by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts on the ongoing debate as to whether the Federal Reserve should hike or pause at its next meeting. Next, we explain why the European Union has taken a vested interest in the Western Balkans. Lastly, we discuss why uncertainty in China has unnerved both investors and businesses.

A Fed Divided: Much to the bewilderment of markets, Fed officials can’t seem to get their story straight regarding the path of future rate hikes.

• Federal Reserve Governors Michelle Bowman and Phillip Jefferson offered seemingly different interest rate outlooks on Thursday. During a “Fed Listens” event in Boston, Bowman implied that higher interest rates had not done enough to pull down housing inflation. Meanwhile, Jefferson warned that higher interest rates could “exacerbate stress” across the banking sector. The opposing viewpoints highlight the disagreements among policymakers as they struggle to articulate a path forward. As a result, investors have not been able to confidently gauge where interest rates will be set at the June meeting as exemplified by the CME FedWatch Tool which swung widely on Thursday. The model initially predicted a 70% likelihood of a 25 bps hike during mid-day, but it later revised its forecast to a 70% probability of a pause by market close.
• Mixed economic data partially explains why Fed officials are having trouble establishing a consensus on the future path of interest rates. The unexpected surge in the number of job openings bolstered investor sentiment regarding the labor market’s tightness, strengthening the belief that the central bank should raise rates. However, later that same day, the release of the Federal Reserve Beige Book supported a more moderate policy approach as firms expressed a decrease in hiring activity and waning inflation pressure. The conflicting business cycle indicators will complicate the efforts of the Fed to communicate a path forward for interest rates.
  • The strong JOLTS report led to a rapid sell-off in equities that nearly wiped out gains made in the S&P 500 in May.

• Despite the disagreements evident within the Federal Open Market Committee (FOMC), it is highly likely that there will be no dissents at the next meeting. While members hold differing views on when to cease rate hikes, most are hesitant to signal the definitive end of the tightening cycle. Therefore, a plausible scenario is that the FOMC may indicate a hike every other meeting, a strategy often referred to as a hawkish pause. This policy adjustment will still be perceived as a form of moderation; however, the market’s response could be negative as investors generally prefer interest rates to decrease by year’s end or before a recession.

Sharing is Caring: As the war in the Ukraine rages on, the European Union is poised to broaden its reach in Eastern Europe.

• The EU countries have softened their stance with prospective members. Brussels announced that it would offer some single-market benefits to countries within the Western Balkans to prevent the region from destabilizing. The move comes amidst ethnic tensions in northern Kosovo which led to a clash between protesters and NATO peacekeepers. The measure would grant access to the bloc’s digital single market in areas such as ecommerce and cybersecurity. Additionally, the EU would also increase pre-accession funding. The decision to further integrate Western Balkan countries into the EU is meant to reduce Russia’s influence and prevent another war from breaking out in Eastern Europe.
  • Last year, The EU drastically increased humanitarian aid to countries in Eastern Europe.

   (Source: European Commission)

• Additionally, the EU is doubling its support for Ukraine. Brussels is working on a four-year financial plan to support the embattled nation. The additional funding will allow Kyiv to manage its budget while it tries to repel Russian forces from its borders. Similarly, French President Emmanuel Macron signaled that he would back a path for Ukraine to join NATO. Ukraine considers membership in the military alliance as key to its future defense and security. However, Kyiv has yet to receive full support from members due to fears that adding war-fighting countries would set a dangerous precedent.
• Europe needs to pursue greater involvement within the Western Balkans to prevent Moscow from destabilizing the region. Since the beginning of the conflict, Russia has sought to broaden its war campaign by stirring up conflict in the Western Balkans. Currently, Russia is using its deep cultural and historical ties with the Serbs to help stir unrest in Bosnia-Herzegovina and Kosovo. To prevent a crisis from spiraling out of control, the EU will have to offer additional aid to prevent these countries from leaving its orbit. At this time, we suspect the greater EU involvement should be enough to prevent disputes within the Western Balkans from turning into major conflicts.

Not Yet! Prominent American CEOs want the government to cool it on talks about the U.S. decoupling from China.

• JP Morgan chief executive Jamie Dimon along with several other corporate executives warned American and Chinese lawmakers against the further exacerbating of tensions. During a summit in Shanghai, Dimon argued that the conflict between the two major powers had hurt investor confidence. His comments mirrored remarks made by Tesla CEO Elon Musk who described the U.S. and China as being conjoined twins. The sentiment expressed by the business leaders broadly reflects the unease companies have about a possible decoupling of the world’s two largest economies. As a result, we expect business leaders will try to lobby governments to resume trade talks.
  • The U.S.-Taiwan trade deal reached on Wednesday will further escalate tensions as Beijing insists that any direct talks with the sovereign province is an encroachment on Chinese sovereignty.
• The recent surge in equities across Japan, Korea, and Taiwan can be attributed to investors hedging against the possibility of a decoupling between the United States and China, as well as concerns over a potential slowdown in the Chinese economic recovery. This strategic shift in portfolio allocations reflect investors’ eagerness to explore alternative opportunities within Asia. Moreover, apart from its ongoing rivalry with the United States, China’s reopening process has been characterized by fragility and unevenness, making it challenging for investors to accurately assess the country’s growth potential.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some unexpectedly soft economic figures out of China, which are weighing on global stock markets so far today.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new sources of tension between China, the U.S., and India and the latest on the deal to raise the U.S. government’s debt limit.

China:  The National Bureau of Statistics said the country’s May purchasing managers’ index for manufacturing fell to 48.8, well short of the expected reading of 49.5 and even lower than the April figure of 49.2.  In contrast, the official PMI for nonmanufacturing industries only fell to 54.5 in May, compared with 56.4 in the previous month.  China’s official PMIs, like most such indexes, are designed so that readings over 50 indicate expansion.

• At their current levels, the PMIs provide more evidence that the economic rebound after the government lifted its draconian Zero-COVID policy is already petering out. Factory activity is shrinking further, and now even the services sector is suffering from slower growth.
• Stagnating demand in China has the potential to drag on economic activity around the world, pushing down commodity prices and weighing on stock markets. Chinese stocks are now in a bear market.

China-United States:  The Department of Defense revealed that on Friday, a Chinese fighter jet flew dangerously close to a U.S. reconnaissance plane flying in international airspace over the South China Sea.  In what the U.S. called an “unnecessarily aggressive maneuver,” the fighter jet crossed the path of the recon plane just 400 feet in front of its nose, forcing the U.S. plane to fly through its turbulence.  The incident shows that U.S.-China tensions continue to spiral, creating greater risks of outright conflict and potentially causing collateral damage to investors.

China-India:  New reports say Beijing has recently ejected the last remaining Indian journalists from its country, while New Delhi has evicted the last Chinese journalists from India.  The evictions reflect a further worsening of bilateral tensions over border disputes in the Himalayan mountains and other issues.  While our analysis puts India in the China-leaning bloc of countries, the ongoing tensions suggest New Delhi is actually “in play” and will likely continue to increase its security cooperation with the U.S.

Japan:  If you’re a seasonal allergy sufferer and have always wondered what would give you real relief, the Japanese might have an answer for you.  The government yesterday proposed a program that would cut down 20% of the country’s cedar forests over the next decade, with the goal of cutting average pollen counts by half over the next 30 years.  The plan will expand the acreage of artificially planted cedars subject to logging, promote the use of domestic wood, and allow more foreign lumberjacks to immigrate.

Eurozone:  Similar to yesterday’s report of moderating price growth in Spain, a report today showed France’s May consumer price index was up just 6.0% from the same month one year earlier, marking a significant cooling from the rise of 6.9% in the year to April and coming in lower than the expected increase of 6.4%.

• Moderating inflation in the eurozone has prompted speculation that the European Central Bank could stop its interest-rate hikes as early as July.
• In turn, that prospect is weighing on the EUR today. As of this writing, the single currency is trading at $1.0686, down 0.5% for the day.

United Kingdom:  The country’s summer of strikes continues, with the U.K.’s main train drivers’ union walking off the job today.  The action has paralyzed most of England’s mainline railroads, heaping more headaches on Prime Minister Sunak and illustrating how inflation and wage demands remain potent issues in the U.K.

Russia-Ukraine War:  According to the Wall Street Journal, Ukraine and its Western European allies are planning a July summit of global leaders (excluding Russia’s) to promote Kyiv’s peace proposal.  European leaders such as French President Macron have reportedly been lobbying for participation by countries that have sided with Russia or have declined to take a position on the war, such as Saudi Arabia and Brazil.  News of the planned summit suggests that Kyiv is operating under a broad, comprehensive plan to win the war by quickly following its expected battlefield counteroffensive with a powerful political operation supporting its own peace plan over China’s rival plan, all the while leaving Russia isolated.

U.S. Fiscal Policy:  New analysis of the preliminary deal to lift the federal debt limit indicates it will ensure that student loan payments and interest accruals will restart no later than August 30, with no further extensions to the pandemic-era pause.  The need for former students to start making loan payments again could noticeably undermine consumer spending and help give the economy a final push into recession.

• The House Rules Committee approved the debt-limit legislation yesterday and sent it for a final vote of the full House which could occur as early as today.
• The vote in the Rules Committee relied on votes from both moderate Republicans and Democrats, illustrating how passage of the bill in the full House will likely require the cooperation of centrists on both sides of the aisle.

U.S. Monetary Policy:  In an interview with the Financial Times, Cleveland FRB President Mester said she sees no compelling reason to pause the Federal Reserve’s interest-rate hikes as long as inflation pressures remain high.  Essentially, Mester argued that the risk involved with hiking rates too little was higher than the risk involved with hiking too much.  Her hawkish statement feeds into growing expectations that the policymakers will lift their benchmark fed funds rate further at their upcoming meeting in June.

U.S. Labor Market:  Goldman Sachs (GS, $330.83) is reportedly planning another round of layoffs, which would be its third since last September.  This round will evidently be focused on employees in its investment banking group.  Financial dealmaking has been crimped over the last year as the Fed hiked interest rates and, more recently, as regional banks ran into trouble.

• The layoffs underscore how the Fed’s rate-hiking campaign has had the biggest negative impacts, so far, on sectors such as housing, commercial real estate, mortgage finance, and investment banking.
• This Wall Street Journal article provides a useful overview of how the Fed’s rate hikes have tightened conditions in various credit sectors.

U.S. Oil Market:  Starting tomorrow, the crude oil transactions used to calculate the Brent benchmark price will include purchases and sales of U.S. oil.  As output from the North Sea’s Brent field has fallen, the basket of prices that go into the Brent average has been gradually broadened in recent years.  The inclusion of U.S. prices reflects the growing heft of U.S. producers in the global oil market.  However, note that the U.S. oil to be included in Brent is not West Texas Intermediate, which is widely referred to as “U.S. crude.”

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the weekend’s preliminary deal to lift the federal debt limit until 2025.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the re-election of Turkey’s president and indications that quantitatively driven investment funds have been a key reason why U.S. stocks have been moving upward this year despite expectations of a recession.

U.S. Fiscal Policy:  For those who were truly “off the grid” over the Memorial Day weekend, on Saturday President Biden and House Speaker McCarthy reached a deal in principle to lift the federal debt limit.  The agreement would make sure the government can keep covering its debt service and other bills past June 5, which is Treasury Secretary Yellen’s new estimate of when the government will run out of cash.  The challenge over the coming days will be for Biden and McCarthy to whip up enough support in their respective parties to pass the bill into law.  On the Democratic side, many progressives are angry about compromises that will cap government spending and ease permitting for energy projects.  On the Republican side, many right-wing legislators are mad that spending wasn’t cut even more.  Nevertheless, we continue to believe the legislation will ultimately be passed into law in time to avoid a financial crisis.

• Key provisions of the deal include:
  • The debt limit would be suspended until January 1, 2025, well after the upcoming federal elections. By that time, the Treasury will have rebuilt its financial flexibility and its ability to use “extraordinary measures” to pay its bills.  That means any new debt crisis could probably be pushed off into mid-2025.
  • Federal discretionary spending will be capped for the next two years. In the upcoming fiscal year, discretionary defense outlays would be allowed to rise by a nominal 3%, while discretionary nondefense outlays would be frozen at current levels.
  • Some $30 billion in unused pandemic relief funds will be clawed back from dozens of programs.
  • Work requirements to be eligible for SNAP nutrition benefits (i.e., food stamps) would be extended to those up to age 54, compared with 49 currently.
  • Federal permitting procedures for energy projects would be accelerated by requiring a decision within one or two years.
• Rising prospects for the deal gave a boost to the stock market in recent trading sessions. However, it’s important to remember that if the deal is passed into law, the Treasury will need to rebuild its cash balances at the Federal Reserve, which will likely mean drawing hundreds of billions of dollars out of the economy in the coming weeks.  That will amount to significant fiscal tightening that could pull stocks down again.

Russia-Ukraine War:  As Ukraine endured another big wave of air attacks last night, officials in Russia today blamed Kyiv for a number of drone attacks on residential areas of Moscow.  If confirmed as an attack by Ukrainian forces, the incident would mark the first such attack on Russian civilian targets, although it seems just as likely that the attack was carried out by Ukrainian sympathizers or partisans, perhaps the same who staged an attack on Russia’s border region last week.

• In any case, the notable attack on Moscow probably aimed to unsettle Russian citizens and undermine their support for Moscow’s invasion. Bringing the war home to the Russian people may be one of the “shaping operations” that the Ukrainians are carrying out to prepare for their expected counteroffensive.
• A key risk is that it could also encourage China or other Russian allies to step up their support for Russia.

Turkey:  In Sunday’s run-off presidential election, right-wing nationalist President Erdoğan defeated opposition leader Kemal Kılıçdaroğlu by 52.2% to 47.8%.  Our analysis suggests that Turkey will remain in the U.S. geopolitical and economic bloc, reflecting its membership in NATO and its tight trade ties to the U.S., but the victory by Erdoğan means he will likely continue trying to play the U.S. off China and its evolving bloc.  Erdoğan is also likely to continue his unorthodox economic policies, such as holding down interest rates in the face of high inflation and a depreciating currency.  The news of Erdoğan’s victory has, therefore, weighed on the Turkish lira (TRY) yesterday and today.

Spain:  In regional and municipal elections on Sunday, the conservative People’s Party led by Alberto Núñez Feijóo roundly beat the ruling Socialist Party of Prime Minister Pedro Sánchez.  Counting so far shows support for the People’s Party surged to 31.5%, up 9% from the elections in 2019, while support for the Socialists was nearly stagnant at 28.1%.  Nevertheless, Sánchez gambled and called a snap national election for July 23 in order to keep some initiative in his hands and stem any momentum of the People’s Party and its far-right ally, the Vox Party.

• Spain’s relatively good economic environment may be one reason the prime minister was willing to gamble on new national elections.
• The country’s statistical agency today said its April consumer price index was up just 2.9% from the same month one year earlier, far better than the rise of 3.8% in the year to March and even below the expected inflation rate of 3.4%. Excluding the volatile food and energy components, the April core CPI was up 6.1%, down from 6.6% in the previous month.

Serbia-Kosovo:  After boycotting recent local elections in northern Kosovo, Serbian protestors on Monday tried to prevent the ethnic Albanian mayoral winners from entering city halls and taking office.  The resulting violence injured more than a dozen NATO peacekeepers, sparking condemnation by Western leaders.  The new violence risks undermining a March peace deal between Serbia and Kosovo.

China:  Now that the unemployment rate for young adults has risen to a record above 20%, officials report a surge in applications for programs that put young college graduates to work in the country’s vast, underdeveloped rural areas.  While many college graduates continue trying to hold out for better-paying jobs in urban areas, the trend reflects the extent to which slowing economic growth has reduced attractive opportunities for young people—a problem that could eventually undermine political support for the Communist Party.

• Not only has China’s economy matured to the point where it can’t grow as fast as it did in past decades, but its recovery from Beijing’s draconian Zero-COVID policies is petering out much earlier than anticipated.
• Reflecting that, Chinese stocks trading in Hong Kong today temporarily dipped into bear market territory, down more than 20% from their peak in January before rallying to close above that marker.

China-United States:  Stephanie Hui, the chief of Asia-Pacific private and growth equity for Goldman Sachs (GS, $332.01), said geopolitical tensions between Washington and Beijing have sapped U.S. investors’ interest in her funds, prompting her to stop trying to raise money in the country.  Instead, Hui said she is now focused on raising money in places like the Middle East and Southeast Asia.  Separately, Beijing has reportedly refused a request by Washington for U.S. Defense Secretary Austin to meet Chinese Defense Minister Li Shangfu at a security conference in Singapore this week.  Taken together, these developments offer even more signs of the worsening estrangement between the U.S. and China.

U.S. Stock Market:  New analysis from Wall Street indicates that the rise in U.S. stock values and the relative calm in the market so far this year can be ascribed to quantitatively driven funds.  The data suggests their buying has been more than enough to offset the pullback in investing by individuals and other discretionary investors.  Of course, a risk is that the quantitative models could start to flash sell signals, which presumably would drive market values down again.

Global Gold Market:  A new survey by the World Gold Council shows that 24% of global central banks plan to increase their gold holdings in 2023.  The survey indicates that the central bank buying plans, which were especially prevalent among emerging market institutions, are being driven by concerns ranging from geopolitical tensions to consumer price inflation.  That’s entirely consistent with our oft-stated belief that aggressive sanctions by the U.S. and its allies against Russia and other authoritarian states will prompt countries to rely more on the yellow metal.  We therefore remain bullish on gold prices in the coming years.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with our thoughts about the potential benefits and risks associated with generative artificial intelligence (AI). Next, we examine the impact that a German recession would have on the European Central Bank’s policy rate decision. Finally, we discuss the Turkish election and what it may mean for markets.

More Chips: As investors clamor for AI-related stocks, regulators are seeking to contain risks associated with the technology.

• Chipmakers are confident that they can capitalize on the generative AI craze. Semiconductor producer Nvidia (NVDA, $379.80) projected second-quarter sales of $11 billion. Nvidia’s strong guidance and positive earnings report boosted sentiment in the tech sector, sending the company’s share price up 24.37% on the day. Meanwhile, the tech-heavy NASDAQ surged 1.7% on Thursday, and the S&P 500 closed up 0.9%. Optimism that the sector will revolutionize the way companies generate profits has outweighed concerns regarding regulatory risks and potential geopolitical disruptions.
• Government authorities are finding it difficult to balance the interests of shareholders with national security concerns. European regulators have proposed new rules that would limit AI companies’ abilities to use copyrighted material and to make critical decisions such as granting loans and hiring. Additionally, friction between the U.S. and China continues to pave the way for tit-for-tat restrictions on chips. Earlier this week, Beijing banned some Chinese companies from purchasing chips from semiconductor company Micron (MU, $69.61). The move is likely in retaliation for U.S. export restrictions of advanced chips to the country and may lead to a response from the Biden administration.

• Concerns over regulation and geopolitical tensions is not likely to sway investors from buying tech shares. This is best seen in the performance of Micron Technology. Despite the company’s shares plunging more than 4% following the news of the ban, its stock price is now trading at its highest level in almost a year. This is likely not a one-off. The fear of missing out may encourage investors to overlook many of the risks associated with AI and semiconductors. That said, we suspect many of the dangers associated with the AI boom will likely play out over time and should not lead to the overall change in outlook for the industry in the short- and medium-term.

Recession or Not: The European Central Bank is expected to raise interest rates at its next meeting, despite data showing that the eurozone’s largest economy is in a recession.

• Germany’s economy shrank 0.3% in the first quarter of 2023, driven by weak consumer spending and a slowdown in exports. This was the second consecutive quarter of contraction; thus, it meets the formal definition of a recession. The lack of growth is related to shoppers reining in their spending to cope with rising inflation. Household final consumption expenditure fell 1.2% in the first three months of 2023. Meanwhile, the overall price level of goods and services has risen 7.1% since April 2022. Despite the recession, the European Central Bank is expected to raise interest rates at its next meeting in June.
• Inflation concerns have kept European Central Bank officials hawkish as they look to restore price stability. Hours after German GDP figures were released, ECB Vice President Luis de Guindos advocated for central bank officials to maintain their fight against inflation. Later that day, Dutch Governing Council member Klaas Knot argued that interest rates should increase until at least July and stay there for some time. Central bankers’ insistence on maintaining policy tightening will make it difficult for countries to recover from a downturn. However, we suspect that hawkish ECB policy may offer support for the EUR, especially if the Federal Reserve holds its interest rates steady at its next meeting as expected.

• If history serves as a guide, the ECB will be less aggressive in easing policy than its American counterpart. As the chart above shows, the ECB did not raise interest rates as fast as the Federal Reserve, but it was also much slower to cut. Overnight index swaps show that traders expect European interest rates to rise by 50 bps and American rates to fall by 25 bps by the end of the year. The narrowing of interest rate differentials should allow the EUR to appreciate against the USD, making European assets relatively more attractive.

Final Round: Markets are worried that another five years of Recep Tayyip Erdoğan as President will be damaging to the Turkish economy.

• After months of speculation about the potential end of his reign, Erdoğan is currently poised as the frontrunner to win the upcoming presidential run-off on Sunday. However, the backlash from victims of the devastating earthquakes combined with the mismanagement of the country’s economy could still hurt his chances of securing a victory. Interestingly, prior to emerging as the top vote-getter in the first round of the election, Erdoğan was trailing behind his rival Kemal Kılıçdaroğlu, with opinion polls indicating a gap of 43.7% to 49.3%. However, with the recent endorsement from the third-place candidate Sinan Oğan, Erdoğan now enjoys increased support and is heavily favored to win, much to the disappointment of investors.
• The market is bracing for another Erdoğan presidency, and as a result, it is expecting the Turkish lira (TRY) to decline in value after the election. Market participants are concerned that Erdoğan will continue to steer the country in a negative direction. Mounting inflation, a burdensome debt load, and sluggish economic growth weighed on investor sentiment. The iShares MSCI Turkey ETF has already fallen by 12% since the first round of elections. As a result, Turkey will need to undergo a significant and comprehensive transformation in order to rebuild the trust of investors.

• However, it is important to acknowledge that Turkish equities have demonstrated the ability to defy expectations in the past. This is evidenced by the remarkable 110% surge in dollar terms of the Borsa Istanbul 100 index last year, compared to a 20% decline in the S&P 500. Although some of those gains have been retracted, this rally highlights the possibility that investors may not always adhere strictly to conventional wisdom. From our perspective, Turkey’s strategic geographic location, robust military capabilities, and growing industrial base position it as an enticing prospect, provided the country manages to address its internal challenges. Only time will reveal if Turkey can fulfill its potential and capitalize on these advantages.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with an update on the debt ceiling negotiations. Next, we argue that the Fed may pause this year but is not likely to pivot. We end the report with our thoughts about the rising likelihood of a hard split between the U.S. and China.

 Debt Ceiling: Ongoing talks between President Joe Biden and House Speaker Kevin McCarthy have yet to yield results, and investors are worried.

• American lawmakers are under pressure to reassure investors that they will raise the debt ceiling in a timely manner. The credit rating agency Fitch Ratings has placed the U.S. triple-A rating on watch for a possible downgrade due to concerns that political brinkmanship could prevent the government from honoring its debts. Despite progress made by negotiators, it is unclear when Congress will raise the debt limit to avoid a catastrophic default. The standoff is expected to continue today, but we are still confident that an agreement will be reached before the June 1 deadline. That said, the market may get a bit choppy as traders respond to the latest developments regarding negotiations.
• Uncertainty over lifting the debt cap has unnerved markets. The S&P 500 and Dow Jones Industrial Index are both trading lower this week (see chart below). At the same time, yields on Treasury bills expiring in the first eight days of June have risen above 7%. Anxiety over when the debt ceiling will be raised has led to a surge in market volatility. On Wednesday, the CBOE Volatility Index (VIX) surpassed 20 suggesting an unusual amount of fear amongst traders. The strong reaction highlights the significant risk a potential default will have on the U.S. economy.

• We are confident that an agreement will be reached with bipartisan votes but suspect that the deal will push the country closer to recession. Despite speculation that McCarthy will need to win unanimous support from his party to get a spending bill through Congress, there are Democrats willing to fill the gap if needed. However, the combination of a liquidity drain and spending cuts from the new deal will remove fiscal stimulus from the economy. As a result, we still believe a recession is likely to happen within the next few quarters, even if the U.S. avoids default.

 Hold Not Cut: The release of the latest Federal Open Market Committee meeting minutes has led investors to boost bets about a possible Fed pause.

• According to the May minutes, tighter financial conditions have led some Fed officials to question the need for additional rate hikes. The notes showed that central bank officials expressed a willingness to keep their options open as the committee determines whether it wants to raise rates further. The decision to maintain policy flexibility is related to concerns that inflation risks remain tilted to the upside. The latest staff projections for the annual change of personal consumption expenditure price index (PCE) were revised upward from 2.8% to 3.1% for 2023. That said, some policymakers argued that the committee should be patient before raising rates further.
• Recent speeches from officials suggest that the committee may be split between those favoring another hike and others preferring a pause. Earlier this month, Federal Reserve Governor Christopher Waller and Cleveland Fed President Loretta Mester advocated for additional rate hikes. Meanwhile, Chicago Fed President Austan Goolsbee and Federal Reserve Chair Jerome Powell expressed support for a pause at the June meeting. The conflicting reports have led traders to become less optimistic regarding a Fed pause. The latest CME FedWatch Tool now forecasts a 56.4% chance that the Fed will hold rates at their current levels at the time of this writing, much lower than the 90.1% prediction from three weeks ago.

• As the chart above shows, the Fed is still far away from achieving its 2% inflation target. The lack of progress in achieving price stability suggests that policymakers will likely keep rates higher for longer than the market anticipates. As a result, the risk of a hard landing is relatively elevated as Fed officials will likely not pivot anytime soon. That said, we still believe the central bank is close to ending its tightening cycle and is more likely to seek a potential off ramp as the country heads toward a recession.

Chinese Rivalry: From spying to resource hoarding, Beijing is leaving no stone unturned as it prepares for its eventual decoupling from the U.S.

• Chinese state-sponsored hackers have implanted malware on critical infrastructure in the U.S. and Guam, according to Microsoft (MSFT, $313.85). The breach was designed to disrupt communications links between America and Asian countries in the event of a potential conflict. Although spying between the two countries is routine, experts believe this was the widest Chinese espionage campaign ever against American infrastructure. This is the second time this year that Chinese spy attempts were discovered and will likely prevent a thaw in tensions between the major powers. Following the report, Chinese stocks erased gains made in 2023 as investors prepared for additional headwinds.
• On a related note, China is building relationships with authoritarian governments as it seeks to avoid being denied access to key resources. Chinese firms have spent $4.5 billion to acquire stakes in lithium mining firms in Latin America and Africa. Those investments are somewhat risky given the security threat within these countries. However, Chinese firms have little choice but to work with these authoritarian governments as Beijing attempts to dominate the electric vehicle market. Additionally, China’s decision to deepen ties with Russia is also evidence of the country’s willingness to work with authoritarian governments to guarantee that it has the commodities it needs to sustain economic growth.
• The rift between the two major powers continues to reinforce our view that the world is likely to split into regional blocs. Although China still offers some attractive opportunities, we believe that investors have options if they seek to maintain their exposure to the second-largest economy without having to invest directly in the country. For example, nations that have a lot of trade exposure to China, such as Japan and the countries of Europe, have had strong stock market rallies following the end of China’s Zero-COVID policies. That said, as the largest economies start to diverge, the need for diversification will likely be necessary to hedge against unexpected changes in the geopolitical landscape. Hence, investors should be wary of putting all of their eggs in one basket.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with a few new developments in Russia’s invasion of Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new evidence of the threat from China’s hypersonic missiles and economic retaliation against other Western countries, plus a few items of note on the U.S. financial markets.

Russia-Ukraine War:  Two right-wing Russian militias that support Ukraine reportedly attacked and occupied at least one Russian village less than a mile from the Ukrainian border earlier this week.  The groups were then surrounded and destroyed by Russian forces yesterday.  Ukrainian officials acknowledged they were aware of the incursion but denied any involvement in it beyond “cooperating” with the groups.  All the same, reports yesterday said the groups had used U.S.-made military vehicles in the raid, including at least two M1224 MaxxPro armored vehicles and several Humvees.  The State Department responded to the allegation by reiterating that the U.S. doesn’t “enable or encourage” Ukrainian attacks on Russia itself.  The attack could marginally help the Ukrainians by diverting Russian military resources to the border area and undermining the Russians’ sense of security within their own country.  Nevertheless, we believe the use of U.S. equipment in the incident raises the risk of U.S.-Russian conflict.

• Separately, in an effort to bolster the U.S.’s commitment to aiding Ukraine, former British Prime Minister Boris Johnson gave a pro-Ukrainian speech on Monday to a group of prominent conservative politicians, donors, and business executives in Dallas. In his speech, Johnson said, “I just urge you all to stick with it . . . . It will pay off massively in the long run.”
• In another effort to address pushback against the U.S.’s support for Ukraine, a new media commentary directly addresses the controversy as to whether the U.S.’s aid to Kyiv is undermining its ability to deter China from seizing Taiwan.
  • The article notes that most of the U.S. military equipment sent to Ukraine so far was designed for a major ground war, leaving most of the naval and air assets needed to deter China in the Indo-Pacific region untouched.
  • The article argues that even if aid to Ukraine has depleted some of the U.S. arsenal, it may actually increase the country’s deterrence against China by signaling the U.S.’s resolve to protect fellow democracies from territorial aggression.

China-United States:  Speaking of a potential U.S.-China conflict, a Chinese technology magazine this month published details of a People’s Liberation Army war game in which just 24 hypersonic missiles were able to destroy a U.S. aircraft carrier and its strike group.  Using a complex three-way attack strategy, the missiles were reportedly able to sink the entire U.S. force in each of the 20 iterations of the game.  Of course, the report can’t be independently verified, and it may not be indicative of China’s true hypersonic capabilities.  Nevertheless, it does underscore China’s head start in hypersonic technology even as the U.S. continues to struggle with its program and with its decision whether to emphasize the hypersonic technology itself or just anti-hypersonic missile defense.

• Separately, the USS George Washington, one of the U.S. Navy’s 11 aircraft carriers, embarked on Monday for sea trials following a full six years out of service due to major maintenance.
• The vessel’s maintenance period was expected to be four years, but it was disrupted due to issues such as the COVID-19 pandemic, cannibalization of some systems for spare parts to be used on other carriers, a shortfall in maintenance funds, and its unexpectedly bad condition when it entered the maintenance period.
• Once the ship is back in service, it could help relieve the shortage in carrier availability as geopolitical threats continue to worsen. The table below shows the current status of all U.S. aircraft carriers.  (Note that none are anywhere close to the Persian Gulf and its critical oil supply lanes.)

Germany:  The latest trade statistics show German exports to China in January through April were down a whopping 11.3% from the same period one year earlier.  The drop reflects German automakers’ reduced market share in China, high costs for German chemical producers and other energy-intensive manufacturers, and the euro’s recent appreciation versus the dollar.

• However, the drop in Chinese demand could also reflect explicit or implicit retaliation for the European Union’s recent hawkishness against China.
• If so, it would provide more evidence that the world is indeed fracturing into relatively separate geopolitical and economic blocs, as we have been arguing.

United Kingdom:  In a speech today, Chancellor of the Exchequer Jeremy Hunt warned that persistently high inflation will prevent the government from cutting taxes anytime soon, based on concerns that tax cuts would provide extra stimulus to the economy and boost prices further.  The chancellor offered assurances that he wanted to cut the U.K.’s tax burden—currently the highest since World War II—but he first had to create economic conditions where it was safe to do so.

• Hunt’s speech came on the same day that the U.K. statistics agency issued its latest report on consumer price inflation. The April consumer price index was up 8.7% from the same month one year earlier, suggesting inflation cooled significantly from the 10.1% increase in the year to March.  However, the April CPI still overshot expectations, which had been that inflation would cool to 8.4%.
• The chancellor’s speech reflects how inflation is discouraging tax cuts in many developed countries; at the same time, politicians are loathe to use tax hikes to cool demand and bring down inflation.

Pakistan:  The country’s anti-terrorism court yesterday granted Former Prime Minister Khan bail on his corruption and terrorism charges, marking another step in the seesaw legal battle between Khan and the government.  The arrest of Khan and the government’s effort to prosecute him continue to rile the country’s politics, making it even more difficult to address Pakistan’s economic and financial crisis.

Mexico:  President Andrés Manuel López Obrador said his administration is considering buying retail bank Banamex, the country’s fourth-largest bank and a unit of Citigroup (C, $45.91) which the U.S. financial giant put up for sale last year.  A well-known Mexican businessman has already bid for Banamex, but the leftist-nationalist president indicated that if the private bid fell through, he would have the government buy it in a public-private partnership to make sure it stays in Mexican hands.

• Any such government purchase of Banamex would increase concerns about AMLO’s penchant for nationalizing businesses.
• That would likely be a further headwind for Mexican stocks, which otherwise would probably be benefiting more from the way global companies are “near-sourcing” production away from China.

U.S. Fiscal Policy:  Staff-level negotiators from the Biden administration and the office of House Speaker McCarthy met yesterday to hash out the details of a deal to raise the federal debt limit and avoid a potentially devastating default, but they reportedly made little, if any, progress.  Other reports this morning suggest Biden and McCarthy will talk later today.  Direct talks between Biden and McCarthy will likely be necessary to secure a deal before the apparent deadline of June 1, when the federal government may no longer be able to pay its bills without taking on new debt.

U.S. Stock Market:  Even though institutional and individual investors have cooled their stock purchases in the face of rising interest rates and recession fears, data from Birinyi Associates shows companies in the Russell 3000 have announced plans to buy back more than $600 billion of their own stock so far this year, matching last year’s record pace.  If actual purchases for the full year come in above $1 trillion, as the first-half pace implies, the buybacks could provide an important support for stock values despite the current headwinds in the market.

U.S. Banking Industry:  To hold on to large depositors with account balances well above the insured amount of $250,000, many regional banks have reportedly boosted their offerings of “reciprocal accounts.”  In these accounts, a customer’s large deposit balance is divvied up and shared among partner banks so that each carries just the insured amount.

• The goal is to keep the customers who were spooked by this spring’s bank failures from moving their money elsewhere.
• According to bank data firm BankRegData, deposits in reciprocal accounts soared to a new record high of $221 billion at the end of the first quarter, up from $158 billion at the end of 2022.

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