by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with signs that the Chinese government is working to prevent further financial market contagion related to its faltering real estate sector.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a desire by the U.K.’s opposition leader to improve relations with the EU and new warnings about debt-financed short positions in the market for short-term U.S. Treasury futures.

Chinese Real Estate Market:  Shadow-banking giant Zhongrong International Trust, which sparked concerns about a financial crisis when it missed payments on some of its trust products over the summer, said it has engaged two state-owned financial companies to help fix its operational problems.  The company insists that the arrangement isn’t a government bailout and that the two state-owned firms won’t have responsibility to make up the missed payments to investors.

• Nevertheless, the deal is likely to be interpreted as a bailout in all but name, with the government trying to quietly stem any contagion from the country’s faltering real estate market and failing developers.
• Chinese economic growth continues to struggle against what we call the Four Ds: Weak consumer demand, high debt levels, poor demographics, and de-coupling by foreign countries.  Massive excess production and high debts among the country’s major real estate developers are a particular problem.

Chinese Gold Market:  The central bank has lifted its temporary ban on gold imports into the country, which was imposed in August to reduce selling pressure on the renminbi (CNY).  We have recently been noting stronger central-bank purchases of gold around the world, and we believe those purchases have been instrumental in buoying the price of the yellow metal.  Stronger personal demand for gold in China could add to the upward pressure on gold prices.

India-China:  An India-based official of iPhone assembler Foxconn (HNHPF, $6.54) said the company aims to double its workforce, investment, and activity in India in the coming year, as part of its effort to diversify production out of China.  That would help keep the company on track to produce half of its iPhones in India by 2027.  The plan is a further reflection of how companies are increasingly trying to hedge their bets by moving production out of China amid worsening tensions between China and the West.  We believe India will be a prime beneficiary of that trend.

United Kingdom-European Union:  In a Financial Times interview, Keir Starmer, the leader of the U.K.’s opposition Labor Party, said he would seek a major re-write of the Brexit agreement between the UK and the EU if his party wins the next election.  According to Starmer, his goal in such a re-write would be to improve the U.K.’s economic relations with the EU as a way to boost economic growth.  For example, he would seek to improve the deal’s veterinary standards to ease U.K.-EU trade in animals and farm products.

U.S. Fiscal Policy:  Consistent with our latest Bi-Weekly Asset Allocation Report, more analysts are starting to focus on the end of the pandemic-era moratorium on student loan payments on October 1.  Over the weekend, an article in the Wall Street Journal estimated that re-starting student loan payments will cut overall consumer demand by about $100 billion in the coming year, as millions of consumers with student loans have to start paying $200 to $300 on their education debt again.  The drop in consumer demand has the potential to finally bring about the long-expected recession, with the associated negative implications for corporate earnings and stock values.

U.S. Monetary Policy:  The Federal Reserve will begin its latest policy meeting tomorrow, with its decision on interest rates due on Wednesday at 2:00 PM EDT.  The policymakers are widely expected to hold the benchmark fed funds rate steady at its current range of 5.25% to 5.50%.  The more important question is whether they will provide any guidance on future policy changes.  While many investors continue to look for outright rate cuts in the coming months, we continue to believe they will be disappointed.  We believe Chair Powell should be taken at his word when he says he will try to keep policy tight for an extended period to make sure consumer price inflation is really snuffed out.

U.S. Bond Market:  Against the backdrop of the Fed’s hawkish monetary policy, we’re seeing more official warnings about “basis trades” by hedge funds.  In its quarterly report today, the Bank for International Settlements said the associated buildup in debt-financed short positions on two-year U.S. Treasury futures could spark chaotic trading.  According to the BIS, “Margin deleveraging, if disorderly, has the potential to dislocate core fixed-income markets.”  We will continue to monitor the situation closely.

U.S. Labor Market:  Last week, the U.S. Army said it met its annual re-enlistment goal early, allowing it to suspend retention bonuses paid to re-enlisting troops at least until the end of the federal fiscal year on September 30.  The U.S. Navy said it will miss its recruiting goal by about 7,000 sailors, but that is actually better than the 13,000 shortfall it expected at the beginning of the fiscal year.

• Over the last couple of years, strong labor demand in the civilian economy has made it difficult for all the services to recruit new personnel or keep current troops from leaving.
• The better-than-expected re-enlistment and recruiting figures could reflect weakening in the civilian labor market, potentially leading to slower wage growth, reduced price pressures, and an end to the Federal Reserve’s long campaign of interest-rate hikes.

U.S. Auto Industry:  After launching their strike against the Big Three automakers last Friday, the United Auto Workers said it resumed negotiations for a new labor contract with each of the companies over the weekend.  The union suggested in a statement that it is making its best progress with Ford (F, $12.61).  However, in a test of the union’s novel tactic of simultaneously striking just one assembly plant at each of automakers, the firms began to warn that the strikes will force them to stop production and furlough workers at related plants.  We suspect the UAW would see that as an effort to “divide and conquer,” prompting the union to expand the strike.

U.S. Real Estate Industry:  Demand for office space in downtown San Francisco has reportedly started to recover from its deep plummet during the coronavirus pandemic.  The stronger leasing activity and renewed office-building sales stem partly from increased demand by firms in the fast-growing artificial intelligence space.  Nevertheless, some of the increased building sales also reflect the fact that some owners have capitulated on price, selling their properties at steep losses.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will be broken into three sections: 1) Why unions are starting to grow in popularity; 2) Why long-duration Treasury yields are likely to rise over the next few years; and 3) Why the market should be cautiously optimistic about the data coming out of China.

Labor Fights Back: Unions are back in fashion as more workers demand higher wages and better terms.

• The United Auto Workers (UAW) announced a strike against the Big Three automakers in one of the biggest labor disputes in recent memory. The strike could weigh on economic growth if it lasts long enough. The union rejected the carmakers’ last-minute bids to end the impasse, with the most significant sticking points being the UAW’s demands for defined-benefit pension plans, a 32-hour workweek, and other work incentives. The automakers have rejected these demands, believing that they would hurt business profitability. Ford (F, $12.62) estimates that the proposal could push it into bankruptcy.
• The long-simmering tension between unions and firms is likely to continue, as firms have been reluctant to share more of their profits with workers. Although most of the pushback against labor unions is coming from industries that are already unionized, there is growing support for labor unions overall. Recent Gallup polling data shows that approval ratings for labor unions have reached their highest point since 1965. This evolving sentiment is exemplified by the recent actions of basketball players at Dartmouth College, who have initiated proceedings to establish a local union. This shift in perspective comes amid a significant decline in labor’s share of economic output from its pandemic peak.

• Over the next thirty years, the bargaining power of unions is likely to weigh on company margins, as labor groups gain influence and extract more concessions from firms, such as higher wages, better benefits, and more job security. These concessions could reduce company efficiency, leading to lower productivity and greater inflation volatility. In this environment, large companies are typically better positioned to absorb losses and capitalize on technological substitutes such as artificial intelligence. However, the trend will likely be drawn out and bumpy, so there is no immediate cause for action.

Bond Bears Return: Long-term Treasury yields hit a post-GFC high as traders weigh hawkish Fed policy and government budget wrangling.

• Bond yields have risen due to uncertainty over fiscal and monetary policy. President Biden warned on Thursday that the government could shut down at the end of September if Congress doesn’t reach an agreement on a new budget. House Speaker Kevin McCarthy (R-CA) has struggled to convince fellow Republicans to keep the government funded. Meanwhile, stronger-than-expected retail sales data and a steady decline in jobless claims have added to speculation that the Federal Reserve may pursue a hawkish pause at its next meeting. The FOMC is expected to leave rates unchanged next week but signal its readiness to raise them further in the future.
• Ten-year Treasury yields have risen over 100 basis points since April, to levels not seen since 2006. This massive jump in interest rates reflects investor concerns about the Federal Reserve’s ability to maintain price stability and the government’s ability to meet its debt obligations. Although the recent CPI report showed signs of improvement in underlying price pressures, rising energy prices have raised concerns that some of this progress will be reversed. Additionally, growing partisanship prevents Congress from passing legislation to address the growing government deficit. As a result, investors are demanding higher yields to compensate for the increased risk.

• Long-duration bond prices are likely to face significant headwinds due to structural shifts in the global economy, particularly the transition from an economy that favors efficiency to one that favors resilience. This transition could lead to increased inflation volatility and supply chain disruptions, as the lack of imports makes it more difficult to meet domestic demand. Additionally, the growing government debt burden will continue to raise concerns about the sustainability of public finances. However, this transition will be uneven, with periods of fluctuating yields.

Chinese Surprise: Beijing received some welcome news, as economic data showed that the economy is starting to rebound.

• Industrial production and retail sales figures beat expectations in August, showing that the limited policy stimulus is having an impact on the economy. Factory output increased by 4.5% year-over-year, well above expectations of 3.9% and the previous month’s increase of 3.7%. Retail receipts jumped 4.6% year-over-year, well above the July increase of 2.5% and the consensus estimate of 3.0%. This progress is likely to boost optimism among investors who feared that the country was in a prolonged slump, which could persuade some that the worst is likely behind. As a result, the Chinese yuan (CNY) gained on the U.S. dollar.
• The positive economic reports show that China’s pro-growth initiatives are working. In recent weeks, Beijing has implemented measures to boost consumer and investor sentiment, including the People’s Bank of China’s most significant rate cut in three years, a slash in stamp duties on stock transactions, and a cut in the reserve requirement ratio to free up liquidity for lending. The measures follow statements made by Beijing officials in July that the government would provide stimulus to help support the economy following years of COVID restrictions. That said, there is still concern that Beijing’s work isn’t finished.

• It is never a good idea to read too deeply into a single month of economic data, and this is no different. China is still working its way through a property meltdown and a municipal debt problem. Additionally, not all of the economic data coming out of China is rosy. For example, the housing price index was down 0.1% from the prior year, and urban youth unemployment has risen above 21%. Thus, China is far from being out of the woods. However, if the growth in consumption does start to pick up, this should aid equities in countries with exposure to the second-largest economy.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment is split into three sections: 1) Why rising energy prices will complicate the Fed’s efforts to project future policy rates; 2) Why European policymakers may be finished with their hiking cycle; and 3) Why the green transition is leading governments to push for more domestic manufacturing.

Where Do They Stand? The disappointing consumer price index (CPI) report may lead to further divisions within the Federal Open Market Committee (FOMC).

• Rising energy prices pushed headline CPI above expectations in August, leading investors to adjust their interest rate expectations. Consumer prices rose 3.7% from the previous year, above economists’ expectations of 3.5% and July’s reading of 3.3%. The rise was driven by a 5.6% surge in petrol prices from the previous month, which accounted for more than half of the month-over-month increase. Energy prices have picked up following efforts by Saudi Arabia and Russia to prop up oil prices through production cuts. The sudden reversal of inflationary pressures has led to investors’ pricing in a near 50% chance of another hike by the end of the year.
• Despite the recent surge in headline inflation, there are some encouraging signs that underlying inflation pressures may be easing. The year-over-year change in core CPI, which excludes food and energy, fell from 4.7% to 4.3% in August. Meanwhile, the frequently cited core services inflation, which excludes goods and shelter, also eased in August, declining from 3.3% in July to 3.1%. Additionally, supercore inflation, which excludes food, shelter, and energy, rose by 2.2% in the same period but was modestly above its 20-year historical average of 1.9%. Therefore, there is still a case for the Fed to stand pat, at least for now.

• The latest CPI report is unlikely to have a significant impact on the FOMC’s decision of whether to keep interest rates unchanged during its next meeting on September 19-20. Although policymakers have not commented on how they would vote in the meeting, members have expressed concern regarding the level of tightness in the labor market. The committee is 25 bps shy of meeting its fed funds target outline in the latest dot plots. As a result, we will be paying close attention to the latest FOMC projection materials and Fed speeches for evidence of the committee’s thinking on future rate hikes.

Policy Pushback: Economic woes are prompting policymakers to reconsider rate hikes amid slowing output and lawmaker complaints.

• The European Central Bank (ECB) raised its benchmark policy rates by 25 bps on Thursday. The increase comes amidst signs that inflation is starting to return to normal but still remains well above the central bank’s 2% mandate. Despite the decision to tighten monetary policy, markets believe that the central bank is likely finished hiking rates. During the press conference, ECB president Christine Lagarde suggested that rates are currently in sufficiently restrictive territory but stopped short of ruling out an additional hike. As a result, the euro (EUR) fell against the USD and Japanese yen (JPY).
• Unlike the United States, the eurozone economy is more fragile, partly due to its greater reliance on exports, which are being hurt by China’s economic slowdown. European Central Bank officials downgraded their growth expectations for the next three years and hinted at the possibility of recession. At the same time, high interest rates have hurt manufacturing activity throughout the bloc, with industrial production falling 2.2% from the prior year in August. These troubles are not likely to go away anytime soon as the ECB projects that rates will likely stay above 3% in 2024, making it harder for them to justify rate cuts.

• Meanwhile, European governments have begun to express their frustration with the ECB’s tight monetary policy. Italian Prime Minister Giorgia Meloni has doubled down on a windfall tax on Italian banks (against the wishes of the ECB Governing Council) in a bid to prevent the banks from profiting at the expense of households due to monetary policy. A similar measure passed in Spain is currently being challenged in court. As the effects of the rate hikes start to work their way through the economy, policymakers will likely face political pressure to cut rates, thus leading to more downward pressure on the EUR.

Return of the Industrial State? Governments are becoming more assertive in protecting domestic industries as the world begins to fracture into blocs.

• The G-7 are increasingly becoming more protectionist as they look to prevent China from dominating the electric vehicle market. On Wednesday, European Commission President Ursula von der Leyen announced that the EU will launch an investigation into allegations of the Chinese dumping of electric vehicles. The probe paves the way for tariffs on foreign manufacturers that are in breach of trade rules. In the U.S., where there is already a 27.5% levy on Chinese made cars, regulators are considering a possible crackdown on EV battery imports from China, as lawmakers are trying to deter American carmakers from relying on China for the critical components of their vehicles.
• The pressure to reduce reliance on Chinese green technology is being driven by governments’ desire to avoid a repeat of the solar panel industry in the 2010s. During this period, Chinese companies backed by state aid undercut domestic producers, forcing many solar companies in the U.S. and Europe into insolvency. Given China’s dominance in EV batteries, automakers may be at risk of a similar outcome. China controls 76% of global battery cell production capacity and accounts for two-thirds of the world’s registered electric vehicles. Concerns over American supply chain exposure to China have led lawmakers to pressure Ford Motor Company (F, $12.64) to abandon its use of Chinese technology for its batteries.

(Source: Wikimedia Commons)

• Governments in advanced economies are likely to play a more active role in the economy than investors are used to, reflecting a long-term trend of supporting domestic firms to compete with foreign competitors. This is already evident in the Inflation Reduction Act, which uses tax subsidies to build domestic manufacturing in the U.S., and in similar incentives offered by the EU. While this shift may help businesses subsidize their research efforts, it could also lead to higher inflation and borrowing costs due to inefficiencies associated with firms being unable to use outside suppliers.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the latest news on souring relations between the West and 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 Russia-Ukraine war and U.S. inflation and banking dynamics.

United States-China:  The House Select Committee on the Chinese Communist Party has been holding hearings and meetings on Wall Street this week to put further pressure on U.S. financial and business elites who have been reluctant to sever ties with China.  In a statement that we think investors should heed, the Republican chairman of the committee, Mike Gallagher of Wisconsin, and the Democratic vice-chairman, Raja Krishnamoorthi of Illinois, both said they favor new laws to restrict U.S. investment in publicly traded stocks and bonds of certain Chinese firms.

• The new legislation mentioned by Gallagher and Krishnamoorthi would go beyond the current U.S. restrictions on bilateral trade, investment, and technology flows, illustrating the risks to investors as U.S.-China geopolitical tensions worsen.
• As a reminder that China is also clamping down on bilateral business, the Chinese government today said it has “noticed reports” of “security incidents” related to iPhones made by U.S. technology giant Apple (AAPL, $176.30). The government emphasized that it is still committed to protecting the rights of foreign businesses and supporting free markets.  Nevertheless, since the statement followed so closely on Beijing’s recent directive which curbed the use of iPhones by certain government workers, it is being taken as a warning that China is prepared to undermine key U.S. economic interests to retaliate for the U.S. pushback.

European Union-China:  As advanced, low-cost electric vehicles from China start to flood Europe’s auto market, European Commission President von der Leyen today announced that she is launching an investigation into the subsidies paid to Chinese producers.  Complaining that European-made autos are often blocked from other markets, von der Leyen signaled Brussels will take a tough approach on subsidized Chinese EVs.

• The move is a reminder that von der Leyen and other leaders in Europe have swung behind the U.S. effort to push back against China’s growing geopolitical and economic aggressiveness.
• In response to von der Leyen’s speech, shares in high-flying Chinese EV companies have fallen sharply today, with Warren Buffett-invested BYD (BYDDY, $65.62) losing 2.8% of its value and rival Xpeng (XPEV, $18.65) losing about 2.5%.

United Kingdom-China:  Just days after British police said they had arrested two people, including a parliament researcher, on charges of spying for China, press reports say the authorities are preparing to arrest several more people in the coming months on charges that they have been secretly working to undermine Britain’s democracy under the direction of the Chinese government.  The news points to a further rupture in China-U.K. relations, which could potentially include new, U.S.-style restrictions on bilateral trade, investment, and technology flows.

Russia-North Korea-Ukraine:  Russian President Putin and North Korean Supreme Leader Kim met today at a Russian space-launch facility in Vladivostok, with both pledging to deepen their cooperation on security and economic issues.  The two leaders are widely expected to strike a deal under which North Korea will sell weaponry to Russia to help it continue its invasion of Ukraine.

• Separately, reports today say Ukrainian missiles struck a shipyard in Russian-occupied Crimea, heavily damaging or destroying two Russian navy vessels in drydock.
• The successful attack reflects how Ukraine’s military reach has been extended now that it has received long-range missiles from countries such as France and the U.K.

Sweden:  The center-right government this week proposed a 2024 budget that would hike military spending by approximately 28%.  The proposed budget would put Sweden on track to meet the North Atlantic Treaty Organization’s standard of spending at least 2% of gross domestic product on defense, even though the country is still waiting to be accepted into the alliance.

U.S. Military:  U.S. Air Force Secretary Kendall has announced that the service will miss its annual recruiting goal by about 10% when the fiscal year ends on September 30, marking the first such shortfall since 1999.  The deficit shows how most of the military is struggling to keep up troop levels because of factors such as the strong civilian job market, lingering disruptions from the coronavirus pandemic, and difficulties in finding enough young people who can meet today’s physical and intellectual standards.

U.S. On-Line Prices:  While investors today will focus on the headline Consumer Price Index (see U.S. Economic Releases below), a separate private index shows on-line prices are falling in year-over-year terms.  The Adobe Digital Price Index for August was down a full 3.2% from the same month one year earlier, including annual price declines of 7.3% for appliances, 7.0% for sporting goods, and 11.6% for electronics.

U.S. Banking Industry:  Incoming data shows net new bank lending has slowed to a crawl, with outstanding loans growing at an annualized, seasonally adjusted rate of just 3.6% so far in the third quarter, compared with average growth of about 7.0% over the long term.  Of course, part of the slowdown reflects weaker loan demand now that the Federal Reserve has hiked interest rates so aggressively since last year.  In addition, however, the slow growth reflects cautious lending as banks worry about rising deposit costs and asset values.  Importantly, slow lending could also help to finally push the economy into the recession that we’ve been expecting all year.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment opens with a discussion of new irritants in the China-India relationship and what they mean for investors.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including indications that the Bank of Japan could end its negative interest-rate policy by year’s end and signs of progress in the negotiations for new labor contracts in the U.S. auto industry.

India-China:  India yesterday imposed anti-dumping tariffs on some Chinese steel imports, responding to a flood of foreign steel and complaints from local producers in recent months.  From April through July, government data shows steel imports into India were up 23% from the same period one year earlier, with imports from China alone up 63%.  The anti-dumping duties are scheduled to last for five years.

• From China’s perspective, India’s new tariffs will only add to the growing list of irritants in the countries’ bilateral relationship. Some other irritants on that list include:
  • Territorial disputes, including fatal clashes, in the Himalaya mountains;
  • Increasing Indian support for the Philippines in its territorial dispute with China in the South China Sea;
  • Indian pressure on Sri Lanka to avoid allying too closely with China;
  • India’s growing participation in the U.S.-led “Quad” security grouping;
  • Indian restrictions on Chinese social media apps based on national security concerns; and
  • Recent efforts by Prime Minister Modi to establish India as the leader of the “Global South,” i.e., poorer countries in South Asia, South America, and Africa.
• Along with the recent reprimand that Chinese President Xi received from senior Communist Party leaders over his domestic and international performance, these irritants probably help explain why Xi declined to attend last weekend’s G20 meeting, which Modi hosted in New Delhi.
• In any case, it is clear that the China-India relationship is souring. To further peel India away from China and bring it closer to the U.S.-led bloc, Washington is likely to encourage that estrangement, including with economic incentives that could help make India more attractive for investors.  Nevertheless, our quantitative, objective methodology for assigning countries to the world’s evolving geopolitical and economic camps currently puts India in the “Leaning China” bloc, mostly because of India’s membership in the China-led Shanghai Cooperation Organization and its relatively modest trade relationship with the U.S. versus China.  India’s continued presence in our “Leaning China” bloc, at least for now, serves as a reminder that there could be delays and speed bumps before India swings more fully into the U.S.-led bloc.

Chinese Economy:  Two of the largest cities in Shandong province, China’s second-most populous region, said they have lifted their restrictions on home purchases.  That adds to the list of major local governments in China that have taken steps to boost their housing markets after being encouraged to do so by the central government.  Nevertheless, the piecemeal regulatory moves are widely viewed as insufficient to spark a significant improvement in home purchases or general economic growth.

Chinese Military:  Satellite imagery and social media posts show a large, nearly completed new drydock and basin at a major shipyard known for producing China’s top amphibious assault vessels.  The new facilities suggest Beijing has given the order to move forward with the construction of its massive, new Type 076 “landing helicopter docks.”  The new LHDs will be able to launch both helicopters and drones, aided by state-of-the-art electromagnetic catapults like those on China’s newest aircraft carrier and the U.S.’s new Gerald Ford-class carriers.

• Even though China already has the world’s largest navy, the new LHD program shows that Beijing intends to expand it further and increase its capabilities in preparation for a potential takeover of Taiwan and/or war with the U.S. On a related note, the Chinese navy today is launching its biggest-ever exercise with an aircraft carrier in the waters around Taiwan, the Philippines, and Guam.
• We continue to believe that China’s unceasing military buildup and modernization program will spark ever-greater concerns among Western officials, drowning out those business elites who argue for maintaining trade and investment ties with China. The result will be further risk for those who invest in companies based in China or who are dependent on the Chinese market.

Japan:  In a recent press interview, Bank of Japan Governor Ueda said his policymakers could be in a position to end their negative interest-rate policy by the end of the year, so long as there is continued growth in the country’s consumer prices and wage rates.  Coupled with the BOJ’s recent decision to allow longer-term bond yields to fluctuate more widely, the statement provides further confirmation that the policymakers are edging toward tighter monetary policy after years of extraordinarily loose policy.

• In response, the yield on longer-term Japanese government bonds has climbed smartly in recent days. The yield on the benchmark 10-year JGB yesterday closed at 0.705%, up from 0.589% one month ago and 0.251% one year ago.
• The value of the Japanese currency has also sharply appreciated. The JPY yesterday closed at 146.51 per dollar ($0.0068), for an appreciation of almost 1.0% from its level just one week ago.

United Kingdom:  In the three months ended in July, average wages excluding bonuses were up a record 7.8% year-over-year, while average total pay was up 8.5%.  The figures show British pay has now grown faster than the 6.8% rise in the consumer price index over the last year, which should boost consumer purchasing power and tempt the Bank of England to hike interest rates further.  On the other hand, the monetary policymakers will be concerned about a separate report today showing that in the three months to June, the value of residential mortgage in arrears was up a full 28.8% year-over-year, as rising interest rates put pressure on homeowners with floating-rate mortgages.

Libya:  Mediterranean Cyclone Daniel has devastated areas of coastal Libya, causing massive flooding and at least 5,000 deaths.  Libya is not a major economy, but the destruction could drive more Libyans toward migrating to Europe, potentially causing a new, politically divisive migration crisis in that important economy.

U.S. Bond Market:  New data from LSEG shows corporate bonds issued so far in 2023 will come due in an average of 10.0 years, marking the shortest average maturity in more than a decade.  The average maturity for investment-grade bonds has fallen to about 10.5 years, while the average for junk bonds has fallen to 6.0 years.  The shorter maturities suggest firms are betting that the Federal Reserve will soon be cutting interest rates.

U.S. Defense Industry:  As we’ve tracked rising U.S.-China tensions and resulting growth in U.S. defense budgets, we’ve noted that the relatively small, post-Cold War defense industrial base is bumping up against capacity constraints that are slowing the effort to rebuild allied defenses.  However, recent articles in Defense News illustrate how the Defense Department is helping address those problems.

• To accelerate the output of submarines, for example, the Navy since 2018 has spent some $2.3 billion on initiatives such as:
  • Promoting “strategic outsourcing,” which removes bottlenecks by shifting heavy subcomponent manufacturing out of the shipyards, and with those modules produced elsewhere, the shipyards can focus on final assembly, outfitting, and testing;
  • Providing funds to help expand and modernize the two existing shipyards that produce ballistic missile submarines and attack submarines; and
  • Expanding the supplier base by providing capital investment funds to smaller private firms so they can begin producing submarine-certified components.
• As these examples illustrate, the effort to expand the defense industrial base will help feed the re-industrialization of the U.S. economy that we’ve been writing about. As we’ve argued, re-industrialization will likely boost investment prospects in the industrial sector.

U.S. Auto Industry:  Automaker Stellantis (STLA, $18.69) said it has made progress in its negotiations for a new labor contract with the United Auto Workers, just days before the Thursday expiration of the current contract and the potential start of a disruptive strike.  The referenced progress probably relates, at least in part, to the company’s industry-leading offer of a 14.5% pay raise and the UAW’s modest cut in its demands to a pay hike of about 35%.  Still, UAW chief Shawn Fain complained that Stellantis and the other major automakers have waited until the last moment to make their economic offers, indicating he will keep up pressure on the firms in the hope of extracting large pay increases and other benefits.

Global Oil Market:  Fatih Birol, chief of the International Energy Agency, argues in an opinion article today that the world is coming to the end of the fossil fuel era, as the agency for the first time forecasts that global demand for petroleum oil, natural gas, and coal will peak before 2030.  According to Birol, the new, earlier forecast for peak consumption of fossil fuels can be attributed to the greater-than-expected investments in renewable energy projects over the last year.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news about Chinese domestic politics and the country’s currency, the renminbi.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including news of a cut in the European Union’s economic growth forecast and increased concerns about a potential federal government shutdown in the U.S.

Chinese Domestic Politics:  According to insider reports, influential Communist Party officials unexpectedly warned President Xi at their annual Beidaihe leadership retreat that if China’s political, economic, and social turmoil continues without any effective countermeasures being taken, the party could lose public support, posing a threat to its rule.  The reports say Xi was stunned by the reprimand and bitterly complained about it to his confidential advisors afterward.

• The reports could help explain why Xi failed to attend the Group of 20 (G20) summit in India over the weekend, why he missed a key speech at the recent BRICS summit, and why he appears to be backing away from a visit to the U.S. later this month.
• Rather than expressing his disdain for U.S.-founded international organizations, as pundits have suggested, Xi might be pulling back from such meetings to avoid being pressed on Chinese security and economic policies. In other words, Xi may have pulled back from these venues not for deliberate strategic reasons, but because of domestic political challenges.
• The reports serve as a reminder that Xi must still contend with domestic political pushback against his policies, even if he has done a good job solidifying his power. Going forward, that may force him to temper some of his policies and provide more stimulus to the economy despite his aim to rein in debt and control the private sector.
• All the same, other reporting suggests he is doubling down on at least some of his initiatives. In several recent speeches, for example, he has urged government officials to prepare for “worst case scenarios” and “extreme circumstances,” which some outsiders have interpreted to mean he is preparing for war with the U.S.

Chinese Economy:  The People’s Bank of China today issued a warning against speculating against the renminbi (CNY), saying PBOC officials “are capable of and feel confident in . . . keeping the renminbi exchange rate at a reasonably stable level.”  In response, the currency has rallied as much as 1.0% to 7.2698 per dollar ($0.1376).  Nevertheless, the renminbi is still trading close to a 16-year low as investors fret over China’s ongoing economic slowdown and worsening tensions with the West.

India:  As foreign investors sour on the Chinese economy, India is reportedly ramping up its infrastructure investment to increase its attractiveness as a place to do business.  For example, the country now has approximately 90,000 miles of national freeways, almost double the mileage one decade earlier.  The expansion and upgrading of India’s infrastructure will probably encourage even more foreign direct investment and portfolio investment.

Japan:  Another Asian country that appears to be benefiting from China’s malaise is Japan.  The Wall Street Journal today carries a useful examination of what’s been driving the Japanese stock market higher after many years in the doldrums.  Besides investors’ shift in focus away from China, the article cites positive developments such as improved corporate governance in the country, recent investments by Warren Buffett, and low valuations.

European Union:  The European Commission today cut its forecast for EU economic growth this year, saying it now expects gross domestic product to grow 0.8% in 2023, rather than the 1.0% it expected in May.  The Commission also said GDP will grow just 1.4% in 2024, down from 1.7% previously.

• The revised forecasts reflect headwinds such as high consumer price inflation and a big slowdown in German industrial output.
• Importantly, the new forecasts could help convince the European Central Bank’s policymakers to hold interest rates steady at their meeting on Thursday, rather than hiking them further in their continued fight against inflation.

United Kingdom-China:  In a bilateral meeting between British Prime Minister Sunak and Chinese Premier Li Qiang at the weekend’s G20 summit, Sunak said he personally expressed his “very strong concerns” to Li about China’s interference in the U.K.’s parliamentary democracy.  Sunak’s announcement followed news that British authorities in March arrested two men on charges related to spying for China.  One of those arrested was a long-time researcher in the U.K. parliament who had close contacts with Conservative Party politicians.

United States-Vietnam:  At their weekend summit, President Biden and Vietnamese leader Nguyễn Phú Trọng signed an agreement elevating their countries’ relationship to that of a “comprehensive strategic partnership.”  The agreement lays the groundwork for increased defense cooperation between the countries and establishes a joint semiconductor supply program to boost Vietnamese computer chip manufacturing in support of U.S. businesses.

• Previously, Vietnam had signed such strategic partnership agreements with only four other countries: China, Russia, India, and South Korea.
• The deal shows that China’s geopolitical aggressiveness in the South China Sea is pushing Vietnam into Washington’s embrace, just as it has done to the Philippines, and as it is likely to do to other countries in the Indo-Pacific region.
• Based on our objective methodology for assigning countries to the world’s evolving geopolitical and economic blocs, we currently assess Vietnam to be in the “Neutral” bloc. For example, note that even as Vietnam tiptoes into a closer relationship with the U.S., it is also continuing to seek weapon imports from Russia to build its defense capability against China.  However, if Washington and Hanoi continue to cooperate more closely, Vietnam could eventually shift to the “Leaning U.S.” camp, or even to the “U.S.-led bloc.”

United States-Venezuela:  Rumors that secret talks between Washington and Caracas will lead to détente and reduced economic restrictions have given a boost to Venezuelan bonds recently.  Although the debt still trades at a tiny fraction of its face value, the hope of renewed cross-border investment has pushed the value of the benchmark 2027 bond up above 10 cents on the dollar.

U.S. Household Wealth:  Data from the Federal Reserve shows the net worth of U.S. households and nonprofits rose to a record $154.3 trillion in the second quarter, driven about equally by the rebound in stock prices and rising real estate values.  The rise in net worth comes despite moderating economic growth and concerns about an impending recession.

U.S. Labor Market:  The United Auto Workers union continues to negotiate for a new labor contract with the top three U.S. automakers—Ford (F, $12.30), General Motors (GM, $32.95), and Stellantis NV (STLA, $18.23)—with the current contract expiring Thursday night at midnight.  In simplistic terms, the auto manufacturers want to channel much of their recent profits into new electric vehicles, but the union, with new leverage because of labor shortages, wants them to share their proceeds with employees to make up for significant concessions they granted over the last decade.

U.S. Policymaking:  The House of Representatives is back in session this week after its summer recess, and all eyes are on the increasing frictions between Speaker McCarthy and the right wing of his Republican Party.  The increasing acrimony has raised concerns about a destabilizing leadership battle and the possibility of a partial shutdown of the federal government.  Such a shutdown could happen if the right-wing of McCarthy’s party prevents passage of the appropriations bills needed to fund the government once the current fiscal year ends on September 30.  Coming just as more pandemic stimulus programs are set to end (including the moratorium on student loan payments and subsidies for childcare centers), a government shutdown could help to finally push the economy into the long-expected recession.

View PDF