by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning on the Feast of St. Nicholas!  It’s actually a rather quiet morning after yesterday’s risk-off day.  U.S. equity futures have been vacillating this morning, mostly trading inverse the dollar.  Gold is higher this morning, but oil is trading lower.  Equities have been taking on a tone of bad news is good news.  Yesterday’s ISM services index, coming in well above the expansion line of 50, raised fears that monetary policy won’t be as easy as hoped.  We note that the WSJ’s latest “Fed whisperer,” Nick Timiraos, published an article yesterday reiterating Chair Powell’s recent comments about moving to slower rate hikes but also signaling that tightening was far from over.  Last week, when that speech occurred, the financial markets viewed the talk as dovish.  The Timiraos article suggests that isn’t the narrative that the FOMC preferred.

In today’s Comment, our coverage begins with China news.  Economics and policy are up next, and an update on the North Carolina substation attack follows.  Our war in Ukraine briefing comes next, and we close with the international roundup.

China News:  The state funeral for Jiang Zemin has begun, as the CPC does its best to project unity.  We also update the COVID situation.

• It is becoming clear that China’s Zero-COVID policy is evolving, but we hesitate to call it a full reopening. Instead, policymakers seem to be moving along three tracks.
  • There appears to be a concerted effort to change the narrative on the disease from something to be feared into more of an inconvenience. COVID has exhibited a wide array of effects with most people seeming to survive it just fine, but it is clearly a risk to the elderly and to those with several preexisting conditions.  Also, the mystery of “long COVID” remains an issue.  Most nations have generally developed a strategy of trying to open as much as possible while simultaneously protecting the most vulnerable.  Finding that balance can be tricky.
  • As part of this narrative change, public health authorities are said to be close to announcing less strict quarantine and testing measures.
  • Expanding immunizations is also being promoted. Unfortunately, Beijing doesn’t want to accept Western vaccines, which have proven to be more effective.  Thus, immunizations may have only a limited effect on reducing risk.
  • Opening is risky, and the use of substandard vaccines coupled with a population that hasn’t had much exposure to the virus further raises the risk that a bout of infection could strain the medical system. However, it has become clear, for economic and social reasons, that the Zero-COVID policy can’t be maintained.  Beijing is adjusting, but it isn’t completely certain how well this will work out.
• The fiscal response by the U.S. to COVID was extraordinary, and the speed that policy stimulus was deployed opened the potential for abuse. Reports of identity theft when applying for unemployment insurance and the abuses of PPP payments were widespread.  Turns out the abuses were also international in nature—the Secret Service reports that Chinese hackers clipped at least $20 million of COVID relief payments.
• As General Secretary Xi starts his third term among expectations of market-unfriendly policies expanding, we are beginning to see reports of capital flight as wealthy Chinese citizens begin moving funds offshore. Singapore appears to be the most prominent beneficiary.  The city-state has a large ex-pat population and is a natural destination for such funds.
• Canada is joining other G-7 nations in conducting freedom of navigation operations in the Taiwan Strait.

Markets, Economics and Policy:  The economic picture is mixed.  Business leaders are worried but still see a soft landing.  Supply chains are improving, but layoffs are rising.

• Recent CEO surveys suggest that business leaders are becoming more concerned about the economy, but still expect a soft landing. It’s not obvious if these leaders have a great track record on forecasting the economy (to be fair, no one else is all that good either) but their attitudes likely reflect present business activity.  Thus, we see it as confirmation that we are not currently in a recession.
• At long last, supply chains appear to be improving. Freight rates have been easing, and we note that in the recent ISM data, there is growing evidence of improvement.

• The number of purchasing managers reporting faster deliveries is rising rapidly, although history would suggest some of this improvement is likely coming from slower economic activity.
• Taiwan Semiconductor (TMSC, $81.62) announced it is increasing its investment in its Arizona facility.
• Pepsico (PEP, $183.12) announced layoffs from its corporate headquarters.
• For years, tech firms have been news aggregators as they give users the ability to find articles and, for a long time, avoid paying subscriptions. Clearly, this content model can’t work indefinitely.  If the content providers can’t get paid, they will eventually stop providing the content.  Congress is apparently working on legislation that would facilitate the providers’ abilities to negotiate fees from the tech firms.  Facebook (META, $122.43) announced it may stop providing news feeds on its platform if the legislation passes.
• Commercial property private REITs are seeing redemption notices.
• Influenza hospitalizations are rising rapidly. The spike in infections may be a hangover from the COVID restrictions, which also reduced flu infections but have lowered resistance.
• The head of the PBOC is making the argument that the dollar has peaked. Although we are not sure that we won’t see one more recovery in the greenback, (especially if Nick Timiraos is right) we do think that we are in the very late innings of this dollar bull market.

North Carolina:  Although authorities are not calling the weekend attack on substations in North Carolina domestic terrorism, the actions were clearly targeted, suggesting that it wasn’t just a random attack.  Utilities are steadily bringing power back online, but it probably won’t be until Thursday before power is fully restored.  Our worry is that if similar attacks become common, not only will it cause disruptions, but mitigation efforts (backup generators, diesel stocks, extra food, etc.) will tend to be costly and could boost inflation.

War in Ukraine:  Ukraine strikes inside Russia which could expose divergences in goals among allies.

• Although Kyiv hasn’t fully accepted responsibility, it appears that Ukrainian drones attacked three Russian airfields inside of Russia proper, including one that houses some of Russia’s strategic air assets[1]. A drone also hit a Russian oil depot.  Ukraine’s ability to strike inside Russia is a new development, and one that the U.S probably isn’t pleased about.  We note that the U.S. “modified” its HIMARS systems given to Ukraine to reduce its range and lessen the likelihood that Ukraine could strike within Russia.
  • This development could mark a serious escalation of the war. First, if Ukraine now has the ability to strike targets deep inside Russia, then Putin’s conduct of the war will come under further scrutiny.  Second, Ukraine’s Western allies are mostly willing to support this war as long as it stays contained, since the West has no interest in seeing this conflict expand.  Attacking Russia proper changes the nature of the war and could prompt Russia to take more aggressive steps, such as engaging tactical nuclear weapons.
  • We will wait to see the U.S./allied response. Since the drones appear to be of Ukrainian origin, the U.S. and its allies can argue that it wasn’t Western arms that attacked Russia.  We doubt the Kremlin will accept this argument.  We look for the West to restrict weapons sales further to discourage this development.
• Meanwhile, polls show some reduction in support among Americans for “indefinite” aid to Ukraine. And Germany is balking on sending the arms it promised earlier.
• As the war continues, the Kremlin is increasing its commandeering of private companies to support the war effort. This action will tend to reduce available supply; if money supply isn’t restricted, then inflation will worsen.

International News:  The EU awakens to the change in U.S. policy.

• The Inflation Reduction Act, in IOHO, is the opening salvo in U.S. industrial policy designed to kick start the reindustrialization of America, but at the expense of our trading partners, mostly Europe. For the Europeans, who have maintained export promotion far beyond just the recovery from WWII, this is a massive threat.  When French President Macron was in Washington recently, he warned that the new law could “fragment the West.”  Perhaps, but given that Europe can’t defend itself, it probably is better described as the U.S. subjugating Europe.  The EU is expected to react, and there is talk of it creating its own energy subsidies and maybe giving up on free trade as a policy[2].  However, we don’t expect the U.S. to change its policies all that much, and if anything, we expect more of the same.
• Although Turkey has thrust itself into global geopolitics in a robust fashion, and is getting some economic benefits, it still faces an ugly inflation problem.
• South Africa’s President Ramaphosa is facing a corruption scandal, but it appears he will escape impeachment.
• Not so for Peru’s President Castillo, who is facing a third attempt to remove him from office.
• Mount Semeru has erupted in Indonesia. The volcano is situated on Java, where, at the other end of the island, sits the city of Jakarta.  Major volcanic eruptions can cool the earth for a time, as volcanic ash spews into the upper atmosphere.
• Papua New Guinea may have underestimated its population by half.

---

[1] In other words, it houses an element of its nuclear weapons delivery.

[2] Which is a bit rich, given that numerous policies, such as regulations on food, are clearly protectionist.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a long discussion of several key developments today in the global energy markets, including the implementation of several sanctions against Russia’s oil and natural gas due to its 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.

Global Energy Market:  This week could be momentous for global energy markets, with the European Union and U.K. set to implement a ban on Russian oil imports, the broader group of industrialized countries set to impose a price cap on Russian oil exports, and Chinese President Xi set to visit Saudi Arabia.  These developments illustrate how the increased friction between the evolving U.S. and China-led geopolitical blocs has sparked a new era of intense economic warfare around the world, creating both headwinds and opportunities for investors.

• As previewed in our Comment on Friday, the Group of Seven (G7) countries and their allies, representing much of the world’s richest and most advanced democracies, approved a plan to cap the price of Russian oil exports beginning today. To cut the revenues available to Russia for its war against Ukraine, the cap will ban Western companies from insuring, financing, or shipping Russian oil unless it is sold for less than $60 per barrel.
  • Russian officials have said they will not send any oil to countries that implement the price cap.
  • There are differences of opinion regarding the impact of the price cap on global oil prices. Oil prices are up so far this morning, but that could primarily be because of looser COVID-19 restrictions in China (see below).
• Separately, today the EU and the U.K. will implement its ban on importing Russian oil, which was approved earlier this year. They will also implement a ban on Russian refined products beginning in early February.
• Yesterday, the Organization of the Petroleum Exporting Countries and its Russia-led partners said that they will stand by their October decision to cut oil production by two million barrels per day, rather than the proposals last month ranging from an output cut to an output increase. The decision will give the OPEC+ group more time to assess the impact of the EU ban on Russian imports and the broader price cap on Russian oil exports.
• Of course, oil isn’t the only front in the energy war. Data from commodity analytics firm ICIS shows that the EU’s demand for natural gas in October and November was 24% lower than its five-year average.  The figures suggest that the EU has made significant progress in finding energy efficiencies and implementing conservation measures, although they were also helped by the relatively warm weather in early autumn.
• Spooked by the energy supply disruptions from the war in Ukraine, the Japanese government has launched a plan to develop a strategic reserve of liquified natural gas. The program would require importing an additional 840,000 tons of LNG per year, consistent with our view that the geopolitical fracturing of the world will not only threaten energy supplies, but will also encourage hoarding behavior, all of which will tend to buoy commodity prices.

Russia-Ukraine War:  As heavy fighting continues primarily in the Donbas region of northeastern Ukraine, and Russian forces continue to launch air, missile, and kamikaze drone attacks against Ukrainian infrastructure, explosions were reported at two air bases deep inside Russia.  The explosions reportedly damaged or destroyed several Russian military aircraft.  They are also consistent with a number of other explosions in Russian territory throughout the war that were likely carried out by Ukraine, although the Ukrainian authorities have not formally acknowledged any role in the attacks.

China:  Following the previous week’s big protests against the government’s Zero-COVID policies and repressions of freedom, we are seeing increasing reports that local government officials are gradually ratcheting back some pandemic restrictions.  The rollbacks include lifting some curbs on residents’ movements, such as by ending mandatory COVID testing for people who want to use public transport, enter parks, or visit other public spaces.  The authorities are also stepping up their efforts to vaccinate vulnerable citizens, especially the elderly, probably in an attempt to shield the population and healthcare system in case looser pandemic rules lead to higher infection rates.

• The modest loosening of COVID restrictions may have helped eliminate the recent protests, but a heavy police presence and surveillance around potential protest sites probably played the bigger role.
• The apparent easing in COVID rules have given a big boost to Chinese stocks and the CNY so far this morning. However, we continue to think the government’s COVID policies will weigh on the economy.  Much of China’s economy is still on lockdown, and even if the pandemic rules are loosened, the lack of herd immunity and weaknesses in the healthcare system mean big new outbreaks of infection will likely hold back activity.  That will also continue to create headwinds for the broader global economy and financial markets.

Iran:  After weeks of anti-government protests touched off by anger at the country’s Islamic “morality police,” the Iranian government said it is dismantling the organization and may roll back some rules such as the requirement that women wear the hijab in public.  However, protests continued over the weekend, signaling that the small grant of freedom may not be enough to relieve the political pressure on the government.  Instability in Iran, a major oil producer, may therefore continue in the near term.

Eurozone:  October retail sales fell by a seasonally adjusted 1.8%, even worse than expected and the biggest drop since last December.  Sales in October were also down 2.7% from the same month one year earlier.  The data supports the view that the Eurozone economy is now falling into recession.

United States-European Union:  In the latest sign that new U.S. subsidies and “buy-American” rules will prompt Europe to respond in kind, European Commission President von der Leyen said that the EU must “simplify and adapt” its rules on state aid to allow similar protectionist policies.  U.S. and EU officials are due to meet today to discuss the issue.

• The Biden administration has not strongly pushed back against insinuations that the EU could respond with its own protectionist policies. Indeed, U.S. Trade Representative Tai recently proposed that the EU adopt similar policies, probably aimed at a reduction in EU trade with China.
• In his meeting with French President Macron last week, Biden also suggested that the U.S. could adjust its rules to address European concerns.
• The Europeans remain quite irritated and concerned about the new U.S. industrial support, which is focused largely on green technology, but President Biden’s conciliatory stance suggests that a trade war is not necessarily set in stone.

United States:  Two electrical substations in rural North Carolina were attacked by gunfire on Saturday evening, leading to power outages that could last for days for over 33,000 customers.  Although the outage is relatively small, the apparently deliberate attack has raised concern about follow-on attacks and the overall vulnerability of the nation’s electrical supply.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Howdy! Equities are down this morning after the jobs report soundly beat expectations, Today’s Comment begins with an overview of the recent sell-off in the U.S. dollar and what it means for financial markets. Next, we discuss the U.S. government’s efforts to resolve tensions with unions and the EU. Lastly, we explain the risk the war in Ukraine poses to equities abroad.

Dollar Peaking? The recent retreat in the greenback is significant, but it isn’t clear if it will last, as evidenced by its recovery today in the wake of the payroll data.

• Although the U.S. dollar is one of the best-performing assets in 2022, it has begun to turn. The greenback has dropped more than 7% from its September peak. Its descent was driven by a combination of speculation that the Fed is almost done hiking and greater positivity about the global economy heading into 2023. The CPI and PCE inflation reports both came in below expectations. Meanwhile, GDP data from Germany and optimism of China’s reopening have made a global recession next year less likely. Additionally, signs that global inflation is approaching its peak have made foreign currencies more attractive.

• The weakness in the dollar will likely make it easier for other central banks to relax monetary tightening. Due to their reliance on imports of dollar-priced commodities such as oil, central banks such as the Bank of Japan and the European Central Bank were pressured to take aggressive monetary action to contain inflation. However, their lack of aggressive action had led to dollar appreciation. As a result, the recent dollar weakness (we note that the dollar is stronger today off the payroll wage data) against peer currencies will likely mean that these banks can take less aggressive policy action to tackle price pressures. In short, a weaker dollar is a positive for international equities. For example, the recent rally in emerging market equities and bonds shows that investors are positioned to take advantage of a depreciating U.S. currency.
• Next year’s FOMC will have more hawks than in 2022. Kansas City Fed’s Esther George and Boston Fed’s Susan Collins will be replaced by hawks Fed President Neel Kashkari and Dallas Fed’s Lorie Logan. Meanwhile, Chicago Fed picked notable dove Austan Goolsbee as the next bank president. He will be a voting member and will offset the loss of St. Louis Fed President James Bullard, a bona fide hawk. Additionally, persistently high employment payroll data like the one released today also supports further tightening in the future and pushes up the dollar’s value. In short, the hawkish tilt of the committee suggests that the dollar could rebound in 2023.
  • Austan Goolsbee was the economic advisor of former President Barack Obama. In an interview with NPR, he called into question the ability of hikes alone to rein in inflation and is likely to be sensitive to economic changes.

U.S. Firefighting: The president and Congress are moving to contain flames both domestically and abroad.

• The Senate passed legislation that would prevent rail workers from going on strike. The bill is expected to be sent to President Biden’s desk to be signed into law. The passage of the bill has prevented a strike from disrupting the U.S. economy but could have political costs for Democrats in upcoming elections. Rail workers were pushing for seven days of paid sick leave, a tenet that should have left-wing support on paper. The Democrats’ decision not to support labor is an example of how the party is becoming more pro-business establishment and less union-friendly. A stricter line by government officials could ease inflation and may be preferable to equities.
  • Government and unions can have a hot and cold relationship depending on the economic environment. In an inflationary period, politicians have been known to turn on labor.
• President Biden is open to negotiating with Russian President Vladimir Putin over the war in Ukraine. This stance is in contrast with the U.S. president’s previous statement that peace talks must include Ukraine. Although there is some sign that Putin may accept the invitation, the change in Biden’s tone suggests that the West wants the war to end. Biden’s offer came after meeting with French Emmanuel Macron. In the past, Macron has criticized the U.S. for profiting from the conflict at Europe’s expense. Thus, there is a possibility that Western support for Ukraine could be fading, which should be favorable to financial markets.
• Although demand remains an important driver of inflation, there are still many supply-side factors that can support higher prices. The growing power of labor unions has given unions more leverage to negotiate higher wages and benefits from firms. Meanwhile, the uncertainty in Ukraine suggests that commodity prices will continue to fluctuate. The Fed will consider these factors when determining whether it should lower rates. That said, U.S. central bank officials have shown no intention of distinguishing demand and supply pressures when deciding policy. Thus, supply-side shocks could lead the Fed to raise rates higher and for longer than the market currently expects.

Russia Risk Rising: A string of suspicious packages sent across Europe raises new questions about the war; meanwhile, the EU continues to bicker over price caps.

• Threatening packages were sent to Ukrainian embassies in Hungary, the Netherlands, Poland, Croatia, Italy, and Austria. Packages contained varying materials, from explosives to animal parts. Although no one was harmed, Western governments believe that the boxes are a form of terrorism and intimidation. The delivery of these threatening items could be a warning that there are factions, within Russia or sympathetic to, who are willing to escalate the war outside of the Ukrainian borders. At this time, the packages do not provide present a risk but could be a warning of something worse to come.
• Meanwhile, EU members still need to settle on a price cap for Russian oil. Although the recent proposal shows a price cap of $60, some countries within the bloc would like the lid to be lower, and others prefer to do away with the price cap entirely. Countries most in danger of being invaded are pushing for a lower limit as it would deprive Moscow of needed revenues to expand its war aims. However, EU members most adversely impacted by the price limit have warned that a low cap could make it harder for countries to receive energy supplies.
  • The EU has until Monday to come to a resolution before the agreed-upon embargo is set to take effect. Failure to do so could lead to disruptions within energy markets.
• Uncertainty in Ukraine represents a prevalent risk for European equities. Despite efforts from the West to curtail Russian oil production, it has still been able to increase its shipments worldwide. OPEC’s willingness to work with Moscow to minimize the impact of Western restrictions makes the problem worse. Meanwhile, the threat of a broader conflict could escalate tensions between the West and Russia. In short, investors should be mindful that any de-escalation of the war effort will likely be taken positively by the markets, especially in Europe. In the meantime, the U.S. remains safe, a place to hide and wait.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with our thoughts about Wednesday’s speech by Fed Chair Powell. Next, we give an overview of China’s move away from its Zero-COVID policy. We end with international news focusing on the growing fractures within the Western alliance.

Fed Talks: Fed Chair Jerome Powell signaled that the central bank is not prepared to lower rates; however, the market is not convinced.

• The market rejoiced following suggestions that the Federal Reserve would scale back the size of rate increases. On Wednesday, Powell hinted that the central bank may moderate the pace of hikes at its December meeting but also that the Fed was not done raising rates. The S&P 500 soared over 3%, there was a bullish steepening in the yield curve, and the U.S. dollar index dropped. This market reaction indicates that investors are confident that the Fed is nearly finished with its tightening cycle. The latest Fed Watch Tools show that the market has priced in a nearly 80% chance that the Fed will raise its policy rate by 50 bps at its meeting later this month. Meanwhile, market bets predict that the Fed will begin cutting rates in the latter half of 2023.

• This bullish reaction from investors was likely not the response Powell expected when he made his comments. Fed officials have insisted that they will not stop tightening until inflation makes sufficient gains toward its 2% target. Thus, we suspect Fed Governors Michelle Bowman and Michael Barr will attempt to rein in expectations when they speak on Thursday. Additionally, stronger-than-expected employment data to be released on Friday might also reduce sentiment that the Fed is close to ending its tightening cycle. Therefore, Wednesday’s gain could be short-lived.
• Although inflation remains stubbornly high, there are signs that price pressures are starting to ease. U.S. rent prices fell for the third consecutive month in November, according to ApartmentList.com. Meanwhile, data collected from the Standard & Poor’s Case-Shiller Home Price Index shows that national home prices are also falling. Shelter prices comprise a third of the Consumer Price Index, so a drop would weigh heavily on price pressures. That said, it generally takes several months for the index to pick up changes in the housing market due to how the data is tracked.
  • There is also a risk that if the dollar weakens and OPEC+ follows through on rumored production cuts, energy prices could rise and prevent inflation from falling further.

China in Focus: Beijing is walking a fine line as it attempts to display confidence in its pandemic response while also pacifying a growingly disgruntled public.

• China hinted that it may reduce the pandemic restrictions as public anger arises after a new round of lockdowns. A top Chinese official announced that the latest variant of COVID was “less pathogenic” than previous strains. This sentiment was also reflected in the state media’s softer tone when discussing the virus. One editorial went as far as to say that people “should not be too afraid of Omicron.” Over recent weeks, the country has ramped up its vaccination efforts and has entertained the possibility of importing Western vaccines. The renewed push is likely a positive sign for Chinese equities.
• Although substantial policy changes did not follow the remarks, the market believes reopening is on the horizon. The news initially led to a sharp rally in the Hang Seng China Enterprises Index, which rose to as high as 3.7% on the day; however, most of those gains subsided as investors realized that a reopening was not expected to be smooth. Beijing will likely drop restrictions at a slow pace as it does not want to give the impression that it is caving to public pressures. Additionally, there may be some hesitancy among people still wary to leave their homes due to COVID concerns.
• The reopening of the Chinese economy provides both positives and negatives for the rest of the world. The loosening of restrictions should increase economic activity, which should then help boost global growth and relieve some supply chain pressures. However, the reemergence of the Chinese consumers will increase the demand for energy products and push up the prices for commodities. In short, the overall impact of China’s reopening is complicated, to say the least. Thus, a slow reopening will likely fare better for equities than a quick one would.

Friends or Foe:  Allies within the North Atlantic Treaty Organization are becoming frustrated with U.S. foreign and economic policies.

• Turkey’s bullheadedness leads to more uncertainty in the Middle East and is straining U.S. ties. On Wednesday, the U.S. warned Ankara against further escalation in Kurd-controlled areas of Syria due to the danger it poses to U.S. military personnel. Tensions between the two countries have been brewing after Turkish President Recep Tayyip Erdoğan blamed Kurdish groups for a November bombing in Istanbul. The ongoing row between the two NATO allies may complicate coordination efforts for their considerable roles in supporting Ukrainian war efforts.
  • Outside of Syria, Turkey has also backed Azerbaijan in its ongoing dispute with Iran. Tehran’s military presence along its shared border with Azerbaijan has angered Anakara. In response to Tehran’s actions, Turkey suggested that it may consider military actions if tensions escalate further.
• European countries continue to rail against the U.S.’s new climate law. French President Emmanuel Macron is the latest European leader to express his frustration. In a speech yesterday, he stated that the Inflation Reduction Act threatens to divide the West. The point of contention between the two sides relates to tax breaks for components used in renewable energy technologies like electric cars. Europe sees it as an opening salvo in a trade war. In our view, the Inflation Reduction Act was designed to convince Europe to prioritize its own industries over China through subsidies of its own. This is supported by U.S. Trade Representative Katherine Tai’s insistence that Europe create its own subsidy program.
• Differences between the U.S. and its allies over trade and foreign policy have yet to lead to a complete fracturing of ties. This is evident in the European Commission’s recent decision to follow through on a price cap on Russian oil, a measure pushed by the Biden Administration. However, that does not mean that things are all fine and dandy. If Washington fails to keep its Western and NATO allies onside, it could lead to a multi-bloc world led by Europe, the U.S., and China as opposed to a two-bloc world led by just the latter two. A fragmented world will likely complicate supply chain efforts, which could harm earnings for companies with foreign exposure.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning on this last day of November.  Risk markets are trending higher this morning, and a key component to the rally in commodities and equities (especially the former) is a weakening dollar.  For most of the year, the dollar has been on a tear, despite the fact that on most valuation measures, it was already richly valued.  Divergences in monetary policy due to the Fed conducting tighter policy than the rest of the world, was behind the strength.  However, as the markets anticipate at least a slowing of tightening in the U.S., the dollar has begun to roll over.  We still suspect that the expectations of easing are overly optimistic, which could mean that the dollar will at least make a recovery in the coming weeks.  However, over next year, our expectation is that the dollar will decline, which will be supportive for commodities and equities.  On the topic of the Fed, we get the Beige Book today and Chair Powell will speak on the economy.  The markets are watching for any hints of a slowing of tightening.

In today’s Comment, our coverage begins with China news.  Economics and policy are up next.  An update on the Ukraine War follows, and we close with international news.

China news:  The government’s Zero-COVID policy is evolving, and former General Secretary Jiang has died.

• In the past, when China’s leaders implemented unpopular policies, a common response to popular opposition to the policies is to blame local officials for “misunderstanding” the policy. By doing this, leaders in Beijing can soften the policy without losing face.  It appears President Xi is deploying this well-worn playbook again, but that doesn’t necessarily mean that the CPC is easing the policy.  Instead, the policy appears to be evolving.
  • Elements of the policy include deepening surveillance, arresting leaders, and stifling less committed protesters. Security officials are systematically looking for participants to the protests, likely to either arrest or intimidate them, and “flooding the zone” with police to discourage gatherings.  The response does appear to be working, as protests seem to have declined.
  • At the same time, the leadership does seem to realize that the lockdown policies are probably no longer workable. The harm they bring to the economy is significant and public support is waning.  So, how does China open without triggering a mass infection event?  The plan emerging looks like it will focus on mass vaccinations, especially of the elderly.  China continues to use its own vaccines, which are less efficient than Western-developed ones, which will slow the process.  However, to avoid an expansion of infections, vaccination looks like the primary tool.
• Analysts are still sorting out the long-term ramifications of what increasingly looks like a massive policy failure. One element of the failure is the damage it has brought to President Xi as a leader.  Is Xi in trouble?  What we watch for are divisions at the top such as does dissention among the party leaders increase?  So far, we have seen no signs of such divisions, but we also note that (a) the CPC is good at hiding such divisions and (b) Xi has mostly sidelined the powerful who opposed him.
• The other major issue is that tensions are not just due to Zero-COVID policy. Youth unemployment in China is terrible, with reports of 20% unemployment rates.  As China’s economic growth slows, the promise of a future to young Chinese appears to be falling away, leading to rising tensions.  The Zero-COVID policies have been a catalyst, but broader worries are notable as well.
• Jiang Zemin, the former General Secretary, has died at the age of 96. He came from the coastal regions of China and was seen as an economic liberalizer.  There has been some speculation that protesters might use his demise to expand protests, perhaps at his state funeral.  If his burial turns out to be a “private” affair, it might be a sign of the level of concern the current regime has over the protests.
• China, facing increasingly tight restrictions on semiconductor imports, is attempting to build out its own semiconductor industry. A key of this development is to convince European lithography firms to defy U.S. restrictions and export chip-building equipment to China.  Although these firms would like to continue to export their wares to China, the U.S. can inflict harsh punishments on those who defy American policy.  This is an area we monitor closely, but we don’t expect the Europeans, in the end, to continue exporting banned products to China.
• NATO is holding its first talks focused on China’s threat to Taiwan. The Pentagon warns that China has designs on more than just Taiwan in its neighborhood.
• As the world evolves into blocs, there will be nations that straddle the divide. Switzerland was such a nation during the Cold War.  Chinese companies are increasingly betting on Singapore to play a similar role as the U.S. and China steadily separate.
  • Although we do note that the Commerce Secretary doesn’t believe that the U.S. wants to decouple from China. That will be “music to the ears” of multinational firms, but in our reading of U.S. politics, it is widely out of step with political trends.
• The Vatican says Beijing violated its deal with the papacy. Who would have guessed?

Markets, Economics and Policy:  Congress moves to prevent a rail strike and the “lame duck” session heats up.

• As a senator, Joe Biden built a narrative of his support for union workers. Holding stances as a senator rarely has ramifications, though,  as a senator is simply part of a larger body and holding dissent positions doesn’t really matter all that much.[1]  With the potential for a paralyzing rail strike looming, the president called on Congress to prevent a strike by taking away the union’s most powerful tool to extract revenue from capital.  Although the decision is understandable, it will likely have political costs.
• With the seating of the next Congress, the U.S. will have a divided government. This prospect is triggering rather frenetic legislative activity to pass as much as possible before early January because once the government is divided, the likelihood of passing anything will become quite difficult.  The biggest surprise is that the existing House and Senate leadership appear to be moving quickly to pass an omnibus spending bill.  The Pentagon is worried that in the absence of a new spending bill, the government will fund itself with a continuing resolution which would mean that defense spending would not grow in a period where spending demands are elevated.  In fact, the GOP is insisting that defense spending grow faster than other spending, and if the Republicans get their way, it may be supportive for the Defense sector.
• As we noted above, Chair Powell speaks today, and the regional banks will report on their local economies. We have seen a parade of Fed officials speaking recently and there is evidence of a growing hawk/dove divide.  Such divisions shouldn’t be a complete surprise; in fact, these sorts of divides are common.  Policy was so easy that for most of this year, there was near unity that tightening was needed.  With divergences emerging, however, Powell’s position becomes increasingly important.  Simply put, we need to know which side he favors, and his speech today may offer some clues.
• European inflation, although still elevated, did fall last month, triggering hope that inflation has peaked. European markets celebrated.  Europe has had a run of good luck recently.  Ukrainian forces have been doing well, the weather has been very mild, easing fears of energy shortages, and with inflation perhaps rolling over, sentiment is improving.
  • The idea that inflation has peaked in the U.S. has triggered a rally in high-yield bonds. Widening credit spreads is usually a feature of recessions.  However, we are still early in this expansion and credit practices have not had enough time to become lax.  Thus, the chances of a spike in yields are less likely as defaults should be manageable.
• Yesterday, it was reported that home prices fell. We are now seeing a rapid decline in home prices, which is usually consistent with recession.

• On the housing market, the government will now offer mortgage guarantees on mortgages of more than $1.0 million, a reflection of recent price escalation.
• One of the ways that companies deal with higher costs is through “shrinkflation” which is the practice of holding the price steady but packaging a smaller quantity. Edgar Dworsky is the go-to guy on this issue.

War in Ukraine:  Is Crimea going to revert to Ukraine?  And Germany recounts its errors.

• Although it looks to us a bit farfetched that Ukraine could retake Crimea, in the peninsula there is increasing evidence that the locals are expecting a direct conflict. If Crimea were threatened, an unconventional response from Russia would become more likely.
• German Justice Minister Marco Buschmann admitted that Germany’s policy of cozying up to Moscow contributed to Russia’s invasion of Ukraine. We note that Buschmann is a member of the Free Democrats, whereas the Social Democrats have been the most supportive of Russian/Soviet engagement going back to the 1970s.  The Free Democrats are part of the ruling coalition along with the Greens.  One of the tensions within the German government is that the dominant SDP continues to support engagement to some extent, but that is not at all in sync with the Greens or the Free Democrats.
• The U.S. is considering labeling the Wagner Group as a terrorist organization.
• Russia is asking India for specific products that have become scarce due to sanctions. This action would require India to break sanctions.  So far, the U.S. has tended to give India a pass on its relations with Russia, wanting to keep India “on side” in containing China.  So, India’s reaction to the request bears watching.

International News:  Orbán is isolated, and “corn wars” are developing.

• Hungarian President Orbán has been on the outs with the EU for some time. His anti-immigration and social policies are seen as out of step with the EU.  For the most part, Orbán has avoided severe penalties because Poland has similar policies and has supported Hungary.  The EU has tended to avoid making both nations upset, so it has mostly not enforced strict constraints on Hungary.  However, that situation does appear to be unwinding.  Poland, a stanch opponent of Putin, opposes Hungary’s support of Russia and therefore isn’t coming to Hungary’s aid.  This is allowing the EU to threaten a material funding reduction.
• Mexico is one of the world’s largest corn importers. It uses the grain for both cattle feed and for subsidized tortillas.  The AMLO regime wants to ban GMO corn which is mostly grown in the U.S.  Washington is threatening to enforce the USMCA to prevent Mexico from banning the GMO sales.
• Pakistan’s former head of its spy agency has been appointed to the head of the army. The military is very powerful in Pakistan, so General Asim Munir is essentially the head of state as well.
• It’s India’s turn to head the G-20, and it plans to make the most of it.

---

[1] This is why, in our analysis of politics, we usually have less regard for senators who become presidents.  Senator’s positions often don’t matter; instead, we prefer people who have actually had to make decisions for which they are responsible.  In this regard, we believe that governors tend to be better candidates.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a hawkish statement on the Eurozone’s monetary policy by ECB President Lagarde and a request from President Biden that Congress take action to thwart a threatened railroad strike.

Russia-Ukraine:  As the Ukrainian military continues to press its counteroffensive in the country’s northeast, east, and south, the Russian military is reportedly planning a new wave of artillery, missile, and kamikaze drone strikes against Ukraine’s civilian infrastructure in an effort to freeze the Ukrainian population into submission.  As we have mentioned previously, that effort has failed so far, raising the question of whether Russia is wasting its remaining precision-weapons inventory for little gain.

• Separately, as Western Europe continues scrambling to replace natural gas supplies cut off by Russia in retaliation for its support of Ukraine, Germany has signed a small-scale deal to import gas from Qatar for 15 years beginning in 2026. The emirate is one of the world’s largest gas exporters, but this will be its first long-term deal to send supplies to Europe.  All the same, the deal will do nothing to help Western Europe regain its gas supplies this winter or, perhaps more crucially, next winter.
• French President Macron arrives in Washington today for a four-day state visit in which he is expected to discuss the joint U.S.-European approach to the war. Macron will likely air a range of European grievances involving the belief that the U.S. is profiteering from the conflict by selling enormous volumes of gas and weapons to Europe at high prices.

Eurozone:  Yesterday, European Central Bank President Lagarde said that in spite of encouraging signs that Eurozone inflation may be set to moderate, the ECB is not yet finished raising interest rates and still “has a long way to go” in tightening monetary policy.  The hawkishness of Lagarde’s statement suggests that the ECB may not be as ready to slow the pace of its rate hikes as the Federal Reserve is, which probably goes far in explaining the euro’s strength against the dollar in recent days.

China:  Although new COVID-19 infections remain near record highs, health authorities today have begun downplaying the risks in an apparent effort to quell concerns about widespread new lockdowns.  As we reported in our Comment yesterday, it also appears that Chinese police and security forces have suppressed the extraordinary wave of anti-government protests that began late last week.

• So far this morning, those developments have sparked a sharp rebound in Chinese stock values as investors bet that the crisis will force the government to loosen its highly disruptive Zero-COVID policies.
• However, investors should take note of how quickly China’s police and security forces gained control over the weekend protests. That could well encourage President Xi to keep his Zero-COVID policies in place, especially since he had already allowed a modest loosening of the policies in recent weeks.

China-Djibouti:  A new report from the World Bank indicates that Djibouti has suspended its debt repayments to China as it faces major economic difficulties.  Djibouti has received $1.5 billion of funding from China, largely as a part of President Xi’s “Belt and Road” initiative that seeks to fund roads, ports, and other trade infrastructure in mostly developing countries.  In return, China had hoped to build political influence and support, and it had even secured a military base in Djibouti.  In recent years, however, China has had to face the fact that its loans won’t necessarily be repaid or be spent wisely, putting a damper on new lending under the program.

China-United States:  The People’s Liberation Army claimed that it warned away a U.S. Navy warship that had entered waters near the Spratly Islands in the South China Sea on Tuesday in what was apparently a “freedom of navigation operation.”  Like previous such incidents, this one highlights the continuing and growing geopolitical tension between the U.S. and China, which has already had negative impacts on Chinese stocks.

U.S. Monetary Policy:  New York FRB President Williams warned yesterday that the Fed has no choice but to continue raising interest rates and tightening monetary policy to bring down high inflation.  In fact, he said he didn’t expect the Fed to start cutting rates again until 2024.  As a consequence, he warned that the U.S. unemployment rate could rise to between 4.5% and 5.0% by the end of 2023.

• Although U.S. monetary officials are intent on continuing to hike rates, they do look like they will soon shift to smaller hikes of 50 basis points at a time.
• Williams’ expectation for higher unemployment is consistent with our view that the U.S. economy is likely to slip into recession in the first half of 2023. One key reason to expect a recession next year is that the U.S. long-term bond yields are now at their deepest inversion relative to shorter-term yields since 1981.  Inverted yield curves are often a harbinger of an economic downturn.

U.S. Railroad Strike:   After four major railroad unions recently rejected a contract compromise proposed by the administration, threatening to strike in the coming days, President Biden yesterday called on Congress to pass legislation that would avert the shutdown by imposing a contract between the workers and the railroad companies.  House Speaker Pelosi said the lower chamber of Congress will vote on the legislation this week.

• Under the Railway Labor Act, Congress can make both sides accept an agreement that their members have voted down. Lawmakers can also order negotiations to continue and delay the strike deadline for a certain period, or they can send the dispute to outside arbitrators.
• In any case, a full-blown rail strike could be a big blow to the economy by disrupting supplies of key commodities and driving up prices. A strike would therefore likely be negative for U.S. equities.

U.S. Cryptocurrency Market:  In yet more fallout from this month’s failure of crypto exchange FTX, major crypto lender BlockFi yesterday filed for bankruptcy protection.  BlockFi attributed its problems mostly to falling cryptocurrency prices and its ties to FTX.  As one of a long string of crypto bankruptcies this year, BlockFi’s bankruptcy illustrates the major problems that the industry is now working through.

View PDF