by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are mixed after the weaker-than-expected PPI report. In a Champions League upset, Barcelona edged past PSG in Paris, and took a 1-goal lead into the return leg. Today’s Comment examines how rising inflation (CPI) impacts interest rates, explores the increase in defense spending due to growing geopolitical tensions, and analyzes the hints of possible easing by the ECB as part of a wider trend among developed central banks.

Rate Cut Expectations: Stronger-than-expected March inflation and hawkish FOMC meetings have led to a rethink on rate cuts.

• Inflation surged in March, exceeding forecasts, and year-over-year consumer prices jumped to 3.5% (up from 3.2% in February). Core CPI, excluding volatile food and energy, also climbed to 3.8%, driven by rising costs in housing, healthcare, and car insurance. This robust report dampens hopes for the Fed achieving its 2% target, as indicated in recent meeting minutes. The minutes also reveal a divided committee, where some members fear geopolitical tensions and relaxed financial conditions could further inflate prices. In contrast, others see the potential for downward pressure from technological advancements and continued immigration.
• Recent data exposes unexpected inflation trends. Despite the Federal Reserve’s anticipation of falling housing costs, shelter inflation remains stubbornly high. The three-month annualized rate rose to a worrying 7.11% in March, a significant departure from the expected disinflation. Furthermore, inflation isn’t limited to housing. Core services, excluding rent, have also seen substantial increases, rising 9.3% at an annualized rate over the past three months. This unexpected increase in core services, which are sensitive to wages, suggests a tight labor market, which could fuel broader inflationary pressures.

• March CPI data complicates the Fed’s policy decisions. Their preferred gauge, core PCE inflation, is near their target (2.78% vs 2.50% target range). However, headline CPI inflation, the more widely followed measure, remains above 3.5%. This divergence creates a challenge. The higher CPI number suggests the Fed may now need to hold interest rates steady for a longer period than initially anticipated to avoid accusations of partisanship in an election year. Although a summer rate cut isn’t entirely off the table, its likelihood has diminished significantly.

Defense Spending Splurge: Rising global tensions are prompting governments to ramp up defense spending in a bid to deter potential adversaries.

• The Middle East simmers with escalating tensions as the US and Israel ramp up collaboration on missile defense. This follows recent threats from Iran vowing retaliation after a strike in Syria killed a high-ranking Iranian general. The simmering conflict raises fears of a wider regional war, with US officials warning of potential targeted missile attacks by Iran. In a defiant move, Israel issued a stark warning, promising a forceful response on Iranian soil if its borders are breached. Adding to the regional turmoil, two major disputes threaten to ignite further chaos: Ukraine and Russia, as well as Armenia and Azerbaijan.
• While a wider Middle Eastern conflict remains a major concern, the drone revolution is another threat to global stability that shouldn’t be underestimated. Iran’s cheap, combat-proven drones are captivating developing nations, bolstering defenses and aiding militaries like those in Ukraine and Sudan. Their global production network, spanning South America and Central Asia (including some US parts), raises questions about the effectiveness of sanctions. Meanwhile, Ukraine’s experience exposes limitations in US drone capabilities, prompting Ukraine to explore Chinese alternatives for reconnaissance. This highlights how any nation, regardless of size, can exploit niche strengths, reshaping the modern military landscape.

• The intensifying tensions in both the Middle East and Asia emphasize the critical importance of resilient supply chains. Recognizing the emerging alliance between Russia, China, and Iran, US allies are joining forces to bolster their military capacities, aiming to deter potential aggression. This collaborative effort is yielding early successes, as shown in the groundbreaking military drone radar developed by a notable French defense company. As geopolitical rifts deepen, the imperative for security investment grows, underscoring the importance for countries to support global defense companies in safeguarding collective defense interests.

 ECB’s Cautious Pivot: The European Central Bank decided to hold rates steady as it prioritizes economic growth over the inflation fight.

• The ECB Governing Council voted to hold interest rates steady for the fifth consecutive meeting. The main refinancing rate remains at 4.5%, and the deposit rate stays at 4.0%. While the central bank’s updated policy statement hinted at a future easing of monetary restrictions, it provided no concrete timeline. However, there are strong indications that a rate cut could come as early as June. The ECB also plans to continue its balance sheet reduction program and will reinvest principal payments from its pandemic bond purchases until the end of 2024.
• In a sign of shifting tides, the ECB’s decision to hold rates steady reflects a growing global trend towards a pause in interest rate hikes. This follows the Swiss National Bank’s surprise rate cut last month, the first among G-7 central banks. Similarly, the Bank of Canada has hinted at a possible June cut as it looks to ease its rate by 100 bps by the end of the year. This cautious approach comes as inflationary pressures, which peaked in the summer 2022, have begun to show signs of moderation, and economic growth has become more of a concern.

• Global monetary policy is in uncharted territory as central banks are deviating from the Federal Reserve’s cautious approach. This divergence, coupled with ongoing doubts about the need for US rate cuts given its economic resilience and robust labor markets, could significantly strengthen the dollar. A stronger greenback could pose a double challenge for economies reliant on dollar-priced imports as it would exacerbate inflationary pressures, forcing them to reconsider planned rate cuts. Additionally, a robust US economy might lead their central banks to maintain higher interest rates than desired, potentially hindering domestic growth.

Other News:  Manhattan rent dips hint at a stabilizing market, but high housing costs remain a hurdle for the central bank in achieving its 2% inflation target. Facing a persistent Russian offensive, Ukraine confronts growing challenges in maintaining momentum. Switzerland will hold a peace conference to mediate the Ukrainian/Russian crisis.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a major new speech by a top European Union policymaker that calls for greater US-EU coordination to counter China’s unfair trade practices — a call that is likely to anger Beijing and fuel greater tensions between the West and China. We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a new downgrade to the outlook for China’s credit rating and an Arizona Supreme Court ruling that could have an important impact on the US elections in November.

United States-European Union-China: In a major speech yesterday, European Commission market competition chief Margrethe Vestager called for the US and the EU to team up and present a more systematic, coordinated approach against China’s unfair trade practices. To protect their key industries of the future, Vestager outlined a strategy in which the US and EU, working together, could convince the Group of 7 countries to erect trade barriers against subsidized Chinese products being sold in the West at artificially low prices.

• Vestager also announced that the EU is launching an anti-dumping probe into Chinese wind turbines, just as it previously announced an investigation into the likely dumping of low-cost Chinese electric vehicles on the EU market.
• According to Vestager, “We saw the playbook for how China came to dominate the solar panel industry . . . We see this playbook now deployed across all clean tech areas, legacy semiconductors, and beyond, as China doubles down on a supply side support strategy to address its economic downturn.”
• The new anti-dumping probe is certain to generate complaints, pushback, and perhaps even retaliation by Beijing. Indeed, some European officials are likely to push back against the probe out of fear that China will retaliate by imposing new restrictions on their trade or investment flows. In the past, those concerns have limited the EU’s actions against China. However, faced with yet another onslaught of subsidized Chinese goods, the EU may ultimately impose tougher restrictions this time, as Vestager calls for.
• In any case, Vestager’s tough speech is a sign that economic tensions between the West and China aren’t going away anytime soon. They actually look set to worsen, since the Chinese government is likely to retaliate in one way or the other and shows no sign of wanting to shift away from its investment/export economic development strategy toward a consumption-led model.

Japan-China:  In a new survey by Japanese news firm Yomiuri Shimbun, 92% of respondents said China is a threat to Japan’s national security, versus 86% who said the same in 2023 and 81% who said so in 2022. The responses help explain Tokyo’s enthusiastic support for the US effort to strengthen allied defense efforts against China’s increased geopolitical aggressiveness in the Indo-Pacific region. The results also suggest tensions between China and the westernized liberal democracies will continue to increase going forward.

China: Reflecting China’s slowing economic growth, slumping property market, and rising fiscal deficit, Fitch today maintained its A+ rating on the country’s sovereign debt but cut its outlook from stable to negative. The move follows a similar one by Moody’s in December, in which that company maintained its A1 rating on China’s long-term debt but also cut its outlook from stable to negative.

• China’s burgeoning public sector debt stems mostly from fiscal shortfalls at the provincial and local government levels. The central government has begun to issue its own new debt to rescue some of those lower-level governments, but that is putting new fiscal pressures on Beijing.
• The rising debt challenges compound other structural economic challenges that have come to light in recent years, such as excess industrial capacity, weak consumer demand, poor demographics, decoupling by foreign countries, and the disincentives from the Communist Party’s increasing intrusions into the economy.
• Not only are China’s debt and other structural economic problems creating headwinds for the country’s own economy and financial markets, but they are also holding down growth in some other countries.

Australia: The government said today that it will toughen the country’s corporate merger rules amid concerns that increased market concentration is stifling competition and boosting prices. Under the plan, the government will give the Australian Competition and Consumer Commission added powers to scrutinize mergers above certain value and market-share thresholds. The ACCC would also be given authority to stop small serial acquisitions that could reduce competition over time, bringing Australia’s rules in line with those of most other developed countries.

Eurozone: Big US money managers are reportedly shifting their bond purchases from US Treasuries to eurozone obligations in hopes that the European Central Bank could begin to cut its benchmark interest rate sooner and faster than the Federal Reserve will cut US rates. The improved outlook for eurozone bonds reflects Europe’s much weaker economy and rapidly falling inflation. In contrast, strong economic growth in the US is keeping price pressures high and threatening to delay the Fed’s interest-rate cuts.

US Politics: Responding to the US Supreme Court decision in June 2022 that rolled back federal protections for abortion, the Arizona Supreme Court yesterday ruled that a nearly total ban still on the books from Arizona’s territorial days must be reinstated. The move follows a recent Florida Supreme Court ruling that also allowed tighter restrictions, even as it approved a referendum on abortion rights in the November election.

• Although the rulings will have no discernible impact on the US economy or financial markets, they have the potential to affect the upcoming elections.
• Given that Democrats have shown they can exploit the June 2022 ruling that overturned Roe v. Wade, the rulings could help the party in Arizona, Florida, and even in other key swing states, despite current polling showing greater support for former President Trump than for President Biden.

US Postal System:  The US Postal Service has requested permission to boost the price of a first-class stamp by an additional 5 cents. If approved in the coming weeks by the Postal Regulatory Commission, the cost of a stamp would rise on July 14 to $0.73, up 10.6% from one year earlier.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some observations on gold prices, which hit a record high yesterday. We next review a wide range of other international and US developments with the potential to affect the financial markets today, including more signs of a Western trade war against China over its dumping of excess production on world markets and another indication that US commercial real estate prospects may be on the verge of improving.

Global Gold Market:  Gold prices hit a new all-time record yesterday, closing at $2,357.80 per ounce despite investors’ realization that the Federal Reserve isn’t likely to cut interest rates as aggressively as previously thought (gold prices have historically been hurt by high real interest rates). In our view, the anomaly reflects a broad commodity rally, geopolitical tensions, and especially strong buying by central banks.

• Gold has long been seen as a “safe haven” asset that can hold its value in the face of currency debasement, rising price inflation, and wars or other geopolitical tensions.
• More recently, it’s become clear that gold is a safe haven even to foreign governments and their central bankers, especially in the rival China-led geopolitical bloc. As those governments and central banks digest how the West has essentially frozen or seized reserves held by countries like Afghanistan, Iran, and Russia, they’ve become much more intent on holding their reserves in hard assets such as the yellow metal.
• The process of central banks shifting their reserve holdings toward gold, silver, or other physical commodities could well continue for some time. Therefore, it’s possible that gold’s current uptrend will continue.

European Union-China: New reports say waves of imported autos are piling up at European ports, reflecting not just the onslaught of mostly Chinese-made vehicles but also a shortage of truckers to move them out and a slowdown in demand among European consumers. We think the situation will only make it more likely that the EU will formally impose anti-dumping tariffs or other trade barriers against China once its current investigation of the issue is completed.

European Union-Russia: Yesterday, the European Commission’s top diplomat, Josep Borrell became the latest high-level European official to warn of an impending war with Russia. In a speech in Brussels, Borrell warned that “Russia threatens Europe . . . War is certainly looming around us, and a high-intensity, conventional war in Europe is no longer a fantasy.” Consistent with our outlook for bigger military budgets around the world, Borrell urged the creation of a joint EU financing mechanism to boost the bloc’s defense industrial capacity to prepare for war.

Eurozone: The European Central Bank said its first-quarter survey of commercial banks revealed a substantial decline in corporate loan demand. The fall in demand for credit apparently reflects weaker investment plans, so the data may more strongly prompt the central bank to signal the beginning of interest-rate cuts when it holds its policy meeting later this week. At this point, investors largely expect the ECB to start cutting rates in June.

Turkey-Israel: Under domestic political pressure to do more to stop Tel Aviv’s war against Hamas in Gaza, the Turkish government today said it will restrict the export of 54 different products to Israel. The restrictions will affect exports ranging from construction machinery and metal products to fuels and oils. The move reflects how Israel’s war on Hamas and the resulting civilian casualties are increasingly isolating the country politically and economically, with potentially long-term consequences.

Japan: In testimony before parliament today, Bank of Japan Governor Ueda said the central bank will keep monetary policy accommodative for now, despite its decision to end its negative interest-rate policy last month. Ueda did say that the policymakers might reduce the amount of accommodation if consumer price pressures worsen, but he offered no firm guidance on when interest rates might rise again. The testimony suggests Japanese rates will rise only slowly and remain relatively low for the time being, keeping downward pressure on the yen.

United States-China: In her visit to China this week, Treasury Secretary Yellen has delivered a tough warning that the US will respond if Beijing keeps pushing unwarranted investment that leads to more excess capacity and increased dumping of cheap Chinese goods on the world market. However, Chinese officials have pushed back on the criticism, claiming that excess capacity is normal, and that China is merely trying to develop its economy appropriately.

• Yellen’s tough message and Beijing’s pushback point to further US-China tensions.
• As we have noted many times before, the increasing tensions threaten to catch investors in the crossfire going forward.

US Bond Market: Treasury yields across the maturity spectrum rose to their highest levels since November, with the benchmark 10-year rate closing yesterday at 4.422%. So far this morning, the higher yields appear to be enticing some investors to buy bonds again, pulling yields a bit lower. Nevertheless, as we noted in our Comment yesterday, investors are likely to remain skittish about buying fixed income in the face of sticky consumer price inflation and a Federal Reserve that is less likely to cut interest rates than earlier thought.

US Commercial Real Estate Market:  Private investing giant Blackstone yesterday said it is buying Apartment Income REIT, known as AIR Communities, which owns 76 upscale apartment communities mostly in coastal markets such as Miami and Boston. The $10-billion buy comes after a period in which Blackstone was being cautious in the face of high interest rates, rising commercial real estate vacancies, and falling building values. The deal, therefore, could signal an upturn in the sector’s fortunes and a potential rebound in commercial real estate values.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

While everyone else today will be talking incessantly about the solar eclipse, our Comment opens with another step in the Biden administration’s effort to strengthen its alliances in the face of China’s geopolitical challenge. We next review a wide range of other international and US developments with the potential to affect the financial markets today, including new tactics being used by Russia in its invasion of Ukraine and multiple developments regarding US interest rates and the bond market.

United States-Australia-Japan: The AUKUS defense ministers today will announce that the pact’s countries are inviting other nations to join in the grouping for its “Pillar II” projects related to technologies such as quantum computing, undersea sensors and weapons, hypersonic missiles, artificial intelligence, and cybersecurity. A key focus will be to bring in Japan, transforming the group to “JAUKUS.”

Russia-Ukraine War: The Russian military has reportedly shifted its tactics recently, launching missile and drone strikes against Ukraine’s energy infrastructure in relatively less protected regions. The attacks appear aimed at causing more long-lasting damage, since the remote facilities can’t be repaired easily or quickly. In addition, it appears the Russians are trying to force Kyiv to shift its air defense systems to areas away from the main urban centers and battle lines to make it easier for Russian forces to launch an expected new ground offensive.

Slovakia:  In presidential elections yesterday, Peter Pellegrini, an ally of pro-Russian, populist Prime Minister Robert Fico, won with approximately 54% of the vote. In Slovakia, the president has only limited power, but the result is seen as burnishing the political power of Fico at the expense of the Slovakian politicians who are more pro-Western, pro-European Union, and anti-Russian.

Ecuador-Mexico:  On Friday, the government of Ecuador’s tough-on-crime President Daniel Noboa intruded on the Mexican Embassy in Quito and arrested a former Ecuadorian vice president who had been granted asylum there from charges of corruption. The move prompted Mexico to cut diplomatic ties with Ecuador, but it is also apparently boosting the political position of Noboa as he begins positioning himself for re-election next year.

Mexico: In a debate ahead of the presidential election looming on June 2, leftist frontrunner Claudia Sheinbaum of the ruling Morena Party appeared to successfully fend off biting personal attacks from Xóchitl Gálvez, the main opposition candidate. In the latest opinion polls, Sheinbaum has had a commanding lead with support from about 59% of likely voters. The polls suggest the leftist Morena Party will likely retain the presidency and perhaps control of Congress as well. That will likely keep Mexican equity prices lower than they otherwise could be.

US Monetary Policy:  After Friday’s report showing strong labor demand and job growth in March, futures trading now suggests investors no longer expect the Fed to cut its benchmark interest rate in June. Based on the CME FedWatch Tool, investors now see a 51.9% probability that the policymakers will keep the rate in its current range of 5.25% to 5.50%. Some investors now expect the Fed to cut rates only twice this year, while others are entertaining the possibility of just one or even no cuts.

• The scenarios of just one cut or no cuts at all are probably less likely, but they are plausible if economic growth remains healthy.
• In any case, adjusting to the possibility of continued high interest rates has become at least a temporary challenge for stock investors, as reflected in the price declines seen last week.

(Source: CME Group)

US Bond Market: Looking further into the future, JPMorgan Chase CEO Jamie Dimon warned today in his widely read annual letter that US interest rates could surge to 8% or more in the coming years in response to expanding fiscal deficits, the energy sector’s “green transition,” and worsening geopolitical tensions. Dimon has been overly gloomy in recent years, but his general analysis is consistent with our view that future inflation and interest rates are likely to be higher and more volatile because of the factors Dimon cites in his letter.

US Fiscal Policy: President Biden today will unveil another sweeping plan to slash student loan debt for millions of borrowers, despite his earlier attempts being turned back by Congress and the courts. The plan marks another effort to curry favor with progressive and younger voters ahead of the November election, and administration officials say they hope borrowers will see reduced payments by the autumn. However, Republican resistance to the plan is already growing and could well thwart it.

• Under the plan, individual borrowers who earn $120,000 or less and married couples who make $240,000 or less would be eligible for forgiveness of the entire amount that their current loan balance has increased beyond the principal.
• The plan would essentially cap accrued interest at the amount of the original principal.

US Industrial Policy: In the latest announcement of subsidies to boost advanced semiconductor manufacturing in the US under the CHIPS and Science Act of 2022, the Commerce Department said it will give $6.6 billion in grants, plus up to $5 billion in loans, to Taiwan Semiconductor Manufacturing Corp. for its effort to build three new fabrication facilities in Arizona.

• Under the deal, TSMC has agreed to start producing its most advanced 2-nanometer chips in the new facilities.
• According to the Commerce Department, that would put the US on track to produce 20% of the world’s advanced computer chips by 2030.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are giving back gains after a surprisingly strong jobs report. In college athletics news, Caitlin Clark, the Iowa star, secured her second straight Player of the Year award. Today’s Comment discusses why the Fed’s tolerance for inflation might be higher than investors anticipate, analyzes the surprising strength of US banks following the one-year mark of the Silicon Valley Bank collapse, and delves into the resilience of European equities despite a stagnant European economy. As usual, our report includes a roundup of international and domestic economic releases.

Not 2%, But Close Enough: The S&P 500 trimmed gains after a Fed president downplayed rate cuts, but signs suggest a Fed policy shift might still be coming.

• The Federal Reserve’s monetary policy stance is in flux. In a recent LinkedIn event, Neel Kashkari, president of the Minneapolis Fed, admitted his prior projection of two rate cuts in 2024 might need to be revised. Wary of inflation proving more persistent than anticipated, Kashkari signaled a possibility that the Fed may not cut rates at all this year. This shift follows hotter-than-expected inflation data in January and February, impacting both consumer and producer prices. However, Loretta Mester, president of the Cleveland Fed, remains optimistic, believing inflation will cool enough to allow for a rate cut as planned.
• The threshold for a rate cut may be lower than most investors realize. The latest FOMC projections showed that the committee expects three rate cuts and inflation to fall to 2.5% by year-end. This suggests policymakers may be comfortable with a slower-than-expected pace of inflation reduction as long as the progress is consistent. Even so, the conflicting inflation data may complicate their decision. In February, the Consumer Price Index (CPI), a common inflation gauge, rose 3.8% from the prior year, while the Fed’s preferred measure, the Personal Consumption Expenditures (PCE) price index, currently sits at 2.8%.

• The timing of any policy easing could hinge on which inflation indicator policymakers prioritize, or even if they consider both. Despite policymakers preferring to use core PCE as their tool to evaluate inflation, they have been known to react to changes in core CPI. This is evident in their recent references to persistent inflation, primarily based on the month-to-month change in the CPI data in March, which overshadowed a noticeable deceleration in core PCE. If they prioritize the CPI, they might hold rates for longer than expected. Conversely, if they focus on the PCE price index, they could be open to a rate cut as early as June.

Slow Moving Train: More than a year after the Silicon Valley Bank collapse, the financial system shows signs of recovery, though some skepticism lingers around regional banks.

• This week, Federal Reserve Vice Chair of Supervision Michael Barr sought to reassure the public about the financial system’s health, while acknowledging potential risks in commercial real estate. At a National Community Reinvestment Coalition event, he declared banks to be “sound” and “resilient,” highlighting improved liquidity. However, he balanced this optimism by acknowledging “pockets of risk” due to firms holding “significant unrealized losses” on their books and having a high concentration of commercial real estate. Instead of an immediate crisis, Barr likened the situation to a “slow-moving train” with potential problems surfacing over several years.
• Despite lingering concerns about the health of the banking system, US banks have surprised analysts with a strong start to 2024. Large-cap bank stocks have surged 11% year-to-date according to a UBS index, significantly outperforming the S&P 500’s gain of just 8.5% over the same period. This robust performance can be attributed to two key factors. First, large banks capitalized on opportunities last year by acquiring struggling but profitable regional banks, which has bolstered their earnings. Second, net interest income has remained healthy due to the Federal Reserve’s decision to keep interest rates elevated.

• Large banks have thrived this year, but regional banks remain a cloud of concern for investors. The KBW regional bank index is currently in negative territory, reflecting investor wariness of smaller banks due to anxieties about their commercial real estate exposure. The recent misstep at New York Community Bank further fueled these apprehensions. Still, it’s important to note that the closure of the Fed’s Bank Term Funding Program hasn’t triggered signs of an imminent regional banking crisis. If this situation continues, it will further add to optimism that the economy may avoid a downturn this year.

Silver Lining in Europe: European equities are showcasing resilience amidst prevailing economic headwinds and Germany’s weakened state.

• The STOXX Europe 600 (SXXP) has soared to new highs in 2024, fueled by a strong performance from large-cap stocks, particularly in banking and car manufacturing. The banking sector has witnessed its best showing in six years, surging 34% year-over-year. This rise is attributed to the banks’ ability to maintain financial health and capitalize on recent interest rate hikes by the European Central Bank (ECB). The recent shift by automakers away from electric vehicles due to perceived slowing demand, though, has also found favor with investors worried about declining profit margins and potentially lower sales.
• Despite a strong stock market performance, the eurozone economy faces ongoing challenges. The region narrowly averted a recession, technically defined as two consecutive quarters of economic decline. Recent data paints a concerning picture, with retail sales dropping 0.5% in February and the March purchasing managers’ index indicating a further contraction in construction activity. Germany, a key eurozone player, appears particularly vulnerable. Its manufacturing sector, a traditional engine of growth, continues to drag. German industrial orders rose a meager 0.2% in February, far below expectations of 0.8%.

• The strong stock market performance may be short-lived if economic conditions continue to deteriorate. Downturns historically lead to credit tightening, making it harder for companies to borrow and potentially hindering their ability to remain profitable. However, the ECB’s planned interest rate cut in June could help ease the situation by making credit more affordable. In the current economic climate of uncertainty, European blue-chip stocks could be a viable option for investors seeking a safe haven. These companies are resilient to major financial fluctuations, while also maintaining relatively attractive valuations compared with their US peers.

Other News: Bank of Japan Governor Kazuo Ueda signaled a possible rate hike in the second half of the year; the comment led the yen to strengthen against the dollar. Argentinian President Javier Milei seemed to retract his commitment to distancing the country from China by indicating that Beijing still wields considerable influence in South America. Treasury Secretary Janet Yellen has underscored the impracticality of the United States severing ties with China, solidifying a persistent trend of simmering tensions between the world’s two largest economies.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are off to a great start after initial jobless claims data came in higher than anticipated. In sports news, the St. Louis Cardinals, considered by many to be World Series contenders, kick off their home opener today. Today’s Comment explores three key market concerns: the impact of future policy rate uncertainty on market jitters, how the AI rally might diverge from the dotcom bubble, and whether Swiss inflation data offers clues about global inflation trends. As usual, our report includes a summary of domestic and international data releases.

Shifting Sands: The Fed’s uncertainty about inflation’s trajectory is muddying the policy path, prompting markets to reassess their interest rate forecasts.

• Fed Chair Jerome Powell reiterated the importance of patience in considering rate cuts for the Federal Reserve. Speaking at a panel discussion at Stanford University, Powell highlighted the significant influence of supply-side factors in curbing inflation since the onset of the pandemic. While he avoided giving a specific rate forecast, he indicated the latest data hasn’t “materially changed” the Fed’s view on inflation. This aligns with San Francisco Fed President Mary Daly, who still favors three rate cuts this year. In contrast, Raphael Bostic has reduced his forecast from two cuts to one.
• Conflicting economic data is further muddying the Federal Reserve’s decision on interest rates. The Institute for Supply Management’s (ISM) latest manufacturing PMI shows prices paid have surged to their highest levels since 2022, indicating persistent inflation. However, the non-manufacturing PMI shows service sector prices at a four-year low, suggesting a potential easing of price pressures in that sector. This surge in manufacturing prices likely reflects rising commodity costs, while the low service-sector prices could signal easing wage pressures, which aligns with the decline in the non-manufacturing employment component. The negative response to manufacturing data and positive reception of service data highlights the market’s current volatility.

• The ISM report, though not directly influencing policymakers, exposes the market’s hair-trigger sensitivity to economic data, as evidenced by contrasting reactions. Uncertainty regarding rate cuts will hang in the air until the Fed’s June meeting, where their updated economic projections will shed light on their path forward. Committee members, especially the hawkish ones, are paying attention to payroll data. A significant drop in March or April jobs could trigger a dovish pivot towards rate cuts this summer. Conversely, persistently strong job reports could lead to a reduction, or even a complete halt, in planned rate cuts for the year.

Tech Moves: Soaring valuations prompt tech companies to seek new income sources to satisfy their investors.

• Tech giants like Google are exploring premium features on select products behind paywalls, creating new revenue streams. This could fund continued development of these enhancements while maintaining their free, ad-supported core offerings. Meanwhile, Apple’s foray into home robotics signals a potential pivot away from their electric vehicle project. These moves, though not finalized, highlight the growing pressure on tech companies, particularly the Magnificent Seven (M7), to diversify income and justify high valuations in a changing market. The recent drop in Tesla stock following weak deliveries exemplifies how investor sentiment can quickly turn after negative news.
• The recent surge in the M7’s stock prices evokes comparisons to the dotcom boom of the late 1990s. However, a crucial distinction lies in the companies’ financial health. The dotcom bubble was fueled by speculation on unprofitable startups with minimal revenue and high debt. In stark contrast, the M7 are established powerhouses generating substantial profits. Their impressive free cash flow of $309.2 billion in 2023, a staggering $100 billion increase year-over-year, demonstrates their financial strength. This massive cash cushion positions them as far more resilient than the fragile dotcom companies, providing a buffer during periods of economic uncertainty.

• While there’s confidence that the large-cap rally will spread to other sectors, the M7’s future path remains uncertain. The upcoming Q1 2024 earnings season will be critical, potentially shaping the rally’s direction as it reveals these mega-caps’ abilities to maintain profitability. However, unlike the dotcom bubble, the size and scale of the M7 provide a buffer. Even if the AI boom weakens, these companies have the resources to explore alternative revenue streams, fostering a more resilient position. This doesn’t necessarily guarantee a complete avoidance of a correction, but investors should be prepared for a more measured market response compared to the dramatic downturns of the dotcom era.

The Swiss’s Dovish Surprise:  March’s lower-than-anticipated inflation data supports the central bank’s decision and raises the possibility of additional stimulus measures.

• Swiss consumer prices have risen just 1% since March 2023, falling short of expectations for a 1.3% increase. This comes on the heels of the Swiss National Bank’s (SNB) decision in March to cut borrowing costs, marking the first such move by a G-10 central bank since November 2020. The SNB’s pivot aimed to curb the Swiss franc’s appreciation against the dollar. A recent study suggests the SNB would require an additional $30 billion alongside a commitment to keeping interest rates low for the next three years to prevent a mere 1.1% appreciation of the Swiss franc’s real effective exchange rate.
• Although a single month’s data shouldn’t be over-emphasized, recent CPI figures offer early signs of potential global inflation moderation. For instance, preliminary data from the eurozone shows core inflation dipping below 3.0% for the first time since March 2022. Similarly, both Japan and Canada have experienced a notable slowdown in inflation over the past several months. If this trend continues throughout the developed world, it is possible that the central banks will likely follow through on plans to reduce their policy rates this year.

• Slower economic growth in some countries is tempering inflation, but rising commodity prices threaten this progress. The robust US economy, with strong wage growth and a tight labor market, might prompt the Federal Reserve to maintain its current stance before easing monetary policy. This could lead to a stronger dollar as the interest rate differential between the US and other countries widens. Consequently, import-dependent nations may face challenges due to higher costs for dollar-denominated goods. This divergence in monetary policy could dampen global interest rate reductions, potentially falling short of market expectations.

Other News: Germany is undertaking military reforms in response to a perceived increase in global hostility. An Israeli cabinet member’s call for early elections highlights the current political instability in Israel.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with new signs that global consumer demand for electric vehicles isn’t growing as fast as previously thought, with major implications for the global economy and policymakers. We next review a wide range of other international and US developments with the potential to affect the financial markets today, including news of a major earthquake in Taiwan and the latest statement from a Federal Reserve policymaker pointing to US interest rates remaining “higher for longer.”

Global Electric Vehicle Market:  Adding to the evidence that global demand for electric vehicles is slowing sharply, EV giant Tesla yesterday stated that its first-quarter deliveries were down much more sharply than expected. The company said it delivered just 386,310 vehicles in January through March, down 8.5% from the same period one year earlier and far below the anticipated rate of about 457,000.

• Even though top Chinese EV makers reported even steeper delivery declines, leaving Tesla as the world’s top seller, the news nevertheless pushed Tesla’s stock price 4.9% lower for the day, leaving it down about 33% for the year-to-date.
• If the delivery shortfalls really do reflect a saturated market or waning demand, it suggests there will be an even greater profit bloodbath as China’s excess capacity leads it to try to dump even more vehicles on the world market.

Taiwan: An earthquake with a magnitude of 7.4 struck the country’s east coast this morning, killing at least nine people and damaging infrastructure and buildings. Of course, a key question for the global economy is the fate of Taiwan Semiconductor Manufacturing Company’s fabs on the island, which produce most of the world’s advanced computer chips. The firm said damage to its plants has been minimal and workers are already returning to their jobs, but the quake will nevertheless refocus attention on the security of chip supply chains.

European Union-China: Just weeks after signaling the EU wouldn’t intervene to help European solar panel makers survive the onslaught of cheap Chinese imports, the European Commission today announced it will investigate whether two Chinese producers are using state subsidies to engage in unfair competition. The probe will utilize a new anti-subsidy law passed by the EU last July. The about-face on solar panels illustrates how political winds are increasingly forcing Western governments to take a tough stand against Chinese military and economic threats.

Eurozone: The March consumer price index was up just 2.4% from the same month one year earlier, coming in a bit better than expected and slowing from the rise of 2.6% in the year to February. The slowdown in inflation mostly stemmed from weaker price growth for food, energy, and other goods, while service inflation remained steady. Despite the sticky service inflation, the figure is likely to increase expectations that the European Central Bank can cut its benchmark interest rate in June.

• With the US’s healthy economic growth and sticky overall price inflation increasingly convincing investors that the Fed will move only slowly in cutting its benchmark interest rate, the prospect of near-term rate cuts by the ECB has been weighing on the euro.
• Even though the EUR is slightly higher today, trading at 1.0783 per dollar, it is still down some 2.5% against the greenback for the year-to-date.

US-China Diplomacy:  Yesterday, during their first phone call in two years, President Biden and President Xi reportedly had a “candid” and “constructive” conversation about a range of issues between the two countries. However, Xi warned Biden that China “will not sit idly by” if the US continues what he called efforts to suppress Chinese economic and technological development. In turn, Biden said he will keep taking what he called limited steps necessary to ensure US national security.

• While it’s probably good that Biden and Xi are talking again, the tit-for-tat exchange on economic and technological relations should serve as a reminder that tensions look set to continue spiraling.
• The US-China relationship continues to show signs of being a “Thucydides Trap,” where the reigning hegemon (i.e., the US) faces a rising power (i.e., China). Some foreign affairs scholars, such as Harvard professor Graham Allison, argue that to avoid war in such a situation, the US should accommodate China’s rise. However, both Democrats and Republicans in Washington continue to show signs that they’re willing to stand up to China in an effort to preserve the US’s dominance in geopolitics and the global economy.

US-China Capital Flows: Reflecting the bipartisan effort to rein in China, Democratic and Republican lawmakers in the House of Representatives have introduced a bill that would bar index funds from investing in Chinese companies. According to the bill’s sponsors, the proposed No China in Index Funds Act is justified because index funds do not research the firms they hold and therefore can’t uncover the unique risks inherent with Chinese companies.

• The bill was introduced by Rep. Brad Sherman, a Democrat from California, and Rep. Victoria Spartz, a Republican from Indiana.
• Sherman and Spartz have also introduced a number of other anti-China bills that would “end tax breaks for Chinese equities, restrict sanctioned Chinese companies’ access to US capital markets, increase transparency on risks to American corporations, and reduce exposure to these risks for retail investors and other Americans saving for retirement,” according to a statement from the lawmakers.

US Monetary Policy: In a speech yesterday, Cleveland FRB President Mester said the continued fundamental strength in the US economy has convinced her that interest rates will settle at a higher level than she previously thought, even after the Fed finishes its impending rate-cutting cycle. Over the long term, Mester said she now expects the benchmark fed funds rate to settle in a range of 2.5% to 3.0%, rather than the flat 2.5% she assumed previously.

• Mester’s view of higher future interest rates is consistent with our view that geopolitical tensions and structural changes in the global economy will lead to increased inflation and interest rates going forward. In our view, inflation and interest rates are also likely to be more volatile.
• Separately, Mester also poured cold water on the idea of any rate cut at the Fed’s policymaking meeting in May. She hinted that a cut was still possible at the June meeting, but only if in-coming inflation data clearly supports it.

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