by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion of the September effect. Next, we review possible headwinds in Europe. We end the report by examining the rivalry between the West, Russia, and China.

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

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

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

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

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

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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

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

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

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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 a key focus is now on the risks to a major nuclear energy plant in eastern Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a few additional words on Federal Reserve Chair Powell’s speech at the Jackson Hole symposium on Friday.

Russia-Ukraine:  Depleted and combat-weary forces from both Russia and Ukraine continue to make only the most minimal territorial advances along their front lines, although both sides continue to use long-range missile and artillery strikes to weaken the other side.  Notably, shelling continues in the area around the Zaporizhzhia nuclear power plant, with both sides accusing the other of putting the plant in danger.  Meanwhile, media reports say a newly formed 3^rd Army Corps composed of recent volunteers from around Russia is now ready to deploy to Ukraine with highly advanced weaponry, although analysts are doubtful that the quickly trained troops will be competent enough to turn the tide of the war.

• Today, the UN’s International Atomic Energy Agency is due to send a team to the Zaporizhzhia nuclear plant to assess its condition.  Led by IAEA Chief Rafael Grossi, the team will also check safety and security systems and evaluate staff conditions.
• On the energy front, the CEO of Shell (SHEL, $54.88) warned that Europe’s energy crisis will last several years at least, even if it gets through this winter.  According to the executive, “It may well be that we have a number of winters where we have to somehow find solutions through efficiency savings, through rationing, and a very, very quick buildout of alternatives.”
  • With Europe facing extremely high energy prices, rationing, and increased interest rates, investors continue to push down the euro.  Investors also continue to bet on further depreciation in the common currency, with net short positions against the euro now at their highest level since the start of the coronavirus pandemic in early 2020.
  • The euro is staging a very modest rebound so far this morning, but it remains below par with the dollar at just $0.9996.

China-Solomon Islands-United States:  Earlier this month, The U.S. Coast Guard said the Solomon Islands failed to respond to an official request for one of its cutters to make a routine port call for replenishment, forcing the vessel to make its port call in Papua New Guinea.

• The refusal to grant permission to dock could be related to a secretive new security agreement struck between China and the Solomon Islands earlier this year.
• The incident suggests China may be requiring the Solomon’s government to distance itself from the U.S.  In return, China could support Solomon’s President Sogavare in his effort to delay his country’s next elections and stay in power.
• In any case, the matter illustrates how the South Pacific islands are becoming a key theater in the U.S.-China rivalry.  It also highlights how countries around the world are being pressured to ally themselves with either the U.S. or China.

United Kingdom:  In the race to succeed Boris Johnson as Conservative Party leader and prime minister, front-runner Liz Truss, the current foreign minister, is coming under increased pressure to outline her plan to support British families facing enormous energy bills this winter.  Truss has tried to hold the line against providing new cash “handouts,” preferring to provide tax cuts instead, but the opposition Labor Party is hammering her for the way that plan could provide outsized benefits to upper-income Brits.

Serbia-Kosovo:  Over the weekend, Serbia and Kosovo reached a deal to resolve administrative hurdles both sides had slapped on their neighbor’s citizens or threatened to do so.  Serbia agreed to abolish entry/exit documents for Kosovo ID holders and Kosovo agreed not to introduce them for Serbian ID holders.  The deal diffuses a flashpoint that could have spiraled into violence just as Europe is already dealing with the war in Ukraine.

Pakistan:  The Pakistani government says it has now secured the $37 billion in loans and investments needed to secure an additional $4 billion loan from the IMF to cover its budget shortfall for the current fiscal year.  IMF officials today will vote on approving the deal.  Securing the new funding means Islamabad now has pushed off the threat of a near-term default, although it still faces financial risks in the medium term because of issues like its fractious political dynamics and recent flooding.

Brazil:  Last night, current right-wing populist President Bolsonaro and leftist former President Lula da Silva squared off in their first debate ahead of this fall’s presidential elections, along with four minor candidates.  Bolsonaro has recently been trailing da Silva badly in the polls, but press reports suggest he landed a few blows by painting the former president as corrupt.  Meanwhile, da Silva stressed how good Brazil’s economy had been under his administration.

U.S. Monetary Policy:  In his keynote address at the Kansas City FRB’s annual conference in Jackson Hole, Wyoming, on Friday, Fed Chair Powell poured buckets of cold water on the idea that U.S. monetary officials would pivot to easier policy anytime soon.  Powell not only signaled that the Fed will keep raising rates until they are high enough to restrain economic growth but will hold them there until inflation pressures come down significantly, even at the risk of pushing the economy into recession.  Isabel Schnabel, the German member of the European Central Bank’s executive board, drove home the point in her speech on Saturday.  According to Schnabel, the cost of inflation is so high that central banks must act decisively to stop it, without fear of causing a recession.

• The speech sparked a sizable pullback in risk assets on Friday, and we suspect it could continue to weigh on stock prices in the near term.
• Indeed, stock futures are down approximately 1% at this writing, and the 10-year Treasury note has risen to a two-month high of 3.116%.

U.S. Energy Policy:  The California legislature this week is set to vote on whether to extend the life of the state’s sole remaining nuclear generating station beyond its planned closure in 2025.  Governor Newsome has recently reversed course and called for extending the life of the plant amid rising electricity demand and reduced availability of electricity from other sources, such as hydroelectric.  A vote in favor of keeping the plant open would add to the recent momentum toward nuclear power not only in the U.S. but globally.

U.S. Space Program:  Earlier today, NASA was forced to temporarily scrub the planned launch of its Artemis I rocket for a trip to the moon, based on unresolved problems with the rocket’s engines.  Getting the program back on track would help ensure the continuance of the program, along with hefty revenue streams to its major aerospace contractors, even though it has been criticized for its cost.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment examines why Thursday’s economic data could encourage the Fed to raise rates more aggressively. Next, we explain how elections in Russia could impact its war with Ukraine. We conclude the report by discussing the U.S.-China rivalry and how it could impact Asia.

More Hikes? The positive Gross Domestic Income (GDI) report for Q2 could overshadow the negative Gross Domestic Product (GDP) numbers and pave the way for more Fed tightening.

• An alternative measure of economic output has bolstered the Federal Reserve’s claim that GDP might not reflect the underlying fundamentals of the economy. In the second quarter, GDI, adjusted for inflation, rose at an annualized rate of 1.4% from the previous period. The number contradicts the GDP reading of a 0.6% drop in economic activity in the same period and suggests that the economy may not have contracted at all this year. In an ideal world, the two numbers should be identical, as total spending should equal total income. However, statistical differences between the two variables have widened to levels never before seen in the series history.

• A strong labor market might be responsible for the divergence between the real GDP and real GDI. While GDP is the sum of the total market value of all the final goods and services produced, GDI is the aggregate income earned and cost incurred during production. In theory, the latter should reflect the underlying labor market strength. Although the initial claims have risen over the last few months, many workers that reentered the workforce were able to find jobs quickly. As a result, the tight labor market may have shielded the economy from the negative impacts of monetary tightening.
• The positive GDI number could push the Fed to raise interest rates aggressively over its next few meetings. St. Louis Fed President James Bullard has insisted that the central bank should lift its policy rate to 4.0%. Kansas City President Esther George has advocated that the bank should go even further. Assuming that the FOMC follows Bullard’s lead, it would suggest that they could raise rates by 50 bps in each of its next three sessions. Hence, financial conditions could tighten significantly throughout the rest of the year and possibly worsen in 2023.

The market will be on pins and needles when Fed Chair Jerome Powell gives the keynote address at the Jackson Hole Symposium. Over the last two days, investors have purchased more than    $1 billion in short-term bond ETFs and have pulled over $2 billion from ETFs attached to the S&P 500. So far, it is speculated that Powell will make hawkish comments during his speech; however, a dovish tone could lead to a strong rally.

Russia-Ukraine: The Kremlin is ramping up pressure in Ukraine to solidify gains before election season for Russia begins in September.

• Russian President Vladimir Putin signed an order to boost the Russian troop total by 137,000 to 1.15 million. It was the first time that Putin had expanded the military headcount in over five years. The new decree has added to speculation that Russia believes that the war will be protracted. However, there is also the possibility that the order could be a bluff. Russia has not been able to take over Ukraine as swiftly as it initially implied it would. In short, Putin likely has a credibility problem. The war has lasted six months despite assurances from Putin that the conflict would only be a few weeks. Additionally, the government was forced to delay annexation referendums in Donbas due to its inability to secure the region properly. Thus, the Kremlin’s decision to increase the number of troops could be a way to signal to its population that the Russian military is still determined to win.
• The Moscow exchange plans to allow evening trading next month. Stock trading was halted for a month after the conflict began as the government attempted to hide the financial damage of the war. The government then began to allow limited securities trading in the morning sessions. The Russian Central Bank has maintained that regulators will block investors from “unfriendly” countries from trading on the exchange. The move to open the market for a full day reflects the government’s attempt to show a return to normalization after the invasion of Ukraine.
• Ukrainian President Volodymyr Zelensky has stated that the world narrowly avoided a radiation disaster. On Thursday, Ukraine’s largest power plant was forced to disconnect after fires damaged a transmission line. The incident has heightened concerns that the war could lead to a major nuclear disaster as Russian forces continue to use the power plant as a shield against attacks from Ukrainian troops. In addition, there was a mass power outage in areas nearby. A nuclear accident in Ukraine could lead to a global crisis and possibly slow the global push to use nuclear energy in other countries.

Elections are essential, even for authoritarian governments. Regional elections will take place on September 11, and this will be the first time Russian constituents are able to showcase their level of satisfaction with the government. A low turnout would suggest that the war has dented sentiment in the country. It could also force Putin to take more extreme measures to end the war as he prepares to run for reelection in early 2024.

Asia Risks: Friction between the U.S. and China remains the top risk in Asia.

• Regulators in the U.S. and China achieved a breakthrough in negotiations to keep Chinese firms listed on American exchanges. Chinese regulators have requested major accounting firms to bring relevant audit documents of Chinese firms to the U.S Public Company Accounting Oversight Board. The order will prevent Chinese companies from being delisted from American exchanges. Although this is a positive development, it does not change the trajectory of the U.S.-China relationship.
• Tensions between the U.S. and China continue to escalate as U.S. lawmakers continue to travel to Taiwan. Senator Marsha Blackburn (R-TN) is the third politician to travel to the self-governing island this month. House Speaker Nancy Pelosi (D-CA) and Senator Ed Markey (D-MA) also made the trip. China responded to the Pelosi trip by holding military exercises near Taiwan. Thus, Blackburn’s trip could also have a similar response. The big takeaway is that American lawmakers believe it is politically beneficial to poke China in its eye over Taiwan. Although China’s reaction has been mild, relative to its threat to the U.S. “not to play with fire,” their response to such provocation could escalate after President Xi is sworn in for a third term. Therefore, we still believe the risk of conflict between the U.S. and China remains elevated.
  • Additionally, China has urged the U.S. not to engage India in planned military drills along the two countries’ shared border, referred to as the Line of Actual Control (LAC). China believes that such exercises would violate the Beijing-New Delhi accords.
• China’s assertiveness has finally pushed Japan to ramp up its defense budget drastically. The Japanese government will double its defense spending over the next five years to address national security threats. In June, the government released a report showing the country’s concern about the Russia-Ukraine war, China’s intimidation of Taiwan, and their vulnerable supply chain technology. Behind only the U.S. and China, Japan will have the third largest military budget in the world.

The rivalry between the U.S. and China could lead to a broader war in the Indo-Pacific. Many countries in the region fear China’s rise as a military power and look to expand their capabilities in the event of a conflict. Although we do not expect tensions to rise significantly over the next few months, we do believe that the Chinese will become more assertive after the National Party Congress in the fall. The increase in defense spending likely favors our analysis that defense industries are positioned to benefit from increased global tensions.

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