by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a major mining merger that underscores our oft-stated view that global commodity markets are set to enter a prolonged boom period once we get past the expected recession.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an unexpectedly strong performance by President Erdoğan in Turkey’s elections over the weekend and upbeat comments by Treasury Secretary Yellen regarding the negotiations over the U.S. federal debt limit.

Global Commodity Markets:  Canadian gold miner Newmont (NEM, $45.94) has agreed to buy Australian miner Newcrest (NCMGY, $18.81) in a move that will expand Newmont’s access to minerals such as copper, which are expected to be in high demand as the world transitions to electric vehicles and other forms of electrification.

• More generally, Newmont’s move is consistent with our view that global fracturing and insufficient investment will boost prices for a range of mineral commodities in the coming years. Even automakers are looking to get into mining in order to control prices for key mineral inputs.
• Separately, the World Platinum Investment Council issued a report forecasting that global platinum demand will jump 28% this year to 8.2 million ounces. However, the report also warned that sporadic electricity production in South Africa, the main producer, will leave a deficit of almost one million ounces.  The deficit is expected to further buoy platinum prices in the near term.

Turkey:  In yesterday’s presidential election, President Recep Tayyip Erdoğan and opposition leader Kemal Kılıçdaroğlu came in first and second, respectively, but it appears neither won the required 50% to avoid a run-off ballot.  That ballot will take place on May 28.  Separately, Erdoğan’s alliance appeared to be on track to maintain its majority in parliament after clinching 323 of the 600 seats in the National Assembly, compared with the opposition alliance’s 211 seats.

• Erdoğan’s tally in the presidential election was better than recent polling suggested, which could prompt destabilizing allegations of fraud.
• In any case, the president’s better-than-expected results could lead to disappointment among investors looking for a return to more orthodox economic policies in Ankara and renewed cooperation with the West. Indeed, Turkish stocks are falling on the news so far this morning.

Greece:  In happier news from the same neighborhood, S&P recently assigned a “positive” outlook on Greece’s sovereign credit rating.  That sets the stage for the country to possibly regain an investment-grade rating if the winner of the May 21 elections commits to continuing favorable economic policies.  S&P currently rates Greece’s foreign debt at BB+/B, one step below investment grade.

• Greece was the poster child for Europe’s fiscal troubles during the Great Financial Crisis more than a decade ago.
• Now, however, economic growth in Greece is skyrocketing and government economic policies have improved markedly.
• Regaining an investment-grade credit rating would lower the government’s interest payments just when rapidly rising rates are becoming a greater headwind.

Russia-Ukraine War:  After months of slowly pulling back as Russian forces advanced through the eastern city of Bakhmut, Ukrainian forces have not only caught the Russians unawares with a small counterattack, but some reports suggest they may now be trying to surround the city.  If that’s the case, the Ukrainians could trap the Russian troops, ammunition, and equipment deployed there.  Such an event, which would probably be distinct from the expected large-scale Ukrainian counterattack, would further weaken the Russian military and be a major embarrassment for President Putin.

China-United States:  The Chinese government said it has sentenced a U.S. citizen to life in prison for espionage.  The U.S. citizen, 78-year-old John Shing-wan Leung, also has permanent-residency status in Hong Kong.  He was arrested in April 2021.  The case could further strain ties between China and the U.S. despite recent government-to-government meetings aimed at reducing tensions.

• Separately, some Chinese students in the U.S. are pushing back against the Chinese Communist Party’s effort to control their activity even when they’re thousands of miles from home.
• The small group of Chinese students studying at George Washington University in Washington, DC, has announced the establishment of an Independent Chinese Student Union to give young local Chinese a platform to organize and express political ideas free from the party’s prying eyes.
• The students say their aim is to protect students from the CCP and the Chinese Students and Scholars Association that the party directs. They also aim to convince the university to fully divest from “companies complicit in the Uyghur genocide and which enable the CCP.”

China-Vietnam-Philippines:  In a new stand-off over control of the South China Sea, the Chinese government has dispatched coast guard ships and ostensibly private fishing vessels to an area where Vietnam said it would expand oil drilling.  Reports indicate the Chinese coast guard ships have provocatively cut off Vietnam’s coast guard vessels sailing near an existing oil well.  Separately, the Philippine government has attempted to assert its sovereignty over areas of the South China Sea by placing navigation buoys in its exclusive economic zone near the disputed Spratly Islands.  China so far has not responded to the placement of those buoys.

Thailand:  In elections over the weekend, two opposition parties took the lion’s share of the 500 seats in parliament.  The progressive Move Forward Party was the top vote-getter, earning a projected 151 seats, while the populist Pheu Thai Party earned 141 seats.  However, the ruling military junta will have the ultimate say in who forms the next government, a process that could take weeks.

Argentina:  The government today will unveil a series of tough economic measures designed to avoid a big currency devaluation ahead of October’s elections.  The measures reportedly will include a 600 bps rise in interest rates, increased central bank intervention in the currency markets, and the elimination of tariffs on food imports to help bring down inflation.  The measures apparently don’t address the key causes of Argentina’s economic problems, such as its big budget deficit.

U.S. Fiscal Policy:  Over the weekend, Treasury Secretary Yellen said administration officials and congressional Republicans were making progress in their negotiations over an increase in the federal debt limit.  According to Yellen, the negotiators “have found some areas of agreement” that could lead to a deal that would avoid having the government default on its debt.  Reports suggest one potential area of agreement is to temporarily cap federal spending, rather than institute outright cuts, while another is to claw back unused pandemic relief funds.  Any deal that removes the risk of a government debt default could prompt a relief rally in financial markets.  However, any such rally could be short-lived as investors start to focus again on the likelihood of a recession.

U.S. Municipal Economies:  Conference and hotel demand in North America finally surpassed 2019 levels in the fourth quarter of 2022, according to the Events Industry Council, an organization consisting of convention trade groups.  Rebounding convention business will likely give a welcome boost to downtown areas in many cities and help bolster municipal tax bases.

U.S. Weather:  The Pacific Northwest has been hit with a record-breaking heat wave, with temperatures reaching the high 80s in Seattle and the mid-90s in Portland.  If they last longer than anticipated, the high temperatures could raise the risk of flooding, worsened drought, and a more dangerous forest fire season.

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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 this weekend’s presidential election in Turkey. Next, we explain why the recent drop in the British Pound Sterling (GBP) against the U.S. dollar may not hold. Lastly, we discuss how the controversy in South Africa may give investors insights into how the U.S. may respond to countries that don’t comply with sanctions.

Turkish Election: Turkish President Recep Tayyip Erdoğan is facing his toughest election test on Sunday as he looks to extend his nearly 20-year rule.

• President Erdoğan’s rival, Kemal Kılıçdaroğlu, is the favorite to win the election this weekend. On Thursday, third-party candidate Muharrem İnce withdrew from the contest after an alleged indiscretion surfaced earlier this week. His exit is expected to support Erdoğan’s rival Kemal Kılıçdaroğlu, who is representing a six-party coalition. Several surveys show that Erdoğan lags in the polls, but the race is still too close to call. Despite İnce’s departure, his name has not been removed from the ballot, so it is possible that the election may still head to an unprecedented second round on May 28.
• Anticipation about the voting result has led to increased market jitters as traders brace for a shift in the country’s unconventional monetary policy. Erdoğan’s insistence that higher interest rates lead to increased inflation has led the country’s central bank to loosen monetary policy and slash its benchmark policy rate by more than half in less than two years despite annual inflation hovering above 40%. Capital restrictions have prevented currency holders from hedging against rising inflation. That said, the country will face significant currency devaluation no matter who wins the presidential race as the government will not have the tools needed to maintain tight currency controls for much longer.

• Sunday’s election has been closely watched by investors as the outcome may have geopolitical implications. Turkey is located between Europe and the Middle East and has control of the strategically important Black Sea and has the second largest army in the NATO military alliance. There has been friction between Turkey and its NATO allies, however, mostly because of President Erdoğan’s reputation for being an unreliable partner due to his tendency to play both sides of an international conflict. Hence, his ouster will likely improve relations between Turkey and the West. Additionally, a new Turkish President could pave the way for more traditional economic policy.

U.K. Confidence: Better-than-expected economic data has led the Bank of England to reassure investors that it has room to raise rates further.

• The U.K. central bank lifted its benchmark interest rate on Thursday by 25 bps to 4.5%, its high level since 2008. Additionally, the BOE revised its economic outlook by removing any prediction of a recession within the year. Despite the optimism, British policymakers insist that inflation remains too high and have warned that food prices would fall more slowly than they had anticipated. The 10.1% annual inflation in the U.K. is higher than in the U.S. and the European Union. As a result, BOE Governor Andrew Bailey vowed that the central bank would continue to work to get inflation down to its 2% target.
• The GBP is the best-performing G10 currency this year, but it weakened following the announcement. On Thursday, the GBP fell 0.9% from the previous day. Its weakness is related to concerns that the BOE may have oversold the health of the economy as investors doubt that the country can tolerate additional rate hikes. Unlike American homeowners, borrowers in the U.K. face significant interest rate risk as loan rates have short-term expirations. Thus, investors fear that the BOE may trigger a recession as it looks to restore price stability. Equities were little changed following the rate decision as interest futures are not convinced that policymakers will maintain their inflation fight.

• A recession will have a negative impact on the currency, but we still foresee the GBP outperforming the greenback this year. In our view, the Federal Reserve will end its hiking cycle before the BOE. The latest CME FedWatch Tool predicts that there is a high likelihood that U.S. policymakers will pause at their next meeting. Meanwhile, Gilt futures suggest that the BOE may institute another two rate hikes before it is finished. The differences in interest rates should put downward pressure on the dollar and may offer some support for British equities.

Beware of the Sanctions: South African assets are facing pressure after the U.S. accused the country of supporting Russian war efforts in Ukraine.

• A U.S. ambassador has accused the South African government of supplying ammunition to the Russians. The alleged incident took place last year after a Russian vessel arrived at a dock in Cape Town. The country’s president has denied that anyone in his administration was authorized to load weapons on the ship but has launched an investigation into the matter.
• The allegation comes at a delicate time as the country struggles to constrain the rolling blackouts that have led to concerns about the country’s grid. Also, electricity production in Africa’s second-largest economy has been plummeting. Despite South Africa’s robust growth over the last two decades, its electricity production is hovering near a 20-year low. Additionally, the situation puts South Africa’s preferential access to the U.S. market in jeopardy. As a result, investors do not believe the country will be able to expand its industrial activity as the country may face weaker demand for its goods.
• The controversy has led to a major sell-off of financial assets as investors’ concerns about growth worsened. The rand (ZAR) dipped below 19.35 against the dollar on Thursday, beating the previous record low set during the pandemic. Additionally, the Johannesburg Stock Exchange sank 1.0% in the same period.

• The situation in South Africa highlights the potential danger that countries could face when they decide to side with America’s enemies. As the world’s largest consumer market, the U.S. has the ability to use trade as a weapon to prevent countries from circumventing Western sanctions. Unlike the dollar, the use of trade cannot be remedied through the use of barter or with a simple workaround. The U.S.’s response to South Africa shows countries that America will have little tolerance for countries seeking to aid Russian war efforts. If we are correct, this may mean that countries will feel more pressure to choose sides as the world breaks into regional blocs. As a result, the incident reinforces our view that the U.S. dollar is headed toward a secular decline.

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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 a discussion about why the market reacted so positively to a subtle drop in U.S. inflation. Next, we provide our thoughts on the latest developments in debt ceiling talks and how they impact U.S. Treasuries. Lastly, we provide an update on the ongoing competition between China and the West.

Now a Pause? A key inflation indicator bolstered investor confidence that the Federal Reserve is close to ending its hiking cycle.

• Consumer price data showed that the Fed is making progress in its inflation fight, despite only a modest decline in price pressures. Last month, the consumer price index rose 4.9% from the prior year. Although the increase only slightly beat consensus estimates of 5.0%, a deeper look into the data tells a different story. Non-housing core services inflation, Fed Chair Jerome Powell’s favorite indicator, declined to 5.2% last month from a peak of 8.2% in September 2022. The price indicator is viewed as a gauge of the wage pressures within the inflation data. Thus, its decline could give Fed officials the greenlight to pause in their next meeting.
• Speculation about the end of the interest rate hike lifted market sentiment. The NASDAQ Composite Index rose 1.04% on Wednesday as tech stocks were favored by traders looking to take on more risk. Additionally, the market is now convinced that the Fed will pause rates in June. The latest CME FedWatch Tool projects that there is more than a 90% chance that the central bank will hold rates at their current levels. Assuming the forecast is right, this may explain the strong performance in risk assets.

• At this time, there is a fundamental disagreement between the market and the Fed over the next policy steps. The market wants the Fed to cut rates as the economy slows down. In contrast, Powell insists that the FOMC should maintain rates in restrictive territory until inflation is under control. So far, there has been no sign that the Fed is ready to pivot interest rates; thus, it is still likely that it will keep rates elevated throughout the year. As a result, the market will likely see a lot of uncertainty over the next few months.

Debt Fiasco: The ongoing dispute over raising the debt ceiling is already starting to spill into financial markets.

• The two major parties continue to use the threat of triggering a potential crisis as the debt deadline approaches. On Wednesday, former President Donald Trump urged Republicans to push the country into an unprecedented default unless the Democrats commit to massive spending cuts. Meanwhile, his successor has floated the possibility of using the 14^th Amendment to remove the debt ceiling. Congress has only six scheduled legislative days left, and there does not seem to be a pathway toward an agreement.
• Uncertainty over whether the U.S. will default on its debts has caused disarray within the Treasury market. One-month Treasury-bill yields have surpassed three-month government yields at levels not seen since one-month Treasury bills were introduced in 2001. This divergence is related to investors’ discomfort with the political brinkmanship over raising the debt ceiling. There is growing fear that the two sides will be unlikely to come to an agreement before the debt limit’s June 1 deadline. Failure to raise the debt limit could have catastrophic consequences for the U.S. economy and will undoubtedly push the country into recession.

• Congress will likely feel pressured to act on the debt ceiling when the market friction moves from the Treasury bills into equities. The lack of equity movement related to the standoff is due to market confidence that lawmakers will eventually come to an agreement even if it includes a few defections. Thus, market participants have been able to focus their attention on other market-related events. This dynamic will change over the next couple of weeks as the impasse draws more attention from investors. At this time, we suspect government officials may look for a temporary solution to avoid a default.

Beijing Pivot: As the West reduces its dependency on China, Beijing is looking to build ties with emerging market countries.

• Government officials in Europe are slowly distancing themselves from the world’s second-largest economy. Italy is expected to hold talks about a possible exit from China’s Belt and Road Initiative. At the same time, German Chancellor Olaf Scholz has described Beijing as being a “systemic rival” and has urged other EU countries to scale back their reliance on China. European countries’ decision to create “strategic distance” is related to concerns that China is looking to replace the global system with something that reflects its own ideology.
• China has looked to developing countries to hedge against its potential decoupling from the West. On Thursday, Ecuador signed a free trade agreement with China that would boost non-oil exports. However, the deal will likely face resistance as it makes its way through the legislature. Across the Pacific, local governments in China have looked to raise capital from sovereign wealth funds in the Middle East. Officials have held talks with the Qatar Investment Authority, subsidiaries of Saudi Arabia’s Public Investment Fund, and the Abu Dhabi Investment Authority. The recent outreach in the Middle East and South America shows how China is prepared to recruit from areas within the U.S.’s sphere of influence.
• Neither the West nor China wants an abrupt end to the trading relationship. Despite President Biden’s tough rhetoric, his administration has been aggressive in pushing the two Major Powers to reengage in talks. Secretary of State Antony Blinken is preparing to set up a visit to China later this year. At the same time, Defense Secretary Lloyd Austin has expressed interest in meeting China’s new defense minister Li Shangfu at an upcoming summit in Singapore. So far, China has rebuffed offers for communication as it describes Washington’s attempts at dialogue contradictory to its broader goal of Chinese containment. However, its lackluster recovery following the end of its Zero-COVID policy may force China to eventually relent to talks.
  • We believe that the markets will welcome any sign of an easing of tensions between the West and China but talks alone won’t lead to an overall improvement in the relationship.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an overview of the devastating heatwave in Southeast Asia and the latest on the Russia-Ukraine war.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including political and economic upheavals in key Latin American countries and new reports on the health of the U.S. banking system.

Southeast Asia:  Countries including Vietnam, Thailand, Cambodia, and Laos have been suffering from a historic heat wave in recent weeks, leading to melted roadways, school closures, and business disruptions.  The new record-high temperatures include 112°F in Vietnam’s northern Tuong Duong district and 110°F in the popular Laotian tourist destination of Luang Prabang.  Since the populations in these countries are largely poor and less able to cope, the heat wave and the region’s unusually dry winter will likely have an outsized impact on the affected economies.

Russia-Ukraine War:  Russian and Ukrainian officials say that at least one large Russian military unit has been destroyed in the embattled city of Bakhmut, potentially reflecting the Kremlin’s failure to provide enough equipment and ammunition to the Wagner Group mercenaries fighting there.  The unit’s destruction, which apparently prompted Russian forces to pull back from part of the city, could also reflect improved resources provided by the West to the Ukrainians ahead of their widely anticipated spring counteroffensive.

• Separately, the U.K. Ministry of Defense estimated that Russia’s total population declined by about two million people more than expected over the last three years because of both COVID-19 and the war in Ukraine.  The ministry estimates that about 1.3 million people emigrated from Russia in 2022, including many young, highly educated people in high-value industries.  In fact, about 10% of the country’s entire IT workforce left.
• Finally, new reporting discusses how the war has been a boon for small, technology-oriented defense companies around the world.

Turkey:  The top opposition candidate in Sunday’s presidential election, Kemal Kılıçdaroğlu, said he will reinvigorate the country’s democratic checks and balances and strengthen its role in the North Atlantic Treaty Organization if he wins.  In recent opinion polling, Kılıçdaroğlu has held a slight lead over incumbent President Erdoğan but not necessarily enough to avoid a run-off election later in May.

Colombia:   The country’s new finance minister, Ricardo Bonilla, said he and leftist President Gustavo Petro plan to cut Colombia’s reliance on producing mineral commodities and instead nurture basic manufacturing in areas like textiles, fertilizers, metalworking, and pharmaceuticals.  Bonilla has also vowed to rein in the country’s budget deficit, but his statement on restructuring the economy suggests Petro’s recent cabinet reshuffle will push Colombian policy leftward, which could be a headwind for Colombian financial markets.

• We would note that Bonilla’s plan to boost domestic manufacturing is also in sync with industrial policy trends in key developed countries, including the U.S., which in recent years has instituted more trade barriers against China and approved hundreds of billions of dollars in subsidies to help boost favored industries such as semiconductors and green technology.
• Bonilla’s plan, therefore, runs counter to free-market ideology. On the other hand, it’s possible to argue that the massive boom in Chinese manufacturing since 2001, driven in part by Beijing’s subsidies and other unfair policies, unfairly short-circuited efforts by Colombia and other emerging markets to develop via manufacturing investment.  One could almost say that when the Chinese economy burst onto the world stage, it forced many emerging markets off the road to manufacturing and instead pushed them onto the road of being dependent on commodity production, with all the volatility, environmental damage, and other issues associated with it.  It would not be a surprise to see more developing countries adopting policies like Colombia’s in the future.

Ecuador:  The national assembly yesterday voted to move ahead with an impeachment trial of President Lasso over charges of corruption.  Under the constitution, however, Lasso could first dissolve congress and trigger presidential and legislative elections.  In any case, the country is likely to face weeks or months of heightened political uncertainty that will likely weigh on Ecuador’s financial markets and currency.

U.S. Fiscal Policy:  President Biden, House Speaker McCarthy, and other congressional leaders met yesterday in an initial effort to resolve the dispute over raising the federal debt limit, but the meeting ended with little apparent progress.  After the meeting, Biden reiterated his stance that the politicians should work to cut the budget deficit, but without tying that effort to raising the debt limit.  McCarthy expressed his frustration that Biden had not met with him on the issue earlier and reiterated his view that raising the debt ceiling must be accompanied by steep spending cuts.  As we mentioned in our Comment yesterday, we expect the discussions, and brinksmanship, to continue in the coming weeks ahead of the June 1 deadline at which time the government may not be able to pay its bills.

U.S. Banking-Discount Window Borrowing:  New data from the Federal Reserve shows that bank borrowing from its discount window plunged to $5.3 billion last week, down from more than $150 billion at the height of the banking crisis in March.  The plunge in discount window borrowing last week is a welcome signal that the worst of the banking crisis has passed, although we believe banks will suffer a prolonged period of “disintermediation” as customers gradually pull their deposits to redeploy them to higher-yielding investments such as Treasury bills and money market funds.

U.S. Banking-Lending Standards:  Consistent with the loss of deposits because of disintermediation, the Fed’s latest senior loan officer survey showed banks tightened lending standards for both large and small corporate borrowers in the first quarter.  That merely continues a trend of stingier lending that began a year ago, but we note that the tightness is now at the levels often seen in recessions.  The data suggests that if the economy isn’t in the expected downturn already, it is rapidly approaching it.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with more signs that major countries and companies are shoring up their alliances and operations to counter China’s increasing geopolitical aggressiveness.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new data suggesting the German economy may finally be slipping into recession and the latest on the U.S. political standoff over the federal government’s debt limit.

Japan-South Korea: Japanese Prime Minister Kishida yesterday visited Seoul for a summit with South Korean President Yoon, marking the first visit by a Japanese leader in 12 years.  The meeting, which led to several bilateral agreements, illustrates the two countries’ rapid rapprochement as they both begin to focus on the growing geopolitical threat from China.

• The recent rapprochement comes after more than three years of estrangement over Japan’s behavior in Korea before and during World War II.
  • Illustrating just how far Japan was willing to go to solidify its relationship with Seoul, Kishida expressed his “unwavering” commitment to the 1998 joint declaration that expressed Japan’s “deep remorse and heartfelt apology” for its wartime aggressions.
  • According to Kishida, “My heart aches as many people went through very difficult and sad experiences in the harsh environment at that time.”
• Kishida’s remarks could give Yoon space to maneuver amid domestic political opposition to a closer relationship with Japan without a fresh apology.

China-Singapore: FedEx (FDX, $229.30) confirmed it will move its regional headquarters for Asia Pacific, the Middle East, and Africa from Hong Kong to Singapore, including about 15% of office jobs.  The firm insisted the move simply aims to connect the regional headquarters and its operational units “with greater speed and agility,” but we suspect it really aims to protect FedEx workers from the draconian security law that China imposed on Hong Kong in 2019.  If so, the move is another example of global fracturing and the way U.S. firms are “friend-shoring” investment into the U.S.-led bloc and away from the China-led bloc.

Russia-Ukraine War: Ukraine has still not launched its much-anticipated counteroffensive against the Kremlin’s invasion forces, but it continues to stage drone attacks against Russian logistics facilities behind the front lines in an apparent effort to soften up Russian forces.  Meanwhile, the Russian forces today launched what local officials said was the biggest wave of drone and missile strikes against Kyiv since the war started.  The Russian attacks came as Yevgeny Prigozhin, the leader of Russia’s Wagner Group of mercenaries, backtracked on threats to withdraw his forces from the embattled city of Bakhmut because of insufficient ammunition and supplies from the Russian Ministry of Defense.  Reports suggest Prigozhin may have been assuaged after former invasion commander Gen. Sergei Surovikin was named as liaison between the Defense Ministry and the Wagner forces.

• Separately, the Kremlin has hiked taxes on Russian oil producers to help make up for the loss of revenue due to Western sanctions on the country’s energy exports. Analysts expect the move to further crimp the producers’ ability to invest in future production.
• The European Union has proposed sanctions on Chinese companies supporting the Russian military for the first time since the Ukraine war began. The move is likely to further heighten tensions between Brussels and Beijing, hastening the EU’s economic decoupling from China.

Arab League-Syria: In an emergency session in Cairo, national leaders of the Arab League decided to readmit Syria after more than a decade of isolation over its brutal tactics in its civil war.  The move is being seen as a sign of waning U.S. influence in the Middle East as it will complicate U.S. efforts to isolate Syrian President Bashar al-Assad.

Germany: March industrial production fell by a seasonally adjusted 3.4%, much worse than expected and enough to mark its biggest monthly drop in a year.  Along with other recent data showing March declines in factory orders, retail sales, and exports, the data suggests that Germany, the EU’s biggest economy, may have slipped into recession in the first quarter.

U.S. Fiscal Policy: Treasury Secretary Yellen yesterday warned that if Congress refuses to pass an increase in the federal debt limit by June 1, the administration would consider invoking the Constitution’s 14^th Amendment to continue paying the government’s bills, including its debt service.  However, Yellen called the potential move a “not good option” that would likely cause a constitutional crisis as scholars dispute whether the amendment could be used in such a way.

• Separately, President Biden and members of his administration plan to meet tomorrow with House Speaker McCarthy and other congressional leaders to discuss a way out of the impasse.
• We continue to believe that brinksmanship surrounding the debt ceiling could prompt elevated volatility in the financial markets as we approach the June 1 deadline by which Yellen has warned that the government could no longer pay its bills.

U.S. Labor Market: The monthly labor report, released on Friday, showed the unemployment rate for Black Americans fell to a record-low of just 4.7% in April.  In tight labor markets, workers who have historically been underemployed are typically drawn into jobs over time.  The longer those workers remain in their jobs, the greater the chance they will build valuable skills, become more productive, and be better able to ease the growing shortage of labor in the economy.

U.S. Manufacturing Sector: Organizers said this year’s SelectUSA summit in Washington, where state and local governments woo foreign investors, had record attendance.  Reports say the hundreds of billions of dollars in federal subsidies for new manufacturing facilities in last year’s Inflation Reduction Act and CHIPS Act have sparked a massive competition by state and local governments to draw in foreign investors.

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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 recent changes to monetary policy in Europe and the U.S. Next, we explain why safe-haven assets have become more attractive over the last few days. Finally, the report ends with a discussion about why the rivalry between the U.S. and China has spilled over into Africa.

Next Stage? Global monetary tightening may be heading toward a close as central bankers focus their attention on a potential downturn.

• Investors are not convinced that the Federal Reserve and the European Central Bank are willing to continue to raise interest rates until inflation is tamed. A day after the Fed removed mention of “additional policy firming” from its statement, ECB President Christine Lagarde tried to reassure markets that the ECB was not going to halt its hiking cycle anytime soon. However, investors fear that the banking turmoil in the U.S. could force most central banks to rethink future policy decisions. Despite hawkish rhetoric from Lagarde, the EUR fell 0.41% to $1.1018 on Thursday.
• The market expects the ECB and Fed to cut rates later this year, regardless of their comments that they won’t. The latest Euro Area Bank Lending Survey for Q1 2023 showed that the net percentage of financial institutions restricting credit has risen to its highest level since the European Sovereign Debt Crisis. At the same time, the Federal Reserve’s Senior Loan Officer Opinion Survey is expected to show similar results on Monday. Expectations of a lending slowdown have added to concerns that policymakers will need to pivot to prevent a severe recession. The CME FedWatch Tool predicts that the Fed will continue to raise rates until November, at the latest. Meanwhile, Euribor future prices suggest that the ECB will take its foot off the pedal this fall.

• Although a recession will likely force the ECB and the Fed to prematurely end their hiking cycle, we expect EU policymakers to be less aggressive. European banks are relatively healthy when compared to their American counterparts. This is mostly because there are fewer banks for depositors to choose from. Additionally, European banks are required to regularly mark to market their securities holdings. Hence, they are unlikely to have the same maturity mismatch problems that plagued Silicon Valley Bank (SIVBQ, $0.41) and First Republic Bank (FRCB, $0.32). The differences between the American and European banking systems will likely mean that the banking turmoil will have less of an impact on ECB policy which should be bullish for the EUR and supportive of European equities.

• • Additionally, the ECB has typically been slower to cut rates than the Fed, as the previous chart shows.

Risk Aversion: Uncertainty over the state of the economy and the future path of U.S. interest rates have investors retreating to safety.

• Investors are still worried that problems within the regional banking system will spill over to the broader economy. On Thursday, several regional lenders ran into financial trouble. PacWest (PACW, $3.17) shares tanked after it confirmed that it was exploring strategic options including a possible sale. Meanwhile, Western Alliance’s (WAL, $18.20) stock took a hit following a now debunked report stating that it was considering a sale. At the same time, a deal for TD Bank (TD, $60.33) to take over First Horizon (FHN, $10.06) collapsed. This overall weakness in the regional banks has led to a steep drop in the sector’s benchmark KBW index.
• Wary investors have sought comfort in traditional safe-haven assets in response to the higher volatility. The recent bank fiasco helped push gold prices close to their all-time high on Thursday, while yields on the two-year Treasury fell 15 bps in the same period. The flight-to-safety response comes amidst rising uncertainty after a week of subpar economic data which led investors to question the health of the economy. The number of workers applying for initial jobless claims hit a six-week high last week; meanwhile, labor productivity was shown to have contracted in the first three months of the year. On Thursday, concerns about the economy helped push the VIX  index past the critical level of 20.

• The shift away from riskier assets reflects overall concerns about an imminent downturn. Luckily, these worries have yet to fully materialize in the data. The latest nowcast model from the Federal Reserve Bank of Atlanta estimates a 2.7% annualized rise in GDP for Q2. Additionally, April’s jobs report shows that the economy is still adding 200k+ jobs a month. As a result, the Federal Reserve may be more inclined to hike rates at its next meeting than the market realizes. That said, safe-haven investments, particularly in precious metals, may be a way to protect against a sharp reversal in economic activity.

African Spotlight: Influence over the commodity-rich continent is becoming increasingly important as the U.S.- and China-led blocs search for additional resources to fuel their economies.

• After years of neglect, the West is now looking to reengage African countries. German Chancellor Olaf Scholz started his three-day trip across the continent earlier this week and is expected to push for deeper Western integration. Meanwhile, Japanese Prime Minister Fumio Kishida told African leaders that G-7 countries are prepared to cooperate to help resolve the conflict in Sudan and would like to invest more in the region. The new attention on African nations is meant to offset the inroads made by China and Russia as the major blocs look to secure access to the continent’s energy commodities and growing market.
• However, the West has a long way to go before it is able to catch up to China. Beijing’s Belt and Road Initiative has invested over $155 billion in the continent over the span of two decades. In comparison, the U.S. has financed roughly $14 billion worth of projects from 2007 to 2020. The funding gap has led to concerns that the West may not be able to convince African governments to join the U.S.-led bloc. For example, it was reported that South Africa allowed a sanctioned Russian aircraft to land on one of its bases earlier this week.
• Africa may not have many investment opportunities at this time, but it still has much potential. The continent’s population is expected to account for 20% of the world by 2030 and could reach 25% in 2050. The massive jump in people will help fuel GDP growth in a region that has largely been ignored by market participants. As the world breaks into regional blocs, we suspect commodity firms in Africa may be attractive for investors looking to broaden their exposure to emerging markets.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning!  In the wake of the FOMC, it’s mostly a risk off day so far this morning.  Treasury yields were lower overnight, but have reversed higher, the dollar and equities are lower, oil is modestly higher after a hard sell off, and gold is higher.

In today’s Comment, we lead off with a recap of the Fed meeting.  The ECB meets today, so we offer our first impressions from that meeting too.  The ongoing banking crisis is up next, followed by an update on the debt ceiling situation.  In the market section, we cover the changes coming to the southern U.S. border and then close with a look at the world: China, Ukraine, and general international news.

The FOMC Recap:  As expected, the Fed raised rates 25 bps and signaled a pause.  Here is the official statement and our take:

• The key difference between the May and March statement is the pause signal:
  • March: The Committee will closely monitor incoming information and assess the implications for monetary policy. The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. In determining the extent of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.
  • May: The Committee will closely monitor incoming information and assess the implications for monetary policy. In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.
• Note that the bolded sentence from the March statement is missing in the May statement. The committee has left itself some leeway to raise rates if necessary, but the markets are signaling a near certainty of steady policy at the June 14 meeting.  Current market projections for the July 26 meeting suggest a near even chance of steady policy or a rate cut.  The market is starting to anticipate rate cuts as, even if it’s a bit early, the September 20 meeting is projecting an +80% chance of a rate cut.
• So far, the White House has backed Fed policy tightening, but left-leaning members of Congress are increasing their criticism of monetary policy. A group of Senators and Representatives sent an official letter to Chair Powell, calling on the committee to pause its rate hikes.  Although the signers of the missive are not surprising, a case can be made that a slowing economy and stress in the banking system support a cautious approach to policy tightening.  The Fed has a dual mandate for price stability and full employment, and the signers of this letter tend to focus on the latter mandate.
• Surprisingly, the FOMC statement took a rather sanguine view of banking stress. The turmoil we have seen in the banking system has raised fears of restricted credit—the so-called “credit crunch.”  In looking at the Senior Loan Officer Survey, which is the current reading regarding commercial and industrial loans for large and medium firms, we are at levels that tend to signal recession over the next year.  It also suggests, which shouldn’t be a shock, that unemployment is rising.

This chart shows the survey and the unemployment rate.  The lags are not consistent, but it’s rather clear that readings above 40% increase the odds of a recession.

• Market reactions were interesting. The initial reactions suggested the markets took the statements as dovish.  For example, the dollar weakened, and gold jumped to $2045 per ounce.  Equities rallied and Treasury yields fell.  During the press conference, the chair made it clear that a pause was not a signal of easing, notwithstanding expectations noted above.  In addition, he said that, in his opinion, he expects inflation to fall slowly.  Since he also noted that he doesn’t expect a recession, his outlook on inflation is consistent.  FWIW, we think a recession is more likely than the chair does, and thus inflation will also fall much more quickly than he expects.  However, on Powell’s comments, the equity market fell off rather sharply, and the other markets mostly moved to areas seen prior to the statement.
• To a great extent, we are now at a critical crossroads. If the economy heads into recession, inflation will fall and the FOMC will cut rates.  This is what the financial markets appear to be discounting.  Powell may genuinely believe that a recession isn’t likely, despite the fact that his staff expects one.  Or it may simply not be politically possible for the chair to signal that a recession is likely; after all, if that is what the FOMC members expect, they should be cutting now.  Paradoxically, if the political problem is why Powell doesn’t expect a recession, his position’s impact on markets raises the odds that we will have a recession.

 The ECB:  As expected, the ECB raised rates by 25 bps.  This was widely expected, but the tone of the statement was rather hawkish.  The bank indicated that policy would remain tight because inflation remains sticky.  Similar to what we are seeing in the U.S., European banks are tightening credit.  And, as we are seeing in the U.S., corporate market power is boosting inflation as firms pass along higher costs to consumers to maintain their profit margins.  The press conference was underway as we were writing this report, but market reaction appears to suggest that market participants were wanting more aggressive tightening; we are seeing the EUR weaken in the aftermath of the release.

The Banking Crisis continues:  As the coronation of King Charles III looms, in deference to another Queen, yet another regional bank looks like it’s in deep trouble.  After the Powell press conference yesterday, PacWest Bank (PACW, $6.42) announced it was in talks with investors about strategic alternatives, which likely means it will need to be sold.  Its shares plunged in afterhours trading.  Overall, mid-sized banks continue to lose ground.

• As we note above, the FOMC seems rather unconcerned about the banking situation. We believe this is because they think that stopping the bank run was sufficient.  As we have stated on numerous occasions, the problem isn’t just the bank run situation, it’s disintermediation.  Banks can’t offer market yields on deposits since their assets were purchased in the ZIRP era and doing so would lead to insolvency.  This situation is very similar to the S&L problems of the 1980s.  There is probably only one solution to this problem—the Fed must lower rates to protect the asset bases of these banks.
• Meanwhile, we are starting to see increasing evidence of a credit crunch. Bank lending fell towards the end of March and it’s likely the slump will continue.  Slowing lending will act as a brake on the economy and increase the odds of recession.
• Adding to problems was the announcement that Toronto-Dominion Bank (TD, $59.76) was terminating an agreement to purchase First Horizon Bank (FHN, $15.05), citing regulatory constraints. Toronto-Dominion Bank will pay First Horizon around $225 million for ending the deal.  First Horizon shares fell sharply overnight.

 The Debt Ceiling:  Treasury Secretary Yellen’s recent signal that the Treasury would “run out of cash” by as early as June 1 has increased the tension on Congress to avoid a debt default or a government shutdown.  Speaker McCarthy is expected to meet President Biden on May 9, but there is little evidence that either the president or speaker are prepared to make concessions.  The president simply wants an increase in the debt ceiling—a “clean bill.”  McCarthy, fresh off his budget vote, wants to use his legislation as the basis for negotiations.  We doubt these meetings will accomplish much.  Meanwhile, there are various tactics and ideas being considered.

• Democrats are crafting a discharge petition, which would force a vote on increasing or suspending the debt ceiling. The petition would put the bill on the floor for a vote over the Speaker’s objections, and given the narrow GOP majority, only a few defections could lead to a clean debt ceiling resolution, which would likely pass the Senate.  If five GOP reps defect, this bill could reach the floor.  However, getting five will still be difficult.
• Whenever the debt ceiling becomes a problem, the argument emerges that the 14^th Amendment makes defaulting unconstitutional. The key clause is as follows:

     The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion,       shall not be questioned…

This clause was designed to prevent Southern Congressmen from attempting to repudiate the Federal debt accumulated to fight the Civil War.  The fear was that the southern states, with voter rolls bolstered by free slaves, could legislate to avoid servicing the war debt.  The 14^th Amendment was designed to prevent that outcome.  Some legal scholars believe the clause could be used to skirt the debt ceiling issue.  Of course, this clause conflicts with Congress’s “power of the purse,” so a unilateral action by the executive branch to keep spending and borrowing would eventually be decided by the courts.  However, it should be noted that it is unclear who exactly could sue.  The Supreme Court ruled in 1997 that individual lawmakers lack standing, but Congress as a whole might.  Given the risks involved, previous administrations have avoided this outcome.  But, it is being considered, apparently.

• Another possibility is Congress could agree to extend the deadline by either raising the debt ceiling by an amount estimated by legislators to be a few week’s or month’s worth in order to negotiate further or suspend the limit while negotiations are going on. This idea may be gaining some traction.  It should be noted that, due to recesses scheduled in both houses, the House is only in session 12 days and the Senate 15 days this month.  Complicating matters further, President Biden will be out of the country this month, visiting Japan and Australia.  At the same time, “kicking the can” doesn’t really resolve the issue and without the deadline looming, it’s unlikely progress will be made.
• Other more arcane solutions have come up in these debates. A favorite of Joe Wiesenthal of Bloomberg (and co-host of the Odd Lots podcast) is the $1.0 trillion platinum coin.
• Another odd twist to the deadline is that the IRS has improved its efficiency in sending refund checks. Because it is sending checks faster, the Treasury General Account is draining faster too.

Markets, Economics and Policy:  The strike in Hollywood continues, and the border crisis is increasing.

• The writers have gone on strike in Hollywood. Late night talk shows tend to be affected first, as the hosts lose their joke pipeline.  Taped shows are usually done a few weeks in advance, so it may be a month or so before TV dramas and sitcoms go to reruns.  Usually, we wouldn’t see this issue as market moving.  But the decision to strike, the first in 15 years, is due to the accelerating shift away from broadcasting to streaming.  Writers are finding that the new environment is turning them into “gig” workers with little job security.  Often, the streaming firms make content that is short-term in nature and is hiring writers for short term projects.  The network broadcast model was designed to put a team of writers on a drama or sitcom which generated steady work.  Breaking work into small segments and hiring workers for only those jobs is a factor across the economy; organized labor is trying to respond.  We note this is a factor in the delivery industry as well.
• Title 42, which has allowed immigration officials to turn away potential immigrants and asylum seekers due to the pandemic, will expire on May 11. The government is moving 1500 troops to assist processers and help secure the border.  The expiry is expected to increase flows to the border and is not just a political problem for the White House, but it will also affect the southwestern border states as they cope with the increased flow.
• Drought is reducing the water levels of the Panama Canal, forcing vessels to reduce their cargo to transverse the waterway.

 China News:  We are monitoring recent changes to China’s national security laws which are affecting Western firms.  And Florida is joining other states in restricting the foreign purchasing of real estate.

• Governments have multiple policy goals. In particular, there can be a tension between economic growth and national security which is especially evident in foreign investment.  In our Weekly Energy Update, we have regularly reported on such tensions rising as Chinese EV battery firms look to make investments in the U.S.  Given China’s lead in this area, it makes economic sense to use their technology.  However, given national security concerns, we should avoid such endeavors.  Recently, China issued a new national security law, effective July 1, which is so broad and vague that just about anything (perhaps even reporting on the economy) could be seen as violating the law.  We will have more to say on this in the coming weeks, but in the meantime, there are reports suggesting that incoming foreign direct investment into China is waning and this decline may be tied to these new regulations.
• When a nation runs current account deficits, it must fund them via a capital account surplus. The dollar’s reserve currency status essentially requires the U.S. to run a current account deficit, which means foreigners have dollars they need to invest in the U.S.  Most of the time, those dollars flow into Treasuries,[1] but, foreigners sometimes prefer other investments.  Real estate is popular for numerous reasons.  Wealthy foreigners may want a place in the U.S. if they need to move quickly.  U.S. farmland has attracted foreign buyers.[2]  Florida has introduced legislation to restrict and regulate “hostile nations” from purchasing real estate in the Sunshine State.  Florida has been a popular destination for foreign capital flight, especially from South America.  There are concerns the legislation may to too broad and introduce unnecessary restrictions.

 International News:  We update the Ukraine War, we have a new head of the World Bank, and England holds local elections.

• The day after an apparent drone attack on the Kremlin, we still aren’t sure who is responsible. Russia is blaming Ukraine for the attack, calling it an assassination attempt.  President Zelensky denies the claim.  If Ukraine was behind the attack, it didn’t signal the action to the U.S.  If Ukraine was responsible, it was ill-advised as it is unlikely that such an attack would be successful, and it would open the possibility for Russia to retaliate in kind.  This is why some analysts are arguing it was a “false flag” operation, made by the Russians themselves.  Or, it could have been elements within Russia, either trying to eliminate Putin, or making the feeble attack to trigger a massive, and perhaps unconventional response.  We will continue to monitor the situation, but we do doubt it was a Ukrainian operation.
• NATO is warning members that Russia may be targeting undersea pipelines and cables. Intelligence officials say Russia is actively mapping these assets.
• An op-ed in the Atlantic makes the case for overwhelming support of the upcoming Ukraine offensive. We note the U.S. announced additional support.
• Zelensky is visiting the Hague
• Ajay Banga has been confirmed as the president of the World Bank.
• England holds local elections today, the first major test for PM Sunak.
• The civil conflict in Sudan is clearly a tragedy. Wars often expose wider vulnerabilities.  It turns out that the country is the world’s primary supplier of gum arabic, which is used as a thickener and stabilizer in numerous food products.  Currently, suppliers are using current inventories but if the conflict continues, it could become a problem.

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[1] Which is one of the reasons why a debt ceiling default is so risky.

[2] Chinese buyers of Missouri farmland has been a “hot button” issue, for example.

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