by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with new, upgraded forecasts for global economic growth from the World Bank.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a big slide today in the Turkish lira (TRY) as the country’s new finance minister begins shifting polices and the prospect for another big labor action in the U.S.

Global Economy:  In its latest Global Economic Prospects report, the World Bank said it now expects global economic output to increase an inflation-adjusted 2.1% in 2023, up from its forecast of 1.7% in January but still weaker than the 3.1% expansion last year.  Nevertheless, it also cut its forecast for 2024 to 2.4%, versus its January estimate of 2.7%.

• The revised forecasts essentially reflect how the U.S. and other key countries have maintained their economic momentum better than anticipated at the start of the year, which will likely push much of their slowdown or recession into next year.
• Prolonged economic momentum may be good for labor demand, but the institution warned that the resulting interest-rate hikes by the Federal Reserve and other central banks are causing increasing strains on many less-developed countries.

China:  Despite the World Bank’s upwardly revised growth forecasts for 2023, the faltering recovery in China remains a concern for global investors.  New analyses suggest the government may be fudging its export data upward to show national growth is better than it really is.  The analyses show discrepancies between China’s official export data and a range of other export indicators.  Faltering demand growth in China would likely be a major headwind for overall global growth and the financial markets.

• In official data released today, China’s May exports were down 7.5% year-over-year, after a rise of 8.5% in the year to April. The reported decline for May was much worse than analysts anticipated, but that won’t necessarily stop the concerns about inaccurate reporting to make the economy look better than it really is.
• Meanwhile, May imports were reportedly down 4.5% on the year, after a fall of 7.9% in the year to April. Falling imports also point to weakening demand in China.

China-United States:  In a sign that bilateral relations could be stabilizing, U.S. Secretary of State Blinken will reportedly visit China later this month.  That would mark a rescheduling of the meeting Blinken planned to make in February before it was derailed by that month’s Chinese spy balloon incident over the U.S.  Any resumption of high-level contact between U.S. and Chinese leaders could help ease the acrimony between the countries, but we believe the overall rivalry will continue to sharpen over time and drive further global fracturing, re-industrialization in the U.S., shortened global supply chains, and higher inflation and interest rates.

United Kingdom:  Mortgage lender Halifax said the average British home price in May was down 1.0% from one year earlier, marking the first year-over-year decline since 2012.  The decline in home values comes as the Bank of England reports that the country’s average mortgage interest rate has topped 4.5% for the first time since the Great Financial Crisis, with more hikes by the central bank expected in the coming months.

Turkey:  The Turkish lira (TRY) is down approximately 7% against the U.S. dollar so far this morning, recently trading at around 23 per greenback.  In contrast with the currency’s previous sharp drops, this one doesn’t appear to stem from concern about new, unorthodox economic policies or the threat of a financial crisis.  On the contrary, today’s decline appears to reflect a move toward better economic policies by newly installed Finance Minister Şimşek.  Specifically, today’s fall appears to reflect the government reducing its support for the currency and letting it trade more freely.

U.S. Fiscal Policy:  Investors are becoming increasingly worried that the Treasury Department will have to auction as much as $850 billion in bills between now and September to replenish its coffers and make up for the months when it was constrained by the recent standoff over a new debt limit.  As we’ve warned before, massive make-up issuance will drain liquidity out of the financial markets, potentially pushing down asset prices at least in the near term.

• Separately, some defense hawks in Congress are unhappy with the military budget’s minimal 3.3% increase under the deal to lift the debt limit. Hawks in both the House and the Senate have floated the idea of an immediate supplemental appropriation bill to boost defense spending further in the coming fiscal year.
• However, House Speaker McCarthy threw cold water on that idea earlier this week. It remains to be seen whether he will be able to hold the line on the defense budget as Congress gets to work on its appropriation bills in the coming weeks.

U.S. Retailing Industry:  While we continue to believe that global geopolitical fracturing will make re-industrialization of the U.S. economy a key trend in the coming years, as discussed in our Comment on Monday, new reporting suggests it will also lead to changes in U.S. retailing.  As foreign retailers become more wary about investing in China and its bloc, many that have only a small presence in the U.S. right now are reportedly planning to open large numbers of new stores here in the coming years.  Besides creating new competition for U.S. retailers, the expansion could help those foreign firms make up for lost opportunities in the China bloc.

U.S. Labor Market:  Teamsters President Sean O’Brien warned that his union will take a highly demanding, “militant approach” to negotiations with employers, including the upcoming talks for a new contract with UPS (UPS, $167.59).  That contract expires on July 31, and O’Brien specifically warned that he would take the union out on strike if the company doesn’t agree to universal pay rises, the end of an existing two-tier pay system, the installation of air conditioning into trucks, and other demands.

• The contract between the Teamsters and UPS is the country’s biggest labor deal, covering some 340,000 drivers and package handlers.
• A strike at UPS could therefore have a significant impact on the economy, not only by disrupting activity for businesses and individuals, but also by further signaling to workers their improved bargaining power amid today’s labor shortages.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news that a major venture-capital business, Sequoia Capital, is splitting up into components that largely reflect the global fracturing that we’ve been talking about for so long.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the destruction of a major dam and power station amid the war in Ukraine and new U.S. lawsuits against major cryptocurrency businesses.

Global Fracturing:  Venture-capital giant Sequoia announced that it will split into three separate geographically focused partnerships that will be distinct firms with separate brands.  The firm’s U.S. and European venture-capital business will retain the name Sequoia Capital, while its Chinese business will split off and change its name from Sequoia China to HongShan, as it’s currently referred to in Mandarin.  Sequoia’s business in India and Southeast Asia will separate and be renamed Peak XV Partners.

• We have been writing extensively about the way the world is fracturing into relatively separate geopolitical and economic blocs. The Sequoia split-up illustrates how this fracturing will have a profound impact on businesses.
  • Under Sequoia’s new structure, the U.S. and European venture-capital business will largely focus on what we call the evolving U.S.-led bloc.
  • The new HongShan will cover the dominant country in what we refer to as the China-led bloc.
  • The new Peak XV Partners looks like it will cover many of the countries we believe will end up in either the China-leaning, neutral, or U.S.-leaning bloc.
• As with overall global economic production and relationships, Sequoia’s split-up will likely reduce some of the firm’s efficiency, synergy, and innovation capacity. On the other hand, it will make each entity more resilient and independent as U.S.-China geopolitical tensions threaten to sever cross-bloc trades and investment.  Many other important firms are facing similar tough decisions, as shown by the grilling recently faced by the chairman of Taiwan Semiconductor Manufacturing (TSM, $98.05).

China-Hong Kong-United States:  A former California-based executive of ByteDance claims in a wrongful dismissal lawsuit that the Chinese Communist Party accessed user data from the company’s hit TikTok app in order to identify democracy protesters in Hong Kong during its political unrest in 2018.  The accusation is likely to intensify U.S. government efforts to rein in TikTok or perhaps even ban it from the U.S. market.  More broadly, it will probably also heighten concerns about U.S. users’ data security on Chinese apps or devices, further worsening U.S.-China tensions.

Russia-Ukraine War:  Shelling overnight has destroyed a major dam and power station in southeastern Ukraine, causing massive flooding and putting the large Zaporizhzhia nuclear power station at risk.  The Russian and Ukrainian governments have accused each other of destroying the facility, but at this point, there appears to be a good chance that the destruction was a desperate attempt by Russia to complicate Ukraine’s planned counteroffensive.  Even though the flooding has reportedly washed away many of Russia’s trenches and other defensive works in the region and will cause water shortages in Russia-controlled Crimea, the water and soaked ground could preclude any Ukrainian attack in that vector, allowing Russia to shift more troops to other parts of the front lines.

U.S. Cryptocurrency Regulation:  Yesterday, the Securities and Exchange Commission sued leading cryptocurrency exchange Binance for running an illegal trading platform in the U.S., misusing customer funds, and placing those funds with affiliates that had a conflict of interest.  The SEC action adds to the legal attacks on Binance that have been launched by the Commodity Futures Trading Commission and the Justice Department.  In response, key cryptocurrencies and related firms fell sharply yesterday, with Bitcoin (BTC-USD, 25,647.03) ending down 5.2%.

• In late-breaking news this morning, the SEC has also sued major crypto exchange Coinbase (COIN, $58.71) for not properly registering as an exchange.
• At the moment, it looks like Coinbase stock will fall some 15% at the open, based on current pre-market activity.

U.S. Artificial Intelligence:  The U.S. Air Force has stepped back from the story we mentioned in our Comment yesterday, in which an official said a drone enabled by artificial intelligence turned on its operator to retaliate for being told to hold off an attack on an enemy air defense installation.  The Air Force now says the official’s comments were “taken out of context and were meant to be anecdotal.”  Evidently, the story not only touches on some of the risks involved in using AI in military operations, but it also reflects how the hype around AI is encouraging over-the-top claims about the technology.

U.S. Commercial Real Estate Industry:  New analysis from data provider Trepp shows that almost $1.5 trillion of commercial real estate mortgages are maturing over the next three years, the majority of which will likely be interest-only loans.  Those loans will be difficult for borrowers to refinance because banks are currently focused on reducing their exposure to commercial real estate, especially office buildings.  The analysis further clarifies the looming risks in the financial sector as the Federal Reserve continues to hike interest rates.

U.S. Labor Market:  Reflecting today’s tight labor markets and the way bargaining power has shifted towards workers, members of the Screen Actors Guild have voted to authorize the union to call a strike if its upcoming negotiations for a new work contract with Hollywood studios falls through.  Those negotiations begin tomorrow.  A strike by SAG would add to the current work stoppage by the writers’ union and the recent deal with directors that boosted their take of royalties and limited the threat that they could be replaced by artificial intelligence.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some trends in the little-followed monthly report on construction spending.  The data suggests that the re-industrialization of the U.S. economy, which we have long expected, is now showing up in the statistical data.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest evidence of worsening U.S.-China tensions and new developments relating to artificial intelligence.

U.S. Re-Industrialization:  In a little-noticed report last week, April construction spending was shown to be up 6.1% from one year earlier, but private nonresidential construction spending was up 30.2%.  That marked the fourth straight month in which private nonresidential construction, a proxy for commercial construction, rose more than 20.0% on a year-over-year basis.  In contrast, private residential construction spending in April was down 9.7% on the year, and public works expenditure was up just 15.1%.

• The strength in commercial construction may seem surprising given today’s high vacancies and pessimism regarding properties such as office buildings and shopping malls. The details in the report, however, showed that the jump in commercial construction came largely from new factory construction, especially manufacturing facilities for electronics and information processing goods.
• The frenzy for building new electronics factories provides some of the first statistical evidence of U.S. re-industrialization, i.e., the rebuilding of the nation’s manufacturing, construction, and mining sectors as companies shift production back home from Asia or elsewhere. We suspect that a lot of the new factory construction reflects the recently announced, high-profile projects for electric-vehicle batteries, semiconductors, and other green-energy or information-processing goods.
• Importantly, we doubt that the recent spending uptick includes much of the hundreds of billions of dollars in subsidies provided by last year’s Inflation Reduction Act or the CHIPS and Science Act. Slow bureaucratic and administrative procedures would suggest that most of those subsidies will kick in later.  In addition, higher military budgets have not yet had their full impact on the defense industrial base.  The recent increase in commercial construction, therefore, is probably only the beginning of a much larger, longer-lasting uptrend.
• As we have been arguing, re-industrialization will likely make the U.S. more resilient to external supply shocks and provide more opportunities for workers without a four-year college degree. Nevertheless, these new facilities and the shortened supply chains they represent will be less efficient than under the extreme globalization of the last few decades.  The result will likely be higher costs, greater inflation, elevated interest rates, and prolonged downward pressure on bond prices.

China-United States:  Of course, the fracturing of the world into relatively separate geopolitical and economic blocs, and the resulting adjustments to supply chains and U.S. re-industrialization, stem mostly from the worsening tensions between the U.S. and China.  In the latest example of that, a U.S. Navy destroyer transiting the Taiwan Strait in international waters on Saturday was forced to slow to avoid hitting a Chinese navy ship that crossed its path, apparently deliberately.  Meanwhile, at the weekend’s Shangri-La Dialogue security conference in Singapore, in response to U.S. Defense Secretary Austin’s call for better U.S.-China military communication and the avoidance of such near misses, Chinese Defense Minister Li Shangfu essentially told the U.S. to butt out, saying, “The best way to prevent this from happening is that military vessels and aircraft [should] not come close to our waters and airspace. What does this have to do with your security? Watch your own territorial waters and airspace, then there will not be any problems.”

• Li’s statement implied that China’s territorial waters cover the entire Taiwan Strait, which they do not. In any case, his statement shows how China is becoming increasingly confident about its ability to compete with the U.S. and intimidate U.S. forces from entering the international waters along China’s coast.  As we have stated before, China’s growing military power and aggressiveness will likely spur further efforts by the U.S. to boost its deterrent forces, leading to a prolonged period of higher defense spending.
• Increasing tensions between China and the West also continue to put investors at risk. Dutch investment firm APG, which manages about €532 billion of pension fund assets, reports that its clients are increasingly reluctant to put their money to work in China because of the growing geopolitical risks.

Global Oil Market:  In a meeting yesterday, the Organization of the Petroleum Exporting Countries and its Russian-led allies struck a deal in which Saudi Arabia will cut its production by one million barrels per day beginning in July to support prices as global economic growth and energy demand weakens.  The move has boosted global oil prices so far this morning, pushing Brent up 1.8% to trade at $77.52.  Nevertheless, it’s not clear whether the cut will be enough to keep buoying prices as Chinese economic growth falters and the U.S. economy remains poised to enter recession in the coming months.

Russia-Ukraine War:  Ukrainian officials continue to signal they are close to launching their much-anticipated counteroffensive against the Russian forces occupying eastern and southern Ukraine.  Nevertheless, it’s important to remember that the Ukrainians may be deliberately drawing out their preparations to encourage the Russians to further deplete their resources by launching pre-emptive missile and drone strikes (sometimes against Ukrainian decoys).  In the meantime, the recent small-scale Ukrainian attacks on Russia itself and on areas of occupied Ukraine probably aim to drive the Russian forces to spread themselves too thin, spark disarray within the Russian leadership, and bring the war home to the Russian people.

• On those latter points, the owner and leader of Russia’s Wagner Group mercenary force, Yevgeniy Prigozhin, in recent days lambasted the Ministry of Defense for its inability to prevent Ukrainian attacks on Russia’s border regions and threatened to move his forces there to do the job even without waiting for permission.
• If Prigozhin follows through on his threat and sends his forces to the Russian border regions, he could potentially spark internecine, civil conflict in Russia itself, creating an existential threat to President Putin’s regime.
  • In Putin’s view, the presence of a large, battle-hardened military force on Russian soil and outside the direct control of the Kremlin or the Ministry of Defense would likely be intolerable.
  • Prigozhin has already accused the Ministry of Defense of mining transportation corridors used by the Wagner forces. Prigozhin’s rhetoric suggests that outright conflict between Wagner mercenaries and official Russian troops is plausible.

Turkey:  Fresh off his re-election, President Erdoğan has installed Mehmet Şimşek as his new finance minister.  Şimşek, a former deputy prime minister and finance minister, has made all the right statements so far to calm foreign investors, saying, “Transparency, consistency, predictability and compliance with international norms will be our basic principles . . . We will prioritize macro financial stability.”  However, it is not yet clear if Erdoğan will really allow him to change to the kind of orthodox policies that would probably be needed to bring down Turkey’s sky-high consumer price inflation and boost the currency again.

Mexico:  Mining industry association Camimex says sweeping new regulations passed this spring are forcing foreign producers of silver, copper, zinc, and other minerals to reconsider their investment plans in the country.  According to Camimex, the legal reforms could jeopardize some $9 billion of investment in the next two years while stymying the development of Mexico’s vast resources for clean energy technology.

U.S. Artificial Intelligence:  According to a U.S. Air Force officer, an AI-enabled drone trained to destroy enemy air defense systems failed a recent simulated test when it unexpectedly turned on its own operator and killed him.  The drone was trained by giving it “points” for taking out enemy surface-to-air missiles.  When the operator ordered the drone to hold off an attack, its drive for points was so strong that it fired its missiles at the operator himself to overcome the order.  When the drone’s programming was changed to stop it from attacking its own pilot, it tried to overcome the hold-off order by firing at the pilot’s communication equipment.

• We think the drone incident is a good example of the risks involved in using AI in military operations.
• Of course, researchers and policymakers are also scrambling to contain the risk of AI in civilian activities. Congress is working on various bills to regulate AI use, and one Democrat is preparing a bill that would require all output from generative AI systems to carry the message, “Disclaimer: this output has been generated by artificial intelligence.”

U.S. Technology Industry:  Despite the excitement over generative AI, the recent pullback by technology firms that over-expanded during the pandemic is now starting to have broader economic implications.  Reflecting the large layoffs by multiple West Coast tech giants, in April California had the nation’s second-highest state unemployment rate at 4.5%, compared with the national rate of 3.4%.  Washington tied for third with a jobless rate of 4.3%, and Oregon was close behind at 4%.

U.S. Media Industry:  The major Hollywood movie studios and the Directors’ Guild of America have reached a tentative deal on a new work contract.  The new contract will avert a strike by directors that would have come on top of the ongoing writers’ strike.  Reflecting the strong bargaining power that workers have in today’s tight labor market, the contract dramatically boosts directors’ royalties for streamed programs.  It also specifically precludes studios from using generative AI to do the work of directors.

U.S. Banking Industry:  According to the Wall Street Journal, bank regulators as early as this month will propose new rules requiring bigger banks to boost their capital by 20% on average.  Banks that are heavily reliant on fee income will face especially large capital requirements.  The expected new rules are largely in response to the regional bank crisis this spring.  Separately, the Financial Times says that many banks plan to unload even their performing commercial real estate loans in a rush to reduce exposure to the sector.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with the reasons we remain cautious about recent market optimism. We then explain why the Bank of Japan’s move away from yield curve control could hurt bond prices. Finally, we discuss the impact the U.S.-China rivalry has had on countries in Southeast Asia.

 Will It Last? Investor sentiment surged on Thursday as the possibility of a soft landing increased, and the U.S. government moved closer to averting a debt default.

• The debt ceiling bill passed through the Senate on Thursday. This crucial legislation ensures that the government can continue to meet its financial obligations. The bill curtails spending until 2024 and extends the legal debt limit until January 2025. Additionally, the Congressional Budget Office estimates that the bill will yield substantial savings of $975 billion in government spending over the next decade. The legislation is now en route to President Joe Biden’s desk, where it is expected to be signed over the weekend. This comprehensive debt-ceiling package will avert potential default but will be a fiscal drag on the economy.
• Additionally, remarks from two prominent Fed officials appear to support a pause in rate hikes in June. During an event for the National Association of Business Economists, Philadelphia Fed President Patrick Harker mentioned that he would like to leave rates unchanged at the next FOMC meeting. At the same time, a post on the regional bank’s website from Saint Louis Fed President James Bullard, a hawk, suggested that rates are now within the sufficiently restrictive zone. Unlike Harker, Bullard is not a voting member this year; however, his remarks suggest that other hawks, such as Fed Governor Chris Waller, may also support a pause at the next meeting.

• • Bullard uses the chart above, based on the Taylor rule, as a guide to where policy should be. It shows that the current policy rate has surpassed the lower level of the recommended range.
• The sudden optimism in the market is likely temporary as the economy still appears to be headed toward recession. Elevated interest rates could possibly deter consumption and investments. Similarly, a reduction in government spending should also weigh on economic activity. The recent surge in the payroll numbers suggests the labor market may be strong but keep in mind that responses for the Current Employment Survey have been on the decline since the pandemic. Hence, the data may not completely represent employment conditions across the country. As a result, it is still too soon to tell whether a downturn is actually around the corner.

Ueda’s Time: Bank of Japan (BOJ) Governor Kazuo Ueda’s impending move to end the central bank’s ultra-loose monetary policy has investors uncomfortable, as the shift is likely to cause a ripple throughout the financial system

• Earlier this week, the BOJ Governor hinted that he is ready to follow other central banks and raise rates. His remarks have added to speculation that the BOJ is preparing to end its policy accommodation. An April survey showed that around two-thirds of economists expect Ueda to lift rates by July. Meanwhile, market pricing suggests that investors believe the BOJ is unlikely to make any major changes to its policy over the coming months. The differing views have added to market jitters as investors don’t want to be caught off guard again when the central bank does decide to tighten policy.
• The lingering uncertainty surrounding the timing of policy changes has made governments nervous. One of the main concerns is that Japanese investors may decrease their purchases of foreign bonds if the central bank abandons yield curve control (YCC), which caps the yield on 10-year Japanese government bonds at 0.5%. This potential shift in investor behavior has prompted the European Central Bank to warn that BOJ normalization could potentially lead to strains in the international financial system. The BOJ is currently studying the matter, and its review is expected to last at least a year. However, Ueda, a former academic, has made it clear that he believes the era of low interest rates is over.

• • The chart above compares Japanese purchases to the yields on the 10-year Treasuries. The two variables have been inversely correlated since the Bank of Japan began YCC back in 2016.
• The upward movement in Japanese government bond yields will capture the attention of both domestic and international investors, which could position the Japanese Government bonds as a genuine competitor to the U.S. Treasury, especially for investors looking to diversify their portfolios. This changing dynamic will likely play a significant role in the ongoing secular decline in bond prices, further shaping the landscape of the global financial system. Close monitoring of these developments is crucial for understanding the potential implications for market participants and stakeholders.

Uncertainty in Southeast Asia: The U.S.-China rivalry is expected to loom over the Asia security summit this weekend, as both countries look to steer clear of one another.

• On Friday, defense chiefs from China and the United States met with Singapore leaders to discuss security concerns. Although not much was disclosed regarding talks besides the usual pleasantries, Singapore announced that it agreed to establish a hotline with China for high-level communications. The agreement comes as tensions continue to escalate between the two major powers. Last week, a Chinese fighter jet intercepted a U.S. spy plane. Although there were no casualties, the incident shows the contentious relationship between the U.S. and China. The hotline will likely ensure that U.S. allies have the ability to maintain communications with both sides in the event of a dispute.
• However, the escalating tensions between the two dominant superpowers have significantly unsettled countries in the Asia-Pacific region. Numerous nations have expressed their apprehensions regarding the increasing hostility between these global powers. The former Malaysian foreign minister, for instance, has openly expressed concerns about the potential for a conflict over Taiwan. Similarly, Singapore’s Deputy Prime Minister has characterized the rift between the United States and China as insurmountable. Southeast Asian countries find themselves in a challenging position, as they are reluctant to align themselves with either side. Their primary objective is to maintain access to the vast Chinese markets while ensuring the security offered by the United States. Striking a delicate balance between these two priorities is of paramount importance to these nations as they navigate through this complex geopolitical landscape.

     Source: Bloomberg

• The intensifying rivalry between the United States and China is anticipated to have adverse consequences for countries across Asia. As depicted in the chart above, governments in the region are projected to witness a significant surge in their military spending. This substantial increase in defense expenditures indicates a growing demand for advanced weaponry, technology, and infrastructure as countries look to prepare for a potential conflict. As a result, we suspect that aerospace and defense companies are poised to benefit from this trend and remain an attractive space for investment.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts on the ongoing debate as to whether the Federal Reserve should hike or pause at its next meeting. Next, we explain why the European Union has taken a vested interest in the Western Balkans. Lastly, we discuss why uncertainty in China has unnerved both investors and businesses.

A Fed Divided: Much to the bewilderment of markets, Fed officials can’t seem to get their story straight regarding the path of future rate hikes.

• Federal Reserve Governors Michelle Bowman and Phillip Jefferson offered seemingly different interest rate outlooks on Thursday. During a “Fed Listens” event in Boston, Bowman implied that higher interest rates had not done enough to pull down housing inflation. Meanwhile, Jefferson warned that higher interest rates could “exacerbate stress” across the banking sector. The opposing viewpoints highlight the disagreements among policymakers as they struggle to articulate a path forward. As a result, investors have not been able to confidently gauge where interest rates will be set at the June meeting as exemplified by the CME FedWatch Tool which swung widely on Thursday. The model initially predicted a 70% likelihood of a 25 bps hike during mid-day, but it later revised its forecast to a 70% probability of a pause by market close.
• Mixed economic data partially explains why Fed officials are having trouble establishing a consensus on the future path of interest rates. The unexpected surge in the number of job openings bolstered investor sentiment regarding the labor market’s tightness, strengthening the belief that the central bank should raise rates. However, later that same day, the release of the Federal Reserve Beige Book supported a more moderate policy approach as firms expressed a decrease in hiring activity and waning inflation pressure. The conflicting business cycle indicators will complicate the efforts of the Fed to communicate a path forward for interest rates.
  • The strong JOLTS report led to a rapid sell-off in equities that nearly wiped out gains made in the S&P 500 in May.

• Despite the disagreements evident within the Federal Open Market Committee (FOMC), it is highly likely that there will be no dissents at the next meeting. While members hold differing views on when to cease rate hikes, most are hesitant to signal the definitive end of the tightening cycle. Therefore, a plausible scenario is that the FOMC may indicate a hike every other meeting, a strategy often referred to as a hawkish pause. This policy adjustment will still be perceived as a form of moderation; however, the market’s response could be negative as investors generally prefer interest rates to decrease by year’s end or before a recession.

Sharing is Caring: As the war in the Ukraine rages on, the European Union is poised to broaden its reach in Eastern Europe.

• The EU countries have softened their stance with prospective members. Brussels announced that it would offer some single-market benefits to countries within the Western Balkans to prevent the region from destabilizing. The move comes amidst ethnic tensions in northern Kosovo which led to a clash between protesters and NATO peacekeepers. The measure would grant access to the bloc’s digital single market in areas such as ecommerce and cybersecurity. Additionally, the EU would also increase pre-accession funding. The decision to further integrate Western Balkan countries into the EU is meant to reduce Russia’s influence and prevent another war from breaking out in Eastern Europe.
  • Last year, The EU drastically increased humanitarian aid to countries in Eastern Europe.

   (Source: European Commission)

• Additionally, the EU is doubling its support for Ukraine. Brussels is working on a four-year financial plan to support the embattled nation. The additional funding will allow Kyiv to manage its budget while it tries to repel Russian forces from its borders. Similarly, French President Emmanuel Macron signaled that he would back a path for Ukraine to join NATO. Ukraine considers membership in the military alliance as key to its future defense and security. However, Kyiv has yet to receive full support from members due to fears that adding war-fighting countries would set a dangerous precedent.
• Europe needs to pursue greater involvement within the Western Balkans to prevent Moscow from destabilizing the region. Since the beginning of the conflict, Russia has sought to broaden its war campaign by stirring up conflict in the Western Balkans. Currently, Russia is using its deep cultural and historical ties with the Serbs to help stir unrest in Bosnia-Herzegovina and Kosovo. To prevent a crisis from spiraling out of control, the EU will have to offer additional aid to prevent these countries from leaving its orbit. At this time, we suspect the greater EU involvement should be enough to prevent disputes within the Western Balkans from turning into major conflicts.

Not Yet! Prominent American CEOs want the government to cool it on talks about the U.S. decoupling from China.

• JP Morgan chief executive Jamie Dimon along with several other corporate executives warned American and Chinese lawmakers against the further exacerbating of tensions. During a summit in Shanghai, Dimon argued that the conflict between the two major powers had hurt investor confidence. His comments mirrored remarks made by Tesla CEO Elon Musk who described the U.S. and China as being conjoined twins. The sentiment expressed by the business leaders broadly reflects the unease companies have about a possible decoupling of the world’s two largest economies. As a result, we expect business leaders will try to lobby governments to resume trade talks.
  • The U.S.-Taiwan trade deal reached on Wednesday will further escalate tensions as Beijing insists that any direct talks with the sovereign province is an encroachment on Chinese sovereignty.
• The recent surge in equities across Japan, Korea, and Taiwan can be attributed to investors hedging against the possibility of a decoupling between the United States and China, as well as concerns over a potential slowdown in the Chinese economic recovery. This strategic shift in portfolio allocations reflect investors’ eagerness to explore alternative opportunities within Asia. Moreover, apart from its ongoing rivalry with the United States, China’s reopening process has been characterized by fragility and unevenness, making it challenging for investors to accurately assess the country’s growth potential.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some unexpectedly soft economic figures out of China, which are weighing on global stock markets so far today.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new sources of tension between China, the U.S., and India and the latest on the deal to raise the U.S. government’s debt limit.

China:  The National Bureau of Statistics said the country’s May purchasing managers’ index for manufacturing fell to 48.8, well short of the expected reading of 49.5 and even lower than the April figure of 49.2.  In contrast, the official PMI for nonmanufacturing industries only fell to 54.5 in May, compared with 56.4 in the previous month.  China’s official PMIs, like most such indexes, are designed so that readings over 50 indicate expansion.

• At their current levels, the PMIs provide more evidence that the economic rebound after the government lifted its draconian Zero-COVID policy is already petering out. Factory activity is shrinking further, and now even the services sector is suffering from slower growth.
• Stagnating demand in China has the potential to drag on economic activity around the world, pushing down commodity prices and weighing on stock markets. Chinese stocks are now in a bear market.

China-United States:  The Department of Defense revealed that on Friday, a Chinese fighter jet flew dangerously close to a U.S. reconnaissance plane flying in international airspace over the South China Sea.  In what the U.S. called an “unnecessarily aggressive maneuver,” the fighter jet crossed the path of the recon plane just 400 feet in front of its nose, forcing the U.S. plane to fly through its turbulence.  The incident shows that U.S.-China tensions continue to spiral, creating greater risks of outright conflict and potentially causing collateral damage to investors.

China-India:  New reports say Beijing has recently ejected the last remaining Indian journalists from its country, while New Delhi has evicted the last Chinese journalists from India.  The evictions reflect a further worsening of bilateral tensions over border disputes in the Himalayan mountains and other issues.  While our analysis puts India in the China-leaning bloc of countries, the ongoing tensions suggest New Delhi is actually “in play” and will likely continue to increase its security cooperation with the U.S.

Japan:  If you’re a seasonal allergy sufferer and have always wondered what would give you real relief, the Japanese might have an answer for you.  The government yesterday proposed a program that would cut down 20% of the country’s cedar forests over the next decade, with the goal of cutting average pollen counts by half over the next 30 years.  The plan will expand the acreage of artificially planted cedars subject to logging, promote the use of domestic wood, and allow more foreign lumberjacks to immigrate.

Eurozone:  Similar to yesterday’s report of moderating price growth in Spain, a report today showed France’s May consumer price index was up just 6.0% from the same month one year earlier, marking a significant cooling from the rise of 6.9% in the year to April and coming in lower than the expected increase of 6.4%.

• Moderating inflation in the eurozone has prompted speculation that the European Central Bank could stop its interest-rate hikes as early as July.
• In turn, that prospect is weighing on the EUR today. As of this writing, the single currency is trading at $1.0686, down 0.5% for the day.

United Kingdom:  The country’s summer of strikes continues, with the U.K.’s main train drivers’ union walking off the job today.  The action has paralyzed most of England’s mainline railroads, heaping more headaches on Prime Minister Sunak and illustrating how inflation and wage demands remain potent issues in the U.K.

Russia-Ukraine War:  According to the Wall Street Journal, Ukraine and its Western European allies are planning a July summit of global leaders (excluding Russia’s) to promote Kyiv’s peace proposal.  European leaders such as French President Macron have reportedly been lobbying for participation by countries that have sided with Russia or have declined to take a position on the war, such as Saudi Arabia and Brazil.  News of the planned summit suggests that Kyiv is operating under a broad, comprehensive plan to win the war by quickly following its expected battlefield counteroffensive with a powerful political operation supporting its own peace plan over China’s rival plan, all the while leaving Russia isolated.

U.S. Fiscal Policy:  New analysis of the preliminary deal to lift the federal debt limit indicates it will ensure that student loan payments and interest accruals will restart no later than August 30, with no further extensions to the pandemic-era pause.  The need for former students to start making loan payments again could noticeably undermine consumer spending and help give the economy a final push into recession.

• The House Rules Committee approved the debt-limit legislation yesterday and sent it for a final vote of the full House which could occur as early as today.
• The vote in the Rules Committee relied on votes from both moderate Republicans and Democrats, illustrating how passage of the bill in the full House will likely require the cooperation of centrists on both sides of the aisle.

U.S. Monetary Policy:  In an interview with the Financial Times, Cleveland FRB President Mester said she sees no compelling reason to pause the Federal Reserve’s interest-rate hikes as long as inflation pressures remain high.  Essentially, Mester argued that the risk involved with hiking rates too little was higher than the risk involved with hiking too much.  Her hawkish statement feeds into growing expectations that the policymakers will lift their benchmark fed funds rate further at their upcoming meeting in June.

U.S. Labor Market:  Goldman Sachs (GS, $330.83) is reportedly planning another round of layoffs, which would be its third since last September.  This round will evidently be focused on employees in its investment banking group.  Financial dealmaking has been crimped over the last year as the Fed hiked interest rates and, more recently, as regional banks ran into trouble.

• The layoffs underscore how the Fed’s rate-hiking campaign has had the biggest negative impacts, so far, on sectors such as housing, commercial real estate, mortgage finance, and investment banking.
• This Wall Street Journal article provides a useful overview of how the Fed’s rate hikes have tightened conditions in various credit sectors.

U.S. Oil Market:  Starting tomorrow, the crude oil transactions used to calculate the Brent benchmark price will include purchases and sales of U.S. oil.  As output from the North Sea’s Brent field has fallen, the basket of prices that go into the Brent average has been gradually broadened in recent years.  The inclusion of U.S. prices reflects the growing heft of U.S. producers in the global oil market.  However, note that the U.S. oil to be included in Brent is not West Texas Intermediate, which is widely referred to as “U.S. crude.”

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