by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the U.S. and European banking crises and what they mean for monetary policy going forward (we also note that the Federal Reserve will release its latest interest-rate decision this afternoon at 2:00 PM EDT).  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an encouraging rapprochement between Japan and South Korea and the latest on the China-Russia summit in Moscow.

U.S. Banking Crisis:  In a speech to the American Bankers Association yesterday, Treasury Secretary Yellen signaled that she and other federal officials stand ready to intervene in the banking system again if more banks suffer deposit runs that threaten to spark contagion to other banks.  That appeared to mark a reversal for Yellen, since she had previously said the federal government would guarantee banks’ uninsured deposits only if the officials again invoked emergency powers to protect them.  In any case, the crisis continues to show signs of dissipating, with bank stocks and other equities having strong price gains yesterday.  All the same, we remain worried that additional stresses are building in the bank sector, especially among smaller banks which have substantial exposure to the possibility of mass defaults in commercial real estate.  The concerns about issues in commercial real estate have recently been rising sharply.

• Yellen’s statement is part of a burgeoning debate on whether the government should fully insure all bank deposits, or at least raise the insured amount above the current cap of $250,000 per depositor, per bank.
• The maximum FDIC-insured amount hasn’t changed since 2008. However, even if that cap were raised substantially, it still might not cover much of a large company’s deposits.  Large corporate deposits can run well into the millions of dollars, or even hundreds of millions of dollars, as shown by the collapse of Silicon Valley Bank (SIVB, $106.04).  Companies withdrawing their deposits en masse can destabilize a bank just as surely as individuals can.
• That helps explain why much of the current reform talk centers on the possibility of insuring all bank deposits. However, many Republicans in Congress are pushing back strongly against the idea, largely on moral hazard grounds.  While we do expect the crisis will eventually lead to new regulatory reforms, it’s still tough to predict exactly what will happen with the insured amount.

U.S. Monetary Policy:  The Federal Reserve wraps up its latest policymaking meeting today, with its decision due out at 2:00 PM EDT.  Despite the strong economic data for January and February, we suspect the banking crises in the U.S. and Europe will discourage the policymakers from hiking their benchmark fed funds rate by anything more than a modest 25 basis points.  Many investors and observers are even expecting them to hold rates steady.

U.S. Stock Market:  With the banking crisis encouraging hopes for lower interest rates, many technology stocks and other “long duration” equities have gotten a boost in recent days.  Nevertheless, new data shows that the combined weighting of Apple (AAPL, $159.28) and Microsoft (MSFT, $273.78) in the S&P 500 has now reached a record high of 13.3%.  Other big technology stocks have recently somewhat recovered from the beating they took from the Fed’s interest-rate hikes over the last year, but the new data underscores how Apple and Microsoft are now in a class by themselves in terms of market dominance.

European Banking Crisis:  Debate continues to rage about Swiss regulators’ decision to zero out the additional Tier 1(AT1) capital bonds of Credit Suisse (CS, $0.9681) as part of its rescue over the weekend.  Although AT1 bonds are designed to absorb losses in a bank failure, essentially making them junior to the bank’s equities, some of Credit Suisse’s AT1 holders are reportedly considering legal action against the regulators’ move.  In any case, the write-down of the bonds is expected to undermine their value throughout Europe, boosting funding costs for banks.

• As noted above, many investors continue to hope the current banking crises will prompt the main central banks to stop, slow, or even reverse their campaigns to hike interest rates in order to fight inflation. However, they were disappointed by the European Central Bank’s decision last week to hike its benchmark short-term interest rate by an aggressive 50 basis points.
• In a sign that the ECB could continue to hike rates aggressively, German central bank Governor Joachim Nagel discounted any fears that the banking crises would have broad effects on the European banking system and called for the monetary policymakers to be “stubborn” in their rate hikes to fight inflation.
• Nagel also showed no sympathy for the holders of Credit Suisse’s AT1 bonds, saying those who profited from their opportunity should be prepared to shoulder the risk they took. However, he did confirm that the ECB would not follow the Swiss decision to bail in AT1s before a bank’s equity was wiped out.

United Kingdom:  The February consumer price index was up a full 10.4% year-over-year, an acceleration from the 10.1% rise in the year to January and far above the expected annual increase of 9.9%.  Much of the unexpected acceleration reflected a jump in service prices.  While investors before the report had been evenly split on whether the Bank of England would keep hiking its benchmark interest rate at its meeting on Thursday, they are now pricing in a likely hike of 25 bps.

Japan-South Korea:  President Yoon Suk-yeol of South Korea yesterday said that he would order his government to return Japan to its “white list” of countries with fast-track trade status after a summit with Japanese Prime Minister Kishida last week.  Yoon also expressed his confidence that Japan would soon reciprocate the gesture.  The countries have black-listed each other since 2019 because of a dispute over Japan’s treatment of Koreans during World War II.

• The diplomatic thaw and improved trade ties between Japan and South Korea reflect their realization that they need to stand together, along with the U.S. and other allies, to resist China’s increasing geopolitical aggressiveness.
• The upside for investors is that increased trade between Japan and South Korea should be good for both countries’ economies, and for their stocks.

Sri Lanka:  The International Monetary Fund (IMF) gave final approval for a $3-billion bailout loan for the country this week, after the government instituted a number of fiscal reforms and convinced key bilateral lenders, including China, to sign onto a debt restructuring program.  The IMF deal unlocks $4 billion in other emergency lending and will help alleviate Sri Lanka’s lack of foreign currency reserves and deep recession, although it doesn’t necessarily allow the country to tap global financial markets again.

China-Russia:  During their summit meeting in Moscow yesterday, Chinese President Xi and Russian President Putin agreed to “significantly increase” trade between their two countries by 2030, and Putin threw his weight behind the greater use of CNY in trade.  Putin noted that about two-thirds of China-Russia trade is now in the Chinese currency, although much of that reflects the fact that Russian exports to the West have been severely crimped by sanctions.

• Separately, the Russian government said it will start using new benchmark oil prices to calculate the taxes its oil firms pay on their exports. Although the G7 countries have imposed a price ceiling of $60 per barrel on Russian oil, recent statistics suggest Russian firms are often getting more than that.
• The tax revamp is reportedly geared to increase the Russian government’s oil revenue by about $8 billion annually.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the U.S. banking crisis and how investors’ concerns appear to be dissipating, at least so far today.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a few words on Chinese President Xi’s continuing visit with Russian President Putin as well as some items touching on U.S. labor tensions.

U.S. Banking Crisis:  Now that investors’ attentions has shifted toward ailing regional lender First Republic Bank (FRC, $12.18), reports indicate that Jamie Dimon, CEO of JPMorgan Chase (JPM, $127.14) is leading an effort to convince a number of major banks to invest in the firm beyond the parking of some $30 billion in deposits there last week.  Coupled with the moves by government officials to stem the crisis, the effort by Dimon appears to be helping to quiet investor concerns.  Although First Republic’s stock price fell 47% yesterday, it has rebounded approximately 15% so far this morning, while bigger banks and the overall market continue to rise.

• The market action may look like the crisis is passing, but we would urge caution, as other stressors in the financial markets could still come to light. In addition, since much of the nation’s bank lending is done by mid- and small-sized banks, any pullback in lending by those banks in response to the crisis could have a noticeably negative impact on U.S. economic growth.
• Investors are particularly worried about big, new headwinds for agency mortgage-backed securities (MBS). Those securities are widely held by mid-sized banks such as the one that touched off the crisis, Silicon Valley Bank (SIVB, $106.04).  Now that the government owns the bank, it is expected to sell off the roughly $78 billion of MBS on Silicon Valley’s books.  To the extent that other banks fail and are taken over by the government, similar sales could add to the supply of MBS and drive down their value.

Germany:  Responding to the banking crises in the U.S. and Switzerland, the ZEW Institute’s index of investor sentiment fell to 13.0 in March, coming in short of both the expected reading of 16.4 and the February reading of 28.1.  The index, which is considered a leading indicator of German economic activity, now stands at its lowest level since January.  The index is designed so that readings over zero indicate greater optimism than pessimism.

France:  Despite the continuing mass protests against President Macron’s decree last week to boost the pension system’s retirement age, opponents in parliament yesterday narrowly failed to win a no-confidence vote against his government.  As a result, the reform of the pension system will stand, lessening the strains on the French budget over time and potentially giving a boost to the economy.  However, as Macron faces even more no-confidence votes, his political position is weakening.

Russia-Ukraine War:  As the Russian invasion continues to disrupt Ukrainian agriculture, Kyiv said the country’s grain harvest this year will likely fall by another 15% from 2022.  On top of that, Russia warned it could pull out early from the UN-sponsored agreement under which Russia is allowing Ukraine to export food products from its Black Sea ports, despite the fact that Moscow agreed to renew the deal last Friday.  The news highlights how the war continues to threaten global commodity supplies and could keep global food prices and inflation high.

Russia-China:  Russian President Putin continues to host Chinese President Xi in Moscow, with much of the discussion today reportedly focused on the China-Russia economic relationship.  One key topic is likely to be the planned Power of Siberia 2 natural gas pipeline, which will help Russia shift its gas exports to China now that it has largely been cut off from Europe.

• As we wrote in our Bi-Weekly Geopolitical Report on January 9 and March 6, China is likely to manage its evolving geopolitical and economic bloc in a largely neo-colonial fashion, where it uses the other members of its bloc, such as Russia, as sources of cheap natural resources and basic commodities, and in return China sends them its higher-value manufactured goods.
• One Financial Times report on today’s China-Russia meetings contains a quote from an unidentified Russian official that drives home our point: ‘“The logic of events dictates that we fully become a Chinese resource colony,” the person said. “Our servers will be from Huawei. We will be China’s major suppliers of everything. They will get gas from Power of Siberia. By the end of 2023, the yuan [renminbi] will be our main trade currency.”’

Venezuela:  Oil Minister Tareck El Aissami announced that he is resigning his position amid a government corruption probe that has already led to the arrest of multiple officials.  Reports suggest El Aissami was pushed out in a political purge, perhaps related to massive graft in the country’s oil sales.  However, we would also note that El Aissami oversaw the negotiations that led to U.S. energy giant Chevron (CVX, $154.58) receiving a license last year to restart its operations in Venezuela.  El Aissami has also been under U.S. sanctions for drug trafficking.  It therefore would not be a surprise if his resignation also involved his relationship with the U.S.

U.S. Monetary Policy:  The Federal Reserve begins its latest policymaking meeting today, with its decision due out on Wednesday afternoon.  Despite the strong economic data for January and February, we suspect the recent banking crises in the U.S. and Europe will discourage the policymakers from hiking their benchmark fed funds rate by anything more than a modest 25 basis points.  Many investors and observers are even expecting them to hold rates steady.

U.S. Labor Market – West Coast Ports:  According to the Pacific Maritime Association (PMA), which represents shippers and port operators, West Coast dockworkers have begun to slow port operations to protest the lack of progress in negotiations for a new contract to replace the one that expired last July.  The workers have reportedly stopped staggering work shifts during mealtimes, forcing terminals to shut down every day for an hour in the afternoon and another hour at night.

• Federal officials have been pressuring the PMA and the dockworkers to come to an agreement, but talks have recently stalled.
• The rising labor tensions are a reminder that the economy could still face disruptive supply chain issues at the West Coast ports.

U.S. Labor Market – LA Schools:  Some 30,000 bus drivers, custodians, special education aides, and other school staff in Los Angeles are beginning a three-day strike today in search of a 30% increase in wages and better working conditions.  In addition, a union representing some 35,000 teachers will also go out on strike in support.  The strike illustrates how low unemployment and high inflation continue to prompt workers to agitate for better pay and conditions, despite growing layoffs in technology and some other sectors.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Happy St. Patrick’s Day! Today’s Comment begins with a discussion about the European Central Bank’s rate decision and how it could impact monetary policy around the world. Next, we review the latest developments in the ongoing banking crisis. Lastly, we give an update on the rivalry between the U.S. and China.

What Now? The European Central Bank raised rates by 50 bps but the reluctance with which they made this move highlights monetary policymakers’ hesitancy to maintain aggressive policy in light of elevated financial strain.

• Some European policymakers were uncomfortable with the central bank’s decision to increase its benchmark policy rate by half a percentage point. ECB President Christine Lagarde noted that some of the members of the governing council wanted to halt rate hikes until the bank situation unfolded. The decision to ditch their written commitment to keep lifting rates further supports the idea that members are not sure about the future path of monetary policy. The indecisiveness among the ECB governing council was interpreted as a dovish shift by the central bank as investors now believe that it is less committed to fighting inflation.
• The ECB’s decision to raise rates now puts pressure on the Federal Reserve to lift its policy rate. Fed officials are dealing with similar circumstances as their European counterparts, but their reaction is far from certain. The Fed is already facing scrutiny for its failure to prevent the collapse of Silicon Valley Bank (SIVB, $106.05) and Signature Bank (SBNY, $70.0). As a result, it may be subject to increased political backlash if it overdoes it next week in its rate decision. The Organization for Economic Cooperation and Development (OECD) has weighed in on the matter by requesting central banks (most likely the Fed) to resume rate hikes. That said, continued tightening by the Fed raises the odds of a recession.
• In the United Kingdom, the decision to tighten monetary policy is even more complicated. The Bank of England and the U.K. Treasury have very different outlooks for the economy over the next few years. While the central bank predicts that output growth will be relatively unchanged by 2025, the Office for Budget Responsibility projects GDP to expand by 5% within that same period. The differing forecasts from monetary and fiscal policymakers suggests the two institutions might impose contradictory policies. In other words, the BOE is likely to become dovish, which may lead to an end to tightening, while the Treasury department may lean more hawkish thus paving the way for possible budget cuts or tax increases.
  • The recent deceleration in U.K. inflation expectations further reaffirms our belief that the Bank of England may lean toward not tightening in its next meeting.

New Developments: Financial contagion may be fading but it is still too early to tell whether the central bank’s job is done.

• Banks have taken full advantage of the Fed’s facilities to shore up their cash positions as they borrowed $165 billion from the discount window and the Bank Term Funding Program in the week ending March 15. The unusually high usage of the discount window shows the level of panic triggered by the collapse of Silicon Valley Bank. The discount window lent $153 billion, a new record. Meanwhile, the BTFP lent $12 billion. J.P. Morgan (JPM, $130.75) estimates that the Fed could administer up to $2 trillion into the U.S. financial system. The new bank funding facilities should prevent a liquidity crunch; however, its usage suggests that the financial system is still on edge.

• In other related news, J.P. Morgan has teamed up with other banks to rescue First Republic Bank (FRC, $34.27). A group of 11 lenders, which include Bank of America (BAC, $28.97), Citigroup (C, $45.62), and Wells Fargo (WFC, $39.30), have offered $30 billion in deposits to prop up the struggling California lender. The large transfer comes as fears of bank runs have led depositors to move their money from small and mid-sized banks to ones with large holdings. The group of banks agreed to park their deposits at First Republic Bank for at least 120 days.
• Fears of a potential financial crisis are fading, but it is not clear where the Fed will go from here. The Fed backstops have reassured markets that the central bank was willing to provide liquidity to stabilize the banking system. However, there are still concerns about whether the financial system is capable of dealing with further tightening. Hawkish Fed policy has made deposits less attractive as investors are now able to get more money using money market funds and purchasing Treasuries. That said, inflation is too high for the Fed to pivot now. The market seems to believe that the Fed will raise rates by 25 bps at its March 22 meeting, which is lower than the prediction of 50 bps made after Powell spoke to Congress last week.

Major Power Rivalry: As the West attempts to isolate China, Beijing looks to bolster its ties with Moscow.

• Russia and China continue to build closer ties, while the U.S. tries to find ways to thwart the two countries’ global ambitions. Chinese President Xi Jinping is set to visit Moscow on Monday to reaffirm the countries’ strong ties. Meanwhile, Republicans are pressuring the Biden administration to deter nuclear cooperation between Russia and China. It was reported that a Moscow state-owned nuclear energy company was providing Beijing with highly enriched uranium. China claims to be acting as a mediator between Russia and Ukraine, but China’s actions show that it does not want Putin to lose the war. China and Russia have used their partnership to reduce American influence around the world.
• Accordingly, the Western alliance is becoming less enchanted with Beijing due to its growing relationship with Russia. In a move that will certainly ruffle feathers in Beijing, a German finance minister is set to visit Taiwan for the first time in 26 years. The trip highlights the precarious relationship between Beijing and Berlin. Although Germany is dependent on trade, it wants to pressure China to distance itself from Russia. Meanwhile, more countries are joining the U.S. in its push to ban TikTok on government devices. The U.K. was the latest country to restrict the social media app. The West believes that the app poses serious security risks, and, as a result, the EU, Canada, and the U.S. have all restricted its usage in government settings.
• We have discussed our belief that the world is breaking up into two major economic and geopolitical blocs as countries move away from globalization, one led by the U.S. and the other by China. The rivalry between the two blocs will lead to proxy conflicts and trade battles. The war in Ukraine and the banning of TikTok are examples of how this has started to play out. As tensions begin to rise, the potential for a direct conflict will increase. At this time, neither the U.S. nor China favor outright war, but that could change if Putin’s failure in Ukraine triggers China to make a Hail Mary run for Taiwan. A conflict between the major powers would be very bullish for commodities as supplies will likely be constrained.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with a discussion about the latest development in the ongoing banking turmoil. Next, we give our thoughts about the path for future central bank policy. Lastly, we review other market movement news.

On the Horizon: If Silicon Valley Bank (SIVB, $106.08) was the opening shot, then Credit Suisse (CS, $2.25) is the bazooka igniting concern about the global banking system.

• America’s six largest banks have lost a total of $183 billion in market value since February 1. The market rout started when Silicon Valley Bank was forced to offload its bond holdings at a loss of $1.9 billion and worsened after Credit Suisse’s largest shareholder, Saudi National Bank (1180, SAR, 41.50), refused to offer more capital. These events are not inter-related, but their timing has led investors to reevaluate their exposure to financial services companies. Although the Fed’s backstops helped alleviate the problems associated with SVB, the Treasury Department is actively reviewing the U.S. financial sector’s exposure to Credit Suisse.

• Credit Suisse remains the biggest problem for markets currently. The bank’s funding costs have become so high that some analysts believe that it will either need a capital injection or a breakup. Unlike Silicon Valley Bank, Credit Suisse has the liquidity to handle a significant outflow of deposits and has access to central bank facilities in multiple countries. Its problem lies with its profitability. Morningstar analyst Johann Scholtz estimates that the bank will lose $2.2 billion in 2023 and could maintain those losses going into 2024. Despite the bank’s bond being rated as investment-grade, on Wednesday it was trading at distress levels due to concerns that the bank could fail without outside financial support.
• While the bank may be too big to fail, it is unclear who will save it. The potential collapse of Credit Suisse has been known since October 2022. Economist Nouriel Roubini went as far as to claim that the bank is “too big to be saved.” Additionally, merger and acquisition options remain limited as major banks debate the price that they would be willing to pay for the struggling institution. Wednesday’s announcement that Credit Suisse will borrow up to 50 billion CHF ($54 billion) to purchase shares has calmed markets, but the bank is far from being out of the woods.
  • In more unwanted news, First Republic Bank (FRC, $31.16) is expected to make a sale after S&P Global Ratings and Fitch Ratings cut its debt to junk status.

Other Central Banks: The backstops provided by the Federal Reserve and Swiss National Bank have alleviated concerns but have also complicated the central banks’ efforts to combat inflation.

• The European Central Bank reluctantly raised rates by 50 bps in its policy meeting today and signaled that it would be paying closer attention to the market going forward. In their statement, policymakers emphasized that they will be monitoring inflation pressures and financial stability. The move suggests that the bank may feel confident that the Credit Suisse issue will not have significant spillover effects. Its lack of guidance indicates that the central bank does not want to lock itself into a decision currently.
• Despite the ECB rate move, the Federal Reserve’s decision to raise rates is still very complicated. Federal Reserve Chair Jerome Powell has put himself in a bind. During his testimony before Congress, Powell emphasized that the cost of failing to restore price stability will exceed the cost of success. Now that we have had two bank scares in less than a week, his words may come back to bite him. Over the last few weeks, Fed officials have assured markets that they were determined to bring down inflation at all costs, but the market now believes their fight is close to an end. Fed futures contracts, at the time of this writing, are signaling that the Fed will likely raise rates by 25 bps at next week’s meeting, and may be more cautious moving forward.
• That said, talk of “disinflationary shock” may be enough for central banks to be less aggressive going forward. The belief is that the ongoing banking crisis could encourage banks to pull back on lending. If true, it would be mean that a recession is much closer than policymakers realize. We have noticed that recent events have made trading government securities’ more difficult as banks look to shore up their cash positions for emergency situations. The Bloomberg Government Liquidity Index, which increases as bonds become less tradable, shows that government securities illiquidity from Japan (gray), the U.K. (orange), and the U.S. (blue) have risen to levels not seen since the start of the pandemic.

U.S. – International Relations: While the market is focused on banks, it is missing other important stories abroad.

• TikTok is under increased pressure to distance itself from China. The Biden administration has threatened to ban the Beijing-based social media site from the United States if Chinese owners don’t sell their stake in the company. The warning comes amidst rising tensions and growing distrust between the world’s two largest economies. The move helped support Snap Inc. (SNAP, $10.48) and Meta (META, $197.50) shares, but is likely to signal further decoupling between the two major powers.
• Meanwhile, tensions between Russia and the U.S. continue to escalate. The Pentagon released footage of the surveillance drone that crashed into the Black Sea. The video showed that a Russian fighter jet had dumped fuel on it and the U.S. military claimed that another jet collided with the drone. Both sides have blamed the other for the downed drone and accused the other of taking more aggressive behavior over the Black Sea. At this time, there do not appear to be calls for retaliation from the U.S., but the incident suggests that there is a heightened risk of direct confrontation between the two countries.
• Iran agreed to stop sending military weapons to the Houthis in Yemen as part of its pact with Saudi Arabia. The two countries had taken opposite sides of the conflict in Yemen. As a result, the Chinese-brokered deal may pave the way for the Houthi rebels to come to the negotiating table for peace talks. The arrangement reinforces the view that China is pivoting its foreign policy toward the Middle East as it looks to prevent being ever dependent on the U.S. for resources.
  • Although China has relied heavily on Russia for its oil needs, there is a concern that Russian crude production will fall in the coming years due to a lack of investment related to Western sanctions.

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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 Silicon Valley Bank crisis.  Although the U.S. banking system appeared to be stabilizing yesterday, the jitters touched off by SVB have now sparked concerns about major European banks.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including several reports touching on economic and political instability in key emerging markets.

U.S. Banking System:  Yesterday brought additional evidence that the crisis touched off by the failure of Silicon Valley Bank (SIVB, $106.04) could be easing, at least domestically.  We have seen no reports of widespread bank runs in the U.S., and the regional banks with relatively high proportions of uninsured deposits saw their stock and bond prices partially recover yesterday from Monday’s selloffs.  However, Swiss banking giant Credit Suisse (CS, $2.51) is suffering enormous declines in the value of its stock and bonds today as the jitters touched off by SVB appear to be spreading to Europe (see next section).

• As the U.S. financial system stabilizes, attention is turning to the longer-term fallout of the crisis. Importantly, many investors still expect the Federal Reserve to slow, stop, or even reverse part of its ongoing interest-rate hikes when it holds its next policy meeting next week.  We agree that the policymakers might slow their pace of rate hikes, but only temporarily.  After all, even though they’re probably close to the end of their tightening cycle, the policymakers haven’t yet gotten inflation back under control.
  • For investors who assume the Fed will cut rates because of the SVB crisis, we would remind them that the central bank now has a separate tool to address that issue: its new “Bank Term Funding Program (BTFP).” This program allows banks to borrow unlimited amounts from the Fed at the par value of any Treasury, Agency, or mortgage-backed securities they have available to pledge as collateral.
  • Since the BTFP backstop appears to be working to stop widespread bank runs here in the U.S., at least so far, the Fed is likely to feel it can keep hiking interest rates to bring inflation down.
• Over the longer term, the crisis is likely to spur increased regulation of the banking system. In particular, federal banking regulators are expected to apply their most stringent capital and reporting rules to relatively smaller banks, including those with assets ranging from $100 billion to $250 billion.  Those banks were spared the additional rules in a deregulation measure in 2018, but now they are likely to be re-regulated.  Fed officials have also indicated that they will investigate the downfall of SVB for any criminal behavior.

European Banking System:  As mentioned above, shares of Credit Suisse (CS, $2.51) have dropped some 20% so far this morning.  The bank’s problems are not a direct result of the SVB crisis in the U.S., as the institution has been struggling for years with enormous losses, scandals, management turnover, accounting issues, and other problems unique to itself.  Today’s sell-off was triggered by news that its largest shareholder, Saudi National Bank (1180, SAR, 42.75), has refused to provide any more capital to the bank.  All the same, the concern is that global depositors and investors have now become more suspicious about banks in general, raising the risk of bank runs despite the apparent stabilization we saw in the U.S. yesterday.

• The stock sell-off in Europe has not been limited to Credit Suisse. Many other major European bank stocks are also selling off sharply so far this morning.
• As in the U.S., the volatility is generating calls for the region’s central banks to slow, stop, or even reverse their recent campaigns to hike interest rates to fight inflation. The European Central Bank holds its next policy meeting tomorrow, and that potentially sets investors up for disappointment if the ECB decides to stick with its plan for continued aggressive rate hikes.

China:  Retail sales in January and February combined were up 3.5% from the same period one year earlier, reversing the 1.8% annual decline in sales registered in December.  Separately, January-February industrial production was up 2.4% on the year, accelerating from a rise of 1.3% in the year to December.  The figures suggest the economy continues to recover modestly following the end of President Xi’s draconian COVID-19 lockdowns late last year.  That’s a welcome sign for global demand as the U.S. still seems likely to slip into recession later this year and global banking systems are suffering a loss of confidence.

China-Honduras-Taiwan:  Honduran President Xiomara Castro today announced that her country will switch to recognizing China instead of Taiwan, granting a political victory for Beijing’s effort to isolate the island and eventually bring it under its control.  Beijing has recently been luring away more of Taiwan’s allies with promises of trade and investment opportunities, leaving just 13 mostly small island countries that still recognize Taiwan.

Pakistan:  Protests have broken out across the country in response to an attempt by police yesterday to arrest opposition leader Imran Khan on charges of corruption stemming from when he served as prime minister.  The attempted arrest occurred after several months of Khan being locked in a bitter political stand-off with the government of current Prime Minister Sharif.  The political instability comes as Pakistan is dealing with a deep financial crisis brought on by domestic mismanagement, high inflation, and soaring commodity prices.

Argentina:  The consumer price index in February was up 102.5% year-over-year, marking the country’s highest inflation rate since 1991.  Argentina’s soaring prices have largely been attributed to central bank money-printing, as well as the Russian invasion of Ukraine. The amount of money in public circulation has quadrupled during President Fernández’s first three years in office.

Bolivia:  As the country’s foreign-currency reserves shrink and the central bank has stopped publishing reserve figures, Fitch yesterday downgraded Bolivia’s debt deeper into junk territory, assigning it a B- rating with a negative outlook.  As citizens begin to panic about the boliviano’s (BOB) peg to the U.S. dollar, they have been mobbing the offices of the central bank in a desperate effort to buy greenbacks.

United States-Russia:  Yesterday, a Russian fighter jet collided with a U.S. drone flying over the Black Sea, forcing the drone to crash land into international waters.  According to the Pentagon, two Russian Su-27 fighters followed and harassed the spy drone for about 30 minutes, after which one of the fighters dropped fuel on it before speeding away.  The other fighter then tried to do the same, but it came into contact with the drone’s propeller.  Both Russian fighters then landed in Russian-held Crimea.

U.S. Regulatory Policy:  The Environmental Protection Agency proposed a new rule this week that would limit the amount of so-called “forever chemicals” in public drinking water supplies.  The EPA is proposing maximum allowable levels for two compounds in a class of chemicals known as perfluoroalkyl and polyfluoroalkyl substances, or PFAS, which take a very long time to break down.  If finally adopted, the rule is expected to impose costs of billions of dollars on water utilities around the country.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Silicon Valley Bank crisis and how it appears to be calming down, at least for now.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including further signs of economic decoupling between the West and China and new moves to lower prices in the U.S. healthcare market.

U.S. Banking System:  Yesterday, in the first full day of trading after Silicon Valley Bank (SIVB, $106.04) was taken over by regulators, it appeared that the government’s response to the crisis prevented serious contagion to other financial institutions.  There have been reports that bigger banks, which are perceived to be safer, are now seeing an influx of new deposits from the customers of smaller, relatively riskier banks, but we’ve seen little indication of widespread, debilitating bank runs.  That makes sense given the aggressive structure of the government’s crisis response and the fact that SVB was arguably a unique institution.  Because of its focus on venture capital and technology customers, and its decision to invest much of its portfolio in long-maturity bonds, SVB was especially susceptible to problems.  We’re optimistic that the financial system has dodged a destabilizing contagion situation, but some banks remain weakened, so it’s probably too early to send the all-clear signal.

• Multiple regional banks with a high proportion of uninsured deposits suffered steep stock and bond sell offs For example, San Francisco-based First Republic Bank (FRC, $31.21) closed 62% down.  Many of those smaller banks’ stocks look set to rally today, but their decline yesterday serves as a reminder that some smaller, tech-focused institutions could still have problems like SVB did.
• Overnight, it appeared that a number of foreign banks were also hit with big stock and bond selloffs related to concerns about their holdings of longer-term U.S. Treasury securities. Those concerns could continue to weigh on those banks’ stock and bond values for a while yet.
• Meanwhile, the Federal Deposit Insurance Corporation told Congress yesterday that they plan to take another swing at auctioning off SVB after failing to find a buyer over the weekend. Since the regulators have now deemed the bank to be “systemic,” the FDIC said it could offer deal sweeteners such as loss-sharing agreements.
• A key remaining issue is whether the crisis will convince the Federal Reserve to slow, stop, or even begin reversing its campaign of interest-rate hikes. Traders have certainly shown that they now expect the Fed to at least moderate future rate hikes, but any unexpected reacceleration in inflation could force the policymakers into making the tough call to keep hiking rates aggressively.  Such a move would boost volatility in the financial markets.

Eurozone Monetary Policy:  Naturally, the SVB crisis has also prompted speculation that the European Central Bank could slow its recent aggressive monetary tightening.  ECB policymakers have already signaled they will hike their benchmark short-term interest rate by 50 basis points at their next policy meeting on Thursday, and that is unlikely to change.  After that, however, the SVB crisis and the fear of “breaking something” in Europe could lead to slower rate hikes.

European Union Trade Policy:  In an interview with the Financial Times, European Commission Trade Chief Dombrovskis revealed that Brussels is exploring ways to police EU companies’ investments in foreign production facilities to circumvent bans on technology exports to China and other rivals.  The revelation provides more evidence that the EU is now getting behind Washington’s effort to clamp down on advanced technology transfers to China in order to suppress its military development.

Global Oil Market:  In its monthly oil market forecast, the Organization of the Petroleum Exporting Countries said it still expects global demand to grow to 101.90 million barrels per day this year, up 2.3 million bpd from last year.  The forecast is essentially unchanged from the previous month.  While OPEC now believes Asian demand will be higher than it originally thought, largely due to China’s abandonment of its strict COVID-19 lockdowns, the organization believes the increase will be offset by weaker demand growth in the developed Western economies.

China:  Industry sources say the Chinese government has begun to impede projects to lay and maintain subsea internet cables through the South China Sea, as Beijing seeks to exert more control over the infrastructure transmitting the world’s data.  According to the reports, long approval delays and stricter Chinese requirements, including permits for work conducted outside its internationally recognized territorial waters, have pushed companies to design routes that now avoid the South China Sea.

• The Chinese measures are at least in part a response to recent U.S. moves to exclude China from international cable consortiums and block direct U.S.-China connections.
• Taken together, the moves are another example of U.S.-China decoupling in the information technology and infrastructure arenas.

United States-United Kingdom-Australia:  President Biden, Australian Prime Minister Albanese, and British Prime Minister Sunak signed a deal yesterday to operationalize their countries’ “AUKUS” defense cooperation deal that was announced in 2021.  Under the deal, Australia would acquire at least eight nuclear-powered submarines in an arrangement that is intended to preserve the West’s lead over China in undersea military systems and cement the alliance between Australia, the U.S., and Britain.

• Under the deal, the U.S. will gain additional submarine basing rights in Australia, boosting its ability to deal with China’s increasing military aggressiveness in the region.
  • Repairing and rotating attack subs through a base near Perth will also give the Australians experience with operating and maintaining advanced vessels.
  • The expanded basing rights are consistent with the U.S. strategy of widely disbursing its Indo-Pacific forces to better protect them from a potential Chinese attack.
• Australia will purchase up to five Virginia class attack subs from the U.S. to improve its sub fleet in the 2030s. Virginia class subs are nuclear-powered, making them quieter than Australia’s current subs and therefore more survivable.  They can also patrol much farther without refueling.  They are not armed with nuclear weapons.
• By the 2040s, Australia will shift to buying a new class of subs that the U.K. will design using advanced U.S. technology. Those subs will be made in Britain and Australia.  As part of the deal, Australia will spend billions of dollars to improve its Perth naval base and expand the submarine industrial bases in the U.S., the U.K., and Australia.

United States-Canada:  Volkswagen AG (VWAGY, $18.33) said it will build its new electric-vehicle battery plant in Canada to take advantage of the clean-technology subsidies from the U.S. in last year’s Inflation Reduction Act.  As we reported in our Comment last week, the company was lured into making its investment in North America by the prospect of billions of dollars in subsidies from the IRA.  It has put plans for a European battery plant on hold to see if the EU comes up with similar subsidies.

U.S. Military Power:  In a move little noticed by the press, last week President Biden invoked the Defense Production Act to authorize a Defense Department program aimed at accelerating the rebuilding and expansion of the U.S. hypersonics industrial base.  The authorization allows the Defense Department to establish incentives for companies to increase production capacity or quality within critical technology areas that the president deems critical to national defense.

• China and Russia remain far ahead of the U.S. in fielding sophisticated hypersonic missiles, which can fly at several times the speed of sound and be maneuvered to dodge anti-missile defenses.
• After several failed tests, the U.S. finally scored some successful tests of its hypersonic technology last year. The new DPA authority suggests the Defense Department is preparing to mass produce the new weapons in order to better compete with China and Russia’s militaries.

U.S. Healthcare Industry:  Novo Nordisk (NVO, $140.54) said it will cut the U.S. list prices of several of its insulin drugs by up to 75% beginning in January 2024.  In addition, the company will cut prices for its unbranded insulin products to match the reduced price of its corresponding brands.  Novo Nordisk’s move follows a similar price cut by Eli Lilly (LLY, $324.49) earlier this month.  The price cuts, made under pressure from the Biden administration, will primarily benefit uninsured people, as insured patients often pay fixed co-pays for their insulin.

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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 the U.S. banking system, which has now seen the collapse of several sizable banks in the last week.  Over the weekend, federal regulators put a plan into place that appears to have removed the fear of massive bank runs, but that plan does nothing to shield bank stockholders and bondholders.  Bank shares and bonds remain under pressure so far today.  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 from the Chinese government’s “two sessions” meetings.

U.S. Banking System:  Following Friday’s collapse of Silicon Valley Bank (SVIB, $106.04) and its takeover by regulators, Signature Bank (SBNY, $70.00), a key depository institution for cryptocurrency firms, collapsed on Sunday and was taken over by regulators.  To avoid a widespread loss of faith in the nation’s banks and their deposit insurance backstop, the Treasury Department, the Federal Deposit Insurance Corporation, and the Federal Reserve declared the two institutions to be a systemic risk to the country’s financial system.  This gave the regulators special powers to guarantee the banks’ uninsured deposits and establish a broad “Bank Term Funding Program” of one-year, collateralized loans to help banks cover their customers’ withdrawals.  The regulators said Silicon Valley’s depositors will have access to all of their funds by Monday.

• The critical issue in this crisis is contagion. Anytime a bank fails, it raises the risk of a widespread run on banks.  Fortunately, Silicon Valley was unusual in that so many of its deposits were bigger than the $250,000 insured by the FDIC.  In addition, under the government’s rescue scheme, the FDIC will cover 100% of the deposits at Silicon Valley and Signature, rather than the standard $250,000.  Federal regulators said any losses to the FDIC would be recovered in a special assessment on banks, and that the U.S. taxpayers wouldn’t bear any losses.  The banks’ equity and bond holders will not be made whole.
• In a statement Sunday night, the Fed said it was closely monitoring conditions in the nation’s financial markets and would use its “full range of tools to support households and businesses” as appropriate.
• The regulators launched their rescue plan after failing to find a buyer for Silicon Valley over the weekend. If their plan is seen as credible, it could restore confidence in the banking system and prompt a rebound in stock prices today following the rout on Friday.  However, the crisis could also spark a reversal of the bank deregulation of recent years and, if it’s seen as a bailout at the public’s expense, it could also be a political black eye for the Fed and the Biden administration.
• We have long warned that the Fed’s aggressive interest-rate hikes had the potential to “break something” in the financial system, and it now appears that the “something” was medium-sized, technology-dependent banks. It was reassuring that last year’s many bankruptcies and financial shenanigans in the cryptocurrency industry appeared to have little impact on the broader financial system.  However, it now appears that the Fed’s rapid rate hikes dried up financial flows into venture capital funds and technology startups, forcing them to withdraw funds from tech-focused banks even as those banks faced falling values for their bond holdings.
  • Fortunately, it appears so far that Silicon Valley and Signature represent relatively rare special cases. Some other smaller, regionally focused banks are facing pressure this morning, but it appears that the regulators’ emergency program will be able to contain the crisis and prevent broader contagion.
    • Another asset class that could come under pressure in the near future is mortgage REITs.
    • If Silicon Valley has to dump large amounts of its $50-billion portfolio as it is cleaned up, then the mortgage-backed securities could face losses.
  • Going forward, the crisis could well prompt the Fed to slow its rate hikes to assess any further stress in the financial system.
  • Reflecting the chance for slower rate hikes, investors today are bidding up bonds, pushing their yields down. The yield on the benchmark 10-year Treasury note has fallen to 3.505% so far this morning.

Chinese Politics:  In the latest developments from the government’s “two sessions” over the last few days, the National People’s Congress (NPC) gave Xi Jinping a precedent-breaking third five-year term as president to go with his October success in garnering a third term as general secretary of the Communist Party of China (CPC).  The vote, which positions Xi to become president for life, was 2,952 to 0.  Xi was also named head of the Central Military Commission, which leads the People’s Liberation Army, for a third term.

• The NPC on Saturday also named Li Qiang as China’s premier, the government’s #2 official. As powerful as that sounds, the role has come to be seen mostly as that of an implementer of the president’s policies, especially in the economic sphere.
• The NPC yesterday also kept Yi Gang as the head of the People’s Bank of China and Liu Kun as finance minister, in an apparent effort to reassure investors by leaving familiar faces at the central bank and finance ministry. However, given that the legislature has also approved Xi’s steps to again give the CPC the lead in setting policy, leaving Yi and Liu in their positions does not necessarily mean policy continuity.

Chinese Mining Industry:  New analysis from a British cobalt trader estimates that China will account for 50% of global cobalt production within the next five years, up from approximately 44% currently.  The increase will come despite Western efforts to gain control over supply chains for critical minerals such as cobalt, lithium, and nickel, which are essential for making EV batteries.  We continue to believe that China and its evolving geopolitical bloc may crimp global supplies of the critical minerals they control as tensions with the West continue to worsen.

China-Saudi Arabia-Iran:  Over the weekend, additional details came out regarding the Friday deal, brokered by China, in which Saudi Arabia and Iran agreed to reestablish diplomatic relations.  Besides Saudi Arabia and Iran agreeing to reopen each other’s embassy and restart normal diplomatic operations within two months, key elements of the deal and interests for the three participants are as follows:

• Saudi Arabia agreed to tone down the critical coverage of Iran by Iran International, a Farsi-language satellite news channel funded by Saudi businesspeople. Iranian officials believe Iran International has been instrumental in encouraging the recent popular protests against Iran’s government.
• In return, Iran agreed to stop encouraging cross-border attacks on Saudi Arabia from Yemen by Iranian-backed Houthi rebels.
• By brokering the deal, China gained the ability to present itself as an independent, influential power broker in the Middle East. China was also able to leverage its growing economic heft and its position as a key buyer of Middle Eastern oil.  For example, it appears that China has promised to help Iran deal with its current currency crisis and other economic woes so long as Iran improves its behavior vis a vis other Chinese friends in the region.  China probably also offered economic incentives to Saudi Arabia to come to a deal.  In any case, the agreement helps deter Saudi Arabia, which we assess to be in the developing “lean-China” geopolitical bloc, from getting too close to Israel and the rest of the U.S. bloc as it seeks protection from Iran’s expansionist policies in the region.  Indeed, it may be that China pushed through the Saudi-Iranian deal to scuttle a potential Saudi-Israeli normalization deal that the U.S. has been pushing.
  • As Israel becomes increasingly alarmed about Iran’s rapidly advancing nuclear program, the deal will probably constrain any plans it may have for a surprise military strike on the country.
  • Such a strike would probably require cooperation from Saudi Arabia, such as allowing Israeli jets to use its airspace. After working with China to reestablish ties with Iran, Saudi Arabia now would probably be more reluctant to allow that.

China-Russia-Ukraine:  In a sign that China may be trying to build on its recent diplomatic successes, the Wall Street Journal has scooped that Chinese President Xi will finally speak with Ukrainian President Zelensky for the first time since Russia’s invasion of Ukraine.  Xi’s call to Zelensky is expected to come after Xi visits Moscow next week to meet with Russian President Vladimir Putin.  It wouldn’t be surprising if Xi fleshes out his recent peace proposal for the Russia-Ukraine conflict, which was widely panned as nothing more than general principles.

Japan:  Investors are complaining that upcoming revisions to the rules Japan applies to companies’ anti-takeover defenses could deter domestic takeover bids, foreign buyers, and shareholder activists.  If so, it would exacerbate Japan’s longstanding reputation as a country where companies don’t prioritize investors and shareholder value.

United Kingdom:  The country continues to deal with continuing waves of strikes by transportation and public-sector workers.  Today, junior doctors in England’s National Health Service will begin a three-day walkout for higher pay.  This week will also bring additional strikes by teachers and other public employees seeking higher wages.

U.S. Military Power:  The nation’s newest aircraft carrier, the USS Gerald R. Ford (CVN 78), has embarked on her first deployment with a full air wing.  The vessel is the lead ship in the Navy’s new Ford class of carriers, incorporating multiple improvements over the previous Nimitz class.  After the Ford’s short deployment last year with a partial complement of aircraft, the current deployment is designed to refine how her crew and the rest of her task group will operate with her new technologies.  Once that is completed, the ship can finally be certified for a regular deployment, some six years after she was commissioned in 2017.

• Among their new features, the Ford-class ships utilize powerful electromagnetic catapults to get aircraft airborne, rather than the older steam-catapult technology. The ships also have advanced new elevators to move aircraft and armaments between the deck and hangers below.  Compared with Nimitz-class carriers, Ford-class vessels have their “islands,” i.e., control towers, farther aft to free up deck space and make deck operations more efficient.
• The six-year period between the Ford’s commissioning and first regular deployment illustrates some of the challenges faced by the U.S. defense industry as the West ramps up its defense spending to push back against authoritarian aggressor states like China and Russia. Part of Ford’s delay came from mechanical problems associated with her new technologies.  Even excluding that issue, however, current Western military procurement processes can be extremely slow and inefficient.

U.S. Fiscal Policy:  Late last week, President Biden released his proposed federal budget for the fiscal year starting October 1.  The proposal envisions total outlays of $6.883 trillion, or 25.3% of forecasted gross domestic product, compared with the current fiscal year’s projected outlays of $6.372 billion, or 24.2% of GDP.  Receipts would total $5.036 trillion, or 18.5% of GDP, compared with this year’s $4.802 trillion, or 18.2% of GDP.  That would leave the coming year’s federal deficit at $1.846 trillion, equal to 6.8% of GDP.  The proposal calls for cutting the deficit in future years by hiking taxes on corporations and individuals with very high incomes.  However, since the Republicans control the House of Representatives, the proposal is unlikely to pass and whatever budget emerges is likely to look far different.

U.S. Environmental Policy:  As the Biden administration prepares to approve the big “Willow” oil-drilling project in the Alaskan Arctic and anger environmentalists, he is also preparing to offer them a sop in the form of a ban on future oil and gas leasing in U.S. Arctic waters.  The ban would make about 2.8 million acres in the Arctic’s Beaufort Sea off limits to future oil and gas leasing indefinitely.

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