Daily Comment (May 2, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a report showing an acceleration in the Eurozone’s consumer price inflation.  While the acceleration was modest, it could still encourage a more aggressive interest-rate hike by the European Central Bank at its policy meeting on Thursday.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an unexpected resumption of rate hikes in Australia and a warning by U.S. Treasury Secretary Yellen that the federal government could be unable to pay its bills by June 1 if Congress doesn’t act to raise the federal debt limit.

Eurozone:  The April consumer price index was up 7.0% from the same month one year earlier, dashing expectations that annual inflation would be unchanged at 6.9%.  The acceleration in headline price growth could encourage the European Central Bank to again hike its benchmark short-term interest rate aggressively at its policy meeting on Thursday.  That’s especially the case given that a separate key measure of inflation also remains worrying.  Excluding the volatile components of food and energy and the government-influenced prices for alcohol and tobacco, the April core CPI was up 5.6% on the year.  That marks somewhat cooler core inflation than in March, when the core CPI was up 5.7%, but it was no cooler than the 5.6% increase in the year to February.

Italy:  The right-wing populist government of Prime Minister Meloni has issued a decree aimed at making it easier for companies to hire new workers.  The decree will reduce the country’s “basic income” support for people who can work and ease regulations to make it easier to hire short-term workers.  In a modest effort to encourage more births, the policy also includes a cut in payroll and benefit taxes for workers with children.  None of the changes are revolutionary, but they could have a small impact on Italy’s labor market, and they could signal further, more substantial moves by Meloni later, despite opposition by labor groups.

Russia-Ukraine War:  The U.S. released a new, unclassified estimate that Russian forces fighting in Ukraine have suffered approximately 100,000 total casualties since December, including about 20,000 killed in action.  According to the report, about half the fatalities were members of the Wagner mercenary group with half of those being prisoners who had been enticed to join up in return for their freedom if they survived a six-month tour of duty.  The enormous losses show how the Russians’ strategy has caused a depletion in their combat strength just as the Ukrainians look set to launch a new counteroffensive.

Australia:  The Reserve Bank of Australia (RBA) unexpectedly resumed its monetary tightening cycle by boosting its benchmark short-term rate 0.25% to 3.85% to help bring consumer price inflation back down to target.  The hike by the RBA was its first since a similarly sized increase in March.

  • The RBA’s rate hike underscores that many major central banks remain committed to monetary tightening despite nascent signs that inflation is cooling. The rate hike is a signal that investors should be prepared for the possibility that rates could go higher than anticipated, and possibly stay there, in key countries around the world.
  • As a result of the RBA hike today, Australian bonds have sold off, boosting the yield on 10-year government obligations to 3.456%. In contrast, the Australian dollar (AUD) has jumped 1.01% to $0.6697.

Canada:  The Canadian government and its main public-employee union yesterday reached an agreement on a new labor contract that will end the workers’ strike.  Under the deal, the government will boost wage rates by 12% over four years and provide a one-time, lump-sum payment equal to 3.7% of annual pay.  The agreement hewed close to what the unions initially demanded, reflecting the bargaining power they had amid the country’s tight labor market.

U.S. Labor Market:  As we warned in our Comment yesterday, Hollywood screen writers failed to strike a deal for a new labor contract last night with the major networks and studios, prompting them to announce a strike.  As the 11,500 members of the Writers Guild of America walk off the job, late-night and variety shows are likely to be the first affected.  The strike reflects both concerns about the impact of streaming technology on writers, and the increased bargaining power workers have in today’s tight labor market.

U.S. Monetary Policy:  The Fed’s policy making committee will begin its latest meeting today, with its decision due tomorrow afternoon at 2:00 pm ET.  The policymakers are widely expected to hike their benchmark fed funds interest rate by another 0.25%, to a 16-year high of 5.00% to 5.25%.  However, as we mentioned in our Comment yesterday, the focus for investors will likely be on the post-meeting statement and comments by Fed Chair Powell to see if they provide any hints that the rate hikes are finished.

  • Given the damage inflicted on the economy from the current rate-hiking cycle, any hint of a pause could give a boost to equities.
  • Also, any strong signal of a pause in U.S. interest rates would likely be a further negative for the dollar. Factors such as slowing U.S. economic growth and the prospect of continued interest-rate hikes abroad have now pushed the greenback lower by 8.6% from its most recent peak last September.

U.S. Fiscal Policy:  Yesterday, Treasury Secretary Yellen warned that the federal government could be unable to pay all its obligations, including Treasury debt service, as early as June 1 if Congress doesn’t raise the debt limit.  In addition, the bipartisan Congressional Budget Office brought forward its deadline of when the government could default, saying lower-than-expected tax receipts this spring could leave the government unable to pay its bills by early June.

  • The new forecasts raise the risk of a near-term default on government debt, which would likely be a significant negative for U.S. asset values.
  • President Biden later invited the Republican and Democratic leaders of Congress to meet next week to discuss a way forward.

U.S. Bank Regulation:  Responding to the recent U.S. bank failures, the Federal Deposit Insurance Corporation yesterday recommended a boost in the business deposit amount that would be insured as one way to help prevent bank runs.  According to the FDIC, a targeted rise in deposit insurance for businesses’ everyday operating accounts would be more cost-effective and less likely to promote risky behavior by bank bosses than just eliminating the $250,000 cap in place on deposit insurance.

  • The FDIC didn’t specify how much the coverage cap should be raised for business transaction accounts.
  • However, it did calculate that raising the insurance cap to $2.5 million would likely cover what most small and medium-sized companies need to keep in their accounts to cover payroll.
  • In any case, any such change in the deposit amount covered by insurance would require approval by Congress.

U.S. Defense Industry:  As major U.S. defense contractors released their quarterly reports over the last couple of weeks, some company officials said on their earnings calls that they are facing far fewer supply chain problems than they did over the last two years.  Greg Hayes, the CEO of Raytheon (RTX, $100.33), even gushed that, “It’s getting a hell of a lot better.”

  • The officials noted that defense supply chains are still not back to normal, but the situation is far better than it was, and revenue growth now looks set to accelerate sharply.
  • We continue to believe that increasing geopolitical tensions will drive military budgets higher around the world. Due to issues like bureaucratic lethargy, labor shortages, and supply chain disruptions, the expected growth in revenues and profits will probably only become notable in the next couple of years.

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Bi-Weekly Geopolitical Report – Implications of the Iran-Saudi Arabia Détente (May 1, 2023)

Bill O’Grady | PDF

In early March, China brokered a thaw between Iran and the Kingdom of Saudi Arabia (KSA).  The two countries have been at odds for decades, even before the Iranian Revolution in 1979.  Essentially, both nations believe themselves to be the rightful leader of the region.  The nations had been allied during the reign of the Iranian Shah under U.S. auspices, but after the revolution, the U.S. broke off ties with Iran and that break remains to this day.  The KSA has seen relations with Iran change over time, where sometimes they are improving and at other times they are at odds.  Before this most recent thaw, the KSA had broken off relations with Iran in 2016 in retaliation for violent protests directed toward Saudi embassies due to the execution of a Shiite activist by the KSA.

The decision to improve relations, especially under the guidance of Beijing, is noteworthy.  In this report, we will begin with why this attempt to improve relations has occurred now.  From there, we will examine the geopolitical implications that the improved relations could bring.  At the same time, as we noted above, Iran and the KSA have been in opposition for a long time, so an assessment of how far this thaw will go is also important.  We will conclude with market ramifications.

Read the full report

Don’t miss the accompanying Geopolitical Podcast, available on our website and most podcast platforms: Apple | Spotify | Google

Daily Comment (May 1, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several notes on the U.S. economy, including a new federal bank seizure and sale, and the risk of a writer’s strike in Hollywood.  We next review a wide range of other U.S. and international developments with the potential to affect the financial markets today, including big new labor union actions in France and Belgium, and important purchasing managers’ indexes in China.

U.S. Banking Industry:  Over the weekend, major banks including JPMorgan (JPM, $138.24) and PNC (PNC, $130.25) placed bids to take over ailing First Republic (FRC, $3.51), the latest mid-sized bank to face falling asset values and deposit flight connected to the Federal Reserve’s interest-rate hikes.  JPMorgan ultimately won the day, giving it control of about $200 billion of First Republic’s assets and all of the bank’s $100 billion in deposits.  As part of the deal, the FDIC will provide JPMorgan with about $50 billion in fixed-rate term financing and share potential losses on First Republic’s loans.

  • At least so far, it appears that the First Republic takeover could close the chapter on this spring’s bank crisis. As of right now, we’ve seen no major ripple effects elsewhere in the financial markets, which suggests the federal regulators have managed to contain the idiosyncratic problems at Silicon Valley Bank, Signature Bank, and now First Republic.
  • However, we continue to be concerned about longer-term “disintermediation” risks in the banking sector, as high short-term interest rates prompt savers to move deposits out of banks and into investments such as mutual funds and Treasury bills. The loss of deposits could force banks to pull back further on lending and make the impending recession worse than it otherwise would be.

U.S. Construction Industry:  Investors continue to look for signs the economy is cooling enough to bring down inflation and allow the Fed to stop hiking interest rates, but we’re starting to focus more on a factor that could delay the slowdown:  construction spending.  Non-residential commercial construction has grown smartly over the last year and looks set to continue growing in the very near term, in part because of federal fiscal stimulus.  Indeed, spending on new factories has recently reached a record high, more than offsetting the decline in residential building.  We still think the economy is likely to slip into recession soon, but the momentum in construction spending could be one reason it’s taking so long for the data to show it.

  • Even as some firms get cautious about underlying demand and pull back on investment, and even as the ongoing bank crisis threatens to prompt a sharper pullback in lending, those forces will be at least partially offset by:
    • Increased investment in defense industry facilities as the military budget rises;
    • Higher investment in semiconductor factories because of the subsidies in last year’s CHIPS Act; and,
    • New investment in battery plants and other green-technology factories because of the subsidies in last year’s Inflation Reduction Act.
  • Although the Fed’s rate hikes pushed residential construction sharply lower over the last year or so, the decline came entirely in the single-family sector. Construction in the multi-family sector has held up well as residential firms try to meet the increased demand for apartments.

U.S. Labor Market:  Hollywood screenwriters are expected to go out on strike if they can’t agree on a new contract with the major networks and studios by their deadline later today.  In part, the potential walkout reflects the country’s current tight employment market, which has given workers increased bargaining power.  However, it also reflects the concern among writers that they’re being shortchanged by new streaming models.

U.S. Monetary Policy:  The Fed’s policy making committee will begin its latest meeting tomorrow, with its decision due on Wednesday afternoon at 2:00 pm ET.  The policymakers are widely expected to hike their benchmark fed funds interest rate by another 0.25%, to a 16-year high of 5.00% to 5.25%.  However, the focus for investors will likely be the post-meeting statement and comments by Fed Chair Powell to see if they provide any hints that the rate hikes are finished.

  • Given the damage inflicted on the economy from the current rate-hiking cycle, any hint of a pause could give a boost to equities.
  • Any strong signal of a pause in U.S. interest rates would likely be a further negative for the dollar. Factors such as slowing U.S. economic growth and the prospect of continued interest-rate hikes abroad have now pushed the greenback lower by 8.6% from its most recent peak last September.

European Union:  Today, May 1, is the Labor Day holiday in much of the world, including the EU.  In addition to the holiday festivities, however, the day will be marked by a number of labor protests, including yet another round of demonstrations against President Macron’s pension reform in France and even a wide-ranging set of labor protests in Belgium.

Russia-Ukraine War:  The Ukrainian defense minister said his country is close to completing its preparations for a spring counteroffensive, and that it is generally ready to launch the operation.  The statement is consistent with a range of signs that the Ukrainians will soon launch a high-stakes attack to push the Russian occupiers back.  If successful, the counteroffensive could help shore up Western support for the Ukrainians and reduce political pressure for negotiations.

  • Meanwhile, NATO’s top commander, Army Gen. Christopher Cavoli, has told the House and Senate armed services committees that the number of Russian forces in Ukraine has now surpassed the number from when Russia first invaded last year.
  • While Russia has the resources to keep fighting in Ukraine for another year, Cavoli said the country’s forces remain vulnerable to Ukrainian weapons, ingenuity, and resolve.

China:  The official purchasing managers’ index for manufacturing fell to a seasonally adjusted 49.2 in April, short of expectations and far below the 51.9 reading in March.  The April PMI for the service sector also fell, but only to 56.4 from 58.2 in the previous month.  Like most PMIs, China’s are designed so that readings above 50 indicate expanding activity.  The figures suggest the Chinese service sector continues to recover from the government’s strict pandemic lockdowns, but the factory sector still faces challenges, in part because of weak demand overseas.

Iran:  The government’s statistical bureau has now failed to publish any data on consumer prices for two straight months, leading to speculation that the annual inflation rate has surged to a new record high of more than 49%.  Driven in part by U.S. sanctions on Iran because of its nuclear program, the inflation surge risks undermining political stability in the country.

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Daily Comment (April 28, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a deep dive into the GDP data and why we believe that the economy may still be headed for a recession. Next, we give our thoughts on the Bank of Japan’s recent policy decision. Lastly, we discuss the yuan’s (CNY) rising prominence on the global stage.

Growth Moderation: The U.S. economy skirted recession in the first quarter of 2023; however, problems remain under the surface

  • Strong spending from households helped prevent the economy from contracting. According to the Bureau of Economic Analysis, U.S. GDP grew 1.1% at an annual rate in the first three months of the year. The most significant gains came from consumption which accelerated from 1.0% in Q4 2022 to 3.7% in the following quarter. The improvement in the level of spending was related to a sharp pick-up in demand for motor vehicles, which expanded at a pace not seen in the pre-pandemic era.
  • Although it is never good to bet against the U.S. consumer, it is unclear how long spending can continue to save the day. Last week, earnings reports from the four major banks reported an increase in customer delinquencies. At the same time, the Bank of America Institute stated that credit card spending slowed to its weakest pace in two years. The increase in defaults and the decrease in spending will likely worsen throughout the year as the Federal Reserve keeps interest rates elevated to combat inflation. Additionally, the slow rise in jobless benefits suggests that the labor market is finally starting to loosen up.

  • The major unknown is how the Federal Reserve will react once the economy enters recession. The market is accustomed to the Fed cutting rates aggressively during a downturn, but with inflation still elevated, policymakers may instead decide to hold rates steady. The central bank has cut rates below 2% in response to the previous three recessions. As the chart above shows, this aggressive easing has helped fuel market rallies in each of those cycles. The expectation of possible rate cuts helps explain why NASDAQ has gotten off to a solid start for the year. However, the Fed’s failure to repeat this trend could lead investors to readjust their portfolios to reflect the elevated risk associated with tighter-than-normal policy.

No Rush: The Bank of Japan is not close to ending yield curve control (YCC) even as data shows that price pressures are building in the economy.

  • In his first meeting, newly appointed BOJ Governor Kazuo Ueda didn’t surprise markets but paved the way for an eventual pivot. The BOJ left its ultra-accommodative monetary policy unchanged, removed guidance on the future path of policy, and included plans to conduct a long-term policy review. The market widely expected the decision to keep rates intact as investors assumed Ueda would not want to make significant changes to interest rates given the ongoing market turmoil. However, his plan to release the findings on the review of the central bank’s ultra-accommodative policy sometime in 2024 has added to speculation that he is not ready to pivot toward more hawkish policy.
  • That said, the central bank’s lack of guidance on future policy suggests that it has not fully committed to maintaining YCC. Its latest statement scrapped references to keeping rates at “current or lower levels,” indicating that it seeks policy flexibility. The softening of its stance comes amidst mounting evidence that price pressures are becoming sticky. Consumer prices, excluding fresh food in the country’s largest city, accelerated from 3.2% to 3.5% in April. Investor concerns about rising inflation and easy monetary policy led to JPY depreciation against other peer currencies following the BOJ’s announcement.

  • Keeping rates low prevents disruption to the international financial system but incentivizes speculative attacks on the 10-year JGB. The popularity of the yen-carry trade, in which traders try to earn arbitrage profits by borrowing at low rates in one country to invest in higher yielding assets in another, has meant that many traders are exposed to exchange rate risk. The International Monetary Fund has warned that an abrupt end to YCC may have spillover effects on global financial markets. However, doubts about whether the BOJ can credibly maintain its peg may lead to central bank intervention. As a result, the JPY may have less upside now than we thought at the beginning of the year.

Renminbi Rising: In a sign that China is looking to set up a parallel trading system, its currency has increased in popularity.

(Source: The National News)

  • The rising demand for CNY reinforces our view that the U.S. dollar is headed for a secular decline. As regional blocs begin to form worldwide, countries may be forced to hold on to both Chinese and American currencies. We suspect that dual holdings will be most prevalent in countries that find themselves on the wrong side of U.S. sanctions. Thus, the CNY should be popular in authoritarian states. That said, China’s unwillingness to open its capital account will prevent its currency from emerging as a true challenger to the greenback. As a result, we still believe that concerns about the dollar losing its hegemonic status are overblown.

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Business Cycle Report (April 27, 2023)

by Thomas Wash | PDF

The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities.  The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis.  Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.

The Confluence Diffusion Index was unchanged but remained in contraction territory in March. The latest report showed that seven out of 11 benchmarks are in contraction territory. The diffusion index was unaffected at -0.3939 but remains well below the recession signal of +0.2500.

  • Financial stress worsened due to banking turmoil
  • Goods-Producing sector received an unexpected boost from housing
  • Employment indicators worsened but are not signaling contraction

The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is in recovery. The diffusion index currently provides about six months of lead time for a contraction and five months of lead time for recovery. Continue reading for an in-depth understanding of how the indicators are performing. At the end of the report, the Glossary of Charts describes each chart and its measures. In addition, a chart title listed in red indicates that the index is signaling recession.

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Daily Comment (April 27, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts about the positive news regarding Big Tech and why it may not relieve concerns about a possible downturn. Next, we discuss the controversy regarding regional banks and the Federal Reserve’s new lending facility. Lastly, the report provides an overview of the ongoing debt ceiling debate and its impact on bond volatility.

Why the Gloom? Earnings are better than expected, but recession fears weigh on investor sentiment.

  • The Tech-heavy NASDAQ Composite rose 0.5% Wednesday after Microsoft (MSFT, $295.36), Alphabet (GOOGL, $103.67), and Meta (META, $209.40) reported earnings and revenue that beat expectations. Microsoft’s fiscal Q3 2023 results showed that the company’s cloud service business slowed but not as much as investors had feared. Alphabet’s Google search engine was able to generate solid ad sales. Meanwhile, Meta added 37 million daily users to its flagship Facebook app. The tech behemoths’ strong performances have boosted confidence in the sector as layoffs and restructuring have helped make the companies leaner and more efficient. That said, market participants are not convinced that the worst has already come to pass.
  • Despite the strong performance by Big Tech companies, there are concerns from the market of further trouble ahead. The S&P 500 closed down 0.4% on Wednesday on investors fear that quarterly earnings are reinforcing views that consumers are reining in their spending. Dutch Semiconductor equipment maker ASM International (ASMIY, $347.99) reported a drop in first-quarter earnings and stated that the company expected sales to decline in the second half of 2023. Similarly, South Korean company Samsung Electronics (SSNLF, $40.60) posted a record $3.4 billion loss in chip sales in Q1 2023. The decline in semiconductor sales is related to a slump in demand for consumer electronics, which has been associated with changes in the business cycle.

  • Although the S&P 500 is up 6% this year, a few stocks have driven much of the gain. Microsoft and Apple (AAPL, $163.76) accounted for 40% of the increase and now account for a record 13.3% of the index. The lack of market breadth has led to concerns that this year’s rally may not be sustainable. The recent banking turmoil has worsened those concerns. That said, investors should remember that much of the recession fears have already been priced into the market, suggesting that equities remain fertile for long-term investment growth.

Now the Zombies! First Republic’s deposit exodus has put the Federal Reserve’s new emergency lending facility into focus.

  • The new lending facilities give the banks funding by offering cash for their securities at par. This feature allows them to meet deposit withdrawals without selling the securities at a loss, but it doesn’t solve the disintermediation problem. If banks keep deposit rates low, then those deposits are still at risk of leaving for better yielding alternatives. The long-term solution is lower short term interest rates, which discourages disintermediation. However, that solution conflicts with the Fed’s goal of raising rates to contain inflation.
    • As a disclaimer, we note that the regional banking system is relatively stable today, and thus zombie banks are a worst-case scenario that is very unlikely to materialize.

McCarthy’s Opening Salvo:  Republicans raised the stakes in their stand-off with President Joe Biden after narrowly passing their debt ceiling bill through the House of Representatives on Wednesday.

  • The bill will not be made into law but suggests that debt talks will likely extend into the summer. Voted primarily on partisan grounds, the bill passed 217 to 215, with four Republicans refusing to back it. The legislation would increase the U.S. debt ceiling by $1.5 trillion in exchange for $4.8 trillion in budget cuts. Additionally, the bill would push back the potential default date to March 31, 2024, at the latest, setting up a potential battle during the election year. President Biden has vowed to veto the bill if it comes to his desk.
  • The Biden administration has made it clear that they prefer a “clean” increase in the government’s borrowing authority. As a result, President Biden has refused to hold negotiations with his Republican counterparts. White House officials argue that it is the responsibility of Congress to raise the debt ceiling, and thus, should come with no conditions.  The president had released his own budget proposal in March. His plan would cut the deficit by $2.9 billion over a decade and raise $4.7 trillion primarily from higher taxes on corporations and wealthy households.

  • There is unlikely to be much incentive to come to an agreement now. Typically, the stand-off over raising the debt ceiling comes down to the wire, and that is when both sides eventually start making concessions. The focus on the debt ceiling has taken on increased importance due to the impact it may be having on Treasury bills. The yield on one-month Treasuries jumped 26 bps on Wednesday; meanwhile, the spread between three- and one-month treasuries continues to widen. The sudden interest rate change is possibly indicating that investors are worried about not being repaid. Although we think the risk of a government default remains relatively low, uncertainty over the debt ceiling could lead to increased volatility within the financial markets.

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Weekly Energy Update (April 27, 2023)

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

After gapping two weeks ago, oil prices have filled the gap on worries about the global economy.

(Source: Barchart.com)

Commercial crude oil inventories fell 5.1 mb compared to the forecast draw of 1.5 mb.  The SPR fell 1.0 mb, putting the total draw at 6.1 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 12.2 mbpd.  Exports rose 0.2 mbpd, while imports rose 0.1 mbpd.  Refining activity rose 0.5% to 91.3% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  After accumulating oil inventory at a rapid pace into mid-February, injections first slowed and have since declined, putting storage levels below seasonal norms.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $58.47.  The recent actions of OPEC+ are clearly designed to prevent this sort of price from emerging.

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 2002.  Using total stocks since 2015, fair value is $94.82.

Market News:

  • As U.S. oil production rises, associated natural gas production is also rising steadily, leading to a glut. This supply situation is keeping U.S. prices low and is encouraging the expansion of American LNG capacity.  However, higher interest rates and permitting issues are acting to constrain projects, thus leading to persistently low prices of natural gas.
  • China’s large SOE refiners are getting privileged access to cheap Russian crude oil.
  • Natural gas finds in the eastern Mediterranean raised hopes that nations in that region could profit from these discoveries. In addition, there was optimism that this gas could pave the way for improving previously fraught relations between states.  However, on the latter front, only modest changes have emerged.

 Geopolitical News:

 Alternative Energy/Policy News:

(Source: IEA)

  • As the chart shows, sales are lifting, with the bulk of those occurring in China. The IEA reports that 20% of car sales this year will be EVs.  Second, China is beginning to export EVs which could roil global car markets.

  • The expansion of EV sales will begin to destroy oil demand by the end of the decade.

(Source: IEA)

  • Even under existing policies, 5.3 mbpd of demand will be lost to electrics. This sort of information will tend to dampen oil investment, and, paradoxically, could be bullish for crude oil.
  • A battery is stored energy. We are used to thinking about batteries as a chemical process, but in reality any sort of energy storage that can be used later is technically a battery.  That energy can also be kinetic.  Renewable energy sources are notorious for creating excess electricity as particularly sunny or windy days can create more energy than is needed at any given time.  The startup Energy Vault is building facilities in Texas and Shanghai that will lift 24-ton blocks of dirt during periods of excess electricity, and then lower them to spin turbines to generate electricity when it is needed.
  • We continue to note news reports on geoengineering. Although controversial, as climate problems emerge, the use of this technology to address them will become attractive.
  • The EU is adjusting rules to encourage the use of sustainable fuels in aviation.

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Daily Comment (April 26, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

 (Source:  Brad Setzer)

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

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

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

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

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

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

[1] Otherwise known as bribes.

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Daily Comment (April 25, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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

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

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