Author: Amanda Ahne

Asset Allocation Bi-Weekly – A Pause That Refreshes? (December 4, 2023)

Posted on by Amanda Ahne

by the Asset Allocation Committee | PDF

(Note: This is the final AABW of 2023; the next report will be published in January 2024.)

In 1929, Coca-Cola® introduced the tagline “a pause that refreshes.”  Although other advertising campaigns have come and gone, this line still sticks around in the public consciousness.  And, it has moved beyond a cold soft drink on a hot day as it can also refer to monetary policy.

First, is the FOMC in or near a pause?  Let’s take a look.

The FOMC, for the most part, still relies on the Phillip’s Curve—the idea that there is a tradeoff between unemployment and inflation.  Although it is doubtful that this relationship is strong enough to use as a basis for policy, the lack of an alternative means the Fed has continued to use this model.  And so, on the lower line in the chart above, we simply take the yearly change in CPI less the unemployment rate.  As the chart shows, prior to 1980, the Fed tended to react to CPI exceeding the unemployment rate (a positive reading in the indicator) by raising the policy rate.  However, as soon as the indictor began to fall, the policy rate was lowered.  The unabated rise in inflation led the Fed to move to a pre-emptive stance.  After 1980, the FOMC would begin to raise rates if the indicator merely approached zero, and it would keep rates elevated until the indicator showed clear signs of falling.  That was true until 2021.  The Powell Fed allowed the indicator to move strongly positive and then reacted aggressively to correct its error.

Now we have an indicator that is -0.7.  Although this level wouldn’t preclude additional rate increases, if the current downward trend in the indicator continues, then the FOMC will likely at least stop raising rates.  Inflation has been falling, and we note that unemployment has been increasing as well.  In fact, we are rapidly closing in on a key recession signal.

In general, when the current unemployment rate exceeds the rate from two years prior, the economy is typically in recession.  If the current unemployment rate continues to hold steady into year’s end, then the difference will be zero.

For the equity market, pauses that are not associated with an immediate recession are bullish.

The above chart shows the weekly close for the S&P 500 and the policy rate.  We have highlighted policy rate pauses in yellow that lasted at least six months going back to the late 1950s.  The index change data is shown in boxes and refers to the change in the S&P 500 over the period of the pause.  The data shows that long pauses raise hopes of a soft landing, which is a policy tightening cycle that doesn’t result in an immediate recession.  The pauses that led to an immediate recession showed a decline in the S&P 500 Index prior to the onset of recession.  However, the pauses that either avoided a downturn or experienced downturns that weren’t immediate, tended to have strong returns over the period of the pause.

This chart illustrates the dilemma for equity investors as we head into 2024.  If the Fed is about to embark on a period of steady policy rates, and the recession is delayed or avoided, history would support a rise of 15% to 25% in the overall equity markets in the coming months.  On the other hand, if a recession comes, then a decline is likely.

Perhaps the most difficult question is the length of the pause.  In the above graph, it’s notable that extended policy rate pauses tended to disappear from the mid-1960s into the mid-1990s, which likely reflects a higher inflation environment.  Simply put, there was increased volatility in the policy rate, likely due to the higher and more volatile inflation environment.  So, if the FOMC is going to implement a lengthy pause, further declines in inflation will probably be necessary.  But, if the recent inflation spike was an artifact of the pandemic, and isn’t structural, a long pause could develop which would be bullish for equities.  Of course, that outcome would depend on the avoidance of a recession, and it’s unclear whether the recent policy tightening will lead to a downturn.

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Daily Comment (December 1, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities are trading lower as investors seek to liquidate some of their holdings ahead of Fed Chair Powell’s speech, and the Dallas Cowboys’ defense failed to live up to the hype on Thursday. Today’s Comment starts with our thoughts about changing interest rate expectations. We then examine the continued stability of oil prices and the potential challenges of providing military aid to other countries. As always, our comprehensive report encompasses the latest domestic and international data releases.

Inflation Cooling: While central bankers unanimously agree on the need for prolonged rate hikes, certain countries are better equipped to withstand the economic implications of this policy stance.

  • Inflationary pressures remain pervasive across the developed world, yet price increases have moderated at a rate exceeding most analysts’ forecasts. The latest eurozone data indicates that headline inflation has climbed 2.4% since November 2022, substantially lower than the consensus forecast of 2.7%. Notably, Portugal and Italy have both reported annual price increases well below 2%. Concurrently, the Federal Reserve’s preferred inflation measure rose 3.4% from the prior year, well below consensus estimates of 3.5%. This progress has emboldened central bankers, who are now signaling their intent to maintain current interest rates while pursuing measures to address underlying price pressures.
  • Despite concerns about a resurgence in inflation, several areas, including the eurozone, the U.K., and Canada, may find it untenable to maintain elevated interest rates without jeopardizing their economic growth prospects. These countries have all experienced economic contractions in the third quarter of 2023, highlighting the delicate balance between curbing inflation and fostering economic growth. In stark contrast, the U.S. economy surged at its fastest pace since 2021 from July to September. This divergence in growth prospects has fueled speculation among investors that other developed economies may be forced to loosen monetary policy ahead of the U.S.

  • The chart depicted above showcases the shift in implied policy rates since August. Implied policy rates refer to market-derived forecasts of future interest rates. During this period, investors adjusted their anticipated policy rates downward for the U.K., Canada, and the eurozone for the next few years. Notably, the U.S. has bucked this trend, with investors revising their expectations for the upcoming year. This divergence in policy paths should be supportive of the U.S. dollar against its major counterparts.

Crude Prices Under Pressure:  Despite lingering supply concerns, oil prices have remained subdued, falling short of the previous year’s level.

  • Oil producers’ efforts to achieve a sustainable rise in crude prices faced a setback due to supply cuts. In an attempt to bolster prices, OPEC+, which includes Russia, reached an agreement on Thursday to deepen production cuts by an additional 1 million barrels per day. While the agreement was nonbinding, it was meant to convey the oil-producing nations’ resolve to collaborate. Despite an initial surge, Brent crude prices closed the day lower, partly due to concerns that producers might not be able to implement the agreed-upon cuts fully. As a consequence, oil prices ended the day down 2%.
  • The stability of oil prices has been partially attributed to weaker demand from China, which is grappling with internal economic challenges, and the looming threat of a global economic downturn. Notably, last year it was expected that oil demand would surge in 2023 as the lifting of China’s Zero-COVID policy was anticipated to increase energy consumption significantly. These expectations were dashed as the country’s low consumer confidence and industrial output have led to a sluggish economic recovery. Furthermore, the Organization for Economic Co-operation and Development (OECD) has forecast a slowdown in GDP growth for member countries to 1.4% in 2024, which will further contribute to weakened demand.

  • This year, energy has been a major headwind for inflation. The base effects from last year’s energy price surge have largely dissipated, narrowing the gap between core inflation and headline inflation. The lack of drag from energy will put pressure on other components of inflation as central banks look to bring inflation back to their 2% target next year. Hence, a possible reversal of oil prices could force central banks to rethink the path of interest rates. If oil prices remain relatively stable in the coming year, policymakers may be encouraged to stand pat.

Wars Far From Over: Conflicts in Central Asia and the Middle East show no signs of waning, putting Washington in a difficult position.

  • Facing mounting fiscal pressures, U.S. lawmakers will likely face heightened scrutiny when justifying foreign military aid, particularly for prolonged conflicts. While Americans generally support limited assistance to other nations, their tolerance may dwindle, especially when faced with persistent domestic challenges. These concerns likely explain the recent instances where lawmakers have conditioned military aid for Israel and Ukraine on the inclusion of funding for border security. Hence, we may be moving toward a world in which countries will be forced to be less reliant on the U.S. for protection. This scenario should lead to greater trade and supply chain uncertainty, which should favor commodity prices in the longer term.

Other News: Oil prices are also being impacted by the use of bot traders. This highlights technology’s growing influence on markets and raises questions about potential risks. In a separate event, Florida Governor Ron DeSantis’ one-on-one debate with California Governor Gavin Newsom fell short of expectations. While DeSantis hoped the debate would reinvigorate his campaign, he failed to clearly differentiate himself from Republican frontrunner Donald Trump.

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Business Cycle Report (November 30, 2023)

Posted on by Amanda Ahne

by Thomas Wash | PDF

The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities.  The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis.  Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.

The Confluence Diffusion Index

was unchanged from the previous month, offering some reassurance that economic conditions are not exhibiting further signs of deterioration. The October report showed that seven out of 11 benchmarks are in contraction territory. Last month, the diffusion index remained unchanged at  -0.2727, below the recovery signal of -0.1000.

  • Risk assets were boosted due to optimism regarding Fed policy.
  • Consumer sentiment is on the verge of a positive shift.
  • The labor market showed signs of cooling.

The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is in recovery. The diffusion index currently provides about six months of lead time for a contraction and five months of lead time for recovery. Continue reading for an in-depth understanding of how the indicators are performing. At the end of the report, the Glossary of Charts describes each chart and its measures. In addition, a chart title listed in red indicates that the index is signaling recession.

Read the full report

Daily Comment (November 30, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! The day is off to a lively start, with equities surging and Arkansas pulling off an upset victory over Duke. In today’s Comment, we delve into the reasons behind investor rate expectations that may be amiss, explore the waning influence of the Magnificent Seven, and provide our insights into how the world might respond to a reduced U.S. presence. As always, our comprehensive report encompasses the latest domestic and international data releases.

Investor Deja Vu? Ignoring the lessons of the previous year, investors have eagerly embraced riskier and longer-duration assets in anticipation of a Fed pivot.

Down With the Kings? The Magnificent Seven have been the market’s top performers in 2023, but their continued dominance into the new year is uncertain.

  • These titans of the S&P 500, including Apple (AAPL, $189.37), Amazon (AMZN, $146.32), Alphabet (GOOGL, $134.99), Meta (META, $332.20), Microsoft (MSFT, $378.85), Nvidia (NVDA, $481.40), and Tesla (TSLA, $244.14), stand as the dominant forces within the index. Collectively, these behemoths account for nearly 30% of the S&P 500’s value, eclipsing their 493 counterparts. While the broader market has gained 19% this year, the Magnificent Seven have surged by an astounding 80%. However, this remarkable growth has been accompanied by a concerning rise in their P/E ratios from 29 to 45, prompting questions about potential overvaluation.
  • Maintaining the remarkable performance of the Magnificent Seven in 2023 could be challenging. Their exponential growth was fueled by investor optimism in their ability to capitalize on artificial intelligence advancements that would translate into exceptional future returns, which is offsetting the risk of sacrificing higher-yielding safe-haven assets today. Their ascent has drawn parallels to the Nifty 50s of the 1970s and the dot-com boom of the 1990s, leading to speculation that these companies could face a correction if expectations are not met. The latest earnings reports show that Amazon and Microsoft may still have some momentum, while the remaining companies are seeing less favorable attention.

  • As the prospect of higher interest rates diminishes, investors may redirect their focus to stocks that were largely neglected throughout 2023. This sentiment shift is evidenced by the recent performance of the S&P 400, an index that tracks mid-cap companies. Despite starting November down nearly 2% for the year, the index surged by an impressive 7.7% during the month, indicating a renewed interest in these often-overlooked companies. This improved performance can be attributed to a resurgence of bargain hunting among investors seeking opportunities to reenter the market. If favorable conditions persist, this trend could extend into the coming year.

A More Hostile World: With the United States gradually relinquishing its mantle as the world’s preeminent superpower, the global community faces the daunting task of navigating a world without a global hegemon.

  • The world’s fracturing into regional blocs is likely to unfold over the next few years. While the U.S. shows no immediate signs of relinquishing its superpower status, political currents are clearly nudging Washington in a different direction. This shift is evident in the growing congressional gridlock over aid packages for Israel and Ukraine. The geopolitical transformation is likely to trigger an upsurge in global military spending, which should bode well for the aerospace and defense industry for the foreseeable future. Furthermore, the burgeoning political uncertainty is poised to render commodities as an attractive haven, since intensifying competition will compel nations to drive up resource prices.

Other news: The U.S. charged an Indian official with plotting to assassinate a Sikh separatist. The incident underscores the challenges the U.S. faces in aligning India with its interests, as India has repeatedly asserted its autonomy as a rising power. Meanwhile, the U.S. and China are poised for a clash of influence in Micronesia, a reflection of their intensifying competition for global influence. On a somber note, political mastermind Henry Kissinger passed away at the age of 100. Renowned as the architect of U.S. foreign policy for decades, his legacy will continue to shape how people view international relations even after his death.

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Weekly Energy Update (November 30, 2023)

Posted on by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil prices have retreated from their early October highs.

 (Source: Barchart.com)

Commercial crude oil inventories rose 1.6 mb compared to forecasts of a 1.7 mb draw.  The SPR rose 0.3 mb, which puts the net build at 1.9 mb.

In the details, U.S. crude oil production was steady at 13.2 mbpd.  Exports were unchanged while imports fell 0.7 mbpd.  Refining activity rose 1.9% to 89.8% of capacity.  Refinery activity has started its seasonal recovery which should last into December.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  Inventories have now risen to seasonal norms.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $63.71.  However, given the level of geopolitical risk in the market, we are not surprised that oil prices are well above this model’s fair value.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in late 1984.  Using total stocks since 2015, fair value is $90.25.

Market News:

Geopolitical News:

  • The Hamas/Israeli conflict is on hold due to a ceasefire that has facilitated the exchange of hostages and prisoners. Each day the ceasefire is extended reduces the odds that the conflict will spread, but we doubt that this ceasefire will hold much longer.
  • A Houthi hijacking team attempted to take control of an Israeli-related oil tanker. The U.S. Navy was able to thwart the hijackers.  However, the action does suggest that shipping in the region is at risk due to the Hamas/Israeli conflict.
  • Over the past several months, there has been a lot of reporting about oil sales being transacted in currencies other than USD. In particular, India has been paying for Russian oil with INR.  Russian oil companies are finding that the Russian Central Bank has no interest in converting INR into RUB, meaning the oil companies are essentially “stuck” with a near worthless currency.  Of course, if Russia were not under sanction, the bank could exchange the INR for USD or some other currency, but because sanctions have excluded Russia from the dollar system, there is no obvious way to liquidate the currency.  It has reached the point where Russian oil companies are threatening to divert shipments to other nations.  Russia is encouraging India to pay in CNY but given that the Chinese have a closed capital account, it may not be easy for India to acquire CNY easily.  Overall, the dollar system works pretty well, while abandoning it is hard.
  • Although the U.S. has tied the easing of sanctions on Venezuela with running free and fair elections, Caracas is moving to invite oil companies into development licenses in a clear sign that it expects Washington to ease sanctions regardless of its behavior.
    • Another worrying development is that Venezuela is claiming a large part of Guyana. Although Venezuela claims the Essequibo region as part of its territory, no one else does nor has for well over a century.  Venezuela’s claims are massive:

(Source:  Washington Post)

    • The problem is that the western border has been disputed since 1814.  In 1895, President Cleveland established a commission to establish a border.  Because Guyana was a British colony, the U.K. initially rebuffed the effort but quickly realized it couldn’t enforce its claim.  At that point, Venezuela, the U.S., and the U.K. agreed to international arbitration, which established the current borders.  Venezuela was not pleased, and evidence that surfaced after WWII suggested that a Russian member of the arbitration board had conspired with London to expand the border in Guyana’s favor.  In the wake of this news, the Kennedy administration quietly looked at allowing either Venezuela or Brazil to expand their claims to prevent communism from gaining a foothold as independence loomed.  Guyana became independent of Britain in 1966.  New talks between Venezuela and Guyana began but never reached a conclusion.
    • President Maduro announced a referendum in the disputed territory to determine where the border should sit.  Given that Venezuela isn’t recognized as being in control, it isn’t obvious how the vote will take place.
    • Until recently, there wasn’t much interest in pursuing claims.  Guyana was desperately poor.  But as we have documented this year, Guyana is rapidly becoming a major oil producer.  Fearing Venezuela will take military action, the Brazilian army has been put on high alert.  Although we don’t expect this event to come to “blows,” Maduro is mercurial and may believe that the U.S. is in such need of oil that he can move with impunity, not just against his domestic opposition, but also to reclaim areas of Guyana.  If war breaks out, it would be hard for the U.S. not to become involved.  And, it would bolster oil prices.
  • Iran postponed a leader visit with Turkey. It was not clear why the visit was delayed.
  • Although Russia and China are “friends,” it is worth noting that Beijing is pressing hard on Moscow about the Siberia 2 pipeline project.

Alternative Energy/Policy News:

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Daily Comment (November 29, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with new projections of global interest rates from the Organization for Economic Cooperation and Development.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including potential territorial aggression by Venezuela against its neighbor Guyana and an important case being heard today by the U.S. Supreme Court that could potentially dismantle much of the modern U.S. regulatory system.

Global Monetary Policy:  In its latest economic outlook, published today, the OECD warned that both the European Central Bank and the Bank of England may need to keep interest rates high until early 2025—much longer than investors are expecting—to guard against stubborn inflation pressures.  In contrast, the OECD projected the Federal Reserve will start cutting U.S. interest rates by the second half of 2024.

Venezuela-Guyana-Brazil:  Venezuela’s National Assembly, dominated by the ruling party, has recently approved a national referendum on the status of the Essequibo territory—the western two-thirds of oil-rich Guyana that Venezuela has claimed for more than a century.  The planned referendum may simply be a ploy to help the government of Nicolas Maduro in Venezuela’s coming elections, but it could also be an example of Chinese- and Russian-style “lawfare” ahead of an attempt to seize Essequibo.  Since Venezuelan forces would likely have to traverse Brazilian territory for any such invasion, the Brazilian military has reportedly been put on alert and is massing troops along its border with Venezuela.

  • Over the last decade, dozens of new oil fields have been discovered in Guyana, setting it up to be a key source of new energy in the coming decades. The country is currently estimated to have the equivalent of more than 11 billion barrels of oil deposits, similar to the number of deposits in Kuwait and the United Arab Emirates.
  • If Venezuela did try to invade Guyana, the potential damage to its oil fields and the risk that they would fall into Venezuela’s hands could spark a significant jump in global oil prices.
  • If Venezuelan forces traversed Brazilian territory to reach Essequibo, such an invasion could also spark a broader conflict, potentially drawing in more South American countries or even the U.S.

 (Source:  New York Times)

China-Lithuania:  In another sign that Beijing is trying to ease tensions with the West, at least temporarily, Lithuanian Foreign Minister Gabrielius Landsbergis said China has now lifted most of the economic sanctions it imposed on the Baltic country in 2021 in retaliation for its approval of a de facto Taiwanese embassy in Vilnius.  Separate data from Beijing shows Lithuanian exports to China in the first 10 months of 2023 were up 54% from the same period one year earlier.

India:  Despite Beijing’s recent efforts to ease its international relations and rekindle stronger economic growth, its ongoing military buildup continues to spur reactions in neighboring countries.  According to recent reports, Indian officials on Friday plan to formally approve the construction of their country’s second indigenous aircraft carrier.  Along with India’s first indigenous carrier and a Russian-built vessel, that would lift New Delhi’s total carrier force to three, enough to eventually ensure a continuous power projection capability throughout the Indian Ocean.

Vietnam:  The government announced it will raise its income tax on multinational firms to 15%, in line with an OECD-led effort to set a minimum rate on companies to avoid tax evasion and tax-rate shopping.  The move threatens to slow the recent surge of foreign direct investment into Vietnam as more multinational firms look to diversify their production out of China.

United States-Argentina:  The newly elected president of Argentina, populist libertarian Javier Milei, has announced that he held fruitful meetings with U.S. officials in Washington yesterday, as he tries to set the groundwork for restructuring his country’s troubled $43-billion loan from the International Monetary Fund.  In addition, Luis Caputo, a former Argentine finance minister considered the frontrunner to lead Milei’s economy ministry, met U.S. Treasury and IMF officials.

  • Milei has said he will postpone his controversial reform, which would replace the Argentine peso (ARS) with the U.S. dollar.
  • On the other hand, he plans to send a package of “shock therapy” reforms to Argentina’s congress on December 11, including spending cuts to balance the budget in 2024.

U.S. Regulatory Policy:  In a case that could undermine administrative courts in multiple sectors, the Supreme Court today will hear a challenge to the Security and Exchange Commission’s use of such panels.  The courts, which are presided over by administrative law judges, are being challenged on grounds that the judges aren’t impartial and that the courts rob defendants of their right to a trial by jury.  A decision is expected by next July.

U.S. Investing Pantheon:  Investing legend Charlie Munger, vice chairman of Berkshire Hathaway (BRK-B, $360.05) and key lieutenant of Warren Buffett, died yesterday in a California hospital at the age of 99.  Munger is often credited with convincing Buffett to abandon his early-career focus on cheap “cigar butt” investments and instead focus on buying great businesses at reasonable prices, an approach we largely share here at Confluence!

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Daily Comment (November 28, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with hints of further tightening in the eurozone’s monetary policy, despite the continuing slowdown in the region’s economic growth.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an extended ceasefire in the Israel-Hamas conflict and positive remarks on the U.S. labor market by popular former Federal Reserve economist Claudia Sahm.

Eurozone:  In a hearing at the European Parliament yesterday, European Central Bank President Lagarde said her policymakers are likely to consider an early end to the reinvestment of maturing bonds related to the ECB’s pandemic stimulus efforts, rather than continuing them to the end of 2024 as currently planned.  Allowing the ECB’s bond holdings to mature without reinvesting the proceeds would effectively soak up liquidity and further tighten eurozone monetary policy even if the ECB stops raising interest rates.  However, it’s entirely possible the policymakers will keep reinvesting the proceeds if the eurozone economy continues to slow.

United Kingdom-Greece:  The British and Greek governments are embroiled in a bitter feud over the “Elgin Marbles” held at the British Museum in London.  The Greek government has long wanted to repatriate the 2,500-year-old, fragmentary sculptures from the Parthenon in Athens after they were taken to Britain in the 18th century, but Prime Minister Sunak and many others in Britain believe they are an essential part of the British Museum’s permanent collection.

Russia-Ukraine-Turkey:  New data shows that Turkish imports and exports of certain dual-use, civilian/military goods needed for Russian military production have surged this year, suggesting Ankara is playing both sides in the showdown between Russia and Western-supported Ukraine.  As the world fractures into relatively separate geopolitical and economic blocs, we would expect to see exactly this kind of behavior among countries situated on the borderlands between rival camps.  On the other hand, the move is risky for Turkey, as it could invite a backlash from its Western allies and complicate the trade and investment relations it needs to make the most of its economic potential.

Israel-Hamas Conflict:  The Israelis and Hamas agreed to extend their ceasefire and hostage exchanges for an additional two days, rather than letting them expire yesterday as originally planned.  If implemented, the extension should lead to Hamas releasing another 20 of its Israeli hostages, while Israel will release 60 of the Palestinians it holds in its jails.  More important for investors, the extended ceasefire may further reduce the risk of the conflict spreading, although we don’t think it would eliminate the risk.

United States-China:  David Solomon, CEO of Goldman Sachs (GS, $337.71) said this week that the worsening U.S.-China rivalry has prompted his firm to abandon its previous China strategy of “growth at all costs.”  According to Solomon, “Today, it’s a more conservative approach [in China] and we’ve probably pared back some of our financial resources there, simply because there’s more uncertainty.”  The statement is consistent with our view that the U.S.-China competition has raised risks for investors, whether they’re direct investors like Goldman or portfolio investors holding assets exposed to China.

U.S. Labor Market:  In one of her “Stay-At-Home Macro” posts over the weekend, popular former Fed economist Claudia Sahm offers a comprehensive argument that most U.S. workers are better off now than they were before the coronavirus pandemic.  While few of her individual observations are groundbreaking, the overall picture she paints probably helps explain the current resilience in U.S. economic growth and the possibility that the country will avoid a recession outright or have only a modest dip in the coming year.

U.S. Pharmaceutical Industry:  President Biden announced yesterday that he will invoke the Defense Production Act to allow government investment in pharmaceutical supply chains as a way to help ensure the availability of key drugs and related medical supplies such as insulin, morphine, vaccines, and ventilators.  The move will allow the Department of Health and Human Services to provide about $35 million for capital investments and other needs in the medical supply chains.

  • The move is consistent with similarly modest DPA investments in the traditional defense industry.
  • With many reports showing defense firms are having trouble ramping up their output of advanced weapons, ammunition, and other supplies, a key question is why the government isn’t making even stronger use of the DPA.

U.S. Green Technology Industry:  As governments around the world keep pushing policies to cut the amount of carbon in the atmosphere, they’ve mostly focused on cutting carbon emissions.  Now, a rising new set of technologies aims to take the carbon out of the air after it’s been emitted.  For example, a start-up firm called Graphyte has developed a product that uses agricultural waste products such as sawdust or tree bark to naturally absorb carbon dioxide.  The product can reportedly remove carbon from the air at a cost of about $100 per metric ton, well below the main competing technology, direct-air capture, which costs about $675 per metric ton.

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Daily Comment (November 27, 2023)

Posted on by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with some ideas we picked up on the world’s geopolitical trends from our reading over the holiday weekend.  We next review a range of recent international and U.S. developments with the potential to affect the financial markets today, including a potential new financial crisis in China, a landslide victory for a far-right candidate in last week’s Dutch elections, and an early take on U.S. consumer spending on Black Friday.

United States-China:  We often write about the intensifying U.S.-China geopolitical rivalry since it’s key to understanding the world’s future economic and financial market environment.  Based on our reading over the Thanksgiving holiday, which included The Strategy of Denial, by Eldridge Colby, lead author of the U.S. government’s 2018 National Defense Strategy, we want to refine one assertion we’ve often made about how the U.S. established and maintained its position as global hegemon in the decades since World War II.

  • As Colby notes, the great lesson of the 20th century was that the U.S. can’t rely on the Pacific and Atlantic oceans to protect its territorial integrity, political freedom, or prosperity. Concentrated economic wealth—and therefore potential military power—in Asia, Europe, and the Middle East means the U.S. can only be secure by blocking the emergence of regional hegemons in those territories.
  • While we’ve often said that one step in establishing U.S. hegemony was to “freeze” past conflicts in those regions, it’s more precise to say the U.S. used its predominant military, economic, and diplomatic power after World War II to hold down the historic hegemonic aspirants in those regions: Japan in Asia, Germany in Europe, and potentially Russia in the Middle East.  This is consistent with Colby’s analysis of U.S. strategy.
  • But importantly, Colby notes that the U.S. can’t just exercise its own power to hold down those want-to-be hegemons. To safely contain aspiring regional hegemons, the U.S. actively developed regional anti-hegemonic coalitions to help keep the peace, such as the North Atlantic Treaty Organization in Europe and various bilateral alliances in Asia and the Middle East.
    • President Trump’s error was casting these alliances as relationships in which the U.S. benevolently provides security for Asia, Europe, and the Middle East.
    • Actually, the U.S. enlists countries in these regions to help protect U.S. national security. While “free rider” problems exist in all such alliances, they’re the price the U.S. pays for these regions to cooperate in protecting U.S. security.
      • By allowing us to maintain military bases on their soil, our allies enable the U.S. to practice an extraordinarily deep “forward defense.”
        • Rather than having a western defense perimeter along our own Pacific coast, we’ve pushed it more than 5,000 miles away to the “First Island Chain” running from Japan and Taiwan through the Philippines, Guam, and Malaysia, as shown in the map below.
        • Rather than an eastern defense line along our own Atlantic coast, we’ve pushed it more than 4,000 miles away to the eastern frontiers Finland, the Baltics, Poland, Romania, Turkey, Jordan, Israel, and Saudi Arabia.
      • Just as important, the U.S.’s preponderant military spending and power give us the leadership role in coordinating and agglomerating our allies’ power in ways that serve U.S. interests as well as their own, especially in managing the coalition to deny China’s bid for regional hegemony.
    • Colby’s book is pretty theoretical, almost like a primer on game theory, but it’s a useful guide to the geopolitical dynamics we’re likely to see between the U.S. and China in the coming years. For investors, the key is that the U.S.’s efforts to build and maintain anti-hegemonic coalitions in Asia and Europe will surely exacerbate the global fracturing that we’ve been writing about, with results ranging from higher inflation and interest rates to potential investment opportunities in short-duration, dividend-paying industrial stocks and commodities.

(Source:  Hudson Institute, 2023)

China:  The government in recent days has been scrambling to avert a meltdown of shadow-banking giant Zhongzhi Enterprise, which last week announced it was insolvent and had at least $31 billion more liabilities than assets.  If the company collapses, it would be one of China’s biggest corporate failures in many years and would likely further sour investors on the country.  In addition, investors in products offered by the company have begun to stage demonstrations demanding their money back, which could lead to broader political unrest.

Taiwan:  The opposition Kuomintang and Taiwan People’s Party have scuttled their effort to present a unified ticket in the January 13 presidential election, while Terry Gou, the founder of giant contract electronics manufacturer Foxconn (HNHPF, $6.29), withdrew from the race.

Malaysia:  The government of Prime Minister Ibrahim has unexpectedly extended the license for Australian mining firm Lynas (LYSDY, $4.38) to run its rare earths processing facility in Pahang state, despite opposition from residents wary of environmental pollution.  Renewing the license to operate the plant, which is the world’s largest such facility outside China, is a signal that Ibrahim will push forward with his plan to make Malaysia a key player in the mining and processing of rare earths, which are critical to the highly electrified economy of the future.

  • Ibrahim’s government believes Malaysia holds some $173 billion of rare earth reserves, which it believes should be exploited to boost foreign investment, economic growth, and Malaysian wealth (the chart below shows how Malaysian per-capita gross domestic product has grown in recent decades).
  • As the U.S. and its evolving geopolitical bloc work to cut their dependence on Chinese rare earths, they would likely be a ready market for anything Malaysia can produce. In turn, that would likely help draw Malaysia closer to the U.S. bloc.  Our analysis currently places Malaysia in the “Leaning U.S.” camp.

Netherlands:  In parliamentary elections on Wednesday, the far-right populist Freedom Party led by anti-Islam and Euroskeptic firebrand Geert Wilders came in first with 23.7% of the vote, well ahead of the Labour-Green Alliance of Frans Timmermans and its 15.6%.  That gives the Freedom Party 37 of the 150 seats in parliament, versus 25 for the Labour-Green Alliance, 24 for the ruling center-right Freedom and Democracy Party (VVD), and 20 for the centrist New Social Contract Party (NSC).  Because of the fractured results and the reluctance of other parties to associate with Wilders, it is not yet clear if he will be able to form a coalition that would have a majority in parliament, despite his unexpected landslide victory.

Turkey:  As the government continues to normalize economic policy after President Erdoğan’s recent re-election, the central bank on Thursday hiked its benchmark short-term interest rate to 40%, boosting the rate from 35% previously and marking its sixth straight rate hike.  Still, the benchmark rate remains far below Turkey’s consumer price inflation, currently over 61%.  The lira (TRY) has therefore continued to weaken, trading on Friday at 28.8656 per dollar ($0.0346), down 35.2% for the year-to-date.

Russia-Ukraine War:  With Russian and Ukrainian forces largely at a stalemate along the front lines in eastern and southern Ukraine, Russia launched big new waves of kamikaze drones against Kyiv and other Ukrainian cities over the weekend.  After rebuilding its missile and drone stocks over the summer, Russia now appears to be repeating last winter’s tactic of attacking Ukraine’s civilian power and heating infrastructure to undermine the country’s will to fight and force it to divert its air defense systems away from the front lines.  To warn off the Kremlin, the Ukrainian military retaliated by striking a power plant in Russian-occupied eastern Ukraine, cutting electricity to several cities and towns.

Israel-Hamas Conflict:  Over the holiday weekend, Israel and Hamas continued to honor a ceasefire and release of Hamas hostages and Israeli-held prisoners.  The released hostages include several Thais, a dual Israeli-Russian citizen, and at least one U.S. citizen.  Nevertheless, Palestinian-Israeli violence continues in the West Bank, and Iran-backed militants elsewhere in the region keep attacking U.S. military forces, keeping alive the possibility that the conflict will expand into a regional conflagration.

U.S. Income Tax System:  The Internal Revenue Service said it will delay several new tax rules mandated by Congress.  The rules, which will be delayed for two years, touch on reporting requirements for e-commerce sales and cryptocurrency transactions, and on catch-up contributions to retirement accounts.

U.S. Labor Market:  New analysis from Glassdoor shows that Generation Z workers (those born from 1997 to 2012) are about to overtake baby boomers in terms of their share in the U.S. labor force.  The baby boomers’ share in the labor force has long been falling as more and more of the cohort retired, faced health problems, or died, and as younger generations started working.  The coronavirus pandemic greatly accelerated the process, just as the Great Financial Crisis did a decade and a half ago.  The mass withdrawal of baby boomers during the pandemic not only helped create today’s labor shortages and rising wage rates, but it also made it that much easier for Gen Z workers to overtake the baby boomers’ share in the labor force.

U.S. Consumer Finances:  Among the nation’s top five credit card issuers, new analysis shows the share of their lending portfolios delinquent by 30 days or more is continuing to surge.  The rise in delinquencies and associated charge-offs likely reflects factors such as the consumer price inflation of recent years, the Federal Reserve’s aggressive interest-rate hikes, and the fact that some households have now spent all their excess savings from the pandemic years.  Rising delinquencies and charge-offs serve as a reminder that the economy remains at risk of recession going into 2024.

U.S. Consumer Spending:  As the holiday spending season swung into high gear over the Thanksgiving weekend, the data so far suggests retailers saw a modest increase in store traffic and sales compared with last year.  Data from Mastercard SpendingPulse™ showed Black Friday sales in stores and on-line were up 2.5% year-over-year.  Data from RetailNext showed foot traffic in stores was up 2.1%.  Nevertheless, it is still too early to gauge just how successful the holiday selling season will be when all is said and done.

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