the U.S., but Pelosi may have wanted to underscore the Democrats’ anti-China credentials just two months before the mid-term elections.  Besides, Pelosi knows that the impact of her trip would be greatest if she is still Speaker, a position she will give up in just a few months if the Democrats lose control of the House as expected.

United States-China: Illustrating how political and economic considerations continue to fracture the world into relatively separate blocs, the recently-passed U.S. Chips and Science Act is already prompting major foreign technology firms to consider abandoning their investments in China in favor of closer ties with the U.S., as intended.

• Until now, reporting on the Chips and Science Act has focused on its $52 billion in subsidies to encourage investment in advanced computer chip factories in the U.S., as well as hundreds of billions of dollars in other science and technology funding. Less noticed, however, is that the bill also contains qualified “guardrails” prohibiting recipients of the funds from expanding or upgrading their advanced chip capacity in China for 10 years.
• Reporting in the Financial Times today says South Korean semiconductor producers Samsung Electronics (005930.KS, ₩61,300.00) and SK Hynix (000650.KS, ₩97,500.00) are re-evaluating their operations in China and may abandon them so as not to run afoul of the guardrails in the U.S. legislation.

U.S. Monetary Policy: Yesterday, a slew of regional Federal Reserve presidents made statements suggesting that the policymakers intend to keep hiking interest rates aggressively, despite recent investor expectations that they might soon pivot to rate cuts as recession risks grow.  The statements pushed up bond yields yesterday, and those yield increases are continuing so far this morning.  In the statements:

• Chicago FRB President Evans said he expects the Fed to hike its benchmark short-term interest rate by 50 bps at its next meeting in September but wouldn’t rule out another big 75 bps hike if inflation doesn’t look like it’s receding.  After that, Evans said he hoped the Fed could return to the more traditional 25 bps hike at the last two policy meetings of 2022.
• Separately, Cleveland FRB President Mester warned against prematurely declaring victory over inflation.  According to Mester, the Fed should keep hiking rates until it sees several months of cooling inflation.
• Finally, San Francisco Fed President Mary Daly said the central bank’s effort to bring down prices by slowing demand was nowhere near done.  Moreover, she poured cold water on the idea that the Fed could pivot to rate cuts next year, saying the next change would likely be to just hold rates steady for an extended period.

U.S. Retail Gasoline Market: According to data provider OPIS, the average price for a gallon of regular unleaded gasoline sank to $4.19 yesterday, marking the 49th straight day that gas costs have declined in the U.S.  Prices are now down 16.5% from their most recent high of $5.02 per gallon on June 14.

Global Energy Markets: The Organization of the Petroleum Exporting Countries and its allies today agreed on a modest boost in crude oil production.  Beginning in September, the OPEC+ members said they will boost output by a collective 100,000 bpd, on top of the increase of 648,000 bpd previously announced for July and August.

• The small boost is probably at least a partial response to President Biden’s controversial rapprochement with Saudi Arabian Crown Prince Muhammed Bin Salman.
• However, the small increase is expected to have little impact in bringing down prices.  The recent price declines for oil can be tied more tightly to factors like demand destruction from the high prices earlier in the summer and slowing demand growth as economies respond to interest-rate hikes by the world’s central banks.

Global Cryptocurrency Markets: In yet another blow to the budding cryptocurrency markets, an apparent cyberattack drained thousands of digital wallets linked to the Solana blockchain.  Along with recent crypto frauds, bankruptcies, and other scandals, cyber thefts like the one at Solana will undermine digital currency promoters’ assertions about the assets being secure, even as the digital currencies face growing regulatory risk.

• In fact, the Senate Agriculture Committee’s top Democratic and Republican leaders plan to introduce a bill that would empower the Commodity Futures Trading Commission to regulate spot markets for digital commodities, a newly created asset class.
• The proposed legislation would target CFTC regulation over the two largest cryptocurrencies: bitcoin and ether.

Netherlands: As the country breaches its legal limits on nitrogen emissions, the government has sparked broad farmer protests with a plan to reduce Dutch livestock populations by one-third through buyouts and other incentives.  Since June, the farmers’ protests have included picketing supermarket distribution centers, blockading roads, airports, and train stations, and even dumping slurry at the home of the minister in charge of the program.

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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 Russia continues to struggle with insufficient troop levels to make more significant territorial gains or to better defend against Ukraine’s counteroffensive in the south of the country.  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 U.S. House Speaker Pelosi’s visit to Taiwan and China’s risky saber-rattling in response to it.

Russia-Ukraine: As Ukrainian forces ramp up their counteroffensive against the occupied southern city of Kherson, the Russians continue to shift troops there from the areas they occupy in Ukraine’s northeastern Donbas region.  However, the Russians’ effort to reinforce Kherson may deprive them of the combat power they need to make further gains in the Donbas.  The shift may also tempt the Ukrainians to launch a separate counteroffensive against the weakened Russian defenders in the Donbas.  Meanwhile, the Russians continue to launch missile strikes across a wide swath of Ukrainian territory.

• The Russian military’s need to shift troops from one battlefield to the other illustrates its continuing shortfall in troops. In further evidence of that, U.S. and British military officials said that the Russian mercenary force known as the Wagner Group has been pulling troops out of Africa and redeploying them as regular Russian army units in Ukraine.
• Separately, imagery and other analysis increasingly suggest that the Russian military was responsible for an explosion that killed more than 50 Ukrainian prisoners of war at a Russian-occupied prison over the weekend. The Russian government had suggested that the Ukrainian military used precision rockets and artillery provided by the West to kill the POWs and prevent defections, but it now appears that the Russians staged the explosion and killed the POWs in yet another Russian violation of the Geneva Convention.
• On the economic front, the Ukrainian infrastructure minister warned that the country’s grain exports will take a long time to ramp up, despite yesterday’s first successful shipment from Odessa since the war began. The warning means Ukrainian supplies won’t quickly help alleviate the evolving global food crisis.

United States-Taiwan-China: It now appears that House Speaker Pelosi intends to carry out her controversial visit to Taiwan today and tomorrow, despite strong but unspecified Chinese warnings not to do so and President Biden’s misgivings about the trip.  At this point, it’s not clear whether China’s warnings amount to anything more than posturing and bluster.  However, given that the country is much more powerful than when a House speaker last visited the island in 1997, it’s impossible to rule out a risky show of force that could lead to miscalculation and potential conflict.  That possibility is weighing on risk assets so far this morning.

• In what is probably part of China’s response, this morning, Chinese fighter aircraft have buzzed the maritime boundary between the mainland and Taiwan.
• On social media, we’ve also seen video of tanks patrolling a beach in China’s southern Xiamen province, opposite Taiwan. Of course, there seems to be little reason for Chinese tanks to be patrolling their own beaches (and disrupting tourists playing in the surf).  Most likely, the move aims to drive home the idea of the Chinese military attacking Taiwan’s beaches.
• The People’s Liberation Army has put its Southern Theater Command on high alert and launched a series of military exercises in the South China Sea set to last until Saturday evening. That makes sense, given that the Southern Theater Command has responsibility for the area off China’s southeast coast where Pelosi’s plane would likely travel enroute from Malaysia to Taiwan.  However, other than the tanks on the beach in Xiamen and reports of closed airspace around Fujian, we have seen no indication of any change in alert status for the Eastern Theater Command, which sits opposite Taiwan and would have key responsibility for any action against the island.

Source:  U.S. Department of Defense

Japan: Continuing its rebound since mid-July, the yen has now appreciated to a two-month high of about 131.00 per dollar.  The rebound reflects factors such as the recent retreat in U.S. bond yields and calculations that the Bank of Japan could abandon its yield curve control policy as other major central banks accelerate their interest-rate hikes to fight inflation.  The move also appears to reflect some safe-haven buying amid geopolitical tensions and global recession fears, as well as short-covering by major investors.

Bulgaria: President Radev has called a snap election for October 2 and appointed Galab Donev, a former labor minister, to lead a caretaker government until a new administration is formed.  The new election (the country’s fourth in the last two years) comes after the June collapse of the government run by Kiril Petkov, who came into office promising to fight the country’s rampant corruption, and who took an unusually strong line against Russia following the invasion of Ukraine.

• Petkov’s government lost a vote of confidence after one of the parties in the fragile four-party coalition abruptly pulled the plug. Afterwards, no other political group was able to secure a majority to govern.
• Observers now fear that the snap election could produce another fractured parliament, potentially undermining the European Union’s support for Ukraine in the war.

Global Cryptocurrencies: The Securities and Exchange Commission has charged 11 people for a $300-million cryptocurrency pyramid scheme in which they used promoters to convince millions of investors worldwide to recruit others into the program.  Besides reflecting increased enforcement efforts by national authorities, the news is another black eye for the industry and will likely buttress calls for increased regulation.

U.S. War on Terror: President Biden announced that a U.S. airstrike in Kabul, Afghanistan, killed Al Qaeda leader Ayman al Zawahiri, a founding member of the movement and one of the key strategists behind its international campaign of terror that culminated in the September 11 attacks.  The strike was the U.S.’s first known counterterrorism operation in Afghanistan since it withdrew its forces last summer.  The attack shows that the U.S. retains the capability of striking terrorists in Afghanistan despite not having a permanent presence there.

U.S. Bond Market: For the first time in this cycle, the yield on the three-month Treasury bill briefly rose above the yield on the 10-year note yesterday.  While the 2-year/10-year yield curve has been inverted for some time, Fed researchers consider the 3-month/10-year to be the better indicator of an impending recession.  The development will help keep investor concerns alive concerning a recession in the U.S. sometime over the next year or so.

U.S. Antitrust Policy: The trial over the Justice Department’s effort to block a merger of major publishers has started.  The lawsuit, in which the DOJ is attempting to stop Penguin Random House’s planned acquisition of rival publisher Simon & Schuster, is expected to signal how successful the government will be in preventing industry consolidation and preserving market competition in the coming years.

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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 details on the first shipment of grain from a Ukrainian port under the recent Turkish-brokered deal for safe passage of food exports from the country.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine: With Ukrainian forces apparently ramping up their counteroffensive against Russian occupiers in the southern Ukrainian city of Kherson, leaders in Moscow continue to face the dilemma of whether to transfer troops from the occupied Donbas region to reinforce the city.  The latest reporting suggests that the Russians may be trying to squirm out of that dilemma by launching new attacks from the Donbas region westward toward the major Ukrainian city of Kharkiv.  That attack has the potential to draw Ukrainian forces northward to help defend it, weakening their attacks on Kherson, but it is not at all clear whether the Russians have enough resources to truly threaten Kharkiv and draw the Ukrainians into that battle.

• To the surprise of many who thought Moscow would scuttle the recent Turkish-brokered deal to allow safe passage for Ukrainian grain shipments, today a Sierra Leone-flagged bulk carrier left Odessa with 26,000 metric tons of corn headed toward Lebanon.  More ships are expected to depart in the coming days, including many which were loaded before the Russian invasion began in February.
  • The flow of Ukrainian wheat, corn, barley, and other food products, which mostly go to less-developed countries, has helped push grain prices lower so far today.
  • Nevertheless, it is still too early to know whether Moscow will allow continued shipments.  The renewed exports, therefore, may not have a significant impact on global markets in the near term.
• Separately, tensions between Serbia and Kosovo are rising, potentially as a result of the Russia-Ukraine war or Russian efforts to divert attention away from it.  The discord has prompted the NATO-led KFOR peacekeeping program to say it will intervene if necessary to keep the tensions under control

United Kingdom: In the race to succeed Boris Johnson as Conservative Party leader and prime minister, Foreign Minister Liz Truss and Former Chancellor Rishi Sunak continue to hammer each other over tax policy.  In recent days, Truss, who remains the odds-on favorite to win the race, has pilloried Sunak for his effort to control the government budget deficit by hiking taxes.

• With her insistence that such “stale economic orthodoxy” has hurt the British economy, Truss underscores how today’s populist, more conservative leaders are abandoning the right’s traditional belief in balanced budgets and austerity when necessary.
• We see similar tendencies in other populist, more conservative leaders elsewhere in the world as well.

Chinese Foreign Policy: Many people are now familiar with President Xi’s “Belt and Road Initiative,” which aims to build Chinese influence around the world by providing capital for infrastructure projects, but it’s now becoming clear that Xi intends to supplement this economic program with his newly announced “Global Security Initiative.”  Under the program, Beijing offers military training, intelligence sharing, and joint counterterrorism activities to developing countries, ostensibly to build their own independent defense capabilities and avoid Western sanctions.

• In a letter to the China-Africa Peace and Security Forum last week, Xi urged African countries to support the GSI.  In May, the GSI also managed to gain the support of leaders from the Latin American countries of Nicaragua and Uruguay.  China’s recent effort to build security links with island countries in the Western Pacific Ocean are probably also related to the effort.
• We suspect that the GSI will be an increasingly important part of China’s effort to build comprehensive influence around the world.  In turn, that’s likely to exacerbate the current U.S.-China geopolitical competition, with all its negative implications for the global economy and financial markets.

Chinese Economy: As shown in the data tables below (see pdf), China’s official purchasing managers’ index for manufacturing fell to a seasonally adjusted 49.0 in July, missing expectations that it would rise to 50.3 from its reading of 50.2 in June.  Like most major PMIs, the Chinese one is designed so that readings below 50.0 point to contracting activity.  Separately, a private housing data provider said that July home sales by the country’s top 100 developers were down 39.7% from the same month one year earlier.

• The figures suggest that the Chinese economy is recovering only slowly and fitfully from the government’s spring COVID-19 lockdowns.
• Naturally, weaker demand growth in China will likely weigh on global economic activity and financial markets.

China-United States: Despite China’s effort last week to forestall the U.S. delisting of Chinese firms that don’t meet U.S. auditing disclosure standards, the SEC on Friday said internet giant Alibaba (BABA, $89.37) has been put on a list of firms scheduled to be kicked off U.S. stock exchanges in the coming years.  More than 150 Chinese firms are now on that list, prompting Hong Kong Financial Secretary Paul Chan to warn that the financial center should prepare for a “worst case” scenario in which U.S.-China relations rupture definitively.  The situation underscores the regulatory risk faced by Chinese companies trading on U.S. exchanges.

U.S. Fiscal Policy: West Virginia Senator Joe Manchin, who last week struck a deal to support the Democrats’ new “Inflation Reduction Act,” insisted the corporate tax hikes in his party’s bill would merely close loopholes and not unduly weigh on corporate investment, as Republicans have charged.

• Besides using some $300 billion from the tax hikes to cut the U.S. budget deficit, the bill would allocate $369 billion toward green initiatives and energy reforms, and $64 billion to shore up the Affordable Care Act.
• The Senate is due to take up the legislation next week before Congress leaves Washington for its August recess.

U.S. Labor Market: Boeing (BA, $159.31) has, at least temporarily, averted a strike which was due to start this afternoon at its defense-related plants in the St. Louis area.  Early this morning, the company offered last-minute contract concessions related to changes it wanted to make to unionized workers’ 401(k) plans.  The new contract will be subject to a union vote on Wednesday.

• Even if the new contract is approved, however, we still believe the dispute and threatened strike show how today’s tight labor market has emboldened workers and given them increased bargaining power to demand better pay, benefits, and working conditions.
• If it lasts long enough, the increased worker leverage will likely increase costs for companies and weigh on profit margins, potentially dragging down stock prices.

U.S. Apartment Market: In more positive news for inflation, a private data firm says U.S. apartment rents in the second quarter were up “just” 9.4% year-over-year, cooling from annual increases of more than 11.0% in each of the two previous quarters.  The firm projects that rental rates will continue this trend through the coming months.  Moderating rents will help lower the overall reported inflation rate, although only with a long lag.

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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 of a broad macroeconomic outlook focusing on the central bank transition away from forward guidance, the U.S. GDP contraction in Q2, and a surge in Eurozone inflation. Next, we discuss U.S.-China relations. Finally, we examine how the Russia-Ukraine war has led to greater cooperation among Western countries.

Macroeconomic Outlook: The U.S. economy has contracted two quarters in a row, but it is still too soon to call it a recession. Calls for the end of the Fed’s tightening cycle may be premature as the lack of forward guidance raises the likelihood of a market surprise, and elevated inflation in the Eurozone pressures the European Central Bank to raise rates more aggressively.

• Recession? The economy shrank an annualized 0.9% in the second quarter. Back-to-back contractions in Q1 and Q2 have led to concerns that the country may be in a recession. Although consecutive contractions are typically associated with a recession, the NBER officially makes that call. The group looks at various measures of economic activity at the general and micro levels. As a result, the group takes a very long time before officially confirming that the economy is in recession. For example, the group waited 15 months after the Great Recession ended to announce that the economy was in recovery, and therefore, it is essential not to put too much weight on the latest GDP report. In our view, the economy is not in recession as Final Sales to Domestic Purchases, which excludes volatile elements of GDP, has contracted in one quarter but is still subject to revision.

• Farwell, Forward Guidance: Central banks may be transitioning from forward guidance as economies slow, and inflation remains elevated. The ECB was the first of the major central banks to ditch forward guidance, and the Federal Reserve followed suit a week later. When inflation was low, forward guidance reassured investors that the central bank policy would not change in the future. However, consistently higher than expected inflation and economic deceleration have led banks to value policy flexibility over market clarity. The shift away from forward guidance will make speeches from voting members and central bankers even more critical.
• Eurozone inflation: The flash estimate of the Eurozone Consumer Price Index jumped 8.9% from the year prior, setting a new record. Although inflation remains lower than in the U.S., the core CPI suggests that the momentum of the price increases continues to build in Europe. The strong reading will pressure the European Central Bank to become more aggressive in its tightening cycle in order to tame inflation. Before the report, Governing Council Member Martins Kazaks hinted at the possibility of a significant rate hike at the next ECB meeting in September. Although there is speculation that the central bank may raise rates by 50 bps, there is a strong possibility that the planned hike could be higher.

In short, the unpredictability of economic data has made it difficult for central bankers to make predictions about upcoming monetary policy. Therefore, the lack of guidance may mean the ECB and Federal Reserve could surprise markets in their next meeting depending on the latest inflation data. Although it is tempting to view a decline in GDP as a sign that the Fed could implement a pause, it is worth noting that the ECB and the Fed are mandated to maintain price stability. As a result, inflation will likely be their top focus when determining future monetary policy. When the central banks hold their respective meetings in September, they will be determining policy based on the August inflation numbers, so investors should take the July reports with a grain of salt.

China: President Biden and Chinese President Xi discussed Taiwan on Thursday, China hints at a possible slowdown in its economy, and Beijing tries to use TikTok to send propaganda to the West.

• The phone call: Yesterday, President Biden and Chinese President Xi Jinping had their long-awaited phone call. As usual, both sides offered each other reassurances that the status quo should remain intact. Although the call allowed the two to clear the air, tensions between the countries persist. There is still no word on whether Speaker of the House Pelosi will travel to Taiwan next month; however, she is still set to leave for her trip to Asia on Friday. Pelosi may be pressured to travel to Taiwan to avoid looking like she is kowtowing to Beijing. In that event, China may be forced to retaliate. As a result, we believe that the trip has the potential to lead to direct conflict between the U.S. and China.
• China slowdown: Leaders in Beijing signaled that China might miss its goal of a 5.5% expansion of GDP this year. This downbeat assessment reflects the negative impact of the property market crash and the country’s controversial Zero-COVID Policy on the economy. The candidness should not be a surprise as the rest of the world is currently distracted by talks about whether the U.S. is in recession. As the economy continues to show weakness, China may inject stimulus to boost growth.
• China propaganda: S. lawmakers have consistently labeled TikTok as a national security threat due to its supposed ties to the Chinese government. On Thursday, a Bloomberg report revealed that a state entity related to public relations tried to create an account to target Western audiences with propaganda. Although TikTok executives supposedly pushed back on the report, the company’s association with Chinese government officials will likely unnerve U.S. politicians that feel that the social media platform may act as an arm of Beijing. Over the last few years, governments have weaponized social media to destabilize rival countries. As a result, we believe this report will not only lead to a more significant push from U.S. officials to have TikTok removed from app stores, but also lead to more regulatory oversight with how these companies manage their users’ data. Hence, this report may also have ramifications for the broader tech sector.

As we have warned in our 2022 Mid-Year Geopolitical Outlook, China is likely to push its narrative of a “rising China, falling West” going into the 20^th National Congress of the Chinese Communist Party. Therefore, it will likely view any move by the U.S. to recognize Taiwan as an independent nation as a direct threat to its national sovereignty.

Russia-Ukraine Update: The war in Ukraine continues to force the West to build closer ties with each other as it looks to respond to Russian aggression.

• Preventing a crisis: The European Union aims to diversify its energy sources to ensure it has ample supply in the winter months. France and Belgium have turned to nuclear energy, Italy has explored Algeria as its new natural gas provider, and Spain has offered to deliver some of its reserves to other countries within the bloc. The sudden change in reducing their energy consumption may not successfully solve the EU’s supply needs by winter, but it will likely position the bloc to make a long-term shift away from using Russian energy in the future. In addition, the EU is planning investments to build pipelines from alternative sources, such as Algeria, Nigeria, Niger and Azerbaijan. As a result, we view the move away from Russian energy as a reflection of a long-term trend of countries looking to sever ties with unfriendly nations.
• Arms sales: The U.S. approved $8.4 billion in arms sales to Germany. The purchase of U.S. weapons signals Russia’s invasion of Ukraine has strengthened the NATO alliance. The trading of weapons among allies reflects a closer military cooperation among Western allies. Over the next few years, NATO allies will ramp up purchases with each other as they look to ensure their security from outside threats. U.S. defense companies should benefit from this push initially; however, nascent European companies could also profit from the increase in defense spending.

As the war continues, we believe the world will begin to break into regional blocs. Thus, the recent moves by the European Union to diversify away from Russia reflect the West’s need not to rely too heavily on a single country outside of its bloc.

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