Daily Comment (February 22, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Markets are buoyant after a stellar earnings report from Nvidia, while Messi returns to action as the reigning Ballon d’Or winner. In today’s Comment, we discuss our reservations about the Magnificent Seven, give our reaction to the latest Fed minutes, and explain why Japan continues to capture the attention of investors. As usual, our report concludes with a summary of domestic and international data releases.

Magnificent Seven: Despite past solid performances, Big Tech valuations may face pressure as investors worry about their ability to sustain growth and meet audacious earnings targets.

  • Chipmaker Nvidia reported stronger-than-expected earnings, indicating that AI hype still has momentum. The company announced that it made $22.1 billion revenue in the three month period ending in January. This surpassed estimates by $1.7 billion and sparked optimism for a $24-billion current quarter, driven by resurgent chip demand. The news comes after a stellar year with Nvidia’s stock surging 240% in 2023 and 40% year-to-date and is likely to buoy the broader tech sector as investors seek to avoid missing out on further gains made in the AI space.
  • While the Magnificent Seven experienced strong overall growth to start the year, it wasn’t evenly distributed, potentially fueling investor concerns. Meta and Facebook surged the most, exceeding 30% growth in the first two months, while Apple and Tesla’s stock prices dipped during the same period. This disparity highlights investor skepticism towards stocks lacking robust earnings to justify their valuations. Currently, these Magnificent Seven stocks trade at a hefty 40.1 times earnings, nearly double the S&P 500 average. The high valuation suggests that these firms may not be able to sustain their current pace for the rest of the year.

  • Investors may be drawn to companies with strong market positions and future growth potential, but these companies are possibly running out of steam. In the AI chip market, Nvidia holds a significant share with its H100 GPUs, and has even caused supply chain challenges for major players like Tesla, as reported by the company. However, concerns are rising about the ability of Big Tech, including Nvidia, to consistently deliver blockbuster earnings growth in the future especially given their rich valuations. This may explain why META has decided to pay out its first dividend. Nevertheless, we recommend keeping a close eye on the technology sector as broader economic factors and company-specific news could impact their valuations in the coming months.

Fed Speaks, Market Reacts: Markets have digested the Fed’s reluctance for aggressive rate cuts in 2024, but uncertainty lingers due to policymakers’ conflicting views on future monetary policy.

  • Federal Reserve officials expressed hesitancy to cut interest rates soon unless they see more progress, according to the January 30-31 meeting minutes. While officials acknowledge inflation’s move toward the 2% target, concerns about persistent economic momentum and the risk of overly restrictive policy have divided the board. Additionally, there was a broad consensus that there are enough reserves to meet bank needs. On Wednesday, Richmond Fed President Thomas Barkin and Governor Michelle Bowman reiterated their concerns, urging patience as recent economic data showed that a lot of upside inflation risk remains.
  • The Fed’s latest remarks significantly diminished the market’s expectation of a rate cut at the upcoming March meeting. At the start of the year, investors anticipated that policymakers could slash rates up to seven times, expecting the central bank to pivot to protect the economy from slowing down. However, sentiment began to change following the Federal Reserve’s January 30-31 meeting, during which Powell suggested that a rate cut in the upcoming meeting was unlikely. The latest swap rates suggest that investors believe that the Fed may cut three or four times this year, which is in line with the Fed’s median projection.

  • Maintaining current interest rates for an extended period could complicate the Fed’s pursuit of a soft landing, as recent meeting minutes reveal. While policymakers expressed confidence in the overall economy, concerns emerged regarding the sustainability of recent growth, primarily driven by volatile factors like net exports and inventory investment. The minutes explicitly labeled these factors as “offering little signal for future growth,” highlighting their limitations as economic indicators. Further, rising bank loan-loss provisions suggest potential credit deterioration later in the year. Although we do not expect a recession this year, we believe that the risk is elevated.

Japan is Back!  The Nikkei 225 index hit a new high for the first time in over 34 years as investors begin to embrace the new normal.

  • The recent resurgence of the Japanese stock market, once a global powerhouse in the 1980s, is fueled by a confluence of factors, including improvements in corporate governance, a shift from deflationary to moderate inflation, and a complex geopolitical landscape. The bounce began after the Tokyo Stock Exchange started its campaign to raise corporate valuations and was supported by the Bank of Japan, which has been reluctant to raise rates as a way of encouraging firms to test its pricing power. Furthermore, the lackluster performance of China’s stock market has led investors seeking regional alternatives to turn to Japan.
  • Echoing 2023’s performance, Japan’s stock market has again outpaced many of its global counterparts in the first few months of 2024. However, uncertainty remains regarding the sustainability of this trend. The Nikkei 225 index currently boasts a 16% year-to-date gain, significantly exceeding the S&P 500’s 5.0% rise and even surpassing the broader MSCI World Index’s 3.6% increase. While foreign investors divesting from China may have fueled some of the initial gains, their return is uncertain and contingent on China’s rebound. Additionally, tepid results from upcoming union wage negotiations could challenge the narrative of Japan’s shift away from deflation, especially as the country flirts with recession.

  • The stock market’s strong performance despite Japan’s economic downturn creates a puzzling disconnect, fueling concerns about market sustainability. Weakening consumer spending, a key factor in the slump, could complicate ongoing union negotiations. Companies might resist wage increases, challenging the optimistic narrative that Japan has finally escaped its multi-decade deflationary period. This could prompt investors to re-evaluate their bullish stance. However, a relatively cheap currency presents an opportunity for Japanese exporters. If leveraged effectively, it could boost earnings and support the export-driven growth strategy, potentially mitigating concerns about sustainability in the long run.

Other News: President Trump’s unveiling of his VP shortlist — comprising Tim Scott, Ron DeSantis, and Vivek Ramaswamy — underscores his mounting confidence as the frontrunner for the Republican nomination, signaling a potential rematch with President Biden. In a display of bipartisan unity, lawmakers engaged in discussions with Taiwan’s President-elect to reaffirm Washington’s steadfast support for the sovereign island. Meanwhile, the US government has committed billions of dollars to replace cargo cranes, previously manufactured by China, at ports — a significant indication of its strategic divergence from its Indo-Pacific rival.

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Daily Comment (February 21, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an interesting development pointing to the long-term potential of hydrogen as a global fuel source.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a new Chinese threat to the developed countries’ auto industries and a surge in US retirements that has driven much of the recent expansion in the country’s budget deficit.

Global Energy Market:  At the American Association for the Advancement of Science’s annual meeting last weekend, the US Geological Survey presented unpublished data indicating as much as 5 trillion tons of hydrogen exist in underground reservoirs worldwide, potentially setting the stage for it to be a key carbon-free energy source in the future.  According to the data, most of the deposits are likely inaccessible.  However, if even just a few percent are recoverable, it would be enough to supply the projected demand of 500 million tons per year for centuries.

  • Currently, economists and analysts are focused on nuclear, solar, and wind energy to replace fossil fuels and reduce carbon emissions in the future. There has been some focus on hydrogen, but it has been modest to date.
  • The new data could potentially help shift interest toward developing hydrogen as an energy source. If technologically and economically feasible, widespread adoption of hydrogen energy would likely create new investment opportunities in the future.

Global Auto Market:  Chinese electric vehicle giant BYD has announced a new version of its plug-in hybrid model, the Qin Plus DM-i, priced at the equivalent of just $11,086.  The firm says its strategy with the new vehicle is to accelerate the global transition from internal-combustion vehicles to EVs.  With the vehicle priced below many of today’s top-selling gasoline cars, such as Toyota’s Corolla, the new BYD offering highlights the threat that low-priced Chinese cars could decimate auto industries throughout developed countries.

China-United States:  At the annual Munich Security Conference over the weekend, FBI Director Wray warned that the Chinese are not only still hacking the computer systems of critical infrastructure such as electricity grids to pre-position malware for use in time of conflict, but they have increased it to a “fever pitch.”  According to Wray, Chinese spies and hackers are increasingly inserting “offensive weapons within our critical infrastructure poised to attack whenever Beijing decides the time is right.”

  • Wray’s comments are only the latest in a long series of FBI warnings about massive Chinese spying and hacking in the US. According to Wray, those warnings were long dismissed by corporate leaders, but they are increasingly being taken to heart as more evidence of the activity is unearthed.
  • Government officials even fear that the Chinese-made cargo cranes at US ports are compromised by sensors and software that could allow Beijing to monitor or disrupt US trade. Therefore, the Biden administration will launch a maritime cybersecurity program today that will provide $20 billion from the Jobs and Infrastructure Act of 2021 to improve port security, including replacing all Chinese-made port cranes with new, US-made cranes.
  • The pre-positioning of Chinese malware across US computer systems is a reminder that World War II, the last Great Power conflict, is probably not a valid template for how a potential US-China conflict would unfold. In World War II, almost all of the conflict consisted of visible, kinetic attacks: bombs being dropped, artillery being fired, etc.  Much of a future US-China conflict might be invisible and non-kinetic, including electromagnetic attacks on satellites in space, malware in cyberspace, and the like.

China-Taiwan:  Tensions between China and Taiwan have worsened in recent days after an incident in which two Chinese fishermen drowned while being chased out of Taiwanese waters by the island’s coast guard.  In response, Beijing says it will step up law enforcement around the Kinmen archipelago, a group of Taiwanese islands that sit as close as three miles from the Chinese mainland and 100 miles from Taiwan’s main island.  The stepped-up Chinese patrols have even included the boarding of a Taiwanese sightseeing boat this week.

  • A potential Chinese effort to take control of Taiwan has long been a key geopolitical risk, as it would probably draw in the US, Japan, and other countries friendly to the island.
  • In recent months, Chinese-Philippine tensions have increased sharply, to the point where we have thought they were the greater near-term risk. This week’s tensions between China and Taiwan are a reminder that the Taiwan Strait remains a high source of risk for investors going forward.

India:  Government officials and farmer groups in recent days have failed to reach an agreement on the farmers’ demands for fixed prices on dozens of crops and debt relief, keeping alive the farmers’ threats to stage mass protests in New Delhi.  Even though the popular Prime Minister Modi remains in the driver’s seat ahead of this spring’s parliamentary elections, the impasse and the tough choice between a budget-busting subsidy deal and mass protests is a political risk.  In turn, that risk could potentially be a headwind for Indian stocks in the coming weeks.

France:  After the government cut its forecast of 2024 economic growth to just 1.0% from 1.4% previously, Finance Minister Le Maire said national budget spending will be reduced by a further 10 billion EUR on top of the earlier cut of 16 billion EUR to keep the deficit at the targeted 4.4% of gross domestic product.  According to Le Maire, the new cuts will come from reduced hiring and other operational expenses at government ministries, less foreign aid, and reductions in various subsidies.  The spending cuts will likely be a further headwind for French GDP growth this year.

US Fiscal Policy:  New analysis shows the US has about 2.7 million more retirees than predicted by a St. Louis FRB model, versus just 1.5 million excess retirees six months ago. There has also been a fiscal deficit frequently, beginning in 2008 until the onset of the COVID-19 pandemic in 2020.  While the pandemic prompted millions of older workers to finally retire, this second wave of retirements was likely prompted by surging stock values.  In any case, the sudden wave of new retirees is one reason why the US fiscal deficit has suddenly widened dramatically.

  • The new wave of retirements has led to a sudden rise in Social Security retirement benefits and Medicare spending.
  • Comparing the year ended in January 2024 to the previous year, the excess of Social Security and Medicare outlays over Social Security and Medicare gross tax receipts expanded by $672.6 billion, accounting for fully 70% of the expansion in the federal budget deficit in the period (after adjusting for the accruals related to the administration’s proposed student loan forgiveness program and its subsequent reversal).
  • Although politicians often claim the expanding federal budget deficit stems from profligate spending by the government, the deficit expansion primarily stems from the aging US population and individual baby boomers finally deciding to retire and start drawing Social Security and Medicare benefits.

US Stock Market:  S&P Dow Jones Indexes announced that on-line retailing giant Amazon.com will replace Walgreens Boots Alliance in the Dow Jones Industrial Average starting on Monday.  While the reshuffling was prompted by Walmart’s upcoming three-for-one stock split, which will reduce its weighting in the index, the move will help make the index more reflective of the broader, technology-dominated US equity market.

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Daily Comment (February 20, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a range of news items related to continued economic and security tensions between China and the West.  We next review a range of other international and US developments with the potential to affect the financial markets today, including an important Russian military victory in Ukraine and an important new effort to regulate one aspect of artificial intelligence in the US.

United States-China:  Senior US Treasury officials have told the Financial Times that they warned Chinese Vice Premier He Lifeng that Washington and its allies will retaliate if Beijing tries to deal with its excess industrial capacity and high debt load by dumping products on the global market.  The US officials said they are most concerned about possible Chinese dumping of high-technology products such as electric vehicles, lithium-ion batteries, and semiconductors.

  • Like many countries that sought to develop their economies via high investment and strong exports, China held on to the strategy too long, leaving it saddled with high debt and a production base that far exceeds domestic demand.
  • For countries that find themselves in that predicament, many strategies are available to bring supply back into balance with demand. For example, the US allowed a sharp depression and a dramatic write-down in asset values during the 1930s.  Japan opted for a long, slow correction marked by weak asset pricing and plodding economic growth from the 1990s until very recently.
  • Other countries have turned to warfare or colonialism. What Western leaders fear is massive Chinese dumping as a kind of quasi-colonialism, which would further decimate Western industries and throw legions of workers into unemployment.  Increasing hints of Chinese dumping are therefore likely to further exacerbate Chinese-Western geopolitical and economic tensions, keeping alive a range of risks for investors.

European Union-China:  Following on the US warning to China, the EU has opened an anti-dumping probe into Chinese state-owned locomotive and railcar maker CRRC, in what Competition Commissioner Margrethe Vestager says is a signal to domestic and foreign firms that the EU won’t hesitate to use its legal tools to fight off unfair foreign competition.

  • The investigation follows on a similar probe into Chinese electric vehicles launched in September.
  • The new probe shows that the EU is slowly coming around to the tough US policies against Chinese subsidies and other unfair trade practices. The move raises the risk that China will retaliate against EU firms active in China or that try to export to China.

China:  On Sunday, The People’s Bank of China left its benchmark interest rates unchanged for a sixth straight month, disappointing investors who have been hoping for stronger economic stimulus measures from the government.  The rate on the key medium-term lending facility was left at 2.5%, apparently to support the sagging renminbi (CNY).

  • Despite the freeze on official central bank rates, major banks today implemented a surprisingly aggressive cut in their five-year prime lending rate from 4.20% to 3.95%. That was the biggest cut in the prime rate since it was introduced five years ago.
  • The five-year prime rate is China’s standard for residential mortgages, so it is likely that the government guided the banks to cut the rate as a way to provide some support for the beleaguered real estate developers.
  • Since many investors had been looking for stronger measures to support the economy, Hong Kong stock prices fell to start the week, but mainland stocks gained as investors caught up from the week-long Lunar New Year holiday.

Australia:  Responding to China’s aggressive military buildup, the Australian government today unveiled a plan to more than double the size of the country’s navy.  The government now plans to spend an additional $7.2 billion on its navy, expanding the fleet to 26 warships, including 11 new frigates and six new large vessels with long-range missile capability.  The Australian navy will then be at its largest size since World War II.

  • The plan is consistent with our belief that rising geopolitical tensions will boost defense budgets around the world in the coming years.
  • Since rising tensions will also keep fracturing the world into relatively separate geopolitical and economic blocs, we think the result will be increased investment opportunities in areas such as defense, broad industrials, basic materials, energy, and even technology firms with strong or potential defense business.

Singapore:  In a potential sign that right-wing populist ideologies may be spreading to Asia, the Internal Security Department has recently detained two youths who espoused extremist views and were reportedly planning attacks on racial minorities, lesbian and gay activists, and “woke” progressives.  One of the youths, an ethnic Chinese, bizarrely espoused white supremacy.  If the ideology continues to spread in Asia, perhaps driven by social media, it could risk destabilizing countries throughout the region, just as it has in Europe.

Russia-Ukraine War:  Kyiv’s forces on Saturday withdrew from the eastern Ukrainian city of Avdiivka, ceding it to the Russians after an intense, weeks-long siege.  Reports indicate that the Ukrainians defending the city were not only overmatched by Russia’s vast firepower and available personnel, but were also increasingly hampered by their shortage of ammunition and other supplies.  Separately, a Russian military pilot who defected to Ukraine last year has been found murdered in Spain, illustrating the brutal vengeance of the Russian intelligence services.

  • Avdiivka is Ukraine’s most significant loss of territory since its unsuccessful counteroffensive last summer and the following loss of Western military aid.
  • Now that the Kremlin has successfully shifted the Russian economy to a war footing, it is enjoying an increasing advantage in available equipment, ammunition, and personnel. The key question is to what extent the Russians can capitalize on their capture of Avdiivka to build momentum and start taking more Ukrainian territory.
  • If the Russians successfully build on their momentum and begin to roll across Ukraine, Western politicians could potentially be galvanized to re-start their assistance to Kyiv. However, it could be too little, too late.  If so, the incentive for peace talks would rise.
  • In US political terms, the closer Russian forces end up from the North Atlantic Treaty Organization’s southern frontier, the more those politicians who opposed aid to Ukraine may be open to criticism for allowing an increased Russian threat to NATO. That could lead to foreign policy being a bigger part of the US electoral campaign, making it more volatile going into the autumn.

NATO-Sweden:  Hungarian Prime Minister Viktor Orbán’s ruling Fidesz Party said it has scheduled a parliamentary vote next Monday on Sweden’s accession to NATO, and it plans to vote in favor.  If so, Sweden will finally have the unanimous approval of all NATO members, allowing it to join the alliance.  With the inclusion of Sweden and its capable military, NATO’s northern flank will be strengthened, and the Baltic Sea will become virtually a NATO lake, potentially helping to deter future Russian aggression in the north.

United Kingdom:  Addressing a parliamentary committee today, Bank of England Governor Andrew Bailey said the central bank may begin to cut its benchmark interest rate even before consumer price inflation falls all the way to its target of 2%, citing encouraging signs that price pressures are falling rapidly.  Despite the prospect for lower bond yields in the UK, investors appear to be encouraged by the prospect for reduced impediments on economic growth.  The British pound has therefore risen 0.4% to a multi-week high of $1.2641 as of this writing.

Israel-Hamas Conflict:  The Israeli government yesterday said gross domestic product in the fourth quarter fell at an annualized rate of 19.4% from the same period one year earlier, far worse than expected and almost matching the rate of decline in the midst of the COVID-19 pandemic in 2020.  Israel’s defense expenditure has surged since its war with the Hamas government in the Gaza Strip began on October 7, but that spending has been offset by a huge drop in personal consumption spending and private fixed investment.

US Artificial Intelligence Regulation:  Late last week, the Federal Trade Commission proposed modifying a rule that already prevents the impersonation of government and business entities to also outlaw the impersonation of individuals.  The proposal follows a move earlier this month by the Federal Communications Commission to ban the use of AI-generated voices in robocalls.

  • These proposals show how government agencies are trying to address the risk of AI-driven scams and frauds via rulemaking, rather than waiting for a deeply polarized Congress to act.
  • The rapid development of AI raises the risk that political operators or fraudsters could use deepfake video and voice for scams. For example, officials fear that people could be manipulated or defrauded using AI-generated deepfakes of their family members, friends, work colleagues, or celebrities.

US Semiconductor Industry:  The Commerce Department said it will provide $1.5 billion in grants to contract semiconductor maker GlobalFoundries to expand the company’s production facilities in New York and Vermont.  The award is the first under the CHIPS and Science Act of 2022, which set aside $52 billion in incentives for firms to expand their US chipmaking factories and shore up secure domestic supplies of semiconductors.  The Commerce Department is expected to announce billions of dollars of additional awards in the coming weeks.

US Banking Industry:  Based on recent regulatory filings, overdue commercial real estate loans at the six largest banks have now grown to 160% of the amounts the banks have set aside to cover losses on those loans, versus 90% one year earlier.  As commercial property owners continue to struggle with high interest rates and increased vacancies, more loans are likely to go sour in the coming months.  In turn, that will likely force banks to boost their loss reserves further, impinging on bank profits and weighing on bank stock prices.

US Energy Market:  US natural gas prices in recent days have fallen close to their lowest levels since 1995, reflecting weak heating demand amid the country’s warmest winter on record, surging US production, and possibly from the administration’s recent pause on liquified natural gas exports.  Near futures prices for gas this morning are down 1.5% at approximately $1.59.  The decline in gas prices will likely help reduce consumer price inflation in the near term, potentially helping to convince the Federal Reserve that it can start cutting interest rates.

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Asset Allocation Bi-Weekly – Who Wants US Treasurys? (February 20, 2024)

by the Asset Allocation Committee | PDF

Before August 2023, the Treasury’s quarterly refunding rarely raised eyebrows. Investors readily snapped up US debt, and announcements were largely ignored by markets. However, Fitch Ratings’ surprise downgrade of the US credit rating from AAA to AA that month, just days after a $6 billion increase in the planned quarterly debt issuance, sparked investor concerns. Now, the question looms: Will there be enough demand to absorb the growing supply of US debt?

The downgrade by Fitch triggered a sharp rise in Treasury yields, especially long-term yields, which hit their highest levels since 2007. The 10-year and 30-year benchmarks spiked to multi-decade highs, reflecting lukewarm participation at Treasury auctions. Higher borrowing costs and weak auction participation sent the S&P 500 Index tumbling. In response to the market’s negative reaction, the Federal Reserve signaled an end to its hiking cycle and a potential cut in policy rates for the coming year, and the Treasury Department tilted its borrowing toward shorter-term maturities.

While the coordinated efforts of the Fed and Treasury successfully reduced borrowing costs and improved overall risk appetites, investors remained uncertain about the government’s plans to finance its burgeoning debt. This year, $8.9 billion of US Treasury bonds will mature, while the budget deficit is expected to be $1.4 trillion, meaning there will be $10 trillion of bonds coming to the market. Additionally, the Congressional Budget Office projects that the deficit could expand to $2.6 trillion by 2025. This leaves a gaping hole in financing, and without a significant change in market conditions, it is unclear who will step up to buy these bonds.

The US Treasury market boasts a unique blend of buyers, each with distinct goals. Central banks, the guardians of global monetary systems, buy Treasurys to secure their reserves and stabilize currencies. Similarly, pension funds prioritize stable, long-term income to fulfill their liability obligations. For the Fed, Treasurys become instruments of monetary policy, influencing interest rates and economic activity. Asset managers diversify their portfolios with these secure assets, reducing risk and volatility. Even households directly participate in holding a portion of the national debt, seeking a safe place for their investments.

The Fed’s shift toward tighter monetary policy in 2022 and 2023 reshaped the allocation of Treasurys. By not rolling over its maturing Treasury holdings, the Fed is now absorbing less of any new supply. Simultaneously, interest rate hikes have incentivized some corporations and foreign central banks to moderate their holdings, creating a demand gap. Households, pension funds, and insurance companies have stepped in to fill this gap, becoming the primary buyers of Treasurys. However, the central bank’s recent suggestion that it will phase in monetary easing later this year introduces uncertainty about who will buy debt going forward.

The high concentration of interest-sensitive investors like households, pension funds, and insurance companies in the bond market raises concerns about the potential impact of future interest rate cuts. Lower short-term rates typically decrease the appeal of risk-free assets like long-term bonds, potentially dampening demand. Households seeking higher returns in an accommodative monetary policy environment may consider diversifying into riskier assets. However, while pensions and insurance companies hold a significant portion of Treasurys, their demand for longer-term bonds is limited by their need to match their obligations.

Historically, broker-dealers have played a key role in stabilizing markets by absorbing available assets, but they face constraints that limit their ability to act as the buyer of last resort when the Fed doesn’t step in and provide liquidity. Broker-dealers, unlike central banks, hold limited inventory as they are primarily focused on facilitating client transactions rather than large-scale asset purchases. This limited capacity restricts their ability to absorb significant volumes of assets during periods of stress. To compensate for the inherent liquidity risk involved in holding large inventories, broker-dealers would require higher premiums, therefore pushing up yields on Treasurys.

With limited demand from traditional buyers putting pressure on long-term Treasury yields, concerns have risen that the Fed may need to intervene to prevent higher borrowing costs for businesses and consumers. Yet, policymakers remain reluctant to increase the balance sheet due to inflation concerns. Chair Powell reiterated during the January FOMC press conference that the committee will discuss slowing QT at their March meeting, suggesting that the committee is not ready to stop reducing its balance sheet.

 While potential rate cuts and future reductions could increase demand for Treasurys, limited impact on yields is expected due to persistent inflation concerns and lukewarm investor sentiment. Given the continued supply-demand imbalance, we believe short-to-intermediate-term securities offer a more attractive risk-reward profile compared to long-duration bonds due to their lower interest rate sensitivity and potentially higher returns.

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Daily Comment (February 16, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with more news of distorting, state-led policies in China and how they are affecting investors.  We next review a range of other international and US developments with the potential to affect the financial markets today, including new moves by Australia to subsidize its nickel miners, indications the European Union is set to subsidize its defense companies, and new research showing US companies still aren’t hiring many more applicants without college degrees, despite today’s labor shortages.

China:  After years of excess investment and debt financing for housing construction, the Chinese Communist Party is reportedly developing a plan for the government to take over swaths of China’s residential real estate and convert it to subsidized low-income housing.  Such a plan would be in sync with General Secretary Xi’s desire for the Communist Party and the government to have more control over the economy, but it’s not clear how those entities would get control over the assets currently owned by private developers.

  • Separately, investors continue to step back from Chinese assets as they increasingly realize the economic and financial market headwinds arising from Xi’s statist policies and other structural challenges.
  • All the same, some investors are looking for ways to keep some indirect exposure to China so they can take advantage of any rebound in its economy. New research suggests that one way investors are trying to do that is by buying shares in European luxury goods companies, which get more than one-quarter of their profits from China on average.

India:  Despite government efforts to stop them, thousands of farmers continue to march on the capital of New Delhi to demand minimum crop prices and debt service moratoria.  The continued protests are increasing the political risk for Prime Minister Modi, who currently leads the opinion polls ahead of the national elections scheduled in the coming weeks.

Australia:  The government has formally designated nickel as a “critical” commodity, making the nickel industry eligible for support from a $3.9-billion stimulus fund and for other steps to protect it from the current glut of low-cost Indonesian nickel.  Australian nickel miners have also been struggling with the price-deflating impact of softening demand for electric vehicles since nickel is a key component of many EV batteries.

United Kingdom:  The Conservative Party of Prime Minister Sunak yesterday lost two parliamentary by-elections.  Adding to the pain for the Conservatives, both seats had been considered safe.  The results highlight the continuing unpopularity of the Conservatives, who continue to trail the resurgent Labour Party ahead of elections expected this autumn.

European Union:  In an interview with the Financial Times yesterday, European Commission President von der Leyen threw her support behind the idea of having Brussels subsidize European defense companies to help them boost their productive capacity in the face of rising threats from Russia and beyond.  As we’ve been arguing, increasing geopolitical tensions look set to spark a long-lasting rise in Western defense budgets, creating greater opportunities in Western defense-industry firms, as well as tech or other firms with a lot of defense business.

Russia:  Officials today said anticorruption campaigner and opposition leader Alexei Navalny died in the Siberian prison where the government of President Putin had been holding him.  The authorities claim the cause of death hasn’t yet been determined.  However, given the convenient timing of Navalny’s death, right before Putin faces the next presidential election in mid-March, it would not be surprising if Putin finally decided he couldn’t accept the risk of having a gadfly like Navalny around.  Navalny’s death will likely exacerbate Russian tensions with the West.

United States-Russia:  The White House confirmed yesterday that it has “troubling” intelligence showing that Russia is developing an advanced anti-satellite weapon, as flagged a day earlier in a message to Congress from the chair of the House Intelligence Committee.  As we reported in our Comment yesterday, the weapon appears to be nuclear in nature, so it could signal that Russia is preparing to break out of an international treaty banning the deployment of nuclear weapons in space.  In any case, the new weapon will further raise US-Russian tensions.

US Labor Market:  Despite today’s labor shortages and companies’ insistence that they are trying to loosen hiring requirements for college degrees, new research shows that even when those requirements are lifted, companies don’t hire many more non-degreed workers.  The research suggests several factors are limiting the progress, from automated screening tools that favor college graduates to the difficulty of changing hiring managers’ beliefs about the value of a degree.

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Daily Comment (February 15, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a mysterious warning from Congress about a new, destabilizing military capability in Russia.  We next review a range of other international and US developments with the potential to affect the financial markets today, including multiple economic reports related to key economies in Asia and Europe and notes on US fiscal policy and the economic impact of immigration.

United States-Russia:  Republican Representative Mike Turner, chair of the House Intelligence Committee, issued a cryptic call for all lawmakers to visit a secure facility in the Capitol so they could review new classified intelligence regarding what he called “a destabilizing foreign military capability.”  Administration officials speaking on condition of anonymity said the intelligence relates to a new Russian nuclear capability that could be used against US satellites in space.  The officials said the weapon is still in development and has not yet been deployed.

  • Reports say Turner’s committee has had the referenced intelligence for about a week, and National Security Advisor Jake Sullivan was already scheduled to brief Congressional leaders on the intelligence on Thursday. It is therefore not clear why Turner issued his unusual call yesterday.
  • It’s possible that Turner is simply trying to whip up anti-Russian sentiment as Congress battles over military aid to Ukraine to help it fight off Russia’s invasion.
  • Nevertheless, Russia is far ahead of the US in modernizing its nuclear force, and it has made progress in developing exotic new technologies, such as hypersonic missiles. As we discussed in our recent Bi-Weekly Geopolitical Report, space has also become a high-priority warfighting domain for today’s top militaries.  It would not be surprising if Russia really has leapfrogged the US in some new, destabilizing capability.
  • In any case, such a development would be more evidence that the world is becoming more chaotic and risky, as we have long expected. However, while the evolving world will create headwinds for many investments, it will also likely create some investment opportunities.  Here at Confluence, we continue to focus heavily on managing investments with a keen eye on both the risks and the opportunities.

Israel-Hamas Conflict:  After Iran-backed Hezbollah militants apparently fired missiles from southern Lebanon into Israel yesterday, killing one Israeli soldier and wounding several others, Israel unleashed artillery and air strikes against southern Lebanon, killing and wounding both Hezbollah members and civilians.  The attacks are a reminder that Israel’s retaliatory war against the Hamas government in Gaza could still spread into a regional conflict, which would threaten energy and commercial supply chains critical to the global economy.

Japan:  New data shows gross domestic product unexpectedly fell for a second straight quarter at the end of 2023, putting the Japanese economy in a technical recession.  After stripping out price changes and seasonal effects, fourth-quarter GDP fell at an annualized rate of 0.4%, after dropping at a rate of 3.3% in the third quarter.  Nevertheless, good growth earlier in 2023 meant that Japanese GDP in the full year was up 1.9%, accelerating from its growth of 1.0% in 2022 and helping confirm positive trends that have recently boosted Japan’s stock market.

South Korea:  The Financial Services Commission has launched a public-private partnership to provide the equivalent of $57 billion in low-cost loans to boost investment in targeted sectors, such as advanced semiconductors, batteries, and smaller companies.  Including two state-owned lenders and five major commercial banks, the program is part of a global trend in which governments are embracing subsidies, trade barriers, and other forms of industrial policy to promote favored sectors.

  • These modern industrial policies largely aim to improve economic resilience, shield the country from external supply shocks, and promote better-paid jobs at home.
  • The downside is that this could further fracture and balkanize global supply chains over time, making the global economy less efficient and leaving inflation and interest rates higher than they otherwise would be.

European Union:  The European Commission today cut its economic growth forecasts for the overall EU and the eurozone.  The Commission now expects gross domestic product in the EU to grow a modest 0.9% in 2024, while it expects eurozone growth to come in at just 0.8%.  Previously, the Commission had forecast growth of 1.3% and 1.2%, respectively.  Despite recent data suggesting Europe’s industrial recession could be bottoming out, the region continues to struggle with high energy prices, elevated interest rates, and weak domestic and foreign demand.

United Kingdom:  Similar to the Japanese experience, British gross domestic product fell for a second straight quarter at the end of 2023, putting the country in a technical recession.  After stripping out price changes and seasonal effects, fourth-quarter GDP fell at an annualized rate of 1.4%, worse than expected and far more than the 0.5% rate of decline in the third quarter.  The British economy continues to struggle against a range of headwinds, including high prices, elevated interest rates, and weak demand.

United States-China:  Volkswagen is reportedly holding thousands of imported Porsche, Bentley, and Audi autos on US docks after the company was informed by one of its downstream suppliers that the cars were equipped with a small electronic component from western China that might have been made with banned forced labor.  Volkswagen is replacing the components at dockside, which is likely to delay US delivery of many of the autos for months.

US Fiscal Policy:  In an interview yesterday, Lael Brainard, director of the White House National Economic Council, argued that the ability of the US economy to keep growing despite the Federal Reserve’s high interest rates and slowing inflation can be largely ascribed to the administration’s stimulative fiscal policies, including its big infrastructure rebuilding law and subsidies for investments in advanced technologies.

  • Those programs probably have started to pump cash into the economy, but we don’t think that’s necessarily the main fiscal stimulus that’s boosting economic growth.
  • Our recent work suggests much of the stimulus comes from expanding Social Security and Medicare outlays now that so many baby boomers retired during the COVID-19 pandemic, along with a drop in personal income tax revenues because of big, inflation-generated adjustments to tax brackets last year.

US Labor Market:  Congressional researchers have estimated that the huge influx of migrants coming across the southern border in recent years will expand the labor force beyond what they previously predicted, thereby boosting future economic growth and government revenues.  However, the researchers also believe the new immigrants are less educated than previous waves, meaning they could be less productive and therefore hold down wages for less-skilled job categories.

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Back to the Future: The Advantages of Dividend Income Over Interest Income (February 2024)

Insights from the Value Equities Investment Committee | PDF

Over the past 15 years, dividend income has often exceeded what could be earned in a money market account. But as seen in the chart below, with the fed funds rate now at 5.5%, the relationship between dividend income and interest income has gone back to what was common before 2008 — where the S&P 500 dividend yield (the blue line) is 2-3% below what could be earned in a money market account invested in U.S. Treasury bills (the red line).

This begs the question:

Why should an income-oriented client still invest in a dividend income-focused stock portfolio yielding 3% when they can now earn 5% in a low-risk money market account?


Higher inflation is causing interest rates to rise on short-term fixed income and money market instruments, and now investors have more choices in generating income returns. While current yields are appealing, we believe it would be short-sighted for long-term investors to abandon the compounding benefits of a growing income stream that can protect purchasing power while also providing for growth of principal.

In this Value Equity Insights report, we highlight some of the potential advantages of growing dividend income through a portfolio of quality, growing businesses — factors which might be underappreciated in the current environment.

Read the full report

Daily Comment (February 14, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with new forecasts showing continued growth in the demand for liquified natural gas and how populist politics in the West could nix the resulting export opportunities.  We next review a range of other international and US developments with the potential to affect the financial markets today, including surprisingly good industrial production figures out of Europe and a few words on yesterday’s market rout in the US.

Global Energy Market:  In a report yesterday, oil-and-gas giant Shell said global demand for liquified natural gas will keep rising through at least 2040, when it will be more than 50% higher than it is today.  According to the report, the continued rise in LNG demand will come largely from China, as that country’s industrial sector transitions from coal to gas, and from fast-growing countries in southern and southeastern Asia.

  • Despite the projected demand growth, however, populist policies in the developed countries could limit the West’s export potential. One example of that is the Biden administration’s recent decision to pause approvals for new LNG export terminals.  Besides appeasing the members of his political base who are against fossil fuels, Biden’s decision probably also aimed at bottling up gas supplies and keeping down energy prices in the US.  A populist Republican administration could be tempted to do the same.
  • In such a world, the natural gas and other key commodity markets could become fractured, with radically different prices between regions. The result would probably be a less efficient global economy and slower economic growth.

Eurozone:  December industrial production rose by a seasonally adjusted 2.6%, beating expectations for a small decline and accelerating from the revised 0.4% gain in November.  Output was up 1.2% from December 2022, marking its first year-over-year rise since last February.  Along with surprisingly good purchasing managers’ index numbers recently, the production figures suggest the eurozone economy may be starting to bottom out, even if it is still struggling with issues such as high energy costs, elevated interest rates, and poor demand.

United Kingdom:  Just a day after data showed continued strong wage growth that could discourage the Bank of England from cutting interest rates soon, a separate report showed the January consumer price index was up 4.0% year-over-year, matching its increase in the year to December instead of accelerating to the expected annual rise of 4.2%.  The report will likely rekindle hopes of a near-term cut in interest rates despite yesterday’s data on wage increases.

India:  With national elections coming up in just a few weeks, Prime Minister Modi’s government is scrambling to defuse mass protests by farmers demanding guaranteed crop prices and loan waivers.  Negotiations yesterday between officials and protest organizers were unsuccessful, and thousands of farmers from across the country are marching on New Delhi, where the government is setting up roadblocks.  To preserve his frontrunner status, Modi could well offer concessions that would expand the budget deficit and weigh on Indian asset prices.

Indonesia:  In an election today, preliminary results show a big lead for controversial Defense Minister Prabowo Subianto, who commanded special operations forces when the country was a dictatorship decades ago and was accused of kidnapping democracy activists.  Subianto has vowed that, if elected, he will continue the current government’s nonaligned foreign policy, as well as its economic policy focused on boosting nickel production to leverage the global shift toward electric vehicles.

Russia-Ukraine War:  Kyiv today said it sank another large Russian navy ship in the Black Sea, this time using Ukrainian-made Magura V5 sea attack drones.  Besides demonstrating Ukraine’s increasingly capable and sophisticated domestic defense industry capabilities, the sinking also illustrates how Kyiv’s most successful military efforts these days are in the maritime domain.  Nevertheless, Ukraine’s military is increasingly on the defensive as it loses Western aid, and the Russians ramp up their military resources.

United States-China:  In another piece of evidence that the Pentagon is preparing for a potential conflict with China in the Indo-Pacific region, the US Army has established its first overseas watercraft unit in decades.  Based at Yokohama, Japan, the 5th Transportation Company will have 13 vessels (including landing craft, support vessels, and tugboats) and 285 Army mariners.  While the Army remains focused on land warfare, the move shows how it is preparing to also fight in an Indo-Pacific maritime environment if needed.

US Stock Market:  Following yesterday’s report that the January Consumer Price Index was up a stronger-than-expected 3.1% from one year earlier, and the core CPI was up 3.9%, a range of US assets sold off strongly yesterday.  The S&P 500 stock price index dropped 1.4%, while the NASDAQ index fell 1.8% and the small-cap Russell 2000 price index plunged 4.0%.  Bond prices also fell sharply, driving the yield on the benchmark 10-year Treasury note up to 4.32%.  Most key commodity prices weakened, and the dollar surged.

  • The selloffs reflected concern that sticky inflation will prompt the Federal Reserve to delay cutting interest rates. Indeed, market indicators showed that investors now expect policymakers to implement their first rate cut in June rather than May.
  • The inflation data and the shifting expectations for rate cuts are consistent with our oft-stated view that investors have probably gotten ahead of themselves in expecting rate cuts in the near term. With egg on their faces for letting inflation get too high in 2021 and 2022, the Fed policymakers now want to be absolutely certain that price pressures have eased before they cut interest rates.  As that continues to sink in with investors, the market could face further bouts of volatility.

US Politics:  In a special election yesterday, voters in New York elected Democrat Tom Suozzi to replace ousted Republican Representative George Santos.  Once Suozzi takes his oath, the Republicans in the House will be left with an even slimmer majority of 219 to 213 (three vacancies will remain).  Suozzi’s healthy victory margin of 54% to 46% has also left Democrats optimistic that they can win despite being on the back foot on immigration issues as migrants continue to flow into the US across the border from Mexico.

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