by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a deal between the European Union and the United Kingdom to resolve their disagreement on how to handle Northern Ireland under Brexit.  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 a disappointing rebound in consumer price inflation in Europe and data showing a slowdown in India’s economic growth.  We end with an in-depth discussion of the new U.S. industrial policy to support advanced semiconductor manufacturing.

European Union-United Kingdom:  At Windsor Castle yesterday, European Commission President von der Leyen and British Prime Minister Sunak unveiled their deal to adjust the Brexit withdrawal agreement’s Northern Ireland Protocol, which regulates U.K. shipments to Northern Ireland that might enter the EU’s single market.  Under the revised plan, goods from Great Britain destined only for Northern Ireland will travel on a new “green lane” with fewer checks, while goods at risk of continuing on to the Republic of Ireland (i.e., entering the EU’s single market) will move through a separate “red lane” with more stringent checks.  The deal will also ease customs paperwork for individuals, normalize some taxes, and allow the Northern Ireland legislature to control some changes to the rules.

• If implemented, the “Windsor Framework” would likely ease EU-U.K. tensions. However, despite Sunak’s success in striking the deal, there is still a strong chance that the far-right wing of his Conservative Party will oppose it on sovereignty and nationalism grounds.  It could also still be rejected by unionists in Northern Ireland.
• Either event could destabilize the Sunak government, potentially prompting some of his ministers to resign and encouraging unionists in Northern Ireland to continue blocking the formation of a coalition government for the province.

Eurozone:  France’s February consumer price index was up 7.2% from the same month one year earlier, worse than expectations that it would be up just 7.0%, as it was in January.  Just as disappointing, Spain’s February CPI was up 6.1% on the year, accelerating from its inflation rate of 5.9% in the previous month.  The figures have sparked concerns that the Eurozone’s inflation will be more persistent than hoped for and that the European Central Bank will have to hike interest rates even more than planned.  The chart below shows the year-over-year change in the French and Spanish CPIs since just before the Great Financial Crisis.

• Swap markets now suggest that investors expect the ECB to hike its benchmark interest rate to a record 3.85% by November, compared with 2.50% currently.
• As a result, government bond yields in the Eurozone have risen so far this morning. The yield on Germany’s two-year notes has risen to 3.10%, their highest level since 2008, while the yield on its 10-year notes has reached 2.65%, which is their highest since 2011.  The yield on Italy’s 10-year notes has risen to 4.53%.

Russia-Ukraine War:  Ukrainian officials say their forces are finding it increasingly difficult to hold the northeastern Ukrainian city of Bakhmut, despite inflicting enormous casualties on the Russian regular and mercenary forces attacking it.  We suspect that the statements could be aimed at preparing their country and allies for an eventual decision to abandon the city.  The current Russian offensive has been only marginally successful, and Russia will probably continue to struggle to generate significant combat power.  However, the Ukrainians may want to limit their potential losses in Bakhmut so they can redeploy their troops for a planned spring offensive of their own.

Russia-China:  Western sanctions meant to punish Russia for its invasion of Ukraine are pushing Moscow into a closer relationship with Beijing, and new reporting indicates that Russia is using the yuan more frequently for trade and investment.  Russian energy exporters are increasingly being paid in the Chinese currency, some companies have borrowed in yuan, and the Russian sovereign wealth fund is now allocating more of its funds to yuan assets.  The development is consistent with our view that China will probably try to push its evolving geopolitical and economic bloc to use some version of the yuan as its reserve currency, which will likely attempt to undermine the dollar at some point in the future.

Hong Kong:  Chief Executive John Lee announced that the city will finally drop its COVID-19 mask mandate beginning on Wednesday.  Hong Kong has been slow to relax its pandemic measures, but it is now making a concerted effort to ease them in order to bring back businesses and tourists to revive the economy.

India:  After stripping out price changes, gross domestic product in the fourth quarter of 2022 was up just 4.4% from the same period one year earlier, marking a pronounced slowdown from the increase of 6.3% in the year ending in the third quarter and 13.2% in the year ending in the second quarter.  The big slowdown at the end of 2022 stemmed primarily from weaker consumption as consumers struggled with high inflation.

U.S. Economic Growth:  A new survey by the National Association of Business Economists shows that 58% of the 48 top economists believe the U.S. will enter into a recession by the end of 2023, the same proportion as in the previous survey in December.  However, only about one-quarter think the recession will start by the end of March, about half as many as did in December.  The survey results are consistent with our current view that the economy will slip into recession this year, most likely around mid-year or later.

U.S. Fiscal Policy:  With state governments still flush with cash ahead of an expected economic slowdown, more than a dozen are planning or implementing a range of tax cuts.  In the latest example, today New Jersey Governor Phil Murphy will propose another $2 billion in property-tax rebate checks as part of his proposed $53 billion state budget.

U.S. Industrial Policy:  Yesterday, the Commerce Department released the rules it will use in awarding the $39 billion in subsidies for advanced semiconductor manufacturing under last year’s Chips and Science Act.  Among the notable provisions, semiconductor manufacturers receiving the funds will be prohibited from expanding their operations in China for the following ten years.  They would also be restricted from any joint research or licensing deals with Chinese entities if they involve sensitive technology.  Other strings attached to the funding will restrict the recipient companies from using the money for stock buybacks or dividends.  To the extent that the funding produces profits over a certain threshold, they will also be required to refund some of the money to the government.

• The Chips and Science Act aims to create a U.S. industry capable of mass-producing leading-edge semiconductors, most of which are currently made in Taiwan. The Act’s $39 billion in subsidies reportedly could be leveraged to generate another $75 billion in federal funding, for total support of more than $100 billion.  The Act also includes another $13 billion for research and development, as well as workforce support.
  • In an interview, Commerce Secretary Raimondo stressed that one key goal of the Act was to ensure the U.S. military has secure access to the cutting-edge computer chips it needs for its warplanes, drones, missiles, and other weaponry.
  • Raimondo also revealed that, since the Act is a national security initiative, the Commerce Department will count on input from Defense Secretary Austin and the defense and intelligence communities as it begins implementing the program this week.
• Coupled with the administration’s stringent new prohibitions on sending advanced semiconductor technologies to China, the U.S. is clearly trying to maintain the biggest possible technological lead over China.

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