by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the weekend’s preliminary deal to lift the federal debt limit until 2025.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the re-election of Turkey’s president and indications that quantitatively driven investment funds have been a key reason why U.S. stocks have been moving upward this year despite expectations of a recession.

U.S. Fiscal Policy:  For those who were truly “off the grid” over the Memorial Day weekend, on Saturday President Biden and House Speaker McCarthy reached a deal in principle to lift the federal debt limit.  The agreement would make sure the government can keep covering its debt service and other bills past June 5, which is Treasury Secretary Yellen’s new estimate of when the government will run out of cash.  The challenge over the coming days will be for Biden and McCarthy to whip up enough support in their respective parties to pass the bill into law.  On the Democratic side, many progressives are angry about compromises that will cap government spending and ease permitting for energy projects.  On the Republican side, many right-wing legislators are mad that spending wasn’t cut even more.  Nevertheless, we continue to believe the legislation will ultimately be passed into law in time to avoid a financial crisis.

• Key provisions of the deal include:
  • The debt limit would be suspended until January 1, 2025, well after the upcoming federal elections. By that time, the Treasury will have rebuilt its financial flexibility and its ability to use “extraordinary measures” to pay its bills.  That means any new debt crisis could probably be pushed off into mid-2025.
  • Federal discretionary spending will be capped for the next two years. In the upcoming fiscal year, discretionary defense outlays would be allowed to rise by a nominal 3%, while discretionary nondefense outlays would be frozen at current levels.
  • Some $30 billion in unused pandemic relief funds will be clawed back from dozens of programs.
  • Work requirements to be eligible for SNAP nutrition benefits (i.e., food stamps) would be extended to those up to age 54, compared with 49 currently.
  • Federal permitting procedures for energy projects would be accelerated by requiring a decision within one or two years.
• Rising prospects for the deal gave a boost to the stock market in recent trading sessions. However, it’s important to remember that if the deal is passed into law, the Treasury will need to rebuild its cash balances at the Federal Reserve, which will likely mean drawing hundreds of billions of dollars out of the economy in the coming weeks.  That will amount to significant fiscal tightening that could pull stocks down again.

Russia-Ukraine War:  As Ukraine endured another big wave of air attacks last night, officials in Russia today blamed Kyiv for a number of drone attacks on residential areas of Moscow.  If confirmed as an attack by Ukrainian forces, the incident would mark the first such attack on Russian civilian targets, although it seems just as likely that the attack was carried out by Ukrainian sympathizers or partisans, perhaps the same who staged an attack on Russia’s border region last week.

• In any case, the notable attack on Moscow probably aimed to unsettle Russian citizens and undermine their support for Moscow’s invasion. Bringing the war home to the Russian people may be one of the “shaping operations” that the Ukrainians are carrying out to prepare for their expected counteroffensive.
• A key risk is that it could also encourage China or other Russian allies to step up their support for Russia.

Turkey:  In Sunday’s run-off presidential election, right-wing nationalist President Erdoğan defeated opposition leader Kemal Kılıçdaroğlu by 52.2% to 47.8%.  Our analysis suggests that Turkey will remain in the U.S. geopolitical and economic bloc, reflecting its membership in NATO and its tight trade ties to the U.S., but the victory by Erdoğan means he will likely continue trying to play the U.S. off China and its evolving bloc.  Erdoğan is also likely to continue his unorthodox economic policies, such as holding down interest rates in the face of high inflation and a depreciating currency.  The news of Erdoğan’s victory has, therefore, weighed on the Turkish lira (TRY) yesterday and today.

Spain:  In regional and municipal elections on Sunday, the conservative People’s Party led by Alberto Núñez Feijóo roundly beat the ruling Socialist Party of Prime Minister Pedro Sánchez.  Counting so far shows support for the People’s Party surged to 31.5%, up 9% from the elections in 2019, while support for the Socialists was nearly stagnant at 28.1%.  Nevertheless, Sánchez gambled and called a snap national election for July 23 in order to keep some initiative in his hands and stem any momentum of the People’s Party and its far-right ally, the Vox Party.

• Spain’s relatively good economic environment may be one reason the prime minister was willing to gamble on new national elections.
• The country’s statistical agency today said its April consumer price index was up just 2.9% from the same month one year earlier, far better than the rise of 3.8% in the year to March and even below the expected inflation rate of 3.4%. Excluding the volatile food and energy components, the April core CPI was up 6.1%, down from 6.6% in the previous month.

Serbia-Kosovo:  After boycotting recent local elections in northern Kosovo, Serbian protestors on Monday tried to prevent the ethnic Albanian mayoral winners from entering city halls and taking office.  The resulting violence injured more than a dozen NATO peacekeepers, sparking condemnation by Western leaders.  The new violence risks undermining a March peace deal between Serbia and Kosovo.

China:  Now that the unemployment rate for young adults has risen to a record above 20%, officials report a surge in applications for programs that put young college graduates to work in the country’s vast, underdeveloped rural areas.  While many college graduates continue trying to hold out for better-paying jobs in urban areas, the trend reflects the extent to which slowing economic growth has reduced attractive opportunities for young people—a problem that could eventually undermine political support for the Communist Party.

• Not only has China’s economy matured to the point where it can’t grow as fast as it did in past decades, but its recovery from Beijing’s draconian Zero-COVID policies is petering out much earlier than anticipated.
• Reflecting that, Chinese stocks trading in Hong Kong today temporarily dipped into bear market territory, down more than 20% from their peak in January before rallying to close above that marker.

China-United States:  Stephanie Hui, the chief of Asia-Pacific private and growth equity for Goldman Sachs (GS, $332.01), said geopolitical tensions between Washington and Beijing have sapped U.S. investors’ interest in her funds, prompting her to stop trying to raise money in the country.  Instead, Hui said she is now focused on raising money in places like the Middle East and Southeast Asia.  Separately, Beijing has reportedly refused a request by Washington for U.S. Defense Secretary Austin to meet Chinese Defense Minister Li Shangfu at a security conference in Singapore this week.  Taken together, these developments offer even more signs of the worsening estrangement between the U.S. and China.

U.S. Stock Market:  New analysis from Wall Street indicates that the rise in U.S. stock values and the relative calm in the market so far this year can be ascribed to quantitatively driven funds.  The data suggests their buying has been more than enough to offset the pullback in investing by individuals and other discretionary investors.  Of course, a risk is that the quantitative models could start to flash sell signals, which presumably would drive market values down again.

Global Gold Market:  A new survey by the World Gold Council shows that 24% of global central banks plan to increase their gold holdings in 2023.  The survey indicates that the central bank buying plans, which were especially prevalent among emerging market institutions, are being driven by concerns ranging from geopolitical tensions to consumer price inflation.  That’s entirely consistent with our oft-stated belief that aggressive sanctions by the U.S. and its allies against Russia and other authoritarian states will prompt countries to rely more on the yellow metal.  We therefore remain bullish on gold prices in the coming years.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with our thoughts about the potential benefits and risks associated with generative artificial intelligence (AI). Next, we examine the impact that a German recession would have on the European Central Bank’s policy rate decision. Finally, we discuss the Turkish election and what it may mean for markets.

More Chips: As investors clamor for AI-related stocks, regulators are seeking to contain risks associated with the technology.

• Chipmakers are confident that they can capitalize on the generative AI craze. Semiconductor producer Nvidia (NVDA, $379.80) projected second-quarter sales of $11 billion. Nvidia’s strong guidance and positive earnings report boosted sentiment in the tech sector, sending the company’s share price up 24.37% on the day. Meanwhile, the tech-heavy NASDAQ surged 1.7% on Thursday, and the S&P 500 closed up 0.9%. Optimism that the sector will revolutionize the way companies generate profits has outweighed concerns regarding regulatory risks and potential geopolitical disruptions.
• Government authorities are finding it difficult to balance the interests of shareholders with national security concerns. European regulators have proposed new rules that would limit AI companies’ abilities to use copyrighted material and to make critical decisions such as granting loans and hiring. Additionally, friction between the U.S. and China continues to pave the way for tit-for-tat restrictions on chips. Earlier this week, Beijing banned some Chinese companies from purchasing chips from semiconductor company Micron (MU, $69.61). The move is likely in retaliation for U.S. export restrictions of advanced chips to the country and may lead to a response from the Biden administration.

• Concerns over regulation and geopolitical tensions is not likely to sway investors from buying tech shares. This is best seen in the performance of Micron Technology. Despite the company’s shares plunging more than 4% following the news of the ban, its stock price is now trading at its highest level in almost a year. This is likely not a one-off. The fear of missing out may encourage investors to overlook many of the risks associated with AI and semiconductors. That said, we suspect many of the dangers associated with the AI boom will likely play out over time and should not lead to the overall change in outlook for the industry in the short- and medium-term.

Recession or Not: The European Central Bank is expected to raise interest rates at its next meeting, despite data showing that the eurozone’s largest economy is in a recession.

• Germany’s economy shrank 0.3% in the first quarter of 2023, driven by weak consumer spending and a slowdown in exports. This was the second consecutive quarter of contraction; thus, it meets the formal definition of a recession. The lack of growth is related to shoppers reining in their spending to cope with rising inflation. Household final consumption expenditure fell 1.2% in the first three months of 2023. Meanwhile, the overall price level of goods and services has risen 7.1% since April 2022. Despite the recession, the European Central Bank is expected to raise interest rates at its next meeting in June.
• Inflation concerns have kept European Central Bank officials hawkish as they look to restore price stability. Hours after German GDP figures were released, ECB Vice President Luis de Guindos advocated for central bank officials to maintain their fight against inflation. Later that day, Dutch Governing Council member Klaas Knot argued that interest rates should increase until at least July and stay there for some time. Central bankers’ insistence on maintaining policy tightening will make it difficult for countries to recover from a downturn. However, we suspect that hawkish ECB policy may offer support for the EUR, especially if the Federal Reserve holds its interest rates steady at its next meeting as expected.

• If history serves as a guide, the ECB will be less aggressive in easing policy than its American counterpart. As the chart above shows, the ECB did not raise interest rates as fast as the Federal Reserve, but it was also much slower to cut. Overnight index swaps show that traders expect European interest rates to rise by 50 bps and American rates to fall by 25 bps by the end of the year. The narrowing of interest rate differentials should allow the EUR to appreciate against the USD, making European assets relatively more attractive.

Final Round: Markets are worried that another five years of Recep Tayyip Erdoğan as President will be damaging to the Turkish economy.

• After months of speculation about the potential end of his reign, Erdoğan is currently poised as the frontrunner to win the upcoming presidential run-off on Sunday. However, the backlash from victims of the devastating earthquakes combined with the mismanagement of the country’s economy could still hurt his chances of securing a victory. Interestingly, prior to emerging as the top vote-getter in the first round of the election, Erdoğan was trailing behind his rival Kemal Kılıçdaroğlu, with opinion polls indicating a gap of 43.7% to 49.3%. However, with the recent endorsement from the third-place candidate Sinan Oğan, Erdoğan now enjoys increased support and is heavily favored to win, much to the disappointment of investors.
• The market is bracing for another Erdoğan presidency, and as a result, it is expecting the Turkish lira (TRY) to decline in value after the election. Market participants are concerned that Erdoğan will continue to steer the country in a negative direction. Mounting inflation, a burdensome debt load, and sluggish economic growth weighed on investor sentiment. The iShares MSCI Turkey ETF has already fallen by 12% since the first round of elections. As a result, Turkey will need to undergo a significant and comprehensive transformation in order to rebuild the trust of investors.

• However, it is important to acknowledge that Turkish equities have demonstrated the ability to defy expectations in the past. This is evidenced by the remarkable 110% surge in dollar terms of the Borsa Istanbul 100 index last year, compared to a 20% decline in the S&P 500. Although some of those gains have been retracted, this rally highlights the possibility that investors may not always adhere strictly to conventional wisdom. From our perspective, Turkey’s strategic geographic location, robust military capabilities, and growing industrial base position it as an enticing prospect, provided the country manages to address its internal challenges. Only time will reveal if Turkey can fulfill its potential and capitalize on these advantages.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with an update on the debt ceiling negotiations. Next, we argue that the Fed may pause this year but is not likely to pivot. We end the report with our thoughts about the rising likelihood of a hard split between the U.S. and China.

 Debt Ceiling: Ongoing talks between President Joe Biden and House Speaker Kevin McCarthy have yet to yield results, and investors are worried.

• American lawmakers are under pressure to reassure investors that they will raise the debt ceiling in a timely manner. The credit rating agency Fitch Ratings has placed the U.S. triple-A rating on watch for a possible downgrade due to concerns that political brinkmanship could prevent the government from honoring its debts. Despite progress made by negotiators, it is unclear when Congress will raise the debt limit to avoid a catastrophic default. The standoff is expected to continue today, but we are still confident that an agreement will be reached before the June 1 deadline. That said, the market may get a bit choppy as traders respond to the latest developments regarding negotiations.
• Uncertainty over lifting the debt cap has unnerved markets. The S&P 500 and Dow Jones Industrial Index are both trading lower this week (see chart below). At the same time, yields on Treasury bills expiring in the first eight days of June have risen above 7%. Anxiety over when the debt ceiling will be raised has led to a surge in market volatility. On Wednesday, the CBOE Volatility Index (VIX) surpassed 20 suggesting an unusual amount of fear amongst traders. The strong reaction highlights the significant risk a potential default will have on the U.S. economy.

• We are confident that an agreement will be reached with bipartisan votes but suspect that the deal will push the country closer to recession. Despite speculation that McCarthy will need to win unanimous support from his party to get a spending bill through Congress, there are Democrats willing to fill the gap if needed. However, the combination of a liquidity drain and spending cuts from the new deal will remove fiscal stimulus from the economy. As a result, we still believe a recession is likely to happen within the next few quarters, even if the U.S. avoids default.

 Hold Not Cut: The release of the latest Federal Open Market Committee meeting minutes has led investors to boost bets about a possible Fed pause.

• According to the May minutes, tighter financial conditions have led some Fed officials to question the need for additional rate hikes. The notes showed that central bank officials expressed a willingness to keep their options open as the committee determines whether it wants to raise rates further. The decision to maintain policy flexibility is related to concerns that inflation risks remain tilted to the upside. The latest staff projections for the annual change of personal consumption expenditure price index (PCE) were revised upward from 2.8% to 3.1% for 2023. That said, some policymakers argued that the committee should be patient before raising rates further.
• Recent speeches from officials suggest that the committee may be split between those favoring another hike and others preferring a pause. Earlier this month, Federal Reserve Governor Christopher Waller and Cleveland Fed President Loretta Mester advocated for additional rate hikes. Meanwhile, Chicago Fed President Austan Goolsbee and Federal Reserve Chair Jerome Powell expressed support for a pause at the June meeting. The conflicting reports have led traders to become less optimistic regarding a Fed pause. The latest CME FedWatch Tool now forecasts a 56.4% chance that the Fed will hold rates at their current levels at the time of this writing, much lower than the 90.1% prediction from three weeks ago.

• As the chart above shows, the Fed is still far away from achieving its 2% inflation target. The lack of progress in achieving price stability suggests that policymakers will likely keep rates higher for longer than the market anticipates. As a result, the risk of a hard landing is relatively elevated as Fed officials will likely not pivot anytime soon. That said, we still believe the central bank is close to ending its tightening cycle and is more likely to seek a potential off ramp as the country heads toward a recession.

Chinese Rivalry: From spying to resource hoarding, Beijing is leaving no stone unturned as it prepares for its eventual decoupling from the U.S.

• Chinese state-sponsored hackers have implanted malware on critical infrastructure in the U.S. and Guam, according to Microsoft (MSFT, $313.85). The breach was designed to disrupt communications links between America and Asian countries in the event of a potential conflict. Although spying between the two countries is routine, experts believe this was the widest Chinese espionage campaign ever against American infrastructure. This is the second time this year that Chinese spy attempts were discovered and will likely prevent a thaw in tensions between the major powers. Following the report, Chinese stocks erased gains made in 2023 as investors prepared for additional headwinds.
• On a related note, China is building relationships with authoritarian governments as it seeks to avoid being denied access to key resources. Chinese firms have spent $4.5 billion to acquire stakes in lithium mining firms in Latin America and Africa. Those investments are somewhat risky given the security threat within these countries. However, Chinese firms have little choice but to work with these authoritarian governments as Beijing attempts to dominate the electric vehicle market. Additionally, China’s decision to deepen ties with Russia is also evidence of the country’s willingness to work with authoritarian governments to guarantee that it has the commodities it needs to sustain economic growth.
• The rift between the two major powers continues to reinforce our view that the world is likely to split into regional blocs. Although China still offers some attractive opportunities, we believe that investors have options if they seek to maintain their exposure to the second-largest economy without having to invest directly in the country. For example, nations that have a lot of trade exposure to China, such as Japan and the countries of Europe, have had strong stock market rallies following the end of China’s Zero-COVID policies. That said, as the largest economies start to diverge, the need for diversification will likely be necessary to hedge against unexpected changes in the geopolitical landscape. Hence, investors should be wary of putting all of their eggs in one basket.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a few new developments in Russia’s invasion of Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new evidence of the threat from China’s hypersonic missiles and economic retaliation against other Western countries, plus a few items of note on the U.S. financial markets.

Russia-Ukraine War:  Two right-wing Russian militias that support Ukraine reportedly attacked and occupied at least one Russian village less than a mile from the Ukrainian border earlier this week.  The groups were then surrounded and destroyed by Russian forces yesterday.  Ukrainian officials acknowledged they were aware of the incursion but denied any involvement in it beyond “cooperating” with the groups.  All the same, reports yesterday said the groups had used U.S.-made military vehicles in the raid, including at least two M1224 MaxxPro armored vehicles and several Humvees.  The State Department responded to the allegation by reiterating that the U.S. doesn’t “enable or encourage” Ukrainian attacks on Russia itself.  The attack could marginally help the Ukrainians by diverting Russian military resources to the border area and undermining the Russians’ sense of security within their own country.  Nevertheless, we believe the use of U.S. equipment in the incident raises the risk of U.S.-Russian conflict.

• Separately, in an effort to bolster the U.S.’s commitment to aiding Ukraine, former British Prime Minister Boris Johnson gave a pro-Ukrainian speech on Monday to a group of prominent conservative politicians, donors, and business executives in Dallas. In his speech, Johnson said, “I just urge you all to stick with it . . . . It will pay off massively in the long run.”
• In another effort to address pushback against the U.S.’s support for Ukraine, a new media commentary directly addresses the controversy as to whether the U.S.’s aid to Kyiv is undermining its ability to deter China from seizing Taiwan.
  • The article notes that most of the U.S. military equipment sent to Ukraine so far was designed for a major ground war, leaving most of the naval and air assets needed to deter China in the Indo-Pacific region untouched.
  • The article argues that even if aid to Ukraine has depleted some of the U.S. arsenal, it may actually increase the country’s deterrence against China by signaling the U.S.’s resolve to protect fellow democracies from territorial aggression.

China-United States:  Speaking of a potential U.S.-China conflict, a Chinese technology magazine this month published details of a People’s Liberation Army war game in which just 24 hypersonic missiles were able to destroy a U.S. aircraft carrier and its strike group.  Using a complex three-way attack strategy, the missiles were reportedly able to sink the entire U.S. force in each of the 20 iterations of the game.  Of course, the report can’t be independently verified, and it may not be indicative of China’s true hypersonic capabilities.  Nevertheless, it does underscore China’s head start in hypersonic technology even as the U.S. continues to struggle with its program and with its decision whether to emphasize the hypersonic technology itself or just anti-hypersonic missile defense.

• Separately, the USS George Washington, one of the U.S. Navy’s 11 aircraft carriers, embarked on Monday for sea trials following a full six years out of service due to major maintenance.
• The vessel’s maintenance period was expected to be four years, but it was disrupted due to issues such as the COVID-19 pandemic, cannibalization of some systems for spare parts to be used on other carriers, a shortfall in maintenance funds, and its unexpectedly bad condition when it entered the maintenance period.
• Once the ship is back in service, it could help relieve the shortage in carrier availability as geopolitical threats continue to worsen. The table below shows the current status of all U.S. aircraft carriers.  (Note that none are anywhere close to the Persian Gulf and its critical oil supply lanes.)

Germany:  The latest trade statistics show German exports to China in January through April were down a whopping 11.3% from the same period one year earlier.  The drop reflects German automakers’ reduced market share in China, high costs for German chemical producers and other energy-intensive manufacturers, and the euro’s recent appreciation versus the dollar.

• However, the drop in Chinese demand could also reflect explicit or implicit retaliation for the European Union’s recent hawkishness against China.
• If so, it would provide more evidence that the world is indeed fracturing into relatively separate geopolitical and economic blocs, as we have been arguing.

United Kingdom:  In a speech today, Chancellor of the Exchequer Jeremy Hunt warned that persistently high inflation will prevent the government from cutting taxes anytime soon, based on concerns that tax cuts would provide extra stimulus to the economy and boost prices further.  The chancellor offered assurances that he wanted to cut the U.K.’s tax burden—currently the highest since World War II—but he first had to create economic conditions where it was safe to do so.

• Hunt’s speech came on the same day that the U.K. statistics agency issued its latest report on consumer price inflation. The April consumer price index was up 8.7% from the same month one year earlier, suggesting inflation cooled significantly from the 10.1% increase in the year to March.  However, the April CPI still overshot expectations, which had been that inflation would cool to 8.4%.
• The chancellor’s speech reflects how inflation is discouraging tax cuts in many developed countries; at the same time, politicians are loathe to use tax hikes to cool demand and bring down inflation.

Pakistan:  The country’s anti-terrorism court yesterday granted Former Prime Minister Khan bail on his corruption and terrorism charges, marking another step in the seesaw legal battle between Khan and the government.  The arrest of Khan and the government’s effort to prosecute him continue to rile the country’s politics, making it even more difficult to address Pakistan’s economic and financial crisis.

Mexico:  President Andrés Manuel López Obrador said his administration is considering buying retail bank Banamex, the country’s fourth-largest bank and a unit of Citigroup (C, $45.91) which the U.S. financial giant put up for sale last year.  A well-known Mexican businessman has already bid for Banamex, but the leftist-nationalist president indicated that if the private bid fell through, he would have the government buy it in a public-private partnership to make sure it stays in Mexican hands.

• Any such government purchase of Banamex would increase concerns about AMLO’s penchant for nationalizing businesses.
• That would likely be a further headwind for Mexican stocks, which otherwise would probably be benefiting more from the way global companies are “near-sourcing” production away from China.

U.S. Fiscal Policy:  Staff-level negotiators from the Biden administration and the office of House Speaker McCarthy met yesterday to hash out the details of a deal to raise the federal debt limit and avoid a potentially devastating default, but they reportedly made little, if any, progress.  Other reports this morning suggest Biden and McCarthy will talk later today.  Direct talks between Biden and McCarthy will likely be necessary to secure a deal before the apparent deadline of June 1, when the federal government may no longer be able to pay its bills without taking on new debt.

U.S. Stock Market:  Even though institutional and individual investors have cooled their stock purchases in the face of rising interest rates and recession fears, data from Birinyi Associates shows companies in the Russell 3000 have announced plans to buy back more than $600 billion of their own stock so far this year, matching last year’s record pace.  If actual purchases for the full year come in above $1 trillion, as the first-half pace implies, the buybacks could provide an important support for stock values despite the current headwinds in the market.

U.S. Banking Industry:  To hold on to large depositors with account balances well above the insured amount of $250,000, many regional banks have reportedly boosted their offerings of “reciprocal accounts.”  In these accounts, a customer’s large deposit balance is divvied up and shared among partner banks so that each carries just the insured amount.

• The goal is to keep the customers who were spooked by this spring’s bank failures from moving their money elsewhere.
• According to bank data firm BankRegData, deposits in reciprocal accounts soared to a new record high of $221 billion at the end of the first quarter, up from $158 billion at the end of 2022.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some key data showing how reduced demand for goods is slowing the global economy, even as post-pandemic demand for services continues to grow.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more signs of tension and decoupling between the West and China.

Global Economy:  Maritime research consultant Drewry has released data showing the world’s production of shipping containers has slumped dramatically in response to the falling demand for goods now that countries have eased their pandemic restrictions.  With consumers shifting their spending back to services instead of goods, shipping activity has declined, leaving a glut of containers around the globe.  Transportation dynamics often reflect the strength of economic activity, so the drop in container production helps confirm that the global economy is slowing.

Eurozone:  S&P Global said its May “flash” purchasing managers’ index for manufacturing fell to a 36-month low of 44.6, compared with 45.8 in April.  Like all major PMIs, this one is designed so that readings below 50.0 point to declining activity.

• The recent readings, therefore, indicate that the Eurozone’s factory output remains in a deep slump.
• On a more positive note, however, the May flash PMI for the service sector merely pulled back to 55.9 from 56.2 in the previous month. That illustrates how service activity in the bloc continues to grow smartly.
• The increased activity in the service sector is keeping the overall Eurozone economy growing despite the post-pandemic pullback in manufacturing. Illustrating that, the May flash composite PMI stood at 53.3, down only modestly from 54.1 in April.

United Kingdom:  The International Monetary Fund reported in an updated forecast that it no longer expects British economic activity to slip into recession this year.  The institution now expects gross domestic product to expand 0.4% in 2023 and 1.0% in 2024, reflecting stronger wage growth, more supportive fiscal policy, and an easing of global energy prices and supply chain blockages.  All the same, the IMF forecasters warned that consumer price inflation is likely to be elevated for some time to come.

Greece:  As we flagged in our Comment yesterday, conservative Prime Minister Mitsotakis called new parliamentary elections for June 25, rather than trying to form a coalition government after winning a plurality, but not a majority, in Sunday’s elections.  Because of how the seats in parliament will be allocated in the second election, Mitsotakis and his New Democracy Party will have a good shot at forming a government by themselves.

• Coupled with the economy’s rebounding tourism and transportation activity, Mitsotakis’ business-friendly policies have given a boost to Greek assets.
• Greek sovereign bonds rallied further yesterday on the election news, driving their yield to a record low against comparable Italian bonds.

Bulgaria:  After having five elections since 2021 that have ended inconclusively or resulted in short-lived governments, the country’s two main political parties have agreed to a power-sharing deal aimed at finally producing an effective government.  Under the deal, the two rival parties will form a coalition government with rotating prime ministers.  The agreement could help the country finally make progress on important issues like cutting inflation, clamping down on corruption, reducing economic dependency on Russia, and joining the Eurozone.

Japan-China:  Semiconductor manufacturers in China say they are worried that Japan’s new rules on selling advanced semiconductor-manufacturing equipment to the country could be tougher than the U.S. and Dutch restrictions.  If so, the executives said the restrictions could crimp China’s output of basic, relatively unsophisticated chips like those used in automobiles or kitchen appliances.  As we’ve warned many times before, investors remain at risk as the West and China try to decouple from each other economically and technologically.

United Kingdom-China:  In a member survey last month, the British Chamber of Commerce in China said only 8% of its members were pessimistic about their prospects in the country, down from 42% at the beginning of China’s post-pandemic opening last December.  However, fully 70% of the members said they were still taking a wait-and-see approach to new investments in the country because of continued regulatory uncertainty.  The survey shows how President Xi’s drive to bring the economy under stricter state control and clamp down on security risks is also playing into the decoupling phenomenon.

United States-China:  Several Chinese residents and a real estate firm filed a federal lawsuit to block a new Florida law restricting the sale of real estate to citizens of China, Russia, Iran, and other “countries of concern.”  The suit seeks to invalidate the law on grounds that it violates the Constitution’s equal protection clause and intrudes on the federal government’s right to manage national security, international affairs, and international commerce.

• The new Florida legislation was championed and recently signed into law by Governor Ron DeSantis, a prospective Republican presidential candidate.
• We think passage of the law illustrates how both Republicans and Democrats will likely compete to look toughest on China in the run-up to next year’s elections. If so, there could be a spiral of aggressive measures and proposals against China, which would likely make U.S.-China tensions even worse than they are at present.

U.S. Fiscal Policy:  In their latest face-to-face negotiation over raising the federal debt limit yesterday, President Biden and House Speaker McCarthy failed to reach an agreement, but McCarthy indicated the discussion was productive and that he expects to keep talking with Biden daily until they reach a deal.  The key sticking points now appear to be how much to raise the debt ceiling and at what level to cap federal spending in the upcoming fiscal year.  We continue to believe a deal will be reached and passed into law before the government loses its ability to pay its bills, but brinksmanship over the next couple of weeks could lead to heightened volatility in the financial markets.

U.S. Consumer Sentiment:  In the Federal Reserve’s annual survey of financial well-being, conducted last October, some 73% of U.S. adults said they were doing OK or living comfortably, down from 78% in 2021.  Importantly, a record 35% of the respondents said they were worse off financially than one year before, with more than half citing price inflation as a major challenge.  The survey underscores how the pain of rising prices was more than enough to offset the impact of low unemployment and rising wages last year.  It also reveals a likely reason why polls show that President Biden’s job approval ratings are so low despite high levels of employment.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a short recap of the Group of Seven (G7) summit in Japan, which finished over the weekend.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more Chinese retaliation against the U.S.’s clampdown on advanced technology flows and the latest on the negotiations over the U.S. federal debt limit.

G7 Summit:  Wrapping up their annual summit over the weekend, the G7 countries (the U.S., Japan, Germany, France, the U.K., Italy, and Canada) said they will work to insulate themselves from Chinese economic coercion and block the transfer of sensitive technology to China.  The statement reflects a growing realization of the way Beijing weaponizes other countries’ dependency on trade or capital flows with China, as we have described extensively in our various publications.

• Despite the tough communiques, however, President Biden said in a post-summit news conference that he wants more open lines of communication with China.
• Biden also predicted that U.S.-China relations would soon thaw, suggesting that there has been some sort of quiet diplomacy going on between the countries.

China-United States:  Although President Biden hinted at the G7 summit about an imminent thaw in U.S.-China relations, the Cyberspace Administration of China said yesterday that products made by U.S. memory chip maker Micron Technology (MU, $68.17) failed its network security review and that it would bar Chinese operators of key infrastructure from buying Micron’s chips.  The Chinese officials provided no details, and they didn’t say exactly which of the firm’s products would be affected.  In any case, Seoul said it didn’t plan to stop South Korea’s big memory chip makers from filling the gap left by Micron, in spite of U.S. entreaties.

• The Chinese move against Micron is widely believed to be retaliation for the U.S.’s draconian restrictions on the sale of advanced semiconductors and related goods and services, which were announced last October.
• Other suspected retaliatory measures include China’s recent clampdown on foreign consulting firms operating in China and the arrests of foreign business executives in the country.
• China’s belated retaliation for the U.S. technology clampdown illustrates the U.S.-China decoupling that is gathering force, at least in the realm of technology. As the U.S. begins to focus more on China’s increasing military threat, such decoupling is likely to expand, creating significant risks for U.S. investors.

European Union-United States:  Regulators in the EU imposed a record fine of $1.3 billion on Facebook parent Meta Platforms, Inc. (META, $245.64) for storing European user data in the U.S. in violation of the bloc’s privacy rules.  At issue is the regulators’ belief that European user data stored in the U.S. could be accessed by U.S. spy agencies with insufficient protections.  Meta said it would appeal the ruling, and the regulators said they would allow such data transfers if the EU and U.S. reach an accord on the protection of personal data.

United Kingdom:  Prime Minister Sunak is facing another headache after news was reported over the weekend that last summer Home Secretary Suella Braverman tried to use her then-position as attorney general to avoid standard penalties for a speeding ticket.  Sunak today will consult his independent adviser on ministerial ethics after being urged to investigate the matter.  The scandal comes as Sunak continues to battle high inflation, public-sector strikes, a controversial immigration proposal, and his Conservative Party’s poor results in recent local elections.

Greece:  In elections yesterday, the conservative New Democracy party of Prime Minister Mitsotakis won the most votes but not enough for a majority in parliament.  Since Mitsotakis then derided the possibility of negotiating a coalition deal to form a government, it appears Greece will face a new election sometime in the coming weeks.

• Given the way that parliamentary seats would be allocated in a second vote, Mitsotakis and New Democracy stand a better chance of winning a majority in parliament in that election.
• In anticipation that the business-friendly conservatives will win a new mandate, Greek assets are trading higher so far this morning.

India:  The Reserve Bank of India announced that it will take all of its largest denomination bills out of circulation by the end of September.  The move, which is reminiscent of a 2016 currency reform that eliminated smaller bills overnight, has sparked fear among consumers even though the central bank offered assurances that the bills would remain legal tender until September.  In fact, the large bills that are now subject to elimination were introduced amid the chaos touched off by the 2016 reform, which in turn was ostensibly aimed at undermining illicit activity.  The move appears to be weighing very slightly on the value of the rupee (INR) in foreign exchange trading so far today.

U.S. Fiscal Policy:  President Biden and House Speaker McCarthy have agreed to meet on Monday afternoon to try to overcome their impasse over raising the federal debt limit.  However, Treasury Secretary Yellen reiterated her view that the government would be unable to pay its bills by June 1 if there is no deal to raise the limit, saying the date is a “firm deadline.”  That underscores the risk that the government could default on its debt and leave many of its bills unpaid, potentially sparking economic havoc and calling into question the U.S.’s role as the foundation of the global financial system.

• All the same, we still suspect that the administration and Congress will reach a deal at the last moment and avert such an outcome.
• One key reason for optimism is that both Biden and McCarthy have already made some concessions to each other—a fact that’s easy to miss amid the political rhetoric.
  • Press reports say Biden, for example, has expressed his willingness to claw back unused pandemic relief funding, tighten work requirements for some social safety-net programs, reform permitting for energy infrastructure, and freeze spending in this year’s budget.
  • Meanwhile, McCarthy and his team haven’t pushed their earlier calls to undo provisions of last year’s Inflation Reduction Act and student debt relief. They also insist on increasing the budget for the armed forces, veterans, and border security.

U.S. Monetary Policy:  In a Friday interview with the Wall Street Journal, Minneapolis FRB President Kashkari said he would be open to holding the Fed’s benchmark fed funds interest rate steady in June to give officials more time to assess the effects of past rate increases and the inflation outlook.  Considering that other Fed officials have recently indicated they’re leaning toward at least one more rate hike in June, the statement by Kashkari illustrates how the June decision is basically too close to call at this time.

U.S. Oil Market:  In a new effort to refill the nation’s Strategic Petroleum Reserve after massive sales from it last year because of the Russia-Ukraine war, the Energy Department has revamped how it will accept bids from oil companies.  In contrast with its tender for fixed-price bids earlier this year, which failed because of the price risk it imposed on oil producers during the two weeks needed to evaluate the bids, the department will now request bids based on a less volatile measure of price spreads.

• If completed, the tender will result in the government purchasing about 3 million barrels of domestically produced sour crude, with more to be purchased later.
• Amid weakening demand and softer crude pricing as the economy slides toward recession, the purchases could provide some support for crude values.

U.S. Labor Market:  In its annual report on foreign-born workers, the Labor Department said immigrants made up 18.1% of the labor force in 2022, the highest level ever in records dating back to 1996.  Of the 164 million in the U.S. labor force (people working or looking for work), 29.8 million were born abroad, for an increase of 1.8 million from the previous year.  That means immigrants accounted for more than half the increase in the labor force last year.

• The analysis suggests the increased weight of foreign-born workers in the work force reflects both the pull of strong labor demand by companies and the high level of retirements and other withdrawals from work by native-born workers.
• Amid strong labor demand and company complaints about worker shortages, the influx of foreign-born workers probably helped hold down average wage rates, potentially helping to limit inflation pressures.  Nevertheless, many will likely see the rise in immigrant labor as competition for native-born workers, so the report could feed into the current backlash against immigration.

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