by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion about whether central banks will continue to raise rates. Next, we explain why investors have varying opinions about the state of the global economy. We end the report with our thoughts about rising friction within the U.S.-led geopolitical bloc.

 Are They Done? Moderating inflation data and fears of a recession have led to calls for central banks to stop tightening; however, policymakers have pushed back.

• Most of the G-7 central banks have resisted pressure from markets to change tack and stop hiking. After a report stated that policymakers were considering slowing hikes after their March meeting, European Central Bank officials decided instead to double down on the need to raise interest rates by 50 bps increments. Governing Council members Gediminas Šimkus and Joachim Nagel argued that the ECB should continue to raise rates in half-point increments throughout the year in order to contain inflation. Meanwhile, Fed policymakers, in the days leading up to the central banks’ one-week silence period, have urged markets to reconsider bets that the Fed could stop hiking as soon as June.
• Global credit conditions are beginning to ease despite the rhetoric from central bank officials. The spread between the 10-year Italian and German bonds, a gauge for financial distress, has narrowed by almost 60 bps from its 2022 peak in October. At the same time, the average 30-year U.S. fixed-mortgage rate has fallen almost 100 bps within a similar period. The relaxation of borrowing costs partially reflects investor expectations that the lending environment may improve in the future.
• The Bank of Canada’s decision to pause rate hikes after Wednesday’s 25 bps increase adds to speculation that central banks could be almost done tightening. It was the first of the G-7 countries to announce at least a temporary reprieve from its hiking cycle. This may force the Federal Reserve and the ECB, who are meeting on back-to-back days, to give more details about their policy path going forward. Equities could take a hit if policymakers signal that they are prepared to lift rates during a downturn. However, anything short of that may be favorable toward shorter-duration equities.

The Recession Debate: Warmer-than-expected weather, China’s reopening, and faster-than-expected U.S. GDP growth have made investors optimistic that a recession may be averted; however, there is still room for cautiousness.

• The improved economic outlook has helped boost investor appetite for equities, particularly in Europe. So far this year, MSCI Europe ex-U.K. UCITS  has outpaced MSCI USA UCITS as the indexes have risen 8.23% and 2.54%, respectively, within that period. Positive economic data and a weaker dollar have driven this preference for European stocks. Earlier this week, the preliminary Purchasing Manager Index (PMI) and Euro Area Consumer Confidence report figures showed that economic activity was gaining steam in Europe. Meanwhile,  December pending home sales showed the first monthly purchase rise in 14 months, a rare win for U.S. real estate that has been hampered as of late.
• Despite the glimpses of sunshine, there still remains much gloom. The U.K. has had a rocky start to the year as rising energy costs in December hurt the country’s manufacturing sector and households, and forced the government to take out more debt to fund energy subsidies. The U.S. has also faced some bad news. Retail sales were weak in December, while the industrial sector may already be in contraction. The deteriorating economic conditions within the two countries partially explain why the GBP is expected to underperform the EUR in 2023, and the USD has depreciated against many of its trade partners so far this year.
• In short, many unknowns remain regarding where equities will peak and bottom this year. Those that are pessimistic about growth in the U.S. and abroad have forecasted a possible low in the S&P 500 of around 3300, while optimists foresee the index rising to 4500. The wide range in forecasts shows the vast amount of uncertainty within the market. As a result of these jitters, many investors have piled into global money market funds, which are now having their best four-week run since May 2020.
  • The winner of these three groups (optimist, pessimist, and the jitters) will depend on the scale of the downturn and the Fed’s response. If the recession is mild and the Fed moderates its policy, participants on the sidelines could miss out on a decent opportunity as many stocks have discounted the possibility of a recession.

 Bloc Battle: Rivalries are brewing between and within blocs as governments prepare for a less globalized world.

• The United States, European Union, and the United Kingdom plan to offer subsidies to support semiconductor production. The push to develop semiconductors locally is related to concerns that the bloc may be cut off from vital chips if China invades Taiwan. The increase in state investment should be a boon for chip developers looking to set up shop in the West. However, the cost of relocation and the increase in labor costs may lead to more expensive chips.
• Despite their coordination over semiconductors, there seems to be tensions brewing between the U.S. and EU over clean energy subsidies. European companies are being pressured to move operations to the U.S. to take advantage of the tax incentives granted in the Inflation Reduction Act. Although there seems to be reluctance among some members of the EU to take up similar initiatives, it does appear that the European Commission is preparing for a response. The EU is considering loosening stimulus rules to help facilitate more lending to member countries. The action could help support European firms but will likely face resistance from fiscally prudent countries.
• That said, the group maintained a united military and trade front in its stance against the China-Russia bloc. On Tuesday, Germany and the U.S. agreed to send tanks to help Ukraine fight the Russians. Dutch officials are traveling to Washington to discuss export controls on China after ASML (ASML, $681.53) urged lawmakers for “sensible” restrictions. Additionally, Politico reported that the EU is preparing to take on China in the Middle East and Africa by offering an alternative to the Belt and Road Initiative. Even with their differences, Brussels and Washington will likely have similar trade and foreign policies going forward. As a result, the two sides may be more prone to work out their issues.
  • On Wednesday, it was revealed that Washington could include European firms in the subsidies offered in the Inflation Reduction Act in exchange for access to the region’s critical minerals and raw materials. Earlier this month, the largest European deposit of rare earth elements was discovered in Sweden.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an apparent agreement between the U.S. and Germany that will unlock the transfer of advanced tanks to Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including some thoughts on how the Biden administration may be hoping to leverage its green energy subsidies from last year’s Inflation Reduction Act.

Russia-Ukraine War:  As we previewed in our Comment yesterday, the U.S. and Germany are set to announce a deal in which the U.S. would reverse its earlier position and donate about 30 of its best-in-class Abrams tanks to Ukraine, while Germany would send a smaller number of its own advanced Leopard 2 tanks and authorize other European countries to send many more.  To get the deal done, President Biden reportedly overruled Pentagon concerns that the Abrams would be too costly and difficult for the Ukrainians to use effectively.

• The Ukrainians reportedly hope to build an entirely new tank division around the donated Abrams and Leopards. Having those tanks would enhance Ukraine’s firepower and help it defend against a new Russian offensive expected in the coming months.
• The Abrams and Leopards could also help Ukraine recapture more territory from the Russians. However, they wouldn’t necessarily guarantee a Ukrainian victory in the war.

Russia-U.S. Arms Control:  The new Republican leaders of the House armed services, foreign affairs, and intelligence committees have requested that the Biden administration formally confirm whether Russia is complying with the New Start nuclear arms control treaty.  That treaty, which governs the number of strategic nuclear weapons Russia and the U.S. can have, is the only remaining arms-control treaty in force that traces its origins back to the Cold War period.

• The congressional concern was triggered by Russia’s decision last November to suspend New Start inspections and its subsequent refusal to participate in the consultations required under the treaty to support its implementation. President Putin’s veiled threats to use nuclear weapons in the war in Ukraine have also raised concerns about Russia’s intentions.
• If the administration determines that Russia has abrogated the treaty, and if no resolution is reached with Russia, it would free the U.S. to respond to the new geopolitical reality in which it will soon have to deter two major nuclear powers, both Russia and China, given that China is so rapidly building up its force of strategic nuclear weapons. The result could be a global arms race, consistent with our view that the world is embarking on a prolonged period of rising military spending.

United Kingdom:  Not only is the country continuing to deal with strikes across its transport and public sectors, but now workers at an Amazon (AMZN, $96.32) facility in Coventry said they will walk off the job in a dispute over pay.  Leaders of the Amazon union said they plan to widen the strike to other Amazon facilities as well.

Italy:  Gasoline station owners across the country are turning off their pumps for two days to protest government pressure on them to hold down prices following the expiration of a subsidy program at the end of last year.  When the subsidies ended, gas prices jumped, prompting the government to require stations to post average prices along with their own at the pumps.

• The pump owners’ strike may cause some disruption to the Italian economy and create political headaches for Prime Minister Meloni.
• On the other hand, some outside observers have praised her for the fiscal discipline she has shown with ending the subsidies after the retreat in energy prices late last year.

U.S.-EU Energy Policy:  Sen. Joe Manchin (D-WV) said he will introduce a bill requiring the Treasury Department to delay issuing its rules governing the $7,500 tax credit for purchasers of an electric vehicle under last year’s Inflation Reduction Act.  Separately, even as top EU leaders float the idea of establishing their own big subsidies to spur investment in European green energy, Dutch Prime Minister Rutte said he would oppose issuing new, common EU debt to fund the effort.  Financing limits could keep the EU subsidies too small to compete with the $369 billion or so of U.S. subsidies available under the law.

• Responding to European protests against the law’s requirement that eligible vehicles must get at least 40% of their value from countries that have a free-trade deal with the U.S., the Treasury Department tweaked its rules to make it easier for some foreign automakers to qualify for subsidies in December.
• Manchin is now arguing that the Treasury’s action undermines the aim of the law, which he said was squarely to promote domestic manufacturing and energy security. Manchin’s bill is currently given little likelihood of passage, but it does reflect how nationalist populism is strengthening in both major U.S. political parties.
• Nevertheless, a final interesting wrinkle is that Treasury Secretary Yellen has revealed that the administration may be planning to use the law’s subsidies as leverage to entice U.S. allies into limited free-trade agreements focused on critical technologies and minerals, such as semiconductors and lithium. U.S. Trade Representative Tai has also suggested that the U.S. wants the EU to adopt aggressive industrial policies to strengthen its economy and reduce its dependence on China.  It appears that the administration’s goal is to create a common, integrated industrial policy for key technologies and natural resources across the entire U.S.-led bloc.  The goal may be to keep the free trade and capital flows associated with the policy limited enough to avoid antagonizing the nationalist populists, but still sufficiently meaningful to strengthen the U.S.-led bloc for its geopolitical competition with China and its bloc.

U.S. Antitrust Regulation:  The Justice Department and eight states yesterday sued Google, a subsidiary of Alphabet (GOOG, $99.21), for abusing what they call monopoly power over the internet ad industry.  The suit alleges that Google’s behavior hurts web publishers and advertisers and seeks to force Google to unwind “uncompetitive” acquisitions such as its 2008 purchase of DoubleClick.  The lawsuit illustrates the Biden administration’s more aggressive antitrust enforcement and the increased regulatory risks faced by the technology sector.

U.S. Labor Market:  Walmart (WMT, $143.02) stated that it will hike its minimum wage to $14 per hour, from $12 per hour currently, beginning in February.  The company said that should boost its average hourly wage to about $17.50 from the current $17.00, helping it compete for workers with rivals that pay even more.  The move points to a continued tight labor market, despite some recent signs of cooling demand for workers.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with some positive economic news out of Europe where the January flash composite PMI unexpectedly swung above the level of 50, indicating a return to growth.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a report that Japan and the Netherlands will join in the U.S. clampdown on sending advanced semiconductor technology to China, and new indications of a broader softening in the U.S. labor market.

Eurozone:  S&P Global said its flash composite Purchasing Managers Index for the Eurozone rose to a seasonally adjusted 50.2, beating the expected reading of 49.8 and the final December reading of 49.3.  The index has now risen for three consecutive months after it reached its most recent low in October.

• As with most major PMIs, this one is designed so that readings over 50 signify expanding activity. At its current level, the figure suggests that the Eurozone economy is already expanding again despite the war in Ukraine, energy shortages, and sky-high inflation.
• In turn, that has bolstered recent hopes that the European economy may have dodged the recession that was widely expected just a few months ago.

Russia-Ukraine War:  As we flagged in our Comment yesterday, the Polish government has formally requested permission from Berlin to send its German-made Leopard 2 tanks to Ukraine.  The move raises the pressure on Germany to finally relent and give its required permission.  However, it’s too early to know if Chancellor Scholz will acquiesce, especially since the Russian government has now warned him that granting such permission would sour future German-Russian relations.

• As a reminder, Poland earlier this week vowed to send the tanks to help Ukraine even if Germany doesn’t approve. Once Poland sends its Leopards, it would probably clear the way for a range of other European countries to send their own Leopards to Ukraine.
• Scholz is concerned that if Ukraine ends up with a nearly entirely German-made tank force, his country will look like the major power backing Ukraine. He and some other officials in Germany are wary about drawing Russia’s ire because of Germany’s past economic links to Russia and Germany’s lack of any nuclear deterrence to defend itself.
  • That’s why Scholz has said that Germany wouldn’t allow shipping the Leopards to Ukraine unless other countries send their advanced tanks, especially the U.S. Abrams tank.
  • However, the turbine-powered Abrams may not be appropriate for the Ukrainians, given the long time needed to train on it, its immense fuel usage, and its need for extensive maintenance capabilities.
• Having dozens of Leopards would enhance Ukraine’s firepower and help it defend against a new Russian offensive expected in the coming months. The Leopards could also help Ukraine recapture more territory from the Russians.  However, they wouldn’t necessarily guarantee a Ukrainian victory in the war.

NATO Expansion:  In a new setback for Sweden and Finland as they work to join NATO, a far-right politician burned a copy of the Quran and denounced Muslims outside the Turkish Embassy in Stockholm over the weekend.  The incident prompted Turkish President Erdoğan to again threaten to veto the Swedish and Finnish applications to join the military alliance.  There is some speculation that Erdoğan is simply playing the strong nationalist card ahead of Turkey’s May elections.  Even if that’s true, however, it would suggest Sweden and Finland can’t move forward in their applications to join NATO for at least several more months.

France:  In its new six-year defense plan, the French government plans to spend some €400 billion (approximately $433.4 billion) to transform its military into a more responsive force that can quickly respond to contingencies around the globe, particularly around French territories in the Indo-Pacific region.

• The spending would represent a 35% increase over the previous six-year plan. The new spending will include a new aircraft carrier, big new investments in drones and undersea warfare equipment, and a massive increase in France’s intelligence and surveillance capabilities.
• The spending increase is consistent with our view that threats from revisionist, authoritarian powers like China and Russia have touched off what will likely be a multi-year boom in global defense spending, much of which will benefit U.S. defense firms.

Brazil:  President Lula da Silva has replaced the country’s top army commander, Gen. Julio Cesar de Arruda, because of what Defense Minister Mucio called a “fracturing of trust” after the riots at Brazil’s capital on January 8 which aimed to prevent Lula from taking power despite his win in the October elections.  Since those riots, Lula has accused many officials in the Brazilian military and security forces of conspiring to let the violence proceed unimpeded.

Japan:  Yesterday, the Bank of Japan held its first bond auction under an expanded bank lending program designed to ease pressure on its yield-curve control policy.  The successful auction and the broader program are expected to boost bank liquidity and improve the demand for Japanese government bonds, helping keep 10-Year JGB yields at the BOJ ceiling of 0.50%.  However, it is not yet certain how long the BOJ will be able to maintain its yield-curve control in the future.

United States-Japan-Netherlands-China:  The Japanese and Dutch governments are reportedly ready to join the U.S. in imposing stringent new restrictions on sending advanced semiconductor technologies to China.  The Japanese and Dutch restrictions could be announced by the end of January.

• The U.S. restrictions, announced last October, aim to suppress China’s ability to develop advanced weapons that could threaten the U.S. and its allies.
  • The rules essentially cut China off from acquiring advanced semiconductors, semiconductor manufacturing equipment, semiconductor manufacturing components and other inputs, and even semiconductor support services that are based on U.S. technology.
  • The pending Japanese and Dutch restrictions appear to be focused more narrowly on exports of advanced semiconductor manufacturing equipment and inputs.
• In any case, having the U.S., Japan, and the Netherlands all restricting advanced semiconductor technology will likely knee-cap China’s effort to build its own advanced computer chip capabilities and impede its development of some military technologies.
  • As the world continues to fracture into at least a U.S.-led geopolitical bloc and a rival China-led bloc, it’s important to remember that there will still probably be a lot of trade and travel between the two camps.
  • However, the competing governments will likely be quite aggressive in limiting the transfer of critical, high-value goods and technologies, as we’ve already seen over the last few years. Importantly, that will likely crimp China’s technological development going forward.

U.S. Labor Market:  On top of the layoffs in the information technology and real estate industries that we’ve been flagging, new reports today hint that labor demand may be starting to wane more broadly.  First, industrial conglomerate 3M (MMM, $122.62) said that it is cutting some 2,500 manufacturing positions globally due to a softening in demand for its products that took hold late last year.  Separately, economists have begun to note a consistent fall in temporary employment over the same period.  Falling temp jobs often signal a broader decline in the labor market.

U.S. Energy Industry:  After years of paltry investment in new oil and gas drilling, offshore drilling in the Gulf of Mexico and elsewhere around the world is quietly growing again.  According to data provider Westwood Global Energy Group, about 90% of the 600 leasable offshore drilling rigs available worldwide were working or under contract to do so in December, versus just 63% five years ago.  The increase in drilling suggests today’s high energy prices and growing energy demand have begun to produce a supply response, despite the prior hurdles like investor demand for capital discipline and social and regulatory preferences for green energy.

U.S. Cryptocurrency Industry:  New reporting indicates that tougher scrutiny by the Securities and Exchange Commission has hindered a number of cryptocurrency companies from going public over the last year.  As we had warned would happen, the regulatory crackdown appears to stem from the wave of bankruptcies and financial problems in the industry.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with multiple reports out of Asia.  Even though China is largely shut down this week because of the Lunar New Year holiday, several news items today reflect how its growing military strength and aggressiveness are having an impact on other countries in the region.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including growing signs that the U.S. labor market is softening as the economy heads into a likely recession.

China:  Although news flow from China will be limited this week because of the Lunar New Year holiday, we are seeing reports that the massive new wave of COVID-19 infections sweeping across the country is now slamming rural areas.  The infections have reportedly peaked in China’s major cities, but the rural healthcare system is now under extreme strain.

Japan:  The country’s parliament, the National Diet, opens its 150^th regular session today, with contentious debate expected over increased defense spending, policies aimed at children, and extending the life of nuclear reactors.  Especially heated will be Prime Minister Kishida’s call for increased taxes to pay for a massive hike in defense spending, which has split his party and thrown his leadership into question.

Australia:  Last week, the Australian government announced that it will replace its European-made Taipan military helicopters, a decade earlier than planned, with U.S.-made Black Hawk choppers from Lockheed Martin (LMT, $443.28).  The 40 Taipans, made by EU aerospace champ Airbus (EADSY, $32.29), have had quality and maintenance issues for years.

• The decision to replace them with Black Hawks illustrates how the developing boom in global defense budgets is likely to disproportionately benefit U.S. defense firms, given their technological leadership, proven quality, and production capacity availability.
• For those reasons, we continue to overweight U.S. defense firms in our updated asset allocations strategies this quarter.

New Zealand:  The ruling Labor Party has named Chris Hipkins, the former education minister, as the country’s new prime minister after Jacinda Ardern announced her resignation from the position last week.

• So far, Hipkins has not outlined a detailed policy program, but he has indicated that the cabinet reshuffle announced earlier by Ardern would go forward, which includes keeping Finance Minister Grant Robertson in his role.
• That would indicate that there will be policy stability and continuity in New Zealand in the near term, which investors will appreciate. However, the Labor Party is still polling poorly and is at risk of losing power in the October elections.

Sri Lanka:  Yesterday, the government said it had received assurances from Chinese officials on the board of the International Monetary Fund that they would approve the country’s proposed debt restructuring, meaning China has fallen in line with previous assurances from India and Japan.  If approved by the IMF board, the restructuring would unlock some $2.9 billion in loans from the institution to help Sri Lanka through its current debt crisis, which includes a default on its debt last May.

United Kingdom:  The Bank of England today said 16 top life insurers passed a recent stress test examining how they would manage with mass credit downgrades and greater client longevity.  However, the institution warned that the insurers may be overly optimistic about their ability to sell down assets in a financial crisis, especially as other financial companies may be trying to sell assets at the same time.

Russia-Ukraine:  Russian forces are reportedly making new progress in pushing the Ukrainians back from the front lines in the southern part of the country, especially in the region around Zaporizhzhia.  The new push suggests that President Putin’s autumn mobilization of hundreds of thousands of fresh conscripts may be helping renew Russian combat power.  On a related note, the Ukrainian government said that it will mobilize fresh reservists to give its front-line fighters a rest.

• Separately, after seeing his political star rise to the point where he could openly disparage the Ministry of Defense and, by implication, Putin himself, financier Yevgeny Prigozhin has reportedly begun to lose influence in the Kremlin because of his Wagner Group mercenaries’ failure to capture the eastern Ukrainian city of Bakhmut. Making matters worse, Prigozhin’s ally General Sergey Surovikin was unable to turn his strategy of bombarding Ukraine’s civilian infrastructure into tangible military gains and last week was demoted to deputy commander of the war.
  • Prigozhin’s waning star could remove a political threat to Putin and ensure that he will retain power at least in the near term.
  • That could reinvigorate Putin’s effort to rebuild and strengthen Russia’s conventional military forces over time.
• In terms of Western support for Ukraine, German Foreign Minister Baerbock signaled yesterday that Berlin “would not stand in the way” if Poland wanted to transfer its German-made Leopard tanks to Ukraine. To test whether Chancellor Scholz has really acquiesced in the idea, Poland said it will formally request German approval for the transfer, as required by its purchase contract for the heavy tanks.  If Germany approves, it could unlock additional Leopard transfers from countries such as Finland, Sweden, Denmark, and Portugal.

Brazil-Argentina:  At a summit this week, the leaders of Brazil and Argentina plan to approve the launching of preparations for a new common currency designed to facilitate trade between the two countries and reduce their dependence on the U.S. dollar.  The “sur” would take many years to develop, and it would initially be used in conjunction with the current Brazilian real and Argentine peso.  Only then could it replace the real and the peso and potentially be adopted by other regional countries.

• Nevertheless, despite the uncertain and long-term nature of the project, the initiative shows how some countries, especially those with deep economic or political ties to China, are looking for ways to reduce their exposure to the greenback.
• As a reminder, our analysis indicates that both Brazil and Argentina will belong to the evolving “Leaning-China” geopolitical bloc, based largely on their exports to China. If China eventually succeeds in developing a digital, commodity-backed form of its yuan to serve as the reserve currency for its geopolitical bloc, as we think it could, the sur could be a secondary reserve currency for that bloc or even be subsumed into the Chinese reserve currency.

U.S.-China Military Competition:  In a webinar with the Council on Foreign Relations last week, U.S. Air Force Secretary Frank Kendall said that he has shifted his service’s focus heavily toward defending against China simply because China in recent years has shifted its focus toward defeating the U.S.  As examples, Kendall cited how the Chinese military has shrunk its army to free up resources for its air force and navy.  He also cited China’s decision to make its Strategic Rocket Forces a separate service, which has a focus on developing long-range precision missiles that could attack U.S. military bases and aircraft carriers in the Asia Pacific region.

• On a more positive note, Kendall also noted that the new Chinese military is still unproven and may not perform that well in real-world operations. He also noted that the U.S. has developed a number of secret capabilities for which the Chinese probably haven’t prepared.
• All the same, Kendall’s discussion suggests that China is preparing to challenge the U.S. in the Asia Pacific region much more aggressively than most Americans probably realize. It’s encouraging that the various U.S. services are responding comprehensively, but Kendall’s statements underline how the risk of conflict with China is rising.

U.S. Executive Branch:  Following reports that White House Chief of Staff Ron Klain will resign, President Biden is expected to name his former pandemic advisor, Jeff Zients, to the position.  Respected more for his organizational skill than his political instincts, Zients also served as former President Obama’s director of the National Economic Council and as supervisor of an operation to fix bugs on the government’s health insurance website.  He has also twice served as acting director of the Office of Management and Budget.

U.S. Labor Market: Spotify (SPOT, $97.91) said today that it will lay off 6% of its global workforce, becoming the latest information technology company to retrench after over-expanding during the halcyon days of the COVID-19 pandemic.

• Recent layoffs have been concentrated in the technology, real estate, and financial services industries, but there is growing evidence that the layoffs are creating a broader softening in labor demand.
• For example, recent data shows that in December, about 826,000 unemployed workers in the U.S. had been out of a job for about three and a half to six months, up from 526,000 in April 2022.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion about how investors’ expectations of the Fed’s rate hikes are impacted by a possible recession. Next, we give our thoughts about U.S. foreign and domestic policy. Finally, we review the latest developments from China.

Economy in Focus: Fresh data on Wednesday dented hopes of a soft landing, much to the chagrin of markets.

• A tightening labor market and a slowdown in residential construction have added to concerns that the market has not fully bottomed. The number of first-time claims for unemployment insurance fell unexpectedly to a four-month low in the week ending January 14. The sharp decline in benefits suggests that the Fed’s attempts to cool the labor market by raising rates have not been effective. Meanwhile, building permits rose at a slower pace than housing starts for the second consecutive month in December, signifying a possible decline in future U.S. economic activity.

• The market responded negatively to these reports as investors weighed the possibility that the Fed could raise interest rates while the U.S. heads into a recession. The S&P 500 and the Dow Jones both fell 0.8% on Thursday. Meanwhile, the two- and 10-year Treasury yields remained below the fed funds rate, indicating that the market anticipates that the central bank may be looking to cut rates soon. Although the latest Atlanta GDPNow forecast shows that GDP expanded at an annualized rate of 3.5% in Q4 of 2022, last month’s data suggests that the economy quickly ran out of steam toward the end of the year.
• Despite tough talks by officials, investors do not believe that the Fed will be able to push rates above 5% this year. On Thursday, Fed Governor Lael Brainard and Boston Fed President Susan Collins joined the chorus of policymakers warning markets that the Federal Reserve will continue to hike rates to combat inflation. However, investors are skeptical as to whether these officials will hold true to their word. Futures and options flow activities suggest that traders believe the Fed will be done with its hiking cycle after its March meetings. This optimism may partially explain why equity futures are slightly up this morning. If the Fed shocks markets by raising rates during a recession, U.S. equities will be negatively impacted.

Looking For a Fight? While lawmakers in Congress are debating whether to raise the debt ceiling, Washington is trying to rally its allies to take on Russia and China.

• The U.S. Treasury was forced to take extraordinary measures to prevent the government from breaching its debt limit. The stalemate in Congress over whether to increase the government borrowing cap threatens to push the country into default which could have disastrous consequences on the U.S. financial system. Although Senate Majority Leader Mitch McConnell offered assurances that the debt ceiling would be raised, there does not seem to be a path toward agreement anytime soon between the two sides. Republicans are pushing for spending cuts, while Democrats want to raise the ceiling without any strings attached. If history serves as a guide, talks will likely go down to the wire as the two groups hold out for leverage.
• On the foreign policy front, the U.S. and Germany are in a dispute over delivering military vehicles to Ukraine. The Germans do not want to send any of their own tanks unless the U.S. sends theirs first. The row over who should send tanks exemplifies Germany’s reluctance to help Ukraine in its war efforts and threatens to undermine Western unity. As we have mentioned in previous reports, the war in Ukraine could cause fractures within the European Union and the North Atlantic Treaty Organization (NATO). Although the issue does not pose short-term risks to financial markets, the situation may accelerate efforts to deglobalize.
• Additionally, the U.S. and its allies are working together to hinder China’s ability to develop advanced military technology. Washington would like to hobble its Indo-Pacific rival by restricting access to semiconductors used for weaponry. Major chip-producing countries Japan and the Netherlands are expected to agree to limit the sales of their technology to China by the end of the month. Beijing views semiconductors as crucial to its endeavor to surpass the U.S. economically and militarily. However, previous investment schemes have not yielded satisfactory results. As a result, there is growing speculation that China may seek to invade Taiwan in order to have access to the nation’s chips.
  • Because of this, U.K. Prime Minister Rishi Sunak would like his country to develop its own chip industry so that it is not dependent on Taiwan for semiconductors.

Energy Rises: As China’s COVID wave approaches its peak, there are growing concerns that the return of Chinese demand may lift inflation overseas.

• The Chinese economy may be poised to come roaring back as COVID cases begin to ease. Vice Premier Sun Chunlan says infections have fallen to a “relatively low level.” The announcement indicates that the Chinese government is prepared to further reduce restrictions to help provide a boost to the economy. As the country prepares to celebrate the Lunar New Year, Chinese travelers are expected to receive extra scrutiny in other countries. As a result, tourists may stay home during the holiday which should be supportive of domestic spending.
• China’s reopening is already having an impact on commodity prices. The price for materials such as copper and aluminum have surged 12% and 11%, respectively, to begin the year. Meanwhile, crude oil demand is expected to jump to an all-time high by the second half of the year. The pick-up in commodity prices is related to concerns that the end of COVID restrictions will make it easier for manufacturers to ramp up production and encourage spending from consumers.
• The potential rise in commodity prices will complicate efforts by central banks to combat rising inflation. Energy prices represent a heavy component within consumer price indexes. Thus, a sharp increase in prices could cause a major setback in the central banks’ abilities to contain rising inflation. The inflationary threat posed by China’s reopening may explain why policymakers have been reluctant to end policy tightening. That said, China’s reopening does have some winners. The rise in commodity prices should boost the stock markets of export-producing countries such as Brazil and Canada.

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