by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with our thoughts about the deepening yield curve inversion and who stands to benefit. Next, we explain why we think major powers will look to make friends with commodity-rich countries. We end our report with a discussion on the impact that global fracturing will have on tech stocks.

Breaking news: WNBA player Brittney Griner was freed in a prisoner swap for an arms dealer. 

Inversion deepens:  In recent weeks, we have seen a general decline in U.S. Treasury yields.  However, the bulk of the declines have occurred in the longer duration segment of the yield curve, causing a deeper inversion. Interestingly enough, the decline in interest rates has supported international equities.

• Recession fears and doubts about the Fed’s willingness to further tighten policy have led to a decline in both the short and long end of the yield curve. The two-year Treasury has dropped 40 bps from a month ago, but the ten-year Treasury has fallen even more, at 70 bps over the same period. As a result, the yield curve inversion is at its lowest point in over 40 years. The depth of the yield curve inversion has added to concerns that the recession could be worse than the market anticipates; however, the decline in interest rates has some unexpected beneficiaries.

• The decline in U.S. Treasury yields has made riskier assets more attractive. Despite being down nearly 9% on the year, the Euro Stoxx 50 index is up more than 18% on the quarter. The rally in European equities is related to optimism that inflation is close to peaking, the dollar is in decline, and the situation in Ukraine won’t markedly deteriorate. Although Europe is still expected to fall into recession next year, it seems that the market is starting to believe it won’t be as bad as originally thought.
• Although the market has been pricing in a U.S. recession over the last several months, investors are still unclear as to whether the downturn will be severe. There are likely three scenarios that will lead to a deep recession: a financial collapse, a housing market crash, and a major geopolitical event. At this time, any of these events could occur. In fact, the National Association of Home Builders suggests that the housing market is already in recession. Meanwhile, deteriorating financial conditions and the ongoing war in Ukraine are also current risks. Investors have likely discounted most of these risks, but there may still be more room for equities to drop. In the event of a crisis, the Fed could be swayed to cut rates drastically; thus, next year could lead to a strong rally.

An Uncertain World: Commodity-producing countries present a major risk to the global economy.

• Peruvian President Pedro Castillo was replaced by Dina Boluarte after his failed attempt to change the constitution in order to avoid impeachment. Boluarte will be the country’s sixth president in less than five years. All things considered, the transition of power went rather smoothly, but Boluarte will likely be plagued by the same corruption scandals as her predecessor. At the same time, her not being elected to office will likely encourage the opposition to push for new elections. Political turmoil in a resource-rich country like Peru has the ability to cause volatility in commodity prices such as copper, gold, and zinc.
• Meanwhile, U.S. officials are fretting over how the Chinese reopening will impact the price caps on Russian oil. Hopes of an increase in Chinese demand have boosted crude prices after four sessions of declines. Russian Urals crude oil trades at about a $20 discount to benchmark crude prices, suggesting a price of around $57 per barrel as of this morning. Although the cap is set at $60 per barrel, there are concerns that if the market price for the Urals rises above that limit, Russia will stop supplying oil to certain countries. Although the agreement to establish price caps allows for readjustment every two months, a limit set above $60 per barrel would undermine this effort to punish Moscow for the war.
  • Although price caps remain above the Russian production cost, estimated to be $40 per barrel, it is still below the $70 per barrel needed for Russia to maintain its fiscal budget.
• Securing commodities within these countries will likely worsen as the world forms into blocs. As a result, leaders of the groups, who we assume will be China and the U.S., will have to increase their engagement in other parts of the world to ensure that the commodity markets remain stable. This new reality likely explains why the U.S. is relaxing tensions with Venezuela, and why China is building closer ties with Saudi Arabia. As a result, commodity-rich countries could become major investment targets as the U.S. and China vie for their interests.
  • Saudi Arabia and China are expected to sign an investment agreement and discuss the possibility of pricing oil in CNY.

Tech Pushback: Government restrictions and political scrutiny are leading to headwinds for the tech sector.

• The West is attempting to block China from securing advanced chips for defense purposes. The Netherlands is working with the U.S. on plans to curb the export of semiconductors to China. The decision comes as the U.S. and EU team up to reduce China’s ability to impose its influence worldwide. China is heavily dependent on chip imports, and it is estimated that the country spends more on semiconductors than it does on oil (see following chart). As a result, foreign suppliers to China will take a revenue hit, while domestic chipmakers could see a boost in investment.

• Meanwhile, social media giants are also being caught in regulatory crosshairs. The Biden administration is pushing the Supreme Court to hold social media companies liable for hate speech promoted on their platforms. Similarly, the push to ban TikTok is gaining momentum after South Dakota barred the use of the app for state agencies over national security concerns. Social media sites generate much of their revenue based on clicks and the data collection of their users; thus, limits on either would hurt the profitability of these firms. As a result, social media sites’ abilities to generate money is likely to be constrained by government regulations.
• The tech sector thrives in a globalized world, and therefore, regional fracturing would significantly disrupt the industry. Tech has the highest exposure to foreign markets when compared to its peers (see the following chart). Its vulnerability to foreign markets means that restrictions will likely have an adverse effect on the industry’s ability to generate revenue. As a result, we believe that investors should be hesitant to pile into tech stocks without a deep understanding of these companies’ susceptibility to regulatory risks. Hence, a Fed pivot should not be the only factor when investing in tech stocks.

Source: Globalxefts

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning, on this 81^st anniversary of the surprise attack on Pearl Harbor.  Only a few surviving servicemen will visit this site today, a reflection of the aging of the WWII generation.  A 17-year-old serviceman in 1941 would be 98 today. In the markets it is another rather quiet morning.  Earlier this morning, U.S. equity futures and oil were lower but have turned higher in the past hour while the dollar is mixed.

In today’s Comment, our coverage begins with China news.  International news comes next, and our update on the war in Ukraine follows.  Coverage of economic and market news is next in line, and we close with a roundup of U.S. news.

China News:  China is moving rapidly to ease COVID restrictions and there is some evidence of a thaw in U.S./China tech relations.

• So far, there has been no national announcement of an end to Zero-COVID policies, but we are seeing a rapid dismantling of the restrictions. Here are some of the changes:
  • The Beijing Capital Airport has dropped its negative test requirement to enter terminals. If this becomes adopted broadly, it should dramatically ease air travel in China.
  • Instead of sending infected patients to quarantine centers, those afflicted can now convalesce at home. Unfortunately, because there have been no national guidelines issued, local government reactions have been varied.  Some podcasts we monitor on China report that local officials sometimes weld rebar on doors to ensure that those with the virus don’t venture out.  In other areas, citizens are self-policing.
  • Testing requirements are ending in most areas.
• An important element of the adjustment to policy is expanded vaccinations. A key worry is the low level of immunizations found among the elderly, who are especially vulnerable to COVID.  China is facing strong resistance to vaccination among its older population.
• This opening brings risks with some models suggesting up to one million deaths could result. But with rising social unrest and a soft economy, Beijing likely feels it has little option but to ease restrictions.  As we noted yesterday, the narrative around the Omicron variant is that it isn’t as deadly as earlier strains.  Although there is some data to support that idea, it is also true that in the West, by the time Omicron was circulating, vaccinations and widespread infections were already in place and resistance was therefore elevated.  In China, with fewer vaccinations and infections, the fast-spreading variant could be a problem.
• A surge in infections could not just overburden the health system, it could expose health workers to the virus.
• The recent actions to thwart China’s efforts to acquire advanced semiconductor chips and the tools to build them is leading to some adjustments. Corporate America is generally opposing the turn against China and their lobbying efforts are leading Congress to ease restrictions.  On China’s side, Beijing is allowing U.S. officials to enforce export controls to ensure that chips don’t end up in the hands of the military.  We don’t think these measures will change the trajectory of policy, but it does show how hard it is to enforce economic restrictions on a country like China, who is deeply enmeshed in the global economy.
  • Another sign of the thaw are moves by Chinese regulators to allow real estate firms to service foreign debt. Throughout the real estate crisis, China has focused on domestic interests, mostly allowing foreigners to bear the brunt of the adjustment.  However, it appears that Chinese officials have concluded that harming foreign investors may weaken their economy in the long run.
• TikTok continues to be a problem for U.S. security officials. The government remains worried that China will use the platform not only to collect data but to execute influence operations.

International News:  Germany uncovers a right-wing coup plot, and Argentina’s vice-president has been found guilty of fraud.

• Twenty-five people were arrested from three countries on suspicion of a coup to overthrow the German government. Among those detained is a former AfD lawmaker, and a member of Germany’s special forces.  It isn’t obvious if the plot was gaining traction or close to operational capacity.  Some members did contact Russian intelligence, but there isn’t any evidence that the Russians were involved.  Germany has a neo-Nazi undercurrent that resurfaces on occasion.  During the 1970s, left-wing groups associated with communist factions, such as the Baader-Meinhof Gang, were prevalent.  None, so far, have seriously threatened the government.
• Cristina Fernández de Kirchner, the current vice-president, a former president, and the wife of a late president, was convicted of fraud by an Argentine court. She was sentenced to six-years in prison and barred from public office for steering public works funding to a family associate while she was president and first lady.  In the short run, nothing will change.  She will appeal her conviction and during the appeal process, she will remain in office.  Her term ends next December, so it is likely she will leave office without the case being resolved.  The Kirchners are polarizing figures in Argentina; though, if the conviction sticks, it may mean the end of her family’s influence in the country.
• The U.K. is facing a wave of labor discontent. PM Sunak is considering anti-strike legislation to stem the tide.

War in Ukraine:  More on the Ukraine strikes inside Russia, and Hungary blocks aid.

• The recent drone attacks (apparently on three airfields) carried out by Ukraine have put the U.S. in a delicate position. Washington does not want to see this war escalate, and thus, isn’t supportive of these attacks.  However, it is also aware that Russia has been attacking Ukrainian infrastructure, so it can’t really tell Kyiv not to attack Russia proper.  One goal of Ukraine was to force Russia to expend resources to defend these airfields.  That goal has apparently been met.
• The EU and Hungary have been at loggerheads over a number of issues, including immigration and social policy. In response, the EU has blocked funds to Hungary, and this decision led Hungary to veto aid to Ukraine.  The EU is looking for ways to circumvent the veto.
• Although there have been steady calls for peace talks, the head of NATO suggests conditions for those talks are “not there now.”

Markets, Economics and Policy:  Lumber futures rise, and supply chain issues slow arms sales.

• Lumber prices soared during the pandemic, as there was a lift in housing and remodeling. However, the rally failed as time passed, and prices slid.  Although prices remain well below pandemic highs, prices jumped to their daily futures limit on reports that Canfor (CFPZF, $17.20) has cut mill output due to the falling demand.
• Arms demand is elevated due to the war in Ukraine and the general rebuilding of defense. However, supply chain issues and rising costs have cut sales over the past few months.

U.S. News:  Part of North Carolina remains without power, and the Georgia Senate seat remains with Democrats.

• Utilities are struggling to fix the sabotaged substations in North Carolina. It is still uncertain who was behind the attacks, but the event highlights the need for redundancies.  It would be prohibitively expensive to defend all infrastructure, but holding inventory of critical parts would likely speed recovery.  Of course, inventory costs money and reduces efficiency.
• Raphael Warnock (D-GA) won a new six-year term by defeating Hershel Walker. This gives the Democrats a 51-49 advantage in the Senate.
• Rackspace Technology (RXT, $3.95) reported a massive ransomware attack. The company hosts emails and cloud computing, mostly for business.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning on the Feast of St. Nicholas!  It’s actually a rather quiet morning after yesterday’s risk-off day.  U.S. equity futures have been vacillating this morning, mostly trading inverse the dollar.  Gold is higher this morning, but oil is trading lower.  Equities have been taking on a tone of bad news is good news.  Yesterday’s ISM services index, coming in well above the expansion line of 50, raised fears that monetary policy won’t be as easy as hoped.  We note that the WSJ’s latest “Fed whisperer,” Nick Timiraos, published an article yesterday reiterating Chair Powell’s recent comments about moving to slower rate hikes but also signaling that tightening was far from over.  Last week, when that speech occurred, the financial markets viewed the talk as dovish.  The Timiraos article suggests that isn’t the narrative that the FOMC preferred.

In today’s Comment, our coverage begins with China news.  Economics and policy are up next, and an update on the North Carolina substation attack follows.  Our war in Ukraine briefing comes next, and we close with the international roundup.

China News:  The state funeral for Jiang Zemin has begun, as the CPC does its best to project unity.  We also update the COVID situation.

• It is becoming clear that China’s Zero-COVID policy is evolving, but we hesitate to call it a full reopening. Instead, policymakers seem to be moving along three tracks.
  • There appears to be a concerted effort to change the narrative on the disease from something to be feared into more of an inconvenience. COVID has exhibited a wide array of effects with most people seeming to survive it just fine, but it is clearly a risk to the elderly and to those with several preexisting conditions.  Also, the mystery of “long COVID” remains an issue.  Most nations have generally developed a strategy of trying to open as much as possible while simultaneously protecting the most vulnerable.  Finding that balance can be tricky.
  • As part of this narrative change, public health authorities are said to be close to announcing less strict quarantine and testing measures.
  • Expanding immunizations is also being promoted. Unfortunately, Beijing doesn’t want to accept Western vaccines, which have proven to be more effective.  Thus, immunizations may have only a limited effect on reducing risk.
  • Opening is risky, and the use of substandard vaccines coupled with a population that hasn’t had much exposure to the virus further raises the risk that a bout of infection could strain the medical system. However, it has become clear, for economic and social reasons, that the Zero-COVID policy can’t be maintained.  Beijing is adjusting, but it isn’t completely certain how well this will work out.
• The fiscal response by the U.S. to COVID was extraordinary, and the speed that policy stimulus was deployed opened the potential for abuse. Reports of identity theft when applying for unemployment insurance and the abuses of PPP payments were widespread.  Turns out the abuses were also international in nature—the Secret Service reports that Chinese hackers clipped at least $20 million of COVID relief payments.
• As General Secretary Xi starts his third term among expectations of market-unfriendly policies expanding, we are beginning to see reports of capital flight as wealthy Chinese citizens begin moving funds offshore. Singapore appears to be the most prominent beneficiary.  The city-state has a large ex-pat population and is a natural destination for such funds.
• Canada is joining other G-7 nations in conducting freedom of navigation operations in the Taiwan Strait.

Markets, Economics and Policy:  The economic picture is mixed.  Business leaders are worried but still see a soft landing.  Supply chains are improving, but layoffs are rising.

• Recent CEO surveys suggest that business leaders are becoming more concerned about the economy, but still expect a soft landing. It’s not obvious if these leaders have a great track record on forecasting the economy (to be fair, no one else is all that good either) but their attitudes likely reflect present business activity.  Thus, we see it as confirmation that we are not currently in a recession.
• At long last, supply chains appear to be improving. Freight rates have been easing, and we note that in the recent ISM data, there is growing evidence of improvement.

• The number of purchasing managers reporting faster deliveries is rising rapidly, although history would suggest some of this improvement is likely coming from slower economic activity.
• Taiwan Semiconductor (TMSC, $81.62) announced it is increasing its investment in its Arizona facility.
• Pepsico (PEP, $183.12) announced layoffs from its corporate headquarters.
• For years, tech firms have been news aggregators as they give users the ability to find articles and, for a long time, avoid paying subscriptions. Clearly, this content model can’t work indefinitely.  If the content providers can’t get paid, they will eventually stop providing the content.  Congress is apparently working on legislation that would facilitate the providers’ abilities to negotiate fees from the tech firms.  Facebook (META, $122.43) announced it may stop providing news feeds on its platform if the legislation passes.
• Commercial property private REITs are seeing redemption notices.
• Influenza hospitalizations are rising rapidly. The spike in infections may be a hangover from the COVID restrictions, which also reduced flu infections but have lowered resistance.
• The head of the PBOC is making the argument that the dollar has peaked. Although we are not sure that we won’t see one more recovery in the greenback, (especially if Nick Timiraos is right) we do think that we are in the very late innings of this dollar bull market.

North Carolina:  Although authorities are not calling the weekend attack on substations in North Carolina domestic terrorism, the actions were clearly targeted, suggesting that it wasn’t just a random attack.  Utilities are steadily bringing power back online, but it probably won’t be until Thursday before power is fully restored.  Our worry is that if similar attacks become common, not only will it cause disruptions, but mitigation efforts (backup generators, diesel stocks, extra food, etc.) will tend to be costly and could boost inflation.

War in Ukraine:  Ukraine strikes inside Russia which could expose divergences in goals among allies.

• Although Kyiv hasn’t fully accepted responsibility, it appears that Ukrainian drones attacked three Russian airfields inside of Russia proper, including one that houses some of Russia’s strategic air assets[1]. A drone also hit a Russian oil depot.  Ukraine’s ability to strike inside Russia is a new development, and one that the U.S probably isn’t pleased about.  We note that the U.S. “modified” its HIMARS systems given to Ukraine to reduce its range and lessen the likelihood that Ukraine could strike within Russia.
  • This development could mark a serious escalation of the war. First, if Ukraine now has the ability to strike targets deep inside Russia, then Putin’s conduct of the war will come under further scrutiny.  Second, Ukraine’s Western allies are mostly willing to support this war as long as it stays contained, since the West has no interest in seeing this conflict expand.  Attacking Russia proper changes the nature of the war and could prompt Russia to take more aggressive steps, such as engaging tactical nuclear weapons.
  • We will wait to see the U.S./allied response. Since the drones appear to be of Ukrainian origin, the U.S. and its allies can argue that it wasn’t Western arms that attacked Russia.  We doubt the Kremlin will accept this argument.  We look for the West to restrict weapons sales further to discourage this development.
• Meanwhile, polls show some reduction in support among Americans for “indefinite” aid to Ukraine. And Germany is balking on sending the arms it promised earlier.
• As the war continues, the Kremlin is increasing its commandeering of private companies to support the war effort. This action will tend to reduce available supply; if money supply isn’t restricted, then inflation will worsen.

International News:  The EU awakens to the change in U.S. policy.

• The Inflation Reduction Act, in IOHO, is the opening salvo in U.S. industrial policy designed to kick start the reindustrialization of America, but at the expense of our trading partners, mostly Europe. For the Europeans, who have maintained export promotion far beyond just the recovery from WWII, this is a massive threat.  When French President Macron was in Washington recently, he warned that the new law could “fragment the West.”  Perhaps, but given that Europe can’t defend itself, it probably is better described as the U.S. subjugating Europe.  The EU is expected to react, and there is talk of it creating its own energy subsidies and maybe giving up on free trade as a policy[2].  However, we don’t expect the U.S. to change its policies all that much, and if anything, we expect more of the same.
• Although Turkey has thrust itself into global geopolitics in a robust fashion, and is getting some economic benefits, it still faces an ugly inflation problem.
• South Africa’s President Ramaphosa is facing a corruption scandal, but it appears he will escape impeachment.
• Not so for Peru’s President Castillo, who is facing a third attempt to remove him from office.
• Mount Semeru has erupted in Indonesia. The volcano is situated on Java, where, at the other end of the island, sits the city of Jakarta.  Major volcanic eruptions can cool the earth for a time, as volcanic ash spews into the upper atmosphere.
• Papua New Guinea may have underestimated its population by half.

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[1] In other words, it houses an element of its nuclear weapons delivery.

[2] Which is a bit rich, given that numerous policies, such as regulations on food, are clearly protectionist.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a long discussion of several key developments today in the global energy markets, including the implementation of several sanctions against Russia’s oil and natural gas due to its invasion of Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today.

Global Energy Market:  This week could be momentous for global energy markets, with the European Union and U.K. set to implement a ban on Russian oil imports, the broader group of industrialized countries set to impose a price cap on Russian oil exports, and Chinese President Xi set to visit Saudi Arabia.  These developments illustrate how the increased friction between the evolving U.S. and China-led geopolitical blocs has sparked a new era of intense economic warfare around the world, creating both headwinds and opportunities for investors.

• As previewed in our Comment on Friday, the Group of Seven (G7) countries and their allies, representing much of the world’s richest and most advanced democracies, approved a plan to cap the price of Russian oil exports beginning today. To cut the revenues available to Russia for its war against Ukraine, the cap will ban Western companies from insuring, financing, or shipping Russian oil unless it is sold for less than $60 per barrel.
  • Russian officials have said they will not send any oil to countries that implement the price cap.
  • There are differences of opinion regarding the impact of the price cap on global oil prices. Oil prices are up so far this morning, but that could primarily be because of looser COVID-19 restrictions in China (see below).
• Separately, today the EU and the U.K. will implement its ban on importing Russian oil, which was approved earlier this year. They will also implement a ban on Russian refined products beginning in early February.
• Yesterday, the Organization of the Petroleum Exporting Countries and its Russia-led partners said that they will stand by their October decision to cut oil production by two million barrels per day, rather than the proposals last month ranging from an output cut to an output increase. The decision will give the OPEC+ group more time to assess the impact of the EU ban on Russian imports and the broader price cap on Russian oil exports.
• Of course, oil isn’t the only front in the energy war. Data from commodity analytics firm ICIS shows that the EU’s demand for natural gas in October and November was 24% lower than its five-year average.  The figures suggest that the EU has made significant progress in finding energy efficiencies and implementing conservation measures, although they were also helped by the relatively warm weather in early autumn.
• Spooked by the energy supply disruptions from the war in Ukraine, the Japanese government has launched a plan to develop a strategic reserve of liquified natural gas. The program would require importing an additional 840,000 tons of LNG per year, consistent with our view that the geopolitical fracturing of the world will not only threaten energy supplies, but will also encourage hoarding behavior, all of which will tend to buoy commodity prices.

Russia-Ukraine War:  As heavy fighting continues primarily in the Donbas region of northeastern Ukraine, and Russian forces continue to launch air, missile, and kamikaze drone attacks against Ukrainian infrastructure, explosions were reported at two air bases deep inside Russia.  The explosions reportedly damaged or destroyed several Russian military aircraft.  They are also consistent with a number of other explosions in Russian territory throughout the war that were likely carried out by Ukraine, although the Ukrainian authorities have not formally acknowledged any role in the attacks.

China:  Following the previous week’s big protests against the government’s Zero-COVID policies and repressions of freedom, we are seeing increasing reports that local government officials are gradually ratcheting back some pandemic restrictions.  The rollbacks include lifting some curbs on residents’ movements, such as by ending mandatory COVID testing for people who want to use public transport, enter parks, or visit other public spaces.  The authorities are also stepping up their efforts to vaccinate vulnerable citizens, especially the elderly, probably in an attempt to shield the population and healthcare system in case looser pandemic rules lead to higher infection rates.

• The modest loosening of COVID restrictions may have helped eliminate the recent protests, but a heavy police presence and surveillance around potential protest sites probably played the bigger role.
• The apparent easing in COVID rules have given a big boost to Chinese stocks and the CNY so far this morning. However, we continue to think the government’s COVID policies will weigh on the economy.  Much of China’s economy is still on lockdown, and even if the pandemic rules are loosened, the lack of herd immunity and weaknesses in the healthcare system mean big new outbreaks of infection will likely hold back activity.  That will also continue to create headwinds for the broader global economy and financial markets.

Iran:  After weeks of anti-government protests touched off by anger at the country’s Islamic “morality police,” the Iranian government said it is dismantling the organization and may roll back some rules such as the requirement that women wear the hijab in public.  However, protests continued over the weekend, signaling that the small grant of freedom may not be enough to relieve the political pressure on the government.  Instability in Iran, a major oil producer, may therefore continue in the near term.

Eurozone:  October retail sales fell by a seasonally adjusted 1.8%, even worse than expected and the biggest drop since last December.  Sales in October were also down 2.7% from the same month one year earlier.  The data supports the view that the Eurozone economy is now falling into recession.

United States-European Union:  In the latest sign that new U.S. subsidies and “buy-American” rules will prompt Europe to respond in kind, European Commission President von der Leyen said that the EU must “simplify and adapt” its rules on state aid to allow similar protectionist policies.  U.S. and EU officials are due to meet today to discuss the issue.

• The Biden administration has not strongly pushed back against insinuations that the EU could respond with its own protectionist policies. Indeed, U.S. Trade Representative Tai recently proposed that the EU adopt similar policies, probably aimed at a reduction in EU trade with China.
• In his meeting with French President Macron last week, Biden also suggested that the U.S. could adjust its rules to address European concerns.
• The Europeans remain quite irritated and concerned about the new U.S. industrial support, which is focused largely on green technology, but President Biden’s conciliatory stance suggests that a trade war is not necessarily set in stone.

United States:  Two electrical substations in rural North Carolina were attacked by gunfire on Saturday evening, leading to power outages that could last for days for over 33,000 customers.  Although the outage is relatively small, the apparently deliberate attack has raised concern about follow-on attacks and the overall vulnerability of the nation’s electrical supply.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Howdy! Equities are down this morning after the jobs report soundly beat expectations, Today’s Comment begins with an overview of the recent sell-off in the U.S. dollar and what it means for financial markets. Next, we discuss the U.S. government’s efforts to resolve tensions with unions and the EU. Lastly, we explain the risk the war in Ukraine poses to equities abroad.

Dollar Peaking? The recent retreat in the greenback is significant, but it isn’t clear if it will last, as evidenced by its recovery today in the wake of the payroll data.

• Although the U.S. dollar is one of the best-performing assets in 2022, it has begun to turn. The greenback has dropped more than 7% from its September peak. Its descent was driven by a combination of speculation that the Fed is almost done hiking and greater positivity about the global economy heading into 2023. The CPI and PCE inflation reports both came in below expectations. Meanwhile, GDP data from Germany and optimism of China’s reopening have made a global recession next year less likely. Additionally, signs that global inflation is approaching its peak have made foreign currencies more attractive.

• The weakness in the dollar will likely make it easier for other central banks to relax monetary tightening. Due to their reliance on imports of dollar-priced commodities such as oil, central banks such as the Bank of Japan and the European Central Bank were pressured to take aggressive monetary action to contain inflation. However, their lack of aggressive action had led to dollar appreciation. As a result, the recent dollar weakness (we note that the dollar is stronger today off the payroll wage data) against peer currencies will likely mean that these banks can take less aggressive policy action to tackle price pressures. In short, a weaker dollar is a positive for international equities. For example, the recent rally in emerging market equities and bonds shows that investors are positioned to take advantage of a depreciating U.S. currency.
• Next year’s FOMC will have more hawks than in 2022. Kansas City Fed’s Esther George and Boston Fed’s Susan Collins will be replaced by hawks Fed President Neel Kashkari and Dallas Fed’s Lorie Logan. Meanwhile, Chicago Fed picked notable dove Austan Goolsbee as the next bank president. He will be a voting member and will offset the loss of St. Louis Fed President James Bullard, a bona fide hawk. Additionally, persistently high employment payroll data like the one released today also supports further tightening in the future and pushes up the dollar’s value. In short, the hawkish tilt of the committee suggests that the dollar could rebound in 2023.
  • Austan Goolsbee was the economic advisor of former President Barack Obama. In an interview with NPR, he called into question the ability of hikes alone to rein in inflation and is likely to be sensitive to economic changes.

U.S. Firefighting: The president and Congress are moving to contain flames both domestically and abroad.

• The Senate passed legislation that would prevent rail workers from going on strike. The bill is expected to be sent to President Biden’s desk to be signed into law. The passage of the bill has prevented a strike from disrupting the U.S. economy but could have political costs for Democrats in upcoming elections. Rail workers were pushing for seven days of paid sick leave, a tenet that should have left-wing support on paper. The Democrats’ decision not to support labor is an example of how the party is becoming more pro-business establishment and less union-friendly. A stricter line by government officials could ease inflation and may be preferable to equities.
  • Government and unions can have a hot and cold relationship depending on the economic environment. In an inflationary period, politicians have been known to turn on labor.
• President Biden is open to negotiating with Russian President Vladimir Putin over the war in Ukraine. This stance is in contrast with the U.S. president’s previous statement that peace talks must include Ukraine. Although there is some sign that Putin may accept the invitation, the change in Biden’s tone suggests that the West wants the war to end. Biden’s offer came after meeting with French Emmanuel Macron. In the past, Macron has criticized the U.S. for profiting from the conflict at Europe’s expense. Thus, there is a possibility that Western support for Ukraine could be fading, which should be favorable to financial markets.
• Although demand remains an important driver of inflation, there are still many supply-side factors that can support higher prices. The growing power of labor unions has given unions more leverage to negotiate higher wages and benefits from firms. Meanwhile, the uncertainty in Ukraine suggests that commodity prices will continue to fluctuate. The Fed will consider these factors when determining whether it should lower rates. That said, U.S. central bank officials have shown no intention of distinguishing demand and supply pressures when deciding policy. Thus, supply-side shocks could lead the Fed to raise rates higher and for longer than the market currently expects.

Russia Risk Rising: A string of suspicious packages sent across Europe raises new questions about the war; meanwhile, the EU continues to bicker over price caps.

• Threatening packages were sent to Ukrainian embassies in Hungary, the Netherlands, Poland, Croatia, Italy, and Austria. Packages contained varying materials, from explosives to animal parts. Although no one was harmed, Western governments believe that the boxes are a form of terrorism and intimidation. The delivery of these threatening items could be a warning that there are factions, within Russia or sympathetic to, who are willing to escalate the war outside of the Ukrainian borders. At this time, the packages do not provide present a risk but could be a warning of something worse to come.
• Meanwhile, EU members still need to settle on a price cap for Russian oil. Although the recent proposal shows a price cap of $60, some countries within the bloc would like the lid to be lower, and others prefer to do away with the price cap entirely. Countries most in danger of being invaded are pushing for a lower limit as it would deprive Moscow of needed revenues to expand its war aims. However, EU members most adversely impacted by the price limit have warned that a low cap could make it harder for countries to receive energy supplies.
  • The EU has until Monday to come to a resolution before the agreed-upon embargo is set to take effect. Failure to do so could lead to disruptions within energy markets.
• Uncertainty in Ukraine represents a prevalent risk for European equities. Despite efforts from the West to curtail Russian oil production, it has still been able to increase its shipments worldwide. OPEC’s willingness to work with Moscow to minimize the impact of Western restrictions makes the problem worse. Meanwhile, the threat of a broader conflict could escalate tensions between the West and Russia. In short, investors should be mindful that any de-escalation of the war effort will likely be taken positively by the markets, especially in Europe. In the meantime, the U.S. remains safe, a place to hide and wait.

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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 our thoughts about Wednesday’s speech by Fed Chair Powell. Next, we give an overview of China’s move away from its Zero-COVID policy. We end with international news focusing on the growing fractures within the Western alliance.

Fed Talks: Fed Chair Jerome Powell signaled that the central bank is not prepared to lower rates; however, the market is not convinced.

• The market rejoiced following suggestions that the Federal Reserve would scale back the size of rate increases. On Wednesday, Powell hinted that the central bank may moderate the pace of hikes at its December meeting but also that the Fed was not done raising rates. The S&P 500 soared over 3%, there was a bullish steepening in the yield curve, and the U.S. dollar index dropped. This market reaction indicates that investors are confident that the Fed is nearly finished with its tightening cycle. The latest Fed Watch Tools show that the market has priced in a nearly 80% chance that the Fed will raise its policy rate by 50 bps at its meeting later this month. Meanwhile, market bets predict that the Fed will begin cutting rates in the latter half of 2023.

• This bullish reaction from investors was likely not the response Powell expected when he made his comments. Fed officials have insisted that they will not stop tightening until inflation makes sufficient gains toward its 2% target. Thus, we suspect Fed Governors Michelle Bowman and Michael Barr will attempt to rein in expectations when they speak on Thursday. Additionally, stronger-than-expected employment data to be released on Friday might also reduce sentiment that the Fed is close to ending its tightening cycle. Therefore, Wednesday’s gain could be short-lived.
• Although inflation remains stubbornly high, there are signs that price pressures are starting to ease. U.S. rent prices fell for the third consecutive month in November, according to ApartmentList.com. Meanwhile, data collected from the Standard & Poor’s Case-Shiller Home Price Index shows that national home prices are also falling. Shelter prices comprise a third of the Consumer Price Index, so a drop would weigh heavily on price pressures. That said, it generally takes several months for the index to pick up changes in the housing market due to how the data is tracked.
  • There is also a risk that if the dollar weakens and OPEC+ follows through on rumored production cuts, energy prices could rise and prevent inflation from falling further.

China in Focus: Beijing is walking a fine line as it attempts to display confidence in its pandemic response while also pacifying a growingly disgruntled public.

• China hinted that it may reduce the pandemic restrictions as public anger arises after a new round of lockdowns. A top Chinese official announced that the latest variant of COVID was “less pathogenic” than previous strains. This sentiment was also reflected in the state media’s softer tone when discussing the virus. One editorial went as far as to say that people “should not be too afraid of Omicron.” Over recent weeks, the country has ramped up its vaccination efforts and has entertained the possibility of importing Western vaccines. The renewed push is likely a positive sign for Chinese equities.
• Although substantial policy changes did not follow the remarks, the market believes reopening is on the horizon. The news initially led to a sharp rally in the Hang Seng China Enterprises Index, which rose to as high as 3.7% on the day; however, most of those gains subsided as investors realized that a reopening was not expected to be smooth. Beijing will likely drop restrictions at a slow pace as it does not want to give the impression that it is caving to public pressures. Additionally, there may be some hesitancy among people still wary to leave their homes due to COVID concerns.
• The reopening of the Chinese economy provides both positives and negatives for the rest of the world. The loosening of restrictions should increase economic activity, which should then help boost global growth and relieve some supply chain pressures. However, the reemergence of the Chinese consumers will increase the demand for energy products and push up the prices for commodities. In short, the overall impact of China’s reopening is complicated, to say the least. Thus, a slow reopening will likely fare better for equities than a quick one would.

Friends or Foe:  Allies within the North Atlantic Treaty Organization are becoming frustrated with U.S. foreign and economic policies.

• Turkey’s bullheadedness leads to more uncertainty in the Middle East and is straining U.S. ties. On Wednesday, the U.S. warned Ankara against further escalation in Kurd-controlled areas of Syria due to the danger it poses to U.S. military personnel. Tensions between the two countries have been brewing after Turkish President Recep Tayyip Erdoğan blamed Kurdish groups for a November bombing in Istanbul. The ongoing row between the two NATO allies may complicate coordination efforts for their considerable roles in supporting Ukrainian war efforts.
  • Outside of Syria, Turkey has also backed Azerbaijan in its ongoing dispute with Iran. Tehran’s military presence along its shared border with Azerbaijan has angered Anakara. In response to Tehran’s actions, Turkey suggested that it may consider military actions if tensions escalate further.
• European countries continue to rail against the U.S.’s new climate law. French President Emmanuel Macron is the latest European leader to express his frustration. In a speech yesterday, he stated that the Inflation Reduction Act threatens to divide the West. The point of contention between the two sides relates to tax breaks for components used in renewable energy technologies like electric cars. Europe sees it as an opening salvo in a trade war. In our view, the Inflation Reduction Act was designed to convince Europe to prioritize its own industries over China through subsidies of its own. This is supported by U.S. Trade Representative Katherine Tai’s insistence that Europe create its own subsidy program.
• Differences between the U.S. and its allies over trade and foreign policy have yet to lead to a complete fracturing of ties. This is evident in the European Commission’s recent decision to follow through on a price cap on Russian oil, a measure pushed by the Biden Administration. However, that does not mean that things are all fine and dandy. If Washington fails to keep its Western and NATO allies onside, it could lead to a multi-bloc world led by Europe, the U.S., and China as opposed to a two-bloc world led by just the latter two. A fragmented world will likely complicate supply chain efforts, which could harm earnings for companies with foreign exposure.

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