by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning. Today’s Comment starts with a discussion of tensions in Asia and how they could impact global supply chains. Next, we review the ongoing energy crisis in Europe and its effects on the global economy. Finally, we conclude with our thoughts on improving relations between Russia and Iran and what this development could mean for the West.

Asia: The continent is rife with political risk as countries are becoming more contentious and less predictable.

• China could escalate tensions over Taiwan after Xi is officially granted an unprecedented third term. Before Pelosi visited the self-governing island, Chinese President Xi Jinping assured President Biden that China was not willing to go to war over the trip; this reluctance was likely related to Beijing wanting to maintain stability as the country prepares for the National Party Congress in the fall. The government is under a lot of pressure due to dissatisfaction with its Zero-COVID Policy and the property market meltdown. Therefore, China does not want to risk angering its people as the country seeks to present itself as a bastion of wealth and economic growth to the rest of the world. After Xi is reappointed as president, analysts expect he could become more hostile to countries that challenge China’s authority.
  • Taiwan rejected China’s claim of a “one country, two systems” model for the region. Beijing has used this model to dictate the relationship of areas such as Hong Kong and Macau. It allows territories to accept China’s sovereignty claim in exchange for greater autonomy.
• North Korean Leader Kim Jong-un might have suffered from COVID during the recent outbreak. The news of his illness is a rare admission from a country that generally likes to keep information secret about its leaders’ health. It is unclear whether the report is accurate or why the government made it public. However, if Kim Jong-un were to die, it could lead to instability in a country that has nuclear weapons.
• South Korea and China are clashing over plans to install a weapons defense system. The disagreement is over the Terminal High Altitude Area Defense (THAAD) system that the U.S. delivered in 2016. China insists THAAD has the potential to spy on its own systems.

The Korean peninsula is a region with risks that are hard to forecast. North Korea’s privacy makes it difficult to gauge political risk within the country. Meanwhile, China’s power projection may hurt countries looking to counter its influence. For example, Beijing could look to limit trade relations as retaliation for countries not doing what it wishes. Additionally, the Taiwan situation will likely escalate. Because many firms have manufacturing operations set up in Asia, tensions on the continent could complicate supply chains. This outcome could hurt firm profits and add to global inflationary pressures.

Europe: The energy crisis in Europe is adding to the continent’s economic woes and will severely impact firms and households as they head into winter.

• European countries are looking to avoid a potential energy crisis by integrating energy channels. For example, German Chancellor Olaf Scholz has backed a proposal that would link the pipelines of Spain and Portugal to the rest of Europe. Although construction of the pipeline will not be finished in time to prevent an energy crisis by this winter, it does suggest that European countries are looking to reduce their dependence on Russia.
• In the U.K., rising energy costs will take center stage as the prime minister battle heats up. Former British Finance Minister Rishi Sunak has plans to cut 200 pounds from household energy bills by reducing the value-added tax. Energy prices will triple this year; thus, consumers will likely welcome any financial assistance. He also has plans to offset the loss of revenue by levying a windfall tax on energy profits. However, his opponent, Liz Truss, has rejected the notion of implementing a windfall tax. Sunak remains an underdog in the prime minister contest; however, his windfall tax plan is very popular among Brits.
• Declining water levels in the Rhine will likely add to Europe’s economic woes. The Rhine River is a crucial trade route for the Netherlands, Germany, and Switzerland. The lack of rainfall and severely hot temperatures threaten to render the rivers impassable for ships. The waterway is expected to dip below the threshold needed for navigation over the weekend, and the problem could extend for months. The lack of maritime trade along the river will make it harder for firms to receive needed supplies such as oil, grains, and chemicals.

Governments in the West are coming under growing pressure to combat rising energy costs to appease their constituents. The lack of infrastructure, Russian energy, and maritime shipping capacity will make it harder to contain energy prices. Even if lawmakers offer financial assistance to households, it is unlikely to be enough to offset the surge in household costs. As a result, Europe will likely fall into recession sometime in the fall of this year.

Russia-Iran:  Russia and Iran have strengthened ties to help each other circumvent Western sanctions.

• Russia, Iran, and India are close to opening a new trade route. The new shipping method will allow Russia to transport its resources to India without relying solely on Western waterways such as the Suez Canal, the Mediterranean, and the Bosporus. The route allows for the sanction-proof transport of goods and could benefit other countries in Central Asia and the Caucasus. Hence, Russia and Iran are learning to live with the sanctions.
• Additionally, the two sides have strengthened their military ties. Tehran has provided weapons to Russia and helped Moscow conduct cyberattacks on Ukraine. Meanwhile, the Kremlin has allowed Iran to use Russian satellites to gather intel on the U.S. and its adversaries in the Middle East. The two sides have also teamed up to help Armenia protect itself from its rival, Azerbaijan. The integration suggests the countries might coordinate some of their foreign policy as they look to counter other alliances in the West and the Middle East.
• Lastly, Russia and Iran are working vigorously to create a system that can be used as an alternative to SWIFT. They have agreed to allow trade using their respective currencies and are looking to expand the payment system to include currencies such as the Turkish lira and Indian rupee. The alternative payment system is paving the way for dollar-free trade for countries not aligned with the West and is an example of the ongoing trend toward deglobalization.

The increased economic and military cooperation between Russia and Iran is an example of countries starting to form blocs based on their financial and geopolitical interests. Given their volatile relationships with countries in the West and the Middle East, their rivals may decide to boost their military capabilities. Thus, strengthening relations between Russia and Iran should benefit defense industries.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment is divided into two main sections, starting with reactions from the market and the Fed to the latest CPI data. We include our thoughts on whether the Fed will pivot and why we are not convinced that inflation has plateaued. Next, we review international news focusing on stories that highlight rising geopolitical risks, namely, the latest developments in Ukraine, Taiwan, and Iran.

The Fed Speaks: Stocks rallied and the dollar weakened on Wednesday after the latest CPI report showed that inflation decelerated for the first time since February 2021.

• Regional Fed Presidents Neel Kashkari and Charles Evans cautioned investors not to assume that the latest CPI report will change the central bank’s policy path toward higher interest rates. Chicago Fed President Evans welcomed the news about the slowdown in price increases but added that the FOMC’s job is not finished. Minneapolis Fed President Kashkari further added that the Fed is far from declaring victory. The comments suggest that central bank officials view the market’s reaction as premature.
• Although both officials downplayed the possibility of a Fed pivot, neither changed his end-of-year target rate. For example, Evans maintained that the central bank should raise rates to around the median year-end projection in the Fed dot plots that was released in June. Meanwhile, Kashkari, who has the highest year-end fed funds target forecast, revealed that his end-of-year projection for the policy rate has not changed. Thus, it would seem Fed officials are not placing much weight on the July CPI report.
• It is too soon to tell whether inflation has indeed hit a turning point. Much of the decline in the CPI index was due to a drop in historically volatile energy prices. Meanwhile, relatively stable shelter prices, which comprise a third of the index, continue to rise well above their long-run averages. Thus, the market could be cruising toward a bruising if it gets too confident in a Fed pause or pivot. The next FOMC meeting will be September 20-21, 2022. At this time, central bank members will have the August CPI numbers, which will play a bigger role in whether the Fed decides to change course on its policy path.
  • Declining fuel prices suggest that the August report may show further decelerating inflation. This month, gasoline prices fell below $4/gallon for the first time since March.

Despite the market’s reaction over the last few days, an economic downturn will not necessarily force the Federal Reserve to end its tightening. The central bank’s mandate is to maintain price stability and prevent rising unemployment. It might want to encourage growth, but it is not under any obligation to do so. Thus, the Fed will likely be open to raising rates as long as the labor market remains strong and inflation remains high. An aggressive Fed determined to bring inflation back to its 2% target and markets brewing with confidence create a fertile environment for a Fed surprise. Thus, investors should be cautious to place too much emphasis on one report.

International Risks: Rising geopolitical tensions suggest that investing abroad may remain difficult.

• The Russia-Ukraine war shows no signs of abatement. Ukraine forces are set to launch a counter-offensive to retake regions lost to Russia. Ukrainian President Volodymyr Zelensky has built up troops around the city of Kherson in preparation for a battle, while also leaving troops to fight in contested areas of the Donbas region. The war will likely be extended if Ukraine successfully regains the lost territory or can force a strategic retreat. A protracted conflict in Ukraine will make investing in Europe challenging as firms struggle to receive much-needed energy supplies. Thus, the possibility of a recession in Europe is elevated.
  • The war will make it harder to reverse burdensome sanctions on Russia. The EU import ban on Russian coal will take effect on Thursday. Meanwhile, the International Energy Association (IEA) has projected that Russian oil output could fall by 20% by the start of next year due to the EU import ban. As a result, Russia’s lack of export capacity and production will likely keep commodity prices elevated going into next year.
• Tensions between the U.S. and China have boiled over for now, but the dispute over Taiwan could still lead to conflict. On Wednesday, China ended its military drills near Taiwan. Officials from Beijing vowed to regularly send patrols across the U.S.-drawn median line in the Taiwan Strait. Additionally, China withdrew its promise never to send troops to Taiwan in the event of a takeover. As this current crisis subsides, both sides will attempt to position themselves with more leverage in subsequent disputes over the island. Accordingly, the decoupling between the U.S. and China will likely accelerate over the next few months as firms come to terms with this new reality.
  • As an example of this decoupling, Apple (AAPL, $169.24) has looked to expand its manufacturing operations into Vietnam. Meanwhile, Foxconn (2354, NT$50.60), a major Apple supplier, is building its production capacity in India. In the short term, firms will try to divest away from China by building capacity in nearby areas in Asia due to their familiarity with many of the countries in the region. Over time, however, the lack of stability and political uncertainty in small Asian countries may force forms to shift operations near the U.S. or possibly into Europe. This shift will be costly and potentially inflationary in the short and medium terms as firms will have to price in additional risks to the supply chains.
• The Biden administration’s hope of securing a nuclear deal with Iran hit another roadblock. Former Secretary of State Mike Pompeo and former National Security Advisor John Bolton were targeted for assassination by affiliates of Iran’s Islamic Revolutionary Guard Corps. Iran has also provided military training for Russian troops fighting in Ukraine. The Biden administration would like to secure a deal with Iran to prevent conflict in the Middle East. In the past, Israel has mentioned that it will not stand idly by while Iran develops its nuclear capacity. Thus, the likelihood of a potential conflict between Iran and Israel is elevated.

The recent slate of international news reinforces our view that global equities remain risky. A more hostile world will likely exacerbate supply chain issues and potentially slow the production of commodities. This outcome should be beneficial to energy-related assets. Additionally, as countries build up their military capabilities, industries related to aerospace and defense should also benefit.

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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 lots of new developments related to the world’s energy markets.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine:  Russian forces continue to stage only limited attacks in Ukraine’s northeastern Donbas region, even as they launch sporadic missile and long-range artillery sites across the country and work to reinforce the territory they hold in and around the southern city of Kherson.  The Ukrainians are still carrying out a limited counteroffensive to retake Kherson, but their efforts in recent days have focused on launching more long-range missile and artillery strikes against Russian logistics nodes.  Unconfirmed reports yesterday suggested that the Ukrainians were able to blow up two major ammunition depots deep inside Russian-occupied Crimea.

• On the energy front, Russian state-owned energy transporter Transneft said yesterday that it shut down all crude oil exports through its Druzhba pipeline running across Ukraine to southern and eastern Europe on August 4, citing payment problems linked to Western sanctions against Moscow.  Transneft said this morning that it is working to restart the pipeline after receiving payment from a Hungarian oil firm, but the renewed flows are not yet confirmed.
  • The move by Transneft would have curtailed oil deliveries to Slovakia, Hungary, and the Czech Republic and would likely intensify European efforts to buy crude from non-Russian sources.
  • In response, oil prices rose approximately 1.3% yesterday, with Brent reaching $97.88 per barrel.  On news of the possible restart of the pipeline, Brent this morning has given back all of that rise and more, now trading at $94.68.
• Separately, IMF modelling has shown that more cross-border sharing of natural gas in Europe could significantly reduce the negative impact of a Russian embargo this winter, almost halving the hits to the economies of central and eastern Europe at low cost to those allowing the gas to flow.  Europe still faces a challenging energy crisis, but the analysis suggests the continent could weather things better than anticipated if it can make quick progress on improving its interconnection infrastructure.
• Nevertheless, Europe still faces challenges in trying to wean itself off Russian energy.  In a new sign of that circumstance, a regasification plant proposed for the port of Piombino in Sicily, which would allow Italy to import more liquified natural gas, is being heavily resisted by local politicians affiliated with the country’s major right-wing parties.

European Energy Crisis:  As drought continues to drain the water reservoirs behind Norway’s hydroelectric plants and pushes up electricity prices, the Norwegian government said it will curb electricity exports to Europe until the reservoirs rise back to normal levels.  Along with reduced electricity exports from France because of corrosion issues at some of its nuclear plants, the reduction in Norwegian supply will further exacerbate Europe’s energy crisis and potentially worsen its economic slowdown this year.

China-Taiwan-United States:  In a dramatic sign of how far Taiwan is willing to go to plant itself firmly in the evolving U.S.-led geopolitical bloc, Taiwanese national security officials vowed to force giant contract electronics manufacturer Foxconn (HNHPF, 7.02) to unwind its recent $800 million investment in privately held Chinese chipmaker Tsinghua Unigroup.

• Although Foxconn hoped the investment would help it move into higher-value added manufacturing and away from its traditional focus on low-margin assembly, Taipei is concerned that the deal could lead to Foxconn bankrolling Beijing’s tech ambitions.
• Taiwanese officials also want to avoid being seen as helping China in its technology rivalry with the U.S., nor do they want to risk being sanctioned for perceived entanglements with Chinese firms.
• The development is another example of how countries around the world are refocusing their investment and trade ties toward their friends in relatively separate geopolitical and economic blocs.  As we’ve written before, the resulting disruptions to global supply chains will likely produce higher prices, higher interest rates, and lower corporate margins over time.

China-Australia:  An Australian metals firm has applied to the government for a review of anti-dumping measures against China in response to a surge in Chinese aluminum extrusion exports to Australia this year.  The new trade action threatens to derail the budding China-Australia rapprochement after two years of tensions and Chinese import restrictions against Australian products.

U.K. Politics:  In the race to succeed Boris Johnson as Conservative Party leader and prime minister, Foreign Minister Liz Truss has proposed that Cabinet ministers should have the power to override financial regulators, including the Bank of England, if they are seen as holding back on post-Brexit reforms.  The proposal is another sign that the central bank is likely to have its wings clipped if Truss wins as expected.  Politicization of monetary policy and financial regulation could ultimately be a negative for the U.K.’s investment climate.

U.K. Labor Market:  The Royal Mail announced today that the Communications Workers Union plans to strike on multiple days in August and September to protest the company’s plan to break up.  The planned strike, along with many others in the U.K. and other countries, illustrates how today’s tight labor markets have given workers around the world more leverage, raising company costs and keeping inflation pressures high.

U.S. Semiconductor Industry:  As firms and consumers continue to shift back to normal after their pandemic-driven plunge into technology investments, Micron Technology (MU, 59.15) yesterday warned that semiconductor demand is weakening much faster than anticipated.  The comments build on a flurry of bad news from chipmakers, which have cited slowdowns in sales linked to PCs, graphics cards, and videogames.

U.S. Fiscal Policy:  New analysis shows that the corporate minimum income tax of 15% in President Biden’s “Inflation Reduction Act” doesn’t meet the standards that the U.S. signed up to when approving the OECD’s global corporate minimum tax deal last year.  With the U.S. as an outlier in the system, multinational companies will face more tax complexity, may try to game the system by shifting operations to other countries, and potentially face make-up taxes abroad.

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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 new estimates of Russian military casualties to date and a call from the Ukrainian president to accept nothing less than total victory.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including concerns that continued Chinese military exercises in the Taiwan Strait may represent an effort to take full control of that body of water.

Russia-Ukraine:  There has been little change in the disposition of Russian and Ukrainian forces over the last day.  The Russians have made few, if any, territorial gains in Ukraine’s northeastern Donbas region, focusing instead on reinforcing their positions near the southern city of Kherson, which they seized early in the war.  The Russians also continue to launch missile and long-range artillery strikes across Ukraine’s territory.  The Ukrainians appear to be focused on launching strikes against Russian troop concentrations and logistics nodes in the country’s southern and eastern regions, using advanced, long-range strike systems provided by the West.  More broadly, Ukrainian President Zelensky has declared that his country will not accept a partial victory that leaves Russian troops on Ukrainian soil in a frozen conflict that might persist for years.

• In the first report of its kind, the U.S. Defense Department yesterday estimated Russia’s casualties to date amount to 70,000 to 80,000 of the 150,000 or so troops it has deployed to the invasion.  A rough rule of thumb would suggest that about one-quarter of the casualties, or up to 20,000, were killed.
  • The enormous loss rate goes far toward explaining Russia’s failure to achieve any of its key objectives in the invasion, although it is now having some success replacing lost troops through “volunteer” battalions, mercenaries, and the like.
  • Of course, various reporting now suggests that the Ukrainians have also lost large numbers of troops, although they continue to hold the exact number as a secret.
• Meanwhile, the Biden administration has announced plans to send $1 billion in additional military aid to Ukraine, marking the largest single drawdown of equipment since the start of the war.  The latest package will include additional ammunition for high-mobility artillery rocket systems (HIMARS), tens of thousands of rounds of artillery and mortar ammunition, anti-armor systems, and armored medical treatment vehicles.
• On the sanctions front, the prime ministers of Estonia and Finland have asked the EU to stop issuing tourist visas to Russians to keep them from skirting existing sanctions on traveling and doing business in Europe.  The new sanction is due to be discussed at an EU summit in October.

Russia-China:  According to recent reports, three prominent scientists working on hypersonic missiles at a Russian research lab in Siberia have been arrested on charges of treason in just the last few months.  The reports indicate the scientists were suspected of selling secrets to China, which has a well-advanced hypersonics program.

• Illustrating the seriousness with which Moscow viewed the security breach, the scientists were immediately whisked away to Lefortovo Prison, the nasty former headquarters of the KGB in central Moscow.  One of the scientists reportedly died there within days.
• If true, the reports are a reminder that China and Russia are still competitors, even if they continue to draw closer in military, economic, and political relations.

China’s Belt and Road Initiative:  Bangladeshi Finance Minister Mustafa Kamal has warned that developing countries should think twice about taking more loans through China’s controversial Belt and Road Initiative as global inflation and slowing growth add to the strains on indebted emerging markets.

• Last month, Bangladesh was forced to appeal to the IMF for financing help after running into balance-of-payment issues due to both high debt and skyrocketing costs for imported energy and other commodities.
• Once one of Chinese President Xi’s main foreign policy tools to curry favor among poorer countries by providing loans for infrastructure projects, the BRI has now become embroiled in controversy for creating debt traps, forcing countries to transfer collateral assets to China, and benefiting Chinese companies more than the emerging markets themselves.
• The BRI controversy has become a key reason why China has begun to face political and economic pushback in its foreign relations around the world.  As such, it has helped bolster anti-Chinese sentiment in the U.S., which will keep alive policy initiatives to curtail U.S.-China trade and investment.

China-Taiwan:  The People’s Liberation Army has extended its military exercises around Taiwan for a second day, prompting Taiwanese Foreign Minister Wu to warn that China may use the drills to establish full control over the Taiwan Strait.  Importantly, Wu seemed to characterize Chinese actions as moving beyond the “first island chain” and therefore threatening global shipping and trade throughout the region.  Indeed, China has also announced a series of military drills in the northern Bohai and Yellow Seas near Japan in the coming weeks.

• Indeed, one key result of the exercises around Taiwan is that Chinese officials are now openly boasting that they have “obliterated” the median line of the strait, which both China and Taiwan had previously respected as the boundary between their waters.  Chinese military officials and commentators add that the PLA will now establish regular operations on Taiwan’s side of the line.
• As evidence that the new Chinese stance could result in a dangerous U.S.-China confrontation, a senior official at the Pentagon said the U.S. military would continue to operate, fly, and sail through the Taiwan Strait, including in the coming weeks.

Iran Nuclear Deal:  EU mediators have put together what they termed the final text of an agreement to restart the 2015 deal limiting Iran’s nuclear program.  However, top leaders in both the U.S. and Iran continue to signal misgivings about signing, and it remains unclear whether the new agreement will come into force.

Japan:  In contrast with investors betting the Bank of Japan will soon need to tighten its monetary policy to keep up with other major central banks, radical reflationist Goushi Kataoka is now arguing that Japan should take advantage of today’s global inflation pressure to loosen monetary and fiscal policy to generate inflation once and for all.  However, Prime Minister Kishida continues to signal the opposite, naming a relative inflation hawk to replace Kataoka when he left the BoJ’s monetary policy board last month.

• Kishida’s next major BoJ decision will be to find a replacement for Governor Kuroda when he retires next April.
• Kuroda’s insistence on maintaining loose monetary policy and yield curve control has been a major reason for the yen’s extreme weakness against the dollar.  Any move to tighten policy would tend to boost the yen.

United Kingdom:  In the race to succeed Boris Johnson as Conservative Party leader and prime minister, Foreign Minister Liz Truss continues to lead polls of party members but has created some headwinds for herself by suggesting she wouldn’t consider any additional “handouts” to families struggling with Britain’s soaring energy costs, while continuing to call for corporate tax cuts.  That’s given a bit of a lift to Former Chancellor of the Exchequer Rishi Sunak, although he still faces an uphill battle in the remaining three and a half weeks of the race.

Colombia:  The newly inaugurated government of President Gustavo Petro, a former leftist guerilla, unveiled a plan to hike taxes on the wealthy and on major commodity exports to finance rural development and social programs for the poor.  Among the tax hikes, the proposal introduces a wealth tax on savings or property worth more than $700,000, as well as a 10% windfall tax on exporters of the country’s main commodities—oil, coal, and gold—that have benefited from high international prices.  The plan will likely raise concerns about higher taxes and regulation on corporations throughout Latin America, where leftist governments have recently swept into power and look like they will continue to do so.

U.S. Economic Outlook:  In an opinion article today, bond market guru Mohamed El-Erian argues that despite last week’s strong July labor market report and a possible cooling in the July Consumer Price Index tomorrow, it’s still too early to sound the “all clear” for the economy.  First, he notes that some labor market indicators, like job openings and initial jobless claims, are already sending up red flags.  Second, he also notes that the Fed remains far behind the curve in cutting inflation and is likely to keep hiking interest rates aggressively.

U.S. Pension System:  According to the Wilshire Trust Universe Comparison Service, public pension plans in the U.S. lost a median 7.9% in the year ended June 30, marking their worst annual performance since 2009 and decreasing many of the plans’ financial cushion for future retirees.

• The pension plans’ decline in fiscal 2022 was actually a bit better than the performance of a standard portfolio of 60% stocks and 40% bonds.  By one measure, a portfolio like that would have posted a negative total return of 9.7% in the year to June 30, reflecting weakness in U.S. equities, foreign equities, and corporate and government bonds.
• However, we note that a more diversified portfolio that encompassed a significant allocation to commodities likely would have performed better than the 60%/40% portfolio.  Indeed, many university endowments and public pension funds include such allocations, as do all of Confluence’s asset allocation strategies at the moment.

U.S. Digital Currencies:  As early as next month, a bipartisan group of House legislators plans to introduce a bill that would encourage the Fed to accelerate its work on developing a U.S. digital currency.  The legislators are concerned that the U.S. central bank is falling behind similar efforts in China and other countries.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where the main news focuses on fighting around a major nuclear power plant and Russian preparations to hold a sham referendum on annexing the territories it occupies to Russia.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine:  Over the weekend, there was little change in the overall disposition and activity of the Russian and Ukrainian forces in theater.  The Russians made only very limited territorial gains in Ukraine’s northeastern Donbas region, while they continued trying to reinforce their positions to defend against a slow-moving Ukrainian counteroffensive designed to retake the city of Kherson, which the Russians have held since early in the war.  Meanwhile, in a development that highlights the broader risks of the war, shelling near the Zaporizhzhia nuclear power plant in eastern Ukraine severed some high-voltage power lines serving the facility, forcing engineers to shut down one of its six reactors over the weekend.

• Separately, reports indicate that Russian occupation authorities are accelerating their plans for a pseudo-referendum in occupied territories on annexation to Russia.  Facing limited cooperation from Ukrainian citizens and partisan threats to any officials that might help legitimize a Russian annexation, the Russian authorities are reportedly planning to dispense with polling places and have the Ukrainians “vote from home,” i.e., have Russian troops visit each home and survey each voter at gunpoint.
• In his regular video address last night, Ukrainian President Zelensky vowed that if Moscow holds referendums on joining Russia in occupied areas of his country, there could be no chance that Kyiv and its Western allies would hold peace talks with Russia.

China-Taiwan:  The People’s Liberation Army has continued its aggressive military exercises around Taiwan, despite saying last week that the maneuvers would end on Saturday.  The continued exercises suggest Beijing might intend to keep pressuring Taiwan over time to punish it for House Speaker Pelosi’s visit to the island last week.

• With China’s maneuvers already disrupting sea and air access to Taiwan, continued exercises could amount to a “soft” blockade of the island, raising a thorny dilemma for the U.S. and the island’s other allies.
• Such a soft blockade would force Taiwan’s allies to make the tough decision of whether and how to break it.  Whatever strategy they would adopt could potentially lead to greatly increased tension or military conflict, with massive impacts on the financial markets.

China:  In data over the weekend, China’s July trade surplus expanded to a seasonally adjusted $101.26 billion, beating expectations and marking a rise from the surplus of $97.90 billion in June.  The expansion came mostly in exports as trading and logistics firms continued to catch up from the disruptions of China’s mass pandemic shutdowns during the spring.

• The country’s July exports were up a robust 18.0% year-over-year, accelerating from a 17.9% year-to-date gain.
• In a significant note of caution, however, the country’s July imports were up just 2.3% from the same month one year earlier, after a weak annual rise of 1.0% in June.  The import figures suggest that China’s domestic demand continues to grow tepidly, with negative implications for the global economy and financial markets.

Israel:  The Israeli government and the Gaza militant group Islamic Jihad agreed to a ceasefire yesterday after three days of fighting that killed more than 40 Palestinians and sent rockets flying deep into Israel’s heartland.  The exchange of fire had been the most intense since an 11-day conflict between the Israelis and the military group last year.

Colombia:  Gustavo Petro, a former leftist guerilla and longtime congressman, was inaugurated as president yesterday.  In his inaugural speech, Petro pledged to lower poverty and hunger in Colombia and secure peace by engaging in talks with several armed groups.  He also laid out a platform to redistribute wealth, modernize the countryside, and adopt environmentally friendly economic policies.

Greece:  Prime Minister Mitsotakis is facing a major political scandal after local media reported that the phone of Nikos Androulakis, a European Parliament member who is the leader of the opposition socialist PASOK party, had been bugged by the Greek intelligence service.  The prime minister’s chief of staff (who is also Mitsotakis’s nephew) and the head of the intelligence service resigned on Friday.

Eurozone Monetary Policy:  According to the Financial Times, the ECB in June and July used €17 billion of maturing bonds in its emergency pandemic relief fund to buy Italian, Spanish, and Greek government obligations, while allowing its portfolio of German, Dutch, and French debt to fall by €18 billion.  The transactions illustrate the ECB’s “anti-fragmentation” effort to keep bond yields from blowing out in the Eurozone’s weaker economies.

• The reinvestments under the pandemic relief program are separate from the ECB’s new “Transmission Protection Instrument” (TPI), which can be used in case the pandemic relief program reinvestments fail to keep spreads under control.  The TPI allows the ECB to buy the bonds, at unlimited scale, of any country it deems to be facing market pressures outside the economic outlook.
• In any case, the reinvestments show that the ECB had already embarked on the controversial anti-fragmentation effort before early this summer.  Nevertheless, there is still some risk that the central bank will run into difficulties in both raising interest rates and trying to control yields in the Eurozone.

U.S. Fiscal Policy:  The Senate yesterday passed President Biden’s “Inflation Reduction Act,” consisting of hundreds of billions of dollars of income tax increases on large, profitable companies to cut the federal budget deficit, partially offset by increased spending on a range of healthcare and climate-stabilization programs.  The bill will now go to the House, where it is likely to be approved on Friday before being sent to President Biden to be signed into law.

• Among its major provisions, the bill would:
  • Impose a minimum corporate income tax of 15% and a 1% excise tax on stock buybacks.  It would also boost funding to the Internal Revenue Service in order to reduce tax evasion.  Of the funds raised, the bill sets aside approximately $300 billion to reduce the budget deficit.
  • Among its key spending provisions, the bill would provide new tax incentives for investments that reduce carbon emissions, extend health insurance subsidies under the Affordable Care Act, and allow the federal government to negotiate pricing for some drugs covered by Medicare.
• Politically, final passage of the bill would mark an unexpected and improbable string of legislative victories for Biden, although it remains to be seen whether the White House political team can finally get that message out and reverse what is still likely to be massive losses in the November midterm elections.  Despite the name of the legislation, a wide range of analysts expect the bill will have very little impact on bringing down inflation, especially in the near term.  Biden’s unlikely tally of legislative wins to date, along with their spending totals, include:
  • American Recovery Act: $1.9 trillion
  • Infrastructure Investment and Jobs Act: $550 billion
  • Chips and Science Act: $280 billion
  • Inflation Reduction Act: ≈$700 billion
  • NATO Enlargement to include Sweden and Finland
  • Gun Safety Legislation
  • Veterans’ Burn Pit Healthcare Legislation

U.S. Labor Market:  Despite the strong headline numbers in the July employment report, released last Friday, some major employers are reporting that it’s getting easier to hire and keep workers.  That’s consistent with our view that the July report probably overstated the actual strength of the labor market, in large part because of challenging seasonal adjustment issues.  While it does appear that payrolls increased in July, the true pace is probably moderating.

• All the same, the labor market remains tight as the pool of available workers continues to grow sluggishly.
• Importantly, the strong headline numbers in the July report and continued inflation pressures suggest the Fed will continue to hike interest rates aggressively in the coming months.

U.S. Coronavirus Vaccines:  Pfizer (PFE, 49.27) and partner BioNTech (BNTX, 183.11) said they will soon start clinical trials for a COVID-19 vaccine designed to block the BA.4 and BA.5 variants of Omicron.  If the trials are successful and the vaccine is approved, the shot could become available as early as October.

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