by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Note to readers: the Daily Comment will go on holiday after today’s Comment and will return on January 3, 2022. From all of us at Confluence Investment Management, have a Merry Christmas and a Happy New Year!

Our Comment today opens with a surprising monetary tightening in Japan that has had a significant impact on global markets so far this morning.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the release of a new U.S. spending bill for 2023 that should eliminate the risk of a partial shutdown of the federal government when the current spending authorization runs out at the end of the week.

Japan:  In its latest policy decision, the Bank of Japan kept its benchmark short-term interest rate unchanged at -0.5%, but then surprised investors with a hawkish change to its yield-curve-control policy.  The BOJ said that it would now allow the yield on 10-year government bonds to rise as high as 0.50%, from a limit of 0.25% previously.  BOJ Governor Kuroda insisted that the change was aimed only to improve the functioning of Japan’s bond market, but the move is being taken as a sign that the central bank has finally been forced to respond to rising inflation and the weak JPY.

• The decision has driven important moves in several key markets so far this morning:
  • Japanese 10-year government bond yields jumped to approximately 0.40% immediately after the decision, pushing up government bond yields in many other countries as well.
  • More importantly, the JPY so far this morning has strengthened some 3.1% to 132.59 per dollar, from about 137.00 per dollar before the decision.
  • Japanese stock values fell approximately 2.5% on the prospect of a stronger JPY and higher borrowing rates.
• It remains to be seen whether and how aggressively Japanese monetary policy will continue to tighten. Nevertheless, the reactions to today’s BOJ move illustrate how sharply markets can move in response to a sudden unhinging of policy.  For example, the market reaction suggests a similar big impact on the dollar if the Federal Reserve were to lift its target inflation rate above the current 2.0%.

China:  After abandoning President Xi’s Zero-COVID policy and with a new wave of COVID-19 infections sweeping across the country and disrupting the economy, Chinese state media has taken to describing this “exit wave” as well planned and temporary.  A report in the state-run China Daily today promises “normalcy by spring.”

China-Hong Kong:  Securities regulators in China and Hong Kong have agreed to expand the scope of their “Stock Connect” program, under which investors can access mainland stock markets through the Hong Kong bourse.  Northbound investments can now include stocks that have a market capitalization exceeding about $717 million or that meet certain liquidity criteria. Southbound investments can now include stocks of primary-listed foreign companies that are constituents of Hang Seng composite indices.

• The move will boost the number of mainland stocks eligible for trading via the northbound link to about 2,516, up from the current 1,458.
• Nevertheless, despite other recent signs that the Chinese government wants to ease tensions with the West in order to support its economy, we still believe the long-term geopolitical competition between China and the West will make it riskier and more difficult for U.S. investors to invest in China.

Russia-Ukraine War:  Fighting continues along the front lines running from northeastern to southern Ukraine, while yesterday the Russians launched a new swarm of Iranian kamikaze drones against Kyiv.  Ukrainian military officials believe that the Russians should only be able to launch three or four more rounds of missiles into Ukraine before they will deplete their available inventory, after which they will need to procure Iranian ballistic missiles, which Ukraine would have trouble defending against.  Meanwhile, Russian President Putin traveled to Minsk yesterday but apparently failed to get President Lukashenko’s agreement to deepen Belarus’s participation in the war.

European Union:  As we previewed in our Comment yesterday, EU energy ministers agreed to impose a price cap if month-ahead prices remain above €180 per megawatt hour on the bloc’s main trading hub for three consecutive days. Prices must also be at least €35 higher than a reference level for global LNG during the same period.  The new rule goes into effect on February 15.  One key risk with the policy is that it could prompt shippers to divert natural gas shipments to Asia or other locales where prices may be unregulated and much higher.

United States-European Union:  Facing strong pushback from the EU against its new subsidies for U.S.-made green technology, the Biden administration yesterday delayed its proposed rules for new tax incentives related to electric vehicles.  Details on the battery-sourcing requirements that electric vehicles must meet in order to qualify for up to $7,500 in tax credit will now be released in March, instead of by the end of this year as earlier planned.

• The delay suggests that the administration is showing some alliance-building sensitivity to EU leaders, who worry that the U.S. subsidies will hurt the EU’s green technology sector. Indeed, German Economy Minister Habeck and French Finance Minister Le Maire today issued a joint paper arguing that the U.S. and EU have a mutual interest in swiftly finding common ground on the controversy.
• All the same, it’s important to remember that the U.S. administration has encouraged the EU to adopt similar subsidies as a way to reduce their economic dependence on China.

United States-Congo-Zambia:  Last week, the U.S. signed a memorandum of understanding with the Democratic Republic of Congo and Zambia to provide them with the funding and technical expertise to develop their supply chains for minerals related to electric-vehicle batteries.  The move shows how the U.S. is working to reverse its disadvantage in the supply of exotic minerals needed for the electrified economy of the future.

• Importantly, the U.S. move also has important geopolitical considerations. We assess that the Congo is currently a member of the evolving China-led geopolitical bloc, while Zambia is in the “leaning China” bloc.
• The U.S. move illustrates how the U.S. and China are likely to work feverishly to peel countries out of their adversary’s blocs in order to ensure access to critical mineral supplies.

U.S. Fiscal Policy:  Earlier today, congressional leaders unveiled an agreed spending bill for the remainder of the 2023 fiscal year.  The bill, which must be passed and signed into law by the end of the week to avoid a partial government shutdown, includes $858 billion in military spending, or $45 billion more than President Biden had requested and up about 10% from $782 billion the prior year. It also reportedly includes $773 billion in nondefense discretionary spending, up almost 6% from $730 billion from the prior year.

U.S. Retirement Policy:  The spending bill expected to be signed into law in the coming days also includes several important changes to the laws related to retirement savings.  For example:

• The bill raises the age at which people are required to start withdrawing money from tax-deferred retirement accounts from 72 today to 73 beginning in 2023 and to 75 in 2033
• It also increases the catch-up contributions older workers are allowed to make to their 401(k)-style retirement accounts. In 2023, people 50 and older will be able to contribute an extra $7,500 a year to these accounts. The bill would also raise the catch-up amount to at least $11,250 a year for people 60 to 63 beginning in 2025.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a review of Japan’s new defense strategy, which was released at the end of last week, and illustrates how Japan intends to become a much more powerful military force and a more potent ally as the U.S.-China geopolitical rivalry worsens.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including new developments in the massive COVID-19 surge in China and the wave of pre-Christmas strikes sweeping across the U.K.

Japan:  In its updated military strategy, the Japanese government stated that China has now become its main security challenge and that meeting that challenge will require the country to double its defense spending to 2% of gross domestic product by 2027.  Based on current GDP, this would bring Japan’s annual military budget to around $80 billion, putting Japan third in the world behind the U.S. and China.  Importantly, the new strategy says that much of that spending will be on “counter-strike” missiles that could be used to attack military bases outside of Japan.

• The new military strategy shows how Japan has woken up to the threat it faces from China, Russia, and North Korea. The commitment to boosting its defense capability also illustrates how Japan will be a critical ally in the evolving U.S.-led geopolitical bloc as it seeks to defend itself from the aggressiveness of the evolving China-led bloc.
• Pacifists have complained that the counter-strike missile capability may violate Japan’s exclusively defense-oriented posture under the Constitution’s war-renouncing Article 9. However, the government has long viewed the capability as constitutional so long as three conditions for the use of force are met:
  • An armed attack has occurred or is imminent;
  • There is no other way to halt an attack; and
  • The use of force is limited to the minimum necessary.
• The planned increase in Japan’s defense budget also illustrates the big increases in military spending that we expect to see across the globe in the coming years. In our view, those increases will create enticing investment opportunities in the traditional defense industry, software and cybersecurity, and other related industries, especially in the U.S.
  • Japan’s new counter-strike capabilities will ultimately be achieved by extending the range of its homegrown Type 12 stand-off missile.
  • However, in the first five years or so until that modification can be made, Japan will be buying hundreds of U.S.-made Tomahawk missiles.

Russia-Ukraine War:  Although fighting continues along the entire front from northeastern to southern Ukraine, the bulk of the violence remains centered on the eastern city of Bakhmut, which Russian mercenaries have been trying to capture for months.  Meanwhile, Russian President Putin will visit Belarus today to confer with its president, probably in part to signal that Belarus could enter the war in support of Russia and pin down significant numbers of Ukrainian troops in the northwest as a precaution.  Separately, a missile attack on the Russian region of Belgorod suggests the Ukrainians continue to get bolder about bringing the war home to Russia, although the Ukrainian officials, as usual, have not taken credit for the attack.  Finally, Ukrainian officials say that Russia has procured another batch of Iranian drones for use in its continuing campaign to destroy Ukraine’s energy infrastructure and freeze the Ukrainians into surrender.

• Contrary to what some observers think, new reporting indicates that the Russian defense industry remains capable of producing at least basic, relatively low-tech artillery shells and missiles despite Western sanctions. The problem for the Russians is that they are firing those shells and missiles much faster than they can produce them.
  • For example, the analyses show that in June, the Russians were firing 60,000 shells and missiles per day. The rate has recently fallen to about 20,000 per day, but that’s still far more than Russian industry can replace.  An analysis by the Jamestown Foundation indicates that the Russian military has fired so many shells and rockets since it invaded in late February that it would cost roughly $92.74 billion to replace the entire range of munitions that have been used.
  • As a result, the U.S. Defense Department believes that, in early 2023, Russia will need to begin using old, less reliable shells and missiles that were stockpiled decades ago.
• In a separate issue, Israeli defense officials warned that Iran isn’t just providing drones and missiles to Russia for the war, but, in return, it is asking Russia to provide it with ships to build up its navy. The Iranian navy is reportedly keen to increase its operations in waters as distant as the Indian, Pacific, and Atlantic oceans.
  • Iran had previously been hoping to acquire Chinese-made combat ships, but Beijing has proven reluctant to share its military technology.
  • Russia’s reliance on Iranian drones and missiles suggest it could be more amenable to helping Iran acquire ships and related equipment.

European Union-Qatar:  As EU officials continue to investigate an apparent Qatari effort to buy influence in the European Parliament, Qatari officials warned that the investigation would endanger negotiations for Qatar to help replace some of Russia’s energy supplies to Europe.

• Since Russia’s invasion of Ukraine, Qatar has emerged as one of Europe’s best hopes for weaning itself off Russian natural gas. Germany, France, Belgium, and Italy have been in talks with Qatar to buy LNG on a long-term basis.
• If Qatar acts on its threat to ratchet back energy supplies to the EU, even as supplies from Russia remain largely cut off, it could undermine the recent improvement in sentiment about EU economic prospects and have a negative impact on European stocks.
• On a closely related note, EU energy ministers today are expected to agree on a price cap of €188/MWh for natural gas in an attempt to stabilize and push down energy prices for consumers. However, some large EU countries are still pushing back on the idea out of fears that the price cap could remove the incentive to economize on use and send some gas shipments abroad.

United Kingdom:  Prime Minister Sunak is convening a cabinet meeting today to develop a plan for dealing with the massive wave of pre-Christmas strikes rolling across the country.  Nurses, ambulance drivers, customs and immigration staff, postal staff, and rail workers will all walk out in the coming days, leaving the government with a growing logistical and political headache.

• Public support for the strikes remains relatively strong, prompting many even in Sunak’s own Conservative Party to urge him to sign off on pay raises, particularly for nurses.
• Of course, doing so would further worsen the government’s finances. In any case, the strikes could also weigh on the British economy and stock market, on top of the recent energy crisis.

China:  As expected, the country’s recent abandonment of its Zero-COVID policies has left the disease running rampant in major cities, causing widespread business disruption as staffing shortages threaten to close down factory production lines and transportation workers fall ill.  Companies have reportedly been left with no direction on how to handle the sudden surge in cases, after they had formerly been operating under strict guidelines handed down by local governments.  As we have previously predicted, the disruptions are likely to weigh on the Chinese and global economies in the coming months until the new “exit wave” runs its course.

China-Australia:  China’s foreign ministry has invited Australian Foreign Minister Penny Wong to attend a renewed Australia-China Foreign and Strategic Dialogue this week, restarting a series that has been on ice since 2018 because of worsening geopolitical tensions between the countries. Just as concerns about China’s economic growth likely played a major role in its abandonment of its Zero-COVID policies, those same concerns appear to be driving China to improve relations with several countries in the evolving U.S.-led geopolitical bloc.

U.S. Energy Policy:  New data suggests that this year’s emergency releases from the U.S. Strategic Petroleum Reserve have left the federal government about $4 billion ahead.  With the sales set to end this month, Washington has sold 180 million barrels of crude at an average of $96.25 a piece, well above the recent market price of $74.29.  Unfortunately, that paper gain may not materialize if prices rebound ahead of any efforts to replenish the reserves.

U.S. Economic Performance:  In a new poll by the Wall Street Journal, a majority of respondents said that they expect the U.S. economy to be worse in 2023 than it was this year, despite the recent cooling in inflation.  The finding is consistent with our view that a recession is likely to begin in the first half of 2023.  Of course, the pessimism could also become self-fulfilling if it means consumers pull back on spending to build a financial cushion for tough times ahead.

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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 about European fragmentation. Next, we discuss how countries within blocs may prioritize their own self-interests over others within their group. Lastly, we review signs that the global economy may enter a recession in 2023.

 Fragmentation Returns: The bond market is unsettled with the European Central Bank’s plan to wind down its balance sheets and accelerate rate hikes

• The ECB is poised to ramp up its tightening cycle in 2023 as it looks to combat inflation. On Thursday, ECB president Christine Lagarde announced that the central bank planned to raise interest rates higher than the market anticipated and wind down its balance sheets starting in March. The bank plans to hike rates in 50 bps increments and reduce its balance sheet by 15 million euros per month, on average, until the end of the second quarter of 2023. When explaining the need for the aggressive decision, Lagarde argued that the ECB has more ground to cover to catch up with the Fed.
• The market responded negatively to the ECB’s hawkish tone. The Euro Stoxx 50 closed down 2.6% on Thursday. Meanwhile, the 10-year yield on Italian bonds jumped 25 bps, pushing its risk premium above the German 10-year bond by 207 bps. The market reaction suggests that investors would like to receive more yield from retaining riskier assets. That said, the central bank’s tough talk did help boost the EUR. The currency peaked at $1.0737, its highest level since June 9, as investors believe that the ECB is prepared to take on inflation.
• At this time, the ECB may not actually be able to tighten policy as much as it claims. Tightening monetary policy aggressively creates diverging borrowing costs among eurozone countries. Differing interest rates will make it harder for the European financial system to operate as a single entity. Although the ECB has developed anti-fragmentation instruments to address these issues, committee members are reluctant to use those tools. As a result, it is more likely that if bond spreads get too out of whack, the ECB could moderate its policy stance.

Friend or Foe? Inter-bloc rivalries may undermine efforts to form regional blocs and could lead countries to become isolationist.

• The U.S. and the European Union are still at loggerheads over the “made-in-America” provision in the Inflation Reduction Act. The law allows U.S.- based firms to receive a tax break if they source materials from American suppliers for parts used to make goods such as electric vehicles. France believes that the regulation will disadvantage European companies. Meanwhile, American think tanks posit that the bill will help the U.S. compete with China. The dispute could turn into a trade war between the U.S. and Europe and undermine efforts to integrate economic and foreign policies.
• Things are not any better in the potential Chinese-led bloc. India has purchased Russian oil under the G-7 price cap. Before the cap was established, Russia insisted that it would not supply countries who complied with the rule. Additionally, China has banned the sale of military-grade processors to Moscow in order to comply with U.S. sanctions. The decision by India and China to follow western sanctions on Russia suggests that countries may not be loyal to their bloc if it goes against their respective interests.
  • This could potentially have geopolitical implications as smaller blocs may form within larger blocs. For example, OPEC countries (who are generally aligned with China) could respond by reducing production, thereby harming other members of the China-led bloc.
• The interwar period between World War I and World War II was the last time countries were truly deglobalized. Although there were military alliances, the lack of a definitive reserve currency made it difficult for countries to maintain trade blocs. As a result, countries were very centralized, and global trade was relatively limited when compared to pre-WWI. As the U.S. withdraws from its position as a global hegemon, other countries may seek to also disengage from the rest of the world. This scenario could lead to higher inflation, which should benefit commodities. As the chart below shows, commodities generally perform well relative to stocks in an inflationary environment.

(Source: Longtermtrends.com)

Warning Signs: There are mounting signs that the global economy may have a rough ride in 2023.

• U.S. economic data shows that the world’s largest economy is slowing down as retail sales and manufacturing dropped in November. The weak economic data shows that consumption and production are waning, adding to woes that the U.S. may be headed toward recession over the next few months. Additionally, firms are becoming wary of the number of workers on their payrolls, and even government agencies are feeling the pinch. As a result, unemployment numbers may rise next year as firms adapt to a decline in demand.
• The COVID spread in China also poses a risk to the global economy. As Beijing slowly starts to reduce its Zero-COVID restrictions, the death toll is beginning to surge. The spread of the virus will make it difficult for the world’s second-biggest economy to purchase global goods and could further complicate supply-chain flows. As a result, international firms could take a hit in revenue and see an uptick in their input costs. Although the drop in Chinese demand could weigh on global inflation, it is also possible that it would make it harder for countries reliant on exports to grow their economies.
• Lastly, there is still rising uncertainty about how major central banks will adjust monetary policy during a recession. Although it is tempting to assume that they will abandon tightening when the economy weakens, the central banks are mandated to reduce inflation to around 2%. Given that these banks aim to maintain unemployment and price stability, it wouldn’t be unreasonable for them to keep rates elevated even when the economy is in recession. As a result, we advise that investors be strategic in their allocations and pay closer attention to shorter-duration assets until the Fed signals that it is prepared to ease monetary policy.

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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 the Federal Reserve’s rate decision from Wednesday. Next, we provide an overview of both the European Central Bank and Bank of England’s decision to tighten monetary policy. Lastly, we give our thoughts about the latest chapter in the fight against global inflation.

 The Fed Presses On: Fed Chair Jerome Powell insists that the Fed will tighten policy until it makes noticeable improvements toward its 2% inflation objective; however, the market is not convinced.

• The Federal Reserve reduced the size of its rate hike but warned markets that peak interest rates would be higher than it had previously anticipated. On Wednesday, the Federal Open Market Committee raised its benchmark rate by 50 bps to a target range of 4.25% to 4.50%. During a press conference, Powell stuck to the Fed statement and maintained that the central bank’s fight against inflation is not over. The latest dot plot shows that the overwhelming majority of Fed officials support peak fed funds above 5.0% in 2023, while the following year shows a sizeable dispersion around a median range of 4.1% (See chart below). As of this morning, Eurodollar futures signaled terminal fed funds of 4.9% in 2023 and 3.4% the year after.
  • Despite his hawkish talk, Powell let slip that the Fed could reexamine its 2% inflation target at some point in the distant future, signaling that the Fed could become significantly more dovish over the next few years.

• The market reaction was mixed. Equities appeared to have accepted that the Fed will raise rates higher than initially anticipated. Although the S&P 500 fluctuated following the announcement, it ultimately closed down 0.6% from the previous trading day. The dollar and bond market had a somewhat muted response to Powell. The U.S. dollar index closed down 0.12% from the prior day. Meanwhile, the spread between the 2- and 10-year Treasury narrowed to a paltry 3 bps lower in the same period. The lack of a reaction suggests that fixed-income and currency traders believe that the Fed will not tighten policy in a downturn. If they are right, the U.S. dollar could weaken in 2023.
• A strong economy and a tight labor market will likely allow the Fed to raise rates without much hassle. However, an economic downturn could complicate matters. The latest summary of economic projections shows that the median forecast for GDP growth will be 0.5% for 2023, with some officials predicting a contraction. A recession could lead the Fed to discontinue hiking rates and, if it is severe enough, could force the central bank to cut rates. An inflation rate of less than 3% could also lead to a Fed pivot, but this is more fantasy than anything. At this time, it appears that the Fed would like to either hike or pause depending on the economic data.

 Other Central Bank News: The European Central Bank and the Bank of England followed the Federal Reserve’s lead but are likely less committed to raising interest rates in 2023.

• The ECB and BOE have both decided to raise interest rates by 50 bps. The two central banks have elected to downshift their hikes to accommodate for a slowdown in inflation and economic growth. The BOE lifted its bank rate from 3.0% to 3.5%, while the ECB pushed its deposit rate from 1.5% to 2.0%. Although the banks maintained that their peaks are likely higher, it appears that both are paying attention to the economic ramifications of continuing to tighten policy. Unlike the Fed, the BOE and ECB are both predicting recessions for 2023.
  • There was a stronger-than-expected consensus at the BOE. Six of the nine members voted for a 50 bps hike, one for a 75 bps hike, and the other two members wanted policy to remain unchanged. This suggests that the BOE has become more dovish.
• The ECB is signaling that it would like to tighten policy more aggressively, but it is unclear if it has the policy flexibility to do so. In its statement, the ECB announced plans to wind down its €5 trillion balance sheet in March 2023. The move comes as the financial stress, as measured by the spread between 10-year German and Italian bonds, has declined more than 50 bps since September. That said, as interest rates rise it will likely worsen European fragmentation. Additionally, ECB President Christine Lagarde stated that the bank could continue hiking rates in 50 bps intervals. Tightening policy during a recession will likely be politically unpopular, and, as a result, the ECB may be more assertive in the short-term to maneuver its policy rate into restrictive territory before it begins receiving pushback.
  • Another sign that they may not raise rates throughout 2023, is that it appears that these is not a strong consensus among council members.
• The tighter monetary policy within these countries may not be as long-lived as these banks are implying. Both the Eurozone and the U.K. are either in or headed toward contraction. As a result, these countries risk harming their economy with higher rate hikes. Although this does not mean that these central banks will cut rates in 2023, it does signal that they are close to finishing their tightening cycle. Assuming that the U.S. does not enter a deep recession, this outcome should be supportive of the dollar as it will likely mean that European inflation will be a persistent problem.

 A New World: Central Bankers are unlikely to be as hawkish in 2023.

• Unlike the U.S., there may not be policy space for other central banks to tighten more than needed. In Europe, governments are becoming more comfortable in dealing with the problem through subsidies and price ceilings. The U.K. and Germany have funded payments to households and businesses to offset rising energy costs. Meanwhile, the Netherlands will implement rental caps to deal with shelter shortages. The government interventions should help reduce inflationary pressures and allow the central banks to become more measured in how they raise rates; however, there is an additional risk of higher inflation volatility in the future once these caps are removed.
• That said, there are many headwinds that could prevent banks from abandoning rate hikes altogether. The major unknown is how China’s reopening will impact global price pressures. China’s recent decision to accept western medicine to help contain the COVID virus shows how eager the government is to reopen. Although there has been much discussion about the future demand for commodities, there is also the possibility of an improvement in supply chains due to the lessening of restrictions. Additionally, rising union power and the war in Ukraine are also likely to boost price pressures as the potential rise in wages and raw materials could force firms to push cost adjustments onto consumers.
• Major central banks are entering a new phase of their tightening cycle. Monetary policymakers will begin to look for signs that they should moderate policy rather than continue to tighten it. Assuming that prices continue to fall globally, we expect the ECB and BOE to be the first of the five major five central banks (which include the Swiss Central Bank, the Federal Reserve, and the Bank of Japan) to signal a pause in tightening. This should make equities within these countries relatively more attractive when compared to the U.S.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with the expected surge in COVID-19 infections in China after it relaxed its pandemic regulations.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest in the Russia-Ukraine war and the beginnings of a wave of strikes in the U.K.  We discuss today’s U.S. inflation data in the “U.S. Economic Releases” section below.

China: Following the government’s recent relaxation of its COVID testing and quarantine policies, a range of indicators suggests the disease is now ripping through the country.  Hospitals and clinics are reportedly facing a surge in cases, although it is still a bit too early for deaths to be rising dramatically.

• Experts predict the new wave will peak in one to three months, with some 60% of the population infected—probably enough to ensure significant economic disruptions as people self-quarantine and businesses face mass absenteeism.
• Those trends are likely to weigh heavily on China’s economy and financial markets, which in turn is likely to present headwinds for the global economy and financial markets.

China-United States: The Chinese Commerce Ministry yesterday filed a complaint with the World Trade Organization against the massive new U.S. restrictions on selling advanced computer chips, chipmaking equipment, and related components and services to China.  The filing comes just days after the WTO ruled against the Trump administration’s imposition of steel and aluminum tariffs against China and other countries based on national security concerns.

• The Biden administration’s restrictions, issued in October, essentially amount to a blockade of advanced information technology going to China in order to suppress the country’s military and economic development.
• In each case, however, the WTO ruling is unlikely to have legal effects because its Appellate Body has been suspended over disagreements among the WTO’s member states. The new U.S. restrictions will likely remain a key source of friction between the U.S. and China and will probably limit China’s technological development going forward.

China-India: Chinese and Indian troops have once again skirmished along the China-India frontier high in the Himalaya mountains.  In contrast with the big 2020 skirmish that killed approximately two dozen, the latest fight only produced minor injuries and was apparently very short-lived.  Nevertheless, the incident serves as a reminder of the geopolitical risks involved as the two countries jockey to maintain control over their frontiers in the Himalaya region.

European Union: Ambassadors from the EU’s member states last night reached a deal with Hungary that will allow the EU to implement a new minimum corporate income tax of 12% and provide some €18 billion in support for Ukraine.  In return, the EU committed to approve Hungary’s €5.8 billion COVID-19 recovery plan, which has been held up since last year because of EU concerns about rule-of-law policies in Hungary.

• In a separate deal today between EU national governments and the European Parliament, officials agreed to impose a tax on imports based on the greenhouse gases emitted to make them, inserting climate regulation for the first time into the rules of global trade.
• The “carbon border adjustment mechanism” has angered a number of EU trading partners, especially some emerging markets that emit relatively large amounts of greenhouse gases when producing goods for the EU market.

Russia-Ukraine War: Heavy fighting continues along the frontlines in eastern and southern Ukraine, with the Russians continuing to mount air, missile, and drone strikes against Ukrainian civilian energy infrastructure throughout the country.  Meanwhile, the Ukrainians launched yet another attack on a key bridge in the Russian-occupied city of Melitopol and put it out of action.  That attack demonstrates Ukraine’s ability to strike Russian forces deep inside occupied territory.  It also shows their intention to keep attacking throughout the winter to prevent the Russians from regrouping.

• President Putin has signed a law allocating over nine trillion rubles (about $143 billion) to defense, security, and law enforcement for Russia’s federal budget in 2023.
  • That amount is about 8% of Russia’s 2021 gross domestic product, and probably an even greater proportion of Russia’s 2022 and 2023 GDP. It also implies that Russia’s defense burden is now more than twice that of the U.S., and several times more than the defense burden in many European countries.
  • The U.K. Ministry of Defense has also assessed that as Russia’s defense spending has significantly increased, it will now represent over 30% of Russia’s entire 2023 budget. This suggests that in order to pay for the war, Putin will have to defund many civilian budget accounts, thereby further undermining the economy.
• Illustrating President Putin’s worsening domestic political position, the Kremlin announced that his annual marathon news conference, in which he takes questions from the public, has been cancelled for the first time in a decade.

Turkey-Greece: As the latest spat in a decades-long series of bilateral disputes, Turkish President Erdogan warned that his country has developed a new medium-range missile that could be fired at Athens if Greece continues to build up its military forces on the Aegean Sea islands close to Turkey.  Although disputes like this have gone on for decades, Erdogan’s assertiveness has raised the risk of a destabilizing conflict between two key NATO members.

United Kingdom: Railroad workers have begun the first of four days of strikes this week in their dispute over pay levels, job security, and working conditions.  The strikes are already snarling transportation throughout the country, but that’s just the first blow for the government as a range of public employees are also set to strike in the coming weeks, including nurses, ambulance drivers, postal workers, border and customs officers, and highway workers.  The wide range of strikes will likely be an additional headwind for the British economy and stocks as the country struggles to deal with its winter energy crisis.

U.S. Monetary Policy: The Fed today begins its latest two-day policy meeting, with the decision due to be released on Wednesday afternoon.  Policymakers are widely expected to hike their benchmark fed funds interest rate by just 0.5%, to a range of 4.25% to 4.50%, after four straight hikes of 0.75%.  They will also release their updated forecasts for key economic indicators and the path of interest rates going forward.

U.S. Fiscal Policy: As congressional leaders scramble to avoid a partial government shutdown when the current funding law expires on Friday night, Senate Majority Leader Schumer said negotiations over the weekend were successful enough to warrant a one-week extension in order to finalize a funding deal for the rest of the fiscal year.  Senate Minority Leader McConnell also signaled that an omnibus spending bill remained a viable option, but he said that Democrats needed to meet Republican conditions.  In any case, the statements suggest Congress will avoid the threat of a government shutdown, which would probably push down financial markets.

U.S. Stock Market: The SEC will vote tomorrow on four proposals aimed at lowering costs for small investors.  The new rules would effectively curtail “payment for order flow” and force brokers and market-making firms to execute deals at the best price available.  For example, the new rules would require brokers to auction customers’ orders and publish detailed data showing how orders were carried out.

U.S. Cryptocurrency Market: Sam Bankman-Fried, founder and CEO of now-bankrupt crypto exchange FTX, was arrested yesterday in the Bahamas after the U.S. Justice Department filed criminal charges against him related to the exchange’s collapse.  The indictment against Bankman-Fried is due to be unsealed this morning.  Also this morning, the U.S. Securities and Exchange Commission sued Bankman-Fried for securities fraud.

• Bankman-Fried had been expected to testify before Congress today regarding the collapse of FTX, but now that will not happen. However, current FTX chief executive and workout specialist John Ray III will testify.
  • Ray will likely unveil even more damning evidence of how poorly FTX was run as he already has during his short tenure at the company.
  • In his prepared testimony for today, Ray will say that FTX’s collapse “appears to stem from the absolute concentration of control in the hands of a very small group of grossly inexperienced and unsophisticated individuals” who failed to implement the controls “that are necessary for a company that is entrusted with other people’s money or assets.”
• The latest developments in the FTX saga, in conjunction with the many other crypto bankruptcies this year, will likely continue to be a black eye on the industry and make it even harder for crypto assets to regain their previous high valuations, at least in the near term.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a major scientific success that could help improve energy supplies in the coming years.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including a scandal over Qatar’s effort to buy influence in the European Parliament.  We also provide a preview of this week’s Federal Reserve policy meeting and the looming deadline to prevent a partial shutdown of the federal government.

Global Energy Supply:  U.S. government scientists have reportedly achieved a net energy gain in a nuclear fusion reaction for the first time ever.  Although industrial-scale fusion is still probably decades away, this breakthrough boosts hope for a future in which energy supply is virtually limitless, emits no carbon, and produces no harmful wastes.

European Union-Qatar:  Over the weekend, Belgian police launched a series of raids on EU politicians’ homes, arrested a member of the European Parliament, and seized €600,000 in cash as part of an international investigation into an attempt by Qatar to buy influence in the bloc’s legislature.  The scandal has already triggered official resignations and the suspension of a parliamentary vote, due next week, which would have granted Qatari nationals visa-free travel to the bloc.

Eurozone:  The European Central Bank has warned that the Eurozone’s banking system is at risk of mounting bad loans and is having a funding squeeze due to rising interest rates, high inflation, and a likely recession.  The ECB therefore plans more frequent inspections of bank offices and will carry out more “targeted reviews” of the largest lenders in the zone in order to push them to address those risks.  Even though the European economy has recently been holding up better than many observers expected, the ECB statement is a reminder that the zone’s banking system faces both economic and regulatory risk in the near term.

Russia-Ukraine War:  Heavy ground fighting continues in northeastern Ukraine along the borders of the Donbas region, while the Russians used an apparently replenished supply of missiles and drones to cripple more of the Ukrainians’ energy infrastructure.  Meanwhile, a Ukrainian artillery strike reportedly killed dozens of Russian troops barracked in a hotel complex in Ukraine’s southeastern city of Melitopol.  The successful attack, which targeted Russia’s mercenary Wagner Group, illustrated how the Ukrainians are continuing to make highly effective use of advanced weapons provided by the West to inflict high casualties on the Russians.

Iran:  In a continued effort to stamp out the recent anti-government protests raging throughout the country, the government hanged a second protestor this morning after he was convicted of stabbing two security force members to death and injuring four others in the holy city of Mashhad.  With at least ten other protestors now on death row, the government may hang more protestors in an attempt to intimidate the opposition but doing so could also risk enflaming opponents of the government.

China:  New research indicates that China has not only lent some $1 trillion to less-developed countries around the world as part of its Belt and Road Initiative (BRI), but the People’s Bank of China has also loaned hundreds of billions in foreign reserves to those countries via currency swaps.  In contrast to the highly transparent, conditional, short-term swaps provided by the Federal Reserve to key U.S. trade partners, the PBOC swaps are highly opaque and often rolled over continuously, making them tantamount to a bailout for countries that have often defaulted on their debts or are likely to have trouble repaying their BRI loans.

• Researchers estimate that the average interest rate on the swaps is about 6%, making them more expensive than the swaps provided by the Fed to other central banks to swap their currencies for dollars. The swaps would also be more expensive than the typical International Monetary Fund loans to poor countries.
• As the world fractures into relatively separate geopolitical and economic blocs, the PBOC swaps illustrate how China’s approach to its evolving bloc is likely to be much more coercive than the U.S.’s traditional cooperative approach to its allies. As the Chinese-led bloc evolves, we suspect Beijing will essentially take a neo-colonial or even neo-imperialist approach to its bloc.

U.S. Monetary Policy:  The Fed will hold its latest policy-setting meeting this week, with their decision due to be released on Wednesday afternoon.  The policymakers are widely expected to hike their benchmark fed funds interest rate by just 0.5%, to a range of 4.25% to 4.50%, after four straight hikes of 0.75%.  They will also release their updated forecasts for key economic indicators and the path of interest rates going forward.

• If the Fed begins hiking rates more slowly, as anticipated, it will confirm a looming divergence between U.S. and European interest rates. Since inflation is expected to be stickier in Europe, its major central banks may well keep hiking their benchmark rates aggressively even as the U.S. central bank hikes begin to slow.
• That prospect probably goes far toward explaining the recent weakening in the dollar versus European currencies. The weakening of the dollar is likely to continue giving a boost to European stocks.

U.S. Fiscal Policy:  Congressional leaders will be scrambling this week to reach a deal on a full-year spending bill or to pass a short-term funding measure to avoid a partial government shutdown when the current funding law expires on Friday.  Any sign of serious struggles to reach a deal or any display of brinksmanship could well push markets lower before the issue is resolved.

U.S. Energy Policy:  In an interview with the Financial Times, top White House energy advisor Amos Hochstein said that Wall Street’s pressure on energy companies to funnel this year’s high profits back to investors rather than investing in new production is “un-American” and hurts U.S. families.  However, the interview will do little to reverse energy companies’ complaints about mixed messages from the Biden administration, as Hochstein also argued that firms should eventually help shift the economy away from its dependence on oil and gas.

U.S. Winter Storm:  A major winter storm that pummeled California with heavy rain and snow over the weekend is now moving eastward and is expected to create difficult winter conditions throughout the central Great Plains and Midwest in the coming days.  While the storm may have helped ease California’s long drought, it is expected to disrupt transportation and other economic activity across much of the country.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equity prices have tanked, and the U.S. dollar surged following the hotter-than-expected Producer Price Index report. Today’s Comment begins with discussing the effectiveness of price caps in deterring Russia’s war effort. Next, we examine some possible changes to inflation and how these could impact Fed policy in 2023. We end with a talk about the risks China’s reopening poses to the global economy and markets.

Price Cap, So Far: The EU limit on the price of Russian oil is already causing unintended consequences, but it isn’t clear whether Moscow’s war aims will be affected.

• Confusion over insurance papers have led to a backlog of oil tankers in the Turkish Strait. There are currently 28 tankers carrying more than 23 million barrels of oil being held up because of paperwork. Although Western countries have agreed to ban shipping service providers like insurance companies from delivering Russian oil above the price cap, many of the stuck ships contain Kazakh oil. Turkish and Western officials are working to resolve the matter, but there is still a chance of future problems given the complicated nature of enforcing sanctions. Oil prices were little affected by the event.
• Despite the hassle, there is no guarantee that the price cap will work. The $60 price level is below the $70 a barrel outlined in Russia’s latest budget proposal. Although the limit is beneath the Kremlin’s desired level,  the difference can be made up through borrowing or increased spending from the wealth fund. Russia’s ability to fund the war despite the price caps suggests that the West will have to look for other ways to punish Moscow. Currently, the EU is working on a cap for natural gas prices, but countries appear to be far apart on a deal. That said, the limits on Russian natural gas mean that the EU will need to import large volumes of the product to make up for the resulting shortfall.
• There is still no sign of war de-escalation, but an end in 2023 isn’t out of the question. Although Russian President Vladimir Putin insists that the war will likely be long, he downplayed the possibility of another mobilization. His hesitancy to call up new soldiers is likely related to concerns of public outcry over the war. Over 370k Russians fled the country within two weeks of the first mobilization. The large-scale departures highlighted the level of dissatisfaction within the country concerning the escalation of the war. Given that Putin stands for reelection in March 2024, he may be swayed to support a temporary resolution next year if he can spin it as a victory.
  • A possible end to the conflict in Ukraine would be favorable to financial assets and reduce volatility in commodity markets.

Inflation Easing: Although the annual change in the Consumer Price Index is well above the Fed’s 2% target, there are signs that price pressures are easing.

• An increase in inventories has led to a slowing of price increases in various sectors. Used car prices, which were a major contributor to inflation in 2021, are finally started to decline from record highs. Meanwhile, an increase in property developments has reduced demand for rentals. Although these are anecdotal evidence of a decline in prices, the recent Purchasing Manager Index data suggests that supply chain issues that prevented firms from getting needed material are much improved from the previous year. As a result, it is likely that inflation will continue its downward trend throughout 2023.
• That said, wage pressure and regulations will likely prevent inflation from hitting the Fed’s 2% target in the coming year. Nominal hourly earnings have remained stubbornly high even as inflationary pressures have eased. Meanwhile, new climate regulations also present a risk to consumers as businesses offset costs through price hikes. Input inflation data collected by the Bureau of Labor Statistics show that trade services, which measure wholesale and retail margins, are well above their pre-pandemic levels and remain one of the primary drivers of supplier price pressures. The November figures indicate that margins are holding up even as the economy slows. As a result, firms have no incentive to shoulder unexpected cost increases due to new regulations.

• Although price pressures are easing, it isn’t clear what inflation rate the Fed will seek before it decides to pause or pivot. Federal Reserve Chair Jerome Powell maintains that the bank needs to see clear progress that inflation has turned a corner before the Fed will change course. The lack of clarity shows that the Fed may not have a consensus. If this is true, there will likely be more dissents after the FOMC meetings, especially as the economy falls into recession. As a result, investors should pay closer attention next year to Fed speeches of voting members for clues on future policy.

COVID Uncertainty: China is expected to relax many of its Zero-COVID policies; however, the impact on the global economy may be more complex than investors realize.

• The removal of restrictions is expected to lead to a massive jump in infections. Although the transition will be slow, it is predicted that the next wave could lead to a total death range between 1.3 and 2.1 million. The rise in infections will likely prevent many workers from returning to their jobs due to fears of contagion. As a result, factories may not be able to produce at very high levels. Additionally, a lack of restrictions could cause infections to spread into neighboring countries.
• As Chinese consumers re-enter the market, the demand for commodities such as oil will likely rise. It is estimated that crude prices could surge above $100 a barrel next year following China’s reopening. This is unwelcome news for the rest of the world, as the recent decline in energy pressures helped push down global inflation. Thus, the rise in commodity prices may make it difficult for major central banks to ease monetary policy. Additionally, it could worsen the energy crisis in Europe and lead to a more severe recession on the continent.
• The impact that the end of Zero-COVID will have on equity markets will likely be revealed over the next several months. If Beijing can ramp up the number of vaccinations, it should save many lives. Additionally, if people decide to isolate themselves while the infections spread, demand for energy products will not be as pronounced. The best-case scenario for markets is for China to take a moderate approach. If they do reduce Zero-COVID restrictions slowly enough for investors to adjust and adapt, the overall impact may be positive for the global markets; however, a hastened approach could lead to disaster.

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