by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with several notes related to China, including changes to a key index of Chinese stocks.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a hotter-than-expected reading on British wage growth and a discussion of how artificial intelligence is affecting the US labor market.

China-Hong Kong:  With the Hong Kong municipal government preparing a new national security law that would hew closer to mainland China’s tough rules, US law firm Latham & Watkins said its attorneys in the city will no longer have automatic access to the firm’s international databases.  The lawyers will still be able to access mainland Chinese documents, but they will need special permission to see foreign information.

• The Latham & Watkins announcement helps confirm that cross-border information flows between China and the US geopolitical bloc will be a new arena of decoupling.
• The restrictions on Chinese-Western information flows follow years of increased barriers to trade, capital, technology, and even travel and tourism flows in each direction.
• As we have long argued, this fracturing of global markets is likely to reduce global economic efficiency and lead to higher costs, increased inflation, and elevated interest rates going forward, with particularly negative impacts on fixed-income assets.

Chinese Stock Market:  Stock index compiler MSCI announced today that it will add five new names to its benchmark MSCI China Index, but it will delete 66 names that now fail to meet its standards because of China’s long stock slump.  The 66 deletions, which stem from MSCI’s regular quarterly review, are more than in its last four quarterly adjustments combined.  With the deletions, the index will now have slightly more than 700 names in total.

• Since many investors seeking to match the MSCI China Index will now have to sell out of the deleted names, those stocks are now likely to come under increased selling pressure. The deleted stocks include the likes of Weibo and China Southern Airlines.
• Currently, the MSCI China Index is down more than 7% for the year-to-date and about 27% over the last year.

Chinese Shipbuilding Industry:  Based on our expectation of ever more intense Great Power competition between China and the US, we pay a lot of attention to each side’s military power and defense industrial capacity.  The Wall Street Journal today carries a good article showing how China’s shipbuilding industry has surged to become the world’s largest and richest, with many times more capacity to build commercial and naval ships than the US and the West.

• As we often note, China now has the world’s largest navy, with more than 350 combat ships. Moreover, the Chinese navy continues to grow rapidly, while the US is basically stagnant at about 295 combat ships.
• While we continue to believe that the US and the West will keep ramping up their defense budgets in the face of increased aggressiveness by the China/Russia geopolitical bloc, the lack of shipyard capacity (including a big shortage of workers) is holding back the US military’s rebuilding so far.

(Source: TheSoundingLine.com)

Russia-Estonia:  The Russian government has put Estonian Prime Minister Kaja Kallas on its wanted list, along with dozens of other Baltic politicians critical of the Kremlin and its war against Ukraine.  Although the move could be mere grandstanding by the Kremlin, it comes amid a surge of extraterritorial law enforcement and intelligence operations by authoritarian or authoritarian-leaning states ranging from China to India.  The risks for Baltic politicians on Russia’s wanted list are therefore elevated.

• Separately, the Estonian foreign intelligence service has issued a warning that the Kremlin plans to double the number of troops it has along its border with Finland and the Baltic states in preparation for a possible war in the coming years. According to the report, Russian leaders are reluctant to attack any NATO territory right now, but they calculate that they could be in a position to do so within a decade.
• Despite Russia’s poor military performance early in its invasion of Ukraine, it has now ramped up its defense industrial capacity and improved its troop mobilization, leaving it in a stronger military position than many expected. With Russian President Putin intent on re-establishing the Soviet/Russian empire, further weakening of the US commitment to defending European territory would risk inviting a Russian invasion.

United Kingdom:  Today, just as data indicated that US consumer price inflation slowed less than expected in January, a report showed UK wage growth slowed less than anticipated in October through December.  The British data revealed that average weekly earnings in the period were up 5.8% from one year earlier, moderating from the annual increase of 8.5% during the summer, but the sticky wage growth will still likely discourage the Bank of England from aggressive rate cuts in the near future.

US Labor Market:  New data suggests that generative artificial intelligence (AI) has already resulted in thousands of layoffs across the US economy, while more than half of all white collar “knowledge workers” report they are using the technology at least on a weekly basis.  The report will likely boost concerns that generative AI will render the jobs of many affluent, college-educated knowledge workers obsolete, although we suspect it will also create many new jobs for those with skills in the technology.

US Weather:  A strong nor’easter storm is lashing the Mid-Atlantic and Northeastern states today, leading to many cancelled airline flights in New York City and other major metropolitan areas.  The storm won’t necessarily have a noticeable impact on national economic or financial market performance, but it could certainly be disruptive for travelers today.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

With China and much of Asia celebrating the Lunar New Year, and with most of the US focused on yesterday’s Super Bowl, it’s a very slow news day, especially for economic and financial news.  Our Comment today is therefore focused heavily on political issues, starting with former President Trump’s controversial comments over the weekend about the US commitment to the North Atlantic Treaty Organization.  We next review several other international and US developments with the potential to affect the financial markets today, including a disputed election in Pakistan and the retirement of a key anti-China member of congress in the US.

United States-NATO-Russia:  At a campaign rally on Saturday, former President Trump said he would “encourage” Russian leaders to do whatever they want to NATO nations that don’t meet the alliance’s target of spending 2% of gross domestic product on defense.  Of course, it’s not clear whether the statement was mere electoral bluster or a harbinger of real policy if he is elected in November.  Nevertheless, the statement is likely to spur even greater doubts in Europe about the US’s commitment to defending NATO territory.

• Trump’s longstanding focus on the 2% target is likely unsettling to the non-US members of NATO for several reasons.
  • For one, it suggests that a NATO member’s defense budget is the key measure of its contribution to the alliance. In reality, it fails to capture the benefit that the US gets from being able to base its troops throughout Europe, extending the US defensive perimeter some 4,000 miles to the east of US shores.
  • The 2% figure is also somewhat arbitrary. To make its optimal contribution to alliance defense, a country might need to spend more than 2% of GDP, while another could make its optimal contribution with less.
  • Of course, the Europeans could also artificially boost their defense spending by rolling nominally civilian budget programs into the military budget, arguing those programs contribute to defense.
    • Another way they could game their budgeting system and inflate their defense budget would be to give their troops an enormous boost in pay, only to take it back by imposing higher income taxes on service members.
    • On average, personnel costs account for more than half the defense budget of NATO’s non-US allies. Simply boosting troop pay and benefits by 50% could therefore lift a typical country’s defense burden from 1.6% to the target 2.0% of GDP, with no change in troop counts or capability.
  • Even if the Europeans met the 2% target, they likely fear that Trump would raise the ante as there is no reason Trump couldn’t then demand 3% or 4%. The Europeans also probably fear that he would demand outright cash transfers to the US for its “defense services,” not recognizing that Europe’s armed forces, military cooperation, and US basing rights also contribute to US defense.  Trump could try to justify the move as a way to help cover the US budget deficit or fund tax cuts.
• Many people likely hope or believe that Trump’s threat to withhold US defense support is mere posturing. However, even if it is, the real-life impact has been to undermine our European (and Asian) allies’ trust in the US commitment to them.  If our European and Asian allies increasingly doubt the US will stand shoulder-to-shoulder with them in a crisis, the US could face unsettling unintended consequences going forward.
  • In our latest Bi-Weekly Geopolitical Report, to be published later today, we note that doubts about the US commitment have already begun to spur US allies into hiking their defense budgets and starting to rebuild their armed forces to deter aggression against them. Since nuclear weapons are the gold standard for deterrence, politicians in Europe and Asia are also starting to call for their countries to develop their own, independent nuclear arsenals.
  • In our report, we note that Beijing and Moscow likely relish the idea of the US pulling back its support from its European and Asian allies, but they may get more than they bargained for.
    • If key US allies in Europe or Asia develop their own nukes, China and Russia could find themselves surrounded by close-in nuclear powers.
    • For example, Russia could eventually face a nuclear Poland or nuclear Baltic states. China could face a nuclear Japan, South Korea, or Australia.
  • By the same token, if the US creates too much doubt about its mutual-defense commitments and prompts its allies to create their own nukes, it could face a nuclear Germany or a nuclear Japan, only a century or so after fighting each of them in World War II.
• In any case, all these developments point to an increasingly chaotic, tension-filled world, which could create headwinds for many investments, but it will also likely create some investment opportunities. Here at Confluence, we continue to focus heavily on managing investments with a keen eye on those risks and opportunities.

Finland:  In national elections yesterday, former Prime Minister Alex Stubb was elected president with 52% of the vote.  In Finland, the president is the commander-in-chief of the armed forces and also takes the lead on foreign policy, so Stubb will be instrumental in determining Finland’s new role as a member of NATO.  Given his past experience heading up Finland’s finance, foreign, and trade ministries, Stubb is believed to have “safe hands” for steering the country’s foreign and security policies into the future.

United States-China:  Representative Mike Gallagher of Wisconsin, a former Marine Corps intelligence officer who is now the China-bashing chair of the House Select Committee on the Chinese Communist Party, said on Saturday that he will retire from Congress at the end of his current term.  The announcement comes just days after Gallagher was one of only four Republican lawmakers to vote against impeaching Homeland Security Secretary Mayorkas for his handling of migration at the southern border.

• Gallagher’s sudden retirement announcement suggests he may have faced punishment by the Republican Party for his vote against impeaching Mayorkas.
• In any case, Gallagher has been a persistent, forceful, articulate advocate for the US to push back against China’s aggressive effort to build its power in the military, diplomatic, economic, and technology spheres. Unless Gallagher finds a new position to advocate for stronger anti-China policies, his retirement could take some of the wind out of the sails for China hawks in Congress, potentially easing US-China tensions and giving a boost to Chinese stocks.

Pakistan:  The final results of last week’s elections were released over the weekend, showing former Prime Minister Imran Khan’s party won the most seats in parliament even though Khan has been jailed on apparently trumped-up charges.  The results are being seen as a rare repudiation of the country’s military and its obvious efforts to keep Khan from power and could point to an increasing risk of political strife in the country.

Israel:  Moody’s has cut the country’s sovereign debt rating from A1 to A2, citing the possible fiscal impact of its war against the Hamas government in the Gaza Strip.  Moody’s also cut Israel’s debt rating outlook to negative from stable out of concern that the conflict with Hamas could spread.  Even though the Moody’s rating is still solidly investment grade, the downgrade will likely raise some concern about Israeli stock and bond values.

US Commercial Real Estate Market:  With interest rates high and vacancies making banks reluctant to roll over property-backed loans, investors who have set up funds to buy distressed properties are finally reporting that prices have come down enough for them to snap up buildings.  According to data firm Preqin, global private-equity funds focused on real estate are sitting on $544 billion in cash that could be put to work on distressed properties, potentially helping prevent a crisis as bank lending to the sector dries up.

US Nuclear Energy Market:  According to CEO Boris Schucht of privately held British fuel processor Urenco, a bill in Congress that would ban imports of uranium from Russia will help encourage a secure domestic supply chain for the nuclear fuel used to generate electricity.  According to Schucht, the law would create enough market certainty to spur millions of dollars in new nuclear fuel capacity in the US and the rest of the West.  The statement is consistent with other signs of growing interest in expanding the nuclear generation industry in the US and abroad.

US Military:  Just weeks after sparking controversy by not informing the White House or the public that he was being treated in hospital, Defense Secretary Austin this morning was rushed by his security detail to Walter Reed National Military Medical Center and put in intensive care for an “emergent bladder issue.”

• Coupled with the previous controversy and his recent treatment for cancer, today’s incident will probably raise new calls for Austin to resign.
• If Austin does resign, he could be replaced by someone who would push for a faster military buildup and an expanded defense industrial base to counter the rising geopolitical aggressiveness of China.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities are off to a great start, and Ravens quarterback Lamar Jackson was crowned MVP for the 2023 season. Today’s Comment analyzes the potential impact of CPI revisions, Yellen’s nonbank lender warning, and the geopolitical boost for chipmakers. Don’t miss the rest of our comprehensive report that includes economic and domestic updates, with expert insights on these key trends.

CPI Revisions: A potential upward revision to the CPI might dampen expectations of a rate cut in the first half of the year.

• The Bureau of Labor Statistics will release its updated seasonal adjustment factors for monthly inflation data later today. Investors will be closely watching these changes for any hints about when the Federal Reserve might consider easing interest rates. While past revisions have typically been minor, last year’s adjustments revealed that inflation hadn’t cooled as quickly as initially reported, raising concerns about the Fed’s policy path. Fed Governor Christopher Waller warned that another upward surprise may undermine the committee’s confidence in the Fed’s progress on inflation.
• However, it is quite probable that the revisions may reveal inflation to have been lower than the initial estimate suggested. Upon closer examination of the non-seasonally adjusted data, it becomes evident that while inflation experienced acceleration at the beginning of the year, prices plunged significantly into deflation by year-end. The sharp fluctuation suggests the previous year’s price movements could have varied widely in both directions, signaling that revisions may not be as bad as some fear.

• While the CPI reigns supreme in popularity thanks to its early release, it’s not without its limitations. A potential revamp would undoubtedly trigger market fluctuations, but it’s crucial to acknowledge the index’s shortcomings. The current methodology heavily weights shelter costs, which react slowly to economic changes, and ignores potential consumer substitutions toward cheaper alternatives. Therefore, it’s important to remember that the Federal Open Market Committee (FOMC) prefers the Personal Consumption Price Index (PCE) as a more accurate inflation gauge. So, while an upward revision to the CPI might grab headlines, its impact on the FOMC’s commitment might be less significant than initially perceived.

 Yellen Concerns: Treasury Secretary Janet Yellen is paying close attention to the mortgage lending industry, even as she maintains a positive economic forecast.

• During her Senate Finance Committee testimony, Secretary Yellen flagged concerns about the increased vulnerability of nonbank mortgage lenders during economic downturns. She emphasized their reliance on short-term, volatile funding sources compared to traditional banks’ access to stable deposits and emergency Fed facilities. This dependence, she argued, amplifies their risk of failure, potentially disrupting borrowers and destabilizing the broader financial system. Her testimony aligns with a growing effort among regulators to strengthen oversight on such institutions, aiming to mitigate the risks they pose and prevent future financial crises.
• Nonbank lenders have witnessed significant growth in recent years, partially fueled by their ability to offer loans to borrowers with lower creditworthiness, a segment often underserved by traditional banks who tightened their lending standards during the same period. This has allowed them to significantly outpace their bank and thrift counterparts in loan originations. According to Standard & Poor’s Global Market Intelligence, nonbank lenders accounted for a staggering 50.9% of mortgage loans issued in 2022. However, their rapid growth and sizable market share raise concerns about potential risks to the broader financial system.

• Secretary Yellen’s testimony highlights potential systemic risks beyond commercial real estate. While rising interest rates have slowed mortgage growth, they’ve also fueled a concerning increase in risky lending practices. Strengthening regulatory oversight of nonbank lenders could mitigate these risks, but we would expect significant resistance from these firms. While current indications suggest limited default risk among households, tightening monetary policy could elevate this risk in the future. That said, this talk about nonbank lenders is an example of how regulators are trying to extend their reach into the shadow banking market.

Global Chip War: Chipmakers are back in vogue as investors look for semiconductors to make a recovery and the US and China look to compete in the space.

• Governments are pouring money into bolstering their domestic chipmaking capabilities, spurred by geopolitical competition and supply chain concerns. The US “CHIPS and Science Act” offers subsidies to entice companies like Intel, TSMC, Samsung, and Texas Instruments to build fabs domestically. China presses on toward self-sufficiency in advanced chipmaking, defying US export restrictions. This week, news emerged that the country’s leading chipmaker is making headway in developing 5-nanometer chips. While not as miniaturized as the West’s 3nm chips, this achievement underscores the potential of China’s investments in the field.
• Chipmakers may find solace in intensifying competition for advanced semiconductors, after a brutal year marked by slumping sales. The Semiconductor Industry Association (SIA) predicts a potential rebound, with chip sales rising 13.1% to $595.3 billion in 2024, following an 8% dip in the previous year. This growth is fueled by the surging demand for advanced chips in artificial intelligence (AI) technology as more companies incorporate it into their products and services. The improved outlook regarding semiconductor sales has helped lift the stock price of chipmakers. So far this year, the Philadelphia Stock Exchange Semiconductor Sector Index (SOX) is currently outpacing the S&P 500.

• While intensifying competition in AI presents exciting opportunities for companies in the space, investors should proceed with caution. Similar to the S&P 500, the SOX index is concentrated, with the top three companies wielding significant influence. Additionally, the index trades at a high valuation, hovering around 30 times earnings. This suggests limited upside potential for established players within the broader index. For investors seeking exposure to AI and chip growth, consider exploring smaller companies. These companies might offer greater room for future growth, while still benefiting from the overall sector momentum.

Other News: Former Fox News host Tucker Carlson’s interview with Russian President Vladimir Putin was released on X on Thursday. Some interpretations, including ours, suggest Putin’s feelings of marginalization by the US were a reason for invading Ukraine. Separately, US President Joe Biden faced heightened scrutiny over his age following a special prosecutor’s warning about Biden’s difficulty recalling details during interrogation over classified documents found at his residence. The renewed criticism is another example of why we think this election will be less predictable than previous cycles.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities are holding steady, and the NBA trade deadline is expected to end with a bang. In today’s Comment, we dive into the recent Treasury auction, explore why New York Community Bank is on investors’ watchlists, and analyze the potential for a US decoupling from the EU and China. As always, we wrap up with a summary of key domestic and international economic releases.

Auction Success: The US Treasury sold a record number of bonds as investors gear up for a Fed pivot; however, policymakers aren’t as confident.

• The US Treasury successfully auctioned $42 billion in 10-year notes at a slightly lower yield than anticipated, 4.093%. This strong demand marks a turnaround from recent auctions plagued by weak participation and “tail” outcomes, where low-priority buyers received bonds at significantly higher yields. The better-than-anticipated demand in the latest bond sale boosted bond prices slightly and fueled a surge in the S&P 500, pushing it closer to the 5,000 mark. This suggests growing investor confidence that the Fed might adopt a more dovish stance later in the year, but Fed officials continue to play down speculation that a policy pivot is imminent.
• Several central bank policymakers urged patience on rate cuts, emphasizing the importance of waiting for clearer signs of disinflation before considering adjustments. Fed Governor Adriana Kugler advocated for further evidence before the committee considers a rate cut. Meanwhile, Minneapolis Fed President Neel Kashkari projected the central bank could reduce rates 2-3 times this year, but acknowledged the need for inflation to remain near the 2% target for several months before action. Recent core PCE readings show that inflation dipped below the Fed’s target on a six-month annualized basis, suggesting a sustained downward trend.

• A successful Treasury auction of $25 billion worth of 30-year bonds today could spark market optimism, but demand for these bonds in the future could hinge on expectations of a Fed pivot. Robust payroll data coupled with persistent inflation appears to be preventing policymakers from acting more aggressively. Meanwhile, Chair Powell’s recent call for fiscal responsibility amplifies concerns within the Fed that Congressional inaction on the fiscal deficit debt could hinder their efforts to manage long-term interest rates. Given this uncertainty, investors should tread carefully and avoid premature exposure to duration risk, as these assets will most likely remain highly susceptible to volatility in the coming months.

Loss Provisions: Recent loan losses at New York Community Bank are fueling fears of a surge in real estate defaults this year.

• Faced with a surprise earnings loss and dividend cut, the New York lender is scrambling to regain investor trust by exploring asset sales, including offloading loans made during lower interest rates. This move reflects concerns about potential losses on real estate holdings in a challenging market. However, the firm’s efforts to shore up its balance sheet may be hampered by a lack of appetite for commercial real estate (CRE). Banks are struggling to value properties due to high vacancies and borrowing costs, making potential buyers wary. As a result, concerns linger that other banks might also face difficulties in managing their CRE.
• Small and mid-sized banks face mounting concerns about CRE loans, according to the latest Senior Loan Officer Opinion Survey. While the report showed a slight easing in credit tightening for nonresidential properties, standards remain significantly stricter compared to pre-pandemic levels. Notably, large banks were less likely to tighten standards, highlighting a potential vulnerability for smaller lenders. Alongside stricter lending practices, banks are expressing growing uncertainty about the economic outlook, reduced risk tolerance, and worsening liquidity conditions, further amplifying concerns about the CRE market.

(Source: Federal Reserve)

• While historical trends show real estate crashes to be major drivers of US recessions, exemplified by the downturns in the early 90s and the Great Recession, current indicators don’t necessarily point to imminent trouble. The latest Household Debt and Credit report reveals increased auto and credit card delinquencies in the final quarter of 2023, but defaults remain significantly lower than pandemic highs. Additionally, the labor market continues to show signs of tightness which is likely to make households more resilient. Hence, despite the gloom in CRE, financial markets still look good.

Trade Flow and Tension: Trade data shows that the US is steadily reducing its dependency on China; however, there are growing concerns that the European Union may be next.

• For the first time in two decades, the US imported more goods and services from Mexico than from China, marking a significant shift in global trade dynamics. This trend is primarily driven by a decline in imports from China, falling from $575 billion to $431 billion in 2023, rather than a significant increase in Mexican imports, which dipped slightly from $459 billion to $448 billion. This shift reflects not only ongoing tensions and potential decoupling between the US and China, but also the growing trend of “nearshoring” as companies and investors seek geographically closer production and supply chains.
• However, a potential shift towards regionalization could strain relations with traditional allies. The European Union has voiced concerns about potential trade disruptions if former President Donald Trump were to be re-elected. Throughout his initial term, Trump publicly criticized the EU, particularly Germany, for its perceived reluctance to adopt a firmer stance against China, as well as its long-standing trade deficit with the United States. Trump is currently considering punitive trade measures against the EU if he regains office, prompting the EU to assess its response to potential actions by the Republican front-runner should he resume power.

• Escalating trade tensions create a complex landscape of uncertainty, presenting both challenges and potential opportunities. Recent price data hints at post-lockdown economic struggles in China, raising questions about whether cost advantages for US companies will be sustainable in the face of trade disputes. Additionally, a potential EU-US feud could prompt the bloc to diversify its imports, particularly in commodities, potentially impacting the US energy sector. However, the EU might also need to balance this with maintaining access to the US consumer market, potentially softening its stance on American tech firms.

Other News: Israel’s PM Benjamin Netanyahu rejected a deal to end the hostage situation, suggesting that the conflict will likely continue for the foreseeable future. The US killed the commander of an Iran-backed militia in Iraq as it looks to retaliate against those responsible for the Jordan attack in late January. The action risks a broader conflict in the Middle East. Lastly, the stock price for UK chip designer Arm surged on Thursday after it reported higher-than-expected earnings. Its strong performance reflects growing demand for AI-related technology.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with our thoughts on a troubling new approach to providing aid to Ukraine that Western policymakers are now considering.  We next review a range of other international and US developments with the potential to affect the financial markets today, including further weak industrial data out of Germany and a few thoughts about what the troubles at New York Community Bancorp might mean for the broader US financial system.

Russia-Ukraine War:  With far-right, populist politicians in the US and Europe opposing more military aid to Ukraine as it tries to fight off Russia’s invasion, one thing we’ve been watching closely is a proposal to channel frozen Russian assets in the West to Ukraine’s war effort.  The latest iteration of the idea is a proposal to use the frozen Russian assets as collateral for new allied borrowing to fund additional assistance to Ukraine.  Officials say the idea is now the leading option to provide further aid to Kyiv.

• The new proposal clearly stems from a perspective that enabling Ukraine to keep fighting off the Russians is so important that it offsets any negative effects from such a policy. However, we suspect that using frozen Russian assets as collateral for Western borrowing would dramatically increase tensions between the evolving US geopolitical bloc and the China/Russia bloc.  When push comes to shove, there would be a high likelihood that Western borrowers would renege on such debt, allowing creditors to confiscate the assets.
• As we’ve written before, tensions between the US bloc and the China/Russia bloc are in a self-reinforcing spiral. Unilaterally pledging Russian assets to Western creditors would almost certainly prompt Beijing, Moscow, and other governments in the China/Russia bloc to further sever their financial ties with the West.
• In such a scenario, we think China, Russia, Iran, and other members of Beijing’s bloc would accelerate their efforts to exit the dollar system and sell off their dollar holdings.
• If the world disintegrates into competing geopolitical, economic, and financial blocs as we think, the loss of efficiency and market competition would likely boost consumer price inflation and inflation volatility, as well as interest rates and interest-rate volatility. As we’ve written before, such an outcome would be especially negative for fixed-income assets.  In contrast, equities and commodities would probably provide higher total returns going forward.

China-South China Sea:  Illustrating the increasingly belligerent attitudes of some Chinese strategists and academics, a new article by maritime strategy expert Wu Shicun calls for Beijing to stop relying on “restraint and forbearance” in its territorial disputes in the South China Sea.  Instead, Wu calls for China to “show our swords when necessary,” essentially declaring that Beijing should threaten military force to counter any pushback against its expansive territorial ambitions.

China:  Following Tuesday’s government directive for the “national team” of major financial firms to buy Chinese stocks in an effort to buoy the market, trading prices and volumes continue to surge today.  The benchmark CSI index of large, liquid stocks is now up more than 4% for the month, after falling some 6% in January.  Separately, General Secretary Xi has replaced the chief of the China Securities Regulatory Commission, further signaling his intent to buoy the market.

Japan:  Workers’ nominal cash earnings in December were up 1.0% year-over-year, in part reflecting strong year-end bonuses.  That was weaker than the expected rise of 1.4%, but analysts considered it sufficiently strong to support the Bank of Japan’s plan to soon exit its longstanding policy of negative interest rates.

Germany:  December industrial production fell by a seasonally adjusted 1.6%, several times worse than the expected decline and far worse than the revised fall of 0.2% in November.  With the decline in December, Germany’s industrial output has now fallen for seven straight months, leaving it down 6.9% year-over-year.  The declines largely reflect Europe’s current high interest rates and German policies that have crimped energy supplies.  Since Germany is Europe’s manufacturing powerhouse, its industrial decline is a big hurdle for the region’s economy.

Argentina:  Radical libertarian President Javier Milei and his La Libertad Avanza coalition have pulled their big, omnibus economic reform bill from the floor of the lower house of Congress after accusing opposition lawmakers of reneging on plans to approve the bill.  With opposition support, the bill was approved on a first reading last week, but now opposition lawmakers have been voting down key sections in the second reading.  Since Milei’s coalition only has a small number of seats, the voting calls into question his ability to push through the reform program.

United States-Guyana-Venezuela:  With the Venezuelan government continuing to threaten military force to seize more than half the territory of Guyana, the US this week committed to sell the Guyanese additional fixed-wing aircraft, helicopters, drones, and radar systems.  As of this writing, the dollar value of the deal has not yet been made public.

US Monetary Policy:  At an event yesterday, Cleveland FRB President Mester said the strong headline numbers in last week’s January employment report masked other signs of moderation in the data and wouldn’t derail the Fed’s plans to cut interest rates gradually over the course of 2024.  Mester said she supported the policymakers’ expectations to cut rates three times, leaving the benchmark fed funds rate at 4.50% to 4.75% by year’s end.

• We agree that the details in the January report showed more moderation than suggested by the massive gain of 353,000 in nonfarm payrolls or the year-over-year rise of 4.5% in seasonally adjusted average hourly earnings.
• For example, we note that the standard approach of using seasonally adjusted figures for year-over-year calculations is prone to distortion, since both the current month’s figure and the year-earlier figure could have bad adjustments. Where possible, we prefer to use non-seasonally adjusted data for year-over-year comparisons.
  • Our approach suggests average hourly earnings in January were up just 3.9% on the year, moderating from a rise of 4.3% in the year to December.
  • Using our approach, annual wage growth is now at its weakest since last May.
• In addition, the report showed that the average workweek plunged to just 34.1 hours in January, down from 34.3 hours in December and 34.4 hours in November.

US Banking System:  Following New York Community Bancorp’s announcement last week of a surprisingly large loss, and in the wake of a dramatic selloff of its shares, Moody’s yesterday cut the firm’s debt to junk status.  Moody’s now rates NYCB’s debt at Ba2, versus Baa3 previously.  Nevertheless, it currently appears that the bank’s problem is limited to profitability, rather than the falling bond values and deposit flight that marked the banking crisis last spring.  For now, that suggests the situation at NYCB does not portend another crisis like last year.

• After acquiring Signature Bank during last year’s crisis and a separate bank in 2022, NYCB surpassed the $100 billion in assets that require greater regulatory scrutiny and higher capital standards. NYCB had noted that working through those acquisitions would require it to shore up its balance sheet, and its recent loan write-offs appear to be part of that effort.
• At the same time, NYCB has reported that its deposits have been largely stable, down just 2% during the fourth quarter of 2023. Its share of insured deposits is also much higher than the banks that saw deposit flight last year.
• On the New York Stock Exchange yesterday, NYCB closed at $4.20 per share, down 22.2% for the day and approximately 60% from its level just before the announced loss. Other regional bank stocks were also down yesterday, but not nearly as sharply as NYCB.

US Housing Market:  While some private data providers say overall apartment rents have stabilized or have even started to fall, new analysis from Yardi Matrix suggests the reversal in rent inflation has been mostly in the luxury segment, where most of the new supply has come. While overall rent costs grew by just 0.3% in 2023, Yardi says rents for lower- and middle-tier apartments rose 2.0%.  Continued increases in apartment rents may be one reason President Biden is struggling to retain the support of working-class voters as he campaigns for re-election.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a considerable rebound in the Chinese stock market after the government implemented a number of strong support policies.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including more signs of pushback against climate stabilization policies in Europe and encouraging forecasts of U.S. consumer price inflation from a key international research group.

Chinese Stock Market:  The Chinese government today seems to have finally gotten some traction in its effort to boost the country’s sliding stock market.  Following a series of actions by the stock market regulator, the country’s $1.2-trillion sovereign wealth fund, and General Secretary Xi, stock indexes on the mainland and in Hong Kong have jumped sharply today.  Nevertheless, it isn’t clear whether the upward momentum will continue going forward, especially considering that earlier efforts weren’t effective.  Included in the moves today:

• The China Securities Regulatory Commission said it will “coordinate and guide various institutional investors” into the stock market to prop up values, including making it easier for the sovereign wealth fund to buy shares;
• The CSRC also advised listed firms to take stronger steps to ensure investor confidence and market stability, including conducting share buybacks, boosting major shareholders’ stakes, and declaring regular dividends;
• Following the CSRC’s statement, sovereign wealth fund unit Central Huijin Investment said it would buy more exchange-traded funds, expand its holdings, and take steps to ensure “the stable operation of the capital market”; and
• Finally, news reports today say Xi will soon meet with market regulators to discuss market conditions and recent policy moves, indicating he will pressure them to ensure the stock market keeps rebounding.

Chinese Military:  As a reminder that both geopolitical tensions and economic headwinds have been weighing on Chinese asset values, on Sunday the New York Times published a detailed article on China’s massive program to expand its strategic nuclear weapons arsenal, which we have described in our past writings. Based on previously unavailable documents, the article shows that General Secretary Xi ordered the expansion just 19 days after assuming power in 2012, saying China needed a major arsenal to truly be a Great Power.

• Now, the article says, Chinese military strategists are looking at how to use the arsenal not only to deter U.S. attacks, but also to bully other nations.
• As more Western policymakers and voters come to realize the aggressiveness of China’s military buildup, we think they will demand pushback against Beijing and even stronger efforts to rebuild Western defenses. Tensions between China and the West are therefore likely to keep deteriorating over time.
• We continue to believe that spiraling geopolitical tensions, along with China’s own structural economic challenges, will continue to weigh on Chinese assets going forward.

Australia:  The Reserve Bank of Australia has cut its forecasts for economic growth in 2024 and 2025, citing slower demand growth from China and the impact of its own interest-rate hikes.  The central bank now sees Australian gross domestic product rising just 1.4% in 2024, versus its previous forecast of 1.8%.  Nevertheless, like many other major central bank chiefs, RBA Governor Michele Bullock is resisting calls for aggressive rate cuts in the near future.

• It’s important to remember that central banks outside the U.S. may have even greater incentives to resist near-term rate cuts than the Fed does.
• If the Fed slow-walks its rate cuts as we expect, leaving U.S. rates relatively high, any country whose central bank cuts rates aggressively would risk a sharp depreciation in its currency, potentially fueling a rebound in consumer price inflation.

European Union:  Faced with massive farmer protests across the EU, the European Commission has scrapped plans to implement a 30% reduction in agricultural greenhouse gas emissions by 2040.  Scrapping the planned cut probably reflects EU officials’ concern that farmer anger over EU agricultural policies might fuel further political gains for far-right populist parties ahead of the European Parliament elections in June.

Germany:  Siegfried Russwurm, head of Germany’s biggest industry association, has slammed the government’s climate policies as “more dogmatic than any other country I know.”  He especially complained about the government’s decision to phase out nuclear energy and coal and switch to renewables, saying the decision has put German firms at a disadvantage to those in other industrialized countries.  Russwurm’s strong statement is further evidence of growing pushback against climate stabilization policies in Europe.

Turkey:  After the resignation of central bank chief Hafize Gaye Erkan on Friday, President Erdoğan has named Fatih Karahan to be her successor.  Karahan is a former economist at the U.S. Federal Reserve, as well as a former deputy governor at Turkey’s central bank.  Finance Minister Mehmet Şimşek praised Karahan for his experience and knowledge, but his appointment nevertheless may prompt concern that Erdoğan is backing away from the more orthodox economic policies he has pursued since his re-election.

Mexico:  Ahead of the presidential and legislative elections this summer, President Andrés Manuel López Obrador has proposed almost two dozen major constitutional amendments that would dismantle many of the good-governance and free-market reforms of recent decades.  Although the president’s Morena Party doesn’t currently hold enough seats in Congress to pass the changes, the proposal allows Morena to set the terms of debate for the coming campaign.  If Morena wins enough seats, it could then pass the changes later.  The proposals include:

• Reducing the size of Congress;
• Directly electing the Supreme Court;
• Dismantling an agency that enforces government transparency;
• Outlawing hydraulic fracturing (fracking) in oil and gas production; and
• Giving workers a pension equal to their final salary.

U.S. Monetary Policy:  The Organization for Economic Cooperation and Development issued new forecasts showing the U.S. should have the second-lowest rate of consumer price inflation among major developed countries in 2025, at 2.2%, and the lowest rate in 2025, at 2.0%.  According to the OECD, the good progress on U.S. inflation could allow the Federal Reserve to start cutting interest rates as early as the second quarter of 2024.

• Nevertheless, we still think investors are expecting the Fed to cut rates more aggressively than it really will. Following Chair Powell’s interview over the weekend, in which he basically said the same thing, stock and bond values fell sharply yesterday.
• With the Fed likely to take its time cutting interest rates, and with economic growth relatively weaker in many other large, developed countries, the dollar in recent days has appreciated sharply. The U.S. Dollar Index now stands at its highest level since early December, having risen approximately 4% over the last five weeks.

U.S. Weather:  Southern California today continues to be battered by torrential rains resulting in extensive flooding, mudslides, disrupted business activity, and property damage.  Portions of downtown Los Angeles have already received 9 inches of rain, and outlying areas have received even more, with the downpours expected to continue until Thursday.  Besides the potential for a noticeable hit to economic activity in the country’s most populous state, we’re also watching for any future increases in insurance rates or insurer withdrawals from the market.

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