by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment covers three main themes: 1) The impact of better-than-expected growth on global interest rates; 2) How China’s economic troubles are not going away anytime soon; 3) Why investors will be paying close attention to gatherings in South Africa and Jackson Hole, Wyoming, next week.

 Party’s Over? Stronger-than-expected economic growth has kept central banks from cutting interest rates, leading to tighter financial conditions.

• Global bond yields have surged to their highest level since 2008 as investors price in additional rate hikes. The IMF had previously forecast that there was a 90% chance of a U.S. and European recession by the end of 2023. However, after two consecutive quarters of expansion, both economies seem on track to finish 2023 in expansion. Additionally, stubbornly high inflation rates suggest that banks may need to keep interest rates in restrictive territory for longer. These higher rates are likely to put a strain on the global financial system, which could spill over into bond markets.
• This higher-for-longer sentiment has weighed on investor appetite for risk, sending the S&P 500 down 2.0% and the NASDAQ 100 down 3.2% since Monday. The major shift away from riskier assets is related to the growing attractiveness of higher-yielding safe assets, such as inflation-adjusted U.S. 10-year Treasuries, which surged to a 14-year high of 1.89%. The rise in yields has also impacted mortgage rates. According to the Mortgage Banker Association, the average 30-year mortgage rate has risen to its highest level since 2002 at 7.09%.

• Despite the economy being more resilient than investors thought at the start of the year, the strong economic performance is not likely to persist indefinitely. One of the primary reasons for the economy’s good run over the last few quarters is that fiscal and monetary policies have likely made households less sensitive to changes in interest rates. Over 60% of homeowners have mortgage rates below 4%, and firms were able to take advantage of favorable credit conditions to extend the duration of their loans before interest rates rose to their current levels. According to the Fed Small Business Credit Survey, over 58% of firms applied for new financing in 2022, which reduced their need for new loans.

China Worries Spreads: There is mounting evidence that China is still facing a severe property crisis.

• The Chinese financial system is coming under scrutiny after several institutions were unable to repay their debts. Zhongrong International Trust Co., which considerable real estate exposure, has missed payments on several products and currently has no immediate plan to make creditors whole. The situation has led to a spate of protests as clients look to hold the trust accountable. At the same time, China Evergrande Group filed for bankruptcy in New York and is currently working on restructuring its debt in Hong Kong. The ongoing turmoil shows that China’s property problems are likely worsening.
• The situation is likely to exacerbate China’s economic woes. Earlier this month, it was revealed that Chinese exports had fallen by the largest amount since the start of the pandemic. Meanwhile, consumer confidence remains near all-time lows. Additionally, Beijing’s resistance to providing additional stimulus is also likely to hamper the country’s economic growth and investor sentiment. The ongoing troubles have led to increasing calls for the People’s Bank of China (PBOC) to provide more aggressive policy easing to address these issues. The PBOC has already cut policy rates twice in three months and may offer more easing if the economic situation continues to deteriorate.

• The financial instability in China is currently isolated from the rest of the world. However, the global markets may still feel the spillover effects. Much of the domestic demand is expected to decline as China deals with its debt burdens. This problem could become more acute if Beijing forces households to absorb the losses from the property fallout. As a result, this could have a negative impact on international trade, as the lack of Chinese demand will weigh on commodity prices and make the country’s exports relatively cheap. This could help to reduce global inflation.

 A New Chapter: Next week, two major conventions will take place, one in South Africa and the other in the United States.

• The 15^th BRICS summit will take place in Johannesburg, South Africa on August 22-24, 2023. Leaders are expected to discuss the development of a new common currency backed by the commodities of the group members. There is also speculation that the bloc may be expanding to include more countries. While the group has denied that it is trying to create a rival to Western dominance in international trade, it is clear that they are at least interested in providing an alternative to the current order. As a result, the event will be closely watched by the global community.
• Meanwhile, central bankers from around the world will be gathering in Jackson Hole, Wyoming, for the annual meeting of the Federal Reserve Bank of Kansas City. The meeting is traditionally a forum for central bankers to share their views on the global economy and monetary policy. This year’s meeting is likely to be particularly important as policymakers grapple with the challenge of tightening monetary policy without triggering a recession. Federal Reserve Chair Jerome Powell is set to speak at the summit, and his remarks will be closely watched for clues about the Fed’s future policy plans.

• The upcoming BRICS summit and the Jackson Hole Economic Policy Symposium may have major ramifications for interest rate expectations. The potential for BRICS to issue bonds backed by a non-U.S. currency could sap future demand for U.S. Treasuries, making it more expensive for the U.S. government to borrow money. Although this is unlikely to happen, it is a risk that investors will be watching closely. Powell’s speech at Jackson Hole is also likely to be closely scrutinized by investors. While he is widely expected to remain vague about the Federal Open Market Committee’s next rate decision, he could give investors some insight into the inner thinking of policymakers. Any hints about the direction of future rate hikes could have a significant impact on financial markets.

Odds and Ends: President Trumps said that he would not reappoint Powell if reelected. There are over 2.2 trillion options set to expire today.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will cover three key themes: what the latest FOMC meeting minutes could mean for monetary policy going forward, an update on the latest complaints regarding artificial intelligence, and why the upcoming Argentine election in October has investors on edge.

Is the Fed Done? The hawkish Fed minutes weighed on market sentiment as investors pulled back on bets of a Fed pause.

• The minutes of the Federal Open Market Committee’s (FOMC) July 25-26 meeting revealed that most members believed that there was a significant upside risk to inflation, which could warrant additional rate hikes. This hawkish tone suggests that, despite the progress made in bringing down inflation, policymakers are not yet confident that inflation has peaked and are willing to take a more aggressive approach in tightening monetary policy. However, there were also a few more optimistic members of the FOMC. Two officials favored leaving rates unchanged or “could have supported such a proposal.” Although there were no dissenting votes, it is clear that not all policymakers are on the same page.
• Investor sentiment soured following the release of the FOMC minutes, as the market could not rule out the possibility of a hard landing. The S&P 500 closed yesterday down nearly 0.8%, while the U.S. Dollar Index (DXY) rallied. Despite the disappointing news, investors did not severely change their rate expectations. The yield on the 10-year Treasury rose a paltry 5 basis points, and the CME FedWatch Tool’s expectation of a September hike increased only modestly from 10% to 12.5%. This suggests that investors still believe that the Fed is near the end of its hiking cycle.

• Despite the market’s reaction, it is too soon to rule out another rate hike this year. As the chart above shows, the economy is projected to accelerate in the third quarter, making it difficult for the Fed to justify easing policy any time soon. This may explain why investors sold off after the report, as they may have wanted to lock in their gains from earlier this year. However, we will be paying close attention to Fed Chair Jerome Powell’s speech at Jackson Hole next week for any hints as to how the Fed is leaning. Our expectation is that Powell will likely keep his options open.

AI Presence Expanding: Generative artificial intelligence (AI) is receiving flak after author Jane Friedman found books generated by the technology that were claimed to have been written by her.

• The rise of AI-generated content has sparked controversy with some people concerned that it will displace human workers. This is because AI models are trained on massive datasets of text and code, including the work of authors. Without proper attribution, this can lead to accusations of plagiarism and copyright infringement. A survey by the Authors Guild found that 90% of writers believe they should be compensated for their work used to train AI models. Others argue that the rising popularity of AI-generated content threatens to crowd out quality work from human writers.
• Generative AI content-generating applications are at the heart of the Hollywood writers’ and actors’ strikes, and their concerns could easily spread to other industries. The strike has gone on for over 100 days, and it appears that studios have already made some concessions, such as crediting writers for work used by the models and using more human-generated content. However, it remains to be seen whether these concessions will be enough to satisfy the picketers. Regardless of the outcome of the strikes, it is clear that AI is here to stay in Hollywood. A recent survey found that over 96% of media executives plan to increase their spending on AI technology.

• The ongoing dispute between Hollywood writers and actors is an example of how workers are concerned about the potential for technology to displace low-skill and middle-skill white-collar workers, particularly among young people. Without adequate regulations in place, the growing ubiquity of AI could lead to a knowledge gap and inequality in the workforce. As a result, we suspect that the technology will likely face increased scrutiny in the coming months as concerns about its disruptive potential enter the national conversation. Investors should be aware of the uncertain regulatory landscape for the technology and how this may impact company earnings in the future.

Argentina in the Spotlight:  The presidential front-runner in Argentina unveiled controversial proposals to overhaul the Argentine economy that have left many investors worried.

• Libertarian presidential candidate Javier Milei has proposed a sweeping set of free-market policies to jumpstart the Argentine economy. In a two-hour interview, he promised to slash government spending by at least 13% of GDP by 2025, shutter the country’s central bank, and replace the national currency with the U.S. dollar. These policies are designed to help rebrand Argentina as a stable and attractive destination for investment, following years of economic turmoil. Argentina narrowly avoided default earlier this year after it was able to restructure nearly $22 billion of domestic debt, extending the maturity into 2024 and 2025. The event led S&P to slash Argentina’s national rating to SD from raCCC+.
• In addition to radically reforming the economy, the new leader vowed to distance Argentina from socialist countries, including its two largest trading partners: Brazil and China. According to the Observatory of Economic Complexity, these two countries imported more than $17 billion worth of Argentine goods in 2021, which is more than the next three countries combined. Milei’s remarks are likely to be a major shift in the country’s trade policy as it has often relied on China for exports and debt relief. Growing uncertainty regarding the impact of his policies led to a steep decline in the Argentine peso (ARS).

• The rise of Javier Milei is a reminder of how volatile Latin American politics can be. The region has typically swung between left-wing and right-wing governments, each promising to bring about a better future. However, as the world moves towards regional blocs, we see the same volatility in foreign and trade policy. For example, Brazil’s relationship with China was very contentious before Lula took over the presidency, since former President Jair Bolsonaro had blamed China for the pandemic. As a result, investors should keep in mind that these blocs will be fluid, especially as the world moves away from globalization.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a brief remark on the importance of linking geopolitics to investment strategy.  We next review a range of international and U.S. developments with the potential to affect the financial markets today, including another instance in which U.S.-China tensions have apparently scuttled an international transaction and ominous signs of a potential autoworkers’ strike in the U.S.

Geopolitics and Investment Strategy:  The Financial Times today carries an interesting opinion piece by Saker Nusseibeh, CEO of asset manager Federated Hermes (FHI, $32.77), in which he argues that de-globalization and the fracturing of the world into blocs requires asset managers to pay closer attention to geopolitics.  According to Nusseibeh, asset managers today need to have a deep understanding of how geopolitics can affect asset values and prospects, and they need to actively develop the skill sets and human capital applicable to understanding those linkages.  As our regular readers know, we are longtime practitioners of geopolitical analysis and take great pride in our ability to walk from an understanding of the world’s political, security, and economic trends to the setting of investment strategy.  Reading Nusseibeh’s article today, our response is:  We couldn’t have said it better ourselves!

China-United States:  As one great example of how geopolitics can directly affect company operations and prospects, semiconductor giant Intel (INTC, $34.77) and Israeli computer-chip maker Tower Semiconductor (TSEM, $33.78) today said they will abandon their planned merger after failing to get timely approval from China’s State Administration for Market Regulation.  Beijing’s failure to approve the deal is being widely interpreted as further retaliation against the West for its clampdown on advanced technology flows to China.  As we have argued many times before, the increasing geopolitical rivalry between the U.S. bloc and the China/Russia bloc presents risks for any investor who has a position in Chinese assets or in assets dependent on the Chinese market and/or Chinese regulators.

China-Vietnam:  New commercial imagery shows China has suddenly started building an airstrip on one of the disputed Paracel Islands in the South China Sea.  At present, it appears the airstrip is too small to host larger military jets.  Nevertheless, its location on Triton Island, which is the Paracel Island closest to Vietnam, will likely be disconcerting to Hanoi.  While it’s become commonplace to note Beijing’s mistakes in economic management, this could be another instance of it over-playing its geopolitical and military hand, since construction of the airstrip could push Vietnamese officials even closer to the U.S.

Russia-United Kingdom:  British police said that in February they arrested five people, including three Bulgarians, on charges of working under non-official cover for the Russian intelligence services.  The arrests are only the latest in a series of arrests of Russian intelligence operatives posing as common citizens in Western countries, rather than as diplomats and other officials.  That likely reflects the damage done to Russian intelligence when Western countries expelled hundreds of official-cover spies immediately after Russia’s invasion of Ukraine last year.  To compensate, the Russians have activated their deep-cover operatives, raising their profiles and putting them at greater risk of arrest.

Russia:  After the central bank’s big interest-rate hike yesterday failed to stem the ruble’s (RUB) steep depreciation, President Putin today is holding an emergency meeting with his top economic officials to discuss ramping up currency controls.  The measures being considered include requiring exporters to convert 80% of their foreign-currency revenue to RUB, banning foreign loans and dividend payments, and cancelling import subsidies.  In New York trading yesterday, the RUB closed at 98.001 per dollar ($0.0102), down 1.0%.

United Kingdom:  Just a day after a report of surging wage rates sparked renewed concerns about inflation, the Office for National Statistics today said the July consumer price index was up 6.8% from the same month one year earlier, considerably better than the 7.9% rise in the year to June and the lowest headline inflation reading since February 2022.  However, after excluding the volatile food and energy components, the July “core” CPI was 6.9%, matching the core inflation rate in June and coming in above expectations.  On balance, the reports suggest the Bank of England will have to continue hiking interest rates to get a handle on the U.K.’s sticky inflation problem.

Japan:  Now that the country is seeing sustained inflation again and longer-term interest rates are moving up, Japanese banks are starting to realize that their bond traders may not have the skill set to deal with higher yields and greater volatility.  Some bankers are therefore actively seeking to hire older traders with experience extending back to the 1980s.  At least one banker has likened the situation to this year’s Top Gun: Maverick movie, in which an aging pilot with specialized skills is called back into service.

Argentina:  Even though the government implemented a sudden currency devaluation and interest-rate hike immediately after radical right-wing economist Javier Milei won the weekend’s presidential primary election, the peso (ARS) has remained under pressure on concerns about Milei’s proposed austerity and currency policies.  The markets increasingly suggest the government will have to devalue the currency further in the coming days, which would only add to Argentina’s sky-high price inflation.  The chaos also puts at risk the International Monetary Fund’s final approval for the latest $7.5-billion installment of its $44-billion bailout package.

U.S. Labor Market:  The United Autoworkers Union said new contract negotiations with the top U.S. automakers have been going too slowly, so it will hold a strike vote next week.  If at least two-thirds of the union members vote to authorize the strike, union leaders would be able to formally call the walk-out as the September 14 expiration of the current contract draws closer.  Based on the recent militant comments by union leaders and the fact that they have made such aggressive requests in the negotiations, the probability of a costly, disruptive strike is elevated.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with disappointing news on the Chinese economy.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including data showing Japan’s economic growth is now far surpassing that of the U.S. and China and other reports of new regulatory trends in the U.S.

China:  The National Bureau of Statistics released several data points today showing continued deterioration in the economy.  For example, July industrial production was up just 3.7% from the same month one year earlier, far weaker than the expected rise of 4.6% and the increase of 4.4% in the year to June.  The agency also said July retail sales were up just 2.5% year-over-year, weaker than both the anticipated rise of 4.4% and the June increase of 3.1%.  The July unemployment rate rose to 5.3%, marking its first increase since February.

• In response, the People’s Bank of China cut several of its key policy interest rates. For instance, it cut the rate on its one-year medium-term lending facility to 2.50% from 2.65% previously.  It also cut its rate on seven-day reverse repurchase operations to 1.80% from 1.90% and pumped the equivalent of $28.1 billion in new loans into the banking system at the new, lower rate.
• In a less helpful response, the statistics agency said it would no longer publish an unemployment rate for youth aged 16 to 24, ostensibly because that series has been distorted by the large number of students in that cohort. The new hide-the-ball tactic illustrates how the government appears to be prioritizing perception control over policies that would stabilize the economy and set it up for stronger growth again.
• So far this morning, the data and associated policy actions have served to weaken the renminbi (CNY) to a rate of 7.2848 per dollar, down 0.4%. Since the weak data bodes poorly for the global economy, many key global stock markets are trading down so far this morning.  However, one exception is Japan, which has not only reported better-than-expected economic growth today, but its stocks have also been driven higher by investors fleeing the Chinese markets.
• Today’s flows out of Chinese assets exacerbate longer-term outflows. For example, Connecticut-based Bridgewater Associates, the world’s largest hedge fund, said in a regulatory filing yesterday that it liquidated almost one-third of its Chinese stock holdings in the second quarter.  Even though Chinese electric vehicles have recently taken the world by storm, Bridgewater also slashed its holdings of Li Auto (LI, $39.95) and XPeng (XPEV, $16.24).  The moves mark Bridgewater’s most drastic pullback from China since it dumped a number of the country’s top technology stocks one year ago.  The activity is consistent with our oft-stated view that rising U.S.-China geopolitical tensions, slowing Chinese economic growth, and Beijing’s increasing intrusions into the economy have significantly raised the risks of owning Chinese assets.

Russia:  Following our story in yesterday’s Comment about the weakening ruble (RUB) and how it has prompted some Russian officials to blame the central bank, the institution today held an emergency policy meeting and jacked up its benchmark interest rate to 12.0%, compared with 8.5% previously.  Nevertheless, the move has given little boost to the currency, which is being pushed down in part by concerns that the war in Ukraine and Russia’s economic and political isolation will continue for the foreseeable future.

Japan:  In contrast with the bad economic news out of the China/Russia bloc, the Cabinet Office today said Japanese gross domestic product expanded at an annualized rate of 6.0% in the second quarter, smashing through expectations and accelerating smartly from the growth rate of 3.7% in the first quarter.  Excluding the distorted period around the coronavirus pandemic, it was Japan’s strongest economic growth since 2015.  It also marked a rare quarter in which Japanese growth exceeded that of the U.S. (at 2.4%) and China (about 3.6%).  The good economic performance will likely give a further boost to Japanese stocks going forward.

United Kingdom:  Average total pay (including bonuses) in April through June was up 8.2% year-over-year, accelerating from the rise of 7.2% in the three months ended in May and marking the biggest annual rise ever recorded outside of the pandemic period.  Excluding bonuses, regular pay in April through June was up a record 7.8% year-over-year.  The strong wage growth will prompt fears of even more consumer price inflation and a need for further aggressive interest-rate hikes by the Bank of England.

U.S. Environmental Regulation:  A judge in Montana has ruled the state can be sued for failing to take climate change into account when approving fossil fuel projects, based on language in the state constitution that guarantees residents “the right to a clean and healthful environment” and stipulates that the state and individuals are responsible for maintaining and improving the environment “for present and future generations.”

• The state government said it will appeal the ruling to the Montana supreme court, but there is probably still a chance that the ruling will stand. If so, it would put new responsibilities on the state and potentially set a precedent for climate-change regulation in other states.
• Only a few state constitutions have similar language related to the environment, so commentators are taking a sanguine view of the decision. Nevertheless, it’s useful to remember how the modernized state constitutions put into place in the 1960s and 1970s eventually spurred a movement which boosted education funding and channeled billions of dollars into economically disadvantaged school districts based on their broad, aspirational guarantees of an equal education.  There is probably some risk that if the Montana ruling stands, activists will be more successful than expected in finding broad, aspirational language in other state constitutions that could support new climate regulations.

U.S. Financial Market Regulation:  According to lawyers, the Securities and Exchange Commission has recently sent subpoenas and other document requests to several asset managers regarding their environmental, social, and governance investment marketing.  The document requests point to a potential new SEC crackdown looming for ESG funds, with an apparent focus on conventional investment funds that have re-purposed themselves as sustainable funds.

U.S. Bank Regulation:  In a speech yesterday, Federal Deposit Insurance Corporation Chairman Gruenberg signaled that the FDIC will soon propose a requirement that regional banks with around $100 billion or more in assets be required to file “living wills,” or plans for how they would be sold in an orderly manner if they run into a crisis.  The speech offers further evidence that U.S. regional banks are heading for increased regulation similar to that of the very largest banks.

U.S. Homebuilding Industry:  Warren Buffett’s Berkshire Hathaway (BRK.B, $358.48) said in a regulatory filing yesterday that it has initiated several new positions in homebuilder stocks.  That’s consistent with our view that a decade of under-building after the Great Financial Crisis has left the nation’s housing inventory much too small, which will probably spur strong makeup homebuilding in the coming years.  On top of that, many homeowners today are reluctant to put their existing home on the market because they’ve locked in very low interest rates with 30-year, fixed-rate mortgages.  The lack of existing home inventory is producing a boom in new home construction and strong pricing for newly built houses, despite today’s high mortgage interest rates.

U.S. Critical Minerals Industry:  A mining start-up backed by the U.S. government and focused on critical minerals such as nickel and lithium has raised $200 million in fresh equity, setting it up to become a “unicorn” with a valuation of more than $1 billion.  The company, Dublin-based TechMet, illustrates how industrial policy funds and the government’s interest in securing critical supply chains has the potential to spawn important new companies in industries of the future.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with new evidence that China’s slowing economy may be setting the scene for a potential financial crisis.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a right-wing electoral win in Argentina’s weekend elections and the latest on last week’s Maui wildfire.

China:  Two new developments are raising concerns today about China’s faltering economy and the risk of a financial crisis in the country.  Along with challenges such as slowing global demand for Chinese exports, bad demographics, and government intrusion into the economy, the growing risk of a financial crisis could slow the economy further, weighing on global economic growth and creating further headwinds for Chinese stocks.

• Following on its missed international bond payments last week, real estate developer Country Garden (CTRYY, $3.23) suspended trading in at least 10 of its mainland bonds. That move has been especially concerning because the company, until now, had weathered the government’s debt crackdown relatively well.  It now appears that developers are in a new crisis, pushing their stocks down sharply so far today.
• In the second concerning development, reports have surfaced that a number of units of conglomerate Zhongzhi (3737.HK, HKD, 1.17) have recently failed to make payments on the high-yield investment funds they offered. The news has raised concerns that the problems in China’s real estate sector are now spreading to the rest of the economy.

China-Taiwan-United States:  On Saturday, Taiwanese Vice President Lai Ching-te, the leading candidate for president in next year’s election, touched down in the U.S. on his way to a meeting in South America.  The transit through U.S. territory is being interpreted as provocative by China and could potentially prompt Beijing to take dangerous retaliatory steps, such as increased naval and air sorties around Taiwan.

Russia-Ukraine War:  The Ukrainian military over the weekend again targeted Russia’s supply lines to its troops in Crimea, with at least two more missile attacks on the bridge connecting Russia proper to the peninsula.  In recent weeks, the Ukrainians have targeted multiple bridges and other infrastructure running to Crimea and the Russian forces occupying southeastern Ukraine.  Some evidence suggests the effort has weakened the Russian forces, but not enough to have a major impact on the war, at least so far.  Meanwhile, Russia launched more missile strikes against Ukraine’s Black Sea port of Odesa this morning, as it continues trying to choke off Ukrainian grain exports.

• Separately, the Russian currency has extended its recent depreciation, weakening to a rate of more than 100 per dollar today. The ruble (RUB) has now lost more than 25% of its value against the dollar this year.
• The plunging RUB has sparked public infighting among top Russian officials, with a senior economic advisor to President Putin and a top legislator both castigating the central bank for keeping monetary policy too loose, despite its interest-rate hike last month.

Brazil:  The government of left-wing populist President Luiz Inácio Lula da Silva has proposed a 371 billion BRL ($76 billion) public works program aimed at spurring economic growth and protecting the environment.  If the program spurs additional investment by state-owned firms and the private sector, the government believes it will channel a total of 1.4 trillion BRL ($287 billion) into new construction, infrastructure repair, and environmental projects.

Argentina:  In a primary election over the weekend, radical libertarian Javier Milei and his Freedom Advances party took first place with a strong 30.1% of the vote, beating right-wing Patricia Bullrich and her Together for Change party, which ended up with 28.3%.  The results illustrate the extent to which Argentines have soured on the left-wing populism of Peronism and Kirchnerism.  Milei has even called for extreme austerity and dollarizing the economy.  However, even though the election results point to a shift toward more orthodox economic policies in Argentina, Milei’s proposals are considered so radical that they could be destabilizing, so it’s not clear that the results will spark a lasting appreciation in Argentine assets.

U.S.–Private Debt Market:  New data shows that private lending, which was already growing strongly before this year, has accelerated even further after the bank crisis this spring.  In part fueled by impending new capital standards being imposed on the traditional banking industry, the increasing amount of lightly regulated lending is raising concerns about further bank disintermediation and growing financial risks.

U.S.–Maui Wildfire:  Federal, state, and local officials continue to search for victims of last week’s devastating fire and investigate how it became such a disaster.  Almost 100 fatalities have been tallied so far, making it the deadliest wildfire in the U.S. in about a century.  Importantly, officials and residents are urging vacationers to skip travel to the island for the time being in order to free up lodging resources for the newly homeless and reduce pressure on other local resources.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment discusses the following key topics: why the Federal Reserve may be closer to reaching its 2% inflation target than investors realize, our concerns about the regional banking system, and how rising crime in South America complicates U.S. efforts to build closer ties in the region.

 It Gets Better: Thursday’s CPI report not only reinforced investors’ views that the Fed may be nearing the end of its hiking cycle, but also suggests that monetary policy may need to ease next year.

• The Consumer Price Index (CPI) increased 3.2% in July from the previous year, according to the Bureau of Labor Statistics. The reading was above the previous month’s increase of 3.0% but below consensus estimates of 3.3%. Core inflation numbers were also impressive, declining from 4.8% to 4.7%. The reacceleration in the headline inflation number is likely due to base effect changes, which may not carry over to the next month. Meanwhile, the core CPI continues to be propped up by reporting lags in shelter data.
• Despite both price gauges being well above the Fed’s inflation target of 2.0%, there is growing optimism that the Federal Reserve may not need to raise rates again this year. The monthly reading shows that headline inflation rose at an annual rate consistent with 2.3%, while core inflation rose at a pace consistent with 1.9%. The market took the CPI report positively as traders loaded up on bets that the central bank was going to pause in September. The CME FedWatch Tool shows that there is over a 90% chance that policymakers will leave rates unchanged at their next meeting.

• Inflation is falling more quickly than most people realize. The July report shows that consumer prices have only risen 2.5% from the previous year after removing shelter, which accounts for over a third of the index weight, from core CPI. This discrepancy may continue going into next year, as it typically takes about 12-18 months for housing data to make its way into the CPI index. Additionally, if the San Francisco Fed is correct that shelter prices will fall into negative territory in 2024, it could mean that central bank policymakers may need to cut rates to avoid deflation.

Regional Bank Troubles: Nearly five months after the collapse of Silicon Valley Bank (SIVBQ, $0.15), small and midsized banks are still struggling to stand on their own.

• Moody’s has downgraded the credit ratings of several regional lenders following a review of their financial positions. The credit rating agency justified its decision by citing several factors, including slowing deposit growth, rising funding costs, and deteriorating asset quality, particularly in real estate. Although the banks maintained their investment-grade ratings, the weak valuations suggest that the banking system still poses a threat to the economy. So far, banks have been able to cling to life by relying on loans from the Federal Home Loan Banks and the new Fed loan facility.
• The latest Senior Loan Officer Opinion Survey (SLOOS) revealed that banks are more cautious than ever about lending. The net percentage of domestic banks tightening their lending standards rose to 50.8% in the third quarter of 2023, the highest reading in the post-pandemic era. This decision to restrict lending is related to the rising risks that banks are having to absorb when lending at higher rates. Many U.S. banks have accumulated heavy losses on their books, and it has reached the point where lenders have been offloading property loans at fire sale prices.

• Regional banks will continue to struggle as long as the Federal Reserve keeps interest rates in restrictive territory. This is because higher interest rates force banks to increase the amount they pay for deposits, which lowers their net interest margins. As a result, banks are not able to lend at the same levels, which could lead to slower economic growth. However, if the Fed commits to offering banks liquidity, it is unlikely that there will be a financial crisis any time soon. That said, regional banks’ inability to offer attractive savings rates to maintain deposits will leave them vulnerable to disintermediation.

Southern Uncertainty: Rising crime in South America is making it more difficult for the United States to build alliances with countries in the region that share its belief in democracy.

• A surge in gang violence has added to concerns about a societal breakdown in South America. On Thursday, Ecuadorian presidential candidate Fernando Villavicencio was assassinated at a campaign event. Once considered a relatively peaceful and stable country, Ecuador has emerged as a hot spot for criminal activity in recent years. Homicides have risen by more than 86% just between 2021 and 2022, as criminal groups use violent tactics to intimidate locals and further their political goals. The recent killing of Villavicencio, an outspoken critic of organized crime, is a stark reminder of how gang activity is spilling over into politics.
• The rise of gang violence in South America is likely to pave the way for more authoritarian leaders like Nayib Bukele, the president of El Salvador. Bukele has consolidated power by removing term limits, purging the Supreme Court, and replacing the attorney general with an ally. Despite these actions, he remains widely popular throughout South America. A recent poll found that he has an approval rating of 87% in his home country. He is also more popular than the pope in Chile, Venezuela, Ecuador, Guatemala, and Honduras. Bukele is hardly an anomaly, as it appears that Venezuelan President Nicolás Maduro, once considered a pariah on the continent, is now on the brink of a comeback.

• Rising violence within South America complicates the Biden administration’s efforts to expand its regional influence. President Biden has made “democracy versus autocracy” the organizing principle of his foreign policy, and his administration has made it clear that it will not support countries that backslide from democratic norms. This is likely why Biden refused to invite Cuba, Nicaragua, and Venezuela to the recent Summit of the Americas. As a result, the Biden administration is at risk of losing influence in the region to China, which has been more willing to overlook human rights abuses in order to expand its economic and political reach.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will focus on three key topics: the growing rift between the U.S. and China over semiconductors, possible threats to the European energy markets, and the White House’s latest attempt to mediate ties between Saudi Arabia and Israel.

 Another Salvo in the Chip War: The U.S.-China rivalry in artificial intelligence (AI) took a new turn after the U.S. government announced investment restrictions on Chinese tech companies.

• The White House issued an executive order that will restrict U.S. investment in Chinese companies developing quantum computing, advanced chips, and artificial intelligence. It will largely affect private equity and venture capital firms and will not take effect until January 1, 2024. This measure is the latest in a series of attempts by Washington to prevent China’s military from advancing its technology ambitions. In 2017, the People’s Republic of China declared that becoming a world leader in artificial intelligence by 2030 is a national priority. After the restrictions were released, China announced that it was considering retaliation.
• The tit-for-tat between the U.S. and China sent tech stocks tumbling on Wednesday, with the Philadelphia Stock Exchange Semiconductor Index (SOX) falling nearly 2%. Investors are concerned that the rivalry will hurt profitability as the U.S. looks to close ranks with other Western countries in a bid to contain China’s technological ambitions. The move by both the U.S. and China to restrict semiconductor exports will add to the headwinds for chipmakers, who are already working their way through a supply glut that is not expected to be resolved until later this year or early next. However, Chinese internet giants have already begun stockpiling chips in anticipation of future restrictions, which should lead to a temporary bump in sales.

• Despite recent moves by the Biden administration to “de-risk” the relationship between the United States and China, the process is likely to be slow and arduous. China accounts for the largest share of the revenue for companies in the S&P 500 outside of North America, and Beijing’s shift toward deleveraging means that it is becoming more reliant on foreign investment for capital. As a result, there are strong incentives for both countries to keep the relationship going, even as tensions rise. Thus, these actions by the Biden administration are steps toward the long-term trajectory of the relationship, but it is unlikely to have a substantial impact on companies in the short- to medium-term.

 Eurozone Energy Concerns: After narrowly avoiding a recession in the last quarter, high energy prices are likely to put the eurozone economy back in focus for investors.

• Earth’s hottest month on known record was July 2023, with global temperatures averaging 62.51 F, six-tenths of a degree higher than the previous record set in July 2019. This was largely due to El Niño conditions, which cause warmer ocean temperatures and more extreme weather events. The effects of El Niño on Europe are less consistent than in other regions, but northern countries could experience colder temperatures during the winter months, while southern countries in the region may experience wetter conditions. Potentially hazardous weather conditions could lead to a rise in energy demands.
• The war in Ukraine and possible labor protests in Australia have added to the energy uncertainty. Russia and Ukraine have launched attacks near each other’s energy infrastructure. On Wednesday, a Russian drone strike hit an oil depot in Ukraine, while Ukrainian drone strikes in the Black Sea have raised concerns about potential supply disruptions, as they could damage shipping vessels carrying oil and gas. Simultaneously, natural gas prices in the region surged almost 40% following reports that workers at important LNG plants in Australia are planning a strike for higher pay and better job security. The issues in Ukraine and Australia raise the likelihood of supply shortages.

• Although the euro area has made significant progress in building up its energy storage for the winter, there are still risks that could lead to energy spikes. A prominent German utility company has cautioned lawmakers against becoming overconfident in the region’s energy security. He warned that there is still much uncertainty concerning the upcoming winters, which could potentially lead to an energy crisis. A possible shortage of natural gas will weigh heavily on the struggling European economy and may push it into recession.

 Middle East Pivot: The White House has made a breakthrough with Saudi Arabia and is now hopeful of reaching a similar agreement with Israel.

• Saudi Arabia agreed to terms that would allow it to recognize Israel in exchange for progress on the Palestinian issue and security guarantees. The details of the arrangement are still being negotiated, but U.S. officials are optimistic that a deal can be reached within the next year or so. Additionally, Washington is also urging Riyadh to impose limits on its relationship with China. In response to the agreement, Israel has also requested a defense pact with the U.S. to join the deal with Saudi Arabia, as it seeks protection from a growingly assertive Iran.
• The U.S.’s efforts to resolve tensions between Saudi Arabia and Israel are a sign that it still wants to be a major player in the Middle East, even as it pivots toward the Indo-Pacific. This agreement will likely help counter the inroads China has made in the region. Over the last year or so, Beijing has engaged in talks with Riyadh over creating a petroyuan and has played a crucial role in restoring ties between Saudi Arabia and Iran. Resolving tensions between the two sides will likely build on the progress made with the Abraham Accords by paving the way for more peaceful relations in the Middle East.

• As the U.S. moves away from its role as an importer of last resort, it will likely continue to provide defense assistance to other countries to maintain its influence. This could take the form of intelligence sharing, joint military exercises, or weapon exports. We have already seen some of this play out in Ukraine and Taiwan, and it is possible that the U.S. would be willing to do the same in the Middle East. American defense and aerospace industries are well-positioned to capitalize on the global rearmament trend, as they have a long history of providing arms to allies and partners around the world.

View PDF