by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with the latest forecasts for global oil demand from the Organization of the Petroleum Exporting Countries. We next review several other international and US developments with the potential to affect the financial markets today, including news of a new, advanced artificial-intelligence chip from Chinese tech giant Huawei, data showing plummeting economic optimism in Europe, and new US regulatory initiatives from the Biden administration.

Global Oil Market: The Organization of the Petroleum Exporting Countries yesterday cut its forecasts of global oil demand in 2024 and 2025, largely because of the ongoing slowdown in Chinese economic growth and the risk that high interest rates could kick the US economy into recession. The cartel now sees demand rising by 2.11 million barrels per day this year, versus its previous growth estimate of 2.25 mbpd. The new growth forecasts put total global demand at 104.3 mbpd in 2024.

• Global oil demand continues to grow faster than right before the coronavirus pandemic, but it is rapidly normalizing.
• The slowdown in demand continues to keep a lid on prices, although geopolitical tensions and the risk of supply disruptions in Eastern Europe and the Middle East have kept oil prices higher than they otherwise would be.

China: Technology giant Huawei has reportedly developed a new artificial intelligence chip to replace the advanced Nvidia chips now barred by the US government from being exported to China. The new Huawei chip, the Ascend 910C, has reportedly been provided to top Chinese internet and communications firms for testing.

• Huawei has apparently had production problems with the Ascend 910C, and it could face more such problems as the US clamps down further on exporting advanced chipmaking equipment and services to China.
• Nevertheless, the new chip illustrates how aggressively Beijing is pushing to develop China’s own independent technologies, both for its own security and to dominate key global markets of the future.
• Beijing’s push to develop advanced technologies such as semiconductors, solar panels, and electric vehicles (which it collectively calls “new quality productive forces”) probably would have happened even without the US’s recent export controls. Now that the effort is in full swing, it will likely feed into the spiral of geopolitical and economic tensions between the Beijing and Washington, presenting risks for investors.

Vietnam-China: The Washington Post reports Hanoi has dramatically accelerated its program to expand islands it claims in the South China Sea, putting it on track to add some 1,000 acres this year through dredging and land reclamation on existing islands and shoals. The program, which aims to thwart China’s territorial claims in the area, mimics the island-building tactics that China itself used about a decade ago to assert its sovereignty in the South China Sea.

• Vietnam’s effort to do the same now could worsen Chinese-Vietnamese tensions, potentially leading to conflict and/or disruptions in the area’s vital shipping lanes.
• As we noted in our Bi-Weekly Geopolitical Report from June 3, 2024, the South China Sea is marked by multiple territorial disputes, many of which are worsening.

Germany-China: Data from the Bundesbank shows German firms’ direct investment in China totaled 7.3 billion EUR in the first half of 2024, compared with 6.5 billion EUR in all of 2023. Much of the rise in foreign direct investment represented the re-investment of profits earned in China, but the acceleration this year also reflects German companies’ new strategy of investing in China to serve the Chinese market, rather than for export. The figures raise concerns that German firms are again discounting geopolitical risks, as they previously did by relying on Russian energy.

Eurozone: The ZEW Economic Sentiment Indicator for the eurozone plummeted by a seasonally adjusted 25.8 points in August to just 17.9, marking its biggest drop since early in the coronavirus pandemic. The indicator for Germany alone fell 22.6 points in a month to 19.2, for its biggest decline in two years. The drops apparently reflect the European Central Bank’s continued high interest rates, concerns about the US economy, and the risk of escalating war in the Middle East. They also raise the likelihood of further ECB rate cuts in the coming months.

Mexico: The government is bracing for a retaliatory war between two branches of the powerful Sinaloa drug cartel after its patriarch, Ismael “El Mayo” Zambada, last month was kidnapped and turned over to US authorities by the son of a longtime associate, Joaquín “El Chapo” Guzmán. To prepare for the conflict between the Zambada and Guzmán families, the government has deployed hundreds of special forces soldiers to the cartel’s home city of Culiacán, but reports say the two families are stockpiling weapons and preparing to fight each other.

• Significant new intra-cartel violence would further worsen Mexico’s reputation for insecurity. Even though Mexico is well placed to benefit from global fracturing and the “near shoring” of production closer to the US, weak rule of law and other factors have blemished Mexico’s investment environment and probably reduced how much it has benefited from current global economic trends.
• Importantly, increased intra-cartel fighting could also spill over into the US, given that the cartels have operatives north of the border.

US Regulatory Policy: As part of its “war on junk fees,” the Biden administration yesterday proposed several rule changes aimed at making it easier for consumers to cancel services and subscriptions. For example, a proposed rule from the Federal Trade Commission would require companies to make canceling a service or subscription as easy as signing up for one. While the proposals might play well politically, they could weigh on the profitability of some firms that rely on “sticky” client relationships.

US Stock Market: The Wall Street Journal today carries an interesting article on the strong outperformance of stocks recently kicked out of the S&P 500. According to new research by investment gurus Rob Arnott and Forrest Henslee, such stocks lose value quickly in the year before they are kicked out of the index, in part because of forced selling by index funds or index mimickers when their looming exit is announced. After they are out and that selling pressure dissipates, however, the stocks often outperform for about five years.

• As might be expected, Arnott and Henslee this week are launching a new index based on the strategy.
• Appropriately, the index will be called the NIXT.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with several items on China’s international relations and domestic economy. We next review several other international and US developments with the potential to affect the financial markets today, including a statement by a British monetary policymaker calling for continued high interest rates and new data showing a recovery in US trucking demand.

China-Philippines: Manila has accused the Chinese air force of harassing a Philippine military transport plane on routine patrol in Philippine airspace near the disputed Scarborough Shoal last Thursday. The Chinese harassment comes despite the recent deal between Beijing and Manila to diffuse tensions over a Philippine military outpost on Second Thomas Shoal, another disputed outcrop in the South China Sea. The new incident suggests dangerous Chinese-Philippine tensions in the disputed waters are likely to continue, despite one-off deals or lulls.

China-Estonia-Finland: On a more positive note, the Chinese government has admitted that a Chinese-owned ship severed an important natural gas pipeline and damaged communication cables in the Baltic Sea last October. As long suspected, the damage was caused by the Chinese ship dragging its anchor along the seabed. However, Beijing insists the incident was an accident caused by bad weather.

• The incident, which affected a pipeline and communications cables running between Finland and Estonia, had raised fears that it was a sabotage operation to punish Helsinki and Tallin for their opposition to Russia’s invasion of Ukraine. Once investigators tied the incident to the Chinese ship, it also raised concern that Beijing might be cooperating in Russian sabotage.
• Of course, the new admission by Beijing won’t necessarily end the concern about China helping Russia politically and militarily; however, it may help ease that concern in the near term.

China: The country’s fourth-largest mutual fund company, Harvest Fund Management, on Friday said its chairman has resigned due to a corruption investigation. The resignation is probably related to Beijing’s new effort to make China a “financial superpower,” in part by cleaning the sector up and purging corrupt officials. Cutting corruption is a laudable goal, but the sector will likely be challenged by other aspects of Beijing’s program, such as capping pay for financial professionals.

• Separately, multiple Western companies have said in their latest quarterly earnings reports that they are seeing steep declines in their sales in China, reflecting both weak consumer demand and a growing preference for Chinese brands.
• The statements are consistent with our view that the US and Chinese geopolitical blocs will continue to decouple. In addition to growing government-imposed trade barriers between the blocs, we think China’s cooling economic growth and reduced appetite for foreign goods and services will increasingly weigh on foreign investment in the country, especially from the US bloc.

United Kingdom: Catherine Mann, an external member of the Bank of England’s monetary policy committee, has warned that consumer price inflation in the UK will likely reaccelerate. According to Mann, who dissented from the central bank’s decision to cut interest rates earlier this month, business surveys show companies plan to continue hiking wages and prices, which will boost inflation again and require continued tight monetary policy.

Russia-Ukraine: The Ukrainian military’s surprise incursion into Russia’s Kursk region last week is apparently continuing. The Ukrainians have now advanced as much as 20 miles into Russia, and reports today say they have tried to open up a new incursion into the Belgorod region, farther south. The Russian military has had to respond by stitching together several inexperienced, poorly prepared, under-strength units, and those units still have not been able to push the Ukrainians back over the border.

• The aim of the incursions may be to force the Kremlin to redeploy troops and other military assets away from the frontlines in Ukraine, easing pressure on Kyiv’s troops.
• Even though Kyiv’s goal may be rather limited, the incursion is embarrassing for Russian President Putin and his military officials. If it continues, it could become a more serious political problem.
• Because of that, it’s important to remember that if the fighting on Russian soil continues, Putin could unleash a bigger-than-expected assault to crush the Ukrainian forces, even if it means temporarily pulling resources off the frontlines in Ukraine.

US Politics: At a campaign rally in Las Vegas over the weekend, Vice President Harris said that along with hiking the federal minimum wage, she would seek to eliminate income taxes on tips for service and hospitality workers. The proposal on tips echoes a recent promise by former President Trump and signals that Harris may try to meet or exceed any populist economic ideas espoused by her rival between now and the November election.

• Exempting tips from taxes would probably have only a small impact on federal revenues. After all, many service and hospitality workers have such low income that they aren’t liable for taxes. Those that are liable for taxes are often in the lowest tax bracket.
• Nevertheless, if the two candidates get into a bidding war for the populist vote, they could begin to promise more costly proposals, such as big spending increases or broader tax cuts for favored groups.

US Industrial Policy: New research by the Financial Times shows that about 40% of the factory investments announced in the first year of the CHIPS Act and Inflation Reduction Act have been delayed or paused. While it isn’t clear whether that rate is unusually small or large for similar unsubsidized project, the data is likely to be a black eye for the Biden administration. On a more positive note, the slow progress on some projects may also reduce or slow their draw on the federal budget, lowering their negative impact on the budget deficit in the near term.

US Trucking Industry:  New data from logistics data firm FreightWaves shows that trucking shipment orders in the second quarter were up 9% year-over-year, while tender rejections (a measure of capacity tightness) rose 1.3%. The figures suggest trucking demand is now rebounding again, even if pricing remains in the doldrums due to issues such as excess fleet size. In turn, stronger trucking demand could point to a rebound in the US industrial sector and help calm fears about a recession in the US economy.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! The S&P 500 is off to a slow start today as investors shrug off yesterday’s rally. In sports news, the US Men’s Basketball team was able to mount a comeback against Serbia in its quest for Olympic gold. Today’s Comment will examine the factors driving investors back to large-cap stocks after the recent market downturn. We’ll also delve into the reasons behind the surge in equity and bond volatility and provide an update on the conflict in the Middle East. As usual, the report will conclude with a summary of key economic indicators.

Market Rotation Trade: A week into the market meltdown, investors have reverted to old habits seeking reassurance.

• The market rallied after initial jobless claims posted their largest weekly decline since January 2023. This drop helped reassure investors that the labor market was cooling more slowly than anticipated, bolstering hopes for a Fed-engineered soft landing. Major tech companies, led by the Magnificent 7, outperformed the S&P 500 by a significant margin, rising 3.0% compared to the index’s 2.0% gain. This sharp increase suggests investors are cautiously re-entering the market and are eager to gauge the sustainability of the improved sentiment.
• The S&P 500 rally may be poised to broaden beyond the tech sector, echoing a pattern observed in the weeks preceding the market downturn. While Yardeni Research indicates a slowdown in earnings growth for the Magnificent 7 in the second quarter, the remaining S&P 500 components have collectively returned to profitability. This strong performance has challenged the notion that the S&P 500 has grown over-reliant on tech companies to drive earnings and reinforce the view that mega-tech companies are running out of steam.

• Don’t be misled by the recent surge in tech stocks. While it’s tempting to get caught up in the excitement, it’s crucial to remember why investors initially exited the sector. Doubts persist about tech companies’ ability to justify their lofty valuations, prompting us to maintain our optimism for other S&P 500 sectors. The prospect of a rate cut has buoyed undervalued sectors like real estate and financials, while the potential for increased power consumption in AI has lifted utility stocks. As a result, we are confident that the market will broaden out once more, replicating the pattern that was seen before the recent sell-off.

Volatility Is Back: The unwinding of the carry trade highlights the unusually low equity volatility of recent months in comparison to bonds.

• For the first time in a significant period, both the VIX and MOVE indexes are signaling heightened market risk. While the MOVE index, a measure of bond market volatility, has persistently exceeded its long-term average of 95 since the Fed’s 2022 rate hikes began, the VIX had remained relatively subdued, generally below its fear threshold of 20, despite prevalent inflation and recession concerns. Contrary to the prevailing view that investor sentiment explains the VIX-MOVE divergence, we believe the discrepancy is linked to carry-trade dynamics, which has artificially held down equity market volatility.
• The global trend to push interest rates higher has encouraged investors to employ leveraged carry trades. This strategy involves borrowing funds in a low-interest-rate environment, such as Japan, and investing in higher-yielding assets in countries like Mexico, Brazil, or the US. Such trades typically thrive in liquid markets that facilitate easy entry and exit and a stable currency. However, these strategies become vulnerable to sudden market disruptions, such as an unexpected interest rate hike from the Bank of Japan or fears of an imminent US recession.

• The recent VIX spike has been partially attributed to the unwinding of carry trades as investors reevaluate positions in light of the yen’s strength and the narrowing US-Japan interest rate differentials. As these positions unwind, equity volatility should gradually subside, though it will likely remain sensitive to shifts in US growth expectations. In contrast, the MOVE index, which is sensitive to interest rate expectations, is likely to remain elevated as long as the Fed remains noncommittal on the path of interest rates. This index should fall if inflation continues on its downward trajectory.

Conflict in the Middle East: Israel and its allies are preparing for a retaliatory attack from Iran and Hezbollah in the coming days, which may impact supply chains.

• Tehran is expected to retaliate for the assassinations of a Hezbollah leader in Lebanon and a top Hamas official visiting Iran. Israel has already intercepted an Iranian aerial attack but faces growing concerns about the sustainability of its defenses. The Israeli government has advised citizens to stockpile food as it prepares for potential defensive and offensive campaigns to deter future attacks. This development could escalate the conflict, drawing in additional nations and undermining recent ceasefire discussions.
• The conflict is likely to exacerbate supply chain uncertainties, potentially disrupting goods transportation through the Red Sea. Retailers have already begun stockpiling merchandise in anticipation of shipping disruptions, while Brent crude prices have increased nearly 3% over the last five days as investors assess potential repercussions. Furthermore, ocean freight costs have surged to their highest levels since 2022 as shippers bolster security measures to safeguard cargo delivery.

• The likelihood of a major Middle East conflict with significant global economic repercussions remains low, though not nonexistent. Iran has indicated a desire for retaliation without triggering a broader conflict. The US is maintaining backchannel communications to minimize the risk of unintended escalation. Presently, we remain optimistic about tensions de-escalating within the next few weeks. However, if our assessment proves incorrect, there is a realistic possibility of direct US involvement in the war. Nevertheless, this scenario remains unlikely.

In Other News: Russian President Vladimir Putin has legalized bitcoin and crypto mining, signaling the country’s intent to leverage its low-cost energy to attract investors in the burgeoning digital market. If elected in November, Republican presidential nominee Donald Trump asserts that he should have a greater say in Federal Reserve policy rate decisions. His statement is likely to fuel concerns about potential threats to the Fed’s independence. UK riots have shown signs of subsiding following days of protests against immigration policies.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! S&P 500 futures are off to a strong start to the day as data reassured investors that the country is not in recession. In sports news, US Men’s Track and Field athlete Quincy Hall staged a comeback in the 400m to take gold. Today’s Comment will discuss the market reaction to poor performance in the Treasury auctions, review the growing signs that consumption is waning, and examine Europe’s decision to target the ultra-wealthy for its budgetary challenges. As usual, our report will conclude with a round up international and domestic data releases.

Auction Failure: Uncertainty over the path of interest rates continue to weigh on the equity market.

• The S&P 500’s early gains evaporated Wednesday, with the index closing down 0.6% amid weak Treasury auction results. A $42 billion sale of 10-year notes was met with tepid demand and ended with a yield of 3.960%, which is 3 bps higher than what investors were anticipating. While lower than the previous auction’s 4.276% yield, the result highlights investors’ ongoing aversion to current bond yields. The miss triggered a sell-off in equities as investors remain concerned that the Fed will fail to implement rate cuts in time to avert a hard landing.
• Treasury bond auctions have struggled since the Fed embarked on its rate-hiking campaign in 2022. The chart below illustrates escalating auction tails, signaling weak demand, which peaked in late 2023 amid expectations of an imminent shift in monetary policy. While shifting Treasury issuance towards shorter maturities has eased some pressure, it has exacerbated challenges in the five-year sector. Recent narrowing of auction tails for both 10-year and five-year Treasury bonds suggests growing investor discomfort with holding mid and long-term bonds.

• The surge in failed bond auctions indicates that the market’s capacity to absorb Treasury issuance has been overwhelmed. While a potential Fed rate cut could offer temporary relief, the underlying issue is excessive government spending. The burgeoning US debt burden will be a formidable challenge for the next administration. Despite vague campaign promises of tax increases or Social Security reform, neither candidate has offered concrete plans to address the growing deficit. Consequently, a return of bond yields to pre-pandemic levels appears unlikely in the near term.

Households Holding Back: Although consumption figures remain positive, a rising chorus of corporate voices warns of potential reductions in consumer spending.

• Earnings reports continue to allude to a consumer pullback in spending. The travel and leisure industry, including key players like Airbnb and Disney, has been hit hard. Airbnb reported delayed bookings and shorter stays, suggesting a shift towards more spontaneous travel plans. Disney blamed declining consumer spending for its bleak outlook. These challenges are mirrored in the fast-food sector, with companies such as McDonald’s and Domino’s also reporting weaker-than-expected results. The pessimism has led shares of these stocks to fall as investors fear a broader economic slowdown.
• Economic indicators point to growing household financial strain. Auto and credit card delinquency rates have soared to levels not seen since the COVID-19 pandemic, according to the New York Fed, signaling mounting pressures on household balance sheets. Moreover, a sharp $1.7 billion decline in consumer debt — the largest since early 2021 — suggests consumers are tightening their belts amid economic challenges. This sudden weakness in the data comes nearly a week after the breach of the Sahm rule.

• While concerns of a looming recession persist, current economic indicators suggest a different trajectory. The Atlanta Fed’s GDPNow forecast predicts a 2.9% annualized growth rate for the third quarter, an acceleration from the previous quarter’s 2.8%. Historically, significant economic downturns in the past three decades were recognized following exogenous shocks like the global pandemic, the collapse of Lehman Brothers, the 9/11 attacks, or the Gulf War. In the absence of such disruptive events, like a major financial crisis or widespread conflict, the economy is likely to continue expanding.

Italy Getting Tough: Italian Prime Minister Giorgia Meloni faces the challenge of balancing the nation’s need for fiscal restraint with her campaign pledge to support struggling families.

• To shield middle-class households from higher taxes, Meloni has focused on the ultra-wealthy and financial institutions. On Wednesday, her cabinet endorsed a plan to double the flat tax on foreign income for new residents from $100,000 to $200,000. Additionally, it was revealed last week that her administration has begun revisiting plans to tax banks and insurers that profited from higher interest rates. Last year, her administration was forced to walk back plans for a 40% windfall tax on excessive financial institution profits after the proposal triggered a market sell-off.
• The move underscores a growing European populist trend targeting the wealthy as countries look to balance their budget. This trend is underscored by the UK’s decision to end non-domiciled tax status and the growing support for France’s Left Alliance, which has promised higher taxes on billionaires and which may revive the wealth tax. This decision stems from the pressure these governments face to address their budget deficits without harming the middle class. France and Italy are currently in breach of the EU’s 3% deficit limit, while the UK is struggling to meet its debt reduction target set in 2020.

• While targeting the wealthy to address budget deficits might be politically expedient, historical evidence suggests that it’s an ineffective strategy. Not only can high-net-worth individuals easily transfer assets offshore, but those in positions of power often possess the means to shape legislation in their favor. Therefore, we predict that a Robin Hood-style fiscal policy will be unsustainable in the long term. As budgetary pressures intensify, governments are likely to resort to more conventional measures, such as pension and social program reforms.

In Other News: Ukraine’s surprise attack on Russia has intensified the ongoing conflict, and it shows no signs of de-escalation. Meanwhile, global economic concerns are mounting as Asian chipmakers face pressure from weakening AI demand. Adding to the uncertainty, a major earthquake struck southwest Japan, triggering tsunami fears and potentially impacting Japanese equities.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! S&P 500 futures are off to a strong start as risk sentiment improves. In sports news, Team USA’s basketball team dominated Brazil, securing their spot in the semifinals against Serbia. Today’s Comment will explore why the market has stabilized since Monday’s sell-off, share our thoughts on carry trades, and provide an update on the UK budget situation. As usual, our report includes a summary of international and domestic data releases.

All Calm on the Market Front: Equities staged a recovery from Monday’s sharp decline, yet investors remain cautious about potential future turbulence.

• The S&P 500 surged 1.7% on Tuesday, rebounding from a global sell-off ignited by recession concerns. Despite these fears, recent economic indicators point to a resilient economy. Wednesday’s S&P Global and ISM Purchasing Managers Indexes not only confirmed continued expansion but also surpassed market forecasts. Moreover, the Senior Loan Officer Opinion Survey revealed that while banks have tightened lending standards overall, the net share of lenders which have tightened conditions has decreased from the previous quarter, signaling potential optimism in the lending market.
• While the market has experienced a slight reprieve, underlying uncertainty persists. The CBOE Volatility Index (VIX) declined from 32.38 to 27.71 on Tuesday, though it remains significantly elevated above the 20 level, indicating continued market anxiety. This elevated reading reflects investors’ continued uncertainty about the Federal Reserve’s interest rate trajectory. While policymakers have indicated that recent events won’t prompt an immediate rate cut, market participants still anticipate potential adjustments to the rate cut outlook beyond the previously projected single reduction this year.

• The market will closely watch economic data in the coming weeks as investors anticipate the Federal Open Market Committee’s next move on September 18. Two additional CPI reports and another employment report will be released prior to the meeting and will likely influence market reactions. While a September rate cut is still expected if inflation continues its downward trajectory, the magnitude of the cut will hinge on labor market conditions. A rise in the unemployment rate to 4.4% could increase the odds of a substantial 50-basis-point reduction.

More than Japan: While the Japanese yen (JPY) dominated market attention, other currencies were also adversely affected by the downturn in the broader market.

• Emerging market currencies were battered by the market turmoil as carry trades unwound since the start of the week, with the Mexican peso (MXN) plunging below the critical 20 level against the dollar, marking its weakest point in two years. The Chinese yuan (CNY) also declined against the dollar. In contrast, the Swiss franc (CHF), a safe haven currency, soared to a six-month high, prompting some Swiss National Bank policymakers to consider currency intervention to curb its appreciation. Ironically, the dollar’s value has remained relatively stable amid these volatile currency movements.
• This turmoil was ignited by the JPY’s sharp appreciation following the Bank of Japan’s (BOJ) surprise rate hike and weak US economic data. Although the BOJ has subsequently indicated no plans for further tightening, which has offered some relief, currencies continue to fluctuate amid growing recession fears in the United States. J.P. Morgan’s one-month volatility index indicates persistent uncertainty in currency markets as the duration of the current unwind remains unclear. By one estimate, the carry trade unwind is somewhere between 50%-60% complete.

• The unwinding of carry trades continues to threaten the equity market, particularly the tech sector, due to its heavy reliance on this funding. While recent market stability is encouraging, normalization is expected in the coming days. Following the BOJ’s announcement, European and Asian stocks rallied this morning, a trend we anticipate will continue. Despite our optimistic outlook, we remain vigilant for signs of significant market disruption, especially if US recession fears intensify.

Labor Party Plan: A month after their decisive victory in the UK Parliament, the Labour Party is finally unveiling its plan to address the government budget deficit.

• UK Chancellor Rachel Reeves is expected to push for higher taxes and pension reform as she seeks to submit her budget by October 30. During a Bloomberg TV appearance this week, she announced plans to strike a balance on taxes and hinted that an increase in the capital gains tax could be on the table. Separately, rumors circulated on Wednesday about her exploring a public pension overhaul modeled after Canada’s system. This could involve consolidating local government pension plans to channel funds to infrastructure projects while also reducing costs and fees.
• Concerns about the new government’s fiscal policy have intensified following the revelation of a 22 billion GBP ($28 billion) public spending overrun last week. This deficit compounds the nation’s efforts to curb spending, as the Office for Budget Responsibility has reported that borrowing has exceeded its March forecast by 3 billion GPB ($3.8 billion) year-to-date. While a surprising first-quarter economic uptick has mitigated some of these costs, there are fears that the Labour Party may need to implement austerity measures unless growth accelerates significantly.

• While the UK’s market influence has diminished since its 2020 departure from the European Union, it remains a key country to monitor. The infamous Truss mini-budget and its subsequent financial market turmoil underscore the UK’s capacity to impact global markets. Unlike Truss’s administration, which triggered market instability with its unfunded tax cuts, the current government has been more measured in its fiscal policy, avoiding lofty spending pledges that could erode investor confidence. If the Labour Party can present a viable budget plan in October, it should support UK assets.

In Other News: Kamala Harris, Democratic presidential nominee, has selected Minnesota Governor Tim Walz as her vice-presidential running mate, a strategic choice aimed at enhancing her appeal among voters in the Rust Belt. Rioting continues in Bangladesh after the prime minister resigned following widespread protests. The country is a significant hub for garment manufacturers supplying US retailers.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with a recap of the wild market swoon around the world on Monday. So far today, the markets have calmed down considerably, and the Japanese equity market regained most of the 12% decline it suffered yesterday. We next review several other international and US developments with the potential to affect the financial markets today, including a potential new point of conflict between China and the Philippines and an antitrust ruling against technology giant Google.

Global Financial Markets: The global rout in risk markets yesterday ultimately drove large-cap US stock prices down about 3.0%, with previously high-flying technology stocks and small-cap stocks faring even worse. All the same, our close read of the markets and our second look at recent economic data still suggest that the culprits were largely what we tagged in yesterday’s Comment: an overreaction to the weak July employment report on Friday, rising Japanese interest rates, and an unwinding of yen carry trades.

• Multiple US data series suggest lower-income consumers continue to struggle with the high price inflation of recent years. Those consumers have been especially whipsawed by the way tax brackets are indexed to inflation only with a lag. Many responded by borrowing more, only to be hit with higher interest charges. On top of that, higher interest rates have cooled parts of the production sector, such as apartment developers. Weaker consumer demand and cooler business investment is now hurting the labor market.
• As we noted in our Economic and Financial Market Outlook for 2024, which we titled “The Slow-Bicycle Economy,” slower economic growth will make the US economy more susceptible to recession, especially if there is an exogenous shock to the system. At this point, however, such an exogenous shock is not readily apparent. It is entirely possible that the US will merely experience a period of slower growth or perhaps a mild, short recession. The silver lining is that such a situation would imply lower interest rates.
• Looking ahead to the coming days, the unwinding of yen carry trades and continued concerns about the US economy could keep the markets volatile. This volatility will likely prompt investors to reassess their expectations and valuations for certain sectors, potentially leading to a longer-lasting rotation away from recent high-flyers to down-trodden assets that may benefit from lower interest rates, such as real estate and bonds.
• In the Japanese stock market, which dropped 12.4% yesterday to get the rout going, indexes closed up about 10.4% today.

Global Oil Market: Saudi Aramco, Saudi Arabia’s largely state-owned oil company and the world’s biggest producer, confirmed it will pay out $124 billion in dividends this year, dwarfing the $32 billion in dividends and share buybacks expected from US oil giant ExxonMobil. More broadly, the firm warned that global oil demand is much stronger than investors realize.

• According to CEO Amin Nasser, global oil demand is “robust,” especially in China, despite its economic slowdown and the broader global transition to green energy.
• If Nasser is correct, it would suggest the US and global economies are still in decent shape. In turn, that could point to ongoing upward pressure on oil prices.

China-Philippines: Yesterday’s South China Morning Post said Manila has deployed a coast guard vessel to a new area of the South China Sea claimed by both China and the Philippines. The Philippine vessel, the Teresa Magbanua, has reportedly been blocking Chinese coast guard ships from interfering with boats from the Philippine Bureau of Fisheries and Aquatic Resources, which have been refueling fishing boats in the area. According to the article, Beijing has accused Manila of intentionally grounding the Teresa Magbanua on the disputed Sabina Shoal.

• The report comes just days after Beijing and Manila reached a deal to defuse tensions around a Philippine naval vessel, the Sierra Madre, which was intentionally grounded in 1999 on the disputed Second Thomas Shoal, also in the South China Sea. The Sierra Madre is now an outpost for Philippine marines, helping assert Philippine sovereignty over the area.
• Since the old, rusting Sierra Madre is now in danger of breaking up, Beijing has been pressuring Manila to stop shoring it up. Once the Sierra Madre breaks up and the Philippine marines have to abandon her, Chinese forces would be free to seize the Second Thomas Shoal and assert Beijing’s sovereignty over the area.
• If Manila really has grounded the Teresa Magbanua on Sabina Shoal, right after promising not to shore up the Sierra Madre any further, it would mark a stunning and aggressive sleight of hand by Philippine President Ferdinand Marcos, Jr. The result would be to keep alive the increasing territorial tensions between Beijing and Manila, which could potentially draw in the US and lead to conflict in the South China Sea.

Australia: The Reserve Bank of Australia (RBA) today held its benchmark short-term interest rate unchanged at 4.35%, right where it has been since November. In its statement, the central bank said underlying inflation pressures remain too high and probably won’t come down enough to support a rate cut anytime soon. That puts the RBA at odds with most other developed-country central banks, many of which have started cutting rates or are preparing to do so.

European Union-Mercosur: According to the Financial Times, European and South American officials have said they recently resolved some sticking points in the 20-year negotiations over an EU-Mercosur free-trade deal and could have the pact signed by the end of 2024. If signed and approved by a majority of the EU’s 27 member states, the deal is expected to save EU businesses more than 4 billion EUR per year in tariffs, while opening new markets in Europe for the five Mercosur nations of Brazil, Argentina, Uruguay, Paraguay, and Bolivia.

Mexico: For the first time, Defense Secretary Gen. Luis Cresencio Sandoval has admitted that the country’s drug cartels have killed some Mexican soldiers with bomb-dropping drones like those being used in the Russia-Ukraine war. In our view, the cartels’ successful use of the drones illustrates why they are revolutionizing modern warfare: The drones are highly effective at killing and destroying equipment, while they are also cheap and relatively easy to use.

US Monetary Policy: After yesterday’s global market selloff, as discussed above, Chicago FRB President Goolsbee vowed the Fed would “fix” any deterioration in the US economy. Separately, San Francisco FRB President Daly said the policymakers “will do what it takes” to meet their price stability and employment goals.

• The statements are far from any commitment to implement an interim interest-rate cut, a 50-basis point cut in September, or even a 25-basis point cut that month.
• However, the statements do confirm that yesterday’s market action and recent soft economic data have gotten the Fed’s attention, raising the probability that they will ease monetary policy this autumn more aggressively than previously planned.

US Antitrust Policy: In a ruling yesterday, a federal judge said Google violated US antitrust law by spending billions of dollars on exclusive deals to maintain a monopoly on internet searches. The judge is still deciding what remedies to impose, and the company said it plans to appeal the ruling in any case. Still, the ruling illustrates the federal government’s increased focus on uncompetitive behavior by big technology firms. The question is how much that focus will hurt those firms’ revenues and profitability going forward.

US Artificial Intelligence Industry: New reports say AI chip darling Nvidia and manufacturing partner Taiwan Semiconductor have suffered production snags on Nvidia’s new Blackwell data center chip. The snags reportedly could delay shipments of Nvidia’s key new product scheduled for later this year. The news could take further wind out of Nvidia’s high-flying stock price.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with an overview of the sharp declines in global financial markets today. Given the recent weak economic data out of the US and the surging value of the yen, the volatility could stay with us in the near term. We next review several other international and US developments with the potential to affect the financial markets today, including new signs that Iran is about to launch an attack on Israel and additional notes on Friday’s weak US labor market report.

Japan: Responding to Friday’s weak US labor market data, rising Japanese interest rates, and the surging yen (JPY), the country’s benchmark Nikkei stock market index plunged 12.4% today, for its worst decline since 1987. The plunging Japanese market pulled down stock values across the region, with the South Korean and Taiwanese markets both falling more than 8%. European equities are also weaker today, and as noted above, current futures trading suggests US stock prices will fall sharply at the open.

• The weak US employment data on Friday has rattled investors worldwide. To complement the quick first take that we provided in our Comment on Friday, we provide a bit more detail later in today’s publication. We also note that today’s upcoming business-sector data from S&P Global and ISM could help calm the markets if they are strong enough.
• The Bank of Japan’s shift toward higher interest rates has also upset the years-long habit among some investors to borrow at ultra-low Japanese rates to fund aggressive bets around the world. With Japanese rates now rising, investors have begun to unwind those trades, taking air out of many high-flying stocks and pushing the JPY higher as they bring their funds back home. The resulting upward pressure on the yen then prompts even more unwinding.
• After weakening some 12.2% against the dollar in the first half of 2024, the yen has reversed almost all of that change in just the last five weeks. As of this writing, the currency is trading at 142.68 per dollar ($0.00701), down just 1.3% from the exchange rate of 140.85 ($0.00710) at the end of 2023. If the JPY continues to strengthen, the global market volatility seen today could continue for a while yet.

Japan-Philippines: In another sign that key US allies in the Indo-Pacific region are increasingly cooperating to thwart Chinese geopolitical aggressiveness, Japan and the Philippines held their first-ever joint naval exercise in the South China Sea on Friday. The drill came just weeks after Tokyo and Manila signed a deal allowing them to deploy troops on each other’s territory in time of conflict. Separately, the German and Philippine defense ministers met yesterday to work on a new defense cooperation deal expected to be signed later this year.

China: The Wall Street Journal on Saturday carried an interesting article on the enormous scale of Beijing’s support for Chinese manufacturers. For example, the article says Beijing channels almost 5% of national income to support the factory sector, six times the share provided by the second-biggest spender, South Korea. Just as important, the article notes that 99% of China’s publicly listed companies report some kind of direct government subsidy. In 2023, the top recipient was battery maker CATL, which got about $790 million.

• The Chinese Communist Party has long maintained an investment-driven economic model marked by high spending on infrastructure, housing, and factories. Since the prior emphasis on housing left that sector with enormous excess capacity and debt, the party is now emphasizing factory investment and competitiveness.
• Along with the outright cash subsidies, Chinese manufacturers receive tax breaks, cheap loans from state-owned banks, low-priced land from provincial and local governments, preferential pricing for raw materials and energy from state-owned producers, and even inexpensive equity financing by government-run investment companies. Beijing also provides valuable non-monetary support, such as discriminatory rules against foreign firms operating in the country and low regulation on Chinese firms.
• Within China’s domestic economy, channeling so many resources to manufacturers leaves much less available for service firms and consumers. Even when Beijing vows to boost consumer spending, the strategy is often underwhelming. Over the weekend, for example, the State Council released a plan to boost consumer spending by increasing support for nursing care and “low altitude tourism,” i.e., hot air balloons.
• Internationally, the resulting excess capacity and low domestic prices have prompted Chinese manufacturers to dramatically ramp up their exports, which threatens to hurt manufacturers and manufacturing workers in the US, other developed countries, and even many emerging markets. As a result, we expect those countries to continue slapping Chinese firms with anti-dumping tariffs and other trade barriers, which will further worsen China-Western tensions.

Malaysia: Government officials, academics, and business managers say the number of Chinese citizens moving to Malaysia has surged in response to China’s slowing economic growth and oppressive Communist Party intrusions. According to the report, the surge is driven largely by students and investors. The number of Chinese citizens living in Malaysia may now be as high as 200,000, up from just 82,000 in 2022. The influx may help goose the Malaysian economy and stocks, although it could also spark social tensions.

European Union: Even though Ursula von der Leyen secured a second term as president of the European Commission earlier this summer, with support from both the EU member states and the European Parliament, she has faced an embarrassing threat to her authority as she works to fill the 27 commissioner posts in the EU’s executive body. For each country that is not just renominating its existing commissioner, von der Leyen has requested both a male and a female nominee. However, at least six countries have simply nominated a man.

• Under EU law, each member state has the right to nominate one commissioner. Then, von der Leyen gets to decide which portfolio each commissioner gets.
• Von der Leyen has promised to build a gender-balanced college of commissioners, but she has no authority to require both a male and a female nominee from each member state. Most returning commissioners are likely to be men, so without more female nominees, the new college of commissioners will likely be male dominated.

United Kingdom: Rioting by far-right activists spread to more cities over the weekend, as a follow-on to the anti-immigrant riots sparked last week by a stabbing attack that killed three children in the city of Southport. Prime Minister Starmer held an emergency meeting with his top ministers on Saturday and declared the government’s full support for police trying to control the violence. Nevertheless, the rioting threatens to disrupt economic activity and tarnish the UK’s reputation as a safe place for business and investment.

Iran-Israel: Tehran today issued a warning for pilots and aviation authorities to consider Iranian airspace off-limits, in what is likely an indication that it will soon launch its expected strike on Israel. Meanwhile, US Secretary of State Blinken yesterday told the Group of 7’s foreign ministers that he expects Iran to attack in the next 24 to 48 hours. Given that world financial markets are already facing economic jitters, an unexpectedly large, dangerous attack that threatens escalation could spark additional market volatility.

United States-Vietnam: In an annual review, the US Commerce Department on Friday unexpectedly maintained its designation of Vietnam as a “non-market economy,” keeping it in the same category as countries like China and Russia. The designation means Vietnamese imports into the US will continue to face special anti-dumping and anti-subsidy scrutiny and higher tariffs.

• The US decision comes despite Hanoi’s recent economic reforms and increased US investment in Vietnam. At first glance, it also seems inconsistent with the US’s recent pressure on Western firms to shift production from China to other countries in the region.
• On the other hand, it’s important to remember that Chinese companies have been looking to set up shop in Vietnam, Mexico, and other countries to get around US tariffs on Chinese products. Keeping Hanoi’s non-market designation may give the US more leeway to impede Chinese goods being routed through Vietnam.

US Defense Policy: Faced with growing threats from China, Russia, and North Korea, a senior Defense Department official said at a conference last week that the military’s current strategic review is exploring an increase in the US arsenal of nuclear weapons and launchers. The statement suggests the Biden administration may already be stepping back from its 2022 Nuclear Posture Review, which some defense analysts considered too dovish. If so, it could portend even more pressure to increase the US defense budget in the coming years.

US Labor Market: Finally, as a follow-up to our quick take on the weak July employment report in our Comment on Friday, we note that much of the issue was that new job creation finally fell sharply below the number of new entrants into the labor market. Our analysis shows most of the weakness came in the private sector, where the net employment gain in July was just 97,000, down 42.3% from the monthly average of 168,000 over the previous year. In the public sector, the jobs gain was 17,000, down 63.9% from 47,000 over the prior year.

• In the private goods-producing sector, net hiring in July was a bit stronger than in the prior year. The problem was in the private services sector, where net hiring weakened to 77,000, down 51.8% from the average of 149,000 in the previous year. In large part, that reflected weaker hiring in ambulatory healthcare offices and professional services, along with payroll declines in industries such as publishing and other information services.
• In the public sector, the weak hiring primarily reflected employment declines in state and local governments outside of education.
• While we’re still working to deeply understand what’s going on in the labor market, the weak labor demand in professional and information services may mean firms over-hired in those areas in the post-pandemic boom. Potentially, it could also point to some shifts related to artificial intelligence. Finally, the weakness in governments’ non-education hiring could reflect continued strong retirements in that relatively older sector.
• In any case, if the weak July figures aren’t reversed in the August report, the Fed policymakers certainly could become more amenable to a 50-basis point cut in the benchmark fed funds rate in September, as many investors now expect.

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