by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are mixed this morning, and the Las Vegas Aces are the new WNBA champions. Today’s Comment begins with our thoughts on why investors will be paying close attention to Powell’s speech today. Next, we explain why investors have preferred commodities over bonds, how China and Russia are teaming up to woo countries in the Middle East, and we conclude with other news. As usual, our report also provides an overview of the latest domestic and international data releases.

Investors All Ears: After months of convincing the market that he will not shy away from the inflation mandate, Powell will now need to assure investors that the Fed will not overdo it.

• Fed Chair Jerome Powell is set to speak at the Economics Club of New York today. Investors will closely follow his remarks to gauge the Federal Reserve’s appetite for more rate hikes as it seeks to bring inflation back to its 2% target. Strong economic data, such as retail sales and September’s job numbers, have led to speculation that the economy may be running too hot for comfort for members of the Federal Open Market Committee. These concerns have caused a steady rise in Treasury yields, with 10-year bonds now approaching 5% for the first time since 2006.
• Momentum is growing for a pause in Fed rate hikes. The Beige Book released on Wednesday showed that economic activity is slowing in the United States. Investors who are betting on a slowdown saw this as a positive, as it could deter policymakers from raising rates further. Additionally, dovish comments from Federal Reserve Board member Chris Waller and New York Fed President John Williams have boosted optimism that the Fed may be nearing the end of its hiking cycle, as higher interest rates in long-duration Treasuries have convinced some policymakers that they have done their job.
• 

• Powell’s speech is unlikely to change the Fed’s “higher for longer” mantra, which will likely carry over into 2024. The latest forecast from the CME FedWatch Tool suggests a more than 60% chance that the Fed will keep rates unchanged through the end of the year and then cut rates by a combined 50 basis points in 2024, which is roughly in line with the latest FOMC dot plots. We expect policymakers to cut rates once in June and once again after the election to avoid being accused of partisanship, but a severe recession could lead the central bank to act more aggressively.

Gold Is Back? U.S. government bonds have lost their appeal as a safe-haven asset, as investors are more worried about tighter monetary policy and political uncertainty.

• Oil prices have surged 7.9% since the start of the Israeli-Hamas conflict on October 7. The rally in fuel prices reflects investor fears that expanding strife in the Middle East will lead to supply disruptions and trade tensions. Following reports of the bombing of a Gaza hospital, Iran has called on Middle Eastern countries to halt oil shipments to Israel. Meanwhile, hopes of a diplomatic resolution were dashed after Jordan and Egypt refused to meet with President Biden following the atrocity. While U.S. intelligence suggests that Israel was not responsible for the bombing, it is unclear whether other countries agree.
• Despite a historical preference for 10-year Treasury notes during crises, investors have opted for gold instead in response to the conflict in the Middle East. The yield on the 10-year U.S. Treasury note jumped 10 bps since the outbreak of war, compared with a decline of 25 bps following the Silicon Valley Bank collapse earlier this year. Some of this discrepancy may be related to Fed policy expectations. A war in the Middle East could increase oil prices, leading to inflation; thus, prompting the policymakers to raise interest rates. Meanwhile, the drop in yields following SVB’s collapse was due to optimism that the Fed would back out of its hiking cycle as a way to prevent further damage to the economy.

• In addition to the uncertainty over Fed policy, congressional dysfunction has also weighed on bond prices. On Wednesday, the House failed for the third time to nominate a speaker, erasing some of the intraday gain in 10-year bonds after the release of the Beige book. The situation may improve over the next few days, as bipartisan support has emerged for empowering Speaker Pro Tempore Patrick McHenry to enable Congress to resume budget talks and send aid to Israel and Ukraine. While electing a House speaker would calm nerves, investors are likely to wait for the Fed to assure them that its policy path has not changed before they return to government bonds.

Closer Than Ever? Russia and China have formed closer ties as they try to recruit more countries to join their bloc against the West.

• Russian President Vladimir Putin and his Chinese counterpart Xi Jinping met on Wednesday at the Belt and Road Initiative forum. The two leaders reaffirmed their “no limits partnership” and sought to portray themselves as alternatives to the West. Unlike the United States and Europe, they have yet to condemn the Hamas attack and have instead criticized Israel’s response. There is speculation that Putin and Xi are using the Middle East conflict to win over developing countries with a history of colonialism. Saudi Arabia is likely their biggest target, as they can leverage the Saudis’ relationship with the Palestinians to draw them into their orbit.
• Over the past few years, Xi Jinping has been trying to convince countries within the Middle East to become less dependent on the West for economic support by expanding China’s investment reach through the Belt and Road Initiative (BRI) and through the expanding the members of its BRICS group. By increasing its economic reach, it has been able to build new relationships with countries within the Middle East and has become a major player in the region. In March, China was able to broker a deal between Iran and Saudi Arabia, ending their long-standing feud. Meanwhile, Egypt issued its first Panda bonds earlier this week, taking advantage of Chinese credit markets.

• The battle for influence in the Middle East is still tilted in the West’s favor, but Russia and China are making gains. China is now the largest trading partner for most countries in the region, and its BRI is expected to increase its investment in the region. If Middle Eastern countries embrace Beijing, the United States will need to spend more resources to keep its allies in the region on its side. This could push Washington to delay its pivot toward Asia. Over time, competition among major powers for influence in the Middle East and other emerging markets could make equities in those regions more attractive.

Other News: Household wealth soared during the pandemic. The increase explains why the economy has been more resilient even as borrowing costs soared over the last few months.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news of further U.S. restrictions on the sales of advanced semiconductors and related equipment and services to China—a move that is sure to put additional strains on the U.S.-China relationship and keep investors on edge.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the Israel-Hamas conflict, sticky consumer price inflation in the U.K., and the prospect for new financial regulation in the U.S.

United States-China:  As we flagged in our Comment on Monday, the Biden administration issued new rules yesterday to further limit the sales of advanced semiconductors and related equipment and services to China.  According to the administration, the new rules are designed to maintain the effectiveness of the draconian controls issued by the administration in October 2022 and August 2023.  They are also designed to close loopholes in those rules and ensure they remain durable over time.  Overall, the evolving controls aim to keep Beijing from gaining a military edge from artificial intelligence and other advanced information technologies.

• The new rules will ban the export of additional types of semiconductor manufacturing equipment to China and expand the licensing requirements for shipping such equipment.
• It appears that the tightened requirements will be especially hard-hitting for high-flying chipmaker Nvidia (NVDA, $439.38), whose stock price has surged this year on the strength of its advanced chips used in artificial intelligence applications. Last year, Nvidia began offering Chinese customers chips specifically designed to get around the original controls, but these new rules appear to close off that option.
• As we noted on Monday, the new controls not only update the technology-transfer rules issued last year, but they also supplement the tariffs and other broad trade barriers against China that were imposed by the Trump administration, which largely remain in place.
• As we have written many times before, the clampdown on bilateral trade, investment, and technology flows are a symptom of the worsening tensions between the U.S. geopolitical bloc and the China/Russia bloc. Those tensions, and the potential for new bilateral restrictions, continue to pose risks for investors.

United States-Marshal Islands-China:  In another move to hinder China’s growing military and political power in the southwestern Pacific Ocean, the U.S. this week struck a deal with the Marshal Islands to renew the two countries’ longstanding security relationship.  Under the updated pact, the U.S. will provide $2.3 billion in aid to the archipelago over the next 20 years in return for continued military access to its land, air, and maritime territories.  The new deal follows the renewal of similar pacts with Palau and Micronesia earlier this year.

China:  Key sectors in the country’s domestic economy continue to falter, with major real estate developer Country Garden (CTRYY, $2.39) today apparently missing its final deadline to make a $15.4-million interest payment on one of its dollar-denominated bonds.  That’s likely to spark a wave of cross-defaults on the rest of its $15.2 billion or so of international bonds and loans.  In turn, that will likely further undermine confidence in China’s huge property sector, hold back investment, and weigh on the country’s asset values.

• Despite Country Garden’s default, regular data out today showed some modest near-term improvement in economic activity. According to official data, gross domestic product rose by a seasonally adjusted 1.3% in the third quarter, after a rise of just 0.8% in the second quarter.  GDP in the third quarter was up 4.9% from the same period one year earlier.
• In September, consumer lending jumped by approximately $44 billion, suggesting an improvement in mortgage lending and home purchases. The growth in retail sales also accelerated, while the unemployment rate ticked down slightly.

Israel-Hamas:  Last night, Jordan canceled the planned Wednesday summit between President Biden and regional leaders after an explosion reportedly killed hundreds of civilians at a hospital in Gaza.  Both Israel and Palestinian leaders in Gaza blamed each other for the apparent missile strike.  In addition, Muslim countries ranging from Turkey to Saudi Arabia pinned the blame on Israel, and Palestinians in the West Bank launched massive protest demonstrations, all of which illustrate the risk that the event will lead to broader regional hostilities.

• Upon his arrival in Israel today, President Biden said he believes the Palestinians were responsible for the blast and suggested the U.S. has at least some intelligence pointing in that direction.
• Some observers have suggested that the hospital blast could have come from a misfired Palestinian rocket. Hamas militants also have a reputation for hiding weapons in hospitals and using civilians as human shields.
• In any case, Biden’s continued strong support for Israel is probably working for him in political terms right now, both internationally and domestically. He is therefore likely to keep supporting Israel in the near term.  Nevertheless, the risk of the conflict broadening out to the rest of the region remains significant.

United Kingdom:  The September consumer price index was up 6.7% from the same month one year earlier, matching the rise in the year to August and dashing expectations that the inflation rate would decline a bit to 6.6%.  Excluding the volatile food and energy categories, the September core CPI was up just 6.1%, decelerating from the 6.2% rise in the year to August, but the report was still seen as encouragement for the Bank of England to keep hiking interest rates.

U.S. Bond Market:  Yesterday’s strong report on September retail sales prompted investors to bail out of bonds, boosting the yield on the two-year Treasury note to a 17-year high of 5.20%.  The yield on the 10-year Treasury note rose to 4.85%, also near its highest level since 2006.  The retail report has rekindled fears that continuing supply-chain disruptions, labor shortages, rising wage rates, and high demand will keep price inflation high and prompt the Federal Reserve to keep hiking interest rates.

U.S. Financial Market Regulation:  The Fed yesterday said it will hold a meeting next week on whether to revise its cap on the fees that merchants pay to debit card issuers when customers make purchases with their cards.  Under the Fed’s current rules, merchants pay large card issuers up to $0.21 plus 0.05% of the transaction amount, but the policymakers are considering lowering that cap.  If the Fed proposes to cut the fees, it would modestly reduce costs for sellers but would likely generate strong pushback by card issuers and some members of Congress.

U.S. Labor Market:  In an interview with the Financial Times, a member of the White House Council of Economic Advisors predicted that the current boom in U.S. factory construction, which we’ve been reporting on, will produce further gains in well-paid manufacturing jobs.  Indeed, the employment report for September showed the number of U.S. manufacturing jobs has surpassed 13 million for the first time since 2008.  Nevertheless, we would note that manufacturing employment as a share of total nonfarm payrolls hasn’t yet started to turn up.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a discussion of how difficult it is for countries to abandon the U.S. dollar for international trade.  We next review a range of other international and U.S. news with the potential to affect the financial markets today, including new geopolitical tensions between China and Canada and a survey showing economists now see less risk of a near-term recession in the U.S.

Russia-India-U.S. Dollar:  As India’s state-owned refiners continue to gorge on cheap Russian crude oil, New Delhi has reportedly clamped down on their use of Chinese renminbi (CNY) to pay for some shipments that otherwise would be subject to Western sanctions.  Although China and other members of its geopolitical bloc are trying to reduce their use of the U.S. dollar, prompting some Western observers to predict a massive depreciation in the greenback, the Indian clampdown on CNY payments illustrates several hurdles to replacing the dollar:

• While Indian buyers initially paid for some shipments in rupees (INR), Russian sellers pushed back on the practice after realizing there was little they could buy with their growing rupee stockpiles.
• Russian sellers and Indian buyers have experimented with a number of different currencies for payment, including Emirati dirhams (AED), but the market hasn’t been able to agree on a dollar alternative.
• Although New Delhi has implied that its clampdown on CNY payments is related to their extra cost, the reality is that India probably wants to avoid anything that would buttress Chinese financial power and influence.

China-Canada:  Ottawa has issued a protest saying Chinese fighter jets harassed a Canadian surveillance plane that was flying in international airspace to help enforce UN sanctions against North Korea.  One of the Chinese jets reportedly came within five meters of the Canadian aircraft.  The incident serves as a reminder that the Chinese military is becoming more aggressive, not only against U.S. forces, but also the forces of its allies.

Israel-Hamas:  Ahead of a summit tomorrow involving President Biden and Middle Eastern leaders, Jordan’s King Abdullah warned that the region is at the edge of an “abyss” because of the conflict between Israel and the Gaza-based terrorist group Hamas.  Abdullah called for humanitarian aid to the civilian population in Gaza, which Israel is besieging, but he insisted Jordan and Egypt would not accept waves of Palestinian refugees who might never leave.  By emphasizing the way massive refugee waves could destabilize Jordan and Egypt, the king’s statement helps clarify the many ways the conflict could spread and cause problems throughout the Middle East.

Russia-Ukraine:  While the world has been focused on the Israel-Hamas conflict over the last week, Russian forces have launched a large-scale attack to seize the small city of Avdiivka in eastern Ukraine.  The Russian forces have made some minimal gains in the area, but the latest reports suggest they’ve done so at a high cost in both equipment and personnel.  If the attack aimed to swing momentum of the war back to Russia, it appears to have failed.  In the near term, at least, that suggests the Russians will fall back on their previous stance of defending territory and sending waves of missiles, drones, and artillery against the Ukrainian power grid over the winter.

United Kingdom:  New data shows average total pay in the three months ended in August was up 8.1% from the same period one year earlier, decelerating modestly from the 8.5% gain in the three months ended in July.  Excluding bonuses, the annual pay gain in the three months to August slowed to 7.8% from 7.9% in the previous period.

• The annual gains remain close to record highs, but their deceleration could point to lower price pressures in the coming months and a lesser need for the Bank of England to keep raising interest rates.
• In response, British stock values are up about 0.4% so far today, while the pound (GBP) has fallen 0.6% to $1.2147.

Italy:  The right-wing government of Prime Minister Giorgia Meloni said its budget for 2024 will include 24 billion EUR ($25.3 billion) in tax cuts and public-sector pay hikes to spur consumption and boost economic growth, despite investors’ concerns about Italy’s fiscal balance.

• The announcement follows the government’s decision last month to allow the fiscal deficit to rise to 4.3% of gross domestic product, versus its April target of 3.7% and the eurozone’s standard of 3.0%.
• The spread between Italian government bond yields and German yields widened slightly on the news to 4.77%.

Poland:  Final figures from Sunday’s elections confirm that the business-friendly, pro-EU former Prime Minister Donald Tusk and his Civic Platform and allied parties will have 248 of the 460 seats in the next parliament.  Since the ruling right-wing Law and Justice Party won the most votes in the election, it will get first crack at forming a government.  However, the seat count for Tusk’s coalition makes it clear that he will regain power.

• Tusk’s return to power in Poland will likely mark a return to more orthodox economic and social policies and better relations with EU leaders in Brussels.
• That will help accelerate an important but little-noticed shift in the EU, i.e., the growing power and influence of countries in the eastern part of the EU.

United States-Venezuela:  U.S. and Venezuelan officials have reportedly struck a deal in which Caracas will allow more competitive, monitored elections in return for the U.S. partially lifting its sanctions on the authoritarian country’s oil industry.  The deal illustrates how the Biden administration is looking for any way it can to boost global oil supplies and hold down energy costs.  However, it’s important to note that even with a fuller lifting of sanctions, the Venezuelans probably can’t boost their oil output significantly in the near term.

U.S. Retirement System:  The latest Global Pension Index from Mercer and the CFA Institute ranks the quality of the U.S. retirement system just 22^nd out of the 47 countries studied.  The study ranks the U.S. system just below those of Kazakhstan and Hong Kong, and just above those of the United Arab Emirates and Colombia.  The study finds that the U.S. system—based on corporate pensions, 401(k) accounts, and individual retirement accounts—provides uneven coverage and is subject to insolvency problems.  (Of course, one way that individuals can try to overcome those challenges is simply to save and invest more.)

U.S. Economic Growth:  The latest survey of economists in the Wall Street Journal showed the average probability of a recession within the next year has fallen to 48%, down from 54% in July.  On average, the surveyed economists now also believe that the Federal Reserve is done raising interest rates, and that consumer price inflation will continue to cool.

• We also believe that the risk of recession has fallen to some extent, that the Fed is at least close to ending its rate-hiking campaign, and that inflation will moderate further in the near term.
• However, even if the economy doesn’t fall into an outright contraction, growth is cooling noticeably, creating a “slow bicycle economy” in which the momentum is so weak that an unexpected crisis could tip it into a downturn.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

With last week’s events in Israel serving as a reminder of how the world is becoming more violent and chaotic as the post-Cold War era comes to an end, today’s Comment opens with an update on the all-important risk of a Chinese move to take control over Taiwan.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more signs that the Bank of Japan may soon intervene to support the yen (JPY) and the latest developments in the U.S. labor market.

China-Taiwan:  Kyodo News recently carried a nice summary of the strategy options Beijing is likely considering to eventually achieve its long-held goal of taking control over Taiwan.  Consistent with our view, the article discounts the likelihood that the People’s Liberation Army would launch an amphibious invasion of the island.  Rather, the PLA’s recent exercises suggest it would establish a naval, air, and missile “quarantine” around Taiwan to cut the island off from needed supplies and pressure its government to submit to Chinese authority.

• Rather than calling the operation a “blockade,” which is an act of war against a foreign country, Beijing would say it is merely controlling access to its own territory. That assertion would aim to make it politically difficult for the U.S., Japan, South Korea, and their allies to intervene.
  • Beijing could also start off with only occasional or targeted quarantine actions, perhaps using coast guard forces on ostensibly “law enforcement” missions.
  • The goal for such actions would be to raise shipping insurance costs and otherwise discourage maritime traffic to the island without necessarily sparking a military response from the U.S. and its allies.
• A major risk for Beijing is that a quarantine strategy would allow the U.S. and its allies time to build up their forces in the region and develop a strategy to defeat the quarantine. Nevertheless, given China’s much closer proximity to Taiwan, it would find it much easier to sustain itself in a long stand-off.
  • Even if the U.S. and its allies rapidly build up their forces and use their superior technology to sink the PLA Navy and down the PLA Air Force, China’s trump card is probably its enormous missile arsenal.
  • Even after losing many ships and aircraft, China could saturate Taiwan and its nearby shipping corridors with ground-attack and anti-ship missiles to keep the quarantine in place. Chinese missiles could also threaten U.S. and allied military bases in places like Okinawa, the Philippines, and Guam.  Taking out those missiles would require a U.S. or allied attack on Chinese territory, potentially sparking a nuclear war.
• In sum, Beijing has big strategic and tactical advantages around Taiwan, along with regional military superiority. If Washington wants to meet its security commitment to the island, maintain the U.S. alliance structure, and protect U.S. interests, the U.S. and allied militaries will have to be rebuild to a scale sufficient to deter China from throwing its military weight around.
  • As we have noted before, Western defense spending will likely rise for years, and domestic reindustrialization will probably continue.
  • That will likely create important new investment opportunities in the industrial and defense-related technology sectors.

United States-China:  White House officials say President Biden will issue new rules this week to further limit the sale of advanced semiconductors and related equipment to China.  The new rules will supplement the draconian controls issued by the administration in October 2022 and in August 2023, which aim to keep Beijing from gaining a military edge from artificial intelligence and other advanced information technologies.

• The Biden administration’s technology controls also supplement the tariffs and other broad trade barriers against China that were imposed by the Trump administration and largely remain in place.
• As we have written so many times before, the clampdown on bilateral trade, investment, and technology flows are symptoms of the worsening tensions between the U.S. geopolitical bloc and the China/Russia bloc. Those tensions, and the potential for new bilateral restrictions, continue to pose risks for investors.

Japan-China:  In a sign the Japanese government is becoming more concerned about Chinese aggression in the near term, Defense Minister Kihara said Japan will start buying the U.S.’s advanced Tomahawk cruise missiles in its fiscal year starting March 2025, one year earlier than previously planned.  To further underscore Japan’s urgency to get the missiles sooner rather than later, the earlier acquisition date requires Japan to accept certain compromises in capabilities.  The FY 2025 purchase means the first 200 missiles bought will be current Tomahawk models, while only the remaining 200 missiles, to be bought in FY 2028 and later, will be the latest Block 4 model.

Japan:  At a Group of 20 meeting on Friday, Finance Minister Suzuki warned that Tokyo may need to intervene to support the yen (JPY) as tightening monetary policy around the world continues to drive the currency lower.  The statement, which followed a separate warning earlier this month, came as the JPY depreciated anew to close the week at 149.56 per dollar ($0.00669), very close to the rate of 150.00 per dollar ($0.00667) that has long been seen as the point at which Japan would step in to support the currency.

New Zealand:  In parliamentary elections over the weekend, the center-right National Party came in first with about 39% of the vote, followed by its preferred coalition partner, the ACT Party, with 9%.  That should allow NP leader and former business executive Christopher Luxon to become prime minister as head of a government consisting of NP, ACT, and possibly the populist New Zealand First Party.

• The new right-wing government would replace the center-left Labor Party that has ruled since 2020.
• In his campaign, Luxon said his government would emphasize fighting crime, reducing road congestion, and increasing personal responsibility.

Saudi Arabia-Israel:  Sources say Saudi Arabia has now formally notified the U.S. that it will suspend its negotiations with Israel for normalizing ties between the two countries.  The notification came as Israel continued to prepare for a massive ground attack on Gaza and its Hamas government to retaliate for the big Hamas terrorist attack on Israel last week.  The Saudis’ suspension of normalization talks was probably a top goal for Hamas.

• Separately, Iran warned Israel over the weekend that while it doesn’t want to see further escalation of the conflict between Israel and Hamas, it will intervene if Israel proceeds with a major ground attack on Gaza. Reports also say Iranian-backed Hezbollah fighters in southern Lebanon have stepped up their missile and artillery strikes on Israel in recent days.
• The developments underscore the continuing risk that the conflict will spread. The worst-case scenario would be a regional conflict involving several states, which would likely be very negative for risk assets but positive for the dollar and crude oil.

Poland:  In elections yesterday, the ruling right-wing Law and Justice Party (PiS) came in first with almost 37% of the vote, but that may not provide enough seats in parliament to stay in power, even in coalition with the country’s far-right parties.  If that is borne out in the final count, it would open the door for former Prime Minister Donald Tusk and his Civic Platform Party to return to power.  Since Tusk is known to be business-friendly and pro-European Union, Polish stock prices have surged so far today, as has the Polish currency.

Ecuador:  In a run-off election over the weekend, center-right businessman Daniel Noboa won the presidency with approximately 52% of the vote, beating his leftist rival Luisa González.  Noboa, who is only 35 years old, campaigned on a platform of encouraging foreign investment and creating better employment opportunities for younger workers.

U.S. Monetary Policy:  In an interview with the Financial Times, Chicago FRB President Goolsbee insisted that U.S. price pressures are on a sustainable downtrend, despite fluctuations in the inflation data.  He also said Federal Reserve policymakers are “rapidly approaching” the point where they will shift from discussing the need to raise interest rates further to discussing how long to hold rates at their current high levels.  That is consistent with our view that the Fed’s monetary policy is almost as tight as it will get, but that it may remain tight for some time.

U.S. Labor Market:  Healthcare giant Kaiser Permanente and its striking unions late last week reached a tentative deal on a new labor contract.  We have yet to see details on the agreement, but we note that the workers had been demanding not only higher wages, but also improved staffing at Kaiser’s facilities to improve work conditions.

• Although demand continues to outstrip supply for relatively lesser-skilled workers, hiring for “knowledge workers” in areas like technology, finance, and consulting has fallen.
• As a result, an unusually large proportion of second-year MBA students are still without job offers and are starting to look for positions in other industries.

U.S. Defense Stocks:  The Wall Street Journal today carries a nice summary of the current challenges and future opportunities in defense stocks.  Despite some current headwinds, such as uncertain funding amid the political polarization in Washington, the article echoes our view that longer-term trends toward a more chaotic, tension-filled world will likely be positive for defense stocks going forward (although we think the new, fractured, tension-filled world will also be positive for firms in defense-related technology, energy, mining, and commodities).

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are up slightly, and the Atlanta Braves are out of the playoffs. Today’s Comment starts with our thoughts on the inflation report. We then follow with discussions on rising global borrowing costs, the Polish Parliamentary elections, and provide an update on Hamas/Israel. As usual, our report also provides an overview of the latest domestic and international data releases.

Inflation Losing Momentum? September’s CPI report spooked investors, raising concerns that stubborn price pressures could persist.

• Consumer prices rose 3.7% in September, unchanged from August and above expectations. Treasury yields rose sharply following the report, with the 10-year yield increasing 11 basis points to 4.71% on Thursday. The S&P 500 and Nasdaq Composite fell roughly 1% on the day. The sell-off in financial assets reflects investors’ concerns that the Federal Reserve will continue to tighten monetary policy to combat inflation. The CME FedWatch Tool now projects a 30% chance of another rate hike before the end of the year, up from 25% the day before.
• Despite the market’s negative reaction, the CPI report offers some grounds for optimism about inflation. The surprise increase in shelter prices, which spiked 0.6% last month, was a key contributor to the overall rise in inflation. However, we are skeptical that this trend will continue into next year. The core CPI, which excludes volatile food and energy prices, continued its downward trend, with the year-over-year change falling from 4.3% in August to 4.1% in September. Additionally, if the trend of the past six months continues, inflation is likely to fall below its five-year average within the next few months.

• The Federal Reserve is likely to face turbulence as it works to move core inflation below 4%, which is expected to happen this year. Fed officials are aware of this and will likely plan to hold rates steady before gradually reducing them over time. However, the decision to hike rates again could change if the October and/or November job reports continue to show that the labor market remains strong. As a result, the latest CPI report is unlikely to be enough to shift the sentiment of policymakers, and another rate hike cannot be completely ruled out.

 Global Credit Squeeze: The lack of available liquidity is starting to impact major economies.

• Countries are struggling to cope with rising global interest rates. UBS (UBS, $24.50) warned on Friday that the rapid increase in unsecured personal loans in India raises the likelihood of a rise in defaults. Bank of England Governor Andrew Bailey has warned that U.K. interest rates have risen to “restrictive” levels and that he will be closely monitoring how policy impacts the country’s mortgage market. Meanwhile, Italian bond yields have surged over the last few weeks, raising concerns that the European Central Bank may need to scale back plans to shrink its balance sheet to prevent financial fragmentation.
• Although the largest economies have avoided recession so far, there are signs of growing financial stress. S&P Global projects that the U.S. junk bond default rates will jump from 3.2% to as high as 6.5% by June 2024, while European junk bond defaults may jump to 5.5% next year from the current 3.1%. This unexpected surge in charge-offs assumes that interest rates remain relatively high, and that economic growth decelerates in the coming months. However, the doomsday scenario may be avoided if central banks are able to act quickly enough.

• One of the biggest mysteries since central banks began tightening monetary policy is how policymakers will react if inflation remains high and the economy falls into recession. Adding to the uncertainty is the expectation that refinancing activity will surge in 2024 to compensate for the loans that are expected to come due that year. Data collected by Bloomberg suggests that firms are in for a rude awakening if rates remain elevated. So far, policymakers have consistently denied that they are considering pivoting away from their current hawkish stance and have only signaled the possibility of a pause in rate hikes. However, their tone may change if economies start to fall into recession.

Polish Elections: Parliamentary elections will happen this weekend in Poland, in what could be the most divisive election since the fall of communism.

• Poland’s upcoming parliamentary election will be a clash of two opposing ideologies: the right-wing, populist Law and Justice (PiS) party and the centrist, pro-European Civic Platform (PO) party. A win for the former could see the country slide further away from democracy, while a win for the latter would likely bring it back in line with European norms. Neither party is expected to win an outright majority, so the outcome of the election is likely to depend on the performance of smaller parties.
• Dethroning the PiS will likely be a difficult task, but it will be necessary for Poland to regain access to much-needed EU funding. In 2019, Poland passed laws that undermined the independence of its Supreme Court, drawing the ire of the European Commission. These laws prevent judges from assessing each other’s compliance with EU standards and questioning the composition of a tribunal, and they give the disciplinary chamber of the Supreme Court the power to penalize judicial officials for the content of their verdicts. Warsaw claims that the changes were necessary to prevent the return of communism, but the European Court of Justice has ruled against it and has fined the Polish government.

• Despite its relatively small size, Poland has the fifth-largest economy in the European Union, and its GDP per capita is expected to overtake that of the U.K. in a little over a decade. However, if it continues on its current path toward authoritarianism, it may become the second country to leave the bloc, and the first to be forced out. An exit of Poland could further undermine the bloc’s legitimacy, as the decline in membership will raise questions about whether it can remain together. Additionally, having a potentially hostile country outside the bloc will likely need to be addressed. As a result, a victory by the PiS could negatively impact the euro.

Israel/Hamas Update: Israel has told people to leave Gaza as tensions rise in the region. The announcement reflects escalating tensions in the Middle East and raises the likelihood of a broader conflict. Iran and Saudi Arabia are in constant communication to prevent miscalculation by either side. Meanwhile, Jordan has cautioned Palestinians from going to Egypt.

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