by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the latest news on China’s deteriorating relations with the West and the problems in its domestic economy.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including reports of rising inflation expectations in the eurozone and negative signs regarding the current labor contract talks in the U.S. auto sector.

China-Taiwan-Japan:  During a rare visit to Taiwan by a high-ranking Japanese official, former Prime Minister and current Vice President of the ruling Liberal Democratic Party Tarō Asō said the current period of peace in the region is now “tilting toward a time of emergency.”  Without specifically naming China and its intention to retake control of Taiwan, he warned that Japan, the U.S., and their allies would only be able to maintain peace in the Taiwan Strait if they bulk up their armed forces enough to deter any military action from a third country.  The warning is consistent with the analysis in our latest Bi-Weekly Geopolitical Report, published on Monday.

China-United States:  In the U.S.’s latest effort to keep the Chinese military from acquiring cutting-edge technology, President Biden will sign an executive order today requiring U.S. investors to report any private-equity or venture-capital stakes that they take in Chinese firms involved with semiconductors, quantum computing, or artificial intelligence.  Under the order, U.S. investors would also be banned outright from making direct investments in specific areas of those sectors.

• The new rules will reportedly be less stringent than China hawks in Congress and the military advocated, probably because of lobbying by business elites and some in the administration who want to limit tensions with China.
• Nevertheless, coming less than a year after the administration’s tough restrictions on sending advanced semiconductor technologies to China, the new rules will surely be seen by Beijing as a further attempt to hamstring China’s economic development. U.S. investment in China has fallen sharply in recent years, but the new rules could push it down even further.
• In any case, the new rules will worsen U.S.-China tensions further, which we continue to believe will dramatically affect the global economy and create risks for U.S. investors in the coming years.

China:  In the latest bad omen for China’s domestic economy, the July consumer price index was down 0.2% from the same month one year earlier, marking the first bout of deflation since 2020.  Unlike the U.S. and many other developed countries, China experienced little inflation amid the supply disruptions at the end of the coronavirus pandemic, at least in part because the government never provided much financial aid to help households get through the crisis.  Now that the pandemic has passed, however, many consumers are focused on rebuilding their savings rather than buying.

• Weak consumption demand and government interference in the economy are also discouraging investment, as is weak demand for Chinese exports. The situation is making it increasingly difficult for Chinese firms to hike prices.
• For the global economy, Chinese deflation translates into lower export prices which may help hold down inflation around the world. On a less positive note, however, low-priced Chinese goods dumped on the global market could weigh on foreign corporate margins.

Eurozone:  Despite the deflation in China, a popular gauge of future inflation expectations in the eurozone suggests investors are becoming more pessimistic about price hikes there.  The region’s “five-year, five-year forward inflation swap — a measure of the markets’ expectation of price growth over the second half of the next decade — hit 2.66% this week,” compared with the eurozone’s average inflation rate of about 1.3% in the decade before the coronavirus pandemic.

Italy:  Prime Minister Meloni’s right-wing populist government was forced to partially backtrack on its surprise windfall profits tax on lending institutions, which we described in our Comment yesterday.  It appears the government was unsettled by the big drop in Italian bank stocks yesterday, so it has instead said the tax will be capped at 0.1% of the banks’ risk-weighted capital.  That’s about one-fifth of the originally estimated hit.

U.S. Labor Market:  In a worrisome sign for the ongoing contract negotiations between the United Autoworkers Union and Stellantis (STLA, $19.34), UAW chief Shawn Fain has complained that concessions demanded by the automaker are a “slap in the face” to union workers.  Coupled with militant statements by other UAW officials recently, Fain’s statement underscores that the union is likely to drive a very tough bargain, as workers and their representatives know they have increased leverage amid today’s tight labor market.  We suspect the major U.S. automakers will need to agree to significant pay increases and improved benefits to avoid a strike this fall.

U.S. Commercial Real Estate Market:  New figures from Jones Lang LaSalle (JLL, $175.05) show real estate developers demolished 14.7 million square feet of office space in the first half of 2023, while breaking ground on only 4.8 million square feet.  That marks the first time in recent memory in which developers tore down more office space than they built.  The data provides further evidence of today’s pessimism regarding the prospects for commercial office space.

U.S. Orange Juice Market:  Nearby futures for frozen concentrated orange juice have hit a record high above $3.00 per pound, reflecting a dramatic decline in Florida’s citrus crop due to a string of hurricanes and tree blight in recent years.  Production in the state has fallen from about 240 million boxes per year two decades ago to just 18 million boxes this year.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with new evidence of military aggressiveness from the China/Russia bloc, which we continue to believe will produce risks for investors exposed to China or to companies dependent on China.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a surprise windfall profits tax on Italian banks and a credit-rating cut on several regional banks in the U.S.

China-Russia-United States:  It was reported yesterday that almost a dozen Chinese and Russian navy vessels sailed close to the Aleutian Islands off Alaska last week, in what is believed to be the largest such joint operation ever.  In response, the U.S. Navy dispatched four destroyers and a surveillance plane to shadow the flotilla.

• Even though the Chinese and Russian ships did not enter U.S. territorial waters and have since left the area, officials are considering it unusually brazen and provocative.
• The incident also highlights our concern about the potential for increased Chinese and Russian naval cooperation.
  • Even though China now has the world’s largest navy in terms of the number of its combat ships, it still consists mostly of smaller vessels geared toward defending the waters along China’s coast. Over time, China intends to build a “blue water” navy that can project power globally, but that remains a work in process.
  • In contrast, the Russian navy, which ranks as the world’s third-largest (just behind the U.S. Navy) has long been able to project power globally, especially via its advanced submarines. Many of its ocean-going surface ships have also been modernized with highly capable cruise missiles, as shown in the war in Ukraine.
  • If the Chinese and Russian navies set their minds to cooperating more fully and building synergies, and if they build up enough bases or port rights in friendly countries, they could potentially help the China/Russia bloc become a much more formidable military force around the world.

China:  July exports were down a whopping 14.5% from the same month one year earlier, after June exports were down 12.4% year-over-year.  Along with similarly bad export declines for other Asian economies, such as South Korea, the figures show how regional economies are being hurt as Western consumers shift from pandemic-driven goods consumption to post-pandemic services.  For China, the export challenges also exacerbate domestic issues, such as the state’s increasing interference in the economy and worsening demographics.

Russia-Ukraine War:  As Ukraine’s forces continue their slow, plodding counteroffensive against the Russians in the eastern parts of the country, new reports suggest that the U.S.’s recent provision of “cluster munitions” has helped improve their progress.  The new munitions are reportedly helping the Ukrainians hit concentrations of Russian infantry, groups of vehicles, and other targets, allowing Kyiv’s forces to make better progress than before.

Pakistan:  Prime Minister Sharif said he plans to dissolve parliament on Wednesday and transfer power to a caretaker administration, a step that would normally lead to new elections within 90 days.  However, a Sharif-led committee on Saturday also said it would redraw the country’s electoral districts in response to Pakistan’s latest census, potentially pushing the next elections into next year.

• If the elections are postponed until early 2024, it would produce a prolonged period in which the country is led by a government not backed by parliament.
• Coupled with the recent jailing of opposition leader and former Prime Minister Khan, the moves suggest Pakistan’s democracy is being steadily undermined. In turn, that could produce further political and social instability.

Italy:  The right-wing populist government of Prime Minister Meloni unexpectedly announced a windfall tax on bank profits generated by higher interest rates.  According to the government, the tax proceeds will be used to provide relief to families hurt by higher interest costs.  The move follows Meloni’s recent criticism that banks have been too slow to boost interest payments to depositors.  As might be expected, the announcement is weighing heavily on Italian banking stocks so far this morning.

U.S. Energy Prices:  With global crude oil prices trending up again in response to OPEC+ supply cuts and stronger-than-expected demand, retail gasoline prices last week rose to an average of $3.87 per gallon, reaching their highest level since last November.  If gasoline prices continue to rise, they could start to put ever more upward pressure on the consumer price index, potentially reversing some of the recent moderation in overall price inflation.

U.S. Banking Industry:  Moody’s (MCO, $342.41) said it has cut the credit ratings of 10 key regional banks and is reviewing the ratings of six other institutions, based on concerns that the Fed’s continued interest-rate hikes will undermine their funding and impinge on their capital.  Each cut was only one notch, and all the banks kept their investment-grade rating.  Nevertheless, the move has rekindled concerns about mid-sized lenders like those that failed in March.  That’s helping push down the value of risk assets so far this morning.

U.S. Commercial Real Estate Industry:  Leading mortgage real estate investment trusts Blackstone Mortgage Trust (BXMT, $22.79) and KKR Real Estate Finance Trust (KREF, $12.51) said they extended no new commercial mortgage loans in the first half of 2023.  Before this year’s problems in the sector, the firms would have likely provided billions of dollars of new loans each quarter.

• The REITs’ pullback in lending offers further evidence of just how much investors have soured on the prospects for commercial real estate, especially office buildings.
• Eventually, the sentiment on commercial real estate will hit rock bottom and potentially produce great bargains in the REIT sector. However, we believe it’s still too early for that to happen.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several items related to China and its relations with the rest of the world.  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 continuing moderate declines in U.K. home prices and more evidence that U.S. scientists on making progress on using fusion as a future energy source.

China-Australia:  The Chinese Ministry of Commerce said it will finally remove the 80.5% tariff on Australian barley that was imposed in May 2020 to retaliate against then-Prime Minister Morrison’s call to investigate Beijing’s role in the global coronavirus pandemic.

• Faced with slowing economic growth, worsening relations with the West, and a realization that the tariffs hadn’t had much impact on Australia, the Chinese government in recent months has been signaling that it will ease off its punitive measures.
• Once the barley tariffs are lifted, Canberra is hoping Beijing will also lift its punitive tariffs on Australian wine.

China-Ukraine-Russia:  The multilateral peace forum on the war in Ukraine held in Saudi Arabia over the weekend failed to produce any concrete results, but diplomats are praising China’s “constructive” participation and its commitment to also attend the next meeting.  China’s participation in the forum, which focused on Kyiv’s 10-point plan to end the war, is being taken as a sign that it is putting a bit of distance between itself and Russia, despite President Xi and President Putin declaring a “no limits” partnership in the past.

China-Philippines:  Despite China’s improved behavior in some aspects of its international relations, the Chinese continue to harass some members of the U.S.-led geopolitical bloc.  On Saturday, a Chinese coast guard vessel blocked and water-cannoned a ship trying to resupply Philippine troops on a contested shoal in the South China Sea.  The shoal is well within the Philippines’ exclusive economic zone, but China claims it as its own territory.

• China’s aggressive action was apparently planned well in advance. The move likely aimed to punish the Philippines for its recent assertiveness in defending its exclusive economic zone, strengthening its U.S. alliance and other security partnerships, and publicizing China’s gray-zone aggression in the South China Sea.
• The Chinese action is particularly concerning because any armed attack on Philippine public vessels, aircraft, or armed forces in the South China Sea would invoke U.S. mutual defense commitments under the U.S.-Philippine security treaty.

China-United States:  Late last week, U.S. authorities arrested two ethnic-Chinese sailors in the U.S. Navy for selling military secrets to a Chinese intelligence officer in California.  The arrests illustrate how China’s Ministry of State Security focuses on recruiting Chinese Americans and ethnic Chinese people living in the U.S. to gain access to sensitive military secrets, technology, and other information.

United Kingdom:  Data from housing firm Halifax showed U.K. home prices declined in July to an average of £285,044, for a fourth straight monthly decline.  Nevertheless, even as the air comes out of the British housing market in response to slow economic growth and a long string of interest-rate hikes by the Bank of England, the home-price declines remain relatively modest.  The average home price reported by Halifax was down just 0.3% from June, and it was down just 2.4% from the same month one year earlier.

Niger:  The junta that seized control of the government last week closed the country’s airspace, forcing several international airline flights to be re-routed.  The airspace closure was apparently to help thwart a threatened military intervention by the Economic Community of West African States (ECOWAS).  The ECOWAS militaries had threatened to intervene if the coup plotters didn’t step down by Sunday, but the deadline has passed with no action so far.

U.S. Private Property Rights:  A nonprofit led by Edward Blum, the activist who pushed for this summer’s Supreme Court decision outlawing affirmative action in college admissions, has sued to block the Black-owned venture capital organization known as the Fearless Fund from running its program offering grants to small businesses owned by Black women.  Alleging the program practices unlawful racial discrimination, the suit suggests that today’s culture wars could potentially trip up private investment funds or investors who want to seed projects by historically undercapitalized groups.

U.S. Bond Market:  Even as the yield on shorter-term fixed income remains relatively stable, the yield on benchmark 10-year Treasury obligations settled at 4.060% on Friday, within striking distance of the 14-year high of 4.321% reached last October.  The “bear steepening” is widely considered a reflection of growing optimism about the economy.  We still think a mild recession is likely soon, but more investors and analysts seem to be looking for a “soft landing” that would encourage the monetary policymakers to keep interest rates high for an extended period.

U.S. Real Estate Market:  New research from the University of Toronto shows that diverse city downtowns with a mix of offices, residences, and attractions have nearly returned to, or even exceeded, their pre-pandemic foot traffic rates.  In contrast, downtowns that feature mainly office buildings remain far below their pre-pandemic foot-traffic levels.  That realization is sparking downtown redevelopment projects in a number of cities, many of which involve municipal governments providing incentives for office-to-residential conversions.

U.S. Fusion Energy:  Scientists at the Lawrence Livermore National Laboratory in California said they have successfully repeated an experiment in which they sparked a fusion reaction that produced more energy than it used.  The successful replication has led to increased optimism that scientists are now on track to eventually be able to produce copious amounts of clean energy, which could dramatically reshape the economy and produce new investment opportunities in the coming decades.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will discuss three topics: recent optimism about the global economy, the Bank of Japan’s recent intervention in bond markets, and the increase in global defense spending due to the rift between the U.S. and China.

 Turning Tide: While a possible recession was a hot topic at the start of the year, there is now growing optimism that the economy may be more resilient than previously thought.

• Persistently strong economic data has shifted the conversation from an imminent downturn to sustained growth. Earlier this week, Bank of America (BA, $31.41) concluded that a recession is unlikely to occur in 2023. Meanwhile, Richmond Fed President Thomas Barkin expressed confidence that the Federal Reserve may be able to achieve a soft landing if inflation continues to ease. This increased confidence is supported by a wave of positive economic data, which suggests that the labor market remains tight, and spending remains robust despite rising borrowing costs. However, this does not mean there is no risk of a downturn.
• Despite some encouraging signals, the state of the business cycle remains uncertain, as there are still several risks. The government’s inability to agree on a budget agreement will likely impact bond yields, which could lead to higher borrowing costs over the next few weeks. At the same time, there appears to be a notable deceleration in the rate of consumption and hiring. The latest GDP report showed a significant slowdown in consumption from an annual pace of 4.16% in the first quarter of 2023 to 1.64% in Q2. At the same time, the jobs report showed that job creation disappointed for the second consecutive month.

• During the pandemic, households and firms took advantage of transfer payments and lower interest rates to pay down debt and extend loan duration. As a result, consumers were prepared and able to absorb higher prices in the months following, while firms were less pressed for financing. This dynamic explains why monetary tightening has not yet led to a sharp increase in defaults. However, it is unclear how long the economy can keep this up, as the farther away we move from the pandemic, the more vulnerable households and firms will be to rising borrowing costs. This may mean that the economy will slow down this year, even if it is able to avoid a recession.

 Not So Fast! A week after its historic shift in monetary policy, the Bank of Japan (BOJ) is signaling that it is not ready to be completely hands-off.

• On Thursday, the Bank of Japan (BOJ) made an unscheduled intervention in the bond market for the second time this week, by offering to buy $2.09 billion of bonds with five to 10 years left until maturity in an effort to control the rise in yields. The announcement came in response to a sudden rise in 10-year Japanese government bonds, which saw yields rise to a nine-year high of 0.65%. The purchases highlight the central bank’s unwillingness to tolerate a massive spike in interest rates following its decision to loosen its grip on 10-year debt yields.
• Investors were confused by the BOJ’s actions, as it was unclear how much the bank was willing to tolerate in terms of the pace of the increase in yields. Although the central bank’s intervention led to a modest decline in yields, the bond market was not significantly impacted as rates quickly returned to their previous level. A similar situation occurred in the currency market, as the yen (JPY) bounced back after initially depreciating against the dollar. However, equities were negatively affected, with the TOPIX index ending the day down 1.45%.

• As the world’s largest creditor, Japan’s monetary policy significantly impacts the global economy. Data from the Japanese Ministry of Finance shows that foreign investors have been increasing their holdings of Japanese long-term debt since the BOJ first tweaked its policy in December 2022. Simultaneously, Japanese investors have been offloading their holdings in the weeks leading up to the central bank’s latest rate decision. As short-term rates in Japan begin to rise, we expect higher yields will encourage residents to bring capital back home. However, this shift is likely to take time to materialize, as rates in the United States and Europe remain attractive.

Military Rising: The United States and its allies are continuing to increase their military spending in an effort to create a stronger deterrent to China in the Pacific.

• The U.S. plans on investing in more sophisticated missile technology in the next spending bill. Last week, lawmakers revealed a bill that earmarked $13 million to expand and manufacture chemical compounds that can be used to propel missiles or replace the explosive material in warheads. Similarly, the White House plans to ask Congress to fund arms for Taiwan as part of its supplemental budget request for Ukraine. Although officials still need to come to an agreement on the final spending package, there does seem to be a bipartisan consensus that the government needs to do more to counter China in the Indo-Pacific.
• Across the ocean, Japan and New Zealand are also looking to increase their defense spending. Japanese lawmakers are considering selling some of the government’s stakes in major companies to fund additional military spending. This is intended to avoid raising taxes or increasing the national debt, as the country seeks to expand its defense capabilities. Meanwhile, a government review of New Zealand’s military capabilities found that the country is not prepared to deal with the growing challenges in the Indo-Pacific region. As a result, the report recommended that the government increase its military budget.

(Source: Wikimedia Commons)

• The growing rivalry between the United States and China is driving a global arms race. Countries are ramping up spending on defense as they look to choose sides and protect their own interests. Rising military demand will likely benefit the defense and aerospace industries, as they will likely be the recipients of much of this new spending. However, the major obstacle to this increase in investment is the need to generate the necessary revenue to pay for new weapons. As a result, we believe that the world’s shift towards building up military capacity will likely be gradual.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will explore three key topics: the U.S. deficit, central bank policy, and the U.K.’s post-Brexit economy. First, we will discuss the U.S. deficit and what it may mean for bond yields. Second, we will explain why other central banks may follow Brazil as it moves away from tight monetary policy. Finally, we will discuss why the Bank of England may be helping boost the British pound.

 Downgrade Trouble: The downgrade by Fitch Ratings of the U.S.’s credit rating and the announcement of another round of debt issuance has investors concerned about the country’s ballooning deficit.

• On Wednesday, the U.S. Treasury Department announced that it would auction off $103 billion in new bonds this quarter in order to resolve a shortfall between tax revenue and government spending. The move has made investors uneasy, as it is unclear whether the market is capable of absorbing such a large amount of issuance. This report comes a day after Fitch Ratings Agency downgraded U.S. credit ratings from its top level. Making matters worse, lawmakers broke for their August recess earlier this week without coming to a resolution on funding the government for the next fiscal year. This has raised concerns about the possibility of a government shutdown in October, which would further strain the U.S. economy.
• Investors are worried that partisan gridlock in Washington will prevent lawmakers from adequately addressing the U.S. budget deficit. This uncertainty has led to a sharp rise in the 10-year Treasury yield, which has risen nearly 20 basis points since August 1. Higher yields threaten to push up borrowing costs for firms, which could weigh on corporate earnings and stock prices. The S&P 500 index has dropped almost 1.7% since the Fitch downgrade. According to the Congressional Budget Office, the government deficit is expected to deteriorate over the next 10 years.

• In 1994, President Clinton’s advisor James Carville once quipped, “that if there were reincarnation, [he] would like to come back as the bond market” because then he could “intimidate everybody.” This week’s market reaction to U.S. debt woes is a good example of how relevant his words are today. That said, we believe that in the long run, yields on long-duration Treasuries will have to rise as investors adjust to a new normal with higher inflation volatility and less Federal Reserve involvement. This should lead to slower economic growth as higher borrowing costs tend to reduce consumption.

 Who’s Next? The Central Bank of Brazil was one of the first to raise interest rates in response to the COVID-19 pandemic, and it is now one of the first to pivot away from hawkish policy.

• Brazil’s central bank cut its benchmark interest rates by 50 bps to 13.25% on Wednesday. The decision came amid pressure from President Luiz Inácio Lula da Silva and his economic team to ease monetary policy in an effort to boost the economy. Although the unemployment rate remains well below the country’s long-run trend of 9.5%, a gauge for gross domestic product showed that economic activity dropped 2% in May. Businesses and consumers will likely welcome lower rates. However, it will be the first test to see if the lower rates will lead to a return to inflation.
• Other central banks are expected to follow suit, as overnight indexed swaps rates suggest that benchmark interest rates will decline in most major economies by 2024. The switch to monetary easing is likely a reflection of a global decline in price pressures. The IMF expects global inflation to fall from 8.7% last year to 6.8% in 2023. Additionally, central bankers are facing pressure from politicians to ease monetary policy, as the high-interest rates are harming households. In the U.K., the Bank of England is on the verge of triggering a potential mortgage crisis; meanwhile, higher interests rates have disproportionately hurt homeowners in southern Europe who are now relying on savings to make monthly payments.

• Generally speaking, central banks in developed countries have made gradual changes when raising rates and more dramatic cuts when lowering them. However, this time may be different. Advanced economies have proven to be more resilient than experts expected at the start of the year. This could lead policymakers to be more cautious with easing monetary policy, as they may be concerned about a return to higher inflation. This approach is typical in emerging markets where inflation is more volatile. This may mean that investors should be more cautious during this easing cycle than the previous one when deciding to add more risk to their portfolios.

U.K. Path: The Bank of England (BOE) may keep monetary policy tight in order to restore confidence in the British pound (GBP).

• The Bank of England raised its benchmark interest rates by 25 bps on Thursday to a 15-year high of 5.25%. This is the bank’s 14^th consecutive hike and reflects its continued fight to bring inflation down toward its 2% target. During his press conference, BOE Governor Andrew Bailey predicted that July inflation has decelerated to around 7%, much lower than last year’s peak of 11%. He added that the central bank plans to continue to raise interest rates further as policymakers aim to push inflation down to 5% by the end of the year. The central bank now forecasts inflation to fall to 4.9%.
• The Bank of England does not seem to be willing to take its foot off the pedal. There were two policymakers within the BOE’s Monetary Policy Committee that pushed for a 50 bps hike in interest rates, with one vote for keeping rates unchanged. This voting breakdown suggests that British policymakers remain relatively more hawkish than their Western counterparts. While the heads of the European Central Bank and the Federal Reserve suggested last week that they may be nearing the end of their hiking cycles, Bank of England Governor Andrew Bailey offered no such reassurances. Instead, he maintained that “in order to get inflation back to target, [the BOE] is going to have to keep this stance of monetary policy.”

• After breaking away from the European Union, the United Kingdom will now have to prove that it can stand on its own. One way it may do this is by legitimizing the value of its currency. Over the last two weeks, the GBP has risen around 4% against the dollar, even as other peer currencies, as measured against the U.S. Dollar Index (DXY), declined about 3% in the same period. This divergence suggests that investors are confident that the Bank of England is willing to take steps to bring down inflation, even if it means causing economic pain. A strong GBP, particularly against major trading partners, will help to quell price pressures by making imports cheaper.

Fed News: Kansas City Fed has hired Jeffrey Schmid to take over as President and Chief Executive Officer. He is a former bank executive and has experience in bank regulation.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a discussion of Fitch’s decision to cut the U.S. government’s bond rating to one notch below its highest score.  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 possible new U.S. restrictions on Chinese semiconductors and rising global food prices as Russia attacks Ukraine’s grain-export facilities.

U.S. Treasury Market:  After market close yesterday, Fitch Ratings cut its assessment of U.S. Treasury bonds to AA+, down from its top rating of AAA.  Fitch attributed the downgrade to growing U.S. fiscal deficits, high debt, and political dysfunction.  The Fitch downgrade is the first such action by a ratings firm since a similar move by Standard & Poor’s in 2011.

• At this point, it appears the downgrade has not produced any considerable disruptions in the Treasury market. We have not been able to identify any major Treasury holder that would be forced to sell the obligations because of the downgrade.  Other analysts and observers that we track also seem to be taking a relatively sanguine view of Fitch’s actions.  Indeed, so far this morning, Treasury prices are up across almost the entire yield curve, pushing yields lower.  The yield on the benchmark 10-year note has fallen slightly to 4.014%.
• Nevertheless, having two of the three major bond assessment firms rating the U.S. government below their top rating has the potential to erode faith in Treasury obligations over time, potentially driving up yields in the future. More immediately, the rating cut has undermined sentiment toward risk assets today, and major stock market indices are modestly lower.

United States-China:  U.S. officials are growing concerned that China is rapidly ramping up its production of less-advanced, highly commoditized semiconductors in order to dump them on the world market and put competitors in the U.S.-led bloc out of business, as it has done with solar panels and other industries.  That would put China in control of the important market (even though the semiconductors at issue are relatively less advanced, they are still critical to a wide range of industries).

• The Chinese move could be retaliation for the Biden administration’s draconian crackdown on selling advanced semiconductor technology to China last October.
• U.S. officials are reportedly starting to consider moves to block the Chinese threat, but no measures are imminent.

U.S. Industrial Sector:  Consistent with our recent analyses, incoming data points to continued strong investment in new factory construction.  Data out yesterday showed that nonresidential construction (which would include manufacturing facilities) rose 17% in the second quarter from the previous three months.  According to last week’s report on gross domestic product, second-quarter business investment in “manufacturing structures,” aka factories, was up nearly 70% from the same period one year earlier.

Russia-Ukraine War:  Russia launched another salvo of missile and drone strikes against Ukrainian port facilities and grain storage infrastructure last night, partially reversing the decline in key grain prices over the last week or so.  Nearby wheat futures are trading up 1.1% to $6.5925 per bushel so far this morning, while corn futures are up 0.5% to $5.0925 per bushel.

• Just as important, we note that the facilities Russia struck last night are on the Danube River, just across from NATO-member Romania. On top of that, the Polish government yesterday said military helicopters from Russian ally Belarus violated its airspace, forcing Poland to rush more of its armed forces to the border.
• The Russian attacks on Ukraine’s grain facilities are raising the prospects for accidental damage to Romanian territory, which would threaten to bring NATO forces directly into the conflict.

Turkey:  Now that President Erdoğan has won re-election and is shifting his economic policy in a more orthodox direction, foreign purchases of Turkish stocks have rebounded and helped push the country’s stock market indices higher.  Adding fuel to the fire, the policy change has pushed the lira (TRY) sharply lower, adding to inflation pressures and pushing more Turks into the market.  With strong buying from both foreign and domestic investors, the benchmark BIST 100 stock price index is up 46% since the end of May in TRY terms, and 14% in USD terms.

India:  Ethnic and religious violence has been surging in India in the run-up to next year’s elections, in which Prime Minister Modi and his Hindu-nationalist Bharatiya Janata Party will be trying to retain power.  In the latest incident, Hindu-Muslim clashes broke out on Monday near a key business district on the outskirts of New Delhi.  The growing violence threatens to undermine investors’ recent focus on India as they pivot away from China because of its slowing economic growth, state interference in the economy, and tensions with the West.

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