by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

• Beijing is encouraging more countries to use the yuan (CNY) to pay for Chinese goods. On Wednesday, the Argentine Prime Minister announced that his government would use CNY instead of USD for transactions with China. The switch in currency preferences was designed to prevent a drain on Argentinian foreign reserves which have been strained by high debt servicing costs and rising import prices. The CNY is already the most popular traded currency in Russia and is now being considered by Saudi Arabia to price oil sales.
• The war in Ukraine has fueled Beijing’s ambition to make CNY a global currency. According to the Standard Charter’s Renminbi Globalization Index (RGI), usage of the Chinese currency increased by 26.6% in 2022. Although cross-border CNY payments have increased for five consecutive years, transactions in this currency have more than doubled their pre-pandemic level. In March of this year, local cross-border payments surpassed the greenback for the first time on record. These statistics suggest that China is becoming more aggressive in reducing its dependency on the U.S. dollar as it fears possible isolation.

(Source: The National News)

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

• First Republic Bank’s (FRC, $5.45) troubles are still weighing on investor sentiment. On Monday, the bank disclosed that it had lost $100 billion in deposits last quarter. Although in March First Republic Bank was able to replace some of the lost holdings with $30 billion in deposits from major banks, the new injections were not enough. In order to shore up its cash position, First Republic has now decided to sell assets, likely at a discount. Its precarious situation has led regulators to consider downgrading their assessment of the bank, which would limit the firms’ access to the Federal Reserve’s lending facilities, if it can’t find a quick solution to its woes.
• The struggles of First Republic Bank are a reminder of the tensions caused by fractional reserve banking. Banks convert deposits, which depositors view as “money,” into loans and securities, which pay a higher interest rate. This model relies on a normally sloped yield curve. When central banks tighten policy, yield curves tend to invert, meaning that funding costs for banks (those short-term deposits) may now be paying a higher rate than the loans and securities held by the bank. What we have seen recently is that a few banks have held long-duration risk on the asset side (loans and securities) as policy tightening has threatened their solvency. As long as deposits “stay put,” the bank can continue to operate, however, if depositors withdraw their funds, the bank is in trouble. As we mentioned in yesterday’s report, unlike Silicon Valley Bank, most regional banks don’t have a high level of exposure to long-term Treasuries, but deposit outflows remain a problem. So far, the smaller financial institutions have been able to depend on Federal Reserve backstops for relief, but even that solution has its flaws.

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

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

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

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

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

 (Source:  Brad Setzer)

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

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

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

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

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

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

---

[1] Otherwise known as bribes.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

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

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

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

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

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

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

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

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

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

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

• Separately, medium-sized California lender First Republic Bank (FRC, $16.00) reported yesterday that its customers withdrew more than $100 billion of their deposits amid last month’s banking scare. First Republic’s stock is down some 20% today in pre-market trading.
• Of course, First Republic’s sudden hemorrhaging of deposits mostly reflected customer concerns about the bank’s stability. Nevertheless, the firm said deposits have been continuing to drift lower this month, suggesting that customers continue to look for higher returns in mutual funds, Treasury bills, and the like.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with new data showing how China’s post-pandemic economic reopening is boosting its imports from other countries, including Australia.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a worrying statement by the Chinese ambassador to France and new research suggesting auto dealers’ markups have been a big driver of U.S. inflation.

China-Australia:  New data shows that China’s imports of Australian coking coal quadrupled in March compared with February, while its imports of Australian thermal coal were 14 times higher.  Chinese coal imports from Australia remain far below their levels from early 2020, when Beijing banned a number of Australian products in retaliation for Canberra’s call to investigate China’s role in the coronavirus pandemic.  Nevertheless, the big jump in the coal trade during March shows that a recent trade thaw between the countries is continuing.

• Beijing’s willingness to drop its trade barriers against Australia probably aims to ensure sufficient supply as the Chinese economy recovers from the government’s strict pandemic lockdowns.
• That reflects the extent to which Beijing has prioritized its post-pandemic economic recovery, which is likely to boost global growth and help support the world’s stock markets in the near term. A major beneficiary is likely to be Australia.

China-European Union:  In an interview on French television, Chinese Ambassador Lu Shaye asserted that ex-Soviet republics such as Latvia, Lithuania, and Estonia have no legal status as independent countries.  The three Baltic states, which are all members of the European Union, have summoned their respective Chinese ambassadors to register their complaints.

• The Chinese government has already shown at least tacit support for Russian President Putin’s illegal invasion of Ukraine. Even though the Chinese foreign ministry today disavowed Ambassador Lu’s assertion, the slip of the tongue suggests at least some Chinese officials are willing to also support Putin’s attitude toward the other formerly Soviet states.
• Lu’s statement illustrates the increasingly tight policy coordination between Beijing and Moscow. With China and Russia offering each other mutual support, the statement suggests Western countries may no longer be able to differentiate between the two rogue nations.  Growing China-Russia policy coordination is likely to further exacerbate the fracturing of the world into relatively separate geopolitical and economic blocs.

Russia-Ukraine War:  New reports indicate that Ukrainian forces have now established a sustained presence on the east bank of the Dnipro River for the first time since early in Russia’s invasion.  Meanwhile, Yevgeny Prigozhin, head of the Wagner Group of Russian mercenaries, late last week called for the Russian forces to adopt defensive positions ahead of an expected Ukrainian counteroffensive.

• The reports suggest the Russians may be conserving ammunition or are otherwise paralyzed by the likelihood of new Ukrainian attacks in force with modern Western weapons. If so, it could point to a coming sea change in the conflict, with Ukraine taking the initiative and potentially forcing the Russians to retreat in at least some areas.
• Separately, officials in Crimea stated that Ukrainian drone boats tried to attack the Russian fleet at Sevastopol, but they were repelled before they could cause any damage. Other Russian reports say a Ukrainian drone aircraft crashed in the forests outside Moscow, but it also apparently caused no damage.

Eurozone:  National Bank of Belgium Governor Pierre Wunsch, who sits on the European Central Bank’s rate-setting committee, warned in an interview that investors are underestimating how high Eurozone interest rates will rise.  Since ECB policymakers want to push down both wage growth and price inflation, Wunsch said the ECB’s benchmark short-term interest rate may have to go to 4.00% at some point, slightly above current market expectations for a peak of 3.75% and well above the current rate of 3.00%.

Switzerland:  First-quarter results show customers of Credit Suisse (CS, $0.8912) yanked about $68.6 billion of deposits from the institution during the first quarter, mostly in the run up to its forced takeover by UBS (UBS, $20.29).  The big drop in business illustrates how severely Credit Suisse was damaged amid the fallout from the March banking crisis in the U.S.  The drop in business means Credit Suisse could be an even bigger challenge for UBS to integrate than previously thought.

United States-Sudan:  As rival Sudanese military groups continue to battle for control of the country, the U.S. military evacuated about 100 Americans yesterday, mostly consisting of U.S. Embassy employees.  The United Kingdom, Germany, and France were among the other countries that also evacuated their citizens.

U.S. Price Inflation:  New research from the Bureau of Labor Statistics shows that dealer markups on new cars were a big driver of price inflation over the last three years.  According to the study, those markups alone accounted for 0.3% to 0.7% of the nearly 16% rise in the consumer price index from the end of 2019 to the end of 2022.  The increase in markups was driven by the fact that auto demand surged after customers got their pandemic stimulus checks, while supply-chain snarls reduced supply.

U.S. Retail Industry:  Yesterday, iconic household goods retailer Bed, Bath, and Beyond (BBBY, $0.2935) filed for bankruptcy protection and said that it expects to eventually close all 360 of its Bed Bath & Beyond stores and all 120 of its Buybuy Baby retail locations.  In the meantime, the bankruptcy filing give the company time to conduct going-out-of-business sales at its physical stores and solicit interest from potential buyers for its remaining assets, such as its branding.  If the firm liquidates as expected, it will leave many large retail buildings vacant across the country, dealing another blow to real estate investors.

U.S. Stock Market:  Washington Service, an insider-trading data provider, said more than 1,000 directors and officers at more than 600 publicly traded firms bought their own company’s stock in March, marking the strongest insider buying since last May.  The strong buying activity, despite last month’s bank crisis, suggests that company officials are looking past the bank issues and remain optimistic about the economy and their corporate prospects.

• Separately, CBOE (CBOE, $139.51) today is launching a new version of the VIX index of stock market volatility. The new one-day Volatility Index, or VIX1D,  is designed to measure expected volatility in the S&P 500 over the next day of trading, rather than over the next month like the VIX.
• The launch of the new one-day VIX is consistent with the recent rise of ultra-short option trading, which is not reflected in the traditional VIX.

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