Daily Comment (March 2, 2023)

Posted on March 2, 2023March 2, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion on how earnings may not provide an accurate picture of the business environment and what that could mean for the economy. Next, we give our thoughts on the recent increase in interest rate expectations and how it affects stocks and bonds. Finally, we end with a review of the dollar’s impact on emerging markets.

Earnings Mismatch: Solid Q4 earnings boosted market optimism at the beginning of the year but concerns over quality have forced investors to rethink their outlook for 2023.

Most S&P 500 companies performed better than expected in the final quarter of 2022. Despite recession concerns, almost 70% of firms reported positive earnings per share and positive revenue surprises. The numbers were far from spectacular but were enough to show that firms were resilient in the face of elevated inflation. This sentiment was reinforced by a FactSet document search showing that the number of S&P 500 firms citing “inflation” in earnings calls fell to its lowest level since February 2021. The strong results helped lift investor confidence that the market may have discounted the worst of a possible recession and buoyed bets of a market rally for when the Fed finishes tightening.
Unfortunately, last year’s earnings numbers may be misleading. The discrepancy can be seen when comparing after-tax earnings with operating earnings. In Q4 2022, the difference between total after-tax and operating earnings widened to a level not seen since the financial crisis. The gap is related to a massive jump in restructuring costs. Firms generally incur these costs when reorganizing their businesses to make them more efficient. Examples of these one-time expenses include furloughs, layoffs, and plant closures.
- Similarly, the divergence between operating cash flows and profits suggests that earnings quality has also fallen.
The market will eventually sort out the inconsistencies in earnings. Going into a recession, managers look for alternative ways to show that their firms remain profitable to compensate for higher borrowing costs and slowing demand. This is seen when firms exclude costs associated with a reorganization or soften revenue recognition standards. Luckily, investors respond to low earnings quality by paying less for stocks. The S&P 500’s retreat below 4000 partially reflects the market’s skepticism about the true profitability of firms. That said, the decline in equities suggests that stocks are positioned for a strong rally once the market is able to value these earnings correctly.

Interest Rate Expectations: Fears over a resurgence of inflation have sent markets into a frenzy as investors try to decide what central banks will do.

Investors were forced to revise interest rate predictions after a faster-than-expected rise in inflation, and strong economic data added to concerns that central banks are not done tightening. Core inflation data in the Eurozone rose 5.6% in the year ending in February, above January’s rise of 5.3%. The strong readings in Europe have contributed to concerns that the U.S. consumer price index may also come in hot later this month. Meanwhile, the U.S. purchasing manager index (PMI) showed improvements in February despite remaining in contraction territory, and Eurozone PMI data showed that output passed the growth threshold last month.
The unexpected rise in inflation and an improvement in manufacturing activity have led investors to revise forecasts of when the Federal Reserve and the European Central Bank will set peak interest rates. Markets predict that the Fed could push rates to 5.5% by September, above a projected peak of just under 5.0% following last month’s Federal Open Market Committee rate announcement. Meanwhile, the European Central Bank is forecast to set rates at 4.0%, their highest level on record. The Bank of England has blunted this trend as comments from BOE Governor Andrew Bailey led investors to revise down peak expectations; however, Thursday’s report of strong wage growth may lead to upward revisions in the BOE’s benchmark policy rate.

Equity and bond markets do not agree on the path of policy rates. Despite modest adjustments over the last few weeks, the Euro Stoxx 50 is up 9.2% to begin the year, while the S&P 500 rose 3.3% in the same period. The resilience in equities indicates that stock traders still believe that the worst is behind them. Meanwhile, the rise in longer-duration bond yields suggests that fixed-income traders are unconvinced. The 10-year U.S. Treasury yield rose above 4.00% for the first time in 16 years on Wednesday, while today similar duration German government bond yields reached a 12-year high at 2.75%.

Dollar Problems: The U.S. greenback has stagnated over the past few weeks, denying a potential tailwind for emerging markets.

Foreign investors in troubled countries are rushing to purchase U.S. dollars to protect their savings from losing value. In Iran, a collapse in sanctions relief talks has led the Iranian rial (IRR) to lose a fifth of its value since last week. The Turkish lira (TRY) may also face pressure after the upcoming elections as the government may be unable to offer the same level of support to the currency. Last month, options were pricing in a 60% likelihood that the TRY would lose 25% of its value by year end. Saver skepticism is shown in the recent outflow from Turkish FX-protected accounts.
Dollar appreciation could lead to higher inflation in emerging market countries. Many foreign transactions are priced in dollars, and thus, currency depreciation will lead to an increase in import prices in items such as fuel and food. Although governments are willing to intervene in markets, their involvement comes at a great cost. Currency support generally leads to some sort of depletion of reserve assets, whether it be gold, monetary reserves, or other liquid securities. This method provides some relief to households, but it also prevents governments from being able to shield economies from the negative impacts of a downturn.
Although the dollar has stagnated, it still poses risks to emerging markets as it blocks countries from the added relief from price pressures related to greenback depreciation. As a result, central banks may be forced to raise rates in certain countries where inflation remains stubbornly high. This does not mean that all is lost for certain countries. MSCI South Korea (3.45%) has seen its equities outperform the S&P 500 (3.30%) year-to-date, despite the South Korean won’s (KRW) depreciation against the dollar. However, we believe that investors will need to be more vigilant when looking at emerging markets as long as the greenback remains elevated.

View PDF

Weekly Energy Update (March 2, 2023)

Posted on March 2, 2023March 1, 2023 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil remains in a trading range between $72-$82 per barrel.

(Source: Barchart.com)

Crude oil inventories rose 1.2 mb compared to a 1.8 mb build forecast. The SPR was unchanged.

In the details, U.S. crude oil production was unchanged at 12.3 mbpd. Exports rose 1.0 mbpd, while imports fell 0.1 mbpd. Refining activity fell 0.1% to 85.8% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. We have been accumulating oil inventory at a rapid pace, even without SPR sales. The primary culprit is low refining activity, which should pick up later this year. The rapid rise in stockpiles is a bearish factor for oil, and current stockpiles have already exceeded the five-year average peak normally seen in early summer.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories. With another round of SPR sales set to happen, the combined storage data will again be important.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001. Using total stocks since 2015, fair value is $94.18.

Natural Gas Update:

Natural gas prices have been under pressure this winter, mostly due to mild temperatures.

This chart shows the deviation of population-weighted heating degree days[1] for the U.S. compared to the average from 1981 through 2010. A negative reading suggests warmer-than-normal temperatures, meaning fewer heating degree days. Although this January was not the mildest on record, heating degree days were clearly below normal.

In looking at the trend of supply and consumption, currently the market is oversupplied (indicated by the balance variable being greater than zero). Interestingly enough, consumption remains robust but so does supply growth.

Because of the warm winter, current inventories are above normal.

The previous chart shows seasonally adjusted working natural gas storage. As the deviation line shows, stockpiles are above normal. We have one more month of storage withdrawals. In April, the inventory injection season begins.

Market News:

As Russian oil flows to Europe decline, we are seeing the U.S. gain market share. Throughout history, the U.S. has, at times, been a major supplier of oil to Europe. Often, these flows have occurred due to wars or other such events. History seems to be repeating itself.
- Reports suggest that Venezuelan crude is also going to Europe.
- Meanwhile, China has been an aggressive buyer of U.S. crude oil as well.
- Last month, the Europeans ended the purchase of Russian oil products, and it appears that these products are now flowing to North Africa. It is not out of the question to assume that some of these products may “leak” to Europe.
- Russia has halted oil flows to Poland.
Platts (SPGI, $341.51) announced it will include WTI in its Brent basket for calculating prices. This decision may narrow the Brent/WTI spread.
OPEC February production rose 150 kbpd. Two-thirds of this rise came from Nigeria.
The IEA has released its annual natural gas report. One key finding is that Europe is rapidly building out LNG receiving capacity.
Despite the recent decline in EU natural gas prices, chemical firms continue to exit Germany due to high costs.
Saudi Aramco (2222, SAR, 31.55) is considering an investment in a foreign LNG plant as demand surges.
After three consecutive La Niña events, the World Meteorological Organization says the odds of an El Niño in 2023 are elevated. The following maps show the possible global impact on temperatures and precipitation.

(Source: NOAA)

The below map shows likely winter temperature effects from El Niño.

(Source: weather.gov)

Although strong pricing of oil should support increased drilling activity, shale producers have been raising output slowly. Rising production costs and less attractive fields are capping production growth.
After more than 70 years, BP (BP, $39.87) announced that it will cease publishing its Statistical Review of World Energy. The report will now be compiled by the Energy Institute.

Geopolitical News:

After a couple months of operating the price cap on Russian oil sales, the data suggests that the cap hasn’t led to lower prices but has succeeded in fragmenting the global oil market. That doesn’t mean the cap will never work, but as of now, the cap hasn’t affected prices. In the wake of this research, there are calls for tighter sanctions. The problem with this approach is that consumers must accept the tradeoff of higher prices.
- Indian buyers report that complying with G-7 sanctions has become complicated and burdensome and may lead to less Russian oil imports.
- Sanctions are degrading Russia’s refining industry. Some sanctions ban purchases of Russia’s refined products, but problems go beyond just the loss of market access. Personnel losses due to the war or emigration are also having an adverse impact.
Two weeks ago, we discussed the report from Seymour Hersh that accused the U.S. of attacking the Nord Stream pipelines. We note that even before the sabotage, natural gas flows had been interrupted on several occasions. It appears that German firms are beginning to take legal action against Russian firms for failing to meet their contractual obligations.
- In the wake of the Nord Stream attacks, we are hearing of increased Russian activity in the North Sea. This region is not only an active oil and gas region, but it is also laced with fiber optic cables that could be severed. The fear is that Russia may begin its own sabotage operations in the area.
Iran appears to be preparing for a broader rupture with the West over uranium enrichment. Meanwhile, the Iranian rial (IRR) is depreciating rapidly; it is reportedly trading at IRR 575,000/USD 1. An iPhone now costs over one billion IRR.
- General Hossein Salami, the commander of Iran’s Islamic Revolutionary Guard Corps, claims that Iran is “at war” with Europe. It’s not clear what triggered this statement, but one likely reason was the EU’s reluctance to break with the U.S. over the JCPOA.
- Iran is claiming it has a hypersonic missile, and the country is working to expand its footprint in space by collaborating with Russia. Russia is also helping improve Iran’s missile program.
- Brazil allowed two Iranian naval vessels to make a port of call despite U.S. objections. The “global south” is increasingly opposing U.S. and European policy goals.

Alternative Energy/Policy News:

China has been able to expand its mining and processing of rare earths and other minerals by accepting lower environmental standards. However, Beijing has been steadily implementing stricter environmental standards in recent years. It appears this rolling crackdown may reduce lithium by as much as 10% of global supplies. We do note that production appears to have resumed, but the fact that it can be closed quickly will likely lead EV producers to hold more inventory.
- China is looking to invest in Bolivia’s troubled lithium industry.
Chinese auto battery makers are reducing costs to their domestic EV industry, which could give them an advantage in the global EV market. Among other EV producers, there is a clear attempt to vertically integrate to secure supply chains.
- Lithium prices are falling due to declining battery prices in China.
- Auto unions are beginning to realize that the shift to EVs will mean fewer jobs.
China is reportedly boosting its wind energy capacity.
One, albeit controversial, way to address climate change is with geoengineering. Geoengineering encompasses a wide range of interventions designed to cool the planet. One idea is to mimic volcanic eruptions which spew particulates into the upper atmosphere. After major eruptions, temperatures tend to fall for several months. We note that a startup firm claims it is using weather balloons to disperse particles into the stratosphere in a bid to cool temperatures. The practice is controversial because it is cheap enough for private actors to perform but various tactics could have unanticipated side effects. Scientists have been calling for more research on geoengineering as a way to slow implementation until we can get a better idea of what various practices will actually do.
Lurking in the background of clean fuels is hydrogen. The gas burns cleanly in a fuel cell with high efficiency. The problem is getting the hydrogen. In general, it comes from two sources: electrolysis and by splitting natural gas. The former breaks down water into oxygen and hydrogen, usually at a great cost, and the latter isn’t much cleaner than just burning natural gas. However, there may be a direct source as there are pockets of hydrogen available in free form. These sources have mostly been ignored by the industry, but there is now growing interest in free hydrogen which may prove to be a cheap, clean, and abundant source of energy.
Direct carbon capture could conceivably reverse climate change. The problem is that current methods are either too small to matter or consume too much energy. Researchers are working to tap thermal energy to address the problem.
Japan is starting commercial production of “semi-solid” batteries. Although they have less capacity, they are considered safer and less polluting.
Japan is also returning to nuclear power, reversing policies enacted after the Fukushima disaster.
China’s purchases of Russian uranium are raising fears of a new arm’s race. In addition, as nations expand their nuclear weapons capacity, it could drive up the price of uranium used for power production.
Biochar comes from heating biomass in the absence of oxygen. The resulting charcoal-like lumps can be applied to soil and will absorb carbon.

[1] Heating degree days (HDD) are a measure of how cold the temperature was on a given day or during a period of days compared to 65^oF. For example, a day with a mean temperature of 40°F has 25 HDD. Two such cold days in a row have a total of 50 HDD for the two-day period.

View PDF

Daily Comment (March 1, 2023)

Posted on March 1, 2023March 1, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with some positive economic news out of China, where manufacturing and services both appear to be recovering from the recent COVID-19 infection wave. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a warning from the Bank of England‘s Governor Bailey that investors shouldn’t necessarily think his central bank will hike interest rates much further.

China: The official purchasing managers’ index for manufacturing jumped to 52.6 in February, bursting past expectations and coming in well above the reading of 50.1 in January. In fact, the February reading was the highest since April 2012. Meanwhile, the February PMI for nonmanufacturing rose to 56.3, also exceeding expectations and marking an improvement from its January reading of 54.4. As with most major PMIs, readings over 50 indicate expanding activity. Taken together, the figures for January and February suggest China’s recovery from its pandemic shutdowns is now gathering pace, although it’s important to remember that Chinese data in those months could be distorted by the shifting Lunar New Year holiday.

China-Belgium: The Belgian government’s Center for Cybersecurity said a Chinese state entity was most likely responsible for the January 2021 spearfishing attack on Belgian parliament member Samuel Cogolati. The attack was launched shortly after Cogolati wrote a parliamentary resolution warning of “crimes against humanity” against the Uyghur Muslims in China.

Coupled with European officials’ recent willingness to warn China against supplying weapons to Russia for its war in Ukraine, the Belgian government’s willingness to call out China’s aggression against Cogolati suggests officials on the Continent are now coming around to a U.S.-style, hardline stance against Beijing.
If that trend continues, it would help solidify the evolving U.S.-led geopolitical and economic bloc, while also likely intensifying the West’s tensions with China and creating new risks for investors.

United States-China: Yesterday, the new House Select Committee on the Chinese Communist Party held its initial meeting, with Republican Chair Mike Gallagher vowing that the panel will “investigate and expose the ideological, technological, and military threats posed by the Chinese Communist party.” The initial meeting included testimony from four witnesses who called out a range of threats from China, along with statements castigating China from both Republicans and Democrats. We suspect the committee will further fuel U.S. voters’ concerns about China and energize support for military, industrial, and political initiatives against Beijing.

Iran: The International Atomic Energy Agency confirmed that it discovered a small amount of uranium purified to a near-weapons grade level of 84% at a spot inspection in Iran last month. Iran has reportedly told the agency that it inadvertently enriched the uranium to that level, but the IAEA’s confirmation of the finding is likely to further heighten tensions between the West and Iran. The news could also bring forward a potential Israeli attack on the country.

Israel: Besides the unsettling news from Iran, the Israeli government is also struggling with growing violence between Jewish settlers and Palestinians in the West Bank. In recent days, fighting erupted after a Palestinian gunman shot two Jewish settlers dead in Huwara, a Palestinian town south of Nablus, where the Israeli army killed 11 Palestinians and injured 100 more last week in its deadliest raid on the West Bank since 2005.

Nigeria: Ruling party candidate Bola Tinubu has now been declared the winner of Saturday’s presidential election after final results showed him with 8.8 million votes. Atiku Abubakar of the opposition People’s Democratic Party came in second with 7.0 million votes, and Peter Obi, the Labor party contender whose youth-focused campaign turned the usual two-party race into a competitive three-man battle, came in third with 6.1 million votes. Because of the fractured vote and Tinubu’s advanced age coupled with his reputation for corruption, it would not be surprising if political tensions and instability remain in Nigeria for some time.

United Kingdom: Bank of England Governor Bailey warned that investors shouldn’t necessarily believe that the central bank will need to impose many additional interest-rate hikes to cool the economy and bring down inflation. According to Bailey, his policymakers still have no presumption that they would need to raise interest rates further from the current 4.00% level.

While financial markets now expect rates to rise to 4.75% by the end of 2023, up from an expectation of a peak of 4.25% at the start of February, Bailey said he had not seen anything in the data to justify the change in outlook.
Despite Bailey’s comments signaling a potential for lower-than-anticipated interest rates, the GBP is trading only slightly weaker today at about $1.2014.

U.S. Labor Market: Two large on-line recruiting companies said they are seeing the number of job openings fall faster than indicated by the government’s monthly JOLTS report. The data suggests that the U.S. labor market may be cooling faster than indicated by the top-line official reports. If so, it could mean that the anticipated recession is taking hold and inflation pressures could soon start to moderate despite the exceedingly strong economic activity in January.

U.S. Student Loans: The Supreme Court held oral arguments yesterday on the validity of President Biden’s pandemic-driven program providing student loan relief. By all accounts, the conservative majority expressed skepticism that the administration could order such a broad-ranging policy change without the consent of Congress, even though it relied on a law giving it some power to modify such a program. Since the court’s final decision may not come until summer, millions of people with student loans will now spend months in a state of uncertainty regarding their debt obligations.

U.S. Cryptocurrency Regulation: After New York officials halted new issues of the BUSD stablecoin last month because of regulatory questions, new reports say investors have pulled about $6 billion from the product, reducing the amount in circulation by one-third. The figures illustrate the cryptocurrency regulatory risks that we have long warned about.

View PDF

Daily Comment (February 28, 2023)

Posted on February 28, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a deal between the European Union and the United Kingdom to resolve their disagreement on how to handle Northern Ireland under Brexit. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs of a disappointing rebound in consumer price inflation in Europe and data showing a slowdown in India’s economic growth. We end with an in-depth discussion of the new U.S. industrial policy to support advanced semiconductor manufacturing.

European Union-United Kingdom: At Windsor Castle yesterday, European Commission President von der Leyen and British Prime Minister Sunak unveiled their deal to adjust the Brexit withdrawal agreement’s Northern Ireland Protocol, which regulates U.K. shipments to Northern Ireland that might enter the EU’s single market. Under the revised plan, goods from Great Britain destined only for Northern Ireland will travel on a new “green lane” with fewer checks, while goods at risk of continuing on to the Republic of Ireland (i.e., entering the EU’s single market) will move through a separate “red lane” with more stringent checks. The deal will also ease customs paperwork for individuals, normalize some taxes, and allow the Northern Ireland legislature to control some changes to the rules.

If implemented, the “Windsor Framework” would likely ease EU-U.K. tensions. However, despite Sunak’s success in striking the deal, there is still a strong chance that the far-right wing of his Conservative Party will oppose it on sovereignty and nationalism grounds. It could also still be rejected by unionists in Northern Ireland.
Either event could destabilize the Sunak government, potentially prompting some of his ministers to resign and encouraging unionists in Northern Ireland to continue blocking the formation of a coalition government for the province.

Eurozone: France’s February consumer price index was up 7.2% from the same month one year earlier, worse than expectations that it would be up just 7.0%, as it was in January. Just as disappointing, Spain’s February CPI was up 6.1% on the year, accelerating from its inflation rate of 5.9% in the previous month. The figures have sparked concerns that the Eurozone’s inflation will be more persistent than hoped for and that the European Central Bank will have to hike interest rates even more than planned. The chart below shows the year-over-year change in the French and Spanish CPIs since just before the Great Financial Crisis.

Swap markets now suggest that investors expect the ECB to hike its benchmark interest rate to a record 3.85% by November, compared with 2.50% currently.
As a result, government bond yields in the Eurozone have risen so far this morning. The yield on Germany’s two-year notes has risen to 3.10%, their highest level since 2008, while the yield on its 10-year notes has reached 2.65%, which is their highest since 2011. The yield on Italy’s 10-year notes has risen to 4.53%.

Russia-Ukraine War: Ukrainian officials say their forces are finding it increasingly difficult to hold the northeastern Ukrainian city of Bakhmut, despite inflicting enormous casualties on the Russian regular and mercenary forces attacking it. We suspect that the statements could be aimed at preparing their country and allies for an eventual decision to abandon the city. The current Russian offensive has been only marginally successful, and Russia will probably continue to struggle to generate significant combat power. However, the Ukrainians may want to limit their potential losses in Bakhmut so they can redeploy their troops for a planned spring offensive of their own.

Russia-China: Western sanctions meant to punish Russia for its invasion of Ukraine are pushing Moscow into a closer relationship with Beijing, and new reporting indicates that Russia is using the yuan more frequently for trade and investment. Russian energy exporters are increasingly being paid in the Chinese currency, some companies have borrowed in yuan, and the Russian sovereign wealth fund is now allocating more of its funds to yuan assets. The development is consistent with our view that China will probably try to push its evolving geopolitical and economic bloc to use some version of the yuan as its reserve currency, which will likely attempt to undermine the dollar at some point in the future.

Hong Kong: Chief Executive John Lee announced that the city will finally drop its COVID-19 mask mandate beginning on Wednesday. Hong Kong has been slow to relax its pandemic measures, but it is now making a concerted effort to ease them in order to bring back businesses and tourists to revive the economy.

India: After stripping out price changes, gross domestic product in the fourth quarter of 2022 was up just 4.4% from the same period one year earlier, marking a pronounced slowdown from the increase of 6.3% in the year ending in the third quarter and 13.2% in the year ending in the second quarter. The big slowdown at the end of 2022 stemmed primarily from weaker consumption as consumers struggled with high inflation.

U.S. Economic Growth: A new survey by the National Association of Business Economists shows that 58% of the 48 top economists believe the U.S. will enter into a recession by the end of 2023, the same proportion as in the previous survey in December. However, only about one-quarter think the recession will start by the end of March, about half as many as did in December. The survey results are consistent with our current view that the economy will slip into recession this year, most likely around mid-year or later.

U.S. Fiscal Policy: With state governments still flush with cash ahead of an expected economic slowdown, more than a dozen are planning or implementing a range of tax cuts. In the latest example, today New Jersey Governor Phil Murphy will propose another $2 billion in property-tax rebate checks as part of his proposed $53 billion state budget.

U.S. Industrial Policy: Yesterday, the Commerce Department released the rules it will use in awarding the $39 billion in subsidies for advanced semiconductor manufacturing under last year’s Chips and Science Act. Among the notable provisions, semiconductor manufacturers receiving the funds will be prohibited from expanding their operations in China for the following ten years. They would also be restricted from any joint research or licensing deals with Chinese entities if they involve sensitive technology. Other strings attached to the funding will restrict the recipient companies from using the money for stock buybacks or dividends. To the extent that the funding produces profits over a certain threshold, they will also be required to refund some of the money to the government.

The Chips and Science Act aims to create a U.S. industry capable of mass-producing leading-edge semiconductors, most of which are currently made in Taiwan. The Act’s $39 billion in subsidies reportedly could be leveraged to generate another $75 billion in federal funding, for total support of more than $100 billion. The Act also includes another $13 billion for research and development, as well as workforce support.
- In an interview, Commerce Secretary Raimondo stressed that one key goal of the Act was to ensure the U.S. military has secure access to the cutting-edge computer chips it needs for its warplanes, drones, missiles, and other weaponry.
- Raimondo also revealed that, since the Act is a national security initiative, the Commerce Department will count on input from Defense Secretary Austin and the defense and intelligence communities as it begins implementing the program this week.
Coupled with the administration’s stringent new prohibitions on sending advanced semiconductor technologies to China, the U.S. is clearly trying to maintain the biggest possible technological lead over China.

View PDF

Daily Comment (February 27, 2023)

Posted on February 27, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with news related to China’s regulation of its technology sector. We next review a range of other international and U.S. developments with the potential to affect the financial markets today, many of which also relate to China and its relationship with other countries. We end today’s Comment with a few positive notes on U.S. inflation pressures.

China: Technology-focused investment bank China Renaissance (1911, HKG, 7.10) said its founder and chairman, Bao Fan, dropped out of sight because he is “cooperating in an investigation carried out by certain authorities” in mainland China. The news seems to confirm that Bao is the target of some kind of criminal or corruption probe. If so, it would probably rekindle concerns that China’s technology sector is still being targeted for discipline, despite recent signs that the government was easing up on it. That’s likely to be a headwind for Chinese technology shares in the near term.

China-United States: New intelligence reports provided to Congress show that the U.S. Department of Energy, which runs several government labs, has now joined the FBI in concluding that the COVID-19 pandemic was caused by a Chinese laboratory mishap. Although other components of the U.S. Intelligence Community still judge that the pandemic began through natural transmission, the new conclusion by the DOE will certainly anger the Chinese and potentially lead them to impose retaliatory measures against U.S. trade and investment.

China-Netherlands-United States: The Dutch company ASML (ASML, $618.38) is virtually the sole supplier of the machines needed to make the world’s most advanced semiconductors. It has reportedly found that a former China-based employee who was accused of stealing technology data from the firm appears to have ties to a Chinese state-sponsored entity which was previously linked to intellectual property theft. The U.S. government is also investigating the incident as a potential case of Chinese industrial espionage.

ASML is so critical to the production of the most advanced computer chips that it is certainly targeted by China for its technology secrets. Even if the West wasn’t trying to clamp down on technology transfers to China, we suspect Beijing would be trying to steal ASML’s technology so that it could share it with Chinese firms and eventually install a Chinese firm at the top of the global semiconductor equipment industry.
If ASML’s technology data theft is confirmed to be linked to Beijing, it will further increase Western-Chinese tensions and put investors at an even greater risk of being caught in the crossfire.

China-Russia: U.S. officials provided more details on their announcement last week that they have intelligence indicating that China is considering sending lethal aid to Russia for its invasion of Ukraine. The officials stated that the aid China is contemplating sending could include drones, artillery, and possibly other weapons. The U.S. revelation likely aims to expose China’s assistance to the aggressor even as it publicly paints itself as a neutral peacemaker and a champion of national sovereignty, independence, and territorial integrity. The U.S.’s hope is that such a revelation will discourage Beijing from following through with sending the lethal aid to Russia.

If China does follow through, then U.S. and European officials have warned that there would be severe consequences for China’s relationship with the West.
It may seem that Western-Chinese relations are already as bad as possible, but the West’s recent moves to “decouple” from China have actually been relatively focused, mostly on the flow of advanced technology and critical resources. Overall, Western trades and investments with China have continued to grow.
That suggests that any further worsening in the West’s relationship with China could lead again to restrictions on a broader range of goods, services, technologies, and capital flows that otherwise wouldn’t be considered sensitive.
As we have warned many times before, worsening tensions with China have the potential to catch investors in the crossfire.

Russia-Ukraine War: Russian forces have launched a new wave of drone attacks on Ukraine and continue their modest counteroffensives at various places on the front lines running from northeastern to southern Ukraine, but their gains appear to be minimal in the face of strong Ukrainian opposition. Separately, Germany, France, and the U.K. have floated a plan under which the North Atlantic Treaty Organization would provide security guarantees to Ukraine as an incentive for it to begin peace talks with Russia.

Nigeria: Although vote counting continues after Saturday’s presidential election, it appears that outsider Peter Obi of the Labour Party has won the state of Lagos, the country’s economic powerhouse and the home state of his main rival Bola Tinubu. As the electoral authorities struggle with various complications in the country’s new voting system, it is unclear when the final election results will be known. That raises the prospect of intensifying political violence in one of the world’s top oil producers.

Mexico: Tens of thousands of protestors rallied in Mexico City yesterday against President Andrés Manuel López Obrador’s “reform” of the electoral system, which passed Congress last week. The changes will slash funding for Mexico’s electoral authority, which is expected to lead to the dismissal of 85% of its professional staff and could potentially put the credibility of the country’s elections in doubt. The protests are a welcome sign that significant numbers of Mexicans are willing to push back against the president’s growing authoritarianism.

European Union-United Kingdom: Several weekend statements by Prime Minister Sunak and his ministers suggest the EU and the U.K. could announce a deal this week to restructure the controversial “Northern Ireland Protocol,” which is the part of the Brexit agreement that keeps shipments from the U.K. to Northern Ireland from flowing duty-free into the EU. The very latest reporting indicates that Sunak could announce the deal as early as today.

However, even if Sunak announces a deal, there is a strong chance that the far-right wing of his Conservative Party will oppose it on sovereignty and nationalism grounds.
Such an event could destabilize the Sunak government, potentially prompting some of his ministers to resign and encouraging unionists in Northern Ireland to keep blocking the formation of a coalition government for the province.

United States-European Union: In an important interview with the Wall Street Journal, European Commission Executive Vice President Vestager toned down her criticism of the new U.S. subsidies for green technology investments found in last year’s Inflation Reduction Act. According to Vestager, a closer analysis of the subsidies suggests that the main threats to European competitiveness will be limited to a handful of sectors, and that even if some European companies may be incentivized to shift their capital investments to the U.S., the subsidies won’t necessarily be the deciding factor.

Vestager’s comments indicate that the U.S. subsidies have become much less contentious, as we have long suggested they would. In part, that’s probably because the U.S. has been encouraging the Europeans to adopt similar industrial policies that would offer support for their own green technology industries over time.
In any case, Vestager’s comments imply that the controversy over the U.S. subsidies will soon subside. That means they won’t be a serious threat to U.S.-European unity going forward.

U.S. Labor Market: The Financial Times released an analysis of the latest corporate earnings reports showing that U.S. companies are now finding it “dramatically” easier to hire, despite recent data pointing to an extraordinarily tight labor market. The report could help reassure the Federal Reserve that wage pressures will soon ease and that the policymakers can soon stop hiking interest rates to slow the economy.

U.S. Apartment Market: Rental housing website Apartment List released data showing the average rental rate on new apartment leases fell in every major metropolitan area in the U.S. over the six months through January. This, in part, likely reflects a spike in supply as newly built apartments become available. According to the data, renters with new leases in January paid a median rent that was 3.5% lower than they would have paid last August. Falling rent prices should eventually help bring down consumer price inflation, although their impact can be slow to show up in the data.

View PDF

Asset Allocation Bi-Weekly – Federal Reserve Policymakers in 2023: Hawks or Doves? (February 27, 2023)

Posted on February 27, 2023February 24, 2023 by Amanda Ahne

by the Asset Allocation Committee | PDF

The Federal Reserve surprised markets when it raised its benchmark fed funds interest rate by a total of 450 bps in 2022, the most rapid increase in over 40 years. Weighed down by technology stocks, equities had their first annual decline in over a decade. The weak stock performance was mainly due to investors’ beliefs that the Fed was not fully committed to its fight against inflation. Recent trends in the fed funds futures market suggest that investors are just now acquiescing to the idea that the Fed is determined to bring down price pressures. However, our analysis shows that the new committee in 2023 may be more dovish than the market currently realizes.

Based on data collected by InTouch Capital Markets, we have given a score to each of the permanent and rotating members of the Federal Open Market Committee based on their level of perceived policy assertiveness. The scores range from 1 to 5, with 1 being a complete dove and 5 being a complete hawk.

The FOMC has 12 seats total with four of those reserved for presidents of the regional Federal Reserve banks. Those four seats are rotated every year, and in 2023 they will be filled by new members from the Federal Reserve banks of Chicago, Dallas, Minneapolis, and Philadelphia. The new group will lean dovish, with an average score of 2.0 for policy assertiveness. In fact, three of the four new members in 2023 rank in the bottom quartile of assertiveness for all permanent and rotating FOMC members. These new members are significantly more dovish than their predecessors, whose average score is 2.6. Indeed, half of the members rotating out in 2023 ranked in the top quartile for policy assertiveness.

In addition to the rotating seats, President Biden’s selection of Lael Brainard as his top economic advisor has left one of the FOMC’s permanent voting seats vacant. There are 10 potential candidates for the position: Mary Daly, Austan Goolsbee, Susan Collins, Lisa Cook, Betsey Stevenson, Karen Dynan, Christina Romer, Janice Eberly, Brian Sack, and Seth Carpenter. Most of the candidates have ties to the Obama administration or are considered reliable doves, so it is unlikely that Brainard’s replacement will add to the current group’s policy assertiveness score. Currently, Chicago Fed President Austan Goolsbee is considered the front-runner. His selection would leave a vacant regional seat, and the Chicago Fed traditionally chooses doves or dove-hawk “swingers” as its president.

Although our analysis suggests that the Fed will favor accommodative monetary policy, the state of the economy and the level of inflation will also guide rate decisions. With unemployment well below its natural rate and inflation significantly above the Fed’s 2% inflation target, the policymakers are still inclined to tighten policy. Hawkish comments from Fed officials following January’s higher-than-expected CPI report illustrate the committee’s sensitivity to backsliding inflation data. Hence, just because the FOMC members may lean dovish doesn’t mean that they will vote that way.

Historically, Fed officials have not been comfortable with raising rates during a recession. The last time the Fed tightened in a downturn was in 1982. Therefore, if unemployment rises significantly, this current group of FOMC voters will likely stop hiking. However, January’s blockbuster payroll numbers and a near-record-low unemployment rate suggest that a pause is unlikely to happen in the short term. Nevertheless, as the economy heads into recession, which we expect to take place in the second half of the year, we will likely begin to see more Fed officials pushing back against further tightening.

We currently forecast that the approaching downturn will probably be a garden-variety recession, which will downplay the need for aggressive rate cuts. Given the Fed’s dovish tilt we suspect that the committee may pause or make a slight pivot by the end of the year. If we are correct, then this outcome will likely lead to a sharp recovery in equities. However, if inflation increases and the economy continues to expand, the Fed could raise rates again which could weigh on stocks.

View PDF

Daily Comment (February 24, 2023)

Posted on February 24, 2023February 24, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with our thoughts about the potential for a bond rally in 2023. Next, we discuss how revisions to economic data may impact our timeline for a recession in both the U.S. and Europe. We end the report with our views on whether the U.S.-led bloc can remain united against Russia and China.

Will the Rally Return? Expectations of higher policy rates have called a potential rally in global bonds into question.

Investors were convinced that a steady decline in inflation and an increased risk of a global recession would force major central banks to moderate their policy stance in 2023. After falling 16.2% in 2022, the Bloomberg EuroAgg Index, which tracks government and corporate bonds within the EU, has climbed 2.2% in the first month of the year. Meanwhile, the Vanguard Total Bond Market ETF, which tracks U.S. fixed-income assets, rose 4.1% in January after falling 13.4% the previous year. These assumptions were turned on their head after a relatively warm January led to stronger-than-expected economic data, and China’s reopening led to upward revisions for global growth.
Hawkish comments from central bankers have led investors to ratchet up their interest rate expectations. Members of the Federal Reserve and the European Central Bank’s Governing Council have argued that strong January data provides evidence that central banks can raise policy rates further. A similar view is shared among members of the Bank of England’s Monetary Policy Committee. Meanwhile, there is speculation that the Bank of Japan is engaging in stealth tightening. Traders have not ignored these changes to central bank sentiment. Overnight index swap rates of four major banks have increased throughout February, suggesting that the market expects global financial conditions to tighten throughout the year.

However, there is still a good chance that bonds could rally this year. Last year’s decline was so deep that any reversal in policy rates could lead to a disproportionate jump in bond demand. The market’s sensitivity to changes in interest rates can partially explain why the U.S. Treasury yield curve has remained inverted for so long. Investors don’t believe that the Fed will keep rates high for long enough to warrant a change in long-run borrowing costs. As a result, fixed-income assets, such as investment grade and government securities, will likely look more attractive as the central bank approaches the end of its hiking cycle.

Recession Fears Are Back: New economic data suggests that Gross Domestic Product growth was slower than investors initially thought in the final quarter of 2022.

Revised figures showed that consumption was less robust than originally estimated, and fixed investment spending continued to be a drag on growth. Although the U.S. economy remained in expansion territory in Q4 2022, revisions have shown that Germany’s economy contracted toward the end of the year. The downward revision in the data suggests that businesses and households had been less active in the economy than sentiment surveys had indicated. Therefore, the risk of a hard landing is now elevated in the U.S. and Europe
That said, all hope isn’t lost for central banks to navigate a soft landing. Governments have attempted to offset some of the negative impacts that rising energy prices and interest rates have had on the economy. In December, the German government approved gas and power subsidies to mitigate the impact of a potential energy crisis for households and firms. Meanwhile, the U.S. is looking at ways to reduce the cost of owning a home. The Biden administration plans to boost homebuying by reducing mortgage insurance costs for some new homeowners. These measures alone may not be enough to prevent a downturn, but they could help delay and/or moderate a future one.
The U.S. and European economies are not deteriorating at the same pace. Downward revisions have not changed our forecast for when a potential U.S. recession could take place. We still suspect a downturn could happen in the second half of the year. A European recession could occur sooner, though, since the region’s higher inflation has caused a greater pullback in consumer spending, and it will be difficult for Europe to stimulate growth while also fighting inflation. It is too soon to tell whether central bank officials will factor in the slower growth in their next policy meetings; however, tighter monetary conditions may raise the likelihood of a deeper recession.

Anniversary of the War in Ukraine: The next year will offer a new durability test for the Western alliance.

The coalition between the U.S. and Europe has held up much better than both Russia and China had anticipated. At the beginning of the war, there was much skepticism about whether the West could remain a united front against Moscow. Russian President Vladimir Putin believed that Europe’s dependency on Russian energy was a key vulnerability of the Western alliance. A multitude of sanctions and billions of dollars’ worth of military equipment proved his thesis wrong. The sanctions may have left much to be desired, but the weapons and equipment sent to Ukraine were critical in slowing Moscow’s territorial ambitions.
China is still the elephant in the room. Although Europe has been willing to sever ties with Russia, they have been less willing to do the same with China. This is not only seen with Germany’s wooing of Beijing last year but also in the reluctance of Dutch chipmaker AMSL($638.09) to participate in U.S.-led export controls against China. Additionally, the reopening of the world’s second-largest economy has provided a major tailwind for Europe. China has noticed this weakness within the alliance and has been trying to play up its role as a peacekeeper to curry additional favor with Europe. Hence, we suspect the U.S. will have a difficult time convincing Europe to clamp down on Beijing without hard evidence of China’s involvement in the war in Ukraine.
Make no mistake about it, there are major divisions within the U.S.-led bloc. However, these differences have not been able to prevent countries from working together to prevent Russia’s advancement in Ukraine. Confronting China will likely provide fresh challenges as the country remains a major export market for European countries. As a result, the U.S. may need to provide Europe with additional assistance if it wants to ensure that the Western alliance remains intact. We are confident that Europe offers many opportunities for investors looking for international exposure. However, this outlook may change if China supplies Russia with lethal weapons.

View PDF

Weekly Energy Update (February 23, 2023)

Posted on February 23, 2023February 23, 2023 by Amanda Ahne

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

Crude oil remains in a trading range between $72-$82 per barrel.

(Source: Barchart.com)

Crude oil inventories rose 7.6 mb compared to a 2.0 mb build forecast. The SPR was unchanged.

In the details, U.S. crude oil production was unchanged at 12.3 mbpd. Exports rose 1.5 mbpd, while imports rose 0.1 mbpd. Refining activity fell 0.6% to 85.9% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. We are accumulating oil inventory at a rapid pace, even without SPR sales. The primary culprit is low refining activity, which should pick up later this year. The rapid rise in stockpiles, though, is a bearish factor for oil, and current stockpiles have already exceeded the five-year average peak normally seen in early summer.

Total stockpiles peaked in 2017 and are now at levels last seen in 2001. Using total stocks since 2015, fair value is $94.35.

Market News:

Environmentalists have been using the courts to prevent oil companies from building pipelines, effectively bottling up supplies. Canadian oil and gas from Alberta have been especially vulnerable to transportation issues. The most logical direction of travel would be south into the U.S., but pipeline capacity issues around the Keystone pipeline limit exports. Attempts to expand the pipeline have been thwarted by regulators. In response, oil interests in Alberta are looking to use rail to expand sales into the U.S. While there is some interest, the recent tragedy in Ohio may present some opposition to this expansion.
- Pipelines to Corpus Christi are reaching capacity, which could cap U.S. oil exports.
- Oil companies are increasingly caught between the pressure to increase output and environmentalists attempting to reduce oil and gas supplies. Overall, this situation will increase costs and will likely reduce supply.
Natural gas prices have had an epic decline over the past several months. High prices in the wake of the war in Ukraine have led to reduced demand and have moderately increased supply. However, a mild winter reduced seasonal demand and the need to reduce storage has caused a sharp drop in prices.[1] The EU’s natural gas consumption fell 19.3% in the period from August 2022 to January 2023 as compared to the same period last year. Price signals matter, and we note there are reports of reduced gas drilling in the U.S.
- The IEA warns that the current low prices for natural gas do not necessarily mean that supply problems won’t emerge in Europe later this year. EU inventories will be elevated going into the spring when inventory injections begin. Nevertheless, high stock levels at the end of winter won’t necessarily guarantee ample supplies for next winter.
- Heat pump sales in Europe are rising rapidly. Although heat pumps are not necessarily ideal for very cold temps, they do reduce heating demands under normal circumstances.
Analysts are becoming increasingly worried that the world’s remaining oil reserves will be of lower quality, requiring higher levels of investment to produce usable oil. If so, this means that costs will rise which will likely lead to higher prices.
Although Saudi Arabia continues to post optimistic demand forecasts for oil, the lack of investment suggests that the country doesn’t believe its own estimates.
One behavior that we often see when supply concerns rise is hoarding. Nations with a key commodity or product will restrict exports to keep prices low in the home country. This is something of a dubious policy since export controls often lead to underinvestment and lower supplies over time. It can also increase smuggling in an attempt to arbitrage the usually higher prices abroad. However, just because a practice doesn’t always yield optimal results doesn’t prevent it from happening. We note that Australia is considering export caps on natural gas, and if this occurs, it could trigger panic buying by consumers who would lose access to this product and drive the prices even higher.
A subcontractor to the CFTC that provides the commitment of traders’ data was hacked; the report has been delayed.

Geopolitical News:

Although the war in Ukraine and subsequent sanctions have not ended Russia’s oil and gas sales, it has caused serious disruptions to trade flows. Natural gas flows from Russia to Europe have been curtailed. Russian oil shipments are increasingly flowing to Asia, and especially China. Increased Russian oil sales to Asia are affecting Middle East oil sales to the region, putting the two oil regions into competition for market share. Despite increased flows from Russia, China continues to show interest in Middle Eastern We commented last week that the Iranian president traveled to Beijing to solidify relations, and China is also attempting to acquire Iraqi oil. However, China remains a significant buyer of Russian crude oil as well. We also note that China usually buys Russian oil at deep discounts.
- Kazakhstan is starting to export crude oil to Germany through the Druzhba pipeline which is owned by Russia. Technically, this oil isn’t under sanction, but it may be difficult to prevent Russian oil from being sold to Europe under the guise of Kazak oil.
- Essentially, we are moving away from a global oil and gas market to one with regional divisions. Commodity markets adapt, but the way markets are dividing is less efficient.
The recent uproar over the Chinese spy balloon has raised questions about how well the CPC actually controls its companies and bureaucracy. In this vein, we note that Chinese officials are talking to refiners, both state-owned and private sector firms, about their oil purchases from Russia. It is unclear exactly what the government is trying to discover, but it is likely that Beijing doesn’t want to get surprised by news of Russian purchases.
China is easing its import ban on Australian coal. The ban was initially implemented when Australia supported an international investigation into the origins of COVID-19. The ban is being lifted now that COVID has fallen from the news and China needs coal.
Dutch intelligence is warning that Russia is targeting energy and internet infrastructure. Reports suggest the Russians are likely to use espionage to disrupt energy and data flows.
The IAEA has indicated that Iran has enriched uranium to 84%, just under the 90% required for nuclear weapons. This level would suggest Iran is at the nuclear threshold, but, so far, there have not been any reactions to this news. Israel has indicated in the past that it views a nuclear-armed Iran as an existential threat, so this news could trigger a strong response from Israel. We note Iran has disputed the IAEA’s report as we suspect that the country does not want this news to become public.
An Iranian drone has struck an Israeli-owned tanker in the Arabian Sea.

Alternative Energy/Policy News:

One of the elements of the Reagan/Thatcher revolution was the discreditation of industrial policy. The idea that government could “pick winners and losers” seemed doomed to fail. The collapse of communism, which epitomized planned economies, further undermined industrial policy. However, as geopolitics is increasingly affecting economics, industrial policy is returning. The Inflation Reduction Act’s provisions to support the buildout of green energy is a clear example of industrial policy.
Tesla (TSLA, $198.39) has cut prices to such an extent that the Model 3 is now the cheapest new car in America.
The IEA is pressing governments to tighten rules on methane emissions. Methane is a greenhouse gas, and although it doesn’t last long in the atmosphere, it is much more potent than carbon dioxide. Tightening these rules will add costs to oil and gas exploration and development, which will likely lead to lower production.
Rare earths are critical in the transition away from fossil fuels. EVs and wind turbines use these minerals, and they are also part of certain tech products such as smart phones. China is not only the world’s leading miner of rare earths, but it also dominates ore processing. The U.S. has reopened a rare earths mine in Mountain Pass, CA, but has exported the ore to China for processing in the past. Japan has built a processing plant and the U.S. has decided to move away from China and export the ore to Japan, further evidence that the U.S. is delinking from China.
Battery technology really doesn’t work well for semitrailers. The need for power is great, and the battery weight becomes prohibitive. There are some efforts to use hybrid technology (going downhill with a semitrailer can generate significant power), but it’s hard to replace diesel. However, fuel cells and hydrogen may be a better alternative over the long term.
On the subject of batteries, for stationary needs, such as utilities, gravity storage may become a solution.
The U.S. is expanding its charging network, and U.S. regulations are requiring the installations to be U.S. made, riling trading partners.
Mexico is planning to nationalize its lithium reserves. Bolivia is wooing China to help it develop its lithium industry. Bolivia has the world’s largest lithium reserves but doesn’t register as a producer due to years of government mismanagement. Although China has the wherewithal to build Bolivia’s industry, the infringement on sovereignty will be a problem.
- Chinese lithium prices are down 30% due to falling demand for EVs.
China is continuing to expand its solar capacity.
China’s leading EV producer BYD (BYDDY, $57.03) is now exporting and selling cars in Germany.
For those keeping score, the map below shows the nations (and states) that have target dates to phase out the sale of internal combustion engines. Automakers remain divided on how fast EVs will replace gasoline-powered cars.

[1] Most natural gas storage is housed in depleted wells. To maintain well integrity, gas must be injected and withdrawn at a steady pace. During mild winters, current production and required storage withdrawals tend to cause significant price weakness.

View PDF

Daily Comment (February 23, 2023)

Posted on February 23, 2023February 23, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning. Today’s Comment begins with our thoughts about the minutes from the latest Federal Open Market Committee meeting. Next, we discuss changes and challenges in the tech sector and what they signal for investors. The report concludes with a discussion about the rising tensions between the U.S.-led and China-led blocs.

Hawkish Minutes: The market has done away with bets for a pivot in June and now expects the Fed to raise rates at least until the start of the third quarter.

According to a Fed statement, the overwhelming majority of Fed members supported slowing the pace of rate hikes. The latest meeting minutes showed that almost all participants favored a 25 bps hike in February, with few participants signaling a preference for a 50 bps hike. Despite the moderation in tightening, the minutes also revealed that all participants agreed that ongoing increases would be needed to help contain inflation. Although the committee acknowledged that inflation was on a downward trend, members insisted that there is still insufficient evidence that inflation is on a sustainable path toward the central bank’s 2% target.
The minutes reinforced concerns from the market that the Fed was not yet prepared to end its hiking cycle. The S&P 500 closed down 0.2% on Wednesday as equity holders weighed the potential for further tightening. Meanwhile, the yield curve was only slightly affected as fixed-income investors had largely priced in the potential for more hikes. The yield on the 10-year Treasury fell 3 bps, while the 2-year yield was relatively unchanged.
The market reaction indicates that investors have accepted that the Fed will at least meet the target rate outlined in its dot plot chart. Following the FOMC policy meeting on February 1, investors had assumed that the Fed was almost done hiking rates. However, this sentiment changed leading up to the release of the minutes as investors weighed hawkish comments from Fed officials. As the chart below shows, investors have drastically revised their expectations of future Fed rates. The change is similar to the level of St. Louis Fed President Bullard’s policy rate outlook. The increase in expectations suggests that financial conditions will likely get tighter throughout the year, and thus, could increase the likelihood of a severe recession.

Down But Not Out: Tech may have taken a beating as of late, but recent changes may make the sector more attractive down the road.

FAANG stocks are down 6.6% over the last five days, despite starting the year strong. The underperformance of the high-tech growth sector is related to concerns that higher interest rates will continue to weigh on earnings. As a result, many of these firms will have to continue focusing on becoming more profitable and managing their expenses to bring more value to their investors. The pivot from tech firms partially explains why the market rallied at the beginning of the year when investors believed the Fed was set to end its hiking cycle.
Tech firms have tightened their bootstraps over the last few months to offset rising interest rate costs. So far, much of the cost-cutting has come from layoffs. For example, Meta (META, $171.12), which fired 13% of its work staff in November, now plans to cut thousands more jobs across the company. Assuming that the job cuts in tech are mostly of inefficient workers, the trimming of the workforce should lead to more productivity and a boost to bottom lines. Therefore, the sector could be positioned for a strong rally when the Fed decides to cut rates.
That said, the tech sector is also facing a litany of challenges that could prevent it from rallying to its full potential. Lawmakers have grown suspicious of the influence big tech firms have over the populace and would like to regulate their ability to collect and sell data. Advancements in artificial intelligence could be impacted as government officials fear that the technology will be misused. AI is an area that both Microsoft (MSFT, $251.51 ) and Amazon (AMZN, $95.79) view as having great revenue-generating potential, but it is also very expensive. Thus, attempts to restrict its use could slow investment in the area.
- Similarly, some U.S. tech firms may face bans in other countries as foreign governments look to promote their own companies. For instance, China plans to restrict access to OpenAI’s ChatGPT service.

Taking Sides: Other countries continue to get caught in the middle of the major power struggle between the U.S. and China.

Tensions between the U.S.-led and China-led blocs continue to ratchet up. Washington insists that Beijing is considering supplying lethal aid to help Russia with the war in Ukraine. The accusation has led to fresh tension between the two largest economies as such actions from China could open the country up to Western sanctions. Additionally, the U.S. plans to ramp up the number of troops it has deployed to Taiwan in the coming months. The move is designed to deter China from invading the autonomous island. Posturing from the U.S. suggests that a thaw in tensions between the two rivals is less likely to happen.
- On a separate but related note, Russian, Chinese, and South African navies will participate in naval exercises off the South African coast later this week. The joint exercises show the growing military ties between Russia and China.
The competition between the two powers has forced smaller countries to choose sides. Western governments are investigating whether a surge of exports from Central Asia included products under sanctions. If these countries are found to have aided Russia with sanctioned goods, they could be hit with penalties from the West. Meanwhile, G-20 host India does not want the word “war” used in any joint statement when referring to the conflict in Ukraine. The country considers itself to be a neutral party in the conflict and does not want the event to be stained by the bickering between rival diplomats. Although India remains a geopolitical ally of the U.S., the country wants to maintain ties with Moscow to preserve its access to Russian mineral resources.

Rising geopolitical frictions between the U.S.-led and China-led blocs remain a prevalent risk for investors. The deep trade ties between the countries mean that any potential unraveling could be felt throughout the world. In the long-term, the decoupling should benefit countries along the periphery of the U.S. as near-shoring should lead to increased capital investment. However, this process will be costly and may force firms to push the adjustment onto consumers. If true, this will likely pose a long-term risk to inflation as less supply-chain diversification will make it more difficult for companies to rely on the lowest-cost producer to manufacture goods.

View PDF