by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will be broken down into three sections: 1) How the rising U.S. dollar is impacting other countries; 2) How political fracturing in Spain and Brazil is representative of a global trend; and 3) What trade and investment flow data says about the U.S.-China relationship.

Dollar Soaring: The U.S. dollar hit its highest level in six months on Wednesday in a troubling sign for global currencies.

• Investors are flocking to the dollar as a safe haven currency, attracted by the U.S. economy’s resilience in the face of global economic headwinds. The latest Institute for Supply Management (ISM) non-manufacturing index unexpectedly rose from 52.7 to 54.5 in August, beating expectations of 52.5. Similarly, last week’s employment data also exceeded expectations, with the U.S. economy adding 187,000 jobs in July, slightly above projections of 174,000. The better-than-expected numbers have led to speculation that the Federal Reserve will favor at least one more rate hike before the end of the year.
• In contrast, Europe and China are experiencing more signs of economic slowdown in their respective regions. Private sector surveys showed that service activity in China expanded at its slowest pace in eight months in August, while business activity in Europe fell deeper into contraction territory. The divergence in growth expectations has weighed on their respective currencies, with the EUR hitting a three-month low and the Chinese yuan (CNY) falling to its lowest against the USD since December 2007. As a result, policymakers at the European Central Bank and People’s Bank of China are likely to use more aggressive policies to prevent further depreciation.

• Central bankers are in a difficult spot. The strengthening dollar is expected to worsen price pressures related to rising commodity prices. On Wednesday, oil prices hit $90 a barrel for the first time in 2023 after Saudi Arabia and Russia agreed to extend voluntary production and export cuts. The combination of a strong dollar and rising commodity prices will likely weigh on global growth by making it more expensive for governments to repay dollar-denominated debt and import energy. As a result, central bankers may be less willing to provide stimulus, which could further dampen economic activity.

Unusual Coalition: Embattled leaders in Spain and Brazil make unsavory deals to stay in power.

• Spanish Prime Minister Pedro Sánchez is considering granting amnesty to Catalan separatists in exchange for their support in forming a government, but only if they also agree to back key legislation over the next four years. Talks between the two sides have not yet begun, but Sánchez’s party is working on a stability pact with the Junts per Catalunya party. If successful, this would allow Sánchez to remain in power. Still, he risks alienating some of his base who are uncomfortable with his perceived concessions to separatist groups within the country. Hence, his party popularity may take a hit.
• Brazilian President Luiz Inácio Lula da Silva reached a deal with the right-wing Progressistas (Progressive) and Republicanos (Republican) parties to secure their support for his agenda. In exchange for the support of these two parties, Lula agreed to give up two seats in his cabinet. The pact is estimated to expand Lula’s support from 250 deputies to 320 out of a possible 513. The growing coalition should make it easier for him to push through difficult legislation such as tax reform. However, there is hope that conservative members of his coalition will be able to check his more radical proposals.
• Political polarization has caused gridlock in the legislatures of Spain, Brazil, and other countries around the world. This has made it difficult to pass legislation, leading to inaction on important issues and the rise of extremism. Situations such as the 2023 attack on the Brazilian Congress and the Catalan Independence referendum in 2017 are examples of how toxic politics have become over the last decade. Although markets sometimes perform well in this environment as the inertia reduces uncertainty about a sudden change in policy, the fragmentation of the electorate suggests that this is not sustainable in the long term, particularly in emerging markets.

 Sino-American Divorce: Economic data for the United States and China shows the two are going their separate ways.

• The latest phone developed by Huawei (002502, CNY, 2.57), the Mate 60 Pro, has led to concerns that China has been able to circumnavigate export bans. The phone caught the eye of U.S. regulators as it was able to download at faster speeds than many of the top 5G phones on the market, including the Apple’s (AAPL, $177.20) iPhone 14 Pro. This has raised questions about whether Huawei has been able to obtain components from American companies in violation of the export bans, as it was widely believed that its Chinese semiconductor producer SMIC (0981, HKD, 19.82) is not known for its advanced chip-making capabilities. In an attempt to get more Chinese consumers to buy phones made domestically, Beijing has banned the use of the iPhone for Government workers.
• Frictions between the two largest economies have started to impact trade and capital flows. In July, the annual change in American imports of Chinese goods fell to its lowest since 2006. Additionally, Chinese companies have started to reduce foreign direct investment (FDI) into the U.S. and instead invest in countries with access to U.S. markets, such as South Korea and Mexico. In 2022, Chinese inflows into the U.S. fell to the lowest level since 2009. At the same time, the U.S. government is trying to restrict American investment in Chinese companies, particularly those linked with strategic ties to Beijing’s military.

• The shifting trade and capital flows between China and the United States highlight the intention of the two countries to reduce their economic dependency on one another. As mentioned in previous reports, we do not expect this to happen quickly, but rather gradually over the next few years. This process will likely be beneficial for countries that have exposure to both China and the United States, such as Mexico and South Korea mentioned previously, but also could include countries such as India, Vietnam, and Indonesia.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning.  Risk markets are under pressure again this morning, with rising Treasury yields raising investor fears.  Rising interest rates are also lifting the dollar.  The JPY is challenging recent lows, and traders are watching for central bank intervention.

In today’s Comment, we start our coverage with a roundup of economic factors.  Up next is our international overview, followed by news on the war in Ukraine.

 Economic Roundup:  The Fed looks set to pause, and a government shutdown may be looming.

• Fed Governor Waller was on CNBC yesterday and signaled that the FOMC was likely to “proceed carefully,” suggesting the committee will stand pat at the next meetings, scheduled for September 19 and 20. Currently, fed funds futures are projecting with near certainty that the policy rate will be held steady.  We also note these futures are leaning toward steady policy from here, although with much less conviction.  Waller tends to lean hawkish, so his remarks are probably a solid signal of steady policy.
  • Although there is ample evidence that the FOMC isn’t united on the future path of policy, Chair Powell has a remarkable ability to forge a consensus on policy. In fact, he has the best track record for the fewest dissents of all the Fed chairs in the post-Treasury agreement era.  The table below shows the chairs since 1951 and the number of dissents divided by the number of meetings over which each chair presided.  By far and away, Powell has been able to create consensus on the FOMC when compared to his predecessors.  It’s hard to know his secret; it’s possible that the members during his tenure have been simply less combative, although that would be hard to determine.  We will have a better understanding five years from now when the full meeting transcripts are released.  In general, policy dissents would be expected to increase volatility.  So, in this regard, Powell is probably, in a small way, holding down market uncertainty.

• Congress is set to name Phillip Jefferson as vice-chair of the Federal Reserve. Although widely expected, Jefferson is likely to lean dovish and thus will give the dovish members of the FOMC more influence.
• Congress averted a shutdown last spring, but it’s starting to look like it will be hard to avoid one later this month. Speaker McCarthy is struggling to move his caucus to a budget deal and probably can’t pass a budget without Democratic support.  McCarthy is trying to keep the government open, and hold his position as speaker, a pair of goals that is looking increasingly tenuous.  Government shutdowns tend to lower bond yields as spending stops and the Treasury reduces its borrowing.  However, coming on the back of recent downgrades, a shutdown now might have a different outcome.
• This has been the summer of labor unrest, as several large companies are either facing the threat of strikes or have decided to capitulate to their unions. The Biden administration finds itself in a difficult spot as these negotiations unfold.  On the one hand, the president fashions himself as a friend of labor, but on the other, strikes in key industries will hurt the economy and massive contract gains could spark inflation.  The president is running for re-election and wants to avoid both a downturn and another spike in price levels.  Thus, the White House is mostly staying out of the contract fights.  Although this is one way to avoid the dilemma we outlined above, it won’t necessarily help him with union voters.
• Although yearly apartment rental rates are in a clear downtrend, the overall number doesn’t capture suburban versus city costs. Reports suggest that suburban rental rates are soaring.

• Announcements from Saudi Arabia and Russia indicating that they will maintain production cuts through year’s end sent oil prices higher. The rise in oil prices, coupled with lingering logistical issues caused by the war in Ukraine, are raising diesel prices which then tend to filter into goods prices.
• As U.S. bank regulators are spinning out new regulations, especially on bank capital, American lenders are looking with envy at Europe. European regulators are taking a lighter touch with their banking system.
• As pandemic savings are exhausted, households are increasing their use of credit cards. Delinquencies on credit cards and auto loans are moving higher.  The expected recession from policy tightening has been avoided so far, in part, because the economy has become less sensitive to interest rates.  However, we may be starting to see evidence that elevated interest rates are having a detrimental effect.
• Japanese investors, fearful of inflation, are increasing gold purchases.
• Europe is implementing new regulations on technology platform providers. The Digital Markets Act will force tech providers to allow more competition on their platforms, reduce data collection by the platforms, and provide companies operating on the platforms easier access to their customer’s data.  The tech firms are not pleased.

 International Roundup:  The defense industry is globalizing and there is a race to gain access to Pacific islands.

• With the growing U.S. aversion to free trade deals, there is a concern that it may be difficult for Washington to build alliances to isolate the Russia/China/Iran axis. Allowing allies to run trade surpluses with the U.S. was a key element in America’s alliance system that isolated the Soviet bloc during the Cold War.  Because such policies are politically untenable at present, we have been closely watching to see if policymakers can create an alternative to trade.  It appears that globalizing supply chains for military spending is becoming one substitute.  As nations begin to rebuild their militaries, the U.S. is “friend-shoring” production to create a broader supply chain.
• China’s anti-access/area denial (A2/AD) strategy is designed to prevent the U.S from moving expensive naval assets into close proximity to a military theater. China has designed missiles and expanded its submarine force to counter U.S. aircraft carriers as part of this strategy.  One way to respond to China’s strategy is to put bases on islands and other land masses around China.  Last week, we noted that the U.S. was recommissioning mothballed facilities in Asia for this purpose.  At the same time, Beijing won’t passively allow the U.S. to engage in this policy.  On Monday, Vanuatu established a new government following a no-confidence vote.  The new PM, Sato Kilman, replaces Ishmael Kalsakau, and is thought to be more friendly to China than his predecessor.  We expect China and the U.S. to actively woo these Pacific nations for defense purposes.
• As Commerce Secretary Raimondo began her visit to China, Huawei (002502, CNY, 2.65) unveiled its new 5G smart phone, a device that apparently houses semiconductor chips that the U.S. is trying to prevent China from acquiring. The announcement was pointed, suggesting that U.S. efforts to restrict China’s access had failed.  In the wake of this announcement, the U.S. is “seeking information” and may add new sanctions.
• In what is being called a mistake, President Biden is not going to the ASEAN meetings next week, sending VP Harris instead as his replacement. If Washington’s goal is to woo Asian nations to the U.S.’s “side,” such no-shows make little sense.  What hurts the optics is that the president is making visits to Vietnam and India.  However, we also note that President Xi is not going to the G-20 meeting in New Delhi, so perhaps we are seeing unforced errors on both sides.
• Southern Europe is facing a deluge, with record rains causing widespread flooding.

War in Ukraine:  The slow offensive may be gathering speed and Russia “woos” Cubans.

• Ukrainian sources suggest that the entrenchments the Ukrainian military is facing are not as strong as what they dealt with initially. The Russians, in anticipation of the offensive, built extensive fortifications, but these comments indicate that progress may be underway.  SoS Blinken is traveling to Kyiv this week and is expected to offer an additional $1.0 billion in aid.
• Cuba has uncovered a trafficking ring, where Russians are trying to encourage Cubans to fight in Ukraine. Havana is not pleased with this development.
• Oil and gas rigs in the Black Sea are becoming targets in the conflict. Given the already tight supplies, this development is another bullish factor for oil and gas prices.
• Kim Jong-un is visiting Russia, with the expectation that Moscow wants to source military equipment from the Hermit Kingdom.  Pyongyang is said to be seeking missile and nuclear warhead technology.  Washington has warned North Korea that it will “pay a price” for cooperating with Russia.  However, given how heavily sanctioned Pyongyang is already, it’s hard to see what additional measures could be implemented.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with Chinese economic news.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including shocking new revelations about corruption in Mexico and unsettling news that the United Auto Workers are increasingly likely to go out on strike against one or more major U.S. automakers.

China:  In a bid to bolster confidence and investment among private businesses, the National Development and Reform Commission said it will set up a new bureau to coordinate government policy for the private sector and improve conditions for non-state owned firms.  However, the bureau’s leadership won’t hold vice-ministerial rank, which suggests it won’t be a heavyweight in policymaking.  That’s consistent with the way that Beijing’s recent economic initiatives have appeared to be half-measures with only limited prospects for boosting growth.

• Separately, major housing developer Country Garden (CTRYY, $3.10) narrowly averted a default on $1 billion of its international bonds by paying $22.5 million in overdue coupons just before their grace period expired.
• Despite the company’s success in averting a default this time around, its recent troubles are a reminder that China’s property developers remain in dire straits as the government works to rein in their debt and as home buyers pull back.

China-United States:  The Wall Street Journal yesterday published a story saying Chinese nationals, sometimes posing as tourists, have entered U.S. military bases and other sensitive defense sites as many as 100 times in recent years.  The “gate crashers” appear to be practicing a nontraditional form of spying under the direction of their handlers in Beijing.  Since many of these amateur spies can only be charged with state or local trespassing crimes, the growing problem has sparked an effort in Congress to tighten up federal security laws.

China-India:  As we noted in our Comment on Friday, the Chinese government has published a controversial new “official” map that shows chunks of India and other countries as belonging to China.  New reporting now suggests the map may have been a response to India’s announcement in mid-August that it would move forward with the construction of a dozen new hydroelectric dams in the Himalaya mountain range, including in areas claimed by both India and China.  The Chinese government also continues to build its own hydroelectric dams in the disputed region.  The competing dams illustrate how resource disputes are an important but little-appreciated aspect of the worsening relations between the two countries.

Russia-Ukraine War:  Amid rumors of procurement and recruitment corruption, Ukrainian President Zelensky has named a new defense minister in the midst of the country’s ongoing effort to push out the invading Russians.  The new defense minister will be Rustem Umerov, a Crimean Tatar who was formerly the head of Ukraine’s state property fund and a special presidential envoy.

• Separately, U.S. intelligence reportedly indicates North Korean leader Kim Jong Un will soon meet Russian President Putin in Russia to discuss further North Korean arms deliveries to support the invasion of Ukraine. The meeting would highlight Russia’s dwindling arsenal and inability to rebuild it as the war continues.
  • The meeting would also highlight how countries in the China/Russia bloc are increasingly cooperating in military affairs. A separate report today indicates Russian Defense Minister Shoigu recently invited Pyongyang to participate in joint Chinese-Russian-North Korean naval exercises.
  • In turn, Russia’s proposal for three-way naval drills is consistent with the way it has been leaning on its large, capable, blue-water navy to boost its position in the China/Russia bloc.
• In still other Russia-related news, the high-level general arrested in connection with Wagner mercenary leader Prigozhin’s June insurrection has reportedly been released. However, it isn’t clear whether the general, Sergei Surovikin, is still subject to restrictions or could still be punished for his prior knowledge of the insurrection.
• Finally, after meeting with Turkish President Erdoğan, President Putin said Russia won’t rejoin the deal allowing Ukraine to export grain through the Black Sea unmolested unless the West does more to ease Russian food shipments. Erdoğan insisted that progress was being made on that demand, but Putin’s position has raised the chance that more Ukrainian food products will be kept off the market, potentially boosting grain prices.

Iran:  The International Atomic Energy Agency issued a report that Tehran sharply slowed its production of enriched uranium over the summer, adding just 7.5 kg of 60% enriched material in the three months to August after producing 51.8 kg in the previous six months.  Coupled with Iran’s recent release of two U.S. citizens from prison to home confinement, the slowdown in enrichment could mean Tehran is responding to backchannel efforts to ease tensions with the U.S. and the rest of the West.

Mexico:  A blockbuster story in the New York Times over the weekend sheds new light on the infamous disappearance of 43 college students near Acapulco in 2014.  Based on some 23,000 previously unknown wire taps by the U.S. Drug Enforcement Agency, which were provided to Mexico only last year, the story says the students were killed by a local drug cartel merely because it wrongly believed them to be members of a rival gang.  The tragedy unfolded when the students, from a nearby teachers’ college, marched into a small town that served as the cartel’s stronghold.  In what appears to have been essentially a college prank, they commandeered buses to go to Mexico City for a political protest.  However, the cartel had so successfully corrupted the local military units, police, and public officials, that it was able to kill the students and incinerate their bodies with impunity.

• The story highlights the depth of corruption among Mexican public officials, who are often on the payroll of the country’s drug cartels. In small towns like the one where the student massacre happened, the cartels can have a virtual monopoly on government power.  In fact, the DEA was reluctant to share its wire taps with Mexican officials precisely because it feared they would pass the taps on to the cartels.
• The corruption in the Mexican government remains a key hurdle to its development and an important impediment to investment by both local businesses and foreign firms, in spite of the opportunities presented as U.S.-China tensions prompt companies to shift production out of Asia.

Argentina:  The running mate of radical libertarian presidential candidate Javier Milei has touched off a controversy by holding an event that appeared to justify the crimes of the rightwing military dictatorship that ruled the country from 1976 to 1983.  Nevertheless, Milei remains the frontrunner for the October election, where voters will give their judgement on his plans to dramatically shrink the Argentine state, shut down the central bank, and dollarize the economy in an attempt to control rampant inflation.

U.S. Labor Market:  Various reports suggest it is increasingly likely that the United Auto Workers will go out on strike when their current labor contract with the top U.S. automakers expires on September 14.  Given UAW President Shawn Fain’s maximalist demands and the reluctance among auto firms, some observers say the only question is whether the union will strike just one of the Big 3, or all at the same time.

• Separately, new analysis of last week’s employment report shows that local government payrolls—which are dominated by school employees—have still not recovered from the coronavirus pandemic.
• Because of mass teacher retirements, furloughs, and the inability to attract new educators and staff because of low pay, local government employment is now stuck at about 2018 levels, even as students have already begun to return to the classrooms.

U.S. Green Energy Investing:  Even as high interest rates and shifting sentiment have soured some investors in green energy recently, big players like BlackRock (BLK, $706.19) are reportedly pouring money into battery recyclers.  Their big investments are based on the premise that battery recyclers will thrive into the future even when the government’s green subsidies end.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will contain three themes: 1) Why Thursday’s inflation report is unlikely to change central banks’ rate decisions later this month; 2) How China’s new map complicates its effort to build a coalition of emerging economies to challenge the G-7; and 3) How political brinkmanship is preventing the U.S. from addressing its debt problems.

Hold the Pause: Central bankers continue to leave the door open for another rate hike later this year despite signs of a slowdown in economic activity and price pressures.

• The Federal Reserve’s preferred inflation gauge, the PCE price index, rose 3.3% in July from a year ago, and was up from 3.0% in June. Core PCE inflation, which excludes food and energy prices, rose 4.2% year-over-year, up from 4.1% in June. The increase in headline PCE inflation was driven primarily by persistently high housing and utilities prices, which were impacted by base effects. However, the increase in core PCE inflation was not as large, suggesting that underlying inflation pressures may be starting to ease. In July, the annualized monthly change in headline and core PCE inflation was 2.6% and 2.5%, respectively.
• Preliminary data showed that inflation in the euro area stagnated in August. The annual change in the region’s Consumer Price Index (CPI) rose 5.3% from the prior year, in line with the previous month’s reading. Much of the rise in inflation in the region was driven by energy. Core CPI, which excludes energy and food, slowed modestly from 5.5% to 5.3%. Despite inflation still being more than double the central bank’s 2% mandate, there are signs that price pressures are easing. Monthly data showed annualized core inflation slowed from 4.54% to 3.46% last month.

• The inflation report is not expected to sway policymakers’ rate decisions. Although goods inflation has been declining, services inflation remains a problem. Service inflation accounted for nearly all of the increase in the July PCE report and still outpaces the overall CPI index in the euro area. This is likely to remain a significant concern for central bankers as they decide whether to raise rates at the next two meetings. We expect that there is, at most, one hike remaining this year, with rate increases being a toss-up next year as countries weigh the likelihood of a downturn.

China Playing Defense: Beijing is seeking to avoid isolation in the Indo-Pacific after releasing a controversial map that claims territory from several of its neighbors.

• China released a new national map on Monday, claiming disputed territory in the South China Sea and land territory also claimed by India. The map has been met with criticism from several countries, including the Philippines, Malaysia, and India. Beijing has defended the map, saying it is simply correcting what it sees as misrepresentations of its territorial borders. However, the map has further inflamed tensions between China and its neighbors and has raised concerns about China’s growing assertiveness in the region. In a sign of Beijing’s dissatisfaction with India’s objection to its new map, Chinese President Xi Jinping has decided not to attend the G-20 meeting in New Delhi next week.
• To prevent other rifts from escalating, China has made overtures to its rivals, offering to mediate tensions and taking other steps to improve relations. In mid-August, Chinese and U.S. military officials met at a defense conference in Fiji to restore dialogue following former House Speaker Nancy Pelosi’s decision to travel to Taiwan last August. China had also backed a three-way summit that included South Korea and Japan that would encourage cooperation between the three countries. These moves suggest that China still favors soft power projection as its primary way to influence countries, even when it has disagreements with them.

(Source: Channel NewsAsia)

• China’s decision to release a controversial map of the disputed border with India just days after President Xi and Indian Prime Minister Narendra Modi agreed to have their officials handle the issue is a clear sign that China is not yet ready to lead a bloc of countries. The map is a provocation that will only further alienate India and other countries in the region. Furthermore, China’s insistence on historical revisionism and its unwillingness to compromise on territorial disputes will make it difficult to build trust and cooperation with its neighbors. As a result, Beijing will have a hard time corralling its coalition partners behind any effort to challenge the United States directly in the Indo-Pacific.

Budget Bickering: The United States is on track for another budget showdown next year, which could further raise market concerns about the country’s growing deficits.

• The Biden administration formally requested a short-term spending extension from Congress on Thursday to avert a government shutdown on October 1. The request is likely to face opposition from the House Freedom Caucus, which is rallying Republicans to withhold support for any funding bill that does not include spending cuts and changes to border policies. Congress has yet to approve any of the 12 annual spending bills that typically fund the government. The showdown reflects the growing polarization in American politics, which has led investors to question the country’s willingness to honor its debt commitments.
• The ongoing political gridlock in Washington has angered credit ratings agencies. Last month, Fitch Ratings became the second credit rating firm to downgrade the United States since S&P Global did so 12 years ago. The agencies are concerned that political brinkmanship will prevent the two sides from addressing the country’s deficit problem, which now stands at $1.4 trillion and is expected to grow even larger. Higher interest rates and a potential recession could exacerbate fears of debt levels getting out of control, as both could add to the growing mismatch of funding and spending.

• Tackling the deficit will be a difficult task for either party in power. Neither side has the political will to make the tough decisions necessary to address the issue, such as reducing popular entitlement programs or raising taxes. However, the longer they delay action, the worse the problem will become. The government’s inability to tackle the deficit is one of the reasons why long-term Treasury yields are likely to be higher in the future and the dollar will weaken against other global currencies, as the rising debt burden will undermine the U.S.’s credibility as a suitable reserve currency.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment has three main themes: 1) Why markets are rethinking expectations that the U.S. was in recovery; 2) How regulators are looking to rein in banks with new regulations; and 3) How El Niño may be a problem for the rest of the world but could lead to lower energy costs in the U.S.

 Optimism Fading:  Data continues to show a mixed picture of the current state of the economy.

• Revision to the gross domestic product (GDP) and a release of private payroll information suggest that the economic activity is slowing. According to the Bureau of Economic Analysis, the economy expanded at an annual rate of 2.1% in Q2 2023, slower than the 2.4% in the previous report. On the same day, ADP private payrolls showed that the economy added 177k jobs in August, significantly lower than the previous month’s revised reading of 371k. The disappointing data has challenged the assumption that the worst is behind us and has raised hopes that the Federal Reserve will pause in September.
• Investors welcomed the report, with many dreaming of a possible end to the rate-hiking cycle. The S&P 500 closed higher on Wednesday, while the yield on the 10-year Treasury fell to a three-week low. This shift in sentiment comes a day ahead of the release of the BLS payrolls report. If the report shows another setback in job growth, it will likely strengthen expectations that the Federal Reserve is done raising rates. The latest CME FedWatch Tool suggests that the FOMC is 90% likely to hold rates in September, and there is a nearly 60% chance of rates rising before the end of the year.

(Source: CME Group)

• The economic outlook is becoming increasingly uncertain and complex. While it was widely expected that rapidly rising interest rates would hinder GDP growth, the fiscal and monetary response has altered this dynamic. Stimulus checks helped households pay down debt, while easy monetary policy allowed consumers to extend maturities and improve balance sheets. President Biden’s Inflation Reduction Act and infrastructure bills are also likely to mitigate the economic impact of tighter monetary policy. As a result, we are becoming more optimistic that the economy may be able to narrowly avoid a recession in 2023. This may also mean that the Fed may be persuaded to maintain tighter policy for longer.

Policing Banks: Lawmakers and regulators are tightening regulations on banks in an effort to mitigate the risk of future economic disruptions.

• The Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) unveiled plans to force banks with $100 million in assets to set up living wills and to issue enough long-term debt to cover capital losses in times of severe stress. The proposal is designed to make it easier for banks to dissolve during a potential collapse. Regulators have wasted little time ensuring that banks fall into compliance with these new rules. Several regional banks, including Citizens Financial Group Inc. (CFG, $27.99), Fifth Third Bancorp (FITB, $26.16), and M&T Bank Corp (MTB, $126.43) have received warnings about failing to meet requirements. This increase in oversight is likely to add to the woes of a banking system still recovering from the March turmoil.
• These new regulations are being implemented at a time when banks are paying higher interest rates on deposits and are tightening their lending standards. S&P Global Market Intelligence reported that net interest margins contracted in the second quarter of 2023, as funding costs rose at a faster pace than earning asset yields. The median taxable equivalent net interest margin of the banking industry fell to 3.40%, down 20 basis points from its peak in Q4 2022. Additionally, lending standards for the banking industry have risen to the highest level since the pandemic recession.

• Major banks also face increased scrutiny from politicians over plans to increase credit card swipe fees. The fee increases, scheduled to take effect in October and April, have been criticized for their potential to increase inflation and hurt small businesses. Lawmakers have used the planned fee hike to promote their Credit Card Competition Act, which will force large banks to offer alternatives to Visa (V, $247.18) and Mastercard (MA, $415.10) for networks to process transactions. The legislation, if passed, could hurt revenue for both credit card providers and banks. A Nilson report, an industry publication, showed merchants paid $160.70 on average last year, while research from a merchant consulting company showed the new fees could cost retailers another $500.00 a year.

Weather Worries: El Niño could cause disruptions in some parts of the world, but its impact on the U.S. may be less severe.

• El Niño conditions in the central and eastern Pacific Ocean are increasing the likelihood of more extreme weather events, such as droughts, floods, and wildfires. We are already seeing the early signs of this impact, with Hong Kong preparing for its strongest typhoon in five years, Greece battling the largest wildfire in EU history, and droughts in Southeast Asia threatening harvests. The impact of El Niño has already cost many countries billions of dollars, and the effects are expected to strengthen until it peaks sometime between December and February.
• El Niño is expected to exacerbate the upward pressure on commodity prices in the coming months. Food prices have already been hurt by India’s export ban on non-basmati rice and Russia’s decision to pull out of the grain deal. This is likely to be felt by developing countries the most, as they rely on food imports. The pessimistic outlook on food prices has led to concerns that central banks in other countries may not be able to cut rates as prices may be on the rise. Despite making progress in the first six months of the year, emerging markets have seen a reacceleration in inflation.

• In the U.S., El Niño conditions in the summer are typically weak, but it can cause wetter and warmer conditions in the South and drier conditions in the North. As El Niño strengthens, it is possible that these effects could become more pronounced. The prospect of a stronger El Niño has so far led to lower gas prices, as households are likely to use less energy as a result. This could weigh on inflation in the U.S. and could lead the Fed to follow through on its pause in interest rate hikes.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with U.S. news, including yesterday’s blockbuster court decision that boosted cryptocurrency prices and a couple of words on the labor market data that boosted stocks.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs of sticky inflation in Europe and yet another coup in Africa.

U.S. Cryptocurrency Regulation:  A federal court yesterday ruled that the SEC acted unreasonably when it rejected an application by Greystone Investments to launch an exchange-traded fund based on spot Bitcoin.  The ruling invalidates the SEC’s effort to force cryptocurrency funds to invest only in futures, which would be traded on U.S.-regulated exchanges.

• Even though the SEC could still decide to appeal to the Supreme Court, the ruling allowing the formation of spot-Bitcoin ETFs is expected to spur a major increase in the demand for cryptocurrencies.
• As a result, Bitcoin and other cryptocurrencies jumped in value yesterday, with Bitcoin alone up approximately 7.7% to $27,970.

U.S. Trade Policy:  Following up on former President Trump’s recent call for a 10% tariff against all imports, there are signs the other declared Republican presidential candidates are swinging to the same view.  The sentiment is especially negative towards China, where several top politicians have called for rescinding permanent normal trade relations with the country and boosting domestic manufacturing through protectionist policies ranging from tariffs and import barriers to subsidies.

• While it’s widely recognized that there is already broad, bipartisan support among centrist Republicans and Democrats for a bigger defense budget and a stronger response to China’s geopolitical aggressiveness, it now appears that industrial protectionism is becoming another area of bipartisan agreement, at least as it relates to China.
• One key question is whether U.S. protectionist policies will be applied broadly, even against the U.S.’s key allies and other members of its geopolitical bloc.
  • Tariffs and other policies applied against Washington’s allies would threaten to weaken the U.S. bloc and potentially spark a global, chaotic trade war marked by an “every man for himself” attitude. It could also drive some U.S. allies or potential allies into a closer economic relationship with China.
  • In contrast, sparing U.S. allies would help preserve Washington’s key economic leverage over China. As shown in the chart below, over 10% of Chinese gross domestic product comes from exporting to the overall U.S.-led bloc, making it imperative to maintain the bloc’s unity and coordination versus Beijing.

U.S. Labor Market:  In the Job Openings and Labor Turnover Survey released yesterday, July vacancies came in at a seasonally adjusted 8.8 million, well below expectations and down from 9.2 million in June.  That means the ratio of job openings to unemployed workers has now fallen to 1.5, far below the roughly 2.0 seen early last year.  In turn, that suggests the demand for labor continues to cool, raising the prospect for slower wage growth, reduced inflation pressures, and a potential end to the Federal Reserve’s interest-rate hikes.  The data release goes far toward explaining the big jump in stock prices yesterday.

U.S. Commercial Real Estate Market:  The Wall Street Journal today has a useful story looking at various indicators of where the commercial real estate industry is headed.  For example, the story notes that publicly traded property stocks are currently trading at about a 10% discount to their gross asset values—a decent proxy for the size of the price falls that investors still expect in private real-estate values.

U.S. Weather:  Hurricane Idalia, now a Category 3 storm, has made landfall this morning in northwestern Florida.  Some 30 counties in the state are under evacuation orders, and damage is anticipated to be extensive.  Travel is also likely to be disrupted throughout the region.  We expect to provide more details on any economic impact from the storm in our Comment the rest of the week.

Eurozone:  New data shows price pressures remain high.  In Spain, the August consumer price index was up 2.4% from the same month one year earlier, accelerating from the gains of 2.1% in the year to July and just 1.6% in the year to June.  Excluding the volatile food and energy components, the August “core” CPI re-accelerated to show a rise of 5.9% on the year.  Meanwhile, in the key German state of North Rhine-Westphalia, the August CPI was up 5.9% year-over-year, accelerating from 5.8% in July.  The figures suggest that overall eurozone inflation data will be worrisome enough to prompt the European Central Bank to hike interest rates further in September.

China-India:  The Indian government lodged a formal protest against China for releasing a new “standard map” that shows Indian territory as part of China.  The two countries have long had territorial disputes along their poorly demarcated border in the Himalaya Mountains, but the frictions have worsened since a bloody clash between Chinese and Indian troops in the area in 2020.  The frictions are a key reason why India has been reluctant to join the China/Russia geopolitical bloc and is instead becoming close to the U.S. and its bloc.

Russia-Ukraine War:  Overnight, Ukrainian forces evidently used swarms of drones to attack military targets across Russia and were able to damage or destroy several aircraft at an air force base near the city of Pskov.  That is just the latest Ukrainian attack to successfully damage some of Russia’s powerful, expensive aircraft, illustrating how the Ukrainians continue to develop their own brand of “asymmetric” warfare.  The Ukrainian successes may not necessarily bring about its key goals in the war, but they will help to further degrade the Russian military.

Gabon:  Following closely on the recent coup in Niger, military officers in the central African nation of Gabon have staged a coup and toppled the country’s recently re-elected president.  The former French colony is a member of the Organization of the Petroleum Exporting Countries, but it is not one of OPEC’s major oil producers.

Guatemala:  Electoral authorities on Monday evening suspended the center-left Seed Movement of President-elect Bernardo Arévalo, potentially preventing the party’s legislators from taking their seats in Congress and hamstringing Arévalo’s administration.  The party has appealed to a higher court, but it is not clear whether they will be successful, given that their focus on fighting corruption threatens many of Guatemala’s vested interests.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with concerns about a new El Niño event that could further boost global food prices and other global data showing a decline in alternative investments.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a renewed commitment by the European Union to expand by 2030 and an analysis suggesting the U.S. labor force participation rate is now being held down mostly by demographics rather than the impact of the coronavirus pandemic.

Global Agriculture Markets:  An expected warming of waters in the Pacific Ocean, known as El Niño, has officials and investors bracing for weather disruptions such as increased heat in Central America and increased rain in the Andes.  Importantly, an El Niño event typically distorts crop cycles and could exacerbate today’s existing food supply issues, such as Ukraine’s grain export challenges because of Russia’s invasion and India’s ban on exports after heavy rains damaged its rice crop.  The results could include higher food prices around the world, boosting overall consumer price inflation and interest rates, and might also lead to political unrest in poorer countries.

Global Alternative Investment Market:  Data from Preqin shows that alternative investment funds—which invest in assets ranging from private equity and hedge funds to real estate and private credit—have raised just $740 billion since the start of this year, down 27% from the $1.02 trillion raised in same period last year.  The drop in fundraising reflects the impact of higher global interest rates, weak stock markets late last year, and a tepid market for initial public offerings.

European Union:  European Council President Charles Michel said in a speech that the EU should be ready to admit Ukraine, various Balkan states, and other countries into the bloc by 2030.  Michel argued that setting a specific target date would force current EU members to grapple with the changes needed to admit new members while also galvanizing reforms in aspirant countries.

Germany:  Average wages in the second quarter were up a record 6.6% from the same period one year earlier, slightly beating the consumer price inflation of 6.5% over the same timeframe and accelerating from a wage rise of 5.6% in the year ended in the first quarter.  Amid Germany’s broader, structural economic challenges, the figures suggest that German workers are at least no longer facing a decline in their real purchasing power.  Nonetheless, the figures also bolster concerns about on-going price pressures and the potential for further monetary tightening by the European Central Bank.

Brazil:  Leftist President Luiz Inácio Lula da Silva is reportedly close to striking a deal with two right-wing parties formerly allied with his defeated rival, Former President Jair Bolsonaro, in a move aimed at overcoming Congressional opposition to his initiatives to hike public spending and pass greater protections for workers, minorities, and the environment.  The deal would cede cabinet posts and potentially other roles in return for support in Congress, where the coalition led by Lula and his Workers’ Party does not command a majority.

China:  Photographs on social media show that the Chinese navy has finally launched the first of its Type 054B frigates, which sport an advanced phased-radar system, a stealth mast aimed at allowing it to sail undetected through the seas along China’s coast, an integrated electric propulsion system that will allow it to power a wider range of weapons, and an active towed-sonar system designed to identify U.S. and allied submarines.  The ship is also the largest Type 054 variant, with an estimated length of 482 feet and a width of almost 60 feet.

• As we have mentioned before, China now has the world’s largest navy, with a combat force of approximately 350 ships. The U.S. Navy is now a distant second, with about 295 ships.
• Importantly, as this report illustrates, China also continues to make steady progress in increasing the size and capabilities of its vessels.

United States-China:  Commerce Secretary Raimondo today tried to counterbalance her Monday statements that the U.S. would prioritize national security and protect its workers, saying the country was nevertheless not intending to “decouple” from China.  The reporting on the second day also indicates that U.S. and Chinese officials have agreed to regular information-sharing meetings designed to ease economic tensions.

• While certain members of the Biden administration have taken a tough stance against the geopolitical and economic threat from China, the administration has recently tried to use bilateral meetings to ease tensions. At least in part, that probably reflects pressure from foreign allies and the left wing of the domestic political system.
• Nevertheless, we suspect that bilateral meetings, information-sharing sessions, and the like can only go so far in easing tensions. China’s economic imperatives probably still include steps to boost its trade and investment activity around the world, often at the expense of established Western companies and their workers.  More important, we think China’s increasingly aggressive military activity and the continued build-up in its conventional and nuclear arsenal (see above) will ultimately spoil any benefit from eased economic tensions.

U.S. Industrial Sector:  The Wall Street Journal’s “Heard on the Street” column has recently run at least few stories extolling U.S. industrial and basic materials firms as likely beneficiaries of the re-industrialization and factory building boom that we’ve been writing about.  Last week, the column featured industrial machine maker Rockwell Automation (ROK, $309.05), and today it features steelmaker U.S. Steel (X, $29.92).  We don’t necessarily endorse the specific analyses or recommendations regarding those stocks.  All the same, we do think the articles illustrate how the investor class is swinging around to our view that the industrial sector is attractive as the world fractures into relatively separate geopolitical and economic blocs, and as more production is shifted out of China and back to the U.S. or to U.S. allies.

U.S. Labor Market:  Analysis from Axios shows the labor force participation rate has recently been exceeding the Congressional Budget Office’s early-2022 forecast for this period.  The LFPR (the share of adult, non-institutionalized civilians who are working or seeking work) has stood at 62.6% for several months, versus a CBO forecast of 62.4%.  The coronavirus pandemic certainly drove the LFPR way below forecast for almost three years, sparking big labor shortages across the economy.  Nevertheless, the new analysis suggests that today’s labor shortages are largely the result of long-standing trends in population aging and high levels of retirement.

• Today’s labor shortages, strong wage growth, and high consumer price pressures, therefore, look to remain in place for the foreseeable future.
• Of course, that will also tend to make today’s high consumer price inflation “sticky” and encourage the Federal Reserve to keep interest rates high for an extended period.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a review of Federal Reserve Chair Powell’s address to the Kansas City FRB’s symposium in Jackson Hole on Friday.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs that U.S. private investments in China are already starting to fall sharply while China launches a new cut in securities transaction taxes to spur more demand.

U.S. Monetary Policy:  At the conference in Jackson Hole on Friday, Fed Chair Powell suggested that the monetary policymakers would likely hold interest rates steady at their upcoming meeting in September, but that they would be prepared to hike rates further if economic growth accelerates and pushes price pressures higher.  He also reiterated his warning that the Fed is likely to hold interest rates “higher for longer” in order to make sure consumer price inflation comes down to the policymakers’ 2% target.

• Based on market indicators, it appears that investors have bought into that view. We also believe the policymakers will try to hold rates at a high level for an extended period, although it is unclear whether they could maintain that discipline if a financial crisis were to erupt or if the economy starts to slow precipitously.
• Investors’ focus on the likelihood of a pause in the Fed’s rate-hiking campaign allowed risk assets to appreciate in value on Friday, while bond yields rose. So far today, however, the yield on the benchmark 10-year Treasury note has fallen back to 4.201%.

United States-China:  Based on new data, the U.S.’s move to restrict investors from privately funding certain advanced-technology startups in China has already begun to discourage private equity and venture capital investments in the country.  The restrictions, which were confirmed in a recent executive order, are apparently freezing investment flows not only into the targeted industries, but also into related industries that the funds and their investors fear could be restricted in the future.  Separately, in her visit to Beijing today, U.S. Commerce Secretary Raimondo warned that the U.S. would not compromise its national security to maintain trade and investment flows, but she argued that there would still be opportunities in non-sensitive areas.

• It’s important to remember that the private investment restrictions don’t just cut the amount of funding available to Chinese firms. Private-equity and venture-capital funds also tend to take a hands-on approach to the companies they invest in, including providing strategic and operational guidance or consulting from the funds’ network of experts.  If the funds stop investing in China’s high-tech startups, the Chinese firms as a whole are likely to develop more slowly than they otherwise would.

• The development is therefore just the latest example of how U.S.-China tensions are exacerbating the other factors weighing on Chinese economic growth, including weak consumer demand, high debt levels, and poor demographics.

Russia-China:  Now that China has banned all food imports from Japan in response to the country’s release of treated radioactive water from the stricken Fukushima nuclear plant, Russia’s food safety agency said it will try to sharply increase Russian food exports to China.  The move comes as Beijing is also whipping up popular boycotts against Japanese imports.  The statement shows how China and Russia are drawing closer to each other amid their various disputes with the West.

• More broadly, the move illustrates how the evolving geopolitical and economic blocs that we’ve written so much about are coalescing, with countries pulling back from their ties with other blocs but deepening ties with countries in their own bloc.
• We count Japan as a key member of the U.S.-led bloc, while we see Russia as the junior partner in the China-led bloc.

Russia-Ukraine War:  In a report that suggests Kyiv’s counteroffensive may now be making more substantial progress, Ukrainian forces are said to have penetrated the first line of Russian defenses at the village of Robotyne, in Ukraine’s eastern Zaporizhzhia region.  The Ukrainian defense ministry says its forces are now driving southeast despite fierce Russian resistance.

• If the report from Kyiv is true, and if the Ukrainians can maintain or build their momentum, it would revive optimism that they can push the Russian forces out of more territory and perhaps even sever the important “land bridge” linking Russia proper with the occupied Crimean Peninsula.

• That kind of progress could also help maintain Western resolve to keep sending arms and supplies to the Ukrainians without putting undue pressure on Kyiv to go to the negotiating table.

China:  In a further move to shore up the local stock market, the Ministry of Finance and the State Tax Administration said the stamp duty of 0.1% on securities transactions will be halved starting today.  The China Securities Regulatory Commission also said it will cut the margin requirement for securities purchases from 100% to 80% starting September 8.

• The moves aim to give a boost to Chinese securities markets, but we suspect buying activity will remain weak in the face of slowing economic growth and increased regulatory risk because of the worsening in U.S.-China trade tensions.
• In fact, Chinese stocks initially jumped some 5% on today’s news, but then they gave up most of those gains and closed up only about 1%.

Taiwan:  Terry Gou, the founder of iPhone assembler Foxconn Technology (HNHPF, $6.72), announced he will run as an independent candidate in January’s presidential election.  The move will further split the relatively pro-China opposition parties on the island.  According to recent polls, current Vice President Lai Ching-te of the anti-China, pro-U.S. Democratic Progressive Party maintains a comfortable lead over the Kuomintang Party and a smaller third party.  Since Gou argues that the government is needlessly stirring up tensions with Beijing, his candidacy is expected to draw further support from the Kuomintang.

Eurozone:  In a release today, the European Central Bank’s key measure of the money supply showed an annual decline for the first time since 2010.  The new data showed that M3 (which encompasses deposits, loans, cash in circulation, and various other financial instruments) was down 0.4% in the year ended in July, after being up 0.6% in the year to June.  The figures illustrate the impact of the ECB’s monetary tightening over the last year, which has helped reduce price pressures but also threatens to further weigh on economic growth going forward.

Japan:  At the Kansas City FRB’s conference in Jackson Hole, Bank of Japan Governor Ueda said he and his fellow policymakers are maintaining their basic yield-curve control strategy because they still see underlying inflation running below their target of 2.0%.  Even though Japan’s core consumer price index for July was up 3.1% year-over-year, Ueda said he expected core inflation to fall back before the end of the year.  Since the statement suggests it’s still too early to expect the BOJ to abandon its yield-curve control strategy, the news helped boost Japanese stocks by about 1.7% today.

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