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

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.

View PDF

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.

View PDF

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.

View PDF

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.

View PDF