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.  Both sides in the war appear to be ramping up their attacks again, but the key developments today revolve around Europe’s intensifying efforts to prepare for a complete cut-off of Russian natural gas supplies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an important decision by Italian Prime Minister Draghi to rescind his resignation offer from last week if the parties in his unity government accept his economic reforms.

Russia-Ukraine:  In Ukraine’s eastern Donbas region, Russian forces are once again staging modest, localized ground attacks under the cover of artillery fire and making slow, creeping territorial gains, but Ukrainian forces are putting up stiff resistance with the aid of new weapons from the West.  The Ukrainians continue to show signs of preparing for a significant counteroffensive to retake the southern city of Kherson by using advance Western missile systems to strike a bridge linking that occupied city to other Russian forces on the south side of the Dnieper River.  Meanwhile, nationalist military bloggers in Russia are increasingly pressuring the Kremlin to fully mobilize the country and to focus on much more extensive war aims.  Although Russian President Putin could choose to ignore those calls, there is some chance that he could use them to provide political cover for a more extensive mobilization and a shift back to maximalist war aims.  Separately, the White House warned that Russia is preparing to annex the Ukrainian territory it occupies by autumn.  A likely date for a sham referendum in the occupied territory is September 11, which is a unified election date for provincial and local elections in Russia.

• Amid fears that Russia won’t restart its deliveries of natural gas to Western Europe after the Nord Stream 1 pipeline ends its maintenance outage tomorrow, President Putin last night hinted that the country’s exports will begin again on Friday.  However, he noted that gas deliveries could soon be cut to just 20% of capacity if sanctioned pipeline equipment from the West isn’t delivered – a likely pretext for further energy blackmail in the future.
• As the European Commission becomes more convinced that Russia could completely cut off its natural gas exports to retaliate for the West’s support of Ukraine, it today proposed new emergency powers allowing it to force EU countries to reduce their gas consumption in the event of devastating supply shortages.
  • The plan calls for EU countries to voluntarily curb their gas consumption by 15% over the next eight months to help build inventories for the winter heating season.  It also calls for countries to set priorities to determine which industrial sectors will be most affected.  Energy-reduction targets could become binding if voluntary actions aren’t enough to prevent a shortage.
  • The plan also promotes switching from natural gas to alternative energy sources including nuclear and coal, setting up auctions that could compensate companies for using less gas, and setting mandatory limits on heating and air conditioning in public buildings.
• In other fallout from Europe’s impending war-related energy crisis, the German government has asked the country’s electricity providers to run stress tests to see if they could guarantee adequate power supplies if Russia cuts off its gas exports this winter.  The government’s deputy spokesperson confirmed that the results of the stress test could justify extending the life of the country’s three remaining nuclear power plants beyond their scheduled shutdown at the end of the year.
  • Germany’s apparent policy shift toward keeping its nuclear plants open highlights one massively important implication of the war:  with the world’s new focus on energy security, many countries may now adopt an “all of the above” energy policy emphasizing a diversified portfolio of energy-producing assets, rather than shifting wholesale to renewable energy sources like wind and solar.
  • The new-found appreciation for traditional energy sources like oil, natural gas, and uranium is a key reason why we remain bullish on commodities in the coming years.
  • In the near term, the evolving energy crisis is driving home the risk that Europe’s economy and financial markets are likely to face enormous headwinds in the coming months, with negative implications for European stocks and currencies.
• In still more economic fallout from the war, the Ukrainian government today plans to ask foreign private creditors to allow a two-year repayment moratorium on $3 billion of its outstanding Eurobonds.  Qualifying as a debt default, the move would amount to the first step in restructuring Ukraine’s foreign-owned sovereign debt.

Western Europe:  Britain and the rest of Western Europe continue to suffer through a massive heat wave and wildfire outbreak, with the U.K. recording a record high temperature of 104.5° F and the death toll in Portugal reaching 659.  Since a lot of European infrastructure was never designed or maintained for such heat, it has been a particular source of disruption.  For example, the British government has had to shut down warping roads and airport runways.

Italy:  In a more positive note for Europe today, Prime Minister Draghi announced in parliament that he would be willing to rescind the resignation request he made to President Mattarella last week, but only if the parties in his broad unity government stop creating hurdles to his reform agenda.  Votes in parliament later today and tomorrow will now serve as de facto votes of confidence in his leadership.

• In the days since Draghi made his resignation request last week, thousands of ordinary Italians, including more than 1,800 mayors, business associations, medical professionals, and Rome’s European allies, have publicly appealed for Draghi to stay and help lead the country through the challenges unleashed by the war in Ukraine.  As Draghi probably intended, the outpouring of support may have chastened the squabbling party leaders in his coalition, forcing them to support the government for at least a bit longer.
• If Draghi had resigned, or if he loses the confidence votes this week and his government falls, Italy will face new elections sometime in the autumn.  Current polling suggests that right-wing, populist, and eurosceptic parties would win that election and form a new government, threatening Europe’s economic stability and its support for Ukraine.
• If Draghi remains in power as now seems likely, at least until the regularly scheduled elections in June 2023, there will be less selling pressure on Italian bonds, and Italian yield spreads could be relatively contained.  That, in turn, would give the ECB more leeway to hike interest rates at its policy meeting tomorrow, which is critical in its fight against inflation.

United Kingdom:  In the race to replace Boris Johnson as Conservative Party leader and prime minister, a vote of parliamentary party members yesterday eliminated Former Equities Minister Kemi Badenoch.  The remaining candidates now are Former Chancellor Rishi Sunak (118 votes yesterday), Trade Minister Penny Mordaunt (92 votes), and Foreign Minister Liz Truss (86 votes).

• Further votes are scheduled for today to whittle the field down to just two candidates.  At that point, the remaining candidates will have several weeks to campaign before a poll of the broad party membership at the end of the summer.
• A poll of Tory activists last week found that both Mordaunt and Truss would beat Sunak in a head-to-head race, since many conservatives dislike Sunak’s record as a tax-raising chancellor and his perceived disloyalty to Johnson.  However, Sunak could yet pull out a victory on the belief that he would be more competitive in a future general election.

Chinese Real Estate Sector:  Hundreds of landscapers, construction companies, sculpture-makers, and other suppliers to the real estate sector have complained that they can no longer afford to pay their bills because some financially strapped developers still owe them money.  The outcry comes just days after the government ordered increased lending to troubled developers so they can deliver long-delayed housing units to their buyers and preempt a threatened payment strike.  If the government now orders still more bank lending to allow developers to pay their suppliers, it will confirm that the government is prioritizing economic stability over reining in the sector’s debt levels in the runup to the Communist Party’s 20^th National Congress in October.

Australia:  In an ominous sign for central bank independence around the world, the Australian government has launched a probe into the Reserve Bank of Australia’s delay in raising interest rates as inflation surged out of control.  The review will consider the performance of the central bank, its board composition, and its inflation targeting strategy, potentially inspiring similar probes (and political meddling) in other countries that have suffered high inflation.

Sri Lanka:  Parliament today elected unpopular six-time Prime Minister Ranil Wickremesinghe as the country’s new president, risking further protests that could complicate urgent bailout talks with the IMF.

Panama:  Despite its long history of stability, in part because its currency is pegged to the dollar, Panama is facing a wave of mass protests over soaring price inflation and government corruption.  As in much of the developing world, rising food and fuel costs are a key reason for the unrest.

United States-Mexico: According to the Wall Street Journal, “the [Biden administration] today launched a trade fight against Mexico, accusing President Andrés Manuel López Obrador’s government of favoring its state-owned utility and oil company at the expense of American businesses.  The U.S. is seeking dispute settlement consultations under the U.S.-Mexico-Canada Agreement—the first step in what could lead to tariffs on a range of Mexican products.”

U.S. Technology Sector:  Last night, the Senate passed the U.S. International Competitiveness Act (USICA), which aims to bolster the country’s competitiveness in key technology industries and reduce dependence on foreign suppliers.  A key provision would provide roughly $52 billion in subsidies to encourage chip companies to boost production in the U.S.

• The vote paves the way for a larger package that would include additional funding for scientific research.
• Even if USICA is now paired with the broader science package and passed in the Senate, the bill would still have to be passed by the House and signed into law.

U.S. COVID Vaccines:  The CDC yesterday recommended the use of a COVID-19 vaccine from Novavax (NVAX, $58.00) in adults 18 years and older who haven’t been vaccinated previously.  The recommendation is the final hurdle before the shot can be made widely available in the U.S.

• Relying on a relatively older, more tested technology based on proteins, the Novavax vaccine will be a new option for people who have avoided the gene-based messenger RNA shots from Moderna (MRNA, $167.14) and Pfizer (PFE, $51.37).
• Like the U.S. vaccines already available, the Novavax shot will be offered at no charge at pharmacies and through state and local government vaccine programs.
• The Novavax vaccine requires two doses given three weeks apart.

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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 further evidence that Russia’s aggression has sparked a major, long-lasting increase in global defense spending.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a swing in investor expectations toward a view that the European Central Bank will hike its benchmark interest rate this week by more than previously anticipated.

Russia-Ukraine:  Both Russian and Ukrainian forces appear to be ramping up their ground attacks, or preparing to do so, after their partial operational pauses of the last several weeks.  Russian forces also continue to launch missile strikes across the country, while Ukrainian forces are reportedly concentrating and converging for what may be a counteroffensive near the southern city of Kherson.  Reports also indicate that the Russian government has been forming volunteer units comprised of non-ethnic Russians, demonstrating President Putin’s political reluctance to order a mass mobilization of ethnic Russians.

• By reminding government leaders that major countries can and do invade their neighbors, the Russian attack on Ukraine continues to spur greater defense spending worldwide. In the latest example, Japanese Prime Minister Kishida will allow his country’s armed forces to request as much funding as they want for the coming fiscal year, while all other ministries will have their budget requests strictly capped.
  • Significantly, there have been almost no objections to the plan by opposition parties, left-leaning media or Japanese society in general.
  • Former Prime Minister Abe consistently faced strong opposition to his proposal to double defense spending to 2% of GDP, but current Prime Minister Kishida has faced no such pushback to similar plans.
• In the EU, the European Commission issued a first-ever proposal to provide financing for the joint procurement of weapons by member states to help their armies restock and improve military hardware in response to the war. The proposal seeks to channel the increase in EU defense spending toward coordinated procurement and prevent larger member states from monopolizing the continent’s arms companies.
• As Germany solidifies plans for energy rationing in case Russia completely shuts off its natural gas exports to Western Europe, as European officials now expect, a fierce debate has opened up regarding whether households or industry should get priority access to limited supplies. Major firms and industry groups are pushing for protection, although political considerations probably mean consumers will be given priority.
• In a bid to encourage European countries to share gas and cap prices if necessary, the IMF warned that a full cut-off of Russian gas would trigger economic contractions of more than 5% over the next year in Italy, the Czech Republic, Hungary, and Slovakia.
  • The IMF modelling suggests that the European economy could manage with Russia curtailing supplies by 70%, but a complete cut-off would cause painful shortages.
  • In a worst-case scenario, the worst affected European countries would only be able to access 15% to 40% of their needs.

European Union:  Based on new comments from ECB President Lagarde and other monetary policymakers in the Eurozone, investors have become increasingly convinced that the officials will hike their benchmark short-term interest rates on Thursday by an aggressive 50 bps, to 0.0%, rather than the 25 bps Lagarde insisted on earlier in the summer.  In recent days, speculation that the ECB could end negative interest rates in the Eurozone has helped drive the euro higher after it essentially reached parity with the dollar last week.

United Kingdom:  Yesterday, in the race to replace Boris Johnson as Conservative Party leader and prime minister, a vote of parliamentary party members eliminated Tom Tugendhat, chairman of the Foreign Affairs Committee.  The remaining candidates include Former Chancellor Rishi Sunak (115 votes), Trade Minister Penny Mordaunt (82 votes), Foreign Minister Liz Truss (71 votes), and Former Equities Minister Kemi Badenoch (58 votes).

• Further votes are scheduled for today and tomorrow to whittle the field down to just two candidates.
• At that point, the remaining candidates will have several weeks to campaign before a poll of the broad party membership at the end of the summer.

Chinese Real Estate Sector:  With dozens of real estate developers on the verge of bankruptcy and unable to finish paid-for housing units due to government efforts to rein in their debt, Beijing is scrambling to quell a move by furious homebuyers to stop making mortgage payments on undelivered homes.  One government tactic has been to censor social-media posts about the crisis.  More importantly, the China Banking and Insurance Regulatory Commission has instructed banks to provide credit to eligible property developers “based on market principles and in compliance with the law” to help them complete unfinished homes.

• Compared with the total amount of outstanding mortgages in China, the loans threatened by the buyers’ payment strike are probably not enough to threaten the banking system.
• Rather, the government seems more focused on averting more social disruption, especially ahead of the Communist Party’s 20^th National Congress this autumn, at which time President Xi aims to win a precedent-breaking third term in office.
• In any case, the move by the CBIRC opens the liquidity taps to developers for the first time in almost one year. In response, Chinese developer stocks jumped sharply.  The intervention also underscores the government’s willingness to goose the economy in order to support growth ahead of the party conclave.

Chinese Technology Sector:  The Cyberspace Administration of China is reportedly preparing to impose a fine of more than $1 billion on ride-hailing company Didi Global (DIDIY, $2.93) for data security breaches discovered last year. However, the government will also ease a ban on Didi’s adding of new users to its platform and will allow the company’s mobile apps to be restored to domestic app stores.  Although China’s tech sector remains under high regulatory risk, the move is another example of Chinese authorities easing up on firms to bolster growth ahead of the party congress.

United States-China:  If you’re looking for a silver lining in today’s high U.S. inflation rate, you can find one in the comparison of U.S. to China gross domestic product (GDP).  Such comparisons are typically calculated in nominal terms at current exchange rates, so galloping U.S. prices and a weak renminbi mean China GDP will likely lag U.S. GDP for years to come.  However, when adjusted for the purchasing power of the currency, China’s GDP surpassed that of the U.S. many years ago.

United States-European Union:  Tomorrow, Secretary of State Blinken will hold a meeting with officials from the EU and 17 other countries to discuss ways to strengthen industrial supply chains among themselves.  Besides the EU, the key countries involved will include Australia, India, Indonesia, Japan, Singapore, and South Korea.  Consistent with the administration’s push to increase “friend shoring,” neither China nor Russia was invited.

• We have long warned that the U.S. is pulling back from its traditional role as global hegemon, contributing to deglobalization and a fracturing of the world into separate geopolitical and economic blocs. In our Bi-Weekly Geopolitical Report of May 9, 2022, we took a stab at forecasting which countries were likely to join each of the evolving blocs, and what that would imply for the global economy and financial markets going forward.  We note that most of the countries Blinken will meet with tomorrow are in our projected U.S.-led bloc.
• To date, the Biden administration has tried to nurture the development of the U.S.-led bloc mostly by incentives and persuasion, and that will likely be the main approach at tomorrow’s meeting. However, it is important to remember that the administration could eventually take a more forceful approach to building the U.S.-led bloc and sealing it off from the Chinese-led bloc, as the Trump administration did.

U.S. Labor Market:  In a call with financial analysts yesterday, Goldman Sachs (GS, $301.26) warned it may slow hiring and eventually cut underperforming staff in response to tightening monetary conditions.  Coming on top of hiring slowdowns and job cuts announced recently by major technology firms, the statement adds to concerns that U.S. economic growth and labor demand are already slowing.

U.S. Corporate Earnings:  U.S. multinational firms like Johnson & Johnson (JNJ, $174.23) have begun to indicate that the strong dollar is weighing on their profits.  Along with higher costs for materials and labor, the super-strong dollar suggests that large companies’ margins and earnings may be set to surprise to the downside through the rest of the year.

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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 appears to be ramping up its ground attacks and missile barrages again after a partial operational pause.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the U.K.’s Conservative Party leadership election and signs of thawing China-Australia relations.

Russia-Ukraine:  Russian forces appear to be ramping up their ground attacks in Ukraine’s eastern province of Donetsk again, following a partial operational pause in recent weeks.  However, we suspect that troop and equipment shortages will prevent them from launching major new offensives.  Indeed, Moscow did not claim any new seizures of territory yesterday.  Meanwhile, Russian forces have not only stepped up their missile attacks across Ukraine, but several reports say they have moved additional troops and equipment into the Kherson region to defend it from a planned counteroffensive that Kyiv has signaled.  Importantly, those troop and equipment moves could weaken Russia’s attacks around Donetsk, perhaps as Kyiv intended when it publicized its counteroffensive against Kherson.  Finally, we note that Russian Defense Minister Shoigu has ordered Russian troops to prioritize attacks on long-range artillery systems provided to Ukraine by its Western supporters.  The order underlines the importance those systems have had in bolstering Ukraine’s military capabilities.

 

• On Sunday evening, Ukrainian President Zelensky fired both the country’s general prosecutor and the head of its security service, a friend from childhood, amid allegations that their offices were riddled with officials who were collaborating with Russia.
• International Energy Agency Chief Fatih Birol today warned that there is a real chance Russia will completely shut off its supply of natural gas to Western European countries in retaliation for their support of Ukraine.  According to Birol, Western European nations must take urgent and coordinated action to avert a potentially disastrous supply crunch this winter, in what he termed “a historic test of European solidarity.”  Birol’s suggested steps include the following:
  • Temporarily step-up coal-and oil-powered electricity generation;
  • Launch public-information campaigns to reduce household gas demand;
  • Compensate industries for forgoing gas supplies;
  • Increase cooperation among national electricity operators; and
  • Plan for EU-wide sharing of what available gas supplies remain.
• EU Foreign Affairs Commissioner Borrell expressed hope that Russia, Ukraine, and other interested countries could strike a deal this week to restart grain shipments out of Ukraine and help ease the worsening global food crisis.
  • The prospect of an agreement to end the blockade comes as the EU prepares legislation to ease its sanctions regime against Moscow to allow trade in Russian food products as it attempts to address anger in Africa and elsewhere that rely on Russia food supplies.
  • Draft legislation to be considered by EU ambassadors today would provide exemptions to existing bans on transactions with certain Russian state-owned entities when it comes to food products, a tacit acknowledgment that sanctions against Moscow may have inadvertently led to a curb on Russian food exports.
  • As global food markets adjust to the war-related supply disruptions to date, and as traders factor in the risk of global recession, grain prices continue to retreat.  For example, corn and wheat futures are now down some 25% and 40%, respectively, from their early-spring highs.
• A recent analysis by the Economist Intelligence Unit estimates that commodity supply disruptions and other fallout from the war will reduce global economic output by approximately $1 trillion this year, with the biggest losses in Germany, France, and Italy.

European Union:  Most of Western Europe this week is suffering through a record-breaking heatwave and wildfire outbreak, which is already starting to threaten economic activity.  What’s less publicized is that the Continent is also suffering through a major drought.  One consequence of the dry weather is that hydroelectric power generation is falling, worsening Europe’s wartime energy shortages.

United Kingdom:  In the race to succeed Prime Minister Johnson as Conservative Party leader and prime minister, the latest poll of parliament members has whittled the field down to just five.  Former Chancellor Rishi Sunak remains the frontrunner, followed by Foreign Minister Liz Truss, Trade Minister Penny Mordaunt, Foreign Affairs Committee Chairman Tom Tugendhat, and Former Equities Minister Kemi Badenoch.

• Despite Sunak’s strength, he remains under threat from candidates to his right.
• After garnering a surge of support last week, Mordaunt’s star seems to be fading, and a poll of grassroots’ party members has revealed a strong preference for Badenoch.
• After a nasty televised debate last night, Sunak and Truss pulled out of a debate scheduled for Tuesday on concern that the divisiveness is damaging the party’s image.  That debate has now been cancelled.
• Another ballot is scheduled for today when the candidate with the lowest total of votes will be eliminated.

China:  As the highly transmissible BA.5 Omicron mutation of the coronavirus continues to spread, a Japanese investment bank estimates that 41 cities in China are now under full or partial lockdowns or district-based controls, covering 264 million people in regions that account for about 18.7% of the country’s economic activity.  More ominous is that major production centers including Shanghai and Tianjin have ordered mass testing in response to new cases, raising the prospect of renewed lockdowns in those cities.  The news highlights the continuing negative economic impact of President Xi’s strict Zero-COVID policies.

China-Australia:  After Chinese officials last week indicated they may resume importing coal from “down under,” Australian Treasurer Jim Chalmers said such a move would help restore ties between the two countries.  He also encouraged China to remove its restrictions on other imports from Australia, such as wine and barley.

• Beijing began blocking Australian imports in late 2020 to retaliate for former Australian Prime Minister Morrison’s call to investigate China’s role in the coronavirus pandemic.
• The potential loosening in Chinese policy stems in part from the fact that Morrison is no longer prime minister, and that the new government in Canberra has made a concerted effort to re-engage with China.  Just as important, Beijing’s interest in resuming Australian coal imports reflects a general tightening in the global energy market, as war-related disruptions to Russian supplies force many European countries to scramble for alternative energy sources.
• Thawing bilateral ties could potentially be a boon for Australia, although China’s economic slowdown would likely reduce the benefit for Australian companies.

Pakistan:  Former Prime Minister Imran Khan’s party won a critical by-election in Pakistan’s most populous province, putting him on track to force early parliamentary polls just months after he was ousted from office.  Khan’s victory is being ascribed to voter anger over high inflation and the painful belt-tightening measures current Prime Minister Sharif has imposed to restart lending under a $7-billion IMF program.  Without that program, Pakistan would be at even greater risk of defaulting on its foreign debt, as Sri Lanka recently has.

Sri Lanka:  Although President Gotabaya Rajapaksa resigned and fled into exile last week, protestors are now demanding that Acting President Ranil Wickremesinghe resign as well.  Wickremesinghe is seen as a close ally of the Rajapaksa clan that has dominated Sri Lanka’s government for decades.  The continuing political and economic turmoil bodes poorly for other emerging markets, some of which are facing challenges similar to those in Sri Lanka, including high debt service costs, rising interest rates, and a strong dollar.

United States-Saudi Arabia:  On Saturday, President Biden completed his visit to Saudi Arabia with no concrete deliverables in terms of Saudi commitments to increase oil production and bring down prices.  On its face, the outcome is a significant disappointment for Biden, especially given that he has been strongly criticized for the trip by progressives looking for stronger U.S. action on human rights and policies to combat global warming.

• Despite Biden’s failure to win big, definitive concessions from the Saudis, it’s important to remember that the trip further advanced what could be called the “Biden Doctrine,” i.e., a concerted effort to rebuild U.S. influence and ties with key allies.
• For more than a decade, U.S. leaders have been trying to disengage from the messy politics and security issues in the Middle East to focus on the rising geopolitical threat from China.  Now that global politics and energy disruptions are drawing Biden back into the region, albeit kicking and screaming, U.S. re-engagement could ultimately help improve global security and economic stability, at least for as long as it lasts.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

In today’s Comment, we will provide updates on U.K. elections, Draghi’s resignation, and possible price caps, all of which are potential threats to the Western bloc’s unification against Russia. Next, we discuss international news with a focus on China’s latest GDP. We end with an overview of U.S. news. Below are the top stories moving financial markets.

 Top Stories: Equity markets clawed back most of the early losses on Thursday after central bankers cast doubts about a potential 100 bps rate hike during the next Fed meeting. Meanwhile, disappointing earnings reports from J.P. Morgan (JPM, $108.00) and Morgan Stanley (MS, $74.69) led to concerns that the economy may be harming financial equities.

• Central Bank: Fed Governor Christopher Waller reaffirmed his support of raising the Fed’s benchmark rate by 75 bps in the Fed’s upcoming meeting, but could back a more considerable rate hike depending on the incoming economic data. St. Louis Fed President James Bullard mirrored Waller’s sentiment by suggesting that he also favors a 75 bps hike. The reluctance of Fed officials to respond aggressively to Wednesday’s hot CPI report suggests that the Fed may be concerned about the economy. Although it is unlikely that the central bank will pause rates anytime soon, Fed officials may be hesitant to signal further rate increases as economic conditions deteriorate.

Maintaining the Western Alliance:  New elections, rising prices, and varying levels of commitment are preventing the West from presenting a unified front against Russia. As the Western bloc struggles to stay on the same page, Putin’s leadership position is pivotal in demonstrating Russia’s willpower to maintain its war in Ukraine.

• UK. elections: An unexpected candidate has taken the lead in the race to replace U.K. Prime Minister Boris Johnson. Betting sites favor Penny Mordaunt to take over as the new leader of the Tory party, although five candidates remain in the running. Predictit.org gives Mordaunt a 56% chance of winning, while Sky Bet also shows her as an early favorite. Assuming she wins, it is unlikely that she will have a different foreign policy than the outgoing prime minister, and therefore U.K. commitment to Ukraine is unlikely to change. Nevertheless, Mordaunt’s victory should be favorable to assets within the U.K. as she is anticipated to provide some political calm to the country.
• Draghi’s resignation: Italian Prime Minister Mario Draghi offered to resign on Thursday; however, his request was promptly denied by Italy’s President Sergio Mattarella who insisted that Draghi wait a week before deciding on whether to step down. The political chaos comes at a vulnerable time for the country as a new Italian government may be less friendly toward the EU. News of Draghi’s resignation caused the spread between Italian and German bonds to widen by 16 bps. A government collapse will probably not impact Italy’s commitment to the war in Ukraine, but it could pave the way for the break-up of the Eurozone. Polls show that the populist party Brothers of Italy is favored to win the majority of seats in an election. The party leader, Giorgia Meloni, is a noted eurosceptic but a vocal supporter of Ukraine.
• Price caps: The West is making progress on price caps for Russian oil. The U.S. and EU have stated that they may be willing to withdraw their sanctions on shipping insurance and financing services in exchange for support of a price ceiling. The move would reduce the price the EU is paying for reduced-volume purchases of Russian crude oil to similar levels that China and India are currently paying. Although price caps are an attractive alternative to sanctions, it isn’t the perfect solution. In theory, countries can refuse to pay the market price for Russian crude; however, Moscow can then respond by not selling to them. As a result, countries must be willing to risk losing access to Russian oil for the plan to work. Europe appears to be the guinea pig in this experiment as its dependency on Russian crude means it will be the primary enforcer of the cap. Given the sensitivity that EU countries such as Germany and France had around securing their energy resources, they may not go along with it, especially in the winter.

International: Improvements in the Middle East and the potential for policy accommodation in China are both positive developments for international equities; however, rising energy prices remain a risk, particularly for countries with limited energy reserves.

• Israel-Saudi Arabia: Normalization between Israel and Saudi Arabia edged closer to reality after the Israeli government green-lit a deal to cede control of two strategic islands in the Red Sea. In exchange for relinquishing control, Israeli airlines will be allowed to use Saudi airspace for flights to China and India. In addition, normalizing relations within the Middle East creates a favorable investment environment for the region.
• Japan energy: To prevent a potential power crunch, Japan would like to bring up to nine nuclear reactors online to diversify the country’s energy sources. As an island nation, Japan does not have the same capability as larger countries (such as the U.S.) to mine fossil fuels and is forced to import to meet its energy needs. As a result, the global rise in commodity prices has pushed the country’s inflation to its highest level in nearly a decade. The new reactors will likely provide some relief for the country, but it won’t be a long-term solution. Japanese officials estimate that the reactors could provide up to 10% of the country’s electricity needs. Approaching wintertime, we suspect Japanese firms will struggle to maintain profitability as they cope with rising energy costs. Therefore, until the BOJ steps in and tightens monetary policy to improve the yen’s strength, we view Japanese equities as having elevated risk.
• China’s growth: GDP in China rose 0.4% from the prior year, much lower than expectations of an increase of 1.2%. The drastic slowdown in Chinese growth is likely related to the country’s property meltdown and Zero-COVID policy. The disappointing GDP number could pave the way for Beijing to provide additional fiscal and monetary support, which should be favorable for Chinese equities.

Recent developments in China and the Middle East should result in improved sentiment about international equities in the short term. However, a hawkish Fed, a stronger dollar, and rising energy prices pose a risk for emerging economies. That said, we believe that Chinese equities are particularly attractive as we suspect Beijing will attempt to boost the economy heading into the 20^th National Congress of the Chinese Communist Party later this year.

 Domestic: A cooling housing market, increased scrutiny, and lower government spending will likely weigh on market sentiment as investors remain risk averse.

• Housing: The supply of homes for sale rose for the first time in two years. The increase in homes on the market suggests that rising pricing and financial costs have started to weigh on demand. Although prices are unlikely to fall on a nominal basis, the decline in demand indicates that housing prices will rise at a slower pace. Because most households derive the majority of their wealth from an increase in the equity value of their homes, a sluggish housing market may lead consumers to spend less. As a result, the economy and financial markets could suffer because of waning consumer and investor sentiment.
• Antitrust: Tech companies face growing regulatory risk as government agencies seek to increase competition within the sector. The DOJ is set to reject concessions from Alphabet (GOOG, $2,207.35), paving the way for a potential antitrust lawsuit over the company’s online ad market dominance. The move to limit tech dominance has bipartisan support. The right feels that tech companies have used their market power to ensure their voice, while the left believes that tech companies have used their platform to profit from disinformation. As a result, we expect the tech sector to be a less attractive place to invest as rising rates and regulatory crackdowns will make it harder for firms to expand.
• Manchin out: Senator Joe Manchin (D-WV) has jettisoned any hope that he would support an economic package that contains new spending on climate change or new taxes. He will now only back legislation that lowers drug prescription costs or extends enhanced ACA subsidies.

Concerns about a possible recession in the U.S. will likely persist as the lack of government spending and slowdown in residential investment weigh on growth. While this will probably hurt pro-cyclical stocks, we suspect defensive stocks in sectors such as Health Care, Utilities, and Consumer Staples may be attractive. Tech stocks, though, will likely face greater scrutiny as governments worldwide look to break up these companies.

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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 latest CPI report and its impact on the Federal Reserve’s decision to raise rates. We then briefly review Biden’s trip to Israel. Next, we give an update on the latest development from Russia’s war in Ukraine. We end the report with an overview of other news stories that we believe will affect financial markets.

Central Bank News: Financial markets sputtered on Wednesday after a disappointing CPI report led to fresh concerns that the Federal Reserve could take more aggressive actions to tame inflation. The CPI report showed that the price index soared 9.1% from June the prior year, marking a four-decade high for inflation. The S&P 500 closed lower, and the two-to-10-year inversion deepened as investors priced in an increased likelihood of a 100 bps hike for the July Fed meeting. Atlanta Fed President Raphael Bostic, a notable dove, reinforced investor concerns after declaring that everything is in play as the FOMC looks to tame inflation. San Francisco Fed President Mary Daly also mentioned that a 100 bps hike is a possibility given the recent CPI report. Despite the hawkish tilt from non-voting FOMC members Bostic and Daly, there are some indications that the Fed may maintain its plans to raise rates by 75 bps. Cleveland Fed President Loretta Mester, a voting member, stated that the data suggested that at least a 75 bps hike was needed, but did not elaborate on whether she favored a more significant hike.

• The faster the Federal Reserve raises rates, the greater the likelihood it will push the economy into a recession. Over the last 40 years, the Fed has not been able to increase its benchmark rate above the previous cycle’s peak without causing an economic downturn. Now that the fed fund’s target rate is currently 1.675%, a 100 bps rate hike would place that target just above the previous peak.

• Four of the 12 Federal Reserve districts reported that economic growth either slowed or declined in the latest Beige Book. The report, which looks at the economic situation of each of the Fed districts, showed that business contacts reported signs of slower demand and substantial price increases. Although the report indicated that economic activity expanded at a modest pace, an improvement from six weeks ago, contacts in five districts noted concerns of an increased possibility of a recession.
• Shelter prices rose at their fastest pace since 1986, and it is still possible that prices will continue to speed up for at least another six to 12 months. Our data shows that shelter prices lag the FHFA House Price Index by about 18 months, with the peak hitting in June of last year. The increase in the prices for homes and shelter is likely the result of low residential inventory. Homebuilders over the last year have struggled to complete construction projects due to the shortage of labor and materials. Although prices for critical resources like lumber and steel have declined in recent weeks, it will probably be some time before the homebuilders can finish these projects.

 Biden’s Middle East Trip: President Biden and Israeli Prime Minister Yair Lapid signed an agreement that the two countries are committed to stopping Iran from developing a nuclear weapon. Despite the appearance of a united front, the two sides appear to have differing views on how to deter Iran’s nuclear program. Biden would like to return to the 2015 nuclear deal, while Israel would like to take more direct action. Besides agreeing to stop Iran from developing nuclear weapons, the two sides have also discussed improvements in military integration.

• We suspect that President Biden’s visit was partially aimed at preventing Israel from taking unilateral action against Iran. The potential for conflict between Israel and Iran remains elevated. We are watching this situation closely.

 Ukraine-Russia Update: In another change in the war’s tide, Russian forces have suffered several defeats on the ground in Ukraine as they try to take over smaller cities in the country’s eastern region. Meanwhile, the Kremlin has pushed the country closer to full-scale mobilization by ordering federal districts to recruit and financially reward volunteers willing to take part in the war. The latest development in Ukraine suggests that the investing environment in Europe will probably be fraught with risk as countries continue to struggle to adapt to the higher energy and food prices resulting from the conflict.

• A deal allowing Ukrainian wheat to leave ports in the Black Sea is close to being reached. The agreement is being worked out between Russia, Ukraine, Turkey, and the United Nations. Although there is optimism that all parties can sign a deal next week, there are some concerns that Russia may back out. If Ukrainian wheat can make it into global markets, it could bring down food prices and reduce the threat of global famine.
• Natural gas disruptions risk triggering a global recession, according to the International Monetary Fund. The multilateral organization warned that Russia’s war in Ukraine has weakened its global growth outlook.

Italy: A potential collapse of the Italian government is weighing on the euro. The Five Star Movement stated that it would pull its support from the current government over concerns that the coalition is not doing enough to help families deal with rising energy and food prices. Although the breakdown of cross-party alliances is not unusual for Italy, the resulting election could have implications for Ukraine. The Five Star Movement does not support offering Ukraine military weapons to fight against Russia due to concerns that it may prolong the war. Thus, if the Five Star Movement gains influence after the next election, Ukraine may have difficulty finding support for its war efforts.

• A pro-NATO right-wing party is expected to gain the most seats in the Italian parliament if the country heads to elections. Assuming polls are correct, the Brothers of Italy party should take the most seats in the parliamentary run-off. Although a populist right-wing party, the Brothers of Italy has recently moderated some of its policy stances to appeal to a broader base. Party leader Giorgia Meloni has been a vocal critic of Russia’s invasion of Ukraine and supports sending weapons to Kyiv. The party’s populist tilt, however, could make it difficult for the group to find partners to form a coalition. The group is known to challenge EU norms, such as marriage equality, and has a reputation for being a party for eurosceptics. As a result, the new elections will probably not improve financial conditions significantly in Italy as political uncertainty will likely remain.

China: Fears of a Chinese housing crisis are rising after a growing number of homebuyers refuse to pay mortgages for unfinished housing projects. As a result of the boycott, Chinese authorities met with major banks to discuss solutions to the upheaval.  The rising defaults from property developers undermines the likelihood that the projects will be completed, leading homebuyers to refuse to repay mortgage loans on unfinished construction.  The weakness in the property sector suggests that China’s traditional method of boosting growth through debt-driven real-estate investment may be losing its potency. Therefore, Beijing may have a more challenging time stimulating the economy as it moves away from its Zero-COVID strategy.

• In another setback for China, SEC Chair Gary Gensler dampened expectations about a deal with Beijing to keep Chinese companies listed on U.S. exchanges. Beijing and Washington are engaged in discussions that would allow a third-party to oversee the audit of Chinese companies listed in the U.S, as required by law. China is hesitant of foreign oversight of its companies, which is the source of the deadlock in talks. If an agreement is not reached, Chinese companies could be forced to delist from U.S. exchanges by 2023.

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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.  Both sides remain in an operational pause, of sorts, but they continue to stage limited, localized attacks on each other.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an overview of President Biden’s trip to Israel and Saudi Arabia, which began today.

Russia-Ukraine:  Russian and Ukrainian forces remain in a partial operational pause as they focus on resting, refitting, and regrouping ahead of future attacks.  All the same, they continue to launch limited, small-scale probing and positioning attacks, especially with long-range artillery.  In particular, the Ukrainians continue to make good use of advanced artillery systems recently delivered by the West.  Reports today say they used one such system to destroy a key Russian air-defense system protecting the skies over occupied Luhansk province.

• The Russian-appointed administrator of a town in occupied eastern Ukraine has been killed in a car bombing, presumably at the hands of Ukrainian saboteurs.  Separately, occupation authorities said the Russian-installed district head of Melitopol, one of the first towns in southern Ukraine to fall to Russian forces, had escaped an attempt on his life by a saboteur shooting at his house.  The reports indicate Ukrainian partisans remain active and could cause significant casualties to Russian forces and their supporters in occupied areas.
• With President Biden and the Democratic Party still polling poorly, many observers are growing concerned that isolationist, “America-first” Republicans will shut off U.S. aid to Ukraine and open the door to a Russian victory after November’s mid-term elections.
  • Moderate, internationalist Republicans in Congress helped push that aid through in the early months of the war, before far-right opponents were able to organize resistance.  Now, far-right isolationists and admirers of Russia’s authoritarian government are better positioned to mount a concerted pushback.
  • We would note that much of the U.S. aid to Ukraine – especially the transfer of major weapon systems – ultimately flows back to U.S. defense firms and their workers.  Because of that consideration, and the risk of Russian aggression in a region where the U.S. has vital national interests, it is probably not a foregone conclusion that a Republican victory in November will end U.S. aid to Ukraine.

United Kingdom:  In the race to replace Boris Johnson as Conservative Party leader and prime minister, nominations closed yesterday with eight parliament members meeting the qualification standards.  Former Chancellor Rishi Sunak remains the front-runner, although he is facing a stiff challenge from candidates from the party’s far-right wing.

• Under party rules, an initial ballot of parliament members will be held today.  Any candidate who wins a majority of the votes will become Conservative Party leader and prime minister.  Any candidate who fails to secure at least 30 votes will be knocked out of the running.
• If needed, a second ballot is expected to take place Thursday, in which the last-place candidate and any candidate securing fewer than 30 votes will be knocked out.
• A third ballot, if one needs to take place, has been penciled for next Monday, July 18. Successive ballots are expected to take place daily on the same terms, until only two candidates remain by July 21.
• The final two candidates will then be put to a vote of grassroots Conservative Party members — thought to number around 200,000 people in total — lasting most of the summer, with head-to-head debates to be held at hustings around the country. The winner of that ballot will replace Johnson as prime minister on September 6.

China:  In Shanghai, 378 new cases of COVID-19 have been discovered across all 16 districts in the last nine days, prompting officials to reopen some centralized quarantine sites.  Many neighborhood committees have also advised residents to prepare 14 days of food and medicine.  The report serves as a reminder that China remains susceptible to tough pandemic lockdowns under President Xi’s zero-COVID policy.

United States – Israel – Saudi Arabia:  As we noted in our Comment yesterday, President Biden embarked on a four-day trip to Israel and Saudi Arabia today, where he will be seeking to repair security and economic relations.  Despite the long-term trend of U.S. leaders trying to extricate America from the Middle East, that’s proving hard to do.  Indeed, U.S. efforts to pull back from the region since at least the Obama administration have ruffled the feathers of regional leaders and created a dangerous opening for Iranian aggression; all of which Biden is now trying to reverse.

• In Israel, Biden’s first stop, the talks will likely focus on the military threat from Iran, cooperation in missile defense, and efforts to further improve relations between Israel and Saudi Arabia.
• In Saudi Arabia later in the week, the talks are expected to focus on U.S.-Saudi relations and securing a boost in OPEC oil production.  In return, reports suggest the Saudis will demand renewed U.S. commitments to the defense of the kingdom, probably in conjunction with warmer rhetoric on Biden’s part.

 Global Oil Market:  In its monthly report, the International Energy Agency cut its forecasts for global crude oil demand by approximately 250,000 barrels per day for both this year and next year, mostly because of slowing economic growth and demand destruction from today’s high prices.  The agency now sees demand rising more moderately to 99.2 million bpd in 2022 and 101.3 million bpd in 2023.  Meanwhile, the new forecasts call for global supply to increase to 100.1 million bpd this year, in part because Russian output hasn’t fallen as much as anticipated in response to Western sanctions over the war in Ukraine.

• Expectations for reduced demand and rising supply help explain the recent pullback in global oil prices.
• So far this morning, WTI is trading at approximately $96.85 per barrel, up 1.1% from yesterday but still down some 20.7% from its recent high in late June.

Global Population:  In updated forecasts, the United Nations Population Division said the world’s population will reach 8 billion in November 2022, but the annual growth rate will slip below 1% for the first time since 1950.  The global population is now projected to plateau at about 10.4 billion in the 2080s.  In other interesting tidbits, the new forecasts state:

• India will become the world’s most populous country in 2023, with more than 1.4 billion people, just ahead of China.
• The population of 61 countries is projected to decrease by 1% or more between 2022 and 2050, driven by a fall in fertility.  The biggest decliners include several countries at risk of Russian aggression including Ukraine, Latvia, and Lithuania.
• Falling fertility rates will produce a temporary “demographic dividend,” in which working-age adults will become a greater share of the population in many countries, boosting average output per capita.
• Eventually, however, the drop-off in births will boost the share of the population that is retired and elderly, creating labor shortages and putting upward pressure on public budgets.

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