by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where a key Russian blogger has broken taboo and directly criticized President Putin for his management of the invasion.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including some welcome signs of increased investments in U.S. manufacturing and energy production.

Russia-Ukraine War:  Reports indicate that Aleksandr Lapin, the former commander of the Central Military District forces that allowed the Ukrainians to recapture huge swaths of territory in eastern Ukraine last summer, has been reassigned to take over as chief of staff of the Russian ground forces.  In response, influential Russian military blogger and former rebel commander Igor Girkin published a criticism of President Putin for appointing and refusing to remove Russian military leaders who oversee frequent and disastrous military failures.  The criticism marks one of the first times an influential nationalist has directly criticized Putin for his management of the war.  It therefore signals how the disastrous invasion continues to undermine Putin’s political position within Russia.

Saudi Arabia-Pakistan:  The Saudi government said yesterday that it is considering offering some $11 billion in aid to Pakistan to help it avoid a threatened default on its foreign debt.  Along with earlier offers of aid from the United Arab Emirates and Qatar, the major Middle East oil producers have now said they may provide up to $22 billion to Pakistan.

• The support could strengthen Pakistan’s hand in negotiating a restart to a stalled bailout from the International Monetary Fund.
• Pakistan has so far been unwilling to agree to the IMF’s terms for a deal, which include raising electricity and gasoline prices and increasing taxes.

Egypt:  As part of its negotiations for a $3-billion bailout from the IMF, the Egyptian government has reportedly agreed to reduce the role of the military in the country’s economy, including via the privatization of military-owned businesses.  The military’s economic activity has spread through the economy since President Abdel Fattah al-Sisi took power in a coup in 2013, reducing opportunities for private business owners.

Brazil:   As prosecutors in Brazil continue to investigate last weekend’s capital rioting by supporters of Former President Bolsonaro, the former leader said he will leave the U.S. and return to Brazil within a few weeks.  Bolsonaro’s return to Brazil would likely be welcomed by the White House, which has come under pressure from some Democrats to expel him.

Peru:  At least 17 people have been killed in political protests this week, as the demonstrations intensify against last month’s removal and detention of Former President Castillo.  According to the country’s independent human rights office, 39 civilians have been killed in the unrest since Castillo’s arrest, while the defense ministry says 75 police officers have been injured.  The continued violence could threaten production at Peru’s globally important mines producing copper and other key minerals.

United States-China-Taiwan:  A series of 24 war games held by the Center for Strategic and International Studies found that an alliance of the U.S., Japan, and Taiwan would likely be able to repel a full-scale Chinese invasion of the self-governing island, but at the high cost of dozens of navy ships, hundreds of aircraft, and tens of thousands of troops over three to four weeks of fighting.  The report recommends that the U.S. improve its effort to increase deterrence against the Chinese by raising the expected costs that they would pay for an invasion.

U.S. Demographics:  A new study from the Aspen Economic Strategy Group finds that falling birth rates, declining population growth, and population aging are among the biggest risks for the future U.S. economy.  To address the threat, the study recommends that the U.S. adopt policies to increase fertility and boost immigration.

U.S. Monetary Policy:  At an event with other central bankers in Sweden yesterday, Federal Reserve Chair Powell said that he remains strongly committed to lowering inflation by restraining economic growth through interest-rate increases, even if doing so fuels political blowback.  In fact, he stressed that preserving the Fed’s ability to make tough economic calls without political interference would require it to avoid straying into issues that aren’t directly related to its economic-management objectives, such as climate change.

U.S. Industrial Policy:  South Korean conglomerate Hanwha Group (000.880.KS, KRW, 27,200) said that it will invest $2.5 billion to expand the production of solar panels and components at a facility in Georgia.  The commitment would reportedly be the biggest foreign direct investment in U.S. solar manufacturing ever.

• The South Korean plan is also a sign that the big green-energy subsidies in the recently passed Inflation Reduction Act are already drawing increased investment to the U.S. that otherwise may have gone to other countries.
• That risk has already generated pushback from the European Union, prompting some limited concessions from the U.S. We suspect that the U.S. subsidies will continue to spur concerns by other countries as more investment is redirected toward the U.S.  The U.S. program will also likely spur calls for similar subsidies in other countries.

U.S. Oil and Gas Industry:  Despite popular perceptions that U.S. oil and gas drilling is at a standstill, the Wall Street Journal has an interesting article today showing that activity in at least some regions is actually beginning to boom again, especially in natural gas fields.  We still suspect that environmental regulations, the rise of green energy, and investor demands for capital discipline will slow new energy investment and contribute to higher energy prices in the future, but today’s article points to at least some new activity after a long period where high prices failed to prompt the usual supply response.

U.S. Air Travel Industry: This morning, the Federal Aviation Administration halted all domestic air departures until at least 9:00 am ET due to an outage of its computer system that alerts pilots to advisories and other flight information.  The halt has reportedly produced numerous flight delays, pushing airline stocks lower.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the news of a potential mine shutdown that would affect global copper supplies and the increased tensions between China, Japan, and South Korea.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs that Pakistan is getting closer to defaulting on its foreign debts, and more indications that the Federal Reserve could soon slow its interest-rate hikes to just 25 basis points per meeting.

Global Copper Market:  Canadian miner First Quantum Minerals Ltd. (FQVLF, $23.19) said that it will shut down its vast copper mine in Panama, which produces about 1.4% of the world’s copper supply, if it can’t resolve a tax dispute with the Panamanian government.  Global copper prices remain in retreat, in large part because of the threat of recession in the West and lower demand from China as it deals with its latest COVID-19 wave.  Nevertheless, any outage at the FQM mine could help put a floor under prices or even give them a boost.

China-Japan-South Korea:  Today, the Chinese government suspended visa issuance to travelers from Japan and South Korea, marking its first formal retaliation for the COVID-19 testing rules those countries and others have imposed on travelers from China because of its massive new wave of infections.

• The move illustrates how willing China is to wield its massive economic power as a source of coercion or consensus-building to influence other countries’ behavior.
• As we wrote in our latest Bi-Weekly Geopolitical Report, published yesterday, China will probably grant or deny access to its vast market and capital flows in order to eventually establish a neo-colonial relationship with the countries in its evolving geopolitical bloc.

Russia-Ukraine War:  After weeks in which the front lines from eastern to southern Ukraine were largely static, Russian forces have reportedly been able to capture most of the town of Soledar, just to the northeast of the embattled city of Bakhmut.  That gives Russia a rare but mostly symbolic victory and will make it more difficult for Ukraine to hold Bakhmut, although the city isn’t expected to immediately fall.  The Russian move also comes as reports indicate that the country’s government will soon announce the mobilization of 500,000 more troops in another special draft.

• Separately, after several countries last week agreed to send light tanks or armored vehicles to Ukraine, British officials said they have been discussing sending their Challenger 2 main battle tanks.
• Poland, Finland, and other European countries are also considering sending heavily armored, powerful tanks, which in sufficient numbers could provide a major boost to Ukraine’s military power.

Brazil:  Following the weekend’s capital rioting by supporters of right-wing Former President Bolsonaro, the country’s supreme court yesterday ordered the suspension of the federal district’s governor, a Bolsonaro ally.  The move is likely to further anger Bolsonaro’s supporters and could exacerbate the country’s political polarization.  Separately, some Brazilian politicians who accuse Bolsonaro of inciting the unrest have demanded he be extradited from the U.S., where he has been for the last two weeks.  Some prominent U.S. Democrats have echoed that call.  However, the White House has merely said that it would treat any extradition request seriously.

Pakistan:  Facing dwindling currency reserves and a high risk of default on its foreign debts, yesterday the Pakistani government begged the International Monetary Fund to ease the harsh conditions on its funding program for the country in order to unleash billions of dollars of additional loans.  The IMF officials made no commitment to easing the terms.

Canada:  The Canadian government announced yesterday that it will buy 88 advanced F-35 fighter jets from Lockheed Martin (LMT, $458.99) to modernize its air combat capabilities.  The total cost of the purchase will be approximately $14 billion.  The purchase illustrates how much the West’s increasing defense budgets and military modernization efforts are likely to benefit U.S. defense firms, given their cutting-edge technologies and production capacity.

U.S. Monetary Policy:  San Francisco FRB President Daly said yesterday that because of the lags before changes in monetary policy affect the economy, it might make sense for the Fed to slow its interest-rate hikes to just 25 basis points beginning at its next policy meeting.  According to Daly, that would give the policymakers more time to assess how their previous aggressive rate hikes are affecting economic activity.  Meanwhile, Atlanta FRB President Bostic yesterday stated he would consider a 25-bps hike more seriously if Thursday’s inflation report shows that the consumer price index is slowing in line with other recent data releases.  The statements place a spotlight on Fed Chairman Powell’s remarks later today when he may weigh in on the issue.

U.S. Student Loan Market:  Today, the Department of Education released a proposed rule that would make it easier for student loan borrowers to use income-driven repayment plans and get out of their debt sooner.  For example, the minimum amount of monthly discretionary income that would have to be paid on their loans would be cut to 5% from the current 10%.  Borrower loan balances wouldn’t grow as long as they make their payments, which basically would amount to loan forgiveness for the borrowers with the lowest incomes.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an update on the post-pandemic landscape in China, where the relaxation of pandemic lockdowns continues to reverberate throughout the domestic, regional, and global economies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the weekend’s big capital riot in Brazil and the election of Kevin McCarthy as Speaker of the House.

China Reopening:  As of Sunday, the Chinese government has removed most of its COVID-19 restrictions on international travel, prompting tens of thousands of air arrivals and departures.  The move could eventually help the tourism industry in countries that had become dependent on Chinese visitors before the pandemic, especially in Asia, but outbound Chinese tourism won’t immediately rise to its pre-pandemic levels given that many foreign countries have slapped testing requirements on them to keep China’s surging infections from spreading.  It may also take the airlines some time to re-orient their fleets toward China again.

• Separately, the reopening of the economy appears to be boosting global oil prices today, even though the relaxation of pandemic lockdowns has led to a current surge in infections and is actually crimping current economic activity.
• So far this morning, front-month Brent crude oil futures are trading up some 2.9% at $80.82 per barrel.

China Regulatory Policy:  The China Securities Regulatory Commission is reportedly preparing to cease allowing local companies in certain sectors to list on the Shanghai or Shenzhen stock exchanges so that the government can channel funding into strategic industries.  The sectors to be “red lighted” will reportedly include food and beverage chains and COVID-19 testing firms.  The CSRC will also name a number of “yellow light” sectors, such as apparel and furniture, where initial public offering requests could come under heavy scrutiny if their growth relies heavily on debt for expansion.

• Over the last few years, the government has clamped down hard on big economic sectors that leaders felt had become too powerful, wasteful, or simply at odds with President Xi’s vision of good communist values. The real estate development, information technology, and on-line tutoring industries were prime targets, and their investors paid a heavy price.
• The new red-light and yellow-light rules mark a further blow to China’s free markets. In turn, they will likely contribute to rising investor skepticism about China and could potentially drive more foreign investors elsewhere.

Russia-Ukraine War:  Fighting continues along the front lines running from eastern to southern Ukraine, with the Russian military continuing to stage air attacks against critical Ukrainian energy infrastructure.  To sustain its air attacks even as it has depleted much of its own conventional and advanced missiles and artillery, Russian officials say they are about to begin domestic production of Iranian-designed kamikaze drones.

• Separately, a new Atlantic Council survey found that 46% of the 167 foreign policy analysts polled thought that Russia could become a failed state or break up by 2033.
• Also in the survey, 40% pointed to Russia as a country they expected to break up for reasons including “revolution, civil war or political disintegration” over that time.

NATO Expansion:  Swedish Prime Minister Kristersson warned that his government can’t meet some of the demands Turkey is making before it would lift its veto over Sweden entering the North Atlantic Treaty Organization.  Turkey’s demands focus on Sweden’s alleged ties to Kurdish separatists in Turkey.  It is not clear whether Ankara will finally acquiesce to Sweden and Finland joining NATO after Turkey’s presidential elections sometime in the coming months.

France:  After abandoning his first effort to reform the country’s pension system due to the COVID-19 pandemic, tomorrow President Macron plans to propose a new reform that would increase the minimum pension but raise the age at which retirees can get the full benefit.  The aim is to cut the massive fiscal cost of the country’s pension system and boost the incentive to work.  However, most French voters object to the proposed reforms, and labor leaders have threatened a series of strikes to oppose them.

United Kingdom:  As the country continues to reel from economically damaging work stoppages across the railroad and healthcare sectors, Prime Minister Sunak’s government is planning to meet union leaders today in an effort to avert further strikes.  Of great importance is a threatened teachers’ strike.  Since the beginning of the year, Sunak has somewhat moderated his stance toward the strikers, although he still insists he will keep any resolution of the strikes from overly burdening the government’s budget or further boosting inflation.

Brazil:  Thousands of supporters of the country’s right-wing former president, Jair Bolsonaro, stormed the presidential palace, national parliament, and supreme court buildings yesterday and demanded that the military remove newly inaugurated leftist President Lula da Silva, who beat Bolsonaro in the October presidential elections by 51% to 49%.  Bolsonaro has refused to concede defeat in the elections, but the military, so far, has not shown signs that it supports his argument that the elections were marred by fraud.

• Bolsonaro has decamped to Florida, as has his former justice minister, who had been named as the federal district’s public security chief.
• The presence of both Bolsonaro and the federal district’s public security chief in Florida will likely raise concerns that the storming of the capitol was preplanned and that the two men left the country in an effort to distance themselves from the action. However, Bolsonaro eventually condemned the rioting and claimed no connection with it.
• In any case, the storming will likely raise concern about the resilience of Brazil’s democracy. Investors certainly have concerns about the leftist president’s economic policies, but political instability would add to the headwinds for Brazil’s stock market.

U.S. Congressional Politics:  The new Republican majority in the House of Representatives finally elected Rep. Kevin McCarthy as Speaker of the House early Saturday morning, but only after he made a series of concessions to far-right wing members of his party that will leave him severely weakened.  The 15 rounds of voting needed to elect McCarthy as well as his compromises are widely being panned as another sign that political polarization is leaving the U.S. ungovernable.

U.S. Monetary Policy:  At a conference on Friday, Richmond FRB President Barkin warned that the Federal Reserve is likely to continue raising interest rates because its mandate to control inflation will trump the risk of causing a recession.  The statement marks a further Fed effort to keep business leaders cautious even though some investors and analysts are already looking for a potential monetary loosening.

U.S. Weather and Drought:  California is preparing for yet another major rain and snow storm today, but scientists warn that the recent torrents aren’t nearly enough to end the state’s drought.  Continued water-use restrictions are therefore likely to continue weighing on California’s economy.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion about Fed officials’ speeches and the U.S. jobs numbers. Up next, we review how rising inflation in the developed world impacts investing in emerging markets. We end the report by focusing on Russia and China’s ability to use state power to generate growth as their economies cope with headwinds.

All About Timing: Some investors are positioning themselves for a Fed Pivot, despite monetary policymakers’ insistence that they are not finished tightening.

• Fed officials reaffirmed the central bank’s commitment to tightening policy until inflation falls to its 2% target. Atlanta Fed President Raphael Bostic argued that inflation is the biggest headwind to the U.S. economy, and in an interview with CNBC, his colleague from Kansas, Esther George, added that she would like the Fed’s policy rate to rise above 5% and have it held there until 2024. Meanwhile, St. Louis Fed President James Bullard struck a moderate tone suggesting that interest rates are almost high enough to bring down inflation.
• The labor market remains too hot for the Fed. According to the Bureau of Labor Statistics, the economy added 233k jobs in December, while the unemployment rate fell from 3.7% to 3.5%. Although job creation has eased in recent months, the Fed has made it known that it would like the unemployment rate to increase before it reverses course on policy. As a result of the data, the S&P 500 dropped, and bonds rallied as it added to evidence that the Fed will need to continue tightening.

• Data suggests that the rise in hourly wages may be a side effect of elevated margins from firms. The chart above looks at the annual change in trade services, a measure of retail and wholesale margins, and average hourly wages. If we are correct, a profit margin decline should contain wage growth, relieving some inflationary pressure.

• The Federal Reserve is in a difficult position as it decides what will be the appropriate policy going forward. Although it is clear that the central bank will be ready to pause rate increases later this year, the Fed is reluctant to commit due to concerns that it might be caught flat-footed by inflation. The anticipation of the conclusion of the Fed’s hiking cycle has led investors to position themselves to take advantage of any positive surprises within the data. This behavior may have the Fed worried that financial markets are assuming that it will cut rates aggressively if the economy falls into recession. As a result, we expect policymakers to stress that a pause is not the same as monetary easing.

The Saver’s Rush: The fight against inflation in the developed world may deter overly sensitive investors from allocating capital to emerging markets.

• Inflation in the Eurozone returned to single-digit territory in December, but concern remains about persisting price pressures. The overall consumer price index rose 9.2% from the prior year, below the previous month’s increase of 10.1%. The dip in the index is related to the slide in energy prices. That said, excluding volatile elements, the index rose 5.2% from last year, a jump from the prior month’s report of a 5.0% increase. Price pressures in core components of the index will motivate the European Central Bank to raise rates by at least 50 bps at its next meeting.
• Meanwhile, in another part of Europe, deceleration in inflation has led to a decline in equity prices. Several days after the Turkish CPI fell by more than 2000 bps, the country’s BIST 100 Composite Index sank by more than 8%. The sharp drop in the index is especially notable, given its strong performance in 2022, when Turkish equities more than doubled. Although much of the decline is related to investors locking in gains from their investments, it also reflects the tendency for investors to pull out of risky countries at the first sign of trouble.

• A lesson can be taken from the situation in Turkey. In this case, we learned that investing can be more about circumstances than solid fundamentals. As the chart above shows, the rise in the BIST 100 in 2022 was largely driven by domestic savers trying to protect the purchasing power of their holdings. Argentina’s stock market, which also performed well in 2022, is another place where this may be happening. The reason for these investments is that equities serve as a form of value storage in countries where inflation is uncontrolled. Hence, high-inflation countries may present short-term opportunities for investors looking to earn capital gains abroad. That said, as global yields begin to rise in the developed world, these countries could face financial outflows as investors become more risk averse.

Return of the State: China and Russia’s governments are intervening in their own economies to prevent backsliding.

• Beijing is pulling out all the stops to help restore faith in its economy. Chinese regulators are considering relaxing the country’s “Three Red Lines” property rules to incentivize more real estate investment. They are also exploring the possibility of raising borrowing caps and delaying the grace period for meeting debt targets. These moves are controversial as China has not fully recovered from the fallout of its property meltdown. However, these measures have added to investor confidence that Beijing will get its economy back on track after ending its draconian Zero-COVID policy.
  •  As a result of Beijing’s actions over the last few months, the off-shore CNY has surged 7% since October 25, when it hit the weakest level on record, and is currently trading above its 200-day moving average.
• Meanwhile, Moscow has ramped up the pressure on state-owned firms to help fund its war efforts in Ukraine. The government has called for “revenue mobilization,” in which state enterprises pay higher dividends and one-time payments to help improve the country’s fiscal budget. The order could be harmful to its coal-producing sector, which has recently returned to near high levels after Europe loosened transportation restrictions. The Russian government’s pressure on companies signals that the West’s sanctions are working to starve Moscow of the funds needed to maintain its war efforts. However, it also shows that the war is still disruptive to the commodity market.
• Recent moves by China and Russia suggest that as the world becomes more polarized, governments will look to have greater economic control. In the short term, this could benefit international equity markets as stimulus will increase domestic demand and make it easier for firms to boost production. However, as blocs and countries become isolated, firms could struggle to find the opportunities to widen their customer base. Thus, we may be headed to a world that is more favorable to real assets, such as commodities, rather than financial assets.

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 global central banking. Next, we discuss why political uncertainty in the U.K. and the U.S. may impact investment decisions within these countries. Lastly, we review the challenges companies may face when navigating in a less globalized world.

Monetary Moderation: Although financial conditions will likely remain tight around the world, interest rates may peak later this year.

• The Federal Reserve wants investors to know that it is not ready to take its foot off the pedal in the fight against inflation. The Federal Open Market Committee (FOMC) meeting minutes released on Wednesday showed that policymakers are concerned that financial markets are prematurely pricing in an interest rate cut. As a result, the FOMC emphasized that policy easing would not start until inflation fell to its 2% target. Additionally, it warned that unwarranted easing in financial conditions could complicate the bank’s efforts to restore price stability. That said, policymakers seem inclined to keep their next few hikes at 50 bps or lower in their upcoming meetings.
  • Although policymakers support keeping the policy rate in restrictive territory, some members are open to a pause. Minneapolis Fed President and notable hawk Neel Kashkari said that he would like rates to rise another 100 bps before the central bank halts its hiking cycle. Based on the market projection of rate increases, this could mean that the Fed could be finished with its hiking cycle in July at the latest.
• China’s central bank reiterated its commitment to maintaining a relatively loose monetary policy in order to promote economic growth. The People’s Bank of China will use its monetary tools to ensure ample liquidity as the economy transitions from Zero-COVID. The country is determined to stimulate growth, and it has already loosened restrictions on property lending and is considering fiscal stimulus. So far, the monetary easing has not boosted household consumption, as consumers are still reluctant to engage in service activities while COVID spreads. Although the country’s latest inflation reports showed CPI rising 1.5% from the previous year, the additional stimulus may prop up inflation down the road.
• Meanwhile, a sharp deceleration in inflation has helped push down bond yields for European countries. The yield on 10-year German bonds fell for the fourth consecutive day on Wednesday, its longest streak since November. Italian bonds also performed well with the yield gap between German and Italian debt, a gauge for financial stress within the Eurozone, narrowed to its lowest level in three weeks. Although the decline in inflation will not prevent the European Central Bank from hiking rates in its next meeting, it does signal that the central bank will not need to be as aggressive to tame inflation as policymakers originally thought.

Populist Uncertainty: The U.S. and U.K. are finding it increasingly difficult to form a government that can satisfy the needs of all the varying party coalitions.

• The U.S. House of Representatives failed to select a new Speaker for the sixth consecutive vote. Although Republicans have a majority, a few holdouts have refrained from choosing Congressman Kevin McCarthy for the position. The constant jockeying from the far-right politicians for more influence within the party may be a bad omen for worse things to come later in the year. For example, if the Republicans can’t agree on something as simple as the Speaker, how are they supposed to agree on a budget? Although situations like this should make reaching across the aisle more appealing, political polarization makes that option costly for lawmakers, and therefore unlikely to happen. As a result, debt default due to a refusal to raise the debt ceiling cannot be ruled out.
• In the U.K., Prime Minister Rishi Sunak has come under scrutiny for not articulating a clear vision for the country going forward. The country is currently undergoing several crises, from rising work stoppages to crumbling National Health Services, as well as an imminent recession. To address these concerns, Sunak has made a five-point pledge he outlined as the peoples’ priorities. The pledge includes: a cut in inflation by the end of the year, growth in the economy with a decrease in the national debt by the end of the current parliament, a cut to the NHS waitlist, and the passage of stringent immigration laws. If Sunak were to fail to make good on these promises, his premiership could be in jeopardy.
  • Although many of the goals are achievable, the first two could be difficult to accomplish. Inflation is expected to be more persistent in the U.K. than in other countries and it is expected that the next recession will be worse than the pandemic downturn.
• The political divergence reflects the toll of the growing polarization within these countries. The last time that the U.S. failed to elect a Speaker of the House was in 1823, and the event served as a prelude to the Civil War. Meanwhile, Brexit still divides the U.K. as the country has yet to figure out its identity going forward. Although it is unlikely that populist elements will be able to take firm root within these governments any time soon, political disruptions are likely to become normal. As a result, investors should pay closer attention to regulatory threats that immigration, free trade, and tech will pose to their investment portfolios within these countries.

Great Powers at Play: As the war rages on in Ukraine, companies are beginning to adjust to a world divided by blocs.

• Despite the recent success of Ukraine, there are still concerns that Russia could stage a comeback. NATO Secretary-General Jens Stoltenberg has warned members not to underestimate Russia. Meanwhile, a possible new mobilization push by Russia has led Ukrainian President Volodymyr Zelensky to ask for more military assistance from the West. The rise in concern has led allies to pledge to send more military equipment. However, the additional aid for Ukraine increases the likelihood of a prolonged war.
  • In an attempt to end the conflict, Turkish President Recep Tayyip Erdoğan has urged Putin to declare a ceasefire to pave the way for peace talks.
• Additionally, companies are starting to diversify their supply chains in order to adapt to a less predictable world. Apple (AAPL, $126.36) has already shifted some of its operations out of China in favor of India and Vietnam. The trend was also reflected in a 2022 survey that revealed that the ratio of executives expressing concern about the political risk in China had jumped to 20-1, compared to 2-1 two years prior. As companies look to rearrange their supply chains, it could lead to higher global inflation but could benefit countries that don’t align with either bloc.
• MSCI Asia ex-Japan is trading near a four-month high and is set for its fourth straight day of gains. Although much of the growth is related to China’s relaxing of its Zero-COVID restrictions, we suspect that other countries within the index could also benefit in 2023 as companies look to reshore their operations in nearby countries. The size of India’s labor force and its neutral status could make it an investment target, and therefore, bears watching. Indonesia could be another country of interest due to its natural resources.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with some positive news from Europe, where year-over-year price inflation looks like it may be moderating.  The news has raised hopes of lower inflation and interest rates even beyond Europe, giving a boost to the stock and bond markets as well.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the Russia-Ukraine war and an update on the historic challenges that the U.S. House of Representatives is having in selecting a new Speaker.

France:  The December Consumer Price Index (CPI) was up just 6.7% in the year ending in December, coming in cooler than expected and marking a slight improvement from the annual gains of 7.1% in each of the previous two months.  Much of the slowdown in inflation reflected falling energy prices—the result of both warm weather across the Northern Hemisphere that has helped bring down global natural gas prices and government efforts to cap prices.

• Excluding energy and unprocessed food, the December core CPI accelerated to an annual rise of 5.3%, compared with a rise of 5.0% in the year to November.
• Despite the acceleration in core inflation, the decline in the headline number has sparked optimism about slowing inflation and lower interest rates throughout Europe and beyond. In turn, that has buoyed stock and bond prices in multiple markets so far this morning.

United Kingdom:  Because of Europe’s recent warm weather and reduced global prices for natural gas, analysts now believe British household energy bills in 2023 will be lower than previously anticipated, dropping below the level of the government’s price guarantee in the second half of the year.  The resulting fall in the cost of living would not only be politically positive for the government, but it would also limit the fiscal cost of its programs to shield households from high inflation.

Russia-Ukraine War:  As heavy fighting continues along the front lines and Russia keeps launching air strikes against Ukraine’s infrastructure, Russian oligarch Yevgeny Prigozhin has admitted that his Wagner Group mercenaries have stalled in their effort to seize control of the eastern Ukrainian city of Bakhmut.  Other reporting suggests that Russian forces have shifted their focus to the smaller city of Soledar, just to the north of Bakhmut.  In any case, Prigozhin’s admission may be laying the groundwork for further criticism of the Russian Ministry of Defense, which Prigozhin is using to implicitly establish himself as a more effective leader who is ready to take power.

European Union-China:  With COVID-19 cases continuing to rip across China following the sudden end of the government’s Zero-COVID policies, the European Union today is expected to finalize a requirement that Chinese travelers must test negative for the disease before boarding flights to the EU.  The move would come as France, Spain, and Italy have already imposed such testing rules, but a bloc-wide requirement would further embarrass and anger Beijing and feed into the global fracturing that we so often write about.

U.S. Congress:  Yesterday’s voting for the new Speaker of the House proved to be inconclusive, after Republican Kevin McCarthy failed to secure a majority even after three rounds of voting.  It was the first time the House hasn’t been able to select a Speaker on the first ballot since 1923.  The voting will continue today.

• The conservatives’ disciplined opposition to McCarthy may be a good example of the “vetocracy” engendered by polarized politics and strong interest groups, as described by Sarah Quinn in her book American Bonds.
• McCarthy has vowed to take as many votes as necessary to win the position, aiming to wear down his right-wing opposition, so it is not clear when the balloting will be complete and when a new Speaker will be selected.

U.S. Labor Market:  Workers at videogame firm ZeniMax, a unit of Microsoft (MSFT, $239.58), have voted to form a union, marking the latest example of labor organization within the largely non-union information technology industry.  The vote illustrates how today’s labor shortages have shifted economic power towards workers and away from managers and owners.

U.S. Weather:  Beginning today, the West Coast will be facing its third major rain and snow storm since Christmas.  The National Weather Service has already warned of flooding, especially in northern California, which implies the risk of meaningful economic disruptions, although the storms could potentially help end California’s recent drought.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with an update on all the key global developments over the holiday period, including the latest on China’s new COVID-19 wave and how it’s affecting international relations.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an update on Brazil’s new president and today’s election in the U.S. Congress for Speaker of the House.

China COVID Crisis:  Over the holiday weekend, additional major developed countries imposed COVID-19 testing requirements on travelers from China due to its recent relaxed pandemic controls which have caused a surge in infections.  The rules generally require travelers on flights originating in China to submit a negative test no more than two days before boarding.

• The list of countries requiring tests now includes the U.S., Canada, Japan, the U.K., France, Spain, and Italy. Although the new rules were probably spurred by legitimate concerns about importing new COVID-19 cases from China, it’s notable that the countries imposing the tests are all important members of the evolving U.S.-led geopolitical and economic bloc.
• Even if the testing rules are short-lived, as planned, they have angered the Chinese government and will likely prove to be yet another brick in the wall being erected between the U.S. and Chinese blocs. This geopolitical and economic wall has, thus far, been focused on impeding trade, technology, and capital flows, but the new COVID-19 testing rules show that the wall can also limit human travel and migration.

China-European Union:  Today, the European Commission announced that it has offered China free doses of the West’s highly effective, variant-adapted vaccines, but Beijing immediately rejected the offer, citing the “strengthening clinical efficacy” of its “ample” domestic shots.

• China’s prompt rejection of the EU’s offer illustrates how strongly politics plays into Beijing’s pandemic policy. In Beijing’s eyes, accepting the EU’s offer would legitimize Western vaccines and highlight the relatively low effectiveness of China’s domestic shots, and would run counter to Beijing’s “East is rising, West is falling” political mantra.
• The relatively low vaccination rates in China, especially among its elderly population, is a key reason for the new wave of infections following the lifting of President Xi’s draconian Zero-COVID policies.

China-United States:  Faced with the U.S.’s aggressive new restrictions on exporting advanced computer chip technology to China, an official at the China Semiconductor Industry Association stated that his country will likely shift its strategy toward making incremental improvements in its current, relatively basic capabilities, rather than building new, cutting-edge technologies.  The revamped approach would put more resources into areas where China already has an advantage and where the U.S. is less likely to impose export curbs, such as mature process technologies.

• Even though the U.S. is still working to bring key allies onboard with its full export restrictions, the CSIA official’s statement shows that the new rules are already proving effective in changing China’s behavior and suppressing its technological and economic prospects. Over time, such technology headwinds will likely weigh on the Chinese military, economy, and financial markets.
• We suspect that many Western observers still don’t fully appreciate how aggressive the new U.S. technology restrictions are.
  • The rules essentially aim to clamp down on exports of advanced U.S. semiconductors, semiconductor technologies, computer chip components, chip-making machines, and even chip-related services to China.
  • If similar rules were being enforced by the U.S. Navy somewhere in the South China Sea, it would amount to a partial naval blockade, i.e., an act of war.

Eurozone:  As the European Central Bank continues to hike interest rates aggressively and cut back on its bond purchases, nine out of 10 economists polled by the Financial Times said that Italy is the Eurozone country most at risk of an out-sized sell off of its government bonds in 2023.  Despite Italian Prime Minister Meloni’s plans to rein in her country’s budget deficit, investors are focused on the fact that Italy’s total government debt burden remains one of the biggest in Europe, at about 145% of gross domestic product.

United Kingdom:  The country continues to face waves of strikes as the new year begins, with railway workers set to walk out on Tuesday, Wednesday, Friday, and Saturday this week in a dispute over pay, job security, and changes to working practices. Train drivers represented by a separate union will walk out on Thursday in a dispute over pay, completing five days of travel misery for passengers.  The strikes, in multiple industries, are creating political challenges for Prime Minister Sunak and further disrupting British economic growth.

European Union-United Kingdom:  Irish Prime Minister Leo Varadkar has admitted that the trading arrangements imposed pursuant to the post-Brexit trade deal between the EU and the U.K. are being applied too strictly.  Importantly, he admitted that the deal’s Northern Ireland Protocol, which creates a trade barrier between Great Britain and Northern Ireland, had made unionists in Northern Ireland feel less British.

• Varadkar’s conciliatory statement raises hopes that the EU and the U.K. may come to an agreement to adjust the protocol in the coming months.
• Adjusting the protocol could ease EU-U.K. tensions and potentially boost British economic growth by restoring some U.K. trading links with the EU.

Russia-Ukraine War:  Heavy fighting continues along the front lines running from eastern to southern Ukraine, although it appears neither side is making significant headway at the moment.  Meanwhile, the Russians continue to launch missile and kamikaze drone attacks against Ukrainian infrastructure, but the Ukrainians claim that they are now able to shoot down virtually all the Iranian-made drones sent against them.  If that claim is accurate, it could potentially mean that Russia will eventually give up on the tactic or escalate to the use of Iranian-supplied ballistic missiles.  Meanwhile, poor operational security apparently allowed the Ukrainians to kill dozens of recently mobilized Russian troops with a U.S.-provided missile system over the holiday weekend, prompting a new round of criticism from Russian ultra-nationalists and creating more political headaches for President Putin.

Brazil:  Former President Luiz Inácio Lula da Silva was inaugurated again on Sunday, but without the traditional passing of the presidential sash meant to symbolize the peaceful transfer of power.  That was precluded because President Bolsonaro had fled to Florida on Friday in an apparent attempt to shield himself from the new government’s corruption investigations.  Among Lula’s first acts under his new presidential mandate to move Brazil’s economic and social policy to the left, he has:

• Reiterated his intention to abandon Brazil’s constitutional cap on public spending to increase outlays on his preferred social programs.
• Revoked an eleventh-hour decree from the Bolsonaro administration that gave a tax break to large companies.
• Ordered his ministers to end studies on privatizing energy group Petrobras and the national post service Correios.
• Revoked a decree that allowed for “artisanal” gold mining on indigenous land.
• Revoked a decree that made it easier to buy guns.

Uruguay:  Allegations that a personal bodyguard to President Luis Lacalle Pou was selling fake passports, potentially to Russians trying to flee their country after its invasion of Ukraine, have now ballooned into a wide-ranging corruption scandal.  The scandal threatens to undermine Uruguay’s reputation as one of South America’s more stable and well governed countries.

U.S. Congressional Politics:  In the race to become the new Speaker of the House, Republican Kevin McCarthy’s bid remains up in the air due to opposition from his party’s right wing.  McCarthy has acquiesced on requested rules changes that give rank-and-file members more power, including making it easier to oust the speaker, but it’s not clear whether that will be enough to win the gavel when the voting takes place at midday.

U.S. Labor Market:  New analysis from the Atlanta FRB shows that wages for workers who stayed at their jobs were up 5.5% in November from a year earlier, averaged over 12 months.  That marked the biggest annual wage gain in the 25 years of available data.  Moreover, the report showed that workers who changed companies, job duties or occupations saw even greater wage gains of 7.7% year-over-year.

• The wage gains are likely contributing to today’s elevated inflation rates as companies boost prices to cover their higher labor costs.
• All the same, the wage gains haven’t necessarily been enough to offset the higher costs that workers are facing. Data from the Labor Department shows that after accounting for price inflation, wages for all private-sector workers were down 1.9% from the same month one year earlier.

View PDF