by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including the latest on the Ukrainian counteroffensive to retake Kherson and an apparent new counteroffensive in the country’s north.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, with a particular emphasis on the energy and economic challenges in China and Europe.

Russia-Ukraine:  Ukrainian forces continue to press their counteroffensive to retake the Russian-occupied city of Kherson in the country’s south, although with an emphasis on surgical missile and artillery strikes against logistics nodes, communication lines, and command centers rather than massed attacks to seize large swaths of territory.  The Ukrainian counteroffensive appears to be progressing methodically around Kherson, but it is also creating opportunities for the Ukrainians elsewhere.  As Russia redeploys its forces from occupied areas in the north and east of the country, the Ukrainians have made some gains against the remaining troops in those areas.  For example, reports indicate that yesterday the Ukrainians seized some territory north of Kharkiv.

• Separately, Russian President Putin has threatened to curtail the export of grain from Ukraine again, falsely charging that the West has been deceiving the developing world by largely keeping the Ukrainian grain exports set in motion by a recent Turkish-brokered deal for itself.  So far, the statement has had little discernible effect on global grain markets.  However, trading on those markets could turn volatile again if it begins to look like Russia will follow through on Putin’s threats.
• While the war has been devastating to much of Ukraine’s industrial base, one industry is benefiting from the country’s unexpected success in standing up to the Russian military.  New reports say Ukraine’s defense industry is enjoying a spike in demand from foreign customers interested in securing weapons proven in combat against Russia’s invasion.  The Ukrainian weapons being exported include the very successful “Skif” man-portable anti-tank missile and the Corsar light portable missile system.

European Energy Crisis:  As part of its effort to manage Russia’s cutoff of natural gas supplies and spiking energy prices, the European Commission plans to recommend that EU governments impose a windfall levy on revenues generated by non-gas electricity producers when market prices exceed €200 per MWh, less than half the current market price. The funds raised by the levy would then be redistributed to help companies and households deal with the crisis.

• EU leaders hope the threshold price is high enough to incentivize further investment in alternative energy sources and encourage energy conservation by businesses and households, while also limiting the politically dangerous price hikes for end users.
• Channeling the funds raised by the levy may be especially important for Europe’s industrial users, as we continue to see reports of production facilities being shut down because of the high cost of energy.

United Kingdom:  In contrast with the EU’s approach, newly minted Prime Minister Truss said in her first parliamentary question-and-answer session that she continues to oppose additional windfall taxes and promised that her government would unveil its energy support package this week.  Truss’s plan is expected to involve a cap on household energy bills of around £2,500 and include some sort of mechanism for the government to make up the difference for energy producers.

Chinese COVID-19 Lockdowns:  To give a sense of how extensive China’s latest COVID-19 lockdowns have become, the country’s media is reporting that 33 cities and an estimated 65 million people were under some sort of lockdown as of Saturday, making this the broadest outbreak since early 2020.

• The new lockdown is also likely to intensify ahead of the Communist Party’s pivotal 20^th National Congress starting in early October.  In all likelihood, the restrictions will further weigh on Chinese economic growth, presenting additional headwinds for the global economy.
• The prospect of weaker demand in China continues to weigh on global commodity prices, along with the impact of rising interest rates and the strong dollar.

Chinese Trade:  The August trade surplus narrowed to just $79.4 billion, far short of the expected surplus of $92.7 billion and down from a surplus of $101.3 billion in July.  Exports in August were up just 7.1% year-over-year, slowing markedly from their gain of 18.0% in the year to July and illustrating how weak demand overseas is weighing on the Chinese economy.  Perhaps more importantly, imports in August were up just 0.3% year-over-year, reflecting how factors like constant COVID-19 shutdowns and government clampdowns on sectors like technology and real estate are sapping the country’s own domestic demand.

Japan:  The yen continues to depreciate rapidly so far this morning, with the currency down some 1.9% from its close yesterday to trade at 144.77 per dollar.  If sustained, the drop in the yen today will be its biggest since June and will leave the currency down 19.8% year-to-date.  As long as the Federal Reserve and other major central banks continue to hike interest rates while the Bank of Japan holds rates steady, the yen could keep losing value.

U.S. Monetary Policy:  In an interview with the Financial Times, Richmond FRB President Barkin insisted that the Fed must lift interest rates to a level that restrains economic activity and keep them there until policymakers are convinced that inflation is subsiding.  Barkin’s statement underlines the message in Chair Powell’s recent speech at Jackson Hole.

• Barkin’s statement suggests investors should not discount the possibility that U.S. interest rates will be hiked much further and stay at high levels longer than many observers expect.
• Indeed, it is looking increasingly likely that the policymakers will implement another 75 bps rate hike at their next policy meeting occurring September 20-21.

U.S. Health Policy:  The federal government plans to recommend that people get COVID-19 boosters once a year, starting with the new shots that are rolling out right now.  The new guidance is a shift from the government’s current practice of issuing new advice every several months.  Authorities hope that coordinating COVID-19 shots with people’s annual flu shots will boost the number of people getting boosters.

U.S. Travel Industry:  According to the Transportation Security Administration, Labor Day 2022 was the first post-pandemic holiday in which airline travel surpassed its pre-pandemic high.  The TSA said 8.76 million travelers went through its checkpoints between Friday, September 2 and Monday, September 5, compared with 8.62 million passengers over the long holiday weekend in 2019.  The figures underscore how the travel industry in particular, and the service sector in general, continue to recover well on the back of pent-up demand.

U.S. Oil Industry:  In a public letter, conservative activist investor Vivek Ramaswamy has urged Chevron (CVX, $157.12) to be less beholden to ESG sentiment, slow its transition to renewable energy, and pump more oil to take advantage of today’s high prices.  Despite the influence Ramaswamy wields, it’s not clear whether Chevron or any other oil company will heed his call.  Nevertheless, it will be interesting to see if his call marks the beginning of stronger pushback against ESG investing orthodoxy.

U.S. Electricity Industry:  California Governor Newsome has warned that the state’s current heatwave is taxing the electricity grid and could lead to rolling blackouts.  According to Newsome, the state will maintain a number of emergency measures to reduce demand.  He also called on consumers to continue conserving electricity, a move that could have some negative impact on California’s economy this month.

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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, with a focus on Ukraine’s ongoing counteroffensive in the south of the country and the latest fallout for the world’s energy markets.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine:  Ukrainian forces continue to press their counteroffensive to retake the Russian-occupied city of Kherson in the country’s south, although their focus is still on degrading Russian logistics points and command centers with precision missile and artillery strikes rather than trying to seize large swaths of territory.  This carefully calibrated strategy appears to be working so far, although it’s still not clear how far it can take the Ukrainians.  In the meantime, Russian President Putin yesterday expressed his frustration with the war as he heaped praise on the ethnic Russian sympathizers who make up the forces raised in the Donbas provinces of Luhansk and Donetsk themselves, suggesting they were fighting better than Russia’s own forces.  At the same time, new reporting suggests the Russians are desperately seeking ways to import advanced computer chips to replenish their stockpiles of military equipment, after many more than anticipated have been destroyed in the war.

• In another sign of Ukraine’s success in its southern counteroffensive so far, Russia-allied separatists in occupied Kherson said they would delay their sham referendum on having the region join Russia due to the new fighting to retake the territory.  However, the officials have not provided a specific date when the vote will be held.
• Kremlin Press Secretary Dmitry Peskov said Russia will not resume natural gas shipments to Western Europe through the Nord Stream 1 pipeline until the “collective West” lifts its sanctions on Russia due to its invasion of Ukraine.  The statement confirms what many political leaders and analysts have long suspected, i.e., that the recent “maintenance” shutdowns of the pipeline have been a ruse to put pressure on the West and force it to acquiesce to the invasion.
• To deal with the shut-off of Russian gas supplies and the resulting price spike, the European Commission is set to propose an emergency cap on wholesale gas prices in the EU, with two potential options for implementing it.  One option involves putting a limit on what can be paid for gas imported from Russia. The second would introduce a capping system that would differ from country to country depending on their energy mix.
• To provide for backup energy supplies in case of a crunch this winter, the German government said two of the country’s three remaining nuclear generating plants will be kept on standby through April, rather than being shut down permanently at the end of the year as previously planned.  The decision highlights the rebounding global interest in nuclear power due to the war and the associated high energy prices around the world.
• In yet another response to Europe’s impending energy crunch as winter approaches, a number of major European utility firms have secured big state-backed credit lines to help them weather the crisis.

Global Oil Supply:  The Organization of the Petroleum Exporting Countries and its Russia-led partners yesterday agreed to cut their collective oil production by 100,000 barrels per day beginning next month, reversing an increase President Biden secured last month in a visit to Saudi Arabia.  Although the cut is small compared with the overall global scale of the oil market, it nevertheless represents a potent political statement that OPEC+ is willing to thwart U.S. preferences in order to buoy oil prices and push back against the West’s sanctions on Russia.

• Nevertheless, global oil prices continue to soften today, largely on concerns about yet another wave of coronavirus lockdowns in major cities in China.  Of course, broader concerns about rising interest rates and recessions in the major developed countries also continue to weigh on oil prices.
• At this writing, Brent crude is trading down approximately 2.6% on the day at $93.43 per barrel.  Prices also continue to soften for a range of other industrial commodities on concerns about Chinese lockdowns and recession in major developed countries.

United Kingdom:  Over the long weekend, Foreign Minister Liz Truss was finally declared the winner of the race to succeed Boris Johnson as Conservative Party leader, setting her to become prime minister today.  After naming her cabinet, Truss’s first order of business will be to finalize a plan to shield households and businesses from a doubling of energy prices in October if current rules remain in place.

• At a cost of almost £100 billion, the energy-price relief plan would freeze gas and electricity bills at the current typical annual cost of £1,971, while other measures would aim to protect businesses from catastrophic price rises.
• The rest of Truss’s economic agenda focuses on tax cuts and deregulation aimed at unleashing more energy development and industrial investment.
• In foreign policy, Truss has struck a tough position on Russia and vowed to stand up to Brussels in a row over post-Brexit trading arrangements in Northern Ireland.

Japan:  The yen’s recent weakness has accelerated sharply today, as the currency plunged 1.0% to a 24-year low of about 141.99 per dollar.  Traders ascribe today’s drop to an aggressive interest-rate hike by the Reserve Bank of Australia.  While the RBA and other major central banks hike interest rates to combat inflation, the Bank of Japan remains the outlier in its insistence on holding its policy extremely loose.

• Since the yen’s current weakening phase took hold in early 2021, the currency has lost approximately 26.9% of its value against the U.S. dollar.  The yen’s decline in 2022 to date now amounts to 19.8%
• As long as the Fed and other major central banks are hiking rates and the BoJ is holding its policy steady, the yen will remain at risk of further depreciation.

China:  An earthquake rating 6.8 on the Richter scale struck the southwestern province of Sichuan today, killing dozens and injuring hundreds.  The quake will compound the economic challenges facing Sichuan as it continues to deal with a major heatwave, drought, energy shortages, and COVID-19 lockdowns.

Chile:  Over the weekend, voters overwhelmingly rejected the country’s proposed new leftist constitution, with 62% voting against the law and 38% voting in favor of it.  The result is likely to buoy Chilean stocks in the near term, although left-wing President Boric has vowed to make a new effort at re-writing the constitution.

U.S. Bond Market:  According to Fitch Ratings, defaults on leveraged loans to below-investment-grade companies spiked to $6 billion in August, reaching their highest level since the midst of the pandemic in October 2020.  Since interest rates on the loans typically fluctuate with the market, the spike in defaults suggests that the Fed’s rate-hiking crusade is beginning to have a noticeable negative effect on junk issuers.  As the Fed continues to hike rates, we remain concerned that it will spark a bigger and broader bout of defaults among junk issuers.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Note: the markets and our office are closed on Monday, September 5, in observance of the Labor Day holiday. Our next report will be published on Tuesday, September 6.

Today’s Comment begins with a focus on how hawkish Fed policy has pushed the value of the dollar higher. Next, we review the latest developments in the Russia-Ukraine conflict, which includes our thoughts on a possible price cap on Russian commodities. The report concludes with an examination of China related risk and its potential impact on the global economy.

Strong Dollar: A possible 75 bps rate hike by the Federal Reserve at its next meeting has pushed the dollar to a 20-year high against global currencies.

• Fed officials this week hinted that the Fed would raise interest rates even if the country falls into recession. Cleveland Fed President and voting FOMC member Loretta Mester said that she expects rates to rise above 4% and stay at the level throughout 2023. On Thursday, Atlanta Fed President Raphael Bostic mirrored Mester’s sentiment and alluded to the bank possibly offloading mortgage-backed securities from its balance sheets. As the Fed continues to fight inflation, other central banks will face pressure to follow its lead.
• The yen sank below 140 for the first time in a quarter century. The currency’s drop against the dollar adds to speculation that the Bank of Japan will eventually tighten monetary policy. The currency’s depreciation against the dollar has contributed to the surge in Japan’s cost of living expenses due to the country’s heavy reliance on imports. Despite investors’ concerns, BOJ Governor Haruhiko Kuroda has not indicated that he is ready to reverse course on central bank policy. His reluctance is likely related to the country’s heavy government debt burden. Japan’s government debt is 266% of GDP and is the highest among developed countries. The lack of BOJ action suggests that the yen will continue to drop against the dollar, especially as the Fed raises rates.
• Slow economic activity and tighter U.S. monetary policy have also tumbled the pound. The currency has depreciated 14% against the U.S. dollar this year and dipped below $1.15 for the first time since March 2020. We predict that the depreciation in the currency will continue as the economy heads into recession. It is unclear as to whether it will continue to raise rates in a downturn, but the recent comments from the Bank of England suggest it might. On Thursday, the BOE announced that it intends to cap yields on its bonds to prevent financial market disruptions and likely to prevent surging borrowing costs. By restricting the interest rate on the long duration while it already has control over its short end through its policy rate, the bank would effectively embrace yield curve control. The move to control yields would mean that the bank would have less control over its exchange rates, therefore leading to further depreciation. As a result, we agree with Capital Economics’ forecast that the pound will fall to $1.05 by the middle of 2023.
  • The country’s spat with the European Union also threatens the currency. The two sides are at loggerheads over the Northern Ireland Protocol. On Thursday, Brussels warned U.K. Foreign Secretary and prime minister frontrunner Liz Truss that the EU will not engage in Brexit negotiations unless it removes a bill allowing London to scrap the NI protocol unilaterally. Although a complete break between the EU and U.K. will hurt both parties, the latter will feel the brunt of the damage.

 Russia- Ukraine Update: The war in Ukraine continues to show that the world is starting to form regional blocs.

• G-7 countries have moved one step closer to a formal agreement to cap Russian oil The deal is designed to keep oil available while also slashing Russia’s export revenue. That said, there is still a hurdle which the group needs to overcome before the agreement is official. The EU would have to amend its sixth round of sanctions prohibiting oil purchases after December 5. In response to the deal, Russia has vowed not to sell its commodities to countries that impose price controls. Assuming Russia does not stop oil deliveries, the agreement should be bearish for commodity prices as it would expand the oil supply.
  • European Commission president Ursula von der Leyen has hinted that Europe could also entertain a price cap on Russian gas.
• Russia is exploring the purchase of $70 billion in yuan and other “friendly” currencies to prevent the ruble’s appreciation. The surge in the currency’s value was fueled by government measures to limit its sales and the increased demand for Russian commodities. The currency’s recent strength has been a double-edged sword. It has provided some price stability while making Russian exports relatively more expensive. The war in Ukraine has shown how dangerous it is for rival countries to hold U.S. dollars as foreign reserves. Thus, we expect more countries will follow Russia’s lead and begin to diversify their respective holdings of FX reserves.

• Despite concerns of a nuclear catastrophe, fighting continues to occur near the Zaporizhzhia nuclear power plant. The UN nuclear agency chief warned that the physical integrity of the site was violated due to frequent attacks around the area. Russia has controlled the site since March, but both sides have accused the other of possibly triggering a nuclear disaster in Europe. A potential accident at the power plant is a significant global risk as it could threaten the food supply, contaminate water, and lead to many civilian deaths.

 China Risks: New lockdowns and friction with the West will make the China a difficult place to invest.

• The lockdown in Chengdu has sparked concerns that the Chinese economy will weigh on global growth. The lockdown in a city of over 21 million has led to a panic in nearby areas. In Shenzhen, there were reports of frantic buying as locals feared their city could be next. Despite reassurances from government officials in Shenzhen that it will not impose a lockdown, the rise in cases has already led to new restrictions. Additional COVID restrictions will likely weigh on the Chinese economy and make it more difficult for companies to sell to consumers within the country.
• S. Senators have proposed a bill that will make it harder for Chinese firms to raise capital on American exchanges. The proposal would target Variable Interest Entities (VEI) used by Chinese companies to list abroad. If passed, the bill would be the latest salvo launched at American investors that fund Chinese companies and would reinforce our view that the two major economies are decoupling. The lack of U.S. investment suggests that Chinese firms could struggle to find outside financing, which may prevent its economy from growing. Although it is unclear how much support the bill has in Congress, the legislation does support our thesis that U.S. policymakers are becoming more hawkish toward China. Hence, companies with exposure to the region may be less attractive.
• American support for Taiwan is another example of this decoupling trend continuing. On Thursday, China sent 23 military aircraft across the median line of the Taiwan Strait. Chinese intimidation tactics suggest that Beijing is less tolerant of the West’s interaction with the island democracy. We believe that China will likely take a tougher stance against countries interacting with Taiwan after the National Congress of the Chinese Communist Party which begins on October 16.

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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 a discussion of the September effect. Next, we review possible headwinds in Europe. We end the report by examining the rivalry between the West, Russia, and China.

Wait, It Gets Worse? September is generally the worst month for equity performance. Known as the September effect, the S&P 500 has averaged a 1% seasonal loss for the month, dating back to 1928.

• There are many reasons for this decline but the theories most frequently cited are parents selling off financial assets to pay for their kids’ college tuition, investors adjusting portfolios after returning from vacation, and/or tax-loss harvesting from mutual funds. Despite the historical record, it is essential to note that this average is biased as September has been a harbinger of adverse market events. For example, the fall of Lehman Brothers, the collapse of Long-Term Capital Management, and the terrorist attack on the World Trade Center all happened in September. These events suggest that the historical average might not accurately reflect the month’s performance. In our view, the median provides the best picture of the long-term seasonal performance. In this instance the S&P 500 median performance for September (1.02%) outperforms both February (0.76%) and May (0.49%). That said, there are still several headwinds that investors should consider for this month.
• Hawkish monetary policy remains a threat to equity performance. The European Central Bank is scheduled to meet on September 8, while the Federal Reserve is set to meet a few weeks later. The central bank officials are expected to make substantial hikes in their benchmark rates at their respective meetings. Persistently low unemployment rates and stubbornly high inflation in both the U.S. and the euro area fuel the need for decisive central bank action. However, the more these institutions tighten, the higher the likelihood that these countries will fall into recession. The sell-off in August will likely soften the blow of the interest hikes from both banks.
• Another significant headwind comes from China. The country has implemented a new lockdown in Chengdu. The city’s new restrictions suggest that global demand and production could slow in September as the world’s second largest economy struggles to contain COVID.
  • The latest PMI for China showed that manufacturing output contracted after the index fell to 49.4 from 50.2 in July.

 Financial markets are full of smoke and mirrors, and therefore, what can look like a historical trend could be an illusion. Although there are plenty of reasons to be skeptical, we believe investment decisions should be based on facts rather than market myths.

 European Risks: Headwinds in Europe will persist as business conditions in the region deteriorate due to tight monetary policy and elevated inflation.

• Traders ratcheted up their bets that the European Central Bank will be more aggressive after yesterday’s Consumer Price Index (CPI) report showed inflation hitting a new high in August. The latest CPI report for the eurozone showed that headline inflation jumped 9.1% from the previous year, while core inflation rose 4.3%. The price statistics suggest that inflation has spread into other sectors of the economy outside of energy and food. The yield spread on German and Italian bonds, a gauge for financial stress within the eurozone, has widened to 2.33%, closing in on this year’s peak of 2.42%.
  • The strong CPI report places more pressure on the ECB to take aggressive actions to curb inflation. On Friday, Fed Chair Jerome Powell asserted that the Fed would keep rates elevated for longer. His statement led to a surge in the Euro Overnight Indexed Swaps due to concerns that the ECB would have to follow suit. Euro Overnight Indexed Swaps show that investors predict that the ECB will support a 75 bps hike in October.
• The European Union proposed new regulations on smartphone production to curb tech waste. Suppliers of smartphones will be required to provide at least 15 different parts for a minimum of five years after a phone is released. Additionally, the EU will require batteries to last through at least 500 full charges without deteriorating below 83% of their capacity. The new directive will hurt the profits of electronics firms as it will reduce the need for consumers to purchase new phones and make it more difficult for firms to profit from repairs. The new rules created by the EU will likely pave the way for a global benchmark and could force tech companies to change their business models.
• Elevated energy prices continue to slow down the European economy. German firms have begun cutting production to cope with costlier energy, and French manufacturers fear they could be next, barring assistance from the EU. Energy prices in Europe have risen 300% in 2022, and a sustained slowdown in manufacturing production threatens to push the region into recession.
  • The latest Purchase Manager Index report for the eurozone showed that the contraction in factory output worsened in August after it slipped to 49.6 from 49.8 in the previous month.

2022 has not been kind to Europe, and we do not think this will change anytime soon. Tight monetary policy, elevated inflation, and the war in Ukraine will make it difficult for the region to avoid recession. As a result, we suggest that investors should be very tactical if they plan to invest in the area.

Tit-For-Tat: The back and forth between the West and its rivals continue to support our view that the world economy is moving away from global markets.

• The deterioration in the EU-Russia relationship remains a prominent risk. On Wednesday, the EU tightened visa restrictions on Russians, and there was even discussion about an outright ban. Although there is much resistance to a visa embargo, the move suggests that EU restrictions could target ordinary Russians. However, assuming this trend continues, we expect Moscow to ramp up its nationalistic rhetoric as it portrays the war as a Western attack on Russia. There is also evidence that talks about punishing Russia over its invasion within the EU could lead to more infighting.
• Ukrainian forces have taken a more creative approach in their counter-offensive against Russia. Although Russian troops have portrayed Ukraine’s new line of attacks as failing instantly, analysts theorized that those perceived failures might be strategic feints and misdirection to exploit Russian weaknesses If analysts are correct, the tactics will make it difficult to discern legitimate Ukrainian failures. It seems that Russia might also be suspicious. Moscow has asked media outlets not to report on the counter-offensive. Therefore, it will take some time before we can discern whether the new counterattack was a success.
• In addition to Europe and Russia escalation, the U.S. also made moves to target Beijing. On Wednesday, the U.S. ordered software company Nvidia (NVDA, $150.24) not to sell its AI semiconductors to China. The decision is another example of how the U.S. plans to contain the growth of its Indo-Pacific rival through export controls. These restrictions on U.S. exports will encourage Beijing to invest in its domestic industries while denying American firms a vast export market. Nvidia warned that the new rules would cost it millions in revenue.
  • On an unrelated note, Taiwan has shot down a Chinese drone over the Kinmen Islands. Although there is no sign that China will retaliate, we suspect the shooting of drones may serve as a pretext for escalation in the future.

Rivalries among major powers pose the most considerable long-term risk. The last time we saw similar developments was in the run-up to WWI. Although we are not forecasting a large-scale war, we believe that global tensions could force countries to accelerate the trend away from globalization.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including the latest on Ukraine’s new counteroffensive to push the Russians out of the southern city of Kherson.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a potentially dangerous new commitment by Taiwan to defend itself against Chinese military incursions.  We wrap up with a few additional words on the stock market’s reaction to Federal Reserve Chair Powell’s hawkish speech last Friday in Jackson Hole.

Russia-Ukraine:  The Ukrainian counteroffensive to push the Russians out of the southern Ukrainian city of Kherson continues with ground forces pushing against the Russians’ front lines and long-range missiles and artillery attacking their ammunition depots, troop concentrations, and lines of communication far behind the lines.  Meanwhile, the Russians are trying to reinforce their most vulnerable defensive positions by ratcheting down their offensives in the northeastern Donbas region and redeploying their best and most experienced troops southward toward the Kherson battlefield.  We believe it is far too early to gauge the success and likely outcome of the Ukrainians’ counterattack.  Indeed, their methodical approach to the offensive so far suggests it could play out over an extended period.  We may not know the true outcome of the offensive for several weeks.

• Retaking Kherson would provide major military, economic, and political benefits to Kyiv.  For example, seizing the city and pushing the Russians out of the region would reduce the Kremlin’s control over Ukraine’s coastline and could help reopen Ukraine’s trade flows through the Black Sea.  A victory would also help convince Western governments to keep supporting Ukraine in the fight.
• Separately, U.S. officials stated that Russia has picked up the first shipments of what could be dozens of Iranian drones designed to attack radars, artillery pieces, and other military targets.  The drones are part of a recent deal to help Russia in its war with Ukraine.  However, Russian tests have reportedly discovered that the drones malfunction frequently and may not be very effective in Ukraine’s congested battle space in which Ukraine is fielding many modern, sophisticated weapons provided by the West.
• Finally, as anticipated, Russia has once again shut off natural gas shipments through its Nord Stream 1 pipeline to Western Europe, ostensibly for “maintenance.”  European officials remain in the dark as to whether the shipments will truly resume on Saturday as the Russians say.  The move has boosted European gas prices by another 5.5% so far this morning.

Russia:  Mikhail Gorbachev, the former leader of the Soviet Union whose efforts to reform the Communist state led to its dissolution, died yesterday in Moscow at the age of 91.  Although Gorbachev was instrumental in ending the Cold War and bringing down the USSR peacefully, he remained vilified by many in Russia because of the economic chaos the breakup caused in the early 1990s.

European Bond Market:  Based on the Bloomberg Pan-European Aggregate Total Return Index, Europe’s market for high-grade government and corporate debt was down 5.3% for the month through yesterday, putting it on track to post its worst month since 1999.  As in the U.S., bonds in Europe have been hammered by rapid consumer price inflation, aggressive interest-rate hikes by central banks, and fears of impending recessions.

• Coupled with the downtrend in stock values so far this year, the fall in bond values has illustrated how the traditional portfolio benchmark of 60% stocks and 40% bonds can falter in a period of high inflation and rising interest rates.  Better performance this year would have come from a portfolio putting less emphasis on bonds and more on commodities, as many of our asset allocation strategies do.
• Illustrating the continuing challenging environment in Europe, the Eurozone’s August consumer price index was up 9.1% year-over-year, marking the region’s highest inflation rate since records began in 1997 and accelerating from the gain of 8.9% in the year to July.

China:  At long last, Communist Party leaders have decided their 20^th National Congress will begin on October 16.  The meeting will likely be historic, given that President Xi is expected to use it to cement his grip on power by being named to a third consecutive term.

• Xi will also use the meeting to announce major new initiatives in international relations, economics, and social policy.
• In the run up to the meeting over the next six weeks, we suspect Chinese officials will pull out all the stops to make the economy look stable and robust, producing positive vibes for Xi.  At the same time, officials are likely to crack down hard on any sign of political unrest that could mar the proceeding.

China-Taiwan:  Today, in a development that could dramatically raise the risk of a military clash, Taiwan warned that it will defend itself and strike back as China ramps up its military incursions in the island’s territorial airspace and waters.  Taiwan has also reportedly begun targeting Chinese drones overflying its outlying islands.  The more assertive approach suggests Taipei is trying to balance the risk of sparking outright conflict against its desire to block China from demonstrating effective control over nearby waters and airspace or even Taiwanese territory.

• The risk is that continued shooting at Chinese drones, or destroying one, could invite retaliation in kind from the Chinese.
• The development is a reminder that China-Taiwanese relations remain a major geopolitical risk for investors, especially as any conflict would likely draw in the U.S., Japan, and other Western allies.

China-Solomon Islands-United States:  After the Solomon Islands recently refused to allow a U.S. Coastguard ship to dock for supplies, President Sogavare said his government will temporarily bar ships from all foreign navies while it reviews its approval processes.  The move deepens concerns that China is now firmly pulling the international policy strings within the Solomon Islands government.  Sogavare struck a secretive new security deal with Beijing earlier this year, presumably in return for Beijing’s support in keeping him in power.

U.S. Monetary Policy:  Yesterday, New York FRB President Williams warned that with the economic momentum still strong and the labor market tight, the Fed will not only need to boost interest rates into restrictive territory, but it will also have to hold them there for some time in order to bring inflation back to the policymakers’ target of 2%.

• Investors now seem to accept that the Fed plans to keep ratcheting up interest rates for the time being, but the statement from Williams may be designed to show that the policymakers also aren’t likely to pivot to rate cuts nearly as soon as some investors think.
• As investors re-price the likely trajectory of interest rates, stocks and other risk assets, along with bonds, continue to depreciate.

U.S. Labor Market:  With companies still faced with labor shortages despite the Fed’s effort to slow economic growth, some are trying to lure workers with what could be a relatively low-cost perk.  Some manufacturers, hotels, warehouses, and restaurants are allowing new hires to work just a few days a week, take on four-hour shifts, or even choose new hours daily using phone apps.  In other words, on-site workers are starting to gain the same flexibility enjoyed by remote workers.

U.S. Stock Market:  Finally, now that investors have been able to digest Fed Chair Powell’s hawkish speech at Jackson Hole last Friday, we thought it would be helpful to provide some perspective on where monetary policy and the stock market are probably headed.  The overall picture that we see is that the market had become way too optimistic that the monetary policymakers would stop hiking interest rates and even pivot to rate cuts at the slightest sign of economic weakness.  We suspect there is something of a consensus that the incoming economic data will show significant weakness around the end of the year or in the first quarter of 2023.  Prior to Friday, that weak data would have suggested the hoped-for pivot was at hand.  It would have been a classic case of thinking that “bad news is bullish.”  Now, however, Powell’s commitment to hiking rates further has sunk in, and investors over the last few days have adopted the view that “good news is bearish,” and “bad news is just as bearish.”

• A case in point was yesterday’s JOLTS report showing a strengthening labor market.  That good data sparked yet another sell-off in equities as investors mulled over the implications now that the “Fed put” is gone.
• We would note that a range of technical indicators are also pointing to further weakness in the market.  For example, the S&P 500 price index is now trading below its 20-, 50-, and 200-day moving averages.  The index is now also threatening to fall below a key support level at approximately 3,920.  Momentum indicators on the index are also weakening.
• All in all, we would say Powell has succeeded in convincing investors that the Fed won’t come riding to the rescue if the economy falters.  Indeed, to re-establish the Fed’s inflation-fighting bona fides, Powell may actually need a recession so he can show just how much pain he’s willing to inflict.  He may even need to let the recession reach a certain level of severity, perhaps to the point of risking a financial crisis.  After all, the issue isn’t just bringing down the inflation number, but rebuilding the Fed’s credibility.
• The implication is that monetary headwinds to the stock market are likely to intensify and continue longer than investors previously thought.  It is probably far too early to get bullish on stocks at this point.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where the key news is Ukraine’s official announcement that it has launched its long-awaited counteroffensive to retake the southern city of Kherson from its Russian occupiers.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, many of which are focused on political and economic turmoil in the emerging markets.

Russia-Ukraine:  In what could be one of the key moments in the war so far, Ukrainian officials announced the beginning of their big counteroffensive to retake the southern Ukrainian city of Kherson.  Although Kyiv has been taking preparatory steps for that attack for many weeks, it has been unclear whether the signaled counteroffensive was really going to happen, or whether it was just a feint.  In any case, Ukrainian forces have reportedly pushed the Russians out of a number of villages west, northwest, and northeast of Kherson and continue to pressure Russian lines elsewhere in the region.  Despite the Ukrainian counteroffensive in the south, Russian forces continue to launch missile and artillery strikes against both civilian and military targets throughout Ukraine.

• Meanwhile, the International Atomic Energy Agency said its mission to assess the safety and condition of the Zaporizhzhia Nuclear Power Plant in eastern Ukraine has now departed.  It is not known when the team will actually be able to visit the plant, and how completely it will be able to examine its status.
• On the energy front, European Commission President von der Leyen said the EU will soon announce emergency measures that will decouple end-user energy prices from the Continent’s soaring natural gas prices.  She also stated that the EU will later introduce a range of longer-term structural reforms to the EU’s energy market.
  • Separately, Russian gas giant Gazprom said it will further cut deliveries to major French utility Engie (ENGIY, $12.27) over an alleged contract dispute.  The new cut in deliveries is due to take effect today.
  • Russia also plans to shut down its Nord Stream 1 gas pipeline to Europe again tomorrow for what it calls maintenance. The shutdown is due to last until Saturday, although European officials fear Russia could keep it in place for longer in order to further ratchet up the pressure on Europe.
  • The cutoffs underscore Russia’s continued willingness to weaponize its energy exports and highlights Europe’s vulnerabilities, even in countries that rely relatively little on Russia, like France.

Eurozone:  ECB Chief Economist Philip Lane said the central bank should strive to hike interest rates in steady, small increments.  His statement suggests he may push back against some ECB officials’ calls for a big 75 bps hike at their policy meeting next week.

China:  Officials have discovered a new coronavirus subvariant, BF.15, in multiple people in the southern Chinese technology hub of Shenzhen, prompting the city to close subway stations, ban restaurant dining, and lock down shopping malls.  Local officials promise the shutdowns won’t become worse, but the outbreak raises new fears of an important new lockdown under President Xi’s Zero-COVID policy.

Iraq:  After ten months of failed negotiations to form a new government, influential Muslim cleric Muqtada al-Sadr said he will quit politics; however, the announcement sparked rioting by his supporters, resulting in dozens of deaths in Baghdad yesterday.  The incident suggests Iraq will continue to face political violence and instability for the near term.

Pakistan:  As predicted in our Comment yesterday, the IMF has approved the resuming of lending to Pakistan under an existing $7 billion deal that had been stalled because of the government’s reluctance to implement austerity policies.  Securing the new funding means Islamabad has now pushed off the threat of a near-term default, although it still faces financial risks in the medium term because of issues like its fractious political dynamics and recent flooding.

Sri Lanka:  Amid Sri Lanka’s ongoing negotiations for a bailout loan from the IMF following its default in May, President Wickremesinghe announced plans for further austerity measures to secure a deal.  The plans would further increase taxes (including hiking the value added tax from 12% to 15%), strengthen central bank independence, and reallocate government funds toward relief programs.

Colombia-Venezuela:  Colombia’s new leftist president, Gustavo Petro, has re-established diplomatic relations between his country and Venezuela.  The move leaves the U.S., Canada, and Brazil as the only large countries in the hemisphere that no longer recognize Venezuela’s authoritarian government.

U.S. Financial Payments System:  Yesterday, Federal Reserve Vice Chair Brainard said the central bank’s new “FedNow” system for faster payments will be live by next summer.  The new system will allow bill payments, paychecks, and other common consumer or business transfers to be available quickly and around-the-clock, versus the existing system that is closed on weekends and can, at times, take several days before funds become available.

U.S. Manufacturing:  Spurred by recent legislation that provides a range of incentives and subsidies for renewable energy, top U.S. solar panel maker First Solar (FSLR, $121.69) said it will spend as much as $1.2 billion to boost its domestic manufacturing capacity by around 75%.  The new capital investment will be targeted toward a new facility in the Southeast and upgrading an existing facility in Ohio.

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