by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where Ukrainian forces continue to make surprising progress in the counteroffensives in northeastern and southern Ukraine.  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 controversy over energy policy in the European Union and a discussion of what has been driving the rebound in the U.S. stock market yesterday and today.

Russia-Ukraine:  The latest reporting indicates that Ukrainian forces continue to recapture significant amounts of territory not only in the northeastern Donbas region but also in the south around Kherson.  Notably, these gains have come at the expense of units that were considered to be among Russia’s finest before the war, which indicates that even Russia’s finest military units are now seriously degraded and have only limited combat forces available to them.

• Ukraine’s reaccelerating military advances are risky, in that Ukrainian forces could over-extend themselves and outrun their supply lines.  However, Kyiv has apparently accepted that as a calculated risk in order to make fast progress while Russia hits snafus and other obstacles with its recent mobilization order.
• As we’ve mentioned before, Russia’s losses have the potential to push President Putin toward playing his nuclear card, most likely by detonating a relatively low-yield tactical nuclear weapon over Ukraine, the Black Sea, or perhaps the Baltic Sea.  Less noted is that Putin could also be subtly threatening to use strategic weapons.  For example, press reports indicate a Russian submarine designed to deliver a nuclear-armed drone has mysteriously left its normal operating area in the White Sea.  We’ve seen other reports of unusual deployments of Russian strategic bombers.

European Union:  The chief technical officer of German electricity grid operator Amprion warned yesterday that Germany may have to reduce or temporarily halt power exports to France and other countries this winter to prevent bottlenecks and shortages across its power grid.  The alert shows that the energy crisis touched off by Russia’s invasion of Ukraine has reached the point where it is more seriously threatening the bloc’s unity.

• Germany has already been criticized for its recently announced €200 billion plan to provide energy subsidies to domestic businesses and households.
• Other EU states worry Germany’s energy subsidies will give it an unfair competitive advantage in the bloc’s marketplace because many countries can’t afford to give their firms and consumers similar help.

United Kingdom:  Just a day after being forced to back down on her plan to cut income taxes for the U.K.’s richest citizens, Prime Minister Truss is facing a new rebellion from her own Conservative Party over her plan to boost social benefits next year by less than consumer price inflation currently about 10%.  Instead, she wants to hike those benefits only in line with average wage growth, or about 5%, in order to reduce public spending.

• The Truss proposal has already prompted pushback by at least one cabinet member and several members of parliament.
• As with the plan to cut taxes for the U.K. elites, the pushback against reining in pensions and other social benefits illustrates how populist policies are now ascendant in Britain’s Conservative Party, as they are in many right-wing and left-wing parties around the world.  Those populist priorities are often unfriendly to the interests of capital holders.

Japan-North Korea:  Today, the North Korean military launched a ballistic missile directly over Japan for the first time since 2017.  The overflight forced Tokyo to issue a rare public alert for people to take cover and prompted condemnation from Japan and other countries.  North Korea’s recent missile launches are likely designed to draw the U.S. and its allies into new negotiations for security and economic concessions.  For investors, the provocations could raise risk premiums for Asian assets.

China-Taiwan-United States:  In an interview Sunday, U.S. Defense Secretary Austin said that the U.S. will help Taiwan “develop the capability to defend itself” against a Chinese invasion.  Austin stopped short of repeating President Biden’s recent vow to send U.S. troops to help Taiwan resist an invasion, but he still seemed to strike a more bellicose stance than officials have typically done under the U.S. “strategic ambiguity” policy.  That fits the pattern of an increasingly fractious U.S.-China relationship that threatens to catch investors in the crossfire.

United States-China:  A bipartisan group of 15 senators is planning to introduce legislation to create a “China Grand Strategy Commission,” which will be given two years to develop a whole-of-government approach guiding Washington’s relationship with Beijing.  The goal will be to formulate a U.S. “grand strategy” on China that could avoid conflict while allowing the U.S. to continue pursuing its interests.

U.S. Economy:  The Institute for Supply Management yesterday said its September ISM Manufacturing Index fell to a seasonally adjusted 50.9, compared with 52.8 in each of the previous two months.  The ISM indexes are designed so that a reading over 50 points to expanding activity, and therefore the report suggests that the U.S. factory sector is still growing, only slowly.  That is likely the kind of data the Federal Reserve policymakers want to see to be sure inflation pressures are coming down, even though New York FRB President Williams yesterday said price pressures are likely to remain sticky and will require a long period of high interest rates to combat them.

• Indeed, the September subindex on supplier deliveries fell to its lowest level since December 2019, suggesting that supply bottlenecks have now eased considerably.  The September subindex on prices fell to its lowest level since June 2020.
• The indication of cooling demand and moderating inflation was probably key to the stock market’s big jump yesterday.  Just as important, investors bid up bonds again, driving the yield on the benchmark 10-year Treasury note down to 3.650%.

U.S. Supply Chains:  Apple (AAPL, $142.45) this week released data showing that 48 of its more than 180 suppliers had manufacturing sites in the U.S. as of September 2021, which is up from just 25 a year earlier.  The figures illustrate how U.S. firms are “re-shoring” or “near-shoring” production back to the U.S. to ensure stable supplies as the world fractures into relatively separate geopolitical and economic blocs.  As we’ve written many times before, such shortened supply chains will likely be costlier and less efficient than fully globalized supply chains, raising inflation and interest rates going forward.

• The U.S. government is also continuing to cut technology exports to China.  Reports indicate that the Biden administration is currently preparing new export controls on semiconductors and the machines to make them.
• The new export controls could be announced as early as this week.

U.S. Retail Real Estate:  Recent data suggests retail real estate is now performing strongly again for the first time in years, or even decades.  According to Cushman & Wakefield, U.S. retail vacancy fell to 6.1% in the second quarter, the lowest level in at least 15 years, while asking rents for U.S. shopping centers in the quarter were 16% higher than five years ago.  A separate analysis shows more stores opened than closed in the U.S. last year for the first time since 1995.  The improvements reflect a rebalancing of supply and demand after poor returns and high vacancies discouraged new building in recent years.

U.S. Cryptocurrency Regulation:  Yesterday, the Financial Stability Oversight Council, chaired by Treasury Secretary Yellen issued a report saying that while the crypto industry remains small compared with the overall financial system, that could change quickly and exacerbate potential systemic risks.  Illustrating the growing regulatory risk for crypto assets, the report called on Congress to write rules covering the crypto industry in areas that don’t currently fall under regulation.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including news that Ukraine has retaken more land with its counteroffensives in the northeast and south of the country.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a dramatic U-turn in the U.K. government’s big tax-cutting proposal.

Russia-Ukraine:  Over the weekend, Ukrainian forces recaptured the important transportation hub of Lyman in Ukraine’s northeastern Donbas region, and the Russian military admitted it had withdrawn its troops to avoid their encirclement.  The loss touched off another round of angry recriminations by ultra-nationalist Russian bloggers and military commentators, who castigated Russia’s military leadership and demanded stronger performance from commanders on the ground.  Importantly, it appears that the Russian military failed to reinforce its position in and around Lyman, probably because President Putin has prioritized holding the southern region around Kherson and Zaporizhzhia against the Ukrainian counteroffensive there in order to preserve Russia’s land bridge to its illegally annexed region of Crimea.

• Ukrainian forces continue to push eastward into the Russian-held province of Luhansk, further pressuring Russian forces and further raising the risk that President Putin will feel so backed into a corner that he would contemplate detonation of a tactical nuclear weapon to try to reverse his fortunes.
  • It’s important to remember that NATO and the U.S. have had decades to refine their surveillance, monitoring, and intelligence capabilities regarding the all-important threat of Russian nuclear weapons. Since Russian tactical warheads are stored in specific bunkers and not married with artillery or missile systems until just before they’re used, our best sources suggest NATO and the U.S. would be able to see their preparation “as the process unfolds.”
  • Of course, President Putin might want that to be the case anyway, since his greatest leverage would come with the threat, rather than the use of such weapons. There is probably a growing chance that Putin will at some point order the initial steps toward using tactical nukes in order to send an even stronger warning to the West, hoping it will split the allies or convince them to back off and let him have Ukraine.
• In a television interview yesterday, NATO General Secretary Stoltenberg warned that any use of nuclear weapons in Ukraine would “change the nature” of the conflict and would result in “severe consequences” for Russia.

OPEC+ Oil Cartel:  Press reports indicate that the Organization of the Petroleum Exporting Countries (OPEC) and its Russia-led partners are planning to cut crude oil production by as much as 1 million barrels per day when they meet on Wednesday.  The reports also suggest that Saudi Arabia, the key country in the group, wants to lower output both to prop up prices and to keep some production capacity in reserve in case Western sanctions lead to a drop in Russian output later this year.  Russia, the other key producer in the group, also wants to prop up prices to help pay for its invasion of Ukraine.

• A question to be resolved is whether OPEC+ members will reduce actual production, their quotas, or a mixture of the two. The group is already 3.5 mbpd short of its target, as Nigeria, Angola, Russia, and others struggle to churn out the barrels they have committed to on paper.
• If implemented as output cuts, the deal could push energy prices up again, exacerbating inflation in the developed countries and complicating the Democrats’ chances in November’s U.S. mid-term elections.
• Indeed, Brent crude futures are up 3.9% to $88.48 per barrel so far this morning.

United Kingdom:  After ten days of financial market turmoil touched off by her massive tax cut proposals, Prime Minister Truss has abandoned her plan to cut the top personal income tax rate from 45% to 40%.  The decision came as Truss faced a revolt by her own Conservative Party members of parliament, which raised the risk that the provision wouldn’t pass the legislature.

• Abandoning the tax cut for Britain’s richest citizens has important political implications in Britain and beyond. The pushback against cutting taxes for elites reflects the enduring power of populism among right-wing parties today.  Truss’s U-turn will likely be a signal to politicians worldwide about the danger in proposing elitist policies over populist ones.
  • Having retreated on the top income tax rate, Truss could now come under pressure to reverse other proposed unfunded tax cuts that have blown a hole in the U.K.’s public finances. Examples include the £13-billion reduction in national insurance contributions, which gives the biggest benefit to better-off voters, and the £17 billion plan to reverse a previously-planned hike in corporate income taxes — a policy that business leaders have said is not a priority.
  • Of course, the mess also seriously damages Truss and her government, raising the chance that she will be pushed out of power relatively soon.
• Abandoning the tax cut only marginally reduces the cost of Truss’s program, but financial markets so far this morning are taking the news positively. The yield on 10-year gilts fell modestly to 4.02%, down from approximately 4.60% at the height of the market turmoil last week, while the pound edged up in value to $1.1212.

European Union:  The European Commission plans to propose a major reform of its “Growth and Stability” fiscal rules this month in order to give EU member countries more time to cut their debts and make space for public investment.  Under the proposal, the EU and national capitals would work out multiyear, country-specific plans for getting their debt burdens under control.  The plan aims to simplify the EU’s hugely complex fiscal rules while also tightening enforcement.

China – National Day Holiday:  Marking China’s National Day on Saturday, President Xi said in an article that the country “has never been closer” to achieving its great national rejuvenation, but that the last mile would be full of perils and challenges.  He urged Communist Party members to press on even as they face major challenges, risks, barriers, and contradictions in the coming years.

• In the run-up to the party’s 20th National Congress later this month, Xi’s article shows that he remains fully committed to his program of strengthening China and eventually displacing the U.S. as the world’s most powerful nation.
• Because of the National Day holiday, China’s stock markets and most business and government activities will be shut down all this week.

Turkey:  The September consumer price index was up 83.5% from the same month one year earlier, accelerating from the rise of 80.2% in the year to August and marking Turkey’s highest inflation rate since July 1998.  Despite the accelerating inflation, President Erdoğan continues to insist on further interest-rate cuts, pushing the value of the lira even lower.  Against the U.S. dollar, the currency is now down approximately 27% year-to-date.

Brazil:  In the first round of Brazil’s presidential election yesterday, leftist Former President Luiz Inácio Lula da Silva led with 48.4% of the vote, beating incumbent President Bolsonaro with 43.2% of the vote.  However, Bolsonaro’s tally was significantly stronger than expected, setting up what could be a close vote in the run-off election on October 30.

• Public opinion polling had long predicted a very strong majority for Lula, prompting fears of a hard swing to the left in Brazilian economic policies and undermining Brazilian stock prices.
• Bolsanaro’s better-than-expected showing in the first round is likely to generate at least a short-term rebound in Brazilian stocks. Indeed, Brazilian stocks are up well over 5% in the U.S. this morning.

China – Real Estate Market:  Ahead of the holiday on Friday, regulators announced a series of policy changes to support the contracting real estate development and housing industries.  The moves include special interest-rate cuts for first-time home buyers and a tax cut for a broader group of home buyers.  The moves prompted a jump in the Hong Kong-listed shares of major Chinese property developers today.

United States-China:  The top Republicans on the House Agriculture and Oversight committees asked the Government Accountability Office to conduct a study examining foreign countries’ acquisition of U.S. farmland and its impact on national security, food security, and trade.

• The lawmakers, along with many Democrats, are especially interested in whether Chinese acquisitions, in particular, could pose a national-security threat.
• Naturally, the requested GAO study could be the first step in a legislative push to further restrict Chinese acquisitions of U.S. assets. That move would likely exacerbate U.S.-China tensions and accelerate the fracturing of the world economy into a U.S.-led bloc and a Chinese-led bloc, as we have often predicted.

U.S. Housing Market:  As rising interest rates push more families out of the market for new homes, builders are reportedly cold-calling investment buyers and offering them discounts of as much as 20% from the price they would charge to individual buyers.

• The phenomenon illustrates the dramatic slowdown in housing demand in response to the Federal Reserve’s interest-rate hikes.
• Of course, that slowdown in demand is also likely to weigh on U.S. economic growth and could help push the economy into recession.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with an overview of the upcoming Brazilian elections on Sunday. Next, we discuss how other countries are looking to fight inflation while generating economic growth. We end the report with a summary of the ongoing troubles in Europe.

 Brazil Election: Sunday’s election has sparked concerns of a potential coup and a return to left-wing policies.

• Brazil will hold its presidential elections on October 2. Former President Lula da Silva and current President Jair Bolsonaro are favored make it out of the first round that has 11 candidates competing to lead the country. Lula is heavily favored to win the election and is predicted to take an outright majority in the first round. Assuming he does not win a majority, a run-off will occur on October 30. The return of Lula will not be viewed favorably by markets as his party has a reputation of being fiscally irresponsible.
  • His campaign promises include increasing cash transfers, expanding social housing, and imposing debt forgiveness.
• A Bolsonaro loss may lead to a military coup. In the run-up to the election, Bolsonaro consistently blamed his potential defeat on electoral fraud. Given the country’s history of right-wing dictatorship from 1964-1985, the risk of political violence following the election is elevated. Although members of Bolsonaro’s political teams have stated that they would seek legal remedies if Lula won, they also mentioned the possibility of national protests and strikes. A military coup could lead to Latin America’s fourth largest economy being targeted by Western sanctions. For now, it does not appear that the military is interested in running the country.
• The next president of Brazil will have to deal with the “Centrão” to pass meaningful legislation. The group contains an established bloc of politicians likely to oppose left-wing policies. Currently, the economy is on pace to grow 2.5% for the year, and the latest CPI report shows that inflation is falling. As a result, Lula is unlikely to have the political clout needed to reverse many of the pro-business laws put in place by his predecessor. Therefore, a Lula victory is unlikely to change investor sentiment about Brazil and should not impact the country’s currency much.

The Fed Speaks: As the Federal Reserve looks to continue tightening its monetary policy, other countries are looking at fiscal stimulus as a way to reduce inflation.

• Fed officials insisted that the central bank will continue to raise interest rates to tame inflation. St. Louis Fed President James Bullard claimed that markets are right about the Fed’s rate intentions going into 2023. Meanwhile, Cleveland President Loretta Mester mirrored the sentiment but added that the bank could increase its policy rate above the Fed’s dot-plot median target rate. Although remarks by officials indicate rates will increase by another 125 bps before the end of the year, the level of hikes for each of the remaining meetings is still unknown. The latest CME FedWatch Tool suggests a 44.8% chance of a 50 bps increase and a 55.2% chance of a 75 bps increase.
  • The next meeting is on November 2; thus, the October CPI report released in two weeks will likely give us insight into how aggressively the Fed will tighten monetary policy.
• In a surprise, revised data showed that economic activity in Britain grew in the second quarter. The latest report showed that output increased by 0.2% from April to June, slightly above the original estimate of a 0.1% decrease. Despite the upward revision, concerns about the British economy remain. The figures reveal that consumption and investment have declined in that period, and this situation likely worsened in Q3 as the country adjusted to higher inflation and borrowing costs. The Truss administration’s stimulus plan may provide some economic reprieve but probably not enough to avoid a recession later this year and could make inflation worse.
  • The U.K. Prime Minister Liz Truss and Chancellor Kwasi Kwarteng are looking for solutions to stem concerns over its controversial tax plan. They will hold an emergency meeting with the Office of Budget Responsibility on Friday. The agency is expected to release the budget estimate on November 23. The meeting most likely explains the recent rebound in the pound.
• Japanese Prime Minister Fumio Kishida instructed the government to develop a budget that will tackle inflation and support a stronger yen. The move comes as the country looks for alternatives to ending its monetary policy accommodation to reduce price pressures. The next budget is expected to add to the country’s burdensome debt load and will probably weigh on future economic growth.

More Problems for Europe: Europe is struggling to cope with rising inflation and lack of energy resources as it looks to punish Russia for its invasion of Ukraine.

• Russia announced that it annexed four of Ukraine’s regions on Friday, a sign that tensions on the European continent are rising. The annexations are controversial because Russian forces do not fully control these areas, and many residents vehemently oppose Moscow. As a result, maintaining stability in the region will likely be difficult and expensive for a country struggling with economic sanctions. That said, the annexations could give Russia a pretext to use more dangerous weapons.
  • The biggest takeaway from the annexation is that Russia is prepared to go all out in this war. Therefore, we believe that, barring an overthrow of Vladimir Putin, the battle is likely to be prolonged. This outcome suggests that the European energy supply crunch could extend into next year and even worsen.
• Eurozone inflation jumped 10.1% from the previous year in September, a new record. The latest CPI report showed that price pressure is becoming more broadly based. Core inflation rose 4.8% from the prior year, higher than August’s reading of 4.3%. Persistently higher inflation could pressure the European Central Bank to increase its policy rate more aggressively in its October meeting. The market has priced in a 75 bps hike at its next meeting; however, we cannot completely rule out a more aggressive move.
  • Diverging borrowing costs among eurozone members may force the ECB to intervene in bond markets if it decides to raise rates. The spread between the Italian and German ten-year bonds is approaching its yearly high, thus increasing the likelihood of European fragmentation.
• The European Union will levy windfall taxes on energy companies in a move designed to pay for subsidies for households. The EU is now expected to focus on implementing a price cap on Russian oil. The moves suggest that the bloc will find it difficult to expand production and may worsen the energy problem.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with our thoughts on the Bank of England’s decision to purchase bonds to maintain financial stability. Next, we will discuss the Federal Reserve’s role in the global economy and how its monetary choices could impact other central banks. Lastly, we review growing geopolitical risks in Europe and Asia.

BOE to the Rescue: The central bank’s market intervention will benefit investors but weaken the bank’s ability to fight inflation.

• The Bank of England announced that it would start purchasing long-dated government bonds to minimize risk to financial stability on Wednesday. The move was aimed at calming markets after the government released its plan to cut taxes by the most considerable amount in half a century. Before the BOE’s action, the pound sank, and gilt yields surged over concerns that fiscal spending from the newly released tax plan would exacerbate inflation. Although the markets have been relatively tamed due to these actions, we cannot rule out an emergency rate hike from the central bank.
  • Despite pressure to reverse the tax plan, U.K. Prime Minister Liz Truss has vowed to stick with it.
• Financial markets initially responded positively as fixed-income investors interpreted the BOE’s move as a signal that it would act in times of crisis. As a result, the pound rebounded from $1.04 on Monday to $1.08 on Wednesday. Meanwhile, the yield on 30-year gilts fell from 5.1% to 3.9% in the same period. The bank’s intervention relieved market participants, such as pension funds and mortgage lenders, that were struggling to cope with higher borrowing costs. However, if the central bank holds to its word to end the bond-buying program after two weeks, we will likely see a return to market turmoil in October.
  • Despite the bank’s involvement, the five-year U.K. credit default swaps spread increased to its widest level since the 2016 Brexit vote.
• The BOE’s actions are evidence of a trend among central banks to maintain some level of policy accommodation as they collectively hike interest rates to counter inflation. For example, the European Central Bank and the Federal Reserve have developed similar policy tools to ensure that their respective financial markets continue to run smoothly. The bank’s decision to inject cash into the market while tightening monetary policy indicates that they are not fully committed to maintaining price stability if it can lead to a financial crisis. As a result, inflation will likely be more challenging to contain, forcing banks to become more aggressive in their rate hikes.

Fed Fallout: Although much attention is paid to the BOE’s solo act on Wednesday, it is essential to remember that the Fed is still the conductor of the financial orchestra.

• Non-U.S. central banks are exploring ways to protect their economies against a strengthening greenback. Over the last few months, tight Federal Reserve monetary and rising geopolitical risk in Asia and Europe pushed up the dollar’s value to a twenty-year high, much to the annoyance of other countries. On Wednesday, the People’s Bank of China warned investors that it would defend its currency from speculators, and Taiwan’s central bank walked back claims that it would impose foreign exchange controls. In the West, calls for a 75 bps hike from the ECB officials grew louder.
• Although the recent BOE actions have led to a global bond rally, it is not likely to last. Around the world, countries are coping with elevated levels of inflation and a weaker currency. To prevent inflation from rising and capital from leaving these countries, central banks will have to implement aggressive monetary policy, especially for developing countries. Thus, tighter financial conditions will weigh on global growth.
• The push by central banks to contain the rise of the dollar could harm financial assets, particularly in developing countries. The capital flight toward safety led to a steep drop in investment in emerging markets throughout the year. Data collected from Bloomberg showed that every asset class within the MSCI Emerging Market Index is on pace to post a negative return for 2022. The poor equity performance in these countries will likely continue as the Fed tightens and the dollar strengthens; however, investment opportunities will be available if these trends start to slow or even reverse in 2023. Although we are not forecasting an imminent change in the dollar’s trajectory, we would like to remind investors that the dollar cannot rise forever or, as the saying goes, “whatever goes up must eventually come down.”

Geopolitical Turmoil: Frictions in Europe and Asia could pave the way to war.

• Abrasive actions from Moscow could pave the way for a direct confrontation between Russia and NATO. On Thursday, the Kremlin announced that it would formally annex several regions in Ukraine following the results of a referendum viewed mainly as a sham. This move by the Kremlin might be a precursor for a nuclear strike in Ukraine after Russia warned that it was willing to take extreme actions to protect its homeland. The U.S. has cautioned Russia that it would be punished if it followed through on its nuclear threat. Although it is unclear whether Moscow is bluffing, its recent setback in Ukraine and its vastly unpopular war mobilization suggest it is desperate to end the war.
  • As we mentioned in previous reports, wars are generally caused by miscalculations. Russia is more likely to use nuclear weapons if it believes that the West will not respond militarily. If Russia is wrong and uses nukes, it could lead to another intercontinental war in Europe.
• NATO warned of a collective response due to evidence that the Nord Stream Pipeline system was sabotaged. The remarks suggest that countries within the military alliance may view attacks on its infrastructure as a provocation. Although there is no evidence that the coalition plans to respond with force, it does indicate that all options are being considered. The sabotage of European pipelines is an example of the growing geopolitical instability within Europe.

• Tensions between North Korea and the U.S. threaten the global economy. Pyongyang fired two short-range missiles toward the East Sea. The hermit kingdom made the provocative move one day before Vice President Kamala Harris is set to visit the peninsula’s Demilitarized Zone. South Korean officials believe that North Korea will conduct another nuclear test in the coming weeks as Pyongyang has been readying its underground nuclear test tunnel. The U.S. and Japan are opposed to North Korea having nuclear weapons. Thus, the country’s steady advancement in its weapons’ development raises the likelihood of a preemptive attack. In the event of a conflict in the Indo-Pacific, supply chains and trade in the region will be disrupted. We will be monitoring this situation closely.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including new details on how Russia’s new mobilization is playing out.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a focus on the turmoil in the U.K.’s financial markets today, which prompted the Bank of England to launch a new, time-limited program of bond purchases to stabilize the markets but has added to the recent weakness in the pound.

Russia-Ukraine:  The Ukrainian military continues to push forward with its counteroffensives in the northeastern region around Kharkiv and in the south around Kherson, while Russian forces try to shore up their new defensive lines even while staging some new attacks in the Donbas region.  Meanwhile, it now appears that Russia’s new mobilization order may generate even less combat power than many observers have expected.  New reports indicate that the freshly mobilized troops, many of which have no military experience at all, are being sent to the front lines near Kharkiv and Kherson with only one day or less of training.  At the same time, Russian authorities are establishing checkpoints at Russia’s borders to forcibly mobilize Russian men who are seeking to avoid deployment by fleeing the country.  Russian officials are also setting conditions to forcibly conscript Ukrainian civilians in soon-to-be annexed areas of occupied Ukraine.

• Yesterday, Russian authorities in their occupied areas of Ukraine wrapped up their sham referendums on annexation to Russia and reported overwhelmingly positive results.  The move will allow President Putin to announce formal annexation of the areas to Russia as early as Friday.  Besides marking a political line in the sand, the move could potentially allow Russia to deploy conscripts to the occupied areas and even extend Russia’s nuclear deterrence over them, based on the argument that the areas will now officially be Russian territory.
• One little-noticed implication of Putin’s new mobilization order is that it will likely further disrupt the Russian economy.  Not only will the marshaling require huge sums to equip and pay the new troops, at a time when the Russian budget is being impacted by falling energy revenue, but it will also disrupt many businesses as workers are scooped up by the military or emigrate to avoid military service.
• On the energy front, European officials continue to investigate what caused the three leaks in the Nord Stream 1 and 2 natural gas pipelines from Russia to Western Europe.  However, Danish Prime Minister Frederiksen and NATO General Secretary Stoltenberg have both indicated it was sabotage.  Since such sabotage would most likely have come from Russia, the incident has touched off a scramble among European countries to secure their energy infrastructure.  A key target of those efforts will be the natural gas pipelines from Norway, which have now become one of Western Europe’s most important sources of gas.

United Kingdom:  Trying to calm the economic and financial market turmoil touched off by the new government’s massive tax cuts and energy subsidies, the Bank of England today said it would pause its planned sell-off of government bonds and instead purchase longer-dated gilts “on whatever scale is necessary” to restore market order.  The move comes just one day after Chancellor Kwarteng said he has been meeting with BOE Governor Baily every day to better coordinate fiscal and monetary policy.

• In the economic and financial market chaos yesterday, the 10-year gilt had sold off to yield 4.51%, and some mortgage companies suspended new fundings.  Following the BOE action today, the benchmark gilt yield has now fallen to approximately 4.00%.  The action also affected other major government bond markets.  For example, the benchmark U.S. Treasury yield had pushed to 4.017% early in the overnight trading session, marking its first foray above 4.000% in over a decade, but it fell back on the BOE news and currently stands at 3.871% as of this writing.
• One particularly disturbing development over the last couple of days has been that many British insurers and pension funds had faced big margin calls on their gilt holdings.  Those margin calls further fed the sell-off in government bonds, driving yields higher and threatening to undermine the U.K.’s financial stability.

• Since the government’s massive fiscal stimulus threatens to drive British consumer prices even higher, investors had been looking for the central bank to implement huge interest-rate hikes, bringing their benchmark rate to 6% or more in the coming months. The move to buy bonds now could potentially raise some question about the BOE’s ability to resist government pressure and to keep tightening policy over time.
• Huge interest-rate hikes that rein in inflation could well push the British economy into recession. Alternatively, if the government convinces the BOE to minimize its rate hikes, investors could start to question the central bank’s commitment to price stability.  In either case, the implication is continued depreciation of the pound.  Indeed, the pound initially rallied on today’s BOE move, but it has since turned lower again and is now down 1.5% for the day to a value of $1.0572.
• Meanwhile, the IMF issued an unusual rebuke of the tax cuts yesterday, saying, “Given elevated inflation pressures in many countries, including the U.K., we do not recommend large and untargeted fiscal packages at this juncture.” In response, supporters of Prime Minister Truss defended the move in part by stressing that the government doesn’t plan to release its spending blueprint until November.  Truss has previously said that she wouldn’t cut spending, but the statements from her supporters indicate the government plan may well go against that promise, most likely to target social spending.

Chinese Currency Markets:  Although the recent dollar appreciation has led to lower values for a range of major currencies, the pound and some others have weakened more than others.  The onshore Chinese yuan so far this morning has fallen to 7.2268 per dollar, marking its lowest level since 2008.  The yuan has now lost 13.8% of its value so far in 2022

• In response, the People’s Bank of China issued a statement saying, “The foreign exchange market is of great importance, and maintaining its stability is the top priority.”
• The central bank statement could signal that it intends to intervene in the market in the near future if the currency continues to weaken.

Chinese Politics:  Putting to rest the weekend rumors about a coup, President Xi reappeared in public leading a delegation to a major propaganda exhibition.  Even though the appearance proved Xi is still in power, and even though we still expect him to secure his precedent-breaking third term in power at the Communist Party’s 20^th National Congress next month, the coup rumors do underline that there is probably some opposition to Xi within the party.

Saudi Arabia:  Yesterday, King Salman named his son, Crown Prince Mohammed bin Salman, as prime minister, further cementing the crown prince’s power over the Saudi state.  The move was probably also meant to help rehabilitate MBS in international politics, given that he has been treated nearly as a pariah due to his role in ordering the death of a dissident journalist in 2018.

Iran:  Protests against the government’s strict morality laws and repression of women continue to expand, prompting a further crackdown from the government.  The protests and crackdowns so far have resulted in some 40 deaths, hundreds of injuries, and hundreds of arrests.  The protests have now become the largest in Iran in years, although the government’s survival does not yet appear to be threatened.

U.S. Monetary Policy:  In an online event yesterday, Minneapolis FRB President Kashkari said that the Federal Reserve must avoid repeating its mistakes of the 1970s, when it eased monetary policy too soon and allowed inflation to reaccelerate.  Rather, Kashkari warned that the central bank needs to tighten monetary policy until underlying inflation is declining and then hold policy tight until it is sure inflation is coming down.  The statement underscores how aggressively the Fed is likely to approach monetary policy in the coming months and quarters, most likely kicking the U.S. economy into recession.

U.S. Fiscal Policy:  After jettisoning Senator Joe Manchin’s proposal to ease regulations around new energy investments, last night the Senate voted to advance a stopgap appropriations bill that will avert a partial government shutdown this weekend when the fiscal year ends.  The bill now moves to final passage in the Senate and will also need approval in the House, which returns Wednesday, before going to President Biden for his signature.

U.S. Housing Market:  Illustrating how rising U.S. interest rates are weighing on the housing market, a report yesterday showed the S&P CoreLogic Case-Shiller National Home Price Index fell a seasonally adjusted 0.2% in July, marking the seasonally adjusted index’s first monthly decline in more than a decade.  The report showed home prices were still up an average of 15.8% year-over-year, but the rate of increase has been slowing, which is likely a harbinger of weaker growth in the broad economy in the coming months.

U.S. Weather Damage:  Hurricane Ian has intensified rapidly early this morning, and with sustained winds of 155 miles per hour, it is now close to the standard of 157 miles per hour needed for it to be rated a Category 5 storm.  Ian is now projected to slam into Florida’s coast around mid-day today and cause intense flooding and other damage.  If it strikes Florida as a Category 5 storm, it would be only the fifth such storm to hit the U.S. mainland.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, including a bit more detail on Russia’s new mobilization plan and news of a possible Russian sabotage of the natural gas pipelines to Western Europe.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Russia-Ukraine:  The Ukrainian counteroffensives in the northeastern area around Kharkiv and in the southern region around Kherson continue to make modest progress, while Russian forces have now succeeded in re-establishing some defensive lines and continue to stage modest attacks in the eastern Donbas region.  Russian President Putin’s mobilization order last week is likely aimed in large part at generating infantry troops with the minimal skills and equipment to defend the new Russian lines into the winter.  While that mobilization is being carried out much more broadly than advertised to the Russian people, it may take some time before significant numbers of new troops can be deployed to the battlefield.  Even then, there is some question as to how well the Kremlin can keep them supplied.  In the meantime, the domestic political costs of the mobilization are rising.  With the call-up affecting people literally across the country, protests against the mobilization are growing, at least for the time being.

• In a possible escalation of the energy war between Russia and the West, officials in Germany and Denmark reported several suspicious leaks in the Nord Stream 1 and 2 natural gas pipelines running from Russia to Western Europe. Although neither pipeline is currently operational, the officials worry that the leaks could have resulted from sabotage.
• The officials are concerned that sabotage against the pipelines could be meant as a Russian warning against a new pipeline that will bring gas from Norway to Poland. Russia might also have an interest in damaging the pipelines as a way of doubling down on its energy war with Europe, especially by signaling that Europe has no hope of renewed gas shipments through the pipelines.

European Union:  As the war in Ukraine and Russia’s cut-off of energy shipments keeps gas prices sky-high across the EU, leaders from a range of member countries petitioned the European Commission today to impose a “dynamic price cap” on gas.  The idea would be to limit prices paid to slightly above the amounts paid in other world regions in order to provide LNG shippers with a continued incentive to make deliveries to Europe.  So far, the Commission has shied away from proposing a cap, and it’s unlikely to be part of the measures put forward ahead of an emergency summit of EU energy ministers on Friday.

United Kingdom:  As the pound continued to weaken yesterday in response to government plans for potentially inflationary tax cuts, the Bank of England warned it stands ready to raise interest rates as much as needed to hit its inflation targets.  However, the central bank did not signal that it would call an interim policy meeting to consider the matter, as some investors were expecting.

• The BOE could still call an emergency meeting at any time, but if they don’t, the next regular policy meeting where the officials could hike rates would be in November.
• That means there is now the potential for weeks of uncertainty before investors know how aggressive the central bank will be in hiking interest rates. The result could well be continued volatility and downward pressure on the pound, even though the currency has rebounded modestly to approximately $1.0790 so far this morning.

China:  In updated forecasts, the World Bank predicted that China’s economic growth this year will trail that of the other developing countries of East Asia for the first time since 1990.  The institution now expects Chinese gross domestic product to grow just 2.8% in 2022, down from its forecast of 4.3% in June.  It now expects regional GDP excluding China to grow 5.3%.

• The new forecasts illustrate the slowdown China is suffering from factors like President Xi’s Zero-COVID policy, a government clampdown on the domestic real estate and technology industries, and a recent drought and heatwave.
• The Chinese economic slowdown will likely weigh on Chinese assets and further undermine the renminbi. It may also present further headwinds for global economic growth and the financial markets.

Colombia-Venezuela:  Illustrating how Colombia’s new leftist president, Gustavo Petro, is continuing to rebuild relations with Venezuela, yesterday the two countries reopened their border for the first time in seven years.  The move raises the risk that Colombia is losing its status as the U.S.’s most trusted ally in the region.

Canada:  Speaking of borders reopening, Canada’s government announced yesterday that it will no longer bar people that haven’t been fully vaccinated for COVID-19 from entering the country. It also stopped a requirement that travelers upload proof of vaccination and other information into a government app called ArriveCan.  The move will likely ease commercial and tourist traffic between the U.S. and Canada, and give a boost to cross-border trade.

U.S. Fiscal Policy:  In an estimate released yesterday, the Congressional Budget Office said President Biden’s student-loan forgiveness program would cost the federal government some $400 billion over the coming three decades.

U.S. Lumber Market:  Amid a continued slowdown in housing construction, lumber futures prices yesterday settled at $410.80 per thousand board feet, down about one-third from a year ago and more than 70% from their peak in March.  Although we remain bullish on commodities over the coming years, the pullback in lumber prices is a reminder that rising interest rates and an impending recession are likely to weigh on commodity values in the near term.

U.S. Hurricane Threat:  Hurricane Ian continues to move northward through the Caribbean, and it is now forecast to score a direct hit on Florida’s Tampa Bay later this evening or tomorrow.  Businesses in the Tampa region have closed in advance of the storm as local counties ordered evacuations for vulnerable coastal areas.

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