Daily Comment (July 14, 2022)

Posted on July 14, 2022July 14, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a discussion about the latest CPI report and its impact on the Federal Reserve’s decision to raise rates. We then briefly review Biden’s trip to Israel. Next, we give an update on the latest development from Russia’s war in Ukraine. We end the report with an overview of other news stories that we believe will affect financial markets.

Central Bank News: Financial markets sputtered on Wednesday after a disappointing CPI report led to fresh concerns that the Federal Reserve could take more aggressive actions to tame inflation. The CPI report showed that the price index soared 9.1% from June the prior year, marking a four-decade high for inflation. The S&P 500 closed lower, and the two-to-10-year inversion deepened as investors priced in an increased likelihood of a 100 bps hike for the July Fed meeting. Atlanta Fed President Raphael Bostic, a notable dove, reinforced investor concerns after declaring that everything is in play as the FOMC looks to tame inflation. San Francisco Fed President Mary Daly also mentioned that a 100 bps hike is a possibility given the recent CPI report. Despite the hawkish tilt from non-voting FOMC members Bostic and Daly, there are some indications that the Fed may maintain its plans to raise rates by 75 bps. Cleveland Fed President Loretta Mester, a voting member, stated that the data suggested that at least a 75 bps hike was needed, but did not elaborate on whether she favored a more significant hike.

The faster the Federal Reserve raises rates, the greater the likelihood it will push the economy into a recession. Over the last 40 years, the Fed has not been able to increase its benchmark rate above the previous cycle’s peak without causing an economic downturn. Now that the fed fund’s target rate is currently 1.675%, a 100 bps rate hike would place that target just above the previous peak.

Four of the 12 Federal Reserve districts reported that economic growth either slowed or declined in the latest Beige Book. The report, which looks at the economic situation of each of the Fed districts, showed that business contacts reported signs of slower demand and substantial price increases. Although the report indicated that economic activity expanded at a modest pace, an improvement from six weeks ago, contacts in five districts noted concerns of an increased possibility of a recession.
Shelter prices rose at their fastest pace since 1986, and it is still possible that prices will continue to speed up for at least another six to 12 months. Our data shows that shelter prices lag the FHFA House Price Index by about 18 months, with the peak hitting in June of last year. The increase in the prices for homes and shelter is likely the result of low residential inventory. Homebuilders over the last year have struggled to complete construction projects due to the shortage of labor and materials. Although prices for critical resources like lumber and steel have declined in recent weeks, it will probably be some time before the homebuilders can finish these projects.

Biden’s Middle East Trip: President Biden and Israeli Prime Minister Yair Lapid signed an agreement that the two countries are committed to stopping Iran from developing a nuclear weapon. Despite the appearance of a united front, the two sides appear to have differing views on how to deter Iran’s nuclear program. Biden would like to return to the 2015 nuclear deal, while Israel would like to take more direct action. Besides agreeing to stop Iran from developing nuclear weapons, the two sides have also discussed improvements in military integration.

We suspect that President Biden’s visit was partially aimed at preventing Israel from taking unilateral action against Iran. The potential for conflict between Israel and Iran remains elevated. We are watching this situation closely.

Ukraine-Russia Update: In another change in the war’s tide, Russian forces have suffered several defeats on the ground in Ukraine as they try to take over smaller cities in the country’s eastern region. Meanwhile, the Kremlin has pushed the country closer to full-scale mobilization by ordering federal districts to recruit and financially reward volunteers willing to take part in the war. The latest development in Ukraine suggests that the investing environment in Europe will probably be fraught with risk as countries continue to struggle to adapt to the higher energy and food prices resulting from the conflict.

A deal allowing Ukrainian wheat to leave ports in the Black Sea is close to being reached. The agreement is being worked out between Russia, Ukraine, Turkey, and the United Nations. Although there is optimism that all parties can sign a deal next week, there are some concerns that Russia may back out. If Ukrainian wheat can make it into global markets, it could bring down food prices and reduce the threat of global famine.
Natural gas disruptions risk triggering a global recession, according to the International Monetary Fund. The multilateral organization warned that Russia’s war in Ukraine has weakened its global growth outlook.

Italy: A potential collapse of the Italian government is weighing on the euro. The Five Star Movement stated that it would pull its support from the current government over concerns that the coalition is not doing enough to help families deal with rising energy and food prices. Although the breakdown of cross-party alliances is not unusual for Italy, the resulting election could have implications for Ukraine. The Five Star Movement does not support offering Ukraine military weapons to fight against Russia due to concerns that it may prolong the war. Thus, if the Five Star Movement gains influence after the next election, Ukraine may have difficulty finding support for its war efforts.

A pro-NATO right-wing party is expected to gain the most seats in the Italian parliament if the country heads to elections. Assuming polls are correct, the Brothers of Italy party should take the most seats in the parliamentary run-off. Although a populist right-wing party, the Brothers of Italy has recently moderated some of its policy stances to appeal to a broader base. Party leader Giorgia Meloni has been a vocal critic of Russia’s invasion of Ukraine and supports sending weapons to Kyiv. The party’s populist tilt, however, could make it difficult for the group to find partners to form a coalition. The group is known to challenge EU norms, such as marriage equality, and has a reputation for being a party for eurosceptics. As a result, the new elections will probably not improve financial conditions significantly in Italy as political uncertainty will likely remain.

China: Fears of a Chinese housing crisis are rising after a growing number of homebuyers refuse to pay mortgages for unfinished housing projects. As a result of the boycott, Chinese authorities met with major banks to discuss solutions to the upheaval. The rising defaults from property developers undermines the likelihood that the projects will be completed, leading homebuyers to refuse to repay mortgage loans on unfinished construction. The weakness in the property sector suggests that China’s traditional method of boosting growth through debt-driven real-estate investment may be losing its potency. Therefore, Beijing may have a more challenging time stimulating the economy as it moves away from its Zero-COVID strategy.

In another setback for China, SEC Chair Gary Gensler dampened expectations about a deal with Beijing to keep Chinese companies listed on U.S. exchanges. Beijing and Washington are engaged in discussions that would allow a third-party to oversee the audit of Chinese companies listed in the U.S, as required by law. China is hesitant of foreign oversight of its companies, which is the source of the deadlock in talks. If an agreement is not reached, Chinese companies could be forced to delist from U.S. exchanges by 2023.

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Weekly Energy Update (July 14, 2022)

Posted on July 14, 2022December 13, 2022 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Since early June, oil prices have fallen significantly, breaking the psychologically important point of $100 per barrel. Technical support exists at $95 per barrel, so we will be watching to see if it holds.

(Source: Barchart.com)

Crude oil inventories rose 3.3 mb compared to a 1.5 mb draw forecast. The SPR declined 6.9 mb, meaning the net draw was 3.6 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.0 mbpd. Exports rose 0.4 mb, while imports fell 0.6 mbpd. Refining activity rose 0.4% to 94.9% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. It is clear that this year is deviating from the normal path of commercial inventory levels. Although it is rarely mentioned, the fact that we are not seeing the usual seasonal decline is a bearish factor for oil prices.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels seen in 2004. Using total stocks since 2015, fair value is $101.09.

With so many crosscurrents in the oil markets, we see some degree of normalization. The inventory/EUR model suggests oil prices should be around $65 per barrel, so we are seeing about $35 of risk premium in the market.

Gasoline demand:

In general, gasoline demand is price inelastic, which is “econ talk” for demand being insensitive to price. Since substitutes for gasoline are mostly non-existent, consumers trying to adapt to higher prices are left with other methods, such as carpooling, combining trips, or using public transportation. Unfortunately, data on public transportation is only available through Q1. However, the data does suggest that ridership is well below pre-pandemic levels. In the long run, demand can fall if car owners shift to more fuel-efficient vehicles; the work-from-home movement may also lead to lower structural demand.

At the same time, gasoline demand is very elastic to economic growth; as growth slows, demand declines. We are seeing clear evidence of weakening demand.

Seasonally, this is where we usually see peak demand. The fact that demand is falling and that it is usually price insensitive likely argues that the economy is weakening.

Market news:

As the above price chart shows, oil prices have come down hard recently. However, the IEA still says that the energy crisis remains a problem and is likely to get worse before conditions improve.
In times of supply uncertainty, the hoarding instinct sets in; nations try to ensure they will have adequate supplies even if it means other nations are left short. We note that India has announced export curbs on diesel, an example of such behavior. Meanwhile, Europe is aggressively buying up global LNG, which is denying the product to poorer nations.
- US. refineries continue to run at high levels, which increases the odds of refinery issues.
- Meanwhile, industrial energy users report that operations are being curtailed due to high prices.
- Shippers are reportedly slowing their vessels to meet greenhouse emission regulations.
Oil and gas workers in Norway went on strike; the government stepped in to end it.
One of the characteristics of the postwar world in the U.S. has been the expansion of the regulatory state. Congress has tended to delegate the responsibility to agencies by granting them wide latitude. This trend has created a backlash. George Friedman has suggested that we are ending the era of the “rule of experts,” mostly because experts tend to have a narrow focus and, thus, when making recommendations their regulations can often ignore collateral issues that impose unexpected costs. A recent Supreme Court ruling looks to counteract this state of affairs by reducing the ability of the regulatory agencies to impose rules not specifically granted by Congress. This action notably affected the EPA’s ability to regulate greenhouse gasses.
Although the Biden administration initially wanted to curtail new oil and gas leases, high prices have led the White House to walk back that position. For example, the Willow project in Alaska is still being considered. This stance has not been well received by the environmental wing of the president’s party. Interestingly enough, the new policy shift hasn’t exactly thrilled the oil and gas industry either.
As oil prices have increased, China has aggressively switched to coal and so has Europe. Russia has been increasing coal exports, which is making a comeback as oil and natural gas prices rise.
A new surge in COVID cases in Shanghai has raised worries about another lockdown. If Beijing implements such policies, it would be bearish for oil prices.

Geopolitical news:

It’s a big week in geopolitics and energy.

President Biden is traveling to the Middle East this week. The broader context is stability in the region. Since Obama, the U.S. has been trying to reduce its “footprint” in the Middle East to focus on the Asia-Pacific, the so-called “pivot to Asia” strategy. In order to accomplish that, the U.S. has to create a regional security structure. This area of the world remains important, not just for the oil markets but for the stability of Europe and South Asia. Obama’s model, based on the ideas of Robert Baer, was that Iran was a reliable stabilizer. Assigning Iran that role was what brought about the JCPOA. Obama assumed that the next Democratic administration would finish normalizing relations with Tehran. However, after Trump’s win in 2016, the focus of stabilization shifted to the Arab states and Israel. The Abraham Accords became the model for such an arrangement. It is now being referred to as a potential “Arab NATO.” Although the Biden administration wanted to revive the JCPOA, as we have been documenting for a while now, there appears to be little chance of success. Therefore, Biden seems to be shifting to working with the security arrangement created by the Abraham Accords.
This is a complicated trip. Biden’s first stop is Israel, which is “between governments” at present. From there, he is off to Riyadh to meet with the crown prince, who the president once labeled a pariah. In general, presidents usually don’t make trips such as this without the agenda resolved. In other words, although there is some concern that Mohammed bin Salman will disappoint the president, it is unlikely that Biden would have gone to the region if he believed he would come away empty handed. However, it is also unlikely that the Kingdom of Saudi Arabia (KSA) will be able to expand production significantly. The kingdom is the key reserve of global excess capacity. If the KSA were to expand output to full capacity, it would mean the world has no production cushion. There have been quiet concerns that the KSA has less capacity than it advertises. It is still possible that MBS will publicly embarrass the president, as he has shown himself to be impetuous. It’s not the most likely outcome, but one that has a higher probability than it would have had with the sons, rather than the grandsons, of King Saud.
- At the same time, it is important not to forget that the U.S. and the KSA are long-term strategic allies. The Saudis operate in a difficult environment and having the U.S. as an ally is important. For example, the U.S. is considering resuming the sale of offensive weapons to the KSA, a significant carrot. Thus, it is quite possible that this visit may reset relations with the KSA, although we harbor serious doubts it will generate much in terms of oil sales.
- It should be noted that OPEC+ continues to be unable to meet production targets.
One potentially bearish factor for oil is sanctions violations. It is well known that China and India have been active buyers of Russian crude oil at deep discounts. However, Europe continues to buy large quantities of oil and natural gas at high prices, leading to dramatic improvements in Russia’s external accounts. One way the G-7 is thinking about addressing this issue is to create a coalition that agrees to buy Russian oil at around $60 per barrel. It isn’t obvious how this would work; after all, if it’s effective, governments could simply set the price of oil globally. The U.S. is warning that oil prices could rise further without the price cap. Treasury Secretary Yellen is pitching the plan to China. Although China is an ally of Russia, so far, Beijing hasn’t rejected the plan.
- Not only is Russia selling oil, but Iran’s sales have also been rising. The Biden administration hasn’t been actively enforcing Iranian sanctions, and sales, especially to China, have increased. Iran has been using deceptive measures to skirt sanctions enforcement. There are also reports that Russian oil products are finding a home in the Middle East, which can then export their own fuel oil to others. This is part of the adjustment process to sanctions. In fact, the “leaking” of Russian oil to world markets is weakening demand for oil from Venezuela and Iran, both also under some form of international sanctions. That being said, the Brent-Urals crude oil spread remains above $30 per barrel, suggesting that the amount of Russian oil flowing into the system isn’t enough to narrow the spread.
- Russian President Putin is expected to visit Iran next week.
- Iran is hopeful that the global oil crisis will improve its bargaining position to return to the JCPOA.
- The US. is claiming that Iran is planning to deliver armed drones to Russia. Such actions suggest Tehran doesn’t really think the JCPOA will go forward.
- Venezuela, which has been subject to international sanctions, has resumed oil sales to the EU.
- Gazprom (trading suspended) is demanding RUB for LNG.
Meanwhile, on natural gas, there are growing worries that Russia is curtailing supplies to create a crisis this winter. The IEA is warning that Europe should prepare for a total suspension of Russian gas flows and also estimates such action by Russia would have devastating economic effects. Germany and the Netherlands are already warning users they will need to curtail consumption. Germany is taking steps to nationalize gas importers to prevent their failure. Recently, the Nord Stream 1 pipeline was closed for maintenance, and there is great fear that Russia will not resume supplies. A key part was being repaired in Canada, and the Canadians were reluctant to return it due to sanctions. The EU petitioned Ottawa and the part is being returned. Now we wait to see if gas flows restart.
- Supply concerns have led France to use fuel oil for electricity production instead of natural gas.
- Europe is aggressively buying up global LNG supplies; a large tender by Pakistan failed to find sellers, in part, because the EU outbid them.
Russia has seized control of the Sakhalin gas project in retaliation for sanctions.
At the same time, Russian courts have allowed Kazakh oil exports to continue; there was a threat by Russia to halt exports due to concerns over oil spills.
General secretary of OPEC+, Mohammad Barkindo, passed away last week.
The civil war in Libya has disrupted oil flows.
Iran has begun yet another crackdown on dissidents in the midst of a severe inflation shock. We also note that there was a cyberattack on a steel mill that led to physical damage of the facility.
The new government in Colombia is cooling investors on the energy sector.

Alternative energy/policy news:

The intelligence apparatus often tries to change policies in target nations. Authoritarian nations, given their control of the media, tend to have a “leg up” in the battle for opinion. A good example of this recently is that China has been using social media to encourage environmental groups to oppose rare earths mining in the U.S. and Canada. Although rare earths mining and processing is often environmentally “dirty,” it is also true that rare earths are critical in alternative energy production. China dominates both mining and processing because it has been willing to absorb the environmental costs.[1] However, as the West has realized its vulnerability in this area, there has been renewed interest in mining and processing rare earths outside of China. Clearly, Beijing is trying to discourage such efforts.
Although nuclear power remains controversial, there are elements in the environmental community that realize it may be necessary to expand nuclear power to reduce carbon emissions. One especially attractive technology is molten salt reactors. Not only are the facilities smaller, but they should also be safer.
One of the issues that concerns policymakers is that Russia and China are now at the forefront of nuclear reactor designs. The IEA estimates that nuclear power will need to double by 2050 to have any chance of reaching net zero emissions.
Thermal technology could also be used to store production from wind and solar power. Currently, utilities must carry traditional redundant capacity to wind and solar capacity due to the natural interruptions of these sources. Having storage would remove that need and improve the economics of renewables. Germany is currently building a similar facility to hold hot water. Finland is experimenting with using geothermal techniques and sand to store power as well.
- Researchers are investigating if old mines could be used for pumped storage to store electricity.
It is likely that carbon capture from the atmosphere will be required to have any chance of reaching climate goals. An Australian design suggests that solar power could be the key to creating the energy for carbon capture.
It is also likely that as global temperatures rise, nations and some large firms may try geoengineering to improve conditions. These technologies could have unexpected effects, and so the scientific community has been reluctant to aggressively pursue them. But, as temperatures rise, so will the drive to make such investments. However, given that we will likely see such techniques deployed, the US. government is starting to fund research in a bid to control their implementation.
- In the face of high heat, voluntary cutbacks to demand in Texas have, so far, avoided power disruptions. Bitcoin miners in the state suspended operations.
Jet fuel made from bacteria may be more energy-dense that that from fossil fuels.

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[1] Lacking an effective tort bar is useful for such efforts.

Daily Comment (July 13, 2022)

Posted on July 13, 2022 by Amanda Ahne

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 remain in an operational pause, of sorts, but they continue to stage limited, localized attacks on each other. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an overview of President Biden’s trip to Israel and Saudi Arabia, which began today.

Russia-Ukraine: Russian and Ukrainian forces remain in a partial operational pause as they focus on resting, refitting, and regrouping ahead of future attacks. All the same, they continue to launch limited, small-scale probing and positioning attacks, especially with long-range artillery. In particular, the Ukrainians continue to make good use of advanced artillery systems recently delivered by the West. Reports today say they used one such system to destroy a key Russian air-defense system protecting the skies over occupied Luhansk province.

The Russian-appointed administrator of a town in occupied eastern Ukraine has been killed in a car bombing, presumably at the hands of Ukrainian saboteurs. Separately, occupation authorities said the Russian-installed district head of Melitopol, one of the first towns in southern Ukraine to fall to Russian forces, had escaped an attempt on his life by a saboteur shooting at his house. The reports indicate Ukrainian partisans remain active and could cause significant casualties to Russian forces and their supporters in occupied areas.
With President Biden and the Democratic Party still polling poorly, many observers are growing concerned that isolationist, “America-first” Republicans will shut off U.S. aid to Ukraine and open the door to a Russian victory after November’s mid-term elections.
- Moderate, internationalist Republicans in Congress helped push that aid through in the early months of the war, before far-right opponents were able to organize resistance. Now, far-right isolationists and admirers of Russia’s authoritarian government are better positioned to mount a concerted pushback.
- We would note that much of the U.S. aid to Ukraine – especially the transfer of major weapon systems – ultimately flows back to U.S. defense firms and their workers. Because of that consideration, and the risk of Russian aggression in a region where the U.S. has vital national interests, it is probably not a foregone conclusion that a Republican victory in November will end U.S. aid to Ukraine.

United Kingdom: In the race to replace Boris Johnson as Conservative Party leader and prime minister, nominations closed yesterday with eight parliament members meeting the qualification standards. Former Chancellor Rishi Sunak remains the front-runner, although he is facing a stiff challenge from candidates from the party’s far-right wing.

Under party rules, an initial ballot of parliament members will be held today. Any candidate who wins a majority of the votes will become Conservative Party leader and prime minister. Any candidate who fails to secure at least 30 votes will be knocked out of the running.
If needed, a second ballot is expected to take place Thursday, in which the last-place candidate and any candidate securing fewer than 30 votes will be knocked out.
A third ballot, if one needs to take place, has been penciled for next Monday, July 18. Successive ballots are expected to take place daily on the same terms, until only two candidates remain by July 21.
The final two candidates will then be put to a vote of grassroots Conservative Party members — thought to number around 200,000 people in total — lasting most of the summer, with head-to-head debates to be held at hustings around the country. The winner of that ballot will replace Johnson as prime minister on September 6.

China: In Shanghai, 378 new cases of COVID-19 have been discovered across all 16 districts in the last nine days, prompting officials to reopen some centralized quarantine sites. Many neighborhood committees have also advised residents to prepare 14 days of food and medicine. The report serves as a reminder that China remains susceptible to tough pandemic lockdowns under President Xi’s zero-COVID policy.

United States – Israel – Saudi Arabia: As we noted in our Comment yesterday, President Biden embarked on a four-day trip to Israel and Saudi Arabia today, where he will be seeking to repair security and economic relations. Despite the long-term trend of U.S. leaders trying to extricate America from the Middle East, that’s proving hard to do. Indeed, U.S. efforts to pull back from the region since at least the Obama administration have ruffled the feathers of regional leaders and created a dangerous opening for Iranian aggression; all of which Biden is now trying to reverse.

In Israel, Biden’s first stop, the talks will likely focus on the military threat from Iran, cooperation in missile defense, and efforts to further improve relations between Israel and Saudi Arabia.
In Saudi Arabia later in the week, the talks are expected to focus on U.S.-Saudi relations and securing a boost in OPEC oil production. In return, reports suggest the Saudis will demand renewed U.S. commitments to the defense of the kingdom, probably in conjunction with warmer rhetoric on Biden’s part.

Global Oil Market: In its monthly report, the International Energy Agency cut its forecasts for global crude oil demand by approximately 250,000 barrels per day for both this year and next year, mostly because of slowing economic growth and demand destruction from today’s high prices. The agency now sees demand rising more moderately to 99.2 million bpd in 2022 and 101.3 million bpd in 2023. Meanwhile, the new forecasts call for global supply to increase to 100.1 million bpd this year, in part because Russian output hasn’t fallen as much as anticipated in response to Western sanctions over the war in Ukraine.

Expectations for reduced demand and rising supply help explain the recent pullback in global oil prices.
So far this morning, WTI is trading at approximately $96.85 per barrel, up 1.1% from yesterday but still down some 20.7% from its recent high in late June.

Global Population: In updated forecasts, the United Nations Population Division said the world’s population will reach 8 billion in November 2022, but the annual growth rate will slip below 1% for the first time since 1950. The global population is now projected to plateau at about 10.4 billion in the 2080s. In other interesting tidbits, the new forecasts state:

India will become the world’s most populous country in 2023, with more than 1.4 billion people, just ahead of China.
The population of 61 countries is projected to decrease by 1% or more between 2022 and 2050, driven by a fall in fertility. The biggest decliners include several countries at risk of Russian aggression including Ukraine, Latvia, and Lithuania.
Falling fertility rates will produce a temporary “demographic dividend,” in which working-age adults will become a greater share of the population in many countries, boosting average output per capita.
Eventually, however, the drop-off in births will boost the share of the population that is retired and elderly, creating labor shortages and putting upward pressure on public budgets.

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Daily Comment (July 12, 2022)

Posted on July 12, 2022July 12, 2022 by Amanda Ahne

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, focusing on the two sides’ artillery attacks even as they remain generally in an 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 an important warning from a Federal Reserve official that the central bank may be tightening policy too rapidly.

Russia-Ukraine: Russian and Ukrainian forces both remain in a relative operational pause, with both sides engaging in only limited, sporadic ground attacks. However, both sides also continue to stage more substantial long-range artillery attacks on each other. According to Kyiv, the Ukrainian military used advanced artillery systems recently delivered from the West to destroy at least one Russian command post and ammunition depot near the occupied southern city of Kherson, killing a dozen Russian officers. Other reporting suggests the Ukrainians may have destroyed as many as 20 ammunition depots with the new weapons, producing increasingly severe shortages for the Russian forces. Meanwhile, the U.S. announced last week that it will send four more HIMARS long-range artillery systems to Ukraine, bringing the total sent to 12. Finally, in a welcome sign that Ukraine could eventually resume some food exports despite the war, officials said the recent liberation of the strategically located Snake Island off Ukraine’s southern coast has allowed eight foreign ships to access Ukrainian ports.

S. National Security Advisor Sullivan said intelligence indicates Iran is preparing to provide Russia several hundred drones, including weapons-capable versions, to help on the Ukrainian battlefield. Under the deal, Iran will also train Russian troops to use the drones, beginning as early as this month.
In a sign that at least France hasn’t yet lost its urgency to rebuild its armed forces in response to Russian aggression, Defense Minister Lecornu proposed a €44-billion military budget for 2023, up €3 billion from the 2022 budget. If enacted, the defense budget increase would be nearly twice as large as any in the last two years.
- In part, the higher defense spending is needed to replenish munitions and equipment that have been sent to Ukraine.
- The government is also looking to fund major modernization efforts, support ongoing efforts to combat terrorism, and boost its defense industrial base.

Eurozone: Reflecting Europe’s wartime energy crisis, record-high inflation, and lagging monetary policy, the euro continues to lose value and almost fell to parity with the dollar earlier today. At its lowest point, the euro could be bought for just $1.0002, its lowest level since 2002.

Despite the inopportune timing, EU finance ministers this morning will give their final thumbs up to Croatia’s adoption of the euro from January 1. According to studies of how the euro transition in other countries worked out, we would look for a modest increase in Croatian inflation early next year as shopkeepers take advantage of the opportunity to round up their new euro prices.
We also note that with its adoption of the euro, Croatia will gain a seat on the ECB’s policy board.

European Travel Industry: London’s Heathrow Airport said it would cap the number of departing passengers from the facility at 100,000 a day until September and has asked airlines to stop selling new tickets from the airport for the summer season. The move follows similar caps imposed at London’s Gatwick Airport and Amsterdam’s Schiphol Airport as rebounding travel demand collides with post-pandemic labor shortages.

United Kingdom: Former Chancellor Rishi Sunak has emerged as the front-runner in the race to replace Boris Johnson as Conservative Party leader and prime minister. Sunak currently has more publicly declared support from other members of parliament than any of the other remaining nine candidates, including several high-profile supporters. However, his challenge is to head off opposition from the right of the party, notably from other contenders with more aggressive tax-cutting platforms.

Argentina: In her first official press conference yesterday, newly appointed Finance Minister Batakis said she is committed to the IMF-Argentina financing deal struck earlier this year. She also promised that Argentina “is not going to spend more than we have.” Meanwhile, IMF Managing Director Georgieva said she felt positive after her first meeting with Batakis last week. Despite the good vibes, however, we think the Peronist government in Buenos Aires will have a hard time regaining investor confidence after its long string of debt defaults.

South Pacific: After months of controversy over China’s move to build security ties among the island nations of the South Pacific, both Kiribati and the Marshall Islands have abruptly pulled out of a Pacific Islands Forum summit meeting. The news has stoked concern that Chinese meddling was behind the rupture, as it tries to weaken the region’s most important diplomatic body and assert its own leadership instead.

Global Personal Computer Market: Data firm Gartner (IT, $244.37) said global PC shipments in the second quarter were down 12.6% year-over-year, marking their steepest annual decline in nine years. The decline reflects several challenges for PC makers, including geopolitical uncertainty sparked by the Russia-Ukraine war, spending shifts as consumers adjust to higher inflation, a reversal of pandemic-driven electronics demand, and ongoing supply chain issues. The report could be a further headwind for technology stocks in the near term.

United States – Saudi Arabia: As President Biden embarks on a trip to the Middle East tomorrow, his administration is reportedly considering reversing its policy of only selling defensive weapons to Saudi Arabia. As Biden seeks to repair U.S.-Saudi relations and secure a boost in OPEC oil production, the reports suggest that the Saudis will demand renewed U.S. commitments to the defense of the kingdom in return, probably in conjunction with warmer rhetoric on Biden’s part.

U.S. Monetary Policy: Kansas City FRB President Esther George, who has traditionally been one of the strongest inflation hawks on the Fed’s policymaking board, said in a speech that the Fed may be hiking interest rates and pulling back its balance sheet too rapidly for the economy and financial markets to absorb.

The statement supports the view that the Fed’s rapid policy tightening will produce a recession in the coming months and force it to reverse course much earlier than planned.
Coupled with other recent signs suggesting that the economy may be losing momentum, George’s statement about economic problems spurred by monetary policy is probably one reason for the further downdraft in risk assets so far today.

U.S. Labor Market: According to new data from the National Labor Relations Board, the number of workplaces where employees have started trying to organize unions jumped to 1,411 in the first half of 2022, up 69% from the same period in 2021.

In large part, the rise probably reflects the increased bargaining power that workers feel after so many people dropped out of the labor force during the coronavirus pandemic. In addition, greater unionization efforts may reflect improved sentiment toward unions among the broader public.
All the same, we note that the unionization efforts in the first half of the year were no higher than in 2015. The long-term trend has been for decreased unionization in the U.S., which has contributed to economic inequality but probably supported corporate profit margins. We suspect that new unionization efforts would need to expand much further to reverse those trends.

U.S. Energy Market: Yesterday, the Electric Reliability Council of Texas asked residents to conserve electricity as extreme heat blanketed much of the state and threatened the power grid’s capacity. If electricity supplies get stretched too thin, the organization can order large customers or transmission companies to turn off their power. In extreme circumstances, it can also begin rolling blackouts, which could meaningfully disrupt economic activity in the state.

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Daily Comment (July 11, 2022)

Posted on July 11, 2022July 11, 2022 by Amanda Ahne

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, although there is relatively little to report since both sides remain in an operational pause. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today. In particular, we note that a resurgence in COVID-19 infections in China and beyond has left many investors concerned about new lockdowns and further headwinds for the global economy and financial markets.

Russia-Ukraine: Both Russian and Ukrainian forces remain in an operational pause to rest, resupply, and regroup for future fighting. However, that doesn’t mean all fighting has stopped. In particular, both sides continue to engage in savage long-range artillery duels, with the Ukrainians saying they are already reaping big benefits from the recent delivery of advanced long-range systems from the West. Meanwhile, the Russian government continues to take extraordinary steps to bolster its limited troop numbers, including forming ad-hoc volunteer units, and private military company combat organizations partly comprised of older men and criminals to support operations in Ukraine.

On Saturday, the Canadian government granted an exemption to its sanctions against Russia, allowing delivery of a turbine vital to increasing the flow of natural gas through the Nord Stream 1 pipeline to Western Europe. Nevertheless, the pipeline was shut down today for 10 days of regular maintenance, and some observers worry that Russia will keep the pipeline shut beyond the maintenance period to further pressure the Europeans to drop their sanctions.
As the U.S. and its Western allies continue to provide advanced weapons, ammunition, and other supplies to Ukraine, there is growing concern that they are dangerously depleting their own stores and won’t be able to restock quickly.

United Kingdom: Following fast on Prime Minister Johnson’s resignation last week, almost ten Conservative Party parliament members have said they will compete to succeed him as party leader and head of government. The process will involve a series of party votes designed to whittle down the candidates to just two top contenders by July 20. So far, the announced candidates’ promises have focused on reversing or softening a recent hike in health insurance premiums and scrapping a planned hike in corporate income taxes.

Top candidates who have announced their intent to compete so far include:
- Former Chancellor Rishi Sunak
- Incumbent Chancellor Nadhim Zahawi
- Former Health Secretary Sajid Javid
- Former Health Secretary Jeremy Hunt
- Former Defense Secretary Penny Mordaunt
- Attorney General Suella Braverman
As early as today, a few other top candidates are also expected to announce, including:
- Foreign Secretary Liz Truss
- Incumbent Defense Secretary Ben Wallace

France: STMicroelectronics (STM, $31.24) and GlobalFoundries (GFS, $45.27) are teaming up to build a semiconductor manufacturing factory in France; a multibillion-euro project that will receive significant government support as part of Europe’s effort to boost its independence in critical technologies.

Japan: In weekend elections for the upper house of parliament, Prime Minister Kishida’s coalition won most of the seats being contested. Importantly, the coalition also may have won enough seats to push through constitutional revisions.

In response, Kishida called for accelerated discussions on an amendment that would affirm the legality of Japan’s military forces and grant the government new authority to deal with national emergencies—ideas long advocated by Former Prime Minister Abe before he was assassinated last week.
The amendment would require a two-thirds vote in both houses of the Diet, but following the concern about Chinese aggression and the Kishida coalition’s strong majority, the amendment may have a better chance of passing than when Abe failed to push it through.
Shifting the constitution away from its current pacifist orientation would complement other initiatives Japan is making to boost its defense capability, including a planned hike in its defense budget, the development of new offensive missiles, and closer military cooperation with the U.S. and other allies. These changes will likely make Japan a more important player in the evolving U.S.-led geopolitical bloc.

Chinese Technology Sector: The State Administration for Market Regulation over the weekend fined some of the country’s largest internet companies for failing to make proper antitrust declarations on previous deals. The regulator also warned it would gradually publish more penalty decisions on other cases. The news is weighing heavily on Chinese technology stocks so far today, as it suggests the government is not yet finished with its effort to rein in the sector.

Chinese COVID-19 Cases: Officials reported more than 3,300 new, locally transmitted COVID-19 cases over the weekend, and Shanghai reported its first case of the BA.5 Omicron subvariant. The resurgence in infections has raised concern about yet another wave of strict lockdowns in and around the country. In fact, Macau has already set a weeklong shutdown of casinos and other businesses to combat its surge in cases.

Fears of new lockdowns in China and its region are weighing further on Asia-Pacific stocks so far this morning.
If broad new lockdowns are implemented in and around China, global demand could take a further hit, hurting risk assets worldwide.

Sri Lanka: President Rajapaksa and Prime Minister Wickremesinghe said they would resign this week after antigovernment protesters stormed and occupied the president’s residence and office on Saturday. The resignations reflect popular anger over an economic crisis that has seen the country deplete its foreign reserves, default on its debt, and lose its ability to import needed food, fuel, and medicines.

The two leaders’ intent to resign comes after an emergency meeting of the country’s political party leaders that demanded they step aside to make way for an interim, all-party government. During the meeting, the party leaders also resolved to hold early elections.
Sri Lanka’s problems stem largely from reduced tourism revenues, excessively large tax cuts, and the government’s delay in seeking aid from the IMF. Nevertheless, its crisis is also being seen as a harbinger of the risks facing highly indebted emerging markets as global oil prices rise, major central banks hike interest rates, and the dollar strengthens. Other key emerging markets at risk include Pakistan, Lebanon, and Zambia.

Iran-Venezuela: The Venezuelan government has agreed to make one million hectares (about 2.5 million acres) of agricultural land available to Iran so it can grow soybeans, corn, and other crops there. The deal aims to improve Iran’s food security and get around the country’s chronic shortage of fresh water. It reportedly follows a similar agreement in which Russia provided 100,000 hectares of land for Iranian agriculture.

After Western countries effectively seized Russian foreign reserves at the outbreak of the Ukraine war, the Iranian deals offer more evidence that countries concerned about the security of their reserves may channel more of their resources into commodities, land, and other physical resources.
If such a shift of foreign reserves becomes widespread, we think it could help buoy prices for those resources.

Global Shipping Rates: In additional evidence that slowing demand is starting to bring down prices, maritime and over-the-road shipping rates are starting to come down, although they remain higher than they were before the pandemic. Weakening demand has also started to push down some commodity prices, including oil and copper.

United States – COVID-19: Hospital admissions are rising across Europe and the U.S. as highly transmissible COVID-19 variants like BA. 5 Omicron drive infections. However, the resulting illness is proving to be less likely to be severe or cause death than in previous waves.

United States – Baby Formula Market: Abbott Labs (ABT, $109.26) has reopened its key baby formula plant in Sturgis, Michigan, following a nearly three-week closure stemming from severe thunderstorms that blew through the state. The company has restarted production of its EleCare formula for babies with digestive issues and will begin shipping it in the next few weeks. The development may soon alleviate a supply shortage that proved politically damaging to President Biden and led to the U.S. easing rules to boost imports of foreign formula.

United States – Commodity Markets: Exchange operator CME Group (CME, $208.90) said it will revamp its lumber contract and give it the new ticker of “LBR” beginning next month. To boost trading in 2×4 derivatives and improve liquidity, the new contract will be fulfilled with a truckload of boards instead of a railcar full (which is about one-quarter the volume of wood) delivered to Chicago rather than a remote Canadian rail junction. The specifications will allow for eastern species of spruce, pine, and fir, instead of only varieties that grow in the West. The current contract that expires in May 2023 will be the last listed under existing specifications.

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Daily Comment (July 8, 2022)

Posted on July 8, 2022July 8, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a discussion about Shinzo Abe’s unfortunate assassination. We then examine central bank news from Europe and the U.S. and its impact on the euro-dollar exchange rate. Next, we provide an update on the latest development from the Ukraine war. Finally, we end the report with an overview of various stories that we believe will affect financial markets.

Attack in Japan: Former Japanese Prime Minister Shinzo Abe was shot and killed during a campaign visit to Nara. His assailant has been apprehended and is currently in police custody. The shooter claimed that the killing was not politically motivated. Shinzo Abe was one of Japan’s longest-serving prime ministers holding office from 2012 to 2020. He will be remembered for his push to rebuild Japan’s military and implement Abenomics, a strategy aimed at boosting the economy’s growth through accommodative monetary policy, fiscal stimulus, and structural economic reforms. So far, there is no sign of whether this event will delay the Japanese national elections scheduled to take place on Sunday.

Central Bank News: The Federal Reserve reaffirmed its commitment to raising rates. Meanwhile, the ECB struggled to articulate its policy path as it plans to raise rates this month. The hawkish tone of the Fed official and lack of policy certainty of the ECB helped drive the euro-dollar exchange rate closer to parity.

ECB’s New Tool: The European Central Bank’s anti-fragmentation tool will not be ready by the July 21 meeting. According to the minutes released by the ECB, the bank is still working out the details of its plan to prevent financial fragmentation within the Eurozone. The specifics of the policy tool were scheduled to be released over the next two weeks, but there are still disagreements about how the central bank should implement the new tool, especially as it seeks to raise rates to contain inflation. Typically, when the ECB increases its policy rates, borrowing costs for southern European countries rise faster than northern European countries. Although a small spread is sustainable, a significant divergence in bond yields threaten to overwhelm southern governments’ debt-paying capacity. The lack of policy uncertainty suggests that the ECB may be reluctant to take aggressive action in curtailing inflation, therefore leading to weakness in the euro.
Fed comments: Despite the recent spate of disappointing economic data, Fed officials are still pushing for a 75 bps hike in July. On Thursday, St. Louis Fed President James Bullard and Fed Governor Christopher Wallace insisted that the Federal Reserve needs to get inflation under control. Bullard argued that the Fed is in danger of losing its credibility if it does not continue raising rates. At the same time, Wallace claimed that high inflation could slow economic activity in the future. The hawkish tone from the Fed officials suggests that they remain certain that the economy can withstand additional rate hikes. Waller described market concerns of a downturn as being “overblown,” while Bullard maintained that the Federal Reserve can still achieve a soft landing.

The comments by Waller and Bullard suggest that they prioritize taming inflation over economic growth. Although both appear to downplay the notion that a recession is imminent, it is unlikely that these officials would ever admit to wanting to raise rates into a recession. Instead, officials may be trying to ensure that the Fed maintains some flexibility in its ability to raise rates in case growth remains stable and inflation is elevated. If we are correct, the Fed may wait to see solid evidence of economic deterioration before ending its tightening cycle.

Russia-Ukraine Update: The Kremlin announced that it is pausing some of its military activity to rest and prepare for new operations. Experts widely expected the pause as Russian forces sustained significant casualties in their fight to take over the Luhansk region. Although troops are expected to continue to maintain small-scale operations, Russia could be preparing for another run to take over Kyiv. In a show of defiance to Western sanctions, Russian President Vladimir Putin stated that the war in Ukraine has not even started, and challenged the West to meet it on the battlefield. Nevertheless, Putin’s provocative remarks suggest that his recent success could encourage him to take more decisive action in the war.

World leaders gathered in Bali earlier today to discuss the war in Ukraine and its impact on the global economy. Although the Indonesian Foreign Minister urged countries to use the gathering to reduce tensions, the divide between the U.S. and Russia was palpable. While U.S. officials were looking to gain support for potential price caps on Russian oil, officials from Moscow were looking to gain reassurances from China. The competition between the U.S. and Russia over influence will probably have geopolitical ramifications. If a country sides with one, it must be prepared to isolate itself from the other. We believe that this trend reflects a broader move toward forming regional blocs, which will eventually affect how countries trade with one another.
Russian Foreign Minister Sergey Lavrov stated that he was prepared to negotiate over wheat; however, he walked out of several meetings after criticism over Russia’s invasion. Lavrov’s exit suggests that Russia will probably continue its efforts to block Ukraine’s wheat exports.
US. Senators Lindsey Graham (R-S.C.) and Richard Blumenthal (D-Conn.) met with Ukrainian President Volodymyr Zelensky on Friday. The two senators are looking to push legislation that would classify Russia as a state sponsor of terrorism, which should open the country to additional sanctions and trade restrictions.

Chinese News: Chinese car sales jumped in June, suggesting that the economy is seeing an improvement in consumption following the lifting of COVID restrictions. The China Passenger Car Association reported that vehicles sales rose 23% from the prior year. The increase in purchases suggests that consumers are feeling more confident about the economy.

The Biden administration is considering reducing U.S. tariffs on Chinese goods. Although President Biden has not made a final decision, members of his administration, including Treasury Secretary Janet Yellen, have argued that tariff reduction could lessen price pressures. Meanwhile, advocates of tariffs have argued that keeping them in place will give the White House more negotiation leverage in trade talks with Beijing.

Housing market: Mortgage rates posted their steepest one-week decline since 2008. According to Freddie Mac, the average 30-year fixed-rate mortgage fell 40 bps from 5.70% to 5.30%. The sharp drop in rates reflects a broader decline in interest rates for longer-term bonds as investors are growing more concerned about a recession.

Boris Johnson Exit: The U.K. conservative party is exploring plans to expedite Prime Minister Boris Johnson’s transition from the premiership. Johnson wanted to stay on for three months while the party chose his successor. The party is currently in the process of selecting two candidates for party leader and is expected to hold a vote by early September. There is no indication that Johnson’s replacement will cause a significant shift in the country’s policy agenda.

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Daily Comment (July 7, 2022)

Posted on July 7, 2022July 7, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a recap of the minutes from the FOMC meeting in June. Next, we discuss the latest events in Ukraine and other situations related to the war. Afterward, we review various stories from around the world, including developments in the European Energy Crisis, China’s new stimulus, and the possibility of inflation cooling in the U.S.

Fed Meeting Minutes: The Federal Reserve reaffirmed its commitment to fighting inflation in its June meeting. The minutes from the meeting revealed that FOMC members were concerned that the central bank was at risk of losing its credibility. As a result, the members decided that a 50 or 75 bps rate hike would be appropriate for their July meeting. The market had little reaction to the minutes, as recent economic data did not convince investors that the minutes represented the Fed’s current thoughts on the economy. Thus, equities closed slightly higher than open, and the two and 10-year Treasury remained inverted.

Russia-Ukraine: For the first time in 133 days, Russia has not reported any territorial gains in Ukraine. The lack of progress suggests that Moscow may be implementing a pause in its invasion. Although Russian forces are still conducting limited military offensives in Ukraine, it appears that the Kremlin is preparing for more expansive operations in the future. This assessment is supported by the Russian government adopting a new law that will give it direct control over its economy. The measure allows government officials to recall workers from vacation, reschedule their time off without consent, and force them to work weekends, holidays, and nights. This change in law will allow the government to allocate more of the country’s resources toward its war effort as it seeks to take over the entirety of Ukraine. This development provides evidence that this war will probably not end soon.

The West is continuing to look for ways to curtail the Russian invasion by targeting its energy exports. After sanctions failed to deter countries from purchasing Russian oil, the U.S. and its allies are now looking to implement price caps. The caps on the price of Russian oil will range from $40-$60 a barrel, and are designed to limit Russian export revenues. So far, it isn’t clear when the caps will be imposed; however, there does seem to be some momentum for the measure. The U.S. officials are meeting with G-20 members in Bali to work out the details.
As the Russian blockade continues to prevent Ukraine from exporting grain to the rest of the world, there is a growing push to transfer these crops via rail. On Thursday, Romania announced that it was able to reopen its railway earlier than expected to help facilitate the shipment of wheat. As a result, Ukraine can transfer its grain to countries whose ports are not blockaded. The improvement in the transportation of wheat will possibly reduce the likelihood of a global food crisis.
Ukrainian President Volodymyr Zelensky revealed that the weapons it received from the West are helping to slow Russian advances in his country. His statement suggests that Ukraine could look to revamp efforts to retake lost territory after a noticeable lull in the conflict. This will likely mean that the stalemate between the two sides will continue as both have the weapons needed to keep the war going.

Shake-up in Europe: As the war looks to ramp up pressure on Russia, Europe is also dealing with political headaches.

PM Boris Johnson: Boris Johnson was forced to resign from his post following a slew of resignations and growing calls from within his party to step down. More than 30 people have left his administration, and Johnson fired a key minister after urging his resignation. Although he plans to stay in power until a new party leader is chosen, there is growing pressure for him to step down immediately. Details of a timeline of his departure are expected to be released next week. The possibility of decreasing political uncertainty following Johnson’s resignation led to a brief rally in the pound. Currently, there are several candidates to replace Johnson, but no clear front-runner.
European Energy Crisis: As commodity prices rise, Europe is taking extreme action to help ensure its energy security. On Thursday, the French government agreed to nationalize nuclear energy company EDF (ECIFY, $1.74). France’s decision to take it over is designed to assure the company’s survival as the country prepares to secure its energy resources moving into the winter. In a similar move, the German government bailed out energy provider Uniper (UNPRF, $10.75) on Tuesday. Recently, energy shocks due to the war in Ukraine have forced governments to make bold moves to protect the stability of energy prices. Although the EU has not altered its commitment to fight climate change, the rise in the amount of coal use and its reclassification of green energy to include natural gas and nuclear suggest it is becoming more flexible in meeting its ambitious climate standards. In the short run, this could bolster commodity prices as it appears Europe has no other alternatives to fossil fuels.
Draghi in trouble? The Italian parliament is in danger of collapse as disagreement over the Ukraine war has led to fractures within the ruling government. Leader of the Five Star Movement Giuseppe Conte met Prime Minister Mario Draghi to deliver a list of demands to ensure the party’s support of the coalition. The list included measures to protect the Five Star welfare payment program and raise the minimum wage. Although the Five Star Movement confirmed its commitment to supporting the current government, it is not clear how long that will last. The inter-coalition rift started when the Five Star Movement voted against offering Ukraine military support and urged the government to use more of the country’s resources to improve people’s lives at home. Tension within Italy has led to heightened political uncertainty risks and could have ramifications for the euro area in the long run.

Inflation cooling: As the economy shows signs of slowing, there is evidence that prices may be cooling. The latest data from Zumper suggest that rental prices are starting to slow. Meanwhile, the chipmakers are reporting quicker delivery times of semiconductors suggesting that the shortage of chips may be waning. Lastly, energy prices, one of the largest contributors to inflation, have started to decline. Brent Crude has dipped below $100 a barrel for the first time since April and declining demand could see it fall further later this year. These developments indicate that inflation may have already peaked.

China: Although economists forecast that the Chinese government will report that its economy grew 1.5% in the second quarter, other data sources suggest that the economy shrank. The slowdown in the economy is forcing Beijing to take action to ensure that it meets its target of 5.5% growth by the end of the year. To meet its goal, China is exploring a rare mid-year sale of bonds to help fund a $220 billion stimulus package. The funds will be used to boost infrastructure and stimulate the economy.

After loosening some of its COVID restrictions and offering stimulus, Beijing may also try to help its economy by improving ties with U.S. politicians and pushing vaccinations. According to the National Counterintelligence Security Service, China plans on recruiting state and local leaders to lobby Washington on its behalf. If true, the report suggests that Beijing may not be in a rush to decouple from the U.S. as it seeks to rebound from its recent economic setback.
New lockdowns may be imposed in Shanghai after the city reported that the number of new infections doubled on Wednesday to 54. The outcome suggests that supply chains issues may persist in China.

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Daily Comment (July 6, 2022)

Posted on July 6, 2022July 6, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including an important indication that Russia still intends to take over or control the whole of Ukraine. We then review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine: Now that Russian forces have seized the province of Luhansk and could seize the province of Donetsk as well, it is notable that Russian Security Council Secretary Patrushev yesterday said his country’s military operation in Ukraine will continue until Russia achieves its goals of protecting ethnic Russian civilians from “genocide,” “denazifying” and demilitarizing Ukraine, and obliging Ukraine to be permanently neutral between Russia and NATO—almost exactly the goals President Putin announced in his February 24 speech justifying the war. The statement seems to confirm that Putin’s public shift to the more limited war aims of defending Luhansk and Donetsk was merely a ruse. Now that Putin feels emboldened by his military success in those regions (and perhaps because he’s facing pressure from Russian nationalists), he appears to be revealing that he still intends to control all of Ukraine in due time.

If Putin hasn’t really abandoned his maximalist war aims in Ukraine, a long, protracted war of attrition is more likely. Putin may order or allow his military to rest and regroup from time to time, especially if he thinks the Western allies are tiring in their support for Ukraine, or if he thinks that the upcoming elections in the U.S. or elsewhere will produce new leaders more likely to acquiesce in Russia’s invasion. However, Putin could then order renewed offensives at a future time.
If Putin retains his maximalist war aims, another important implication is that it would make no sense for the Ukrainians to concede any territory to the Russians in hope that they would be appeased.
New reporting by the Wall Street Journal indicates Russian forces have transformed Ukraine’s massive Zaporizhzhia Nuclear Power Plant into a forward military base, likely hoping that safety concerns will prevent the Ukrainians from attacking it. The report indicates that the Russians are deploying heavier, longer-range weapons to the plant almost daily, and that the base has therefore become the linchpin of Russia’s control over the surrounding region.

Global Oil Market: Despite the ongoing supply disruptions from the war in Ukraine, the recent slump in some commodity prices accelerated sharply yesterday. Crude oil prices fell especially hard, with Brent Crude closing 9.5% lower at $102.77. Prices have rebounded to some extent this morning, but the sell-off reflects intensifying concerns about rising interest rates, signs of slowing demand, and a growing risk of recession in the coming months. Other factors pushing down oil prices include the strong dollar and indications of increased production.

The fall in crude oil prices and weakening demand already appear to be pushing down gasoline prices as well.
According to AAA, average U.S. gasoline prices have now fallen modestly to $4.80 per gallon, compared with more than $5.00 per gallon last month.

Global Digital Currency Markets: In more fallout from the recent plunge in cryptocurrency values, crypto broker Voyager Digital (VOYG.TO, 0.3350) filed for bankruptcy protection. The move comes just days after the firm suspended withdrawals and trading on its platform and secured a $400 million emergency credit line from crypto broker FTX.

Voyager Digital’s problems stem mostly from a loan that one of its subsidiaries made to crypto hedge fund Three Arrows Capital, which defaulted after taking heavy losses on its investment in multiple cryptocurrencies.
FTX has recently played a key role in propping up other crypto firms in trouble, so it will be interesting to see if it takes a significant loss from the Voyager Digital debacle, or whether the debacle forces it to step back from helping other firms.

European Union Digital Markets Regulation: The European Parliament yesterday gave final approval to two key laws that analysts believe could become models for global digital markets regulation. The laws aim to rein in anti-competitive behavior and control services on digital platforms, with fines in extreme cases ranging up to 20% of an offending company’s annual revenue. As we have warned in the past, such legislation reflects the growing regulatory risk facing technology companies in countries around the world.

The Digital Markets Act, which is aimed at anti-competitive behavior, will impose new obligations on how a small number of digital giants operate, with rules dealing with online messaging, digital advertising, and the app ecosystem. For example, the law would bar dominant tech companies from using their platforms to promote their own goods and services over those from other companies.
- On a related note, the EU and Amazon (AMZN, 113.50) have reportedly struck a deal that will lift an anti-competitiveness action against the company in return for Amazon changing some of its practices.
- For example, Amazon would allow third-party sellers on its marketplace to access more information that can help them sell more products online.
The Digital Services Act, which is aimed at regulating digital content, will require large social-media platforms to take steps to deal with illegal content and other material regulators view as harmful, and give users an avenue to register their complaints about content moderation

United Kingdom: Prime Minister Johnson suffered a potentially career-ending blow yesterday when both his chancellor, Rishi Sunak, and his health secretary, Sajid Javid, resigned in protest over Johnson’s long string of ethical scandals. More government members resigned early today. Johnson has vowed not to resign, and internal Conservative Party issues suggest he could cling to power for months. However, even if he remains in power for the time being, he may no longer have the political capital to push forward any policy proposals.

The U.K. is likely to enter a period of greater political uncertainty, which would likely be a further drag on its economy and financial markets.
Reflecting the economic and financial risks, the pound fell further. As of this writing, it is valued at $1.1909, down 0.4% from yesterday and 11.8% from the end of 2021.

Norway: The government stepped in to end a strike that threatened to more than halve the country’s natural gas exports, saying the walkout was causing widespread risks to Europe’s energy security. Nonetheless, the Norwegian strike and similar ones around the globe show that raging consumer price inflation is spurring higher wage demands from workers and threatening to create wage-price spirals.

The strikes also reflect falling labor force participation in some major countries, which has reduced the supply of labor and given employees more bargaining power.
We continue to think that inflation rates will moderate over the rest of the year, but as we noted in our Comment yesterday, falling labor force participation, reduced labor supply, and workers’ increased bargaining power make up a key reason why inflation rates aren’t likely to return all the way to their low pre-pandemic levels.

Japan-South Korea: To repair Japanese-South Korean relations as the two countries try to resist China’s rising power, the South Korean government has reportedly launched an initiative to resolve longstanding compensation claims against Japan for its forced labor practices during World War II. Although South Korean courts have allowed the country’s citizens to sue Japanese firms for compensation, the initiative will try to channel those claims into an alternative process that doesn’t threaten seizures of Japanese corporate assets.

China: We continue to see nearly constant reminders that President Xi’s Zero-COVID policies could disrupt the Chinese economy at any time, potentially undermining global growth and pushing down commodity prices.

Authorities in Shanghai ordered a new round of mass testing for more than half of the city’s districts after 24 new cases were found.
Officials in Beijing today announced that people wanting to enter public facilities such as museums, libraries, and gyms will need to show proof of vaccination starting July 11, instituting a vaccine pass for the capital for the first time.
Authorities in Xi’an reported the country’s first community outbreak of cases related to the Omicron subvariant BA.5, prompting officials in the city of around 13 million people to shutter entertainment businesses, schools, and dine-in services for a week.

Congo-Rwanda: The president of the Democratic Republic of Congo has warned that war could break out with Rwanda unless his neighbor stops backing rebel groups fighting in his country. The statement by President Félix Tshisekedi follows a strong offensive in eastern Congo by the M23 armed group, which he said was backed by Rwanda.

U.S. Environmental Regulation: A federal judge in California yesterday threw out Trump-era changes to the Endangered Species Act, including one that allowed economic factors to be considered when government officials are deciding whether to list a species as threatened or endangered. The ruling also voids regulations that made it more difficult to give protections to species threatened by anticipated future events, such as the impacts of climate change.

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Daily Comment (July 5, 2022)

Posted on July 5, 2022July 5, 2022 by Amanda Ahne

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 Russian forces seem to be on their way toward fully seizing Ukraine’s eastern Donbas region. We next review other international and U.S. developments with the potential to affect the financial markets today with a focus on the disrupted supply of labor and industrial inputs that is keeping inflation so high. Our discussion explains why those supply disruptions are likely to linger and prevent inflation from falling all the way back to pre-pandemic levels.

Russia-Ukraine: Russian forces over the weekend took control of the key city of Lysychansk and the overall province of Luhansk in eastern Ukraine’s Donbas region, while maintaining defensive positions in the areas they hold in southern Ukraine. Following the seizure of Luhansk province, Russian President Putin appeared to order an operational pause so that the involved units can rest and refit, although the Russian military will likely be wary of taking the pressure off Ukrainian forces. Meanwhile, influential Russian military bloggers criticized the seizure of Luhansk as too little gain for the manpower and equipment lost in the battle, probably to increase pressure on the Kremlin to call for a fuller military mobilization. At the same time, the Ukrainian military is increasingly employing Western-provided precision artillery and missiles to destroy Russian military supply resources.

The Ukrainian government released a $750-billion recovery plan to rebuild and get the economy moving again once the war has ended. Releasing the plan, Prime Minister Shmyhal said Russia’s invasion had caused more than $100 billion of damage to infrastructure and demanded that the “key source” of funds for reconstruction should be the confiscated assets of the Russian government and its oligarchs.
In Germany, the government has drafted a law that allows it to take stakes in companies crippled by the soaring cost of imported gas as tensions with Russia threaten to plunge the country’s power sector into crisis. If passed by parliament, the law would clear a path for the government to bail out Uniper (UNO1.DE, 10.96), the largest importer of Russian gas into Germany.

Global Semiconductor Market: The recent rout in cryptocurrencies and a slowdown in personal computer sales have combined to put a damper on semiconductor demand, easing the shortages that have caused problems for industries ranging from autos to home appliances. As evidence of the change, Intel (INTC, 36.34) recently initiated a hiring freeze in its PC-chip division. If semiconductor supply and demand now come into balance, it could help ease inflation pressures and eventually prompt the Federal Reserve to cool its interest-rate hikes.

Global Labor Market: We continue to note increasing labor unrest across the globe. In a new example, union workers at Norwegian oil and natural gas producer Equinor (EQNR, 33.83) went on strike last night in a bid for higher wages to compensate for raging consumer price inflation, forcing the firm to shut down three oil and gas fields. The union is threatening even stronger measures in the coming days, which the Norwegian Oil and Gas Association warns could cut Norway’s gas exports by 13%. Since Norway is now Europe’s second-biggest supplier of gas and has become a go-to source to replace supplies from Russia, the move has helped push European gas prices up some 8% so far today.

The strike at Equinor follows a major British railway strike, a Scandinavian airline pilots’ strike, a picket by U.S. airline pilots over the holiday weekend, a potential strike by West Coast longshoremen, and a move to increase unionization at iconic technology and consumer services firms.
This labor unrest probably reflects not only the challenges faced by workers during the pandemic, but also the way they’ve gained bargaining power as the pandemic pushed legions of workers out of the labor market (especially Baby Boomers). The fall in labor supply has increased workers’ relative power versus employers, although probably not enough to dramatically bring down wealth and income inequality.
Since the many workers who finally went into retirement probably won’t come back, labor supply will likely continue to be restrained in the future. As with the supply of key goods, this will likely keep inflation from dropping back to pre-pandemic levels.
- Our labor market analysis has long emphasized that as workers approach and first enter retirement, they tend to reduce their spending and boost saving, helping push down inflation. However, our recent research has focused more on what happens once they are fully into retirement.
  - At that point, even though they have dramatically cut their spending, they still consume plenty of food, energy, and other goods and services. The difference is that they are no longer contributing to the production of such goods and services.
  - With the demand from legions of retirees (and other dependents) relatively high compared with their production, the result will likely be increased upward pressure on overall prices.
- We see a similar dynamic taking hold in global supply chains. While factors like increased investment, the end of pandemic lockdowns, and demand destruction will probably help bring down global prices for a range of goods in the coming months and quarters, we still think deglobalization and increased geopolitical tensions will keep supplies tighter than they were at the height of globalization over the last decade. That will also tend to keep inflation from falling all the way back to the levels seen in the decade before the pandemic.

Cryptocurrencies-China: The slump in cryptocurrencies has also led to well-publicized problems for crypto lenders, brokerages, and hedge funds, but now we are also seeing more reports of corporate investors facing problems. The latest example is the Chinese selfie app owner Meitu (1357.HK, 0.93), which has said its first-half loss may more than double because of bad bets that it recently made on cryptocurrencies.

Eurozone: The strikes, the war, and other economic challenges continue to weigh on the euro, driving the currency down as much as 1.4% so far this morning, to a 20-year low of $1.0279. With the Eurozone expected to face continued headwinds even as the ECB continues to tighten monetary policy slowly, it increasingly looks like the currency will soon reach parity with the dollar (a value of $1.00).

Spain-Morocco: In an incident little noticed amid the Russia-Ukraine war and major Western summits last week, some 2,000 migrants tried to storm Spain’s enclave of Melilla on Morocco’s northern coast in late June, resulting in 23 deaths. Spanish Prime Minister Sánchez said the deaths were necessary to defend “the national sovereignty and the territorial integrity of Spain,” but he has been taking intense criticism at home and abroad for the tough response.

United States-China: Reports over the weekend said President Biden this week plans to lift tariffs on some Chinese consumer goods, such as clothing and school supplies, to help bring down inflation. He reportedly also plans to announce a new framework allowing importers to request tariff waivers.

However, there are sharp disagreements over the move within the administration, so the move could still be delayed.
- Officials including Treasury Secretary Yellen oppose the tariffs on grounds that they are a drag on economic growth and often push up prices unnecessarily. Yellen and Chinese Vice Premier Liu He reportedly discussed the tariffs today in a video conference, which the Chinese state press described as “constructive.”
- Officials including National Security Advisor Sullivan and Trade Representative Tai support the tariffs because they provide leverage in the U.S.’s geopolitical and economic disputes with China. At most, these officials want any reduction in consumer good tariffs to be matched by higher tariffs on key industrial goods.
In any case, even if the consumer goods tariffs are lifted, we expect the impact on inflation would be minimal.

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