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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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 details on the first shipment of grain from a Ukrainian port under the recent Turkish-brokered deal for safe passage of food exports from the country.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine: With Ukrainian forces apparently ramping up their counteroffensive against Russian occupiers in the southern Ukrainian city of Kherson, leaders in Moscow continue to face the dilemma of whether to transfer troops from the occupied Donbas region to reinforce the city.  The latest reporting suggests that the Russians may be trying to squirm out of that dilemma by launching new attacks from the Donbas region westward toward the major Ukrainian city of Kharkiv.  That attack has the potential to draw Ukrainian forces northward to help defend it, weakening their attacks on Kherson, but it is not at all clear whether the Russians have enough resources to truly threaten Kharkiv and draw the Ukrainians into that battle.

• To the surprise of many who thought Moscow would scuttle the recent Turkish-brokered deal to allow safe passage for Ukrainian grain shipments, today a Sierra Leone-flagged bulk carrier left Odessa with 26,000 metric tons of corn headed toward Lebanon.  More ships are expected to depart in the coming days, including many which were loaded before the Russian invasion began in February.
  • The flow of Ukrainian wheat, corn, barley, and other food products, which mostly go to less-developed countries, has helped push grain prices lower so far today.
  • Nevertheless, it is still too early to know whether Moscow will allow continued shipments.  The renewed exports, therefore, may not have a significant impact on global markets in the near term.
• Separately, tensions between Serbia and Kosovo are rising, potentially as a result of the Russia-Ukraine war or Russian efforts to divert attention away from it.  The discord has prompted the NATO-led KFOR peacekeeping program to say it will intervene if necessary to keep the tensions under control

United Kingdom: In the race to succeed Boris Johnson as Conservative Party leader and prime minister, Foreign Minister Liz Truss and Former Chancellor Rishi Sunak continue to hammer each other over tax policy.  In recent days, Truss, who remains the odds-on favorite to win the race, has pilloried Sunak for his effort to control the government budget deficit by hiking taxes.

• With her insistence that such “stale economic orthodoxy” has hurt the British economy, Truss underscores how today’s populist, more conservative leaders are abandoning the right’s traditional belief in balanced budgets and austerity when necessary.
• We see similar tendencies in other populist, more conservative leaders elsewhere in the world as well.

Chinese Foreign Policy: Many people are now familiar with President Xi’s “Belt and Road Initiative,” which aims to build Chinese influence around the world by providing capital for infrastructure projects, but it’s now becoming clear that Xi intends to supplement this economic program with his newly announced “Global Security Initiative.”  Under the program, Beijing offers military training, intelligence sharing, and joint counterterrorism activities to developing countries, ostensibly to build their own independent defense capabilities and avoid Western sanctions.

• In a letter to the China-Africa Peace and Security Forum last week, Xi urged African countries to support the GSI.  In May, the GSI also managed to gain the support of leaders from the Latin American countries of Nicaragua and Uruguay.  China’s recent effort to build security links with island countries in the Western Pacific Ocean are probably also related to the effort.
• We suspect that the GSI will be an increasingly important part of China’s effort to build comprehensive influence around the world.  In turn, that’s likely to exacerbate the current U.S.-China geopolitical competition, with all its negative implications for the global economy and financial markets.

Chinese Economy: As shown in the data tables below (see pdf), China’s official purchasing managers’ index for manufacturing fell to a seasonally adjusted 49.0 in July, missing expectations that it would rise to 50.3 from its reading of 50.2 in June.  Like most major PMIs, the Chinese one is designed so that readings below 50.0 point to contracting activity.  Separately, a private housing data provider said that July home sales by the country’s top 100 developers were down 39.7% from the same month one year earlier.

• The figures suggest that the Chinese economy is recovering only slowly and fitfully from the government’s spring COVID-19 lockdowns.
• Naturally, weaker demand growth in China will likely weigh on global economic activity and financial markets.

China-United States: Despite China’s effort last week to forestall the U.S. delisting of Chinese firms that don’t meet U.S. auditing disclosure standards, the SEC on Friday said internet giant Alibaba (BABA, $89.37) has been put on a list of firms scheduled to be kicked off U.S. stock exchanges in the coming years.  More than 150 Chinese firms are now on that list, prompting Hong Kong Financial Secretary Paul Chan to warn that the financial center should prepare for a “worst case” scenario in which U.S.-China relations rupture definitively.  The situation underscores the regulatory risk faced by Chinese companies trading on U.S. exchanges.

U.S. Fiscal Policy: West Virginia Senator Joe Manchin, who last week struck a deal to support the Democrats’ new “Inflation Reduction Act,” insisted the corporate tax hikes in his party’s bill would merely close loopholes and not unduly weigh on corporate investment, as Republicans have charged.

• Besides using some $300 billion from the tax hikes to cut the U.S. budget deficit, the bill would allocate $369 billion toward green initiatives and energy reforms, and $64 billion to shore up the Affordable Care Act.
• The Senate is due to take up the legislation next week before Congress leaves Washington for its August recess.

U.S. Labor Market: Boeing (BA, $159.31) has, at least temporarily, averted a strike which was due to start this afternoon at its defense-related plants in the St. Louis area.  Early this morning, the company offered last-minute contract concessions related to changes it wanted to make to unionized workers’ 401(k) plans.  The new contract will be subject to a union vote on Wednesday.

• Even if the new contract is approved, however, we still believe the dispute and threatened strike show how today’s tight labor market has emboldened workers and given them increased bargaining power to demand better pay, benefits, and working conditions.
• If it lasts long enough, the increased worker leverage will likely increase costs for companies and weigh on profit margins, potentially dragging down stock prices.

U.S. Apartment Market: In more positive news for inflation, a private data firm says U.S. apartment rents in the second quarter were up “just” 9.4% year-over-year, cooling from annual increases of more than 11.0% in each of the two previous quarters.  The firm projects that rental rates will continue this trend through the coming months.  Moderating rents will help lower the overall reported inflation rate, although only with a long lag.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will begin with a discussion of a broad macroeconomic outlook focusing on the central bank transition away from forward guidance, the U.S. GDP contraction in Q2, and a surge in Eurozone inflation. Next, we discuss U.S.-China relations. Finally, we examine how the Russia-Ukraine war has led to greater cooperation among Western countries.

Macroeconomic Outlook: The U.S. economy has contracted two quarters in a row, but it is still too soon to call it a recession. Calls for the end of the Fed’s tightening cycle may be premature as the lack of forward guidance raises the likelihood of a market surprise, and elevated inflation in the Eurozone pressures the European Central Bank to raise rates more aggressively.

• Recession? The economy shrank an annualized 0.9% in the second quarter. Back-to-back contractions in Q1 and Q2 have led to concerns that the country may be in a recession. Although consecutive contractions are typically associated with a recession, the NBER officially makes that call. The group looks at various measures of economic activity at the general and micro levels. As a result, the group takes a very long time before officially confirming that the economy is in recession. For example, the group waited 15 months after the Great Recession ended to announce that the economy was in recovery, and therefore, it is essential not to put too much weight on the latest GDP report. In our view, the economy is not in recession as Final Sales to Domestic Purchases, which excludes volatile elements of GDP, has contracted in one quarter but is still subject to revision.

• Farwell, Forward Guidance: Central banks may be transitioning from forward guidance as economies slow, and inflation remains elevated. The ECB was the first of the major central banks to ditch forward guidance, and the Federal Reserve followed suit a week later. When inflation was low, forward guidance reassured investors that the central bank policy would not change in the future. However, consistently higher than expected inflation and economic deceleration have led banks to value policy flexibility over market clarity. The shift away from forward guidance will make speeches from voting members and central bankers even more critical.
• Eurozone inflation: The flash estimate of the Eurozone Consumer Price Index jumped 8.9% from the year prior, setting a new record. Although inflation remains lower than in the U.S., the core CPI suggests that the momentum of the price increases continues to build in Europe. The strong reading will pressure the European Central Bank to become more aggressive in its tightening cycle in order to tame inflation. Before the report, Governing Council Member Martins Kazaks hinted at the possibility of a significant rate hike at the next ECB meeting in September. Although there is speculation that the central bank may raise rates by 50 bps, there is a strong possibility that the planned hike could be higher.

In short, the unpredictability of economic data has made it difficult for central bankers to make predictions about upcoming monetary policy. Therefore, the lack of guidance may mean the ECB and Federal Reserve could surprise markets in their next meeting depending on the latest inflation data. Although it is tempting to view a decline in GDP as a sign that the Fed could implement a pause, it is worth noting that the ECB and the Fed are mandated to maintain price stability. As a result, inflation will likely be their top focus when determining future monetary policy. When the central banks hold their respective meetings in September, they will be determining policy based on the August inflation numbers, so investors should take the July reports with a grain of salt.

China: President Biden and Chinese President Xi discussed Taiwan on Thursday, China hints at a possible slowdown in its economy, and Beijing tries to use TikTok to send propaganda to the West.

• The phone call: Yesterday, President Biden and Chinese President Xi Jinping had their long-awaited phone call. As usual, both sides offered each other reassurances that the status quo should remain intact. Although the call allowed the two to clear the air, tensions between the countries persist. There is still no word on whether Speaker of the House Pelosi will travel to Taiwan next month; however, she is still set to leave for her trip to Asia on Friday. Pelosi may be pressured to travel to Taiwan to avoid looking like she is kowtowing to Beijing. In that event, China may be forced to retaliate. As a result, we believe that the trip has the potential to lead to direct conflict between the U.S. and China.
• China slowdown: Leaders in Beijing signaled that China might miss its goal of a 5.5% expansion of GDP this year. This downbeat assessment reflects the negative impact of the property market crash and the country’s controversial Zero-COVID Policy on the economy. The candidness should not be a surprise as the rest of the world is currently distracted by talks about whether the U.S. is in recession. As the economy continues to show weakness, China may inject stimulus to boost growth.
• China propaganda: S. lawmakers have consistently labeled TikTok as a national security threat due to its supposed ties to the Chinese government. On Thursday, a Bloomberg report revealed that a state entity related to public relations tried to create an account to target Western audiences with propaganda. Although TikTok executives supposedly pushed back on the report, the company’s association with Chinese government officials will likely unnerve U.S. politicians that feel that the social media platform may act as an arm of Beijing. Over the last few years, governments have weaponized social media to destabilize rival countries. As a result, we believe this report will not only lead to a more significant push from U.S. officials to have TikTok removed from app stores, but also lead to more regulatory oversight with how these companies manage their users’ data. Hence, this report may also have ramifications for the broader tech sector.

As we have warned in our 2022 Mid-Year Geopolitical Outlook, China is likely to push its narrative of a “rising China, falling West” going into the 20^th National Congress of the Chinese Communist Party. Therefore, it will likely view any move by the U.S. to recognize Taiwan as an independent nation as a direct threat to its national sovereignty.

Russia-Ukraine Update: The war in Ukraine continues to force the West to build closer ties with each other as it looks to respond to Russian aggression.

• Preventing a crisis: The European Union aims to diversify its energy sources to ensure it has ample supply in the winter months. France and Belgium have turned to nuclear energy, Italy has explored Algeria as its new natural gas provider, and Spain has offered to deliver some of its reserves to other countries within the bloc. The sudden change in reducing their energy consumption may not successfully solve the EU’s supply needs by winter, but it will likely position the bloc to make a long-term shift away from using Russian energy in the future. In addition, the EU is planning investments to build pipelines from alternative sources, such as Algeria, Nigeria, Niger and Azerbaijan. As a result, we view the move away from Russian energy as a reflection of a long-term trend of countries looking to sever ties with unfriendly nations.
• Arms sales: The U.S. approved $8.4 billion in arms sales to Germany. The purchase of U.S. weapons signals Russia’s invasion of Ukraine has strengthened the NATO alliance. The trading of weapons among allies reflects a closer military cooperation among Western allies. Over the next few years, NATO allies will ramp up purchases with each other as they look to ensure their security from outside threats. U.S. defense companies should benefit from this push initially; however, nascent European companies could also profit from the increase in defense spending.

As the war continues, we believe the world will begin to break into regional blocs. Thus, the recent moves by the European Union to diversify away from Russia reflect the West’s need not to rely too heavily on a single country outside of its bloc.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning. We have a lot to discuss today. Today’s Comment will begin with an overview of the latest Fed meeting. Next, we will analyze the latest development in the Russia-Ukraine war and explain why we think the conflict could end in 2023. Afterward, the report examines the latest international news, including rising tensions on the Korean peninsula. We conclude the report by discussing the latest domestic developments.

FOMC: Stocks rallied and Treasury yields plunged on Wednesday after the Federal Reserve raised its benchmark rates by 75bps to 2.25% and 2.50%, in line with market expectations. Although the central bank statement maintained that further increases in its policy rate would likely continue, the market’s reaction suggests that investors believe that the tightening cycle could end soon. During the press conference, Fed Chair Jerome Powell stated that the Fed aims to lift rates into a moderately restrictive territory and described the current level as being neutral. Powell reiterated that another 75 bps might be appropriate for the September meeting.

• What does it mean? The Fed is likely committed to taming inflation; however, we expect the central bank to raise rates at a slower pace throughout the remainder of the year. Powell’s insistence that the Fed will not likely provide forward guidance suggests that the central bank is open to raising rates less than 75 bps. Assuming that the latest dot plot reflects the Federal Open Market Committee’s current thinking, the Fed is set to raise rates another 100 bps this year. Barring a change, the Fed could raise rates in its next two meetings and pause in December.
  • Other central banks may follow the Fed if it scales back its rate hikes. The ECB in particular is likely to reconsider its monetary path as higher rates can cause fragmentation throughout the Eurozone.

Russia-Ukraine: Russia is slashing natural gas deliveries, Ukraine forces are slowing Russian advances with U.S. weapons, and grain exports are set to leave Ukrainian ports. These developments suggest that the war will persist. However, we do see a path for potential de-escalation.

• Russian gas flow to Europe dropped on Wednesday after operation capacity for Nord Stream 1 fell to 20%. Gazprom, a state-owned energy company, warned that further problems with its turbines could continue the possibility of further reduction in gas flows. As a result, gas prices in Europe surged 30% over the last two days over concerns that Russia may stop delivering gas to the EU in retaliation for the bloc’s support for Ukraine in the war.
  • That said, we are not sure how long Moscow plans to withhold gas from Europe. Russia does not have the pipelines needed to redirect its natural gas to other countries; therefore, if it chooses to deny gas to Europe, it risks taking some of its wells offline due to the lack of production. Gazprom reports that natural gas production has been down 10.4% since January and 33% from a year ago.
• Ukrainian forces attacked critical Russian supply routes with U.S.-supplied long-range missiles. Ukraine has used high-grade weaponry to prevent further advances from Russia into Ukraine. So far, U.S. private estimates show that over 75,000 Russians have been killed or injured or roughly half of the troops sent into Ukraine during the spring.
• Wheat futures have dropped over the last few days as Ukraine prepares to deliver its grains exports through the Black Sea. Since the Russian invasion, more than 20 million tons of grains have been stranded in Ukrainian ports. The delivery should help global wheat prices. However, there are still concerns that the grain may not make it to markets.

Despite grain exports offering some price relief, commodities will perform well if Russia and Europe continue to play chicken with natural gas. Much has been made of Europe’s dependence on Russian gas, and it is therefore easy to ignore Russia’s limitations. For example, suppose Europe can make it through the winter. In that case, the Russian economy will feel the force of the sanctions, pressuring the government to reallocate its funds away from the war effort and toward bolstering the domestic economy. Remember, Russian President Vladimir Putin plans to run for an unprecedented third term in 2024. The fusion of rising inflation, a slowing economy, and burdensome sanctions is likely to cloud his election push. As a result, we expect there to be a possibility for Russia to pause its invasion in 2023 to regroup and possibly try again in the future.

International News: Rising tensions on the Korean peninsula, the increased likelihood of a left-wing populist president in South America’s largest economy, and declining consumer confidence suggest rising economic and geopolitical risks abroad.

• North Korean Leader Kim Jung Un threatened to wipe out South Korea if provoked by his southern neighbor. The threat is in response to the U.S. and South Korea’s plans to have joint military exercises next month. The two sides have not carried out in-person joint military drills since 2018. While threats from North Korea are not new, there are concerns that joint exercises may agitate the country after having made progress in its missile program earlier this year.
• Brazil’s Presidential front-runner Luiz Inacio Lula da Silva, revealed that if he wins the election, his economic minister will need to be politically-minded rather than a bureaucrat. Given the former president’s pro-leftist leanings, investors are concerned that Lula could pick a minister that would not support fiscally sound policies. Brazilian equities performed well during Lula’s first term in office due to a global rally in commodity prices. However, the policies he introduced toward the end of his tenure partly contributed to the downfall of his successor Dilma Rousseff.
• Eurozone consumer confidence fell to an all-time low in July. The drop in sentiment reflects household concerns regarding the rising energy prices, a slowing economy, and the continuing war in Ukraine.

Domestic Developments: The U.S. is poised to pass new legislation that should provide some stimulus to the economy. Meanwhile, today’s phone call between President Biden and President Xi has the potential to be mutually beneficial for both the U.S. and China.

• Democrats may have reached a deal on Biden’s scaled-back agenda. Senator Joe Manchin (D-WV) and Senate Majority Leader Chuck Schumer (D-NY) agreed to legislation that would address climate change, modify tax policy, and extend the Affordable Care Act subsidies. The bill will spend $369 billion on energy-climate initiatives. Democrats still need support from Senator Kyrsten Sinema (D-AZ) for the bill’s passage. In other related news, the Senate passed legislation to support chip manufacturing in the U.S. The move will likely pave the way for additional stimulus for the economy.
  • The Congressional Budget Office projects government debt as a percent of GDP to rise to 185% by 2052. The possibility of additional stimulus will likely provide some economic relief for the country. However, not enough to alter its GDP growth trajectory.

President Xi and President Biden will talk on Thursday. The focus of the discussion will be Speaker of the House Nancy Pelosi’s planned trip to Taiwan, China’s role in the Ukraine war, and possible plans for the U.S. to drop tariffs. A conversation between the world leaders will likely help the sides moderate tensions. Beijing is reeling over the news that Pelosi plans to visit Taiwan in August. Meanwhile, the U.S. does not like that China continues to elicit support for Russia. In light of rising tensions between the two countries, both seem to be in a position to make concessions. Beijing wants U.S. businesses to invest in China to generate growth before the 20^th National Congress of the Communist Party. Meanwhile, Washington is pushing China to support a price cap on Russian oil. Although we expect no significant breakthroughs in this phone call, we believe that discussions could pave the way for smoother relations.

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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 more fallout for the world’s energy and food supplies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new signs of labor unrest across the globe, and a preview of the Federal Reserve’s latest monetary policy decision, due later today.

Russia-Ukraine: Russian forces are again seizing incremental territory in Ukraine’s eastern Donbas region. They are likely to consolidate control over the region so they can hold a contrived referendum on annexation there on Russia’s national election day in mid-September.  The Russians also continue to launch long-range missile strikes against a variety of targets across Ukraine, but especially in the southern region around Ukraine’s grain-exporting ports.  Meanwhile, Ukrainian forces continue to attack Russian ammunition depots, logistics centers, and personnel concentrations, as well as a key bridge running into Kherson, an occupied city in the country’s south that Ukraine is attempting to recapture from the Russians.

• U.S. and other NATO officials continue to signal that they are shifting their position toward supplying Ukraine with advanced fighter jets and training pilots to fly them in the coming months.  The changed posture stems in part from Ukraine’s tenacious battlefield performance to date and a tacit understanding that Kyiv is likely to lean closer to the NATO alliance in the future.
• Meanwhile, U.S. officials are redoubling their efforts to convince China, India, and other countries that have been buying up cheap Russian crude oil to sign on to a low-price cap for the product.  The plan aims to supplant the Western countries’ scheduled ban on insuring tankers carrying Russian oil beginning in December, in a move U.S. officials fear would lead to a new spike in oil prices and ultimately provide more funds to Moscow.
• Separately, European natural gas prices are continuing to spike in response to Russia’s latest cut in supplies.  As of this writing, the European benchmark gas price is up some 12% to the equivalent of $231.17 per megawatt hour.  The benchmark price has now risen approximately 37% this week alone.
  • In response to the price surge, German chemicals giant BASF (BASFY, $10.61) said it would reduce its production of ammonia, a gas-intensive product that is a key ingredient for many fertilizers.
  • The production cut is a reminder that Europe’s energy crisis also feeds into the evolving world food crisis.  Reduced supplies and higher prices for fertilizers are already affecting food production around the world.
• Finally, in another aspect of the Western sanction regime, the Wall Street Journal reports that auditors trying to avoid running afoul of the sanctions are demanding that their clients promise they have no significant connections to Russians or Russian firms.  Sanctions experts and some corporate board members say the auditors are going beyond what is necessary and could be placing legal liability on their clients if authorities question their Russia connections.

Global Labor Market: In another sign that tight labor markets have emboldened workers all over the globe, several new strikes or strike announcements have popped up in recent days.  Taken together, the actions illustrate how labor shortages are giving increased bargaining power to workers, raising costs for companies, and potentially signaling lower profit margins.

• In Germany, ground crew for Deutsche Lufthansa (DLAKY, $5.92) have gone on strike over a wage dispute.  The action has forced the airline to cancel nearly all flights at its big hubs in Frankfurt and Munich.
• In the U.K., railroad employees have staged another massive one-day strike over pay, job security, and working conditions.  The strike follows three similar one-day strikes last month.
• Finally, in the U.S., a union representing 2,500 machinists at three defense plants owned by Boeing (BA, $155.92) has voted to go on strike beginning August 1.  The impending action at facilities near St. Louis aims to fight Boeing’s plan to phase out its automatic contributions to the machinists’ 401(k) accounts.

Italy: With polls showing right-wing parties are likely to form Italy’s next government after elections in September, European Union Economics Commissioner Paolo Gentiloni warned that the EU would not renegotiate the fundamentals of its €200-billion pandemic relief plan for the country, and that Rome must stick firmly to the reform pledges made by lame duck Prime Minister Mario Draghi in order to receive the money.  The statement sets up a possible conflict over the funds once a new government is in place, potentially undermining Draghi’s economic reforms and depriving Italy of major financing for big infrastructure changes and other investments.

Hungary: Prime Minister Viktor Orbán, a darling of the world’s growing right-wing populist movement, has touched off an international backlash over comments he made decrying Western “mixed race” nations and warning Hungarians not to intermarry with “non-Europeans.”  The statements are likely to further exacerbate Hungary’s ties with the rest of the European Union.

Tunisia: The country’s electoral commission said nearly 95% of voters approved Tunisia’s new constitution in a referendum this week.  The new constitution provides virtually dictatorial powers to populist President Kais Saied, essentially tearing up the democratic reforms launched in Tunisia after the Arab Spring uprising in 2011.

El Salvador: Yesterday, President Nayib Bukele announced that his country will use some of its international reserves and financing from a regional lender to buy back $1.6 billion of its sovereign debt coming due in 2023 and 2025.  The plan aims to take advantage of the bonds’ current low prices as investors fret about a potential default by the country.  The plan also comes as El Salvador’s intention to sell an exotic $1-billion bond, which bet on a rise in bitcoin’s value, stalled when the crypto asset fell sharply in recent months.

United States-China: With tensions rising over House Speaker Pelosi’s potential trip to Taiwan to show support for the island as it comes under increased pressure from China, the White House said President Biden and Chinese President Xi will talk by telephone tomorrow.  Meanwhile, Chairman of the Joint Chiefs of Staff Gen. Mark Milley said he worried that a Pelosi trip could touch off a crisis, but that the U.S. military is always prepared to support lawmakers’ trips and ensure they are safe.

U.S. Monetary Policy: The Fed today ends its latest two-day monetary policy meeting, with the decision expected to come out at 2:00 pm ET.  The officials have signaled they will hike their benchmark fed funds interest rate by another 0.75% to a range of 2.25% to 2.50%, and investors widely expect further aggressive rate hikes through the end of the year before the officials reverse course sometime in 2023.

• Reflecting those expectations, the yield curve remains inverted.
• As of this morning, the yield on the 2-year Treasury note stands at 3.061%, while the yield on the 10-year Treasury stands at 2.801%.

U.S. Technology Sector: Yesterday, the Senate voted 64 to 32 to advance a $280-billion package of subsidies and research funding to boost U.S. competitiveness in semiconductors and advanced technology.  A particular focus of the bill is to spur more investment in U.S. computer-chip factories, reducing the country’s dependence on foreign chips.  If the measure passes a final Senate vote as expected today, it will then have to be passed by the House before being signed into law.

• Separately, Director of the Consumer Financial Protection Bureau Rohit Chopra warned, in an interview, that big technology companies’ entry into the buy now, pay later lending business could undermine competition in the nascent sector and raise questions about the use of customer data.  The statement points to a new vector for regulatory risks facing big technology firms.

Meanwhile, technology firms Alphabet (GOOG, $105.44) and Microsoft (MSFT, $251.90) posted better-than-expected earnings last night, suggesting their post-pandemic retrenchment may not be as bad as anticipated.  The results have helped give a boost to U.S. equity markets so far today.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, with a focus on its associated disruptions to global natural gas and grain supplies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a preview of the Federal Reserve’s latest monetary policy meeting.

Russia-Ukraine: Russian forces are once again making small territorial gains in Ukraine’s eastern Donbas region, but at a very high cost.  Meanwhile, Ukrainian forces continue to attack Russian positions around the occupied southern city of Kherson.

• On the economic front, Russian state-owned energy giant Gazprom (GAZP.ME, $198.00) warned that natural gas exports through the vital Nord Stream 1 pipeline to Germany would drop to about a fifth of the pipe’s capacity this week, blaming sanctions-related problems with turbines.  Separately, Ukraine’s gas transmission system operator said Gazprom had sharply increased pressure in the Urengoy-Pomary-Uzhgorod pipeline without giving any notice, which the operator said “can lead to emergency situations” such as damage to pipelines.
  • The announcements show that Russia continues trying to use energy as a weapon of war, especially to pressure Western European countries to stop supporting Ukraine.  The latest cuts are probably designed to prevent Western Europe from building up sufficient inventories to get it through the winter heating season.  Running out of energy in the winter would maximize the pain of Russian energy cut-offs.  In response to the news, European gas prices jumped some 12% yesterday and a further 10% or so this morning.
  • Separately, EU energy ministers approved last week’s European Commission proposal for a system of 15% energy consumption cutbacks, but with a long list of exceptions.  For example, the approved plan will exempt Ireland and Malta who are not directly connected to the European grid, states that are heavily reliant on gas for electricity, and countries that are exporting gas at 90% of their total capacity to other member states.  Coupled with the new Russian gas disruptions, the exemptions will make it even harder for Western Europe to build up sufficient inventories to get through the winter.
• Separately, a Ukrainian official yesterday said Kyiv is still preparing to implement the Russia-Ukraine deal on grain exports that was brokered by Turkey last week.  Despite the Russians’ weekend attack on port facilities in Odessa, the Ukrainians are removing mines and setting up special naval corridors for the safe passage of merchant vessels, as well as constructing a coordination center in Istanbul.  However, we think it’s still possible that Russian attacks will short-circuit the deal and keep Ukraine’s grain bottled up, worsening the evolving global food crisis.
• Finally, Russian Foreign Minister Lavrov is touring Africa to make the case that the West is responsible for the global food crisis touched off by the war.
  • The warm welcome Lavrov has received shows how Moscow’s military and economic aid to Africa has bought it some much needed political support.
  • More broadly, our analyses show that as the U.S. steps back from its traditional role as global hegemon, and as the world breaks up into relatively separate geopolitical and economic blocs, less-developed countries like those in Africa are much more likely to end up in the bloc led by China and Russia.

Global Economy: Today, the International Monetary Fund sharply cut its forecasts for global economic growth and raised its expectations for world price inflation.  Because of Russia’s invasion of Ukraine, supply disruptions caused by the coronavirus pandemic, and rapidly tightening financial conditions, the IMF now expects global gross domestic product to grow just 3.2% in 2022, which is down 0.4% from its April forecast.  It sees growth of just 2.9% in 2023, down 0.7% from its previous outlook.  The figures are consistent with our view that growing headwinds are combining to significantly slow global economic activity and will likely weigh on global stocks in the near term.

Germany: The IFO Economic Institute said its July business sentiment indicator dropped sharply to 88.6 from 92.2 in June, reflecting German businesses’ worsening outlook for the coming months.  The figure provides more evidence that falling global growth, the evolving European energy crisis, and other fallout from the Russia-Ukraine war are pushing Germany and the rest of Europe to the brink of recession.

Pakistan: In an interview with the Financial Times, Pakistan Central Bank Governor Murtaza Syed played down financial market concerns about the country’s worsening liquidity crunch.  Even as Pakistan contends with rising commodity prices, falling foreign exchange reserves, and a depreciating currency, Syed said he expected the IMF to sign off on $1.3 billion of new loans for the country in August, to be supplemented by funds from China, Saudi Arabia, and other Middle Eastern countries.

United States-China: An investigation by Senate Republicans found that, over the last decade,  China has tried to build a network of informants within the Federal Reserve system to provide it with nonpublic intelligence on U.S. economic performance and monetary policy.  The efforts included both threats to Fed officials and offers of monetary compensation for information.

• The investigation also faulted the Fed for lax security efforts, but Fed Chairman Powell pushed back against that suggestion.
• In any case, the finding illustrates the broad intelligence effort China has mounted against the U.S. and its aggressiveness in seeking ways to undermine the U.S. government.  The incident will likely contribute further to the frictions between the U.S. and China.

U.S. Monetary Policy: The Fed begins its latest two-day monetary policy meeting today, with its rate hike decision expected to be announced on Wednesday afternoon.  The officials have signaled they will hike their benchmark fed funds interest rate by another 0.75% to a range of 2.25% to 2.50%, and investors widely expect further aggressive rate hikes through the end of the year before the officials reverse course sometime in 2023.

• Reflecting those expectations, the yield curve remains inverted.
• As of this morning, the yield on the 2-year Treasury note stands at 3.000%, while the yield on the 10-year Treasury stands at 2.769%.

U.S. Dollar: In a Financial Times opinion article today, well-known international economist Barry Eichengreen warned that if the U.S. economy slows precipitously, inflation falls, and the Fed pauses its interest-rate hikes, the dollar could suddenly reverse course and begin depreciating.

• According to Eichengreen, the risk stems from the fact that many foreign central banks are now starting to catch the Fed’s fever to tighten monetary policy aggressively.  If the Fed pauses while those central banks keep hiking, those countries’ currencies could suddenly look more attractive.
• Reflecting the broad hikes in interest rates and rising bond yields around the world, a separate report today shows that the world’s total stock of negative-yielding debt stood at just $2.4 trillion last week, down 87% from the $18.4 trillion peak in December 2020.

U.S. Corporate Earnings: After market close yesterday, Walmart (WMT, $132.02) warned that rising food and fuel costs are forcing the company’s customers to cut back on purchases of higher-margin products, even as the firm struggles with an earlier announced excess of inventory.  As a result, the company said it now expects its operating profit to fall between 10% and 12% this fiscal year.  The news is weighing heavily on the stock of Walmart and other major consumer businesses so far today.

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