Daily Comment (August 18, 2022)

Posted on August 18, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment is split into two sections. In the first half, we explain why speculation about a Fed pivot is premature. We briefly summarize the meeting minutes, show the market’s reaction, and discuss how the strong jobs market will affect the central bank’s decision to raise rates. In the second half, we review reports indicating that regional bloc formation can change over time. We discuss India’s military exercises with U.S. rivals China and Russia, Beijing’s reaction to the U.S. trade negotiations with Taiwan, and Turkey’s growing disenchantment with the West. After each section, we provide a synopsis of the stories covered and their possible ramifications.

Central Bank News: Meeting minutes revealed the Fed’s openness to a pivot, but employment and inflation data suggest that monetary tightening is still needed.

The Federal Reserve meeting minutes reinforced the market’s dovish perception of the central bank. Although Fed officials agreed unanimously to raise rates by 75 bps at the July 27 Federal Open Market Committee meeting, the minutes revealed that policymakers were also concerned about the economy. Fed officials noted that specific interest-rate-sensitive sectors, such as housing, were hurt by higher rates and warned the impact would spread into other areas of the economy. Additionally, it mentioned that some officials could support a pause once the rates reach the restrictive territory.
Investor optimism that the Fed will end its tightening cycle before achieving its 2% target is misguided. On Wednesday, the S&P 500 pared back most of the day’s losses, Treasury yields dipped, and the dollar fell from the day’s high. The market’s reaction suggests that a recession will force the Fed to change its policy path. However, the minutes revealed the central bank is only focused on achieving its dual mandate of price stability and low unemployment.
Prediction of policy moderations is overblown. The Fed would like the labor market to show tangible signs of deterioration before it ends its tightening cycle. The July employment payrolls report exceeded expectations, and the unemployment rate dropped from 3.6% to 3.5%. The Fed fears that an overly tight labor market leads to wage pressure, thus contributing to inflation. As a result, it is unlikely to stop raising rates as long as inflation remains high, and the unemployment rate is low.
- Another reason for our skepticism of a Fed halt or reversal in its policy path is real fed funds. The Fed has never stopped tightening with a negative real Fed funds rate, which stands at -6.82% as of August 10. The Fed would need to raise rates almost 700 bps before the real Fed funds returned to positive territory.

The period of ultra-low inflation has likely passed, but it was good while it lasted. Although the Federal Reserve remains optimistic that slower economic growth will eventually resolve supply chain issues, we are not. Ongoing geopolitical tensions in Europe and Asia will make firms rethink their supply chains. Relatively safe countries that are friendly to the U.S. will be attractive destinations for firms looking to move their operations. That said, in the short run, labor will be able to extract higher wages from their employers, especially as the U.S. unemployment rate remains low. As a result, we believe investors should position themselves to adjust to a higher interest rate and inflation environment.

Geopolitical Tensions: Regional blocs are forming in ways that are hard to predict in the long run.

U.S. ally India will join China, Russia, and Belarus for joint military exercises. India’s participation highlights the delicate balance countries are playing not to align with major power blocs. Its decision to play both sides isn’t without precedence. India was one of the founding members of the nonalignment movement during the cold war. The U.S. has recently turned a blind eye to India’s buying of Russian fuel and weapons. However, it isn’t clear if they will continue to do so indefinitely. The U.S. has built closer ties with India as a way to isolate China in the Indo-Pacific region. If it turns out that India is cozying up to China, the U.S. could back away and look for an alternative country to challenge China’s dominance within the region.
- India has been a significant foreign direct investment target over the last two years. Firms have relocated manufacturing and service operations to the country due to its vast labor market and relatively low costs. If India’s relationship with the U.S. begins to sour, it could force firms to change tactics and look elsewhere.
The U.S. continues to annoy China with its flirtation with Taiwanese recognition. The White House plans to hold trade discussions with Taiwan in the fall of this year. The talks have angered China, which views the gesture as another attempt to undermine its sovereign claim over the self-governing island. Although the negotiations are unlikely to lead to conflict, they may pave the way for further escalation. Hence, the possibility of a direct confrontation between the two major powers remains elevated. Firms with considerable revenue exposure or deep supply chains within China or Taiwan may be at risk.
- Despite the dangers, European firms are still investing in China. Financial inflows from Europe increased 15% in the first half of 2022 compared to a year earlier. The increased investment suggests that firms are prioritizing short-term gains over long-term security.
Internal rivalries within the Western military alliance threaten the group’s commitment to supporting Ukraine. To the annoyance of Ankara, Greece has played a central role in the U.S.’s ability to transport weapons to the Ukrainians. The Mediterranean nations have a long and heated rivalry, including conflict over Cyprus and other territorial disputes. Turkey fears its ties with the U.S. are threatened by Greece’s growing importance in the war. The growing closeness between the U.S. and Greece can partially explain why Turkey has built closer economic relations with Russia. The breakdown of the Western alliance will likely make it harder for Ukraine to maintain its war efforts and could pave the way for the war’s conclusion. Any end to the conflict will be taken positively by markets.
- Turkish President Recep Tayyip Erdoğan will meet with Ukrainian President Volodymyr Zelensky to discuss steps to end the war.

The reshuffling of allies is not unusual during times of war. During World War II, Italy notoriously declared war on its former Axis partner Germany. Therefore, as regional blocs start to form, we do expect that certain countries could decide to switch sides or choose to fly solo. Over the last few weeks, we have been paying close attention to the European Union. Although it has historical and economic ties with the U.S., its reliance on Russian energy and its exposure to China shows its interests are not fully aligned with its American counterparts. We are not predicting a break of ties but rather that the two regions may push for separate aims. If we are correct, the lack of foreign policy cohesion between the U.S. and Europe could severely complicate firms’ ability to operate in different countries.

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Weekly Energy Update (August 18, 2022)

Posted on August 18, 2022December 13, 2022 by Amanda Ahne

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

Crude oil prices remain under pressure on fears of a deal with Iran and weakening economic growth.

(Source: Barchart.com)

Crude oil inventories fell 7.1 mb compared to a 0.3 mb build forecast. The SPR declined 3.4 mb, meaning the net draw was 10.2 mb.

In the details, U.S. crude oil production was steady at 12.2 mbpd. Exports rose 2.9 mb, while imports were unchanged. Refining activity dipped 0.8% to 93.5% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. Clearly, this year is deviating from the normal path of commercial inventory levels although this week’s outsized decline is consistent with seasonal behavior. We will approach the usual seasonal trough for inventories in mid-September.

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

Total stockpiles peaked in 2017 and are now at levels last seen in 2004. Using total stocks since 2015, fair value is $104.45.

With so many crosscurrents in the oil markets, we are beginning to see some degree of normalization. The inventory/EUR model suggests oil prices should be around $64 per barrel, so we are seeing about $24 of risk premium in the market.

Market news:

Oil prices have been coming under pressure mostly on fears of slowing demand, and weak economic data from China have been particularly worrisome. Weaker demand has taken US. retail gasoline prices below $4 per gallon. Last month, futures markets were weaker than physical price markers, but even the physical markets are now showing signs of weakness. OPEC+ recent demand forecasts confirm softening consumption, although some of this may be self-serving. If the cartel wanted to justify its modest production increase, citing slowing demand would be a reasonable assertion.
Meanwhile, we are seeing nations take steps to moderate consumption to reduce prices and ensure adequate supplies. The U.K. is preparing for energy shortages by creating plans to ration energy. The Indian Parliament recently passed conservation measures.
As we noted last week, German natural gas inventories have risen rapidly. However, even with this inventory accumulation, regulators are still pressing for further cuts in current usage to avoid rationing. Despite this news, natural gas prices are surging in Europe.
As energy company profitability soars, in the U.K., there is a movement to use these profits for “green” investments. If this becomes a norm, fossil fuel supplies will remain constrained.
The Ukraine War and subsequent sanctions have disrupted physical supply chains. As the war continues, consumers and producers are working to restructure energy infrastructure. Germany, Portugal, and Spain are considering a plan to build natural gas pipelines through France from the Iberian peninsula to bring LNG to central Europe. Kazakhstan is considering a plan to transmit crude oil through the Azeri pipeline network to avoid Russian pipelines. Also, Azerbaijan itself is likely to become an important supplier of oil and natural gas to the EU. Although these actions will take time, the more that supply chains adjust, the more supply will equalize and bring prices down in currently high priced markets.
- Egypt will ration electricity to reduce domestic natural gas consumption in a bid to increase exports.
- Meanwhile, Hungary is receiving Russian natural gas through the Turkstream pipeline that runs through Serbia. Hungary has generally opposed EU sanctions against Russia.
- Power shortages have led to the closure of a second aluminum smelter in Europe.
At the same time, resource hoarding is always a temptation. Australia is considering actions to reduce LNG exports to ensure ample domestic supplies.
Although there has been disruption to crude oil flows due to the war, the IEA suggests that Russian production has fallen only modestly. In contrast to OPEC+, the IEA is projecting higher demand this year due to fuel switching away from natural gas.
Although new refining projects are considered impossible in the U.S., it hasn’t prevented global refinery building from occurring. However, this new capacity may not relieve product shortages in all markets.
OPEC’s recent market analysis could lay the groundwork for a production cut. At the same time, Saudi Aramco (2222, SAR, 39.80) claims it can produce 12.0 mbpd.

Geopolitical news:

We saw conflicting trends on the JCPOA/Iranian situation. The EU has proposed a plan to end the IAEA’s investigation of suspect weapons sites in exchange for Tehran disclosing what it knows. In addition, the EU has also suggested a way to circumvent U.S. sanctions on the Iranian Revolutionary Guard Corp. Reports suggest that the U.S. is considering these changes, and Iran is on board as well. The EU offer was said to be final, but, in dealing with Iran, it is hard to say when negotiations end. Iran did deliver a response, but it was not to accept or reject the deal, but rather to negotiate further. Iran is simultaneously trying to suggest it is “flexible” while suggesting that the U.S. isn’t negotiating in good faith. At press time, the EU was still examining the Iranian response. One element of the response is that Iran wants compensation if the U.S. withdrawals again from the deal. It’s not clear to us if an administration in office could bind a subsequent administration to such an arrangement without legislation or treaty. Thus, this could be a deal killer. We also note Iran wants the U.S. to end the IAEA’s investigation into Iran’s violation of the pact earlier. Again, the IAEA is an independent agency of the UN and the U.S. can’t order them to back away from this investigation (nor should the administration do this, IOHO). Talks appear to have reached the “fish or cut bait” stage, as the U.S. stance is either accept the deal or walk away. We do note that if the administration does allow these changes, the political blowback could be considerable. At the same time, Iran claims it is sitting on 100 mb of crude oil and natural gas condensate that would hit the market immediately. If this is true, it would make a major impact on oil prices, but we have our doubts about this claim. It is clear that the sanctions has been eroding for some time and to the best of our knowledge, these inventory numbers have not been independently verified. Complicating matters further:
- S. intelligence agencies suggest Iran has trained Russian soldiers on the use of drones.
- There are reports that Iran tried to arrange for the assassination of John Bolton, the former National Security Director. To add insult to injury, Tehran only wanted to spend $300k for the effort.
- Although it would likely be difficult to directly tie Iran to the attack on author Salman Rushdie (although the lack of ties didn’t stop SoS Blinken from making the connection), the fatwa issued against him by Iranian clerics was almost certainly a factor. We do note that Iran has officially denied any involvement.
There are reports that President Xi is planning to visit the Kingdom of Saudi Arabia this week, although these plans have not been confirmed. Closer ties between Beijing and Riyadh will not sit well with the U.S. We also note that there may be something of a market share war developing between Iran, the KSA, and Russia. China has become a favorite market for Russian oil. Xi may be making this trip to maintain relations. We do note that China and the KSA are working on oil and gas investments jointly, and China does appear to be replacing the U.S. as a key market for the Saudis.
Prince Alwaleed bin Talal made large investments in Russian oil and gas firms just before the attack on Ukraine. Although there is some element of plausible deniability, the optics are unfavorable. Moreover, it suggests closer ties between the KSA and Russia, which could become increasingly problematic for the U.S.
Intra-Shiite tensions in Iraq have the potential to cause a civil conflict. Essentially, the fight is between al-Sadr and other Shiite groups. The former wants to create a government based on majority rule while the latter wants proportional representation. The inability to come to an agreement may lead the KSA and Iran to become involved.

Alternative energy/policy news:

With the Inflation Reduction Act now signed into law, a backlash against economists for pushing for a carbon tax is developing. To some extent, this makes sense as using other tools can be more politically popular. However, from an efficiency standpoint, a carbon tax would still be a superior policy, but obviously, if you can’t get it passed, holding on to that policy to the exclusion of all others makes little sense. What the bill is really all about is industrial policy. Government shaping the economy is nothing new but is generally considered legitimate only in cases of clear market failure. Since a carbon tax was never implemented, it really hasn’t been proven that a market failure exists.
- Despite the lack of a carbon tax or a carbon price, market participants are increasingly behaving as if one exists.
- The bill is poised to create an EV production boom in the Midwest.
There is great excitement in the environmental community over the new measures but one potential concern is the lack of workers to build out the plan.
Germany is extending the life of its three remaining nuclear power plants.
Any commodity activity disturbs something. Whether its drilling, ranching, farming, or mining, something or someone gets disturbed. As demand for lithium rises, opposition to mining or brining has emerged. Although such opposition may be overcome, higher costs are likely to result.
As we noted last week, the price of EVs continues to climb. Ford’s (F, $16.18) announcement of substantial price increases on its F-150 “Lightning” EV pickup is the most recent example of this issue.
There is growing evidence that the Arctic is warming faster than other parts of the world. The impact is difficult to estimate, but we would expect greater weather variability from this situation.
Much of the Midwest, parts of the Southwest, Florida, and the Atlantic coast could become subject to extreme heat events in the coming decades. But the real worry is heat in areas unprepared. The linked map shows the areas of installed air conditioning.
Hot weather just isn’t an inconvenience. The drought and warm weather is affecting industrial activity in Germany. In China, power shortages, caused by hot weather, are causing car and battery plants to suspend operations. Tech firms have also temporarily shut down.
Delays of utility-scale solar projects are steadily rising. These delays may be tied to trade restrictions which have recently been eased.
California looks ready to extend the life of the Diablo Canyon nuclear power plant that was scheduled for decommissioning.
Increasingly, we are seeing an “all of the above” strategy in energy investment. Investing in renewables doesn’t necessarily preclude investing in fossil fuels.
Although wood burning is not necessarily environmentally friendly, it appears Germans are considering it in the face of rising fossil fuel prices. Wood pellets are also seeing rising demand in Europe and Asia.
This recent report from the Peterson Institute details China’s dominance in rare earths processing.

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Daily Comment (August 16, 2022)

Posted on August 16, 2022August 16, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where the Russians continue to face troop constraints and the Ukrainians continue to find success in attacking Russian troop concentrations and logistical nodes. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine: Russian forces continue to make small, incremental territorial gains in the eastern Donbas region of Ukraine, but we are seeing more reports of conscripts from one ethnic Russian part of the region refusing to fight other ethnic Russian parts. The reports are consistent with other signs that Moscow’s troop depletion and reliance on a hodgepodge of volunteers and other less-qualified troops have left it with a relatively ineffective fighting force. Adding to morale problems, there are also reports that Moscow is failing to pay some Russian reservists and volunteers fighting in Ukraine. Meanwhile, Ukrainian officials urged civilians around the Russian-occupied southern city of Kherson to evacuate so Kyiv’s forces could continue ramping up their counteroffensive to retake the area.

Separately, it appears that the Ukrainians have exploded another of Russia’s large ammunition depots far from the front lines in occupied Crimea. At least some of the successful attacks by the Ukrainians have involved precision, long-range artillery provided by the West, but some may also be the work of Ukrainian partisans or special operations forces.
New official data from Turkey shows that the country’s exports to Russia from May to July were almost 50% higher than in the same period one year earlier. The figures suggest that Turkey, ostensibly a U.S. ally and a member of NATO, has stepped into the breach to support Russia even as the rest of the West tries to punish it with sanctions.

European Energy Market: As the EU looks for ways to cut its reliance on Russian energy, bloc officials are reportedly considering the possibility of lowering regulatory barriers to the mining and production of critical green energy materials such as lithium, cobalt, and graphite. While it appears that any such deregulation of mining is still off in the future, even the consideration of such an idea seems to illustrate just how desperate EU leaders are to shore up their energy security.

Germany: The ZEW Institute’s closely watched index of investor expectations fell to an 11-year low of -55.3, down from -53.8 last month. Against the backdrop of the Ukraine war, surging energy costs, and rising inflation, the figures suggest investors are now more pessimistic about the German economy than they have been at any time since the Eurozone debt crisis more than a decade ago.

United Kingdom: The Office of National Statistics reported that second quarter real wages fell by a seasonally adjusted 3.0%, marking their steepest decline in at least two decades. According to the report, nominal pay rose 4.7% in the quarter, but that rise was more than wiped out by increased consumer prices. As energy and other prices rise faster than wage gains, similar declines in real wages are being reported in countries across the globe.

China: Property developers’ stocks have risen sharply today on rumors that the government will instruct state-owned institutions to guarantee their domestic bonds. If true, the new government support would likely be targeted toward helping the developers complete homes that have already been paid for but not yet finished or delivered. That could help stabilize China’s housing market and weaken one of the headwinds facing the Chinese economy, but the country and its financial markets would still face a range of challenges, such as unpredictable, draconian pandemic lockdowns, a regulatory crackdown on its technology industry, and fracturing trade and investment ties with the West.

Australia: In what could be a major new scandal, Former Prime Minister Scott Morrison has been accused of secretly appointing himself as head of five separate ministries during the coronavirus pandemic. Morrison has tried to defend himself by arguing that the moves were necessary to cut the risk of ministers contracting COVID-19 during the pandemic, but he is being widely pilloried for undermining democracy and government accountability, even by members of his own opposition Liberal Party.

Kenya: Deputy President William Ruto has been declared the winner of last week’s presidential election with 50.5% of the vote, but his main rival’s supporters and some election commissioners are disputing the result. The risk is that Kenya could be thrown into yet another round of political unrest and violence, adding to the overall instability sparked by rising commodity prices and high interest rates in many emerging markets.

U.S. Bond Market: New analysis shows that just 6.2% of U.S. junk bonds are now trading at distressed levels, down from 11.6% as recently as early July. The new study, which defines “distressed” bonds as those trading at a yield greater than 10.0% above comparable U.S. Treasury obligations, illustrates just how dramatically investors have jumped back into the junk bond market as they’ve come to expect the Fed will pivot to interest rate cuts as early as 2023.

U.S. Technology Trade: In a potential scandal in the U.S., a new analysis shows that a Commerce Department-led process meant to review sensitive technology exports to China approves almost all requests and hasn’t stopped an increase in the sales of some particularly important technologies. As a result, the U.S. continues to send to China an array of semiconductors, aerospace components, artificial-intelligence technology, and other items that could be used to advance Beijing’s military development.

Given that being tough on China is now a political necessity for both Republicans and Democrats, it would not be a surprise if the news prompts tightened restrictions.
The news therefore presents new regulatory risks for U.S. technology and aerospace firms that could be forced to cut their sales to China.

U.S. Agriculture Market: Faced with a withering drought, cotton growers in the Southwest are abandoning up to 40% of the acres that they planted in spring, prompting forecasts for the weakest U.S. harvest in more than a decade and sending prices sharply higher. Cotton futures prices rose some 13% in the last week, ending Monday at approximately $1.136 per pound.

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Asset Allocation Bi-Weekly – The Devil Is in the Details (August 8, 2022)

Posted on August 8, 2022August 5, 2022 by Amanda Ahne

by the Asset Allocation Committee | PDF

U.S. policymakers used deregulation and globalization to corral inflation from 1966 to 1982. Unfortunately, that policy was at odds with America’s superpower role, which required the U.S. to act as global importer of last resort. If the U.S. didn’t consume all the goods the world wanted to sell to Americans, the world economy would face a liquidity crisis. Policymakers addressed the issues of containing inflation and providing global liquidity by deregulating financial services, which made it easier for households to borrow money. Although deregulation and globalization slowed real income growth, the ability to borrow allowed households to absorb global imports, holding the international system together. After 1995, this lending was increasingly attached to residential real estate, which was considered safe. Sadly, one of the key economic imbalances that was revealed during the Great Financial Crisis was excessive household debt. Since the crisis, the economy has been trying to address this debt overhang. There has been some progress as household debt peaked at 129.4% of after-tax income in Q1 2008 but fell to 84.4% in Q1 2021. Since then, it has risen to 96.5%.

Although policymakers haven’t targeted this issue, we believe that addressing this debt situation is not only key to improving the health of the economy, but the austerity required to reduce debt may be a factor behind political polarization. The last time the U.S. had a similar debt issue was in the late 1920s when the Great Depression was the resolution, although the situation wasn’t fully addressed until WWII. From a financial perspective, WWII finally resolved the private sector debt problem by placing that debt on the public balance sheet. The debt relative to the size of the economy was reduced on the public balance sheet through financial repression.

One of the difficulties in discussing debt is proper scaling; in other words, how do we know when debt is “too high”? Economists often use nominal GDP or some sort of income measure to scale debt. The problem is that both GDP and income are “flow” data, meaning that they measure a quantity calculated over a period of time, while debt is “stock” data, which is a level at a specific time. In terms of debt, income or GDP may or may not tell us much about the ability to service the debt.

Accounting often creates ratios that measure stock or flows. For example, assets divided by liabilities are two stock numbers that give us some idea about the balance sheet of a firm or household. Clearly, if the assets exceed liabilities, it suggests solvency.

From 1970 to 1990, American households had more cash than debt.[1] After 1990, household leverage rose, peaking with debt exceeding cash to the tune of nearly $6.0 trillion. The difference narrowed after the Great Financial Crisis by more than 50%. The huge injection of fiscal aid to households during the COVID-19 pandemic finally led to cash exceeding debt for the first time in three decades.

So, have we resolved the household debt problem? Perhaps, but the Federal Reserve’s Distributional Financial Accounts, which examines household balance sheets by income, suggests that the debt situation hasn’t necessarily been fixed.

We divide households into three groups: the top 10%, the middle 40%, and the bottom 50%. The top 10% has seen its cash levels rise relative to debt for most of this century, but this difference widened dramatically during the pandemic. Since the upper income brackets were mostly excluded from direct cash payments, it’s likely that this group liquidated appreciated assets. We do note that all three classes took on more debt, but in the case of the top 10%, the cash accumulation far exceeded these new liabilities. The middle 40% saw cash rise relative to debt into Q1 2021, but over the past year, liabilities grew modestly relative to debt. However, for the bottom 50%, net debt continued to rise even with the influx of pandemic transfer payments.

We don’t have a data series by income prior to 1989, so we can’t compare what occurred during and after WWII, but, given the high marginal tax rates of that period, we suspect that the lower income classes saw their balance sheets improve. What can we take away from the above chart? First, as interest rates rise, consumption may fall since the bottom 50% increased their leverage during the pandemic. Consumption will then have to come from the upper 50%. Second, given the massive cash balances of the top 10%, asset prices could find support in the coming months. Although higher cash yields from rising interest rates might keep this cash on the sidelines, we suspect this level of cash will eventually find its way into the equity, commodity, and debt markets. This flow may depend on signs that the FOMC is near the end of its tightening cycle, but once such a catalyst emerges, the conditions for a strong financial market recovery are in place. The great unknown, of course, is which market the potential flows will favor.

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[1] This dataset, from the FRB’s Financial Accounts of the U.S., includes households plus non-profits that service households. Thus, strictly speaking, this isn’t just households, but data suggests the non-profit contribution is relatively minor.

Daily Comment (August 5, 2022)

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

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment starts with a focus on the potential spillover effects of Russia’s invasion of Ukraine. Next, we examine policymakers’ dilemma of whether to promote growth or contain inflation. We conclude by discussing a possible rightward shift in U.S. policy.

Russia: The Ukraine war could potentially lead to new conflicts in other parts of Europe and the Middle East.

NATO Secretary-General Jens Stoltenberg stated that the Ukraine war was the most dangerous moment in Europe since WWII and that Russia must not win it. He also suggested that NATO might act if Russia seeks to extend its military campaign into an allied country. His comments appear to be a veiled threat to Moscow not to provoke a NATO ally. Although the Kremlin has not directly mentioned another country, there are concerns that Russia could incite a war over Kosovo, a non-aligned country with NATO forces.
Tensions in Eurasia pose a threat to the continent’s delicate commodity supply. Azerbaijan has reignited tensions with Armenia over the heavily contested Nagorno-Karabakh. On Thursday, Azerbaijan forces took over a strategic region in the disputed territory. While Moscow has forces stationed in the area to prevent clashes, the war in Ukraine has made Russia’s presence less effective. Thus, Azerbaijan’s advancement in Nagorno-Karabakh exemplifies how tensions between rival countries within Eurasia could heighten as war continues in Ukraine. Although many countries in Eurasia are typically ignored, disruptions in the region could make it harder for firms to secure natural resources. As a result, these conflicts could exacerbate the energy crisis in Europe.
- It is estimated that the region contains over 31% of the world’s proven natural gas reserves, 17% of oil reserves, 23% of iron ore, 14% of gold, and 7% of copper.
Vladimir Putin is expected to meet with Turkish President Recep Tayyip Erdoğan in Sochi on Friday. The two leaders will discuss the ongoing situation in Syria. Turkey would like to mount a military offensive against Kurdish fighters within Syria without worrying about a possible conflict with Russian troops stationed in the area. Because Turkey is a NATO ally, a conflict with the Russian military could lead to a broader conflict that includes other members of the security pact.

A broader war in Europe would rattle financial markets and could make commodity supply concerns deeply entrenched. As a result, we expect European firms may look to set up operations in areas that are resource-rich and relatively safe, like the U.S. and Canada.

Inflation worries: Around the world, governments struggle to determine whether they should prioritize inflation or GDP growth when creating new economic policy.

Chinese Premier Li Keqiang implied that the government would tolerate GDP growth rates below its target as long as inflation and unemployment stay under 3.5% and 5.5%, respectively. Like the rest of the world, China is seeing an increase in consumer prices. In June, headline CPI rose 2.43% from the prior year, its highest jump in over a decade. Keqiang’s remarks suggest that Beijing is reluctant to inject fiscal stimulus into the economy due to concerns that it might worsen inflation. The lack of government support in China will weigh on global growth.
In the U.K., Liz Truss, the frontrunner candidate for prime minister, directed her ire at the Bank of England and the Treasury for the country’s inflation problem. Although the BOE was the first major central bank to raise interest rates after the pandemic, Truss insists that it should have acted even sooner. Her criticism of the BOE suggests that she may favor eliminating the central bank’s independence. In a speech at a husting of Conservative party members, Truss hinted at changing the BOE’s mandate to align more closely with the other central banks. Her rebuke suggests that she will likely place the blame for inflation on the central bank in order to gain support for her tax cut proposal.
In Europe, countries are looking to implement measures designed to combat rising inflation. For example, the French Parliament passed legislation on Thursday that would cap rent increases and extend fuel subsidies. Meanwhile, Ireland is considering imposing a windfall tax on energy profits. Government actions to rein in inflation will likely not be too effective because subsidies on fuel and windfall taxes on energy profits prevent consumers and suppliers from adjusting to the market. Fuel subsidies prevent demand destruction, while taxes on excess profits limit energy companies’ ability to expand investment in production capacity.

The decision to address inflation over GDP suggests that governments fear the public may be more sensitive to prices than the economy. This preference could mean countries will be reluctant to stimulate their economies as inflation remains elevated. The lack of financial support from the government during times of economic weakness suggests that any recovery from recession will likely be slow. Thus, we could be headed toward a sustained period of slow economic growth.

U.S. policy: The Democrats may be on the verge of passing another bill, but conservatives still strongly influence domestic and foreign policy.

Senator Kyrsten Sinema (D-AZ) has agreed to support the climate and tax bill. Her support came after Democrats revised the legislation to eliminate a provision that would narrow a tax break for carried interest. Additionally, there were provisions to alter the 15% minimum corporate tax and add a 1% excise tax on stock buybacks. The tax changes in the bill may not have a significant impact on investors. Instead, they reflect a broader trend away from government spending as the country copes with rising inflation.
The fallout continues following House Speaker Nancy Pelosi’s provocative trip to Taiwan. On Friday, China announced that it would impose sanctions on Pelosi and has halted cooperation with the U.S. in several areas, including talks on climate change and defense. Her visit to Taiwan has not only accelerated the decoupling between the U.S. and China but is also forcing firms to reconsider plans to invest in Taiwan.
- Equities are already starting to see movement following the trip. Since Pelosi’s visit, stocks related to chipmakers have surged due to predictions that the U.S. and China will invest more in domestically made semiconductors.

There does seem to be relatively more support for conservative policies going into the midterm elections. Democrats who initially pushed for a bill that would have added to the deficit over 10 years are now backing a bill that reduces the deficit, suggesting the country is becoming fiscally cautious. Additionally, Pelosi’s trip reinforces our view that the country is becoming more skeptical of China. It is too soon to say whether this represents a broader trend, but it is something we are monitoring closely.

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Daily Comment (August 4, 2022)

Posted on August 4, 2022August 4, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a discussion on the central banks’ decision to raise rates despite slowing economic growth. Next, we examine how rising geopolitical risks make it more difficult for firms to rebuild their supply chains. We end the report with an update on the climate and drug bill.

Monetary Policy: Central banks in the U.S., U.K. and the Eurozone appear to be plowing ahead with tighter monetary policy even as their economies slow.

Fed officials downplayed expectations that the central bank was close to ending its tightening cycle. Despite the disappointing economic data, regional Fed Presidents Neel Kashkari and Thomas Barkin dismissed speculation that the Fed was finished raising rates and warned of a possible recession. Meanwhile, St. Louis Fed President James Bullard, a voting member, insisted that the central bank must front load big rate hikes to cool inflation. Additionally, he revealed his desire for the Fed’s policy rate to be between 3.75% and 4.00% by the end of the year.
To keep pace with the Federal Reserve, the Bank of England raised its benchmark rate by 50 bps on Thursday. Although the increase is less than the Fed’s 75 bps hike in July, the rate rise was the country’s largest in 27 years. By increasing its policy rate, the BOE aims to prevents the pound from depreciating against the dollar and exacerbating the country’s inflation problem. The BOE warned that the country is expected to fall into a recession and that inflation could rise as high as 13%.
The European Central Bank appears to have used funds from maturing bonds in the portfolio of its pandemic program to purchase the debt of southern European economies. The data showed that the bank’s net holdings of German, French, and Dutch bonds dropped by 18.9 billion euros in July. In the same month, statistics showed that the bank made 17.3 billion euros of net debt purchases from Italy, Spain, Portugal, and Greece. The central bank’s intervention suggests it will also aggressively raise rates in its next meeting.
- Fitch Ratings Agency expects that the ECB’s new anti-fragmentation tool will allow the bank to raise rates while reducing debt sustainability risk. Fitch Ratings is one of the three most respected credit rating agencies. Thus, its analysis will likely help reassure investors that the ECB has a credible tool to fight fragmentation.

Strong U.S. economic growth and tight monetary policy have pushed the euro and British pound to near multi-decade lows against the dollar. The depreciation of the euro and pound have contributed to the inflation problem in their respective regions as it makes dollar-priced commodity imports more expensive. Unfortunately, neither the EU nor U.K. economies have expanded at the same rate as the U.S. since the pandemic started in 2020. As a result, they likely have less flexibility in raising rates. Although all three regions have elevated recession risks, the EU and U.K. are in a worse position than the U.S.

Geopolitical Risks: As the calls for a ceasefire in the Ukraine-Russia war become increasingly louder, conflicts in other parts of the world are becoming more noticeable, making it difficult for firms to return to pre-pandemic normalcy.

European leaders are now pushing Ukraine to engage in ceasefire talks with Russia. On Wednesday, former German Chancellor Gerhard Schröder urged Kyiv to negotiate with Russia to end the conflict and modify its demands. Meanwhile, the Irish president and his wife stirred controversy after the first lady posted a letter on the presidential website pleading for world leaders to encourage ceasefire talks. The push by Putin’s allies within Europe is evidence that the conflict may be headed toward a pause. Ukrainian President Volodymyr Zelensky has also sought a meeting with Chinese President Xi Jinping to help negotiate an end to the contest. However, Xi has not replied to any of his requests to talk.
- Although the possible end of the conflict is good news, it is foolhardy to assume that the relationship between Europe and Russia will return to normal. Russia’s weaponization of its natural resources will mean Europe will still need to reduce its dependence on Russia significantly. Meanwhile, Russia’s limited ability to deliver its natural gas to countries outside of Europe suggests it also needs to invest in building its pipeline capacity to new regions. Figuring out how to remove sanctions is another can of worms no one in the West wants to open. Although it is too early to determine whether the conflict will end soon, the path toward de-escalation is forming.
- The U.S. and Italy has passed legislation that will allow Sweden and Finland to enter NATO.
As the U.S. gears up for another round of nuclear talks, there is speculation that Iran might direct its proxies to attack American and partner targets in the region. Such an attack could lead to a crisis in the Middle East and push up the price of commodities like oil. Iran blames NATO for the recent unrest in Iraq. Over the weekend, protesters stormed the Iraqi parliament to demand new parliamentary elections. The rising tension between the West and Iran suggest that the Middle East remains politically unstable.
China engaged in more military drills around the Taiwanese peninsula the day after U.S. Speaker of the House Nancy Pelosi visited the self-ruled island. In China’s most immense provocation in 16 years, its military launched several missiles into Taiwanese waters. The drills are expected to continue until Sunday. However, possible escalation cannot be ruled out. China is in a difficult bind. Pelosi’s visit undermines Beijing’s argument that the U.S. views it as a threat. Meanwhile, U.S. politicians on both sides of the aisle are pushing for Washington to take a tougher stance against China. As a result, we believe that the risk of possible miscalculation leading to direct conflict is elevated.
- The White House is attempting to rein in Congress after Pelosi’s trip to Taiwan has encouraged politicians to flex their toughness on China’s credentials going into the mid-terms. The Senate is currently working on legislation that would designate the sovereign island as a major non-NATO ally.

One of the trends that we are noticing is that the world is becoming increasingly hostile. Rising global tensions will make it difficult to repair supply chains and could accelerate U.S. firms’ withdrawals from the rest of the world. This shift from relying on global supply chains in emerging markets will be expensive in the short term as firms look to adjust to this new normal.

Biden’s Agenda: The U.S. Senate is expected to pass the Inflation Reduction Act. The bill aims to raise corporate taxes and may negatively impact corporate earnings.

Arizona Senator Kyrsten Sinema (D-AZ) is pushing for changes in the bill before backing it. She is a pivotal vote in getting the legislation through the Senate. She has concerns about the changes to the corporate minimum tax and has hinted at possible opposition to a carried interest tax. Additionally, she favors beefing up the amount of funding for the climate and energy portions of the bills.
The Congressional Budget Office forecasts that the bill will reduce the deficit by a net $101.5 billion over the next decade. However, the CBO’s estimate did not include the $204 billion tax revenue gain from the increased Internal Revenue Service enforcement. The analysis is key to getting the bill passed as Democrats are trying to make themselves look more fiscally responsible after the initial stimulus package contributed to a surge in inflation.

The new bill from the Democrats is austerity disguised as fiscal stimulus. The trend of reducing the government deficit will likely be a central theme going into mid-terms and could continue afterward. The lack of government spending will lead to slower economic growth.

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Weekly Energy Update (August 4, 2022)

Posted on August 4, 2022December 13, 2022 by Amanda Ahne

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

Prices are testing long-term support near $90 per barrel for crude oil.

(Source: Barchart.com)

Crude oil inventories rose 4.5 mb compared to a 1.5 mb draw forecast. The SPR declined 4.7 mb, meaning the net draw was 0.2 mb.

In the details, U.S. crude oil production was steady at 12.1 mbpd. Exports fell 1.0 mb, while imports rose 1.2 mbpd. Refining activity declined 1.2% to 91.0% of capacity.

(Sources: DOE, CIM)

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

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

Total stockpiles peaked in 2017 and are now at levels last seen in 2004. Using total stocks since 2015, fair value is $104.04.

With so many crosscurrents in the oil markets, we are beginning to see some degree of normalization. The inventory/EUR model suggests oil prices should be around $65 per barrel, so we are seeing about $30 of risk premium in the market.

Gasoline Prices

One of the challenges in determining “how high” gasoline prices truly are is to find the proper scaling variable. The most common metric is to deflate the current price by some price index. Although that method is sound (it compares gasoline prices to other items), it doesn’t, in our opinion, capture the centrality of gasoline prices. After all, a commuter often has limited ability to substitute either a fuel (cars tend to only use gasoline) or a travel method (car sharing requires coordination, public transportation varies by locale).

As an alternative to using a price index, we take the nominal hourly wage for a non-supervisory worker and divide into that wage the current average national price of gasoline. This measure calculates how many gallons of gasoline a worker can purchase for an hour’s worth of work. The scaling method isn’t perfect as it doesn’t take into account taxes and benefit costs, for example, but it does allow us to compare the current price to history.

The below chart shows that calculation along with the Presidential Approval Ratings. On the left axis, the higher the number, the more gallons one can buy with an hour’s worth of work. So, the higher the reading, the better off the worker is. Over time, the average is 8.6 gallons. As the chart shows, we are well below that level at present. It’s also clear that Presidential Approval Ratings and the number of gallons one can buy “rhyme.” The two variables are not perfectly correlated. There are several spikes in approval tied to wars or other geopolitical events that sometimes occur with lower gallon per hour readings. But, overall, President Biden’s low approval ratings is not being helped by falling gallon per hour numbers.

Market news:

The current energy crisis has a multitude of factors behind it. Green power hasn’t come online as fast as hoped, and fossil fuel production has not responded to higher prices for a number of reasons. This article provides a summary, and this podcast, from Odd Lots, highlights the differences between consumer goods (especially technology) and energy products. With consumer tech, when a better product hits the market, the old technology disappears rapidly. That is not the case with energy.
OPEC+ met this week to set production targets. The cartel agreed to a cosmetic increase of 0.1 mbpd, which fulfills the White House’s goal of an increase, but will not have any significant impact on supply.
It appears the EU is rethinking its stance on banning insurance firms from selling protection on Russian crude oil shipments. The U.S. has been concerned for some time that the program could unexpectedly reduce sales and drive oil prices higher. The G-7 is considering other measures to reduce the profitability of Russian crude oil without curtailing supply.
As it has become apparent that Russia is an unreliable supplier of natural gas, Germany is moving rapidly to build LNG regassification capacity.
In light of the energy crisis, coal has made a dramatic recovery, with global demand set to have a record high in 2022. The EU is reducing Russian purchases on its way to an outright ban.
West Virginia has banned five major Wall Street banks from doing business with the state over their policies toward lending to fossil fuel companies.
In periods of shortages, nations often turn to hoarding. For energy producers, the temptation is to reduce exports in order to provide oil, natural gas, or coal at lower prices domestically. Bans can be hard to enforce, and after such actions consuming nations often become hoarders themselves, stockpiling due to the insecurity of supply. When that happens, the relationship between inventory levels and price becomes positive while under normal circumstances, the relationship is negative. So far in oil, that correlation inversion hasn’t occurred yet. We note that Australia is considering mandating a reduction in coal exports, which may be an early warning of hoarding activity. In addition, Australia’s LNG exports might be curtailed to ensure domestic prices remain below global ones.
Russian LNG supplies to India have been cut, forcing India to ration gas by cutting supplies to industrial users.
- We also note that Russia has signaled to Germany that repairs on Nord Stream 1 are not its responsibility.
- France claims it will have fully filled its natural gas inventories by November 1.
Demand for hydraulic fracking equipment has been strong, which is leading to constrained supply. The lack of equipment could prevent oil production from rising.
Power companies report a shortage of key distribution equipment as hurricane season heads into its active period.
Baker/Hughes (BKR, $25.50) is selling its Russian business unit to a local management team.

Geopolitical news:

Protestors have stormed the Iraqi Parliament twice recently, due to anger over the potential for a government run by groups other than Moqtada al-Sadr. They are especially upset by the candidacy of Mohammed al-Sudani, who is backed by Iran. The protestors are also calling for a new constitution. The worry is that if the political unrest escalates, it might disrupt oil production at some point.
Although Iran is pressing to resume JCPOA talks, U.S. officials suggest a deal is “highly unlikely.” Meanwhile, the U.S. is considering expanding sanctions against the smuggling network that is selling Iranian crude oil.
- Iran is trying to improve relations with India, but is struggling to make progress.
OPEC+ is showing no signs of ending Russia’s membership.
When a company makes direct investment into a foreign nation, the risk of expropriation exists. Miners are facing such a threat in Kyrgyzstan.

Alternative energy/policy news:

The “big news” this week was the unexpected agreement between the Democrat leadership in Congress and Sen. Manchin (D-WV) on climate regulation. Although this bill isn’t as ambitious as earlier versions (which Manchin opposed) it is surprisingly expansive. It includes clean energy tax credits for nuclear power, clean hydrogen, and direct carbon capture. Incentives to buy EVs, including tax credits, were included, as were aids for solar power. There are some sticks, too. These include a fee on methane emissions, which could boost the cost of drilling, especially for natural gas. There are also taxes for oil imports. We doubt this bill will get any support from the GOP and it isn’t completely clear it will get unanimous Democratic support. But for now, the agreement is something of a breakthrough, and we will be watching to see if it actually passes.
- We are also closely watching another bill that can’t go through reconciliation but would streamline the permitting process for oil and gas drilling along with pipeline construction. While permitting delays have been a favorite tactic of environmentalists, this bill would put a two-year limit on objections, meaning that the project either get approved or rejected in a shorter time frame. This bill could be filibustered, so it must gain some GOP support.
- Another interesting sidelight is that the bill offers tax incentives for making EVs using minerals from nations with which the U.S. has free trade agreements. Sadly, there aren’t any.
Even with the aforementioned bill, EVs continue to struggle for adoption. Prices are high since the market for low cost EVs is still rather small. The majority of EVs reside in a handful of states.
Last week, we noted the unusual weather events we were seeing across the country. It is clear (especially in St. Louis and vicinity) that the infrastructure isn’t adequate for such events. Hot weather continues across the country with some 100 million Americans affected. Although the notion of climate change remains polarized, polling does suggest that unusual weather events are increasingly being tied, in the mind of the public, to climate change.
- As temperatures rise in Singapore, the city-state is investigating various methods to manage heat.
Farming is a source of greenhouse gases; steers and dairy cows emit CO₂, for example. At the same time, they are a source of food. Taking steps to curtail agriculturally based gases will raise food costs – a step that is rarely politically popular. The Netherlands and Canada are considering such steps, triggering a backlash from farmers. Given soaring food prices, these steps appear rather mistimed.
Lyondell (LYB, $86.50) is closing a refinery in Texas, but is considering repurposing it to process recycled plastic.
German automakers are turning to China’s Contemporary Amperex Technology (CATL, ¥534.92) for auto batteries for EVs.
- Ganfeng Lithium (GNENF, $9.32) is planning to build a solid state EV battery facility. Solid state batteries hold the promise of longer range and faster recharging.
Is sand a viable, cheap, alternative to other batteries for utilities? Finnish researchers are testing the concept. The idea is that sand can hold heat and that heat can be tapped for a number of different applications.
S. regulators have certified a small nuclear design.
Under hot and dry conditions, wind can falter. Texas is reporting a drop in renewables output, further constraining electricity supply. Interestingly enough, hot weather can also curtail nuclear power. In France, as temperatures rise, river water used to cool reactors becomes too hot, forcing utilities to restrict output.
- Warm weather is also lowering the water level of the Rhine River, nearly closing it to shipping. If it closes, coal shipments might be adversely affected.
New England utilities are finding that expanding solar capacity is reducing demand during daylight hours.
Aurora Hydrogen, a startup, is testing the concept of making hydrogen from natural gas with a process that generates no CO₂.

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Daily Comment (August 3, 2022)

Posted on August 3, 2022August 3, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including a revelation that President Biden has personally threatened Chinese President Xi with trade restrictions if China helps Russia with its invasion. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, with a specific focus on House Speaker Pelosi’s now-completed trip to Taiwan and its impact on U.S.-China relations.

Russia-Ukraine: Russian forces continue to make small territorial gains around Ukraine’s northeastern Donbas region while shifting some troops to defend against the Ukrainians’ counteroffensive against the occupied southern city of Kherson. Officials in Moscow have also ramped up their false claims of destroying multiple HIMARs systems and other weapons provided by the West, most likely in an effort to thwart rising exasperation from Russian military bloggers. Not only have the Western weapons discouraged those bloggers and other Kremlin supporters, but Western intelligence analysis believe they are also causing significant casualties among Russian troops. Other reports say Iran has provided its first batch of military drones to Russia for field testing.

In a New York Times opinion article, foreign affairs author Thomas Friedman revealed that President Biden personally threatened Chinese President Xi with a ban on Chinese exports to the U.S. and Europe if China provided help to Russia in its invasion of Ukraine. According to Friedman, the threat has been instrumental in preventing China from providing new arms or other assistance to Russia in the war. However, he now fears that House Speaker Pelosi’s visit to Taiwan this week will prompt Beijing to help the Russians out of retaliation.
On the economic front, German Chancellor Scholz endorsed the idea of extending the life of Germany’s last three nuclear-generating stations to help cushion the blow from Russia’s reduced energy exports to Western Europe. The plants, which are scheduled to be retired at the end of 2022, produce only a small portion of the country’s electricity, but even that would be valuable to Russia-dependent Germany in the event of a fuller cut-off in Russian natural gas supplies.

United States-Taiwan-China: Undeterred by China’s threats and President Biden’s misgivings, yesterday House Speaker Pelosi landed in Taiwan on a trip designed to underscore the U.S.’s support for the island democracy. Pelosi’s trip, which included a long, circuitous route from Kuala Lumpur across Borneo and around the Philippines to avoid flying over Chinese military facilities in the South China Sea, immediately spurred a series of protests by Beijing. The Chinese government also sent more fighter aircraft into the Taiwan Strait and announced further live-fire military exercises in the six zones surrounding the island. China also temporarily halted most food imports from Taiwan.

As of this writing, China’s response to the Pelosi visit has been tough and high-profile, but not necessarily over-the-top. However, the full extent of the retaliation may not be known for days or even weeks. One concern is that China has told commercial ships and air carriers to stay out of its six military-exercise zones surrounding Taiwan. If kept in place, those no-sail/no-fly zones could become a soft blockade on the island, potentially threatening to strangle it.
On Pelosi’s side, we’ve noticed that there’s been little explanation as to why she chose to make such a provocative trip right now. One obvious explanation would be to show the Democratic Party is just as tough on China as the Republican Party. Thwarting China’s geopolitical aggressiveness is now a solidly bipartisan effort in the U.S., but Pelosi may have wanted to underscore the Democrats’ anti-China credentials just two months before the mid-term elections. Besides, Pelosi knows that the impact of her trip would be greatest if she is still Speaker, a position she will give up in just a few months if the Democrats lose control of the House as expected.

United States-China: Illustrating how political and economic considerations continue to fracture the world into relatively separate blocs, the recently-passed U.S. Chips and Science Act is already prompting major foreign technology firms to consider abandoning their investments in China in favor of closer ties with the U.S., as intended.

Until now, reporting on the Chips and Science Act has focused on its $52 billion in subsidies to encourage investment in advanced computer chip factories in the U.S., as well as hundreds of billions of dollars in other science and technology funding. Less noticed, however, is that the bill also contains qualified “guardrails” prohibiting recipients of the funds from expanding or upgrading their advanced chip capacity in China for 10 years.
Reporting in the Financial Times today says South Korean semiconductor producers Samsung Electronics (005930.KS, ₩61,300.00) and SK Hynix (000650.KS, ₩97,500.00) are re-evaluating their operations in China and may abandon them so as not to run afoul of the guardrails in the U.S. legislation.

U.S. Monetary Policy: Yesterday, a slew of regional Federal Reserve presidents made statements suggesting that the policymakers intend to keep hiking interest rates aggressively, despite recent investor expectations that they might soon pivot to rate cuts as recession risks grow. The statements pushed up bond yields yesterday, and those yield increases are continuing so far this morning. In the statements:

Chicago FRB President Evans said he expects the Fed to hike its benchmark short-term interest rate by 50 bps at its next meeting in September but wouldn’t rule out another big 75 bps hike if inflation doesn’t look like it’s receding. After that, Evans said he hoped the Fed could return to the more traditional 25 bps hike at the last two policy meetings of 2022.
Separately, Cleveland FRB President Mester warned against prematurely declaring victory over inflation. According to Mester, the Fed should keep hiking rates until it sees several months of cooling inflation.
Finally, San Francisco Fed President Mary Daly said the central bank’s effort to bring down prices by slowing demand was nowhere near done. Moreover, she poured cold water on the idea that the Fed could pivot to rate cuts next year, saying the next change would likely be to just hold rates steady for an extended period.

U.S. Retail Gasoline Market: According to data provider OPIS, the average price for a gallon of regular unleaded gasoline sank to $4.19 yesterday, marking the 49th straight day that gas costs have declined in the U.S. Prices are now down 16.5% from their most recent high of $5.02 per gallon on June 14.

Global Energy Markets: The Organization of the Petroleum Exporting Countries and its allies today agreed on a modest boost in crude oil production. Beginning in September, the OPEC+ members said they will boost output by a collective 100,000 bpd, on top of the increase of 648,000 bpd previously announced for July and August.

The small boost is probably at least a partial response to President Biden’s controversial rapprochement with Saudi Arabian Crown Prince Muhammed Bin Salman.
However, the small increase is expected to have little impact in bringing down prices. The recent price declines for oil can be tied more tightly to factors like demand destruction from the high prices earlier in the summer and slowing demand growth as economies respond to interest-rate hikes by the world’s central banks.

Global Cryptocurrency Markets: In yet another blow to the budding cryptocurrency markets, an apparent cyberattack drained thousands of digital wallets linked to the Solana blockchain. Along with recent crypto frauds, bankruptcies, and other scandals, cyber thefts like the one at Solana will undermine digital currency promoters’ assertions about the assets being secure, even as the digital currencies face growing regulatory risk.

In fact, the Senate Agriculture Committee’s top Democratic and Republican leaders plan to introduce a bill that would empower the Commodity Futures Trading Commission to regulate spot markets for digital commodities, a newly created asset class.
The proposed legislation would target CFTC regulation over the two largest cryptocurrencies: bitcoin and ether.

Netherlands: As the country breaches its legal limits on nitrogen emissions, the government has sparked broad farmer protests with a plan to reduce Dutch livestock populations by one-third through buyouts and other incentives. Since June, the farmers’ protests have included picketing supermarket distribution centers, blockading roads, airports, and train stations, and even dumping slurry at the home of the minister in charge of the program.

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Daily Comment (August 2, 2022)

Posted on August 2, 2022August 2, 2022 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where Russia continues to struggle with insufficient troop levels to make more significant territorial gains or to better defend against Ukraine’s counteroffensive in the south of the country. 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 U.S. House Speaker Pelosi’s visit to Taiwan and China’s risky saber-rattling in response to it.

Russia-Ukraine: As Ukrainian forces ramp up their counteroffensive against the occupied southern city of Kherson, the Russians continue to shift troops there from the areas they occupy in Ukraine’s northeastern Donbas region. However, the Russians’ effort to reinforce Kherson may deprive them of the combat power they need to make further gains in the Donbas. The shift may also tempt the Ukrainians to launch a separate counteroffensive against the weakened Russian defenders in the Donbas. Meanwhile, the Russians continue to launch missile strikes across a wide swath of Ukrainian territory.

The Russian military’s need to shift troops from one battlefield to the other illustrates its continuing shortfall in troops. In further evidence of that, U.S. and British military officials said that the Russian mercenary force known as the Wagner Group has been pulling troops out of Africa and redeploying them as regular Russian army units in Ukraine.
Separately, imagery and other analysis increasingly suggest that the Russian military was responsible for an explosion that killed more than 50 Ukrainian prisoners of war at a Russian-occupied prison over the weekend. The Russian government had suggested that the Ukrainian military used precision rockets and artillery provided by the West to kill the POWs and prevent defections, but it now appears that the Russians staged the explosion and killed the POWs in yet another Russian violation of the Geneva Convention.
On the economic front, the Ukrainian infrastructure minister warned that the country’s grain exports will take a long time to ramp up, despite yesterday’s first successful shipment from Odessa since the war began. The warning means Ukrainian supplies won’t quickly help alleviate the evolving global food crisis.

United States-Taiwan-China: It now appears that House Speaker Pelosi intends to carry out her controversial visit to Taiwan today and tomorrow, despite strong but unspecified Chinese warnings not to do so and President Biden’s misgivings about the trip. At this point, it’s not clear whether China’s warnings amount to anything more than posturing and bluster. However, given that the country is much more powerful than when a House speaker last visited the island in 1997, it’s impossible to rule out a risky show of force that could lead to miscalculation and potential conflict. That possibility is weighing on risk assets so far this morning.

In what is probably part of China’s response, this morning, Chinese fighter aircraft have buzzed the maritime boundary between the mainland and Taiwan.
On social media, we’ve also seen video of tanks patrolling a beach in China’s southern Xiamen province, opposite Taiwan. Of course, there seems to be little reason for Chinese tanks to be patrolling their own beaches (and disrupting tourists playing in the surf). Most likely, the move aims to drive home the idea of the Chinese military attacking Taiwan’s beaches.
The People’s Liberation Army has put its Southern Theater Command on high alert and launched a series of military exercises in the South China Sea set to last until Saturday evening. That makes sense, given that the Southern Theater Command has responsibility for the area off China’s southeast coast where Pelosi’s plane would likely travel enroute from Malaysia to Taiwan. However, other than the tanks on the beach in Xiamen and reports of closed airspace around Fujian, we have seen no indication of any change in alert status for the Eastern Theater Command, which sits opposite Taiwan and would have key responsibility for any action against the island.

Source: U.S. Department of Defense

Japan: Continuing its rebound since mid-July, the yen has now appreciated to a two-month high of about 131.00 per dollar. The rebound reflects factors such as the recent retreat in U.S. bond yields and calculations that the Bank of Japan could abandon its yield curve control policy as other major central banks accelerate their interest-rate hikes to fight inflation. The move also appears to reflect some safe-haven buying amid geopolitical tensions and global recession fears, as well as short-covering by major investors.

Bulgaria: President Radev has called a snap election for October 2 and appointed Galab Donev, a former labor minister, to lead a caretaker government until a new administration is formed. The new election (the country’s fourth in the last two years) comes after the June collapse of the government run by Kiril Petkov, who came into office promising to fight the country’s rampant corruption, and who took an unusually strong line against Russia following the invasion of Ukraine.

Petkov’s government lost a vote of confidence after one of the parties in the fragile four-party coalition abruptly pulled the plug. Afterwards, no other political group was able to secure a majority to govern.
Observers now fear that the snap election could produce another fractured parliament, potentially undermining the European Union’s support for Ukraine in the war.

Global Cryptocurrencies: The Securities and Exchange Commission has charged 11 people for a $300-million cryptocurrency pyramid scheme in which they used promoters to convince millions of investors worldwide to recruit others into the program. Besides reflecting increased enforcement efforts by national authorities, the news is another black eye for the industry and will likely buttress calls for increased regulation.

U.S. War on Terror: President Biden announced that a U.S. airstrike in Kabul, Afghanistan, killed Al Qaeda leader Ayman al Zawahiri, a founding member of the movement and one of the key strategists behind its international campaign of terror that culminated in the September 11 attacks. The strike was the U.S.’s first known counterterrorism operation in Afghanistan since it withdrew its forces last summer. The attack shows that the U.S. retains the capability of striking terrorists in Afghanistan despite not having a permanent presence there.

U.S. Bond Market: For the first time in this cycle, the yield on the three-month Treasury bill briefly rose above the yield on the 10-year note yesterday. While the 2-year/10-year yield curve has been inverted for some time, Fed researchers consider the 3-month/10-year to be the better indicator of an impending recession. The development will help keep investor concerns alive concerning a recession in the U.S. sometime over the next year or so.

U.S. Antitrust Policy: The trial over the Justice Department’s effort to block a merger of major publishers has started. The lawsuit, in which the DOJ is attempting to stop Penguin Random House’s planned acquisition of rival publisher Simon & Schuster, is expected to signal how successful the government will be in preventing industry consolidation and preserving market competition in the coming years.

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