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 conflict in Ukraine, which includes a discussion about China and Russia’s relationship. Next, we review the dollar’s impact on the global economy. We conclude the report with an overview of U.S. efforts to adapt to a changing geopolitical landscape.

Ukraine Updates: The war shows no signs of ending soon, but Ukraine’s odds of retaking lost territory have drastically increased.

• The UN’s nuclear watchdog urged Moscow to remove its forces from the Zaporizhzhia Power Plant to avoid a potential catastrophe. Russian troops took over the area early in the war and used the region to launch attacks against Ukrainian forces. The call from the regulators for Russia to depart the site reflects the clear and present danger the conflict is having on the region. The plant’s strategic importance suggests that it is unlikely that the Russians will leave the area. Thus, the possibility of a nuclear disaster is elevated.
• Russian President Vladimir Putin admitted that China has concerns about the ongoing war in Ukraine. The rare acknowledgment of the two countries’ differences likely signals that Russia does not feel as if it has Beijing’s full support. If correct, this could potentially force Putin to take more decisive action in Ukraine to prevent further losses in the conflict. History shows that Russian leadership does not survive after the country loses a war. Therefore, we expect Putin to take more extreme action to change the tide of the conflict.
• Ukraine’s recent success in its war efforts has encouraged the West to provide the country with more military support. President Biden announced that the U.S. would provide Ukraine with $600 million in additional weaponry, while Germany said it would send two more rocket launchers and 50 armored vehicles. The increase in Western military aid shows that the war is far from over. As a result, Europe will likely not be able to avoid an energy-supply crunch in the winter.
  • In a related story, Germany seized refineries owned by Russian oil giant Rosneft as Berlin looks to take over its energy sector. The move is designed to prevent disruptions in German energy supply as the country weans itself from Russian gas. In addition to taking over Rosneft, the country plans to take over Uniper (UNPRF, $4.03) and two other gas importers.

Dollar takes off: The greenback’s rise against global currencies will prevent central banks from providing policy stimulus even as economies slow.

• The yuan surpassed 7 per dollar for the first time since 2020. This sharp decline in the yuan was driven by the deceleration in GDP growth and the rise of the U.S. dollar against global currencies. Although the depreciation of the yuan has typically led to a surge in capital flight to safer currencies, new regulation prevents this from happening. The decline in the yuan could prevent the People’s Bank of China from easing monetary policy while also pushing up the cost of imports. As a result, the depreciation of the yuan will likely add to a long list of economic woes in China, which already include COVID lockdowns, consumer pessimism, and slowing exports.
• Today, concerns over the U.K. economy have pushed the pound to its lowest level since 1985. The British currency fell to $1.137 after weak retail sales signaled a slowdown in consumer spending. In addition to the sales numbers, investor expectations of a jumbo rate hike from the Fed also weighed on the sterling. The currency’s depreciation will force the Bank of England to continue tightening, possibly even if the economy contracts. Hence, the currency’s weakness could trigger a long and deep recession.
• The U.S. Dollar Index, which tracks the greenback’s strength relative to global currencies, is up 14.5% year-to-date. For comparison, Energy is the only stock market sector with better performance. As a result, the dollar’s rise has pushed up import prices, making global inflation worse. This trend will likely continue as long as the Federal Reserve continues its currency policy path.

Geopolitical Shifts: The U.S. is adjusting to changes in the geopolitical landscape.

• S. policymakers cannot agree on whether they want to send military aid to Taiwan. The new legislation, the Taiwan Policy Act, is criticized for being too provocative toward China. The bill would grant the sovereign island $4.5 billion in aid over four years and includes extensive language on sanctions toward Beijing if it were to become more hostile toward the region. As we have mentioned in previous reports, there are many political benefits to getting tough with Beijing. A recent poll showed that 82% of Americans hold an unfavorable opinion toward China. This bravado could backfire at some point if China retaliates, but it is unlikely that Beijing will take aggressive actions before its National Party Congress on October 16. However, this will likely not be the case once the summit is over. Further provocation from the U.S. might lead to a direct conflict with China.
  • China has imposed sanctions on U.S. defense companies for selling arms to Taiwan. The measure is another example of Beijing’s sensitivity to the One China Policy in Taiwan.
• S. Secretary Tony Blinken has assumed a crucial role in ending military clashes between Armenia and Azerbaijan. The two sides began fighting on Tuesday over disputed territory. A previous cease-fire brokered by Moscow earlier this year failed as Russia was distracted by its invasion of Ukraine. The U.S. involvement in ending the conflict is a possible sign that Washington would like to fill the void left by Russia.
  • House Speaker Nancy Pelosi will visit Armenia during her trip to Europe for the G-7 Summit, another example of the increased U.S. interest in the region.

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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 overview of the implications of a more aggressive Federal Reserve. Next, we discuss the latest developments in the EU and U.S. fight against inflation, which includes an update on rail worker negotiations. The report concludes with a discussion on how sanctions are affecting Russia’s relationships with its allies.

Go Big or Go Home: Higher than expected inflation numbers have added to speculation that the Federal Reserve could be more aggressive in its tightening cycle. However, this does not mean it won’t cut rates.

• The market expects the Federal Reserve to go big at its next meeting. The CME FedWatch Tool shows that the Federal Reserve will raise rates by at least 75 bps in September and potentially push its benchmark policy rate up 100 bps. This change in the policy-rate forecast was related to disappointing CPI and PPI reports. In August core CPI accelerated unexpectedly, while core PPI failed to drop as much as the market anticipated. Higher fed funds expectations could lead to a choppy market over the next few days as the FOMC meeting approaches.
• The Fed’s next rate hike will be historic even if it raises the policy rate by only 25 bps. This next rate decision should lift the policy rate above the previous cycle’s peak for the first time since 1981. The milestone possibly reflects the central bank’s confidence in financial market conditions. The previous two economic downturns exposed the weaknesses in the financial system and forced the Fed to develop policy tools designed to prevent a crisis. Therefore, we may be heading into a new finance regime in which the Federal Reserve raises interest rates, but also maintains those rates for much longer. If we are correct, the tech sector’s dominance in the S&P 500 is likely over. However, the financial services industry could be on the ascent.

• The Fed’s new policy tools will be tested as the central bank ramps its balance sheet reduction and rate hikes over the next few months. Quantitative tightening is expected to cause financial strain as traders struggle to get deals done. The Bloomberg U.S. Government Securities Liquidity Index, a gauge of deviations in yield compared to a fair value model, dropped to its lowest level since March 2020. The deterioration in the index suggests that traders find it more challenging to exchange treasuries for cash and vice versa. If the problem worsens, the Fed will be forced to intervene. Although the financial system is withstanding monetary tightening now, we are still not sure that a financial mishap will not take place in the future. In the event of a blowup in the financial system, we expect the Fed to become more accommodative in its rate policy. As a result, we believe that the Fed could pause or cut rates by mid-2023 if financial conditions deteriorate significantly.

The West Needs a Break: The European Union and the U.S. are exploring ways to prevent further inflation within their respective regions.

• Vice President of the European Central Bank Luis de Guindos wants to anchor inflation expectations. In a speech to EU ministers, Guindos urged the central bank to prioritize price stability over growth. His comments are another example that the central bank could look to slow GDP growth in Europe to tame inflation. Higher European interest rates increase the likelihood that the region will fall into recession, leading to further fragmentation throughout the bloc. That said, a decline in gas prices could provide a tailwind for Europe, but we are not optimistic about that happening anytime soon.
• As energy woes continue in Europe, EU countries rolled out plans designed to protect households from big jumps in their utility bills. France plans to cap energy price increases at 15% for next year. Meanwhile, Germany is considering purchasing a controlling stake in gas import company Uniper (UNPRF, $4.08) to ensure the company does not fall into bankruptcy. These extreme actions by countries demonstrate the growing angst over energy security.
  • Italy might not be as vulnerable as initially thought. Energy company CEO Claudio Descalzi claimed that Italy could make it through the winter without Russia’s gas, assuming the temperatures are mild. Last year, the country imported nearly 40% of its gas from Russia.
  • On the other hand, Germany may not be so lucky. The country’s head energy regulator warned that Germany would run into gas shortages if the winter is gruesome.
• The U.S. rail workers reached a tentative agreement with rail companies to avert a strike on Wednesday. At the last minute, White House officials intervened on a deal that secured better pay and improved working conditions for workers. A shutdown would have prevented almost 30% of cargo shipments by weight from shipping in the U.S., potentially adding to already elevated inflationary pressure. The agreement ended a two-year negotiation and will be welcomed by markets.

Ukraine War and Russian Sanctions Update: As Ukrainian troops continue to progress in their counteroffensive, the West looks for new ways to punish Russia for the invasion.

• The West wants Turkey to stop helping Russia avoid sanctions. Although a NATO ally, Turkey has tried to remain neutral in the Ukraine conflict. It has supplied Ukraine with sophisticated military drones to help in its war efforts while deepening its trade ties with Russia. Turkey has received limited pushback from the U.S. and Europe up to this point. However, this may change soon. The West is considering slapping sanctions on Turkish banks that are integrated into Russia’s domestic payment system, known as MIR. The crackdown from the West suggests that it will become less conciliatory toward neutral countries that aid Russia in averting sanctions.
• Chinese President Xi and Russian President Putin met in Uzbekistan on Thursday at the Shanghai Cooperation Organization Summit. The two countries will discuss the ongoing war in Ukraine, with Russia hoping for additional support from China. Despite the two’s agreement that their relationship has no limits, Beijing has implicitly shown that it is unwilling to run afoul of U.S. sanctions. China’s position is unlikely to change as Russia’s inability to secure a quick invasion, as it initially promised, has made it look weak in the eyes of many within the Chinese leadership. Moreover, China’s lack of military support will likely make Russia’s losses from the war even greater.
  • Although there is some speculation that U.S. actions in Taiwan could lead China to ramp up its support for Russia, we are not so sure. In our view, Russia’s vulnerabilities may have encouraged the U.S. to take a greater interest in Taiwan as the sovereign island has much more geopolitical significance than Ukraine. Thus, there are likely factions within the Chinese Communist Party that are less inclined to support the additional backing to 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 an update on how Russia is responding to Ukraine’s recent battlefield gains.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, along with some additional commentary on yesterday’s disappointing inflation data and the resulting big drop in stock prices.

Russia-Ukraine:  As Ukrainian forces continue to consolidate their hold on recently retaken territories in the northern Kharkiv region and around Kherson in the south, the Russian government finally acknowledged its defeat in those areas.  The acknowledgement has focused on failures by the Ministry of Defense and the uniformed military leadership, likely to deflect the blame from President Putin himself.  With the Kremlin’s propaganda machine in disarray, some politicians are calling for a formal declaration of war, a full mobilization, or even a partial mobilization, although we continue to believe a full mobilization would be hard to pull off and remains Putin’s last resort, given how politically risky it would be.  Finally, in new evidence of how Ukraine’s recent successes have impacted Russian resolve and morale, reports indicate that some Russian officials in occupied Crimea are sending their families back to Russia in case the Ukrainians are able to retake the peninsula.

• The Ukrainian success in recapturing northern transportation hubs like Izyum will likely prevent Russia from achieving its goal of seizing the entirety of Ukraine’s eastern Donbas region.  Meanwhile, Ukrainian forces continue to push eastward into the Donbas, even as they slow their advance to consolidate their control over the recently retaken territories.  In a telephone call yesterday, German Chancellor Scholz told President Putin his position in Ukraine was hopeless and urged him to withdraw his forces completely.
• Following on the summer’s Russia-Ukraine-Turkey deal to allow safe passage of Ukrainian grain shipments through the Black Sea, the UN is pressing for a similar deal that would allow the export of key fertilizer chemicals from Ukraine’s coast.  The deal would help erase the current global shortage of fertilizer, which has further weighed on food supplies and boosted agriculture commodity prices.
• We’ve mentioned before how Russia’s invasion has scared Western democracies into what is likely to be a multi-year effort to rebuild their defense capabilities and boost their defense spending.  One example is offered by the U.S.-supplied High-Mobility Artillery Rocket System (HIMARS) that Ukraine has used to such great effect in its recent counteroffensives.  Now that the system has proven so effective in real-life combat, the U.S. Army has asked defense contractors how they could produce up to 500 additional HIMARS over the next five years – an amount that would essentially double the number of existing HIMARS.  Other countries seeking to boost their HIMARS arsenals include Romania, Singapore, and Taiwan.

Global Oil Market:  In its monthly crude oil report, the International Energy Agency cut its forecast of global oil demand this year to 99.7 million barrels per day (bpd), largely because of slowing economic growth in the developed countries and continued COVID-19 lockdowns in China.

• The IEA’s reduced demand forecasts are consistent with the fall in energy prices since early summer.  If continued high inflation prompts the major central banks to keep hiking interest rates and China keeps imposing pandemic lockdowns, oil demand could skid further and put even more downward pressure on prices.
• The IEA now sees global oil demand only surpassing its pre-pandemic high next year when it is expected to total 101.8 million bpd.

European Union Energy Crisis:  European Commission President von der Leyen detailed her proposal for a windfall profit tax on electricity producers that don’t rely on natural gas.  With the Russian gas shutoff boosting prices for that fuel, the non-gas producers have been boosting prices in tandem and raking in profits.  Von der Leyen’s proposal would raise €140 billion from an EU-wide levy on those companies and use the funds to soften the blow of record high prices this winter on consumers and businesses.  EU member states will meet to discuss the proposal on September 30.

Armenia-Azerbaijan:  Yesterday, both Armenia and Azerbaijan claimed that the other side had fired on their border communities, sparking a crisis that could potentially reignite their 2020 war.  Moscow has already brokered a ceasefire, but the violence illustrates how Russia’s military failures and political isolation in the Ukraine war have weakened its sway over the countries in its region.

U.S. Inflation and Monetary Policy:  Following up on our initial take on the August consumer price index in our Comment yesterday, we think what was most disconcerting to the market was the unexpected acceleration in the “core” CPI, which excludes the often-volatile food and energy components of the overall CPI.  The August core CPI was up 0.6% from the previous month, which was double its rate of increase in July.  Much of that acceleration reflected faster cost increases for housing, but that wasn’t the whole story.  The acceleration in core inflation reflected faster price hikes in a wide range of non-energy and non-food products.

• The acceleration in prices for non-energy and non-food products suggests inflation pressures continue to broaden despite the Federal Reserve’s long string of aggressive rate hikes.  To date, the Fed’s rate hikes haven’t seemed to do much to tighten financial conditions and bring down inflation pressures.
• The continued broadening in inflation pressures undoubtedly will encourage the Fed to keep raising rates aggressively.  As we mentioned in our Comment yesterday, the August data probably guarantee at least a 75 bps hike in the benchmark fed funds interest rate at the Fed’s policy meeting next week.
• In addition, we note that the Fed’s accelerated quantitative tightening also seems to be putting strain on the market for U.S. Treasury securities.  Bid-ask spreads in that market have widened considerably, and price swings have expanded to levels unseen since the beginning of the pandemic in early 2020.  The market action is a reminder that the Fed’s tightened monetary policy could spark a crisis in some sector of the financial markets at some point.
• The prospect of continued aggressive rate hikes, tighter monetary policy, and a potentially deep recession goes far toward explaining the sharp drop in stock prices yesterday, in which the S&P 500 price index dropped 4.2%.  Meanwhile, gold prices fell 1.6% and crude oil prices fell 0.4%.  The yield on the 10-year Treasury note jumped to 3.422%, almost matching its cycle high in mid-June.
  • In turn, that gave an additional boost to the U.S. dollar, while driving down other major foreign currencies.
  • The Japanese yen fell approximately 2% to 144.95 per dollar, prompting the Bank of Japan to check in with traders on market conditions (a move that has often presaged a market intervention in the past).
• As investors price in further big interest-rate hikes, it would not be surprising to see these trends continue in the coming days.

U.S. Railroad Strike:  As the major railroads and their unions remain at an impasse in their contract negotiations, the risk of an economically damaging strike on Friday continues to increase.  The threat has prompted a number of major businesses to appeal to Congress to take action to prevent a shutdown.  The White House has also launched an effort to coordinate alternate transportation providers such as trucking firms and ship companies.

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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, and a discussion on the latest Ukrainian successes not only in northern Ukraine but also in the south.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including concerns about the possibility of major new strikes in the U.S. as early as Friday.

Russia-Ukraine:  Although media reports have focused on the Ukrainians’ routing Russian forces in the northern region around Kharkiv over the last week, the latest details suggest their counteroffensive to retake the southern city of Kherson is also progressing well.  Some observers have referred to the Ukrainians’ southern attack as merely a feint to draw Russian forces away from the north, but that’s probably overstating the situation.  More likely, the Ukrainians’ southern attack created an opportunity in the north that they then exploited.  As evidence of the new successes in the south, the latest reports indicate Russian forces have abandoned some of their positions to the northwest of Kherson.  We have also seen unconfirmed reports that Russian units in the area are negotiating a surrender to the Ukrainians.  Nevertheless, U.S. military officials warn that the war is far from over, and that the Ukrainians still have a tough fight in front of them.

• In a document shared with U.S. lawmakers and reviewed by the Wall Street Journal, Ukrainian officials are preparing to request a large number of new, advanced, “offensive” weapons to use as they seek to push the Russians out of their territory.  The requested weapons include the Army Tactical Missile System, or ATACMS, which has a range of about 190 miles. The wish list also includes modern tanks, drones, and artillery systems; more Harpoon anti-ship missiles; and 2,000 missiles for the High Mobility Artillery Rocket System, or HIMARS, which the U.S. began providing earlier this year.
  • Other reporting that we’ve seen suggests the Biden administration is getting more comfortable with the idea of sending more advanced weapons to the Ukrainians.
  • Along with other reports showing that the Western European nations are increasingly turning to U.S. defense firms to rebuild their military forces in response to the war, we continue to believe that the U.S. defense companies are in for a long period of strong orders.
• On the energy front, new Russian budget figures suggest falling global energy prices and Russia’s own cutoff of energy supplies to Western Europe are blowing back on Moscow.  While Russia recorded a budget surplus of almost 500 billion rubles in the first seven months of the year, the cumulative total fell to only 137 billion rubles last month, suggesting a big deficit in August which economists attributed to sharp declines in oil and gas revenues.  The deteriorating budget situation may add to the economic and political pressures on Russia, although it would probably take a while for them to reach a critical level.

Global Semiconductor Industry:  In another sign of deglobalization, shortening supply chains, and countries trying to ensure they can produce critical goods domestically, Indian industrial group Vedanta (VEDL.NS, INR, 277.55) and Taiwan technology company Foxconn (2354.TW, TWD, 49.80) said they will build an integrated computer chip and display production center in India’s province of Gujarat.  The government-backed project will cost almost $20 billion and comes on top of massive new semiconductor production capacity being planned in the U.S. and Europe.

Global Agriculture Industry:  EU officials are reportedly delaying implementation of the European Commission’s proposed “Sustainable Use of Pesticides” regulation out of fears that the required cut in pesticide use could push down crop yields and further boost food prices in the EU and globally.

• The regulation intends to reduce the amount of chemicals used in food production by 50% within the next seven years.
• The delay in implementing the rule could signal that officials around the world are now rethinking their approach to regulation as the world faces insufficient commodity supplies and surging prices.

Chinese COVID-19 Shutdowns:  Along with new Zero-COVID lockdowns elsewhere in the country, Beijing officials are taking especially stringent steps to contain their latest outbreak ahead of the Communist Party’s important 20^th National Congress next month.  The government suddenly announced yesterday that employees and students must show a negative COVID-19 test taken within the previous 48 hours to return to work and school today after the three-day Mid-Autumn Festival holiday.  The move led to chaos this morning when commuters found subway gates would not open because they could not verify their tests.  President Xi’s stringent Zero-COVID policies continue to weigh on Chinese economic activity and discourage new investment in the country, with negative implications for the global economy and financial markets.

Chinese Housing Market:  Massively indebted property developer Evergrande (EGRNY, $3.05) said it will resume construction work on all its remaining stalled projects by the end of this month and accelerate work on its other projects to a “normal” level.  The announcement likely reflects Beijing’s push to stabilize the country’s home construction market ahead of the 20^th National Congress next month.

Argentina:  In a meeting with IMF Managing Director Georgieva yesterday, Economy Minister Sergio Massa promised that Argentina would stick by its deal to reduce its fiscal deficit and trim energy subsidies in exchange for pushing back the debt payments to the IMF.

• Nevertheless, it’s important to remember that Massa is a leading figure in Argentine Peronism, which has been hostile to IMF-imposed austerity measures that could directly hurt its constituents.
• Given Argentina’s long history of breaking such deals, we suspect investors will continue to discount the country’s assets for the foreseeable future.

U.S. Labor Market:  With the massive U.S. labor shortage continuing to give leverage to employees, faltering contract negotiations are raising the risk of major strikes against the nation’s railroads and West Coast ports as early as Friday.  Key railroads have already warned they will restrict shipments of hazardous chemicals so they would not be left unattended in the event of a work stoppage.

• In addition, some 15,000 nurses in Minnesota launched a three-day strike yesterday as they push for a roughly 30% pay hike over three years.
• The potential railroad and port strikes could be especially damaging to the economy as they would further snarl the supply shortages that have been disrupting activity over the last year or more.  And of course, that would likely exacerbate the current high level of inflation.

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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 some notes on Ukraine’s devastating victories over Russian forces since late last week.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an important election in Sweden and new research on how COVID-19 continues to hold down the U.S. labor force.

Russia-Ukraine:  Over the weekend, Ukrainian forces continued to rout the Russians in the northern region of Kharkiv and make new territorial gains with their counteroffensive to retake the occupied city of Kherson in the south.  Ukrainian military officials indicate Kyiv has now retaken an area roughly the size of Rhode Island since the beginning of the month.  All reports indicate the Russian retreat is disorganized and desperate.  Nevertheless, the Ukrainians are already slowing their advance this morning in order to consolidate their hold on the recaptured territories and prepare for a possible Russian counterattack.  It is still much too early to expect a full Ukrainian victory or a complete withdrawal by the Russians, but the Ukrainian successes over the last week could mark a turning point that boosts the country’s confidence, encourages further military and other support from the West, and worsens the Russia’s shortfalls in morale, manpower, and equipment.  The Ukrainian military is also likely to benefit greatly from the equipment and ammunition the Russians have abandoned in their retreat, as well as from the intelligence to be gleaned from the Russians’ abandoned command posts.

• Importantly, the rout of Russian forces in Ukraine is generating intense criticism of the Ministry of Defense, although there is less discernable criticism of President Putin himself.  Indeed, Putin may be to the point where he wants the MOD to take the criticism to deflect blame from himself.  The Kremlin has even announced that Putin has postponed all his meetings with the leadership of the MOD and representatives of the Russian defense industry, which is a bizarre decision in the face of the military operational and defense industrial crisis facing Russia.
• On the energy front, Russia’s nearly complete cutoff of natural gas supplies is now idling more and more of Western Europe’s industrial capacity, from steel and aluminum to cars, glass, ceramics, sugar, and toilet-paper makers. Some industries, such as the energy-intensive metals sector, are shutting factories that analysts and executives say might never reopen, imperiling thousands of jobs.  The shutdowns illustrate how important it is for Ukraine to continue showing battlefield successes as a way to hold out hope that the economic costs to Western Europe will be short-lived.

United Kingdom:  Queen Elizabeth II’s funeral has now been set for Monday, September 19, in Westminster Abbey.  Importantly, all indications are that leaders from across the world will descend on London for the event, making it a major unscheduled diplomatic meeting.  Confirmed attendees so far include U.S. President Biden, European Commission President von der Leyen, Japanese Emperor Naruhito, and New Zealand Prime Minister Ardern.  We would not be surprised if the funeral ends up spawning several important meetings and initiatives.

United Kingdom-European Union:  To take advantage of the U.K. leadership change last week, Chief EU Brexit Negotiator Maroš Šefčovič has offered an idea to resolve the EU-U.K. dispute over customs checks for goods going from the British mainland to Northern Ireland.  Under his proposal, the U.K. would share data on the shipments with the EU in real time, and physical checks would only be required in rare instances in which there was a suspicion of smuggling or other issues.

• We have not seen a firm response to the idea from the British government so far, and it isn’t clear whether the idea would mollify those in Northern Ireland who most oppose any arrangement that interferes with its connection to the mainland.
• All the same, the idea could potentially help resolve one of the main sources of tension between the U.K. and the EU.

Sweden:  In parliamentary elections yesterday, preliminary results showed a center-right bloc of parties with a slim majority over a center-left bloc, but the real news was that the right-wing nationalist Sweden Democrats took their biggest-ever share of votes in a general ballot. Final results are not due for several days, but it appears that the Sweden Democrats will be the largest party in the right-wing bloc and the second-largest party overall.  If the right wing takes power, one important implication is that they are likely to push more reliance on nuclear electricity generation in Sweden, further bolstering a global trend.

Colombia:  In an interview with the Financial Times, Environment Minister Susana Muhamad said the government of leftist President Gustavo Petro will, for the first time, require environmental licenses for mining exploration as part of a wider overhaul of the process for awarding concessions.  The move likely signals the kinds of new regulations that will be put in place as left-wing leaders take control of more governments in Latin America.

U.S. Dollar:  Ahead of tomorrow’s release of the August Consumer Price Index (CPI), the dollar is weakening substantially against all major currencies except the yen.  The softening in the greenback partly reflects expectations that CPI inflation will slow, potentially setting the stage for the Federal Reserve to slow its interest-rate hikes down the road.  In addition, investors may still be digesting the European Central Bank’s aggressive 75 bps hike in its benchmark interest rate last week.

• At this writing, the euro is trading up approximately 1.1% against the dollar, at a value of $1.0152.
• At the same time, the pound is up 0.9% to $1.1694.

U.S. Labor Market:  New research by economists at Stanford University indicates that illnesses caused by COVID-19 have reduced the U.S. labor force by about 500,000 from what it would otherwise be.  Retirements and other social impacts from the pandemic probably account for a greater share of today’s workforce shortfall, but the research still illustrates the ongoing cost of not reducing infections further.  The shortfall in the labor force from what it would be otherwise has likely contributed to labor shortages, spiking wage rates, and higher inflation.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a discussion about the raging energy crisis in Europe. Next, we give an overview of stories that show that the world is still adapting to a new normal. We end the report with our thoughts on the latest central bank developments.

Russia’s Energy, Europe’s Problem: The risk of a deep European recession remains elevated as countries grapple with finding alternatives for Russian energy.

• Some countries have ignored calls for price caps and cooperation as governments struggle to compensate for Russian energy loss. The latest threat from Moscow to halt shipments has made the situation worse. Vulnerable countries such as Germany and Austria admitted that they were reluctant to back the price caps due to their dependence on Russian energy. Germany attempted to reduce its reliance on Russia by securing gas-sharing agreements. However, neighboring Belgium, Luxembourg, the Netherlands, and Poland failed to sign off on the arrangement. The lack of coordination among countries undermines European unity and may cause fractures within the bloc.
• The White House’s plan to supply Europe with gas angered U.S. lawmakers. The Energy Information Administration forecasts the natural-gas spot-price will be $9/MMBtu this winter. Although the cost is cheap for European buyers, it will drastically increase energy bills for U.S. households. Governors of northeastern states have informed the Biden administration that they would prefer that the U.S. keep its gas domestically as the country copes with elevated inflation. The rising politicization of gas shipments in the U.S. could exacerbate the energy crisis in Europe.
• As energy markets brace for a supply crunch in the winter, financial instability remains a risk. An ECB review of bank vulnerabilities to a potential surge of company defaults is underway over concerns that gas stoppage could strain the financial system. Earlier this year, the central bank warned traders that it would not provide emergency funding to bail them out in a crisis. The lack of support threatens the financial system because utility companies reliant on energy futures will be desperate for cash to cover shorts and meet margin calls. As a result, exchanges are now demanding more collateral to protect against a possible default. Although a potential cap on prices could help relieve some of this pressure, the ECB and governments may still need to get involved in ensuring that financial institutions remain liquid. As a result, we think the chance of a financial crisis in Europe remains a distinct possibility if immediate action is not taken to address ongoing issues.

 A Whole New World: The post-pandemic world is still taking shape as countries work out the best pathway forward.

• After 70 years on the throne, Queen Elizabeth II passed away on Thursday and will be succeeded by Prince Charles of Wales. The country will spend the next ten days mourning the death of its oldest and longest-serving monarch. Her death will likely delay the new government’s effort to implement its energy agenda.
  • Additionally, with the country distracted, the Truss administration might use the time to clean house. U.K. Treasury official Tom Scholars was sacked as the new Truss administration looks to refocus the finance ministry away from financial prudence and toward economic growth. The overhaul will likely pave the way for Truss to implement her new policies that lower taxes and push through her £150 billion energy plan.
• Wheat prices jumped over concerns that Turkey and Russia might scrap their grain deal. Turkish President Tayyip Erdoğan and Russian President Vladimir Putin have criticized the arrangement as benefiting wealthy nations and not developing countries. The leaders have advocated that Russia should be allowed to export its grains. Although food sales have been exempted from sanctions, many shippers and bankers are reluctant to do business with Russia. As a result, the wheat export has benefited Ukraine at Russia’s expense. The deal is set for 120 days, and markets are sensitive to any news that the agreement could collapse.
• Firms are forced to choose between the U.S. and China as politicians are determined to force a decoupling. On Thursday, Apple (AAPL, $154.46) faced scrutiny from republican lawmakers over its decision to use Chinese-made semiconductors for its new iPhone 14. The attack on Apple reflects the growing animosity among U.S. lawmakers toward companies doing business with China. This political pressure will dissuade many companies from setting up supply chains in rival countries and accelerate a push toward deglobalization.

Central Bank News: Stocks rallied, and bond prices dropped after the Fed Chair’s hawkish comments and the European Central Bank’s historic rate hike.

• Stocks closed higher on Thursday despite hawkish Fed rhetoric. On Thursday, Federal Reserve Chair Jerome Powell reiterated the central bank’s intention to raise interest rates until inflation drops to the bank’s 2% His comments reaffirmed expectations that the Fed will raise rates to 3.25% at its next meeting. Surprisingly, equities rebounded following Powell’s perceivably bearish comments. The rally was related to short-covering as investors grew confident that the market had already priced in a 75 bps hike. So far, the market anticipates that the Fed will lift rates to 4.00% by the end of the year.
• There was a sell-off in Eurozone bonds after the ECB raised rates by a record 75 bps. The rate hike pushed German two-year bond yields to 1.37%, its highest level since 2011. The spike in yields reflects European interest rate expectations, hence the market believes the ECB is far from finished. During Thursday’s press conference, ECB president Christine Lagarde acknowledged that the benchmark rate’s jump signaled to markets that the bank was committed to the inflation fight and hinted that another jumbo hike could happen at its next meeting.
  • The yield spread between the Italian and German 10-year bonds, a measure of European financial stress, narrowed after the rate hike. The decline in the yield gaps suggests that investors are confident that the bank is prepared to intervene in bond markets in an emergency.
• In China, data from the People’s Bank of China showed that financial institutions are not lending. Although demand rebounded from a low in August, credit growth remains anemic as households are cautious about taking out new loans. This lack of credit circulation throughout the real economy, even with easy monetary policy, has added to concerns that the country is in the midst of a liquidity trap. If correct, this could mean that China will struggle to achieve robust GDP growth over the next few years.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will begin with a discussion concerning the European Central Bank’s rate decision. Afterward, we will discuss the impact monetary tightening has had on the global economy. Lastly, we review the latest moves by major powers to expand their influence in other countries.

 The Euro Bounce: The euro is strengthening following the European Central Bank’s decision to raise rates. Meanwhile, rising inflation and slowing growth remains a risk for Europe.

• As expected, the ECB lifted its main refinancing rate by a record 75 bps. The massive jump in interest rates comes as the Eurozone combats unusually high inflation. The bank’s statement shows that it projects inflation to remain elevated but does not forecast a recession. During the press conference, ECB President Christine Lagarde emphasized that future rate decisions will be data dependent and be made on a meeting-to-meeting basis. She also added that the bank will continue to raise rates to 2.3% by end of the year and will proceed with its rate cycle if inflation remains a problem.
  • That the ECB decided to downplay recession concerns suggests that it is less focused on growth and more on inflation. As a result, we suspect that the banks could consider large rate hikes in the future.
• Gas prices retreated on Thursday as investors brace for new emergency measures to help offset rising energy costs. European Union Ministers are scheduled to meet on Friday to discuss ways to curtail energy demand. The group is expected to discuss five moves to help bring down energy demand. Potential plans include the redistribution of some windfall energy profits, a price cap on Russian gas, mandatory targets during peak hours, and other measures. The decision to constrain energy usage is a response to concerns that Russia will halt the supply of gas to the region in the coming months. Limits on energy will worsen the impact of a European recession and disproportionately hurt industrialized countries such as Germany.
  • That said, members will not share the pain equally. Spain, which has already filled its gas capacity to the critical 80 percent level, has been able to export some of its excess to neighboring France.
• Despite measures to curb energy demand, countries are likely to ease household pain through government intervention. For example, on Thursday, U.K. Prime Minister Liz Truss unveiled a £150B energy plan. The plan will cap annual household bills to £2,500 over the next two years. In Germany, the government has vowed to offer pandemic-era funds to companies struggling with the surge in energy costs. The increase in fiscal stimulus will likely prevent a worst-case scenario in Europe but will not stop the continent from falling into recession.

The Fed Strikes: Global currencies suffer as the Fed continues to tighten monetary policy; however, there are positive signs that inflation may be on a steady downward path.

• Market confidence that the Federal Reserve will lift rates by 75 bps skyrocketed this month. Over the last several weeks, Fed officials dismissed assumptions that the central bank could reverse course in response to weakening economic data. On Wednesday, Cleveland Fed President Loretta Mester and Fed Governor Lael Brainard affirmed that the Fed still needed to raise rates to contain inflation. The latest projection from the CME FedWatch Tool suggests a 76% likelihood that the Fed will lift its policy rate to 3.25% in its next meeting.

• • The newest Federal Beige Book showed that the economic outlook remained weak as business contacts expressed skepticism over future demand over the next six to 12 months. Although survey respondents reported moderation in price pressure and labor availability, firms still view inflation and hiring as an issue. The report suggests that the economy may head into a recession within the next few months.
• Hawkish Fed policy continues to push up the dollar’s value against its global peers. On Thursday, the British pound fell to its lowest against the dollar since 1985. Meanwhile, the Japanese yen slipped to a 24-year low. Out of the top three major currency pairs, the euro bucked the trend as anticipation of an ECB rate hike helped give it a slight boost against the greenback. As the dollar continues to gain in value, we expect other central banks to raise rates. Hence, global financial conditions will likely tighten over 6 to twelve months. Firms with U.S. dollar exposure are very attractive in this environment.
  • Japan’s Chief Foreign Exchange Minister Masato Kanda signaled that the bank would consider all options to halt the yen’s slide but emphasized that the bank’s position has not changed. In addition, the Bank of Japan may purchase yen in the open market to help bring down the currency’s value. Traders expect that the BOJ could intervene when the yen breaches ¥147.
• Rent and home prices may be close to their respective peaks. According to data collected by Zillow, rental prices slowed for three consecutive months. Meanwhile, potential home buyers surveyed by Fannie Mae expressed optimism that home prices would decline over the next few months. If valid, the deceleration will affect the overall Consumer Price Index as shelter prices represent nearly a third of its weight. The Zillow index lags the CPI by about 6-9 months, and as a result, we suspect that category to rollover around March of next year.

The Great Power Tussle: The U.S. and China blocs continue to battle over global influence, while the war in Ukraine shows no signs of ending.

• In a speech, Russian President Vladimir Putin stated that his country was winning the war in Ukraine and vowed to proceed with the invasion in Ukraine. His remarks highlight the pressure of progress in the war as the country heads into regional elections over the weekend. Although the outcome is likely to be favorable for the Kremlin, low turnout would signal that the government is losing support. Although Putin insists that he feels no pressure to end the conflict, a potential voter backlash could force him to rethink the invasion, especially as he plans to run for reelection in early 2024.
  • Ukrainian President Volodymyr Zelensky revealed that Ukrainian troops were able to retake territory lost to Russian troops.
• The U.S. will meet with 13 Asian countries to discuss an economic framework that limits China’s influence in the region. The deal has been low on details but appears to be focused on limiting tariffs in exchange for market access for exporters. It is not clear when an agreement will be reached, but we believe that it should be beneficial to firms which conduct business in Asia.
• President Putin is scheduled to meet with Chinese President Xi Jinping at the Shanghai Cooperation Organization summit in Uzbekistan next week. The two leaders will discuss the ongoing developments of the war as well as improvements in trade relations. Although it has maintained its neutrality in the war, China has allied with Russia. That said, the relationship still has its flaws. Thus, the meeting could give insights as to whether China still plans on expanding its support for Moscow.
  • China’s reluctance to provide Russia with weapons has forced Moscow to look to pariah nations such as Iran and North Korea for its needs. Additionally, China has used the Ukraine war to expand its influence in Eurasia as earlier this month Beijing urged Russia to stop blocking oil exports from Kazakhstan.

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