Author: Amanda Ahne

Daily Comment (January 4, 2024)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Global markets hum with cautious optimism as investors dissect the latest FOMC minutes, while the European football world holds its breath for Kylian Mbappé’s blockbuster transfer decision. In today’s Comment, we delve into the Fed’s policy signals, why Europe’s central bank deserves a closer look, and the escalating tensions in the Red Sea. As always, our comprehensive report equips you with the latest domestic and international data releases.

 Pivot or Not? While some investors anticipate swift rate cuts, FOMC minutes suggest a more gradual and data-dependent approach, prompting concerns about unrealistic expectations in the market.

  • Wednesday’s minutes revealed that policymakers acknowledged potential 2024 rate cuts while stressing ongoing restrictive policy for now. Inflation progress toward the 2% target was noted, but officials demanded further proof of easing pressures before declaring victory. However, optimism was tempered by concerns from others within the committee. They flagged potential risks to inflation from global energy/food prices, geopolitical developments, a potential rebound in core goods, and effects of nearshoring. While some saw the labor market’s cooling, which was further buttressed by the JOLTS report’s low job vacancy figures, as evidence for dovishness, others remained cautious, emphasizing the need for comprehensive data before changing course.
  • Beyond conventional economic gauges, Fed officials highlighted a potentially disruptive factor influencing their policy decisions — the looming commercial real estate debt wall. Over $117 billion of office building loans in the U.S. face maturity in 2024, according to the Mortgage Bankers Association. Issued during an era of low rates, these loans now burden properties whose value has fallen, raising concerns about potential losses and limited lender capacity for extensions. The ongoing crisis in CRE markets adds a layer of complexity to the Fed’s decision-making process, as they must weigh not just inflation and employment risks but also financial stability concerns.

  • The 2019 mid-cycle adjustment by the Federal Reserve serves as a reminder that an outright recession isn’t always necessary for them to cut rates. Following a series of hikes to normalize monetary policy during that period, Fed Chair Jerome Powell explained the policy shift as a tactical move to mitigate the dampening effects of international developments on U.S. growth, manage downside risks to the economy, and support a symmetrical return to the Fed’s 2% inflation target. However, complications within the repo market emerged as a key driving force behind the decision. With inflation exceeding its target, the central bank is likely to prioritize price stability over short-term growth concerns, potentially leading to less aggressive rate cuts than the market anticipates.

ECB Bluffing? After pulling back on bets for U.S. rate cuts, investors should consider revising their expectations for the European Central Bank as well.

  • Growth expectations have taken center stage in shaping rate expectations for the European Central Bank (ECB). After a promising first half of 2023, the eurozone economy stumbled in the third quarter, with GDP contracting at an annualized rate of 0.1%. This slowdown was further underscored by the recent Purchasing Manager’s Index (PMI) reading of 47.6, dipping below the 50 threshold that indicates a contraction in private sector activity. These indicators have significantly increased the possibility of the eurozone slipping into a technical recession, defined as two consecutive quarters of negative GDP growth. As a result, bets for rate hikes have faded, and speculation about potential easing measures is rising.
  • Investors dismissing the ECB’s commitment to a tight policy may be overlooking a hidden weapon — the lingering Pandemic Emergency Purchase Programme (PEPP). While the bank has hiked rates to record highs and started shrinking its balance sheet, PEPP’s ongoing reinvestments of maturing securities suggest it hasn’t fully embraced monetary tightening.  Even though net purchases ceased in 2022, PEPP has continued to reinvest maturing securities. Despite its initial aim of preventing fragmentation, PEPP’s ongoing presence has inadvertently provided the eurozone with a buffer against the potential negative impacts of tighter policy on its financial system.

(Source: Bloomberg)

  • While the eurozone’s financial system is better equipped to handle rising rates compared to the U.S., a looming debt maturity wall in their junk bond market could still force cuts. The share of lower-rated firms facing debt repayments within the next three years has risen to its highest level since 2015, particularly in high-yield debt for telecom, consumer staples, and real estate. This significant vulnerability could lead policymakers to rethink monetary policy stance. As a result, we maintain that aggressive rate cuts as soon as the market expects are unlikely in the near term. However, we acknowledge that conditions may change in the future.

 Middle East Uncertainty: Houthi rebel attacks on commercial vessels in the Red Sea have spooked markets, raising fears of a wider Middle Eastern conflict.

  • While current oil prices and consumer spending trends haven’t fueled a major inflation hike due to the conflict in the Red Sea, escalating tensions could quickly disrupt supply chains or amplify energy market volatility, triggering a more pronounced surge in price pressures. Although crude oil has seen a 6% increase recently, it remains below $80 a barrel, and slowing global demand, evident in the economic slowdown in Europe and China, could provide some downward pressure on global prices. However, the conflict’s unpredictable nature keeps the inflation threat on the table, requiring close monitoring of its potential economic fallout.

Other news: Former President Donald Trump faces a crucial legal hurdle as he pushes the Supreme Court to decide if Colorado can remove his name from its presidential ballot. The dispute reinforces our view that the outcome of this year’s presidential election will be less predictable than previous contests. Meanwhile, economic cracks widen in China as the world’s second-largest economy grapples with a property market slump and declining exports. Chinese provinces have been forced to pump billions into their fragile banking system, raising concerns about a prolonged slowdown and its global ripple effects.

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Daily Comment (January 3, 2024)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with recent reports suggesting U.S. and European leaders are shifting their focus from helping Ukraine expel the invading Russians to simply helping it defend the territory it still holds.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including an Israeli strike on a Hamas leader in Lebanon that raises the risk of escalation and new private-sector data confirming the recent slowdown in U.S. labor demand.

Russia-Ukraine War:  Now that Russian and Ukrainian forces have fought to an apparent draw and many U.S. and European politicians staunchly oppose further aid to Kyiv, President Biden and allied leaders have reportedly begun to shift their focus toward bolstering Ukraine’s ability to defend the territory it still holds, rather than pushing the Russians out of the country.  Their aim is to bolster Kyiv’s bargaining position when peace negotiations eventually come about.

  • In our view, the U.S. and European resistance to further aid for Ukraine is essentially political and strategic, rather than economic.
    • The officials who support Ukraine are often traditional center-left or center-right establishment elites. Those who oppose more aid to Ukraine are often on the far left or the far right.  U.S. and European far-right populists have been especially energized by working class anger over post-Cold War globalization, migration, de-industrialization, and income and wealth inequality.  Those populist isolationists are often strongly opposed to more assistance for Ukraine.
    • Some of international relations theorists also argue that while the U.S. and Europe might face an existential threat if Ukraine lost its independence to Russia, the West wouldn’t face much additional risk if Russia merely holds on to the territory it has already conquered.
  • In contrast with the very real political pushback and strategic disagreements, the U.S. and European aid to Ukraine so far in the war is small from an economic standpoint. For example, the U.S.’s total assistance of $75.4 billion to date equals:
    • About 0.16% of the estimated $46.116 trillion in U.S. gross domestic product from the start of Russia’s invasion until late 2023;
    • Roughly 0.65% of the U.S. government’s total spending of about $11.689 trillion over the same period;
    • About 5.1% of the U.S.’s defense spending of $1.491 trillion over that period; or
    • Approximately the same amount that the U.S. spent on health research in that period, and well below what it spent on disaster relief.
  • For investors, the longer-term strategic implications of reduced Western aid for Ukraine may be most important.
    • Recent research from the Institute for the Study of War notes that if the conflict is frozen with Russia retaining the almost 20% of Ukrainian territory it now holds in the east and south, President Putin would almost certainly use the freeze to rebuild his forces for a new invasion in the future.
    • That would likely require the U.S. and NATO to drastically bulk up their defenses in Europe, further bolstering our thesis of higher future defense spending and new investment opportunities in the defense sector.

Israel-Hamas Conflict:  In an apparent Israeli drone strike, a top Hamas political leader and at least two of the group’s military commanders were killed in an explosion in the suburbs of Beirut yesterday.  Since the assassinations took place in an area dominated by the Iran-backed Hezbollah militant group, which previously warned against any Israeli strikes in Lebanon, the incident further ratchets up the risk of the conflict spreading beyond the Gaza Strip.

European Union:  José Manuel Campa, head of the European Banking Authority, said in an interview that the regulator is launching an investigation into the relationship between banks and non-bank financial institutions (NBFIs) such as hedge funds, private equity firms, and cryptocurrency groups.  The goal is to determine if there is any risk that financial stress in the NBFIs could spread to banks.  Importantly, the initiative may encourage similar scrutiny in the U.S., with the possibility of new regulations down the road.

United Kingdom:  According to a union leader representing the junior physicians who yesterday launched a planned seven-day strike against the National Health Service, the doctors would accept a 35% pay hike spread over several years, rather than all at once.  The statement could potentially diffuse the strike, which would be the longest in NHS history.  It could also help bring an end to the U.K.’s year-long labor unrest.

United States-Netherlands-China:  ASML (ASML, $716.92), the world’s top manufacturer of fabricating equipment for advanced semiconductors, yesterday said the Dutch government has revoked some of its licenses to export deep ultraviolet lithography systems to China.  Under U.S. pressure to help constrain China’s ability to make advanced chips, the Dutch government already bans ASML from selling its top-of-the-line extreme ultraviolet lithography systems to China.  Revoking the licenses for less advanced systems shows the U.S.-China tech war is expanding.

  • The U.S.-China geopolitical rivalry, and especially the U.S. clampdown on technology flows that could help China’s military, continue to present risks for investors who own Chinese assets or have positions in companies that depend on Chinese capital or markets.
  • As proof of that, ASML’s depository receipts in the U.S. fell 5.3% yesterday, as the loss of DUV export licenses convinced investors that even more of the company’s China revenue could be at risk.

United States-China:  Reflecting China’s growing competitiveness in making electric vehicles, Shenzhen-based BYD (BYDDY, $53.70) for the first time delivered more all-electric cars than U.S. rival Tesla (TSLA, $248.42) in the fourth quarter of 2023.  While China still lags in some advanced technology industries, in part because of Western restrictions, it continues to come on strong in EVs.  As Chinese EV exports increasingly threaten other countries’ auto industries, the question is whether, when, and how those countries might clamp down on the Chinese cars.

  • On a related note, the Financial Times this morning carries an article in which top officials from General Motors (GM, $36.05) and Nissan (NSANY, $7.80) warn against former President Trump’s plan to gut the Inflation Reduction Act’s subsidies for EVs made substantially in the U.S.
  • The officials warn that if the subsidies are revoked, the recent U.S. investment boom in EV-related factories will end, inward foreign investment will weaken, and consumers will be tempted to buy vehicles from China and elsewhere.

U.S. Energy Regulation:  Oil giant Chevron (CVX, $149.48) yesterday warned that it will book impairment charges of $3.5 billion to $4.0 billion in the fourth quarter, in part to reflect the impact of tough regulations in California.  The California issue is a reminder of the regulatory drag that can hit energy firms operating in the U.S.  In addition, Chevron said the charges would also reflect hiccups in the disposal of certain assets in the Gulf of Mexico.

U.S. Labor Market:  Recruitment site Indeed has released data showing that its total job postings at the end of 2023 were down 15% from one year earlier.  However, the data shows that the pace of decline slowed in the second half of the year, and that overall postings remain more than one-quarter higher than before the pandemic.  In sum, the report helps confirm that labor demand slowed markedly in 2023, especially early in the year.  As we argued in our outlook, slowing momentum will leave the economy more susceptible to a recession in 2024.

U.S. Stock Market:  On the year’s first day of trading yesterday, the NASDAQ Composite price index dropped 1.6%, as some large, growthy technology stocks sold off sharply.  The stodgier Dow Industrials rose marginally to a new record high of 37,715.04.  In fact, the Dow has now risen for nine straight weeks.

  • Of course, one day does not make a trend. Nevertheless, we note that recent action and yesterday’s trading in particular were consistent with the arguments we made in our recent Outlook for 2024.
  • In our Outlook, we argued that the run-up in large-cap tech and artificial intelligence stocks last year has left them richly priced. Going into the new year, we think investors are likely to see better opportunities in value and small-cap equities.

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Daily Comment (January 2, 2024)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a discussion of what some observers are starting to describe as a Stalinist purge by General Secretary Xi.  We note that Xi’s firing of military officers and defense industry officials may not be for corruption, but for real or imagined susceptibility to being recruited by the CIA.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more attacks on Red Sea shipping and a range of new labor laws in the U.S.

China:  The country’s top legislative body, the National People’s Congress, said on Friday that it has kicked out nine People’s Liberation Army generals, including five from the scandal-ridden PLA Rocket Force, two working on weapons procurement at the Central Military Commission, and one each from the PLA Air Force and the PLA Navy.  Also late last week, the Chinese People’s Political Consultative Conference, a prestigious government advisory body, said it has removed three top-level defense industry leaders from its membership.

  • The sackings come three months after the mysterious firings of former Defense Minister Li Shangfu, who had previously been involved with procurement at the CMC, and former Foreign Minister Qin Gang, who was rumored to have had an affair that led to the birth of a child in the U.S. Prior to that, several top PLARF leaders were fired and put under investigation in July, sparking a scandal that has now reportedly caught up more than 70 officials.
  • At first glance, the common thread linking most of these firings is that the officials were involved with developing and procuring equipment for the military. That suggests the officials were involved with kickbacks or other types of financial corruption, and that’s how most press reports seem to be describing the story.  That alone would point to some organizational weakness and lack of loyalty in the Chinese military.  However, we think there may be a more profound implication for U.S. security and global investors:
    • China’s widespread corruption among government and business leaders is usually described as a political challenge or economic risk, but it has also been a key source of leverage for Western spies to recruit Chinese sources.
    • Like other intelligence services, the Central Intelligence Agency knows that the way to convince a Chinese citizen to sell Beijing’s secrets is to use MICE: Money, Ideology, Compromise, or Ego.  Corrupt officials or lower-ranking workers are already susceptible to being bought with money.  If the CIA threatens to expose their corruption, they can also be susceptible to compromise.
  • What many people don’t realize is that the CIA had leveraged Chinese corruption to build an extensive and effective network of human intelligence sources within China in the first decade of this century, but it was compromised and destroyed by the Chinese Ministry of State Security from 2010 to 2012, just as General Secretary Xi was coming to power. Discovery of the CIA’s network in China was reportedly a key factor in sensitizing Xi to the threat from Western spies and corruption in his own ranks.
    • CIA Director Burns has recently said his agency is successfully rebuilding its network in China. If so, it’s probably doing so by leveraging corruption again, and the corrupt Chinese officials with some of the most valuable secrets would be those associated with procuring weapons — especially the PLARF missiles that threaten U.S. forces in the Western Pacific Ocean and even the U.S. mainland.
    • In sum, the U.S.-China intelligence war is already in full swing, so the true import of Beijing’s military corruption scandal is that it suggests large numbers of Chinese military and defense industry personnel are susceptible to being turned by the CIA. We suspect that will exacerbate Xi’s security concerns, prompting further aggressive moves against the U.S. geopolitical bloc and even more of the global fracturing that is creating risks for investors.

China-Philippines:  Responding to Manila’s stated plan to build permanent civilian facilities on a disputed shoal in the South China Sea, Beijing on Friday warned that such an action would “seriously impinge on China’s sovereignty” and prompt it to “respond resolutely.”  The warning shows how the increasingly acrimonious territorial dispute between China and the Philippines could spark a conflict.  Given that the U.S. and the Philippines have a mutual defense treaty, any such conflict could potentially lead to a U.S.-China conflict.

China-Mexico:  Late last week, the Mexican government imposed an anti-dumping tariff of almost 80% on some types of steel imported from China.  The action came in response to complaints by Mexican producers that Chinese steelmakers have been disposing of their excess output abroad at artificially low prices.

  • One little noticed aspect of China’s economic rise over the last two decades is that the country’s state-supported, low-cost producers have often undercut budding manufacturers in other so-called emerging markets around the world. Waves of cheap Chinese goods have often put domestic producers in Latin America, Africa, and South Asia out of business, short-circuiting their governments’ economic development strategy of boosting manufacturing and forcing them to stick with low-value added commodity production.
  • Under pressure from imports, domestic steel production in Latin America is expected to cover just 83% of the region’s needs in 2023.
  • More broadly, various reports suggest that China’s current economic slowdown is prompting many of its manufacturers in multiple industries to dump goods at low prices on world markets. In turn, that’s pushing down import prices and helping push down consumer price inflation in the U.S. and elsewhere.

Taiwan:  As campaigning ramps up for the presidential election on January 13, front-runner Lai Ching-te of the ruling Democratic Progressive Party has come under fire for the government’s 2019 decision to slash readings of classical Chinese literature in school curricula.  The DPP has long leaned toward independence from China, but Lai’s opponents are casting the curriculum change as an example of anti-Chinese extremism that could prompt Beijing to attack if the DPP stays in power.  It’s still unclear if the controversy could throw the election to the China-friendly KMT.

Japan:  An earthquake registering 7.6 on the Richter scale hit the western coast of Japan yesterday, causing widespread damage and prompting a tsunami warning.  At this point, it appears the quake has produced relatively limited casualties and damage, probably because it struck a sparsely populated area on the coast.

South Korea:  Lee Jae-myung, head of the opposition Democratic Party, was attacked and stabbed in the neck today by an assailant at a public event in Busan.  His injuries are considered serious but not life threatening.  Nevertheless, the incident is a reminder of the potential political volatility we could see in 2024 as countries ranging from South Korea and Taiwan to Mexico and the U.S. hold important elections.  South Korea holds legislative elections in April.

United Kingdom:  Although many of the strikes the country faced last year have died down, some labor actions continue.  Today, junior physicians are launching a six-day strike against the National Health Service for better pay and working conditions, in what may turn out to be one of the most disruptive labor actions to date.  Continued labor unrest is feeding into the sense of economic malaise gripping the U.K. as it deals with challenges like high interest rates, slow growth, continuing trade lethargy due to Brexit, and the uncertainty of upcoming elections.

Israel-Hamas Conflict:  As Iran-backed Houthi rebels in Yemen continue to aggressively attack commercial shipping in the Red Sea in sympathy with the Hamas government in Gaza, the U.S. Navy sank three Houthi vessels over the weekend that were attacking a private container ship.  With the threat of the Israeli-Hamas conflict now escalating again, global oil prices so far this morning have risen about 2%, with Brent trading at $78.58 per barrel.

U.S. Labor Market:  Even though the federal minimum wage remains at the same $7.25/hour rate that it’s been at since 2009, 22 states lifted their minimum rate starting yesterday.  The highest minimum wage in 2024 will be in the state of Washington, where it will stand at $16.28, up 3.4% from the previous rate of $15.74.  However, a new analysis by the Wall Street Journal suggests the minimum wage is becoming increasingly irrelevant, as even the lowest-paid workers in most states typically make almost 50% more than their state’s wage floor.

  • In an interesting new law going into effect in Alabama, any employee hours in excess of 40 per week will be exempt from state income taxes.
  • Essentially, the law will exempt overtime from state taxation. The law could therefore help incentivize overtime work, effectively increasing the labor supply.

U.S. Business and the Elections:  As mentioned above in the paragraph on South Korea, business leaders around the world are looking warily at the large number of countries holding key elections in 2024.  In the U.S., a new survey indicates that senior executives and risk managers now see escalating political polarization as their second-most important emerging risk, right after generative artificial intelligence.  The report shows many leaders are starting to prepare for the possibility that political protests could disrupt their companies’ operations.

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Daily Comment (December 20, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Note to readers: the Daily Comment will go on holiday after today’s Comment and will return on January 2, 2024. From all of us at Confluence Investment Management, have a Merry Christmas and a Happy New Year!

Our Comment today opens with new research on the challenges facing emerging markets because of today’s high interest rates and strong dollar.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more signs of a potential future wind-down in the Israel-Hamas conflict and new data on U.S. population growth.

Global Emerging Markets:  According to the World Bank’s latest International Debt Report, the strong dollar and aggressive interest-rate hikes by advanced countries’ central banks have created severe financial distress among low- and middle-income countries.  For example, the report identifies 18 sovereign debt defaults by 10 different countries in the last three years, exceeding the total number in the previous two decades.

  • Excluding China, the report says external debt among low- and middle-income nations now stands at 33% of gross national income, down a bit from the previous year but still much higher than the 26% of GNI one decade ago. Also excluding China, interest costs have risen to 1.06% of GNI from 0.94%, siphoning budget funds away from domestic uses and making it harder to service the debt.
  • The report says that if the top central banks keep interest rates “higher for longer,” as we expect, more poorer countries will face default in the coming years.

Israel-Hamas Conflict:  The Wall Street Journal today reports that there is a growing rift between Hamas’s political leaders based in Qatar, who want to end the group’s war with Israel, and its administrative and military officials in Gaza, who want to keep fighting.  Importantly, the Hamas political leaders have been talking with other Palestinian factions in the broader Palestine Liberation Organization about postwar governance in Gaza.  The talks add to other evidence that the endgame of the war is coming closer.

China:  The province of Guangdong and two of its municipal governments have set up a new $1.5-billion fund to invest in the local semiconductor industry, just as Shanghai set up a similar fund in 2016.  Supplementing the central government’s “Big Fund,” the provincial funds illustrate how lower-level governments in China are encouraged to help achieve the goals set out by top leaders, including the rapid development, resilience, and self-reliance of the country’s advanced semiconductor industry.

European Union-China:  The European Commission announced today that it is launching an anti-dumping investigation into Chinese biodiesel imports.  According to the Commission, EU companies have submitted evidence that biodiesel imports from China are coming into the EU at artificially low prices that local companies can’t compete with.  The probe further illustrates how the EU is now taking a more skeptical, confrontational approach to China, aligning it more closely with the U.S.

India-United States:  In an interview with the Financial Times, Indian Prime Minister Modi for the first time responded to U.S. allegations that Indian agents tried to assassinate an expatriate Sikh separatist on U.S. soil.  However, Modi appeared to play down the allegation, promising that his government would “look into” any evidence the U.S. provided and insisting that relations between the U.S. and India will continue to strengthen despite “a few incidents.”

  • Modi’s nonchalant response suggests he wants U.S.-India relations to keep strengthening as both sides seek to counter China’s increased geopolitical aggressiveness.
  • For investors, closer relations between the U.S. and India will likely help open up opportunities in the Indian financial markets.

Colombia:  The central bank cut its benchmark short-term interest rate to 13.00% yesterday, after keeping it at a nearly quarter-century high of 13.25% since May.  According to Banco de la República Governor Leonardo Villar, he and five board members voted in favor of the rate cut, while two voted against.  With the rate cuts, Colombia now joins other South American countries, including Brazil and Peru, that have begun to ease monetary policy.

France:  The lower house of parliament yesterday approved President Macron’s proposed immigration reform, but only after he toughened its restrictions enough to attract the votes of right-wing populists.  The move sparked defections from scores of liberal legislators in Macron’s own coalition, potentially portending political instability in France in the coming months.

  • The French bill increases the government’s power to deport foreigners and limits access to welfare and citizenship to dissuade asylum seekers from coming.
  • More broadly, the U.K. and several other European countries are also tightening immigration restrictions as the region faces its biggest wave of migrant arrivals in years.
  • Even in the U.S., right-wing populist Republicans have forced President Biden into negotiations to tighten refugee and immigrant rules as the price for his proposed bill providing more military aid to Ukraine and other U.S. allies.
  • The tightened rules reflect the extent to which citizens in the developed Western countries are angry at the disruption and social change they perceive in times of mass immigration. Right-wing populists have responded to that anger throughout the West, forcing more traditional, centrist parties to tighten the rules.

United States-Mexico:  Citing the need to shift personnel to handle the current wave of migrants coming across the southern border, U.S. Customs and Border Protection closed the railway bridges this week at Eagle Pass and El Paso, Texas, which respectively rank as the second and fourth busiest freight rail crossings with Mexico.  Shippers and railroad industry groups warned the closures could disrupt more than one-third of U.S.-Mexican rail traffic, hitting industries from automobile manufacturing to farming.

U.S. Population Growth:  The Census Bureau has released an estimate that the U.S. population grew 0.5% this year, reaching 334.9 million as of June 30.  The growth this year marked a slight acceleration from the 0.4% increase registered in 2022.  That has helped keep the U.S. among the better-growing developed countries, many of which are seeing declines in their overall populations and work forces because of falling birth rates and higher average ages.

  • Of course, the U.S. is also facing those challenges. As a result, there were only about 504,000 more births than deaths in the U.S. over the last year.
  • The big difference for the U.S. is that it attracts so many immigrants. According to the Census Bureau, net migration into the U.S. came to 1.1 million over the last year.  That means immigration accounted for about 70% of U.S. population growth in 2023, versus about 40% a decade ago.

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Daily Comment (December 19, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Note to readers: the Daily Comment will go on holiday after December 20, 2023, and will return on January 2, 2024. From all of us at Confluence Investment Management, have a Merry Christmas and a Happy New Year!

Our Comment today opens with a discussion of the potential fallout if the U.S. and its European allies stop providing military aid to Ukraine.  While some observers say there would be no impact, a new study argues that it would lead to much higher costs later on.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including a decision by the Bank of Japan to hold its monetary policy unchanged and a call by one Federal Reserve policymaker for multiple U.S. interest-rate cuts in 2024.

Russia-Ukraine-United States:  A new report by the Institute for the Study of War warns that if the U.S. and its European allies end their military aid to Ukraine, the country would be at risk of being overrun and conquered by Russian forces.  In such an event, the Kremlin’s battered but triumphant army would stand on NATO’s borders from the Black Sea to the Arctic Ocean, posing a major conventional military threat to NATO for the first time since the 1990s.

  • The study finds that Russia’s current wartime defense industry expansion and large pool of potential military recruits would allow it to recover quickly from its steep equipment and troop losses in the Ukraine invasion to date. At the conclusion of fighting, the Russian army would also have a wealth of experienced officers and troops, effective tactics honed on the modern battlefield, and innovative new weapons.
    • The study argues that the second-worst scenario would be to freeze the conflict with Russia holding the 20% of so of Ukrainian territory it currently controls in the country’s east and south. President Putin would almost certainly use such a freeze to rebuild his forces and prep them for a new invasion in the future, but at least his forces would remain far from NATO’s southern frontier.
    • The best scenario for the U.S. and NATO would be to help Ukraine drive the Russians completely out of their territory. Putin would still likely respond by rebuilding his forces for a new future invasion, but those forces would then have to transverse all the territory of a potentially rebuilt Ukraine.
  • If President Putin could deploy his rejuvenated army to positions along NATO’s entire eastern frontier, perhaps with Chinese approval and/or prodding, the study finds that the U.S. and its allies would need to invest enormous sums to rebuild the military strength needed to deter them, even as the allies are forced into an expensive defense buildup against China in the Indo-Pacific region. The study argues that the cost of this European defense buildup would far exceed the current cost of military aid to Kyiv.
    • Such a scenario would force the U.S. to make painful trade-offs between deploying deterrence forces to Europe or to Asia.
    • In other words, allowing Russia to win in Ukraine (either in full or in part) wouldn’t allow a full focus on Asia. Russia’s appetite for aggression would only increase, forcing the U.S. and its allies into an expensive two-front military buildup in both Europe and Asia.
  • The ISW study is therefore consistent with our thesis that rising frictions between the U.S. geopolitical bloc and the China/Russia bloc will continue to fracture international relations, creating risks for investors but also creating opportunities in sectors such as broad industrials, defense companies, defense-focused technology firms, and mining and energy firms.

United States-NATO:  Speaking of NATO, one little-noticed provision of the National Defense Authorization Act passed by Congress last week prohibits any future U.S. president from pulling the country out of NATO without a two-thirds vote of approval in the Senate or separate legislation from Congress.

Israel-Hamas Conflict:  As Iran-backed Houthi rebels in Yemen continue to launch retaliatory missile and drone strikes on ships in the Red Sea, the U.S. and six of its allies yesterday agreed on an expanded naval task force to protect shipping in the region.  The task force will include ships from the U.S., the U.K., France, Bahrain, and several other countries to protect commercial ships and oil tankers in the region.

Germany-Norway:  In a deal signed today, Norwegian energy giant Equinor (EQNR, $31.71) agreed to supply 129 billion cubic meters of natural gas to German state energy firm SEFE through 2039.  Worth about 50 billion EUR ($54.8 billion) at today’s prices, the long-term pipeline supply deal would reportedly be enough to cover one-third of Germany’s industrial gas demand over the period, helping replace the cheap Russian gas shut off after the Kremlin’s invasion of Ukraine.

  • The deal will therefore be important in ensuring energy security for Germany, and for Europe in general, in the coming years.
  • The deal is also an example of how global geopolitical fracturing will sometimes merely shift trade patterns, rather than end cross-border shipments.

United Kingdom:  Bank of England Deputy Governor Ben Broadbent yesterday warned that volatile, inconsistent data on wage growth will keep the central bank from making an early judgment on whether inflation pressures are easing, which in turn will discourage it from early interest-rate cuts.  The statement adds to the pushback from major central banks against investors betting on rate cuts in the near term.

  • Responding to the risk that BOE policymakers could keep interest rates too high and prompt a big slowdown in the British economy next year, the chief investment officer of bond giant PIMCO said he is keeping his exposure to U.K. government bonds higher than he usually does.
  • Other investors have apparently also been buying British bonds aggressively, pushing the yield on 10-year Gilts to about 3.673% recently, down approximately 100 basis points since late October.

Japan:  Dashing some investors’ hopes for policy normalization, the Bank of Japan today held its benchmark short-term interest rate at -0.1% and made no change to its “soft” ceiling on 10-year Japanese government bond yields.  In addition, BOJ chief Ueda said in his post-decision press conference that the policymakers want to see more evidence of sustained wage and price rises before ending their negative interest rates and yield curve control policies.  Without even a hint of monetary normalization, the yen (JPY) today has weakened by 1.1% to 144.34 per dollar ($0.0069).

U.S. Monetary Policy:  In contrast with the recent pushback against rate-cutting talk from other Fed policymakers, San Francisco FRB President Daly told the Wall Street Journal yesterday that cooling U.S. inflation in 2023 should prompt the policymakers to consider cutting interest rates several times in 2024.  As inflation cools, Daly said it makes sense for the Fed to make sure its high interest rates don’t disrupt the U.S. labor market.  The statement could potentially give a further boost to risk assets in trading today.

U.S. Air Travel Industry:  A recent report from the Federal Aviation Administration said the agency is struggling to find enough fully certified air-traffic controllers.  With nearly all FAA facilities facing controller shortfalls, the crisis is raising concerns that the agency might have to slow flight operations around the country.  Besides affecting airlines and air shippers, such a slowdown in air travel could disrupt supply chains, boost price pressures, and weigh on overall economic growth.

  • The shortage of air-traffic controllers can be ascribed in part to mass retirements in recent years. At the same time, the tight labor market has made it harder to attract applicants.
  • On a related note, the National Defense Authorization Act passed by Congress last week calls for U.S. active-duty military personnel to fall to 1.285 million by the end of fiscal 2024, down almost 64,000 from three years ago. As with the air-traffic controllers, the smaller target mostly reflects the difficulty of recruiting in a tight labor market, rather than a decline in the mission or responsibilities.

U.S. Political Dysfunction:  In yet another sign of how political tensions and disdain for compromise are affecting U.S. policymaking, new analysis shows that just 20 bills have passed both chambers of Congress and been signed into law this year, with another four awaiting President Biden’s signature.  Most of the bills that have become laws were uncontroversial measures like naming Veterans Affairs clinics.

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Bi-Weekly Geopolitical Report – The 2024 Geopolitical Outlook (December 11, 2023)

Posted on by Amanda Ahne

by Bill O’Grady & Patrick Fearon-Hernandez, CFA | PDF

(This is the final BWGR of 2023; the next report will be published on January 15, 2024.)

As is our custom, in mid-December, we publish our geopolitical outlook for the upcoming year.  This report is less a series of predictions as it is a list of potential geopolitical issues that we believe will dominate the international landscape for 2024.  It is not designed to be an exhaustive list; instead, it focuses on the big-picture conditions that we believe will affect policy and markets going forward.  They are listed in order of importance.

Issue #1: The Jungle Grows Back

Issue #2: Elections Everywhere

Issue #3: The U.S. Elections

Issue #4: U.S.-China Tensions

Issue #5: Shifting Geopolitical Blocs

Issue #6: Russia-Ukraine

Issue #7: Israel-Hamas

Read the full report

Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify | Google
The podcast episode for this particular edition is posted under the Confluence of Ideas series.

Daily Comment (December 8, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Risk assets are down following stronger-than-expected jobs data. Meanwhile, the Los Angeles Lakers and Indiana Pacers have secured their spots in the NBA In-Season Tournament championship game. Today’s Comment kicks off with our insights on the latest craze in artificial intelligence followed by an analysis of why investors suspect the Bank of Japan may soon abandon negative interest rates and a discussion on Saudi Arabia, which continues to work with both the U.S. and Russia to achieve its aims. As always, our comprehensive report encompasses the latest domestic and international data releases.

AI’s Last Hoorah: Fear of missing out has led investors to pile into tech companies after each new development, but there are doubts about how long this can last.

  • Alphabet subsidiary Google (GOOGL, $138.10) unveiled its highly anticipated answer to OpenAI’s technology on Wednesday. The company’s new artificial intelligence, dubbed Gemini, boasts capabilities exceeding anything currently available. Gemini can process information from audio, video, and text, which should expand the customer’s use. Additionally, it is believed to possess advanced reasoning and understanding abilities and was able to outperform the latest OpenAI on a range of industry benchmarks. So far, Gemini has been released in limited markets as Google would like to test the technology before releasing it early next year.
  • Google’s answer to OpenAI is a reflection of the ongoing turf war for dominance in the AI space, which has also expanded to the chip market. Advanced Micro Devices Inc. (AMD, $127.69) unveiled its new MI300 accelerator chip, a direct challenge to Nvidia’s (NVDA, $464.22) dominance in the semiconductor market. This powerful new graphics processor boasts greater memory bandwidth and capacity compared to Nvidia’s H100 chip, positioning it as a compelling and potentially cheaper alternative. Major tech players, including Meta (META, $327.06), OpenAI, and Microsoft (MSFT, $370.75), have already expressed interest in acquiring the newly developed chip, indicating its potential to disrupt the current market landscape.
  • While the excitement surrounding AI technology continues, its path to widespread adoption faces significant challenges in 2024. Intense competition within the space threatens to squeeze profitability as companies engage in price wars, potentially hindering their ability to meet ambitious earnings targets and justify their high valuations. Furthermore, lingering regulatory uncertainty surrounding AI, fueled by concerns about privacy and societal risks expressed by policymakers, poses a further obstacle. As a result, investors should exercise caution and recognize that today’s industry leaders may not remain so in the future. Focusing on undervalued companies outside the AI sector may offer greater potential for long-term returns.

BOJ Regime Shift: The Japanese yen (JPY) has jumped following speculation that the Bank of Japan will move away from its ultra-accommodative monetary policy.

  • BOJ Governor Kazuo Ueda hinted at potential policy adjustments in remarks to Japanese lawmakers on Thursday, stating that the central bank has “several options” available once short-term interest rates rise above zero. These comments followed Deputy Governor Ryozo Himino’s remarks the previous day, which suggested that a measured transition toward a more restrictive monetary policy could benefit the overall economy. The combined statements fueled speculation among traders that a significant policy announcement might be imminent at the BOJ’s upcoming meeting on December 18. This speculation contributed to a surge in the Japanese yen, reaching a peak of 4% appreciation against the dollar (141.71 yen per dollar) on Thursday, reflecting a decline in bearish sentiment toward the currency.
  • The recent surge in price increases, driven by a departure from traditional corporate pricing and compensation strategies, suggests a significant shift in Japanese business culture. This has propelled inflation above the central bank’s 2% target for 19 consecutive months, boosting the BOJ’s confidence that deflation may be fading. However, a seamless transition to a hawkish monetary policy remains elusive. The latest GDP figures reveal a contraction of 2.9% in the third quarter of 2023 and a 2.5% decline in household spending since October 2022, suggesting the central bank’s tightening might not be as swift as investors anticipate.
  • Higher yields on Japanese government bonds (JGBs) may entice foreign investors, reversing the country’s sizable net outflows and transforming them into inflows. This could lead to capital appreciation for foreign investors with exposure to Japan, driven by a strengthening JPY. Additionally, global bond yields may rise as Japanese buyers, incentivized to hold more domestic debt, exert less downward pressure on international yields. However, the change could also lead to an increase in servicing costs for traders who profited from the yen carry trade. It shouldn’t be a problem as long as those traders are able to make payments on their loans. However, if they are unable to do so, it could lead to another financial crisis.

Saudi Arabia Weighs Its Options: The ongoing conflict between Israel and Hamas highlights Riyadh’s cautious approach to picking sides between regional rivals.

  • Despite being the world’s largest exporter of crude oil, Saudi Arabia is currently struggling to diversify its economy. Its attempts to branch out into different fields beyond energy have yielded weak results so far. On Thursday, the Kingdom announced a delay in its ambitious 2030 Vision due to concerns over growing budget deficits. The recent drop in oil prices, which has slowed down the global economy, has likely exacerbated these problems. To attract foreign investment, Saudi Arabia has announced a 30-year tax exemption for any company willing to relocate its headquarters to the country.

In Other News: The European Union is considering challenging U.S. steel tariffs with the World Trade Organization. The move highlights growing concerns that the Western alliance may be weakened following the next presidential election.

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Daily Comment (December 7, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Risk assets are enjoying a lift as investors eagerly await tomorrow’s crucial jobs data. Meanwhile, former Padres’ outfielder Juan Soto is making his way to the Big Apple for his next adventure. Today’s Comment kicks off with our insights on the anticipated rate cuts for next year, then explores why banks are wary of the new Basel regulations, and finally delves into how China’s economic struggles might ultimately benefit the rest of the world. As always, our comprehensive report encompasses the latest domestic and international data releases.

Are Rate Cut Bets Overdone? Investors are having second thoughts on how aggressive the Fed will be when cutting rates next year.

  • Although inflation remains significantly above the Federal Reserve’s 2% target, it is still too early to predict with certainty whether the Fed will cut rates or stand pat next year. Furthermore, aggressive cuts, as anticipated by the market, are highly unlikely without a major economic crisis. The Atlanta Fed’s latest forecast projects a modest 1.3% annualized growth for the final quarter of 2023. Therefore, if we assume there will be no recession or perhaps a mild one, then any potential rate cuts in the coming year will likely be moderate.

Wall Street Woes: CEOs from major banks gathered on Capitol Hill to express their concerns about new financial regulations.

  • Implementation of new banking standards dubbed the “Basel III Endgame,” which are due to take effect in 2028, was the central topic of discussion. The chief executives argued that the proposed changes, which have not been finalized, are likely more burdensome than regulators realize. For example, the new capital requirements could make it harder for financial institutions to lend to households and small businesses, particularly those who already struggle to access credit. Additionally, the executives argued that the changes could push lending into less regulated sectors of the financial system. The banks’ concerns about the impact of the new regulations on lending come amid a significant rise in private credit lending, which has seen a dramatic increase in recent months.
  • The new rules were announced in July in response to growing concerns about the weakness within the financial system. These rules will apply to banks with holding over $100 billion in assets, exempting smaller institutions. The aim is to compel banks to adopt a more conservative and standardized approach to risk measurement, effectively requiring them to hold more capital as a buffer against losses. Regulators estimate a 19% average capital increase for globally systemically important banks (G-Sibs), although industry groups believe the actual increase could be significantly higher. Nevertheless, the stricter rules should help bring U.S. banks into compliance with international standards.

China Needs a Break: The country faces a growing number of obstacles as it seeks to expand its global reach and revitalize its struggling economy.

  • The country’s escalating economic problems will likely discourage Beijing from seeking major disruptions in its international relations in the near term. This is evidenced by Xi Jinping’s recent efforts to foster warmer ties with the United States, despite President Biden’s earlier remarks referring to him as a dictator. As the government seeks to manage its debt burden, promoting exports becomes an increasingly important strategy for generating growth and maintaining industrial production levels. This explains Xi Jinping’s recent trip to the EU, where he aimed to convince lawmakers not to place barriers on trade. In all, China’s shortcomings may lead to more stability as it may be too distracted to start a fight with the West.

Other News: Venezuelan President Nicolás Maduro recently unveiled a controversial map claiming Guyana’s Essequibo region as part of Venezuela. This action marks a significant escalation in Maduro’s ongoing efforts to assert control over the eastern region. President Biden suggested that there are Democrats who could possibly defeat Trump in an election, a possible sign that he may be weighing his options. Meanwhile, the Senate’s failure to pass legislation funding Ukraine due to demands for increased aid for U.S. border security highlights a growing trend of inward-focused politics as the nation grapples with its changing role in the global landscape.

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