by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an apparent assassination attempt against Japanese Prime Minister Kishida.  Although Kishida escaped unharmed, the security failure raises concerns for leaders attending the Group of Seven summit in Japan next month.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs that China’s first-quarter economic growth will come in healthy when it’s released tomorrow and new evidence suggesting the U.S. is about to experience a rebound in manufacturing activity.

Japan:  Prime Minister Kishida was apparently the target of an attempted explosives attack as he prepared to deliver a stump speech for a local by-election near the southwestern city of Osaka on Saturday.  The assailant’s pipe bomb landed just feet from Kishida, but security personnel whisked him away before it exploded, and the prime minister was not injured.

• Coming just nine months after Former Prime Minister Abe was assassinated by an assailant with a homemade gun, the incident on Saturday points to continuing gaps in the security for Japanese leaders.
• Moreover, the incident raises questions about the security environment for the global leaders who will attend a G7 summit in Hiroshima next month.

China:  Numerous signs indicate that tomorrow’s report on first-quarter gross domestic product will be in line with the government’s goal of 5% growth this year.  New data today showed that March new home prices were up 0.5% month-over-month, accelerating from a rise of 0.3% in February and marking their strongest increase in almost two years.  The People’s Bank of China also kept its one-year medium-term lending facility interest rate unchanged at 2.75% today rather than cutting it, and last week the government announced better-than-expected export growth.  Continued economic recovery from China’s pandemic lockdowns will likely be positive for global stocks and commodity prices, at least in the near term.

Turkey:  National oil champ Turkish Petroleum will begin shipments this week from its new Sakarya gas field, just three years after discovering the deposit.  According to President Erdoğan, supplies from the new gas field will help slash energy costs for Turkish consumers and businesses.  The timing of the announcement was probably driven by President Erdoğan, who is at risk of losing his bid for a new term in office in the May 14 elections.

• Erdoğan’s electoral strategy is to tout his achievements in completing key economic projects and making Turkey a stronger player in global politics.
• Last week, Erdoğan also presided at a ribbon-cutting for the Turkish navy’s new flagship, the TCG Anadolu.  The landing ship, which can carry helicopters and armed drones, is Turkey’s largest ever naval ship.

Poland-Hungary-Ukraine:  Faced with a glut of imports from Ukraine due to the European Union’s policies to help the country deal with the Russian invasion, the Polish and Hungarian governments have announced a temporary ban on Ukrainian grain despite EU warnings that they could be violating the bloc’s trade policy.  The grain shipments were supposed to be re-exported to the Middle East and Africa but have been bottled up in Poland and Hungary due to a lack of truck and train capacity.

Russia-Ukraine War:  Reports indicate a Russian power station in the southern border region of Belgorod was knocked off line by an apparent Ukrainian drone strike.  Ukraine has staged numerous attacks on military sites within Russia, but today’s strike seems to mark an expansion of its attacks.  By shutting off power to Russian citizens, it broadens the impact of the attacks, potentially undermining Russian citizens’ confidence in the war effort and perhaps sparking stronger retaliation by the Russian military.

United Kingdom:  As the West continues to worry about China’s stranglehold on the rare minerals needed for future energy technologies, British geologists have identified eight sites in the U.K. that have the right geology to potentially yield 18 key metals and minerals, including cobalt and lithium.  The mapping marks the first time the U.K. has systematically identified geological potential for the resources needed to produce electric car batteries, semiconductors, and wind turbines.  The sites will still need to be explored, and any commercially viable deposits would probably take more than a decade to develop.

Sudan:  Over the weekend, military forces led by two rival generals began attacking each other in the capital Khartoum and elsewhere in the country, dashing hopes that the country could continue its transition to democracy after the country’s armed forces toppled its dictator in a 2019 coup.  Continued political instability opens the country to further interference from Russia and other countries that would want to take advantage of its strategic location in northeastern Africa.

U.S. Intelligence Leak:  New reporting indicates the classified U.S. intelligence documents posted by Air National Guardsman Jack Teixeira in his chat room were further disseminated by a pro-Russian blogger who had been in the U.S. Navy until late last year.  The revelation adds to concerns that the U.S. military could be infiltrated with Russia sympathizers who are willing to undermine the U.S. and potentially put U.S. military and government personnel at risk.  Such concerns could encourage even stronger U.S. government action against authoritarian states such as China, Russia, and Iran.

U.S. Industrial Policy:  New research by the Financial Times suggests the U.S. is about to enjoy a manufacturing boom sparked by the $400 billion or so in subsidies provided in last year’s Inflation Reduction Act and CHIPS Act.  The research identifies more than 75 large-scale factory commitments that will take advantage of the laws, which will create about 82,000 jobs.

• The research is consistent with our view that deglobalization, increased defense spending, and Washington’s new embrace of industrial policy will prompt significant re-industrialization in the U.S., creating new investment opportunities while also imposing such costs as higher interest rates and the risk of malinvestment.
• Even though Republicans largely opposed the two industrial policy measures and continue to criticize them, the analysis indicates more than 75% of the investments identified so far will be in Republican-held congressional districts, where they will create some 58,000 jobs. If true, that could eventually boost Republican support for the laws and ensure they have political support going forward.

U.S. Bank Regulation:  According to officials attending the International Monetary Fund’s annual meeting last week, the banking crises last month in the U.S. and Europe could prompt the Basel Committee on Banking Supervision to try enforcing its strictest regulations on small and mid-sized U.S. banks that are currently exempt.  The possible change would expand the Basel Committee’s reach beyond those that are just “internationally active” to those that are “internationally relevant.”  Such a move could impose greater compliance costs on smaller banks and reduce their profitability and lending activity.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with the market’s reactions to the reduction of supplier price pressures in March and last week’s jump in unemployment claims. Next, we give our thoughts on commercial real estate and its potential threat to the economy. Finally, we focus on why we believe investors should look toward neutral countries that may not align with either the U.S. or China-led blocs.

Is It Over? The market responded positively to the mixed economic data that was released on Tuesday.

• A sharp decline in producer inflation and a steady increase in jobless claims have increased speculation that the Fed may soon pause rate hikes. The prices paid by suppliers for goods and services decelerated in March from 4.9% to 2.7%. The steep declines in trade services, transportation, and warehouse prices were the primary drivers of the slowdown. Additionally, initial jobless claims rose by 11,000 to 239,000 in the week ending April 8, the highest level since January 2022. The increase in the weekly applications for benefits could be a signal that the labor market is cooling. The combination of easing price pressures and increased layoffs could pressure the Fed to rethink its interest rate strategy.
• Investors were surprised by the economic reports released on Thursday, and equity holders responded by piling into risk assets. The S&P 500 rose 1.3% from the previous day, while the NASDAQ Composite gained 1.9% in the same period. At the same time, yield-curve inversion deepened as the data reinforced fears of an imminent recession. The yield on two-year Treasuries fell by 5 bps from 4.75% to 4.70%, while the 10-year Treasury yield dropped 21 bps from 4.50% to 4.19%.
• The latest economic releases may not be enough to convince the Fed to pause in May, but they may deter policymakers from hiking in later meetings. Although PPI is highly correlated with the consumer price index, it is unlikely that the next report will show a similar decline. The unemployment data has a similar problem. Initial claims remain too close to pre-pandemic lows to justify a shift in Fed policy. As a result, it is still highly probable that the Fed will raise its benchmark interest rate by 25 bps at its next meeting.

No Need to Fear: The regional bank crisis has fueled speculation that commercial real estate (CRE) loans may pose a risk to the overall economy; however, we have a different perspective.

• The CRE sector is risky for lenders looking to maintain healthy balance sheets following the recent bank turmoil. Bank of America reported that clients pulled $451 million from real estate stock due to concerns about the commercial property market. The massive withdrawal comes as the sector faces a series of headwinds from higher borrowing costs, work-from-home trends, and a possible recession. Other sources of liquidity, such as commercial mortgage-backed securities, may not provide much help as bond issuance is down 82% from the prior year.
• With over $1.5 trillion worth of U.S. commercial real estate debt due by 2025, the CRE sector has limited financing options. Mortgages on office spaces are particularly vulnerable as nearly a quarter of the loans are set to expire in 2023. Shadow lenders are positioning themselves to fill the void left by prudent banks. Private credit providers typically offer smaller loans at higher spreads than traditional lenders. A syndicated loan fetches about 4.5% over the secured financing overnight rate, while direct lenders receive close to 6.0%. Therefore, commercial property owners’ bottom lines will be pressured due to the increase in borrowing costs.
• The risk that CRE loans pose to the economy, though, may not be as critical as reports suggest. Regional banks do indeed provide 70% of the loans to the CRE sector, but this does not mean the sector is in imminent danger. Private lenders have the liquidity necessary to help struggling firms and may be better suited than traditional banks to take them over in the event of default. Unlike regional banks, debt funds typically have experts that understand how these companies operate. Additionally, the lack of regulation may give these lenders more flexibility to offer support for struggling property firms. The CRE sector may be poorly positioned, but its unwinding is unlikely to be as detrimental to the U.S. economy as is currently being speculated.

Nonalignment Flex: Countries that are capable of managing relationships with both the U.S. and China-led blocs may offer investment opportunities.

• Lula’s refusal to expand the U.S. ties created by his predecessor shows how Brazil can sway between blocs. On Friday, Brazilian President Luiz Inácio Lula da Silva advocated for developing countries to abandon the use of USD for trade. Latin America’s largest country by population and economy could assist in U.S. foreign policy efforts to rein in Beijing’s ambitions, as China relies on the two countries for grain exports. However, it seems Lula has no interest in antagonizing Beijing. Since his inauguration, Brazil has been pushed closer to China, much to the dismay of Washington.
• Meanwhile, India and Turkey have been able to exercise strategic ambiguity between the two blocs. Despite being a member of the North Atlantic Treaty Organization, document leaks revealed that Turkish officials had met with mercenaries from the Wagner Group to discuss weapons sales. Although no arrangement was made, the discussions show how Turkey has dual aims in this conflict. Meanwhile, India continues taking advantage of the war in Ukraine to access cheap oil. Russia’s discounted crude prices have allowed New Delhi to pressure other suppliers to slash their prices. India and Turkey’s ability to work with Russia without significant consequences from the U.S. exemplifies these countries’ viability in a fractured world.
• Neutral countries will likely be targets for foreign direct investments as the two major powers compete for influence. The strategic importance of these countries will give them greater flexibility to maintain trade ties with both blocs. Additionally, the neutral countries will likely have a much greater voice in negotiating favorable bilateral agreements as it can always threaten cooperation with the other bloc as leverage. As a result, we believe that countries capable of resisting both the U.S. and China may be attractive destinations for investments.

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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 on why monetary policymakers are reluctant to articulate a coherent message on future policy. Next, we give our thoughts about a potential credit crunch. Lastly, we review the latest headlines coming out of Asia.

Is Tightening Over? Sticky inflation and slowing economic growth have central bankers divided on future rate hikes.

• The failures of Silicon Valley Bank (SIVBQ, $0.57) and Signature Bank (SBNY, $0.15) in March have prompted several Fed officials to push for a rate pause. Minutes from the central bank’s March 21-22 meeting showed that policymakers were concerned that the banking turmoil could spread throughout the economy. Despite Federal Reserve officials having confidence that the banking system was sound and resilient, Fed staff predicted that the crisis could lead to a recession in late 2023. That said, the committee still voted unanimously to raise rates by 25 bps as members concluded that the emergency lending program sufficiently solved the bank run problem.
• The U.S. banking crisis and the collapse of Credit Suisse (CS, $0.92) led several European Central Bank policymakers to rethink the need to raise rates further. ECB Vice President Luis de Guindos and Governing Council Member Pablo Hernández de Cos have insisted that rates need to rise to help get inflation to its 2% target. However, both policymakers were unsure whether the ECB should raise its benchmark rate at its next meeting. The central bank’s reluctance to commit to further rate hikes reflects the hesitancy of policymakers in a time of heightened uncertainty.
• There is still palpable fear that the financial system has not fully recovered. The indecisiveness regarding the path of future hikes suggests that officials are close to implementing a pause. That doesn’t necessarily mean that the central banks will stop anytime soon. Austrian Central Bank Chief Robert Holzmann is pushing for the ECB to raise rates by 50 bps. Meanwhile, St. Louis Fed President James Bullard insists that the Fed should keep raising rates while the labor market remains strong. Overnight index swaps for the EUR and the USD show that the market expects central banks to raise rates at least one more time this year.
  • On a related note, new Bank of Japan Governor Kazuo Ueda has stated that he is in no rush to tighten policy. Meanwhile, the Bank of Canada paused rates in its latest meeting but may raise in the future.

Credit Crunch: Signs of a credit crunch have led the government to develop more safeguards to protect the public from any financial fallout.

• There is a growing debate about whether the drop in bank lending reflects tightening lending standards. Fed data showed that U.S. commercial bank lending fell by $105 billion in the two weeks ending March 29. Analysts at Goldman Sachs and Treasury Secretary Janet Yellen attributed the decline to the transfer of assets from failed banks Silicon Valley Bank and Signature Bank. In contrast, Lael Brainard, head of the National Economic Council, stated that she is seeing signs of banks pulling back credit. The discussion over lending has added to worries that the banking system may still need assistance.
• The lack of lending may be related to financial institutions preparing for extra scrutiny of their lending practices. European regulators are working on a plan that would complicate government efforts to inject liquidity into struggling banks. In the U.S., a recent survey showed that there is bipartisan support in favor of restoring bank regulations that were repealed in 2018. At the same time, Bank of England Governor Andrew Bailey warned that potential reforms to increase guaranteed deposits will have cost implications for banks.
• Investors are worried about potential hangover effects from the banking crisis. Despite the rebound in investment grade bonds, investors are wary of junk bonds. The lack of risk appetite reflects growing fears of an incoming recession, particularly in the U.S. Although a downturn is widely expected in the Eurozone and U.S., factory output data suggests that the EU may be better positioned. When combined with a weakening dollar, we suspect that there may be attractive opportunities outside the U.S. So far this year, the Euro Stoxx 50 has outperformed the S&P 500, 12.95% to 7.05%.

Asia in Focus: There are new risks developing in the Indo-Pacific region, but we remain optimistic.

• Several Asian countries have reported a substantial jump in COVID infections; however, this outbreak remains contained at this time. Singapore, India, Indonesia, and Vietnam have all reported yearly highs in their number of cases. The latest strand, known as the Kraken variant or XBB.1.5, is viewed as a highly transmissible omicron strain but with relatively mild side effects. Hospitals have been able to manage the caseloads so far, but governments are still looking to take more preventive measures. For now, we do not expect this new wave to lead to major supply chain disruptions, but it is something we will be monitoring.
• North Korea fired a new type of intercontinental ballistic missile on Thursday. The launch triggered a scare in northern Japan as residents were told to take shelter. There were no casualties, but the launch reflects North Korea’s improvement in its weapons capabilities and its growing assertiveness. Additionally, the provocative act will put pressure on Japan to ramp up its defense expenditures as it looks to protect itself from rivals. The Japanese government plans to double its military budget within the next five years and may be encouraged to increase it even further. The new military spending should benefit U.S. aerospace and defense industries as Tokyo may seek to collaborate with Washington to meet its ambitious target.

• On a positive note, China’s need for economic growth may lead it to moderate tensions with the U.S. On Thursday, Beijing announced that it would scale back its no fly-zone over Taiwan to 27 minutes, after initially notifying Taipei that it was planned to last from April 16-18. Although the Taiwan protests helped, the move may reflect a temporary thaw in U.S.-China tensions. Recently, government officials from Washington and Beijing have made comments in favor of the two countries maintaining ties. Although the relationship between the two countries will continue to be rocky, we believe that China may be a desirable investment destination for risk tolerant investors in the short to medium term.
  • The recent surge in Chinese exports (see previous chart) reflects its need to bolster its GDP after it lifted its COVID restrictions.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with updated projections for global economic growth from the International Monetary Fund.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new evidence that China has reverted to its old strategy of infrastructure investment to boost economic growth.

Global Economic Growth:  The IMF released updated forecasts yesterday showing global economic growth will slow from 3.4% in 2022 to just 2.8% in 2023.  The updated forecast for 2023, contained in the institution’s latest World Economic Outlook, is slightly lower than the 2.9% figure issued in January, reflecting the IMF’s continued concerns about high inflation, rising interest rates, increased financial stresses, and the impact of Russia’s war against Ukraine.

• The weaker forecast for 2023 is consistent with our view that the U.S. and other major economies are likely to slip into a moderate recession later this year.
• Although the upcoming recession is now widely anticipated, it still presents the risk of a renewed pullback in stock values. We therefore remain cautious on equities and other risk assets for the time being.

China:  New data shows the country’s total fixed railway investment in the first quarter of 2023 was up 6.6% from the same period one year earlier, hitting its highest level since 2013.  The big increase in railroad spending illustrates how Beijing has reverted to its traditional strategy of massive infrastructure investment to boost economic growth, even though the country is already struggling with excess industrial capacity and high debt.

• In the short term, this type of stimulus spending will likely boost economic growth and stock values in China and those countries that export to it.
• In the longer term, however, this uneconomic spending will exacerbate the Chinese economy’s deep structural imbalances, making it harder to maintain growth and raising the risk of economic and social crises.

China-India:  Imagery analysis by London-based think tank Chatham House suggests China has been building new military intelligence facilities on Myanmar’s Coco Islands, just 55 km north of India’s military installations on its Andaman and Nicobar Islands in the Bay of Bengal (see map below).  The expanded facilities include a lengthened runway and hangars for aircraft, an upgraded radar installation, and docks for supplies.  Along with China’s access to ports in Pakistan and Sri Lanka, the Coco Islands’ facilities show that Beijing is gradually tightening its military and intelligence noose around India, which will likely continue to drive New Delhi toward a closer military, economic, and diplomatic relationship with the U.S.

United States-South Korea:  More of the purported U.S. intelligence documents recently leaked on social media, which we described in our Comment on Monday, have been found to be fabricated, including much of the intelligence that had suggested U.S. spying on its key ally South Korea.  According to Seoul, the South Korean and U.S. defense ministers agreed in a phone call yesterday that much of the information had been fabricated, and that the two countries would continue to cooperate closely.  The report suggests the leak may not be as damaging as originally thought to the U.S. and its allies.

NATO-Germany:  A leaked memo from the Bundeswehr’s inspector general indicates that Germany wouldn’t be able to meet its pledge to provide a fully-equipped division to NATO in time of war by 2025.  According to the assessment, “the army will not be able to hold its own in high-intensity combat and will also only be able to fulfill its obligations to NATO to a limited extent.”  The report also contended that continued underfunding and military support for Ukraine have already led to a “clearly noticeable reduction in the army’s operational readiness.”  The revelation could potentially put more pressure on Germany to boost its defense budget in the near term.

China-Russia-Iran-Ukraine:  Diplomatic sources say China and Russia are secretly negotiating with Iran to provide it with large amounts of ammonium perchlorate, the main ingredient in the solid propellants used to power missiles.  The amounts of the chemical under negotiation would reportedly be enough to build thousands of medium-range rockets, some of which could then be exported to Russia for its war against Ukraine.

United States-Russia:  Officials yesterday revealed that the U.S. Embassy in Moscow still has not received permission from the Russian government to visit Wall Street Journal reporter Evan Gershkovich, whom the Russians have detained on charges of spying.  The U.S. officials also said Russia has given no legitimate reason for the failure to grant permission.  The breach in diplomatic and consular standards will further poison the U.S. relationship with Russia and its ally, China.

U.S. Monetary Policy:  Yesterday, the new leader of the Chicago FRB, Austan Goolsbee, warned that monetary policymakers should be cautious about hiking interest rates further, now that banks have already started tightening lending standards and regulators had to take over two mid-sized lenders last month.  Even though Goolsbee voted for rate hikes at the two Fed policy meetings held since he took over at the Chicago FRB in January, his speech contained no endorsement of any further rate hikes.  His presentation confirms that interest rates probably can’t be raised much more before generating pushback from the policymaking committee.

U.S. Environmental Regulation:  As we flagged in our Comment a few days ago, the Environmental Protection Agency proposed new rules today that would limit vehicle tailpipe emissions across each automaker’s entire fleet between 2027 and 2032.  The rules aim to reduce overall emissions and force automakers to transition most of their production to electric vehicles.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with key news on the global technology sector, including data showing a steep downturn in personal computer shipments and increasing regulatory pressure on the evolving artificial intelligence industry.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs that the new Bank of Japan leader will keep monetary policy unchanged for at least the near term.

Global Computer Industry:  Research firm International Data Corp. reported that global personal computer shipments in the first quarter were down 29% from the same period one year earlier.  In fact, shipments were even lower than in the first quarter of 2019, prior to the onset of the coronavirus pandemic, indicating the industry is now giving back much of the surge in activity it enjoyed in the midst of the pandemic.  With PC inventories expected to remain excessive until at least mid-2023, the data suggests much of the information technology sector could see soft business conditions and weak stock prices for some time yet.

Global Artificial Intelligence Industry:  Yesterday, just hours after Alibaba (BABA, $101.54) became the third Chinese technology giant to launch a generative artificial intelligence chatbot, the Cyberspace Administration of China issued a draft of rules aimed at slowing the development of AI models and ensuring they work to support Communist Party priorities.  Meanwhile, separate reporting indicates that the Biden administration is exploring whether checks should be imposed on AI chatbots in the U.S., such as the popular ChatGPT, amid growing concerns that they could be used to discriminate or spread harmful information.

• Under China’s drafted rules, AI developers would have to register their models with the CAC, submit them for security reviews before releasing them to the public, ensure that they “embody core socialist values,” verify users’ identity, and make sure that users can be tracked.
• In the U.S., the Commerce Department issued a formal public request today for comments on what it called accountability measures, including whether potentially risky new AI models should go through a certification process before they are released. The comments, which will be accepted over the next 60 days, will be used to help formulate advice to U.S. policymakers about how to approach AI.

Emerging Market Debt:  Advocacy group Debt Justice issued a report showing that for 91 of world’s poorest countries, debt service paid to non-residents this year will account for 16% of government revenues.  That would be the highest foreign debt burden since 1998, illustrating the impact of rising global interest rates and the strong dollar.

• The report suggests governments in poorer countries may increasingly struggle to fund public services ranging from defense and policing to infrastructure and anti-poverty programs. That could raise public frustrations and spark political instability in some countries.
• In turn, the high debt burdens also raise the prospect for more financial crises in less developed countries, which could adversely affect their foreign bond holders and lenders.

Japan:  Yesterday, at the end of his first weekday as the Bank of Japan’s new leader, Kazuo Ueda stated that he will maintain monetary easing and negative interest rates despite market expectations for an early policy change.  According to Ueda, returning Japanese price inflation to the BOJ’s target of 2% is a job that will take many years, and he wants to finish it.  In response, the JPY dropped 1.1% yesterday to about 133.60 per dollar, while today Japanese stocks have jumped more than 1.0%.

China-Australia:  The Chinese government said it will review the up to 80% tariffs that it imposed on Australian barley in 2020 after Canberra called for an investigation into China’s role in the coronavirus pandemic.  In return, the Australian government said it would suspend its complaint against the tariffs at the World Trade Organization.  The moves are part of a broader easing of tensions between the countries as China tries to set the stage for improved economic growth.

North Korea:  New reports say the government banned the use of foreign currency such as the Chinese yuan (CPY) and U.S. dollar this month and ordered its citizens to exchange their foreign money for the domestic won (KPW).  According to the reports, the government is confiscating any foreign currency that citizens attempt to hide from the authorities.

• The program may indicate that North Korea is preparing to fully reopen foreign trade with China and wants to have sufficient foreign reserves to pay for any imports.
• In turn, that may mean the North Korean economy is faltering so badly that the government has no choice but to reinvigorate trade with China again.

France-United States:  French President Macron has once again sparked concern about Western unity with statements about his cherished concept of European “strategic autonomy.”  During his visit with Chinese President Xi last week, Macron said in an interview that Europe shouldn’t just blindly follow U.S. policy on Taiwan or other important international conflicts so that it won’t be caught up in “crises that are not ours.”  His remarks have drawn condemnation from a range of political leaders not only in the U.S., but also in Europe.

• Without a doubt, Macron’s statements were music to Xi’s ears, given the Chinese leader’s desire to drive a political wedge between the U.S. and Europe. Because of China’s rapidly growing military power, enormous economy, and increasing diplomatic influence, the ongoing effort to thwart China’s geopolitical aggressiveness will require the U.S., Europe, and other key Western allies to maintain unity.  Macron’s call for Europe to be more independent is a threat to that.
• Nevertheless, Macron’s vision remains aspirational, just as de Gaulle’s vision of French power and glory was in the decades after World War II. The French soul laudably embraces its history— from its Napoleonic victories and its Empire to the contributions it has made to world culture in terms of political principles, diplomacy, law, philosophy, science, architecture, design, visual and performing arts, fashion, style, cuisine, and the simple art of living.  But France in particular and even Europe in general are far from having the military, economic, or diplomatic power needed to act as an independent and secure superpower.  In time of crisis, French and European vulnerabilities become clear, and the imperative of their alliance with the U.S. becomes obvious.  As such, Macron’s statements do raise tensions and weaken the Western alliance, but they are unlikely to be fatal to it.

United States-Philippines:  Today, the U.S. and the Philippines have launched their largest joint military exercises in 31 years.  The drill will include a total of 17,500 soldiers, sailors, and airmen and will even include a small contingent of troops from Australia.  The U.S. and Philippine foreign and defense ministers are also due to hold their first so-called “2+2 meeting” in seven years today in Washington.  Today’s activities come a week after the Philippines formally identified four of its military bases which it will permit the U.S. to use under the countries’ security agreements.  These activities illustrate the renewed military cooperation between the two countries as the Philippines becomes more concerned about China’s geopolitical aggression.

U.S. Military Recruiting:  New analysis by The Military Times indicates the recent big shortfalls in troop recruiting may be tied to a new medical records system adopted by the Pentagon in 2022.  Since the new system does a better job of vacuuming up an applicant’s entire medical history from multiple digital sources, military recruiters interviewed for the article said the new system has ended an applicant’s ability to gloss over or knowingly ignore minor medical issues, such as past use of ADHD meds or inhalers, before signing up.

• Some politicians and political pundits have blamed the recruiting shortfall on “woke” diversity training or out-of-shape kids. Pentagon officials have pinned the blame largely on today’s roaring civilian jobs market and bad perceptions of service fueled by negative headlines.  The recruiters blamed the new medical records system above all else.
• If the new medical system is indeed the key problem, it suggests the Pentagon could tweak the system to flag fewer problems or adopt a more flexible approach that allows more young people to enlist.

U.S. Monetary Policy:  New York FRB President Williams yesterday downplayed signs in the financial markets that investors are expecting the monetary policymakers to begin cutting interest rates later this year, despite Fed projections that they will hold rates steady once they have gotten the benchmark fed funds rate slightly above 5.0%.  According to Williams, investors may have a more pessimistic view of economic growth going into the second half of the year, or investors may not understand how hard it will be to get inflation back down to the Fed’s 2% target.  In any case, his statements are consistent with our view that interest rates will rise at least a bit more and then may stay elevated for longer than investors currently think.

U.S. Weather Conditions:  New data shows that drought has now taken hold in about two-thirds of Florida, up from about one-fifth of the state a year ago.  The drought is creating challenging economic conditions for ranchers and farmers and creating a higher risk of widespread wildfires.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the latest on the big leak of classified U.S. intelligence documents that was discovered late last week.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including increased military tensions surrounding Taiwan, big new strikes in the U.K., and news that the EPA will soon propose strict new emissions rules for U.S. vehicles.

U.S. National Security Leak:  U.S. officials continue to investigate the big leak of classified Pentagon documents onto social media sites late last week.  Over the weekend, additional documents were posted, some dealing with topics beyond the U.S. efforts to help Ukraine defend itself against Russia’s invasion.  The FBI is now investigating who had access to the leaked documents, which appear to be briefing slides prepared for the Joint Chiefs of Staff.  The postings on social media show the hard-copy documents were folded and unfolded before being photographed, which would suggest that they were secretly taken out of a secure location.  Although at least one of the photographs was altered to put Russia in a better light, identifying markings on the documents could help identify the culprit.  One possibility is that there is a Russian mole at the Pentagon.  Another possibility is that the culprit is a Russian sympathizer with access to officials high up in the Pentagon bureaucracy, or perhaps someone opposed to certain aspects of U.S. foreign policy, such as providing more aid to Ukraine.

• One document shows that the U.S. was secretly listening in on communications between top South Korean national security officials late last year when President Yoon Suk-yeol was considering whether to sell 155-mm artillery ammunition to the U.S. to replenish supplies that Washington had sent to Ukraine.
• The report showed Foreign Secretary Yi Mun-hui warned his boss, National Security Adviser Kim Sung-han, that if the ammunition were later re-sold to Ukraine, it would violate official South Korean policy not to provide lethal military goods to countries in active hostilities. Yoon ultimately approved the sale on the condition that the U.S. military would be its “end user.”
  • Both Yi and Kim later resigned for unclear reasons, suggesting they may have been forced out for pushing back against the deal.
  • If so, it would suggest Yoon went out on a limb politically to support the U.S. In turn, that would underline how much Yoon has prioritized cooperation with the U.S. as he seeks to further cement South Korea into the evolving U.S. geopolitical bloc and prepare for a potential conflict with China.

China-Taiwan-United States:  China has launched a series of military drills near Taiwan to express its anger at Taiwanese President Tsai’s visit to the U.S. and her talks with House Speaker McCarthy in California last week.  The Chinese military said on Saturday that the drills would aim to test its ability to “seize control of the sea, air and information” in the area, and that they would involve a wide range of naval, air, missile, and electronic-warfare assets.  Nevertheless, the drills appear to be somewhat smaller and less threatening to Taiwan than the exercises China launched last summer after former House Speaker Pelosi visited the island itself.

China:  Ten Chinese companies had their initial public offerings today, marking the first batch of IPOs under a new set of listing rules for Shanghai and Shenzhen.  The average first-day gain for the new stocks was 96%, suggesting the rules still aren’t producing an efficient market for new listings.

Saudi Arabia-Yemen:  A Saudi delegation has arrived in Yemen to begin negotiations with that country’s Iranian-backed Houthi rebels.  The development is one result of the recent Chinese-brokered rapprochement between Saudi Arabia and Iran.  Saudi Arabia’s involvement in ending Yemen’s civil war could also help ease tensions between Riyadh and Washington.

United Kingdom:  The British government continues to face big, disruptive strikes by public sector workers who are seeking higher pay.  Tomorrow, junior physicians plan to launch a four-day walkout across England for a 35% pay hike.  Meanwhile, passport workers last week launched a five-week strike, and additional strikes are feared in education after teaching unions recently rejected the government’s offer of a 4.5% pay rise and a £1,000 one-off payment.

Brazil:  Now that leftist President Luiz Inácio Lula da Silva is back in power, a radical agrarian rights group known as the Landless Workers’ Movement said it expects to step up its use of “land invasions,” where it illegally occupies rural land to assert control over it and push out private owners.  Increased land invasions would be a threat to Brazil’s important agribusiness sector and could touch off increased political tensions within the country.

U.S. Environmental Regulation:  Next week, the Environmental Protection Agency reportedly plans to propose extensive new limits on vehicle tailpipe emissions in order to push U.S. auto makers toward making and selling more electric-vehicles.  The stringent new rules are expected to apply to model years from 2027 to 2032.

U.S. Manufacturing Industries:  New analysis shows U.S. manufacturing capacity last year grew at its fastest rate since 2015, driven by the extensive new construction of factories and related facilities.  The increase in factory construction is consistent with our belief that deglobalization, the fracturing of the world into relative separate geopolitical and economic blocs, and increased international tensions will all tend to drive a new period of re-industrialization in the U.S.

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