Daily Comment (April 15, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Iran-Israel situation, where investors are expecting tensions to cool, but we think risks remain elevated. We next review a wide range of other international and US developments with the potential to affect the financial markets today, including new provocative naval actions by China against the Philippines and a discussion of the US Treasury’s disappointing bond auctions last week.

Iran-Israel: As widely expected, Iran launched a strike against Israel over the weekend in retaliation for Tel Aviv’s recent attack on Iranian diplomatic facilities in Syria, which killed several high-level Iranian military leaders. So far, it appears Iran has launched over 300 ballistic missiles, cruise missiles, and drones at Israel, mostly from Iranian territory. The Israeli military claims 99% of those attacks were intercepted before they could cause any damage, but the world now braces for a potential Israeli strike directly on Iran that could spark a wider conflict.

  • Since Israel avoided any significant damage from the strikes, President Biden has reportedly urged Prime Minister Netanyahu to hold his fire. However, we suspect that Netanyahu’s domestic political environment will prompt him to retaliate in some way.
  • If Netanyahu does decide to retaliate, a key question is how far he will go. One potential avenue would be to launch a go-for-broke attack to eliminate Iran’s nuclear weapons arsenal — something hardline Israeli officials have long wanted to do. Such a strike would almost certainly invite a strong response from Iran, as well.
  • Of course, Netanyahu could also show restraint and decide on only a limited response or reserve the right to respond sometime in the future. Indeed, market action today suggests that is what investors are expecting. For example, near Brent crude oil futures are currently trading down 0.9% to $89.64, near their lowest level of the last week. Gold prices are steady at $2,373.40 per ounce.
  • Despite today’s apparent expectation for a quick cooling of tensions, we suspect that the Israel-Hamas conflict could still be on the brink of widening and intensifying, as many have feared over the last six months. The situation will likely remain a risk for global financial markets in the near term.

China-Philippines: As a reminder that the Middle East isn’t the only place where a major war could start, the Chinese coast guard has blocked a Philippine maritime research vessel and its coast guard escort as they were about to cross the “nine dash line,” which marks China’s expansive, unrecognized claim to virtually all of the South China Sea. The incident happened just 35 miles from the Philippine coast in waters recognized by international law as part of the country’s exclusive economic zone.

  • This occurred just days after President Biden reiterated the US’s commitment to defend the Philippines under the two countries’ mutual defense treaty.
  • As we have noted previously, the US-Philippine defense treaty means today’s escalating Chinese-Philippine tensions are probably even more dangerous than China’s ongoing military provocations against Taiwan. If Chinese forces directly attack Philippine vessels, the US could be obligated to intervene and come into direct conflict with China.

China: The People’s Bank of China today held its key interest rates steady, with its one-year medium-term lending facility at 2.5%. However, it also drained liquidity from the financial system. The moves suggest that, on balance, Chinese monetary policy will be steady in the near term as the economy continues to face strong structural headwinds but is also showing signs of a near-term improvement.

North Atlantic Treaty Organization-France:  Reflecting how the growing threat from Russia has spurred Europeans to take stronger defense measures, France will put an aircraft carrier and its strike group under NATO command for the first time ever in a naval exercise next week in the Mediterranean Sea. Besides the Charles de Gaulle carrier, the French strike group will include two frigates and a nuclear attack submarine, augmented by US, Spanish, Portuguese, Italian, and Greek navy ships.

United States-United Kingdom-Russia: The US and UK on Friday said they will ban Russian aluminum, nickel, and copper from Western metals exchanges in a further retaliation for the Kremlin’s invasion of Ukraine. Since the Russian metals can still be off-exchange, there will be no immediate impact on actual supply and demand. However, the move has raised concern about further restrictions in the future. Prices for the metals are therefore trading higher so far this morning. For example, near copper futures are currently up 1.6% to $4.3236 per pound.

US Bond Market:  Although last week’s unsettling report on continued consumer price inflation was probably the key reason that bond yields rose, it’s important to remember that Treasury auctions also suffered from weak demand. That’s raising the prospect that the government may be hitting its limit in terms of investor demand for new Treasury obligations. That would be a negative development because the Treasury plans to sell another extraordinary volume of $386 billion in bonds next month.

US Industrial Policy: The Commerce Department today said Samsung Electronics will be granted up to $6.4 billion to help the company build a major semiconductor manufacturing facility outside Austin, Texas. The company will also be eligible for billions of dollars in loans. The funding is part of the CHIPS and Science Act of 2022, which aims to boost production of advanced computer chips in the US and cut the country’s reliance on suppliers abroad, especially those in China and East Asia.

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Bi-Weekly Geopolitical Report – Rebirth of US Nuclear Deterrence (March 11, 2024)

by Daniel Ortwerth, CFA & Patrick Fearon-Hernandez, CFA | PDF

Fifteen years ago, a revolution in United States national security policy began very quietly.  It occurred within a subject we have recently addressed in this forum and that is re-emerging as a hot topic of discussion in national security circles after a long hiatus: deterrence, and specifically the unique role of nuclear weaponry as the preeminent deterrent force.  This report uses the timeline and key events of the last 15 years to illustrate the current modernization program for the US military’s nuclear enterprise and to examine how it relates to today’s global geopolitical landscape.  The report concludes with a discussion of the program’s implications for investors.

Read the full report

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Daily Comment (March 11, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news that the Russian military was actively considering the use of nuclear weapons in Ukraine in the autumn of 2022.  We next review a range of other international and US developments with the potential to affect the financial markets today, including new policy directions that have come out of China’s big “two sessions” political meetings and signs that more mothballed uranium mines are being reopened in the US.

Russia-Ukraine-United States:  On Saturday, the New York Times revealed that in October 2022, US intelligence intercepted several Russian military messages in which commanders were having detailed talks about using tactical nuclear weapons in Ukraine as their invasion of that country temporarily began to falter. Even though the US detected no sign of nukes being taken out of storage or moved to firing positions, the intelligence prompted the Pentagon to prepare several potential responses and issue firm warnings to Moscow.

  • The intelligence reports are a reminder that as today’s Great Powers come into conflict with each other, even if indirectly, the risk of a dangerous escalation has increased. Of course, the release of this story now may aim to affect the continued US and European discussions about new military aid to Ukraine, although it isn’t clear whether the story would help or hurt that cause.  In any case, it seems believable that there is an increased risk that Russia would use tactical nuclear weapons in certain circumstances.
  • It’s important to remember that the Russian military has the advantage when threatening to use nuclear weapons since it has a more complete spectrum of military forces, from big, civilization-destroying intercontinental ballistic missiles to tactical nuclear weapons designed for battlefield use to heavy conventional forces, special operations forces, and intelligence operatives. It therefore has a more viable “ladder of escalation,” while the US has few intermediate forces between its conventional military and its nuclear ICBMs.
  • Here at Confluence, we’re proud to be among the first investment strategists to recognize, analyze, and scope out the investment implications of today’s growing propensity for countries to expand or develop their nuclear arsenals. We refer our readers to our recent Bi-Weekly Geopolitical Reports from February 12, on the strategy of deterrence, and today, March 11 (publishing later today), on the US effort to modernize its nuclear arsenal.
  • We see today’s nuclear brinksmanship and the potential for a new, global nuclear arms race as flowing from the US’s perceived reluctance or hesitation in maintaining its traditional role as global hegemon. China, Russia, and other authoritarian nations not only see that as a sign of weakness, but they also see themselves as strong enough to try to take advantage of the situation and assert themselves.
  • This new, tension-filled geopolitical environment looks much scarier than the three decades of globalization after the end of the Cold War, but we don’t think investors should panic or be discouraged. Rather, we think this is a time to look for ways to try to control risks and find any associated opportunities in the new environment.  We continue to take that approach, which has already prompted us to make key adjustments in our various portfolios.

China:  At the annual “two sessions” meetings of the National People’s Congress and the Chinese People’s Political Consultative Conference over the last week, it has become clear that General Secretary Xi’s major new focus for economic policy is “high quality development” and “new quality productive forces,” by which he means domestically produced high-technology products and services.  Xi has signaled a particular focus on promoting China’s prowess in electric vehicles, lithium batteries, and solar panels.

  • Separately, Housing and Urban-Rural Development Minister Ni Hong signaled the government is comfortable with more major real estate developers going bankrupt and being liquidated.
  • Three years into Beijing’s clampdown on excessive building and ever-increasing debt by the developers, the government has already pushed industry giants Evergrande and Country Garden Holdings over the edge, sparking a deep freeze in the housing market.
  • Ni’s statement suggests investor hopes for a reprieve are unfounded. The continued clampdown on property development and a range of other structural economic headwinds are likely to weigh on growth and Chinese asset prices for the time being.

Global Rice Market:  The South China Morning Post today carries an article discussing how a new, mutant “weedy rice” has been infesting fields from Asia to the US.  The new mutant, which is not fit for human consumption, can cut the output of marketable rice in affected fields by up to 80%.  Scientists are still looking for a solution, so at this point, it isn’t yet clear how much of a threat the new variety is to global food supplies and the global rice market.

Australia:  The center-left Labor government of Prime Minister Albanese has announced it will unilaterally eliminate almost 500 “nuisance tariffs” that raise little revenue but impose significant red tape for importers.  The tariffs are equal to about 14% of all Australian import duties, but they raise only about $20 million per year.

Eurozone:  While US data on Friday showed the average value of output per hour worked was up a healthy 2.6% year-over-year, data from the eurozone showed productivity was down 1.2%.  The figures have worsened concerns of a “competitiveness crisis” in the eurozone and sparked sharp discussion of whether Brussels can reverse the trend of weak productivity growth by improving incentives for investment or expanding fiscal stimulus programs.

  • Productivity growth is key to boosting living standards in an economy and keeping price inflation in check.
  • The eurozone’s weak productivity growth, therefore, raises concerns about future economic growth, price stability, and financial market returns in the region.

Portugal:  In elections yesterday, the center-right Democratic Alliance coalition won the most votes, but not enough for a majority in parliament.  The center-left Socialist Party saw its support virtually collapse from just two years ago, while the far-right Chega Party surged to take second place.  However, Democratic Alliance leader Luís Montenegro has insisted that he will not govern with Chega, so the result could be an unstable minority government when all is said and done.

United Kingdom:  In another victory for right-wing populists in Europe, the former deputy chairman of the center-right Conservative Party, Lee Anderson, has defected to join the far-right Reform UK camp.  The move by Anderson came after he refused to apologize for saying that London’s Labour mayor, Sadiq Khan, was in the grip of Islamists and Anderson was therefore stripped of his position as the Conservatives’ party whip.  The move gives Reform UK its first seat in parliament.

India:  In response to proposed rules by stock market regulator SEBI that would require certain foreign hedge funds to provide “granular” detail on their investors, several of the funds have warned SEBI that their rules may force them to withdraw from the Indian market.  However, it’s not clear if the regulator will back down, given that its proposed rules appear to be in response to a recent short-seller’s report that led to a sharp decline in the value of conglomerate Adani, one of the country’s biggest companies.

US Stock Market:  In a little-noticed development, various indicators now show the US equity rally is broadening out beyond the “Magnificent 7” group of large-cap technology stocks.  For example, the equal-weighted version of the S&P 500 price index set a new record high last week, indicating good price gains for stocks with relatively smaller market values.  Also, almost 80% of the stocks in the S&P 500 now have a market price above their 200-day simple moving average, well above the 70% that many traders see as a sign of a broad market rally.

US Uranium Mining Industry:  The Financial Times over the weekend carried an article noting that the push by governments around the world for more nuclear energy and the resulting rise in uranium prices have prompted at least five US uranium miners to reopen mines mothballed after the Fukushima disaster of 2011.  The findings are consistent with the analysis in our most recent Bi-Weekly Asset Allocation Report from March 4, in which we explained why we have introduced an exchange-traded fund investing in uranium miners into the majority of strategies of our Asset Allocation portfolios.

US Movie Industry:  Finally, in yet another development touching on nuclear issues in today’s Comment, we note that last night’s Academy Awards were dominated by “Oppenheimer,” a movie about the father of the atomic bomb.  The movie won a total of seven awards, including the coveted award for best picture and the awards for best director, best actor, and best supporting actor.  Enough said!

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Daily Comment (March 8, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Equities are off to a blazing start today, fueled by a stellar jobs report. Adding to the excitement, Phoenix secured its place as the host city for next year’s NBA All-Star Game! Today’s Comment delves into central bank views on the economy and interest rates, why gold is still king, and the regulatory challenges facing Big Tech giants. We’ve also got a comprehensive roundup of international and domestic news to keep readers informed on the latest developments.

Together but Different: While the European Central Bank (ECB) and Federal Reserve agree on interest rate cuts in 2024, their stances diverge on economic health and financial stability.

  • Although usually in sync on policy decisions, the ECB and the Fed might diverge this time around. A slowing economy and worries about the commercial real estate market are pushing the ECB toward considering looser monetary policy. An April rate cut is even on the table if current trends hold. Historically, the ECB has preferred a more accommodative stance, likely aiming to keep the euro weaker relative to the dollar to boost exports. However, deep cuts are unlikely from either central bank this year as both remain concerned about the persistent threat of inflation.

Flight to Safety: Gold and Bitcoin soar as investors seek safe haven amid rising uncertainty.

  • Gold prices have surged 5% in the past month, fueled by a buying spree from China. The Asian nation has become the world’s largest gold purchaser, partly driven by its central bank’s strategy to diversify reserves away from the US dollar. This diversification allows China greater flexibility in conducting trade and potentially mitigating sanctions, especially as it seeks to strengthen economic ties with Russia. Increased trade between these two countries benefits both as China boosts its exports, while Russia gains access to essential imports.
  • Gold’s resurgence as a safe-haven asset faces a unique challenge—the rise of Bitcoin. While gold regains investor interest, the most popular cryptocurrency has surged 51.5% in the last 30 days. This digital asset’s popularity is partly fueled by potential applications in traditional finance, like the SEC considering its use in options trading. However, Bitcoin’s high volatility casts doubt on its reliability as a store of value. As the chart below shows, Bitcoin is about four times as volatile as gold prices, indicating it may be a riskier option for long-term investors.

  • The choice between gold and Bitcoin might hinge on age. Younger investors, comfortable with technology, may embrace the potential of digital assets like Bitcoin. Older generations, valuing stability, might favor the established security of physical gold. Gold boasts advantages; its tangibility and long history as a store of value inspire greater trust among some. Bitcoin, however, faces regulatory uncertainty and limited mainstream adoption, reflected in its lower trading volume compared to traditional financial instruments. It’s essential to conduct thorough due diligence before venturing into this asset class as cryptocurrencies are still susceptible to significant price corrections.

Tech’s Regulatory Dance: Geopolitical tensions are fueling growing concerns from US lawmakers about the expanding influence of Big Tech.

  • Escalating tensions, particularly between the US and China, threaten to ensnare major tech companies in a global regulatory web. Their vast international presence makes them especially vulnerable to a shifting regulatory landscape. Western companies could face the brunt of this, with increased restrictions inflating development costs and limiting access to crucial foreign markets. China’s push for self-sufficiency in key components like semiconductors further complicates the picture. For investors, this environment suggests a need for diversification. Investors may consider broadening their portfolios beyond traditional tech giants and exploring sectors with stronger fundamentals that are less susceptible to geopolitical headwinds.

In Other News: In his State of the Union address, President Joe Biden championed a call for increased taxes on billionaires and corporations, marking a notable shift toward a more populist stance. The US embassy warned of an extremist attack in Moscow, another sign of growing geopolitical risks. There is growing speculation that the Bank of Japan could tighten monetary policy in March.

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Daily Comment (March 7, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Stocks are rallying this morning as investors gain confidence in the possibility of central banks lowering interest rates later in 2024. On the sports front, Real Madrid secured a hard-fought victory against RB Leipzig, advancing to the Champions League quarterfinals. Today’s Comment begins with our thoughts on the financial system following Fed Chair Powell’s testimony before Congress. We also include an analysis of the current state of the labor market and explore why emerging economies, particularly Turkey, have recently captured investor interest. As usual, our report concludes with a round-up of international and domestic data.

Financial System Focus: Banks take the spotlight as the Fed chair testifies before Congress, while New York Community Bank seeks a lifeline.

  • In a surprise move on Wednesday, Federal Reserve Chair Jerome Powell announced that regulators intend to ease some of the stricter banking requirements introduced under the Basel III framework. This shift in policy follows complaints from Wall Street that the regulations could limit lending to businesses and consumers. However, the claims remain fiercely contested. Powell’s comments suggest the Fed might be aiming to avoid a major regulatory overhaul during a volatile election year. The issue is highly partisan, with Democrats advocating for increased bank regulations, while Republicans lean toward looser regulations.
  • At the same time, New York Community Bank is seeking to shore up investor confidence. The struggling commercial lender secured a much-needed $1 billion equity investment led by a group that includes former Treasury Secretary Steven Mnuchin. This significant cash infusion aims to alleviate concerns about NYCB’s ability to weather potential losses, stemming from revelations of inadequate internal controls that exposed the bank to riskier loans than previously reported. The company’s stock price surged by 7.45%, reaching $3.46 per share following the announcement. Nevertheless, this increase only partially mitigates previous losses, thus leaving the stock price still considerably below its starting level at the beginning of the year.

  • Despite significant uncertainty in the US regional banking system, investor confidence remains somewhat resilient. The KBW Nasdaq Regional Banking Index, while down nearly 8.5% year-to-date, has shown mixed performance since the NYCB issues surfaced. Homestreet Bank, another bank facing scrutiny, has also seen its stock hold steady recently. However, the lack of immediate changes to capital requirements offers a positive sign, particularly as banks prepare for a potential rise in loan defaults as repayments come due in the coming months. Therefore, we do not see any evidence of a possible financial crisis at this time.

Labor Softening: Even though labor markets remain tight, there are signs that employers might be hitting the brakes on hiring.

  • A recent JOLTS report indicates a decline in job listings by US employers. January saw a drop in job openings from 8.89 million to 8.86 million, the lowest level in over three months. This significant decrease in job postings reflects a broader trend within the labor market, where employers are reevaluating their workforce needs. The ongoing uncertainty regarding job security likely contributes to the persistently low quit rates. At 2.1%, the quit rate remains below pre-pandemic levels, suggesting a lack of confidence among workers in their job prospects.
  • A weakening labor market could signal a return to a more balanced relationship between employment and inflation. This aligns with the historical trend of PCE Core Services excluding housing, a measure sensitive to wage pressures, tracking closely with quit rates. Fewer worker resignations likely translate to a gradual decline in overall inflationary pressures. However, this trend could exacerbate if businesses continue to grapple with passing higher costs onto customers, as highlighted in the latest Fed Beige Book. The resulting profit squeeze may impede firms’ capacity to retain employees.

  • This Friday’s jobs report will likely provide more clarity on the health of the labor market. While the latest estimate projects the creation of around 200,000 jobs in February, this represents a slowdown compared to the robust 350,000 increase seen in the previous month. We will be paying close attention to the prior month’s data revisions as these often provide valuable insights into underlying trends. Three consecutive months of downward revisions could signal potential labor market troubles. While the previous report did see upward revisions, it’s worth noting that downward revisions were more common throughout 2023, suggesting potential limitations in capturing the complete economic picture.

Emerging Markets En Vogue: Emerging market equities have defied expectations, posting strong gains in the year’s first quarter despite lingering concerns about high interest rates and a potential global slowdown.

  • Fueled by a surge in its technology sector, Turkey has become a leader in the recent emerging market rally. The sector’s growing prominence has captured significant investor attention, propelling Turkey’s benchmark Borsa Istanbul 100 Index up nearly 20% year-to-date. Notably, the technology sector itself has skyrocketed over 60%. This performance aligns with a broader trend of investors seeking undervalued stocks outside the US to capitalize on the global tech investment boom. However, Turkey’s case is unique in that it also seems to be attracting domestic investors seeking a hedge against inflation.
  • Turkey’s booming tech sector has fueled its impressive performance in the emerging market rally. However, some uncertainties cloud this optimistic outlook. The upcoming municipal elections in March presents a hurdle as these elections are seen as a test of Erdoğan’s popularity in the country. A strong victory for Erdoğan’s party could raise the prospect of a constitutional change to extend his rule. Additionally, this could complicate efforts from the opposition to field a strong candidate for prime minister in the next election, potentially impacting investor confidence in Turkey’s long-term ability to undertake much-needed economic structural reforms.

  • Turkey’s case exemplifies the growing interest in emerging markets as investors seek attractive valuations and potentially higher yields. This trend could be further amplified by a potential decrease in US interest rates, weakening the dollar against other currencies. As a result, countries like Poland, Mexico, Vietnam, Indonesia, and Morocco, often viewed as bridge economies due to their strong trade ties with both the US and China, could become attractive destinations for investors seeking to diversify their portfolios and mitigate risks associated with a US-China trade war escalation.

Other News: The European Central Bank (ECB) kept its interest rates unchanged but hinted at the possibility of a reduction later in 2024. This move aligns with market expectations of central banks adopting more dovish stances. Meanwhile, President Biden proposed a moderate 1% increase in defense spending for 2025, falling short of expectations as concerns over the debt ceiling resurface.

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Daily Comment (March 6, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a discussion of the European Union’s proposed new defense industrial strategy, which is designed to boost the region’s ability to produce weapons, military equipment, and ammunition.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a surprise financial reform in debt-ridden Egypt and a preview of Federal Reserve Chair Powell’s testimony before Congress today.

European Union: The European Commission yesterday released its defense industrial strategy, which constitutes its plan for shifting the EU economy to a war footing in the face of potential Russian aggression.  The plan includes multiple steps aimed at expanding and shoring up the EU’s defense industry base so that it can produce more military supplies.  For example, the plan calls for more joint purchases of weapons and ammunition, new subsidies to expand defense industry capacity, and new authorities to compel firms to prioritize EU defense orders in crisis.

  • The plan is a response not only to Russia’s increasing territorial ambitions, but also to concerns that former US President Trump could stop the US from meeting its mutual defense obligations to the North Atlantic Treaty Organization if reelected in November.
  • Nevertheless, it isn’t clear that the plan will get the required unanimous approval of all 27 members of the EU. Many national leaders are wary of a potential power grab by Brussels and would prefer to keep defense procurement and overall policy as a national prerogative.  National leaders are also wary of the potential cost of the plan.
    • The plan calls for the EU to support it with €1.5 billion (about $1.63 billion) through 2027.
    • However, EU officials have floated the possibility of eventually providing some €100 billion (about $109 billion) to finance the plan. That sum would likely require some kind of joint bond issuance and/or tax hikes.
  • We would note that many EU countries are already boosting their defense budgets. As we predicted more than a year ago, the bulk of their procurement spending recently has gone to US defense contractors.  One risk for those US firms is that a successful expansion of the EU defense industry base could result in a loss of sales.

United Kingdom: Chancellor Jeremy Hunt today released the government’s proposed budget for the coming fiscal year, with multiple tax and spending initiatives designed to help the ruling Conservative Party turn around its dismal polling ahead of elections this autumn.  The proposals so far include a 2% cut in required payroll contributions to the National Insurance scheme and an announcement that the government will buy land for large, new nuclear power plants and solicit bids to build small modular nuclear reactors to boost the country’s energy supply.

Egypt: President Al Sisi’s government today unexpectedly announced a series of financial reforms long demanded by the International Monetary Fund to help the country manage its massive foreign debt.  Among the key reforms, the government allowed the currency to float and hiked benchmark interest rates.  The currency swiftly lost more than half its value, which will likely boost Egyptian price inflation, but the move could help unlock an IMF rescue package and avert a potential default down the line.

Venezuela: The government said it will hold a presidential election on July 28.  Authoritarian President Maduro has not announced his candidacy for a new term, but he is widely expected to do so.  And of course, given the government’s stranglehold on political power and its practice of disqualifying any viable opposition candidates, Maduro would be expected to win.  The rigging of the electoral system will likely maintain Venezuela’s pariah status and continue to exacerbate tensions with the US, just as its recent territorial threats to Guyana have done.

China-Philippines: Chinese and Philippine coast guard vessels once again collided yesterday in the South China Sea around the disputed Second Thomas Shoal.  In response, Beijing accused the Philippines of deliberately ramming its vessel, while Manila accused the Chinese vessel of “reckless and illegal” behavior.

(Source: South China Morning Post)

Chinese Stock Market: Sharmin Mossavar-Rahmani, the chief investment officer at Goldman Sachs Wealth Management, said in an interview with Bloomberg that she could not advise clients to buy Chinese stocks, despite the government’s recent success in stabilizing stock prices and touching off a modest recovery.  According to Mossavar-Rahmani, Chinese stock values are likely to be held back by structural problems such as moderating economic growth, opaque policymaking, and doubts over the authenticity of economic data.

  • As our regular readers know, we think Chinese stock prices will also continue to be hurt by worsening tensions between the US and the China/Russia geopolitical blocs.
  • The statement from Mossavar-Rahmani illustrates how major Wall Street investment firms and big investors are coming around to our view of the headwinds facing Chinese stocks.
  • The statement also echoes a 2022 report from JPMorgan Chase that called Chinese technology stocks “uninvestable” before retracting the statement later, possibly under Chinese pressure.

US Politics: In yesterday’s Super Tuesday presidential primary elections, former President Trump won in 14 of the 15 states holding Republican contests, with former UN Ambassador Haley winning in Vermont.  By our calculation, Trump won about 72% of the votes in the Republican ballots, with Haley taking about 28%.  Meanwhile, President Biden won in all 15 states holding Democratic contests, pulling in an average of 89% of his party’s voters.

  • With Trump’s victories to date leaving him on the cusp of clinching the Republican nomination, Haley this morning will reportedly suspend her campaign. However, sources say Haley won’t yet endorse Trump.  Instead, she will at least temporarily withhold her endorsement in an effort to encourage Trump to respond to the interests and concerns of her supporters.
  • While it certainly looks like Biden and Trump will be the official candidates in the November election, this campaign still has the potential to turn volatile. For example, the advanced age of each candidate alone suggests that either or both could drop out before the November balloting.  We could also see the emergence of a third-party candidate (potentially even Haley).  And in any case, if no candidate wins enough electoral votes, the decision could be thrown to the House of Representatives.

US Monetary Policy: Federal Reserve Chair Powell today begins his semi-annual testimony to Congress with an appearance at the House Financial Services Committee.  Early indications are that he will assure lawmakers that the central bank is on track to cut interest rates this year, but it will not move until it is sufficiently confident that price pressures have fallen and won’t rebound.  Powell will speak before the Senate Finance Committee tomorrow.

US Financial Markets: The Securities and Exchange Commission has signed off on a new type of security backed by royalty streams from songs recorded by such artists as Taylor Swift, Beyoncé, and even Stevie Wonder.  The securities, offered by start-up firm JKBX and designed for everyday investors, are essentially bonds backed by the royalties from hit songs.  It’s not clear yet whether the new securities will be a hit with investors.

US Military: The US Air Force published images of an operational hypersonic missile, the “Air-Launched Rapid Response Weapon” (ARRW), loaded onto a B-52 bomber at Guam.  The Air Force has said the ARRW is a test weapon not intended for large-scale procurement, but showing the missile deployed at one of the US’s main Western Pacific bases is thought to be a message to China of US capability in this cutting-edge type of weapon.  We take this as further evidence of US commitment of resources to high-tech weaponry and a broader defense build-up.

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Daily Comment (March 5, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with a discussion of the fiscal challenges faced by Western governments as they look to rebuild their defenses in the face of increased threats from countries like China and Russia.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a new economic growth target in China and research pointing to more US companies tapping the convertible bond market.

Global Fiscal Policy: In a recent interview with the Financial Times, Danish Prime Minister Mette Frederiksen castigated European governments that slashed their defense spending after the end of the Cold War and then remained far too complacent about the growing threat from Russia in recent years.  Importantly, Frederiksen warned that hiking defense budgets as necessary now will require countries to reverse the tax cuts and welfare spending hikes they funded with their post-Cold War defense budget cuts.

  • As our regular readers know, we at Confluence believe the intensifying rivalry between the US and China/Russia geopolitical blocs will lead to bigger defense budgets in many countries in the coming years. To put it another way, the Western nations that cut their defense spending so dramatically following the end of the Cold War and happily spent the resulting “peace dividend” on civilian programs may now need to reverse course.
  • We have argued that growing geopolitical tensions will likely lead to stronger government intervention in Western economies. Frederiksen’s warning is one of the first in which a top Western leader has been willing to state the trade-offs so clearly: Hiking defense budgets as required now may well require tax hikes and civilian spending cuts.
  • How would this look? To start scoping out the prospects, we conducted a quick analysis of how the US federal budget would look in an environment like the late Cold War.  In the chart below, we show the Office of Management and Budget’s estimated fiscal year 2023 federal receipts and outlays as a share of gross domestic product and compare them to their average shares of GDP in 1985-1989.

    • The chart clearly suggests the enormous drop in US defense spending since the Cold War has been absorbed mostly by increased outlays on Medicare, Medicaid, and other healthcare, along with Social Security retirement benefits. That likely reflects the aging of the US population and rampant healthcare price inflation.
    • If US leaders now wanted to boost the defense budget back to the late-Cold War average of 5.8% of GDP from today’s 3.1% of GDP (to about $1.5 trillion from today’s $815 billion), we think political considerations would likely count out any substantial cuts to Social Security, Medicare, and Medicaid outlays.
    • The problem is that other civilian outlays today are not much higher (as a share of GDP) than they were in President Reagan’s second term. Even if they were cut to their share of GDP in 1985-1989, the savings would cover less than half of the required $708 billion hike in defense spending.
    • That suggests unpalatable tax hikes of some $400 billion might be needed to bring defense spending back to late-Cold War norms. And these outlay cuts and tax hikes wouldn’t even address the $605 billion reduction in the deficit to bring it back in line with its average of 3.7% of GDP in 1985-1989.

European Union: The European Parliament last night gave preliminary approval to a bill that aims to reduce packaging materials for consumer products.  If signed into law, for example, the bill could lead to hotel mini-toiletries and single-use plastic wraps to be banned by 2030.  Many paper and cardboard packaging products were spared by intense industry lobbying, but the law will nevertheless probably become another symbol of excessive EU regulations that could be discouraging investment and growth in the region.

Chinese Economic Policy: At the formal opening of the National People’s Congress today, Premier Li Qiang said the government will target economic growth of “about 5%” in 2024, helped by issuing some $139 billion of special, ultra-long-term government bonds to help relieve fiscal pressure on provincial and local governments and investing in high-priority sectors.  The target for growth in gross domestic product is the same as last year’s, but analysts believe the target will be harder to achieve because of China’s accumulating structural headwinds.

Chinese Economic Growth: The February Caixin purchasing managers’ index for the services sector declined to a seasonally adjusted 52.5, down from 52.7 in January.  Like most major PMIs, the Caixin indexes are designed so that readings over 50 point to expanding activity.  Even though the February figure suggests the Chinese services sector is still growing, the number is now at its lowest since November.  We believe that illustrates the continued weak momentum in the Chinese economy.

Japan: The Jibun Bank February PMI for the services sector fell to a seasonally adjusted 52.9 from 53.1 in January.  Again, as with most major PMIs, the Jibun indexes are also designed so that readings over 50 indicate expanding activity.  The February reading signals that Japan’s services sector has now been growing for a year and a half, despite the small drop last month.  In other data today, the Tokyo region’s February consumer price index excluding fresh food was up 2.5% from one year earlier, accelerating from a rise of 1.8% in the year to January.

  • Taken together, the data point to further strength in the Japanese economy and consumer price pressures.
  • That, in turn, will likely keep the Bank of Japan on track to soon exit its negative interest rate policy.

South Korea: The government’s biennial ranking of countries by technological development found that China’s overall score has pulled ahead of South Korea’s for the first time.  Taking US development in key economic sectors as the baseline, the study put the European Union at 94.7% of the US level in 2022, while Japan was at 86.4%, China was at 86.2%, and South Korea was at 81.5%. Since being overtaken by China is seen as a national humiliation, the results are expected to intensify the government’s US-style effort to crack down on technology flows to China.

Haiti: In what appears to be an effort to oust Prime Minister Ariel Henry, armed gangs in recent days have attacked police stations, stormed prisons, and freed about 5,000 inmates.  Widespread rampages and violence are reportedly continuing today.  The prime minister has been in Africa trying to secure a United Nations peacekeeping mission for the country, and his whereabouts are reportedly unknown.

US Politics: Today is Super Tuesday, with presidential primary elections and other balloting in 15 states across the country.  Former President Trump is expected to win enough votes to come very close to clinching the Republican nomination, but he isn’t expected to win it outright today.  One key question is therefore whether Former UN Ambassador Haley will keep fighting. President Biden is naturally expected to win the vast majority of Democratic votes and eventually clinch his party’s nomination.

  • Separately, interesting new reporting by Axios and The New Yorker indicate that Biden is pushing his campaign staff for a much more aggressive approach than the traditional “Rose Garden” strategy often adopted by sitting presidents.
  • Biden is reportedly pushing for a strategy in which he would actively goad and taunt Trump on a near daily basis, hoping to take advantage of Trump’s perceived lack of discipline and make him “go haywire in public.”
  • The strategy, if implemented, would also aim to show Biden as a spirited fighter, taking some focus off his age.
  • The reporting suggests that the presidential election campaigns could get nastier and more chaotic than we’ve seen so far.

US Bond Market: New analysis from BofA Global Research shows that the share of new convertible bonds issued by companies with investment-grade ratings has surged in the last year.  Investment-grade deals made up 26% of convertible deals in 2023, up from 7% in 2022 and just 2% in 2021.  Since the opportunity to convert to equity is a powerful sweetener, convertible debt typically comes with relatively low interest rates.  The surge in investment-grade convertibles is a reflection of how companies are trying to cut their interest expenses in today’s high-rate world.

(Sources: BofA Global Research, Axios)

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Daily Comment (March 4, 2024)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with several items touching on the global outlook for consumer price inflation and interest rates.  We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a preview of some important government policy meetings in China and a discussion of new rules aimed at improving the functioning of the US Treasury bond market.

Global Price Inflation and Monetary Policy: The Bank for International Settlements today warned that the recovery in supply chains and weaker commodity prices since the coronavirus pandemic won’t necessarily be enough to bring price inflation down to the major central banks’ targets.  Instead, the BIS warns that price inflation in the labor-intensive services sector tends to be stickier, which could limit how quickly overall inflation falls.  In turn, that could inhibit central banks from cutting interest rates as aggressively as investors expect.

Global Oil Market: At a meeting yesterday, the Organization of the Petroleum Exporting Countries and their Russia-led partners agreed to maintain their voluntary cuts to oil production for another three months to June.  The cuts are intended to buoy global oil prices, but rising output in the US and weak economic growth in some countries has nevertheless kept a lid on prices.

  • The cuts have only boosted Brent crude prices by about 6% and WTI crude by about 8% since they were first announced in late November. So far today, near futures prices are down slightly, with Brent at $83.54 per barrel and WTI at $79.90.
  • Since the cuts have left major OPEC+ producers with plenty of excess capacity, it’s important to remember that even if prices rise substantially from here, those producers would have the incentive and the ability to open the floodgates again, driving prices back down. In sum, the near-term prospects for oil prices remain modest.

Global Nuclear Energy Industry: Ahead of a first-of-its-kind nuclear energy summit in Brussels later this month, International Atomic Energy Agency chief Rafael Grossi has castigated multilateral lenders such as the World Bank and the Asian Development Bank for not making their loans available for new nuclear projects.  According to Grossi, the summit in Brussels will debate how to overcome opposition from a small number of nations, such as Germany, to using development banks to fund nuclear projects.

  • Despite the lack of funding from multilateral lenders, we believe the use of nuclear energy to generate electricity will grow markedly in the coming decades, even as uranium supplies are crimped. As we examine in our latest  Asset Allocation Bi-Weekly report, published today, that should result in rising uranium prices and strong returns for uranium miners going forward.
  • Indeed, investors have recently begun to bid uranium prices up strongly, as shown in the chart below.
(Source: Tradingeconomics.com)

Germany-Russia: The government of German Chancellor Sholtz is facing a scandal today after a Russian website released intercepted phone calls of German military officials discussing the possible transfer of Taurus cruise missiles to Ukraine to help it repel Russia’s invasion of the country.  The intercepts have raised concerns about Germany’s ability to keep its high-level communications secret.

  • More broadly, the scandal also will probably make Sholtz even more resistant to sending the missiles to Ukraine. Sholtz has been extremely reluctant to do anything that might provoke the ire of the Kremlin, and he recently argued that the missiles would have to be targeted by German soldiers, bringing Germany into the conflict.
  • Indeed, to exploit the scandal, the Kremlin today accused Germany of plotting to attack Russia. The assertion likely aims to put the German government on the back foot and make it even more reluctant to provide the missiles to Ukraine.

Japan: Not only has the main Japanese stock index finally started setting new record highs again, but today it surpassed 40,000 for the first time.  We’ve also noted that a lot of the gains are coming from technology stocks expected to benefit from artificial intelligence, as in the US.  The Japanese leaders include stocks the likes of Tokyo Electron, which makes semiconductor manufacturing equipment, Advantest, a maker of semiconductor testing equipment, and Renesas Electronics, a semiconductor manufacturer.

China: The annual “two sessions” meetings, consisting of the National People’s Congress and the Chinese People’s Political Consultative Conference, opened today in Beijing.  The annual economic growth target is typically released at the sessions, and analysts this year appear to be expecting a target of around 5%, like last year.

  • Top leaders will also provide some hints about their political and economic strategies. For example, they are likely to offer ideas about how they want to tackle China’s big structural problems, such as excess capacity and debt.
  • However, General Secretary Xi is widely expected to resist offering any major new stimulus programs to address those problems. Rather, Xi is likely to continue trying to end China’s past practice of addressing economic growth shortfalls by adopting new debt-driven investment.

United States-China: The Biden administration on Friday issued its 2024 trade policy agenda and report to Congress, in which it vowed to double down on efforts to reverse the harms wrought by Beijing’s “trade and economic abuses.”  The document indicated the administration will keep trying to enlist foreign countries to push back against Beijing’s trade abuses, including its stringent barriers to the Chinese market and massive subsidies for exporters in strategic industries, such as electric vehicles, solar energy, and lithium.

  • The trade policy statement will be a disappointment for anyone dreaming of cooler tensions between the US and China.
  • As we’ve noted so many times before, US-China tensions continue to spiral upward, so on any given day, investors could be faced with a sudden, disruptive new restriction on trade, capital, technology, or travel flows between the two countries, with potentially negative consequences for US and/or Chinese companies.

US Treasury Bond Market: The Financial Times today carries an in-depth analysis of recent rule changes by the Securities and Exchange Commission that are aimed at buttressing the market for Treasury obligations but will impose new costs on financial market participants.  One goal of the change is to ensure that the Treasury market remains attractive for institutional and other investors around the world even as some countries in the China/Russia bloc and beyond work to reduce their use of the dollar.

  • One such change is a requirement that Treasury trades go through a clearing house. The change aims to increase oversight and improve investor protections during market volatility.
  • The second rule change described in the article brings high-speed traders and potentially some hedge funds under regulatory scrutiny.

US Weather: Following a major blizzard that dropped some 60 inches of snow on the Sierra Nevada over the weekend, California is bracing for another major storm later today.  The storm over the weekend closed a major freeway and knocked out power for thousands of businesses and homes.  Although storms like this can certainly be disruptive and have a local economic impact, they typically have only minor effects on national economic activity and those effects are usually quickly reversed.

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