by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning!  It’s a mixed market this morning after a rough day yesterday.  The dollar and interest rates are lower, while S&P futures were higher but have seen gains erode as the morning wears on.

In today’s Comment, we open with President Biden’s announcement of his second and last campaign.  From there, we move to financial news, with a focus on the banking system (again).  China news is next (spoiler alert—Xi has talked to Zelensky).  International news comes after, and we close with economic news.

Biden’s Last Campaign:  As widely anticipated, President Biden formally announced he is running for a second term.  Although polling shows little enthusiasm for this news, there isn’t really an obvious alternative for the Democrats at this point.  Beyond the spoiler candidate of Robert Kennedy, we don’t expect a serious challenge to this nomination.  What is getting a good deal of focus is the president’s decision to keep Kamala Harris as this running mate.  Harris has had a rocky tenure as VP and given Biden’s advance age, there is a higher-than-normal chance she could become president if Biden is reelected.  Usually, the VP candidate doesn’t garner this amount of attention, but that doesn’t appear to be the case for now.

Financial News:  First Republic Bank (FRC, $8.10) is in trouble and Microsoft’s purchase of Activision has been scotched.  We also note the curious case of one-month T-bill yields.

• Equity markets were rocked yesterday as FRC shares plummeted after the bank released its Q1 results. The loss of $100 billion of deposits is what raised fears about the soundness of the bank.  There are clear worries about the ability of the bank to continue operations.  Essentially, the bank is holding assets that have fallen in value due to rising interest rates and is facing a jump in funding costs.  The bank is attempting to sell off assets (although it will probably be at a loss), but will likely need some sort of government support to remain in business.  Although this news has rekindled worries about the banking system, we note that this bank is part of a handful of banks that made aggressive investments in long duration assets.  It doesn’t appear that this practice was widely adopted.  Still, bank runs are psychological events, and we will be watching to see if this news spurs another jump in money market assets.
• Microsoft’s (MSFT, $275.42) acquisition of Activision Blizzard (ATVI, $86.74) has been blocked by U.K. regulators. This would have been Microsoft’s largest acquisition to date.
• In the wake of the Great Financial Crisis, leveraged loans became the preferred vehicle for leveraged buyouts, supplanting high yield bonds and other similar instruments. These leveraged loans were considered senior debt to bonds and so in bankruptcy, the loans tended to be safer.  However, a recent court ruling has upset the “capital stack” which has forced these loans into the pool of more junior debt.  This ruling is upsetting the leveraged loan market and could lead to widening credit spreads.
• Short duration Treasuries tend to be one of the sleeper parts of the financial system. These short-term government obligations are nearly cash like and constitute much of the “plumbing” of the non-bank financial system. Recent behavior in the one- and three-month T-bill market is raising worries.

• Most of the time, the difference in rates between these two instruments is negligible, although the one-month rate has lagged the three-month since early last year. Recently, though, we have seen a sharp divergence between the two rates.  It is generally thought that the drop in one-month yields is tied to the debt ceiling issue (see below).  The government may not be able to issue short-debt as it runs out of borrowing capacity, leading to scarcity.  The market expects the situation to be resolved shortly though, and so three-month rates are holding up.  However, we do worry that this divergence may be signaling something less benign.  We could be seeing a scramble for collateral that is often used in repo transactions, and the drive to secure this collateral is leading to a drop in yields on this short-dated paper.  Given the turmoil in the banking system, a problem in the non-bank system could be a significant worry.  Again, it is hard to separate the debt ceiling issues from other issues, but this is a situation we will be monitoring closely.
• Remember SPACs? It is becoming clear those were a function of easy money.

China News:  As we noted above, Xi has spoken to Zelensky.  China is crawling toward implementing a property tax, and Chancellor Scholz has invited Premier Li to Berlin amid a major revolution in the car market.

• For years, the CPC leadership has considered implementing a property tax. The government recently announced that it has built a real estate register, an important step in applying a property tax.  However, putting a property tax in place is fraught with risk.  First of all, it is widely believed that high ranking CPC officials hold lots of property surreptitiously.  Property is still the preferred method of holding assets in China and party officials who may have acquired cash in unorthodox ways[1] often invest in real estate under false names or under the names of other family members.  A tax would reveal this practice and likely trigger another purge and capital flight.  Second, a tax would almost certainly trigger additional losses in property, something that would hurt the economy.  So, for now, we don’t expect a tax, but at some point, the need for revenue will probably overcome these objections.
• Chancellor Scholz has invited Chinese Premier Li Qiang to Berlin in a bid to ease tensions. We note that something is developing in the auto market that could be a serious problem for Germany’s auto industry.  In fact, there are twin developments underway.  First, Chinese car quality standards have been improving and there is growing evidence that Chinese car companies are boosting export sales.

 (Source:  Brad Setzer)

• This development may be especially problematic for the EU in general and Germany in particular.

• Now, this isn’t just gasoline cars.  EVs sales are growing rapidly, especially in China, and given China’s dominance in battery production and rare earths, Chinese automakers have a strong advantage in this area.  German automakers have been slower to adopt EVs and could face an onslaught of Chinese EV imports.
• Although French President Macron’s recent comments on EU relations with China have been widely panned, he may not be as much of an outlier as portrayed. The U.K. foreign secretary gave a speech opposing isolating China, for example.  Although we believe the world is evolving into competing blocs, there will be those who oppose this development, or prefer to work between the blocs to maintain the benefits of wider trade.
• China’s development model was based on investment and exports. This model of development isn’t unique to China as Japan and Germany used it after WWII, and to some extent, the U.S. did too, from 1870 to 1930.  Once a certain level of development is achieved, the model ceases to work, because at some point, diminishing returns on investment occur and foreign nations tire of absorbing imports.  There are a few paths of transition with the most durable being to shift to domestic consumption (the U.S. path after the Great Depression) or colonization (the U.K. after its industrial revolution or Germany with the Eurozone).  Japan never made the transition and has suffered economic stagnation for three plus decades.  We believe this is where China is now.  The Belt and Road initiative is a form of imperialism and one potential path.  Still, giving up on the development model is hard, and we note that China is rolling out an export promotion plan that will be hard to execute given how fraught relations have become with the West.
• In our 2023 Bi-Weekly Geopolitical Outlook, we noted that a new space race was underway. China has unveiled a three-stage project to have a moon base operational by 2050.  The U.S. sees China’s activities as a serious national security threat.

Markets, Economics and Policy:  There is a glimmer of hope that the House will pass a budget bill.

• The GOP holds a slim five-vote majority in the House, meaning that passing legislation is devilishly hard, given the divided nature of the party. The party needs to pass a budget bill to begin negotiations on the debt ceiling.  Without a budget bill, there is nothing to negotiate, so Speaker McCarthy knows he needs the budget bill to start the process.  He has a bill in place, which would cut spending, and he claims to have the votes to pass it after making a deal with some elements of his caucus.
• There is virtually no chance that this budget will pass into law. The GOP doesn’t control the Senate or the White House.  However, it could become the basis of difficult negotiations and could force the White House to accept some spending cuts.  And, more importantly for markets, it raises the odds of a debt crisis and potentially a temporary default.  If, on the other hand, the budget fails to pass, the House would likely be forced to accept a “clean” increase in the debt ceiling.  Although financial markets expect a resolution, there are concerns growing (see T-bill commentary above) that a disruption is possible.

International News:  South Korea and the U.S. discuss nuclear deterrence, and Sudan remains tense.

• During the Cold War, the U.S. and the U.S.S.R. controlled the bulk of the world’s nuclear weapons, however, they weren’t the only nuclear powers. France, the U.K., and China also had small programs, and Israel has a well-known, but officially denied, program.  For the most part, though, France and the U.K. operated under American doctrine, and China was subservient to the Soviets.  The key to nuclear deterrence is that a nuclear power can never be forced into unconditional surrender, since if a nuclear power fears it is about to fail, it can threaten to launch against its adversary.  Both major nuclear powers had numerous nations under their “nuclear umbrella.”  Although these nations didn’t have warheads themselves, there was a credible threat from an allied nuclear power that if the umbrella nation were to be invaded, then the nuclear power would prevent surrender.  For the nation under the umbrella, there was always a worry that, at the 11th hour, the nuclear power would balk at deployment.
  • South Korea is facing this problem. North Korea has nuclear weapons and likely the ability to deliver them, and the South Korean leadership is increasingly worried that the U.S. will “sacrifice Seoul for San Francisco.”  In other words, if North Korea threatens the South with nukes, or even with conventional invasion, the U.S. won’t use nuclear weapons to protect it, due to worries that America could be bombed by Pyongyang.  Thus, South Korea has suggested it would like nuclear weapons on its soil to counter the North Korean threat.
  • For obvious reasons, the U.S. is reluctant to take that step, but when South Korean President Yoon comes to the U.S. this week, the administration is expected to provide assurances to the South Koreans.
• A shaky ceasefire in Sudan appears to have broken down. Western nations are struggling to evacuate citizens during the continued violence.
• There is growing evidence that the long-awaited Ukraine spring offensive may be about to start. Continued Western support will likely require some degree of success.
• There is a continued debate over Ukraine grain supplies. Neighboring nations are facing a glut of grain from Ukraine, who has struggled to export grain via the Black Sea.  There is a program to export grain, but it looks like it may expire soon.  The EU is trying to stop neighboring nations from freezing imports of grain from Ukraine, but the farm sectors in these nations are reeling from falling prices.
• Quietly, the EU is looking to ease rules on government spending. Although Germany remains reluctant to change regulations, the current rules tend to trigger austerity during recessions.
• We are noting widespread military exercises in the Far East. These appear to involve multiple carrier groups.  Although nothing will likely come of these actions, so many warships floating in a small area does bear watching.
• Japan’s lunar mission failed.

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[1] Otherwise known as bribes.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a leading global investor’s view on the economic implications of climate change and the world’s responses to it (spoiler:  the result is more inflation).  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a big U.S. technology firm’s effort to appease European antitrust regulators and multiple new signs of weakening demand in the U.S.

Global Economics of Climate Change:  In an interview with the Financial Times, the chief of Norway’s massive sovereign wealth fund warned that global warming and the responses to it will contribute to higher price inflation in the coming years.  According to Nicolai Tangen, the changing climate is already disrupting food production, but societies will also face higher costs as they shift their energy mix to greener sources and invest in new infrastructure to mitigate the impact of warming temperatures.

• Here at Confluence, we have long argued that the fracturing of the world into relatively separate geopolitical and economic blocs will tend to push up both inflation and inflation volatility. The key inflation drivers in this world include shortened and less efficient supply chains, the need to invest in new and more resilient production facilities, commodity trade embargos by rival blocs, and insufficient past investment in new sources of energy and other commodities.
• Tangen’s observations suggest the impacts of climate change will be an additional source of inflation, as will slowing birth rates and continued labor shortages in many countries.
• If inflation does remain relatively high as we expect, interest rates will probably also be elevated. For investors, that means bonds are likely entering a long-lasting bear market, while commodities will likely be buoyed.

Global Defense Spending:  The Stockholm International Peace Research Institute reported that global defense spending in 2022 reached an all-time high of $2.24 trillion, up 3.7% from the previous year after stripping out inflation.  Much of the increase reflected a 13% rise in Europe which was related to Russia’s ongoing invasion of Ukraine.  The data is consistent with our view that global fracturing and increased geopolitical tensions will drive higher defense spending in the coming years.

EU Antitrust Regulation:  Microsoft (MSFT, $281.77) has reportedly decided to stop bundling its Teams video conferencing and messaging app with its Office suite of software products in an effort to avoid an official antitrust probe by European Union regulators.  Microsoft will now make Teams an optional additional app that a business can purchase when buying Office.  The decision illustrates how the EU’s tough efforts to regulate big U.S. technology firms have been effective in changing their behavior.

South Korea-Japan:  The South Korean government has reinstated Japan to its “white list” of preferred trading partners, signaling a further cooling of tensions after years of acrimony over Japan’s treatment of Koreans before and during World War II.  The move will significantly cut the red tape South Korean manufacturers must deal with in order to sell to Japan.  Better Japan-Korea trade ties will also bolster U.S. efforts to reduce China’s role in global supply chains and build a close-knit alliance of liberal democracies to thwart China’s geopolitical aggressiveness.

Australia:  Yesterday, the government released a new “defense strategic review” that calls for the country to revamp its armed forces to combat threats faster, farther away, and alongside regional partners amid concerns over China’s rapid military build-up.  For example, the review calls for cutting planned investments in armored vehicles geared for use on Australian territory to free up funds for new, long-range precision strike missiles and nuclear-powered attack submarines under the AUKUS agreement with the U.S. and Britain.

U.S. Diesel Demand:  Wholesale diesel prices have now fallen more than 43% since their peak last summer, reaching approximately $2.53 per gallon.  The big decline largely reflects much weaker trucking activity, which in turn provides more evidence that U.S. economic growth is faltering rapidly ahead of the much-anticipated recession.

U.S. Office Demand:  In another sign of spreading economic weakness, new data shows the decline in office demand is now spreading from the big, expensive coastal cities like New York and San Francisco to cities in the Sun Belt.  Asking rents in the Sun Belt are beginning to stagnate, and floorspace available for sublease is surging.  The data adds to the signs that the economy is weakening ahead of the expected recession.

U.S. Financial Markets:  Official data shows individuals bought $48.4 billion of U.S. Treasury bills through accounts on the Treasury department’s website in March.  Direct individual purchases reportedly have remained strong in April, illustrating how people are pulling deposits out of the banking system in search of higher yields elsewhere.  We continue to believe that this process of “disintermediation” adds to the risk of slower bank lending and even weaker economic growth.

• Separately, medium-sized California lender First Republic Bank (FRC, $16.00) reported yesterday that its customers withdrew more than $100 billion of their deposits amid last month’s banking scare. First Republic’s stock is down some 20% today in pre-market trading.
• Of course, First Republic’s sudden hemorrhaging of deposits mostly reflected customer concerns about the bank’s stability. Nevertheless, the firm said deposits have been continuing to drift lower this month, suggesting that customers continue to look for higher returns in mutual funds, Treasury bills, and the like.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with new data showing how China’s post-pandemic economic reopening is boosting its imports from other countries, including Australia.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a worrying statement by the Chinese ambassador to France and new research suggesting auto dealers’ markups have been a big driver of U.S. inflation.

China-Australia:  New data shows that China’s imports of Australian coking coal quadrupled in March compared with February, while its imports of Australian thermal coal were 14 times higher.  Chinese coal imports from Australia remain far below their levels from early 2020, when Beijing banned a number of Australian products in retaliation for Canberra’s call to investigate China’s role in the coronavirus pandemic.  Nevertheless, the big jump in the coal trade during March shows that a recent trade thaw between the countries is continuing.

• Beijing’s willingness to drop its trade barriers against Australia probably aims to ensure sufficient supply as the Chinese economy recovers from the government’s strict pandemic lockdowns.
• That reflects the extent to which Beijing has prioritized its post-pandemic economic recovery, which is likely to boost global growth and help support the world’s stock markets in the near term. A major beneficiary is likely to be Australia.

China-European Union:  In an interview on French television, Chinese Ambassador Lu Shaye asserted that ex-Soviet republics such as Latvia, Lithuania, and Estonia have no legal status as independent countries.  The three Baltic states, which are all members of the European Union, have summoned their respective Chinese ambassadors to register their complaints.

• The Chinese government has already shown at least tacit support for Russian President Putin’s illegal invasion of Ukraine. Even though the Chinese foreign ministry today disavowed Ambassador Lu’s assertion, the slip of the tongue suggests at least some Chinese officials are willing to also support Putin’s attitude toward the other formerly Soviet states.
• Lu’s statement illustrates the increasingly tight policy coordination between Beijing and Moscow. With China and Russia offering each other mutual support, the statement suggests Western countries may no longer be able to differentiate between the two rogue nations.  Growing China-Russia policy coordination is likely to further exacerbate the fracturing of the world into relatively separate geopolitical and economic blocs.

Russia-Ukraine War:  New reports indicate that Ukrainian forces have now established a sustained presence on the east bank of the Dnipro River for the first time since early in Russia’s invasion.  Meanwhile, Yevgeny Prigozhin, head of the Wagner Group of Russian mercenaries, late last week called for the Russian forces to adopt defensive positions ahead of an expected Ukrainian counteroffensive.

• The reports suggest the Russians may be conserving ammunition or are otherwise paralyzed by the likelihood of new Ukrainian attacks in force with modern Western weapons. If so, it could point to a coming sea change in the conflict, with Ukraine taking the initiative and potentially forcing the Russians to retreat in at least some areas.
• Separately, officials in Crimea stated that Ukrainian drone boats tried to attack the Russian fleet at Sevastopol, but they were repelled before they could cause any damage. Other Russian reports say a Ukrainian drone aircraft crashed in the forests outside Moscow, but it also apparently caused no damage.

Eurozone:  National Bank of Belgium Governor Pierre Wunsch, who sits on the European Central Bank’s rate-setting committee, warned in an interview that investors are underestimating how high Eurozone interest rates will rise.  Since ECB policymakers want to push down both wage growth and price inflation, Wunsch said the ECB’s benchmark short-term interest rate may have to go to 4.00% at some point, slightly above current market expectations for a peak of 3.75% and well above the current rate of 3.00%.

Switzerland:  First-quarter results show customers of Credit Suisse (CS, $0.8912) yanked about $68.6 billion of deposits from the institution during the first quarter, mostly in the run up to its forced takeover by UBS (UBS, $20.29).  The big drop in business illustrates how severely Credit Suisse was damaged amid the fallout from the March banking crisis in the U.S.  The drop in business means Credit Suisse could be an even bigger challenge for UBS to integrate than previously thought.

United States-Sudan:  As rival Sudanese military groups continue to battle for control of the country, the U.S. military evacuated about 100 Americans yesterday, mostly consisting of U.S. Embassy employees.  The United Kingdom, Germany, and France were among the other countries that also evacuated their citizens.

U.S. Price Inflation:  New research from the Bureau of Labor Statistics shows that dealer markups on new cars were a big driver of price inflation over the last three years.  According to the study, those markups alone accounted for 0.3% to 0.7% of the nearly 16% rise in the consumer price index from the end of 2019 to the end of 2022.  The increase in markups was driven by the fact that auto demand surged after customers got their pandemic stimulus checks, while supply-chain snarls reduced supply.

U.S. Retail Industry:  Yesterday, iconic household goods retailer Bed, Bath, and Beyond (BBBY, $0.2935) filed for bankruptcy protection and said that it expects to eventually close all 360 of its Bed Bath & Beyond stores and all 120 of its Buybuy Baby retail locations.  In the meantime, the bankruptcy filing give the company time to conduct going-out-of-business sales at its physical stores and solicit interest from potential buyers for its remaining assets, such as its branding.  If the firm liquidates as expected, it will leave many large retail buildings vacant across the country, dealing another blow to real estate investors.

U.S. Stock Market:  Washington Service, an insider-trading data provider, said more than 1,000 directors and officers at more than 600 publicly traded firms bought their own company’s stock in March, marking the strongest insider buying since last May.  The strong buying activity, despite last month’s bank crisis, suggests that company officials are looking past the bank issues and remain optimistic about the economy and their corporate prospects.

• Separately, CBOE (CBOE, $139.51) today is launching a new version of the VIX index of stock market volatility. The new one-day Volatility Index, or VIX1D,  is designed to measure expected volatility in the S&P 500 over the next day of trading, rather than over the next month like the VIX.
• The launch of the new one-day VIX is consistent with the recent rise of ultra-short option trading, which is not reflected in the traditional VIX.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion about the growing popularity of generative artificial intelligence. Next, we give our thoughts on crypto’s sudden resurgence this year. Lastly, we review the latest developments in the race for clean technology and how they may impact the rivalry between the U.S. and China.

Artificial Intelligence: Five months after the launch of ChatGPT, generative AI has sparked both concerns from lawmakers and the imagination of Big Tech firms.

• The multiple applications of artificial intelligence can potentially disrupt the global economy. The ability of machine-learning algorithms to improve chatbots will make it easier for people to conduct research and develop solutions. Although the products are currently in the early stages of development, there are fears that the technology could have negative side effects. For example, there are concerns that governments could use artificial intelligence to enhance spy capabilities or that the new technology could allow hackers to access company trade secrets.

• That said, the largest tech companies are clamoring to join the generative AI market. The innovation is expected to revolutionize the way businesses generate content. Google (GOOGL, $105.91) is using the technology to create sophisticated ad campaigns. Meanwhile, Amazon (AMZN, $103.81) intends to utilize AI in its web services cloud business. After investing $10 billion into parent company Open AI, Microsoft (MSFT, $286.11) plans to integrate artificial intelligence into its employee platform Viva. We suspect more companies will follow this trend. The year-to-date performance of Microsoft’s stock has outpaced the NASDAQ, 20.58% to 16.10%, in a possible sign that investors are confident in AI’s earning potential.
• AI will likely be a boon to tech companies as long as governments do not stand in the way. These machine learning apps will be able to provide major tech firms with an alternative source of revenue and could improve company efficiency. However, if the technology leads workers to being displaced, lawmakers may implement regulations to limit the use of these algorithms. The biggest winners of the growing popularity of AI may be the semiconductor industry, as special chips will be needed to handle the large amounts of data required for training and interfacing with AI applications.

Is Crypto Cool Again? Investors have flocked to digital currencies despite fears of a regulatory crackdown as some traders view crypto as an alternative safe-haven asset.

• Governments are studying ways to prevent speculation within the crypto market from spreading into the economy. Lawmakers in the European Union just approved a comprehensive regulatory framework for the crypto industry. Meanwhile, the United Kingdom is set to roll out its own set of rules over the next few months. The push to regulate digital currencies is due to concerns that the multi-trillion-dollar industry is rife with scams. During his testimony before Congress, U.S. Security and Exchange Commission Chair Gary Gensler testified that he has never seen an industry so non-compliant with laws.
• Crypto has come back into focus with investors as they look to hedge against exposure to the U.S. dollar. Bitcoin has gotten off to a strong start in 2023. The most actively traded cryptocurrency is up 69.72% since January, significantly outpacing the U.S. dollar index, which is down 1.56% in the same period. The rush into digital currencies is largely related to the speculation that the Fed will end its hiking cycle before it has successfully tamed inflation. Additionally, the strong returns of crypto may be a reflection of investor wariness of U.S. dollar dominance.
• The surge into digital currencies will likely be bumpy but may be suitable for an investor with a substantially high risk tolerance. The strong performance of crypto is likely being driven by a relatively small group of traders. For example, cryptocurrency exchange volume, by month, peaked at over $2 trillion in May 2021, less than a third of the $6.6 trillion in volume during a typical forex trading day in 2019. As a result, the crypto market has a lot of liquidity concerns for those traders looking to invest in digital assets. That said, as the world moves toward deglobalization, we suspect that crypto may benefit as countries look to diversify away from the greenback.

Climate Change Competition: Competition for market share in the renewable tech industry is heating up.

• The Chilean government has announced its plan to nationalize the country’s lithium industry. As the world’s second-largest producer of the metal, Chile has decided to seize control of this key mineral resource to prevent the country’s resources from falling into foreign hands. Chile is the latest country to seek greater control over lithium. Last year, Mexico nationalized its lithium sector, while Zimbabwe banned unprocessed lithium exports. Meanwhile, Indonesia is expected to restrict the export of battery-related commodities. The move to protect key renewable commodities is a reflection of the growing importance that green technology will play over the next few years.
• Additionally, there is a growing turf war among EV automakers as new firms begin looking to expand into foreign markets. On Thursday, Tesla (TSLA, $162.99) announced another round of sweeping price cuts for some of its vehicles as it looks to compete with rivals entering the space. The move was shunned by investors, which led the automaker to adjust the prices of its higher-end vehicles but appears to be a part of the company’s long-run strategy to remain competitive. Meanwhile, motor shows in Shanghai have allowed Chinese automakers to display advancements in vehicle and battery technology. The country is already the world’s biggest market for electric vehicles but there are expectations that Chinese firms may look to sell to other countries. After overtaking Germany in 2022, China is now set to dethrone Japan as the top exporter of cars in terms of volume later this year.
• The fight over clean energy supremacy will play a major role in the rivalry between the U.S. and China. Renewable technology is one area where China performs better than anyone else. Despite being the world’s top carbon emissions emitter, China has been at the forefront of green technology development. The government has invested significantly in its clean technology and is currently better positioned to capitalize on the global pivot toward sustainable energy. Many U.S. renewable companies use Chinese technology in their products, which explains why the Biden administration has been so adamant in its quest for automakers to source materials from firms operating in North America. Although U.S.-China cooperation is ideal for these countries to meet their climate goals, it doesn’t seem likely at this juncture.
  • If we are correct, governments will be reluctant to completely move away from fossil fuels as the green energy transition is going to take longer than lawmakers realize.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion about concerns regarding bank lending. Next, we explain why stubborn inflation has led to greater scrutiny of the central banks. Lastly, we give our thoughts on supply chain efficiencies and the performance of the U.S. dollar as tensions between the U.S. and China continue to escalate.

Lending Sentiment Sours: The latest earnings report has added to concerns that a credit crunch is imminent.

• Despite the four largest banks showing strong earnings in the first quarter of 2023, there are still concerns about the financial system. On Wednesday, Morgan Stanley (MS, $90.25) announced an increase in the company’s provision of credit losses to $234 million, up from $57 million a year ago. The upward revision in its loss expectations is related to concerns about commercial real estate and the overall economy. Goldman Sachs (GS, $335.91) announced that its profits fell 18% in the year’s first three months due to a slump in dealmaking and bond trading. Additionally, Zions Bank (ZION, $32.72), US Bancorp (USB, $36.01), and Citizens Financial Group (CFB, $30.50) each reported declines in deposits, primarily from their wealthier clients.
  • On a positive note, Western Alliance (WAL, $40.35) had an unexpected rebound in deposits.
• Lenders were already tightening their lending standards before March’s SVB debacle. In February, a Fed survey showed that senior loan officers were restricting the amount of credit due to worries about demand weakness and deteriorating loan quality in the final quarter of 2022. The report showed that the net percentage of respondents tightening standards has risen to its highest level since the pandemic. Although the next report on senior loan officer sentiment will not be released until May, the latest Beige Book shows that banks are increasingly reluctant to issue credit given the recent banking crisis. 

• Tightening credit conditions raises the likelihood of a hard landing. The Federal Reserve is expected to raise its target range for interest rates to 5.00%-5.25% in May. The Fed’s decision to increase borrowing costs will raise transaction expenses for bank dealmaking and reduce the value of bond holdings, thus weighing on the profitability of financial institutions. The Fed’s new emergency facility did relieve pressure on the regional banks from needing to lift rates in order to keep borrowers, but banks may still be reluctant to lend due to interest rate uncertainty. As a result, businesses and consumers may be unable to obtain loans when they need them as the economy slows.

It’s Getting Sticky: Stubborn inflation adds to concerns that the central banks are not finished tightening monetary policy.

• The lack of progress toward price stability has hurt the credibility of the central banks. The current board of the Reserve Bank of Australia is set to lose responsibility for setting interest rates because it has come under scrutiny for its poor guidance. The task will be given to a separate board within the RBA that will specialize in managing monetary policy. Several months before it started its most aggressive tightening cycle in three decades, the RBA had stated that a rate hike was unlikely before 2024. Additionally, its inflation forecast failed to detect the acceleration in price pressures. The revamp of the central bank is expected to take place in July of this year after the RBA Act is amended.
• Australia is not the only country with a central bank currently under pressure. The Bank of England, the European Central Bank, and the Fed have all moderated expectations of a pause due to higher-than-expected inflation. Their inability to succeed in reining in price pressures may be related to demand-side inflation. The chart below breaks down inflation by demand, supply, and ambiguous contributors, as determined by the U.S. personal consumption expenditure price index. The series suggests that improvements in the supply chain are the primary drivers in the recent decline of price pressures.
  • The chart may reflect issues with containing service-related inflation figures.

• A tight labor market and a resilient economy have given central banks more leeway to increase benchmark interest rates. The Federal Reserve Beige Book, which provides anecdotal information on economic conditions within regional Fed districts, showed that the country is not currently in a recession. Meanwhile, better-than-expected growth from China has boosted confidence that a global recession is not imminent. These positive signs have forced market participants to push back their expectations of a shift in central bank policy. The latest CME FedWatch Tool now forecasts a Fed pause or cut in interest rates to take place at the September meeting, a month later than investors were predicting last week. Overnight index swaps for the EUR and GBP have also shown a similar trend.
  • That said, we believe that many central banks will be finished hiking rates by the third quarter.

 The Great Decoupling: Supply chain efficiency and the dominance of the U.S. dollar may be casualties as the world splits into separate blocs.

• Companies are accepting that they may have to prioritize supply chain resiliency over efficiency as a way to hedge against geopolitical risks from rising U.S.-China tensions. India appears to be an attractive destination target. A day after opening its first store in India, Apple (AAPL, $167.63) CEO Tim Cook met with Indian Prime Minister Narendra Modi to discuss plans for future investment in the country. The iPhone maker is expected to double or triple its investment expenditure in Asia’s second-biggest economy which could pave the way for more companies to follow suit.
• The decision to broaden supply chains comes amidst heightened rhetoric from the U.S. regarding China. Treasury Secretary Janet Yellen is expected to warn Beijing of a U.S. response if it continues unfair trade practices. Her remarks will reinforce the notion that China and the U.S. are headed for a divorce as the two sides grapple with disagreements over human rights, support for Russia, and accusations of industrial espionage. Although U.S.-China trade increased to an all-time high last year, it is now showing signs of slowing.

Source: Investors.com

• Frictions between the U.S. and China will lead to a decline in the usage of the dollar for global trade. Beijing has already gotten a head start in this process as its foreign exchange reserves have declined from nearly $4 trillion in 2014 to slightly above $3 trillion as of March of this year. Meanwhile, Brazilian President Lula has called on emerging economy countries to reduce their reliance on the U.S. greenback for trade. We suspect countries that align with China will be persuaded to use other currencies for trade, especially if they want access to the world’s second-largest economy. If we are correct, the U.S. dollar should be headed toward a secular decline against other global currencies.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several new initiatives in European economic policy, including subsidies for semiconductor manufacturing and a tax on imports tied to greenhouse gas emissions.  We next review a range of other international and U.S. developments with the potential to affect the financial markets today, including a report on consumer price inflation in Britain that has raised concerns about more interest-rate hikes in the advanced countries.

EU Industrial Policy:  The European Commission formally unveiled its proposed “EU Chips Act” yesterday, which would provide some €43 billion ($47 billion) in subsidies and other assistance for semiconductor manufacturers operating in the EU.  The support represents an attempt to compete with the subsidies in last year’s U.S. Chips Act and could make the EU more self-sufficient in both commoditized and advanced computer chips.  The proposed program also illustrates how it has become more acceptable for governments to use active “industrial policy” to offer protections and backing for certain industries.

EU Environmental Regulation:  The EU parliament approved a first-of-its-kind law yesterday that will tax imports into the bloc based on the greenhouse gases emitted to make them.  The new legislation is designed to make sure that EU manufactured goods are not put at a competitive disadvantage by imports from countries with looser, less costly environmental regulations.

Eurozone Bank Health:  Concerns are growing ahead of the late-June expiration of the European Central Bank’s pandemic bank-support program known as “targeted longer-term refinancing operations,” or TLTROs.  Expiration of the program will require banks in the Eurozone to repay hundreds of billions of euros back to the ECB, replacing them with more costly sources of funding.  Many banks, especially some in Italy, may find it challenging to raise the required liquidity.

United Kingdom:  The March consumer price index came in 10.1% higher than in the same month one year earlier, marking a modest deceleration from the 10.4% rise in the year to February but dashing expectations that inflation would finally fall into single digits.  Excluding the volatile food and energy components, the core CPI in March was up 6.2% on the year, just as it was in February.  The report has rekindled concerns about continued high inflation and additional interest-rate hikes throughout the advanced countries in the coming months, which are weighing on global stock markets so far this morning.

Turkey:  An in-depth article in the Wall Street Journal yesterday linked the massive devastation and loss of life from the country’s February earthquakes to a systemic weakening of building regulations as President Erdoğan relied on construction to goose the economy and boost his political support over the last two decades.

• The article shows that the government’s deliberate easing of building rules and failure to prosecute rule-breaking likely resulted in tens of thousands of building collapses and deaths during the quakes.
• Since Erdoğan is now so closely identified with the construction boom of the last two decades, the scandal about building regulations is a key threat to his re-election prospects when the nation goes to the polls on May 14.

India:  The United Nations Population Division released new data today showing that India has now overtaken China as the world’s most populous country.  Reflecting its higher birth rate, India’s estimated population now stands at 1.428 billion, while China, with its low birth rate, has an estimated population of 1.425 billion.  Meanwhile, technology giant Apple (AAPL, $166.47) opened its first retail store in India yesterday, further expanding its commitment to the country after its recent opening of manufacturing facilities there.  The population data and the move by Apple are being taken as further validation of India’s increasingly attractive investment prospects compared with China.

Mexico:  The Supreme Court invalidated part of a law pushed by President Andrés Manuel López Obrador last year that put the country’s national guard under the military’s control.  The ruling is a strong rebuke to the president’s penchant for putting more government functions under the control of the military and means that the national guard must now remain under civilian control.  While the president argues correctly that the Mexican military is one of the country’s most efficient and competent institutions, putting more government functions in its control raises concerns about transparency and whether the military is being given jobs for which it is poorly equipped, including local policing.

China-Taiwan-United States:  Admiral John Aquilino, the head of U.S. Indo-Pacific command, said in testimony before Congress yesterday that he would not join his fellow top military officials in speculating about when China might try to seize control of Taiwan and spark a war with the U.S.  However, Aquilino did say the Defense Department and defense industry need to accelerate their efforts to boost U.S. military power in order to deter China.  We continue to believe that increased geopolitical frictions will boost global defense spending in the coming years, presenting attractive opportunities for investors, but Aquilino’s statement matches our concern that the U.S. military buildup still appears to lack urgency.

U.S. Financial Regulation:  In testimony before the House Financial Services Committee yesterday, Securities and Exchange Commissioner Gensler was heavily criticized by Republicans for his efforts to crack down on the cryptocurrency markets.  In response, Gensler stated that crypto companies flout regulations worse than any firms he has ever seen.  The exchange points to continued muddled enforcement efforts by the SEC and prolonged political pushback in Congress.

U.S. Media Industry:  Yesterday, Fox Corporation (FOX, $31.20) agreed to pay $787.5 million to settle its legal conflict with Dominion Voting Systems just before the start of a trial on the voting-machine company’s allegations that it was defamed by Fox News after the 2020 presidential election.  The settlement avoids a court case that could have ultimately clarified and tightened the legal responsibilities of media companies in potential defamation cases.  All the same, the big payment to settle the case is a shot over the bow of media firms and could make them more cautious about how they report on political news going forward.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a couple of big-picture views on the global economy and a key commodity market.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including stronger-than-expected economic growth in China and a range of developments in U.S. economic policy.

Global Fracturing and Inflation:  European Central Bank President Lagarde warned in a speech yesterday that if the world continues to fracture into relatively separate geopolitical and economic blocs, global consumer prices would be boosted by about 5% in the short run and about 1% over the long term due to less efficient supply chains.  She also warned that global fracturing would threaten the position of the U.S. dollar as the world’s key reserve currency.

• Clearly, Lagarde has been reading the many analyses Confluence has been publishing on this topic. Her analysis is consistent with our view that as the world breaks into U.S.-led and China-led blocs, shortened supply chains and increased geopolitical tensions will lead to higher costs, increased inflation, and rising interest rates.
• The evolving U.S.-led bloc is likely to look much like today’s group of rich, advanced, highly industrialized countries with a few closely related emerging markets but will have more manufacturing “brought home” to that bloc from China and its bloc. We suspect companies will eventually adjust to this new world, meaning equities and commodities are likely to remain attractive.  However, higher inflation and interest rates will likely contribute to the beginnings of a long-lasting bear market in bonds.

Global Copper Market:  At this week’s World Copper Conference in Santiago, Chile, a key topic of discussion is the worsening outlook for the metal’s supply/demand balance.  Driven by new construction and soaring use in green technologies such as electric vehicles, global demand for copper is expected to rise to 36.6 million metric tons per year by 2031.  However, because of lackluster investment at the present time, which is driven in part by restrictions in South America, global output is expected to grow slowly to just 30.1 million metric tons per year.

• Analysts expect the supply shortfall to drive prices much higher over the coming years.
• We agree that tepid investment today is likely to boost prices for a range of commodities in the coming years. We think geopolitical tensions and the fracturing of the world into relatively separate blocs will also tend to drive values higher.  We therefore continue to believe commodities will offer attractive returns in the coming years, once we get through any short-term softness due to the impending recession in the U.S.

China:  As we flagged in our Comment yesterday, first-quarter gross domestic product was up a relatively healthy 4.5% from the same period one year earlier, beating expectations and marking a strong acceleration from the growth of 2.2% in the year ending in the fourth quarter of 2022.  The acceleration in the first quarter came largely from stronger consumption spending as the economy continues to recover from its previous Zero-COVID restrictions, but it also benefited from increased government infrastructure investment and rebounding exports.

• China’s growth in the first quarter puts it on track to meet the government’s target of having GDP expand about 5% in 2023.
• The rebound in Chinese GDP growth will likely give a boost to global economic activity and commodity prices, at least to the extent that it relies on investment and imports. However, some economists are concerned that rebounding consumption spending, especially on services, will mute the benefit of economic growth outside of China.

Germany:  The country’s last three nuclear electricity plants were shut off over the weekend pursuant to a law passed two decades ago and strong anti-nuclear protests over the last decade.  The shutdowns come despite an energy crunch touched off by Russia’s invasion of Ukraine last year.  The shutdowns are expected to leave German and European energy supplies more volatile and precarious going into the future.

Saudi Arabia-Iran-Israel:  Reflecting the recent China-facilitated rapprochement between Iran and Saudi Arabia, the Iranian government said it has invited Saudi King Salman bin Abdulaziz to visit the country in the near future.  The invitation comes as Iranian President Ebrahim Raisi has already accepted an invitation to visit Saudi Arabia, although no date has been set for his visit.  Meanwhile, senior Saudi officials on Sunday met with leaders of the Palestinian militant group Hamas, which is backed by Iran, to discuss renewing their ties for the first time since they were put on ice in 2007.

• The rapprochement with Iran threatens Israel’s strategy of strengthening ties with the Saudis and other Sunni Muslim states to form a bulwark against Shiite Muslim Iran in the Persian Gulf region.
• Saudi Arabia’s renewed ties with Hamas also threaten to unleash new terrorist attacks directly on Israel.

Ecuador:  In an interview, conservative President Guillermo Lasso said he would dissolve the country’s congress and call new elections if the leftist-dominated legislature tries to impeach him on what he called trumped-up corruption charges.  However, opinion polls indicate Lasso only has the support of about 22% of the population, and it appears his days in office are numbered.  The result could be a constitutional crisis and lead to further political instability in Ecuador, potentially leaving it as yet another major Latin American commodity producer taken over by the left.

China-United States:  Yesterday, U.S. prosecutors charged dozens of Chinese security officers and their associates in absentia for running thousands of fake social-media personas to discredit U.S. policies.  They also arrested and charged two ethnic Chinese for setting up a secret Chinese police station in New York City to harass Chinese dissidents.  Along with last week’s revelation that a former U.S. Navy sailor helped disseminate classified documents posted online by an Air National Guardsman, yesterday’s charges highlight how rogue-state officials and their domestic sympathizers are active in U.S. cyberspace and on U.S. territory.  Reports today indicate the FBI is investigating the Navy sailor involved in the further dissemination of the leaked intel documents.

• Naturally, that realization is likely to further worsen U.S. relations with China and Russia.
• It could also potentially spark moves to root out any domestic “fifth column” of China and Russia sympathizers.

U.S. Fiscal Policy:  Even though House Speaker McCarthy hasn’t gotten the Republicans he leads to agree on a budget proposal for the upcoming federal fiscal year, he said in a speech yesterday that the party would soon pass legislation linking a rise in the federal debt limit to cuts in spending.  According to McCarthy, the majority of Republicans would only agree to a rise in the debt limit if it were linked to a limit on federal spending, a claw back of COVID-19 aid, and a requirement that people work to receive federal benefits.

• President Biden has signaled that he is willing to negotiate on federal spending levels, but he rejects linking those talks to the debt limit.
• McCarthy’s speech is a reminder that federal fiscal policy and the risk of a default remain a risk for the financial markets, even if the most likely scenario is a last-minute compromise.

U.S. Environmental Policy:  The Treasury Department yesterday released an updated list of electric vehicle models that qualify for tax credits under last year’s Inflation Reduction Act.  Because of tightened rules on pricing and the country of origin for key components, the list now includes just 16 models from U.S. brands.  The pared down list illustrates the impact of the law’s preference for North American-made vehicles and technology, which has strained relations between the U.S. and some of its allies.

U.S. Banking Regulation:  New research drawing on public filings indicates that most U.S. banks haven’t been hedging their exposure to rising interest rates.  For example, the research shows that only about 6% of bank assets have recently been hedged with interest-rate swaps.  The findings suggest that the rise in interest rates that helped bring down two key banks last month could have also left other institutions at risk.  We continue to watch carefully for signs that other banks could be in trouble or that financial stresses will crimp bank lending and help push the economy into recession.

U.S. Labor Market:  Privately held consulting giants McKinsey & Co. and Bain & Co. are reportedly delaying the start dates for new MBA hires to as late as April 2024, in some cases paying them thousands of dollars to work for a charity for a few months before starting their consulting jobs.

• The actions by McKinsey and Bain reflect concerns about an impending recession and slowdown in business. They also serve as a reminder that as recession nears, demand will likely soften even for expensive workers in business services.
• Separately, UPS (UPS, $193.29) and the Teamsters union begin negotiations this week for a new five-year contract covering some 330,000 employees before the current contract expires on July 31. Because the number of covered employees is so large, the negotiations and resulting contract could have significant implications for overall U.S. wage rates and labor market conditions.

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