Daily Comment (July 21, 2023)

Posted on July 21, 2023July 21, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with an explanation of why today could be a rocky day for markets. Next, we will discuss two major developments that may reshape international finance. Finally, we will share our thoughts on the Spanish elections occurring on Sunday.

Triple the Effect: A trifecta of events will weigh on market activity on Friday: a reshuffling of a popular tech index, the expiration of option contracts, and the release of corporate earnings.

The tech-heavy Nasdaq 100 index is undergoing a special rebalance today to address concerns about the weighting of mega tech companies. The index is typically rebalanced quarterly, but an exception was made earlier this month due to the growing dominance of these companies. Boosted by the excitement of artificial intelligence, the top five tech companies now account for over 50% of the index, significantly higher than the 40% cap typically preferred by the providers. The special rebalance will reduce the weightings of these companies and increase the influence of smaller companies. This will likely lead to increased volatility in the market as investors adjust their portfolios accordingly.
In addition to the Nasdaq 100 rebalance, an estimated $2.4 trillion worth of options tied to stocks and indexes are set to mature. The expiration of these contracts will likely impact trading activity as investors decide whether they would like to roll over existing positions or start new ones. July has been the slowest month of trading in two years, and there is speculation that investors may be sitting on the sidelines until there is more clarity about the future direction of monetary policy. If investors do decide to roll over their options, it could lead to a surge in trading volume and volatility. However, if investors decide to start new positions, it could lead to more sustained performance.

Finally, the day is likely to be heavily influenced by corporate earnings releases. Several companies are expected to report their results, including regional lenders Comerica (CMA, $52.93) and Regions (RF, $20.35), as well as credit card company American Express (AXP, $177.11). Comerica and Regions are expected to give insights into the deposit market, important information given the fears of disintermediation. At the same time, American Express’s earnings will provide information on the discretionary spending habits of consumers. The results could have a significant impact on the direction of the market in the coming weeks as it may give investors a better sense of the state of the economy.

Institutional Shifts: The World Bank and the Federal Reserve have made major announcements that suggest both organizations are looking to modernize.

The Chinese-backed Asian Infrastructure Investment Bank (AIIB) has joined forces with the World Bank. The deal with the AIIB will help alleviate the World Bank’s financial constraints. However, this new partnership is likely to raise eyebrows, as it comes weeks after reports that members of the Chinese Communist Party infiltrated the bank. Suspicions of Chinese involvement in the World Bank led Canada to withdraw its membership from the multilateral organization. The move also comes as the two supranational financial institutions look to restructure the debt of emerging market companies.
The Federal Reserve in the United States has upgraded its payment system to make it easier for Americans to transfer money. FedNow is a much-needed shift in a banking system where people still rely on paper checks and cash to send payments through Automated Clearing House (ACH) transfers, which can take several days to process. Although banks still need to sign up for the new system, its implementation is expected to lead to some disruption. The real-time payment system network should increase competition among credit card companies and offer new opportunities for fintech companies.

These two developments show how the world is slowly adapting to a new normal. China is one of the world’s largest creditors, and its partnership with the World Bank makes sense given its influence in developing countries. Meanwhile, the U.S.’s current payment system is antiquated and needed to be improved to keep up with the demands of a world that is increasingly dominated by digital transactions. Taken together, these reports reflect how difficult it is for the financial system to keep up with changing trends as one could argue that both events should have happened much earlier.

¿A La Derecha? The upcoming Spanish election is widely expected to result in a rightward shift in the country’s political landscape.

Recent polls suggest that the Popular Party (PP), led by Alberto Núñez Feijóo, is poised to win the most votes in the upcoming Spanish election taking place on Sunday. This would put the PP in a strong position to form a government. However, there is speculation that Feijóo may seek to form a coalition with the controversial Vox party. The far-right group has been accused of racism, xenophobia, and Islamophobia. If Feijóo were to form a coalition with Vox, it would be a significant shift in Spanish politics, as it would give a far-right party a seat in parliament for the first time since the end of Francisco Franco’s rule in 1975.
The rise of populist parties in the European Union is linked to the bloc’s encouragement of unpopular reforms. In Spain, for example, the government barely passed a labor reform in order to unlock pandemic funds last year. Similarly, pressure to push through reforms in Italy helped lead to the ouster of Mario Draghi from the premiership. Meanwhile, French President Emmanuel Macron’s controversial pension reforms have boosted support for his political rival, Marine Le Pen. This situation will likely worsen as the European Central Bank plows ahead with rate increases despite signs that inflation is slowing, and the region narrowly avoided a technical recession in Q2 of 2023.

The European Union’s inability to adapt to each country’s individual needs is a major weakness that could undermine the bloc’s ability to function in the future. This is evident in the fact that Spain will be subject to tighter monetary policy despite the fact that it is making better progress in its inflation fight than other countries. This lack of flexibility could lead to more populist leaders being elected in the EU, who would likely look to protect their countries’ interests, even if it means going against the bloc. As a result, if this trend continues, it could lead to a much weaker euro in the future.

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Asset Allocation Quarterly (Third Quarter 2023)

Posted on July 20, 2023 by Amanda Ahne

by the Asset Allocation Committee | PDF

Our three-year forecast still includes a relatively mild recession followed by a recovery and the potential for an economic expansion.
We expect inflation to moderate in the near-term but modestly re-accelerate in the back half of the forecast period given underlying structural influences.
The Fed’s monetary policy is likely to ease as economic conditions slow. Additionally, we expect a measured and careful approach by the FOMC as the presidential elections draw nearer.
The duration posture remains short-term. We anticipate the yield curve will begin flattening from its current inverted state.
In domestic equities, we maintain our value bias as well as large cap cyclical sectors and quality factors within lower market capitalizations.
International developed markets include an overweight to Japan. We maintain emerging markets exposure in the most risk-accepting portfolio but exclude China.
Gold exposure is maintained for its benefits as a low-correlation asset along with its potential to act as a haven during economic turmoil and as a hedge against geopolitical risk.

ECONOMIC VIEWPOINTS

The economy has generally remained resilient despite the Fed’s tightening actions and a widely anticipated recession. While fiscal spending has supported the economy, consumer spending has carried the expansion on the back of strong household balance sheets. However, we are seeing the first signs of slowdown in consumer sentiment. As this chart indicates, household non-mortgage debt-to-cash ratios have crept higher recently, indicating weakening balance sheets which could negatively affect spending. Savings that were bolstered by stimulus payments have now been depleted by strong discretionary spending and inflationary pressures on the overall consumer basket. Early signs of slowing consumer spending are emerging from the Consumer Staples and Discretionary categories, which we believe are due to price elasticities of demand in response to higher inflation. It is significant to note that we are seeing household balance sheets deteriorate even before the resumption of student debt payments. An estimated 37 million borrowers had a three-year reprieve in student debt payments and reports indicate this primarily supported consumption and did not accrue into savings. We expect these debt payments to further suppress spending.

At the same time, labor markets have remained strong with unemployment near cycle lows. The unemployment rate may be artificially understated as employers are hoarding labor in fear of labor shortages even when consumer demand is slowing. Here, again, we are seeing early signs of a slowdown in hours worked and falling rates of wage growth.

Macro headwinds combined with monetary policy tightening reinforce our forecast for a mild recession, which is likely to be uneven among different segments of the economy. For example, the increased cost of capital is likely to weigh more heavily upon more highly leveraged companies and those embarking on new projects or expansionary efforts. The overall recession is not expected to be severe since it has been widely anticipated and elevated levels of liquidity on the sidelines should provide support to risk markets. As this chart shows, we continue to see historically high levels of money market and ultra-short bond fund assets. These levels are high for two main reasons. First, the inverted yield curve is offering attractive yields in the short end of the curve with low levels of risk. Second, accruing this yield is attractive for investors waiting on the sidelines for a dip in the market, providing support to risk markets.

Inflation is already showing signs of slowing. We believe this is primarily in response to the short-term smoothing of the supply-chain problems and is only secondarily affected by slower demand caused by tightening monetary policy. Our expectation is that inflation will return toward the end of the forecast period due to underlying structural issues, such as deglobalization and aging demographics. We also expect the new inflation regime to be higher than during the ZIRP epoch but lower than it has been since the pandemic.

One of the mega-trends supporting domestic economic activity longer-term is the re-shoring of manufacturing capacity and generally shortening supply-chains. Geopolitical tensions are likely to remain elevated and further support international polarization into regional blocs. Reliability of supply is now prioritized over the absolute lowest cost of manufacturing. Capacity buildouts are multi-year endeavors, which will place increasing demands on construction labor and materials initially and skilled labor to operate in the long-term. We believe these pressures, alongside general supply-chain complications, will further reveal inflationary bottlenecks in the economy and could lead to the resurgence of inflation.

We expect the path of monetary policy to be measured and careful over the forecast period, especially as we head into the 2024 presidential elections. Fed fund rates are likely to settle higher following the recession as the FOMC attempts to control a systemically higher inflationary regime.

STOCK MARKET OUTLOOK

A mild recession is generally discounted into current equity fundamentals, especially lower capitalization stocks. Domestic large cap stock valuations remain near cycle highs, with the expansionary cycle extended by excitement around AI and machine learning. We remain cautious regarding large cap exposure as concentration remains at historic highs. For example, the top 10 names in the S&P 500 accounted for roughly 30% of that index at quarter end. To guard against concentration risk, we lean our style tilt toward value over growth. Additionally, we retain our Aerospace & Defense position and cyclical sector overweights as we project that deglobalization and re-militarization of foreign countries is a sustainable long-term trend. We maintain our sector overweights to Mining, Energy, and Industrials in most strategies. The Mining and Energy sectors are likely to benefit from electrification/green energy policies as electrification is metals heavy.

We believe small and mid-capitalization stock valuations remain attractive, while fundamental earnings power remains healthy. Mid-cap stocks, specifically, remain at historically wide valuation discounts to large cap stocks. Last quarter, we introduced a quality factor in our mid-cap exposure. Similarly, we remain in a quality-screening vehicle on the small cap side. The quality factor screens for profitability, leverage, and cash flows, which should support the group through economic volatility.

We continue leaning into the value bias across all market capitalizations. We view the sustainability of earnings growth as more attractive in equities categorized as value and the fundamental valuation multiples are modest compared to historical data. In addition, value style has a lower exposure to sectors that we view as overpriced. Although growth has vastly outperformed value year-to-date, we anticipate that we are in the early stages of a value outperformance cycle.

International developed equities remain attractively valued, while their earnings potential remains healthy. This quarter, we added a country-specific overweight to Japan as shareholder-friendly reforms are starting to take hold in the country and as capital flows are moving out of the rest of Asia and into Japan, which could potentially lead to earnings multiple expansion. We also forecast positive returns from emerging market stocks on the back of U.S. dollar weakness, although exposure to this asset class is limited to only the most risk-accepting strategy. Given the potential economic slowdown and geopolitical risks stemming from China, we have directed our exposure to an emerging market ex-China investment vehicle.

BOND MARKET OUTLOOK

With the anticipated decline in the fed funds rate (the Fed’s reaction to the recession) and a more docile near-term level of inflation, the most attractive segment of the Treasury curve is in short duration. While our base case is for a flat yield curve to reign by the end of the three-year forecast period, we harbor concerns regarding intermediate-term bonds and especially long-duration bonds. Should inflation reassert itself within the forecast period, yields on long-term debt could rise, exerting downward pressure on prices and resulting in a traditionally shaped yield curve. Consequently, the duration posture of the strategies with income as a component remain short-duration with a concentration in one-year Treasuries.

Among investment-grade corporate bonds, it is notable that spreads have not compressed beyond historic averages, underscoring the absence of investor concern even in the face of the much-anticipated recession. Moreover, corporate debt issuance has been subdued over the past few years and has not led to excessive debt levels on most corporate balance sheets. Nevertheless, it would be consistent with our thesis for spreads to widen modestly as the recession takes hold and the maturing of low coupon debt to be refinanced with bonds reflecting higher rates than what prevailed during the years prior to 2022. As a result, corporate bond exposure in the strategies represents a lower proportion than popular market indices.

In the speculative-grade corporate bond category, we find caution is warranted due to the sizable increase over the past 15 months in the cost of capital for highly leveraged companies that are refinancing debt. As with investment-grade corporates, spreads have been relatively contained. However, an uneven recession is likely to cause spreads on lesser rated corporates rated B or lower, especially those in the distressed category, to widen markedly. Accordingly, all exposures to speculative-grade bonds in the strategies are exclusively in BB-rated debt.

OTHER MARKETS

Allocations to REITs are absent as our forecast for the sector over the near-term calls for continued headwinds and low levels of demand for office and retail space, compounded by the difficulty in arranging financing. Although the strategies similarly avoid broad-based commodities owing to recession-induced pressure on prices, we maintain the allocation to gold across the strategies. We favor the continued gold exposure as it can act as a haven during economic contractions and as a hedge against geopolitical risk. Furthermore, gold can be beneficial due to the potential strength it offers during periods of U.S. dollar weakness and its use as a reserve asset for global central banks.

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Asset Allocation Fact Sheet

Daily Comment (July 20, 2023)

Posted on July 20, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our concerns about the banking sector. We then discuss how the war in Ukraine and El Niño could impact Fed policy. Finally, we explain why the recent improvement in U.S.-China relations may be short-lived.

Deposit Flight: While banks have mostly recovered from the March fiasco, disintermediation remains a challenge.

Three of the country’s biggest banks by assets were able to beat expectations in the second quarter. JP Morgan (JPM, $154.25), Citigroup (C, $47.52), and Wells Fargo (WFC, $46.26) made a combined profit of $22.3 billion going into the year’s second half, thanks in part to hawkish Fed policy. The surge in interest rates have benefited banks in two ways. First, they were able to charge more for loans, which increased their net interest income. Second, the banking crisis in March led to an increase in deposits at major banks as savers fled regional banks. This surge in new clients made it easier for banks to lend out capital. However, it is unclear whether this trend will continue into the third quarter.
Several major headwinds are expected to plague banks over the next few months. First, as interest rates rise, customers are pushing for more compensation for their deposits. In fact, institutional depositors are already moving their savings to higher-yielding accounts. Second, the prospect of new regulations and loan losses from commercial real estate is forcing banks to shore up their balance sheets. For example, U.S. Bancorp (USB, $38.68) announced that it has increased its Common Equity Tier 1 (CET1) by 60 basis points, offloaded assets, and securitized auto loans in order to reduce its balance sheet exposure. On top of that, banks have noticed that households are holding back on spending, and credit card losses are increasing.

The good news is that deposits at commercial banks have stabilized since the fall of Silicon Valley Bank. However, these holdings will be under threat as long as the Fed keeps raising rates. Regional lenders are the most sensitive to interest rate changes, as evidenced by the deposit outflows reported by U.S. Bancorp, Citizens (CFG, $31.06), M&T Bank (MTB, $138.08), and Charles Schwab (SCHW, $66.00) in the second quarter. Even Bank of America (BAC, $31.40), the second-largest bank by assets, saw a deposit flight. If bankers are forced to pay more on deposits, it could lead to even higher borrowing costs and further weigh on consumer spending. As a result, we are still paying close attention to the banking system.

It’s Hot in Here: Adverse weather conditions and the war in Ukraine could complicate Fed efforts to ease monetary policy.

Temperatures in the United States, Europe, and Asia have reached record highs this year, driven by relatively strong El Niño conditions. Global ocean temperatures have exceeded the 20^th-century average by 1.89 F, according to the National Oceanic and Atmospheric Administration. The unusually hot weather has pushed up energy consumption in the United States, with power demand in Texas and Arizona expected to set records. The unprecedented heatwave has also led to wildfires in Greece and Canada. Additionally, there are concerns that poor conditions could hurt crop yields.

At the same time, the war in Ukraine is also leading to uncertainty regarding food prices. On Wednesday, Russia announced it would consider all vessels headed to Ukrainian ports to be military threats. The declaration comes a week after Moscow pulled out of the Black Sea grain deal. Wheat futures surged 8% following the report as investors expect grain supply to fall. So far, grain prices remain lower than at the start of the year; however, they could rise if shipments are disrupted or become more expensive to insure. This may lead to an increase in food inflation just as cost pressures were trending downward.

Adverse weather conditions and the war in Ukraine are likely to dissuade talks of policy cuts. Central banks appear to be indifferent as to whether inflation is supply- or demand-driven. They are instead focused on containing price pressures, regardless of the source. As the chart above shows, most of the progress made in U.S. inflation has come from supply-side factors. Hence, supply disruptions could reverse some of the gains made in the inflation fight. While this does not necessarily mean that they will continue to raise interest rates, they are less likely to consider a cut if there is a chance of inflation accelerating.

There Is a Glimmer: Despite ongoing friction between the two global superpowers, there are signs that both sides are willing to de-escalate and avoid direct conflict.

The U.S. and China are taking tentative steps to improve relations while trying to avoid actions that could provoke the other side. On Thursday, Washington officials rebuked Taiwanese presidential frontrunner Lai Ching-te’s assertion that his country’s political goal is to “enter the White House.” The “One China” policy prohibits top Taiwanese officials from making official visits to Washington. Meanwhile, Beijing has finally started holding diplomatic talks with U.S. representatives. Special Presidential Envoy John Kerry agreed with his Chinese counterpart to continue to hold discussions about climate change goals. Additionally, Chinese President Xi Jinping met with former Secretary of State Henry Kissinger to discuss warmer U.S.-China ties.

That said, the two largest economies in the world will continue to take steps to protect their own interests. On Wednesday, China’s envoy to Washington warned that his country would respond if the U.S. proceeds with pushing through laws that hurt China’s advancement in military technology. The threat comes amidst speculation that the Biden administration is considering limiting investment into companies linked to the Chinese defense industry. Although White House officials maintain that the restrictions will be limited in scope, it is possible that the measure could pave the way for more discussion regarding the topic, especially going into the 2024 election.

A deceleration in the global economy is likely to slow the pace of the decoupling between the United States and China, but it is unlikely to disrupt it entirely. The two countries are deeply interconnected, and both would suffer if there were a complete break in economic ties. China’s economic recovery will receive a boost from an increase in exports to the United States and maintaining access to China’s supply chains and materials will help the United States with its green energy transition and prevent trade disruptions. However, trade between the two countries is unlikely to return to its pre-pandemic pace anytime soon.

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Weekly Energy Update (July 20, 2023)

Posted on July 20, 2023July 19, 2023 by Amanda Ahne

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

On Monday, oil prices spiked on reports that the Kingdom of Saudi Arabia (KSA) was going to extend its voluntary production cuts until year’s end. The report was incorrect but does show the power that the news has on the oil markets.

(Source: Barchart.com)

Commercial crude oil inventories fell 0.7 mb, less than the 2.5 mb draw forecast. The SPR was unchanged.

In the details, U.S. crude oil production was steady at 12.3 mbpd. Exports rose 1.7 mbpd, while imports increased 1.3 mbpd. Refining activity rose 0.6% to 94.3% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories. After accumulating oil inventory at a rapid pace in the first quarter, stockpiles have moved into a pattern consistent with the seasonal. Current inventories are in line with seasonal levels.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $59.94. Commercial inventory levels are a bearish factor for oil prices, but with the unprecedented withdrawal of SPR oil, we think that the total-stocks number is more relevant.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in 2002. Using total stocks since 2015, fair value is $92.96.

About the Heat: We have been commenting on the unusually warm temperatures currently in the Northern hemisphere. Europe, unaccustomed to such heat, is having a very difficult time adjusting. In the U.S. the southern tier of states has experienced extreme heat, especially in the Southwest. China is seeing hot weather as well. Temperature reporting is now front and center in the media. Although climate change is being blamed for much of it, our experience with climate is that it’s complicated. There are two complications that are important to mention:

Sunspot cycles: The sun plays a major role in the earth’s climate. Sunspots are the result of magnetic activity on the sun that causes flares and ejections from the sun’s surface. The scientific community is divided on the impact of sunspots on climate. Some argue that it is an important factor, others dismiss the activity as negligible. We are not climate scientists but interested observers. Our take is that the cycles likely amplify the normal variation. That means that sunspot cycles probably don’t drive climate by themselves but do play a role.
- Sunspot cycles run 22 years, from trough to trough. The current cycle will peak in 2025. In general, increased activity tends to lead to higher temperatures. Thus, we are in the part of the cycle that should lift global temperatures. The current cycle isn’t unusually amplified, but its current readings exceed the peaks observed in the last cycle.

(Source: NOAA)

ENSO cycles: The ENSO cycle has three phases—El Niño, La Niña, and neutral. In recent years, we had experienced a set of La Niña events. We are currently in an El Niño event, and current projections suggest it will be moderate to strong. El Niño events often lead to hot North American summers, especially across the south. It has also coincided with mild winters.

The combination of elevated sunspot activity and an El Niño ENSO cycle indicates that hot weather will continue. In the developed world, this climate condition tends to be bullish for summertime natural gas prices, as it boosts air conditioning demand and consequently, electricity consumption. So far, U.S. natural gas production has been robust enough to keep injections on par with seasonal norms. This factor has kept natural gas prices low. If winters are mild, it could be bearish for natural gas prices going forward. There have been other effects as well:

Hot, dry weather in parts of Europe have caused the water levels of the Rhine River to decline, forcing shippers to lighten barges by shipping less product. Mississippi River water levels are also low.

High river temperatures are limiting nuclear power production in France.
Hot weather in Spain has sent (olive) oil prices soaring.
Temperature and rainfall changes have created situations where it is hard to find any part of the U.S. that is unaffected.

Market News:

The IEA’s oil market report increased oil demand by 2.4 mbpd to 102.3 mbpd, a new record. Most of the demand will be met by non-OPEC+ suppliers. Meanwhile, we note that the KSA is losing its spot as top oil producer within OPEC+. In the early 1980s, something similar occurred which led the Saudis to aggressively retake market share, tanking oil prices in the mid-1980s.
- As the KSA reduces output, Kuwait is aggressively lifting productive capacity. We doubt that the Saudis will tolerate this absorption of market share indefinitely.
The global natural gas market is experiencing a generational adjustment in the wake of the war in Ukraine. The IEA’s recent global natural gas report details how the world market for gas has changed.
The recovery in oil prices has lifted the Russian Urals price to the G-7 cap of $60 per barrel. The breach will begin triggering financial sanctions for traders and the financiers of these oil purchases. We will be watching to see if Russian oil sales are affected.
The Biden administration is planning modest injections into the SPR, but in no way is this going to replace all the oil that was sold.
California, once a major oil producer and still the 7^th largest oil producing state, has essentially stopped new oil well approvals.
Turkey has suspended oil flows from Iraq over a dispute over payments. So far, there has been little progress in freeing up these flows.
One of the surprises of the past year has been the rather modest increase in U.S. oil production despite elevated prices. As we have noted in the past few months, higher costs for drilling and financing issues have stifled output. Now, there are reports that drilling rig counts are fading, suggesting that production may decline in the coming months.

Geopolitical News:

India has been a major buyer of Russian crude oil, but the two nations have struggled to establish payments. India has been paying in INR, but the Russians have discovered that the usefulness of INR is limited due to the lack of deep Indian financial markets and capital controls. And so, to facilitate further sales and avoid USD transactions, Russia and India have agreed to transact in CNY. It’s unclear how much is being done in the Chinese currency and what India’s CNY reserve status is at the moment. However, if this continues, then at some point India will need to run a trade surplus with China to acquire CNY. We doubt China will support that outcome.
Israel is working to improve relations with Azerbaijan. The Israeli defense minister has visited the country recently. At the same time, Azerbaijan is working to improve relations with Iran as well.
Russia recently suggested that the UAE had the rightful claim to the Greater and Lesser Tunbs and Abu Musa, three islands in the Persian Gulf that are controlled by Iran. The Iranians were not pleased. Although Iran and Russia have seen relations improve recently, there have been notable differences over the years that still affect the relationship.
As part of the thaw in Saudi/Iranian relations, the KSA, Kuwait, and Iran may be working to jointly develop offshore natural gas in the Persian Gulf.
In response to Iran’s interdiction of Persian Gulf shipping, the U.S. is increasing its deployment of F-16s to the region. The U.S. has also moved F-35s and a destroyer to protect shipping. There is also talk of boosting air defense systems in Iraqi Kurdistan as Iran has also been threatening that region.
The morality police in Iran were sidelined during last year’s headscarf protests. The police have apparently returned, along with a crackdown on women not wearing the hijab.
Although sanctions on Russian energy sales have affected global oil supply, they haven’t really prevented Russian oil from entering the market. The sanctions have reduced the Russian revenues from oil sales (evading sanctions costs money), but the Russian economy continues to muddle through, although there is increasing evidence that economic conditions are deteriorating. Essentially, Western nations really didn’t want to shut off the flow of Russian oil, but they just didn’t want to pay high prices due to sanctions. The real goal was to reduce Russian revenue, and in those terms, sanctions have been generally effective.
- Saudi Arabia is increasing its imports of Russian petroleum products. We suspect these are for reexport. Exporting product to friendly nations is one way Russia is evading sanctions.
- Sanctions on Russian oil have benefited Venezuela and Iran, who have both seen sanctions on their respective nations ease. Dubai has benefited by becoming the place where Russian oil deals are consummated. The role of busting sanctions used to belong to Switzerland; that has changed.
- Interestingly enough, the U.S. has also benefited from sanctions. The shift from coal to oil disadvantaged Europe, which had plenty of coal but lacked oil. The U.S. has attempted to use oil as a diplomatic tool to gain European compliance to American policy goals. Europe, obviously wanting to avoid this pressure, and against American opposition, bought Russian oil. The U.S. was open to Europe buying oil from the Middle East as well, but Europe’s goal was diversity of sources. The war in Ukraine has exposed the risks of being dependent on Russia, which has led to a boom in U.S. oil and gas sales to Europe.
Schlumberger (SLB, $56.41) has finally ended sales to Russia.
Relations between the UAE and the KSA leaders have deteriorated recently. Mostly, it appears to be driven by the goal of both leaders to project power in the region.

Alternative Energy/Policy News:

Solid state EV batteries could be the technology that moves transportation to electricity. The batteries promise not only to recharge in a time frame similar to filling a car with gasoline, but also to have a range that may exceed 700 miles per charge. Nio (NIO, $10.48) announced it will start using these batteries. The current technology is still emerging, but the more the industry moves to solid state, the quicker the transition is likely to be.
- We continue to monitor the progress in not just solid state batteries, but cheaper materials to make batteries. Lithium prices have soared as EV production rises, so replacing such metals with cheaper alternatives would be another form of progress.
The European heatwave, noted above, is boosting solar power output.
The EU is trying to use trade policy to secure critical EV metals. Mercosur and the EU have been in trade negotiations for some time, but now the EV buildout is increasing European’s interest in getting a deal done. However, for the Mercosur nations, the echoes of colonialism continue, prompting resource nationalism.
- The U.S. Senate has approved a tax treaty with Chile, which could support lithium imports.
- The Economist magazine notes that the process of energy conversion may not be possible without buying such products from China.
Chinese GDP data was disappointing, but two bright spots are EVs and solar panels. China is aggressively building out battery storage which is critical to the expansion of solar power.
According to reports, China is aggressively hacking the U.S. energy grid and could use cyberattacks on the grid in case of a war.
One of the paradoxes of the energy transition is that environmental concerns about mining key metals is hampering the expansion of supplies needed to replace fossil fuels.
- As the world scrambles for critical EV minerals, mining the deep sea is being considered. Concerns about environmental damage are being raised.
- Maine has deposits of lithium, but the state prohibits commercial mining of the resource.
Clean hydrogen offers the promise of clean energy using the existing infrastructure. However, it isn’t clear if that promise will ever materialize.
A new deal to build and deploy small modular nuclear reactors in the Northwest shows the steady growth and interest in this new technology.
The CFTC is drafting guidance for the eventual creation of a carbon market. Economists hold that the fastest way to address carbon reduction is to properly price it. Having this trading done on exchanges is one way to create a market for carbon credits.

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Daily Comment (July 19, 2023)

Posted on July 19, 2023July 19, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with good news on consumer price inflation in the United Kingdom, which has helped push down bond yields so far this morning. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including news that Russian President Putin is handing control of expropriated Western assets to his cronies and a discussion of new antitrust policies issued yesterday in the U.S.

United Kingdom: The June consumer price index was up just 7.9% from the same month one year earlier, much cooler than expected after the rise of 8.7% in the year to May. Obviously, the U.K. inflation rate remains very high, but it now appears it could be on the verge of falling more rapidly, as the U.S. inflation rate has.

The moderation in inflation has sparked hopes that the Bank of England might respond by slowing or stopping its aggressive interest rate hikes.
That hope has sparked a furious rally in U.K. government bond prices so far today, driving yields lower. Currently, the yield on the benchmark two-year Gilt has fallen sharply to 4.858%, while the yield on the 10-year Gilt has declined to 4.185%. The yield on 10-year U.S. Treasury notes has fallen only modestly to 3.763%.
The sharp decline in U.K. yields has also pushed down the value of the pound so far today. At this writing, the GBP is trading down 1.0% versus the dollar, to $1.2910.

Japan: In contrast with the pound’s fall today, the yen (JPY) continues to rally in response to investor expectations that the Bank of Japan will soon loosen its policy of yield curve control and allow longer-term bond yields to rise. So far this morning, the JPY is trading up 0.8% to 139.94 per dollar ($0.0071 per JPY). That translates to an increase of approximately 4.0% just in July.

China: Foreign Minister Qin Gang has not been seen in public now for almost a full month, and with government spokesmen unable to give a consistent explanation of his whereabouts, rumors are swirling about what might have happened. The rumors range from a health issue to the possibility that he has been caught up in some kind of scandal.

Of course, Communist Party Foreign Affairs Chief Wang Yi remains very much in the public’s view. Therefore, no matter what has happened to Qin, it wouldn’t necessarily mean a substantial change in China’s foreign policy.
All the same, Qin’s mysterious absence raises questions about Chinese leadership politics and policy disputes.

Russia: Days after the government “temporarily” seized the Russian assets of French dairy firm Danone (DANOY, $12.42) and Danish brewer Carlsberg (CABGY, $30.63), new reporting says President Putin ordered the expropriations after businessmen close to the Kremlin expressed an interest in the businesses. The key allies of Putin were named to lead the companies yesterday. The transfers are being widely seen as a sign that other seized Western assets in Russia will be transferred to Putin loyalists.

Thailand: The constitutional court yesterday temporarily suspended the parliamentary duties of Pita Limjaroenrat, leader of the progressive Move Forward Party that won May’s elections. The suspension gave conservatives in the senate an opening to declare Pita ineligible to serve as prime minister, adding to their moves against his premiership last week.

The maneuvers involving the constitutional court and senate illustrate how Thailand’s conservative establishment of generals, oligarchs, and royal officials are determined to keep Pita out of power.
Some of Pita’s supporters have called for mass protests in the streets, creating a risk of political instability in what we consider a member of the evolving U.S. geopolitical and economic bloc. Indeed, Thailand has been benefiting as global businesses and investors shift away from the China/Russia bloc.

Kenya: Opposition leaders, including the former prime minister and five-time presidential candidate Raila Odinga, have called for three days of mass protests against new taxes signed into law last month by President William Ruto. Previous violent demonstrations in recent weeks have already killed dozens, despite widespread beliefs that the conflict is really a personal feud fed by Odinga’s frustration at never having won the presidency.

United States-North Korea: A low-ranking U.S. soldier stationed in South Korea yesterday crossed into North Korea and was taken into custody, apparently in a willful effort to escape prosecution for an assault charge south of the border. The soldier is now the only known U.S. citizen in North Korean custody, potentially creating more tensions between the two countries.

U.S. Antitrust Policy: In an announcement yesterday, the Justice Department and the Federal Trade Commission jointly issued draft guidelines on how they will police proposed mergers. According to the agencies, the new guidelines have been designed to reflect current business practices and recent court rulings on company combinations.

For the first time, the guidelines explicitly address problems that can result from deals involving dominant technology companies and private-equity firms.
In another first, the guidelines say the agencies will examine whether a merger will leave the combined company so dominant in a local labor market that it reduces the competition for workers, potentially pushing down their wages.

U.S. Stock Market: New research from S&P Global (SPGI, $421.85) found that nonfinancial investment-grade companies in the S&P 500 stock index cut their total operating expenses by 5.3% in the first quarter. The figures illustrate the way firms turned their attention to cost cutting as wages and interest rates rose and sales growth slowed in the period. Nevertheless, the cost cuts were mostly offset by a 3.9% fall in sales, leaving only a small rise in operating profits.

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Daily Comment (July 18, 2023)

Posted on July 18, 2023July 18, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news that the U.S. is sending more military forces to the Middle East to counter Iranian mischief there. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a warning from the International Energy Agency that Europe remains vulnerable to energy shortages and price hikes, and news of a deal that will postpone the day when U.S. companies will face higher taxes from the OECD-brokered agreement on minimum corporate tax rates.

United States-Iran: As Iranian forces ramp up their harassment of ships in the Persian Gulf, the U.S. has decided to deploy advanced F-35 fighter jets, additional F-16 fighter jets, and an additional Navy destroyer to the region. While the move is likely to help deter Iran from trying to seize more foreign tankers, it will also raise the risk of an accidental confrontation that would boost energy prices and slow economic growth around the world.

Iran’s recent aggressive harassment in the region is partly a result of the U.S.’s effort to shift its military power out of the region and to focus more on Great Powers like China and Russia.
It also reflects the shortage of U.S. Navy ships available to deploy to the Middle East. Throughout the War on Terror and its immediate aftermath, the Navy’s combat force, currently at about 294 ships, has been only a fraction of its size during the Cold War.

China-Russia: The Chinese and Russian navies this week are holding joint exercises in the waters that separate Japan from Russia and South Korea. The maneuvers are further evidence that the countries are increasing their military cooperation to bolster their ability to project power internationally. Even though Russia’s ground forces are still mired in their disastrous invasion of Ukraine, the country’s naval forces remain quite capable and can offer synergies to the world-leading Chinese navy. As the China-Russia bloc increases its effort to project power globally, tensions with the West are unlikely to ease significantly.

China: In recent days, Zhejiang province has cleared its website of recent data which showed a jump in cremations after President Xi ended his strict Zero-COVID lockdowns late last year. The data had shown that cremations in the province jumped to 171,000 in the first quarter of 2023, compared with first-quarter readings of just 99,000 in 2022 and 91,000 in 2021. The figures had been widely discussed on social media as evidence that lifting the pandemic restrictions so suddenly caused a surge in excess deaths.

It appears that the data was wiped off Zhejiang’s website because the implied jump in deaths is an embarrassment to the government.
The move is also a reminder that rising deaths and sickness from the coronavirus could be adding to the other headwinds that are slowing China’s economic recovery, including weak exports, high corporate debt, worsening government intrusion into the economy, and consumers trying to rebuild their finances after the pandemic lockdowns.

Russia-Ukraine War: The Saudi and Turkish governments are reportedly trying to broker a deal to repatriate Ukrainian children taken to Russia and held in children’s homes or adopted by Russian families. According to the reports, officials in Kyiv and Moscow are compiling lists of the thousands of children moved to Russia since President Putin’s invasion of Ukraine, as part of the mediation process. That points to at least some measure of cooperation and raises hopes for a return of the seized children.

European Union: The International Energy Agency warned that even if Western Europe’s natural gas storage facilities are 100% by this winter, the agency’s modeling shows the region could still face shortages and price spikes if the winter is cold and Russia shuts off its remaining exports. The EU’s gas storage currently stands above 80% of capacity, nearly 20% above the previous five-year average.

United Kingdom: Sticky consumer price inflation and the likelihood of further interest-rate hikes by the Bank of England have pushed U.K. government bond yields well above those of other major developed economies. At this writing, 10-year Gilts today are trading to yield 4.370%, versus 3.977% for Australian obligations, 3.774% for U.S. Treasurys, and 2.405% for German bonds. The surge in U.K. yields illustrates the risk in longer-maturity U.S. bonds, which could be repriced lower if investors swing around to the idea that U.S. inflation will be higher and more volatile in the future.

U.S. Corporate Tax Policy: The Treasury Department yesterday struck a deal with the Organization for Economic Cooperation and Development that will give U.S. companies an extra year, until 2026, before they will face higher foreign taxes under the OECD-brokered global agreement on minimum corporate taxes. The deal also preserves favorable treatment for U.S. tax credits.

U.S. Telecommunications Industry: The Wall Street Journal’s recent series on the telecom industry’s use of lead-sheathed cables helped crush the shares of major incumbents such as AT&T (T, $13,53) and Verizon (VZ, $31.46) yesterday. Those two companies and several smaller firms suffered sharp declines in their stock price as Congress looks set to get involved and investors begin to expect major regulatory issues and mitigation costs. The firms’ stock prices have also been hurt by their high debt levels in the face of rising interest rates, the slowing real estate market, and the end of the 5G technology roll-out.

U.S. Consumer Spending: Despite today’s data showing a rise in June retail sales, new analysis from Bank of America (BAC, $29.40) shows that renters have been pulling back their spending on credit cards, even as home owners are still slightly increasing theirs. The figures suggest that renters are reacting to the rent inflation of the last couple of years, while the many homeowners who have locked in low mortgage rates are still able to boost their spending.

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Daily Comment (July 17, 2023)

Posted on July 17, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with several items related to China. As usual, the trend remains negative. We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including further efforts by the Turkish government to improve its economic policy and a discussion of the unexpectedly low yields on longer-term U.S. bonds.

United States-China: At a Group of 20 meeting of finance ministers, U.S. Treasury Secretary Yellen warned it would be premature to relax the tariffs imposed on Chinese imports by President Trump in 2018, despite the Biden administration’s current effort to cool tensions.

According to Yellen, “The tariffs were put in place because we had concern with unfair trade practices on China’s side, and our concerns with those practices remain. They really have not been addressed, and China put in place retaliatory tariffs of its own.”
Yellen’s statement underscores our view that U.S.-China relations remain on a downward trajectory, even if there are temporary efforts to slow the descent from time to time. The result will be continued risks for investors.

Taiwan-China: Taiwanese Vice President Lai Ching-teh, the ruling party candidate in January’s presidential elections, announced he plans to make two stops in the U.S. on a trip to South America next month. Such visits by high-level Taiwanese politicians to the U.S. typically spark sharp anger and retaliatory measures by Beijing, so we would expect the trip to further worsen U.S.-China tensions.

Japan-China: Japan’s deepening defense alliance with the U.S. remains the main source of today’s Japan-China tensions, but Tokyo’s plan to release treated radioactive wastewater from the disabled Fukushima nuclear reactor into the ocean has become another simmering feud. Over the weekend, high-level Japanese officials were forced to cancel their plans to visit China at the last minute. Even though the International Atomic Energy Agency has approved the water release as safe, some Chinese officials have even called for boycotting Japanese seafood.

China: Data today showed China’s second-quarter gross domestic product was up just 0.8% from the previous quarter, decelerating sharply from the 2.2% increase in the first quarter. A separate report today showed that tepid hiring in the face of the economic slowdown helped push youth unemployment to a new record high of 21.3% in June. Still another report over the weekend showed June resale home prices in major cities were down 0.7% from the prior month, after a slide of 0.4% in May and an increase of 0.2% in April. The report showed similar depreciation for newly built homes and for housing units in lower-tier cities.

Taken together, the reports illustrate just how badly China’s economic growth is faltering these days, due to factors ranging from weakening export growth, excessive debt, and government intrusion into the economy. The reports are weighing on global risk assets so far this morning.
The reports will likely bolster expectations for more fiscal and monetary stimulus from the government.
All the same, those expectations could be dashed because of President Xi’s apparent desire to de-emphasize economic growth and rein in China’s problematic excess capacity and high debt levels.

Russia-Ukraine War: The Russian government today said it would no longer honor its deal allowing Ukraine to keep exporting grain through its southern ports. The Russians said they would once again allow safe passage of Ukrainian grain through the Black Sea if Western countries would facilitate Russia’s own exports of food and fertilizers, but that appears to be unlikely. Now that Ukrainian exports are again at risk because of the war, grain prices are rising so far this morning, with nearby corn futures up 1.0% to $5.19 per bushel and wheat up 2.9% to $6.81 per bushel.

Separately, the Kremlin announced that it has taken “temporary” control of the Russian subsidiaries of French dairy firm Danone (DANOY, $12.52) and the Danish brewer Carlsberg (CABGY, $31.22). The announcement gave no details, but the government in the past has described such takeovers as retaliation for Western seizures of Russian assets.
On the battlefield, it is now clear that the Ukrainian military has adjusted its counteroffensive plans to de-emphasize big, massed armor strikes in favor of careful, limited attacks aimed at attrition of the Russian forces. Not only could that gradually wear down the Russians, but it could also lay the groundwork for more dissention and insubordination to percolate up within the Russian chain of command. As shown by the mutiny of Yevgeniy Prigozhin and his Wagner Group mercenaries at the end of June, that dissention and insubordination has become a big problem for the Russian military.

Turkey: The government yesterday tripled its tax on gasoline and also hiked duties on other key fuels. The tax hikes were an apparent effort to cover the cost of the government’s huge giveaways ahead of May’s election and to fund the $100-billion reconstruction bill from February’s devastating earthquake. President Erdoğan’s new, post-election economic team has also hiked the country’s value-added tax and taken other steps to bring policy into balance. Taken together, the policies mark at least a partial return to economic orthodoxy, although they could exacerbate inflation and weigh on economic growth.

U.S. Bond Market: New analysis shows that long-term bond yields are currently trading with a “term premium” of -0.75%, far below the average premium of +1.50% since 1961. The figures suggest investors are demanding an unusually low yield premium to hold longer-maturity obligations (i.e., they’re valuing long bonds too richly). The analysis is consistent with our often-expressed concern that long yields are too low, and that those investors who own long bonds are at risk as worries about long-lasting inflation and high interest rates spread.

U.S. Weather Disruptions: Heavy rains continue in the Northeast. In addition to causing mass floods that have killed multiple people, the rains have prompted the cancellation of at least 1,000 airline flights, which will probably require several days to unsnarl. The worst-hit airport has been Newark Liberty International in New Jersey.

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Asset Allocation Bi-Weekly – Are Higher Interest Rates Bearish for Risk Assets? (July 17, 2023)

Posted on July 17, 2023July 13, 2023 by Amanda Ahne

by the Asset Allocation Committee | PDF

Orthodox finance and economics rests on the idea that higher interest rates reduce economic activity and lower the attractiveness of risk assets. We have no real quarrel with the part about reducing economic activity as higher borrowing costs will tend to slow investment and consumer durable spending. The effect on risk assets seems rather straightforward as well. Higher rates should divert funds to fixed income and away from equities and commodities.

However, when debt levels are elevated, rising interest rates could increase interest income. Current debt levels are high.

This chart shows private sector debt (household plus non-financial business sector) scaled to GDP along with general government debt. Although the total is down from the pandemic peak of 304.1%, it is still 262.0% of GDP. Combine that debt level with rapid policy tightening, and interest income would be expected to rise. In fact, in raw terms, it is.

Interest income is about 8% of total personal income, which is lower than the peak of 18% in 1984. Thus, in looking at the overall data, there isn’t a strong case that interest income is all that significant yet.

However, there is a distributional factor that may affect risk assets.

In this chart, we estimate the flows of interest income by wealth distribution. As the chart shows, over the past 18 months, interest income to the top 10% of households has increased significantly. The middle 40% has seen modest gains, while the bottom 50% has seen small increases.

In terms of asset allocation, the top 10% hold around 50% to 60% of their wealth in equities. Increased income flows to this wealth bracket, paradoxically, means that more liquidity is available for other purchases. As long as interest rates stay elevated, we would expect fixed income and cash balances to remain high. Although once policy starts to ease, this additional income will likely look for other alternatives; put another way, the bounce to stocks from policy easing could be higher than expected.

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Daily Comment (July 14, 2023)

Posted on July 14, 2023July 14, 2023 by Amanda Ahne

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a discussion about a possible shift in Fed policy. Next, we give an update on the latest stories surrounding artificial intelligence. Lastly, we end the report detailing the possible ramifications of the breach in the price cap on Russian oil.

Doves Take the Wheel: After months of wishful thinking, traders are now more confident than ever that the Federal Reserve is close to ending its hiking cycle.

Producer price data released by the Bureau of Labor Statistics on Thursday showed that supply price pressures are easing, similar to the recent report on consumer price inflation. The Producer Price Index (PPI) rose 0.24% from the prior year in June 2023, which is much lower than its peak of 12.5% in March of last year. In fact, the June report showed that supplier prices slowed to their lowest rate in nearly three years. This could lead to a slowdown in consumer price inflation, as firms will have an easier time maintaining margins without having to raise prices for their goods or services.
Markets cheered the Federal Reserve’s apparent victory in its inflation fight. The S&P 500 closed up 0.9% on the day, while yields on 10-year Treasury notes fell to a two-week low. Additionally, speculation over monetary policy weighed on the U.S. dollar index, which fell to its lowest level in more than a year. The positive report led traders to downgrade their expectations for the number of rate hikes left for the rest of 2023. Currently, overnight index swaps are pricing in one remaining increase from the Fed, down from the two hikes forecast a week ago.

Despite the investor reaction to the economic statistics, the Fed may still keep interest rate hikes on the table. The year-over-year change in core inflation is still well above the central bank’s 2% inflation target. Federal Reserve Board member Christopher Waller seized on this fact to justify the possibility of two additional rate hikes for the year. However, there appears to be a dovish tilt in the Fed, which is likely to worsen with the recent departure of St. Louis Fed President James Bullard. As a result, it is possible that the next rate hike could possibly be the last of the year.

Pushback Against AI: Excitement over the rapid advances in artificial intelligence (AI) is being tempered by growing concerns about its potential risks.

The Federal Trade Commission is investigating ChatGPT over claims that it has the potential to harm consumers. The technology has been accused of generating misinformation that has caused harm, and of distributing copyrighted work without the consent of the owners. Meanwhile, China released its highly anticipated regulatory framework for AI that is designed to ensure that the chatbots are able to stay true to core socialist values. Similar to what the FTC wants to accomplish, Beijing’s restrictions look to ensure that generative AI technology is publishing reliable information. However, the Chinese government’s framework also goes further, placing restrictions on the types of topics that chatbots can discuss and the way that they can interact with users.
In related news, there is growing concern that artificial intelligence (AI) will lead to major job displacements in the future. On Thursday, Hollywood actors joined screenwriters on strike as they advocate for greater protection against the growing use of AI technology. The backlash was in response to an AI proposal to scan and use images of actors in perpetuity. As depicted in the first episode of the most recent season of Netflix’s Black Mirror, workers in the entertainment industry fear that their likeness and work will be used without their permission. Over the last few years, AI has been used to de-age actors, help generate movie trailers, and even bring back the voices of late performers.

(Source: Variety)

- AI was used to digitally enhance the picture above to make Will Smith look younger.

The recent controversy surrounding AI is a reminder of the ongoing regulatory and political threats that the technology faces in the coming months. There is a legitimate fear that AI will begin to displace workers on a massive scale, with some estimates predicting that it could replace up to 40% of jobs in the U.S. economy. AI’s disruptive potential is likely to make it a target of politicians and regulators, who may seek to implement policies that restrict its use. As a result, investors should take into account current and potential scrutiny when deciding whether to join the recent AI craze.

Price Cap Troubles: The price of Urals crude oil has breached the $60 per barrel cap set by the West, putting countries that continue to import Russian oil at risk of sanctions.

The recent rise in the price of Russian oil is putting pressure on G-7 nations to enforce disciplinary actions in their efforts to cap Russian oil exports. The Western bloc imposed the cap as a way to constrain Moscow from receiving much-needed revenue for its war efforts. Recent data showed that the restrictions have been successful in limiting Russia’s ability to profit from its oil, with revenue nearly halving since last year. However, the increase in oil prices is threatening to undermine the cap’s credibility, as it suggests that Moscow may have more market power than the West realized.
That said, it is unclear whether other countries are willing to risk sanctions to obtain Russian oil. India and China have been the biggest beneficiaries of the price target as the countries have been able to take advantage of the steep discounts. The recent breach may force buyers to consider alternatives as it is unclear whether they are willing to tolerate the headache of possible sanctions. Indian refiners are already preparing for talks with local banks over financing Russian cargoes. So far, it is unclear how China will deal with the situation.

The breach of the $60 per barrel cap on Russian oil will provide a fresh test of the effectiveness of Western sanctions. If firms abide by the restrictions set by the G-7 countries, Moscow will need to offer steeper discounts on its oil in order to continue selling its goods abroad. This should dissuade Russia from cutting production to boost prices. If firms continue to purchase Russian oil despite the threats of sanctions, Russia could then collaborate with its OPEC counterparts to implement new production cuts, which could lead to an increase in global oil prices.

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