by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including an update on how Russia is responding to Ukraine’s recent battlefield gains.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, along with some additional commentary on yesterday’s disappointing inflation data and the resulting big drop in stock prices.

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

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

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

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

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

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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

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

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

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

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