by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment summarizes yesterday’s GDP report, including how it may impact U.S. monetary policy. Next, we review why central banks are hesitant to totally remove their policy accommodations as the world heads into recession. We end the report with a discussion about how countries are adapting to a more uncertain world.

 It Isn’t All Good: Don’t be fooled by Thursday’s Gross Domestic Product (GDP) report; a recession may still be on the horizon.

• The U.S. economy expanded at an annualized rate of 2.6% in Q3 2022. The growth exceeded the Bloomberg consensus estimate of 2.4% and ended a two-quarter streak of economic contractions. Most of the positive news came from net exports, which benefited from a decline in imports and an increase in exports. That said, there were concerns about the GDP data. Personal consumption slowed in the quarter, while residential investment contracted in the same period. The poor performance in the two areas suggests that higher interest rates are slowing the economy.

• Equities rallied initially after the GDP report was released; however, the S&P 500 and NASDAQ indexes dipped after another day of disappointing earnings. The brief optimism was related to a sigh of relief from the market that the economy was not in recession. That said, company earnings indicate that the country isn’t far from one. Earlier this month, the Conference Board U.S. Recession Probability Model showed a 96% chance of an economic downturn within the next 12 months. Although the latest GDP figure does not eliminate the possibility of an imminent recession, it does mean that the economy is more resilient than previously thought.
• The positive employment and GDP reports will likely encourage the Federal Reserve to be aggressive in its next two meetings. Although employment numbers have not been officially released, estimates show that U.S. firms added 200k workers to their payrolls in October. Assuming the employment numbers are in the ballpark, the Fed could raise rates higher than most investors are anticipating leading into the end of the year. Hence, we have yet to rule out the possibility of another 150 bps hikes over the last two meetings of 2022. As long as inflation remains elevated, the Fed will try to push rates as high as possible before the economy enters into a recession.
  • Other possible threats to the economy include labor strikes. Rail workers’ unions have rejected the latest proposal suggesting that workers can go on strike in mid-November. This work stoppage could exacerbate supply chain issues and inflation.

 Central Banks Won’t Commit: Policymakers are reluctant to ditch their monetary-easing tools as they seek to fight inflation and promote growth.

• The European Central Bank is sending mixed signals to the market about its commitment to fighting inflation. The ECB hiked rates by 75 bps, scaled back support for banks, and maintained quantitative easing. The last of the three measures likely fueled Thursday’s sell-off of the euro as investors worried that the bank will not be able to restore price stability to the Eurozone. Additionally, it is widely speculated that the ECB may scale back the rate hikes. The bank’s lack of aggressiveness could mean inflation will likely stay elevated for longer.
• There is no backing down in Japan as the Bank of Japan maintained its ultra-accommodative monetary policy and plans to increase the frequency of bond purchases next month. The central bank’s refusal to cave to pressure to tighten monetary policy has led to a sell-off in the yen. Additionally, Prime Minister Fumio Kishida proposed a $199 billion stimulus package. The country’s yield-curve control policy will likely shield the government from rising borrowing costs; however, a depreciating yen should add to inflation, especially as the country continues to import commodities.
• Central banks’ wariness to abandon bond-buying programs is related to concerns about debt markets. A lack of intervention from the ECB could lead to fragmentation, while Japan’s heavy government debt burden requires its central banks to manage bond yields. These banks’ unwillingness to fully commit to tightening has led investors to seek haven in the U.S. dollar. Thus, we can see the greenback’s strengthening continuing into next year as investors seek refuge in the dollar due to the Federal Reserve’s hawkishness, the slowing global economy, and the war in Europe.

Global Chess: Countries have shifted their priorities as they prepare for a world that is more hostile and less friendly to globalization.

• Brazilians will take to the polls on Wednesday for run-off elections. Although former President Luiz Inácio Lula da Silva leads his right-wing rival Jair Bolsonaro in polls, there is still the possibility for an upset. Both candidates have pledged to be fiscally responsible if elected as the country deals with stubbornly high inflation. However, the two have different approaches to achieving growth and maintaining price stability. Bolsonaro has pledged to privatize state-owned firms and cut taxes; meanwhile, Lula wants to make the country self-sufficient in oil and force the wealthy to pay more taxes.
  • This election can serve as a bellwether for sentiment within the broader regions of South America. If Lula wins, as suspected, it could mean that the continent may be returning to the pre-Washington Consensus era when countries prioritized equality over efficiency. However, a Bolsonaro upset would signal that conservative policies may be staying put longer. The latter is the most favorable for equities within the region.
• Putin is possibly looking for an off-ramp to the war in Ukraine if he can save face while doing so. On Thursday, Russian President Putin advocated for talks with the West about a possible ceasefire. The gesture comes as Ukraine makes continued headway in the southern and eastern parts of the country. Although investors might view the remarks as positive, it is not. Putin refuses to acknowledge Ukraine as an independent nation, instead implying that the country is a Russian state. As a result of his inability to recognize Ukraine’s sovereignty, negotiation between the two sides is not truly possible.
  • In a veiled threat, a Russian official cautioned that U.S. satellites could be legitimate targets. The warning could pave the way for direct conflict between the U.S. and Russia.
• Lastly, the U.S.’s decision to withdraw fighter jets from Japan confused its Pacific allies. The Air Force’s plans to replace the fleet with a rotational force have led to accusations that the U.S. is sending the wrong message to China. The move may be a way to convince Japan to invest more in its own military. Whatever the case, the gesture suggests that the U.S. may not be fully committed to footing Japan’s defense expenditure bill. As a result, this could lead Japan to ramp up its military spending to defend itself from a more assertive China.

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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 our thoughts about a possible shift in Fed policy. Next, we discuss the rising angst in the European financial markets. Finally, the report reviews how the West is adapting to a changing geopolitical landscape.

 Are We There Yet? Stocks rose on Thursday due to speculation that a slowing economy could sway the Fed to moderate its policy stance.

• Weak economic data and a smaller-than-expected increase in the Bank of Canada’s policy rate buoyed expectations that the Fed could ease the pace of rate hikes. The trade deficit expanded for the first time in six months due to a decline in exports, while the number of home sales fell sharply in September. Higher rates make American goods more expensive for foreigners and home prices unaffordable for borrowers. Meanwhile, the Bank of Canada surprised the market by hiking rates 50 bps which was below the expectations of a 75 bps increase. The move by the BOC could pave the way for other central banks to curb future rate increases as well. American investors hope that the reports could possibly sway the Fed in future policy changes.
• Although the BOC news led to a brief rally in equities, weak third-quarter earnings brought investors back to reality. Facebook (F, $128.92 ) and Google’s parent company Alphabet (Googl, $94.93), reported a steep decline in sales. The disappointing report pushed NASDAQ down 2% and the S&P 500 down 0.7% on Wednesday. The drop in tech shares reflected investors’ skepticism that the market had already hit bottom. That said, optimism about policy moderation was visible in currency markets. The sterling, yen, and euro all strengthened against the dollar on Wednesday. If sustained, the depreciating greenback will provide a tailwind for the global economy as it should make dollar-priced commodities less expensive for users of other currencies.
• The Fed has consistently dampened expectations every time the market has priced in a policy change. When the markets responded positively to the Federal Open Market Committee (FOMC) minutes released last week, several Fed officials reiterated the bank’s commitment to raising rates until inflation falls. We are currently in a blackout period, and therefore, we will not hear from any Fed officials until after the FOMC meeting on November 1-2. As a result, we believe investors should wait to adjust their holdings until after the meeting concludes to avoid being caught flat-footed. At this time, we are still determining if the Fed will change tack while the economy is still showing signs of growth.

No Backing Down: Dysfunction within the European financial system is a growing problem as bonds continue to be a sore spot for their economies.

• The European Central Bank raised its three key policy interest rates by 75 bps on Thursday, in line with market expectations. In addition to increasing rates, the ECB altered the terms and conditions of its targeted longer-term financing operations (TLTRO), which will disincentivize bank lending to the real economy. As a result, the euro dipped to dollar parity as investors priced in the possibility of a worsening Eurozone recession. Although the bank reiterated its desire to continue hiking rates, it was noncommittal on its plans to implement quantitative tightening. Thus, the bank is still hesitant to remove policy stimulus altogether.
• The sharp rise in interest rates has threatened to clog up the Eurozone repo and money markets as traders struggle to find collateral to meet liquidity requirements. Concerns about a collateral shortage within the Euro banking system have led the International Capital Market Association to urge ECB officials to make changes to prevent a potential crisis. The association proposed that the bank provide the financial system with extra collateral and implement a Eurozone Treasury bill issuance program. It is unlikely that the ECB will make these changes soon; however, the letter could push officials to delay quantitative tightening.
• Investors are only partially sold on the new U.K. Prime Minister Rishi Sunak. British gilt yields rose after his Chancellor of the Exchequer, Jeremy Hunt, delayed the release of the government budget proposal to November 17. The sell-off in U.K. bonds reflects a growing angst as investors fret over how Hunt plans to resolve the country’s public financing shortfall of £35 billion caused by rising inflation and soaring interest rates. Although Hunt claimed that the delay was designed to fine-tune the plan, he is likely still working out the details. PM Sunak aims to regain market confidence after his predecessor’s stimulus package called into question the country’s willingness to fight inflation.
  • The new proposal will likely include multiple austerity measures, including tax hikes and budget cuts. Thus, there is a concern that Hunt’s plan could hurt the U.K. economy.

 A Group Rethink: Western allies are adjusting how they confront rising threats from Russia and China.

• The Biden Administration may dial down the plans to impose price caps on Russian oil. Initially, the White House wanted to establish a price range of $40-$60 a barrel; however, new reports suggest that the price could be closer to $63-64 a barrel. The price cap is designed to prevent Russia from raising revenue while still giving it the incentive to maintain production. So far, the U.S., EU, and some western allied countries such as South Korea and Australia are poised to join the price cap. However, China and India remain noticeable holdouts. If successful, the cap should allow Russian oil to sell on the open market and relieve price pressures.
• On a related note, warmer-than-expected weather conditions are likely to undermine Russian leverage over Europe. The higher temperatures have reduced demand for energy imports so much that there are concerns about countries having too much natural gas. The excess energy resources should weigh on commodity prices as countries rely more on their stockpiles as winter approaches. Prices of natural gas have already dropped 70% from their August high. The drop in commodity prices could cushion a potential slowdown in the global economy.
• Meanwhile, Western allies are mulling over how to counter an increasingly hostile Russia and China. On Wednesday, Russian President Vladimir Putin oversaw military drills that included a simulation of a nuclear strike. On the same day, U.S. Secretary of State Antony Blinken accused China of undermining the status quo in Taiwan. The rising threats have encouraged allies to mend grievances. German Chancellor Olaf Scholz and French President Emmanuel Macron met in Paris to iron out policy differences. If the West wants to bring China and Russia to heel successfully, they must ensure that the alliance stays on the same page. If the group effectively reins in the two countries, it could lead to a calmer market due to a reduced risk of conflict between major powers.
  • Moscow has warned that it could start targeting U.S. satellites in response to its support for Ukraine. Thus, there is still a risk for escalation between the U.S. and Russia.

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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 the latest on Moscow’s misinformation campaign claiming that the Ukrainians are planning to detonate a radioactive “dirty bomb.”  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the U.K.’s transition to a new prime minister.

Russia-Ukraine:  Ukrainian forces continue to recapture modest amounts of territory in the country’s northeastern Donbas region and in the southern region around Kherson, while the Russians continue launching missile, air, and kamikaze drone strikes against civilian energy infrastructure throughout the country.  The continued Russian attacks prompted the Ukrainian government to request additional air-defense weapons systems in calls with U.S., U.K., and France.  Meanwhile, the Russian government continues its misinformation campaign claiming that Ukraine plans to detonate a “dirty bomb” consisting of conventional explosives laced with radioactive materials.  This time, the accusation was made in a letter to the UN Security Council.  Western officials remain concerned that the misinformation campaign is aimed at justifying a further Russian escalation of the war.

• Separately, the Joint Coordination Center managing the Russia-Ukraine deal allowing Kyiv to ship grain out of its southern ports is investigating reports of a possible sea mine in the authorized Black Sea shipping corridor.
  • Russia has recently expressed its dissatisfaction with the way the deal is being implemented, which raises the prospect that it is trying to sabotage the deal.
  • If Russia does scuttle the deal and Ukrainian grain is once again bottled up, one likely result would be renewed upward pressure on global grain prices.
• As we have reported previously, financier and mercenary leader Yevgeny Prigozhin continues to build a power base that could potentially allow him to challenge President Putin in the future.
  • In addition to criticizing and demeaning the Russian Ministry of Defense, Prigozhin is also building a large following on his various social media platforms.
  • That following is beginning to challenge the Kremlin’s previous near monopolization of information in the country.

EU Energy Crisis:  Reflecting our concern that high energy prices will help prompt a process of deindustrialization in Europe, German chemicals giant BASF (BASFY, $11.43) has warned that it will have to downsize permanently in the region because of unstable natural gas supplies and soaring prices.

• The statement came less than a month after BASF opened a new €10 billion plastics engineering facility in China, but we don’t think Asia will necessarily be the prime beneficiary of Europe’s deindustrialization.
• Rather, we think much of the investment pulled out of Europe in the coming years will be channeled toward the energy-rich U.S., boosting the U.S. economy and prompting positive spillover effects into a range of U.S. companies.

Germany-China:  Chancellor Scholz has approved a Chinese company’s acquisition of a large stake in Germany’s largest seaport, drawing criticism from the country’s lawmakers and officials in Brussels.

• Scholz’s approval for the acquisition came despite opposition over national security concerns from his own foreign affairs, defense, economy, and interior ministries.
• Scholz’s decision is being seen in the same light as Germany’s prior decision to build the Nord Stream natural gas pipelines that made Germany overly dependent on Russian energy. The port decision has increased concern that Scholz and his Social Democratic Party are failing to appreciate the national security implications of increased dependency on autocratic states like China and Russia.

Norway-Russia:  Norwegian authorities have arrested a Brazilian university researcher at the Arctic University of Norway in Tromsø on suspicion that he is, in fact, a Russian spy.  The researcher had been working in a group studying irregular warfare methods such as cyberattacks and disinformation campaigns.

United Kingdom:  Yesterday, newly-named Prime Minister Sunak began building his cabinet, keeping a striking number of officials in their previous positions and working hard to build unity by offering positions to all the major Conservative Party factions.

• Importantly, Chancellor of the Exchequer Hunt will remain in his job, lending some continuity to fiscal policy in the face of concerns over Britain’s debt levels.
• In one of his first acts under Prime Minister Sunak, Hunt announced he will delay the date for his long-awaited medium-term fiscal plan from October 31 to November 17, ostensibly to fine-tune the economic forecasts and projections.
• The plan will now take the form of a full Autumn Statement, accompanied by forecasts from the Office for Budget Responsibility.
• The fiscal plan will aim to close the U.K.’s fiscal hole, estimated at between £30 billion and £40 billion, with a series of tax raises and spending cuts.

U.S. Energy Market:  Spot prices for natural gas in west Texas fell below zero yesterday, as surging production in the Permian Basin region butts up against pipeline constraints and outages at liquefied natural gas terminals used to export the U.S. gas overseas.  However, the situation is expected to rectify itself in the coming days after the end of a scheduled maintenance outage on a key pipeline.

U.S. Financial Regulation:  The SEC has proposed a crackdown on the misleading marketing of investment funds by tightening the rules on fund names.  Under the proposal, funds would have to be able to prove that at least 80% of their holdings match their names. The proposal would apply to everything from “core” and “growth” funds to those that invest in “sin stocks” or claim to rely on environmental, social, and governance investing factors.

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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, where Russia appears to have ratcheted down its recent missile, air, and drone attacks as it runs low on its inventory of weapons.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including further fallout from China’s recent Communist Party conference and the installation of a new prime minister in the U.K.

Russia-Ukraine:  As Ukrainian forces continue to slowly press the Russians back in the northeastern Donbas region and the southern Kherson region, Russian forces continue to attack Ukrainian civilian infrastructure targets with missile, air, and kamikaze drone attacks.  However, Ukrainian officials report that the scale of the Russian strikes on Monday was markedly smaller than in previous days, probably because the Russians have now depleted much of their stockpiles of missiles and drones and because the attacks have proven largely inconsequential.

• Meanwhile, Russian military officials continue to push their misinformation campaign claiming that Ukraine plans to detonate a “dirty bomb” consisting of a conventional explosive laced with radioactive material.
  • The Russian misinformation campaign is being taken mostly as a threat that Russia plans to use such a weapon itself.
  • All the same, U.S. officials said they had detected no signs that Russia is planning to use nuclear arms, and therefore had no reason to raise the alert level of U.S. nuclear forces.
• Meanwhile, financier Yevgeny Prigozhin continues to build a power base that could put him in position to challenge President Putin’s authority. Besides lambasting Russia’s uniformed military, Prigozhin’s Wagner Company mercenaries continue to threaten Ukraine’s hold on the Donbas city of Bakhmut, even as Prigozhin begins to build his own volunteer battalion.

EU Energy Crisis:  European natural gas prices have dropped below €100 per megawatt hour this week for the first time since Russia slashed supplies earlier this summer.  The drop reflects the unexpectedly warm weather and the fact that the EU’s gas storage facilities are now close to full, easing concerns about winter shortages.

• The drop in energy prices is a welcome development that has the potential to pull down inflation and minimize the impending recession in Europe.
• All the same, the EU still faces much worse conditions than it did in recent years, especially if weather patterns turn negative again.
• More broadly, EU energy ministers are meeting in Luxembourg today to continue hashing out a potential price cap on natural gas, and to consider a longer-term change in the EU’s energy-pricing mechanism.

China:  Chinese stocks stabilized today following foreign investors’ scrambling for the exits on Monday after President Xi’s election to a norm-breaking third term in office and his tightened political grip on the country.  However, the renminbi has lost another 0.6% against the greenback to trade at 7.3084 per dollar.  At that rate, the Chinese currency has now lost a whopping 12.8% year-to-date.

Turkey:  In recent years, in a move largely unnoticed by investors around the world, Turkey has become a key supplier of advanced military goods, particularly drones and other autonomous weapons.  In the latest development, a Turkish defense firm has been awarded government subsidies to produce one of the world’s first viable long-range, unmanned helicopters known as the Alpin.  Once the drone chopper is field tested and combat proven, the government plans to export the Alpin worldwide.

South Korea-North Korea:  South Korean President Yoon Suk-yeol warned that North Korea has now completed preparations for its seventh nuclear test.  If North Korea goes ahead with the test, it would be the first such provocation since 2017 and would likely touch off a new geopolitical crisis and further sanction efforts against Pyongyang.

United Kingdom:  Many British pension funds and the companies that manage their “liquidity driven investment” programs are reportedly amending their contracts to allow the funds to post liquid assets other than cash, such as government bonds, when they have to provide collateral to hedge their positions in the market.

• The need to sell Gilts was a key reason for the spike in British interest rates and the fall of former Prime Minister Truss after she released a budget-busting series of tax cuts and spending hikes last month. If enough pension funds amend their credit support documentation, it could make the British financial system less susceptible to a future run on Gilts.
• Separately, Rishi Sunak today formally became Britain’s new prime minister, succeeding Truss. Next week, Sunak’s government intends to release a new fiscal plan aiming to reassure investors that Britain’s debt is under control.  In his speech today, Sunak said he would act with “compassion” but that he would not let future generations pay for debt that “we are too weak to pay ourselves.”

U.S. Semiconductor Industry:  Pat Gelsinger, the CEO of Intel (INTC, $27.18), said at a conference that recently imposed U.S. restrictions on semiconductor-industry exports to China were a necessary shift in supply chains as the U.S. seeks to maintain technological leadership in its competition with China.

U.S. Fiscal Policy:  Data late last week showed that the federal budget deficit for the fiscal year ending September 30 came in at $1.375 trillion, down from the deficit of $2.772 trillion in the previous fiscal year.  The report showed that the improvement in the deficit mostly stemmed from a 21.0% surge in revenues as the recovering economy boosted tax receipts.  In contrast, federal outlays declined 8.0% as many pandemic relief programs got scaled back.

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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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