by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today, the one-year anniversary of the Hamas attacks on Israel, opens with rumors that Iran may have tested a nuclear weapon as it tries to deter more Israeli attacks on its interests. We next review several other international and US developments with the potential to affect the financial markets today, including a statement by Japan’s new finance minister that suggests financial conditions in that country will remain accommodative and new analysis showing the US federal budget deficit is likely to expand no matter which presidential candidate wins the November election.

Iran: On Saturday night, seismic monitoring stations near the Middle East detected a moderate earthquake in Iran’s Kavir Desert, raising concerns that Iran may have conducted a nuclear test to retaliate for Israel’s recent attacks on Iranian proxy forces in the region. Those concerns were heightened by reports that the seismic signature of the event was more consistent with a nuclear explosion than a natural earthquake. A test explosion would confirm Iran as a nuclear state.

• Although outside observers have long thought Iran could quickly produce a nuclear bomb, few thought the country had an operational one already. If Iran does have an operational bomb that could be delivered to Israel, it would greatly raise the stakes of the ongoing conflicts in the region. An Iranian nuclear test would probably aim to deter Israel from any further attacks.
• Even if the reports are erroneous and Iran hasn’t conducted a nuclear test, there is still a heightened risk that Israel will soon attack Iranian oil facilities directly. Israel then might even strike at Iran’s nuclear research and development facilities in an effort to keep Iran from making a bomb. Whichever way Iran would respond to such an attack, it would heighten the risk of a wider, more dangerous war in the region.
• In response to these concerns, global oil prices have jumped again so far this morning. Near WTI futures are currently trading up 2.6% to $76.29 per barrel, while Brent futures are up 2.2% to $79.79.

China: Provincial and local governments have reportedly begun demanding that teachers and other rank-and-file school workers hand in their passports, preventing them from traveling abroad. It isn’t clear to what extent the action has been directed by Beijing, but it appears that the reason for the crackdown is to prevent teachers from being influenced by non-Communist ideas in the West, which they might then pass on to their students.

• We have long noted that the world is fracturing into relatively separate geopolitical and economic blocs, and that key governments around the world are putting up barriers to inter-bloc trade, investment, technology, and information flows.
• To date, there have been relatively fewer new barriers to migration and human travel between the blocs. If China really is pushing to keep its people from visiting countries outside its bloc, it would suggest that global fracturing is now broadening to encompass people flows.

Japan: Newly appointed Finance Minister Katsunobu Katō today insisted he will focus on stamping out the last vestiges of price deflation in Japan. The statement suggests Japanese financial conditions will remain more accommodative than investors originally expected under the new prime minister, Shigeru Ishiba. The prime minister’s mixed messages on monetary and fiscal policies have made the yen extremely volatile over the last week, although it has been relatively stable today.

European Union: US private equity investors have reportedly provided more than 65% of the venture capital flows into European defense technology start-ups so far this year. That’s consistent with our view that US investors are increasingly attuned to the good prospects for smaller firms with dual-use or defense-related technology. Many of those firms will likely have their initial public offerings of equity in the coming years.

• On a related note, Ukrainian President Zelensky said late last week that his country can now produce up to 4 million surveillance and attack drones per year, up from virtually none when Russia invaded in February 2022. In Zelensky’s words, Ukraine has quickly developed a “virtually new defense industry.”
• In another example of how drones are becoming a bigger part of military force, the French navy has signed a deal to buy underwater drones to conduct surveillance on subsea communications cables, pipelines, and other critical infrastructure that could be attacked by an adversary.
• While we still think that global fracturing and rising geopolitical tensions will lead to higher defense budgets around the world, a key question is how those budgets will be structured. It appears that powerful, game-changing drones can be produced cheaply and in great numbers, so some defense budget funds currently spent on big, expensive assets like aircraft carriers will likely be diverted to drones and other new technologies over time. We think that will create opportunities for smaller defense and technology firms.

Germany: August factory orders fell by a seasonally adjusted 5.8%, nearly three times as much as expected and more than enough to reverse the 3.9% rise in July. Importantly, the data shows that demand for German capital equipment is turning especially weak. That underlines the weak economic momentum in Europe and other key economies around the world outside the US.

US Fiscal Policy: New analysis by the nonpartisan Committee for a Responsible Federal Budget estimates that former President Trump’s fiscal policies would expand the budget deficit by about $7.5 trillion over current projections through 2035, while Vice President Harris’s policies would increase the deficit by about $3.5 trillion. The difference stems in part from Trump’s desire to extend the 2017 income tax cuts versus Harris’s aim to increase corporate tax rates.

• The CRFB findings are similar to those of a recent study by the Wharton School.
• The studies assume each candidate can get his or her agenda passed. In reality, Congressional politics after the election will have a big impact on what parts of their agendas actually get passed into law. Neither candidate’s full agenda is likely to be passed.
• All the same, the important finding may simply be that the federal deficit is likely to widen no matter which candidate is elected. That means the federal debt is also likely to keep rising, leading to increased risk of a fiscal crisis at some point in the future.

US Energy Industry: The Wall Street Journal said over the weekend that several top oil and gas firms have been meeting with former President Trump’s campaign team to secure a commitment not to gut key elements of President Biden’s Inflation Reduction Act if Trump is elected again. The energy firms are reportedly worried that Trump would side with conservative lawmakers who want to end the law’s lucrative tax credits for their investments in renewable fuel, carbon capture, and hydrogen.

• Conservative Republicans in Congress have argued that President Biden’s policies have hamstrung the domestic energy industry, even though domestic oil output is now at or near a record high. To the extent that energy firms have become more restrained in their investment spending, it appears that it is largely because investors are demanding capital discipline and more attention on cash flow.
• Obviously, it’s still unclear who will control the White House and Congress after the November elections. Nevertheless, the oil and gas firms’ early lobbying to protect their future-fuel investments suggests the environment for the green energy industry may not change as much as popularly assumed if Trump wins.

US Robotics Industry: New reports say US manufacturers have greatly slowed their purchases of industrial robots over the last year. The slowdown apparently stems from the manufacturers’ moderating production growth, improved labor supply, higher interest rates, and a realization that robots can require a lot of maintenance and programming skill. However, the report says robot purchases by aerospace and defense firms are still rising briskly.

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