by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with energy industry warnings about insufficient oil supplies in the coming years, which is consistent with our positive outlook for commodity prices once the economy gets past the impending recession.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an overview of Federal Reserve Chair Powell’s testimony before the Senate Banking Committee yesterday.  Powell continues his semi-annual testimony today at 10:00 AM EST before the House Financial Services Committee.

Global Oil Supplies:  Energy industry leaders attending the annual CERAWeek conference in Houston have been warning that rising exploration and production costs and investor pressure to return cash to shareholders will crimp the growth of future shale oil supplies, leading to higher oil prices in the future.  The assessment is consistent with our view that commodities, in general, and mineral fuels, in particular, are likely entering a period of elevated prices and good returns due to geopolitical frictions, deglobalization, and insufficient investment.

Russia-Ukraine War:  After U.S. and German media reports suggested that a “pro-Ukrainian” group was responsible for last September’s bombing of the Nord Stream 1 and 2 natural gas pipelines under the Baltic Sea, a top Ukrainian official denied that his government had any involvement in the attack.  Nevertheless, German officials today detailed some aspects of their investigation that seem to point in the same direction as the media reports.

• All the same, the media reports do sound plausible, given that the pipelines running from Russia to Western Europe were key to building Europe’s dependence on Russian energy. Putting the pipelines out of commission has helped accelerate the Continent’s rapid shift away from Russian energy sources and arguably helped buttress Western Europe’s ability to support Ukraine in its defense against Russia’s invasion.  The bombings were, therefore, certainly in Ukraine’s interest.
• An important question remaining is whether Ukrainian special forces or intelligence operatives had the expertise and equipment needed to carry out the attacks without being detected. A further question would be whether they had any help from the U.S. or other countries.

Georgia:  Mass protests and rioting have broken out in the capital of Tbilisi after the government’s proposed “foreign agent” law passed its first reading in parliament.  The draft law is modelled on Russian President Putin’s restrictive regime for media and non-governmental organizations.  For example, it would deem any Georgian media organization or NGO receiving more than 20% of its funding from foreign sources as a “foreign agent” and would subject it to undefined “monitoring.”  The controversy will further sour relations between Georgia and the EU, making it more difficult for Georgia to eventually become a member of the bloc.

United Kingdom:  Prime Minister Sunak has unveiled a proposed new law that would significantly toughen the U.K.’s approach to illegal migration into the country.  The legislation would impose a legal duty on the home secretary to remove irregular migrants to a “safe” third country or to their country of origin.  It would also bar any migrant deemed to have entered the U.K. illegally from ever claiming asylum in the future.  Although British officials insist the legislation would be consistent with international law, the fact that it contravenes European standards means it could worsen U.K.-EU tensions again, despite Sunak’s apparent success in renegotiating the Brexit treaty’s Northern Ireland Protocol.

China:  At the Chinese government’s big “two sessions” meetings yesterday, President Xi presented a major bureaucratic reorganization aimed at solidifying the Communist Party’s control over the agencies of state power and accelerating the country’s technological and financial development.  Among other initiatives, the plan would:

• Cut the government’s workforce by 5% across the board;
• Shift some responsibilities of the Ministry of Science and Technology to other agencies in order to make the ministry more focused on spurring scientific and technological innovation;
• Establish a national data bureau to regulate the control and use of information, which is expected to be the lifeblood of China’s evolving artificial-intelligence driven economy;
• Consolidate the existing banking and insurance regulatory bodies into a new State Administration for Financial Supervision and Administration which would also absorb some functions from other agencies, such as the central bank’s oversight powers over financial holding companies and the securities regulator’s investor protection duties;
• Resurrect the Communist Party’s Central Financial Work Commission to oversee the government’s financial regulation effort and ensure it conforms to Party priorities.

U.S. Monetary Policy:  In the first day of his semi-annual testimony before Congress, Fed Chair Powell told the Senate Banking Committee yesterday that since recent data on demand, employment, and inflation had come in hotter than expected, monetary officials would likely hike interest rates further than previously anticipated.  Even more concerning for the financial markets, Powell said that “If the totality of the [upcoming] data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.”

• In other words, Powell was signaling that the policymakers could return to hiking rates at an aggressive pace of 50 basis points per policy meeting, as they had been doing over much of the last year before slowing the pace to 25 bps at the last meeting.
• Investors quickly repriced a range of financial assets to reflect the more aggressive policy tightening. The target-rate probability tool from CME Group (CME, $182.22) quickly shifted to show that investors now see about a 75% chance that the Fed will hike its benchmark fed funds rate by 50 bps at its March 21-22 meeting, versus just a 31% chance prior to Powell’s testimony (see chart below).  Equities sold off sharply in response.
• The renewed signals of even tighter monetary policy appear to be worrying officials at the White House. Asked about the Fed’s plans yesterday, a top official insisted that the Biden administration wouldn’t try to interfere with the monetary policymakers but suggested they take a longer look at the data before hiking rates more aggressively.

U.S. Industrial Policy:  Illustrating the impact of the green-technology subsidies provided in last year’s Inflation Reduction Act (IRA), Volkswagen AG (VWAGY, $18.81) stated that it will prioritize its plan to build an electric-vehicle battery plant somewhere in North America.  According to Volkswagen, the company should expect to receive more than $10 billion in incentives from the IRA and other U.S. laws over the lifetime of the plant.  In contrast, the company said it will put a similar battery plant planned for eastern Europe on hold until the EU clarifies what support it is willing to provide.

• The news will likely exacerbate EU leaders’ irritation over the IRA subsidies, which they fear will draw billions of dollars of investment toward the U.S. and away from Europe.
• On the other hand, U.S. officials have encouraged the EU to adopt similar industrial policies to support its manufacturing base, and the competitive threat from the U.S. will probably convince the EU to do just that in the future.

U.S. Antitrust Regulation:  The Justice Department filed a lawsuit yesterday to block the proposed merger between JetBlue Airways (JBLU, $8.16) and Spirit Airlines (SAVE, $17.13) on grounds that the linkup would stifle competition and boost airfares for travelers.  The two companies vowed to fight the lawsuit.  Nevertheless, the Justice Department’s action illustrates the Biden administration’s stepped-up antitrust regulations.

U.S. Labor Market:  An analysis of recent employment data shows that more women than men have gained jobs over the last four months, pushing the female share of nonfarm payrolls to 49.8%.  As recently as 2019, women represented more than half of all nonfarm payrolls, but that changed with the COVID-19 pandemic, when women lost 12 million jobs and men only lost 10 million.  The surge of women coming back into the labor force could help unshackle the economy and could potentially hold down excessive wage increases.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the latest key developments from China’s “two sessions” government meetings.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including another round of strikes in France against President Macron’s proposed pension reform.  We also preview Federal Reserve Chair Powell’s semiannual testimony before Congress, which begins this morning.

China-United States:  At the Chinese government’s big “two sessions” meeting yesterday, President Xi took the rare step of calling out the U.S. directly and accusing it of leading a multinational effort aimed at “all-round containment, encirclement and suppression against us, bringing unprecedentedly severe challenges to our country’s development.”  In a follow-up statement today, Foreign Minister Qin Gang praised China’s friendship with Russia, decried what he called a “new McCarthyism” in the U.S., and vowed that China will respond tit-for-tat to any additional steps the U.S. might take to confront his country.

• Taken together, the two top-level declarations should provide investors with all the proof they need that U.S.-China tensions are likely to keep spiraling. The statements show that China will work to counter every step the U.S. belatedly takes to preserve its military, economic, technological, diplomatic, and political leadership around the world.
  • Although there is strong bipartisan support for the U.S. to assert itself against China’s growing geopolitical aggressiveness (e.g. Former House Speaker Pelosi’s provocative visit to Taiwan last summer), Taiwan’s president has reportedly convinced incumbent House Speaker McCarthy not to make a similar trip for now in order to avoid a dangerous Chinese military response.
  • Instead, McCarthy will meet President Tsai Ing-wen in California when she visits the U.S., Guatemala, and Belize in April.
• As we have mentioned many times before, worsening U.S.-China tensions will put investors at risk, especially as the two countries clamp down on trade, technology, and capital flows between their respective geopolitical camps.

China-Sri Lanka:  Officials in Colombo said China has finally agreed to support their country’s debt restructuring, a step the International Monetary Fund said it would require before releasing a $2.9-billion rescue package.  While China has lent hundreds of billions of dollars to developing countries around the world under its “Belt and Road” initiative, it has proven reluctant to restructure any such debts or take any significant haircuts when they’ve gone sour.  These actions feed into international concerns that China is really setting up debt traps as a way to get control over the projects or other collateral posted for the loans.

Russia-Ukraine War:  Even though Russian forces continue to make incremental gains in their effort to surround and capture the northeastern Ukrainian town of Bakhmut, it now appears that the Ukrainians intend to pull back from some areas of the town but will otherwise keep defending it as a way to inflict even higher casualties and equipment losses on the Russians.

• Ukrainian President Zelensky said yesterday that both the commander in chief of his military, Valeriy Zaluzhnyi, and the commander of ground forces, Oleksandr Syrsky, have recommended reinforcing the city rather than giving it up.
• If the Ukrainians do decide to keep defending Bakhmut and keep inflicting high casualties on the Russians, one key additional goal may be to pin the Russians down while the Ukrainians await new shipments of advanced tanks and other weapons from the West.

France:  The country is facing a fresh new round of strikes today as labor unions and other groups protest President Macron’s proposal to raise France’s retirement age.  In a tactical change, some unions representing public transport workers, truckers, and nuclear plant technicians said they will go on rolling strikes, unlike the less-disruptive daylong walkouts that have taken place since January. Almost two-thirds of primary schoolteachers are also expected to strike.

• As a result of the strikes, today France’s national railway has cancelled three-quarters of trains, while airlines have cancelled about one-third of their scheduled flights.
• So far, however, Macron continues to insist that the pension reform is needed to prevent the government’s budget deficit from exploding and to preserve the overall pension system.

Greece:  In an interview with the Financial Times, Bank of Greece head Yannis Stournaras said he was confident that global credit rating agencies would upgrade Greek bonds to investment grade again within months, so long as Greek lawmakers signal their intent to maintain the country’s fiscal reforms and lower the country’s debt burden.  If that happens, Greek debt would be rated investment-grade again for the first time in 12 years.

Israel:  Protests against Prime Minister Netanyahu’s judicial reform have now spread to the country’s armed forces, sparking concerns that they will compromise their readiness even as the government considers a military attack on Iran to destroy its growing nuclear weapons program.

• To protest the reform, which sharply curtails the powers of the Supreme Court, hundreds of reservists have signed letters expressing a reluctance to participate in nonessential duty or have already pulled out of training missions.
• The affected units include a key division that deals with signals and cyber intelligence and whose graduates have helped drive the country’s tech industry, as well as elite combat units.

United States-Mexico:  The U.S. Trade Representative’s office has formally requested consultations with Mexico under the U.S.-Mexico-Canada trade agreement to address Mexico’s decision to ban genetically modified corn and other crops from north of the border by 2024.  The U.S.’s filing aims to protect farmers who would otherwise lose an important foreign market.  For perspective, the U.S. exported some $5 billion of corn to Mexico last year, about 90% of which was genetically modified.

U.S. Monetary Policy:  Fed Chair Powell will begin his semi-annual testimony to Congress today with an appearance before the Senate Banking Committee at 10:00 AM EST.  He’ll appear before the House Financial Services Committee tomorrow at the same time.  In each case, we suspect that Powell will continue to talk tough on consumer price inflation, stress the need the raise interest rates further, and make the case for keeping monetary policy tight for an extended period.  Indeed, he also appears to have most of the policymaking committee behind him.  Over the weekend, for example, San Francisco FRB President Daly made similar hawkish statements at a Princeton University event.

• In other words, Powell will keep trying to convince investors that the Fed will get control over inflation and eventually bring it down to the Fed’s target. Investors will be especially focused on any signs that the policymakers will hike rates by an aggressive 50 basis points at their March 22 meeting.
• If Powell deviates from that message in any meaningful way, markets could react strongly. That’s especially true given that investors are likely to be on edge ahead of the two critical inflation reports due to be released in the next seven days:  February’s employment report on Friday and the February consumer price index next Tuesday.

U.S. Housing Market:  A bipartisan group of Senators has introduced legislation to spur the renovation of single-family homes in blighted neighborhoods to help boost the U.S. housing supply.  If passed into law, the legislation would create a new tax credit to cover a developer’s costs when the renovation of a crumbling building exceeds a home’s potential selling price so the project becomes feasible.  Although it’s questionable whether the new tax credit would have an appreciable effect on the nation’s housing supply, it would likely lead to a frenzy of efforts to game the system and take advantage of the credit.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with some observations on the important high-level government meetings that began in China over the weekend and included an announcement that China will target a relatively modest economic growth rate of just 5% in 2023.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a new statement by European Central Bank President Lagarde which pointed to further aggressive interest-rate hikes in the Eurozone and signs that the U.S. junk bond market is weakening again ahead of a likely recession.

China:  Over the weekend, the country opened its annual “two sessions,” consisting of key meetings of the National People’s Congress and the People’s Political Consultative Conference.  Among the key decisions already reported, outgoing Premier Li Keqiang announced a relatively conservative economic growth target of “around 5%” in 2023, compared with about 5.5% in  2022, while the proposed national budget would hike Chinese military spending by 7.2%.

• Later in the meetings and potentially this week, President Xi is expected to secure a precedent-breaking third term in office to go along with his October success in gaining a third consecutive term as head of the Communist Party.
• The meetings are also likely to approve a new set of top government officials and agency restructurings that would further consolidate power into Xi’s hands, including the establishment of a new data regulator.

China-Hong Kong:  The Shanghai, Shenzhen, and Hong Kong stock markets have jointly announced the stocks that will participate in China’s expanded “Stock Connect” program, which allows mainland investors to buy certain equities in Hong Kong, and vice versa.  About 80 additional foreign stocks trading in Hong Kong will now be available to mainland investors, including the stocks of British bank Standard Chartered (SCBFY, $19.03) and Australian coal miner Yancoal Australia (YACAF, $4.15).  Foreign investors will gain access to hundreds of additional yuan-denominated stocks trading in Shanghai and Shenzhen.  Nevertheless, as the U.S.-China geopolitical competition intensifies and the countries squeeze the capital flows between them, the expanded program may have little practical effect for U.S. firms or investors.

United States-China:  U.S.-China relations continued to fray over the last week, as the Biden administration placed 28 additional Chinese firms on its “Entity List” of companies that are off limits for U.S. exporters.  Under law, the Commerce Department has the authority to put foreign companies on the list and cut them off from U.S. exports if they are working against U.S. interests.  Many of the hundreds of Chinese companies now on the list are there because they provide advanced technologies and computing services to China’s surveillance, intelligence, and military systems.  As we have reported many times in the past, the U.S. has also taken aggressive steps to restrict the flow of advanced technology and investment capital to China as a way to suppress its ability to establish itself as the new global hegemon.

• At the same time, China continues to impose its own restrictions on trade and capital flows. In an interview with Fox Business last week, billionaire investor Mark Mobius said Chinese authorities are preventing him from withdrawing and repatriating personal funds that he has at a bank in Shanghai.
• Even though Mobius was the longtime chief of emerging market investments at Franklin Templeton and a recognized China bull, he stated in the interview that investors should be “very, very careful” now about investing in China due to the government’s tight control over the economy. Instead, Mobius said he is increasing his exposure to other emerging markets such as India and Brazil.

Japan-South Korea:  The governments of Japan and South Korea appear to be nearing a deal to resolve a conflict over Japan’s use of forced labor from South Korea in World War II.  Under the developing agreement, the South Korean government would ensure compensation payments to Koreans who were forced to work for Japan through a government-backed foundation, instead of asking Japanese companies to do so.  In return, Japan would lift restrictions on certain technology exports to South Korea and agree on the resumption of reciprocal visits by the countries’ leaders.

• The potential rapprochement between the two countries is driven in part by a shared concern about China’s growing geopolitical aggressiveness. Our analysis suggests that both Japan and South Korea will be key members of the evolving U.S.-led geopolitical and economic bloc.
• If an agreement is reached, it could significantly improve relations between Japan and South Korea, potentially boosting trade and investment between the two countries.

Iran:  International Atomic Energy Agency Chief Grossi visited Iran on Saturday to address concerns over evidence that Tehran has been processing uranium to near-weapons grade purity levels.  However, all he appears to have gained was Iranian promises to voluntarily allow the IAEA to reinstall some cameras and other monitoring devices that Iran shut down last year.  With Iran still appearing intent on advancing its nuclear program, the stage is increasingly being set for a potential Israeli attack on Iran that would attempt to stop Tehran from achieving a workable nuclear weapon.

Pakistan:  In an apparent effort to muzzle Former Prime Minister Khan and end his calls for early elections, the government of Prime Minister Sharif sent police to arrest Khan yesterday on what appear to be trumped-up charges of corruption, but Khan refused to meet with them.  The standoff suggests that Pakistan will continue to face political paralysis even as it tries to secure an important IMF loan to stave off default on its foreign debts.

Eurozone:  In an interview with Spanish newspaper El Correo, European Central Bank President Lagarde warned that the upward pressure on consumer prices in the Eurozone will remain sticky for the foreseeable future and could require further interest-rate hikes to bring them under control.  To limit the damage to the region’s economy, she also urged banks to reschedule debt repayments for households struggling to cope with soaring borrowing costs on variable-rate mortgages.

Estonia:  Prime Minister Kaja Kallas and her liberal Reform Party won the biggest share of votes in yesterday’s parliamentary election, putting her in position to remain in power with a new, refreshed governing coalition.  The result ensures that the Estonian government will remain strongly pro-Western and anti-Russian, and that it will retain its current center-left stance.

Russian Invasion of Ukraine:  Russian forces continue to make incremental gains in their effort to surround the northeastern Ukrainian town of Bakhmut, even as they keep launching artillery, missile, and air attacks on infrastructure elsewhere around Ukraine.  Despite a range of analysts judging that the Russians would not be able to capture Bakhmut in the near term, Ukrainian forces still appear to be considering a tactical withdrawal from the town in order to conserve troops and equipment for a potential offensive elsewhere later in the spring.

U.S. Junk Bond Market:  Various indicators suggest that the rebound in junk bond prices during January and February is already reversing course as overall bond yields began rising again.  Any renewed weakness in junk bond prices, with the associated rise in yields, would likely put added pressure on financially weaker companies as the economy hurtles toward a likely recession.

U.S. Labor Market:  New research posted by the National Bureau of Economic Research confirms that wage growth among lower-paid and less-educated workers has outstripped wage growth among the better-paid and more highly educated since the onset of the COVID-19 pandemic.  The research suggests lower-paid, less-educated workers have benefited not only from stronger demand for their services, but also from the way the pandemic forced people out of their old jobs and made the labor market more dynamic.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Today’s Comment begins with our thoughts on the Fed’s overreliance on economic data to dictate policy. Next, we review signs that interest rates are finally starting to weigh on the economy. We end the report by discussing the ongoing feud between Brazilian President Luiz Inácio Lula da Silva and his central bank.

Market Choppiness: Noisy economic data and conflicting views from central bankers have made it difficult for investors to parse out the future path of policy rates.

• Fed officials refuse to commit to future rate decisions. On Thursday, Federal Governor Christopher Waller and Atlanta Fed President Raphael Bostic offered conditional support for maintaining the current policy path. Bostic stated that he would prefer a 25 bps rate hike in March, while Waller argued that a peak rate between 5.1% and 5.4% would make sense if inflation cools. These estimates are roughly in line with the latest Fed dot plot. However, both officials have argued for higher rates if inflation begins to reaccelerate. Their comments led to a sharp, but likely temporary, jump in the S&P 500 yesterday as investors reacted positively to Fed officials not ruling out a pause before the end of the year.
• Economic statistics are still distorted due to pandemic-related anomalies. For instance, labor hoarding and delays in termination have made employment data look good on the surface. Last month’s blockbuster 517k jobs number was elevated due to seasonal adjustments related to fewer layoffs than in a typical January. Meanwhile, many tech job cuts are slated to take effect in March, meaning that they won’t show up in the employment report until the following month. The lack of accuracy in the data suggests that the Fed may be slow to react to real-time changes in the business cycle.
  • As a side note, markets will be closed when April’s job report is released, since it falls on Good Friday. Coincidence? We think not.
• The Fed wants to keep its options open when deciding future policy. It may fear that if it stops hiking too soon, inflation expectations could become unanchored. Although the Fed’s position is understandable, it puts investors in an awkward position as they await a signal that it is a good time to jump back into the market. So far, investors have allocated a record $4.8 trillion of their funds to money market accounts. The elevated level of cash holdings should fuel a strong rally toward the end of the year. In the meantime, we expect Fed policy uncertainty to keep equities relatively stagnant in the short-term and possibly even the medium-term.

 Tightening Pain: A strong start to the year has overshadowed underlying problems within the U.S. economy

• The housing market is firmly in contraction. Data from Redfin has shown that U.S. home sale prices had their first annual decline in over a decade. The average sale price for a home fell 0.6% from the prior year in the final four weeks ending February 26. The price declines come as higher mortgage rates hinder home affordability for new home buyers. Although homebuilders reported higher confidence in the housing market in February, it was largely based on the idea that financial conditions would continue to ease. However, the upward movement of 10-year Treasury yields above 4%  will likely dent hopes of a sudden resurgence in the demand for homes.
• Meanwhile, high lending rates have also hurt the auto market. Car prices have slumped over the last few months due to higher inventory and weaker demand. The decline in auto value has increased the number of car owners with negative equity in their vehicles, which will make it harder for households to get out of debt and could sap future vehicle demand. Additionally, those who bought cars at peak demand in 2021 may be incentivized to stop making payments. The resulting defaults and repossessions could flood the used car market, possibly exacerbating the decline in auto prices.
• The U.S. economy’s resiliency has bolstered optimism that the Fed may be able to avoid a hard landing. The ability of the financial system to avoid the blowback from the crypto fallout, thus far, has added to this confidence. However, there are reasons to be worried that the Fed has overplayed its hand. The housing and auto markets are two areas where we notice trouble lurking, but we also believe that traditional indicators may be masking trouble. For example, the CBOE Volatility Index (VIX), also known as the fear gauge, remains below its complacency level of 20 despite the recent pull back in equities and the rise in bond yields.

 

Lula Headaches: The new Brazilian president is having trouble achieving his objectives to boost living standards and reduce poverty.

• The Brazilian economy contracted in the final three months of the year. Gross domestic product fell 0.2% in Latin America’s largest economy with weak services and shrinking industrial output driving the quarterly decline. Mining remained the bright spot in the report, as oil production prevented a deeper decline in industrial activity. High-interest rates may weigh on economic activity further throughout the year as the Central Bank of Brazil tries it best to return inflation to its 3.25% target.
• Brazil was among the first and most aggressive central banks to hike its benchmark policy rate. At 13.75%, it currently has the second-highest policy rate out of the top five Latin American economies, trailing only Argentina. Elevated interest rates have angered Lula, who believes the Central Bank of Brazil policies will prevent him from realizing his campaign pledges. He has blamed Central Bank Chief Roberto Campos Neto for the economic slowdown. To Lula’s credit, Campos Neto has voiced concerns that the new government’s spending plan could undermine the central bank’s progress in fighting inflation.

• We will be paying close attention to the ongoing spat between Lula and the Central Bank of Brazil. Campos Neto has vowed to finish out his term as the head of the central bank, which is set to expire in December 2024. However, his ongoing feud with Lula and his left-wing allies threatens the central bank’s credibility. It has been speculated that the government could raise the inflation target to a higher level to pressure the central bank to begin easing policy. That said, any extreme move by the government to impact the central bank authority will likely negatively impact the Brazilian real (BRL).

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with a discussion on how earnings may not provide an accurate picture of the business environment and what that could mean for the economy. Next, we give our thoughts on the recent increase in interest rate expectations and how it affects stocks and bonds. Finally, we end with a review of the dollar’s impact on emerging markets.

 Earnings Mismatch:  Solid Q4 earnings boosted market optimism at the beginning of the year but concerns over quality have forced investors to rethink their outlook for 2023.

• Most S&P 500 companies performed better than expected in the final quarter of 2022. Despite recession concerns, almost 70% of firms reported positive earnings per share and positive revenue surprises. The numbers were far from spectacular but were enough to show that firms were resilient in the face of elevated inflation. This sentiment was reinforced by a FactSet document search showing that the number of S&P 500 firms citing “inflation” in earnings calls fell to its lowest level since February 2021. The strong results helped lift investor confidence that the market may have discounted the worst of a possible recession and buoyed bets of a market rally for when the Fed finishes tightening.
• Unfortunately, last year’s earnings numbers may be misleading. The discrepancy can be seen when comparing after-tax earnings with operating earnings. In Q4 2022, the difference between total after-tax and operating earnings widened to a level not seen since the financial crisis. The gap is related to a massive jump in restructuring costs. Firms generally incur these costs when reorganizing their businesses to make them more efficient. Examples of these one-time expenses include furloughs, layoffs, and plant closures.
  • Similarly, the divergence between operating cash flows and profits suggests that earnings quality has also fallen.
• The market will eventually sort out the inconsistencies in earnings. Going into a recession, managers look for alternative ways to show that their firms remain profitable to compensate for higher borrowing costs and slowing demand. This is seen when firms exclude costs associated with a reorganization or soften revenue recognition standards. Luckily, investors respond to low earnings quality by paying less for stocks. The S&P 500’s retreat below 4000 partially reflects the market’s skepticism about the true profitability of firms. That said, the decline in equities suggests that stocks are positioned for a strong rally once the market is able to value these earnings correctly.

Interest Rate Expectations: Fears over a resurgence of inflation have sent markets into a frenzy as investors try to decide what central banks will do.

• Investors were forced to revise interest rate predictions after a faster-than-expected rise in inflation, and strong economic data added to concerns that central banks are not done tightening. Core inflation data in the Eurozone rose 5.6% in the year ending in February, above January’s rise of 5.3%. The strong readings in Europe have contributed to concerns that the U.S. consumer price index may also come in hot later this month. Meanwhile, the U.S. purchasing manager index (PMI) showed improvements in February despite remaining in contraction territory, and Eurozone PMI data showed that output passed the growth threshold last month.
• The unexpected rise in inflation and an improvement in manufacturing activity have led investors to revise forecasts of when the Federal Reserve and the European Central Bank will set peak interest rates. Markets predict that the Fed could push rates to 5.5% by September, above a projected peak of just under 5.0% following last month’s Federal Open Market Committee rate announcement. Meanwhile, the European Central Bank is forecast to set rates at 4.0%, their highest level on record. The Bank of England has blunted this trend as comments from BOE Governor Andrew Bailey led investors to revise down peak expectations; however, Thursday’s report of strong wage growth may lead to upward revisions in the BOE’s benchmark policy rate.

• Equity and bond markets do not agree on the path of policy rates. Despite modest adjustments over the last few weeks, the Euro Stoxx 50 is up 9.2% to begin the year, while the S&P 500 rose 3.3% in the same period. The resilience in equities indicates that stock traders still believe that the worst is behind them. Meanwhile, the rise in longer-duration bond yields suggests that fixed-income traders are unconvinced. The 10-year U.S. Treasury yield rose above 4.00% for the first time in 16 years on Wednesday, while today similar duration German government bond yields reached a 12-year high at 2.75%.

Dollar Problems: The U.S. greenback has stagnated over the past few weeks, denying a potential tailwind for emerging markets.

• Foreign investors in troubled countries are rushing to purchase U.S. dollars to protect their savings from losing value. In Iran, a collapse in sanctions relief talks has led the Iranian rial (IRR) to lose a fifth of its value since last week. The Turkish lira (TRY) may also face pressure after the upcoming elections as the government may be unable to offer the same level of support to the currency. Last month, options were pricing in a 60% likelihood that the TRY would lose 25% of its value by year end. Saver skepticism is shown in the recent outflow from Turkish FX-protected accounts.
• Dollar appreciation could lead to higher inflation in emerging market countries. Many foreign transactions are priced in dollars, and thus, currency depreciation will lead to an increase in import prices in items such as fuel and food. Although governments are willing to intervene in markets, their involvement comes at a great cost. Currency support generally leads to some sort of depletion of reserve assets, whether it be gold, monetary reserves, or other liquid securities. This method provides some relief to households, but it also prevents governments from being able to shield economies from the negative impacts of a downturn.
• Although the dollar has stagnated, it still poses risks to emerging markets as it blocks countries from the added relief from price pressures related to greenback depreciation. As a result, central banks may be forced to raise rates in certain countries where inflation remains stubbornly high. This does not mean that all is lost for certain countries. MSCI South Korea (3.45%) has seen its equities outperform the S&P 500 (3.30%) year-to-date, despite the South Korean won’s (KRW) depreciation against the dollar. However, we believe that investors will need to be more vigilant when looking at emerging markets as long as the greenback remains elevated.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with some positive economic news out of China, where manufacturing and services both appear to be recovering from the recent COVID-19 infection wave.  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 Bank of England‘s Governor Bailey that investors shouldn’t necessarily think his central bank will hike interest rates much further.

China:  The official purchasing managers’ index for manufacturing jumped to 52.6 in February, bursting past expectations and coming in well above the reading of 50.1 in January.  In fact, the February reading was the highest since April 2012.  Meanwhile, the February PMI for nonmanufacturing rose to 56.3, also exceeding expectations and marking an improvement from its January reading of 54.4.  As with most major PMIs, readings over 50 indicate expanding activity.  Taken together, the figures for January and February suggest China’s recovery from its pandemic shutdowns is now gathering pace, although it’s important to remember that Chinese data in those months could be distorted by the shifting Lunar New Year holiday.

China-Belgium:  The Belgian government’s Center for Cybersecurity said a Chinese state entity was most likely responsible for the January 2021 spearfishing attack on Belgian parliament member Samuel Cogolati.  The attack was launched shortly after Cogolati wrote a parliamentary resolution warning of “crimes against humanity” against the Uyghur Muslims in China.

• Coupled with European officials’ recent willingness to warn China against supplying weapons to Russia for its war in Ukraine, the Belgian government’s willingness to call out China’s aggression against Cogolati suggests officials on the Continent are now coming around to a U.S.-style, hardline stance against Beijing.
• If that trend continues, it would help solidify the evolving U.S.-led geopolitical and economic bloc, while also likely intensifying the West’s tensions with China and creating new risks for investors.

United States-China:  Yesterday, the new House Select Committee on the Chinese Communist Party held its initial meeting, with Republican Chair Mike Gallagher vowing that the panel will “investigate and expose the ideological, technological, and military threats posed by the Chinese Communist party.”  The initial meeting included testimony from four witnesses who called out a range of threats from China, along with statements castigating China from both Republicans and Democrats.  We suspect the committee will further fuel U.S. voters’ concerns about China and energize support for military, industrial, and political initiatives against Beijing.

Iran:  The International Atomic Energy Agency confirmed that it discovered a small amount of uranium purified to a near-weapons grade level of 84% at a spot inspection in Iran last month. Iran has reportedly told the agency that it inadvertently enriched the uranium to that level, but the IAEA’s confirmation of the finding is likely to further heighten tensions between the West and Iran. The news could also bring forward a potential Israeli attack on the country.

Israel:  Besides the unsettling news from Iran, the Israeli government is also struggling with growing violence between Jewish settlers and Palestinians in the West Bank.  In recent days, fighting erupted after a Palestinian gunman shot two Jewish settlers dead in Huwara, a Palestinian town south of Nablus, where the Israeli army killed 11 Palestinians and injured 100 more last week in its deadliest raid on the West Bank since 2005.

Nigeria:  Ruling party candidate Bola Tinubu has now been declared the winner of Saturday’s presidential election after final results showed him with 8.8 million votes.  Atiku Abubakar of the opposition People’s Democratic Party came in second with 7.0 million votes, and Peter Obi, the Labor party contender whose youth-focused campaign turned the usual two-party race into a competitive three-man battle, came in third with 6.1 million votes.  Because of the fractured vote and Tinubu’s advanced age coupled with his reputation for corruption, it would not be surprising if political tensions and instability remain in Nigeria for some time.

United Kingdom:  Bank of England Governor Bailey warned that investors shouldn’t necessarily believe that the central bank will need to impose many additional interest-rate hikes to cool the economy and bring down inflation.  According to Bailey, his policymakers still have no presumption that they would need to raise interest rates further from the current 4.00% level.

• While financial markets now expect rates to rise to 4.75% by the end of 2023, up from an expectation of a peak of 4.25% at the start of February, Bailey said he had not seen anything in the data to justify the change in outlook.
• Despite Bailey’s comments signaling a potential for lower-than-anticipated interest rates, the GBP is trading only slightly weaker today at about $1.2014.

U.S. Labor Market:  Two large on-line recruiting companies said they are seeing the number of job openings fall faster than indicated by the government’s monthly JOLTS report.  The data suggests that the U.S. labor market may be cooling faster than indicated by the top-line official reports.  If so, it could mean that the anticipated recession is taking hold and inflation pressures could soon start to moderate despite the exceedingly strong economic activity in January.

U.S. Student Loans:  The Supreme Court held oral arguments yesterday on the validity of President Biden’s pandemic-driven program providing student loan relief.  By all accounts, the conservative majority expressed skepticism that the administration could order such a broad-ranging policy change without the consent of Congress, even though it relied on a law giving it some power to modify such a program.  Since the court’s final decision may not come until summer, millions of people with student loans will now spend months in a state of uncertainty regarding their debt obligations.

U.S. Cryptocurrency Regulation:  After New York officials halted new issues of the BUSD stablecoin last month because of regulatory questions, new reports say investors have pulled about $6 billion from the product, reducing the amount in circulation by one-third.  The figures illustrate the cryptocurrency regulatory risks that we have long warned about.

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