by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with the latest development from Treasury Secretary Yellen’s trip to Beijing. Next, we discuss the heightened risk of unrest in Russia. Lastly, we examine why tech companies are looking to take greater control of access to consumer data.

Back to China: While the Biden administration may be willing to make some concessions in order to improve relations with China, it is unlikely to abandon its attempt to pivot away from the world’s second largest economy.

• U.S. Treasury Secretary Janet Yellen called out China for its mistreatment of U.S. firms over the last few months. On her first day in the country, she criticized recent crackdowns on U.S. firms headquartered in China as well as Beijing’s decision to restrict exports of critical minerals needed to make semiconductors. Beijing’s harshness is seen as retaliation for U.S. attempts to limit China’s ability to grow its own semiconductor industry. Although Yellen mentioned that the U.S. is not looking for a winner-take-all approach, it is unlikely that the feud will end in the near future.
• China continues to flex its military muscles in an attempt to show that it is now capable of taking on the U.S. in a direct conflict. Last month, a Beijing think tank released a paper claiming that China’s military is capable of sinking the U.S. Navy’s most advanced aircraft carrier strike group. This claim has largely been dismissed as propaganda, designed to convince Taiwan that China is capable of taking over the region whenever it sees fit. Furthermore, it is still highly doubtful that China is preparing to take over Taiwan anytime soon. Nevertheless, the recent military exercises and propaganda efforts do show that annexing Taiwan remains part of China’s long-term agenda.
• The ongoing meetings between the U.S. and China are unlikely to deter the Biden administration from promoting reshoring efforts. The White House believes that it is in the country’s best interest to “de-risk” from China due to national security concerns. This broader shift will likely lead to a new industrial push in the U.S. On the one hand, reindustrialization can help reduce U.S. reliance on China and other countries for critical goods and services. This shift could improve national security and make the U.S. economy more resilient to disruptions in the global supply chain. On the other hand, reshoring could lead to higher prices for consumers and businesses.

Something Brewing: There are mounting concerns of an imminent armed rebellion in Russia as the Wagner Group does not seem inclined to follow Moscow’s orders to disband.

• Yevgeny Prigozhin, the leader of the Wagner Group, is back in Russia despite agreeing to a peace deal in which he would relocate to Belarus. This report comes from Belarusian President Alexander Lukashenko, who was a key figure in brokering the deal following last month’s failed mutiny. Prigozhin’s presence in Russia is likely to call into question Vladimir Putin’s authority. Although Prigozhin’s whereabouts are unknown, state-run television has shown that his offices and home were raided on Thursday. Despite Putin’s best efforts, the Wagner Group is still a force to be reckoned with and thus the possibility of a civil war cannot be ruled out.
• The controversy may incentivize efforts from the White House to create a potential off-ramp for Russian government officials looking to escape a possible takeover attempt. Last week, CIA officials argued that disarray in Russia has created a massive recruitment opportunity. Additionally, there have been reports that former U.S. officials held informal talks with officials in the Kremlin in April regarding a peace deal, suggesting there is backchannel communication between the two sides. The Russian ruble has declined 12% against the U.S. dollar since Ukraine’s counteroffensive began on June 4, and it is now hovering near a 15-month low. At the same time, Ukrainian dollar bonds have rallied to pre-war levels, further supporting the case that the tide has turned against the Kremlin.

• Putin is running out of time and options. He vastly underestimated the West’s support for Ukraine as well as his own military’s ability to secure a quick victory. More than a year after the conflict began, he is now facing his most serious threat to hold onto power since taking office 23 years ago. The next few weeks will likely be crucial in determining whether he will be able to maintain control of the country. If Putin is removed from office, it is not clear who would replace him. As a result, there is the risk of a power vacuum or even a civil war. This could lead to a sudden spike in commodity prices and a rush to safe haven assets.

Tech Wars: Competition between social media companies is heating up as the major players battle for social media supremacy.

• The rivalry between tech billionaires Elon Musk and Mark Zuckerberg escalated this week as Instagram released its new Threads app in an attempt to provide users with an alternative to Twitter. The app added 30 million new users since Thursday, which still pales in comparison to Twitter’s 300 million subscribers. Musk’s social media company has come under much scrutiny after establishing rules that limit users’ access to the website. Threads, on the other hand, appears to offer similar features with none of the same restrictions. The launch of Threads shows how tech firms that alter their services too quickly may open themselves up to unwelcome competition.
• That said, Musk’s decision to limit access to Twitter’s website may be a way to prepare for a world built around artificial intelligence (AI). Tech companies have been able to use a method known as “scraping” to grab data needed to improve machine-learning algorithms. Scraping can be a valuable tool for AI research as it allows programmers to gather information about Twitter users free of charge. Hence, by protecting the data, Musk is ensuring that he keeps a valuable revenue stream open for future use.
• We are now entering the era of Big Data. This new period will be defined by companies buying and selling information as if it were a commodity. This changing dynamic will be particularly important as companies start to integrate AI into their business processes. Social media companies will likely try to compete in the space to ensure they can offer premium data for these models. Additionally, control over the access of data may be critical for companies looking to profit from the AI craze.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion about friction between policymakers in the U.S. and Europe over the pace and direction of interest rate changes. We will then discuss why households are not as confident in the economy as the data suggests. Finally, we will explain why China may be able to make a comeback later in the year.

Less United: Central bankers in Europe and the United States are still undecided about when to end the ongoing hiking cycle.

• The Federal Open Market Committee was divided on whether to pause rates in June, according to the latest meeting minutes. Despite the lack of any dissents to last month’s pause, some policymakers argued for an increase of 25 basis points in the central bank’s benchmark policy rate. Members who favored a rate hike pointed to recent data showing that the labor market remains tight and inflation remains elevated. Despite the disagreement, Fed officials have left the door open for future hikes, with the market pricing in another quarter-point hike toward the end of the month.
• Despite the economic contraction in the Euro area, members of the European Central Bank are still divided as to whether to increase rates again this year. Earlier this week, Joachim Nagel, a member of the ECB’s Governing Council, advocated for additional rate hikes due to elevated inflation. In contrast, Italian governor Ignazio Visco has cautioned against additional increases in the policy rate as the region continues to assess the damage from previous tightening. The tensions between members of the ECB Governing Council reflect growing anxiety about the state of the Eurozone economies. Most countries in the bloc are showing signs of slowing, which raises the political and economic costs of higher interest rates.

• It will be difficult for central banks to justify their hawkish stance as price pressures continue to ease. Producer prices in the U.S. fell well below 2% in June, a sign that producers are feeling less need to pass on costs to consumers. Similarly, Spain has also seen inflation fall well below 2%, making it the first major Eurozone country to do so. This progress suggests that central bankers are getting closer to achieving price stability. However, it is still unlikely that either the ECB or the Fed will cut rates this year as both central banks fear the return of inflation.

Not Sure: Although the government data shows that the economy remains resilient, households are still worried about a potential downturn.

• Middle-class people are becoming more concerned about an imminent recession. Americans making between $45,000 and $180,000 annually and wealth between $100,000 and $1 million reported higher levels of anxiety regarding the economy, according to polls conducted by Bloomberg. The findings showed that only 39% of survey respondents expect their economic situation to improve within the next year. This report comes amidst a series of positive economic surprises showing that the country is stronger than most analysts believed at the start of the year. The rising anxiety among middle-class Americans is a reminder that the economy is not always as it seems.
• Although consumer spending has reverted to pre-pandemic levels, households are still expressing concerns about their present situation. This reality reflects the growing angst that households are feeling in an economy with rising interest rates and elevated inflation. That said, it does appear the data may be catching up to household perceptions of the state of the business cycle. Average weekly hours have fallen in three out of the last four months, meanwhile initial claims data has been trending higher over that same period. These trends generally serve as a precursor to a weakening labor market. As a result, we still believe that it is too early to say whether or not the economy has averted a downturn as some analysts believe.

• The Fed’s reliance on government data could be its Achilles heel, as it may be limiting its perspective. Initiation rates, which measure the percentage of respondents who agree to participate in a survey, have fallen well below pre-pandemic levels. For example, Fed officials have often cited strong payroll data as a reason to keep monetary policy tight. However, initiation rates for establishment surveys have dropped from 67.0% in February 2020 to 38.5% as of April 2023. This decline in initiation rates raises doubts about the accuracy of the Fed’s data-driven decision-making as it shows that policymakers may not have a complete picture of the economy as it sets interest rate policy. Therefore, the likelihood of a Fed mistake is still somewhat elevated.
  • During the last Fed meeting, policymakers also raised doubts as to whether the payroll data accurately reflects the strength of the labor market.

New Day, New Way: Despite its weak start to the year, China still may be able to finish the year strong.

• Top leaders are expected to hold off from making major economic reforms at the July Politburo meeting. The meeting of the 24 most influential Communist Party leaders is likely to set the stage for economic policy in the second half of the year. Investors will be keen to see how the Chinese government plans to respond to the disappointing economic recovery following the end of pandemic restrictions. Additionally, onlookers will be paying close attention to a potential thaw in tensions with the U.S. as well as the outlook for the Chinese property market.
• Despite the recent misses, there is still optimism that China will be able to turn things around in the second half of the year. The People’s Bank of China (PBoC) has reassured markets that it has ample tools to prevent a severe depreciation of the yuan (CNY) against the U.S. dollar (USD). At the same time, there is hope that U.S. Treasury Secretary Janet Yellen’s visit to Beijing may improve diplomatic ties between the two largest economies in the world. This possible change in trajectory is also reflected in the data. According to the OECD leading economic indicator, the Chinese economy is currently gaining momentum and is outperforming the U.S.

• The changing geopolitical landscape has made it more difficult to predict China’s long-term trajectory. However, there is still a reasonable chance of a market recovery over the next 6-12 months. There are a few factors that suggest this could be the case. First, the government does not appear to be in a rush to sever ties with the West. In fact, it is trying to maintain relations with Europe. Additionally, China may be reluctant to completely isolate itself from the U.S. as it seeks to restore confidence in its economy. Second, it is still possible that the government will implement large-scale stimulus later in the year, as it has in previous major downturns. These factors suggest that China may be better positioned than it was at the start of the year.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news of more trade frictions between China and the West.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including reports of a new breakthrough in electric vehicle batteries out of Japan and further evidence that the U.S. economy may finally be sliding into recession.

China: The Ministry of Commerce on Monday imposed a license requirement on exports of gallium, germanium, and dozens of other related minerals and metals that are produced and refined mostly in China and are critical for manufacturing semiconductors, modern missile systems, and solar cells.  According to the ministry, the licensing requirement, which will take effect on August 1, aims to protect national security and interests.

• The license requirement is widely seen as an effort to retaliate for the West’s clampdown on sending advanced semiconductor technology to China. It also likely aims to put U.S. Treasury Secretary Yellen on the back foot when she visits Beijing later this week.
• At this point, China will likely issue the required licenses, so exports of the minerals may not be immediately impacted. However, there would be a continuing threat to withhold the licenses and cut the flow of exports.  The licensing regime is therefore a bargaining chip for China as it faces the U.S. technology bans.
• In any case, the move could backfire on China by further highlighting the risk of depending on it for any important good or resource. It will therefore incentivize more “de-risking” by the West.  At the risk of sounding like a broken record, we continue to believe that the unending escalation of tit-for-tat restrictions on trade, technology, and capital flows between the West and China will likely put investors at risk.
  • In one new example of how Western firms are de-risking and building supply chains outside of China, the Indian minister of electronics and information technology said U.S. chip firm Micron Technology (MU, $63.90) will break ground on its first semiconductor assembly plant next month and begin producing the country’s first domestically manufactured microchips by the end of 2024.
  • India is likely to be an important beneficiary of the new, de-risked supply chains, and investors have already begun to bid up Indian assets in response.

China-Russia-Ukraine-European Union: The Financial Times cites unnamed sources as saying that Chinese President Xi in March privately warned Russian President Putin against using nuclear weapons in his faltering invasion of Ukraine.  The sources say Chinese diplomats are now taking credit for holding back Putin from a nuclear war to curry favor with European leaders and split them off from the U.S.’s strong anti-China policies.

• We believe there is still substantially less than a 50% chance that Putin would use a nuclear weapon or start a dangerous escalation toward it.
• Nevertheless, the Chinese diplomatic messaging probably resonates more in Europe than it would in the U.S. That highlights the ongoing challenge the U.S. will face in keeping the Europeans on board with a tougher approach to China’s geopolitical aggressiveness.

Japan: Auto giant Toyota (TM, $160.47) announced it has made a technological breakthrough that will allow it to halve the size, cost, and weight of solid-state batteries for its electric vehicles by 2027 or 2028.  The company said electric vehicles with its new batteries could have a range of over 600 miles and be able to re-charge in 10 minutes or less.

• The announcement serves as a reminder that electric vehicle technology remains in flux.
• As we’ve been writing, China appears to be in the driver’s seat with electric vehicles at the moment. However, its leadership is not necessarily guaranteed for the long term.
• That’s especially true if Western governments restrict Chinese vehicle imports and new, more competitive technologies are developed in the West.

South Korea: The government today announced it will allow new entrants into the country’s banking market for the first time in three decades.  The new policy will allow more online banks, permit commercial bank licenses for existing financial firms, and ease the loan-to-deposit rules for local branches of foreign banks.  The government said the aim is to spur competition after President Yoon Suk Yeol criticized existing banks for enjoying a “feast of bonuses” and “easy” profits as interest rates rise.

South Korea-North Korea: A joint U.S.-South Korean analysis of debris from North Korea’s failed spy satellite launch in May indicated the craft’s surveillance capabilities weren’t military grade in any case.  Although North Korea garners a lot of headlines with its high-profile weapons advances, the findings are a reminder that Pyongyang’s actual capabilities may be less than meets the eye.

Guatemala: After a center-left candidate and an anti-corruption reformer appeared to win the first-round presidential election in June, the country’s top court has ordered a suspension of the official results.  The move has raised suspicions that Guatemala’s political and business elites may be trying to ensure a place for the governing party’s candidate, Manuel Conde, in the two-person run-off election next month.  A victory by Conde would likely preclude any meaningful improvement in the country’s corruption, crime, and political polarization, which have prompted large numbers of Guatemalans to try to emigrate to the U.S.

U.S. Re-Industrialization: In data released on Monday, overall construction spending in May was up a healthy 2.4% from the same month one year earlier.  Private residential spending was down 10.8% on the year, but public works spending was up 13.3%.  Even more impressive, private nonresidential construction spending, a proxy for commercial construction, was up 19.6%, marking the fifth straight month of year-over-year increases at that level or above.

• As we discussed in our most recent Bi-Weekly Asset Allocation Report, the recent jump in commercial construction comes in large part from booming factory construction. To be more precise, much of that increase is being driven by new manufacturing facilities for electrical and information-processing goods like electric vehicles, electric vehicle batteries, and semiconductors.
• We continue to believe the jump in factory construction is early statistical confirmation that the U.S. is in a period of re-industrialization as companies shift much of their production back home from Asia or other foreign locales. We think re-industrialization will create equity opportunities in the broad industrial sector, in construction firms and the service companies that support them, in providers of manufacturing materials and equipment, and potentially even in industrial real estate firms.

U.S. Manufacturing Sector: Despite the burst in factory construction, actual manufacturing activity continues to weaken.  The Institute for Supply Management on Monday said its June ISM manufacturing index fell to a seasonally adjusted 46.0, short of expectations and down from 46.9 in May and 47.1 in April.  As with all major purchasing managers’ indexes, the ISM index is designed so that readings below 50 point to contracting activity.  All the key subindexes are now below that standard, but the real drivers of the overall decline in June came from deepening contractions in production, employment, and inventories.  We believe that confirms a sharp slowdown in factory activity, consistent with the overall economy edging toward recession.

Global Fund Management: The Financial Stability Board and the International Organization of Securities Commissioners have issued guidance saying that funds investing in hard-to-sell assets such as property should charge clients for withdrawing their cash to discourage a rush for the exit in times of stress.  The recommendation is especially pertinent as investors today worry about the value of office buildings amid rising interest rates and work-from-home challenges.  Some major fund managers have already implemented such policies.

LIBOR’s Demise: For one final time, we also want to remind investors that use of the London Interbank Offering Rate, or LIBOR, ended on Friday.  We provided a detailed analysis of LIBOR’s demise and its implications in our Comment on Friday, but to reiterate the main points:

• The Federal Reserve and other regulators moved to end LIBOR and shifted to the Secured Overnight Financing Rate (SOFR) as of Friday.
• One important implication is that the market therefore loses the “TED Spread,” or the spread of Eurodollar yields versus T-bill yields. For years, the TED Spread was one of the key indicators of market stress.  The SOFR/T-bill spread will not likely exhibit the same characteristics as the TED spread.
• Bank loans will also lose a buffer. Bank loans are often tied to LIBOR as a base rate.  A typical floating loan is LIBOR plus a spread.  Since LIBOR rates would rise during periods of financial stress, banks were provided a modicum of protection from such events.  Since SOFR is collateralized, the rate relative to the risk-free rate shouldn’t rise when credit conditions deteriorate, so we would expect loan pricing to eventually change to reflect the shift.
• Credit lines could be utilized more frequently during periods of stress. Banks routinely issue credit lines to corporate borrowers, assuming few will use them.  Tying the credit line to a LIBOR rate tended to discourage credit line use because (as noted above) the LIBOR rate would rise when credit conditions weakened.  Since SOFR is secured, the rate probably won’t rise when stress emerges, which may encourage the use of credit lines just at the moment when banks would rather see them lay dormant.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with energy news, including further oil output cuts by Saudi Arabia and Russia, as well as a spate of negative prices for wholesale electricity in Europe.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including further EU support for “de-risking” its supply chains with China and yet another significant strike in the U.S. labor market.

Global Oil Market: The governments of Saudi Arabia and Russia today announced they will further cut their oil production in August to boost prices as global demand slows.  Russia alone will cut its output by an additional 500,000 barrels per day.  Nevertheless, slowing economic growth and expectations of a recession in the U.S. continue to weigh on prices for oil and some other commodities.  So far this morning, nearby Brent crude futures are trading at $76.03 per barrel, up just 0.8% on the day.

European Union: Another commodity with weak pricing these days is wholesale electricity in the EU.  Prices were negative for much of the weekend and for an entire day in Germany, reflecting ample natural gas supplies and a surge of new solar and other green energy sources amid sunny weather.  The negative prices can complicate finances for utility firms and will likely spur more interest in batteries and other storage mechanisms.

European Union-China: At their summit on Friday, the EU’s 27 national leaders formally supported European Commission President Von der Leyen’s call to “de-risk” supply chains with China.  Although the leaders also stressed that they don’t want to completely “de-couple” from China, the statement illustrates how EU leaders continue to shift toward the U.S. position of taking a stronger stance toward China’s political, economic, and military aggressiveness.  As we have noted many times before, these de-risking policies and China’s reaction to them are growing risks for investors.

• On a related note, the Dutch government has tightened its restrictions on selling advanced semiconductor manufacturing equipment to China, as requested by the U.S. Starting September 1, top equipment maker ASML (ASML, $724.75), which is headquartered in the Netherlands, will be required to get a license before selling its most advanced immersion deep ultraviolet (DUV) lithography systems to customers in China.
• On China’s side, the country’s new anti-espionage law went into effect on Sunday. The law potentially criminalizes the release of even basic economic and corporate financial information.  It also could compel locally employed Chinese nationals of Western companies to assist in Chinese intelligence efforts.

China: The Communist Party has named Pan Gongsheng, head of the State Administration of Foreign Exchange, to be its new party chief at the People’s Bank of China.  Not only does the appointment highlight how President Xi has pushed for stronger party representation in public and private organizations, but it has also raised speculation that the central bank could be preparing to defend the renminbi, which has recently weakened to a seven-month low against the dollar.

Brazil: The country’s top electoral court on Friday convicted right-wing Former President Bolsonaro of abusing his political power and misusing the media ahead of last year’s election.  The decision bans Bolsonaro from running again for any political office until 2030, which would likely end his political career, but the former president is likely to appeal to the Supreme Court.  In sum, the electoral court’s decision and ongoing criminal investigations against Bolsonaro suggest the Brazilian investment environment will remain unstable in the near term.

U.S. Labor Market: Thousands of hotel workers in Los Angeles went on strike for higher pay and better benefits yesterday.  Along with the many other strikes we’ve reported on recently, the hotel workers’ strike reflects the increased cost of living and workers’ realization that they have greater bargaining power amidst today’s labor shortages.

• Over much of the last two years, galloping price inflation was more than enough to offset the jump in wage rates. The resulting drop in inflation-adjusted compensation or “real” purchasing power goes far toward explaining today’s worker activism, low consumer sentiment, and the Biden administration’s low approval ratings.
• We would note, however, that the modest cooling in inflation in recent months has started to boost real income. This chart shows that disposable personal income (i.e., income after taxes) is now up about 3.5% year-over-year even after stripping out taxes.  That could potentially cool worker dissatisfaction and help Biden politically going forward.

U.S. Travel Market: AAA estimates that 43.2 million people will travel by automobile for the Independence Day holiday this year, which is 4% higher than the previous all-time high of 41.5 million in 2019.  The organization’s analysis suggests the jump in travel will come largely from the fact that gasoline prices this year are about 30% lower than their peak early last summer, at a national average of $3.49 per gallon.

U.S. Student Loan Market: Despite the slowdown in inflation and the jump in consumer purchasing power at the present, we’re increasingly focused on the risk that consumption demand could suddenly slow in October, when the pandemic-era pause on student loan repayments ends and 27 million people have to start writing those checks again.  In addition, the Supreme Court on Friday invalidated President Biden’s student loan forgiveness plan, which would have cancelled up to $20,000 of debt for some particularly low-income borrowers.  Even though the administration is reportedly working on rules to ease the transition back to normal, the shock of sudden new debt service payments could well undermine consumption spending and finally bring about the recession that we’ve been expecting for some time.

LIBOR’s Demise: Finally, we think it’s important to remind investors that use of the London Interbank Offering Rate, or LIBOR, ended on Friday.  We provided a detailed analysis of LIBOR’s demise and its implications in our Comment on Friday, but to reiterate the main points:

• During the Great Financial Crisis, it was discovered that banks were manipulating their reported interest rates to help their respective institutions and, in the most egregious cases, encouraging other banks to do the same as “a favor.” Because LIBOR was the rate tied to the Eurodollar futures market, this manipulation ran afoul of U.S. commodity trading regulations.  In the wake of the scandal, the Federal Reserve and other regulators moved to end LIBOR and shifted to the Secured Overnight Financing Rate (SOFR) as of Friday.
• One important implication is that the market therefore loses a key data point. For years, one of the key indicators of market stress was the T-bill over Eurodollar spread, commonly called the “TED spread.”  Since LIBOR represented non-government guaranteed dollar deposits, there was credit risk embedded in the rate.  Market participants began to notice that when credit stress developed in the financial markets, the TED spread would widen, with LIBOR rates rising above T-bill rates.  The SOFR/T-bill spread will not likely exhibit the same characteristics as the TED spread, meaning that traders and investors will lose the TED spread as a market indicator.
• Bank loans will also lose a buffer. Bank loans are often tied to LIBOR as a base rate.  A typical floating loan is LIBOR plus a spread.  Since LIBOR rates would rise during periods of financial stress, banks were provided a modicum of protection from such events.  In other words, the rate on LIBOR-based loans would rise as stress levels rose.  Assuming the borrower remains current, the rise in the loan’s rate would exceed the level of the risk-free rate by a wider margin.  This protection would allow banks to offer more competitive rates to borrowers, knowing that the lender had some protection from financial stress events.  Since SOFR is collateralized, the rate relative to the risk-free rate shouldn’t rise when credit conditions deteriorate.  Eventually, we would expect loan pricing to change to reflect the shift.
• Credit lines could be utilized during periods of stress. Banks routinely issue credit lines to corporate borrowers, assuming few will use them.  Tying the credit line to a LIBOR rate tended to discourage credit line use because (as noted above) the LIBOR rate would rise when credit conditions weakened.  Since SOFR is secured, the rate probably won’t rise when stress emerges, which may encourage the use of credit lines just at the moment when banks would rather see them lay dormant.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a farewell to LIBOR and ends with a few comments on the overnight news.

The End of LIBOR: As of today, the use of the London Interbank Offering Rate, or LIBOR, will end.  LIBOR developed in London as an ad hoc arrangement in 1969 to set the rate on an $80 million syndicated loan to the Shah of Iran.  By the mid-1980s, the process of establishing the LIBOR rate was formalized by the British Bankers Association (BBA).  A set of London banks would submit their borrowing rates for 15 different maturities and up to 10 different currencies.  The LIBOR rate originally was tied to the Eurodollar market, which represented unregulated dollar deposits held offshore, but over time (especially with the end of Regulation Q in the U.S., which set deposit rates), LIBOR was designed to reflect bank cost of funds.  The BBA would calculate a trimmed-mean average by removing the top and bottom four rates.

During the Great Financial Crisis, it was discovered that banks were manipulating the submissions to help their respective institutions and, in the most egregious cases, encouraging other banks to do the same as “a favor.”  Because LIBOR was the rate tied to the Eurodollar futures market, this manipulation ran afoul of U.S. commodity trading regulations.  In the wake of the scandal, the Federal Reserve and other regulators moved to end LIBOR and shifted to the Secured Overnight Financing Rate (SOFR). And so, effective today, LIBOR is no longer being calculated and will not be available for loans.

What are the ramifications?

We lose a market indicator: For years, one of the key indicators of market stress was the T-bill over Eurodollar spread, commonly called the “TED spread.”  Since LIBOR represented non-government guaranteed dollar deposits, there was credit risk embedded in the rate.  Market participants began to notice that when credit stress developed in the financial markets, the TED spread would widen, with LIBOR rates rising above T-bill rates.

The Chicago FRB National Financial Conditions index rises when financial stress develops.  As the chart shows, the TED spread tends to widen when stress increases; in fact, the two series are correlated at 92.6%.  Since the SOFR rate is secured lending, meaning it is collateralized by a safe asset, it should not exhibit the same reaction to financial stress.  Essentially, the SOFR/T-bill spread will not likely exhibit the same characteristics as the TED spread, meaning that traders and investors will lose the TED spread as a market indicator.

Banks will lose a buffer: Bank loans are often tied to LIBOR as a base rate.  A typical floating loan is LIBOR plus a spread.  Since LIBOR rates would rise during periods of financial stress, banks were provided a modicum of protection from such events.  In other words, the rate on LIBOR-based loans would rise as stress levels rose.  Assuming the borrower remains current, the rise in the loan’s rate would exceed the level of the risk-free rate by a wider margin.  This protection would allow banks to offer more competitive rates to borrowers, knowing that the lender had some protection from financial stress events.  Since SOFR is collateralized, the rate relative to the risk-free rate shouldn’t rise when credit conditions deteriorate.  Eventually, we would expect loan pricing to change to reflect the shift.

Credit lines could be utilized during periods of stress: Banks routinely issue credit lines to corporate borrowers, assuming few will use them.  Tying the credit line to a LIBOR rate tended to discourage credit line use because (as noted above) the LIBOR rate would rise when credit conditions weakened.  Since SOFR is secured, the rate probably won’t rise when stress emerges, which may encourage the use of credit lines just at the moment when banks would rather see them lay dormant.

At the end of May, some $700 billion of high-yield loans remained priced at LIBOR.  We do expect some loans will slip through the deadline.  The rate behavior of these loans will depend on the loan covenants in place.  It is not inconceivable that the loans become essential fixed rate at today’s closing LIBOR rate.  Although the financial industry has had ample time to adjust and prepare, some issues may still emerge.  But, as we note above, the bigger issue is that this change could lead banks to inadvertently take risk.  From our perspective, the loss of the TED spread is a disappointment; although other credit signals exist, the TED spread was an easily accessible way to view financial stress.  Adieu, TED…

In Other News: Inflation is falling in the Eurozone, and currencies in the two largest Asian economies are plummeting against the dollar.  Meanwhile, France is still trying to get protests under control.

• June CPI for the Eurozone declined from 6.1% to 5.5%. The reading was lower than the consensus estimate of 5.6% but still above the European Central Bank’s 2% target.  Although the decline will be welcomed by the central bank, it is unlikely to dissuade policymakers from further tightening.  The ECB has raised rates in eight consecutive meetings and is expected to do so again in July and September.  Futures contracts show that traders are pricing in an additional rate increase of 50 bps by the end of the year.
• Japanese and Chinese currencies are weakening relative to the dollar for opposite reasons. The yen is weakening as traders doubt that the Bank of Japan (BOJ) will tighten monetary policy to counteract rising inflation.  In contrast, the yuan has dropped as China’s central bank, the People’s Bank of China (PBOC), refuses to provide sufficient stimulus to support its struggling economy.  The currency weakness has led the PBOC to intervene through fixing to support the yuan and is expected to lead to action from the BOJ.

The chart above is inverted to show that an increase in the price of a U.S. dollar in another currency reflects a depreciation.

• In France, President Emmanuel Macron is struggling to contain protests following a police shooting of an unarmed teenager. Over 875 people were arrested in France on Friday in the third consecutive night of protests.  Prime Minister Elisabeth Borne is considering setting up a crisis meeting to deal with the situation.  The unrest in France is likely to further diminish President Macron’s popularity, which was already hurt by his handling of pension reforms and other protests.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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.

• Following reports that China has been able to access banned chips through the black market, the U.S. is considering implementing new export restrictions on semiconductors. The South China Morning Post reported on Tuesday that firms in China have been able to purchase banned chips from the Chinese social media site Douyin. This has drawn the ire of the Biden administration, which is expected to offer updated restrictions by the summer. Regulators are considering requiring companies to apply for a license to send chips to China. Speculation about the updated export controls to China is likely to hurt revenues for chip companies.
  • 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.

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