by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities are off to a blazing start today, fueled by a stellar jobs report. Adding to the excitement, Phoenix secured its place as the host city for next year’s NBA All-Star Game! Today’s Comment delves into central bank views on the economy and interest rates, why gold is still king, and the regulatory challenges facing Big Tech giants. We’ve also got a comprehensive roundup of international and domestic news to keep readers informed on the latest developments.

Together but Different: While the European Central Bank (ECB) and Federal Reserve agree on interest rate cuts in 2024, their stances diverge on economic health and financial stability.

• The heads of the two central banks recently spoke publicly to offer their perspectives on the future of policy and the economy’s condition. ECB President Christine Lagarde announced the bank will maintain its current policy, keeping the benchmark interest rate at 4.0%. Similarly, Fed Chair Jerome Powell, testifying before the Senate Committee, signaled the Fed won’t rush rate cuts at their next meeting. However, both central bankers anticipate inflation subsiding later this year, with markets pricing in the first rate cut potentially happening in June.
• Despite their shared focus on inflation, Christine Lagarde and Jerome Powell offered contrasting views on the economic outlook. Lagarde, reflecting the eurozone’s current struggles, took a cautious approach. She acknowledged surveys suggesting a later-year bounce but highlighted existing economic weakness. Conversely, Powell struck a more optimistic tone, emphasizing sustained and healthy growth in the US economy. He even expressed confidence in the Fed’s ability to handle a potential commercial real estate crisis. Interestingly, while Lagarde hasn’t addressed commercial real estate directly, ECB Vice President Luis de Guindos has raised concerns about its potential impact on financial stability.

• Although usually in sync on policy decisions, the ECB and the Fed might diverge this time around. A slowing economy and worries about the commercial real estate market are pushing the ECB toward considering looser monetary policy. An April rate cut is even on the table if current trends hold. Historically, the ECB has preferred a more accommodative stance, likely aiming to keep the euro weaker relative to the dollar to boost exports. However, deep cuts are unlikely from either central bank this year as both remain concerned about the persistent threat of inflation.

Flight to Safety: Gold and Bitcoin soar as investors seek safe haven amid rising uncertainty.

• Gold prices have surged 5% in the past month, fueled by a buying spree from China. The Asian nation has become the world’s largest gold purchaser, partly driven by its central bank’s strategy to diversify reserves away from the US dollar. This diversification allows China greater flexibility in conducting trade and potentially mitigating sanctions, especially as it seeks to strengthen economic ties with Russia. Increased trade between these two countries benefits both as China boosts its exports, while Russia gains access to essential imports.
• Gold’s resurgence as a safe-haven asset faces a unique challenge—the rise of Bitcoin. While gold regains investor interest, the most popular cryptocurrency has surged 51.5% in the last 30 days. This digital asset’s popularity is partly fueled by potential applications in traditional finance, like the SEC considering its use in options trading. However, Bitcoin’s high volatility casts doubt on its reliability as a store of value. As the chart below shows, Bitcoin is about four times as volatile as gold prices, indicating it may be a riskier option for long-term investors.

• The choice between gold and Bitcoin might hinge on age. Younger investors, comfortable with technology, may embrace the potential of digital assets like Bitcoin. Older generations, valuing stability, might favor the established security of physical gold. Gold boasts advantages; its tangibility and long history as a store of value inspire greater trust among some. Bitcoin, however, faces regulatory uncertainty and limited mainstream adoption, reflected in its lower trading volume compared to traditional financial instruments. It’s essential to conduct thorough due diligence before venturing into this asset class as cryptocurrencies are still susceptible to significant price corrections.

Tech’s Regulatory Dance: Geopolitical tensions are fueling growing concerns from US lawmakers about the expanding influence of Big Tech.

• House Majority Leader Steve Scalise (R-LA) is poised to introduce a bill that could force TikTok’s parent company ByteDance to divest the popular video-sharing platform due to national security concerns. The House Committee on Energy and Commerce unanimously approved the measure (50-0) on Thursday, propelling it closer to a vote on the House floor. This push to restrict access to TikTok, a favorite app among Gen Z, stems from anxieties that the Chinese government could be using it for surveillance and propaganda purposes. If ByteDance refuses to sell TikTok, the legislation could lead to a nationwide ban.
• In the wake of congressional restrictions on TikTok due to national security concerns, speculation is rising that similar actions could target generative AI. This is being underscored by the European Parliament, which is poised to pass legislation on March 13 regulating AI based on potential risks. For instance, the law would ban the use of AI for “emotion recognition” systems in workplaces. Importantly, this legislation applies to any provider or developer whose products enter the EU market, meaning US companies will also be impacted. Although the US is considering its own AI legislation, it has not formally introduced a bill to regulate its use.

• Escalating tensions, particularly between the US and China, threaten to ensnare major tech companies in a global regulatory web. Their vast international presence makes them especially vulnerable to a shifting regulatory landscape. Western companies could face the brunt of this, with increased restrictions inflating development costs and limiting access to crucial foreign markets. China’s push for self-sufficiency in key components like semiconductors further complicates the picture. For investors, this environment suggests a need for diversification. Investors may consider broadening their portfolios beyond traditional tech giants and exploring sectors with stronger fundamentals that are less susceptible to geopolitical headwinds.

In Other News: In his State of the Union address, President Joe Biden championed a call for increased taxes on billionaires and corporations, marking a notable shift toward a more populist stance. The US embassy warned of an extremist attack in Moscow, another sign of growing geopolitical risks. There is growing speculation that the Bank of Japan could tighten monetary policy in March.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Stocks are rallying this morning as investors gain confidence in the possibility of central banks lowering interest rates later in 2024. On the sports front, Real Madrid secured a hard-fought victory against RB Leipzig, advancing to the Champions League quarterfinals. Today’s Comment begins with our thoughts on the financial system following Fed Chair Powell’s testimony before Congress. We also include an analysis of the current state of the labor market and explore why emerging economies, particularly Turkey, have recently captured investor interest. As usual, our report concludes with a round-up of international and domestic data.

Financial System Focus: Banks take the spotlight as the Fed chair testifies before Congress, while New York Community Bank seeks a lifeline.

• In a surprise move on Wednesday, Federal Reserve Chair Jerome Powell announced that regulators intend to ease some of the stricter banking requirements introduced under the Basel III framework. This shift in policy follows complaints from Wall Street that the regulations could limit lending to businesses and consumers. However, the claims remain fiercely contested. Powell’s comments suggest the Fed might be aiming to avoid a major regulatory overhaul during a volatile election year. The issue is highly partisan, with Democrats advocating for increased bank regulations, while Republicans lean toward looser regulations.
• At the same time, New York Community Bank is seeking to shore up investor confidence. The struggling commercial lender secured a much-needed $1 billion equity investment led by a group that includes former Treasury Secretary Steven Mnuchin. This significant cash infusion aims to alleviate concerns about NYCB’s ability to weather potential losses, stemming from revelations of inadequate internal controls that exposed the bank to riskier loans than previously reported. The company’s stock price surged by 7.45%, reaching $3.46 per share following the announcement. Nevertheless, this increase only partially mitigates previous losses, thus leaving the stock price still considerably below its starting level at the beginning of the year.

• Despite significant uncertainty in the US regional banking system, investor confidence remains somewhat resilient. The KBW Nasdaq Regional Banking Index, while down nearly 8.5% year-to-date, has shown mixed performance since the NYCB issues surfaced. Homestreet Bank, another bank facing scrutiny, has also seen its stock hold steady recently. However, the lack of immediate changes to capital requirements offers a positive sign, particularly as banks prepare for a potential rise in loan defaults as repayments come due in the coming months. Therefore, we do not see any evidence of a possible financial crisis at this time.

Labor Softening: Even though labor markets remain tight, there are signs that employers might be hitting the brakes on hiring.

• A recent JOLTS report indicates a decline in job listings by US employers. January saw a drop in job openings from 8.89 million to 8.86 million, the lowest level in over three months. This significant decrease in job postings reflects a broader trend within the labor market, where employers are reevaluating their workforce needs. The ongoing uncertainty regarding job security likely contributes to the persistently low quit rates. At 2.1%, the quit rate remains below pre-pandemic levels, suggesting a lack of confidence among workers in their job prospects.
• A weakening labor market could signal a return to a more balanced relationship between employment and inflation. This aligns with the historical trend of PCE Core Services excluding housing, a measure sensitive to wage pressures, tracking closely with quit rates. Fewer worker resignations likely translate to a gradual decline in overall inflationary pressures. However, this trend could exacerbate if businesses continue to grapple with passing higher costs onto customers, as highlighted in the latest Fed Beige Book. The resulting profit squeeze may impede firms’ capacity to retain employees.

• This Friday’s jobs report will likely provide more clarity on the health of the labor market. While the latest estimate projects the creation of around 200,000 jobs in February, this represents a slowdown compared to the robust 350,000 increase seen in the previous month. We will be paying close attention to the prior month’s data revisions as these often provide valuable insights into underlying trends. Three consecutive months of downward revisions could signal potential labor market troubles. While the previous report did see upward revisions, it’s worth noting that downward revisions were more common throughout 2023, suggesting potential limitations in capturing the complete economic picture.

Emerging Markets En Vogue: Emerging market equities have defied expectations, posting strong gains in the year’s first quarter despite lingering concerns about high interest rates and a potential global slowdown.

• Fueled by a surge in its technology sector, Turkey has become a leader in the recent emerging market rally. The sector’s growing prominence has captured significant investor attention, propelling Turkey’s benchmark Borsa Istanbul 100 Index up nearly 20% year-to-date. Notably, the technology sector itself has skyrocketed over 60%. This performance aligns with a broader trend of investors seeking undervalued stocks outside the US to capitalize on the global tech investment boom. However, Turkey’s case is unique in that it also seems to be attracting domestic investors seeking a hedge against inflation.
• Turkey’s booming tech sector has fueled its impressive performance in the emerging market rally. However, some uncertainties cloud this optimistic outlook. The upcoming municipal elections in March presents a hurdle as these elections are seen as a test of Erdoğan’s popularity in the country. A strong victory for Erdoğan’s party could raise the prospect of a constitutional change to extend his rule. Additionally, this could complicate efforts from the opposition to field a strong candidate for prime minister in the next election, potentially impacting investor confidence in Turkey’s long-term ability to undertake much-needed economic structural reforms.

• Turkey’s case exemplifies the growing interest in emerging markets as investors seek attractive valuations and potentially higher yields. This trend could be further amplified by a potential decrease in US interest rates, weakening the dollar against other currencies. As a result, countries like Poland, Mexico, Vietnam, Indonesia, and Morocco, often viewed as bridge economies due to their strong trade ties with both the US and China, could become attractive destinations for investors seeking to diversify their portfolios and mitigate risks associated with a US-China trade war escalation.

Other News: The European Central Bank (ECB) kept its interest rates unchanged but hinted at the possibility of a reduction later in 2024. This move aligns with market expectations of central banks adopting more dovish stances. Meanwhile, President Biden proposed a moderate 1% increase in defense spending for 2025, falling short of expectations as concerns over the debt ceiling resurface.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a discussion of the European Union’s proposed new defense industrial strategy, which is designed to boost the region’s ability to produce weapons, military equipment, and ammunition.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a surprise financial reform in debt-ridden Egypt and a preview of Federal Reserve Chair Powell’s testimony before Congress today.

European Union: The European Commission yesterday released its defense industrial strategy, which constitutes its plan for shifting the EU economy to a war footing in the face of potential Russian aggression.  The plan includes multiple steps aimed at expanding and shoring up the EU’s defense industry base so that it can produce more military supplies.  For example, the plan calls for more joint purchases of weapons and ammunition, new subsidies to expand defense industry capacity, and new authorities to compel firms to prioritize EU defense orders in crisis.

• The plan is a response not only to Russia’s increasing territorial ambitions, but also to concerns that former US President Trump could stop the US from meeting its mutual defense obligations to the North Atlantic Treaty Organization if reelected in November.
• Nevertheless, it isn’t clear that the plan will get the required unanimous approval of all 27 members of the EU. Many national leaders are wary of a potential power grab by Brussels and would prefer to keep defense procurement and overall policy as a national prerogative.  National leaders are also wary of the potential cost of the plan.
  • The plan calls for the EU to support it with €1.5 billion (about $1.63 billion) through 2027.
  • However, EU officials have floated the possibility of eventually providing some €100 billion (about $109 billion) to finance the plan. That sum would likely require some kind of joint bond issuance and/or tax hikes.
• We would note that many EU countries are already boosting their defense budgets. As we predicted more than a year ago, the bulk of their procurement spending recently has gone to US defense contractors.  One risk for those US firms is that a successful expansion of the EU defense industry base could result in a loss of sales.

United Kingdom: Chancellor Jeremy Hunt today released the government’s proposed budget for the coming fiscal year, with multiple tax and spending initiatives designed to help the ruling Conservative Party turn around its dismal polling ahead of elections this autumn.  The proposals so far include a 2% cut in required payroll contributions to the National Insurance scheme and an announcement that the government will buy land for large, new nuclear power plants and solicit bids to build small modular nuclear reactors to boost the country’s energy supply.

Egypt: President Al Sisi’s government today unexpectedly announced a series of financial reforms long demanded by the International Monetary Fund to help the country manage its massive foreign debt.  Among the key reforms, the government allowed the currency to float and hiked benchmark interest rates.  The currency swiftly lost more than half its value, which will likely boost Egyptian price inflation, but the move could help unlock an IMF rescue package and avert a potential default down the line.

Venezuela: The government said it will hold a presidential election on July 28.  Authoritarian President Maduro has not announced his candidacy for a new term, but he is widely expected to do so.  And of course, given the government’s stranglehold on political power and its practice of disqualifying any viable opposition candidates, Maduro would be expected to win.  The rigging of the electoral system will likely maintain Venezuela’s pariah status and continue to exacerbate tensions with the US, just as its recent territorial threats to Guyana have done.

China-Philippines: Chinese and Philippine coast guard vessels once again collided yesterday in the South China Sea around the disputed Second Thomas Shoal.  In response, Beijing accused the Philippines of deliberately ramming its vessel, while Manila accused the Chinese vessel of “reckless and illegal” behavior.

• The Wall Street Journal today carries a fascinating article about what it’s like for the crews on the Philippine ships being harassed by the Chinese. The article includes a video of how the Chinese coast guard vessels use heavy-duty water cannon to force the Philippine vessels away from the area.
• We continue to believe that the frictions between China and the Philippines are a key risk for investors, especially since any outbreak of fighting between the countries could draw in the US because of its mutual defense treaty with Manila.

Chinese Stock Market: Sharmin Mossavar-Rahmani, the chief investment officer at Goldman Sachs Wealth Management, said in an interview with Bloomberg that she could not advise clients to buy Chinese stocks, despite the government’s recent success in stabilizing stock prices and touching off a modest recovery.  According to Mossavar-Rahmani, Chinese stock values are likely to be held back by structural problems such as moderating economic growth, opaque policymaking, and doubts over the authenticity of economic data.

• As our regular readers know, we think Chinese stock prices will also continue to be hurt by worsening tensions between the US and the China/Russia geopolitical blocs.
• The statement from Mossavar-Rahmani illustrates how major Wall Street investment firms and big investors are coming around to our view of the headwinds facing Chinese stocks.
• The statement also echoes a 2022 report from JPMorgan Chase that called Chinese technology stocks “uninvestable” before retracting the statement later, possibly under Chinese pressure.

US Politics: In yesterday’s Super Tuesday presidential primary elections, former President Trump won in 14 of the 15 states holding Republican contests, with former UN Ambassador Haley winning in Vermont.  By our calculation, Trump won about 72% of the votes in the Republican ballots, with Haley taking about 28%.  Meanwhile, President Biden won in all 15 states holding Democratic contests, pulling in an average of 89% of his party’s voters.

• With Trump’s victories to date leaving him on the cusp of clinching the Republican nomination, Haley this morning will reportedly suspend her campaign. However, sources say Haley won’t yet endorse Trump.  Instead, she will at least temporarily withhold her endorsement in an effort to encourage Trump to respond to the interests and concerns of her supporters.
• While it certainly looks like Biden and Trump will be the official candidates in the November election, this campaign still has the potential to turn volatile. For example, the advanced age of each candidate alone suggests that either or both could drop out before the November balloting.  We could also see the emergence of a third-party candidate (potentially even Haley).  And in any case, if no candidate wins enough electoral votes, the decision could be thrown to the House of Representatives.

US Monetary Policy: Federal Reserve Chair Powell today begins his semi-annual testimony to Congress with an appearance at the House Financial Services Committee.  Early indications are that he will assure lawmakers that the central bank is on track to cut interest rates this year, but it will not move until it is sufficiently confident that price pressures have fallen and won’t rebound.  Powell will speak before the Senate Finance Committee tomorrow.

US Financial Markets: The Securities and Exchange Commission has signed off on a new type of security backed by royalty streams from songs recorded by such artists as Taylor Swift, Beyoncé, and even Stevie Wonder.  The securities, offered by start-up firm JKBX and designed for everyday investors, are essentially bonds backed by the royalties from hit songs.  It’s not clear yet whether the new securities will be a hit with investors.

US Military: The US Air Force published images of an operational hypersonic missile, the “Air-Launched Rapid Response Weapon” (ARRW), loaded onto a B-52 bomber at Guam.  The Air Force has said the ARRW is a test weapon not intended for large-scale procurement, but showing the missile deployed at one of the US’s main Western Pacific bases is thought to be a message to China of US capability in this cutting-edge type of weapon.  We take this as further evidence of US commitment of resources to high-tech weaponry and a broader defense build-up.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a discussion of the fiscal challenges faced by Western governments as they look to rebuild their defenses in the face of increased threats from countries like China and Russia.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a new economic growth target in China and research pointing to more US companies tapping the convertible bond market.

Global Fiscal Policy: In a recent interview with the Financial Times, Danish Prime Minister Mette Frederiksen castigated European governments that slashed their defense spending after the end of the Cold War and then remained far too complacent about the growing threat from Russia in recent years.  Importantly, Frederiksen warned that hiking defense budgets as necessary now will require countries to reverse the tax cuts and welfare spending hikes they funded with their post-Cold War defense budget cuts.

• As our regular readers know, we at Confluence believe the intensifying rivalry between the US and China/Russia geopolitical blocs will lead to bigger defense budgets in many countries in the coming years. To put it another way, the Western nations that cut their defense spending so dramatically following the end of the Cold War and happily spent the resulting “peace dividend” on civilian programs may now need to reverse course.
• We have argued that growing geopolitical tensions will likely lead to stronger government intervention in Western economies. Frederiksen’s warning is one of the first in which a top Western leader has been willing to state the trade-offs so clearly: Hiking defense budgets as required now may well require tax hikes and civilian spending cuts.
• How would this look? To start scoping out the prospects, we conducted a quick analysis of how the US federal budget would look in an environment like the late Cold War.  In the chart below, we show the Office of Management and Budget’s estimated fiscal year 2023 federal receipts and outlays as a share of gross domestic product and compare them to their average shares of GDP in 1985-1989.

• • The chart clearly suggests the enormous drop in US defense spending since the Cold War has been absorbed mostly by increased outlays on Medicare, Medicaid, and other healthcare, along with Social Security retirement benefits. That likely reflects the aging of the US population and rampant healthcare price inflation.
  • If US leaders now wanted to boost the defense budget back to the late-Cold War average of 5.8% of GDP from today’s 3.1% of GDP (to about $1.5 trillion from today’s $815 billion), we think political considerations would likely count out any substantial cuts to Social Security, Medicare, and Medicaid outlays.
  • The problem is that other civilian outlays today are not much higher (as a share of GDP) than they were in President Reagan’s second term. Even if they were cut to their share of GDP in 1985-1989, the savings would cover less than half of the required $708 billion hike in defense spending.
  • That suggests unpalatable tax hikes of some $400 billion might be needed to bring defense spending back to late-Cold War norms. And these outlay cuts and tax hikes wouldn’t even address the $605 billion reduction in the deficit to bring it back in line with its average of 3.7% of GDP in 1985-1989.

European Union: The European Parliament last night gave preliminary approval to a bill that aims to reduce packaging materials for consumer products.  If signed into law, for example, the bill could lead to hotel mini-toiletries and single-use plastic wraps to be banned by 2030.  Many paper and cardboard packaging products were spared by intense industry lobbying, but the law will nevertheless probably become another symbol of excessive EU regulations that could be discouraging investment and growth in the region.

Chinese Economic Policy: At the formal opening of the National People’s Congress today, Premier Li Qiang said the government will target economic growth of “about 5%” in 2024, helped by issuing some $139 billion of special, ultra-long-term government bonds to help relieve fiscal pressure on provincial and local governments and investing in high-priority sectors.  The target for growth in gross domestic product is the same as last year’s, but analysts believe the target will be harder to achieve because of China’s accumulating structural headwinds.

• We tend to categorize China’s intensifying headwinds as: Weak consumer demand, excess capacity and debt, poor demographics, foreign decoupling, and disincentives from the government’s intrusive economic policies. We think those forces will continue to hold down Chinese growth in 2024, although the government’s recent effort to boost the stock market has helped push Chinese stock prices higher for now.
• Separately, Li’s economic work report also calls for China’s military budget to expand by 7.2% this year, matching the increase in last year’s official budget. However, Li provided no detailed breakdown of the defense spending plan, prompting the Japanese government to complain about the lack of transparency.

Chinese Economic Growth: The February Caixin purchasing managers’ index for the services sector declined to a seasonally adjusted 52.5, down from 52.7 in January.  Like most major PMIs, the Caixin indexes are designed so that readings over 50 point to expanding activity.  Even though the February figure suggests the Chinese services sector is still growing, the number is now at its lowest since November.  We believe that illustrates the continued weak momentum in the Chinese economy.

Japan: The Jibun Bank February PMI for the services sector fell to a seasonally adjusted 52.9 from 53.1 in January.  Again, as with most major PMIs, the Jibun indexes are also designed so that readings over 50 indicate expanding activity.  The February reading signals that Japan’s services sector has now been growing for a year and a half, despite the small drop last month.  In other data today, the Tokyo region’s February consumer price index excluding fresh food was up 2.5% from one year earlier, accelerating from a rise of 1.8% in the year to January.

• Taken together, the data point to further strength in the Japanese economy and consumer price pressures.
• That, in turn, will likely keep the Bank of Japan on track to soon exit its negative interest rate policy.

South Korea: The government’s biennial ranking of countries by technological development found that China’s overall score has pulled ahead of South Korea’s for the first time.  Taking US development in key economic sectors as the baseline, the study put the European Union at 94.7% of the US level in 2022, while Japan was at 86.4%, China was at 86.2%, and South Korea was at 81.5%. Since being overtaken by China is seen as a national humiliation, the results are expected to intensify the government’s US-style effort to crack down on technology flows to China.

Haiti: In what appears to be an effort to oust Prime Minister Ariel Henry, armed gangs in recent days have attacked police stations, stormed prisons, and freed about 5,000 inmates.  Widespread rampages and violence are reportedly continuing today.  The prime minister has been in Africa trying to secure a United Nations peacekeeping mission for the country, and his whereabouts are reportedly unknown.

US Politics: Today is Super Tuesday, with presidential primary elections and other balloting in 15 states across the country.  Former President Trump is expected to win enough votes to come very close to clinching the Republican nomination, but he isn’t expected to win it outright today.  One key question is therefore whether Former UN Ambassador Haley will keep fighting. President Biden is naturally expected to win the vast majority of Democratic votes and eventually clinch his party’s nomination.

• Separately, interesting new reporting by Axios and The New Yorker indicate that Biden is pushing his campaign staff for a much more aggressive approach than the traditional “Rose Garden” strategy often adopted by sitting presidents.
• Biden is reportedly pushing for a strategy in which he would actively goad and taunt Trump on a near daily basis, hoping to take advantage of Trump’s perceived lack of discipline and make him “go haywire in public.”
• The strategy, if implemented, would also aim to show Biden as a spirited fighter, taking some focus off his age.
• The reporting suggests that the presidential election campaigns could get nastier and more chaotic than we’ve seen so far.

US Bond Market: New analysis from BofA Global Research shows that the share of new convertible bonds issued by companies with investment-grade ratings has surged in the last year.  Investment-grade deals made up 26% of convertible deals in 2023, up from 7% in 2022 and just 2% in 2021.  Since the opportunity to convert to equity is a powerful sweetener, convertible debt typically comes with relatively low interest rates.  The surge in investment-grade convertibles is a reflection of how companies are trying to cut their interest expenses in today’s high-rate world.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with several items touching on the global outlook for consumer price inflation and interest rates.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a preview of some important government policy meetings in China and a discussion of new rules aimed at improving the functioning of the US Treasury bond market.

Global Price Inflation and Monetary Policy: The Bank for International Settlements today warned that the recovery in supply chains and weaker commodity prices since the coronavirus pandemic won’t necessarily be enough to bring price inflation down to the major central banks’ targets.  Instead, the BIS warns that price inflation in the labor-intensive services sector tends to be stickier, which could limit how quickly overall inflation falls.  In turn, that could inhibit central banks from cutting interest rates as aggressively as investors expect.

Global Oil Market: At a meeting yesterday, the Organization of the Petroleum Exporting Countries and their Russia-led partners agreed to maintain their voluntary cuts to oil production for another three months to June.  The cuts are intended to buoy global oil prices, but rising output in the US and weak economic growth in some countries has nevertheless kept a lid on prices.

• The cuts have only boosted Brent crude prices by about 6% and WTI crude by about 8% since they were first announced in late November. So far today, near futures prices are down slightly, with Brent at $83.54 per barrel and WTI at $79.90.
• Since the cuts have left major OPEC+ producers with plenty of excess capacity, it’s important to remember that even if prices rise substantially from here, those producers would have the incentive and the ability to open the floodgates again, driving prices back down. In sum, the near-term prospects for oil prices remain modest.

Global Nuclear Energy Industry: Ahead of a first-of-its-kind nuclear energy summit in Brussels later this month, International Atomic Energy Agency chief Rafael Grossi has castigated multilateral lenders such as the World Bank and the Asian Development Bank for not making their loans available for new nuclear projects.  According to Grossi, the summit in Brussels will debate how to overcome opposition from a small number of nations, such as Germany, to using development banks to fund nuclear projects.

• Despite the lack of funding from multilateral lenders, we believe the use of nuclear energy to generate electricity will grow markedly in the coming decades, even as uranium supplies are crimped. As we examine in our latest  Asset Allocation Bi-Weekly report, published today, that should result in rising uranium prices and strong returns for uranium miners going forward.
• Indeed, investors have recently begun to bid uranium prices up strongly, as shown in the chart below.

Germany-Russia: The government of German Chancellor Sholtz is facing a scandal today after a Russian website released intercepted phone calls of German military officials discussing the possible transfer of Taurus cruise missiles to Ukraine to help it repel Russia’s invasion of the country.  The intercepts have raised concerns about Germany’s ability to keep its high-level communications secret.

• More broadly, the scandal also will probably make Sholtz even more resistant to sending the missiles to Ukraine. Sholtz has been extremely reluctant to do anything that might provoke the ire of the Kremlin, and he recently argued that the missiles would have to be targeted by German soldiers, bringing Germany into the conflict.
• Indeed, to exploit the scandal, the Kremlin today accused Germany of plotting to attack Russia. The assertion likely aims to put the German government on the back foot and make it even more reluctant to provide the missiles to Ukraine.

Japan: Not only has the main Japanese stock index finally started setting new record highs again, but today it surpassed 40,000 for the first time.  We’ve also noted that a lot of the gains are coming from technology stocks expected to benefit from artificial intelligence, as in the US.  The Japanese leaders include stocks the likes of Tokyo Electron, which makes semiconductor manufacturing equipment, Advantest, a maker of semiconductor testing equipment, and Renesas Electronics, a semiconductor manufacturer.

China: The annual “two sessions” meetings, consisting of the National People’s Congress and the Chinese People’s Political Consultative Conference, opened today in Beijing.  The annual economic growth target is typically released at the sessions, and analysts this year appear to be expecting a target of around 5%, like last year.

• Top leaders will also provide some hints about their political and economic strategies. For example, they are likely to offer ideas about how they want to tackle China’s big structural problems, such as excess capacity and debt.
• However, General Secretary Xi is widely expected to resist offering any major new stimulus programs to address those problems. Rather, Xi is likely to continue trying to end China’s past practice of addressing economic growth shortfalls by adopting new debt-driven investment.

United States-China: The Biden administration on Friday issued its 2024 trade policy agenda and report to Congress, in which it vowed to double down on efforts to reverse the harms wrought by Beijing’s “trade and economic abuses.”  The document indicated the administration will keep trying to enlist foreign countries to push back against Beijing’s trade abuses, including its stringent barriers to the Chinese market and massive subsidies for exporters in strategic industries, such as electric vehicles, solar energy, and lithium.

• The trade policy statement will be a disappointment for anyone dreaming of cooler tensions between the US and China.
• As we’ve noted so many times before, US-China tensions continue to spiral upward, so on any given day, investors could be faced with a sudden, disruptive new restriction on trade, capital, technology, or travel flows between the two countries, with potentially negative consequences for US and/or Chinese companies.

US Treasury Bond Market: The Financial Times today carries an in-depth analysis of recent rule changes by the Securities and Exchange Commission that are aimed at buttressing the market for Treasury obligations but will impose new costs on financial market participants.  One goal of the change is to ensure that the Treasury market remains attractive for institutional and other investors around the world even as some countries in the China/Russia bloc and beyond work to reduce their use of the dollar.

• One such change is a requirement that Treasury trades go through a clearing house. The change aims to increase oversight and improve investor protections during market volatility.
• The second rule change described in the article brings high-speed traders and potentially some hedge funds under regulatory scrutiny.

US Weather: Following a major blizzard that dropped some 60 inches of snow on the Sierra Nevada over the weekend, California is bracing for another major storm later today.  The storm over the weekend closed a major freeway and knocked out power for thousands of businesses and homes.  Although storms like this can certainly be disruptive and have a local economic impact, they typically have only minor effects on national economic activity and those effects are usually quickly reversed.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with several items related to the U.S.-China geopolitical rivalry and what it means for investors.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more bad economic data out of Europe, a growing risk that Japan’s prime minister may be forced to resign, and new warnings from Federal Reserve officials that U.S. investors are being too optimistic about early cuts in interest rates.

U.S.-China Technology Flows:  A new report from the Chinese Academy of Sciences warns that China is at risk of falling into a “middle technology trap” because of the recent U.S.-led curbs on sending advanced technologies with potential military applications to the country.  The report defines such a trap as a situation where a developing country partially industrializes via technology importation, imitation, absorption, and tracking, but fails to join the top tier of rich, advanced countries because it can’t produce its own innovative technologies.

• The report confirms that one of the major challenges for the Chinese economy these days is the U.S. geopolitical bloc’s clampdown on trade, investment, technology, and even human capital and tourism flows with China, as countries in the bloc belatedly work to reduce their vulnerability to China’s military and economic power.
• In 2024, we believe China will continue to face economic headwinds from what we call the “Five Ds”: weak consumer demand, high corporate and local government debt, poor demographics, economic disincentives from the Communist Party’s increasing intrusion into the economy, and decoupling by foreign countries.
• These challenges have prompted General Secretary Xi to seek an easing of tensions with the West, and we think he’ll remain focused on détente in 2024, at least in diplomatic and economic relations. That could spark a temporary rebound in Chinese asset prices, but we think the Five Ds will still limit the returns available in China in the near term.

U.S.-China-Mexico Trade Relations:  To get around the broader U.S. tariffs and other trade barriers against Chinese imports, the Financial Times says at least three of China’s electric vehicle makers and one of its EV battery producers are looking to set up factories in Mexico.  Because of the U.S.-Mexico-Canada trade agreement, producing in Mexico would potentially give the companies tariff-free access to the U.S. market, while also spurring new investment and economic growth in Mexico.

U.S.-China Military Relations:  While we write a lot on the growing U.S.-China geopolitical rivalry and what it will mean for investors, sometimes it’s the small operational changes in the military that best illustrate the situation.  On that score, the New York Times on Friday had an article on how the U.S. Army is again ramping up its jungle training school in Hawaii.  After two decades focused on fighting in dry, desert locations like Iraq and Afghanistan, the Army is trying to prepare its troops for a potential war with China in the jungles of the Indo-Pacific region.

• The effort to re-introduce U.S. troops to jungle warfare comes as the U.S. Marine Corps has embarked on a controversial re-design that will transform its Pacific expeditionary forces into light, highly mobile ship killers who, in time of conflict, could deploy to islands throughout the region with powerful anti-ship missiles to wreak havoc on the Chinese navy.
• For those of us who travel often and see lots of soldiers in desert camouflage in the airport terminals, the shift in geopolitical tensions toward the Indo-Pacific and Europe may really hit home when we notice more and more of those soldiers in dark-green jungle or woodland camouflage.
• On the Chinese side, provincial civilian officials have begun appearing at public events in military uniforms, in an effort to show their support for the military and military-civilian coordination.

Israel-Hamas Conflict:  As Israeli troops continue their attacks on Hamas fighters in Gaza, Iran-backed Houthi rebels in Yemen continue to launch retaliatory missile and drone strikes on ships in the Red Sea.  In response, oil giant BP (BP, $34.81) said today that it is temporarily pausing all its tanker transits through the area.  Shipping majors A.P. Moller-Maersk (AMKBY, $8.58) and Hapag-Lloyd (HPGLY, $68.88) on Friday also curbed operations in the Red Sea after attacks on their vessels.  The moves reflect the conflict’s risk to world oil supplies and commerce.

• Separately, the Israel Defense Force admitted over the weekend that its soldiers mistakenly shot and killed three Israeli hostages during a chaotic combat operation, even though the hostages were waving a white flag and shouting in Hebrew.
• True to character, Prime Minister Netanyahu was slow to acknowledge the mistake or take responsibility for it, drawing further anger from Israelis who see him as having allowed the Hamas attacks on Israel on October 7 and then risking the hostages and Israel’s reputation with the IDF’s attack on Gaza.

Japan:  After the ruling Liberal Democratic Party’s spiraling illegal fundraising scandal forced Prime Minister Kishida to sack four of his ministers last week, government and party officials are now openly discussing the possibility that Kishida may soon be forced to resign as party chief.  Since elections aren’t required until 2025, another LDP official would likely take Kishida’s place as prime minister.  The risk for investors is that increased political chaos could undermine confidence and short-circuit the Japanese stock market’s recent strong run.

Germany:  The IFO Institute’s December business climate index fell to a seasonally adjusted 86.4, well short of expectations that it would rise slightly from the November reading of 87.2.  Along with a decline in the December purchasing managers’ indexes published last week, the findings suggest the German economy is limping to the end of the year with declining activity.  Because of the German economy’s large size, its weakness is likely to weigh on other European economies and asset prices.

Serbia:  In parliamentary elections yesterday, right-wing populist President Aleksandar Vučić’s ruling Serbian Progressive Party won 47% of the vote, which will allow it to govern without relying on any coalition partners.  Vučić had already been accused of building an authoritarian state modelled largely on Viktor Orbán’s Hungary, and opposition leaders immediately complained that his win yesterday reflected electoral fraud.

Chile:  In a ballot yesterday, Chileans voted 56% to 44% against a new constitution that would have shifted policy decidedly to the right.  The rejection came about a year after voters strongly rejected a radical leftist constitution and four years after the widespread rioting and protests that kicked off the effort.  For now, the result will leave in place the pro-business constitution passed under the Pinochet dictatorship in 1980.

U.S. Monetary Policy:  In a speech today, Cleveland FRB President Mester warned that investors have gotten ahead of themselves by pushing up asset prices in anticipation of early interest-rate cuts by the central bank.  Her comments align with similar warnings on Friday from New York FRB President Williams and Atlanta FRB President Bostic.  They also align with our view that Fed policymakers are so intent on rebuilding their reputation as inflation fighters that investors should take them at their word when they say rates will stay “higher for longer.”

• In her comments, Mester said, “The next phase is not when to reduce rates, even though that’s where the markets are at. It’s about how long do we need monetary policy to remain restrictive in order to be assured that inflation is on that sustainable and timely path back to 2%.”
• More to the point, she also added that, “The markets are a little bit ahead. They jumped to the end part, which is ‘We’re going to normalize quickly,’ and I don’t see that.”

U.S. Fiscal Policy:  Data from the Organization for Economic Cooperation and Development shows government revenue as a share of gross domestic product has risen noticeably in the U.S. and other major developed countries in recent years.  According to the analysis, the rise generally hasn’t come from newly legislated tax hikes.  Rather, the increase has come from price and wage inflation, which can push taxpayers into higher tax brackets.

• In the U.S., tax receipts at all levels of government rose to almost 28% of GDP last year, up from 25% in 2019 and one of the highest levels in decades.
• While the higher tax take can impede consumer spending and entrepreneurship, the new resources will also be available to help fund new initiatives, such as infrastructure rebuilding and increased defense spending.

U.S. Corporate Finances:  An updated review of bankruptcy filings shows business failures in the U.S. in the year ended in September were up 30% from the previous year.  The data shows that bankruptcies in several other key countries have also climbed by a similar amount.  The research suggests that the rise in bankruptcies can be attributed to higher costs, rising interest rates, and the continued withdrawal of pandemic relief funds by governments.

U.S. Energy Industry:  New forecasts from the Energy Information Agency project that solar and wind-generated electricity will surpass coal-generated electricity in the U.S. energy mix for the first time in 2024.  The report shows natural gas will remain the top source of electricity, accounting for 42% of the nation’s total, while all renewables will account for 24% and nuclear will stand at 19%.  Coal is projected to provide only 15% of U.S. electricity in the coming year.

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