by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities have pared early gains due to stronger-than-expected PPI data and subpar retail sales figures. Meanwhile, Purdue, UConn, Houston, and Tennessee were able to secure top seeds for the NCAA Tournament. Today’s Comment dives into our thoughts on central banks moving away from ultra-accommodative policy, the potential for broader social media scrutiny beyond TikTok, and how the IEA’s reversal on its oil demand forecast reinforces our concerns about future inflation volatility. As always, we’ll wrap up with a summary of key international and domestic data.

The Next Monetary Regime:  The European Central Bank and the Federal Reserve have signaled potential rate cuts, but this easing cycle could be unlike past ones.

• The European Central Bank (ECB) is poised to implement changes to its operational framework, granting lenders greater autonomy in managing liquidity within the financial system. This shift aims to gradually wean banks off their reliance on the ECB for cash and foster a more self-sufficient approach to liquidity distribution. Interestingly, the Federal Reserve may be following a similar path. The Fed’s recent closure of its Bank Term Funding Program and its encouragement for banks to utilize the discount window suggest a potential move toward a less interventionist approach to liquidity management.
• These central bank adjustments signal a potential departure from pre-pandemic monetary policy norms, which could include a more cautious approach to future interest rate cuts. The White House’s recent inclusion of higher interest rate expectations in its forecasts further reinforces this shift. The strategy to uphold elevated peaks and troughs in interest rates is driven by the imperative need to preserve central bank agility in striking a delicate equilibrium between sustaining price stability and fostering optimal employment levels. The overarching objective is to mitigate the likelihood of exhausting all available monetary instruments once the economy succumbs to recessionary pressures.

• The evolving approach to monetary policy signals a potential paradigm shift for investors. With the era of near or below zero interest rates likely coming to a close, investors will need to adapt their strategies. While central banks may not entirely abandon this tool, their use of it is expected to be more measured moving forward. This shift in preference suggests a new normal for interest rates — they will likely settle at higher points across the yield curve compared to what we’ve witnessed over the past decade and a half. This is likely to remain true not just for the US but for most other developed economies as well.

Election Meddling: With presumptive presidential nominees likely secured by both major parties, lawmakers are shifting their focus to the growing influence of social media, particularly in the age of advancing artificial intelligence.

• A bipartisan effort in the House recently passed a bill that could see TikTok banned in the US. The legislation requires the app’s Chinese owner, ByteDance, to sever ties with the platform or face a potential shutdown in the US. Citing national security concerns, lawmakers worry about the app’s ability to be used for propaganda or voter manipulation. President Biden reportedly supports the bill, but its fate now rests with the Senate. However, Senate Majority Leader Chuck Schumer hasn’t scheduled a vote yet, as concerns about potential free speech limitations and government overreach are expected to be debated.
• While TikTok faces intense scrutiny for potential national security risks, other platforms haven’t escaped criticism. Former President Donald Trump has repeatedly labeled Facebook “the enemy of the people,” alleging bias against conservative voices. On the other hand, New York Rep Alexandria Ocasio-Cortez (D-NY) described the decision of X, formerly known as Twitter, to alter its algorithm to promote or suppress free speech as a form of election interference. The potential of AI-generated deepfakes to spread disinformation on social media platforms is likely to put more pressure on lawmakers to rein in Big Tech.

• The growing pushback against tech giants is likely to extend beyond this year’s election cycle. Countries are grappling with the immense power wielded by these companies, and Europe has already implemented a regulatory framework to rein them in. US regulators are also taking a more aggressive stance. However, despite their high stock prices, this increasing regulatory scrutiny highlights the importance of diversification in investment portfolios, given the potential risks associated with tech’s high valuations.

Crude Oil Concerns: A brighter economic outlook in the US is raising concerns that crude oil demand will be significantly higher than the initial projections for 2024.

• The International Energy Agency (IEA) adjusted its oil forecast, predicting a shift from a surplus to a deficit due to reduced OPEC supply and robust US economic growth. This adjustment reflects the IEA’s expectation that OPEC will likely maintain production cuts throughout the year, even though the group previously aimed for these cuts to last only until mid-2024. The agency further amplified its oil demand forecast, raising its projection by 50% compared to its June 2023 estimate. This significant upward revision reflects an anticipated increase in bunker fuel consumption due to shipping route adjustments to bypass Red Sea conflict zones.
• The revised economic outlook is likely to further exacerbate the upward pressure on Brent crude prices, which have already surged 11% this year. Continued oil price hikes could significantly impact inflation. This connection is evident in the latest CPI report, where the increases in energy price heavily influenced the overall reading. Notably, even non-energy sectors like airline fares have experienced a recent surge, rising 15.2% at an annualized rate over the past three months. Rising price pressures could prompt the Fed to delay cutting interest rates to ensure that it doesn’t lead to a reacceleration of inflation.

• Inflation volatility, particularly due to swings in commodity prices, is a major concern for the committee. While oil prices have garnered significant attention, rising copper prices are also emerging as an issue. This volatility is amplified by the uncertainty surrounding geopolitical tensions. Despite recent low oil prices amidst the Middle East conflict, we lack confidence in their long-term stability. Our primary concern lies in the potential for countries to hoard and weaponize their resource exports as global political fractures widen, aiming to extract concessions from rivals. As a result, we remain skeptical that inflation will be able to remain, sustainably, under the Fed’s 2% target.

 Other News: The US has held secret talks with Iran about ending the violence in the Red Sea, and these discussions highlight efforts from both sides to prevent a broader conflict in the region. Donald Trump, the presumptive Republican presidential nominee, is eying John Paulson as Treasury Secretary, signaling a strategic move to populate his administration with trusted allies. Meanwhile, SpaceX, led by Elon Musk, is poised for its third launch, with ambitions to successfully land a spacecraft on the moon. This endeavor underscores the increasing reliance of the United States on private enterprises for cutting-edge research and exploration.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment opens with a discussion of today’s expected congressional vote on forcing Chinese tech giant ByteDance to divest the US operations of TikTok.  We next review a range of other international and US developments with the potential to affect the financial markets today, including strong wage increases in Japan that could help prompt the central bank to end its negative-interest rate policy and more detail on the Biden administration’s proposed federal budget for the coming fiscal year.

US-China Espionage:  The House of Representatives is set to vote on a bill today that would force Chinese tech giant ByteDance to divest the US operations of its social media app TikTok or have the app banned in the US.  The move by the lawmakers stems from growing concern by intelligence officials that the app could be used to funnel data back to China for espionage or influence campaigns.  The House is widely expected to approve the bill, but its fate in the Senate is less certain.

• The renewed focus on reining in TikTok will surely add another source of friction between the US and China, raising the risk that China will try to force a major US technology firm to divest its operations in China. Obvious potential targets might be Tesla or Apple.
• More broadly, the anti-TikTok bill illustrates how big, influential technology firms are being forced to choose sides in the US-China rivalry. Both Washington and Beijing are now so distrustful that they don’t want their rival’s companies doing business on their home turf.  To the extent that they ban firms owned by their adversary from their home market, the result is basically “decoupling.”
• Major US technology firms are generally very globalized, and many count China among their most important markets or their top manufacturing base. Some may try to maintain their businesses in China, but they will run the risk of increasingly brutal pressure to pull out of that market.  Naturally, the resulting shift in addressable market will have a major impact on those companies’ sales, profits, and stock values.

US-China Trade:  New analysis shows Chinese solar panel makers have doubled their output capacity in just the last year to 1 trillion watts annually and now produce fully three times as many panels as there is global demand.  The resulting glut of panels has driven global prices down some 50%, and the surge of imports into the US is threatening to put US producers out of business despite the expansion subsidies they’ve been offered through the Inflation Reduction Act.  We therefore suspect solar panels will become another key point of US-China frictions.

China:  The central government has ordered a stop to a string of big, expensive infrastructure projects in several poorer, highly indebted provinces in the country’s interior.  The move marks an expansion of Beijing’s effort to rein in excess capacity and debt, which has tripped up the real estate development sector over the last couple of years.  Importantly, the clampdown on investment and debt will likely exacerbate the Chinese economy’s other structural headwinds and could make it difficult to meet the government’s target of 5% economic growth this year.

Japan:  In the annual “shunto” wage negotiations that mostly wrapped up today, major Japanese companies granted average pay hikes of 4% or more, marking an acceleration from last year’s 3.6% increase and the biggest wage increase since 1992.  The robust raise will likely help ensure that Japanese consumer prices will keep rising and encourage the Bank of Japan to finally lift its negative-interest rate policy as early as this month.

Russia-Ukraine War:  The Ukrainian military has reportedly launched drone strikes against at least three oil refineries deep in Russian territory near Moscow and St. Petersburg.  Sources say the strikes, which were designed to starve the invading Russian military of resources, caused “significant damage.”  However, we suspect that even knocking out three refineries temporarily would have only a limited impact on Russia’s warmaking capability and economy.

US Politics:  After winning primary elections in several states yesterday, both President Biden and former President Trump have locked up enough of their respective party convention delegates to win their nominations for president.  Given the candidates’ ages and other factors, there is probably still some chance that either or both could be replaced at the head of their party ticket before November, but for now, it’s a Biden-Trump race until we see if a third-party candidate emerges.

US Artificial Intelligence:  If you’re fascinated by the new Sora artificial intelligence tool for generating videos with simple prompts, the Wall Street Journal’s technology editor has a story today with new examples.  Like some of the Sora-generated videos already released publicly, the videos are fascinating by themselves.  In addition, they suggest how difficult it’s becoming to discern real videos from those that might be artificially generated to influence political opinions or defraud consumers.

US Fiscal Policy:  While yesterday’s Comment discussed President Biden’s overall proposed budget for the fiscal year starting October 1, today we give more detail on the proposed budget for defense, since one of our key theses is that global defense spending is likely to rise in the coming years.  The proposed budget calls for total defense spending of $926.8 billion, up just 2.1% from FY 2024 because of a deal between the White House and Congress to cap spending.  That marks a big slowdown from the estimate’s rise of 10.7% in defense spending this year.

• Since the nominal 2.1% rise in defense spending is below the expected rise in prices, the proposed budget actually represents a small decline in the military’s purchasing power.
• The main savings in the proposed defense budget comes in weapons procurement and research, development, testing, and evaluation. Spending on those items will fall even in nominal terms.
• In contrast, the proposal calls for a 4.5% increase in troop pay, partially offset by a small decline in troop counts and shifting more of the force from active duty to reserves.
• In any case, increasing US-China geopolitical tensions and healthy Congressional support for the military will likely result in a bigger increase in funding than in the proposed budget.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a Nigerian government crackdown on cryptocurrencies and their use to avoid the country’s currency controls.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a worrisome spike in attempted terrorist attacks in Europe and a potential new US probe into unfair Chinese trading practices.

Nigeria-Cryptocurrencies:  Highlighting how governments around the world likely see cryptocurrencies as a threat to their sovereignty, Nigerian authorities have detained two high-level employees of crypto exchange operator Binance, apparently for facilitating Nigerian citizens’ use of stablecoins to skirt central bank exchange-rate controls.

• Such transactions are a risk to Nigeria’s currency controls because cryptocurrencies have become prevalent in the country. Nigeria now has the world’s second-highest rate of cryptocurrency adoption, after India.  Nigerian cryptocurrency transactions in the year ended June 2023 totaled almost $60 billion.
• The ability of citizens to skirt government financial and currency controls using crypto assets is one reason why countries may increasingly clamp down on their use, as China has already done. As we have written before, many central banks are instead studying the possibility of issuing their own digital currencies.

Argentina:  Radical libertarian President Milei is facing a scandal today after opposition Peronist legislators revealed that he signed a decree giving himself a 50% pay raise last month.  In response, Milei has fired his labor secretary and argued that he inadvertently signed the decree because it was an automatic inflation adjustment instituted by the previous Peronist government.  The scandal could become another headwind for Milei’s effort to rein in Argentina’s government spending, reduce bureaucracy, spark faster economic growth, and stabilize the currency.

Russia-Ukraine-NATO:  Following on French President Macron’s statement last month that the North Atlantic Treaty Organization shouldn’t rule out sending troops to Ukraine, the Polish foreign minister on Friday told his parliament that it “is not unthinkable” that NATO forces could be deployed there.  The statement from the foreign minister, which contradicts the view of Polish Prime Minister Tusk, shows how Russia’s new momentum in Ukraine is increasingly scaring Western European leaders and forcing them to consider previously unthinkable actions.

European Union:  Authorities in multiple European countries have recently arrested a number of terrorists who were planning attacks on EU soil against Jewish and Israeli-connected targets, apparently in sympathy with Palestinians suffering from the Israel-Hamas war in the Gaza Strip.  The terrorists, at least some of whom have posed as refugees, are being directed in part by Iran and its militant Islamist proxies in the Middle East, including Hamas and Hezbollah.  The news suggests there is a rising risk of a successful attack that could undermine market confidence.

Israel-Hamas Conflict:  In its annual threat assessment report yesterday, the US intelligence community warned that Israeli Prime Minister Netanyahu’s grip on power is “in jeopardy” because of the Hamas attacks on Israel last October 7 and the government’s continued war against Hamas in Gaza.  If that leads to new elections in Israel, the assessment argues that voters could elect a more moderate government than Netanyahu’s.

• Separately, Israel and Hezbollah fighters in southern Lebanon have sharply escalated their attacks on each other over the last day. Israel has even launched airstrikes deep into Lebanese territory.
• The intensified fighting in southern Lebanon is a reminder that Israel’s fighting with the Palestinians and Iran-backed militant groups still has the potential to spark a broader conflict that could be deeply concerning for financial markets.

China:  Moody’s has downgraded the debt of Vanke, the China’s second-largest real estate developer, to below-investment grade status and warned of further downgrades in the future as the company struggles with declining contracted sales.  The downgrade illustrates the ongoing challenges facing the country’s enormous real estate sector as the government leans on it to cut excess capacity and debt, which in turn has prompted lower prices and falling demand.

United States-China:  In case you thought you could read a Comment from us that doesn’t include a new US-China friction, think again.  The United Steel Workers union will file a petition today with the US Trade Representative alleging that China uses discriminatory practices in shipbuilding and maritime logistics to undermine US producers.  The petition will ask the government to launch an investigation into the matter, which could eventually result in further tariffs or other trade barriers against Chinese products or services.

• Ultimately, pushing back against China’s dominance in global shipbuilding aims to help revive the once-thriving US shipbuilding industry. That could have important implications for both private industry and the US Navy, which is constrained by limited domestic shipyards.  However, any potential revival of the US industry would be a very long-term project.
• In any case, any new investigation into Chinese unfair trading practices or punitive trade barriers would exacerbate the spiraling tensions between the West and China, further fracturing the global economy and presenting risks for investors.

United States-Philippines:  As the Biden administration keeps trying to solidify US alliances to protect against Chinese aggression, Commerce Secretary Raimondo has urged US technology firms to at least double their investment in Philippine facilities that handle a key part of the info-tech supply chain:  assembling, testing, and packaging computer chips produced in the US or elsewhere.  Raimondo’s call is an example of US “friend shoring,” or trying to shift more of its critical supply chains to friendly countries, both to shore up those allies and boost resilience.

US Fiscal Policy:  The Biden administration yesterday released its proposed federal budget for fiscal year 2025, which starts on October 1. The plan calls for total outlays to rise 4.7% to a total of $7.265 trillion, largely because of Social Security, Medicare, Medicaid, and other entitlements passed by Congress in previous years.  The plan calls for receipts to rise 7.9% to $5.485 trillion, reflecting both economic growth and proposed tax increases on higher-income people.

• The deficit of $1.781 trillion would be modestly lower than the estimated $1.859 trillion in FY 2024.
• The plan also calls for a number of sweeteners designed to help the Democratic Party in the November election. For example, it calls for a new mortgage tax credit and subsidy for home sales.
• Nevertheless, because of the fractured Congress, the proposed budget is seen as highly unlikely to pass in anything resembling its current form. Rather, the proposal will serve as a key reference point for Biden’s re-election campaign.

US Labor Market:  Port operators on the East Coast and Gulf Coast are starting negotiations with the International Longshoremen’s Association for a new, multi-year labor contract to follow the current one when it expires on September 30.  However, the dockworkers are already threatening to strike if they don’t get the concessions that they’re demanding.  If the negotiations fail and a strike occurs, it will likely happen at the peak of the delivery season for holiday imports, potentially causing important disruptions to the economy and pushing prices higher.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Financial markets are off to a sluggish start today. In sports news, University of Iowa star and top WNBA prospect Caitlin Clark declared for the draft. In today’s Comment, we delve into the impact of the NYCB turmoil, analyze the latest inflation data, and explore the possibility of tightening monetary policy at the Bank of Japan (BOJ). We conclude, as always, with a summary of recent domestic and international data.

More Regional Bank Pain: Regional banks are under increased scrutiny following turmoil at New York Community Bank, raising concerns about a potential financial crisis linked to commercial real estate.

• On Thursday, NYCB announced a $2.4 billion earnings hit, citing a “material weakness” in its loan review process. The bank’s CEO resigned and NYCB revealed it would miss its annual report deadline due to “ineffective oversight and risk management.” This news follows a prior announcement of a $552 million loan loss provision, 10 times greater than analysts’ expectations. The disclosure raises concerns about potential defaults on commercial real estate loans, sending NYCB’s stock down 19% in after-hours trading and potentially sparking broader sell-offs in similarly exposed banks on Friday.
• While the commercial real estate market’s vulnerabilities are widely recognized, its potential to trigger a major financial crisis remains the subject of heated debate. According to research from the American Enterprise Institute, banks have accumulated $1.5 trillion in unrealized mark-to-market interest losses on fixed income securities since September 2023. This could erode their ability to absorb potential loan losses in the event of a downturn in the commercial real estate market, adding to concerns about financial stability. However, it’s important to acknowledge the Federal Reserve’s ongoing efforts to collaborate with banks to address these concerns. Thus, there is also a strong possibility that the central bank has a contingency plan in case of an emergency.

• While the Federal Reserve’s primary mandate prioritizes price stability and maximum employment, its historical role in preventing bank panics remains relevant in the context of rising risks within the regional banking system. The expected termination of the Fed’s Banking Term Funding Program alongside these concerns could incentivize policymakers to reconsider their monetary policy stance. So far, the Fed has only hinted at potentially lowering rates, while maintaining its quantitative tightening. Based on these factors, we believe a rate reduction of at least 50 basis points could be warranted if the situation worsens, and potentially even more if a significant crisis erupts.

The January Spike: January’s hot inflation raises concerns that the Federal Reserve might delay rate cuts, but historical trends suggest a wait-and-see approach is likely.

• The core Personal Consumption Expenditures (PCE) Price Index, the Federal Reserve’s preferred inflation gauge, saw a notable 0.4% uptick in January. Despite this substantial rise, the year-over-year change in the price index actually dipped from 2.94% to 2.85%. While this moderation might suggest a momentary relief, it has also sparked concerns about the Fed’s ability to effectively combat inflationary pressures. Policymakers seem to put little emphasis on the report. Atlanta and Chicago Fed Presidents Raphael Bostic and Austan Goolsbee suggested that the recent inflation report has not influenced their views on monetary policy.
• Policymakers’ dismissal of the report might be linked to the seasonal nature of inflation data. Historically, January tends to have the highest inflation rate compared to other months, often around 3.1% as the chart below demonstrates. This sharp increase is due to what some economists refer to as “residual seasonality,” in which prices increase due to changing out of contracts. This year’s inflation increase notably surpassed the historical average, hitting an annualized rate of 5.2%, though it marks an improvement over the preceding two Januarys, which recorded increases of 6.2% and 5.7%, respectively.

• Wages undoubtedly wield significant influence over inflation. The recent surge in strikes and a constricted labor market have empowered workers to negotiate higher earnings from employers, possibly fueling price pressures. However, there exists a trade-off between increased wages and employment levels. January witnessed a notable increase in WARN notices, which are expected to filter into employment figures over the next few months. While we anticipate most layoffs to be concentrated in finance and tech, it wouldn’t be surprising to see other industries affected as well.

BOJ Ready for Lift Off: Despite the risk of recession, the Bank of Japan (BOJ) continues to signal its intent to exit its ultra-accommodative monetary policy.

• On Thursday, BOJ board member Hajime Takata declared that the central bank’s price target is “finally coming into sight.” His remarks add to the growing indication that Japanese policymakers are prepared to begin phasing out negative interest rates and yield curve control. While BOJ Governor Kazuo Ueda maintains that it’s premature to declare victory over deflation, he emphasized that the outcome of ongoing wage negotiations between unions and companies will be a key determinant of future inflation trends. A settlement is set to be released on March 13, a few days before policymakers start their two-day meeting on March 18-19.
• Predicting labor negotiations amidst the current economic climate and tight labor market poses significant challenges. Japan endured two consecutive quarters of economic contraction in 2023, meeting the technical definition of a recession. The downturn stemmed largely from decreased consumer and investment spending, compounded by a sharp decline in industrial output that threatens to further dampen growth prospects. Despite this, the labor market remains surprisingly strong, with a 2.4% unemployment rate — a four-year low. Additionally, surveys reveal that two-thirds of small and mid-sized firms face labor shortages, highlighting the unusual disconnect between the economy and the job market.

• That said, there is optimism that labor will be able to receive a notable bump in pay this spring. Economists are predicting that wage hikes will rise by about 3.9% from the prior year. Although lower than the 5% minimum initially sought by labor leaders, the negotiated pay increase still exceeds the previous year’s three-decade high of 3.58%. A rate hike is likely to occur in March or April. This development could pressure the greenback, put upward pressure on global bond yields, and potentially drive increased investment in Japanese financial markets.

Other News: Brazil’s and China’s economies are showing signs of weakness, reflecting broader global economic stagnation. The slowdown in these nations underscores a worrisome trend affecting economies worldwide. Moreover, George Galloway’s victory in Rochdale highlights a potential decline in the Labour Party’s popularity, possibly linked to its stance on the Gaza conflict. Lastly, Tesla CEO Elon Musk is suing OpenAI and its CEO Sam Altman. This legal dispute reflects the ongoing struggle in tech for control and dominance as various entities vie to shape the trajectory of artificial intelligence development.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! It’s been a positive start for equities as inflation data meets expectations. Meanwhile, Dallas Mavericks’ star Luka Dončić celebrated his 25th birthday with a triple-double. Today’s Comment dives into three key topics: the impact of bitcoin on small indexes, the possibility of a June rate cut by the Federal Reserve and European Central Bank, and the ongoing influence of the war in Ukraine on defense and aerospace companies. As always, the report concludes with a summary of international and domestic data releases.

Crypto Powers Small Cap Growth: Fueled by bitcoin’s rally, the Russell 2000 Index has surged as investors seek growth opportunities beyond the established large-cap tech stocks.

• The combined market cap of cryptocurrency hit a record of $2 trillion earlier this week, fueled by the recent surge in popularity for bitcoin ETFs. Additionally, bitcoin surpassed $60,000 for the first time since November 2021. This rise followed the launch of Grayscale Bitcoin Trust last month and was further bolstered by several subsequent ETF launches, which are now attracting record inflows. Retail investors have been the primary driver of this popularity, eager to capitalize on bitcoin’s momentum. However, concerns are rising as early signs suggest leverage may be re-entering the market, potentially increasing volatility.
• Bitcoin’s surge has boosted small-cap stocks, particularly those with bitcoin exposure like MicroStrategy, Riot Platforms, and Marathon Digital Holdings. This shift may signal that investors are diversifying away from the AI craze that dominated the early part of the year. The Russell 2000 outpaced the S&P 500 over the last week, rising 2.2% compared to 1.7%. However, mirroring its large-cap counterpart, gains remain concentrated in a handful of companies. MicroStrategy fueled much of this growth, rising an impressive 43% and outperforming even media favorite Nvidia, which rose 15% in the same period.

• While current fundamentals raise concerns about the sustainability of this trend, it may reflect a broader shift as the business cycle nears maturity. The Russell 2000’s P/E ratio has soared from just above 30 to over 74 in just a week, highlighting the increasingly optimistic (but potentially risky) behavior of investors seeking growth opportunities in small-cap stocks. Historically, late-cycle expansions witness a transition from large-cap value to large-cap growth, followed by a shift into small-cap growth. If this pattern holds, investors’ growing risk tolerance could signal the need for portfolio caution. We remain optimistic but maintain vigilance for potential sentiment shifts.

June a Possibility? Policymakers in Europe and the US have unequivocally rejected the possibility of an interest rate cut this spring but have signaled the potential for a cut this summer.

• The Federal Open Market Committee (FOMC) signaled that interest rate cuts are likely this year, though the pace of easing will be less aggressive than in previous cycles. While a baseline scenario is three cuts, New York Fed President John Williams emphasized that economic data will guide the ultimate decision. Atlanta and Boston Fed Presidents Raphael Bostic and Susan Collins also support rate cuts, with a potential start as early as June. This hesitancy comes in response to strong employment data and a hot January CPI report, fueling concerns that the Fed’s fight against inflation is far from over.
• European policymakers remain committed to using economic data to guide interest rate decisions, but some are signaling a potential rate cut by summer. Members of the European Central Bank’s Governing Council, Gediminas Šimkus and Peter Kažimír, have warned that premature cuts could harm efforts to control inflation and have urged patience. However, Kažimír also expressed concern about Europe’s declining competitiveness and suggested that low-interest rates alone may not be enough to avert economic hardship. This concern is underscored by the euro area’s narrow avoidance of a technical recession in Q4, where output remained unchanged from the previous quarter. This stagnation may prompt policymakers to consider policy accommodation.

• Market expectations of a June rate cut seem largely accurate; however, the size remains uncertain. US policymakers have expressed concerns about reducing the size of the cut due to persistent economic growth and lingering inflationary pressures. Therefore, while the three cuts outlined in the latest projections are still likely, a smaller, Greenspan-style 50 basis point “maintenance” cut is also a possibility. Europe, on the other hand, may take a slightly more aggressive approach than the US to mitigate a worsening downturn. Consequently, a 100 bps rate reduction before year-end should not be ruled out.

Ukraine on the Brink? Russia’s perceived military success in Ukraine is raising concerns about the potential for escalation into a wider European conflict.

• Russian President Vladimir Putin issued a stark warning, cautioning that direct Western intervention in the Ukraine conflict could escalate into a nuclear confrontation. His statement follows recent remarks by French President Emmanuel Macron, who acknowledged discussions within NATO regarding potential troop deployment to support Ukrainian efforts. Despite Western officials firmly rejecting the possibility of direct NATO involvement in the war, Putin’s comments suggest that he is taking the perceived threat seriously, especially as Ukraine struggles to maintain its war efforts amid dwindling resources while it waits for additional aid from the West.
• Putin’s menacing rhetoric regarding nuclear warfare has surged in prominence as nations scramble to stymie Russian aggression, particularly in light of its potential spillover beyond Ukraine. Recently, US officials issued cautionary alerts, suggesting Moscow’s contemplation of deploying anti-satellite nuclear weaponry within the year. President Biden has conceded that such a launch wouldn’t directly imperil human lives; however, security experts fear that the launch may risk an accidental explosion in space. Nevertheless, this development further highlights the intensifying military competition between Western powers and their adversaries, likely contributing to the record-breaking global military spending witnessed in 2023.

(Source: Washington Post)

• Though the threat of nuclear warfare is sadly not new, Putin’s repeated threats underscore the increasingly perilous state of global security. Tensions continue to show signs of escalation between the West and its rival. Although a conflict is not imminent, the risk is becoming increasingly elevated. While NATO member states have demonstrated their commitment to developing collective defense capabilities, the specific response of the United States to an attack on its allies remains unclear. That said, the increased military spending should boost revenue for defense and aerospace companies.

Other News:  The House is expected to pass a temporary stopgap bill to avert a government shutdown, highlighting the struggles of a divided Congress to reach consensus on essential legislation. Meanwhile, the Supreme Court’s acceptance of former President Donald Trump’s appeal regarding presidential immunity, (still likely to lead to an unfavorable ruling) suggests further a delay in a potential trial until after the general election. Turkish tech stocks have been on a tear this year, as investors consider tech stocks in emerging markets.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with new restrictions on information flows within and between the US and China, which will likely further decouple the two economies and exacerbate tensions.  We next review a range of other international and US developments with the potential to affect the financial markets today, including signs of potential new British curbs on Chinese electric vehicle imports and a range of US political and policy news.

China:  The government yesterday passed amendments to its State Secrets Law that will expand the types of information that must be protected.  Importantly, the amendments establish a new category of “work secrets” at government and party bodies that aren’t considered state secrets but could “cause certain adverse effects if leaked,” adding a potentially broad new category of restricted information.  Other provisions will restrict travel and work by people who leave sensitive positions and impose new rules on private businesses exposed to state secrets.

• Implementing rules on the work secrets category are to come at a later date. The overall package of amendments is due to take effect on May 1.
• The toughened law is only the latest example of how General Secretary Xi is actively prioritizing national security over economic growth or Chinese “soft power.”
• The toughened provisions will likely add to the concerns of Western firms trying to do business in China, since they will put those companies and their employees at greater risk of running afoul of the law. In turn, that may further discourage Western investment in China, adding to the country’s economic headwinds.

United States-China:  In another development relating to information flows, President Biden will sign an executive order today limiting the sensitive personal data on US citizens that data brokers can sell to China and other adversarial countries.  The restrictions will apply to data such as genomic, biometric, personal health, geolocation, financial, and certain types of personal identifiers.  In large sets, those types of data could be used by adversaries for intelligence gathering and to facilitate illicit influence campaigns or computer hacking.

United Kingdom-China:  Reporting by Politico indicates the British government is considering launching an investigation into whether the Chinese government has subsidized its burgeoning electric vehicle exports in violation of global trade rules.  The probe would follow a similar action by the European Union last fall, which has angered Beijing and worsened China-EU relations.

• Now that Chinese EV makers have begun to make ultra-cheap, high-quality cars (aided by government subsidies and protection), their EV exports are rapidly rising and posing what could be an existential threat to automakers in the developed countries.
• With the threat of massive job losses in their auto sectors, the EU and the UK are therefore taking steps that will likely lead to tough restrictions against the Chinese. Along with the existing US restrictions on Chinese vehicles, that could eventually lead to excess capacity in China’s EV industry, which would further weigh on Chinese economic growth in the coming years.

Russia:  The Financial Times carries an article today describing what it says is a series of secret Russian military documents on the country’s policies for when it would use tactical nuclear weapons in a conflict.  The report suggests Russia’s threshold for using tactical nukes is lower than previously thought, including numerical standards such as the loss of 20% of its nuclear ballistic missile submarines.

• We are still analyzing the article, so our view on its implication may still evolve. Nevertheless, it appears that the documents’ scenarios for going nuclear are fundamentally defensive.  For example, one scenario is if an adversary has invaded Russian territory and Russian conventional forces are unable to stop it.
• Of course, it’s always useful to ask oneself: “Why is this being reported now?” It could well be that this is a leak designed to influence the current US and European debate over the future threat from Russia if it can consolidate its invasion of Ukraine.
• Regarding the war in Ukraine, we believe the stalemate that seemed to be evolving late last year is now shifting toward an advantage for the Russians. With Western aid to Kyiv faltering and Ukraine struggling to field the requisite manpower, equipment, and ammunition to fight effectively, it looks increasingly like Ukraine’s defenses are becoming brittle and could soon fail, allowing the Russians to sweep westward.

United States-European Union-Russia:  European Commission President von der Leyen today formally proposed that the Group of 7 countries use profits from the $300 billion or so of Russian foreign reserves that they have frozen to support Ukraine in fighting off Russia’s invasion.  The formal proposal, which is also supported by the US, comes despite a lack of consensus among the allies over the legality of doing so and how it could be done.

• Recent proposals have called for designating the frozen Russian assets as collateral to support G7 loans to Ukraine for its war effort and rebuilding, based on the idea that Russia will eventually owe reparations to Ukraine. The expected Ukrainian default would then result in the Russian assets being confiscated.
• Despite the machinations being considered, the confiscation of Russian assets at the end of the day would not only be a major provocation against Moscow, but it would likely accelerate the loss of the US dollar’s status as the world’s reserve currency. Countries in the China/Russia geopolitical bloc and any other nations worried about crossing the US would have an even greater incentive to reduce or end their use of the greenback, with unpredictable consequences for the world’s financial system.

US Politics:  In yesterday’s Michigan presidential primary elections, former President Trump handily beat former UN Ambassador Haley again in the Republican contest, and President Biden won the Democratic one, but the protest votes on each side were large.  In the Republican contest, Trump won 68.2% to Haley’s 26.5%.  In the Democratic ballot, Biden won 81.1% against an “uncommitted” vote of 13.3%.

• It increasingly looks like Trump and Biden will have a rematch in the November general election. Nevertheless, we still think that age and other potential issues could ultimately keep one or even both of the candidates off the ballot.  On top of that, a close race exacerbated by a potential third-party candidate could throw the election into Congress, with very unpredictable consequences.
• At the end of the day, this election season is looking unusually chaotic and hard to call. It would not be a surprise if the unpredictability at some point begins to weigh on the financial markets.

US Fiscal Policy:  After a meeting with President Biden at the White House yesterday, Republican and Democratic congressional leaders expressed confidence they would soon reach a new funding deal that would avert a partial shutdown of the federal government when the current stopgap law expires Friday night.  However, Senate Majority Leader Schumer, a Democrat, warned that the likely solution would be yet another short-term funding package designed to give the two parties time to agree on funding for the remainder of the fiscal year.

• Despite the optimism expressed by the lawmakers yesterday, neither a short-term nor a full-year deal can be assured, especially given the existence of a large body of Republican deficit hawks in the House who seem willing to torpedo any deal that doesn’t meet their aggressive goals for spending cuts.
• In any case, yet another stopgap measure and a further delay in passing funding for the rest of the fiscal year through September will impinge even more on the US military’s effort to rebuild and expand to meet the growing threat from the China/Russia geopolitical bloc.

US Antitrust Policy:  In another sign that the administration is trying to tighten antitrust policy, the Justice Department has reportedly opened an investigation into health insurance giant UnitedHealthcare.  The probe appears to be focused on the relationship between the company’s insurance operations and its Optum health-services operation.  It isn’t clear whether the probe will lead to an antitrust lawsuit.  As we mentioned in our Comment yesterday, the administration has had a mixed record in antitrust because of the prevailing Bork Standard in the courts.

US Economic Growth:  The National Association of Business Economists said its updated US economic forecasts now show gross domestic product growing 2.2% in 2024, up sharply from its December forecast of 1.3%.  The improved growth would reflect better-than-expected increases in personal consumption expenditures, corporate and residential investment, and government spending.  The forecasts also call for lower unemployment and price inflation, which should allow the Federal Reserve to start cutting interest rates in Q2.

US Cryptocurrency Market:  Just weeks after financial firms won regulatory approval to launch exchange-traded funds holding bitcoin, reports say about 10 companies have now filed applications to offer ETFs holding ether, the second-biggest cryptocurrency.  In response to the news, ether prices have surged approximately 42% so far this month.  That has given a further boost to bitcoin prices, which are now up about 33% in the month to date.

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