by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment will begin with a discussion on Thursday’s ECB announcement and what it could mean for markets in the future. Next, we examine Russia’s notable military slowdown in Ukraine and other developments in the war. The report concludes with various international news stories that have the potential to influence markets.

 ECB Moment: A higher than expected rate rise, a new policy tool, and the end of forward guidance suggest that the ECB wants more flexibility during its tightening cycle as it aims to tackle rising inflation and growing fragmentation.

• ECB: The European Central Bank unanimously agreed to create a bond-purchasing tool to prevent borrowing costs among member countries from diverging. The decision to develop a tool likely played a role in the central bank’s decision to hike rates by 50 bps instead of the anticipated 25 bps. However, the market’s reaction was moderate as the ECB remained relatively ambiguous about its next step forward. The euro initially strengthened against the dollar but weakened later in the day as investors were wary of the bank’s commitment to the bond-purchase program. The spread between 10-year Italian and German bonds climbed as high as 250 bps on Thursday before settling around 240 bps.
• Whatever It Takes, Kind of? Unlike predecessor Mario Draghi, current European Central Bank President Christine Lagarde failed to reassure investors that the central bank was willing to do “whatever it takes” to preserve the euro. When describing the new anti-fragmentation tool, she stated that the central bank could use it to buy an unlimited number of bonds to prevent unwanted market dynamics, but later emphasized that she hopes never to have to use the tool. This apparent lack of commitment could mean that investors will likely be paying close attention to snap elections in Italy to determine whether they will continue to hold on to Italian bonds.
  • Italian Snap Elections: President Sergio Mattarella officially called for snap elections to take place on September 25. A conservative right-wing bloc led by the populist party Brothers of Italy is expected to win a majority of seats, setting up a possible clash between the EU and Italy over economic reforms. The heavily debt-laden Italy is set to receive 200 billion euros of aid on the condition that it makes structural changes to its economy. A eurosceptic government could slow these reforms, thus leading to a sell-off in the country’s bonds by risk-averse investors.
• End of Forward Guidance: During the ECB press conference, Lagarde implied that the bank is set to abandon its forward-guidance policy as it seeks to maintain flexibility in its policy decisions. The decision to raise rates by 50 bps went against its forward guidance of 25 bps. The decision to do away with forward guidance is related to the central bank’s having to decide on appropriate monetary policy that will allow it to control inflation and prevent a recession. The death of forward guidance suggests that the market could be very responsive to surprises in the economic data.

The biggest unknown is how the European Central Bank will respond to rising uncertainty in Italy. If the country elects a eurosceptic government, investors will likely sell off Italian bonds in droves, thus pressuring the bank to intervene to keep borrowing costs downs. At this point, it is unclear how the ECB could respond to an Italian government that refuses to comply with mandated reforms. However, failure to prevent bond yields from spreading will likely weigh on the euro and could sink the currency to parity with the U.S. dollar or possibly lower.

Russia-Ukraine: The two sides finally agreed to allow Ukrainian wheat to be exported out of the Black Sea; however, the war does not appear to be close to ending. Meanwhile, Russia has been able to display its influence around the world.

• Russia Vulnerable: The lack of available forces and weapons has led to a slowdown in the Russian offensive in Ukraine. Since taking over Lysychansk, Russian troops have not made much progress which has led to speculation that Russia may be losing steam. Leader of the U.K. secret intelligence service Richard Moore predicted that Ukrainian troops would be able to mount a strong counter-offensive against Russian forces in the coming weeks. In addition, he argued that the Russian military would eventually have to pause due to logistical and supply reasons. His comments suggest that the West plans to support Ukraine’s right to defend itself from the Russian invasion. As a result, this could mean energy uncertainty within Europe is likely to persist.
• Russian Friends: Putin and Mohammed bin Salman met on Thursday in a sign of the close ties between Russia and Saudi Arabia. The meeting came several days after Biden met with MBS, and the juxtaposition showed the gap of influence between the U.S. and Russia in the Middle East. Earlier this week, Putin met with the leadership of Iran to discuss drone purchases. Meanwhile, Russian Foreign Minister Sergey Lavrov is set to meet with several African leaders next week to remind the continent of its long-standing ties with Russia, particularly during the colonial period.
• Wheat Exports: Russia agreed to allow Ukrainian grain exports to leave the Black Sea. The deal will allow the shipment of wheat out of Ukrainian ports. This release of wheat will likely help reduce grain prices and prevent a potential global famine. However, there are still concerns that Russia could renege on its commitment.

As we mentioned in our June 6 Bi-Weekly Geopolitical Report, the world may be breaking into geopolitical and economic blocs. In the report, we showed that the Russia-China bloc likely has the advantage when it comes to supply, which it could use as leverage in disputes with the West.

International Uncertainty: Rising COVID cases, heightened security risks, and trade disputes continue to add to global-growth uncertainty.

• COVID Cases: COVID cases are rising again. In Japan, daily cases topped 30,000 for the first time on Thursday. Meanwhile, infections in Europe have tripled in the last six weeks. President Biden has even contracted the virus. The new variant is proving to be more elusive and contagious than its predecessors; however, it is not creating the same level of economic disruptions.
• Pelosi’s Visit to Taiwan: Tensions are rising between the U.S. and China due to House Speaker Nancy Pelosi’s plan to travel to Taiwan in August. Beijing has warned that it would forcefully respond if she were to travel to the sovereign island. Although it isn’t clear what China would do in response, President Biden cautioned Pelosi that the Pentagon does not think the trip is a good idea.
• Japanese Defense Spending: Rising concerns over national security have led the Japanese government to ramp up its defense spending. Its latest security assessment cited the rising military cooperation between Russia and China as a reason to increase its military capabilities.
• USMCA Spat: Mexico may be penalized $10 to $30 billion over its decision to prioritize its state-owned energy company over private renewable companies. The source of the dispute is related to Mexico’s decision to amend legislation to favor power distribution to state-owned CFE. The law change has led foreign firms to be shut out of Mexico’s energy sector. Canada and the U.S. have requested dispute-settlement talks with Mexico. If all parties cannot agree on a settlement, the U.S. and Canada could hit Mexico with tariffs.

Ongoing disputes between countries and rising COVID cases will lead to some international uncertainty but will be unlikely to have an impact on markets in the short-term. Although the rise in COVID cases is concerning, countries are more prepared to deal with them currently than in the past. Meanwhile, the trade dispute with Mexico and increased Japanese defense spending likely are not significant today, but they have the potential to be important in the future, especially if Mexico decides to leave the USMCA or if Japan becomes more assertive in its foreign policy. However, our biggest concern is that Pelosi’s trip to Taiwan will likely lead to deteriorating U.S. and China relations and could further accelerate the decoupling of the two major economies.

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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 European Central Bank’s decision to raise rates by 50 bps. Next, we examine changes in governments in the U.K. and Italy, followed by an update on the Russia-Ukraine war. The report ends with a review of the warning signs of a possible downturn in the U.S. economy.

 Central Bank News:  Under pressure due to rising energy prices, central banks are being forced to choose whether they will prioritize economic growth or price stability as they set their monetary policy.

• European Central Bank: The ECB raised rates by 50 bps for the first time in 11 years as the EU looks to tame historically high inflation. The hike was above expectations of 25 bps. In addition to tightening policy, the ECB unveiled the Transmission Protection Instrument (TPI) designed to combat fragmentation. The combined rate increase and new fragmentation tool did not lead to panic from investors. After the rate news, the euro strengthened against the dollar, while the spread between Italian and German 10-year bond spreads widened by 9 bps from 223 bps to 232 bps.
• • The ECB stated that the new tool will not be limited by “ex-ante” restrictions suggesting that the bank has not put a cap on the level of intervention.
• Bank of Japan: The BOJ continues to defy expectations by continuing its ultra-low interest rate policy despite rising inflation. The central bank expects core CPI, which excludes food, to rise 2.3% from the prior year. BOJ Governor Haruhiko Kuroda dismissed the possibility of raising rates as the country recovers from the pandemic. The decision to maintain its monetary policy suggests that the yen’s weakness against the dollar will continue for the foreseeable future. Moreover, the currency’s recent depreciation has exacerbated its inflation problem as rising global commodity prices, which are elevated in dollar terms, make it difficult for Japanese firms and households to control costs.

Moving away from negative rates will be difficult for both the ECB and BOJ to navigate. The BOJ’s burgeoning debt burden limits its ability to raise rates. Meanwhile, the ECB needs to ensure that borrowing costs remain close among EU members to prevent a break-up of the bloc. That said, it is unlikely that the moves by either central bank will calm market concerns as rising inflation threatens both countries’ economic outlooks. At this time, we view the investing environment for Japan and Europe as risky.

Shake Up in Europe:  Leadership changes in Italy and the U.K. will likely not have an impact on the Ukraine war but could lead to more friction within the western alliance.

• Italian Crisis: Italian Prime Minister Mario Draghi was forced to resign on Wednesday after several key parties within his coalition boycotted a no-confidence vote. Draghi’s departure will plunge the country into political turmoil as investors fret over the possibility of a less market-friendly Italian government. Italian President Sergio Mattarella is expected to hold snap elections in early 2023. At this time, recent polls suggest that the center-right bloc led by the populist Brothers of Italy will likely take over the government. The unfortunate exit of Draghi will probably weigh on Italian equities as it appears that a new government could be less friendly toward the European Union.
• U.K. Premiership: Foreign Secretary Liz Truss and former Finance Minister Rishi Sunak are set to face off in the final round of Tory voting to become the leader of the party and the U.K.’s next prime minister. Sunak, who has led all voting rounds, vowed to maintain taxes at current levels, while his opponent Truss is running on a platform of deregulation and tax cuts. The result of the final vote will be released on September 5, with betting sites showing Truss, a notable Brexiteer, as a favorite to win.

The change in government in the U.K. should be favorable to British equities as it may provide some political calm. However, the rise of eurosceptics in both U.K. and Italy could lead to renewed clashes with the European Union.

Russia-Ukraine: Russia’s push for more territory and the West’s continued backing of Ukraine suggest that the geopolitical risks from the war will likely persist.

• Moscow Wants More: In a supposed shift, Russia declared that it would take complete control over regions outside of eastern Ukraine, including the Kherson and Zaporizhzhia regions in the south. Earlier in the year, Moscow stated that its goal was to “liberate” the east Donbas border region. After several months of fighting, Moscow claims that its objective has changed because Kyiv refused to agree to peace talks. The move by Moscow to expand its geographical aims was not surprising. On Tuesday, the White House warned that Russia had plans to annex southern parts of Ukraine.
• Russian Aims: Russia’s desire to expand its gains into areas within Ukraine is likely a negotiation tactic. Although it has had some recent success over the last several weeks, the West’s delivery of long-range missiles to Ukraine has opened Russia up to a fierce counter-offensive. Ukraine’s weapon capabilities have ratcheted up the cost for Russian forces to hold ground in newly gained territory. As the war continues, Russia will be inclined to annex the freshly controlled regions to strengthen its leverage against Ukraine and secure support at home.
  • The Paris Club, a group of international creditors, suspended Ukrainian debt service until at least the end of 2023. The move will save Ukraine around $6 billion over the next two years and will likely prevent the country from defaulting on its debt.
  • The White House may provide Ukraine with fighter jets and the training to operate them. The measure would drastically increase the West’s war involvement, and possibly escalate tension with Russia.
  • Gas flows from the Nord Stream 1 pipeline restarted on Thursday after a ten-day annual maintenance break. There was concern that the gas flow would slow after the pipeline returned online; however, orders indicate that flows are on pace to return to 40% of the capacity level reached before maintenance.
  • The U.S. is expected to impose a price cap on Russian oil in December as the EU prepares to impose a ban on companies insuring Russian vessels delivering the commodity.

Warning Signs:  Growing reports of a slowdown in hiring, a cooling housing market, and weaker consumer spending suggest the economy may be headed toward a downturn.

• Labor Market: More companies are announcing plans to either reduce hiring or lay off workers as economic conditions deteriorate. Ford (F, $12.73) is expected to cut as many as 8,000 roles as it shifts its focus away from internal combustion engines and toward electric vehicles. Meanwhile, tech companies Alphabet (GOOG, $113.90), Lyft (LYFT, $14.07), and Microsoft (MSFT, $262.27) are all set to reduce hiring.
• Housing Market: Existing home sales fell for the fifth consecutive month in June as high mortgage rates and residential prices made it harder for potential home buyers to enter the market. Existing home sales dipped 5.4% from the prior year in June, while the median price for existing homes rose 13.4% in the same month.

• Spending Slowdown: Higher prices may lead to a broader consumption In Q1, major retailers such as Walmart and Target warned that households were shifting their preference away from discretionary products in favor of staple goods. However, recent data collected by Bloomberg in Q2 suggests that consumers have even cut the purchase of necessities such as shampoo and diapers.

As the economy begins to slow, we believe that real estate may be a good place to hide. Although there is a decline in demand, the lack of supply will be likely to keep property prices relatively elevated.

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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.  Both sides in the war appear to be ramping up their attacks again, but the key developments today revolve around Europe’s intensifying efforts to prepare for a complete cut-off of Russian natural gas supplies.  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 decision by Italian Prime Minister Draghi to rescind his resignation offer from last week if the parties in his unity government accept his economic reforms.

Russia-Ukraine:  In Ukraine’s eastern Donbas region, Russian forces are once again staging modest, localized ground attacks under the cover of artillery fire and making slow, creeping territorial gains, but Ukrainian forces are putting up stiff resistance with the aid of new weapons from the West.  The Ukrainians continue to show signs of preparing for a significant counteroffensive to retake the southern city of Kherson by using advance Western missile systems to strike a bridge linking that occupied city to other Russian forces on the south side of the Dnieper River.  Meanwhile, nationalist military bloggers in Russia are increasingly pressuring the Kremlin to fully mobilize the country and to focus on much more extensive war aims.  Although Russian President Putin could choose to ignore those calls, there is some chance that he could use them to provide political cover for a more extensive mobilization and a shift back to maximalist war aims.  Separately, the White House warned that Russia is preparing to annex the Ukrainian territory it occupies by autumn.  A likely date for a sham referendum in the occupied territory is September 11, which is a unified election date for provincial and local elections in Russia.

• Amid fears that Russia won’t restart its deliveries of natural gas to Western Europe after the Nord Stream 1 pipeline ends its maintenance outage tomorrow, President Putin last night hinted that the country’s exports will begin again on Friday.  However, he noted that gas deliveries could soon be cut to just 20% of capacity if sanctioned pipeline equipment from the West isn’t delivered – a likely pretext for further energy blackmail in the future.
• As the European Commission becomes more convinced that Russia could completely cut off its natural gas exports to retaliate for the West’s support of Ukraine, it today proposed new emergency powers allowing it to force EU countries to reduce their gas consumption in the event of devastating supply shortages.
  • The plan calls for EU countries to voluntarily curb their gas consumption by 15% over the next eight months to help build inventories for the winter heating season.  It also calls for countries to set priorities to determine which industrial sectors will be most affected.  Energy-reduction targets could become binding if voluntary actions aren’t enough to prevent a shortage.
  • The plan also promotes switching from natural gas to alternative energy sources including nuclear and coal, setting up auctions that could compensate companies for using less gas, and setting mandatory limits on heating and air conditioning in public buildings.
• In other fallout from Europe’s impending war-related energy crisis, the German government has asked the country’s electricity providers to run stress tests to see if they could guarantee adequate power supplies if Russia cuts off its gas exports this winter.  The government’s deputy spokesperson confirmed that the results of the stress test could justify extending the life of the country’s three remaining nuclear power plants beyond their scheduled shutdown at the end of the year.
  • Germany’s apparent policy shift toward keeping its nuclear plants open highlights one massively important implication of the war:  with the world’s new focus on energy security, many countries may now adopt an “all of the above” energy policy emphasizing a diversified portfolio of energy-producing assets, rather than shifting wholesale to renewable energy sources like wind and solar.
  • The new-found appreciation for traditional energy sources like oil, natural gas, and uranium is a key reason why we remain bullish on commodities in the coming years.
  • In the near term, the evolving energy crisis is driving home the risk that Europe’s economy and financial markets are likely to face enormous headwinds in the coming months, with negative implications for European stocks and currencies.
• In still more economic fallout from the war, the Ukrainian government today plans to ask foreign private creditors to allow a two-year repayment moratorium on $3 billion of its outstanding Eurobonds.  Qualifying as a debt default, the move would amount to the first step in restructuring Ukraine’s foreign-owned sovereign debt.

Western Europe:  Britain and the rest of Western Europe continue to suffer through a massive heat wave and wildfire outbreak, with the U.K. recording a record high temperature of 104.5° F and the death toll in Portugal reaching 659.  Since a lot of European infrastructure was never designed or maintained for such heat, it has been a particular source of disruption.  For example, the British government has had to shut down warping roads and airport runways.

Italy:  In a more positive note for Europe today, Prime Minister Draghi announced in parliament that he would be willing to rescind the resignation request he made to President Mattarella last week, but only if the parties in his broad unity government stop creating hurdles to his reform agenda.  Votes in parliament later today and tomorrow will now serve as de facto votes of confidence in his leadership.

• In the days since Draghi made his resignation request last week, thousands of ordinary Italians, including more than 1,800 mayors, business associations, medical professionals, and Rome’s European allies, have publicly appealed for Draghi to stay and help lead the country through the challenges unleashed by the war in Ukraine.  As Draghi probably intended, the outpouring of support may have chastened the squabbling party leaders in his coalition, forcing them to support the government for at least a bit longer.
• If Draghi had resigned, or if he loses the confidence votes this week and his government falls, Italy will face new elections sometime in the autumn.  Current polling suggests that right-wing, populist, and eurosceptic parties would win that election and form a new government, threatening Europe’s economic stability and its support for Ukraine.
• If Draghi remains in power as now seems likely, at least until the regularly scheduled elections in June 2023, there will be less selling pressure on Italian bonds, and Italian yield spreads could be relatively contained.  That, in turn, would give the ECB more leeway to hike interest rates at its policy meeting tomorrow, which is critical in its fight against inflation.

United Kingdom:  In the race to replace Boris Johnson as Conservative Party leader and prime minister, a vote of parliamentary party members yesterday eliminated Former Equities Minister Kemi Badenoch.  The remaining candidates now are Former Chancellor Rishi Sunak (118 votes yesterday), Trade Minister Penny Mordaunt (92 votes), and Foreign Minister Liz Truss (86 votes).

• Further votes are scheduled for today to whittle the field down to just two candidates.  At that point, the remaining candidates will have several weeks to campaign before a poll of the broad party membership at the end of the summer.
• A poll of Tory activists last week found that both Mordaunt and Truss would beat Sunak in a head-to-head race, since many conservatives dislike Sunak’s record as a tax-raising chancellor and his perceived disloyalty to Johnson.  However, Sunak could yet pull out a victory on the belief that he would be more competitive in a future general election.

Chinese Real Estate Sector:  Hundreds of landscapers, construction companies, sculpture-makers, and other suppliers to the real estate sector have complained that they can no longer afford to pay their bills because some financially strapped developers still owe them money.  The outcry comes just days after the government ordered increased lending to troubled developers so they can deliver long-delayed housing units to their buyers and preempt a threatened payment strike.  If the government now orders still more bank lending to allow developers to pay their suppliers, it will confirm that the government is prioritizing economic stability over reining in the sector’s debt levels in the runup to the Communist Party’s 20^th National Congress in October.

Australia:  In an ominous sign for central bank independence around the world, the Australian government has launched a probe into the Reserve Bank of Australia’s delay in raising interest rates as inflation surged out of control.  The review will consider the performance of the central bank, its board composition, and its inflation targeting strategy, potentially inspiring similar probes (and political meddling) in other countries that have suffered high inflation.

Sri Lanka:  Parliament today elected unpopular six-time Prime Minister Ranil Wickremesinghe as the country’s new president, risking further protests that could complicate urgent bailout talks with the IMF.

Panama:  Despite its long history of stability, in part because its currency is pegged to the dollar, Panama is facing a wave of mass protests over soaring price inflation and government corruption.  As in much of the developing world, rising food and fuel costs are a key reason for the unrest.

United States-Mexico: According to the Wall Street Journal, “the [Biden administration] today launched a trade fight against Mexico, accusing President Andrés Manuel López Obrador’s government of favoring its state-owned utility and oil company at the expense of American businesses.  The U.S. is seeking dispute settlement consultations under the U.S.-Mexico-Canada Agreement—the first step in what could lead to tariffs on a range of Mexican products.”

U.S. Technology Sector:  Last night, the Senate passed the U.S. International Competitiveness Act (USICA), which aims to bolster the country’s competitiveness in key technology industries and reduce dependence on foreign suppliers.  A key provision would provide roughly $52 billion in subsidies to encourage chip companies to boost production in the U.S.

• The vote paves the way for a larger package that would include additional funding for scientific research.
• Even if USICA is now paired with the broader science package and passed in the Senate, the bill would still have to be passed by the House and signed into law.

U.S. COVID Vaccines:  The CDC yesterday recommended the use of a COVID-19 vaccine from Novavax (NVAX, $58.00) in adults 18 years and older who haven’t been vaccinated previously.  The recommendation is the final hurdle before the shot can be made widely available in the U.S.

• Relying on a relatively older, more tested technology based on proteins, the Novavax vaccine will be a new option for people who have avoided the gene-based messenger RNA shots from Moderna (MRNA, $167.14) and Pfizer (PFE, $51.37).
• Like the U.S. vaccines already available, the Novavax shot will be offered at no charge at pharmacies and through state and local government vaccine programs.
• The Novavax vaccine requires two doses given three weeks apart.

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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 further evidence that Russia’s aggression has sparked a major, long-lasting increase in global defense spending.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a swing in investor expectations toward a view that the European Central Bank will hike its benchmark interest rate this week by more than previously anticipated.

Russia-Ukraine:  Both Russian and Ukrainian forces appear to be ramping up their ground attacks, or preparing to do so, after their partial operational pauses of the last several weeks.  Russian forces also continue to launch missile strikes across the country, while Ukrainian forces are reportedly concentrating and converging for what may be a counteroffensive near the southern city of Kherson.  Reports also indicate that the Russian government has been forming volunteer units comprised of non-ethnic Russians, demonstrating President Putin’s political reluctance to order a mass mobilization of ethnic Russians.

• By reminding government leaders that major countries can and do invade their neighbors, the Russian attack on Ukraine continues to spur greater defense spending worldwide. In the latest example, Japanese Prime Minister Kishida will allow his country’s armed forces to request as much funding as they want for the coming fiscal year, while all other ministries will have their budget requests strictly capped.
  • Significantly, there have been almost no objections to the plan by opposition parties, left-leaning media or Japanese society in general.
  • Former Prime Minister Abe consistently faced strong opposition to his proposal to double defense spending to 2% of GDP, but current Prime Minister Kishida has faced no such pushback to similar plans.
• In the EU, the European Commission issued a first-ever proposal to provide financing for the joint procurement of weapons by member states to help their armies restock and improve military hardware in response to the war. The proposal seeks to channel the increase in EU defense spending toward coordinated procurement and prevent larger member states from monopolizing the continent’s arms companies.
• As Germany solidifies plans for energy rationing in case Russia completely shuts off its natural gas exports to Western Europe, as European officials now expect, a fierce debate has opened up regarding whether households or industry should get priority access to limited supplies. Major firms and industry groups are pushing for protection, although political considerations probably mean consumers will be given priority.
• In a bid to encourage European countries to share gas and cap prices if necessary, the IMF warned that a full cut-off of Russian gas would trigger economic contractions of more than 5% over the next year in Italy, the Czech Republic, Hungary, and Slovakia.
  • The IMF modelling suggests that the European economy could manage with Russia curtailing supplies by 70%, but a complete cut-off would cause painful shortages.
  • In a worst-case scenario, the worst affected European countries would only be able to access 15% to 40% of their needs.

European Union:  Based on new comments from ECB President Lagarde and other monetary policymakers in the Eurozone, investors have become increasingly convinced that the officials will hike their benchmark short-term interest rates on Thursday by an aggressive 50 bps, to 0.0%, rather than the 25 bps Lagarde insisted on earlier in the summer.  In recent days, speculation that the ECB could end negative interest rates in the Eurozone has helped drive the euro higher after it essentially reached parity with the dollar last week.

United Kingdom:  Yesterday, in the race to replace Boris Johnson as Conservative Party leader and prime minister, a vote of parliamentary party members eliminated Tom Tugendhat, chairman of the Foreign Affairs Committee.  The remaining candidates include Former Chancellor Rishi Sunak (115 votes), Trade Minister Penny Mordaunt (82 votes), Foreign Minister Liz Truss (71 votes), and Former Equities Minister Kemi Badenoch (58 votes).

• Further votes are scheduled for today and tomorrow to whittle the field down to just two candidates.
• At that point, the remaining candidates will have several weeks to campaign before a poll of the broad party membership at the end of the summer.

Chinese Real Estate Sector:  With dozens of real estate developers on the verge of bankruptcy and unable to finish paid-for housing units due to government efforts to rein in their debt, Beijing is scrambling to quell a move by furious homebuyers to stop making mortgage payments on undelivered homes.  One government tactic has been to censor social-media posts about the crisis.  More importantly, the China Banking and Insurance Regulatory Commission has instructed banks to provide credit to eligible property developers “based on market principles and in compliance with the law” to help them complete unfinished homes.

• Compared with the total amount of outstanding mortgages in China, the loans threatened by the buyers’ payment strike are probably not enough to threaten the banking system.
• Rather, the government seems more focused on averting more social disruption, especially ahead of the Communist Party’s 20^th National Congress this autumn, at which time President Xi aims to win a precedent-breaking third term in office.
• In any case, the move by the CBIRC opens the liquidity taps to developers for the first time in almost one year. In response, Chinese developer stocks jumped sharply.  The intervention also underscores the government’s willingness to goose the economy in order to support growth ahead of the party conclave.

Chinese Technology Sector:  The Cyberspace Administration of China is reportedly preparing to impose a fine of more than $1 billion on ride-hailing company Didi Global (DIDIY, $2.93) for data security breaches discovered last year. However, the government will also ease a ban on Didi’s adding of new users to its platform and will allow the company’s mobile apps to be restored to domestic app stores.  Although China’s tech sector remains under high regulatory risk, the move is another example of Chinese authorities easing up on firms to bolster growth ahead of the party congress.

United States-China:  If you’re looking for a silver lining in today’s high U.S. inflation rate, you can find one in the comparison of U.S. to China gross domestic product (GDP).  Such comparisons are typically calculated in nominal terms at current exchange rates, so galloping U.S. prices and a weak renminbi mean China GDP will likely lag U.S. GDP for years to come.  However, when adjusted for the purchasing power of the currency, China’s GDP surpassed that of the U.S. many years ago.

United States-European Union:  Tomorrow, Secretary of State Blinken will hold a meeting with officials from the EU and 17 other countries to discuss ways to strengthen industrial supply chains among themselves.  Besides the EU, the key countries involved will include Australia, India, Indonesia, Japan, Singapore, and South Korea.  Consistent with the administration’s push to increase “friend shoring,” neither China nor Russia was invited.

• We have long warned that the U.S. is pulling back from its traditional role as global hegemon, contributing to deglobalization and a fracturing of the world into separate geopolitical and economic blocs. In our Bi-Weekly Geopolitical Report of May 9, 2022, we took a stab at forecasting which countries were likely to join each of the evolving blocs, and what that would imply for the global economy and financial markets going forward.  We note that most of the countries Blinken will meet with tomorrow are in our projected U.S.-led bloc.
• To date, the Biden administration has tried to nurture the development of the U.S.-led bloc mostly by incentives and persuasion, and that will likely be the main approach at tomorrow’s meeting. However, it is important to remember that the administration could eventually take a more forceful approach to building the U.S.-led bloc and sealing it off from the Chinese-led bloc, as the Trump administration did.

U.S. Labor Market:  In a call with financial analysts yesterday, Goldman Sachs (GS, $301.26) warned it may slow hiring and eventually cut underperforming staff in response to tightening monetary conditions.  Coming on top of hiring slowdowns and job cuts announced recently by major technology firms, the statement adds to concerns that U.S. economic growth and labor demand are already slowing.

U.S. Corporate Earnings:  U.S. multinational firms like Johnson & Johnson (JNJ, $174.23) have begun to indicate that the strong dollar is weighing on their profits.  Along with higher costs for materials and labor, the super-strong dollar suggests that large companies’ margins and earnings may be set to surprise to the downside through the rest of the year.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where Russia appears to be ramping up its ground attacks and missile barrages again after a partial operational pause.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the U.K.’s Conservative Party leadership election and signs of thawing China-Australia relations.

Russia-Ukraine:  Russian forces appear to be ramping up their ground attacks in Ukraine’s eastern province of Donetsk again, following a partial operational pause in recent weeks.  However, we suspect that troop and equipment shortages will prevent them from launching major new offensives.  Indeed, Moscow did not claim any new seizures of territory yesterday.  Meanwhile, Russian forces have not only stepped up their missile attacks across Ukraine, but several reports say they have moved additional troops and equipment into the Kherson region to defend it from a planned counteroffensive that Kyiv has signaled.  Importantly, those troop and equipment moves could weaken Russia’s attacks around Donetsk, perhaps as Kyiv intended when it publicized its counteroffensive against Kherson.  Finally, we note that Russian Defense Minister Shoigu has ordered Russian troops to prioritize attacks on long-range artillery systems provided to Ukraine by its Western supporters.  The order underlines the importance those systems have had in bolstering Ukraine’s military capabilities.

 

• On Sunday evening, Ukrainian President Zelensky fired both the country’s general prosecutor and the head of its security service, a friend from childhood, amid allegations that their offices were riddled with officials who were collaborating with Russia.
• International Energy Agency Chief Fatih Birol today warned that there is a real chance Russia will completely shut off its supply of natural gas to Western European countries in retaliation for their support of Ukraine.  According to Birol, Western European nations must take urgent and coordinated action to avert a potentially disastrous supply crunch this winter, in what he termed “a historic test of European solidarity.”  Birol’s suggested steps include the following:
  • Temporarily step-up coal-and oil-powered electricity generation;
  • Launch public-information campaigns to reduce household gas demand;
  • Compensate industries for forgoing gas supplies;
  • Increase cooperation among national electricity operators; and
  • Plan for EU-wide sharing of what available gas supplies remain.
• EU Foreign Affairs Commissioner Borrell expressed hope that Russia, Ukraine, and other interested countries could strike a deal this week to restart grain shipments out of Ukraine and help ease the worsening global food crisis.
  • The prospect of an agreement to end the blockade comes as the EU prepares legislation to ease its sanctions regime against Moscow to allow trade in Russian food products as it attempts to address anger in Africa and elsewhere that rely on Russia food supplies.
  • Draft legislation to be considered by EU ambassadors today would provide exemptions to existing bans on transactions with certain Russian state-owned entities when it comes to food products, a tacit acknowledgment that sanctions against Moscow may have inadvertently led to a curb on Russian food exports.
  • As global food markets adjust to the war-related supply disruptions to date, and as traders factor in the risk of global recession, grain prices continue to retreat.  For example, corn and wheat futures are now down some 25% and 40%, respectively, from their early-spring highs.
• A recent analysis by the Economist Intelligence Unit estimates that commodity supply disruptions and other fallout from the war will reduce global economic output by approximately $1 trillion this year, with the biggest losses in Germany, France, and Italy.

European Union:  Most of Western Europe this week is suffering through a record-breaking heatwave and wildfire outbreak, which is already starting to threaten economic activity.  What’s less publicized is that the Continent is also suffering through a major drought.  One consequence of the dry weather is that hydroelectric power generation is falling, worsening Europe’s wartime energy shortages.

United Kingdom:  In the race to succeed Prime Minister Johnson as Conservative Party leader and prime minister, the latest poll of parliament members has whittled the field down to just five.  Former Chancellor Rishi Sunak remains the frontrunner, followed by Foreign Minister Liz Truss, Trade Minister Penny Mordaunt, Foreign Affairs Committee Chairman Tom Tugendhat, and Former Equities Minister Kemi Badenoch.

• Despite Sunak’s strength, he remains under threat from candidates to his right.
• After garnering a surge of support last week, Mordaunt’s star seems to be fading, and a poll of grassroots’ party members has revealed a strong preference for Badenoch.
• After a nasty televised debate last night, Sunak and Truss pulled out of a debate scheduled for Tuesday on concern that the divisiveness is damaging the party’s image.  That debate has now been cancelled.
• Another ballot is scheduled for today when the candidate with the lowest total of votes will be eliminated.

China:  As the highly transmissible BA.5 Omicron mutation of the coronavirus continues to spread, a Japanese investment bank estimates that 41 cities in China are now under full or partial lockdowns or district-based controls, covering 264 million people in regions that account for about 18.7% of the country’s economic activity.  More ominous is that major production centers including Shanghai and Tianjin have ordered mass testing in response to new cases, raising the prospect of renewed lockdowns in those cities.  The news highlights the continuing negative economic impact of President Xi’s strict Zero-COVID policies.

China-Australia:  After Chinese officials last week indicated they may resume importing coal from “down under,” Australian Treasurer Jim Chalmers said such a move would help restore ties between the two countries.  He also encouraged China to remove its restrictions on other imports from Australia, such as wine and barley.

• Beijing began blocking Australian imports in late 2020 to retaliate for former Australian Prime Minister Morrison’s call to investigate China’s role in the coronavirus pandemic.
• The potential loosening in Chinese policy stems in part from the fact that Morrison is no longer prime minister, and that the new government in Canberra has made a concerted effort to re-engage with China.  Just as important, Beijing’s interest in resuming Australian coal imports reflects a general tightening in the global energy market, as war-related disruptions to Russian supplies force many European countries to scramble for alternative energy sources.
• Thawing bilateral ties could potentially be a boon for Australia, although China’s economic slowdown would likely reduce the benefit for Australian companies.

Pakistan:  Former Prime Minister Imran Khan’s party won a critical by-election in Pakistan’s most populous province, putting him on track to force early parliamentary polls just months after he was ousted from office.  Khan’s victory is being ascribed to voter anger over high inflation and the painful belt-tightening measures current Prime Minister Sharif has imposed to restart lending under a $7-billion IMF program.  Without that program, Pakistan would be at even greater risk of defaulting on its foreign debt, as Sri Lanka recently has.

Sri Lanka:  Although President Gotabaya Rajapaksa resigned and fled into exile last week, protestors are now demanding that Acting President Ranil Wickremesinghe resign as well.  Wickremesinghe is seen as a close ally of the Rajapaksa clan that has dominated Sri Lanka’s government for decades.  The continuing political and economic turmoil bodes poorly for other emerging markets, some of which are facing challenges similar to those in Sri Lanka, including high debt service costs, rising interest rates, and a strong dollar.

United States-Saudi Arabia:  On Saturday, President Biden completed his visit to Saudi Arabia with no concrete deliverables in terms of Saudi commitments to increase oil production and bring down prices.  On its face, the outcome is a significant disappointment for Biden, especially given that he has been strongly criticized for the trip by progressives looking for stronger U.S. action on human rights and policies to combat global warming.

• Despite Biden’s failure to win big, definitive concessions from the Saudis, it’s important to remember that the trip further advanced what could be called the “Biden Doctrine,” i.e., a concerted effort to rebuild U.S. influence and ties with key allies.
• For more than a decade, U.S. leaders have been trying to disengage from the messy politics and security issues in the Middle East to focus on the rising geopolitical threat from China.  Now that global politics and energy disruptions are drawing Biden back into the region, albeit kicking and screaming, U.S. re-engagement could ultimately help improve global security and economic stability, at least for as long as it lasts.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

In today’s Comment, we will provide updates on U.K. elections, Draghi’s resignation, and possible price caps, all of which are potential threats to the Western bloc’s unification against Russia. Next, we discuss international news with a focus on China’s latest GDP. We end with an overview of U.S. news. Below are the top stories moving financial markets.

 Top Stories: Equity markets clawed back most of the early losses on Thursday after central bankers cast doubts about a potential 100 bps rate hike during the next Fed meeting. Meanwhile, disappointing earnings reports from J.P. Morgan (JPM, $108.00) and Morgan Stanley (MS, $74.69) led to concerns that the economy may be harming financial equities.

• Central Bank: Fed Governor Christopher Waller reaffirmed his support of raising the Fed’s benchmark rate by 75 bps in the Fed’s upcoming meeting, but could back a more considerable rate hike depending on the incoming economic data. St. Louis Fed President James Bullard mirrored Waller’s sentiment by suggesting that he also favors a 75 bps hike. The reluctance of Fed officials to respond aggressively to Wednesday’s hot CPI report suggests that the Fed may be concerned about the economy. Although it is unlikely that the central bank will pause rates anytime soon, Fed officials may be hesitant to signal further rate increases as economic conditions deteriorate.

Maintaining the Western Alliance:  New elections, rising prices, and varying levels of commitment are preventing the West from presenting a unified front against Russia. As the Western bloc struggles to stay on the same page, Putin’s leadership position is pivotal in demonstrating Russia’s willpower to maintain its war in Ukraine.

• UK. elections: An unexpected candidate has taken the lead in the race to replace U.K. Prime Minister Boris Johnson. Betting sites favor Penny Mordaunt to take over as the new leader of the Tory party, although five candidates remain in the running. Predictit.org gives Mordaunt a 56% chance of winning, while Sky Bet also shows her as an early favorite. Assuming she wins, it is unlikely that she will have a different foreign policy than the outgoing prime minister, and therefore U.K. commitment to Ukraine is unlikely to change. Nevertheless, Mordaunt’s victory should be favorable to assets within the U.K. as she is anticipated to provide some political calm to the country.
• Draghi’s resignation: Italian Prime Minister Mario Draghi offered to resign on Thursday; however, his request was promptly denied by Italy’s President Sergio Mattarella who insisted that Draghi wait a week before deciding on whether to step down. The political chaos comes at a vulnerable time for the country as a new Italian government may be less friendly toward the EU. News of Draghi’s resignation caused the spread between Italian and German bonds to widen by 16 bps. A government collapse will probably not impact Italy’s commitment to the war in Ukraine, but it could pave the way for the break-up of the Eurozone. Polls show that the populist party Brothers of Italy is favored to win the majority of seats in an election. The party leader, Giorgia Meloni, is a noted eurosceptic but a vocal supporter of Ukraine.
• Price caps: The West is making progress on price caps for Russian oil. The U.S. and EU have stated that they may be willing to withdraw their sanctions on shipping insurance and financing services in exchange for support of a price ceiling. The move would reduce the price the EU is paying for reduced-volume purchases of Russian crude oil to similar levels that China and India are currently paying. Although price caps are an attractive alternative to sanctions, it isn’t the perfect solution. In theory, countries can refuse to pay the market price for Russian crude; however, Moscow can then respond by not selling to them. As a result, countries must be willing to risk losing access to Russian oil for the plan to work. Europe appears to be the guinea pig in this experiment as its dependency on Russian crude means it will be the primary enforcer of the cap. Given the sensitivity that EU countries such as Germany and France had around securing their energy resources, they may not go along with it, especially in the winter.

International: Improvements in the Middle East and the potential for policy accommodation in China are both positive developments for international equities; however, rising energy prices remain a risk, particularly for countries with limited energy reserves.

• Israel-Saudi Arabia: Normalization between Israel and Saudi Arabia edged closer to reality after the Israeli government green-lit a deal to cede control of two strategic islands in the Red Sea. In exchange for relinquishing control, Israeli airlines will be allowed to use Saudi airspace for flights to China and India. In addition, normalizing relations within the Middle East creates a favorable investment environment for the region.
• Japan energy: To prevent a potential power crunch, Japan would like to bring up to nine nuclear reactors online to diversify the country’s energy sources. As an island nation, Japan does not have the same capability as larger countries (such as the U.S.) to mine fossil fuels and is forced to import to meet its energy needs. As a result, the global rise in commodity prices has pushed the country’s inflation to its highest level in nearly a decade. The new reactors will likely provide some relief for the country, but it won’t be a long-term solution. Japanese officials estimate that the reactors could provide up to 10% of the country’s electricity needs. Approaching wintertime, we suspect Japanese firms will struggle to maintain profitability as they cope with rising energy costs. Therefore, until the BOJ steps in and tightens monetary policy to improve the yen’s strength, we view Japanese equities as having elevated risk.
• China’s growth: GDP in China rose 0.4% from the prior year, much lower than expectations of an increase of 1.2%. The drastic slowdown in Chinese growth is likely related to the country’s property meltdown and Zero-COVID policy. The disappointing GDP number could pave the way for Beijing to provide additional fiscal and monetary support, which should be favorable for Chinese equities.

Recent developments in China and the Middle East should result in improved sentiment about international equities in the short term. However, a hawkish Fed, a stronger dollar, and rising energy prices pose a risk for emerging economies. That said, we believe that Chinese equities are particularly attractive as we suspect Beijing will attempt to boost the economy heading into the 20^th National Congress of the Chinese Communist Party later this year.

 Domestic: A cooling housing market, increased scrutiny, and lower government spending will likely weigh on market sentiment as investors remain risk averse.

• Housing: The supply of homes for sale rose for the first time in two years. The increase in homes on the market suggests that rising pricing and financial costs have started to weigh on demand. Although prices are unlikely to fall on a nominal basis, the decline in demand indicates that housing prices will rise at a slower pace. Because most households derive the majority of their wealth from an increase in the equity value of their homes, a sluggish housing market may lead consumers to spend less. As a result, the economy and financial markets could suffer because of waning consumer and investor sentiment.
• Antitrust: Tech companies face growing regulatory risk as government agencies seek to increase competition within the sector. The DOJ is set to reject concessions from Alphabet (GOOG, $2,207.35), paving the way for a potential antitrust lawsuit over the company’s online ad market dominance. The move to limit tech dominance has bipartisan support. The right feels that tech companies have used their market power to ensure their voice, while the left believes that tech companies have used their platform to profit from disinformation. As a result, we expect the tech sector to be a less attractive place to invest as rising rates and regulatory crackdowns will make it harder for firms to expand.
• Manchin out: Senator Joe Manchin (D-WV) has jettisoned any hope that he would support an economic package that contains new spending on climate change or new taxes. He will now only back legislation that lowers drug prescription costs or extends enhanced ACA subsidies.

Concerns about a possible recession in the U.S. will likely persist as the lack of government spending and slowdown in residential investment weigh on growth. While this will probably hurt pro-cyclical stocks, we suspect defensive stocks in sectors such as Health Care, Utilities, and Consumer Staples may be attractive. Tech stocks, though, will likely face greater scrutiny as governments worldwide look to break up these companies.

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