by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several indicators of increasing tensions between the U.S. and members of the evolving China-led geopolitical bloc, including Russia and Saudi Arabia.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including new analysis showing that a rebound in large-cap technology stocks was the key reason that the U.S. stock market was able to rise last month despite the crisis that engulfed small and mid-sized banks.

United States-China:  Republican and Democratic members of the House Select Committee on the Chinese Communist Party will embark on a three-day visit to Silicon Valley and Hollywood this week to talk about U.S.-China relations with top technology and entertainment executives.  Some U.S. finance, technology, and entertainment firms have resisted the growing effort by policymakers to suppress China’s expanding military power and geopolitical influence.  While the members of Congress will listen to the firms’ perspectives, we suspect they will also use the meetings to educate the executives about the Chinese threat to U.S. security and the need to put security above narrow business interests.

• Separately, China appears to be ramping up its response to recent U.S. restrictions on its semiconductor industry. In what appears to be retaliation, the Chinese government last week opened a cybersecurity investigation into Micron Technology (MU, $60.34), a top U.S. maker of DRAM memory chips.
• The Micron investigation is likely meant to be a warning to other countries with big memory-chip firms, such as South Korea. In all probability, China is trying to caution those countries that if they sign on to the U.S.’s clampdown on advanced technology transfers to China, the Chinese government will hinder their key companies’ activities in China.

China:  The Caixin purchasing managers’ index for manufacturing came in at a seasonally adjusted 50.0 in March, falling short of expectations and marking a big decline from the 51.6 registered in February.  Like all major PMIs, this one is designed so that readings over 50.0 indicate expanding activity.  The current Caixin and official PMIs suggest China’s post-pandemic manufacturing recovery has quickly lost steam, at least in part because of weakening demand overseas.  If they continue, such tepid readings are likely to be a headwind for risk assets going forward.

Russia-Saudi Arabia-United States:  Yesterday, the Organization of the Petroleum Exporting Countries and its Russia-led allies unexpectedly announced that they will cut their total crude oil output by 1 million barrels per day.  Saudi Arabia alone said it will voluntarily cut its production by 500,000 bpd, while other OPEC+ members said they will cut their output by smaller amounts.  Russia said it will extend its 500,000-bpd cut announced last year.

• The move was aimed at reversing a recent decline in oil prices prompted by fears of slowing economic growth around the world. It also appears to be Saudi’s retaliation after the Biden administration last week said it had no near-term plan to replenish the U.S.’s Strategic Petroleum Reserve despite previously giving the Saudis assurances that it would buy oil if prices fell.  In any case, oil prices so far today have surged more than 5%, with Brent now trading at $84.13 and WTI at $79.71.
• Saudi Arabia’s cooperation with Russia also underlines its increasingly close alliance with Russia and the rest of the evolving China-led geopolitical bloc. That is likely a harbinger of increasingly tense U.S.-Saudi relations and further threats to global oil supplies.

Russia:  In a sign that internal political tensions are rising, the Federal Security Service (FSB, successor to the KGB) is reportedly confiscating the passports of senior officials and state company executives to prevent overseas travel, information leaks, and defections.  The move reflects deep suspicions about the loyalty of the country’s civilian elite, many of whom privately oppose the war in Ukraine and are chafing over its impact on their lifestyles.

• Separately, nationalist blogger Maxim Fomin, known publicly as Vladlen Tatarsky, was killed by a bomb yesterday while conducting a meet-and-greet event at a café in St. Petersburg. Fomin had been a vocal advocate of Russia’s invasion of Ukraine, although he had also sharply criticized the Ministry of Defense for its failures and shortcomings in running the invasion.  He likely had enemies in Russia’s official defense bureaucracy, although the lone suspect arrested in the case so far is a woman who had previously attended a demonstration against the war last year.
• On the Ukrainian battlefield, Russian officials said they have finally taken control of central Bakhmut, the eastern Ukrainian city they have focused on for months and suffered huge casualties trying to capture. However, Ukrainian officials say they still control other parts of the city and will continue fighting to degrade Russia’s forces.

Finland:  Petteri Orpo and his center-right National Coalition Party leveraged a focus on economic issues to narrowly win Sunday’s parliamentary election, ousting Prime Minister Marin and her center-left Social Democratic Party.  However, the National Coalition only came away with 48 of the 200 seats in parliament, slightly more than the 46 seats for the right-wing Finns Party and the 43 seats for the Social Democrats.  That will likely make it difficult for Orpo to form a governing coalition in the coming weeks.

Switzerland:  Federal prosecutors announced that they will investigate whether any criminal behavior was involved in last month’s government-led takeover of Credit Suisse (CS, $0.8898) by UBS (UBS, $21.34).  Numerous aspects of the rushed deal have arisen, but the prosecutors haven’t specified any particular offenses that they are targeting.

U.S. Stock Market:  If you’re wondering how the U.S. stock market was able to perform so well last month despite the crisis in small- and mid-sized banks, it appears the answer is that large technology firms did quite well.  Since the beginning of the crisis in early March, new analysis shows that Apple (AAPL, $164.90) and Microsoft (MSFT, $288.30) alone contributed more percentage points of gains to the S&P 500 price index than all financial stocks in the index subtracted.  In turn, that reflects how investors looking for an eventual retreat in interest rates are already positioning themselves back into technology (probably too early, we think).

U.S. Labor Market:  New analysis from the Wall Street Journal shows that the nation’s strongest job markets in 2022 were Nashville, TN; Austin, TX; and Jacksonville, FL.  The rankings were calculated based on five criteria, including each city’s 2022 unemployment rate, labor-force participation rate, changes to employment levels, size of the labor force, and wage rates.  In contrast, cities that did well right after the end of the pandemic, such as Salt Lake City, UT and Phoenix, AZ slipped in the rankings.

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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 an update on the ongoing banking crisis and how it may impact the real estate sector. Next, we review why precious metals, such as gold, have been able to perform well during a time of heightened uncertainty in the market. Lastly, the report discusses the ongoing friction between the U.S.-led and China-led blocs.

 Back to Banks: Deposit withdrawals are becoming less of a problem; however, it is still too soon to say that the banking crisis is over.

• There is growing evidence that banks are in need of less cash. The latest data from the Federal Reserve shows that the U.S. bank liquidity problem is slightly improving. Emergency loans to banks from the Federal Reserve backstops declined from $163.9 billion to $152.6 billion in the week ending March 29. Meanwhile, European Central Bank official Isabel Schnabel noted that deposit outflows were not a problem for European banks. Research published by Jefferies Group (JEF, $30.58) went further and argued that the average European bank could lose 38% of its deposits before having to sell any of its government bonds at a loss.
• Despite improving financial conditions, some central bankers remain wary about the health of the banking system. Minneapolis Fed President Neel Kashkari hinted that the banking crisis might not be over. Given his experience working at the Treasury during the financial crisis, he explained that strains in banking may take a while to work themselves out. He added that the ongoing crisis could extend longer than many people realize. His colleague at the Richmond Fed, Thomas Barkin, also cautioned that it is too soon to tell whether the banking turmoil will lead to tighter credit conditions.
• That said, deposit flight remains a major threat to commercial real estate. According to JPMorgan (JPM, $129.57), European banks have as much as €1.9 trillion ($2.07 trillion) worth of commercial real estate exposure, while U.S. banks have $1.7 trillion. This asset class has been the hardest hit since the pandemic due to the drop in demand for office space and would be severely impacted by a credit crunch. Hawkish central bank policy worsens the problem by incentivizing depositors to move their money out of banks and into money market funds and U.S. Treasuries. As a result, we advise investors to pay close attention to their real estate exposure as this banking situation plays out.
  • The European real estate market is already showing signs of weakness due to the banking turmoil. The MSCI Europe Real Estate Index of large and mid-cap property companies has dipped to its lowest level since 2009.

Gold Great Again? Precious metals have performed well amidst the growing market turmoil.

• Concerns over the financial system and the economy have led investors to retreat temporarily from equities and move into safer assets. Gold has outperformed the S&P 500 this year, 8.5% to 3.4%. Similarly, the Bloomberg Commodity Precious Metals Subindex has rallied 10.9% since March 8, despite being down in the first three months of the year. The preference for precious metals over equities is related to uncertainty over interest rates. As inflation remains elevated and a recession approaches, investors are unsure of what the Fed’s next moves will be and have sought safety in real assets.
• Central banks have expressed a willingness to hike policy rates, but the market doesn’t buy it. On Thursday, Boston Fed President Susan Collins insisted that the banking system remains sound and that the Federal Reserve is still focused on taming inflation. Meanwhile, stickier core inflation in Europe has complicated efforts by the ECB to conclude its tightening cycle. Because of the central bank’s insistence on raising rates, financial market participants anticipate a cut later this year. The CME Fed Funds Watch Tool shows that there is an 80% chance of a cut in the Federal Reserve policy rate by the end of 2023, while the overnight index swap curve for the EUR shows that the ECB will also cut within that period.
• Although there is much to be worried about in markets, there is still a lot of opportunity to earn solid returns. Precious metals are an attractive option as they are relatively more liquid when compared to digital currencies and have a solid reputation for being a hedge against market uncertainty. Additionally, the movement into cash and cash equivalents could also lead to sub-optimal portfolio returns. That is why we would like to caution investors away from fleeing the market, as there is a realistic possibility that they could miss many attractive opportunities. As the saying goes, there is no great reward without at least some risk.

 

Beijing Shuffle: China and Russia are looking for ways to outmaneuver the West as they seek to avoid being isolated from the rest of the world.

• The U.S. and its allies continue to form a united front against China and Russia. On Thursday, the Turkish parliament approved Finland’s petition to join NATO. Turkey’s consent removes a significant hurdle for the military alliance as it looks to deter Moscow from further aggression by adding new members. Meanwhile, European Commission President Ursula von der Leyen has urged EU countries to back restrictions on the transfer of sensitive technologies to China. The remarks come amidst pressure from the U.S. to have EU members support trade restrictions on goods that can potentially boost Beijing’s defense capabilities.
• The ostracization of China and Russia has made it difficult for their economies to recover. Beijing is still working to boost GDP growth following its stringent Zero-COVID policies and a wave of infections that limited consumption. Recent PMI data shows the economy is improving, but consumer confidence indicates that sentiment remains stubbornly low. At the same time, President Vladimir Putin recently admitted that Western sanctions are starting to negatively impact the Russian economy. The isolation of these two countries has made them draw closer to one another as they look to work together to reduce their dependence on Western markets.
• The rivalry between the U.S.-led and China-led blocs shows how trade can quickly devolve into a zero-sum game. As the two sides look to decouple from one another, we expect that, in the long term, the rest of the world will split into two camps that prioritize trade ties with one of the major blocs. Although a few countries, such as Turkey and Brazil, will be able to find some middle ground to work with both blocs, we suspect that others will be forced to choose. As noted in previous reports, China is looking to build alliances with major commodity producers, while the U.S. prefers to build security ties with other advanced economies.
  • At some point, there may be a direct confrontation between the two sides; however, that time remains in the distant future.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning!  It’s Opening Day for major league baseball.  In the financial markets, it’s a “risk on” day: equities and commodities are moving higher, while the dollar is weaker but interest rates have reversed higher.

In today’s Comment, we open with China news where Taiwan’s president has arrived in the U.S., and both China and the U.S. are hardening their blocs.  Markets are up next, with a look at banking.  International news follows, and we close with an update on the war in Ukraine.

China News:  Taiwan’s president is arriving in the U.S. today.  Steadily, China and the U.S. are pressing other nations to choose with whom they will align despite resistance from nations wanting to avoid such a choice.

• Taiwan President Tsai Ing-wen will visit the U.S. and Central America this and next week. Semi-official visits of Taiwanese leaders tend to aggravate Beijing and this trip is no exception.  The focus of the tension is an expected meeting between House Speaker McCarthy and Tsai.  Much like former Speaker Pelosi’s visit to Taiwan, China is threatening to respond negatively to the meeting.  The administration is taking great pains to portray the tour as “private,” meaning it isn’t officially a state visit.  We also note that McCarthy is meeting Tsai in California, not Washington, next week.
  • We will be closely watching to see how Beijing reacts to the trip. In the wake of Pelosi’s visit, China seemed to be practicing a blockade.  Our expectation is that China is less likely to invade Taiwan, but more likely to blockade it instead.  Amphibious invasions are very hard, and China has no real experience with such operations.  Given that the official position is that Taiwan is a province of China, exercising such a control, like a blockade, would fall into an unclear legal situation.  If China does something similar this time, it would likely increase the odds that if/when China moves to take control of Taiwan, a blockade may be the preferred tactic.
  • We also note that National Security Advisor Sullivan had a call with Wang Yi, China’s top diplomat. The White House has been trying to place guardrails around the U.S./China relationship for some time, but events continue to keep tensions elevated.  We note that there was no readout from the call, but we would not be surprised to hear that the Tsai visit was part of the discussion.
• One of our geopolitical themes has been the idea that the world is evolving into a China-led bloc and a U.S.-led bloc. As this process continues, both group leaders are trying to woo nations into “their” alignment.  This process is taking on multiple forms.
  • We note VP Harris has recently made a trip to Africa. This continent is likely to become increasingly important in the coming decades.  Not only is it a source of key minerals for the energy transition, but it also has young people, something that the developed nations are increasingly beginning to lack.  The U.S. is promising increased investment in Africa.
  • It isn’t just countries that are being pressed to choose. Companies are too.  After three decades of globalization when production was moved to China, the U.S. and China are slowly unwinding their economic interdependence.
  • As part of its Belt and Road Initiative, China has lent large sums to frontier economies. As often occurs, some of these loans have failed, forcing China into the unfamiliar role of providing emergency support.  Although this is a short-term problem for Beijing, if it is handled well, it could increase China’s influence.
• In a recent Bi-Weekly Geopolitical Report, we discussed China’s moves to undermine the dollar system. We note that Brazil and China have agreed to use their own currencies in bilateral trade.  China has also settled an LNG trade in CNY.  In a related development, Saudi Arabia is taking preliminary steps to join the Shanghai Cooperation Organization, a China-led Eurasian bloc.
• The southern U.S. border is perhaps the prime gateway for immigrants. Although most of those attempting to cross the border are from the Americas, there has been a surge of Chinese nationals reportedly showing up on the Mexican/U.S. frontier seeking asylum.
• As it turns out, the crypto exchange Binance (BNB, $319.21) has deep ties to China, something it tried to hide from U.S. financial regulators.
• China is seeing a new surge in African swine fever, and if not contained, this event could lead to reduced pork supplies.

Markets, Economics and Policy:  We update the latest on the banking issue.  There is also a growing realization that margins matter to inflation.

• Fractional reserve banking is fraught with risk. Banks take deposits and, through leverage, expand the money supply through lending.  Depositors don’t think of their money in the bank as a loan; there is almost a belief that the bank has taken your money and is holding it in an envelope with your name on it.  Of course, that isn’t the case.  It instead lends that money into the economy, and, as long as depositors don’t demand their funds all at the same time, the system provides ample, low-cost credit to the economy.  However, if a large number of depositors decide to get their money back, chaos can develop.  Essentially, societies that use fractional reserve banking make a tradeoff—cheap credit but with the potential for occasional crises.
  • Over time, governments have tried to address this problem. Deposit insurance has been one response.  By ensuring that the money will be there, the impetus to “go get it” and thus triggering a bank run is dampened.  But by guaranteeing deposits, bankers can take excessive risks, leading to the moral hazard problem.  In the U.S., the response has been to limit deposit coverage, although in practice, all deposits are usually covered.
  • Another way governments have addressed this issue is to allow banks to avoid pricing their assets at market. This means that there is a bit of uncertainty as to the value of bank assets at any given time.  Since bank loans are often unique, it may be difficult to actually price these assets.[1] Although when banks have securities on their books, these can be priced.  To avoid asset price volatility, banks are allowed to claim that a security will be held to maturity.  Since bonds usually expire at par, there is no price risk as long as the bond doesn’t need to be sold in order to meet depositor demands.
  • It has become increasingly apparent that large banks become so important to the economy that governments can’t allow bank runs or failure. To deal with this situation, large banks are heavily regulated.  In most nations, large banks are the only choice, but in the U.S., due to our fear of economic concentration[2] (especially in banking), we have a strange mix of a few very large banks and a whole bunch of small ones.  Unfortunately for the small banks, there is some degree of uncertainty about how depositors will be treated.  Thus, we are seeing something of a “slow motion” run on small banks.  Although most financial crises occur quickly, some take a long time. For example, the savings and loan debacle took over a decade to resolve.  This problem of large vs. small banks might be similar.
  • Because small bank failures are rarely systemic, they tend to get a lighter regulatory treatment. But after recent bank failures, regulators are looking to expand regulation, which may lead to fewer banks.
• In economic theory, inflation is usually addressed in simple terms; e.g., it’s all about the money supply or supply constraints. In reality, it can be devilishly complicated.  One factor gaining attention is that market power can lead to inflation if margins are maintained.
• The debt ceiling issue has sort of fallen from the news, but it remains a threat to stability. The House GOP seems no closer to a plan on how to address it.
• Young graduates are finding a tentative job market. As we note below, initial claims remain remarkably low and stable, which likely reflects labor hoarding.  Firms loath to lose current employees, fearing the cost of replacement.  However, it may be leading to a lower number of new graduates being hired.

International News:  Russia detains a Wall Street Journal reporter, Britain gets a trade deal, and Cargill stops carrying Russian grain.

• WSJ reporter Evan Gershkovich has been detained by Russian security services on charges of spying. He was reportedly investigating the Wagner group.  This is a high-profile event and will likely weaken already fraught relations.
• Britain has joined the Indo-Pacific trade bloc, the CPTPP, which is the successor of the failed TPP. The U.K. is the first nation to join the group since its founding in 2018.
• Cargill, a top 10 exporter, announced it will stop handling Russian grain.
• The German ruling coalition is showing signs of stress. The Greens are increasingly out of step with the Social Democrats and the Free Democrats.

War in Ukraine:  There are renewed concerns over the safety of the Zaporizhzhia nuclear plant.  Russia has been shelling the region around the plant and both sides are increasing troop strength around it.  The IAEA is trying to work out an arrangement to prevent the plant from being directly attacked.  This is the largest nuclear plant in Europe and although the cores are in hardened containment units, a direct attack could lead to a potential catastrophe.

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[1] Private equity does something similar.

[2] This is why we have 12 Federal Reserve districts, for example.

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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 U.S. banking crisis, where the Senate Banking Committee took testimony yesterday from Federal Reserve Vice Chair for Supervision Barr and other top bank regulators.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including this week’s big break-up of a major Chinese internet-commerce company and increasing weakness in the Russian economy.

U.S. Banking Crisis:  In his testimony to the Senate Banking Committee yesterday, Fed Vice Chair for Supervision Barr revealed that the central bank regulators had issued numerous warnings to Silicon Valley Bank (SIVB, $106.04) about its asset and liability risks over more than a year, virtually up until the time that the bank failed earlier this month.  Nevertheless, the Senators on the committee castigated the Fed for not following through on those warnings and not forcing the bank to take action.  Barr and other top bank regulators will testify today before the House.

• When asked how quickly a bank should respond to supervisory directives from the Fed, Supervisory Chair Barr, incredibly, said he didn’t know the time frame for such action.
• The hearing showed that legislators are not only considering making more banks subject to the stricter regulatory regime imposed on the biggest banks, but they may also consider new supervisory rules and procedures for the Fed itself.

U.S. Labor Market:  With multiple state and local governments now requiring that job listings include pay ranges, new research suggests the added information can incentivize employees to work harder, so long as they believe the pay system is fair.  The research helps ease some employers’ concerns that the new pay transparency could spark tension in their workforce and cause lower productivity.

U.S. Artificial Intelligence Industry:  Elon Musk and more than 1,000 other technology executives and researchers have signed a public letter calling for a six-month pause in the development of advanced artificial intelligence systems, such as OpenAI’s ChatGPT, in order to halt what they call a “dangerous” arms race.  According to the letter, the advanced AI systems which are now being developed so quickly are beyond what humans can understand, predict, or reliably control.

• The signatories hope that a break would allow for the development of safety protocols and other controls for the technology.
• If the pause can’t be put into place voluntarily and verifiably, the signatories urge a government-mandated moratorium.
• While we doubt such a pause will be implemented, we think the letter does reflect the extraordinarily rapid development of the technology, which is already transforming everything from key industries to military strategy.

China-Taiwan-United States:  As Taiwanese President Tsai Ing-wen prepares to embark on her 10-day visit to the U.S. and Central America, the Chinese government warned that her planned meeting with House Speaker McCarthy would be “another provocation” and that China would “resolutely hit back”.  When then House Speaker Pelosi visited Taiwan last year, the Chinese responded with an aggressive series of military exercises around the island.  The coming “transits” through the U.S. and the meeting with McCarthy could well spark a repeat of those exercises or other potentially dangerous responses.

China:  Internet commerce giant Alibaba (BABA, $98.40) announced yesterday that it will reorganize into a holding company with six independently-run units for cloud computing, Chinese e-commerce, global e-commerce, digital mapping and food delivery, logistics, and media and entertainment.  Each of the units could seek their own initial public offerings of stock.

• In all probability, the breakup was ordered by the Chinese government as part of President Xi’s continuing effort to rein in the country’s technology giants and bring them to heel. While that effort has diminished the companies’ power, it could also be a positive for investors.  Alibaba’s shares have surged in response to the reorganization.
• Government officials and investors here at home have also called for some big U.S. technology giants to be broken up on antitrust and freedom of speech concerns, which could likewise unlock a lot of value. However, authoritarian governments like the one in China have much more power to do so.  In a democracy like the U.S., bringing such break-ups into effect can be much more difficult due to the diffuse power structure and multiple political actors that would need to agree.

United States-Russia:  Attempting to retaliate in a calibrated manner against Russia’s recent decision to suspend its participation in the New START nuclear arms control treaty, the U.S. yesterday said it will stop sharing certain detailed data on its strategic nuclear forces with Russia.

• The move will likely lead to a further weakening of the last remaining Cold War-era arms control agreement between the U.S. and Russia.
• Full abrogation of the treaty would allow the U.S. to boost its nuclear arsenal to account for China’s rapid nuclear build-up, but that would also likely set off a risky nuclear arms race between the U.S., China, Russia, and potentially other countries.

Russia:  Although the Russian economy initially appeared to be weathering the Western sanctions imposed after the Kremlin launched its invasion of Ukraine, it now appears that it is starting to suffer more substantially.  Since global oil and gas prices have retreated from their post-invasion highs, the resulting revenue declines and big military expenditures have left the government with huge budget deficits.  The ruble has also started to decline sharply, while emigration and mass conscription have produced labor shortages.

• The intensifying difficulties are likely a harbinger of continued economic weakness in the long term.
• As we have long argued, Russia’s economic problems will also force it ever more deeply into China’s embrace, making it a key-but-junior partner in China’s evolving geopolitical and economic bloc.

Source:  Russian Finance Ministry via CEIC Data

United Kingdom:  Yesterday, the pro-independence Scottish National Party narrowly elected Humza Yousaf to replace Nicola Sturgeon as its leader.  The election also puts Yousaf in line to be elected as Scotland’s first minister in the coming days.  Because of the narrowness of Yousaf’s win and the attacks he endured over his past roles as Scotland’s transport, justice, and health minister, he may not be a strong advocate for independence in the coming years.  If he does prove to be a weak leader for the SNP, the resulting political stability could be a positive for British stocks.

Brazil:  Former President Bolsonaro plans to return to Brazil tomorrow for the first time since he fled to Florida after losing his bid for re-election in last year’s elections.  Bolsonaro will face a number of probes into corruption and his role in the post-election takeover of the capitol by rioters, but he will also reportedly attempt to re-energize Brazil’s right-wing movement and undermine his successor and political nemesis, leftwing leader Luiz Inácio Lula da Silva.  Any resulting political instability would likely be negative for Brazilian stocks.

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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 U.S. banking crisis.  Federal Reserve Vice Chair for Supervision Barr will be testifying on the crisis before the Senate today.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including at least a temporary truce in Israel’s unrest over judicial reforms and news of an important new U.S.-Japanese trade deal on critical minerals.

U.S. Banking Crisis:  Fed Vice Chair for Supervision Michael Barr will testify before the Senate today on the failure of Silicon Valley Bank (SIVB, $106.04) and the broader U.S. banking crisis.  In his written testimony, Barr is expected to paint Silicon Valley as a “textbook case of mismanagement.”  However, the Senators are also likely to grill Barr intensively over the regulators’ failures to discipline the bank before it failed.  Meanwhile, calmer financial markets continue to suggest that the overall banking crisis in the U.S. has dissipated, at least for now.

European Union-Germany:  Over the weekend, Germany and the European Commission reached an agreement under which Germany will lift its opposition to a new EU law banning the sale of automobiles with internal combustion engines starting in 2035.  In return, the EU Commission has committed itself to finding a legal way to allow the sale of such engines if they burn synthetic “e-fuels.”  The deal diffuses an EU governance crisis and may also help preserve tens of thousands of jobs in Germany’s auto-centric economy.

France:  Prosecutors have raided several large French banks today as part of Europe’s broad “cum-ex” tax evasion scandal.  The targeted institutions include BNP Paribas (BNPQY, $28.05) and Société Générale (SCGLY, $4.32).

Russia-Ukraine War:  Russian President Putin still hasn’t announced another “partial” mobilization of troops like he did last fall, probably because of the political risks in doing so. Reports indicate, though, that the government is still making a concerted push to generate new volunteers for the military to replace the enormous casualties in the war to date.  Potential volunteers are being offered a wide range of incentives, including lucrative combat pay, educational assistance, tax breaks, and debt assistance.

• Separately, the Hungarian government approved Finland’s accession to the North Atlantic Treaty Organization yesterday, furthering the strengthening and expansion of NATO that was touched off by Russia’s invasion.
• However, Turkey and Hungary continue to stall their approval of Sweden’s bid to join NATO, based on Turkey’s concern that Stockholm hasn’t been tough enough on what it calls Kurdish terrorists that have sought refuge in Sweden.

Saudi Arabia-China-Russia:  Saudi state oil company Aramco (2222, SAR, 32.15) said it has signed deals to supply a total of 690,000 barrels per day of Saudi crude oil to Chinese refiners.  Aramco will also take a 10% stake in a major Chinese oil refiner.  The deals illustrate how the Saudis are fighting to retain their market share in China even as Russia boosts its cut-rate sales to the country in response to the sanctions imposed on it because of its invasion of Ukraine.  That sets up an intensifying Saudi-Russian competition to supply China, which will likely help cement China’s influence over the two countries.

Israel:  Faced with mass protests and the risk of military opposition, which we described in our Comment yesterday, Israeli Prime Minister Netanyahu has agreed to postpone the initial voting on his controversial judicial reforms.  However, he also vowed to have the Knesset take up the legislation again at the end of April, following its spring break.  That suggests the crisis isn’t necessarily over and may heat up again later in the spring, which would likely be detrimental to Israeli equities.

United States-Japan:  The U.S. and Japan today plan to sign a trade agreement covering critical minerals used in electric-vehicle batteries.  Under the deal, the two countries will refrain from imposing export duties against each other for lithium, cobalt, manganese, nickel, and graphite. They will also share information on potential labor violations in the supply chain for those critical minerals and “identify opportunities to build their respective capacities.”

• The deal provides further evidence of how the U.S. and Japan are strengthening their ties in the face of growing geopolitical and economic threats from China.
• With the critical-minerals trade deal in place, Japanese electric vehicles made with metals processed in Japan could become eligible for the tax incentives included in last year’s Inflation Reduction Act. That would further improve U.S.-Japanese ties.

U.S. Commercial Real Estate Industry:  New data show that employees working from home and rising interest rates are now even putting financial stress on “Class A” office buildings, which until now had been holding up well.  The data shows that these buildings, which are often well-located and rich with modern amenities, are now facing reduced occupancy, falling rents, and even several mortgage defaults.

U.S. Defense Industry:  Yesterday, President Biden invoked the Defense Production Act (DPA) to spend $50 million on expanded U.S. and Canadian production facilities for printed circuit boards, which are used in missiles and radars, as well as civilian energy and healthcare electronics.  With supply chain hurdles continuing to hinder the production of key military goods, we suspect we will see further, bigger DPA orders in the future.

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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 U.S. and European banking crises.  Fortunately, it is looking more and more like the crises are dissipating for now, although we remain cautious about any other stresses in the financial system because of the central banks’ continuing interest-rate hikes.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including signs that U.K.-style mass strikes for higher pay are spreading to Germany and an outbreak of major political protests in Israel.

U.S. Banking Crisis:  Earlier today, the Federal Deposit Insurance Corporation announced that First Citizens Bancshares (FCNCB, $550.00) had agreed to acquire the deposits, loans, and branches of failed Silicon Valley Bank (SIVB, $106.04).  To facilitate the deal, the FDIC said it would share any of First Citizens’ losses or potential gains on Silicon Valley’s commercial loans.

• Overall, the FDIC estimated that the failure of Silicon Valley will cost the federal insurance fund about $20 billion.
• In response to the deal, shares of regional banks are surging so far this morning, offering additional evidence that the crisis is abating, at least for now. Nevertheless, since the Federal Reserve continues to hike interest rates, we are keeping our eyes open for additional stresses that could arise in the financial system.  For example, commercial real estate lending could be a concern, as could a drop in the demand for corporate bonds (see chart below).
  • Illustrating the turmoil in the financial system, data provider EPFR said flows into U.S. money market funds have totaled some $286 billion so far in March.
  • The jump in inflows likely stems in large part from individual and corporate bank depositors shifting investments to money market funds in search of higher yields and greater security.

Source:  Axios Visuals.

European Banking Crisis:  Ammar al-Khudairy, the chairman of Saudi National Bank, said he will resign his position “for personal reasons” two weeks after his comments about Credit Suisse helped spark a panic about the Swiss banking giant and led to its government-led takeover by UBS (UBS, $18.99).  The resignation is just one aspect of the fallout from the Credit Suisse collapse and takeover.  All the same, consistent with the rebound in U.S. regional bank shares so far this morning, major European bank shares are also on the upswing today.

Germany:  Strikes by two major transportation unions have disrupted economic activity throughout the country today, potentially indicating that public sector strikes for higher pay like those in the U.K. may be spreading to the rest of Europe.  Organizers of the 24-hour warning strike in Germany say they are protesting huge increases in the costs of food and energy and are demanding higher pay to compensate for them.

Russia-Ukraine War:  Ukraine’s top military commander, Gen. Valeriy Zaluzhnyi, stated that his forces are close to halting any further Russian advances around the eastern Ukrainian city of Bakhmut.  Meanwhile, an analysis by the British Ministry of Defense also suggests the Russian advances around the city have run out of steam in the face of massive losses of troops and equipment.

• If the Ukrainians can indeed stabilize the front around Bakhmut and avoid having to abandon the city, the victory could help maintain Western support and continued arms deliveries.
• At the same time, the huge losses incurred in trying to take Bakhmut have left Russian forces extremely weakened. That could potentially set the Ukrainians up for a romp against the Russians when they finally launch the spring counteroffensive they have long telegraphed.

Israel:  Prime Minister Netanyahu fired his defense minister, Yoav Gallant, yesterday after he publicly urged postponement of Netanyahu’s controversial proposal to weaken the country’s judiciary.  Not only has the proposal sparked massive protests among Israeli citizens, but Gallant said it had also caused turmoil in the country’s military and was therefore undermining security.

• The firing highlights the political polarization and instability touched off by Netanyahu’s proposal, which could impede Israel’s hard-won attractiveness as a place to invest.
• The firing and imminent final passage of the legislation has sparked especially large and intense protests so far today. The Israeli president has called on Netanyahu to postpone the reform, the country’s biggest union is threatening to strike, and flights out of the major airport, Ben Gurion, have been suspended after its workers said they would join the protests.  As of this writing, members of the governing coalition are reportedly deeply divided on whether or not to proceed.

Japan-China:  Illustrating how strained relations between Japan and China have become, new reports say Japanese Prime Minister Kishida declined to meet with former Chinese Ambassador to Japan Kong Xuanyou before his departure in late February.  Kishida’s decision not to bid farewell to the ambassador was also aimed at registering his complaint about a Chinese spy balloon that recently passed over Japan. The reports claimed that Kishida took the unusual step to protest the Chinese navy’s recent forays into the waters around the Japanese-controlled Senkaku Islands in the East China Sea, which China also claims.

• The incident suggests Japan will remain fully onboard with the aggressive U.S. efforts to suppress both China’s military and its territorial aggression in the region.
• That means investors could suffer collateral damage not only from actions taken by the U.S. and China directly, but also from Japan and other allies of either power.

China-Honduras-Taiwan:  As suggested by President Xiomara Castro earlier this month, the Honduran government formally recognized the People’s Republic of China yesterday, severing its longstanding diplomatic relations with Taiwan and leaving Taiwan recognized by just 13 countries.  The announcement appeared to be a warning to the U.S. to stop intensifying its relationship with Taipei, as Taiwanese President Tsai Ing-wen embarks on a trip to the U.S. this Wednesday.

• As we have noted before, China is leaning heavily on its enormous economic heft to manage the countries in its own evolving geopolitical bloc and try to peel countries away from the evolving U.S. bloc (our analysis assigns Honduras to the U.S.-led bloc). Many countries are also trying to play China and the U.S. off each other to maximize their own economic and political benefits.
• Prior to switching its diplomatic relations to Beijing on Sunday, Honduras reportedly asked Taipei to double its economic aid to the country and restructure its debt, but the request was refused. As part of China’s economic carrots and sticks, it is highly likely that Beijing offered Honduras an attractive package of economic aid, infrastructure investment, and debt relief.

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