The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
The Confluence Diffusion Index improved slightly in May but continues to signal that a recession is close. The latest report showed that six out of 11 benchmarks are in contraction territory. The diffusion index rose from -0.3333 to -0.2121 but still sits well below the contraction signal of +0.2500.
Residential construction spiked but the goods-producing sector remains weak.
Labor markets appear to be strong but the number of unemployed workers is starting to climb.
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is in recovery. The diffusion index currently provides about six months of lead time for a contraction and five months of lead time for recovery. Continue reading for an in-depth understanding of how the indicators are performing. At the end of the report, the Glossary of Charts describes each chart and its measures. In addition, a chart title listed in red indicates that the index is signaling recession.
Good morning! Today’s Comment begins with the market reaction to Wednesday’s financial stress test report. Next, we review the political risks central bankers face as they look to raise rates. Lastly, we will expand upon yesterday’s comments about potential curbs by the U.S. on AI sales and how they could contribute to tensions between the U.S. and China.
Banks on the Rise: Investors are beginning to dismiss concerns of an impending banking crisis as the financial system demonstrates its resilience since the turmoil in March.
All 23 banks were able to pass the Federal Reserve’s annual stress test. The review examines these banks’ ability to weather a severe financial crisis while continuing to provide credit throughout the economy. The positive results lifted investor sentiment regarding the sector after the failure of several regional banks sparked concern over the financial system in March. Banks are expected to benefit from a relaxation of capital requirements, which should make it easier for them to issue more loans and may lead to higher shareholder payouts.
Despite major banks catching a potential tailwind from the passage of the stress test, new regulations are expected in the coming months. Federal Reserve Chair Jerome Powell has stated that he is open to additional bank limits to protect against a repeat of the banking events that took place in March. During a conference in Madrid, Powell insisted that the regional banking turmoil would have been much worse had the largest banks been undercapitalized and illiquid. Hence, we do not think the optimism will likely spread into regional banking stocks anytime soon.
Disintermediation remains the greatest risk to banks as the Federal Reserve continues to raise policy rates. As the chart above shows, commercial banks are losing deposits at their fastest rate in at least 60 years. This trend has slowed over the past couple of months but will likely not reverse anytime soon as depositors look to take advantage of higher-yielding alternatives such as U.S. Treasury bills and money market funds. We do not think this is a major problem right now, but we do believe it could get worse as the Fed increases its policy rate.
Future Clash: As central bankers prepare the world for more hikes, lawmakers are starting to push back.
On Wednesday, several central bank leaders vowed to push through further rate hikes as they aim to restore price stability. Fed Chair Powell insisted that policy rates are not restrictive enough to bring down inflation. At the same time, European Central Bank President Christine Lagarde and Bank of England Governor Andrew Bailey made similar statements. The hawkish tone among monetary policymakers comes as the labor market remains relatively tight in much of the developed world. Futures markets expect the end-of-year policy rate to be 25 basis points higher than current levels in the U.S., 50 basis points higher in the EU, and 100 basis points higher in the U.K.
The seemingly never-ending monetary tightening cycle is starting to unnerve lawmakers. Italian Prime Minister Giorgia Meloni argued that the rate hikes would hurt other Eurozone economies. This sentiment was echoed by American lawmakers, led by Senator Elizabeth Warren, who wrote a letter to Fed Chair Powell requesting him to pause rate hikes. Meanwhile, members of the British Tory Party are growing worried that the impact of the BOE interest rate hikes on mortgages will hurt them at the polls. The furor over the central banks’ handling of the economy is unlikely to subside, with politicians already starting to point fingers at the institutions as their economies head into recession.
Tightening monetary policy is a relatively straightforward decision when inflation is rising and economic growth is strong. However, the situation becomes more complex when a recession is looming. The EU is already in an economic contraction, and the U.S. and U.K. economies are expected to decline in the second half of the year. This means that policymakers will likely face more political pressure to ease away from tightening to prevent exacerbating a potential downturn. So far, market participants seem to believe that the next recession will be relatively mild. However, these opinions may change if central banks continue to tighten monetary policy.
Chip Wars: Semiconductor firms get caught in the crosshairs as the U.S. and China tangle for AI supremacy.
Despite the tech-heavy NASDAQ closing up 0.3% on Tuesday, the Philadelphia SOX index, which tracks semiconductor companies, fell 0.9%. This suggests that so far investor wariness has not led to an overall sell-off of tech stocks.
In addition to black market purchases, China is still trying to convince native investors to develop the country’s AI industry. Beijing hopes that billionaires within the country will pour money into AI as it tries to bridge the gap between tech companies in Silicon Valley. Although two major powers are home to the top seven AI companies in the world, Chinese investment into the sector still lags behind the U.S., which totaled $26.6 billion in the year to mid-June versus China’s $4 billion. Additionally, the decision to spur domestic investment is also related to expectations that President Biden will unveil limits on investment in China.
The battle over AI is likely to add another layer to the overall tense relationship between the U.S. and China. The U.S. has an advantage in chipmaking and investment, which currently gives it an edge , but this lead may not last long. According to Kai-Fu Lee, a prominent AI specialist and Chinese influencer, Chinese chatbot technology is likely to lag behind its American competitors for now but should catch up relatively quickly. The competition between the two countries is likely to lead to increased state aid for the AI industry in both countries, which should provide a tailwind for tech companies. However, AI-related stocks may experience bouts of volatility due to uncertainties over regulation.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF
Oil prices may be establishing a new trading range between $67 and $75 per barrel.
(Source: Barchart.com)
Commercial crude oil inventories fell 9.6 mb when compared to the forecast draw of 1.3 mb. The SPR fell 1.4 mb, putting the total draw at 11.0 mb.
In the details, U.S. crude oil production was steady at 12.2 mbpd. Exports rose 0.8 mbpd, while imports rose 0.4 mbpd. Refining activity declined 0.9% to 92.2% of capacity.
(Sources: DOE, CIM)
The above chart shows the seasonal pattern for crude oil inventories. After accumulating oil inventory at a rapid pace into mid-February, injections first slowed and then declined. This week’s draw is consistent with seasonal norms. The seasonal pattern would suggest that stocks should fall in the coming weeks, but this pattern has become less reliable due to export flows.
Fair value, using commercial inventories and the EUR for independent variables, yields a price of $61.31. Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.
Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories. With another round of SPR sales set to happen, the combined storage data will again be important.
Total stockpiles peaked in 2017 and are now at levels last seen in 2002. Using total stocks since 2015, fair value is $94.62.
OPEC+ is trying to woo Guyana into the cartel. So far, the South American nation has fended off the invitation. The government argues that with oil demand set to decline over time, the country needs to maximize revenue in the short run; thus, producing to a quota may harm that effort.
From the 1970s into the late 1990s, the Kingdom of Saudi Arabia’s (KSA) rank as foreign supplier of oil to the U.S. was a reliable signal for the market. If the Saudis’ position fell below second place, within a few months, the Saudis would tend to flood the market with oil to maintain dominance of the U.S. oil market. The shale revolution ended that relationship, but we are watching closely to see if a similar pattern develops with the China market. It will be more difficult to establish the foreign rank given China’s tendency to control information, but we would not be surprised to see foreign oil producers try to become the largest supplier to China. Thus, we note with interest the reports that Russia is gaining share in China. This development could end the KSA’s recent thrust to raise oil prices via unilateral production cuts.
As a heat wave develops in the Pacific Northwest, a county in Oregon is suing fossil fuel companies. Although we doubt this action will have any effect, it does suggest a vulnerability for energy producers.
The DOE says that the majority of the lower 48 will be at risk of electricity disruptions due to high temperatures.
News of the Russian “coup” dominated last weekend, but for the oil markets, it’s not obvious if it will make much difference. Although there are many articles suggesting Putin is finished, we will wait and see. Chaos in Russia would be bullish for oil prices but, in the short run, not much has changed for oil flows.
New research shows how geopolitical insecurity is leading China to stockpile oil and expand relations with oil and gas producers. The research suggests that insecurity of supply is driving policy.
The KSA is sending high-ranking officials to China’s “Summer Davos,” or formally, the Annual Meeting of New Champions. The decision highlights the Saudis’ close relations with Beijing.
The latest on the Nord Stream sabotage is that Ukrainian operatives based this action in Poland. If true, it complicates inter-EU relations with Germany.
Ford (F, $14.12) has won a $9.2 billion DOE loan to build three EV battery factories. The UAW is unhappy with the development as the factories will be in non-union states and will likely not be manned with union labor.
Synthetic fuels could replace traditional fossil fuels and, if created by nuclear power, they could be nearly carbon-free or carbon-negative if captured CO2 is used in the process.
China and Sweden have had political spats over the years, mostly over human rights issues. China has unofficially banned graphite sales to Sweden; the metal is a key component in EV batteries. Although it’s possible that China’s refusal to sell to Sweden is political, it’s more likely that Beijing wants to cripple Sweden’s battery industry.
Our Comment today opens with some interesting new revelations on the weekend’s short-lived rebellion in Russia. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs of growing pushback against the European Central Bank’s aggressive interest rate hikes and news of a potential new clampdown on the sale of artificial intelligence-related computer chips to China, which is weighing significantly on technology stocks so far today.
Russia Rebellion: Reports yesterday confirmed that Yevgeniy Prigozhin, the erstwhile ally of President Putin who led his Wagner Group mercenaries in a short-lived mutiny against the Ministry of Defense over the weekend, has landed in Belarus as agreed upon in a deal brokered by Belarusian President Lukashenko to defuse the crisis. However, the extent to which the Wagner mercenaries will be disarmed or subsumed into the traditional armed forces remains unclear.
Separately, President Putin claims the deal that convinced Prigozhin to cease his march on Moscow involved paying off him and his fighters with billions of dollars from the Russian government.
As we have assessed previously, the incident has surely weakened Putin by undermining his popular image as a strong leader who doesn’t brook dissent and doesn’t back down from a fight. Putin’s admission that he paid Prigozhin and the Wagner fighters billions of dollars would likely further undermine Putin’s image.
If true, the reports suggest the Defense Ministry and the military leadership may be deeply fractured and riddled with dissent. That, too, would weaken Putin politically, although reports today say Putin is carrying out a widescale purge of disloyal officers throughout the military.
At the same time, it’s entirely possible that Putin is whitewashing the real deal that got Prigozhin to back down. One theory that we find compelling is that the payoff to Prigozhin and his fighters actually came from powerful Russian oligarchs who had much to lose if the country descended into civil war or if Putin were deposed.
In any case, if Prigozhin remains safely ensconced in Belarus, he will likely remain a political threat to Putin and his government for the foreseeable future.
Eurozone: Italian Prime Minister Meloni, in an impassioned speech to parliament earlier today, lashed out at the European Central Bank for its aggressive interest rate hikes. According to Meloni, the ECB’s “simplistic” approach to fighting consumer price inflation would hurt Eurozone member countries more than it would help them. Meloni said today’s high inflation was tied to the last year’s energy price shock, implicitly arguing that the ECB should look past the problem. In any case, her statement points to growing pushback against the ECB’s plan to keep raising rates in the near term.
France: The suburbs surrounding Paris were wracked by rioting overnight following an incident in which police officers shot and killed a teenager during a traffic stop. The violence was touched off after citizen video of the killing showed that police killed the driver, who was apparently unarmed, as he attempted to drive away. Thousands of police have been deployed to control the rioting, which exacerbates the disruptions caused by this summer’s frequent protests against President Macron’s unpopular new retirement system reform.
United Kingdom: Senior physicians working for the National Health Service in England have voted to strike for higher pay next month. We haven’t written much about the summer of labor action in the U.K. recently, but the latest vote shows that the country (and government) continues to face increased demands from employees in both the public and private sectors. To the extent that the strikers win higher pay, it will likely bolster the U.K.’s current high price inflation and prompt still more interest rate hikes by the Bank of England.
Japan-China: In another apparent case of Chinese technology theft, a Chinese researcher at Japan’s National Institute of Advanced Industrial Science and Technology (AIST) has been arrested on suspicion of illegally sending research data obtained at the institute to a Chinese company. The spate of these cases is likely to further worsen relations between China and the major developed countries, which we have frequently argued will likely present risks to investors.
United States-China: As the U.S. clamps down on selling advanced technology with potential military applications to China, sources say Chinese users have developed a large black market in smuggled U.S. computer chips. The Chinese are reportedly focused on acquiring the graphics processing units (GPUs) needed to train artificial intelligence systems, such as the A100 and H100 from Nvidia (NVDA, 418.76). The report says the black market has thousands of individual intermediaries sourcing the chips, often at a considerable premium to list prices.
This news suggests the U.S. technology clampdown will merely slow China’s AI development but probably won’t completely stop it.
U.S. Cybersecurity: Cybersecurity experts are becoming increasingly concerned about a recent, little-noticed hack of software firm Progress Software Corp. (PRGS, $54.00). After Russian hackers broke into the company’s systems and stole sensitive data from hundreds of its corporate customers, investigators expected the criminals to launch extortion scams against them. However, now it appears the criminals are focused on sensitive personal data that could be used, in conjunction with deepfake software, to launch more lucrative extortion scams against masses of individuals.
U.S. Uranium Market: As we wrote in our Bi-Weekly Geopolitical Report from May 15, 2023, we think global uranium prices will be buoyed in the coming years by heightened U.S.-China tensions and a potential new nuclear arms race between the two countries. As if to confirm that viewpoint, a number of nuclear-related asset prices have recently been climbing. The latest data shows spot prices for uranium (triuranium octoxide) are up roughly 18% year-to-date, while the share price for Canadian uranium miner Cameco Corp. (CCJ, $29.58) is up 29%.
U.S. Private Credit Market: Moody’s (MCO, $338.83) has issued a report warning that the young private credit industry faces its first serious challenge as tens of billions of dollars of loans underwritten at the top of the market in 2021 are strained by sharply higher interest costs and a slowing economy. Nevertheless, the credit rater didn’t downgrade its ratings or outlook for any of the major, publicly traded firms in the sector.
Our Comment today opens with an update on Russian political stability following the weekend rebellion by Wagner Group mercenaries. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including fresh signs of further interest rate hikes in the Eurozone, the likelihood of currency market intervention in Japan, and some unexpected good news for office valuations in New York City.
Russia: In the aftermath of the short-lived weekend mutiny by Yevgeniy Prigozhin and his Wagner Group mercenaries, President Putin and Prigozhin himself spent yesterday trying to spin the events to their favor. In a televised statement, Putin pilloried Wagner for threatening bloodshed and extolled the Russian people for rallying around their government, despite clear evidence that many Russians were indifferent to Putin’s fate and supported Prigozhin. Meanwhile, Prigozhin insisted he had never tried to topple the government itself, despite the fact that his troops marched to within 125 miles of Moscow and killed over a dozen Russian aviators.
Having survived the rebellion, at least for now, Putin has tried to go on the offensive against Prigozhin, initially announcing through his government that the Wagner leader still might be arrested and offering the Wagner troops just three options: sign up as regular soldiers in the official armed forces, go home, or follow Prigozhin into exile in Belarus. The Putin government today also said that Wagner’s heavy weapons would be transferred to the national guard.
In any case, Putin’s statement suggests Wagner is finished as an independent, organized force. A key question will be whether Prigozhin accepts that fate as it would render him completely powerless. As we mentioned in our Comment yesterday, the crisis in Russia’s leadership is almost certainly not yet over.
Eurozone: At the European Central Bank’s annual conference in Portugal today, ECB President Lagarde said tight labor markets, rising wages, and sticky price inflation will require “persistent” new interest rate hikes in the coming months. The statement provides additional evidence that the ECB’s benchmark rate will continue to move higher from its current level of 3.5%. If the Federal Reserve continues to slow its rate hikes, or if it stops them altogether, the additional rate hikes in the Eurozone could help push the value of the euro beyond its current resistance level of approximately $1.10 per dollar.
According to Gopinath, the central bankers risk being faced with a stark choice between solving a future financial crash among heavily indebted countries and raising borrowing costs enough to tame stubborn inflation.
So far today, the yen is trading at approximately 143.57 against the dollar, down almost 11% from its most recent high early this year.
The yen is still a bit stronger than the 150.15 per dollar level that it hit last October before the government stepped in to buy up yen and sell foreign reserves to prop up the currency. Nevertheless, it is looking increasingly likely that the Japanese government could soon intervene in the currency markets again to prop up the yen.
Indonesia: President Widodo has indicated in a speech that he won’t back down on a new law that bans the export of bauxite ore despite concerns that China could file a complaint about it at the World Trade Organization. The law forces miners to refine their bauxite into aluminum before it can be exported, thereby creating domestic manufacturing jobs. It is similar to an older rule banning the export of raw nickel ore. The rules exemplify the growing global trend toward industrial policy that intervenes in the free market to bolster domestic industrial development.
United States-China: U.S. Treasury Secretary Yellen plans to visit Beijing in early July to meet with her new Chinese counterpart, according to press reports. The meeting would mark another step in the Biden administration’s efforts to ease tensions with China, or at least to been seen as doing so. However, if the meeting happens, it could come just before the administration announces new measures aimed at further curtailing U.S. investments in China. Prospects for improved relations from the meeting therefore seem low.
U.S. Dollar: The latest annual survey of central banks by the Official Monetary and Financial Institutions Forum (OMFIF) found that reserve institutions managing almost $5 trillion of assets combined expect the U.S. dollar to decline only gradually as a proportion of global reserves over the coming decade. The surveyed banks estimate the greenback will still account for 54% of total global reserves in 10 years’ time compared with 58% currently.
U.S. Stock Market: Just in the month through yesterday, investors have now bought more call options on the VIX volatility index than in any other month on record. The data suggests that investors are becoming more concerned that stock prices could turn volatile after a relatively smooth, technology-driven run up for the year to date. Since we continue to believe the economy is likely to slip into recession in the second half of the year, we would not be surprised if the U.S. stock indexes stage a significant retreat in the coming months.
U.S. Commercial Real Estate Market: Rising interest rates and work-from-home trends continue to batter office owners and commercial real estate lenders, but real estate investment trust SL Green (SLG, $28.20) has managed to sell its stake in a prime New York City office tower at a price that values the building at $2 billion. The price was only a modest decline from the building’s previous value, giving a healthy boost to much of the REIT sector in trading yesterday, including a 19.8% jump in SL Green shares.
U.S. Supreme Court: With the court wrapping up this year’s term on Friday, investors are bracing for the release of several key decisions over the coming days. The expected decision with perhaps the most implications for businesses will relate to the legality of affirmative action in college admissions. Whatever the justices rule, the decision is likely to affect affirmative-action policies in corporate settings as well.
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