by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a few additional remarks on how the swaggering monetary policies of the major central banks have once again unsettled global stock markets.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including renewed threats to commodity supplies because of the war in Ukraine and evidence that global inflation is pushing up wages, even in Japan.

Global Monetary Policy:  This afternoon the Federal Reserve will release the minutes of its latest policy meeting, and investors are bracing for any additional signs that the policymakers are intent on continuing to raise interest rates further and keep them there for an extended period, as Chair Powell insists.  At the same time, yesterday’s surprisingly strong economic data in Europe has boosted expectations that the European Central Bank could hike its benchmark interest rate to a record high.  European swap markets now suggest investors are expecting the ECB to hike its key rate to 3.75% by September, up from 2.50% currently.

• In the U.S., the yield on 10-Year Treasury notes temporarily rose above 4.00% yesterday, surpassing their level from the end of 2022. The burgeoning concerns about surging interest rates drove U.S. stock prices sharply lower.
• European stocks yesterday fell less dramatically than in the U.S., although they continue to falter so far this morning.

Japan:  In an example of how global price inflation has dramatically changed economic trends,

Toyota Motor Corp. (TM, $139.18) said it had fully accepted its Japanese labor union’s wage demands and will give its employees their biggest pay increase in two decades.  The move by the bellwether manufacturer is likely to encourage other major Japanese employers to follow suit.

• In fact, Honda Motor Co Ltd (HMC, $25.90) also accepted its union demands in full to raise overall wages by about 5%, including base pay and seniority-based pay.
• Such moves in Japan and elsewhere are likely to keep concerns alive about a wage-price spiral that could keep inflation high for longer than investors currently expect.

China:  In recent days, there have been numerous reports that an influential Chinese technology investment banker, Bao Fan, has gone missing.  Bao and his investment bank have been instrumental in bringing many of China’s key technology companies to market.  His disappearance, which may indicate he is under investigation by the government, has raised fears that the country’s technology companies are about to face a new round of corruption and regulatory scrutiny despite recent hopes that Beijing was easing up on the sector.

Pakistan:  Former Prime Minister Khan plans to launch mass protests across the country today in a bid to topple incumbent Prime Minister Sharif, his arch rival, and force new elections.  The protests come as the government is struggling to convince the International Monetary Fund to release the next tranche of a $7 billion assistance package it needs to avoid defaulting on its foreign debts.

Russia-Ukraine War:  As Russian forces continue their underwhelming counteroffensive in the eastern Donbas region, the Ministry of Defense and the Wagner Group mercenaries owned by financier Yevgeny Prigozhin continue trying to undercut each other, exposing an important political rift within the Russian war effort.  To illustrate the damage, Prigozhin has even accused the MOD of withholding ammunition needed by his mercenaries.  For months Prigozhin has been trying to bolster his political power by highlighting the shortcomings of Russia’s official military organizations and demonstrating his mercenaries’ success, but it now appears that at least some officials in the Kremlin are trying to cut him down to size before he gets too powerful.

• Separately, reports indicate Ukrainian grain exports have been declining ahead of the March 19 expiration of the UN-brokered deal in which Russia has allowed Ukraine to export food products through its southern ports. The pullback in exports has already boosted world wheat prices by approximately 10% over the last month to about $8.00 per bushel.
• Similarly, new Western sanctions imposed this month on Russia’s refined crude oil products have refiners worried that they won’t have enough supply of an important input for gasoline. That raises the prospect that global gasoline prices could soon start rising again and keep global inflation from falling as much as it otherwise would.

U.S. Artificial Intelligence:  Microsoft (MSFT, $252.67) said yesterday that it will ease some of the caps it imposed just last week on users of its new artificial-intelligence search engine.  The company had limited the number of questions a user could ask the search engine each session after determining that long conversations confused it and led it to provide disturbing answers.  The company said it was easing the limits based on feedback from users.

• With interest in natural-language artificial intelligence systems growing rapidly, Microsoft’s decision to let everyday users essentially serve as testers has the potential to popularize the new technology even further.
• Workers in a range of industries have already started experimenting with the system, raising expectations that artificial intelligence could revolutionize many knowledge jobs in the future.

U.S. Cryptocurrency Regulation:  The Securities and Exchange Commission is reportedly investigating whether Paxos Trust’s stablecoin, BUSD, violates investor-protection laws.  If the SEC eventually brings a lawsuit and wins against Paxos, the agency could gain much broader authority to regulate the evolving cryptocurrency marketplace.  However, securities lawyers say the SEC faces an uphill climb to convince a court that stablecoins fall under its jurisdiction.

U.S. Winter Storm:  A major winter storm this week is causing heavy snowfall, high winds, and plummeting temperatures from the Rocky Mountains through the northern Great Plains and from the Midwest into New England.  The storm is expected to ground many airline flights and impede ground transportation for much of the nation, potentially causing temporary economic disruptions.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with more evidence that the European economy is growing much better than expected.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new tensions between the West and both Russia and China.  We also include a discussion of why investors should consider not just the central banks’ monetary policy but also the broader mix of economic policies when assessing the outlook for inflation.

Eurozone:  S&P Global reported that its flash composite Purchasing Managers’ Index for February jumped to 52.3, smashing both the expected reading of 50.6 and the final January reading of 50.3.  The unexpectedly strong reading in February mostly reflected a jump in the PMI for the services industries, since the PMI for manufacturing plateaued at just below 50.  As with most major PMIs, readings above 50 indicate expanding activity, so today’s report suggests the Eurozone’s economy has now expanded for two straight months and is currently growing at its best rate in nine months.

• On a related note, S&P Global said its flash composite PMI for the U.K. jumped to an eight-month high of 53.0 from 48.5 in the previous month.
• The reports are likely to be positive for European equities and currencies, although they will also probably encourage the major European central banks to keep hiking their benchmark interest rates aggressively.

Russia-Ukraine War:  President Biden made an unannounced visit yesterday to see Ukrainian President Zelensky in Kyiv and to signal the U.S.’s continuing support for the country as it fights to resist the Russian invasion.  Meanwhile, U.S. Secretary of State Blinken over the weekend said that he has evidence showing the Chinese government is preparing to expand its support for Russia to include lethal equipment.  Chinese officials have denied any such intention, but reports indicate that the U.S. administration has warned China that taking such a step would cross a red line and result in negative consequences for the U.S.-China relationship.  Ironically, Chinese Foreign Policy Chief Wang Yi said China would soon offer its own peace proposal to end the war.  European officials seem to be quite wary of the prospect.

Russia-United States:  In a speech to the national legislature today, President Putin stated that Russia will suspend its participation in the New START arms control treaty with the U.S., which limits the number of strategic nuclear weapons each side is allowed to deploy.

• The U.S. State Department had already formally notified Congress last month that Russia violated the treaty by refusing to allow on-site inspections and rebuffing Washington’s requests to discuss its compliance concerns. Putin’s announcement, therefore, breaks little new ground regarding the treaty’s operational effect.
• On the other hand, as China ramps up its inventory of nuclear weapons with no arms control constraints, the formal or informal demise of New START could free the U.S. to expand its nuclear forces to meet the new challenge of deterring both China and Russia simultaneously. Of course, that would likely entail a dangerous new nuclear arms race.

Iran:  Diplomatic sources say the International Atomic Energy Agency has detected that Iran has been enriching uranium to a purity of 84%, near the weapons-grade level of 90% and far above the 3.67% level it was capped at under the now-defunct limitation agreement of 2015.  If confirmed, the advancement could prompt a sharp reprisal from the international community and potentially lead to a military attack on Iran by Israel.

China-South Pacific Islands:  Illustrating its focus on building influence in the South Pacific region, the Chinese government named its first permanent special envoy to the region last week.  The new envoy will be Qian Bo, who has been China’s ambassador to Fiji since 2018.  The naming of the special envoy will likely cause alarm in the U.S. government and will serve to worsen the U.S.-China geopolitical rivalry, which we believe has the potential to hurt investors.

United States-China:  On the sidelines of the Munich Security Conference over the weekend, U.S. Secretary of State Blinken met with Chinese Foreign Policy Chief Wang and warned him that Beijing must “never again” repeat its “unacceptable” deployment of a surveillance balloon through U.S. airspace as it did late last month.  In its statement on the meeting, the Chinese government countered that the U.S. would “bear all the consequences” if Washington escalated the controversy.

• Overall, the Blinken-Wang meeting gave each side a chance to present their views on the balloon incident, and communication is probably a good thing.
• On the other hand, it is clear that the U.S. and China have diametrically opposed views of key world issues, and those differences are likely to keep U.S.-China tensions high and ensure that investors remain at risk as the relationship deteriorates.

U.S. Monetary Policy:  With the minutes from the Fed’s last policy meeting due to be released tomorrow, investors are worried that the U.S.’s recent strong economic data could push policymakers to hike interest rates even further and hold them there for a prolonged period.  We agree that it is a significant risk, and it is also a key reason why we continue to think that a recession will take hold later this year and that stock prices could fall substantially further before turning upward again.  However, it’s important to remember that such a scenario doesn’t depend on economic trends and monetary policymaking alone.  Another thing to keep in mind is the importance of policy coordination, or how monetary policy affects, and is affected by, other areas of economic policy.  Some strategists and investors should consider that the Fed’s rate hikes to tackle inflation may need to be more aggressive if they aren’t matched by anti-inflation measures in fiscal policy (including both tax policy and spending policy), regulatory policy, industrial policy, and perhaps even social policy (such as education and workforce policies).

• The Fed’s current rate-hiking program is clearly aimed at dampening demand to bring it back into balance with supply. That may get easier as supply chains continue to recover from the COVID-19 pandemic, but factors such as high wage growth and pandemic-era savings balances are still pushing up prices.
• Many other policies could also weaken demand and help boost supply. For example, tax hikes and government spending cuts can decrease demand.  Deregulation that reduces the cost of doing business can boost supply, and the same can be said for industrial policies that help expand particular industries so that they more quickly achieve economies of scale.  Education and workforce policies could boost the effective labor supply.
• The successful fight against U.S. inflation at the beginning of the 1980s illustrates how strategists and investors sometimes lose sight of the importance of policy coordination. The Fed and many other observers continue to believe that it was simply tight monetary policy that finally broke inflation’s back at the time.  In reality, we believe that deregulation and globalization were probably just as instrumental in bringing inflation down and re-establishing the dollar’s value.
• Looking out at the coming years, we expect inflation to moderate significantly, but we continue to believe it will settle at average rates that are higher than in the decades before the pandemic, in large part due to the type of policy mix we expect to hold sway. Regardless of the Fed’s monetary policy, supply is likely to be constrained and made more expensive by deglobalization (a form of re-regulation that cuts off efficiency gains from international trade) and near-shoring (a form of industrial policy that builds relatively more expensive, resilient supply networks closer to home).  Meanwhile, our read of political trends suggests there is no great move toward social policies that might significantly expand the labor force.  Populist tax policies might be targeted toward the wealthy, reducing their ability to invest to expand productive capacity, while the growth in Social Security and Medicare spending as the population ages will help keep demand higher than it otherwise would be.  In sum, investors may need to pay more attention to the thrust of the overall economic policy mix and policy coordination in order to understand where future inflation and interest rates are likely to end up.

U.S. Auto Loan Market:  New data indicates the share of subprime auto loans that were at least 30 days late reached 9.3% at the end of 2022, marking their highest delinquency rate since 2010.  The report suggests that even though the labor market remains strong, a significant number of consumers has been put into financial stress by last year’s spike in auto prices and high inflation for essential household goods.

• Many lower-income families will also soon face the end of their pandemic bump in food stamp benefits. Food stamp recipients in 35 states will lose at least $95 per month in benefits beginning in March.
• That’s consistent with our view, as we noted above, that the economy is still likely to fall into recession later this year.

U.S. Commercial Real Estate Loan Market:  On a related note, data provider Trepp reported that the delinquency rate for loans backed by office buildings in commercial mortgage-backed securities last month jumped to 1.83% from 1.58% previously.  Other reports point to higher delinquency rates and outright defaults for office building loans due to persistently high vacancies and rising interest rates.

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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 mixed signals coming from central bank policymakers concerning future rate decisions. Next, we explain how the transition away from COVID policies and restrictions will affect the West and China differently. Finally, we discuss how potential talks between the U.S. and China could impact the eventual disentanglement of the two economies.

Rate Hike Uncertainty: Future central bank policy is becoming harder to predict as policymakers and investors disagree on the best path forward.

• Monetary policymakers around the world are becoming more hawkish. Regional Fed Presidents James Bullard and Loretta Mester are entertaining the possibility of future 50 bps hikes. Although neither Fed member has a vote on the Federal Open Market Committee, investors have adjusted their estimate for a new peak in the Fed’s target range of its benchmark rate. Investors now expect rates to hit 5.2% by July, up from 4.9% two weeks ago. The S&P 500 fell 1.4% on Thursday following the comments as investors offloaded risk assets.
• European policymakers are sending conflicting messages about their potential policy path after their March meeting. Chief Economist Philip Lane, a noted dove, urged fellow policymakers to bear in mind that the increase in inflation has yet to be felt throughout the economy. Meanwhile, European Central Bank hawk Joachim Nagel insists that borrowing costs have not yet risen to a level that would injure the economy. The ECB is expected to raise interest rates by 50 bps in March and will then discuss future rate increases on a meeting-by-meeting basis. The rate uncertainty led to a 1% decline in the Stoxx Europe 600 and a 1.1% decline in the German DAX on Thursday.
• There is growing angst concerning when the Bank of Japan will pivot. With inflation above the central bank’s 2% target, the market anticipates that the BOJ will tighten policy this year. Newly nominated central bank governor Kazuo Ueda has publicly stated that he would like to maintain the bank’s ultra-accommodative policy. However, investors are betting that the BOJ will wind down its yield curve control by April or mid-July at the latest. In anticipation of the policy change, the JPY has rallied against the USD to start the year.
  • The bank plans to launch a pilot of its central bank digital currency beginning in April. The transition will give the central bank more flexibility when making policy decisions.

Pandemic Past: Countries are ending the last vestiges of COVID-19 policies as the pandemic enters a new phase.

• China has declared a “decisive victory” over the virus as the country continues to pivot away from its controversial Zero-COVID policies. Beijing claims, without supporting evidence, that the country’s death toll has dropped to the lowest in the world since the government ended many of its COVID restrictions. Officials cautioned that although the situation is improving, the virus is still circulating. Therefore, China still plans to continue its vaccination program. The self-proclaimed victory is another example of how the country is attempting to control the narrative surrounding its controversial policies as its moves to reopen its economy.
• In the U.S., Johns Hopkins University has ended its COVID tracker program. The initiative provided users with a simple and understandable interface for information on the pandemic. It was designed to make the data from the Centers for Disease Control and Prevention accessible and transparent to the masses. It was one of the most widely cited pandemic databases in the country, and thus, its end reflects how far the country has come since the pandemic began.
• Policy differences between the West and China will affect how they each transition toward a post-pandemic normal. An exodus of older workers has contributed to labor shortages in the U.S. and Europe, while the extensive COVID measures have led to a growing distrust of the government. These challenges have impacted fiscal and monetary decisions as government officials look to return their countries to the pre-pandemic normal. A tight labor market in the West has allowed central banks to maintain hawkish monetary policy to bring down inflation caused by the pandemic. China, on the other hand, has ramped up fiscal stimulus to help boost consumer confidence, which is near an all-time low.
  • The differences may mean that in the long run China may have an inflation problem, but until then, its markets should benefit. That said, hawkish policy in the West should make equity markets more resilient after inflation is under control.

 Another Attempt: Chinese and U.S. officials are scheduled to meet again as the two countries look to move past their row over spy balloons.

• Secretary of State Antony Blinken and his Chinese counterpart Wang Li will both attend the Munich Security Conference. Although there has been no formal announcement, there is speculation that the two will meet at the conference. The potential encounter would be the first high-level meeting between the two countries since the discovery of the spy balloon. Before that incident, the officials were scheduled to work on a thaw in relations between the two countries. Tensions between the major powers have simmered over the last two years due to concerns regarding Taiwan, Russia, and technology restrictions. A major breakthrough is not likely to take place, but we do believe that the meeting could lay the groundwork for future talks.
• The mutual antagonism will probably persist. The Pentagon announced that its top China defense minister arrived in Taiwan on Friday. The move will likely upset Beijing, which views military contact with Taipei as undermining the “One China Policy.” Moreover, China plans to respond to U.S. restrictions on semiconductors by limiting the U.S.’s access to its clean energy technology. China’s new technology czar acknowledged that his country might not be able to bypass U.S. controls on key chip technology but could still flex its muscles in other ways. Beijing’s decision to review the CATL-Ford deal to ensure that critical battery technology isn’t transferred is a prime example of the czar’s new strategy.
• The decoupling between the major powers will not be a smooth process. Trade ties between the two sides remain as strong as ever despite their growing mistrust. U.S. exports and imports with China remain near an all-time high, even as the countries attempt to reduce their dependence on one another. In other words, the talk has been cheap about a potential split over the last few years. What isn’t cheap, though, is the political landscape. There is a growing animosity among lawmakers within these countries. We suspect that the spy balloon may have been sent by Chinese officials to prevent a possible thaw in U.S.-China relations. Therefore, we believe the two are still on the path to divorce.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion about the possibility of a soft landing for the economy. Next, we review how the battle for semiconductors is causing friction within the U.S.-led bloc. Lastly, we give our thoughts on the recent rally in the U.S. dollar.

Soft Landing? Better-than-expected economic data in January has led to optimism that the Fed may be able to end its hiking cycle before a recession happens.

• January was full of positive economic surprises. The employment payroll numbers nearly tripled consensus estimates. Homebuilders’ confidence surged to a four-month high. Retail sales receipts rose and blew past expectations, and manufacturing output jumped by the largest amount in nearly a year. The strong data helped bolster claims that a recession may be further away than the markets realize and suggests that the Fed may have more time to continue raising rates. As a result, the S&P 500 closed 0.3% higher on Wednesday after trailing most of the day, and the USD surged to a six-week high.
• The strong data has forced the markets to take the Fed seriously. Fed futures swap rates indicate that investors believe there is a 63% chance that interest rates will rise at or above the Fed’s median projection range of 5.00%-5.25%. Some investors are even betting that the Fed could go as high as 6.00%. This is a sharp contrast to a few weeks ago after the comments from Fed Chair Jerome Powell led to speculation that the Fed could end its tightening cycle this June.
• However, don’t confuse good weather with an economic recovery. January temperatures were the sixth warmest in almost 189 years, and households spent more money on outside activities causing firms to add more workers to meet the demand. Food services receipts were 25.4% higher than the previous year, while leisure and hospitality made up almost a quarter of the month’s employment gains. Additionally, much of those gains in homebuilder optimism were related to a decline in borrowing costs. Last month, mortgage rates fell to a four-month low but then rebounded in February. Therefore, we believe last month’s data showed that the recession has not been averted but merely delayed.
  • Also, the potential for a government default on the deficit remains a black swan event that could trigger a deep recession. The latest CBO forecast shows that the government has until July to raise the debt ceiling before a default is triggered.

Chip War: Rising geopolitical risk is causing headwinds for the semiconductor industry.

• The U.S.-led bloc is clamping down on technology transfers to its rivals. The European Union is proposing new restrictions on the exports of electronic components to Russia. The measure is aimed at curtailing Moscow’s ability to develop the weapons needed to maintain its war efforts in Ukraine. Meanwhile, semiconductor equipment maker ASML (ASML, $676.81) reported that it had found yet another Chinese spy who had stolen information about its technology. This is the second time in less than a year. The theft, along with the Russian war effort, reflects the West’s growing unease with sharing key technology with Russia and China.
• Although the U.S.-led bloc appears to be on the same page regarding Russia, there seems to be a divide when it comes to China. European firms do not want to risk disrupting trade relations with the second-largest economy over semiconductors. For example, ASML was hesitant to agree to limit sales of its technology to China as it did not want to take the revenue hit. Although the Dutch company eventually relented, it was after much resistance. European reluctance to limit trade ties with China will make it harder for the U.S. to curb its rival’s growth in semiconductors. Hence, these restrictions could slow, but may not stop Beijing from closing the technological gap.
  • Another danger of getting tough on China is the risk of retaliation. On Thursday, China announced that it had placed Lockheed Martin Corp (LMT, $480.51) and Raytheon Technologies Corp (RTX, $101.46) on the trade blacklist due to their arms sales to Taiwan.
• Although semiconductor firms’ stocks have been surging since September of last year, the rift between the West and its rivals may hurt industry earnings. As the chart below shows, semiconductor stocks have outperformed the S&P 500 and the NASDAQ 100 since the beginning of 2020. The increased demand for chips by firms looking to improve their technology will likely bolster sales in the future. That said, semiconductors are procyclical and are therefore vulnerable to boom-and-bust cycles. Chipmakers have been forced to cut the prices of their goods due to the glut of semiconductors. As a result, the sector may be hurt if the economy falls into recession but could rebound once demand returns.

Is The Dollar Back? The greenback has been on a hot streak since the employment data was released. However, we are not convinced that it will last.

• After several months of decline, the USD has regained some of its strength. Much of the currency’s resurgence is related to fears that the U.S. will be tougher on fighting inflation relative to its peers. Over the last few weeks, the European Central Bank, Bank of Japan, and Bank of England have all added to speculation that they may not be willing to tighten policy further. Moderating inflation in the European Union and the United Kingdom has led to calls from policymakers that both central banks should moderate their rate hikes. Meanwhile, newly selected BOJ Governor Kazuo Ueda pushed back against speculation that he was considering ending the central bank’s ultra-accommodative monetary policy.
• The rally in the USD may be short-lived. Although Europe has seen some cooling in price pressures, the region still lags the U.S. in its inflation fight. Therefore, it is still likely that the ECB’s rate hike in March will exceed the Fed’s. Additionally, China’s reopening will likely help support strong GDP growth in Europe over the next few months which should support the EUR. Meanwhile, the ongoing deficit battle will encourage investors to diversify some of their currency holdings away from the USD. Also, the deepening yield curve in the U.S. indicates that financial conditions are weakening, therefore raising the likelihood of a harsh recession.
• Although the strengthening USD has hurt foreign economies, especially in emerging markets, its reversal will likely make investing overseas worthwhile. European equities remain largely undervalued, and warmer-than-expected temperatures meant that the region was able to avert a severe recession. Additionally, relatively low inflation in Southeast Asian economies and their increased exports to China should support growth within those areas. Consequently, investors may still be able to find investment opportunities abroad despite the recent strength in the greenback.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a new forecast indicating that global oil demand is expected to rebound to a record high in 2023.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a report showing modestly cooler price inflation in the U.K., a dramatic jump in Turkish stocks, and the latest on the U.S.-China balloon saga.

Global Oil Market:  In its monthly forecast update, the International Energy Agency boosted its expectation for global oil demand in 2023 to an all-time high of 101.9 million barrels per day, up 0.2 mpbd from its previous forecast.  That would mark an increase of 2.0 mbpd, or 2.0%, from the demand of 99.9 mbpd in 2022.  The agency ascribed the increase largely to China’s decision to end its strict Zero-COVID lockdowns.

• Meanwhile, the agency reported that it expects global production in 2023 to rise just 1.2 mbpd, implying a continued tightness in oil markets.
• Nevertheless, global oil prices have fallen so far this morning, with Brent Crude trading down some 0.9% to $84.83 per barrel.

U.K. Politics:  Scottish leader Nicola Sturgeon resigned her position as first minister and as leader of the Scottish National Party today, responding to a backlash against her strategy for securing independence and a fall in her popularity over proposed gender laws.  The resignation adds to the political upheaval Britain has faced over the last year owing to a churn in the position of prime minister, rampant inflation, and a wave of public sector strikes over pay.

U.K. Economy:  The January Consumer Price Index was up just 10.1% year-over-year, coming in cooler than both the expected rise of 10.3% and the December increase of 10.5%.  British inflation is also now noticeably slower than its most recent peak of 11.1% in October.  Nevertheless, price increases remain far stronger than targeted by the Bank of England, which suggests that its policymakers will continue to hike interest rates aggressively in the near term.

Russia-Ukraine War:  The British Defense Ministry estimates that 97% of Russia’s entire army has now been deployed to Ukraine in preparation for its new offensive there, which we described in yesterday’s Comment.  The massive Russian deployment is exacerbating a disagreement in which some U.S. military officials believe that the Ukrainians should abandon the eastern city of Bakhmut to preserve forces, but some leaders in Kyiv believe it is worthwhile to attempt to hold the city. The Ukrainian officials believe that they should continue inflicting heavy losses on the Russians to prevent them from deploying more forces elsewhere along the front lines.

Turkey:  The Istanbul stock market reopened today following its shutdown in response to last week’s devastating earthquakes, and the government’s order that private pension funds increase their allocation to Turkish stocks appears to be giving the market a major boost.  So far this morning, Turkish equity prices are up some 9.7%, and are on track for their best daily performance since 2008.

Brazil:  In an interview with the Wall Street Journal, Former President Bolsonaro stated that he will return to Brazil next month to defend himself against accusations that he fomented January’s rioting at the Brazilian capitol, despite the legal risks in doing so.  He also said he would lead the conservative opposition against leftist President Lula da Silva, although he was undecided as to whether he would run for the presidency again.  In any case, Bolsonaro’s return could worsen the country’s political polarization and could potentially be a headwind for Brazilian stocks.

China-Philippines:  Philippine President Ferdinand Marcos, Jr., summoned China’s ambassador yesterday to complain about an incident last week in which a Chinese coast guard ship trained a military-grade laser on Philippine Navy sailors trying to resupply a contingent of marines at a South China Sea outpost.  The laser temporarily blinded the Philippine sailors, prompting Manila to lodge a formal protest against China earlier this week.

• As we noted in our Comment in recent days, Marcos has recently been mending Philippine security ties with the U.S. with moves to give the U.S. more basing rights and laying the groundwork for a tripartite U.S.-Japan-Philippines security treaty.
• The Chinese laser incident could well be meant as a warning against such a rapprochement and serve as a reminder that Beijing asserts territorial rights to much of the waters claimed by the Philippines.

U.S.-China Surveillance Balloon Crisis:  Unidentified officials have told The Washington Post that the U.S. tracked the first Chinese balloon shot down earlier this month from the time it took off from China’s Hainan Island in late January.  The balloon was evidently tracked as it passed over the U.S. territory of Guam, with its important military installations.  It then took an unusual turn northward to Alaska, possibly because it was captured by strong winds in the upper atmosphere, until southeasterly winds finally pushed it down to the U.S. mainland.

• The pattern of events suggests there may be some credence to China’s claim that the balloon was blown off course.
• Nevertheless, the balloon’s initial passage over Guam would still suggest that it was meant for spying.

U.S. Economy:  At an industry conference yesterday, the leaders of some of the country’s biggest banks remarked that they have been surprised by the recent resilience of the U.S. economy and now believe the country could avoid a recession.  However, we are now only at the very beginning of the period in which our various models suggest a recession could begin.  We think it remains far too early to call a “soft landing.”  In fact, it would not be surprising to us if the recession began perhaps even late in the third quarter, which means we couldn’t confirm it in the data until well into the fourth quarter.  For investors, that means there is still a heightened risk that the stock market could embark on another downward leg before starting to trend upward for good.

U.S. Regulatory Policy:  The Federal Trade Commission’s only Republican member, Christine Wilson, has announced she will resign in protest against Chair Khan’s leadership strategy and ethics.  Until Republican leaders nominate a replacement for Wilson and for the other current Republican vacancy, the move will leave the commission’s three Democratic members with a freer hand to pursue their planned intensification of antitrust and consumer protection rules.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with two key developments in European Union economic policy, including a suggestion that the European Central Bank will tighten monetary policy more than expected and the passage of a new law that will ban the sale of gasoline-powered cars in the EU from 2035.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including NATO’s confirmation that Russia has launched its anticipated new offensive in Ukraine and signs that the Federal Reserve may also tighten monetary policy more aggressively than investors currently expect.

European Union Monetary Policy:  ECB board member and Irish Central Bank Governor Gabriel Makhlouf said the ECB may hike its benchmark short-term interest rate to more than 3.5% this year, from 2.5% currently, and won’t cut rates until at least 2024 as it fights to bring down inflation.  The statement is at odds with investors’ current expectations for the ECB’s terminal rate to stop rising at 3.5% and for rate cuts to begin later in 2023.  In response, the EUR is trading up approximately 0.3% today at $1.0761.

European Union Regulatory Policy:  The European Parliament approved a law today that would ban the sale of gasoline-powered cars in the bloc beginning in 2035, although vehicles that run on carbon-neutral fuels would still be allowed.

• The new law aims to accelerate Europe’s shift to electric vehicles, although it threatens to disrupt one of the EU’s key industries in the meantime.
• Indeed, Ford Motor (F, $13.09) announced today that it will lay off 3,800 workers in Europe over the next three years in order to cut costs and boost profits amid its transition to making electric vehicles.

Russia-Ukraine War:  The North Atlantic Treaty Organization (NATO) confirmed that Russia has launched a major new offensive in eastern Ukraine, as widely expected.  The announcement came as NATO defense ministers are meeting today in Brussels to discuss the provision of further support for Ukraine, including ramping up production of ammunition and other military aid in NATO countries.  Even though the Russians have started their new offensive after spending weeks replenishing their forces with newly conscripted troops and massing equipment along the front, it appears that they have made only limited gains so far, mostly to the north of the heavily embattled city of Bakhmut.

Russia-Moldova-Ukraine:  Moldova’s pro-European President Maia Sandu said she has confirmed that Russia had tried to instigate a coup over the last year that would topple her government and replace it with a pro-Russian government.  Moldova, on Ukraine’s southwestern border, has been a target of Russia in part because it is trying to join the European Union and cooperates closely with NATO.  In an apparent abundance of caution regarding possible Russian retaliation for Sandu’s announcement, the country has shut down its airspace today.

Turkey:  One day before Istanbul’s stock exchange reopens after a shutdown caused by last week’s earthquakes, President Erdoğan’s government has ordered the country’s private pension funds to boost their holdings of Turkish stocks to support the market.  The move is likely a further effort by Erdoğan to shore up his re-election chances ahead of May’s national balloting.

• Under the new rules, pension funds must allocate 30% of the funds the government contributes to match individual pension contributions to Turkish stocks, up from the previous requirement of 10%.
• The pension funds will also be allowed to increase the weighting of a single stock in their portfolio to 5%, up from 1% previously.

Israel:  Yesterday, the Knesset passed Prime Minister Netanyahu’s controversial judicial reform on its first reading, prompting a mass strike, protests by tens of thousands, and expressions of concerns by key business leaders who fear it will lead to a dictatorship and be bad for business.  The proposed law, which would give parliament the right to override court decisions with a simple majority vote, still needs to pass two more readings before it becomes law.

China:  Following on our note in yesterday’s Comment that the U.S. will restrict its citizens from direct investments in certain Chinese technology firms, reports say Singapore’s sovereign wealth fund GIC has significantly slowed its investments in China-focused private equity and venture capital funds.  The pullback by GIC evidently comes after an intense internal debate over Chinese investment prospects under the authoritarian leadership of Chinese President Xi.

• GIC is widely recognized as an astute, sophisticated investor, and it was an early adherent to the Chinese investment story. Its decision to pull back from the market is therefore an important indicator that investor sentiment toward China has deteriorated.  Indeed, beyond China’s domestic economic management, the volatile and intense geopolitical tensions between the U.S. and China (illustrated this month by the Chinese surveillance balloon crisis) raise serious questions as to whether China is truly investable anymore.
• Nevertheless, investors do seem to believe that China is still at least tradable. New data from Refinitiv Lipper shows that global investors have poured money into Chinese stock funds for five straight weeks, bringing the year-to-date total to some $2 billion.  The new investments in China appear to be driven by bets on its dismantling of COVID-19 pandemic lockdowns.

United States-China:  The U.S. military stated it has recovered important electronic components from the suspected Chinese surveillance balloon that was shot down earlier this month off the coast of South Carolina.  According to the announcement, crews have retrieved significant debris, including all the “priority sensor and electronics pieces” as well as large sections of the payload structure.

• That should help U.S. intelligence and counterintelligence analysts figure out exactly what information the balloon was designed to gather, how it operated, and whether it relied on any U.S. or allied technology.
• However, U.S. and Canadian officials say they have not yet been able to retrieve debris from the other three unidentified flying objects shot down over the U.S. and Canada in the last week.

United States-Japan-Philippines:  Philippine President Ferdinand Marcos Jr. said he wants a tripartite defense treaty between the U.S., Japan, and the Philippines to supplement the individual defense deals he has recently signed with the U.S. and Japan.  According to Marcos, stronger military relations between the three countries would help keep the peace as China becomes more geopolitically assertive in the region.

• One of Marcos’s recent deals gives the U.S. access to four additional Philippine military bases where it can conduct training, stockpile weapons, and build infrastructure to help fight a potential conflict with China. His other deal eases the Japanese military’s access to Philippine bases.
• Marcos’s embrace of the U.S. and Japan marks a sharp reversal from the policies of Former Philippine President Duterte, who tried to distance himself from the U.S. and its alliance system.

U.S. Monetary Policy:  Fed board member Bowman said the monetary policymakers are still “far from achieving price stability,” which means they will have to keep raising interest rates and hold them at a high level for a prolonged period.  The statement underlines the view of other key Fed officials and suggests that many investors are being overly optimistic as they look for an end to rate hikes and a potential pivot to rate cuts in the near term.

U.S. Fiscal and Regulatory Policy:  Various reports say President Biden will name Fed Vice Chair Brainard as his new economic policy coordinator this week.  Brainard will replace Brian Deese as chief of the National Economic Council, which advises the president on policy and personnel decisions and coordinates policy making across executive branch agencies.  That will open up her spot on the Fed’s board of governors and remove one monetary policymaker who has been more dovish on interest rates than Chair Powell.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a number of observations regarding China’s relations with the rest of the world, driven by the wave of Chinese surveillance balloons belatedly discovered in North American airspace (although we don’t delve into why the North American Defense Command (NORAD) can track a small sleigh and eight reindeer every Christmas but can’t seem to locate a 200-foot-high balloon).  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including improved economic forecasts for the European Union and the stock market implications of the Kansas City Chiefs’ win in the Super Bowl last night.

United States-China:  As U.S.-China tensions continue to spiral, the U.S. is set to expand its economic measures against China to include restrictions on direct investments and private equity stakes in certain Chinese technology sectors.  The new rules will add to the U.S.’s big tariffs against Chinese imports, its clampdown on data and technology transfers to China (an effort that was expanded Friday with the naming of six additional Chinese firms that will be shut off from U.S. exports due to their work on China’s surveillance balloon program), and its hurdles to investing in the publicly traded stocks of certain Chinese companies, such as those that don’t share their accounting data with U.S. regulators and those related to the Chinese military.  The restraint on direct investments and private equity will reportedly apply to Chinese sectors such as artificial intelligence and supercomputing.

• The new rules could be issued within two months, after the Treasury Department finishes reaching out to other governments, including the EU, to ensure that they don’t rush in to provide similar financing to China after the U.S. cuts it off.
• U.S. firms reportedly are still trying to resist the new restrictions, but the report suggests the new limitation is virtually a foregone conclusion. Of course, big U.S. technology and finance firms are among the most active private equity investors in China, and the new rules will likely cut them off from many opportunities in the country.
  • This illustrates yet another way in which investors are likely to be caught in the crossfire as U.S.-China tensions worsen.
  • With the recent discovery of Chinese surveillance balloons in North American airspace, the latest of which was apparently shot down by the U.S. on Sunday, the risk of outright conflict and further harm to investors appears to be growing. That’s especially true now that the Chinese are saying they’ve spotted unidentified flying objects over their own territory and are ready to shoot them down if needed.  The situation seems ripe for a trigger-happy fighter pilot or missile operator to shoot down a manned vehicle (or, God forbid, an airliner) from one side or the other, which in these tense conditions could easily spiral out of control.

China-Africa:  Not only is China facing a broad economic counteroffensive from the U.S., but it is also running into pushback against its influence-building campaign in less developed countries.  A new report shows that Chinese infrastructure development loans to sub-Saharan Africa under its signature Belt and Road Initiative fell by 54% to just $7.5 billion in 2022.  The lending decline reflects both new Chinese caution after several previous loans went sour and borrower fears that China is deliberately pushing them into debt traps.

• The ongoing pullback in BRI lending is notable, given that the program provided almost $1 trillion in infrastructure development loans primarily to developing countries over the last decade.
• The drop in BRI lending is probably slowing China’s effort to build influence in less developed countries, but the country still has plenty of other economic carrots in the form of export opportunities, cheap imports, and direct investments. We suspect China will continue using those incentives to attempt to bring more developing countries into its evolving geopolitical and economic bloc.

China-South America:  As evidence that China’s BRI stumbles are not stopping it from trying to build alliances with less developed countries, last week, the Chinese and Brazilian central banks signed a memorandum of understanding to set up yuan-clearing arrangements in Brazil.  The deal shows how China continues attempting to establish the CNY as a reserve currency for its evolving bloc (perhaps in a digital, resource-backed form in the future).  We note that Brazilian President Lula da Silva has recently called for a free-trade agreement between China and the Mercosur economic area composed of Brazil, Argentina, Uruguay, and Paraguay.

Japan:  Investors continue trying to assess the surprise announcement that independent academic economist Kazuo Ueda will be named as the next Bank of Japan governor.  Amid concerns that Ueda may be more willing to abandon Japan’s longstanding yield-curve control and allow bond yields to rise, Japanese stocks are trading down so far this morning.  The JPY has also weakened today, apparently reflecting concerns that Ueda would still not be able to close the gap between Japan and U.S. interest rates.

European Union:  The European Commission today boosted its forecast for EU economic growth in 2023 to 0.8%, compared with an expectation of just 0.3% last November.  It lifted its forecast for the Eurozone’s growth to 0.9% from 0.3%.  In each case, the organization now believes there will be no recession this year, matching private forecasts and validating the recent outperformance in European stocks.

Germany:  The conservative Christian Democratic Union (CDU) won Berlin’s municipal elections over the weekend, dealing an embarrassing defeat to Chancellor Scholz’s center-left Social Democratic Party (SPD) and pushing it out of the city’s government for the first time in decades.  The CDU may have trouble forming a coalition capable of governing the city, but the results still illustrate how Scholz and the SPD have been politically damaged by a range of missteps over the last year.

Turkey:  Following last week’s big earthquakes and complaints about the government’s response, President Erdoğan has ordered the arrest of dozens of architects, engineers, and others potentially involved in shoddy construction that led to the building collapses.  With the death toll from the quakes now approaching 30,000, the president is apparently trying to divert attention from his government as he prepares for the elections upcoming in May.

U.S. Defense Industry:  Last week, the Defense Department released a targeted list of weapons it’s willing to purchase under long-term contracts, which defense firms argue would be necessary in order for them to invest in expanded production capacity.  The list includes weapons such as specialized air defense systems, long-range missiles, and rockets.

• Shifting toward multi-year contracts from single-year orders is becoming a key demand of defense contractors as they bump up against factory capacity constraints in their struggle to boost output and make up for the weapons and ammunition being sent to Ukraine for its defense against Russia. Longer-term funding commitments by the Defense Department may also be needed to boost defense industry expansion as the U.S. prepares for a potential future conflict with China.
• Nevertheless, as shown in a hearing by the House Armed Services Committee last week, multi-year contracts alone would not be a panacea for any U.S. rearmament program. Defense contractors also warn that such multi-year orders also need to include inflation adjustments.  The contractors also say their ability to surge production is being hampered by other factors, such as a lack of skilled workers and supply disruptions.
• In any case, the increased policy debate on expanding the defense industrial base is consistent with our view that U.S. and allied defense spending is likely on a prolonged upswing that should be a boon for traditional defense contractors and the producers of dual civilian-military goods and technology.

U.S. Cryptocurrency Regulation:  The New York Department of Financial Services has ordered Paxos Trust, which issues and lists Binance’s dollar-pegged cryptocurrency, to stop creating more of its BUSD token, although it can continue redeeming the stablecoin.  The order reflects the ongoing crackdown on crypto assets in the U.S., following a year of widespread bankruptcies and other issues in the sector.

U.S. Super Bowl Indicator:  With the Kansas City Chiefs’ 38-35 win in the Super Bowl yesterday, adherents of the “Super Bowl Indicator” will be looking for a further down-leg in U.S. stock prices.  The indicator supposedly shows that a win for a team from the American Football Conference is historically associated with a bear market in stocks in the coming year.  We continue to believe that the impeding recession is the more likely reason for a potential further decline in stocks.

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