by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with a discussion about the U.S. dollar’s impact on equities. Next, we give an overview of the upcoming Italian election over the weekend. Finally, we conclude with an update on the Ukraine war.

Fed Hangover: All focus seems to be on the dollar after the Fed lifted its policy rate by 75 bps. Here are our thoughts regarding the greenback’s impact on equities.

• The U.S. dollar index rose to its highest level in over 20 years due to the Fed’s tightening cycle and the Russian war in Ukraine. The greenback’s strength hurt firms with substantial overseas sales as these companies receive a weaker currency for payment for their goods and services. An index that tracks the S&P 500 performance of firms based on revenue exposure shows how the lack of dollar exposure may have led to worse performance this year.

• Although eye-catching, the chart above does not explain the complete picture of how dollar exposure impacts equities. Most of the decline in the foreign revenue exposure index was driven by tech. Weakening overseas sales hurt the sector’s performance, but the rise in borrowing costs is also an important factor. Additionally, the Real Estate sector, whose U.S. revenue exposure is only surpassed by Utilities and Telecommunication Services, has underperformed the aggregate S&P 500 Index. Thus, dollar impact on equity performance may be ambiguous at best.
• More hawkish policy from non-U.S. central banks is a possible cure to the dollar’s rise. However, it does come with risks as political backlash could pressure governments to support dovish fiscal and monetary policy as economies barrel into recession. We are seeing this situation play out in the U.K. The Truss administration plans to implement the largest tax cut in the country’s history since 1972. The pound sank to a 37-year low against the dollar following the report as investors fear that the Bank of England will not be able to contain inflation. The political ramifications of a recession will likely mean the BOE may not be the only central bank hesitant to raise rates. Thus, the dollar’s surge should continue if other central banks abandon or slow their monetary policy tightening prematurely to the Fed. In short, we would like to remind our readers not to put too much emphasis on one parameter when making allocation decisions. Although the U.S. dollar’s impact on revenue provides insight into firm profitability, it is essential to consider the broader macroeconomic environment when making investment decisions.

Italian Elections: The right-wing bloc is expected to take over the Italian parliament; however, there are concerns that the coalition may not hold together.

• Italian voters are set to pave the way for right-wing populists to take over parliament. Led by the historically Eurosceptic Brothers of Italy party, the new government will potentially include the League, Forza Italia, and Noi Moderati. Unlike in 2018, the differences between these parties are not significant enough to prevent the formation of a government. The leader of the Brothers of Italy, Giorgia Meloni, will take over as prime minister. Although she is known for being a nationalist on the campaign trail, she has openly supported keeping Italy in the EU and NATO.
• Meloni might not struggle to form a government, but that does not mean there isn’t friction within the coalition. Right-wing bloc leaders Meloni and Matteo Salvini both share a dislike for immigration, support law and order, and promote conservative family values. However, the two have differing views on Russia and government spending. Although the pair get along on the surface, there are rumors that their relationship is far from amicable. The Italian parliament could fall if the rivalry gets out of hand.
• The rise of a right-wing populist coalition in parliament does not seem to be startling Italian bond investors as much as we once feared. Despite desires from members within the coalition for household subsidies to curtail inflation, Meloni has assured Brussels that Italy will be fiscally responsible under her control. At 150.8% of GDP, Italy has the second highest debt burden in the EU. Meloni’s commitment to sound fiscal policy has likely calmed concerns over a potential EU-Italy clash. As a result, the yield gap between Italian and German 10-years bonds has narrowed from 2.40% in June to 2.27% as of September 22.

Ukraine Update: Everyone is looking for an off-ramp from the Ukraine war; however, political pressure is forcing the West and Russia to make uncomfortable decisions.

• Russia is threatening to use nuclear weapons as it grows desperate to consolidate its territorial gains in Ukraine. Despite not fully controlling any of the four regions it is attempting to annex, Moscow wants to give the illusion that it has made progress in its mission to protect separatists in the Donbas and Luhansk regions. However, recent setbacks from the Ukraine counteroffensive and political backlash due to partial mobilization has forced the Kremlin to double down on its claim that the war was necessary. Although the fight is far from over, recent moves from Russia suggest that hardline nationalists may pressure the ruling party to secure a victory at all costs.
• The European Union faces resistance as it gears up to impose another round of sanctions and place price caps on Russian oil. Hungarian President, and Putin ally, Viktor Orban called on the EU to scrap sanctions altogether over concerns that they are worsening the energy crisis in Europe. His remarks come as officials look to dissuade Russia from using nuclear weapons in Ukraine. That said, Viktor Orban is not alone; disputes over sanctions have led to party infighting in Italy and Germany. The disunity has added to speculation that the energy crisis could lead to a break-up of the EU.
  • The European energy crisis has contributed to the decline in the euro against the U.S. dollar as it will likely tip the continent into recession. However, if the winter is mild and energy supplies prove sufficient, the euro could rebound.
• Neutral countries India and Turkey are not pleased with Russia’s referendums to annex parts of Ukraine and mass mobilization efforts. Turkish President Recep Tayyip Erdoğan called the elections illegal, and Indian Prime Minister Narendra Modi demanded the war come to a stop. These leaders’ comments signal that countries may be concerned that non-alignment will hurt them in the long run as Russia ramps up its war efforts. Although we do not believe India or Turkey will jump ship, it is becoming clear that the countries are hedging their bets. In a speech at Columbia University, India’s external affairs minister admitted that his government is starting to rethink its suspicions of the U.S.
  • The gestures from Turkey and India suggest that Russia faces further isolation as it intensifies its operations in Ukraine. Although this does not necessarily pave the way for an end to the conflict, this could prevent Moscow from taking its most extreme action in the war.

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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 the latest on how the conflict is driving up global energy prices.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including news that consumer price inflation in the U.K. has now reached 10.1%, its highest level in more than 40 years.

Russia-Ukraine:  Russian forces continue to make small, incremental territorial gains in Ukraine’s eastern Donbas region, while seeking to reinforce the territories they occupy around the southern city of Kherson, all while launching missile and artillery strikes against other parts of Ukraine.  Meanwhile, the Ukrainians continue to gradually ramp up their counteroffensive to retake Kherson, which includes attacking Russian logistical nodes in Crimea with Western-supplied long range artillery and/or sabotage operations.

• Separately, the U.S. Agency for International Development announced it will spend more than $68 million to purchase and ship Ukrainian grain for the UN’s World Food Program.  The grain will be used as aid for poorer countries around the world that are struggling with disrupted food supplies and spreading hunger.  Ukraine has also been ramping up its grain shipments to other customers under the recent Russia-Turkey-Ukraine safe-passage deal.
• On the energy front, Europe’s intense heatwave is exacerbating its evolving energy crisis, as the Continent gobbles up energy for air conditioning.
  • Futures for natural gas at a trading hub in the Netherlands, the benchmark in northwest Europe, rose 3.2% yesterday to an all-timer record of €233.56 a megawatt-hour, and they’ve risen another 6.0% so far this morning.
  • Sky-high energy prices are now starting to force the closure of European mining and manufacturing operations, which will further weigh on the Continent’s economic activity and financial markets.
  • Although it is less recognized in the press, China is also undergoing a painful heatwave and drought.  As in Europe, the resulting drop in hydroelectric output has forced the government to ration electricity in the southwestern province of Sichuan, shutting down some industrial activity, including lithium output.

Germany:   Officials in Berlin have confirmed that the government will temporarily postpone the planned year-end closure of the country’s last three nuclear power plants in order to deal with Russia’s cut-off of natural gas supplies, although the decision will likely need to be ratified by the German parliament.  The decision confirms how desperate Europe’s energy supply situation could get this winter, even if U.S. investors haven’t fully recognized the risks.

United Kingdom:  The July consumer price index was up a whopping 10.1% from the same month one year earlier, accelerating from the 9.4% gain in the year to June and marking the U.K.’s highest inflation rate in more than 40 years.  To make matters worse, inflation is likely to accelerate further if energy price caps are lifted as planned in October.

• The high inflation rate is likely to pile more pressure on the Bank of England to keep hiking interest rates.  In response, British government bonds have sold off modestly so far this morning, driving the yield on the benchmark 10-year Gilt to 2.242%.
• The inflation numbers could also lead to more generous consumer assistance offerings from the two Conservative Party candidates set to replace Boris Johnson as party leader and prime minister, Foreign Minister Liz Truss and Former Chancellor Rishi Sunak.  Although polls suggest Truss remains in the lead, she has taken some heat for offering stingier responses to the cost-of-living crisis.

China:  More than a dozen Chinese ministries and departments have released a joint policy statement aimed at boosting fertility and childbearing in order to arrest China’s collapsing birthrate and impending population decline.  China’s declining workforce and population aging are key reasons we expect the country’s overall economic growth to keep moderating in the future.

Kenya:  As we warned in our Comment yesterday, opposition leader Raila Odinga has rejected the official count in last week’s presidential election that showed him losing to Deputy President William Ruto.  Odinga has indicated he will fight the results in court, likely setting up weeks or months of political uncertainty in the key African country.

Global Supply Chains:  Even though global shipping rates have started to retreat, it appears that port congestion, dockworker strikes, and other challenges are still disrupting exports and imports in many countries.  The continuing supply disruptions are likely to keep inflation from falling back as soon as it otherwise would.  In turn, that will likely keep the world’s major central banks in rate-hiking mode, potentially prompting a pullback in risk assets.

U.S. Fiscal Policy:  Yesterday, President Biden signed his Inflation Reduction Act into law, which will hike corporate taxes and increase funding to the IRS in order to rein in the federal budget deficit and fund some additional spending in areas such as healthcare and climate stabilization.

U.S. Drought:  For the first time ever, the Bureau of Reclamation has declared a Tier 2 water shortage for the Colorado River basin in seven southwestern states and Mexico.  In addition, the Bureau has ordered those entities to cut their water use by a total of 721,000 acre-feet (each acre-foot is about the amount that a family of four uses in one year).  The resulting water use restrictions will likely be a drag on agricultural and industrial activity in the region over the coming months.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where the disposition of forces has changed relatively little in recent days.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, most notably a bevy of disappointing economic news from China and a surprise interest-rate cut from the country’s central bank.

Russia-Ukraine:  Russian invasion forces continue to make only incremental territory gains in Ukraine’s eastern Donbas region, while reinforcing their troops occupying the southern region around Kherson.  The latest reports highlight that those reinforcement efforts have left the Russians with a hodgepodge of forces from different military districts and of different capabilities, which would likely make them hard to manage and relatively ineffective.

• Ukrainian forces continue to destroy the bridges linking Kherson with the rest of the territory occupied by the Russians, which will make it even harder for the Russians to defend the territory against Ukrainian counteroffensives.
• Meanwhile, global leaders are becoming increasingly alarmed about the fighting around the Zaporizhzhia nuclear power plant in eastern Ukraine.  One concern is that the fighting could damage the reactors and cause a nuclear disaster.  Another concern is that the Russians are reportedly siphoning off electricity from the plant and sending it to Russia.
• On the energy front, the leaders of Spain and Portugal said they support German Chancellor Scholz’s call last week for a north-south natural gas pipeline that would run from Portugal via Spain and France to Central Europe.
  • According to Spanish Ecological Transition Minister Teresa Ribera, the Spanish portion of the pipeline could be finished in eight or nine months.
  • The next major approval would have to come from France.

China:  After a wide range of data today showed China’s post-pandemic economic recovery stumbled in July, the People’s Bank of China announced a surprise interest-rate cut.  However, the cut in the medium-term interest rate was just 0.1%, to 2.75%, perhaps signaling the central bank’s reluctance to ease policy more aggressively after it recently warned about inflation pressures.

• Among the weak data points, July industrial production was up just 3.8% year-over-year, well short of the expected rise of 4.5%.  July retail sales were up 2.7% on the year, compared with an anticipated rise of 5.0%.  A key index of new home prices was down 1.7% year-over-year, after being down 1.3% in the prior month.
• The broadly weak economic data and tepid interest-rate cuts suggest China’s economy will offer little support to global economic activity this year.  This news coupled with high inflation around the globe, aggressive interest-rate hikes by many key central banks, and the impact of the Russia-Ukraine war, suggests the U.S. economy and financial markets are likely to face headwinds in the coming months.
• One major impact so far this morning:  commodity prices have fallen dramatically, with Brent crude oil down 5.2% to $93.06 and copper down 3.0% to $3.5555.

China-Taiwan-United States:  Following House Speaker Pelosi’s controversial visit to Taiwan earlier this month, a bipartisan group of Congressmen landed on the island yesterday, prompting another round of protests and threatening military exercises by Beijing.  Like Pelosi, the legislators said they were visiting Taiwan to express support for its democracy and to demonstrate their right to visit the island.

• Indeed, these Congressional visits could be seen as political “freedom of operation sailings” or FONOPS, similar to those the U.S. Navy makes throughout the waters around China to assert the right of foreign ships to sail in international waters.
• The Congressional visits, like their naval counterparts, help to push back against Beijing’s geopolitical aggressiveness in the Indo-Pacific region, but they also raise U.S.-China tensions and increase political risks for cross-border investors.

United States-Iran:  U.S. Secretary of State Blinken has explicitly linked Iran to the attempted murder last week of irreverent novelist Salman Rushdie.  Specifically, Blinken called out Iranian institutions for inciting violence against Rushdie for generations and then gloating over the news of his stabbing last week.  The statement illustrates how the stabbing has become yet another source of tension between the U.S. and Iran.

European Drought:  As Europe’s historic drought worsens, the depth of the Rhine River between Wiesbaden and Koblenz fell to just 40 cm on Friday.  At that depth, most barges can only carry a fraction of their capacity, meaning companies needing to send coal, chemicals, or components upstream from Rotterdam and Antwerp will have to use much more expensive truck and rail systems.

United Kingdom-Leadership Race:  In the race to succeed Boris Johnson as Conservative Party leader and prime minister, polling over the weekend showed Foreign Minister Liz Truss’s lead over Former Chancellor Rishi Sunak has narrowed to 22%.  However, other reports say as many as 8 in 10 party members have already sent in their ballots, which likely works in Truss’s favor because her lead hadn’t begun to narrow until recently.

United Kingdom-COVID:  The Medicines and Healthcare Products Regulatory Authority has approved a COVID-19 vaccine from Moderna (MRNA, $171.18) that is specifically targeted to the highly transmissible Omicron variant.  The move makes the U.K. the first country in the world to approve an Omicron-specific vaccine and likely sets up an autumn vaccination drive for it.

U.S. Fiscal Policy:  On Friday, the House passed President Biden’s “Inflation Reduction Act,” which includes higher taxes on corporations and increased funding for the IRS to raise funds for deficit reduction, as well as providing new funding for healthcare, climate-stabilization, and sustainable agriculture policies.  As we’ve noted previously, passage of the bill may marginally improve the Democrats’ prospects in the mid-term elections in November, but we still expect the Republicans to take control of at least the House.

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