by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including a new Russian misinformation campaign alleging that the Ukrainians are preparing to detonate a radioactive bomb.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, with a particular focus on the Chinese Communist Party’s big national congress, which wrapped up over the weekend by electing Xi Jinping to a precedent-breaking third term in power.

Russia-Ukraine:  As Ukrainian forces slowly push the Russians back in the northeastern region of the Donbas and in the southern region around Kherson, Russian forces continue to stage missile, air, and kamikaze drone attacks against Ukraine’s civilian energy infrastructure.  Reports indicate that the Russians are also preparing to destroy a major dam on the Dnipro River upstream from Kherson to flood the region around the city and complicate Ukraine’s effort to recapture it.  Beyond that, the Russians are reportedly planning to retreat from Kherson in the coming days.  Separately, Russian Defense Minister Shoigu held telephone calls yesterday with his counterparts in the U.S., U.K., France, and Turkey to warn them that the Ukrainian military was preparing to detonate a “dirty bomb” (a conventional bomb laced with radioactive material) in order to accuse Russia of using weapons of mass destruction.  The calls were probably aimed at intimidating the U.S. and its NATO allies in order to undermine their support for Ukraine.

• Following the recent sabotage of the Nord Stream natural gas pipelines from Russia to Western Europe, along with other apparent sabotage of European communications and transportation infrastructure, governments around the world are placing more focus on the security of those facilities.
• One country to watch in that regard is France, which earlier this year released a new “Seabed Warfare Strategy.” Putting that strategy to work, France has recently signed a contract with a Norwegian firm for trial tests of a Hugin Superior Autonomous Unmanned Vehicle (AUV) which can operate in depths of down to 6,000 meters.  Deep-sea robotics could well be an important growth area as countries work to rebuild their military forces in response to Russia’s war in Ukraine.

China:  As the Communist Party wrapped up its 20^th National Congress over the weekend, Xi Jinping secured a norm-breaking third term as the party’s general secretary and replaced four of the seven members of the ruling politburo standing committee with his hand-picked allies.  Among those replaced was Premier Li Keqiang, a former rival of Xi’s.  It appears he is being replaced by Shanghai party boss Li Qiang, whose loyalty to Xi evidently was enough to offset his bungled COVID lockdown in Shanghai earlier this year.  It also appears that Xi orchestrated a brutal kneecapping of his predecessor, Hu Jintao, who was hustled off the leadership rostrum on Saturday, ostensibly for “health” reasons.  Separately, the delegates also approved a new party constitution that enshrined “opposing and containing Taiwan’s independence” as a key task.  The new constitution also beefed up the party’s commitment to “common prosperity” and using state-owned enterprises to drive the economy.

• Three People’s Liberation Army generals on the Central Military Commission were retired from the party’s Central Committee after reaching age 68, but an exception was made for General Zhang Youxia, aged 72. Zhang, a close ally of President Xi, reportedly will become first vice-chairman of the Commission under Xi’s chairmanship.
  • Zhang is one of the few remaining Chinese military leaders with combat experience, having served as a company commander in China’s 1979 war with Vietnam.
  • Allowing Zhang to remain on the CMC could indicate that Xi is desperate to have a top military decisionmaker with the experience of combat. Of course, having that kind of experience would be especially useful if Xi is contemplating some kind of military action around Taiwan.
• If you think these Chinese political moves would have no immediate impact on the financial markets, think again. Investors in mainland China and Hong Kong reacted to Xi’s tightening grip on the country and his failure to announce eased Zero-COVID restrictions by selling off stocks.  Hong Kong’s Hang Seng Index ended down 6.4%, marking its biggest decline since the Great Financial Crisis and ending at its lowest level since 2009.
• Adding to the downward pressure on Chinese stocks, the government finally released its delayed data on economic growth. Third-quarter gross domestic product was up 3.9% from the same period one year earlier, modestly beating expectations but still far below the government’s target of about 5.5% for 2022.

European Union-China:  As Xi was preparing to win a third term in power, EU leaders reportedly held a secret discussion on China at their summit last Friday. Reports indicate that the three-hour discussion resulted in a broad agreement that Europe has become too dependent on the powerful autocracy in manufacturing supply chains and raw materials.

• Nevertheless, some leaders, apparently including German Chancellor Scholz, continued to argue that Europe needs to keep engaging with China to tackle common problems.
• Driving home the point, next week Scholz will travel to China with a business delegation, raising fears that Germany is making the same mistake it did by getting too close to Putin’s Russia.

France:  New regulatory filings indicate that many of France’s nuclear generating plants that were idled because of corroded piping are taking longer than expected to repair.  As a result, 26 of the 56 nuclear plants in France are now offline for maintenance or repairs.  In addition, strikes at 18 reactors owned by EDF SA (EDF.PA, €11.94), France’s state-controlled power giant, have delayed their restart by several weeks.  The outages threaten to make it even more difficult for Europe to make up for the energy supply disruptions caused by Russia’s invasion of Ukraine.

Italy:  Conservative Brothers of Italy Party leader Giorgia Meloni finished putting together her governing coalition and was sworn in as prime minister over the weekend.  While Meloni’s support for the U.S., NATO, and Ukraine is clear, all eyes will likely now be focused on how her government will work with the EU bureaucrats in Brussels.  A key challenge will be to balance Italy’s economic dependence on EU support with the Eurosceptic tendencies of Meloni’s right-wing coalition partners.

United Kingdom:  In the race to succeed Liz Truss as Conservative Party leader and prime minister, Former Chancellor Rishi Sunak has won a poll of support among the party’s members of parliament today after former Prime Minister Johnson pulled out of the race and challenger Penny Mordaunt struggled to win supporters.  That means Sunak will now become the U.K’s next prime minister.

• Sunak, a wealthy Brit of Indian heritage, is widely seen as committed to sound economic management and orthodox economic policy.
• As Sunak’s prospects for the prime minister’s job have improved, the pound, so far this morning, has risen approximately 0.3% to $1.1336. Benchmark 10-year Gilts traded up, pushing the yield down to 3.81%.

U.S. Military:  In its annual report on U.S. military power, the conservative Heritage Foundation assessed that the U.S. has only a “weak” ability to fight and win in a hypothetical crisis involving two simultaneous major regional wars.  The report assesses that the Marine Corps has retained “strong” capabilities for such a scenario, but it scores the Army as “marginal,” the Navy as “weak,” and the Air Force as “very weak.”

• The weak scores stem in large part from what the Foundation sees as under-investment in modern equipment. For example, it argues that the U.S. Navy needs a combat fleet of at least 400 manned ships, compared with the 298 currently available.
• The report supports our view that China’s geopolitical aggressiveness and Russia’s invasion of Ukraine will likely spur the U.S. and its allies to reinvest enormous sums into their military forces in the coming years, eventually giving a big boost to defense industry firms.
• Notably, the call for a stronger defensive effort from the Foundation is a reminder that the right wing of the political spectrum is still pro-defense, even if many right-wing politicians are isolationist and want to ratchet back U.S. support for Ukraine and other allies. As the isolationists realize that such support often means higher orders for U.S. defense firms, they may become more supportive of Ukraine and Europe as time goes on.

U.S. Education System:  New data from the Education Department shows fourth- and eighth-grade students’ math scores dropped by the largest amount ever this year.  The data also showed a nationwide plunge in reading scores that wiped out three decades of gains.  The declines are ascribed largely to the lingering effects of the COVID-19 pandemic.

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