by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a note about the Pentagon’s annual report on Chinese military power.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the Israel-Hamas conflict, a loosening of the Bank of Japan’s yield-curve control policy, and what to expect from this week’s Federal Reserve policy meeting.

Chinese Military Power:  As is usual at this time of year, the U.S. Department of Defense last week released its annual report on Chinese military power, which is the basis for much of our analysis regarding U.S.-China relations (and our popular in-person presentation on global fracturing, geopolitical blocs, and their investment implications, which we provide to financial advisors and their clients all over the country).  The DOD report does a deep dive into all aspects of Chinese military power, and we’ll be incorporating the latest information in our writings and presentations over the coming weeks.  Today, we want to stress that the report also provides a useful discussion of what’s driving Chinese leaders.  As we continually write about the increased geopolitical aggressiveness of General Secretary Xi and the rest of the Chinese Communist Party, and how that has ushered in a new, riskier era for investors, the DOD report helps explain why they’re acting the way they are.  As you read our discussions of China, we encourage you to keep in mind the following:

• In both public pronouncements and private documents, Xi and the CCP have said that their overarching mission is to achieve the “great rejuvenation of the Chinese nation” by 2049 (the centenary of the People’s Republic of China). This mission encompasses:
  • Reclaiming China’s traditional status as the world’s richest, most powerful, most culturally advanced nation, and
  • Erasing the “Century of Humiliation” from the mid-1800s to the mid-1900s, when China was dominated and nearly dismembered by foreign powers.
• To achieve their mission, Xi and the CCP have adopted the following priorities:
  • Defending and advancing sovereignty, especially over Hong Kong and Taiwan,
  • Ensuring the security of China, and of the CCP’s rule, and
  • Protecting China’s economic development
• To achieve the “great rejuvenation” by 2049, Xi and the CCP have selected certain subsidiary and interim goals, including:
  • Protect the CCP’s monopoly on power,
  • Develop the economy and become a technology leader,
  • Revise the global political and economic system to serve China’s rejuvenation,
  • Leverage tribalism, i.e., the sense that “East is rising, West is declining,”
  • Create a global “community of shared future” dependent on China, and
  • Build a “world class military” that can “fight and win” wars, including a conflict with a “strong adversary” (a euphemism for the U.S.), by 2049.
• Finally, we note that these missions, priorities, and goals stem from deeply ingrained, longstanding instincts that have evolved over millennia to help humans survive in a dangerous, challenging world: the drive for status, the resistance to being dominated, the sense of security that comes from being a part of a strong group, and the motivation that comes from casting the adversary group as evil (in-group vs. out-group thinking).  To the extent that Xi and the CCP are operating on the basis of these deep motivations, China’s new aggressiveness is likely to be long-lasting and could extend even to the point of conflict with the U.S. and its evolving geopolitical bloc, with big implications for investors.

Chinese Economic Growth:  The official purchasing managers’ index for manufacturing declined to 49.5 in October, down from 50.2 in September.  The PMIs for construction and services also fell, leaving the October composite PMI at just 50.7.  Like most major PMIs, the official Chinese gauges are designed so that readings above 50 point to expanding activity.

• At their current levels, the figures suggest the Chinese economy continues to struggle against headwinds such as weak consumer demand, high debt, poor demographics, and foreign decoupling.
• Given the huge size of China’s economy, its current weak growth will likely be a headwind for businesses around the world. That could help mollify global inflation pressures, but it could also take some wind out of global asset values.

Israel-Hamas Conflict:  Dashing hopes for a more limited ground offensive, the Israel Defense Forces have ratcheted up their infantry attacks and airstrikes on Gaza over the last 24 hours.  IDF tanks, troops, jet fighters, and other forces are actively engaging Hamas fighters in a wider area of the enclave, with a focus on destroying the extensive tunnel network used by Hamas to hide and protect its fighters and move supplies and equipment from place to place.  Along with Islamist attacks on Israel from Lebanon and Syria, and retaliatory Israeli strikes against them, the risk of the conflict spreading regionally remains.

Venezuela:  The country’s top court, which is packed with supporters of the authoritarian Maduro government, has “suspended” the opposition’s recent primary election, throwing a wrench into the recent deal in which Venezuela agreed to allow free and fair elections next year in return for the U.S. to relax sanctions on its energy industry.  If the move prompts the U.S. to reimpose its sanctions, it could lead to new oil supply challenges and put upward pressure on prices.

Eurozone:  Third quarter gross domestic product fell at a seasonally adjusted, annualized rate of 0.4%, erasing most of the annualized 0.6% increase in the second quarter.  In contrast with the U.S.’s third-quarter growth rate of 4.9%, the figures illustrate how the eurozone economy is now faring much worse because of headwinds such as high inflation, rising interest rates, and a crisis of confidence in the face of geopolitical tensions.

• On a more positive note, the eurozone’s October consumer price index was up just 2.9% from the same month one year earlier, after a 4.3% rise in the year to September.
• Excluding the volatile food and energy components, the October Core CPI was up 4.2% year-over-year, compared with 4.5% in September.

Japan:  As previewed in our Comment yesterday, the Bank of Japan today held its benchmark short-term interest rate steady at -0.1% but said that it will now consider its 1.0% upper bound for 10-year Japanese government bond yields to be merely a “reference rate” rather than a hard limit.  Since investors were looking for a more substantial loosening or even abandonment of the BOJ’s yield-curve control policy, both the 10-year JGB yield and the yen (JPY) fell back after an initial jump.  Separately, as if to emphasize that the era of ultra-low consumer price inflation in Japan is over, the policymakers also projected that annual price increases would remain close to 3.0% until 2025.

• The yield on the 10-year JGB ended trading in Tokyo at 0.95%, compared with 0.774% at the end of September.
• The JPY closed at 150.70 per dollar ($0.0066), compared with its September close of 147.85 per dollar ($0.0068).

U.S. Monetary Policy:  The Federal Reserve begins its latest two-day policy meeting today, with the decision due to be released tomorrow at 3:00 PM EDT.  As shown in the chart below, the popular CME FedWatch Tool (based on 30-day fed funds futures prices) indicates investors are nearly unanimous in believing the policymakers will hold the benchmark short-term interest rate unchanged at 5.25% to 5.50%.  The focus will therefore be on any guidance regarding future rate changes in the committee’s statement or in Chair Powell’s post-meeting press conference.

• No new economic projections are due to be released at this meeting.
• Nevertheless, the statement and Powell’s discussion could well express a bias toward further tightening, consistent with Powell’s “higher for longer” mantra.
• We think it makes sense to take Powell at his word. Even though we think U.S. interest rates are probably near their peak, we continue to believe the Fed will try to hold them at elevated levels for an extended period to wring inflation out of the economy.

U.S. Regulatory Policy:  The Securities and Exchange Commission is suing information technology company SolarWinds (SWI, $9.31) in connection with the company’s failure to stop Russian hackers from infiltrating its systems, a scandal discovered in 2020.  According to the SEC, the company mislead investors about its cybersecurity and failed to disclose known risks.  The lawsuit illustrates how cyber breaches not only put companies at operational and reputational risk, but also at regulatory risk.

U.S. Commercial Real Estate Industry:  According to data provider Trepp, net new bank lending for commercial real estate is now growing at historically low levels.  Commercial real estate loans held by banks were only up about 1% from the same period one year earlier.  Since banks are the top source of funding for the sector, the slowdown in lending bodes poorly for commercial borrowers’ ability to roll over their loans as they come due, probably adding to the stress in the market today and pulling down commercial real estate values even further.

U.S. Auto Industry:  As we flagged in our Comment yesterday, the United Auto Workers on Monday struck a tentative deal for a new labor contract with General Motors (GM, $27.36), the last of the Big Three U.S. automakers it was striking.  The tentative deals mean that workers at GM, Ford (F, $9.77), and Stellantis (STLA, $18.00) can go back to work immediately.

• If approved by the companies’ UAW workers, the deals will raise wage rates by about 25% over the four-year life of the contracts, improve job security, and increase benefits.
• That will put pressure on the firms to cut other costs, potentially by investing in new labor-saving technologies.
• The deals may also encourage labor organizing, strikes, and higher wage demands beyond the auto industry.
• In any case, the deals will probably add to pressures shifting the share of national income toward workers and away from capital owners.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the latest on the Israel-Hamas conflict.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a preview of the Bank of Japan’s important new policy meeting starting today and a discussion of the U.S. labor market as the auto industry’s strikes look like they’re finally drawing to a close.

Israel-Hamas Conflict:  Over the weekend, the Israeli Defense Forces launched what Prime Minister Netanyahu called the “second stage” of Israel’s war against the terrorist Hamas government in the Gaza Strip.  While the initial stage focused on airstrikes targeted against Hamas leaders and military forces, the new stage has sent IDF ground forces into Gaza on extended incursions.  Meanwhile, Netanyahu is facing increased political peril for his perceived reluctance to take responsibility for the October 7 attacks by Hamas that started the conflict.  Over the weekend, Netanyahu blamed Israeli intelligence services for not warning him of the attacks beforehand, but he was forced to backtrack and apologize after his statement sparked a wave of criticism.

• So far, Israel’s new, extended ground incursions appear to be more focused and limited than many observers feared, suggesting Israeli leaders have heeded U.S. advice not to launch the feared massive ground invasion until they have a set of clear, realistic objectives and a plan to achieve them. The relative restraint being shown by Israel right now is a welcome development that could lower the risk of the conflict expanding into a regional conflagration.
• Nevertheless, Iranian-backed Hezbollah fighters in southern Lebanon continue to launch missile barrages into Israel, prompting Israeli retaliatory strikes and keeping alive the risk of escalation. Israel today also reportedly carried out airstrikes against military targets in Syria and against Palestinian targets in the West Bank.

Russia-Ukraine War:  Media analysts are reporting a surge in on-line disinformation aimed at discrediting Ukrainian President Zelensky and undermining Western support for military aid to Ukraine.  The disinformation, which is believed to have been placed by Russia, has appeared mostly on social media networks.  Nevertheless, U.S. and European officials are vowing continued support for Kyiv no matter what.

China-United States:  U.S. semiconductor giant Broadcom (AVGO, $838.36) and cloud software firm VMware (VMW, $142.20) said they will miss their goal to complete their $69-billion merger today, as Chinese authorities still have not provided their approval.  The firms still have time to complete the deal before their final contracted deadline of November 26, but there is increasing concern that China will continue to slow-walk its approval or even scuttle the deal in retaliation for the Biden administration’s latest clampdown on transferring U.S. advanced semiconductor technology to China.

China:  New analysis by the Financial Times suggests foreign direct investment in September was down a whopping 34% year-over-year, marking the largest decline since monthly records became available in 2014 and leaving monthly FDI at just $10 billion.  FDI in China has now been down by double-digit percentages on a year-over-year basis every month since May, reflecting increased pessimism regarding China’s structural economic headwinds (including poor consumer demand, high levels of debt, bad demographics, and foreign de-coupling), along with President Xi’s statist economic policies.

Japan:  The Bank of Japan begins a two-day policy meeting today, and when it releases its decision tomorrow, many observers believe it will signal that it is finally preparing to drop its longstanding policy of negative short-term interest rates and/or further modify its yield-curve control policy.  After expanding its tolerance band for 10-year government bond yields to 1.0% in July, some observers expect the policymakers to widen the band to 1.5%, while others believe they will abandon the limit entirely.

• Such policy modifications are increasingly likely as the yen (JPY) continues to weaken toward multi-decade lows.
• Recently, Japanese 10-year government bond yields have risen near 0.90%, suggesting increased market consensus that the policy band will be widened.

European Union-Australia:  EU and Australian officials hit an impasse in their negotiations for a free-trade deal, likely postponing any new talks or agreement until at least 2025.  Sticking points reportedly included the EU’s reluctance to open its market to Australian beef and sheep, and Australian resistance to the EU’s food-labeling requirements.  The failed deal is yet another example of how the last three decades’ trend toward ever-greater globalization has largely ended.

Germany:  Third-quarter gross domestic product fell by a seasonally adjusted 0.1%, slightly better than the expected decline but still almost enough to reverse the prior period’s small increase.  Germany’s economy continues to stagnate in the face of headwinds such as weak foreign demand, high inflation, and rising interest rates.  GDP in the third quarter was down 0.3% from the same period one year earlier.

U.S. Auto Industry:  On Saturday, the United Auto Workers reached a tentative agreement on a new labor contract with giant automaker Stellantis (STLA, $18.04), days after reaching a separate deal with Ford (F, $9.96).  The agreements have raised hopes that the UAW’s historic, six-month strike against the top three U.S. automakers may come to an end soon.  However, it’s important to remember that General Motors (GM, $27.22) continues to hold out.  To encourage GM to get in line with Ford and Stellantis, the union over the weekend expanded its strike against the company to include one of its key factories in Tennessee.

• The tentative deals with Ford and Stellantis still need to be voted on and approved by their respective union workforces.
• However, the overall contours of those deals suggest UAW workers at the firms will get a substantial pay raise spread over the life of the contract, better retirement and other benefits, improved work conditions, and job protections.
• As we have argued in the past, the labor shortages spawned by the mass retirement of Baby Boomers and other hurdles to employment during the pandemic have given workers greater bargaining power, prompting increased union demands and fast-growing wage rates.
  • Over time, that will likely shift a greater share of national income toward workers and away from capital owners. This will likely erode corporate profit margins.
  • Nevertheless, the impact on potential economic growth is still indeterminate. Since workers tend to spend a greater share of their income, stronger wage growth could potentially boost consumer demand.  Companies might also increase their investment in labor-saving equipment, offsetting some of the investment cuts they might otherwise adopt as profit margins tighten.

U.S. Retirement Investment Industry:  Under the Department of Education’s new rules for the Free Application for Federal Student Aid, pre-tax investments in retirement accounts will no longer be counted in a family’s income for purposes of calculating financial aid.  The change is expected to result in increased financial aid of $5,000 to $10,000 per year for many families.  Of course, it could also incentivize continued or increased retirement investing among those with kids in college.

U.S. AI Regulation:  Using emergency powers in the Defense Production Act, President Biden issued an executive order today that will force major artificial-intelligence companies to notify the government when developing any system that poses a “serious risk to national security, national economic security or national public health and safety.”  While rapid developments in AI are widely seen as promising great economic and social benefits, the new executive order aims to address various risks until a slow-moving Congress can study the technology and come up with a comprehensive regulatory scheme.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are off to a great start, and the Diamondbacks look to prove doubters wrong in the first game of the World Series. Today’s Comment begins with our analysis of the S&P 500’s recent poor performance, followed by a closer look at the GDP data and rising geopolitical risks in the Middle East and the South China Sea. As always, our report includes an overview of the latest domestic and international data releases.

Correction Coming? After getting off to a strong start to the year, large caps may have finally hit an inflection point.

• The S&P 500 closed below its 200-day moving average of 4,238.41 on Thursday, ending the day at 4,179.50. This dip below a key technical level has historically signaled a broader sell-off. The index’s fall was related to a confluence of negative factors, including rising yields on long-duration Treasuries, a war in the Middle East, and a deteriorating outlook for tech stocks. The last of the three has come under scrutiny due to their high valuations relative to earnings, as investors have been willing to pay a premium for companies with strong AI capabilities.
• The Magnificent Seven—Alphabet (GOOG, $123.44), Amazon (AMZN, $119.57), Apple (AAPL, $166.89), Meta (META, $288.35), Microsoft (MSFT, $327.89), Nvidia (NVD, $388.65), and Tesla (TSLA, $205.76)—have seen the least amount of losses since July 21, 2023, outperforming the broader tech sector and the overall S&P 500. Their strong performance is likely due to investor confidence in these companies’ ability to capture market share given their size and expertise. According to an analyst at Bernstein Quantitative, the Magnificent Seven are projected to have profit growth of 33.1% and revenue growth of 10.9% year-over-year, while the remaining companies are predicted to have profit contraction of 8.6% and revenue growth of 0.3%.

• Despite their strong performances, the Magnificent Seven remain more vulnerable to fluctuations than investors may realize, due to their sensitivity to idiosyncratic risk. This was evident in the sell-off in Alphabet and Meta stocks this week, despite both companies reporting strong overall earnings. Alphabet’s cloud business is struggling to meet investor expectations, while Meta’s forward guidance was weakened by changes in the macroeconomic landscape. Investors should keep in mind that the Magnificent Seven’s strong year-to-date performance is due in part to lofty expectations, and it is unclear whether these companies can live up to them. As a result, investors may find value by focusing on other companies with strong fundamentals that are being ignored.

Blowout Q3: The latest GDP report showed that the economy surged in the third quarter in another sign that a recession is not imminent.

• The U.S. economy grew at a robust 4.9% annual rate in the period from April to September, a significant increase from the 2.1% growth in the preceding three months. This sharp rise has raised doubts about the possibility of a recession, as the report showed that consumption remains strong even in the face of rising interest rates. Strong retail sales have boosted optimism that households have not yet run down their pandemic savings, raising the likelihood of a spillover effect into the following quarter. The report was also supported by strong inventories, but this is unlikely to persist.
• Despite strong consumption, GDP data shows that spending has shifted to smaller ticket items. Expensive and interest-sensitive goods like new and used vehicles declined in Q3, while recreational goods like TVs and PCs jumped. This may reflect households having more spending power due to higher wages, as firms compete to retain workers. The stubbornly low jobless claims reinforce this view as they show that labor hoarding is still rife throughout the economy. Assuming our assessment is correct, the economy may be more resilient to higher interest rates than investors realize.

• Despite the strong reading, the report is unlikely to sway policymakers at next week’s Federal Open Market Committee meeting. The yield on the 10-year Treasury fell 4 bps to 4.91%. Meanwhile, the CME FedWatch Tool shows that there is an 80% chance that the Federal Reserve will hold rates steady for the rest of the year. The indifference to the report reflects the broader sentiment that the market expects Fed officials to enter a new phase in its policy stance, in which it looks to navigate a soft landing. Projections show that the Fed will look to cut interest rates in the second half of 2024.

Rising Geopolitical Tensions: The chances of a broadening conflict in the Middle East are increasing, while tensions between the U.S. and China show no signs of abating.

• Israeli forces have undertaken another operation in Northern Gaza, with the aim of neutralizing Hamas fighters and disabling their anti-tank weaponry, as they prepare for an imminent ground invasion. Simultaneously, the U.S. military conducted airstrikes against two facilities located in eastern Syria, which were suspected of having connections with Iran-backed militia groups. These actions by the Israeli and U.S. governments have sparked concerns about the potential for escalating violence across the Middle East, which could result in disruptions in the sales of essential commodities. Following the report, Brent oil prices surged $2 per barrel overnight, hitting $90 per barrel.
• Across the Pacific, the U.S. and China have accused each other of provocations in the South China Sea. The situation started after a Chinese vessel collided with a Philippine boat on Sunday near the disputed Second Thomas Shoal. After the incident, President Joe Biden warned Beijing that the U.S. was willing to defend the Philippines from Chinese aggression. The row escalated on Thursday after a Chinese fighter jet was recorded flying within 10 feet of a U.S. Air Force B-52 bomber. China responded to the allegation by showing a video of a U.S. ship harassing a Chinese navy task group during routine training in the South China Sea.

• Despite strong advocacy for diplomatic mediation, geopolitical tensions and the ever-present risk of miscalculation loom large, significantly heightening the possibility of a major conflict. The situation in the Middle East remains precarious, with uncertainty surrounding the extent of Israel’s invasion of Gaza, while incidents in the South China Sea threaten a more extensive conflict in the Pacific region. Despite recent promising developments, such as a delay in Israel’s invasion and high-level talks between Washington and Beijing, the mounting geopolitical tensions underscore the potential for defense companies to deliver substantial value to investors in the coming years.

Other News: China’s former premier, Li Keqiang, died on Friday. He was seen as a rival of President Xi Jinping and as an advocate of the business class in China.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Concerns over earnings are weighing on equities, and Astros manager Dusty Baker announced that he is retiring. Today’s Comment begins with a discussion about the ECB’s latest rate decision. Next, we analyze the recent plunge in the yen and assess how political realignment may impact support for Ukraine. As always, our report includes an overview of the latest domestic and international data releases.

Throwing in the Towel? With high inflation and a looming recession, the European Central Bank is reluctant to predict the future path of policy.

• European policymakers held policy rates steady at their October 26 meeting, following 10 consecutive hikes. The decision to keep rates at their current levels comes amidst signs that euro area inflation has dropped. In September, the consumer price index rose 4.27% year-over-year, well below the previous month’s rise of 5.01%. At the press conference, ECB President Christine Lagarde reiterated the central bank’s commitment to containing inflation and its readiness to raise rates if necessary. While confident that inflation will continue to make progress, ECB President Christine Lagarde stated that the central bank will take a wait-and-see approach before deciding whether to hike rates again.
• In addition to interest rate uncertainty, the European Union faces concerns about implementing a bloc-wide 3% deficit-to-GDP target and a 60% debt-to-GDP ratio by its self-imposed January 2024 deadline. Although there isn’t an agreement in place, the plan is for EU members to resume their deficit and debt targets, which were temporarily suspended during the pandemic, and amend the fiscal rules to allow governments more flexibility in meeting targets over four years, with a possible seven-year extension in exchange for reforms and investments. Details of the arrangements are still being negotiated, with the sides far apart. The lack of guidance may force policymakers to hold rates tighter for longer to prevent inflation from arising from fiscal spending.

• The European Central Bank faces a more precarious predicament than the Federal Reserve when deciding future policy. Eurozone inflation is higher and growth is slower than in the United States, limiting policymakers’ flexibility to raise rates. On the other hand, policymakers may be reluctant to ease monetary policy on concerns that currency depreciation due to interest rate differentials could counterintuitively push up inflation. As a result, the ECB is more likely to hold policy steady for longer than the Federal Reserve, and rely more on other tools for tightening, such as raising the minimum reserve requirement.

Yen Troubles? The Japanese currency dropped to a 33-year low against the dollar on Wednesday, raising the likelihood of intervention from the Bank of Japan (BOJ) and a policy shift.

• The yen (JPY) closed at 150.25 per dollar on Wednesday, its lowest level since August 1990. The BOJ has stated that it was willing to intervene in exchange rate markets to prevent extreme swings in currency movements. Last October, the Bank of Japan intervened by selling dollars and buying yen, worth about $42 billion, after the JPY breached 150 to the dollar. Although BOJ officials have been mum about whether it is weighing another intervention, the central bank’s reputation of being the “widowmaker” has prevented analysts from betting big against the currency.
• The BOJ may tweak its yield curve control (YCC) policy at its next meeting on Monday, as currency weakness and rising inflation have fueled speculation about an end to its ultra-accommodative monetary policy. The 10-year Japanese government bond (JGB) yield is trading at 0.87%, its highest level in over 13 years, with the current YCC band set at 1.0%. A possible readjustment to the YCC band could reduce pressure on the currency and inflation, while also signaling to the market that the BOJ is transitioning away from its ultra-accommodative stance.

• The BOJ is likely to phase out its ultra-accommodative monetary policy in 2024, as inflation becomes a political problem for the ruling party. Earlier this week, the government announced that it plans to extend utility and gasoline subsidies through April to protect households from rising price pressures. This shift will impact global bond yields, as JGBs will offer more competition to other government debt, such as the U.S. Treasury. It will also hurt investors in the yen carry trade, as the resulting currency appreciation will make debt payments more expensive for borrowers that hold foreign currencies. Additionally, the change should act as a headwind for the USD.

War Fatigue? Political parties pushing to reduce financial support for Ukraine in its conflict with Russia are gaining popularity across the West.

• The U.S. elected its new House speaker following the end of a 22-day stand-off. Republican Representative Mike Johnson from Louisiana won the election to become the 56^th Speaker of the House. Despite having a relatively low profile prior to his win, he has been labeled the most conservative speaker by some publications. After taking the gavel, his first move was to approve aid for Israel in its conflict with Hamas. He is also expected to hold budget talks with the White House, which will likely include discussions on aid for Ukraine. While he has expressed support for Ukraine, he has been skeptical of using U.S. taxpayer money without proper oversight.
• Speaker Johnson is not alone in expressing concerns about how aid to Ukraine is being spent, as politicians in the United States and abroad have also raised doubts. Republican presidential candidate Vivek Ramaswamy has made opposing aid one of the tenets of his presidential campaign. Meanwhile, Germany’s populist AfD party has seen a surge of support in recent months and Slovakia has elected a president that is likely to push back against additional aid to Ukraine. While public support for Ukraine remains strong, public interest is waning.

• War funding is poised to become a central issue in the coming months, as governments grapple with a slowing global economy and elevated budget deficits. The U.S. budget talks will provide a glimpse into how other governments will handle this issue. If U.S. lawmakers struggle to reach a consensus, given their resilient economy, it will be even more difficult for EU countries on the brink of recession to do so. It is too early to gauge the West’s long-term support for Ukraine, but next year’s U.S. presidential election and EU parliamentary elections may provide some clues. Regardless of the outcome, the market will likely favor a quick resolution.

Other News: The U.S. found that a chip made by Huawei may have been made using machines subject to export controls. This discovery suggests that China may not have made as much advancement in semiconductor manufacturing as once feared, but it also raises questions about the effectiveness of export restrictions. Separately, the United Auto Workers (UAW) has reached a tentative agreement with Ford Motor Company (F, $11.54). The deal is likely to pressure other automakers to reach agreements with the UAW as well. Lastly, Israel is preparing to carry out its ground invasion of Gaza. The move raises the likelihood of a broader Middle Eastern conflict.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! S&P 500 futures are trading lower before the open and the Diamondbacks made it to the World Series for the second time in franchise history. Today’s Comment starts with a discussion about the resurgence of the S&P 500. Next, we will give our thoughts on the recent rally in bitcoin and China’s hardball tactics with foreign companies. As always, our report includes an overview of the latest domestic and international data releases.

There is Life: The S&P 500 rebounded after briefly testing the 4,200 support level earlier this week, but it doesn’t appear that the asset class is out of the woods yet.

• Strong earnings and positive economic data boosted the large-cap equity index performance on Tuesday. Several companies, including Verizon (VZ, $34.30), 3M (MMM, $90.12), and Coca-Cola (KO, $55.64), reported better-than-expected earnings, lifting sentiment that companies are becoming more profitable. Microsoft’s (MSFT, $330.12) results also supported an improved outlook, with the second-largest company by market capitalization rising 4% overnight after posting strong growth for its cloud services business. Additionally, S&P Global data showed that U.S. manufacturing activity entered expansion for the first time in six months, with the Purchasing Manager Index hitting 51. The report suggests that economic momentum from Q3 may carry over into the next quarter.
• However, negative news for the tech sector has dampened some of the S&P’s momentum. Google parent company Alphabet (GOOG, $140.12) reported a failure in its cloud services business, which overshadowed its estimate-beating revenue and earnings. Investors are concerned that Alphabet may not be able to catch up to rivals Amazon (AMZN, $128.56) and Microsoft, especially as it looks to make gains in generative artificial intelligence. Meanwhile, Meta (META, $312.55) is facing lawsuits from 41 different states and the District of Columbia, alleging that the tech giant has harmed children by making its platform too addictive. The allegation comes as lawmakers from both parties are becoming increasingly concerned with the impact social media is having on society.

• A sustained rally in large caps is far from assured, given the lingering risks both domestically and abroad. The Federal Reserve has maintained the possibility of another rate hike, defying suggestions that rate increases are coming to an end. Furthermore, concerns about an escalating conflict in the Middle East are growing, with the U.S. issuing a warning to Iran against exploiting the situation in Gaza to target American troops. This heightened uncertainty explains why the CBOE VIX index briefly exceeded 20 on Tuesday, as investors worry about more volatility over the next 30 days.

Crypto Rally: Investors have flocked to digital currencies, drawn by the prospect of exchange-traded funds based on crypto and rising global tensions.

• A federal judge ruled against the SEC in its bid to block Grayscale’s Bitcoin ETF on Monday. The regulator argued that the ETF lacked adequate oversight to detect fraudulent activity and manipulation. Earlier this week, the SEC stated that it will no longer contest the ruling, boosting optimism that it was ready to allow Grayscale’s Bitcoin Trust to become a listed BTC ETF. So far, regulators have not approved a single spot crypto ETF to be listed on U.S. exchanges but have paved the way for similar investment vehicles containing futures for bitcoin and ether.
• The ongoing conflict in the Middle East has prompted investors to flock to digital currencies as safe-haven assets. Bitcoin rose 7% in the days leading up to the court’s ruling and following the outbreak of the Israel-Hamas conflict. Comparatively, gold price futures rose about 8% within the same period. Bitcoin’s strong performance has led to optimism that it may be maturing past the early adoption stage and into a legitimate asset class. Several asset managers have argued that cryptocurrencies can be used to diversify geopolitical risks similar to other hard assets.

• Despite cryptocurrency’s recent momentum, we remain skeptical of its readiness for widespread adoption. Persistently low trading volumes and a 30-day moving average below pre-stablecoin crash levels suggest that confidence in the asset class remains relatively low, making it vulnerable to substantial price fluctuations. Additionally, significant regulatory challenges loom ahead, including demands for more oversight of the crypto industry, especially related to anti-money laundering. Senators Elizabeth Warren (D-MA) and Kristen Gillibrand (D-NY) are pushing their party to take a stand against the industry. Consequently, we believe that more traditional hard assets and commodities are better suited for conservative investors looking to hedge against geopolitical risks.

Companies Must Choose: Beijing is increasingly assertive in pushing foreign companies to lobby their governments for better trade ties with China.

• Chinese regulators opened an investigation into Foxconn (2354.TW, TWD, 53.30), a Taiwan-based Apple (AAPL, $173.44) iPhone supplier, over alleged tax and land violations. The crackdown appears to target Terry Gou, the company’s founder and largest shareholder, who is running as a long-shot independent candidate in Taiwan’s presidential election in January. Although he has stated that he would push to improve ties between the sovereign island and Beijing, he has maintained that he will not be bullied. The probe has unnerved investors, suggesting that Beijing may be preparing to crack down on other foreign multinational companies as well. Shares of the Foxconn’s stock have dropped 2.2% over the past two days.
• Beijing’s heavy-handedness may have discouraged Western companies from taking sides in the escalating feud with China. Mercedes-Benz (MBGYY, $16.26) CEO Ola Källenius has walked back his claims that China was a potential growth market by describing it as maturing. Tesla (TSLA, $216.52) CEO Elon Musk has warned that the U.S. no longer has a significant edge over its geopolitical rivals and could be defeated in a conflict. European auto suppliers have advocated for regulators to focus on creating incentives for cheaper car production in Europe instead of imposing tariffs on Chinese car imports. However, many companies have responded to China’s actions by redirecting investments to other countries.

• China’s decision to target companies that do not comply with its demands comes with significant risks. Increased pressure on foreign businesses could lead them to seek out alternatives, undermining China’s efforts to attract foreign investment to resolve its debt problems. Additionally, China’s tactics could encourage governments to increase scrutiny of Chinese investment. U.S. regulators are already cracking down on Chinese partnerships and purchases of American tech companies, and this trend could spread to other industries. The growing friction between the West and China suggests that domestic companies with exposure to the other’s market may become less attractive as global tensions rise.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Israel-Hamas conflict.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including weak economic indicators in the eurozone and the United Kingdom, and a discussion of the U.S. government’s deficit situation as shown in a new data release.

Israel-Hamas Conflict:  The Israeli air forces and intelligence services continue working to set conditions for their expected ground assault against Hamas in the Gaza Strip, while Western leaders urge steps to minimize civilian casualties.  Meanwhile, U.S. Defense Department said the USS Dwight D. Eisenhower and her strike group will now be sent to the waters around the Persian Gulf and Red Sea, rather than joining the USS Gerald R. Ford and her strike group in the eastern Mediterranean as originally planned.  The U.S. will also deploy additional air defense systems to the region.

• The moves follow a series of small attacks on U.S. forces in Syria, Iraq, and near Yemen. They also highlight how the Israeli-Hamas fighting could broaden if regional Islamist groups escalate their sympathy attacks on U.S. interests or military units in the region.
• In the event of a substantial Islamist attack on U.S. interests or military units in the region, a self-defensive or retaliatory attack by U.S. forces could potentially prompt Iranian forces to join the fray. And even worse scenario would be if the half-dozen or so Chinese navy ships in the region came to the aid of the Iranians or the Islamist fighters.

China:  President Xi today officially signed an order firing Defense Minister Li Shangfu, nearly two months after he disappeared from public view.  Xi also signed an order removing former Foreign Minister Qin Gang, who was sacked in a similar way in July, from the State Council.  The Li and Qin cases have sparked rumors of corruption and misbehavior, but they could also reflect internal power politics.  Given China’s opaque leadership, it is impossible to know for sure at this point.

Hong Kong:  Recent data shows Western firms are increasingly leaving Hong Kong on fears that it is being subsumed into the Chinese economy and legal system.  The city’s own data shows the number of U.S. companies operating in Hong Kong has now fallen for four straight years, to 1,258 in June 2022.  Mainland Chinese firms with regional headquarters in Hong Kong now outnumber U.S. firms with regional offices there, for the first time in at least three decades.  While we often note how China’s geopolitical, economic, and legal environment are becoming less amenable to investment, it appears that Hong Kong is now in a similar situation.

Eurozone:  The S&P Global “flash” composite purchasing managers index for October fell to a 35-month low of 46.5, significantly below the consensus expectation of 47.4 (all in seasonally adjusted terms).  As shown in our “Foreign Economic News” section below, the decline in the composite index reflected weaker readings in both the manufacturing and the service-sector indexes.  Like most major PMIs, this one is designed so that readings below 50 indicate declining activity.

• Today’s reading will therefore raise concerns about a further economic slowdown in Europe and stronger headwinds for European stocks because of factors such as high inflation and high interest rates.
• The data is adding to speculation that the European Central Bank will hold interest rates steady at its meeting later this week. Nevertheless, ECB chief Lagarde continues to suggest rates will remain high and won’t be cut again for some time.

United Kingdom:  Similar to the eurozone’s data, the U.K.’s S&P Global/CIPS composite PMI for October came in at a seasonally adjusted 48.6, nearly as weak as the September reading of 48.5 and enough to indicate continued weakness in the British economy.

U.S. Politics:  In the House of Representatives, the majority Republicans yesterday held a forum for the nine candidates now seeking to be speaker, with each laying out their strategy for pushing forward party priorities such as cutting federal spending.

• No single candidate appeared to have a lock on the party, but press reports say the strongest support is swinging toward:
  • House Majority Whip Tom Emmer of Minnesota,
  • Republican Study Committee Chair Rep. Kevin Hern of Oklahoma,
  • House Republican Conference Vice Chair Rep. Mike Johnson of Louisiana, and
  • Byron Donalds of Florida, an ally of former President Donald Trump.
• The Republicans will vote to select their candidate for Speaker this morning, with a floor vote planned in the coming days.

U.S. Fiscal Policy:  The Treasury Department has finally released its report on federal revenues, outlays, and deficits for the fiscal year ended in September.  However, the overall deficit figures for FY 2023 and the prior year are distorted because of the way the department accounted for the entire cost of the administration’s proposed student-loan forgiveness program in just one month, i.e., September 2022, as we showed in a recent Asset Allocation Bi-Weekly Report.  After the courts negated that program, the department reversed its accrual all in August 2023.  The budget deficit therefore looks bigger in FY 2022 than it really was on a cash-accounting basis, and narrower in FY 2023.

• As reported, federal receipts in FY 2023 totaled $4.439 trillion, down 9.3% from the previous year. Federal outlays totaled $6.134 trillion, down 2.2% from the prior year.  That resulted in a reported deficit of $1.695 trillion, versus a shortfall of $1.375 trillion in FY 2022.
• One simplistic way to correct for the student-loan program’s accrual accounting would be to strip out its recognized cost of about $383 billion from the monthly figure for September 2022 and add it back in August 2023. Doing so would result in a FY 2022 deficit of roughly $1.312 billion and a FY 2023 deficit of about $1.758 billion.  The chart below shows how the rolling 12-month totals for federal receipts and outlays would look with this adjustment.
• The adjusted chart clearly shows the widening gap between federal outlays and receipts. As we noted in our Asset Allocation Bi-Weekly Report, we still think there will be some fiscal tightening in the coming quarters from developments like the end of the temporary student-loan payment moratorium.  Nevertheless, the current expansion in the federal deficit is likely an important reason for the recent surge in bond yields.

U.S. Labor Market:  The United Auto Workers yesterday announced the union would expand its strike against the major automakers to include the largest pickup-truck factory of Stellantis (STLA, $18.94).  The move came despite the company’s offer last Thursday to boost wages by 23% over the life of the new contract being negotiated, and to increase the firm’s retirement plan contributions by 50%, along with added job security.  The UAW’s tough bargaining reflects how the tight labor market has strengthened labor’s bargaining power and likely portends continued sharp increases in wage rates and higher consumer price inflation in the coming years.

U.S. Energy Markets:  Helped on by the seasonal transition to cheaper winter blends, average prices for unleaded gasoline have fallen recently to just $3.51 per gallon, close to the lowest levels of the year.  The fall in gas prices could help offset the recent rise in interest rates and student loan repayments, thereby buoying consumer spending in the coming months.

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