by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today, our Comment opens with an update on the Russia-Ukraine war; Russian forces continue to seize some territory in Ukraine’s eastern Donbas region, and Ukrainian forces continue staging what appears to be a tactical retreat.  We next review a range of international and U.S. developments with the potential to affect the financial markets.  We close with the latest news on the coronavirus pandemic.

Russia-Ukraine:  Russian forces continue to focus on consolidating their control over the Donbas region of eastern Ukraine.  Their superiority in equipment and troop levels allows them to make slow but steady gains.  In addition, it appears Ukraine has made a strategic decision to offer only limited resistance to that effort.  It is probably a measure to preserve its military resources for future counteroffensives against the Russians if, and when, the balance of forces shifts more toward Ukraine’s favor, perhaps after the delivery of more powerful weapons from the West.  Today, the Biden administration plans to announce a new tranche of weapons shipments to Ukraine, including long-range rocket launchers and precision ammunition with a range of up to 80 kilometers.  The announcement of that shipment comes after Ukraine provided the U.S. with assurances it would not use the missiles to attack Russian territory.

• In recent days, alarmist press articles have again highlighted growing “cracks” in the alliance against Russia’s invasion, this time centered on the fact that some countries (such as Germany and France) have misgivings about providing ever more powerful weapons to Ukraine that could prolong the war without guaranteeing a Ukrainian victory, while other countries (such as the U.S., the U.K., and Poland) want to provide such weapons to inflict as much damage as possible on Russia’s military and discourage President Putin from further territorial aggression. However, despite the alarmist tone of the reporting, it’s probably too early to assume the alliance is in danger of fracturing.
  • Military conflicts are so destructive and dangerous that wartime alliances always generate sharp internal disagreements as leaders ponder the opportunities and risks at hand for their own countries. From World War II to the Gulf War, the U.S. has successfully managed such differences within its alliances and coalitions.
  • The risk of destruction in wartime is, at the same time, a glue that can help keep alliances together as leaders ultimately realize they are safer in a coalition than they are striking out on their own.
  • Beyond that, NATO has been singularly successful in cultivating its fundamental unity over the decades, even in peacetime. That can be lost on some national leaders, press pundits, and armchair generals who don’t know what it is to eat lunch every day with colleagues from a dozen different NATO countries in the headquarters cafeteria in Brussels or who have never taken part in a NATO military exercise.  Persistent, intensive, large-scale NATO alliance-building activities have produced a coalition that is probably more resilient than many observers realize (President Putin, for example).   The best proof of that may be that after the end of the Cold War, the NATO alliance merely softened and got flabby rather than disintegrating.  Differences of opinion within the alliance bear watching, but they are still just arguments at this point.  They are probably still far from endangering the allied effort against Russia.
• With Western sanctions pushing down Russia’s oil production, some OPEC members are exploring the idea of exempting the country from its output targets under the OPEC+ deal. Exempting Russia from its targets could potentially pave the way for Saudi Arabia, the United Arab Emirates, and other OPEC producers to pump significantly more crude, something that the U.S. and European nations have pressed them to do in order to help bring down inflation.
• Additional details on yesterday’s sanctions package from the EU indicate the bloc will not only ban most seaborne imports of Russian oil by the end of the year, but it and the U.K. will also ban their insurance companies from covering ships carrying Russian oil anywhere in the world. The move threatens to further complicate Russia’s efforts to bring its crude to market, contributing to a further jump in oil prices so far today.
  • Senior insurance executives have stressed to British and EU officials how hard it is to establish the provenance of oil cargoes on ships.
  • The executives have warned that insurers, fearing they might violate the sanctions, could pull back from covering any ships coming out of a particular port. For example, they might refuse to cover ships coming out of a Russian port, even if it appears to be carrying oil from Kazakhstan.  Such a development could further crimp global oil supplies and drive prices even higher.
• Other Western sanctions on Russia are also increasingly complicating global trade in food commodities. In a summit with EU leaders yesterday, the president of the African Union complained that cutting Russian banks from the SWIFT system for international funds transfers has made it difficult for poor African countries to buy needed food supplies from Russia.  We continue to believe that rising food costs because of the war and other factors could spark widespread hunger or political instability worldwide in the coming months.

Germany:  Police, public prosecutors, and financial regulators yesterday raided the offices of DWS and its majority owner Deutsche Bank (DB, $11.18).  It is part of a probe into whether the asset manager has been engaging in “greenwashing,” i.e., making misleading statements that its assets were invested using environmental, social and governance criteria.

• The Germans launched their probe following a similar action by the U.S. Securities and Exchange Commission, prompted by allegations from a former DWS staffer.
• The probes may signal intensifying scrutiny of asset managers going forward.  In an environment where ESG criteria can be vague, fluid, and inconsistently applied, those who have gotten out too far over their skis in making ESG claims could face high regulatory and reputational risk.

United Kingdom:  Britons today are prepping for a four-day celebration of Queen Elizabeth II’s platinum jubilee.  The holiday will mark the queen’s 70 years on the throne, a record in a royal dynasty that stretches back over a thousand years.

• The celebration will include all the pomp and ceremony associated with a British royal event.
• There will be a military parade, street parties, a pop concert outside Buckingham Palace, and a religious service at St. Paul’s Cathedral.

Mexico:  After years of racking up debts to its suppliers, state-owned oil giant Pemex said it would offer to pay back about $2 billion it owes to big-ticket suppliers using new debt.  The notes would pay a coupon of 8.75% and mature in 2029, potentially benefitting major service providers like Schlumberger (SLB, $45.96) and Halliburton (HAL, $40.50).

Sri Lanka:  Illustrating the country’s worsening economic and political crisis, the government has begun applying for food donations from a regional food bank that supplies rice and other staples to member states during food crises.  Severe shortages of essential goods have wracked the country, which defaulted on international debts of more than $50 billion last month since it effectively ran out of foreign reserves.

U.S. Monetary Policy:  Neither the White House nor the Federal Reserve provided any details on yesterday’s meeting between President Biden and Fed Chair Powell, other than National Economic Council Director Deese’s statement that it was “a very constructive meeting focused on the outlook for the U.S. and the global economy.”  If anything, reports prior to the meeting underscored that both Biden and Powell remain intent on bringing down consumer price inflation rapidly.

• With the Fed driving up bond yields and stocks sliding, individual investors poured a net $20 billion into mutual and exchange-traded funds that focus on U.S. Treasury securities over the four-week period ended May 25. It marked the largest such infusion in records going back 29 years.
• At the same time, some investors are starting to buy heavily beaten down small-cap stocks, although that could well prove to be premature given the way rising inflation and higher interest rates have increased the risk of recession in the coming quarters.

U.S. Cryptocurrency Markets:  Amid the latest pullback in digital currency values, lawsuits over investment losses are picking up around the country.

• Many of the cases have been fueled by investors who allege some digital coins were hyped and sold under false pretenses. Some proposed class-action suits allege pump-and-dump schemes involving celebrity promoters.
• Others allege that some digital tokens are unregistered securities or that cryptocurrency issuers were deceitful in their marketing.

COVID-19:  Official data show confirmed cases have risen to  530,184,304 worldwide, with 6,292,981 deaths.  The countries currently reporting the highest rates of new infections include the U.S., Taiwan, Germany, and Australia.  (For an interactive chart that allows you to compare cases and deaths among countries, scaled by population, click here.)  In the U.S., confirmed cases have risen to 84,215,080, with 1,007,047 deaths.  In data on the U.S. vaccination program, the number of people considered fully vaccinated now totals 221,292,360, equal to 66.7% of the total population.

• In the U.S., the latest wave of infections already appears to be topping out, although hospitalizations are still accelerating with their usual lag.  The seven-day average of newly reported cases has now reached 98,688, down 2% from two weeks ago.  The seven-day average of people hospitalized with confirmed or suspected COVID-19 in the U.S. came in at 26,512 yesterday, up 16% from two weeks earlier.  New COVID-19 deaths are now averaging 298 per day, down 6% from two weeks earlier.
• Although the CDC only recommends self-isolating for five days after the first appearance of COVID-19 symptoms or a positive result from an at-home test, many people find they continue to test positive for as many as ten days.  In other words, they may still be contagious even after the recommended five-day isolation period.
• In China, authorities in Shanghai today lifted most pandemic restrictions as planned.  Along with dozens of government stimulus programs launched around the country to offset draconian lockdowns, the end of the restrictions in Shanghai offers some hope that the Chinese economy can start growing again, helping buoy Chinese stocks and global commodity prices in recent days.
• In Japan, the government further eased travel restrictions today by allowing people arriving from 98 countries where the coronavirus risk is deemed to be low to be exempt from testing at airports and quarantine.
• In contrast, authorities in Hong Kong said a planned late-June easing of social-distancing rules on pubs and restaurants might be delayed because of recent infections tied to two bar clusters.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where Russian forces continue to make progress toward their scaled-down goal of seizing all of Ukraine’s eastern Donbas region.  In other major news regarding the war, the European Union has finally agreed on a partial ban on Russian oil imports, helping drive up global oil prices so far this morning.  We next review a range of international and U.S. developments with the potential to affect the financial markets today.  We wrap up with the latest news on the coronavirus pandemic.

Russia-Ukraine:  Russian forces continue to capitalize on their superiority in the quantity of equipment and manpower available to pour into the fight, especially now that they are concentrating their efforts on seizing territory in the Donbas region of eastern Ukraine.  The Russian superiority in equipment and personnel quantities has allowed them to seize more of the city of Severodonetsk, despite their continued losses of junior officers and rank-and-file soldiers.  The Russians are also regrouping near Izyum to renew offensives towards Slovyansk and Barvinkove.  It now appears more likely that Russia will eventually achieve its scaled-down goal of controlling all the Ukrainian provinces of Luhansk and Donetsk.  Meanwhile, we continue to see growing domestic dissent within Russian military circles, claiming that the Kremlin is not doing enough to win the war.

• As evidence that Europe’s post-invasion defense spending hikes will likely have staying power, Germany’s government and center-right opposition parties on Sunday struck a deal to write its €100 billion defense budget hike into the country’s constitution.  The agreement provides for a special constitutional fund to support the Bundeswehr until as late as 2026, after which the government is committed to providing the finances necessary for German forces to meet NATO capability goals.
  • In a sign that German citizens are now more open to flexible budget financing, if necessary, to fund high-priority goals, the new fund will be financed entirely by new public borrowing.
  • According to Chancellor Scholz, the new fund ensures that German defense spending on average will meet or exceed the NATO standard of 2% of GDP.
  • The deal also calls for administrative reforms to accelerate weapons procurement and strengthen German military operations.
• On the sanctions front, European Council President Michel said the EU has finally struck an agreement to ban imports of Russian oil, with a temporary exemption for oil delivered by pipeline.  The ban would apply to about two-thirds of all EU oil purchases from Russia.  Focusing on initially banning only seaborne oil imports will spare Hungary, Slovakia, and the Czech Republic, which are particularly dependent on Russian oil delivered by pipeline.  The EU ban is expected to be finalized on Wednesday, but in conjunction with relaxed Chinese pandemic restrictions, it is already helping boost global oil prices.
  • The partial ban risks distorting competition in the EU oil market, with refineries connected to pipelines from Russia enjoying a price advantage.
  • Hungarian oil group Mol (MOL.BD, 2,646.00) says it has enjoyed “skyrocketing” margins for its refineries since March because of the widening Brent-Ural spread.
• In further disruptions to the global energy markets, major natural gas traders in the Netherlands and Denmark said they expect Russia to stop shipments to them as early as today, following their governments’ refusal to pay Russia in rubles in violation of EU sanctions.
  • The Netherlands and Denmark would join Finland, Poland, and Bulgaria in having their supplies of Russian gas turned off.
  • Those countries account for 16% of the volume Russia was contracted to deliver to Europe at the start of the year and now be sourced elsewhere.

Eurozone Inflation:  As shown in the data tables below, the Eurozone’s May Consumer Price Index (CPI) was up a record 8.1% from the same month one year earlier, far above both the expected inflation rate of 7.7% and the April rate of 7.4%.  Excluding the volatile food and energy components, the zone’s May Core CPI was up a worse-than-expected 3.8% compared with 3.4% in the year to April.

• Although top ECB officials have recently said they plan to hike interest rates by just 25 basis points at upcoming meetings, the soaring inflation rate could force the policymakers to impose some 50-basis-point hikes.
• If the ECB signals a faster rate hike pace, it will likely produce additional headwinds for Eurozone equities, although it could also boost the euro.

United Kingdom:  Almost ten more Conservative Party members of parliament have said they submitted letters of no confidence in Prime Minister Johnson, following last week’s report accusing him of breaking pandemic social distancing rules and the government’s tardy release of an inflation-relief program.

• That brings the number of publicly known letters to 34, although some observers believe unacknowledged letters would bring the total close to 50.
• A vote of no confidence that could topple Johnson would be required if the number of letters reached 54.

China-South Pacific:  A summit of South Pacific island nations yesterday deferred a decision on endorsing China’s proposed “China-Pacific Island Countries Common Development Vision,” at least temporarily setting back China’s effort to bring those countries under its influence.  While some South Pacific nations have been open to China’s overtures (including the Solomon Islands, which has just signed a new security agreement with Beijing), others remain wary of Chinese influence and are concerned that China is not working hard enough to limit global warming, which is a major threat to their low-lying territories.

• Under Beijing’s proposed program, China would:
  • Help train police and diplomats from Pacific Island nations.
  • Set up Confucius Institutes, which in other countries have funded language studies but also have disseminated Beijing’s views on certain issues.
  • Provide aid, including new border-control technology and further infrastructure funding under China’s controversial Belt and Road Initiative.
  • Deepen cooperation in industries such as fisheries.
  • Promote rules for data security.
• The U.S. and its key allies, including Australia, have belatedly been working to counter China’s move in the region, including measures through the Biden administration’s limited new Indo-Pacific Economic Framework.

Israel-United Arab Emirates:  The governments of Israel and the UAE signed a free-trade agreement today, boosting business ties less than two years after they established formal diplomatic relations in a U.S.-brokered deal.  The deal will cut tariffs and otherwise loosen restrictions on some 96% of trade between the two countries.

Colombia:  Leftist former guerilla Gustavo Petro won the first round of Colombia’s presidential election on Sunday with 40.3% of the vote, followed by populist right-wing real estate tycoon Rodolfo Hernández with 28.1%.  The two will now compete in a June 19 run-off election.

• As in many countries around the world in recent years, the results are a rebuke to the country’s traditional centrist politicians, who are widely scorned for failing to end problems like poverty and drug violence.
• While Petro and Hernández would probably both scare some investors away from Colombian assets, Petro may be the greatest risk, given his pledges to insert the state into Colombia’s market economy, heavily tax the rich, and move the country away from its dependence on oil and coal.

U.S. Monetary Policy:  The White House announced that President Biden will meet today with Federal Reserve Chair Powell to discuss the state of the U.S. and global economies.  The president has pledged not to try to influence Fed policy, but he has broadly supported the Fed’s plans to withdraw stimulus and fight inflation.

• Separately, Fed board member Waller yesterday said he would support raising interest rates in half-percentage-point increments for several more meetings, adding that he wouldn’t take such increases “off the table until I see inflation coming down closer to our 2% target.”  The statements put Waller on the hawkish side of Fed policymakers, given that their public comments recently have centered on 50-basis-point hikes only at the policy meetings in June and July.
• In one sign that the Fed’s rate hikes are having their desired effect, the developing weakness in the housing market has pushed lumber prices dramatically lower.  Lumber futures for July delivery recently traded at $695.10 per thousand board feet, down 52% from their high in early March. On-the-spot wood prices have plunged, too. Cash prices fell about 12% last week to end at $794, down from $1,334 in March.
• In another development, investors are increasingly worried that the Fed will soon start to sell its holdings of agency mortgage-backed securities.  That fear has pushed agency mortgage-backed bond yields higher, boosting their spread over Treasury yields to 1.20% from 0.70% at the beginning of the year and prompting some bargain-hunting.
• Going forward, we still believe there is a heightened risk that the Fed’s policy tightening will reveal financial fragilities or spark a financial crisis and/or recession.  That chance may have declined somewhat because of reduced risk-taking following the financial blowups of the last two years, such as the Archegos hedge fund collapse or the plunge in the Terra USD cryptocurrency.  All the same, it’s important to remember that the negative impact of higher interest rates, a stronger dollar, and weakening demand in the real economy are all still working their way through the financial markets.  We continue to believe the current environment of high energy prices and rising interest rates require heightened caution on the part of investors.

U.S. Fiscal Policy:  Senate Majority Leader Schumer and Sen. Joe Manchin are reportedly nearing a deal to advance some elements of President Biden’s stalled economic program.  While the details remain closely held, some Democrats and outside analysts now expect a possible agreement could raise roughly $1 trillion in revenue and spend about $500 billion over a decade.

• Roughly half the new revenue would be dedicated toward reducing the deficit.
• The spending would focus on tax incentives for reducing carbon emissions and some support for fossil fuels, as well as an extension of subsidies for purchasing health insurance under the Affordable Care Act.

COVID-19:  Official data show confirmed cases have risen to  529,459,106 worldwide, with 6,289,228 deaths.  The countries currently reporting the highest rates of new infections include the U.S., Taiwan, Germany, and Australia.  (For an interactive chart that allows you to compare cases and deaths among countries, scaled by population, click here.)  In the U.S., confirmed cases have risen to 84,012,408, with 1,004,760 deaths.  In data on the U.S. vaccination program, the number of people considered fully vaccinated now totals 221,190,484, equal to 66.6% of the total population.

Virology

• In the U.S., the latest wave of infections already appears to be topping out, although hospitalizations and deaths are still accelerating with their usual lag.  The seven-day average of newly reported cases has now reached 109,105, up 14% from two weeks ago.  The seven-day average of people hospitalized with confirmed or suspected COVID-19 in the U.S. came in at 26,781 yesterday, up 20% from two weeks earlier.  New COVID-19 deaths are now averaging 368 per day, up 22% from two weeks earlier.
• In China, plummeting infections in Shanghai suggest the city can lift most of its draconian restrictions on Wednesday as planned.  More than 22 million residents living in low-risk areas will be able to leave their compounds freely and fully resume using public transport. Private cars will also be allowed on the roads again.
• On the other hand, Hong Kong has identified two new infection clusters centered on high-end nightclubs.  Health officials on Monday confirmed 275 new infections, including 48 imported ones, as well as two more related deaths.
  • The development came as officials prepared to roll out the third stage of their vaccine pass scheme on Tuesday.
  • Under that plan, most residents will need three jabs to enter premises unless they have already recovered from an infection less than six months ago.

Economic and Financial Market Impacts

• The end of pandemic restrictions in Shanghai and elsewhere in China has raised hopes for reviving economic activity in that country, driving global oil prices up to a two-month high of approximately $117 for Brent crude.
  • Analysts estimate China’s latest pandemic lockdowns have cut its oil demand by approximately 1.2 million barrels per day.
  • Most or all of that demand is now likely to come back in the coming weeks and months.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! U.S. equities continue to rally as investors no longer fear that the Fed will become more hawkish. Additionally, a drop in mortgage rates and a strong performance from retailers have boosted investor sentiment. Today’s report begins with the rising popularity of windfall taxes. Next, we discuss the latest updates on the Russia-Ukraine war and other related stories. We comment on the latest U.S. economic and policy news, focusing on the rivalry between Washington and Beijing and waning inflation expectations. We conclude with our COVID-19 coverage.

Tax on Energy: On Thursday, the U.K. government announced that it would introduce a 25% tax on the profits of energy producers. The government will use the tax to provide subsidies of £650 in two installments to low incomes households and £300 to some pensioners. The U.K. is not the first country to push corporations to use their profits to help the country. On Wednesday, the Hungarian government made a similar request for companies to use their “excess profits” to help the government fund utility subsidies. Italy also taxed profits on energy companies to fund aid packages earlier this month.

We suspect that taxing excess profits of firms, particularly those in the energy sector, could be detrimental to resolving the oil shortage. By taxing firms for being extremely profitable, the government gives them less incentive to expand production capacity. Moreover, by using the funds for consumer subsidies, the government is disrupting the communication mechanism for the consumer to purchase less. As a result, the tax on excess profits may hinder attempts to lower prices because it does not reduce demand or encourage firms to expand capacity.

Russia-Ukraine: Russian soldiers are having more success in eastern Ukraine as the troops learn from their previous mistakes. Russian forces are advancing in Severodonetsk and are close to encircling the region. These forces also appear to be closing in on the west and south of Popasna. Despite these gains, Ukrainian officials have maintained a solid defense.

Other Russia-Ukraine news

• The White House stated it expects a Russian default to have a minimal effect global economy. The remarks came after the Treasury decided not to extend the waiver to allow Russia to repay bondholders in dollars. Last month, World Bank economist Carmen Reinhart warned that a Russian default could stress a financial system already burdened with rising inflation and slowing growth. Russia is expected to pay about $100 million of interest on its foreign debt on Friday.
• In a phone call with Italian Prime Minister Mario Draghi, Russian President Vladimir Putin stated his country would be willing to help ease the food crisis in exchange for lifting sanctions. U.K. and U.S. officials have described the offer as blackmail. The Kremlin’s decision to block the export of grains is another sign that Russia is trying to raise the cost of the West’s loyalty to Ukraine. The blockade has benefited Russia as it has raised the price it can charge for its grains; meanwhile, it hurts the West by contributing to rising inflation. As food prices increase, we suspect that the Western coalition will start to fray. If we are correct, it would mean that Ukraine is running out of time to retake regions lost to Russia. The rising inflation due to conflict may lead the West to pressure Ukraine to agree to a cease-fire with Russia.

U.S. economic and policy news

• The U.S. pivot: Despite the ongoing conflict in Russia, Washington still views China as its primary geopolitical rival. In a speech, SoS Antony Blinken stated that the U.S. would attempt to influence China’s behavior by shaping the “strategic environment around Beijing.” The remark came on the eve of economic talks between the U.S. and Taiwan. The Biden administration is developing the Indo-Pacific Economic Framework, designed to create greater economic integration with the U.S. and countries within the region. Meanwhile, China has been trying to expand its military influence throughout the region by acquiring security pacts. Despite the U.S. and China’s supposed advantages, it isn’t clear who has the upper hand. The U.S. is unwilling to provide the market access that China is willing to offer. Meanwhile, China does not have the defensive capabilities to provide the same level of protection as the U.S. military. As the two countries compete for influence, countries within the Indo-Pacific will likely benefit, and thus, these areas could be attractive places for investment.
• Fiji announced it would join the Indo-Pacific Economic Framework on Friday.
• Inflation expectations: Although inflation remains elevated, there are growing signs that it may have peaked. Research from the New York fed suggests that consumers’ inflation expectations are starting to wane. The finding shows that consumers expect inflation to fall to 3% in about five years. Consequently, the study suggests inflation expectations are more anchored than most people realize. In another sign that inflationary pressures are fading, staffing companies report firms are becoming more reluctant to raise wages due to concerns that consumers are starting to push back. Although inflation will likely remain above the Fed’s two percent target for the foreseeable future, we suspect the Fed will be less inclined to be more assertive in raising rates.

International news

• Chinese lockdowns have led to a worker revolt in a factory in Shanghai. To minimize the impact of lockdowns on the global economy, China has forced laborers to work in a bubble. The unrest adds pressure on Beijing to abandon its controversial Zero-COVID Strategy. The lockdown is affecting the economy. In April, industrial profits fell 8.5% from the prior year.
• The E.U. is preparing for Russia to halt natural gas shipments to the bloc. Europe is already building its inventory stock and is willing to ration gas supplies to industries.

 Interesting fact

• Following the decline of several of its competitors, Bitcoin has reclaimed its dominance as the most widely held cryptocurrency.

COVID-19: The number of reported cases is 527,941,243, with 6,284,762 fatalities. In the U.S., there are 83,837,175 confirmed cases with 1,004,122 deaths. For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics. The CDC reports that 744,812,955 doses of the vaccine have been distributed, with 586,008,740 doses injected. The number receiving at least one dose is 258,394,333, and the number of second doses is 221,128,528. The number receiving the first booster is 103,110,612, and the number receiving the second booster is 13,235,706. The FT has a page on global vaccine distribution.

• The White House has stepped up its efforts to make it easier for patients to access the COVID-19 oral pill treatment, The Federal government plans to reimburse a clinic in Rhode Island that immediately prescribes the pill to patients who test positive for the virus. The new approach suggests that the Biden administration is looking for alternative methods outside of vaccinations to contain the spread of the virus.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s report begins with a summary of the Fed meeting minutes and other central bank news. Next, we discuss the latest developments in the Russia-Ukraine war. Afterward, we go over the pushback regarding China’s zero-COVID strategy and the possibility of global famine due to the Russian blockade of the Black Sea. We end with international news and our COVID-19 coverage.

Fed Meeting Minutes: The Fed meeting minutes revealed a consensus among voting members for the central bank to hike rates 50 bps over the next couple of meetings. The minutes reaffirmed market sentiment that the central bank might push rates into restrictive territory to tame inflation. As a result, the S&P rose slightly, and Treasuries were relatively unaffected. The Fed’s decision to maintain 50 bp hikes appears to be related to its confidence that the economy is strong and capable of withstanding additional tightening. Fed members and staff shrugged off the unexpected decline in Q1 GDP as being temporary. Additionally, the group downplayed the possibility that decreases in inventory spending, government spending, as well as net exports, would persist throughout the year. Although the Fed was generally upbeat about the economy, it mentioned the Russia-Ukraine war and lockdowns in China as threats to the expansion.

Central Bank News

• Federal Reserve Bank of Kansas City President Esther George has announced that she will be stepping down in January. The decision to leave her post was not surprising. Fed officials are required to step down due to mandatory retirement rules of Fed Presidents. Chicago Fed President Charles Evans is also expected to step down for a similar reason. As a result, there will likely be two vacancies in 2023 among the 12 regional banks.
• There are growing fears that the ECB is behind the curve in containing inflation. Veteran British economist Charles Goodhart warned wage pressures would contribute to inflation as workers demand higher pay to cope with increasing food and energy prices. There seems to be a broad consensus among ECB members to end negative rates next quarter, with Dutch central bank chief Klaas Knot stating that he would support a 50 bp rate hike in July. By one of our central bank policy measures, seen in the chart below, the ECB may be behind the curve but still in a better position than the U.S. This suggests that the ECB may not have to raise rates as aggressively.

• The chart above shows the annual change in CPI minus the unemployment rate. When CPI exceeds that unemployment rate, it signals that the economy may be overheating.

Russia-Ukraine: As the war enters its fourth month, the Kremlin faces growing criticism on social media regarding the way it is handling the Ukraine war. Bloggers on Telegram have complained that the government has not adequately supplied Russian soldiers with military equipment needed to hold off Ukraine troops. Although it is unclear how impactful these messages are on the general public, the backlash suggests the government may be losing control over the narrative. Meanwhile, the West is preparing for the possibility of a long war. NATO general Jens Stoltenberg urged countries need to be prepared to provide Ukraine with additional support. We believe that as the conflict rages on, the West will struggle to maintain its coalition. The inability of the EU to secure an agreement on the Russian oil ban reinforces the concern that this coalition may fracture in the future. If we are correct, it could mean the West could push Ukraine into accepting a ceasefire with Russia. At this time, leaders in both Russia and Ukraine have been postponing peace talks, hoping to secure more leverage. We believe such negotiations will happen sooner rather than later.

On the ground, Russian forces have entered Lyman and are closing in on Popasna. Russian troops are making gains in Ukraine but very modestly. The military is struggling to find reserves to carry out the mission.  It has raised the maximum age for army recruits and forced border guards to cancel their vacations.

The Global Food Crisis: The Russian blockade of Ukrainian ports continues to stir fears of global famine and instability. Russia and Ukraine supply about 30% of the world’s wheat, a crucial food source for developing countries. In response to criticism, Russia has agreed to relieve some of the pressure by opening the Black Sea port for foreign ships. The move should put downward pressure on grain prices.

• Brazil agreed to supply China with corn. The move comes as Beijing looks to build up its stocks to hedge against a potential food crisis. The agreement led to a decline in corn prices due to concerns that the deal could reduce demand for U.S. corn.

Zero-COVID Policy:  In a rarity, Chinese Premier Li Keqiang openly acknowledged that the zero-COVID strategy is harming the economy. In a meeting with multinationals operating in China, Li offered reassurances that the country would do its best to expand vaccinations. In addition, conceding the need for increased vaccinations, Li warned that the Chinese economy could struggle to avoid a contraction in the second quarter. His remarks highlight the growing unease among members of Chinese leadership about Xi’s decision to reimpose COVID-19 restrictions.

International News

• Hungarian President Viktor Orban has demanded the largest companies turn over “extra profits” to help the government with its finances. The Hungarian government lacks funding for it wants to pay for utility subsidies and improvements in the country’s armed forces. The government had its funding frozen by the EU over accusations that Orban is undermining democracy.
• Iran’s nuclear program was likely more advanced than previously thought. Intelligence officials believed Iran secured access to United Nations atomic agency reports and falsified a record to conceal its past work on nuclear weapons. However, the revelation may complicate the efforts of the Biden administration to secure a nuclear agreement.

Interesting facts:

• Saudi Arabia is exploring a takeover of Valvoline’s lubricant business.
• A financial scam has led to protests in China’s Henan Province.

COVID-19:  The number of reported cases is 527,228,581, with 6,282,713 fatalities. In the U.S., there are 83,702,508 confirmed cases with 1,003,738 deaths. For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics. The CDC reports that 739,095,455 doses of the vaccine have been distributed, with 583,221,364 doses injected. The number receiving at least one dose is 258,312,266, the number of second doses is 221,050,854, the number receiving the first booster is 102,997,276, and the number receiving the second booster is 12,988,274. The FT has a page on global vaccine distribution.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war, where Russian forces are now making better gains toward their newly reduced goals.  We next review a range of international and U.S. developments with the potential to affect the financial markets.  We wrap up with the latest news on the coronavirus pandemic.

Russia-Ukraine:  Russian forces continue to implement their latest strategy shift, which involves abandoning their effort to make a major encirclement of Ukrainian forces in the eastern Donbas region.  They are instead completing a series of smaller encirclements.  The strategy shift has allowed them to seize more territory than they did earlier in May, but their progress is still relatively minor, and the tough, costly urban combat would likely slow them if they try to take the city of Severodonetsk.  Meanwhile, we continue to see increased complaints about the war within Russia, even by nationalist politicians who generally support President Putin.

• The Treasury Department today will end its sanction exemption that allows U.S. banks and investors to process and receive payments on existing Russian bonds.  The move puts Russia on a path toward defaulting on its foreign debts this summer and deepening the country’s economic isolation after its invasion of Ukraine.
• Amid fears Russia will continue its efforts to destabilize its enemies and help its friends in regional governments, Moldova has detained pro-Russian Former President Igor Dodon on charges of treason, corruption, and illicit political financing.

United Kingdom: Prime Minister Johnson has come under new political pressure today as an official investigation found he must “bear responsibility” for a culture in Downing Street during the pandemic that allowed the repeated breaking of COVID-19 rules.  However, the long-anticipated report was not as critical of him as some had expected, increasing the chance that he could survive what has been one of his most dangerous political scandals.

Saudi Arabia:  Finance Minister Al-Jadaan said the kingdom will use its huge windfall from today’s high oil prices to top up its reserves, fund more domestic development projects, and invest more into its massive sovereign wealth fund.

• The kingdom posted a $15.3 billion budget surplus in the first quarter, putting it on track to meet its goal of a $24.0 billion surplus for the entire year.
• If Saudi Arabia succeeds in posting a surplus this year, it would be the kingdom’s first since 2013.

Pakistan:  Foreign Minister Bilawal Bhutto Zardari said he wants to negotiate a deal with the IMF to resume lending under a $6 billion loan program agreed upon in 2019 but in limbo since a dispute with the previous government over energy subsidies.  The renewed lending would be used to help replenish the country’s foreign reserves and deal with the surge in food and energy prices touched off by the war in Ukraine.

United States:  As the Federal Reserve continues to tighten monetary policy, driving interest rates higher, top U.S. mortgage lenders are reporting a sudden plunge in refinancing demand.  Firms ranging from Wells Fargo (WFC, $43.29) to Rocket (RKT, $8.75) are laying off staff, selling servicing rights, and otherwise trying to survive.

COVID-19:  Official data show confirmed cases have risen to  526,808,553 worldwide, with 6,280,679 deaths.  The countries currently reporting the highest rates of new infections include the U.S., Germany, Taiwan, and Australia.  (For an interactive chart that allows you to compare cases and deaths among countries, scaled by population, click here.)  In the U.S., confirmed cases rose to 83,505,455, with 1,002,743 deaths.  In data on the U.S. vaccination program, the number of people considered fully vaccinated now totals 221,001,614, equal to 66.6% of the total population.

• As yet another wave of infections seems to be hitting the U.S., newly reported cases are on the rise, again.  The seven-day average of newly reported cases has now reached 108,082, up 40% from two weeks ago.  However, hospitalization and death rates are still rising much more slowly.  The seven-day average of people hospitalized with confirmed or suspected COVID-19 in the U.S. came in at 25,383 yesterday, up 30% from two weeks earlier.  New COVID-19 deaths average just 331 per day, down 10% from two weeks earlier.
• The chief executive of Pfizer (PFE, $53.41) has warned that the stage is set for “constant” waves of infections because of growing complacency about the virus, politicization of the government response, and waning immunity from infections and vaccinations.
• In China, the government is cracking down even harder on students at elite universities who have been protesting strict pandemic restrictions.  The action raises the risk of wider political protests and instability in the country.
• To help cushion the economy from President Xi’s super-strict “zero- COVID” strategy, the government has released a 33-point stimulus package.  The measures are centered on greater financial relief for more industries via tax refunds, tax cuts, and fee reductions.
  • The government will also support banks by allowing borrowers of various types of loans to postpone principal and interest repayments until the end of this year.  Bank lending quotas for small and micro-sized businesses will be doubled.
  • The additional measures will bring the government’s total planned tax refunds and reductions to 2.64 trillion yuan (US$396 billion) for 2022.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning.  After a strong rally off the lows on Friday and impressive follow-through yesterday, risk assets are lower this morning.  However, one pattern emerging in the past couple of weeks is that the correlation between stocks and bonds has again become inverse.  Since about May 6, we have seen the inverse pattern that has mainly been in place since the mid-1990s and is the backbone of the 60/40 portfolio.  We remain cautious about the long-term path of this relationship.  If inflation becomes persistent, higher bond yields are probably unavoidable. The fact the pattern has returned suggests that (a) the market thinks the current yield on longer duration Treasuries is “about right,” and (b) the debt markets believe the Fed will defend bond values against inflation.

In today’s Comment, we open with China news, focusing on the aftermath of President Biden’s statements on Taiwan.  From there, we take a look at economic news.  The Ukraine update follows.  International news comes next, and we close with the pandemic update.

China news:  Was it a gaffe, or not?  As we reported yesterday, President Biden seemed to end the U.S. policy of strategic ambiguity regarding Taiwan.  Within 24 hours, the White House tried to walk the comments back, suggesting “nothing has changed.”  To be fair to the president, strategic ambiguity has been fraying for some time.  We note that SoS Blinken once referred to Taiwan as a “country,”  and it isn’t the first time the president has suggested the U.S. would defend the island militarily.

So, has anything changed?  In some ways, yes, but in others, no.  What has changed?  Japan seems much more committed to the defense of Taiwan.  As we have noted before, Taiwan in the hands of Beijing is an existential threat to Tokyo.  What remains the same?  We seriously doubt anyone in China’s leadership believes the U.S. would not come to the aid of Taipei if China tried to invade Taiwan.  That isn’t anything new.  The rhetoric surrounding the president’s remarks in Beijing will escalate; if the PLA hasn’t been pondering how to thwart American defense efforts in its invasion plans, they should be relieved of duty.  We note that within the international relations community, the end of strategic ambiguity is being widely cheered.  The primary benefit of ending strategic ambiguity is that China won’t be as likely to miscalculate, assuming the U.S. won’t act; that was, in part, why the Korean War occurred.  However, as noted above, the odds of such a miscalculation were small anyway.  The most serious risk of ending the policy is that it reduces American optionality and might lead to less cautious behavior on the part of Taiwan.  We still view Taiwan as a chief point of geopolitical risk; the president’s “gaffe” doesn’t change that.

• Airbnb (ABNB, USD, 1113.28) is closing its domestic business in China, although it will maintain an office for outbound travelers. It appears the company simply could not compete against Chinese incumbents.
• The incoming Australian PM has indicated that he doesn’t expect relations with China to improve anytime soon.

Economics and policy:  It’s day two of Davos.  Some softening in monetary policy may be coming.

• The attitude of Davos appears downbeat. A big part of this mood is that this crowd really benefited from globalization.  Although we have been suggesting for some time that globalization was under threat, the tensions with China, the rise of populism, and the Ukraine war have pretty much confirmed that it’s over.  Among the attendees, the general consensus is that recession is coming.
  • Weakening globalization further is the realization that data is being constrained within borders.
• On the FOMC, St. Louis FRB President Bullard is considered a hawk, while Atlanta FRB President Bostic is more dovish. Yet, both made statements suggesting they may relent on policy.  Bullard suggested the Fed might cut rates next year.  Such a shift is what the Fed did in the mid-1990s when it executed a rare soft landing.  Bostic indicated a “pause” in the fall might make sense to see how the market deals with rate hikes.  In the near term, we expect nothing other than tightening.  These comments suggest the FOMC is looking past the tightening cycle.
  • Congress has approved two new governors along with Jay Powell’s renomination. In addition, Michael Barr is likely to be approved for the Vice-Chair of Supervision.
• Whether we have a recession or not in the next 18 months will likely depend on the consumer. A Fed survey conducted last fall showed that the consumer was doing quite well; of course, that was before inflation jumped.  However, JP Morgan (JPM, USD, 124.60) said yesterday that the bank’s read on the consumer is that things are just fine.
  • One interesting indicator—birth rates showed a modest improvement last year.
• As diesel prices soar, the administration is considering a release from the Strategic Heating oil reserve.

Larry Summers has been a problem for the administration.  He criticized the fiscal stimulus in 2021, saying it would likely lead to higher inflation.  Although fiscal spending wasn’t the only reason for inflation, it certainly contributed.  He is now attacking the idea that industry concentration leads to higher prices.  The basic issue is that industry concentration can improve efficiencies but also gives market power to firms.  Firms can decide how to allocate the gains to efficiency because they have market power.  Since the mid-1980s, when the Bork Standard for antitrust emerged, firms have mostly allocated these efficiencies to profits and consumers by keeping price hikes contained.  Labor has generally been excluded from benefiting from any efficiencies.

This chart shows the share of output going to labor.  The trend was mainly declining but clearly accelerated this century.  So, back to Summers’s argument.  He contends that antitrust action might actually lead to higher inflation if it undermines the efficiencies from concentration.  But, that is true only if two conditions are met.  First, increased competition should make it more difficult to pass along high costs.  Second, it appears that Summers believes current profit margins will be maintained.  With S&P 500 earnings nearly 8% of GDP, an all-time record, it seems reasonable that a return to trend could allow for antitrust to at least not contribute to higher inflation.  At the same time, we think the administration is overstating the case for antitrust to bring down inflation.  It’s easier to blame industry concentration for inflation than to cool the economy by cutting spending and raising taxes.

• Here are some random facts we found interesting:
  • Walmart (WMT, USD, 122.60) is expanding drone delivery in six states. Items up to 10 pounds can be delivered for $3.99.
  • The last payphones in New York City have been removed.
  • The average age of a U.S. vehicle is 12.2 years, a new record.

The Ukraine War:  The conflict appears to be evolving into a trench war, with both sides building fortifications to thwart offensive actions.  Here is the latest map:

• The most active fighting continues in Severodonetsk as Russia attempts to solidify gains in the territory it holds.
• We see increasing criticism of the war effort from Russian nationalist figures, who are pressuring the Kremlin to at least make a partial mobilization to rebuild troop strength. Mobilization would be a significant escalation, and if Moscow is going to continue the conflict, it will need, at some point, to mobilize.  Yesterday, we noted growing comments on a ceasefire.  If Russia announces a mobilization, we doubt a ceasefire is possible.  Thus, for now, the Russian war effort is to continue in the current pattern despite heavy losses to maintain gains in eastern Ukraine.
  • It’s not just nationalists attacking the Kremlin. A Russian diplomat attached to the nation’s U.N. mission in Geneva has resigned because of the war.
• The EU is accusing Russia of purposely attacking Ukrainian agriculture in a bid to worsen the global food shortage.
• NATO continues to send heavier weapons into Ukraine as the war develops into an artillery battle. The U.S. has sent the M777 howitzer, a weapon with significant firepower that is easily transportable.  The Czech Republic has sent attack helicopters and is acting as a repair depot for Ukraine armor.
• Ukraine has convicted a Russian soldier for war crimes.

International roundup:  A big deal is in the works and more from the president’s trip.

• The U.S. is reportedly working on a deal between Israel, Egypt, and the KSA over two small islands near the Gulf of Aqaba. The islands, Tiran Island and Sanafir Island, were said to be “given” to Egypt by the KSA in 1950.  In the aftermath of the 1973 Yom Kippur War, the islands were demilitarized and currently occupied by a multinational U.N. force.  Legally, they remain Egypt’s.  The deal being struck is ostensibly between the KSA and Egypt, but Israel would have to approve.  The negotiation might lead to a normalization of relations between the KSA and Israel, further extending the Abraham Accords.
• Although the economic deal offered by the administration is underwhelming, 12 Asian nations have been invited. Essentially, it will set up a talking shop for various issues that would have been part of TPP.  Since multilateral trade deals are no longer politically possible, such arrangements are about the only thing the U.S. can offer.  Interestingly enough, the reception was better than we expected.
• The OECD has been working on a minimum corporate tax program that would prevent companies from shifting to jurisdictions that offer lower taxes. Poland, likely to gain leverage in EU negotiations over COVID-19 relief funds, is opposing the tax measure.
• Turkey continues to oppose Sweden’s entry into NATO, demanding that Kurds operating in Sweden and Finland be extradited to Turkey. We still expect a deal to be struck, but Ankara’s actions are slowing the process.
  • Turkey also says it no longer recognizes the existence of the Greek leader. Greek PM Kyriakos Mitsotakis is lobbying Congress and the administration to deny Turkey F-16s.
• Starbucks (SBUX, USD, 73.42) announced its exiting Russia.
• U.K. professional services firms are finding that restrictions on providing services to Russians are making it impossible to avoid breaking the law. They want relief.
• As we have been reporting for some time, Egypt is at high risk of political unrest due to rising grain prices.
• Conditions in Venezuela have become so dire that the national output of vehicles was eight last year. Maintaining old cars has become a necessity, much like in Cuba.

COVID-19:  The number of reported cases is 526,196,860 with 6,278,868 fatalities.  In the U.S., there are 83,393,876 confirmed cases with 1,002,385 deaths.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high-frequency data on various factors.  The CDC reports that 741,676,155 doses of the vaccine have been distributed, with 584,449,398 doses injected.  The number receiving at least one dose is 258,174,992, while the number fully vaccinated, which would grant the highest level of immunity, is 220,933,970.  For the population older than 18, 76.5% of the population has been fully vaccinated, with 61.1% of the entire population fully vaccinated.  For those over 65, 90.9% have been fully vaccinated.  The FT has a page on global vaccine distribution.

• Pfizer (PFE, USD, 52.88) says studies show its vaccine triggers a strong immune response in young children.

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