Daily Comment (August 3, 2023)

Posted on August 3, 2023August 3, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will explore three key topics: the U.S. deficit, central bank policy, and the U.K.’s post-Brexit economy. First, we will discuss the U.S. deficit and what it may mean for bond yields. Second, we will explain why other central banks may follow Brazil as it moves away from tight monetary policy. Finally, we will discuss why the Bank of England may be helping boost the British pound.

Downgrade Trouble: The downgrade by Fitch Ratings of the U.S.’s credit rating and the announcement of another round of debt issuance has investors concerned about the country’s ballooning deficit.

On Wednesday, the U.S. Treasury Department announced that it would auction off $103 billion in new bonds this quarter in order to resolve a shortfall between tax revenue and government spending. The move has made investors uneasy, as it is unclear whether the market is capable of absorbing such a large amount of issuance. This report comes a day after Fitch Ratings Agency downgraded U.S. credit ratings from its top level. Making matters worse, lawmakers broke for their August recess earlier this week without coming to a resolution on funding the government for the next fiscal year. This has raised concerns about the possibility of a government shutdown in October, which would further strain the U.S. economy.
Investors are worried that partisan gridlock in Washington will prevent lawmakers from adequately addressing the U.S. budget deficit. This uncertainty has led to a sharp rise in the 10-year Treasury yield, which has risen nearly 20 basis points since August 1. Higher yields threaten to push up borrowing costs for firms, which could weigh on corporate earnings and stock prices. The S&P 500 index has dropped almost 1.7% since the Fitch downgrade. According to the Congressional Budget Office, the government deficit is expected to deteriorate over the next 10 years.

In 1994, President Clinton’s advisor James Carville once quipped, “that if there were reincarnation, [he] would like to come back as the bond market” because then he could “intimidate everybody.” This week’s market reaction to U.S. debt woes is a good example of how relevant his words are today. That said, we believe that in the long run, yields on long-duration Treasuries will have to rise as investors adjust to a new normal with higher inflation volatility and less Federal Reserve involvement. This should lead to slower economic growth as higher borrowing costs tend to reduce consumption.

Who’s Next? The Central Bank of Brazil was one of the first to raise interest rates in response to the COVID-19 pandemic, and it is now one of the first to pivot away from hawkish policy.

Brazil’s central bank cut its benchmark interest rates by 50 bps to 13.25% on Wednesday. The decision came amid pressure from President Luiz Inácio Lula da Silva and his economic team to ease monetary policy in an effort to boost the economy. Although the unemployment rate remains well below the country’s long-run trend of 9.5%, a gauge for gross domestic product showed that economic activity dropped 2% in May. Businesses and consumers will likely welcome lower rates. However, it will be the first test to see if the lower rates will lead to a return to inflation.
Other central banks are expected to follow suit, as overnight indexed swaps rates suggest that benchmark interest rates will decline in most major economies by 2024. The switch to monetary easing is likely a reflection of a global decline in price pressures. The IMF expects global inflation to fall from 8.7% last year to 6.8% in 2023. Additionally, central bankers are facing pressure from politicians to ease monetary policy, as the high-interest rates are harming households. In the U.K., the Bank of England is on the verge of triggering a potential mortgage crisis; meanwhile, higher interests rates have disproportionately hurt homeowners in southern Europe who are now relying on savings to make monthly payments.

Generally speaking, central banks in developed countries have made gradual changes when raising rates and more dramatic cuts when lowering them. However, this time may be different. Advanced economies have proven to be more resilient than experts expected at the start of the year. This could lead policymakers to be more cautious with easing monetary policy, as they may be concerned about a return to higher inflation. This approach is typical in emerging markets where inflation is more volatile. This may mean that investors should be more cautious during this easing cycle than the previous one when deciding to add more risk to their portfolios.

U.K. Path: The Bank of England (BOE) may keep monetary policy tight in order to restore confidence in the British pound (GBP).

The Bank of England raised its benchmark interest rates by 25 bps on Thursday to a 15-year high of 5.25%. This is the bank’s 14^th consecutive hike and reflects its continued fight to bring inflation down toward its 2% target. During his press conference, BOE Governor Andrew Bailey predicted that July inflation has decelerated to around 7%, much lower than last year’s peak of 11%. He added that the central bank plans to continue to raise interest rates further as policymakers aim to push inflation down to 5% by the end of the year. The central bank now forecasts inflation to fall to 4.9%.
The Bank of England does not seem to be willing to take its foot off the pedal. There were two policymakers within the BOE’s Monetary Policy Committee that pushed for a 50 bps hike in interest rates, with one vote for keeping rates unchanged. This voting breakdown suggests that British policymakers remain relatively more hawkish than their Western counterparts. While the heads of the European Central Bank and the Federal Reserve suggested last week that they may be nearing the end of their hiking cycles, Bank of England Governor Andrew Bailey offered no such reassurances. Instead, he maintained that “in order to get inflation back to target, [the BOE] is going to have to keep this stance of monetary policy.”

After breaking away from the European Union, the United Kingdom will now have to prove that it can stand on its own. One way it may do this is by legitimizing the value of its currency. Over the last two weeks, the GBP has risen around 4% against the dollar, even as other peer currencies, as measured against the U.S. Dollar Index (DXY), declined about 3% in the same period. This divergence suggests that investors are confident that the Bank of England is willing to take steps to bring down inflation, even if it means causing economic pain. A strong GBP, particularly against major trading partners, will help to quell price pressures by making imports cheaper.

Fed News: Kansas City Fed has hired Jeffrey Schmid to take over as President and Chief Executive Officer. He is a former bank executive and has experience in bank regulation.

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Weekly Energy Update (August 3, 2023)

Posted on August 3, 2023August 2, 2023 by Amanda Ahne

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

Oil prices challenged the upper end of the trading range but so far have failed to breakout above that level.

(Source: Barchart.com)

Commercial crude oil inventories fell a massive 17.0 mb, well above the 2.3 mb draw forecast. The SPR was unchanged.

In the details, U.S. crude oil production was steady at 12.2 mbpd. Exports rose 0.7 mbpd, while imports increased 0.3 mbpd. Refining activity fell 0.7% to 92.7% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. Last week’s large decline has put inventories below their seasonal average.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $65.79. Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

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.

Total stockpiles peaked in 2017 and are now at levels last seen in late 1985. Using total stocks since 2015, fair value is $94.97.

Market News:

Analysts expect the Kingdom of Saudi Arabia (KSA) to extend its voluntary production cuts. However, the continued loss of revenue is probably not sustainable. We do note that production from OPEC+ fell sharply in July.
Rating agencies are threatening to downgrade PEMEX bonds due to its high debt load. There is a growing likelihood that PEMEX will default on its bonds, but given the government’s close relations with the company, a massive restructuring is also likely.
The U.K. is easing environmental restrictions in a bid to boost North Sea oil and gas production. Although the Sunak government is being criticized by environmentalists, this sort of behavior isn’t uncommon. Most voters support environmental measures until standards of living are threatened.
Managing pollution is a textbook economics problem. Pollution is an externality; in economic terms, it’s a bad outcome that isn’t reflected in the market price. Without outside intervention, the cost is shifted to society and away from the parties to the transaction. Gasoline consumption does trigger air pollution. In addition, insofar as gasoline is refined from foreign oil, there is a potential geopolitical externality that isn’t captured by the price at the pump. The most efficient way to address this problem is to estimate the externality’s cost and apply a tax. It’s also the least politically popular. For this reason, Congress and regulators have used other means to achieve this goal instead. Specifically, the government has applied mileage standards to automakers, called the Corporate Average Fuel Economy (CAFE) standards. This leads to automakers selling small, fuel-efficient cars at a discount so they can sell more of the popular larger vehicles. The EPA is looking to raise the CAFE standard to 58 mpg by 2035, which will likely force automakers to sell more EVs to meet this standard. A standard of this level would likely lead to lower gasoline consumption.
Brazil and Guyana are expected to increase oil production over the next few years. The latter has turned out to be a very promising find. However, it’s unlikely that this new production will do much more than merely offset the impact of depletion.
China and India have been driving global coal consumption. At the same time, China is running a broad-based energy policy. We note that it is building 23 nuclear reactors, accounting for 42% of global reactor construction.
- The U.S. has completed its first new nuclear power station since 2016. The 2016 plant was the first in two decades. The plant, in Georgia, was seven years overdue with cost overruns of $17 billion.
Due to rising costs, the 6.0 mb planned injection into the SPR has been postponed.

Geopolitical News:

The Trump administration’s diplomatic breakthrough in the Middle East, which led several Arab states to normalize relations with Israel, is starting to stall. The key goal was a normalization of relations between the KSA and Israel. The Saudis’ demand is a two-state solution with the Palestinians, which the Abraham Accords essentially undermined. It’s not clear just how much progress would be required in order to implement a two-state solution, but the Netanyahu government would probably have to take the Palestinians’ goals into account. The benefits of normalization would be significant. Israel could potentially develop military relations with the KSA, which would help both nations contain Iran. From the U.S. perspective, it could allow for a smaller American security footprint in the Middle East. Pivoting to China requires the U.S. to reduce its attention in other parts of the world, including the Middle East.
Last week we reported that the U.S. had blacklisted 14 Iraqi banks from transacting in dollars due to their relations with Iran. The U.S. feared the banks were facilitating sanctions avoidance. The move sent the IQD plunging and triggered protests in Iraq.
- Iran and Iraq have a complicated energy trade which is mostly designed to evade sanctions.
Iran has continued to escalate tensions in the Persian Gulf and the Gulf of Oman. This action has led the U.S. to send military resources to protect shipping.
Pakistan is trying to import oil from Russia. However, it is struggling to make payment in CNY.
Although most EU nations have either ended or curtailed Russian natural gas purchases, Austria is still importing a sizable amount of Russian gas. Before the war, Russia provided almost 80% of Austria’s natural gas. It still provides more than half, and in March, Russia supplied 74%. Austria, a bit like Switzerland, is officially neutral as this was the agreement reached in 1955 to end Soviet occupation. Like Germany, Austria was divided into four occupied zones after WWII. However, unlike Germany, this occupation didn’t evolve into two separate states. The occupation ended in 1955 with Austrian neutrality, and as such, the country isn’t a member of NATO, for example.
Mongolia, wedged between China and Russia, is attempting to tread an independent policy path by seeking closer relations with the U.S. Mongolia is a major producer of energy transition minerals. We doubt the country will be able to make this goal work, but its attempt is worth watching.
The KSA has become an aggressive investor in the mining industry. This action is likely an attempt to diversify its economy from its dependence on oil and gas. The entrance of Saudi Arabia into the industry intensifies the race to secure these metals.

Alternative Energy/Policy News:

As EV sales rise, China is aggressively expanding its EV industry across the globe. So far, the U.S. is trying to fend off Chinese EV imports in order to build the domestic industry. The problem for the U.S. is that protecting domestic producers will slow the achievement of climate goals. Europe, on the other hand, appears to be more open to buying China’s EVs.
- China is also expanding its overseas efforts to secure EV metals.
- China’s main EV producers are setting new sales records.
Several automakers are collectively trying to build out EV charging stations. Some of this drive is to create an alternative charging network to Tesla’s (TSLA, $255.71).
Research by Capital Economics projects that EVs will displace 7.5% to 8.0% of global oil demand by 2050.
The Swiss solar company Meyer Burger (MYBUF, $0.65) is postponing plans to expand a solar plant in Germany and opting for a new plant in Colorado to take advantage of U.S. subsidies.
Commodity production throughout history has often been a dangerous pursuit. Turns out, mining for the metals needed for the energy transition is not exempt from this issue.
China and the KSA have effectively gutted attempts to apply greenhouse gas emissions targets. Essentially, China is signaling that it will not comply with global attempts to curtail fossil fuel consumption.
- The lack of international compromise increases the odds that geoengineering will be tried as a solution to climate change.
Hydrogen offers promise as a replacement fuel for hydrocarbons. By separating out the “carbon” part, the gas could be used directly with no pollution. However, the method by which hydrogen is created is complicated. The “greenest” hydrogen, using only renewable energy to split water, for example, is very expensive and difficult to scale. Energy groups want to tap the subsidies available for making hydrogen but use less “clean” methods in order to lower costs.
Germany’s attempts to ban boilers in favor of heat pumps have been unpopular. Now, a controversy has emerged over the use of hydrofluoroolefins in heat pumps. Germany wants to prohibit the use of such gases in German heat pumps, meaning U.S. and other EU heat pumps would not be allowed. Foreign providers of heat pumps are arguing against the exclusion of hydrofluoroolefins.
Offshore wind projects are in trouble due to rising costs of construction and key metals needed for the windmills.
During the 1970s, oil companies, flush with cash, ventured into other businesses. Some bought coal companies, while others tried to diversify in other ways from oil and gas. For the most part, these investments didn’t do much for the oil companies. We note that oil companies are looking to invest in lithium production as extracting lithium from brine is a similar chemical process to petrochemicals. Whether this foray proves fruitful is another matter.

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Daily Comment (August 2, 2023)

Posted on August 2, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a discussion of Fitch’s decision to cut the U.S. government’s bond rating to one notch below its highest score. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including news of possible new U.S. restrictions on Chinese semiconductors and rising global food prices as Russia attacks Ukraine’s grain-export facilities.

U.S. Treasury Market: After market close yesterday, Fitch Ratings cut its assessment of U.S. Treasury bonds to AA+, down from its top rating of AAA. Fitch attributed the downgrade to growing U.S. fiscal deficits, high debt, and political dysfunction. The Fitch downgrade is the first such action by a ratings firm since a similar move by Standard & Poor’s in 2011.

At this point, it appears the downgrade has not produced any considerable disruptions in the Treasury market. We have not been able to identify any major Treasury holder that would be forced to sell the obligations because of the downgrade. Other analysts and observers that we track also seem to be taking a relatively sanguine view of Fitch’s actions. Indeed, so far this morning, Treasury prices are up across almost the entire yield curve, pushing yields lower. The yield on the benchmark 10-year note has fallen slightly to 4.014%.
Nevertheless, having two of the three major bond assessment firms rating the U.S. government below their top rating has the potential to erode faith in Treasury obligations over time, potentially driving up yields in the future. More immediately, the rating cut has undermined sentiment toward risk assets today, and major stock market indices are modestly lower.

United States-China: U.S. officials are growing concerned that China is rapidly ramping up its production of less-advanced, highly commoditized semiconductors in order to dump them on the world market and put competitors in the U.S.-led bloc out of business, as it has done with solar panels and other industries. That would put China in control of the important market (even though the semiconductors at issue are relatively less advanced, they are still critical to a wide range of industries).

The Chinese move could be retaliation for the Biden administration’s draconian crackdown on selling advanced semiconductor technology to China last October.
U.S. officials are reportedly starting to consider moves to block the Chinese threat, but no measures are imminent.

U.S. Industrial Sector: Consistent with our recent analyses, incoming data points to continued strong investment in new factory construction. Data out yesterday showed that nonresidential construction (which would include manufacturing facilities) rose 17% in the second quarter from the previous three months. According to last week’s report on gross domestic product, second-quarter business investment in “manufacturing structures,” aka factories, was up nearly 70% from the same period one year earlier.

Russia-Ukraine War: Russia launched another salvo of missile and drone strikes against Ukrainian port facilities and grain storage infrastructure last night, partially reversing the decline in key grain prices over the last week or so. Nearby wheat futures are trading up 1.1% to $6.5925 per bushel so far this morning, while corn futures are up 0.5% to $5.0925 per bushel.

Just as important, we note that the facilities Russia struck last night are on the Danube River, just across from NATO-member Romania. On top of that, the Polish government yesterday said military helicopters from Russian ally Belarus violated its airspace, forcing Poland to rush more of its armed forces to the border.
The Russian attacks on Ukraine’s grain facilities are raising the prospects for accidental damage to Romanian territory, which would threaten to bring NATO forces directly into the conflict.

Turkey: Now that President Erdoğan has won re-election and is shifting his economic policy in a more orthodox direction, foreign purchases of Turkish stocks have rebounded and helped push the country’s stock market indices higher. Adding fuel to the fire, the policy change has pushed the lira (TRY) sharply lower, adding to inflation pressures and pushing more Turks into the market. With strong buying from both foreign and domestic investors, the benchmark BIST 100 stock price index is up 46% since the end of May in TRY terms, and 14% in USD terms.

India: Ethnic and religious violence has been surging in India in the run-up to next year’s elections, in which Prime Minister Modi and his Hindu-nationalist Bharatiya Janata Party will be trying to retain power. In the latest incident, Hindu-Muslim clashes broke out on Monday near a key business district on the outskirts of New Delhi. The growing violence threatens to undermine investors’ recent focus on India as they pivot away from China because of its slowing economic growth, state interference in the economy, and tensions with the West.

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Daily Comment (August 1, 2023)

Posted on August 1, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news that the coup leaders who seized power in Niger have announced an embargo on sending uranium and gold to France—a move that’s entirely consistent with the type of behavior we’ve been warning about from the China/Russia bloc. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including modest new economic stimulus measures in China and more political pressure to clamp down on U.S. investment into Chinese companies.

Niger-France-Russia: The junta that seized power in a coup late last week accused France of plotting a military attack to return democratically-elected President Bazoum to power. The coup leaders also said they will immediately ban all exports of uranium and gold to France.

Because of strong anti-Western sentiment in parts of Africa, we believe France (and the U.S.) would be reluctant to launch military action in Niger. The coup leaders’ statement is more likely just an effort to ward off French interference, and their uranium embargo probably aims to inflict pain on Niger’s former colonial master. Uranium from Niger reportedly provides 75% of the fuel for France’s nuclear reactors.
Some reports suggest the coup leaders had help from Russian mercenaries. Whether or not that’s true, cutting France off from Niger’s uranium is consistent with the behavior we’ve been warning about from members of the China/Russia geopolitical bloc. Since members of the China/Russia bloc, including Niger, control so much of the world’s key mineral resources, we think they are likely to cut off those supplies to exert pressure against the U.S. and the rest of its bloc, exactly as Russia has done in its war with Ukraine.

Russia-Ukraine War: For the second time in three days, Ukrainian drones have apparently struck Moscow’s premier IQ-Quarter skyscraper, which houses several big government ministries and key Russian companies. The repeat attack suggests the Ukrainians are trying to bring the war home to the Russian elites and perhaps force the deployment of more air defense assets to the capital region. Meanwhile, Russian forces last night staged their own missile attacks against residential areas of Kharkiv, and combat remained intense on parts of the front line running from eastern to southern Ukraine.

Chinese Economy: The government yesterday published a long list of measures it said it would implement to encourage more consumer spending and help boost economic growth. However, the measures were generally vague and seemed quite modest. For example, people who trade in older automobiles for newer ones would receive a subsidy, as would people who buy insulation and other goods to cut home energy use. The announcement also suggested that the central government would leave it up to the cash-strapped provincial and local governments to pay for the programs.

The modest measures show how the central government has become reluctant to rely on the big, dramatic, debt-fueled fiscal programs of the past, which have helped create a serious problem with excess debt among companies and provincial and local governments.
In sum, the modest measures are unlikely to provide a significant boost to Chinese economic growth, which is likely to remain in the doldrums for the time being, although the positive side of that is that weaker Chinese demand will probably help bring down global inflation.

Chinese Armed Forces: President Xi has apparently purged the top two commanders of the People’s Liberation Army Rocket Forces, which are responsible for the country’s conventional and strategic nuclear missiles. The little press reporting available suggests the two commanders were sacked for “corruption,” possibly related to selling military secrets. The firing comes fast on the heels of the sacking of former Foreign Minister Qin Gang. It also comes shortly after CIA Director Burns said his agency is making progress on rebuilding its spy network in China.

Eurozone: The region’s June unemployment rate fell to 6.4%, and revisions showed the jobless rate was also at that level in each of the previous two months. The jobless rate was not only better than anticipated, but it also marked a record low for the eurozone. The figures will raise hopes that strong labor demand and firm wages will help the region’s economy rebound in the coming months but falling vacancies in Germany and France suggest the labor market could soften from here.

European Union-China: On a visit to the Philippines today, European Commission President von der Leyen rebuked China for offering tacit support to Russia in its invasion of Ukraine, rather than supporting the principle of territorial integrity. She also warned that China’s own territorial aggressiveness in the South China Sea could have “global repercussions.” The speech illustrates von der Leyen’s effort to align more closely with the U.S. in its approach to China, even though many other European politicians continue to resist any de-coupling.

United States-China: Yesterday, the House Select Committee on the Chinese Communist Party notified giant investment manager BlackRock (BLK, $738.85) and index provider MSCI that they are being investigated for facilitating investment in Chinese companies that the U.S. government has accused of bolstering China’s military and violating human rights. The investment activities already studied aren’t illegal, but the committee said they are “exacerbating an already significant national-security threat and undermining American values.”

Reporting so far suggests the HSCCCP is focusing on international or global index funds that channel a portion of assets into Chinese companies.
To reiterate, the HSCCCP hasn’t accused the firms of illegal activity. Indeed, the point here is the growing U.S. political pressure against economic ties with China. As we have warned repeatedly, the strengthening bipartisan trend toward clamping down on China presents risks for investors, who could face new investment restrictions suddenly and unexpectedly.

U.S. Stock Market: Some of the nation’s top active fund managers say they’re having trouble attracting money from large investors, given that those investors today can enjoy such high yields in money market funds without taking much risk. Indeed, some fund managers are suffering net outflows from their funds as large, sophisticated investors pull back from equities. All the same, we also think the enormous amounts in money market funds represent future fuel for equities, especially if the stock market rally broadens and/or the Fed eventually starts to cut interest rates.

Global Gold Market: Data from the World Gold Council shows second-quarter demand for the yellow metal totaled 1,255 tons, up 7.0% year-over-year. In contrast with recent trends, buying by central banks fell to 103 tons, but that was mainly because of net sales by Turkey’s central bank due to that country’s unique economic turmoil. Central bank buying in the entire first half of the year hit a record 387 tons. We continue to believe that geopolitical tensions and the longer-term uptrend in central bank purchases will help boost gold prices over time.

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Asset Allocation Bi-Weekly – #103 “Part-Time Troubles” (Posted 7/31/23)

Posted on July 31, 2023 by Amanda Ahne

Daily Comment (July 31, 2023)

Posted on July 31, 2023July 31, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several reports touching on China’s economy and foreign relations. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a modest acceleration in eurozone economic growth and news of an important bankruptcy in the U.S. trucking industry.

China: Financial data provider Preqin reported that China-focused venture capital funds raised just $2.7 billion in the second quarter, down 54.2% from the first quarter. Separately, a Beijing think tank on Friday said total investments in China’s internet sector during the second quarter were down 69.8% from the same period one year earlier. The figures illustrate how global investors, especially those from the U.S., are channeling capital away from China in response to its slowing economic growth, increased government interference in the economy, dire demographics, and increasing geopolitical tensions with the West.

Separately, the official July purchasing managers index for manufacturing rose slightly to 49.3, beating expectations that it would remain at its June reading of 49.0. Nevertheless, the July reading marks the fourth straight month in which the index was below the level of 50 that points to expanding activity.
The July nonmanufacturing index fell to 51.5 from 53.2 in June, suggesting that growth in that sector is now at its weakest all year.

China-United States: U.S. military, intelligence, and national security officials now believe the Chinese malware discovered in May within the telecommunications systems on Guam was only the tip of the iceberg. The officials now believe Chinese hackers have inserted well-hidden malware in networks controlling power grids, communications systems, and water supplies that feed military bases in the U.S. and around the world, with the goal of disrupting or slowing U.S. military deployments and resupply operations in a future conflict. If activated, the malware would probably also disrupt civilian communications and economic activity.

The reports say U.S. officials have been working to hunt down and eradicate the malware, although it isn’t clear how successful they’ve been.
Even though Western business elites continue to resist “de-risking” or “de-coupling” with China, based largely on their own economic interests, we still think increased Chinese military threats will prompt Western leaders to clamp down further on trade, investment, technology, and personnel flows with the China/Russia bloc over time, raising risks for investors with exposure to China or to companies that are highly dependent on China.

United States-Australia: Over the weekend, the U.S. and Australia struck a deal in which Australian manufacturers, in partnership with U.S. defense firms, will produce missiles and potentially other ammunition for the U.S. military beginning in 2025. The officials also agreed on a further expansion of U.S. military rotations through Australia to help build a bulwark against Chinese geopolitical aggressiveness in the region.

Among the Western allies, the large U.S. defense industry still has the bulk of the arms production capability. All the same, replenishing equipment and ammunition sent to Ukraine to help it in its defense against Russia’s invasion and rebuilding the U.S. military to deal with the Chinese threat have stretched the weapon makers’ capacity.
S. defense budgets are rising, but we see increasing evidence that the country will need to rely on innovative new schemes to increase its stockpile of weapons and ammunition in the near term. Relying more on allied producers is clearly one part of that.
We’ve been arguing that re-industrialization is already becoming apparent in the U.S., and that an increased defense effort will feed into it. We therefore think U.S. industrial stocks are poised for good growth, as are U.S. defense stocks in particular. If the U.S. continues to buy more weapons and other material from allied countries, despite the obvious supply-chain security risks, it suggests there could also be good opportunities in foreign industrials and defense industry stocks.

United States-Japan-South Korea: The White House announced that President Biden will host Japanese Prime Minister Kishida and South Korean President Yoon for a trilateral summit at Camp David on August 18. The meeting will focus on further steps to increase the three nations’ security against the growing threats from North Korea and the rest of the China/Russia bloc in the Indo-Pacific region. The announcement came just as new reports suggest Russia has been buying North Korean missiles and using them in its invasion against Ukraine.

Japan: As global investors continue to digest last week’s move by the Bank of Japan to loosen its yield curve control and allow longer-term bond yields to rise, the yield on 10-year government bonds today rose to a nine-year high of 0.607% before falling back to 0.590% after the BOJ announced unscheduled purchases of 300 billion JPY in five- to 10-year government bonds. Higher bond yields are expected to draw funds back to Japan, driving up the JPY, and the currency so far today is up 0.7% to 142.10 per dollar.

Eurozone: New data today shows second-quarter gross domestic product grew at an annualized rate of 1.1%, still very weak but better than the tiny 0.1% growth rate in the first quarter and a modest decline in the fourth quarter of 2022. The region’s economy continues to struggle with weakening exports to China, high interest rates, and high price inflation.

Chile: On Friday, the central bank slashed its benchmark short-term interest rate by 100 basis points to 10.25%, citing reduced inflation pressure and prospects for weaker economic growth in developed countries. Some major Latin American central banks were among the first to hike interest rates in the current global cycle, helping support their currencies. Responding to the Friday rate cut, the Chilean peso (CLP) so far this morning has weakened 0.9%, trading at 834.77 per dollar.

Niger: Responding to last week’s coup, the Economic Community of West African States warned that if the coup leaders don’t restore Niger’s democratically-elected government to power within one week, the bloc will launch military action to do so. The statement follows calls by the U.S. and France for President Mohamed Bazoum to be restored to power. The coup leaders have rejected those calls, portending a likely period of instability ahead.

U.S. Labor Market: Over the weekend, debt-ridden trucking firm Yellow (YELL, $0.7069) said it has shut down operations and will file for bankruptcy. The move will throw as many as 30,000 employees out of work, including 22,000 members of the Teamsters union. The firm clearly had its own issues, so its failure doesn’t necessarily say anything about the health of the overall economy or the recession that we still think is likely to arrive in the coming months. All the same, the failure may help to soften the labor market slightly.

U.S. Commercial Real Estate Market: Blackstone Real Estate Income Trust, a unit of Blackstone (BX, $105.05) that is also known as BREIT, has reportedly sold some $10 billion in assets since last autumn, allowing it to return $8 billion to investors and raise cash for new investments related to artificial intelligence, such as data centers. The move marks a big turnaround from last autumn, when BREIT’s decision to limit withdrawals helped spark fears of commercial real estate calamity.

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Asset Allocation Bi-Weekly – Part-Time Troubles (July 31, 2023)

Posted on July 31, 2023July 28, 2023 by Amanda Ahne

by the Asset Allocation Committee | PDF

The job market has greatly surpassed the expectations of leading experts so far this year. Back in December, a Bloomberg survey found that economists predicted that monetary policy tightening by the Federal Reserve would push the country into a recession in the first half of 2023. They estimated that payrolls would decline in the second and third quarters and the unemployment rate would rise to 4.9% by 2024. However, these predictions have proven to be decidedly premature. Against all odds, the economy has added 1.29 million jobs in the first six months of the year, well above its historical average. Meanwhile, the unemployment rate currently stands at 3.6%, nearly a 50-year low. While these labor market indicators inspire optimism, we suspect that the economic situation may be a bit more complex.

Last month, the rate of underemployed individuals experienced a significant acceleration and reached its fastest pace since the onset of the pandemic. Part-time employment for economic reasons rose 15.4% from the prior year, raising concerns about the true state of the labor market. The only other time the underemployment rate has risen at this speed without an economic downturn was in 1967, when swaths of workers went on strike. Comparatively, part-time work for noneconomic reasons has increased by only 2.96% in the same period. Hence, the increase in underemployment may not be explained by workers choosing to work part-time for personal reasons, such as caring for children or elderly relatives.

The rise in the number of workers resorting to part-time work might be indicative of households facing financial hardships. Despite the Federal Reserve’s attempt to tighten monetary policy to curb the level of debt accumulation, household liabilities have reached new heights. According to the most recent quarterly report on household debt and credit from the Federal Reserve Bank of New York, consumer debt has surged to reach a 20-year high. This suggests that borrowers are relying on costlier forms of debt to cover their everyday expenses.

An abundance of job openings could possibly be concealing the growing financial distress. In the aftermath of the pandemic, there was a sizable drop in the labor force as many older workers retired, which left a gap in the labor force. In May, there were nearly 4 million more job openings than there were workers available to fill them. However, this surplus of available job opportunities was not evenly distributed as many of the new openings have come from industries that offer below-average wages. According to the Bureau of Labor Statistics, sectors like leisure and hospitality and retail trade collectively accounted for a quarter of the job openings in May. So, just because jobs are being created does not mean financial conditions are improving.

Looking beyond job openings, it becomes evident that firms are actively seeking ways to reduce their overhead costs. Some firms have begun cutting work hours, while others are considering layoffs. A report released by Challenger, Gray & Christmas, a global outplacement and business and executive coaching firm, found that businesses issued 458,209 warning notices for job cuts in the first six months of 2023. This is a 244% increase from the 133,211 cuts reported during the same period in the previous year. These cuts have primarily targeted the technology and financial sectors, suggesting that the increase in part-time work may be related to workers facing challenges in their job searches and potentially settling for lower-level positions until they can secure more suitable employment.

While the sudden acceleration in the rate of workers taking on part-time work for economic reasons is indeed troubling, it is crucial not to draw too strong of conclusions. Examining other indicators of labor underutilization reveals that even when factoring in part-time workers, the job market remains resilient. Additionally, while debt-to-income and debt-service ratios have risen from their pandemic lows, they are still well below the levels seen prior to the Great Financial Crisis.

However, it is important to pay attention to deviations from historical norms, such as the unprecedented change in the rate of people taking on part-time work. These divergences can provide insights into future shifts within the business cycle. As the data continues to offer mixed signals about the health of the U.S. economy, we will continue to broaden our approach and remain attentive for possible signs of trouble or improvement.

History shows us that investors who become overly confident that a recession has been successfully avoided are often tempted to take unwarranted risks that can ultimately harm their portfolios. As John Kenneth Galbraith’s book, The Great Crash, 1929, reminds us, identifying an impending recession is not always straightforward even for experts. In the book, he describes how the Harvard Economic Society went from being mildly bearish in early 1929 to bullish by the summer:

“By wisdom or good luck, the Society in early 1929 was mildly bearish.

Its forecasters had happened to decide that a recession (though assuredly

not a depression) was overdue. Week by week they foretold a slight setback

in business. When, by the summer of 1929, the setback had not appeared, at

least in any very visible form, the Society gave up and confessed error.

Business, it decided, might be good after all.”

The events leading up to Black Thursday on October 24, 1929, demonstrated how even an apparently strong economy, characterized by low unemployment and a thriving stock market, can still be susceptible to an unforeseen downturn.

While we are not currently predicting a major recession, we are cautious about ruling out the possibility of an economic downturn altogether. The significant increase in part-time workers due to economic reasons is one example of potential vulnerabilities within the labor market. Additionally, the mounting debt burden of households and rising borrowing costs could foreshadow challenges ahead. In light of these uncertainties, we advise investors to approach recent strong and positive economic data with cautious optimism. While the current indicators may appear promising, it is essential to remain vigilant and recognize that the future remains uncertain.

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Daily Comment (July 28, 2023)

Posted on July 28, 2023July 28, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion about the Bank of Japan’s latest policy decision. Next, we will provide an in-depth analysis of the GDP report, including why we believe that the warm weather may hurt economic growth in the third quarter. Finally, we end with our thoughts about the underlying tensions within the Western bloc.

New Day for BOJ: The Bank of Japan has left its policy rate unchanged but made a tweak to its yield control

The Bank of Japan (BOJ) has made a surprise move to relax its yield curve control policy, allowing 10-year Japanese government bond yields to rise to 1.0%. The BOJ had previously capped yields at 0.5%, but it now says that the limit will no longer be rigid but rather a reference rate. This signals that the BOJ is planning to get less involved in anchoring the yield curve. The move comes after reports showed that consumer prices excluding fresh food rose 3% in Tokyo in June, well above the BOJ’s 2% target.
Traders viewed the Bank of Japan’s (BOJ) decision to relax its yield curve control policy as a sign that the central bank was moving away from its ultra-accommodative monetary policy. Yesterday’s reports that the BOJ was considering such a move led to a drop in all major indexes in the U.S., with the S&P 500 falling 0.62%, the NASDAQ slipping 0.64%, and the Dow Jones Industrial Average dropping 0.67%. The dollar also slipped against the yen (JPY), from 144 per dollar to 139. The move is a sign that the BOJ is preparing to normalize monetary policy.

The BOJ’s decision to relax its yield curve control policy marks a significant shift in financial markets, particularly in the yen carry trade. The trading strategy involves borrowing JPY at low-interest rates and investing in assets that offer higher yields. Low rates and a weak currency have made the JPY an attractive funding currency for this strategy. However, if interest rates in Japan rise, the yen carry trade will become less profitable and hurt traders who will have to repay loans with a stronger currency. Additionally, the move will cause investors to reassess their risk appetite, especially as the global economy shows signs of slowing.

Keep on Surprising: Strong GDP growth in the second quarter of 2023 has bolstered hopes that the U.S. economy may be able to skirt a recession, but we have doubts.

The American economy expanded at a faster-than-expected pace in the second quarter of 2023, according to the Bureau of Economic Analysis (BEA). GDP grew at an annualized pace of 2.4% from April to June, up from a revised 2.0% in the first quarter. The figure was also above the consensus estimate of 1.8%. A rebound in investment spending boosted the growth, as it offset deceleration in both government spending and consumption. Although it is unclear whether we are out of the woods, the report does provide reassurances that the economy is more resilient than many suspected.
A deeper dive into the investment GDP numbers shows that much of the increase came from private investment, particularly in transportation. Purchases of transportation equipment accounted for more than half of the growth in fixed investment and more than a fifth of the rise in overall growth. Although it is unclear where the rise has come from, there is speculation that it may have something to do with the government infrastructure bill passed in 2021. Additionally, steps made toward reshoring manufacturing may have also played a role. If this is true, it suggests that investment may be able to support a longer expansion.

That said, hotter-than-normal temperatures and El Niño conditions could lead to an unexpected drop in growth in the third quarter. These factors could make it harder for workers to perform outside jobs and deter consumers from engaging in outdoor activities. There are signs that the heat is leading to a decline in consumer spending and business investment. On Thursday, President Biden instructed the Department of Labor to ramp up enforcement of on-the-job heat hazards. At the same time, theme parks such as Disney World have experienced a sharp decline in attendance. The extent of the economic impact of high temperatures on economic activity is unclear, but it is likely to weigh on GDP.

Let’s Be Friends: NATO allies are vying for support in the Oceania region as geopolitical tensions in the Indo-Pacific heat up.

As geopolitical tensions rise in the Indo-Pacific, Western leaders have traveled to Oceania to build ties with countries in the region. French President Emmanuel Macron is currently on a week-long tour of the Polynesian islands, where he warned of a “new imperialism” threatening the sovereignty of numerous states in the South Pacific. On the same day, U.S. Defense Secretary Lloyd Austin gave a speech in Papua New Guinea, reassuring government officials that the U.S. was not planning to set up a permanent base in the country, and the U.S. Secretary of State Antony Blinken invited New Zealand to join AUKUS.
Western overtures in Oceania are part of a strategic pivot toward Asia to counter China’s growing influence in the region. In April 2022, the Solomon Islands authorized the Chinese navy to make routine port visits, raising concerns that Beijing could establish a permanent military base in the region. In response, the United States and European countries have increased their engagement with Oceania. This year, the U.S. has signed defense agreements and reopened embassies after decades of closure. France has also sought to improve ties with Australia and position itself as an alternative to China and the United States in the Oceania region.

Along with security agreements, the U.S. is also looking to increase trade ties with Australia
While the West agrees on the need to stand up to China in the Indo-Pacific, there are signs that the two sides are not completely aligned. Europe’s focus on strategic autonomy is one example of this, as it suggests that the bloc is seeking to avoid putting all of its eggs in the U.S. basket. France has been particularly vocal in this regard, with President Macron stating that he wants to maintain a “constructive relationship” with China, despite U.S. calls for de-risking. Although we do not expect the Western allies to have a major fallout over this dispute, we do foresee a less cooperative relationship, especially if the war in Ukraine ends.

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Business Cycle Report (July 27, 2023)

Posted on July 27, 2023July 27, 2023 by Amanda Ahne

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 continues to improve but is still signaling a possible recession. The June report showed that six out of 11 benchmarks are in contraction territory. Last month, the diffusion index rose from -0.2121 to -0.1515, slightly below the recovery signal of -0.1000.

Tech stocks, particularly those associated with artificial intelligence, provided a boost to equities.
Construction activity waned; however, other measures of the real economy remained mixed.
Employment indicators suggest that the labor market is tight.

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.

Read the full report