by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning. We have a lot to discuss today. Today’s Comment will begin with an overview of the latest Fed meeting. Next, we will analyze the latest development in the Russia-Ukraine war and explain why we think the conflict could end in 2023. Afterward, the report examines the latest international news, including rising tensions on the Korean peninsula. We conclude the report by discussing the latest domestic developments.

FOMC: Stocks rallied and Treasury yields plunged on Wednesday after the Federal Reserve raised its benchmark rates by 75bps to 2.25% and 2.50%, in line with market expectations. Although the central bank statement maintained that further increases in its policy rate would likely continue, the market’s reaction suggests that investors believe that the tightening cycle could end soon. During the press conference, Fed Chair Jerome Powell stated that the Fed aims to lift rates into a moderately restrictive territory and described the current level as being neutral. Powell reiterated that another 75 bps might be appropriate for the September meeting.

• What does it mean? The Fed is likely committed to taming inflation; however, we expect the central bank to raise rates at a slower pace throughout the remainder of the year. Powell’s insistence that the Fed will not likely provide forward guidance suggests that the central bank is open to raising rates less than 75 bps. Assuming that the latest dot plot reflects the Federal Open Market Committee’s current thinking, the Fed is set to raise rates another 100 bps this year. Barring a change, the Fed could raise rates in its next two meetings and pause in December.
  • Other central banks may follow the Fed if it scales back its rate hikes. The ECB in particular is likely to reconsider its monetary path as higher rates can cause fragmentation throughout the Eurozone.

Russia-Ukraine: Russia is slashing natural gas deliveries, Ukraine forces are slowing Russian advances with U.S. weapons, and grain exports are set to leave Ukrainian ports. These developments suggest that the war will persist. However, we do see a path for potential de-escalation.

• Russian gas flow to Europe dropped on Wednesday after operation capacity for Nord Stream 1 fell to 20%. Gazprom, a state-owned energy company, warned that further problems with its turbines could continue the possibility of further reduction in gas flows. As a result, gas prices in Europe surged 30% over the last two days over concerns that Russia may stop delivering gas to the EU in retaliation for the bloc’s support for Ukraine in the war.
  • That said, we are not sure how long Moscow plans to withhold gas from Europe. Russia does not have the pipelines needed to redirect its natural gas to other countries; therefore, if it chooses to deny gas to Europe, it risks taking some of its wells offline due to the lack of production. Gazprom reports that natural gas production has been down 10.4% since January and 33% from a year ago.
• Ukrainian forces attacked critical Russian supply routes with U.S.-supplied long-range missiles. Ukraine has used high-grade weaponry to prevent further advances from Russia into Ukraine. So far, U.S. private estimates show that over 75,000 Russians have been killed or injured or roughly half of the troops sent into Ukraine during the spring.
• Wheat futures have dropped over the last few days as Ukraine prepares to deliver its grains exports through the Black Sea. Since the Russian invasion, more than 20 million tons of grains have been stranded in Ukrainian ports. The delivery should help global wheat prices. However, there are still concerns that the grain may not make it to markets.

Despite grain exports offering some price relief, commodities will perform well if Russia and Europe continue to play chicken with natural gas. Much has been made of Europe’s dependence on Russian gas, and it is therefore easy to ignore Russia’s limitations. For example, suppose Europe can make it through the winter. In that case, the Russian economy will feel the force of the sanctions, pressuring the government to reallocate its funds away from the war effort and toward bolstering the domestic economy. Remember, Russian President Vladimir Putin plans to run for an unprecedented third term in 2024. The fusion of rising inflation, a slowing economy, and burdensome sanctions is likely to cloud his election push. As a result, we expect there to be a possibility for Russia to pause its invasion in 2023 to regroup and possibly try again in the future.

International News: Rising tensions on the Korean peninsula, the increased likelihood of a left-wing populist president in South America’s largest economy, and declining consumer confidence suggest rising economic and geopolitical risks abroad.

• North Korean Leader Kim Jung Un threatened to wipe out South Korea if provoked by his southern neighbor. The threat is in response to the U.S. and South Korea’s plans to have joint military exercises next month. The two sides have not carried out in-person joint military drills since 2018. While threats from North Korea are not new, there are concerns that joint exercises may agitate the country after having made progress in its missile program earlier this year.
• Brazil’s Presidential front-runner Luiz Inacio Lula da Silva, revealed that if he wins the election, his economic minister will need to be politically-minded rather than a bureaucrat. Given the former president’s pro-leftist leanings, investors are concerned that Lula could pick a minister that would not support fiscally sound policies. Brazilian equities performed well during Lula’s first term in office due to a global rally in commodity prices. However, the policies he introduced toward the end of his tenure partly contributed to the downfall of his successor Dilma Rousseff.
• Eurozone consumer confidence fell to an all-time low in July. The drop in sentiment reflects household concerns regarding the rising energy prices, a slowing economy, and the continuing war in Ukraine.

Domestic Developments: The U.S. is poised to pass new legislation that should provide some stimulus to the economy. Meanwhile, today’s phone call between President Biden and President Xi has the potential to be mutually beneficial for both the U.S. and China.

• Democrats may have reached a deal on Biden’s scaled-back agenda. Senator Joe Manchin (D-WV) and Senate Majority Leader Chuck Schumer (D-NY) agreed to legislation that would address climate change, modify tax policy, and extend the Affordable Care Act subsidies. The bill will spend $369 billion on energy-climate initiatives. Democrats still need support from Senator Kyrsten Sinema (D-AZ) for the bill’s passage. In other related news, the Senate passed legislation to support chip manufacturing in the U.S. The move will likely pave the way for additional stimulus for the economy.
  • The Congressional Budget Office projects government debt as a percent of GDP to rise to 185% by 2052. The possibility of additional stimulus will likely provide some economic relief for the country. However, not enough to alter its GDP growth trajectory.

President Xi and President Biden will talk on Thursday. The focus of the discussion will be Speaker of the House Nancy Pelosi’s planned trip to Taiwan, China’s role in the Ukraine war, and possible plans for the U.S. to drop tariffs. A conversation between the world leaders will likely help the sides moderate tensions. Beijing is reeling over the news that Pelosi plans to visit Taiwan in August. Meanwhile, the U.S. does not like that China continues to elicit support for Russia. In light of rising tensions between the two countries, both seem to be in a position to make concessions. Beijing wants U.S. businesses to invest in China to generate growth before the 20^th National Congress of the Communist Party. Meanwhile, Washington is pushing China to support a price cap on Russian oil. Although we expect no significant breakthroughs in this phone call, we believe that discussions could pave the way for smoother relations.

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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 more fallout for the world’s energy and food supplies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new signs of labor unrest across the globe, and a preview of the Federal Reserve’s latest monetary policy decision, due later today.

Russia-Ukraine: Russian forces are again seizing incremental territory in Ukraine’s eastern Donbas region. They are likely to consolidate control over the region so they can hold a contrived referendum on annexation there on Russia’s national election day in mid-September.  The Russians also continue to launch long-range missile strikes against a variety of targets across Ukraine, but especially in the southern region around Ukraine’s grain-exporting ports.  Meanwhile, Ukrainian forces continue to attack Russian ammunition depots, logistics centers, and personnel concentrations, as well as a key bridge running into Kherson, an occupied city in the country’s south that Ukraine is attempting to recapture from the Russians.

• U.S. and other NATO officials continue to signal that they are shifting their position toward supplying Ukraine with advanced fighter jets and training pilots to fly them in the coming months.  The changed posture stems in part from Ukraine’s tenacious battlefield performance to date and a tacit understanding that Kyiv is likely to lean closer to the NATO alliance in the future.
• Meanwhile, U.S. officials are redoubling their efforts to convince China, India, and other countries that have been buying up cheap Russian crude oil to sign on to a low-price cap for the product.  The plan aims to supplant the Western countries’ scheduled ban on insuring tankers carrying Russian oil beginning in December, in a move U.S. officials fear would lead to a new spike in oil prices and ultimately provide more funds to Moscow.
• Separately, European natural gas prices are continuing to spike in response to Russia’s latest cut in supplies.  As of this writing, the European benchmark gas price is up some 12% to the equivalent of $231.17 per megawatt hour.  The benchmark price has now risen approximately 37% this week alone.
  • In response to the price surge, German chemicals giant BASF (BASFY, $10.61) said it would reduce its production of ammonia, a gas-intensive product that is a key ingredient for many fertilizers.
  • The production cut is a reminder that Europe’s energy crisis also feeds into the evolving world food crisis.  Reduced supplies and higher prices for fertilizers are already affecting food production around the world.
• Finally, in another aspect of the Western sanction regime, the Wall Street Journal reports that auditors trying to avoid running afoul of the sanctions are demanding that their clients promise they have no significant connections to Russians or Russian firms.  Sanctions experts and some corporate board members say the auditors are going beyond what is necessary and could be placing legal liability on their clients if authorities question their Russia connections.

Global Labor Market: In another sign that tight labor markets have emboldened workers all over the globe, several new strikes or strike announcements have popped up in recent days.  Taken together, the actions illustrate how labor shortages are giving increased bargaining power to workers, raising costs for companies, and potentially signaling lower profit margins.

• In Germany, ground crew for Deutsche Lufthansa (DLAKY, $5.92) have gone on strike over a wage dispute.  The action has forced the airline to cancel nearly all flights at its big hubs in Frankfurt and Munich.
• In the U.K., railroad employees have staged another massive one-day strike over pay, job security, and working conditions.  The strike follows three similar one-day strikes last month.
• Finally, in the U.S., a union representing 2,500 machinists at three defense plants owned by Boeing (BA, $155.92) has voted to go on strike beginning August 1.  The impending action at facilities near St. Louis aims to fight Boeing’s plan to phase out its automatic contributions to the machinists’ 401(k) accounts.

Italy: With polls showing right-wing parties are likely to form Italy’s next government after elections in September, European Union Economics Commissioner Paolo Gentiloni warned that the EU would not renegotiate the fundamentals of its €200-billion pandemic relief plan for the country, and that Rome must stick firmly to the reform pledges made by lame duck Prime Minister Mario Draghi in order to receive the money.  The statement sets up a possible conflict over the funds once a new government is in place, potentially undermining Draghi’s economic reforms and depriving Italy of major financing for big infrastructure changes and other investments.

Hungary: Prime Minister Viktor Orbán, a darling of the world’s growing right-wing populist movement, has touched off an international backlash over comments he made decrying Western “mixed race” nations and warning Hungarians not to intermarry with “non-Europeans.”  The statements are likely to further exacerbate Hungary’s ties with the rest of the European Union.

Tunisia: The country’s electoral commission said nearly 95% of voters approved Tunisia’s new constitution in a referendum this week.  The new constitution provides virtually dictatorial powers to populist President Kais Saied, essentially tearing up the democratic reforms launched in Tunisia after the Arab Spring uprising in 2011.

El Salvador: Yesterday, President Nayib Bukele announced that his country will use some of its international reserves and financing from a regional lender to buy back $1.6 billion of its sovereign debt coming due in 2023 and 2025.  The plan aims to take advantage of the bonds’ current low prices as investors fret about a potential default by the country.  The plan also comes as El Salvador’s intention to sell an exotic $1-billion bond, which bet on a rise in bitcoin’s value, stalled when the crypto asset fell sharply in recent months.

United States-China: With tensions rising over House Speaker Pelosi’s potential trip to Taiwan to show support for the island as it comes under increased pressure from China, the White House said President Biden and Chinese President Xi will talk by telephone tomorrow.  Meanwhile, Chairman of the Joint Chiefs of Staff Gen. Mark Milley said he worried that a Pelosi trip could touch off a crisis, but that the U.S. military is always prepared to support lawmakers’ trips and ensure they are safe.

U.S. Monetary Policy: The Fed today ends its latest two-day monetary policy meeting, with the decision expected to come out at 2:00 pm ET.  The officials have signaled they will hike their benchmark fed funds interest rate by another 0.75% to a range of 2.25% to 2.50%, and investors widely expect further aggressive rate hikes through the end of the year before the officials reverse course sometime in 2023.

• Reflecting those expectations, the yield curve remains inverted.
• As of this morning, the yield on the 2-year Treasury note stands at 3.061%, while the yield on the 10-year Treasury stands at 2.801%.

U.S. Technology Sector: Yesterday, the Senate voted 64 to 32 to advance a $280-billion package of subsidies and research funding to boost U.S. competitiveness in semiconductors and advanced technology.  A particular focus of the bill is to spur more investment in U.S. computer-chip factories, reducing the country’s dependence on foreign chips.  If the measure passes a final Senate vote as expected today, it will then have to be passed by the House before being signed into law.

• Separately, Director of the Consumer Financial Protection Bureau Rohit Chopra warned, in an interview, that big technology companies’ entry into the buy now, pay later lending business could undermine competition in the nascent sector and raise questions about the use of customer data.  The statement points to a new vector for regulatory risks facing big technology firms.

Meanwhile, technology firms Alphabet (GOOG, $105.44) and Microsoft (MSFT, $251.90) posted better-than-expected earnings last night, suggesting their post-pandemic retrenchment may not be as bad as anticipated.  The results have helped give a boost to U.S. equity markets so far today.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, with a focus on its associated disruptions to global natural gas and grain supplies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a preview of the Federal Reserve’s latest monetary policy meeting.

Russia-Ukraine: Russian forces are once again making small territorial gains in Ukraine’s eastern Donbas region, but at a very high cost.  Meanwhile, Ukrainian forces continue to attack Russian positions around the occupied southern city of Kherson.

• On the economic front, Russian state-owned energy giant Gazprom (GAZP.ME, $198.00) warned that natural gas exports through the vital Nord Stream 1 pipeline to Germany would drop to about a fifth of the pipe’s capacity this week, blaming sanctions-related problems with turbines.  Separately, Ukraine’s gas transmission system operator said Gazprom had sharply increased pressure in the Urengoy-Pomary-Uzhgorod pipeline without giving any notice, which the operator said “can lead to emergency situations” such as damage to pipelines.
  • The announcements show that Russia continues trying to use energy as a weapon of war, especially to pressure Western European countries to stop supporting Ukraine.  The latest cuts are probably designed to prevent Western Europe from building up sufficient inventories to get it through the winter heating season.  Running out of energy in the winter would maximize the pain of Russian energy cut-offs.  In response to the news, European gas prices jumped some 12% yesterday and a further 10% or so this morning.
  • Separately, EU energy ministers approved last week’s European Commission proposal for a system of 15% energy consumption cutbacks, but with a long list of exceptions.  For example, the approved plan will exempt Ireland and Malta who are not directly connected to the European grid, states that are heavily reliant on gas for electricity, and countries that are exporting gas at 90% of their total capacity to other member states.  Coupled with the new Russian gas disruptions, the exemptions will make it even harder for Western Europe to build up sufficient inventories to get through the winter.
• Separately, a Ukrainian official yesterday said Kyiv is still preparing to implement the Russia-Ukraine deal on grain exports that was brokered by Turkey last week.  Despite the Russians’ weekend attack on port facilities in Odessa, the Ukrainians are removing mines and setting up special naval corridors for the safe passage of merchant vessels, as well as constructing a coordination center in Istanbul.  However, we think it’s still possible that Russian attacks will short-circuit the deal and keep Ukraine’s grain bottled up, worsening the evolving global food crisis.
• Finally, Russian Foreign Minister Lavrov is touring Africa to make the case that the West is responsible for the global food crisis touched off by the war.
  • The warm welcome Lavrov has received shows how Moscow’s military and economic aid to Africa has bought it some much needed political support.
  • More broadly, our analyses show that as the U.S. steps back from its traditional role as global hegemon, and as the world breaks up into relatively separate geopolitical and economic blocs, less-developed countries like those in Africa are much more likely to end up in the bloc led by China and Russia.

Global Economy: Today, the International Monetary Fund sharply cut its forecasts for global economic growth and raised its expectations for world price inflation.  Because of Russia’s invasion of Ukraine, supply disruptions caused by the coronavirus pandemic, and rapidly tightening financial conditions, the IMF now expects global gross domestic product to grow just 3.2% in 2022, which is down 0.4% from its April forecast.  It sees growth of just 2.9% in 2023, down 0.7% from its previous outlook.  The figures are consistent with our view that growing headwinds are combining to significantly slow global economic activity and will likely weigh on global stocks in the near term.

Germany: The IFO Economic Institute said its July business sentiment indicator dropped sharply to 88.6 from 92.2 in June, reflecting German businesses’ worsening outlook for the coming months.  The figure provides more evidence that falling global growth, the evolving European energy crisis, and other fallout from the Russia-Ukraine war are pushing Germany and the rest of Europe to the brink of recession.

Pakistan: In an interview with the Financial Times, Pakistan Central Bank Governor Murtaza Syed played down financial market concerns about the country’s worsening liquidity crunch.  Even as Pakistan contends with rising commodity prices, falling foreign exchange reserves, and a depreciating currency, Syed said he expected the IMF to sign off on $1.3 billion of new loans for the country in August, to be supplemented by funds from China, Saudi Arabia, and other Middle Eastern countries.

United States-China: An investigation by Senate Republicans found that, over the last decade,  China has tried to build a network of informants within the Federal Reserve system to provide it with nonpublic intelligence on U.S. economic performance and monetary policy.  The efforts included both threats to Fed officials and offers of monetary compensation for information.

• The investigation also faulted the Fed for lax security efforts, but Fed Chairman Powell pushed back against that suggestion.
• In any case, the finding illustrates the broad intelligence effort China has mounted against the U.S. and its aggressiveness in seeking ways to undermine the U.S. government.  The incident will likely contribute further to the frictions between the U.S. and China.

U.S. Monetary Policy: The Fed begins its latest two-day monetary policy meeting today, with its rate hike decision expected to be announced on Wednesday afternoon.  The officials have signaled they will hike their benchmark fed funds interest rate by another 0.75% to a range of 2.25% to 2.50%, and investors widely expect further aggressive rate hikes through the end of the year before the officials reverse course sometime in 2023.

• Reflecting those expectations, the yield curve remains inverted.
• As of this morning, the yield on the 2-year Treasury note stands at 3.000%, while the yield on the 10-year Treasury stands at 2.769%.

U.S. Dollar: In a Financial Times opinion article today, well-known international economist Barry Eichengreen warned that if the U.S. economy slows precipitously, inflation falls, and the Fed pauses its interest-rate hikes, the dollar could suddenly reverse course and begin depreciating.

• According to Eichengreen, the risk stems from the fact that many foreign central banks are now starting to catch the Fed’s fever to tighten monetary policy aggressively.  If the Fed pauses while those central banks keep hiking, those countries’ currencies could suddenly look more attractive.
• Reflecting the broad hikes in interest rates and rising bond yields around the world, a separate report today shows that the world’s total stock of negative-yielding debt stood at just $2.4 trillion last week, down 87% from the $18.4 trillion peak in December 2020.

U.S. Corporate Earnings: After market close yesterday, Walmart (WMT, $132.02) warned that rising food and fuel costs are forcing the company’s customers to cut back on purchases of higher-margin products, even as the firm struggles with an earlier announced excess of inventory.  As a result, the company said it now expects its operating profit to fall between 10% and 12% this fiscal year.  The news is weighing heavily on the stock of Walmart and other major consumer businesses so far today.

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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 all signs point to Ukraine launching a significant counteroffensive in its southern region around the occupied 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, many of which involve increased Western pushback against China.

Russia-Ukraine: Officials in Kyiv continue to hint more openly that Ukrainian forces have either opened up a counteroffensive against Russian occupiers in the southern Kherson region or are setting conditions to do so.  Meanwhile, nationalist influencers on Russian social media are increasingly expressing alarm over the way Russian troop advances have been brought to a standstill by the advanced weapons Ukraine has recently received from the West.  The analyses echo U.S. Defense Department assessments that HIMARS mobile rocket systems have been particularly effective in disrupting Russia’s massed artillery attacks by forcing Russian troops to adopt mitigation tactics like camouflage and frequent relocation of their batteries.  At the same time, the Russians continue to attack cities across Ukraine with artillery and long-range missiles, including a Saturday attack on Odessa’s port facilities that appeared to violate their agreement to stop hindering Ukraine’s seaborne grain exports.

• CIA Director Burns last week said the Russian military suffered approximately 15,000 troops killed and 45,000 wounded in the war.  While that’s significantly less than the Ukrainian government estimates, it’s still a sizable proportion of the 130,000 or more Russian troops that invaded Ukraine beginning in February.  The CIA figures, which ring true to us, underscore how badly the Russians have been mauled in the conflict and why they’re having trouble maintaining their fighting power.
• As we’ve noted before, Russia’s aggression has touched off what is likely to be a multi-year trend of increased defense budgets among the Western democracies.  Reflecting that, the U.S. Navy recently sent Congress an assessment that carrying out its missions around the world would require a battle force of 373 ships, up 75 from the current battle force of 298 ships.
• On the other hand, rebuilding military forces may face challenges.  For example, last week U.S. Army Vice Chief of Staff Gen. Joseph Martin told Congress that the service will end Fiscal Year 2022 with just 465,000 troops, compared with an initial end-strength goal of 485,000.  The Army’s troop shortfall is far worse than in the Navy or Air Force.
  • Army personnel continue to re-enlist at record rates.  The main problem comes from a huge shortfall in recruiting stemming from problems such as tougher medical screenings, a shrinking proportion of Americans eligible to serve, poor marketing practices, and low civilian unemployment.
  • In a recent experiment, the Army allowed applicants without a high school diploma or GED to enlist if they scored in the top 50% of Americans on their entry aptitude tests, but the policy was cut less than a week after it came out.
• As widely expected, the European Union’s proposal last week for a mandatory 15% cut in each member country’s natural gas consumption to prepare for a Russian supply embargo has touched off bickering and demands for exemptions.  The plan is due to be discussed at a meeting of EU energy ministers this week.

Brazil: Yesterday, President Bolsonaro launched his re-election bid with a colorful campaign rally aimed at burnishing his conservative credentials.  To further bolster his chances, he also recently convinced Congress to pass a 50% hike in cash handouts to Brazil’s poorest citizens.  Nevertheless, polls show his support continues to trail that of left-wing Former President Lula da Silva by 10% to 15%.

Argentina: Confidence in the Argentine government and its currency is (again) evaporating, with consumers rushing to convert their pesos to dollars despite an official limit of buying $200 per month.  The black-market exchange rate has now risen to 337 pesos per dollar, up 15% just in the last week.

China: The State Council has reportedly passed a plan to establish a real estate fund worth up to $44.4 billion to support at least a dozen property groups whose operations have been stalled by government demands that they curb their debt.

• To diffuse popular anger over housing units that have been paid for but not delivered, the fund will be used in part to complete stalled development projects.  It may also be used to buy developers’ bonds, issue them loans, or take equity stakes.
• Chinese developer’s stocks soared on the report, although it is important to remember that Beijing is still intent on keeping tight control over the sector and reining it in.  President Xi undoubtedly wants to defuse consumer anger over the disruptions in the housing market, but once he secures a third term in office at a Communist Party conclave in October, the government could well crack down on the developers once again.

United Kingdom-China: In the race to succeed Boris Johnson as Conservative Party leader and prime minister, Former Chancellor Rishi Sunak called for a number of measures to cut China’s influence in Britain, including shutting down dozens of its “Confucius Institutes” that promote Chinese culture in the country and using national security laws to protect British technology start-ups from Chinese investment.  Foreign Secretary Liz Truss, his rival in the race, countered that she has always been tougher on China than Sunak has.

• The Sunak-Truss argument shows how political dynamics in some Western countries are moving inexorably toward more distrust and disengagement regarding China.  That will likely bolster the current trend toward deglobalization and a fracturing of the world into relatively separate geopolitical and economic blocs.
• Separately, Truss today will announce plans for a series of “investment zones” with looser planning rules, low regulation, and tax breaks, which she claims would lead to the building of a new generation of model towns and faster economic growth.  However, the plan is being panned as being similar to Sunak’s proposal to create a series of freeports around the country — also with tax breaks and streamlined planning processes.

United States-Taiwan-China: The Chinese government has reportedly issued unusually stark private warnings to the Biden administration about Speaker of the House Pelosi’s upcoming trip to Taiwan.  The Chinese warnings, which reportedly included threats of military force, have been much stronger than the threats Beijing has made in the past when it was mad about U.S. actions or policy on Taiwan.

• The administration is now trying to determine whether China is making serious threats or just engaging in brinkmanship to pressure Pelosi to abandon her trip.  If serious, China’s military could try to block Pelosi from landing in Taiwan or take other actions to impede her visit, such as using fighter jets to intercept her U.S. military aircraft.
• In any case, the result could be a dangerous confrontation that would likely drive down global stock prices and boost gold and other commodities.

United States-China: As the U.S. continues threatening to delist Chinese companies over their failure to share audit information, Beijing is reportedly preparing a system to sort its U.S.-listed firms into groups based on the sensitivity of the data they hold.  Beijing could then allow firms with less sensitive data to meet the U.S. audit information demands; firms with more sensitive data could potentially be restructured to allow more data sharing.  Coupled with an earlier concession that eased Chinese data-sharing rules, the new idea is designed to forestall any further rupture in U.S.-China capital flows, but there is little indication that U.S. regulators are willing to play ball.

U.S. Monetary Policy: The Federal Reserve will hold its latest two-day monetary policy meeting this week, with the decision expected to be announced on Wednesday afternoon.  The officials have signaled they will hike their benchmark fed funds interest rate by another 0.75% to a range of 2.25% to 2.50%, and investors widely expect further aggressive rate increases through the end of the year before the officials reverse course sometime in 2023.

• Reflecting those expectations, the yield curve remains inverted.
• As of this morning, the yield on the 2-year Treasury note stands at 3.012%, while the yield on the 10-year Treasury stands at 2.817%.

U.S. Weather: As the country continues to deal with an extensive, long-lasting heat wave, there is an increasing concern about its negative effects on U.S. agriculture operations.  Continuing high heat and drought not only threaten to push down crop yields, but they also raise feed and other operational costs for ranchers.

U.S. COVID-19 Treatments: Even though Paxlovid, made by Pfizer (PFE, $51.23), has quickly become the most popular drug for treating COVID-19, health data analytics group Airfinity has warned that lower-than-expected patient uptake could dent sales over the coming months and result in a surplus of 70 million doses by the end of the year.  COVID-19 is still big business, but the estimates show that waning concern over the disease and broadening immunity are starting to take the wind out of it.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment will begin with a discussion on Thursday’s ECB announcement and what it could mean for markets in the future. Next, we examine Russia’s notable military slowdown in Ukraine and other developments in the war. The report concludes with various international news stories that have the potential to influence markets.

 ECB Moment: A higher than expected rate rise, a new policy tool, and the end of forward guidance suggest that the ECB wants more flexibility during its tightening cycle as it aims to tackle rising inflation and growing fragmentation.

• ECB: The European Central Bank unanimously agreed to create a bond-purchasing tool to prevent borrowing costs among member countries from diverging. The decision to develop a tool likely played a role in the central bank’s decision to hike rates by 50 bps instead of the anticipated 25 bps. However, the market’s reaction was moderate as the ECB remained relatively ambiguous about its next step forward. The euro initially strengthened against the dollar but weakened later in the day as investors were wary of the bank’s commitment to the bond-purchase program. The spread between 10-year Italian and German bonds climbed as high as 250 bps on Thursday before settling around 240 bps.
• Whatever It Takes, Kind of? Unlike predecessor Mario Draghi, current European Central Bank President Christine Lagarde failed to reassure investors that the central bank was willing to do “whatever it takes” to preserve the euro. When describing the new anti-fragmentation tool, she stated that the central bank could use it to buy an unlimited number of bonds to prevent unwanted market dynamics, but later emphasized that she hopes never to have to use the tool. This apparent lack of commitment could mean that investors will likely be paying close attention to snap elections in Italy to determine whether they will continue to hold on to Italian bonds.
  • Italian Snap Elections: President Sergio Mattarella officially called for snap elections to take place on September 25. A conservative right-wing bloc led by the populist party Brothers of Italy is expected to win a majority of seats, setting up a possible clash between the EU and Italy over economic reforms. The heavily debt-laden Italy is set to receive 200 billion euros of aid on the condition that it makes structural changes to its economy. A eurosceptic government could slow these reforms, thus leading to a sell-off in the country’s bonds by risk-averse investors.
• End of Forward Guidance: During the ECB press conference, Lagarde implied that the bank is set to abandon its forward-guidance policy as it seeks to maintain flexibility in its policy decisions. The decision to raise rates by 50 bps went against its forward guidance of 25 bps. The decision to do away with forward guidance is related to the central bank’s having to decide on appropriate monetary policy that will allow it to control inflation and prevent a recession. The death of forward guidance suggests that the market could be very responsive to surprises in the economic data.

The biggest unknown is how the European Central Bank will respond to rising uncertainty in Italy. If the country elects a eurosceptic government, investors will likely sell off Italian bonds in droves, thus pressuring the bank to intervene to keep borrowing costs downs. At this point, it is unclear how the ECB could respond to an Italian government that refuses to comply with mandated reforms. However, failure to prevent bond yields from spreading will likely weigh on the euro and could sink the currency to parity with the U.S. dollar or possibly lower.

Russia-Ukraine: The two sides finally agreed to allow Ukrainian wheat to be exported out of the Black Sea; however, the war does not appear to be close to ending. Meanwhile, Russia has been able to display its influence around the world.

• Russia Vulnerable: The lack of available forces and weapons has led to a slowdown in the Russian offensive in Ukraine. Since taking over Lysychansk, Russian troops have not made much progress which has led to speculation that Russia may be losing steam. Leader of the U.K. secret intelligence service Richard Moore predicted that Ukrainian troops would be able to mount a strong counter-offensive against Russian forces in the coming weeks. In addition, he argued that the Russian military would eventually have to pause due to logistical and supply reasons. His comments suggest that the West plans to support Ukraine’s right to defend itself from the Russian invasion. As a result, this could mean energy uncertainty within Europe is likely to persist.
• Russian Friends: Putin and Mohammed bin Salman met on Thursday in a sign of the close ties between Russia and Saudi Arabia. The meeting came several days after Biden met with MBS, and the juxtaposition showed the gap of influence between the U.S. and Russia in the Middle East. Earlier this week, Putin met with the leadership of Iran to discuss drone purchases. Meanwhile, Russian Foreign Minister Sergey Lavrov is set to meet with several African leaders next week to remind the continent of its long-standing ties with Russia, particularly during the colonial period.
• Wheat Exports: Russia agreed to allow Ukrainian grain exports to leave the Black Sea. The deal will allow the shipment of wheat out of Ukrainian ports. This release of wheat will likely help reduce grain prices and prevent a potential global famine. However, there are still concerns that Russia could renege on its commitment.

As we mentioned in our June 6 Bi-Weekly Geopolitical Report, the world may be breaking into geopolitical and economic blocs. In the report, we showed that the Russia-China bloc likely has the advantage when it comes to supply, which it could use as leverage in disputes with the West.

International Uncertainty: Rising COVID cases, heightened security risks, and trade disputes continue to add to global-growth uncertainty.

• COVID Cases: COVID cases are rising again. In Japan, daily cases topped 30,000 for the first time on Thursday. Meanwhile, infections in Europe have tripled in the last six weeks. President Biden has even contracted the virus. The new variant is proving to be more elusive and contagious than its predecessors; however, it is not creating the same level of economic disruptions.
• Pelosi’s Visit to Taiwan: Tensions are rising between the U.S. and China due to House Speaker Nancy Pelosi’s plan to travel to Taiwan in August. Beijing has warned that it would forcefully respond if she were to travel to the sovereign island. Although it isn’t clear what China would do in response, President Biden cautioned Pelosi that the Pentagon does not think the trip is a good idea.
• Japanese Defense Spending: Rising concerns over national security have led the Japanese government to ramp up its defense spending. Its latest security assessment cited the rising military cooperation between Russia and China as a reason to increase its military capabilities.
• USMCA Spat: Mexico may be penalized $10 to $30 billion over its decision to prioritize its state-owned energy company over private renewable companies. The source of the dispute is related to Mexico’s decision to amend legislation to favor power distribution to state-owned CFE. The law change has led foreign firms to be shut out of Mexico’s energy sector. Canada and the U.S. have requested dispute-settlement talks with Mexico. If all parties cannot agree on a settlement, the U.S. and Canada could hit Mexico with tariffs.

Ongoing disputes between countries and rising COVID cases will lead to some international uncertainty but will be unlikely to have an impact on markets in the short-term. Although the rise in COVID cases is concerning, countries are more prepared to deal with them currently than in the past. Meanwhile, the trade dispute with Mexico and increased Japanese defense spending likely are not significant today, but they have the potential to be important in the future, especially if Mexico decides to leave the USMCA or if Japan becomes more assertive in its foreign policy. However, our biggest concern is that Pelosi’s trip to Taiwan will likely lead to deteriorating U.S. and China relations and could further accelerate the decoupling of the two major economies.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a discussion about the European Central Bank’s decision to raise rates by 50 bps. Next, we examine changes in governments in the U.K. and Italy, followed by an update on the Russia-Ukraine war. The report ends with a review of the warning signs of a possible downturn in the U.S. economy.

 Central Bank News:  Under pressure due to rising energy prices, central banks are being forced to choose whether they will prioritize economic growth or price stability as they set their monetary policy.

• European Central Bank: The ECB raised rates by 50 bps for the first time in 11 years as the EU looks to tame historically high inflation. The hike was above expectations of 25 bps. In addition to tightening policy, the ECB unveiled the Transmission Protection Instrument (TPI) designed to combat fragmentation. The combined rate increase and new fragmentation tool did not lead to panic from investors. After the rate news, the euro strengthened against the dollar, while the spread between Italian and German 10-year bond spreads widened by 9 bps from 223 bps to 232 bps.
• • The ECB stated that the new tool will not be limited by “ex-ante” restrictions suggesting that the bank has not put a cap on the level of intervention.
• Bank of Japan: The BOJ continues to defy expectations by continuing its ultra-low interest rate policy despite rising inflation. The central bank expects core CPI, which excludes food, to rise 2.3% from the prior year. BOJ Governor Haruhiko Kuroda dismissed the possibility of raising rates as the country recovers from the pandemic. The decision to maintain its monetary policy suggests that the yen’s weakness against the dollar will continue for the foreseeable future. Moreover, the currency’s recent depreciation has exacerbated its inflation problem as rising global commodity prices, which are elevated in dollar terms, make it difficult for Japanese firms and households to control costs.

Moving away from negative rates will be difficult for both the ECB and BOJ to navigate. The BOJ’s burgeoning debt burden limits its ability to raise rates. Meanwhile, the ECB needs to ensure that borrowing costs remain close among EU members to prevent a break-up of the bloc. That said, it is unlikely that the moves by either central bank will calm market concerns as rising inflation threatens both countries’ economic outlooks. At this time, we view the investing environment for Japan and Europe as risky.

Shake Up in Europe:  Leadership changes in Italy and the U.K. will likely not have an impact on the Ukraine war but could lead to more friction within the western alliance.

• Italian Crisis: Italian Prime Minister Mario Draghi was forced to resign on Wednesday after several key parties within his coalition boycotted a no-confidence vote. Draghi’s departure will plunge the country into political turmoil as investors fret over the possibility of a less market-friendly Italian government. Italian President Sergio Mattarella is expected to hold snap elections in early 2023. At this time, recent polls suggest that the center-right bloc led by the populist Brothers of Italy will likely take over the government. The unfortunate exit of Draghi will probably weigh on Italian equities as it appears that a new government could be less friendly toward the European Union.
• U.K. Premiership: Foreign Secretary Liz Truss and former Finance Minister Rishi Sunak are set to face off in the final round of Tory voting to become the leader of the party and the U.K.’s next prime minister. Sunak, who has led all voting rounds, vowed to maintain taxes at current levels, while his opponent Truss is running on a platform of deregulation and tax cuts. The result of the final vote will be released on September 5, with betting sites showing Truss, a notable Brexiteer, as a favorite to win.

The change in government in the U.K. should be favorable to British equities as it may provide some political calm. However, the rise of eurosceptics in both U.K. and Italy could lead to renewed clashes with the European Union.

Russia-Ukraine: Russia’s push for more territory and the West’s continued backing of Ukraine suggest that the geopolitical risks from the war will likely persist.

• Moscow Wants More: In a supposed shift, Russia declared that it would take complete control over regions outside of eastern Ukraine, including the Kherson and Zaporizhzhia regions in the south. Earlier in the year, Moscow stated that its goal was to “liberate” the east Donbas border region. After several months of fighting, Moscow claims that its objective has changed because Kyiv refused to agree to peace talks. The move by Moscow to expand its geographical aims was not surprising. On Tuesday, the White House warned that Russia had plans to annex southern parts of Ukraine.
• Russian Aims: Russia’s desire to expand its gains into areas within Ukraine is likely a negotiation tactic. Although it has had some recent success over the last several weeks, the West’s delivery of long-range missiles to Ukraine has opened Russia up to a fierce counter-offensive. Ukraine’s weapon capabilities have ratcheted up the cost for Russian forces to hold ground in newly gained territory. As the war continues, Russia will be inclined to annex the freshly controlled regions to strengthen its leverage against Ukraine and secure support at home.
  • The Paris Club, a group of international creditors, suspended Ukrainian debt service until at least the end of 2023. The move will save Ukraine around $6 billion over the next two years and will likely prevent the country from defaulting on its debt.
  • The White House may provide Ukraine with fighter jets and the training to operate them. The measure would drastically increase the West’s war involvement, and possibly escalate tension with Russia.
  • Gas flows from the Nord Stream 1 pipeline restarted on Thursday after a ten-day annual maintenance break. There was concern that the gas flow would slow after the pipeline returned online; however, orders indicate that flows are on pace to return to 40% of the capacity level reached before maintenance.
  • The U.S. is expected to impose a price cap on Russian oil in December as the EU prepares to impose a ban on companies insuring Russian vessels delivering the commodity.

Warning Signs:  Growing reports of a slowdown in hiring, a cooling housing market, and weaker consumer spending suggest the economy may be headed toward a downturn.

• Labor Market: More companies are announcing plans to either reduce hiring or lay off workers as economic conditions deteriorate. Ford (F, $12.73) is expected to cut as many as 8,000 roles as it shifts its focus away from internal combustion engines and toward electric vehicles. Meanwhile, tech companies Alphabet (GOOG, $113.90), Lyft (LYFT, $14.07), and Microsoft (MSFT, $262.27) are all set to reduce hiring.
• Housing Market: Existing home sales fell for the fifth consecutive month in June as high mortgage rates and residential prices made it harder for potential home buyers to enter the market. Existing home sales dipped 5.4% from the prior year in June, while the median price for existing homes rose 13.4% in the same month.

• Spending Slowdown: Higher prices may lead to a broader consumption In Q1, major retailers such as Walmart and Target warned that households were shifting their preference away from discretionary products in favor of staple goods. However, recent data collected by Bloomberg in Q2 suggests that consumers have even cut the purchase of necessities such as shampoo and diapers.

As the economy begins to slow, we believe that real estate may be a good place to hide. Although there is a decline in demand, the lack of supply will be likely to keep property prices relatively elevated.

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