by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Gold prices are rising as investors eagerly await the Federal Reserve’s next policy decision, while Gerrit Cole has been named the American League Cy Young Award winner. Today’s Comment delves into the reasons behind the surge in investor risk taking being fueled by optimism over a possible end to interest rate hikes, the potential easing of commodity inflation next year, and Xi Jinping’s softening stance towards certain adversaries. As always, our comprehensive report summarizes the latest domestic and international data releases.

Monetary Inflection Point? Risk appetite has started to pick up as investors are growing confident that monetary tightening is over.

• Recent economic data suggests that central banks are making progress towards their inflation targets. The Bureau of Labor Statistics (BLS) released data earlier this week showing that producer prices (PPI) rose 1.4% since October 2022, while consumer prices (CPI) increased 3.2% in the same period. This trend is also evident in other countries, with the eurozone and the U.K. both making headway toward achieving their respective 2% inflation targets. While policymakers have not ruled out further rate hikes, fed funds futures contracts indicate a 97.3% probability that the central bank will hold rates steady at its next meeting and an 81% likelihood of a rate cut by June 2024.
• Expectations of a Fed pivot have led investors to diversify away from safe assets. The Bloomberg indexes for global bond and dollar performances have also reflected the recent shift in risk sentiment. The investment-grade debt index from a multitude of countries has surged 3.1% in the past two weeks, recouping half of the losses it had incurred since mid-July. This impressive rally aligns with the Bloomberg Dollar Index, which indicates a similar resurgence of global currencies against the greenback within the same period. While this market response to economic data is encouraging, some investors remain cautious, recognizing that underlying uncertainties may reverse the present trend.

• In the near term, this shift might provide some respite for investors who have endured losses in riskier assets earlier this year. Notably, the weakening U.S. dollar should uplift emerging market equities. However, the sustainability of this trend remains uncertain. Much of the performance of the dollar and risk assets has been driven by expectations of central banks halting their tightening cycle, which may or may not materialize. Nevertheless, investors should also be mindful that as monetary policy concerns recede, attention may shift back to GDP growth, which could favor U.S.-denominated assets due to the country’s robust economic outlook.

Commodity Price Pressures: Increased supply and weakening demand are expected to put downward pressure on food and other commodity prices going into 2024.

• Global food prices are expected to fall next year, according to agribusiness lender Rabobank’s annual outlook. A key factor driving this downward trend is the surge in production resulting from firms seeking to capitalize on higher prices. Prices for sugar, coffee, corn, and soybeans are all expected to be impacted by the projected increase in supply. Conversely, China’s anticipated growth in copper output is likely to keep metal prices below 2022 levels in 2024. S&P Global Market Intelligence expects the London Metal Exchange’s three-month price per metric ton to hit $8602 in 2024, below its $8784 from two years prior and roughly in line with this year’s estimated price of $8596. However, copper prices are expected to spike in 2025 and onwards.
• On the demand side, there are also indications that commodity prices may face resistance. Rabobank forecasts that slower economic growth due to higher interest rates and elevated prices could dampen demand. Several major economies are already teetering on the brink of recession. The German economy is projected to contract by 0.3% in 2023. Meanwhile, China’s economic woes are expected to persist into the following year. The lack of growth across the globe could make it more challenging for commodities to sustain their current price levels.

• The moderation in commodity prices offers a glimmer of hope amidst the looming threat of a global economic downturn. The anticipated easing of food inflation should provide a much-needed boost for emerging markets, where high food prices have historically been linked to social unrest. Moreover, the relaxation of commodity pressures is likely to contribute to global efforts to curb inflation. If these supply and demand dynamics persist, the improvement in commodity prices could facilitate economic growth for non-commodity producers, even in the face of a potential recession.

Xi’s Delicate Dance: The Chinese president faces difficulties in fostering cordial relations with his Indo-Pacific rivals.

• President Biden’s seemingly impromptu remark calling Xi Jinping a “dictator” during a post-meeting Q&A session likely altered the tone of their discussions. Prior to this comment, the two leaders had reportedly engaged in productive talks, agreeing to collaborate on combating fentanyl trafficking and reestablishing military communication channels. Following his meeting with Biden, Xi is expected to meet with Japanese Prime Minister Fumio Kishida on Thursday. The two will likely discuss the recent detaining of well-known Japanese businessman Hiroshi Nishiyama on suspicion of espionage. His imprisonment has raised concerns about China’s recent crackdowns on foreign workers.
• Xi Jinping’s recent efforts to cultivate stronger ties with the international community underscore his determination to revitalize China’s economy, which has encountered hurdles following its stringent pandemic lockdowns. While investment spending has traditionally been a cornerstone of China’s growth, its aversion to accumulating debt necessitates a diversification of growth strategies. Trade emerges as an appealing option as it would allow the country to preserve its manufacturing base while alleviating deflationary concerns. In October, headline CPI dipped 0.1% year-over-year, while core CPI increased by 0.7%. A possible reset in relations with China and its rivals may help lead to an increase in its net exports which have been a drag on growth.

• Xi’s recent overture should not be misinterpreted as a change of heart. He has offered no indication that he is prepared to retract his willingness to decouple from the U.S. or remove his country’s backing of Russia. Therefore, the thaw in intentions is likely a tacit acknowledgment that he does not desire an abrupt end to relations with the world’s largest economy. However, this does imply that he may be more focused on addressing domestic challenges rather than settling historical scores such as the reunification of Taiwan, suggesting that the risk of conflict between the two largest economies may be diminishing.

Other News: West Virginia Senator Joe Manchin announced that he is contemplating a presidential bid. His inclusion adds another layer of complexity to an already crowded field, further clouding the outlook for the 2024 election. The GM-UAW contract is expected to be approved, thus reducing the chance of another strike. The Senate approved the stopgap spending bill to keep the government funded into 2024. This sets up another fight in two months but should calm nerves about disruption to governmental operations.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with new impediments to U.S. investments in China.  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, new signs of economic weakness and falling inflation pressure in Europe, and House passage of a new stopgap funding bill for the U.S. government.

United States-China:  The U.S.-China Economic and Security Review Commission, an advisory panel on China policy, issued a recommendation yesterday that Congress pass a law forcing U.S. publicly traded companies to disclose how their investors are exposed to risks related to China.  For example, the commissioners recommended that the companies disclose the percentage of their total assets in China, their joint ventures with Chinese firms, the amount and nature of research and development they undertake in China, and the influence of any employee associated with the Chinese Communist Party in corporate decision-making.

• If passed, the disclosure requirement would be yet another impediment to U.S.-China capital flows.
• Separately, the Federal Retirement Thrift Investment Board, which oversees approximately $771 billion of retirement savings for federal workers, said today that it will change the benchmark index for its international fund to avoid exposure to stocks listed in China or Hong Kong, citing increased U.S.-China geopolitical tensions.
• Finally, we note that President Biden and President Xi plan to meet for four hours today at the Asia-Pacific Economic Cooperation summit in San Francisco. At the end of the meeting, Biden and Xi are expected to announce a number of smaller-scale agreements.  More broadly, the summit may help slow the current downward spiral in U.S.-China relations.

Taiwan:  The country’s top two opposition parties, the China-friendly Kuomintang and the Taiwan People’s Party, have struck a deal to field a joint ticket in January’s presidential election.  The deal aims to help the opposition compete better against Vice President Lai Ching-te, the leading candidate of the ruling Democratic Progressive Party, which has forged tighter ties with the U.S. and is currently leading in the polls.

Israel-Hamas Conflict:  Hours after the U.S. officially backed Israeli assertions that the Hamas government in Gaza places military command posts in hospitals, the Israel Defense Forces said they launched a targeted strike against Hamas personnel in the territory’s besieged Al-Shifa Hospital.  The IDF says the raid turned up weapons and other “concrete evidence” that the facility was being used as a Hamas command post.  The IDF says that evidence will be shared publicly in the near future.

• Meanwhile, Hamas authorities say Israel’s airstrikes and other attacks on Gaza during the conflict have now killed about 11,000 people, many of them noncombatant women and children. If that figure is accurate at all, it is certainly brutal and horrifying, and it reflects an apparent policy decision by the Israeli government to defang Hamas no matter what the cost to civilians or to Israel’s own reputation and political support.
• Still, given that Gaza had a population of about 2.0 million at the start of the conflict, 11,000 dead (and perhaps tens of thousands injured) seems low enough to suggest that the IDF really is taking some care to avoid hurting civilians. Besides, other reports suggest that up to 50% of all the structures in Gaza have been destroyed or severely damaged by Israel’s attacks.  If that translates to 11,000 structures hit, it suggests “only” one death and perhaps several other injuries for each structure targeted.

European Union:  In a new sign that the European economy is failing to keep up with activity in the U.S., the European Commission today cut its 2023 growth forecasts for both the broad EU and the eurozone.  In each region, the commission now forecasts that gross domestic product this year will expand just 0.6%, compared with a forecast of 0.8% in September.  The faltering growth reflects a range of problems, from high inflation and interest rates to weaker global demand for European exports.

United Kingdom:  In another sign that inflation pressures are easing worldwide, the U.K.’s October consumer price index was up just 4.6% from the same month one year earlier, less than expected and much less than the 6.7% increase in the year to September.  Excluding food, energy, and other volatile categories, the October core CPI was up an annual 5.7%, versus 6.1% in the year to September.  Signs of cooling inflation have boosted hopes that the Bank of England can forego further interest-rate hikes and may even start to cut rates in 2024.

Russia-Ukraine War:  The Ukrainian government has struck a deal with major insurers to provide war-risk coverage for ships carrying grain and other foodstuffs out of Ukrainian ports.  After Russia withdrew from a safe-passage deal with Ukraine over the summer, Kyiv has managed to get several ships moving out of its ports, but the new deal could further boost the country’s agricultural shipments, bolstering global supplies and helping hold down prices.

• Separately, EU officials are looking for new ways to clamp down on Russian oil revenues following recent reports that Moscow is largely circumventing the West’s $60-per-barrel cap on its exports.
• One proposal would have Denmark stop, inspect, and potentially impound tankers carrying Russian oil through Danish waters without Western insurance, under laws permitting states to check vessels they fear pose environmental threats.
• If implemented, the plan would naturally be high risk, potentially producing serious naval tensions in the Baltic region.

U.S. Fiscal Policy:  The House of Representatives yesterday passed Speaker Johnson’s two-step stopgap funding measure to keep some federal departments operating until mid-January and others until early February.  Since many of Johnson’s own Republican Party voted against the bill because it lacked spending cuts and other positions favored by the far right, passage of the measure required the votes of many Democrats.

• The “continuing resolution” now moves to the Senate, where prospects appear to be good that it will pass and be sent to President Biden to be signed into law.
• Nevertheless, even if the bill passes and averts a partial government shutdown this weekend, there will still be the chance of a fresh impasse and potential shutdown when the new bill expires early in 2024.

U.S. Labor Market:  Despite the national sigh of relief when the United Auto Workers and the major U.S. automakers struck a tentative deal on a new labor contract, workers at several plants run by General Motors (GM, $28.20) have voted to reject the deal.  That puts the GM tally to date at about 50%, with voting set to continue for another week or two.  In contrast, the proposed deals at Ford (F, $9.86) and Stellantis (STLA, $20.25) are on track to be approved by comfortable margins.  The neck-and-neck voting at GM is a further reflection of just how empowered workers feel in the midst of today’s labor shortages.

U.S. Consumer Price Inflation:  In the interest of acknowledging contrarian viewpoints, we note that the Wall Street Journal today carries an interview with Cathy Wood, the founder of ARK Investment Management and a major technology-stock cheerleader, in which she argues that new technologies and falling commodity prices will lead to a future of deflation rather than inflation.  Of course, this could simply be an instance of Wood “talking her book,” since lower inflation implies lower interest rates and higher valuations for long-duration stocks like technology start-ups.  We continue to believe that consumer price inflation in the coming decades will be higher and more volatile than in the post-Cold War period of relative peace and globalization over the last three decades.

• It’s difficult to forecast inflation rates over such a long period, but we would not be surprised if they average between 3.0% and 4.0% between now and mid-century, versus the average of 2.5% over the last 30 years (see chart below).
• While technology advancements will help bring down some costs, we think that will be offset by factors such as:
  • The global economy’s fracturing into relatively separate blocs;
  • The shift to less efficient global supply chains;
  • The relocation of production back to relatively expensive countries in the West;
  • Increased corporate and government investment spending to support those shifts;
  • Higher commodity prices because of recent under-investment and the expected weaponization of supplies by the China/Russia bloc;
  • Population aging and its associated labor shortages; and
  • Potential increases in consumer spending as lower-skilled workers gain a bigger part of national income.

U.S. Financial Markets:  After driving stock and bond prices sharply higher yesterday, the euphoria over yesterday’s report of falling inflation as measured by the consumer price index appears set to continue today.  After the S&P 500 stock price index surged 1.7% yesterday, it and all the other main U.S. equity indexes are pointing to a higher open at the moment.  Precious metals are also a bit firmer today, but longer-maturity bonds have given back some of yesterday’s rally, pushing yields up modestly so far this morning.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with new data suggesting Russia is now almost completely getting around the West’s $60 price cap on its oil exports, potentially setting up new Western efforts to clamp down.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a slowdown in British wage growth that could help ease consumer price inflation in the U.K. and the latest on efforts in the U.S. Congress to avoid a partial shutdown of the federal government, which could begin this weekend.

Global Oil Supplies:  New analysis shows virtually all of Russia’s seaborne oil exports are now selling for more than the $60-per-barrel cap that Western nations have tried to enforce as a way to limit Russian revenues for its invasion of Ukraine.  The Group of Seven countries and Australia had some initial success when they tried to enforce the cap by banning insurance and other services for shipments priced above $60 per barrel, but now it appears the Russians have learned to circumvent the ban with tactics such as buying up and using old tankers without Western insurance and falsifying price certifications.

• It should be no surprise that the $60 cap has been circumvented. From time immemorial, government efforts to control trade have been undermined by smugglers and sanctions busters.
• Nevertheless, the West’s restrictions on trade have probably imposed additional costs on Russian oil exports. Even if the oil is sold at prices above $60, the profitability of that oil and the revenues it provides to the Kremlin have probably been reduced.
• In any case, the wide circumvention of the ban has prompted Western officials to start discussing ways to tighten the cap. If such tightening happens, it could potentially reduce global oil supplies and help buoy energy prices.

China-Taiwan:  The Central Election Commission of Taiwan has certified the independent candidacy of Terry Gou, the founder of Foxconn (HNHPF, $5.93), for the presidential election coming up on January 13.  Although Gou is currently trailing the three main candidates in opinion polls, Beijing is concerned that he will drain support from its preferred candidate, the Kuomintang Party’s Hou Yu-ih.

• The Chinese government has recently opened a large-scale investigation into Foxconn’s tax and land-use practices in China, in a move that has been widely interpreted as an effort to pressure Gou to drop out of the race. Company officials say they are bracing for additional such measures from China.
• Foxconn is best known as a supplier to Apple (AAPL, $184.80), and it is the key assembler of the company’s flagship iPhone. Additional Chinese pressure on Foxconn to force Gou out of the Taiwanese race could therefore potentially have an impact on Apple.

United States-Asia-China:  After launching its Indo-Pacific Economic Forum last year to promote trade between the U.S. and the rest of the region and to loosen countries’ economic ties to China, the Biden administration has unexpectedly withdrawn its support for IPEF measures designed to ease cross-border data flows and coordinate labor standards.  The retreat on free data flows apparently stemmed from administration efforts to tighten regulations over U.S. technology firms, while the retreat from labor standards came at the request of at least one U.S. lawmaker facing a tough election.

• Because of domestic political opposition, the U.S. is currently precluded from offering traditional tariff cuts and reduced import barriers to tease Indo-Pacific countries away from China’s economic pull. The administration, therefore, hoped that IPEF’s non-tariff measures would be attractive enough.
• Without the promise of free data flows and common labor standards, the IPEF deal will lean heavily on less attractive features, such as initiatives related to supply chains, clean energy, anti-corruption measures, and taxation.
• Perhaps most significant, the pullback from free data flows suggests the U.S. may soon adopt Chinese-style restrictions on data transfers. If so, it’s a sign that the fracturing of the world into relatively separate geopolitical and economic blocs, which we’ve been writing about so much, will disrupt not only trade, capital, and technology flows between the U.S. bloc and the China/Russia bloc, but it will also disrupt data flows.

United States-China Travel:  New research by the Institute for International Education shows the number of U.S. citizens studying in China fell from more than 11,000 in the 2018-2019 academic year to just 211 in 2021-2022.  The figures suggest many U.S. students have been put off by the Chinese government’s draconian pandemic shutdowns and aggressive law enforcement actions.  Although the number of Chinese students in the U.S. remains about 290,000, the study illustrates how global fracturing is disrupting human travel and migration, just as it’s disrupting inter-bloc trade, capital, technology, and data flows.

United States-China Summit:  When President Biden and General Secretary Xi meet tomorrow at the Asia-Pacific Economic Cooperation summit in San Francisco, they will reportedly announce a deal under which China will clamp down on companies exporting the precursor chemicals for fentanyl, the synthetic opioid that has spread addiction and death throughout the U.S.  They are also expected to announce a deal to reopen military communication channels that Beijing shut after then-U.S. House Speaker Pelosi visited Taiwan in August 2022.

European Union:  Recent data indicates the EU’s labor market is softening much more dramatically than the U.S.’s, especially in the industrial powerhouse of Germany and other northern countries.  Much of the problem can be traced to weakening demand overseas and high energy costs.  Higher unemployment will likely impose new fiscal burdens on EU governments but could also weaken inflation pressures, discourage further interest-rate hikes, and hold down the value of the euro.

United Kingdom:  Average wages in July through September, excluding bonuses, were up 7.7% from the same period one year earlier, marking a modest deceleration from the year-over-year increase of 7.9% in May through July.  Total pay was up 7.9% on the year, versus 8.5% in the prior period.  The figures point to a modest cooling in wage pressures, which could help bring down consumer price inflation in the U.K. and allow the Bank of England to hold off on further interest-rate hikes.

U.S. Fiscal Policy:  In the House of Representatives, at least half a dozen Republican lawmakers have come out against Speaker Johnson’s proposed two-part stopgap funding bill, which aims to avoid a partial government shutdown when the current stopgap expires on Friday.  Since the Republicans only control 221 seats in the chamber, while the Democrats have 213, the defections from Johnson’s own party mean his measure would likely need the support of at least some Democrats to advance the bill to the Senate, where its prospects seem better.  At this point, prospects for a partial government shutdown this weekend appear to be too close to call.

U.S. Labor Market:  Industry groups say the demand for seasonal workers during the upcoming holidays will be much cooler than in recent years, with public advertisements for such workers at the lowest level in a decade and hiring intentions down about 40% from their recent high in 2021.  Individual companies are also reporting relatively modest hiring plans.  Weaker demand for seasonal workers suggests the overall labor market is softening, which is likely to contribute to slower wage growth and weaker economic growth.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the latest on the West’s slowing demand for electric vehicles.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an easing of data regulations in China and a proposal by House Speaker Johnson for a two-step stopgap funding bill to keep the federal government functioning after the current stopgap expires on Friday.

Global Electric Vehicle Industry:  As incoming data continues to point to a slowdown in the West’s demand for electric vehicles, new research by HSBC (HSBC, $37.03) indicates dealers in key markets now have to offer discounts from the vehicles’ suggested retail price.  For example, the average discount in October was 11% in the U.K., 10% in the U.S., and 7% in Germany.

• The slowdown in demand reflects a range of factors, from the high price for EVs, rising interest rates, concerns about recharging and safety, and political attacks.
• If it continues, the slowdown threatens to undermine what has been seen by some as a promising new investment sector and a source of new economic growth.
• Nevertheless, at least some companies are continuing to invest in the sector. In news this morning, oil giant Exxon (XOM, $103.75) announced it is starting to drill for lithium in Arkansas and aims to become a major U.S. supplier for makers of EV batteries by 2030.

United States-China:  When President Biden and General Secretary Xi meet on Wednesday at the Asia-Pacific Economic Cooperation summit in San Francisco, they will reportedly announce an agreement not to incorporate artificial intelligence into autonomous weapons, such as drones, or into the command and control of nuclear weapons.  We haven’t seen any details on the deal, but if it is substantive, it would suggest that U.S. and Chinese diplomats have been able to make more progress on cooling bilateral tensions than earlier expected.

• On the other hand, any ban on military AI announced at the meeting could be much less than meets the eye. One big hurdle to such a ban is that verification might be difficult.  If neither side can verify with confidence that the other side isn’t deploying military AI, the deal could have little practical effect.
• Moreover, it is questionable whether Beijing would countenance or abide by such restrictions. Chinese military doctrine and official statements make clear that the People’s Liberation Army not only intends to bulk up to the point where it can compete with the U.S., but also intends to fully leverage AI and other technologies to bolster its warfighting capabilities.

China:  Information provider Qichacha announced that the Cyberspace Administration of China has approved its data export security plan, which will allow the company to offer databases of Chinese corporate information in other countries.  The approval of Qichacha’s plan is a sign that Beijing may be easing its recent draconian limits on providing Chinese information to foreigners.

• Coupled with a range of other government intrusions into business operations, the data export limits have helped sour foreign businesses on China, likely contributing to the recent sharp drop in foreign direct investment into China.
• Easing up on the data export rules and other regulations may be an effort by Beijing to reattract foreign capital and reverse China’s ongoing slowdown in economic growth.

Spain:  Over the weekend, tens of thousands of protestors marched in cities across the country to register their anger at Prime Minister Sánchez’s gambit to win parliamentary support for his Socialist Party government by offering amnesty to Catalan separatists.  The move has sparked especially strong condemnation by right-wing populists, who accuse the prime minister of allowing the Catalan separatists, who held an illegal referendum on independence in 2017, to achieve a “coup.”  The political crisis could potentially weigh on Spanish assets despite the country’s relatively good economic performance recently.

United Kingdom:  Prime Minister Sunak today replaced Home Secretary Suella Braverman, a controversial right-wing firebrand, with Foreign Secretary James Cleverly.  He also named former Prime Minister David Cameron, a moderate who campaigned against Brexit and resigned when the measure passed in 2016, to take over the foreign ministry.

• The moves apparently aim to drag the Conservative Party back toward the political center and close its massive polling gap with the Labor Party ahead of the next election.
• Nevertheless, they could spark increased chaos in the Conservative Party, as Braverman now seems likely to launch a bid to replace Sunak as prime minister.

Israel-Hamas Conflict:  Illustrating many of issues involved in the fighting, the Israel Defense Forces are focusing much of their invasion force on Gaza’s Al-Shifa hospital to destroy what they say is a Hamas command post located in the facility and in tunnels underneath it.  The IDF has demanded that Hamas abandon the hospital, but the militants have refused.  Meanwhile, the hospital has virtually run out of fuel, electricity, food, and medical supplies.

• The IDF claims it delivered supplies to a location about 1,000 feet from the hospital, but they were not retrieved. Hospital officials say the fighting has been too intense to collect the supplies, but it isn’t clear whether Hamas actually prevented them from doing so.
• Separately, a key foreign policy advisor to the president of the United Arab Emirates warned that Israel’s “unparalleled” and “disproportionate” attacks on civilians threaten to spark increased radicalization in the region.
• Indeed, Iran-backed Hezbollah fighters and other Islamist groups continue to attack Israel from the north, keeping alive the risk that the conflict will spread regionally.

U.S. Military:  The Air Force’s future heavy bomber, the B-21 “Raider,” made its first test flight on Friday, about two years later than initially planned.  The sixth-generation bomber, with its flying-wing design and advanced capability to network with other platforms, is designed to replace the aging B-1 and B-2 starting later this decade.  Its mission will be to deliver either strategic-nuclear or conventional weapons around the world to deter U.S. adversaries such as China, Russia, Iran, and the rest of Beijing’s geopolitical bloc.

• The Air Force currently plans to buy at least 100 units of the B-21, at a projected cost of about $750 million each.
• The Defense Department continues struggling to ramp up the output of weapons, ammunition, and supplies as geopolitical tensions rise, but the launch of the B-21 is a reminder that it is making some progress. Other ongoing programs to modernize the U.S. strategic deterrent force include replacing the Air Force’s Minuteman III intercontinental ballistic missile with a new “Sentinel” missile and replacing the Navy’s Ohio-class ballistic missile submarines with new “Columbia-class” subs.

U.S. Fiscal Policy:  As Congress continues to bicker over fiscal policy ahead of this Friday’s expiration of the current stopgap spending authorization, Moody’s (MCO, $344.57) at the end of last week cut its outlook on U.S. Treasury debt from “stable” to “negative.”  Moody’s remains the last of the major credit-scoring firms to give the Treasury its top debt rating, but it warned that the outlook is worsening because of political polarization, expanding federal budget deficits, and worsening debt sustainability.

• With federal spending rising rapidly while tax revenues wither, the widening budget shortfall was probably a contributing factor to the run-up in longer-maturity bond yields over the last couple of months.
• With the current stopgap funding bill set to expire on Friday, newly installed Speaker of the House Mike Johnson has proposed a “laddered” new stopgap measure that would keep the government funded at current levels until early 2024. Under the proposal, some departments would be funded at their current levels until late January, while others would be funded at their current levels until early February.
  • The new continuing resolutions would give lawmakers more time to come up with a deal on funding for the rest of the fiscal year, which runs to September 30.
  • A vote on Johnson’s proposal could come as early as Tuesday.

U.S. Labor Market:  New analysis by the Federal Reserve Bank of Atlanta shows lower-skilled workers are now seeing much more moderate wage growth than in the first two years of the post-pandemic period.  For example, average hourly earnings for workers in the bottom quartile of the wage distribution were up just 5.9% in the year to October, versus a 7.2% rise in the year to January.

• The end of out-sized wage gains for lower-skilled workers suggests the economy is continuing to normalize from the pandemic era’s disruptions.
• Nevertheless, their exceptionally large previous wage gains mean that those workers are now capturing a larger share of total wage income, potentially reducing wage inequality and allowing them to consume more in the coming years.

U.S. Commercial Real Estate Market:  New analysis by the Wall Street Journal shows that lenders this year have issued a record number of foreclosure notices on mezzanine loans and similarly risky loans connected with commercial properties.  Mezzanine loans, similar to second mortgages, can be foreclosed much more quickly than first mortgages, so the rapidly rising number of foreclosures provides a more real-time view into the financial stresses caused by rising vacancies and higher interest rates.  As the Federal Reserve raises interest rates or keeps them higher for longer, the commercial real estate and/or private debt sectors are probably the most likely domestic source of financial crisis or a recession.

 

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Gold has retreated on Powell’s monetary policy comments, and the National Women’s Soccer League has signed major TV deals. Today’s Comment begins with our thoughts on declining demand for U.S. government bonds. We then discuss the impact of geopolitical competition on the semiconductor industry, and the political ramifications of Senator Joe Manchin’s (D-WV) decision not to run for re-election. As always, our report includes a summary of the latest domestic and international data releases.

Auction Flop: A Treasury bond auction drew weaker-than-expected demand, raising concerns about the path of interest rates.

• Thursday’s auction of 30-year government bonds yielded 4.769%, 5 basis points higher than the start of pre-auction trading, reflecting investors’ reluctance to buy long-duration debt. Wednesday’s Treasury auction also underwhelmed expectations. This poor performance has raised concerns that the bond market may be struggling to absorb new U.S. debt issuance. Following the auction, the S&P 500 sank 0.8% and the NASDAQ fell 0.9%, ending the duo’s longest winning streaks in almost two decades. The market reaction suggests that investors are concerned about the Federal deficit and the lack of participation from the Federal Reserve in the bond market.
• Treasury auctions have become more important than employment data in recent months, according to research from Citi Global Markets. After analyzing 22 Treasury auctions, the bank found that equity sales have fluctuated more after Treasury auctions than on the day the jobs data is released. This may explain why the stock market rallied earlier this month after the Treasury announced that it would sell $112 billion in fixed-income securities, less than the $114 billion primary dealers had expected. The growing importance of Treasury sales underscores concerns that bondholders’ appetite for U.S. debt is waning.

• The scarcity of bond buyers is likely to push up interest rates and tighten financial conditions, as investors demand higher yields to compensate for the liquidity risk. This trend will persist unless policymakers take steps to control the federal deficit, or the Fed expands its balance sheet. Policy rate cuts may also relieve some of this pressure on long-duration securities by discouraging investors from purchasing shorter-duration bonds. Uncertainty about high interest rates will likely lead to increased scrutiny of risky assets, as investors assess the potential impact of higher borrowing costs on corporate earnings. However, the lack of demand for Treasury issuance reduces the chance of another rate hike from the Federal Reserve.

Semiconductor Slump: Despite a strong start to the year fueled by excitement about AI, chipmakers’ profits have slipped due to weak demand and a growing supply of semiconductors.

• The PHLX Semiconductor Sector Index has plummeted 11% from its peak in August 2023, drastically outpacing the 3% decline in the S&P 500 from the same period. This is driven by a pessimistic outlook after last year’s chip shortage turned into a glut. However, recent earnings reports from Samsung Electronics Co.(005930.KS, KRW, 70,500) and Taiwan Semiconductor Manufacturing Co.(TSM, $91.62) have offered a glimmer of hope for a reversal, as both companies suspect that the market is inching closer to balancing. Meanwhile, Chinese chipmaker Semiconductor Manufacturing International Corp. (SMIC) has voiced concerns that growing geopolitical competition within the space could lead to overcapacity.
• SMIC’s concerns appear to be a veiled criticism of U.S. efforts to stifle China’s advancement in chipmaking. The Biden administration has imposed export controls that make it more difficult for China to develop chips for military technology. Additionally, the U.S. has allocated resources to build its own domestic chip fabs to reduce its reliance on Taiwan, a major chipmaking hub. China has responded by increasing its spending on semiconductor production. This increased competition has led to a surge in investment in semiconductor production, as both countries seek to insulate themselves from possible supply chain disruptions.

• The easing of tensions between the United States and China is unlikely to improve the outlook for the semiconductor industry, as both sides are seeking to reduce their reliance on the other. As a result, chipmakers are likely to face increased competition, as the massive investments in semiconductors should lead to a battle for market share. This could make technology more affordable in the long term, as firms struggle to maintain market power in an environment where new entrants are likely to emerge. However, the lack of market dominance could also make it difficult for firms to maintain healthy profit margins.

Senate Majority in Danger? West Virginia Senator Joe Manchin’s decision not to seek reelection in 2024 gives Republicans a prime opportunity to flip a Senate seat.

• Manchin’s decision not to seek reelection in 2024 jeopardizes the Democratic Party’s control of the U.S. Senate. The party will struggle to find a replacement for the moderate Manchin, as there is no apparent frontrunner in the race. West Virginia has a long history of favoring Republican candidates, and former President Donald Trump won the state by a nearly 40% margin in 2020. If the Democrats lose Manchin’s seat, the Senate will likely fall into Republican hands. The seat is favored to switch to Conservative West Virginia Governor Jim Justice, and it isn’t clear whether the Democrats will look to save it.
• Senator Manchin’s decision not to run for re-election may be related to the growing demand for a third-party challenger in the 2024 presidential election. He has long been associated with the bipartisan No Labels political party, and in his announcement, he mentioned a desire to test the level of support for a candidate who could bring the middle together. So far, several challengers have thrown their hats in the ring, including Harvard Professor Cornel West, environmentalist Jill Stein, and environmental lawyer Robert Kennedy. While third-party candidates are often seen as spoilers, it is unclear whether any of these candidates can swing the election.

• The entrance of third-party candidates increases the likelihood of a contingent election, in which no candidate wins the 270 electoral votes required to win the presidency outright, which has not occurred since 1877. In this case, the Constitution requires the House of Representatives to choose from the top three candidates who received the most electoral votes. Each state gets one delegate, and a candidate needs to receive at least 26 delegates to secure the nomination. The last time this happened, the Democratic and Republican candidates agreed to give the presidency to Republican Rutherford B. Hayes in exchange for the end of Reconstruction in the South. Markets would likely react poorly to this outcome, as it would call the legitimacy of the government into question.

Other News: China is investigating a ransomware attack on the U.S. unit of the Industrial and Commercial Bank of China. The attack on U.S. Treasuries disrupted trading and reflects the ongoing battle to develop the cyber infrastructure needed to prevent hackers from accessing sensitive information. Israel is concerned over a possible war with Hezbollah, in another example of the risk of a spreading Middle East conflict. Cleveland Fed President Lorretta Mester is set to resign in 2024, and she will likely be replaced by another policy hawk. Fed Chair Jerome Powell has warned that Fed officials may look beyond data when determining whether inflation is improving.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equity markets are treading cautiously ahead of Fed Chair Jerome Powell’s speech, while Real Madrid advances to the Champions League knockout stages for the 27^th consecutive year. Today’s Comment begins with why investors should remain cautiously optimistic about the shift in central bank sentiment. We then give our thoughts on the potential impact of proposed bank regulation changes, and how the Republican debate may hint at future foreign policy direction. As always, our report includes a summary of the latest domestic and international data releases.

Policy Sentiment Shift: Bond investors are convinced that rates have already peaked. However, policymakers seem less certain.

• After reaching their October highs, global bond yields have embarked on a downward trajectory. The 10-year Treasury yield has plummeted nearly 50 basis points since its peak two weeks ago, mirroring the retreat observed in its British and German counterparts, which have shed 40 and 30 basis points, respectively, during the same period. This surge in bond demand has extended to mortgage rates, with the average 30-year fixed-rate mortgage experiencing a 25 basis point decline in a week, settling at 7.61%. The collective pause adopted by central banks has fueled investor speculation about a potential bond rally, leading to a renewed interest in fixed-income securities.
• While investors appear to believe that central banks have concluded their rate-hike cycle, central bankers themselves remain more cautious. Bank of England Governor Andrew Bailey has decisively dismissed speculation of a policy easing in mid-2024, underscoring the ongoing struggle against inflation. Echoing this sentiment, Bank of Canada Governor Tiff Macklem has warned that the lingering effects of energy price shocks could hinder inflation control efforts. Reinforcing this cautious outlook, Federal Reserve Governor Michelle Bowman and Minneapolis Fed President Neel Kashkari have hinted at the possibility of further interest rate increases to ensure inflation’s return to the 2% target.

• The future course of monetary policy will largely hinge on expectations for economic growth. While concerns about a potential recession in 2024 are mounting, similar worries were prevalent at the beginning of this year. One encouraging aspect is the continued resilience of the labor market across the developed world. Even Canada, which experienced a technical recession in the third quarter, boasts an unemployment rate of 5.7%, below its historical average of 7.6%. Most evidence suggests that even if there is a downturn, it is likely to be mild. Hence, a recession may not be enough to pivot policy, especially if inflation returns.

Regional Banks: Several months after endangering the financial system, small to midsize lenders may begin another chapter.

• Regulators want to limit bank access to funds from Federal Home Loan Banks (FHLB). The decision comes after lenders relied heavily on the $1.3 trillion system meant to encourage mortgage loans to meet their short-term funding needs after the fall of Silicon Valley Bank. Several months after the March banking turmoil, FHLB had over $880 billion in outstanding loans to U.S. banks and credit unions. The Federal Housing Finance Agency (FHFA) has proposed requiring banks to hold 10% of their assets in mortgage loans, establishing new safeguards for lending to struggling banks, and implementing stricter stress tests.
• The new rules are designed to help FHLB return to their original mission of supporting banks in providing loans to potential homebuyers, but banks argue that the regulators are overreaching. The banking industry has rejected claims that its problems were due to a lack of regulation and instead are blaming the Federal Reserve’s lack of guidance. JPMorgan CEO Jamie Dimon has ridiculed policymakers for being “dead wrong” on inflation and pleaded for the Fed to show greater humility, given its proposal for more capital requirements. The pushback suggests that regulators may not be able to implement all the changes they want to protect the banking system.

(Source: Federal Reserve)

• New capital restrictions would complicate banks’ efforts to lend across the country. The latest Senior Loan Officer Opinion Survey (SLOOS) shows that banks are already tightening their lending standards, particularly for non-government-backed and non-residential loans. If these rules are implemented, they could dampen the potential stimulative impact of a pivot in Fed policy, which is likely to be less aggressive than in previous easing cycles. This may mean that when the Fed does decide to make the policy change, it might be less successful in generating demand than in previous easing cycles, especially if the rate cuts are modest as we would expect.

Rethinking Defense: Although all Republican presidential candidates have voiced support for Israel in its fight against Hamas, they have taken a more Jeffersonian stance on other foreign policy issues.

• During the debate, most candidates expressed skepticism about further funding for Ukraine. Former UN Ambassador Nikki Haley said the U.S. should support Ukraine by sending weapons, not aid. Entrepreneur Vivek Ramaswamy argued that Ukraine’s occupied areas should remain with Moscow. Republican Gov. Ron DeSantis of Florida and Sen. Tim Scott of South Carolina both expressed concerns about how the money is being spent. In contrast, former New Jersey Gov. Chris Christie was the only candidate to show restraint, warning that the cost was warranted to prevent another world war.
• Their wariness regarding Ukraine comes as Americans are voicing more concern about deteriorating law and order in the United States. A recent Gallup poll showed that Americans’ perception of safety has fallen to its lowest level in five years. The most frequently proposed solution to the rising crime problem discussed on the debate stage was to increase security along the U.S.-Mexico border. Candidates also proposed finishing the border wall and possibly designating drug cartels as foreign terrorist organizations. China was also mentioned, with Haley vowing to stop all trade with the world’s second-largest economy until it prevents fentanyl from entering the U.S.

• The candidates’ notable tone on the debate stage suggests that a sizeable Republican base may now prefer a more Jeffersonian approach to foreign policy, with a focus on domestic issues over global affairs. While the United States may not completely abandon its leadership role in the world, it may need to redefine that role to be more palatable to a populace that has grown tired of its hegemonic status. This could involve off-budget spending programs similar to the Lend-Lease Act or aid packages with strings attached akin to the Marshall Plan.

Other News: Bank of Japan Governor Kazuo Ueda has stated that the central bank will proceed cautiously as it moves away from its ultra-accommodative policy. His remarks suggest that Japanese policymakers may be averse to significant changes in policy. Hollywood actors and studios have reached a tentative agreement to end the 118-day strike, with new restrictions on the use of artificial intelligence technology. The agreement reflects labor concerns about the threat that AI poses. Spanish Prime Minister Pedro Sánchez and the Catalan separatist Junts have reached an agreement that could pave the way for a new government.

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