by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities slumped and Treasury yields are up following a really strong jobs number. In other news, the GOAT of Formula One, Lewis Hamilton, will be joining the iconic Ferrari team next year. In today’s Comment we dive into Thursday’s tech earnings bonanza, explore the surging popularity of leveraged loans, and unpack recent central bank policy decisions. As always, we’ll include a roundup of global and domestic economic releases.

The Train Keeps Moving: Tech giants pleasantly surprised investors with earnings that exceeded expectations, and yet the duration of this upbeat trend remains uncertain.

• Meta (META, $457.50) basked in the afterglow of stellar financial results and notched its highest quarterly revenue in over two years while tripling profits through strategic cost-cutting. To amplify the joy, it announced its first-ever dividend and a whopping $50 billion share buyback, grabbing headlines and investor attention. This wasn’t the only good news in the tech world. Both Amazon (AMZN, $169.39) and Apple (AAPL, $180.32) delivered positive surprises. Yesterday’s earnings report showed that Amazon is solidifying its dominance in cloud computing, demonstrating its significant revenue potential, while Apple defied naysayers with strong iPhone sales, proving the device’s enduring appeal.
• Despite continued strong financial performance, tech firms are facing significant headwinds from geopolitical and regulatory risks. The slowdown in China, a key growth market, will likely impact overseas profits, as Apple’s recent sales outlook demonstrates. Additionally, growing concerns about tech giants’ influence and limited accountability are fueling regulatory scrutiny. Lawmakers like Missouri Senator Josh Hawley have publicly criticized platforms like Facebook for failing to adequately protect children from harmful content. The growing adoption of AI by tech companies is raising concerns among governments who are looking for ways to mitigate potential risks to the public.

• Tech stocks currently outperform the market, but questions linger about the sustainability of their growth. The average P/E ratio of 38, while lower than the dotcom bubble peak, is still significantly higher than historical market averages, raising concerns about future valuations. Meeting current market expectations would require unprecedented revenue growth. Additionally, regulatory hurdles pose a major potential challenge. While navigating these hurdles successfully won’t guarantee smooth sailing, failing to do so could significantly impact performance and valuations. As a result, we still believe that investors could probably find better value in other places in the market.

Debt Wall Solution? As concerns rise about large amounts of maturing debt, companies are exploring options to restructure their obligations and avoid default.

• As companies grapple with maturing debt, many are turning to private credit funds for relief, seeking lower interest rates or longer maturities. Leveraged loans offer a potential solution, allowing them to refinance existing debt with lien debt. However, this comes at the cost of potentially higher interest rates and the risk of asset seizure in case of default. While this trend offers relief from elevated interest rates, it also raises concerns about potential risks to the broader market if economic conditions worsened.
• The record-breaking issuance of U.S. leveraged loans in January ($140.1 billion) highlights the growing global appeal of this financing option, while European debt issuance in this category surged by 20.1% in 2023. This increase in issuance reflects companies seeking to manage their existing debt in a challenging economic environment, but also raises concerns about increased refinancing risk for borrowers with higher risk profiles. Notably, refinancing activity reached a record high of $50.4 billion, while repricing (renegotiating loan terms) reached $78.7 billion, suggesting a strong focus on reducing debt payments through various strategies.

• Leveraged loans offer a double-edged sword in tackling the debt maturity wall. While they can ease debt pressure and potentially mitigate the broader economic impact of rising interest rates, concerns linger about their long-term stability. This stems from the subjective valuation of underlying collateral, particularly for loans backed by volatile assets like commercial real estate. The opaqueness of private credit funds, where some of these loans reside, further complicates matters, making it difficult for investors to conduct thorough due diligence. However, if the economy remains strong and default rates stay low, these loans may not pose a systemic risk.

The Dust Settles: With central banks in the U.S., Europe, and Japan all signaling that rates are unlikely to change, the market awaits the exact timing, which remains anyone’s guess.

• All G-7 rate-setting bodies opted to maintain their policy rates during their most recent meetings, affirming to the markets that they are embarking on a new phase of the monetary cycle. Among the four major central banks announcing their decisions, the Bank of Japan stood out as the sole institution contemplating a rate hike. Meanwhile, all the other institutions have signaled that interest rates will be cut sometime this year but likely not as soon as the market anticipates.
• Interest rate uncertainty could deter institutional investors from re-entering the stock market, despite the S&P 500’s current proximity to all-time highs. Bank of America strategist Jill Carey Hall’s research shows that institutional investors recently sold the most U.S. equities in nearly a decade, suggesting a shift towards safer assets due to economic uncertainty. The outflows were recorded in seven out of the 11 sectors, predominantly driven by sales in Technology, Consumer Discretionary, and Consumer Staples. This reluctance likely stems from a fear of being caught off guard if central banks reverse course on interest rates.

• Elevated interest rates may keep a significant amount of money parked in low-risk investments, but it could act as a potential tailwind for riskier assets once central banks start easing interest rates. This is evidenced by the record-breaking $6 trillion in U.S. money market assets. Although small and mid-cap stocks have not been able to grab headlines, these companies may be an attractive target for investors looking for a bargain. Valuations suggest that these firms provide investors with a lot of upside when risk sentiment changes.

Other News:  Fed Chair Jerome Powell will appear on 60 Minutes on Sunday, sparking speculation that he may aim to clarify recent remarks interpreted by the market in unexpected ways, or possibly to address concerns about the overall health of the financial system. Tensions are rising between China and the Philippines after Beijing criticized the latter’s congratulatory message to Taiwan’s newly elected president. This incident highlights China’s growing influence and its sensitivity towards its neighbors’ formal interactions with Taiwan. Hungary is looking to play ball with the West after finally approving an aid package for Ukraine and possibly approving Sweden’s NATO bid.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities are unfazed by Powell’s remarks this morning, while Caitlin Clark continues her dominant run in women’s college basketball. Today’s Comment dives into the latest Fed rate decision, explores renewed concerns about regional lenders, and examines the potential impact of China’s overcapacity on other nations. As always, we’ll wrap up with a summary of key international and domestic data releases.

Mission Not Accomplished: The Federal Reserve dashed hopes for a March rate cut, sending stocks plummeting and lifting bond yields from their intraday lows yesterday as investors recalibrated their expectations.

• The Federal Open Market Committee (FOMC) kept its benchmark interest rate unchanged at 5.25%-5.50% in its January meeting. While the decision was largely expected, the accompanying statement and Chair Powell’s comments offered valuable insights into the Fed’s future plans. The FOMC statement notably dropped any mention of further rate hikes and instead mentioned that it would consider “any adjustments” to its key policy rate. Chair Powell elaborated during the press conference, expressing the committee’s confidence in the trajectory of inflation toward the 2% target. However, he emphasized the necessity for additional evidence before contemplating rate cuts, suggesting such measures are unlikely to materialize by March.
• Stronger-than-expected economic data, including a robust December jobs report and resilient consumer spending, could be behind the Federal Reserve’s decision to delay rate cuts. The December jobs report smashed expectations, with the economy adding 216,000 jobs and far exceeding the forecast of 170,000. Additionally, personal consumption remains a key driver of GDP, with December discretionary spending accelerating from 6.2% to 6.5%, significantly outpacing the 10-year average of 5.0%. Despite robust data, inflation has remained largely unaffected, prompting some members of the committee to express concerns about economic conditions that could potentially hinder the attainment of the 2% inflation mandate.

• The Federal Reserve is expected to closely scrutinize economic data over the next few months, searching for signs that could justify a policy shift. Two key inflation and employment reports will be released before the Fed’s next meeting, and the upcoming revisions to the Consumer Price Index (CPI) on February 9 could provide further clarity on the central bank’s progress against inflation. While the Fed has ruled out interest rate cuts in March, a policy pivot within the first half of the year remains a possibility. The latest CME FedWatch Tool shows that there is a 90% chance that policymakers will vote to cut interest rates in May.

Regional Bank Worries? The surprise earnings loss reported by New York Community Bancorp fueled fears of instability in the U.S. financial system amidst fresh concerns about the U.S. commercial real estate market.

• Fourth-quarter earnings at New York Community Bancorp (NYCB, $6.47) sent shockwaves through the market with a staggering $252 million loss, primarily driven by loan losses. The bank was forced to slash its dividend by 70% and scrambled to bolster its capital reserves to comply with stricter regulations imposed on larger institutions. This news sent the stock price plummeting 37%, while the broader KBW regional bank index dipped 6% as investors feared similar challenges across the industry. The bank’s weak performance comes just under a year after its acquisition of New York Signature Bank, which ultimately collapsed due to deposit flight driven by the failure of Silicon Valley Bank.
• NYCB’s news ignited an initial sell-off, but deeper anxieties linger regarding broader financial health. Falling inflation has pushed real interest rates to their highest levels since the pandemic, squeezing banks’ margins as they compete to retain deposits with attractive rates. While deposit flight has subsided since March, fears persist that savers may flee to higher-yielding money market accounts if rates remain elevated. The Federal Reserve’s bank term lending facility, which addressed the deposit run problem in the short term, is scheduled to end in March, thus raising concerns about potential economic challenges if broader policy changes are not implemented.

• The Federal Open Market Committee (FOMC) omitted its prior statement about the banking system being “sound and resilient,” which raises concerns that policymakers are increasingly worried about financial conditions when compared to the previous meeting. While the impact of NYCB’s news on FOMC discussions surrounding the banking system remains unclear due to the absence of questions on the topic during Powell’s Q&A, his suggestion of initiating discussions on balance sheet reduction in March indicates potential measures to address liquidity risk. However, the specific form this reduction will take — whether tapering quantitative tightening or complete cessation — is yet to be determined.
• The fallout from NYCB spread to other banks around the world with Tokyo-based Aozora Bank and German bank DeustchBank both reporting losses on loans on U.S. commercial properties. Such issues in real estate could likely put more pressure on central bankers to loosen monetary policy.

 China’s Economic Fallout: There are fears that China’s economic slowdown could have spillover effects on the global economy, according to a business lobby group.

• The American Chamber of Commerce in China (AmCham China) sounded the alarm on persistent overcapacity woes, warning that Beijing’s credit shift from real estate to manufacturing could exacerbate the problem. This policy change, they say, raises the specter of “dumping” lower-priced goods into global markets, especially in strategically important sectors like electric vehicles. The report coincides with growing concerns that China might resort to increased state lending and industrial subsidies to prop up its flagging manufacturing sector.
• A potential glut of Chinese goods in the global market threatens to reignite Western concerns about unfair trade practices. The European Union is actively exploring measures to curb the influx of Chinese electric vehicles (EVs) within its borders, while the U.S. is pressuring companies to diversify their reliance on Chinese-made legacy chips for their devices. Pivoting exports towards developing countries within the Belt and Road Initiative might seem like a solution for China’s overcapacity woes, but the viability of this option is questionable. The global economic slowdown is expected to disproportionately impact these very countries, limiting their capacity to absorb significant amounts of additional imports.

• China’s bloated industrial capacity and escalating trade protectionism cast a long shadow over its fight against deindustrialization. Despite impressive recent growth, the country lacks concrete measures to unleash domestic consumption, a critical step needed to stabilize internal demand for its manufactured goods. Unfavorable demographic trends have further exacerbated this challenge and dampened consumption potential. While China’s economic resilience is undeniable, a strategic shift is necessary to navigate this complex crossroads and ensure sustainable, long-term growth.

Other News: The U.S. continues launching strikes against Houthi rebels in Yemen, escalating tensions in the region amid preparations for a response to the Jordan drone attack that killed three American service members. This escalating conflict in the Red Sea raises concerns about the potential for a broader war in the Middle East. U.S. regulators have targeted Chinese chipmakers over concerns that they aided AI firms with ties to the Chinese military. This crackdown on chip manufacturers reflects the intensifying competition between the two economic giants for dominance in the field of artificial intelligence.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the latest on the tensions in the Middle East, which still could expand into a broader regional conflict and disrupt key global oil supplies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more indications of weak Chinese economic growth and a preview of key U.S. monetary and fiscal policy announcements due out today.

Israel-Hamas Conflict:  Kataib Hezbollah, the Iran-backed militant group thought to be responsible for this week’s drone attack on U.S. forces in Jordan that killed three Americans, said yesterday that it will temporarily halt further attacks on the U.S.  Nevertheless, U.S. military officials said the announcement would not stop a planned retaliatory strike against the group, and President Biden said he has already decided how that strike will be carried out.

• Kataib Hezbollah’s stand-down could well reflect pressure from Iranian officials, who likely fear a U.S. strike and the prospect that the conflict sparked by the Hamas attacks on Israel on October 7 could expand to a regional war.
• Separately, Israeli forces continue their military operations against Hamas in Gaza; Prime Minister Netanyahu is still considering what kind of government should rule the territory when the fighting is over. Netanyahu remains under pressure from right-wing members of his governing coalition to eventually push Palestinians out of Gaza — a move that would likely be criticized around the world as ethnic cleansing and potentially spark further sympathy attacks by militant groups.
• In sum, the conflict remains a major source of global instability, especially if it widens and more seriously disrupts Middle Eastern energy supplies or Asian-European shipping.

China:  The National Bureau of Statistics said its January purchasing managers’ index for manufacturing rose to a seasonally adjusted 49.2, improving slightly from the December reading of 49.0.  The January PMI for services and construction rose to 50.7 from 50.4.  As with most major PMIs, the official Chinese gauge is designed so that readings over 50 indicate expanding activity.  At their current levels, the Chinese PMIs reflect the strong headwinds that are holding down growth, especially in manufacturing.

• Separately, the slowdown in Chinese growth continues to manifest itself in falling prices for Chinese real estate and stocks. Naturally, weak pricing in those two areas has forced Chinese investors to scramble for other ways to protect or build wealth.
• Recent reports indicate many Chinese investors have piled into domestic funds that invest in the U.S. or Japan. Those funds have recently provided good returns to the Chinese investors that own them, offsetting their losses from Chinese assets.
• Now, new data from the World Gold Council shows Chinese investors have also turned to buying gold as a way to protect themselves. Along with “blistering” demand from the world’s central banks, the WGC says strong Chinese purchases of gold jewelry and investment products were a key factor driving up gold prices in 2023.
• Based on our desire to hedge against today’s rising geopolitical risks and take advantage of the rising global demand for gold, we maintained our positions in the yellow metal across all our asset-allocation portfolios during our adjustments for the first quarter.

Hong Kong:  The municipal government has released a summary of the new national security law that it intends to add to its mini-constitution this year.  The proposed law, which is subject to popular discussion for 30 days, is intended to supplement the national security law imposed by Beijing in 2019.  Observers have already raised concerns about its provisions against sedition and the release of state secrets.  If passed, the law would likely further discourage foreign investment and travel to Hong Kong.

European Union-Russia:  The European Parliament has launched an investigation into allegations that Latvian lawmaker Tatjana Ždanoka has been spying for Russia for years.  The allegations were first published in a Russian investigative newspaper.  Ždanoka was one of just a dozen or so European Parliament lawmakers who voted against a resolution condemning Russia’s invasion of Ukraine in March 2022.

European Union-Mercosur:  French officials yesterday said the European Commission has stopped negotiating over a free-trade agreement between the EU and Mercosur, a trade bloc consisting of Brazil, Argentina, Uruguay, and Paraguay.  If true, it appears Brussels has caved to protesting farmers in France and elsewhere in the EU, who fear a surge of cheap South American food imports, despite the promise of greater EU industrial exports.  The end of talks over the deal also illustrates how politics has swung against free trade throughout the developed countries.

Eurozone:  French consumer prices in January were up just 3.4% from the same month one year earlier, compared with 4.1% in the year to December.  The good figures on price inflation have kindled new hopes that the European Central Bank could soon start to cut interest rates.  However, in an interview last night, ECB chief Lagarde warned that the monetary policymakers still want to see more data confirming that price pressures are easing.  Lagarde specifically cited a need to see easing wage growth.

U.S. Monetary Policy:  The Fed wraps up its latest policy meeting today, with its decision due at 2:00 PM EST.  The officials are expected to leave the benchmark fed funds interest-rate target unchanged at its current range of 5.25% to 5.50%.  Investors will focus on the decision statement and Chair Powell’s press conference, either of which could provide clues as to when the Fed will finally start cutting rates and reducing its balance sheet runoff.  Many investors expect those moves as early as March, but we continue to think they’ll come a bit later than that.

U.S. Fiscal Policy:  Today, the Treasury Department will release its borrowing plan for the coming quarter, including its planned debt issuance by maturity.  The quarterly refunding plan has recently been a market mover, and investors will be watching closely for any major change in the Treasury’s issuance of short-term obligations versus longer-term maturities.  If the plan shows larger-than-expected issuance of longer-term debt, it will likely drive down Treasury prices, boost yields, and potentially weigh on risk asset values as well.

U.S. Immigration Politics:  After Republicans in Congress pushed President Biden to accept tighter limits on immigration in return for new military aid to Ukraine, former President Trump has scuttled the deal to avoid giving Biden a win in the run-up to the election in November.  Meanwhile, Republicans on the House Homeland Security Committee have pushed through a measure calling for the impeachment of Homeland Security Secretary Mayorkas for failing to enforce the national immigration laws and stop the recent surge of illegal border crossings.

• The tussling over border policy signals that immigration reform and border security will be a big part of the presidential campaign leading up to November.
• Given that polling suggests voters are more supportive of the Republicans’ tougher restrictions, it’s probably no surprise that Biden tacked to the right on border security in his effort to win support for more aid to Ukraine. Now that the Republicans have apparently decided not to accept the win, a key question is whether voters will punish them for playing politics with an issue they previously called essential to national security.

U.S. Defense Industry:  As countries around the world work to rebuild their armed forces in response to worsening geopolitical challenges, new data shows U.S. defense companies recorded $81 billion in new foreign military sales in 2023, up 56% from 2022.  The figures are consistent with our view that increased geopolitical tensions have set the stage for years of increased sales and profits for traditional defense contractors and other industrial or technology firms producing defense-related goods and services.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a couple of notes on global oil supplies, including reduced capacity investment in Saudi Arabia but a new supply discovery in China.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, such as new data confirming Europe’s slow economic growth and a preview of key U.S. monetary and fiscal policy decisions due this week.

Global Oil Industry:  In Saudi Arabia, state-owned Saudi Aramco (2223.SR, SAR, 144.40) said it will comply with a request from the energy ministry to suspend a planned investment program that would have expanded its maximum sustainable production capacity from 12 million barrels per day to 13 million bpd by 2027.

• The energy ministry didn’t provide an explanation for its move, but other big oil producers in recent years have cut back investment because of profitability concerns and fears of falling future demand associated with the transition to green energy.
• Saudi Arabia and its OPEC+ partners have also been holding down current output in an effort to boost prices amid weakening global demand. Therefore, the energy ministry’s decision to limit new capacity investment could aim to help raise concerns about future supplies, thereby helping to boost prices.

China Oil Industry:  Officials yesterday announced the discovery of a large new oil field in central Henan province, saying the field could hold up to 732 million barrels of light crude.  That volume alone would amount to more than half of China’s current annual oil production.  The field, therefore, could help replace declining output elsewhere and modestly help reduce China’s dependence on foreign energy supplies, although the available volume probably isn’t enough to have a significant impact on global prices.

China Stock Market:  In yet another move to support China’s flagging stock market, the Chinese Securities Regulatory Commission and both major stock markets yesterday said strategic investors would be prohibited from lending out shares for short selling during specific lock-out periods.  The modest measure isn’t likely to help the stock market very much, but the drumbeat of new efforts to buoy the market show that the government is intent on at least arresting its recent decline.

China Military:  The Chinese People’s Political Consultative Conference has removed another high-ranking military official associated with missile development, meaning at least 16 such officials are now being investigated or disciplined for corruption or espionage.  As we’ve noted previously, the continued chaos surrounding the People’s Liberation Army Rocket Forces has likely unsettled General Secretary Xi, although we don’t necessarily subscribe to the theory that it has reduced Xi’s willingness to use military force if needed.

EU Regulation:  Amazon (AMZN, $161.26) and robotic vacuum maker iRobot (IRBT, $15.50) called off their proposed merger yesterday, largely because of pushback from antitrust regulators in the European Union and the U.K.  The deal’s scuttling shows how European officials have become much more aggressive than their U.S. counterparts when it comes to ensuring free-market competition and combating market concentration.  Going forward, large U.S. firms hoping to combine will probably continue to face high antitrust hurdles in the region.

EU Economic Growth:  The EU’s gross domestic product in the fourth quarter of 2023 was unchanged after a modest decline in the third quarter.  As a result, the region’s GDP in all of 2023 was up just 0.5%, much weaker than the U.S.’s growth of 2.5%.  The EU economy continues to struggle with elevated interest rates, high energy prices because of Russia’s invasion of Ukraine, and now broader supply disruptions because of the conflict in the Middle East.  As a result, EU stock values rose much less than U.S. stock values in 2023.

Germany:  A panel of outside advisors today issued a report saying the country’s constitutional “debt brake” is too rigid and should be broadly reformed to allow for more future-oriented fiscal spending.  Implemented in 2016, the rule limits the country’s structural budget deficit to 0.35% of GDP, adjusted for the economic cycle.  It was suspended at the outset of the COVID-19 pandemic, but it has nevertheless been criticized by left-wing and centrist politicians for slowing growth-enhancing public investment in infrastructure and green technology.

U.S. Monetary Policy:  The Fed today begins its latest policy meeting, with its decision due tomorrow at 2:00 PM EST.  The policymakers are widely expected to leave the benchmark fed funds interest-rate target unchanged at its current range of 5.25% to 5.50%.  We think investors will be focusing on the decision statement and Chair Powell’s press conference, either of which could provide clues as to when the Fed will finally start cutting rates and reducing its balance sheet runoff.  Many investors expect those moves as early as March, but we continue to think they’ll come a bit later than that.

• Separately, Elizabeth Warren and three other Democratic senators wrote a letter to Chair Powell over the weekend urging him to cut the current “astronomical rates” in order to bring down housing costs.
• Without doubt, the policymakers at the Fed are feeling a lot of political pressure to cut rates these days. Importantly, they’re likely feeling pressure from the Biden administration and from former President Trump, as well as Warren and her Democratic colleagues.  Nevertheless, we still believe Powell will try to delay easing policy a bit longer than investors currently expect in order to be sure inflation pressure is under control.

U.S. Fiscal Policy:  The Treasury Department will release its borrowing plan tomorrow for the coming quarter, including its planned debt issuance by maturity.  The quarterly refunding plan has recently been a market mover, and investors will be watching closely for any major change in the Treasury’s issuance of short-term obligations versus longer-term maturities.  If the plan shows larger-than-expected issuance of longer-term debt, it will likely drive down Treasury prices, boost yields, and potentially weigh on risk asset values as well.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with news that an Iran-backed militant group has killed several U.S. troops in Jordan, boosting the chance that the Israeli-Hamas conflict will broaden.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including the forced liquidation of a major Chinese housing developer and a few words on the Federal Reserve’s policy meeting this week.

Israel-Hamas Conflict:  In sympathy for the Hamas militant government now being attacked by Israel in retaliation for its October 7 attacks, an Iran-backed militant group in Syria launched a drone strike against a U.S. military base in northern Jordan yesterday, killing three U.S. troops and injuring dozens.  Iran this morning has tried to distance itself from the strike, but the casualties will surely put heavy pressure on the Biden administration to retaliate against Iranian interests, potentially broadening the Israel-Hamas war into a regional conflict.

• Separately, Israeli intelligence reports shared with the U.S. reveal that at least a dozen employees of the United Nations Relief and Work Agency participated in Hamas’s October 7 attacks on Israel. Moreover, the reports indicate that UNRWA, which is the UN’s organization to help Palestinian refugees, is riddled with staff members who have ties to Islamist militant groups.
• Taken together, the U.S. troop casualties and the intelligence reports have ratcheted up investor concerns about a broader Middle East conflict so far this morning. Gold and crude oil prices initially rose on the news, although oil prices are now trading slightly lower for the day.

European Union:  Manfred Weber, leader of the center-right European People’s Party (EPP) that is expected to place first in the European Parliament election in June, said in an interview last week that Europe needs to focus more on developing its own, independent military power outside the North Atlantic Treaty Organization, so it could defend itself even if the U.S. refused to come to its aid.  Importantly, Weber even suggested that the EU develop its own nuclear weapons, perhaps under the leadership of the U.K. and France, which are already nuclear powers.

• As we have written many times, we think the most likely scenario going forward is that the growing U.S.-China rivalry fractures the world into a U.S.-led bloc consisting mostly of large, rich, highly developed liberal democracies and a few closely related emerging markets, and a China-led bloc consisting largely of authoritarian, commodity-focused emerging markets and frontier markets.
• However, if former President Trump is elected U.S. president in November, his first-term policies suggest he could renege on the U.S.’s alliance commitments, leaving the U.S. isolated and alone or scrambling to rebuild an alternative alliance structure while its former allies turn distrustful and adversaries like China and Russia keep rapidly building their armed forces. In this case, the EU, the non-U.S. NATO countries, Japan, and other former U.S. allies could be cut adrift and feel they’ve been left to defend themselves.
• We think leaders in the Chinese bloc hope for such an outcome, thinking they could then dominate the former U.S. allies, but Weber’s statements show that such a development could backfire on the Chinese bloc. If a dismantling of the U.S. bloc prompts the EU, the U.K., Japan, South Korea, Australia, and other former allies to develop or expand their own nuclear weapons, the Chinese and Russians would suddenly feel they are surrounded by dangerous enemies.  The result would likely be a global nuclear arms race.

Germany:  The far-right, anti-immigrant Alternative for Germany (AfD) party unexpectedly lost a district election in the state of Thuringia, dashing the fast-rising group’s hope to secure control of a local government for only the second time in its history.  Mainstream voters have recently rallied against the AfD following revelations that it has explored a plan for mass deportations of German residents with foreign backgrounds, including citizens.  However, the AfD could quickly recover from the Thuringia loss and continue to draw new support.

Japan:  As Japanese stocks continue to perform strongly, we think the rise in prices partly reflects unexpectedly strong profits and productivity.  Complementing those positive trends, new research shows that the number of Japanese companies offering stock as part of their employee compensation surged to 767 by August 2023, up from just 110 in 2015.  If stock-based pay helps increase Japanese workers’ engagement and incentives, the move could be an additional reason for Japanese stocks to keep rising.

China:  A court in Hong Kong today ordered the liquidation of giant, highly indebted housing developer China Evergrande (3333.HK, HKD, 0.163), about two years after the company’s default on its dollar bonds kicked off the financial crisis in China’s real estate market.  After many years of debt-fueled overbuilding, the resulting heavy debt load and market retrenchment are now a major headwind for China’s economy, and, by extension, global demand.

China-Taiwan:  As China continues to ramp up its military, economic, and diplomatic pressure on Taiwan to thwart any independence moves, the Taiwanese military this week inducted its first one-year draftees.  To improve the quality of its troops, Taiwan in late 2022 increased its compulsory military service from just four months to one full year.  The island is also trying to boost its arsenal of weapons to deter any potential Chinese invasion or blockade.

U.S. Monetary Policy:  The Fed this week holds its latest policy meeting, with its decision due on Wednesday at 2:00 PM EST.  The policymakers are widely expected to leave the benchmark fed funds interest-rate target unchanged at its current range of 5.25% to 5.50%.  The focus for investors will be on the decision statement and Chair Powell’s following press conference, either of which could provide clues as to when the Fed will finally start to cut rates and reduce its balance sheet runoff.  Many investors expect those moves as early as March, but we continue to think they’ll come a bit later than that.

U.S. Military:  In its 2024 Index of U.S. Military Strength, the Heritage Foundation has assessed that the country’s military is “not ready to carry out its duties effectively” and that its condition has “worsened over the past two to three years.”  Issued last week, the report also faults U.S. leaders for not matching the renewed commitment to defense being demonstrated by allies such as Japan, Germany, Poland, and Lithuania.

• The report comes as all kinds of data also points to the increasing strength and aggressiveness of adversarial countries such as China, Russia, Iran, and North Korea.
• We continue to believe that a growing popular awareness of the global threats and the U.S. military shortcomings could prompt a stronger, more urgent effort to rebuild the country’s defense capability, with positive impacts for stocks in the industrial, technology, and other sectors that focus on selling to the military.

(Source: Heritage Foundation, 2024)

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Wall Street cheers better-than-expected inflation news. Meanwhile, Novak Djokovic’s perfect streak in the Australian Open came to an abrupt end. In our Comment, we explain why optimism should be measured. We also delve into the regulatory storm clouds over Big Tech and dissect the ongoing move toward rate hikes by the Bank of Japan. Plus, we include your usual data for a well-rounded start to your day.

Recession to Paradise? Defying expectations, the economy not only remained in expansion territory in 2023, but it actually accelerated.

• U.S. GDP surged 2.54% in 2023, exceeding analysts’ forecasts and comfortably surpassing the previous year’s 1.9% rise. This robust performance, fueled by strong consumer spending and business investment, has defied fears of recession and has demonstrated the economy’s resilience in the face of tighter monetary policy. Sustained growth coupled with falling inflation have revived hopes for a soft landing, even as geopolitical and trade uncertainties linger. This brighter outlook has fueled a surge in stock prices and expectations for lower interest rates, which have provided a boost to risk assets.
• Thursday’s figures have given investors plenty to cheer about, but beneath the surface, there are still signs that the economy isn’t humming along as smoothly as it might appear. Despite strong job growth headlines, in 2023 revisions lowered payrolls in all but one month, raising concerns about data accuracy. Further casting doubts on the economy’s health, regional Fed data like the Chicago National Activity Index and New York Fed Empire Manufacturing Index revealed weak economic activity. Moreover, Gross Domestic Income, another measure of growth, has consistently lagged behind Gross Domestic Product, suggesting potential underlying issues.

• Recessions can arise unexpectedly, even in the presence of positive indicators. A prime example is the 1973 downturn, which became the third-longest on record, when the U.S. economy added 313,000 jobs during the first month. Similarly, there was positive economic data leading up to the 2008 recession. We anticipate a slowdown in the U.S. economy rather than a full-blown downturn, and we remain optimistic about the potential for equities, particularly small and mid-caps. While recent economic data has been encouraging, it is important for investors to exercise caution and not become overly optimistic.

Regulators Take On AI:  Concerns over market dominance have prompted regulators to launch an investigation into the AI practices of major tech firms.

• The FTC has initiated an inquiry into Big Tech’s aggressive acquisition practices concerning smaller AI firms. This investigation will scrutinize how industry giants like Microsoft (MSFT, $404.87), Alphabet (GOOG, $153.64), and Amazon (AMZN, $157.75) exploit their market dominance to procure smaller AI competitors, raising concerns about potential consumer harm and innovation suppression. The agency’s heightened attention to AI aligns with similar probes opened by U.K. and EU regulators, reflecting a growing chorus of concern about the tech giants’ tightening grip on the rapidly evolving AI landscape.
• Emerging language-learning startups, heavily reliant on Microsoft, Alphabet, and Amazon for crucial infrastructure, face an alarming vulnerability to hostile takeovers. These tech giants controlled two-thirds of the funding for AI firms in 2023, according to Pitchfork data, giving them immense leverage over fledgling companies. Big Tech’s control over cloud computing further intensifies the takeover risk for AI startups who heavily rely on these services for their core operations. A study by Deloitte revealed that 70% of companies derive their AI capabilities from cloud-based software, while 65% utilize cloud services to construct AI applications.

• Amidst the prevailing optimism surrounding AI-related enterprises, the outlook may be considerably more nuanced than initially perceived by investors. As major tech companies brace for heightened government scrutiny, with regulatory bodies collaborating to enhance oversight, the impact on tech-stock valuations remains uncertain. While acknowledging the market’s anticipation of potential upside in these stocks over the next few years, we believe that much of this optimism is already priced in. Consequently, while these companies may still present opportunities for capital gains, we foresee other sectors offering potentially superior relative returns in the future.

BOJ’s Hawkish Turn: While most developed central banks are looking to pivot toward dovish policy, the Bank of Japan hints that it may be going in the other direction.

• The Bank of Japan’s latest minutes hint at a possible turning point in monetary policy, as members debated the terms of exiting their ultra-loose quantitative easing (QE) program. Although disagreement persists, growing optimism about hitting their inflation target suggests a shift might be closer than previously thought. While some committee members proposed raising short-term rates and leaving long-term borrowing costs low, others urged caution, citing concerns about market turbulence if the bank stops buying risky assets. This split opinion suggests a gradual exit from QE might be more likely than a sudden shift.
• That said, recent Japanese price data offers mixed signals about the future path of inflation. Tokyo’s core Consumer Price Index (CPI) rose 1.8% year-over-year, well below the central bank’s target of 2.0%. Meanwhile, the annual increase in producer prices reached 2.4% in December, matching the previous month’s nearly nine-year high. With mixed economic signals swirling, policymakers are putting extra weight on sustainable wage increases as a potential indicator of lasting inflation. Ongoing negotiations with Rengo, Japan’s largest union, could be the tipping point. If they secure their sought-after 5% wage hike, then this could be enough to convince policymakers that inflation has truly found its footing.

• Japanese investors, major players in the U.S. and European bond markets, face potential asset relocation if the Bank of Japan tightens monetary policy. This could trigger a domino effect in global debt markets with rising yields and currency fluctuations. However, the BOJ’s delay in this shift offers welcome news for the yen (JPY), potentially strengthening it and boosting returns for dollar-based investors who hold Japanese assets. The April timeline may be etched in market forecasts, but we see a different picture. Our conviction is that the BOJ will postpone its tightening path until summer, giving ample time for domestic data to solidify.

Other News:  Despite growing skepticism from U.S. officials, Russian President Putin has hinted at a possible shift toward peace talks with Ukraine. This cautiously optimistic development follows a recent U.S.-China collaboration on AI regulation and Red Sea issues, suggesting a potential thaw in tensions. Meanwhile, Brazil is mediating a territorial dispute between Guyana and Venezuela, offering hope for further conflict reduction in South America. In short, geopolitical risks are starting to ease.

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