by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! S&P 500 futures have cooled this morning following favorable inflation data. In sports news, England defeated the Netherlands in the semifinals and will now play Spain in the Euro final. Today’s Comment will begin by examining the significant role that momentum has played in the market rally, followed by a discussion on why uranium remains a commodity with substantial upside potential for investors. We will also provide an update on the UK in the wake of the Labour Party’s recent victory. As usual, the report will conclude with a roundup of international and domestic data releases.

Momentum Propels Large Cap: The S&P 500 leapt past 5,600 for the first time ever on Wednesday, as investors piled into large-cap stocks in anticipation of a Federal Reserve policy shift.

• The market surged following comments made by Fed Chair Powell during his second day of testimony on Capitol Hill. While speaking with lawmakers, Powell stated that although he does not believe the central bank is ready to cut interest rates, Fed officials will not wait for inflation to fall to the 2% target before making a cut and will do so regardless of the upcoming election. Risk assets rose following his remarks, with the S&P 500 climbing 1.0% on the day and the Magnificent Seven stocks increasing by 1.2%.
• The S&P 500’s record high might mask a troubling truth: many underlying companies lack the fundamentals to justify the rally. Bloomberg data confirms this, showing momentum chasing and a focus on large caps have dominated investment returns in 2024. Investors have been relentlessly buying a limited pool of large-cap stocks at any hint of good news, inflating their portfolios. In an uncertain economic climate with rising interest rates and inflation, investors are seeking stability and believe larger, established companies with growth potential will be better positioned to weather these headwinds.

• The S&P 500’s momentum dependence exposes it to steeper losses in the future. Mega-cap tech stocks, leading the large-cap surge, appear particularly inflated, making them more vulnerable if investor sentiment weakens. This concern is amplified as earnings season approaches and firms such as Nvidia are expected to meet lofty expectations. However, while we remain optimistic about equities overall, mid-cap and small-cap stocks might be better suited for this environment. They offer not only a lower correction risk but also the potential for more upside if interest rates fall.

Uranium Popularity: While renewables gain momentum, nuclear energy from uranium remains a powerful tool for countries transitioning away from fossil fuels.

• On Wednesday, President Biden signed legislation aimed at promoting the development of advanced nuclear reactors. The new law will cut licensing times and processing fees, making it easier for companies to bring these clean energy sources online. While nuclear power currently generates about 20% of US electricity, development has been hampered by cost concerns and unpredictable permitting timelines. The passage of this legislation should make it easier for firms to capitalize on clean energy incentives and offer potential solutions to concerns over the rising energy use of artificial intelligence (AI) technology.
• Fueled by the insatiable energy demands of AI, big tech giants are leading the charge in adopting nuclear power. A Wall Street Journal report reveals that one-third of US nuclear plant owners are in talks with tech firms to discuss the powering of data centers, with Amazon on the cusp of a deal with the nation’s largest nuclear company. This surge in demand is prompting utility companies like Dominion Energy Virginia and Bill Gates’ TerraPower to develop the first of their own commercially viable small modular reactor (SMR) in the US.

• Uranium and nuclear power stocks have skyrocketed this year, eclipsing the broader market. This surge is likely driven by a widening supply-demand gap for uranium. Booming AI and the global push for clean energy are fueling demand, while uranium production capacity lags behind. To bridge this gap, countries are expected to invest heavily in SMRs due to their lower cost and faster deployment timelines. While a near-term correction can’t be ruled out, we believe nuclear companies remain a compelling long-term investment.

The UK Comeback: A surprise surge in economic growth has likely eased concerns about the UK’s debt burden, but also strengthens the case for keeping interest rates high.

• The UK economy defied expectations with a robust 0.4% expansion in May. This is a significant improvement over the previous month’s flat growth and double the forecasted rate for the period. The surge was fueled by a rebound in construction activity, which had been lagging for three months, and an increase in manufacturing production. This positive data strengthens the Labour Party’s position as they navigate economic policy. They can potentially avoid austerity measures while still promoting growth, all within the constraints of fiscal rules that require a balanced budget.
• However, the stronger-than-expected economic data likely diminishes the prospect of an interest rate cut at the next Bank of England meeting. The central bank had previously anticipated a slowdown to 0.2% growth in the second quarter, down from 0.7% in the first. The recent data suggests the quarter will exceed the estimates. Further complicating a rate cut, some voting members, including Huw Pill, have reportedly expressed concerns about high services inflation and wage growth leading to further price pressures.

• Strong economic growth is poised to bolster the attractiveness of UK assets, especially for value investors seeking bargains. British companies currently trade at a discount compared to their US peers, presenting a potential opportunity. Furthermore, the prospect of the Bank of England maintaining higher interest rates for longer than the market anticipated at the start of the year should help stabilize the pound (GBP) against the US dollar. While we remain skeptical of the UK market due to the Labour Party’s proposals, the overall sentiment towards the pound is improving.

Other News: Prominent Democrats and donors continue to urge Joe Biden to step aside, highlighting ongoing uncertainty about the party’s presidential nominee. In other news, Apple will not face fines from the EU after deciding to allow other providers to use its wallet technology for free. This decision underscores the impact of regulations on Big Tech earnings. Meanwhile, US officials are frustrated with India and Saudi Arabia for maintaining relationships with both sides of the conflict in Ukraine. This development illustrates how some countries can avoid aligning exclusively with either the US or China.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Good morning! Equity futures are off to a great start ahead of Federal Reserve Chair Powell’s second day of testimony. In sports news, Spain has successfully knocked out France in the Euro semifinal. Today’s Comment discusses how Powell has opened the door for a policy shift, the reasons emerging markets are likely to continue building up their gold reserves, and why Brazilian President Lula may be forced to make uncomfortable decisions to protect the country’s currency. As usual, the report includes a roundup of international and domestic news.

Powell Talks to Congress: The Fed Chair mostly stuck to the script during his testimony, but he gave subtle hints that the central bank might be considering goals beyond its inflation mandate.

• Fed Chair Jerome Powell expressed growing concern about the labor market for the first time on Tuesday. During his testimony, he mentioned that recent employment data prompted him to reconsider his views on the economy, as unemployment rose to 4.1% in June, slightly above the median year-end estimate outlined in the Fed’s summary of economic projections. While he acknowledged that further measures are necessary to achieve the Fed’s 2% inflation target, he cautioned that an excessive focus on inflation could negatively impact the economy.
• While Powell did not specify a timeline, the market still anticipates a rate cut from the central bank in September. The latest CME Fedwatch tool shows that investors believe there is a 75% chance the central bank will lower interest rates before the election. This is a sharp increase from over a month ago, when the indicator suggested a less than 50% chance. The boost in confidence appears to be a response to a string of weaker-than-expected economic data over the last couple of months. In addition to a rising unemployment rate, retail sales and personal consumption have also been disappointing.

• Powell’s testimony before Congress reinforces our earlier view from May that the Fed is preparing for a rate cut based on labor market conditions rather than inflation. Since we made that call, the unemployment rate has risen for the fourth consecutive month and is now approaching the Sahm Rule threshold, an indicator of recession. The Sahm Rule is triggered when the three-month moving average of the unemployment rate climbs 0.5% above the lowest rate of the past 12 months. If the unemployment rate reaches 4.2% within the next two months, it may be sufficient to prompt a rate cut.

Bullion on the Rise: More emerging market countries are showing a preference for holding gold as they look to diversify their reserve holdings.

• Nigerian lawmakers are drafting legislation that would empower the Central Bank of Nigeria to hold a larger share of its reserves in gold. The bill prioritizes domestically produced gold for acquisition and proposes raising the minimum gold reserves from 4% to at least 30% of total external reserves. The decision to ramp up the holdings comes as the country struggles to contain its inflation and repay its debts, since a rising US dollar has made imports more expensive and interest payments more burdensome.
• Emerging markets are increasingly diversifying their foreign reserves, reflecting concerns about the West’s use of the dollar as a financial weapon after Russia’s invasion of Ukraine. This trend is likely to continue as these countries aim to increase their gold holdings, which currently represent only 6% of their reserves, roughly half the level in developed markets. Notably, India repatriated 100 tons of gold from the UK just before its recent elections, and China had been actively accumulating gold for 18 months, adding 300 tons before pausing purchases in May.

• While Nigeria’s actions alone might not significantly impact global markets, emerging markets as a whole have the potential to do so. Their increasing holdings of reserve currencies reflect a broader trend likely to be followed by other central banks in these economies. However, the People’s Bank of China (PBoC) will likely be the most watched central bank during this transition as it seeks to reduce its reliance on the US dollar. As a result, we expect gold prices could be on the verge of an upward trend over the next few years.

Lula and the Currency: Brazilian President Luiz Inácio Lula da Silva’s plan to deliver renewed economic prosperity is under threat as the Brazil real continues to plummet against the dollar.

• On Tuesday, Gabriel Galipolo, the overseer of currency intervention in Brazil, stated that he does not plan to prop up the currency without the full support of the central bank board. His comments come as the currency has fallen 10% since the start of the year, making it the second-worst-performing currency in Latin America behind only the Argentine peso. While he has the power to use over 2.5% of the country’s international reserves to protect the currency, his reluctance appears to be driven by concerns that the market could undermine his efforts.
• The currency’s weakness stems from concerns about the country’s fiscal and monetary future. Earlier this year, Brazil relaxed its fiscal target for 2025, aiming for a balanced primary budget, which excludes interest payments, instead of the previous year’s goal of achieving a surplus. Additionally, there are concerns that Lula will replace the current central bank head, Roberto Campos Neto, with the aforementioned Galipolo. Although inflation remains within the 1.5% tolerance range of the 3% target, there are fears that Galipolo might cut rates prematurely to help boost growth.

• The attractiveness of Brazilian assets hinges on Lula’s ability to convince investors of his commitment to central bank independence and fiscal responsibility. His past criticism of the central bank has undermined its credibility as an independent institution. Additionally, a higher-than-expected increase in public spending has fueled concerns about his adherence to budget goals.  In the short term, this trend is unlikely to change. However, a shift toward central bank independence and fiscal discipline could make Brazil a more attractive investment destination.

In Other News: Colorado Senator Michael Bennet has officially requested President Joe Biden to end his bid for re-election. This shows that Biden is still facing intense pressure to pass the torch. BP raised its outlook on demand for oil and gas as it sees a moderation in the clean energy transition. This could lead to higher energy prices.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with new color on the dangerous China-Philippines standoff in the South China Sea. We next review several other international and US developments with the potential to affect the financial markets today, including an impending shift in investment strategy by a major Japanese pension fund and several notes on US politics and economic policy.

China-Philippines: Amid the worsening tensions between China and the Philippines over disputed territory in the South China Sea, we are increasingly struck by the strong domestic political winds that appear to be pushing on Philippine President Ferdinand Marcos Jr. Popular opinion appears to be pushing Marcos to be more assertive against Beijing. Still, the president’s sister, Imee Marcos, in recent days has warned that her brother’s growing closeness to the US and strong moves against China could prompt Beijing to attack.

• Imee Marcos is a senator in the Philippine legislature. She is known to be close to Sara Duterte, the daughter of former President Rodrigo Duterte, whose foreign policy was initially much more deferential to China and uncooperative with the US.
• Rodrigo Duterte and Ferdinand Marcos Jr. eventually became allies in the country’s 2022 elections. When Marcos won the presidency, Sara Duterte was named as his vice president. Since then, former President Rodrigo Duterte has continued to express a view that the country must be stronger in protecting its sovereignty against China.
• However, it now appears Imee Marcos and Sara Duterte may be trying to undermine President Marcos’s stronger alliance with the US and efforts to bolster Philippine sovereignty, which has included a new defense cooperation agreement with the US in which Washington gained expanded access to Philippine military bases.
• Last week, Philippine Armed Forces Chief Gen. Romeo Brawner claimed the US offered to aid his country in its dispute with China, implying US willingness to help resupply the Philippine marines posted on a disputed shoal in the South China Sea. However, Brawner insisted Manila turned down the offer. Given the Biden administration’s extreme caution, Brawner could well be blowing smoke. Still, if his claim is true, it implies President Marcos may be sensitive to charges that he is getting too close to the US.
• Even if Imee and Sara have helped retard President Marcos’s embrace of the US so far, it isn’t clear that they can soften the broader public’s strong support for a more aggressive stance toward Beijing. That would keep alive the risk of a Philippine miscalculation that could draw the US into a direct conflict with China.

Hungary-Ukraine-Russia-China: Just a week into Hungary’s six-month stint chairing the Council of the European Union, Prime Minister Orban has ruffled feathers in Brussels with trips to Kyiv, Moscow, and Beijing, ostensibly seeking to facilitate peace talks between Russia and Ukraine. As noted in our Bi-Weekly Geopolitical Report from July 1, the chair of the Council has no authority to represent the EU in international affairs. Therefore, Orban’s theatrics appear aimed at bolstering his own image, embarrassing the EU, or both.

Japan: As the massive Government Pension Investment Fund starts prepping for its regular five-year strategy review in 2025, analysts say the recently improved performance of domestic assets implies a substantial shift back into Japanese stocks and bonds. Since the fund has more than $1.5 trillion in assets, any such shift could push prices for those assets upward, while taking some air out of the US and other foreign stocks or bonds to be sold. Analysts think the likely shift could also buoy the weak yen.

United Kingdom: In her first speech since the Labour Party took power, Chancellor Rachel Reeves said she had already seen data suggesting the UK is now in its worst fiscal position since World War II. She also announced that she has directed the Treasury to launch a review of the UK budget position, a move many observers fear could be a prelude to tax hikes when the new budget is introduced in the autumn.

United States-China: At the Hudson Institute yesterday, Republican Speaker of the House Johnson vowed his chamber would soon pass a series of new bills empowering the government to take even stronger economic measures against China. For example, Johnson said the House would vote on bills imposing new curbs on US investment in China and imposing tariffs on low-value imports that currently enter the US duty-free. Johnson’s vow is consistent with our view that US-China relations will likely continue to spiral in the near term.

US Fiscal and Trade Policy: Following up on Johnson’s remarks, the Republican Party yesterday released its platform for the November elections. The document clearly indicates the party would continue to pursue former President Trump’s “America First” foreign policy, protectionist trade policies, tax cuts, and deregulation. For example, the platform says the Republicans would:

• Impose base-line tariffs on foreign goods, using the income raised to cut taxes;
• Punish foreign countries that practice unfair trade;
• Revoke China’s “Most Favored Nation” trade status;
• Revive the US auto industry by cutting regulations; and
• Ban imports of Chinese vehicles.

US Politics: As many in the Democratic Party keep trying to convince President Biden to end his re-election bid because of his age, a new poll shows Biden’s national support down to 42% versus 43% for former President Trump. In a head-to-head matchup, the poll also puts Vice President Harris’s support at 42% versus 41% for Trump. Even though former Secretary of State Hillary Clinton isn’t being seriously considered, the poll puts her support at 43% versus 41% for Trump, while a hypothetical Harris-Clinton ticket would have the advantage at 43% versus 40%.

US Monetary Policy: Federal Reserve Chair Powell today begins his semiannual testimony to Congress. At 10:00 ET today, he addresses the Senate Banking Committee, and at the same time tomorrow, he’ll address the House Financial Services Committee. Powell is expected to say that while progress has been made in bringing down consumer price inflation, policymakers want to be more certain that price pressures are under control before they start cutting interest rates.

US Artificial Intelligence Frenzy: Corning, the maker of glass screens for televisions and smartphones, saw its stock price jump approximately 12% yesterday after boosting its guidance for second quarter revenues and profits. A key reason for the upward shift was good uptake of the company’s new optical connectivity products for generative artificial intelligence. The jump in the stock price suggests investors remain excited about AI and are still looking for new ways to participate in the frenzy.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM ET] | PDF

Our Comment today opens with new data illustrating just how broadly and sharply trade tensions with China are evolving around the world. We next review several other international and US developments with the potential to affect the financial markets today, including key election results in France and the United Kingdom and the minutes from the latest Federal Reserve policy meeting.

China-Global Markets: Data from China’s Ministry of Commerce show the country was hit with 64 anti-dumping probes by its trading partners in the first half of 2024, up 166% from the same period one year earlier. India alone initiated 16 of the new probes, while the US and Brazil each launched seven. The data show how Beijing’s strategy to rekindle economic growth by boosting investment and exports is hitting resistance around the world, even beyond the US and EU tariffs on Chinese electric vehicles and other advanced goods that we’ve written so much about.

• Indeed, the new tidal wave of Chinese exports, which some economists have dubbed “China Shock 2.0,” is far broader than EVs, solar panels, wind turbines, and other advanced goods.
• About 40% of the new anti-dumping probes relate to basic chemicals from China. Other major targets include non-metallic items such as glass wine bottles, iron and steel products such as steel coil, and clothing and food products.
• To the extent these anti-dumping probes lead to more tariffs and other trade barriers against China, they amount to trade de-coupling. The breadth of Chinese exports subject to this de-coupling suggests the trend will be a meaningful headwind for China’s economy and Chinese companies, along with other structural problems such as excess capacity and high debt, weak consumer demand, bad demographics, and disincentives from the Communist Party’s intrusion into the economy.

China: Within China, consumers also continue to shift their purchases toward domestic brands for a range of products. For example, new data show foreign brands accounted for only 43.0% of Chinese auto sales in the first six months of 2024, down from 50.5% in the same period in 2023. The loss of business to domestic competitors has left several foreign brands with excess production capacity in China. Some have pulled out of the market entirely after realizing their bet on the country was ill-placed.

Japan: In a new survey by the Japanese Chamber of Commerce and Industry, 54.8% of small and medium-sized businesses said the yen’s current weakness is a big problem, up from 47.8% in a poll last November. Only 2.3% in the new poll said the weak currency was a help. While many of Japan’s big, international exporters have gotten a boost from the weak yen, the poll shows that smaller firms have been hit by skyrocketing costs for fuel, raw materials, and imported components.

• Notably, the new survey was conducted between June 13 and June 19, when the yen was trading at an average rate of ¥157.4 to the dollar ($0.0064). So far this morning, the currency has depreciated even further, to about ¥160.8 to the dollar ($0.0062).
• The poll results may put added pressure on the government to intervene in the market again, although the yen is not likely to get much lasting relief until the Federal Reserve starts cutting US interest rates, reducing the differential between US and Japanese rates.

European Union: Although Marine Le Pen’s far-right National Rally party was thwarted in France’s run-off parliamentary elections yesterday (see below), it has boosted its power within the European Parliament today by allying its legislators with a new group of far-right national parties called “Patriots for Europe.” With legislators from Italy’s League, Hungary’s Fidesz, Austria’s Freedom Party, and other national parties, the group should overtake the somewhat less right-wing European Conservatives and Reformists as the parliament’s third-largest group.

• As a reminder, our Bi-Weekly Geopolitical Report from July 1 provided a primer on the EU’s governing bodies, including a discussion of the European Parliament and the major political groupings in the body at that date.
• The importance of the new Patriots of Europe group is that it will put the more radical elements of the far right ahead of the more moderate European Conservatives and Reformists. As we’ve noted, this should help shift the European Parliament and overall European policy toward a new set of priorities, such as more restrictive immigration and greater national autonomy.

France: In yesterday’s run-off parliamentary elections, the far-left New Popular Front (NFP) unexpectedly came in first, with a projected 180 of the 577 seats in the legislature. President Macron’s centrist Ensemble alliance came in second with 159 seats (doing better than expected but still losing almost 100 of the seats it previously held). The far-right National Rally (RN) came in third with 143 seats, despite being supported by the Russian government.

• The results validate last week’s coordination deal between the far left and the centrists to keep RN from power. However, with no party having anything close to a majority of seats in parliament, France looks set for an extended period of political gridlock.
• Macron will be under pressure to appoint a leftist affiliated with NFP as the new prime minister as far-left politicians have argued that their strong showing means he should appoint one of their own. However, Macron could choose someone from the relatively more moderate Socialists or Greens.
• In any case, the leftists will be in position to push their priorities, such as reversing the hike in the retirement age that Macron pushed through, imposing a wealth tax, and hiking public salaries.
• Investors so far today have given a split verdict on the outcome. French stock prices at this moment are modestly higher, probably reflecting relief that the far right has been vanquished. Investors have sold off French bonds, pushing their yields modestly higher, but their spread over benchmark German bonds narrowed slightly. The euro today is roughly steady against the dollar.

United Kingdom: In Thursday’s general elections, the center-left Labour Party won in a massive landslide, taking an estimated 411 of the 650 seats in the House of Commons. The center-right Conservative Party won just 121 seats, marking the lowest total in its 190-year history and ending its 14-year lock on the government. The centrist Liberal Democratic Party rebounded from near obscurity to take 72 seats. Reflecting the results, Labour leader Keir Starmer was appointed prime minister on Friday.

• Labour now has its biggest majority since the election of Tony Blair in 1997. Starmer hasn’t been specific about the policy changes he’ll pursue, but many investors worry he will push through big tax hikes to fund progressive policy initiatives. All the same, relief over the end of Tory rule has helped push British stock prices higher, at least so far.
• While the results suggest the UK has bucked the recent far-right surge elsewhere in Europe, we note that Nigel Farage’s far-right Reform UK Party drew millions of votes and entered parliament for the first time, with five seats. Looking forward, a key question is whether Reform will continue to draw right-wing voters away from the Conservatives.

Iran: In the presidential run-off election on Friday, reformist Masoud Pezeshkian came out on top with about 55% of the vote. Pezeshkian has pledged to relax unpopular social restrictions and re-engage with the West to secure sanctions relief. However, since conservative clerics continue to dominate Iran’s government, Pezeshkian will largely have his hands tied, so Iran’s relations with the West may not improve much.

US Monetary Policy: In the minutes from the Fed’s June 11-12 policy meeting, released last Wednesday, the policymakers discussed the growing financial strains on lower- and middle-income consumers due to elevated prices, high interest rates, and depleted pandemic savings. According to the minutes, the officials expressed concern that the strains could lead to a sharp drop in consumer spending.

• Those worries are consistent with other recent signs of distress among consumers with low or moderate incomes. Those concerns could eventually prompt the Fed to revisit its current “higher for longer” approach to interest rates, although there is still a risk that the Fed could cut interest rates too late to avoid a big economic slowdown.
• Of course, the economic stress on lower- and middle-income households is probably also a key reason for the weak support given to President Biden in the opinion polls, along with the concerns about his age.

US Defense Industry: An interesting article in today’s Financial Times discusses how the growing importance of relatively small, inexpensive, quickly modified drones is starting to disrupt the traditional defense industry. While we still believe the new era of higher defense budgets will give a boost to today’s legacy defense “primes,” we agree that evolving military technologies mean there will also be new opportunities for start-ups, technology firms, and the producers of goods and services with dual civilian-military uses.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some notes on the China/Russia bloc’s military buildup and increasingly aggressive military operations. We next review several other international and US developments that could affect the financial markets today, including Chinese General Secretary Xi’s visit to Europe this week and a couple of notes on the US labor market.

China: The Fujian, China’s third aircraft carrier and its first domestically-built one, reportedly left the port of Shanghai last week for her maiden sea trial. According to press reports, the initial trial will focus on testing Fujian’s propulsion, navigation, and communications systems. Other systems, such as her state-of-the-art electromagnetic catapults, will be tested in other trials over the next year, before a planned “experimental” cruise in late 2025.

• Reports suggest the People’s Liberation Army Navy (PLAN) wants to eventually maintain round-the-clock carrier coverage in both the western Pacific Ocean and the Indian Ocean. To account for vessels out of action for maintenance, training, transit, etc., that implies the PLAN will ultimately need at least three more carriers.
• As we’ve noted before, the Communist Party continues working to boost China’s “comprehensive power” in diplomacy, economics, technology, culture, and military capability. China’s surging economic heft was long the main source of its power. However, now that the country has begun to hit big, structural economic headwinds, its rapidly increasing military force is becoming the main threat to the US and its allies.
• As we’ve also noted before, many US voters and policymakers have become tired of the costs of global hegemony. The resulting populism and isolationism have probably helped encourage China and other authoritarian powers to assert themselves. A key question now is whether Beijing’s growing carrier force, rapidly expanding nuclear arsenal, and other aspects of the Chinese military threat might convince Americans to coalesce again and recommit to international leadership in the name of national defense.

Fujian embarking on her maiden sea trial. (Source: South China Morning Post)

China/Russia Geopolitical Bloc: In addition to building up their armed forces, China and other members of its bloc keep launching aggressive military and intelligence operations against US treaty allies. For example, Chinese forces continue to harass Philippine ships trying to resupply the country’s marines at an outpost in the South China Sea. Russian intelligence services are also reportedly ramping up their sabotage against infrastructure and defense industry facilities in NATO countries, including an apparent arson attack against a German defense firm last week.

• As we’ve noted in the past, Chinese and Russian attacks on US treaty allies are especially dangerous. If such attacks are deemed serious enough, the US could come under pressure to help defend the targeted country per their mutual defense agreement.
• Given their aggressiveness, China’s military operations against the Philippines and Russia’s sabotage attacks on NATO soil are probably more dangerous than most observers realize. Beijing and Moscow clearly feel emboldened, and they appear to be probing the West’s willingness to defend itself. That presents a risk that they could cross a red line and potentially touch off a conflict.

China-European Union: General Secretary Xi today began an important visit to Europe, where he is expected to try to break US-European unity against China on international issues such as Beijing’s backing of Russia in its invasion of Ukraine and its dumping of low-cost exports onto the world market. Xi today met with European Commission President von der Leyen and French President Macron, who have taken a hard line against China’s actions. However, the more conciliatory German Chancellor Scholz declined to join the meeting.

• The recent Chinese and Russian military buildups, provocative military actions, and spying have already prompted the US and its allies to start boosting their defense budgets and rebuilding their armed forces, but the progress to date has been slow and spotty.
• Notably, Prof. Steve Tsang, director of the SOAS China Institute in London and author of a new book on Xi’s political thought, has argued that the general secretary is too bent on global domination to be deterred militarily. Tsang argues that Xi is more afraid of being cut off from Western markets, capital, and technology, which could destabilize China’s domestic economy and political environment. If true, a united European threat to freeze out China economically could help bring Beijing to heel.

United Kingdom: In local elections late last week, the ruling Conservative Party of Prime Minister Sunak lost about half the municipal council seats it was defending, likely portending a significant loss in the national parliamentary elections this fall. Election observers are warning that the projected results could result in a hung parliament, in which neither the Conservatives, Labor, nor any other party can cobble together a majority. The political uncertainty is likely to be a headwind for UK equities in the coming months.

Israel-Hamas Conflict: The Israeli military today warned Palestinians around the southern Gaza city of Rafah to evacuate ahead of its planned offensive against Hamas fighters in the area. The warning comes as the latest Israeli-Hamas negotiations for a peace deal appear to have faltered. Any Israeli attack on Rafah is likely to again raise concerns about the conflict broadening and potentially further isolate Israel on the world stage.

Panama: In national elections yesterday, pro-business conservative José Raúl Mulino won the presidency, putting him in a position to carry out his agenda of reinvigorating the economy. Mulino has vowed to focus on infrastructure investment, such as building a train line across the country to complement the Panama Canal. However, it isn’t clear how he will approach the sudden closure of the Cobre Panama copper mine, which accounted for about 1% of global supply before it was suddenly shuttered last year amid protests over environmental damage.

US Labor Market: Although our Comment on Friday included our initial reaction to the April labor report, we want to add one more observation. Specifically, when calculated using our preferred method, the year-over-year rise in average hourly earnings slowed much more sharply than indicated by the financial press’s measure. Press reports say average hourly earnings in April were up 3.9% from the same month one year earlier, slowing from a rise of 4.1% in the year to March. Our measure shows the growth rate slowed all the way to 3.2%.

• The press typically calculates annual wage growth using seasonally adjusted figures. Since both the current figure and the year-earlier one could be distorted by bad adjustments, that raises the risk of an inaccurate growth calculation. We prefer to use non-adjusted figures for year-over-year changes. We think our approach reduces the risk of inaccuracies from bad adjustment factors.
• In any case, as we noted on Friday, the report included several indicators pointing to softer labor demand, i.e., much more moderate growth in payrolls, a rise in the unemployment rate, and a contraction in the average work week. The apparent cooling in labor demand doesn’t necessarily point to a big economic contraction. Still, it could well keep the Federal Reserve on track to start cutting interest rates by late summer.

US Stock Market: In another development that touches on both the labor market and stocks, Chipotle Mexican Grill has proposed a massive 50-to-1 stock split to make it easier for small investors, including the firm’s own workers, to buy the stock. At Chipotle’s recent price of about $3,155 per share, the split should bring the price down to about $63. Shareholders are due to vote on the proposed split on June 6. Chipotle officials say easier access to the stock aims to improve employee retention amid labor shortages for lower-skilled workers.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equity futures are higher as a relatively weak jobs report has reaffirmed hopes for Fed easing. In sports news, the New York Knicks edged out the Philadelphia 76ers in a thrilling playoff victory! Today’s Comment dissects how big tech companies are increasingly prioritizing shareholder rewards, explores the impact of the Federal Reserve’s policies on central banks worldwide, and examines the potential hurdles that upcoming local elections pose for UK Prime Minister Rishi Sunak. To wrap things up, we provide a comprehensive overview of key international and domestic data releases.

Big Tech Brings Value: Apple becomes the third company in the “Magnificent 7” to return capital to investors this year, a move that might signal a trend.

• Apple made a splash on Thursday by announcing a record-breaking $110 billion share buyback program, surpassing its previous high set six years ago. The company further emphasized its financial strength by raising its quarterly dividend for the 12^th consecutive year. Before the announcement, investor concerns ran high due to anticipated disappointing sales figures stemming from the recent decline in iPhone market share in China, a crucial market for the company. However, the company was not only able to beat estimates, but it also expects to return to growth in the current period.
• Following Meta and Alphabet’s inaugural dividends this year, Apple’s decision further underscores a growing focus on shareholder returns among the tech giants. Fueled by investor expectations of high future growth, these companies have channeled significant resources into burgeoning areas like virtual reality, electric vehicles, and artificial intelligence, albeit with mixed results. This move to reward investors is likely a way of signaling strength even as the company looks to meet its lofty valuation and comes at a time of rising speculation that big tech stocks may be nearing their peak valuations.

• In a higher interest rate environment, value stocks tend to outperform growth stocks. This is because value stocks, trading at lower valuations (e.g., price-to-earnings ratio), offer more attractive current cash flows compared to the higher cost of borrowing. While buybacks and dividends from the big tech companies signal financial strength and the ability to return capital, this strategy is probably not sustainable for all companies in the sector, especially those prioritizing reinvestment for future growth. Investors will likely remain interested in the long-term potential of big tech, but they will also be looking for continued growth to justify valuations.

No Fear, Powell is Here: Central banks are growing more confident in maintaining a relatively accommodative policy stance this year, buoyed by Federal Reserve Chair Jerome Powell’s dovish signals on interest rates.

• A day after Powell’s dovish comments on Wednesday, ECB Governing Council member Yannis Stournas offered a glimpse into the bank’s evolving plan. In a recent interview with the Greek media site Liberal, he indicated the ECB might institute three rate cuts this year, revising down prior expectations of four. This revision suggests European policymakers, despite concerns about future inflation, appear confident in their ability to navigate an easing cycle. Additionally, the Bank of Japan’s efforts to prop up the yen on Thursday signal its reluctance to use monetary policy to combat currency weakness.
• Recently, strong economic data in the US has caused the Fed to dampen market enthusiasm for rate cuts. Expectations peaked at six cuts in January and have dwindled to just two as of this Thursday. This shift in sentiment has strengthened the US dollar against its peers, raising concerns about whether other central banks with more accommodative policies can hold their ground. As a result, expectations for ECB rate cuts have fallen from seven to three, while the BOJ is now anticipated to hike rates three times, up from previous estimates of two.

• Despite holding off on interest rate hikes in 2024 so far, central banks could find themselves constrained in their ability to cut rates aggressively. Premature rate cuts in the US could undermine the Fed’s fight against inflation, a risk that makes policymakers hesitant to commit. This hesitancy extends to economies like Japan and the eurozone, which rely heavily on dollar-denominated energy imports. Easing monetary policy in these regions could exacerbate inflation due to weakening exchange rates. Therefore, investors should brace for the possibility of tighter global financial conditions driven, in part, by US monetary policy.

Tories in Trouble: The UK’s Conservative Party suffered significant losses in local elections, signaling potential challenges ahead for them in upcoming general elections.

• Early reports indicate the Conservative Party has lost over 120 seats as of the time of this writing. This setback is worse than anticipated and fuels speculation the party is losing ground to the rival Labour Party. The poor performance reflects public desire for change as evidenced by national polls that showed the Conservative Party trailing Labour over the last 18 months. UK Prime Minister Rishi Sunak faces mounting pressure to schedule general elections, although he’s not legally required to do so until January 2025.
• Since taking office, Sunak has struggled to fulfill his economic promises, which include halving inflation, growing the economy, reducing debt, cutting hospital waitlists, and moderating immigration. While inflation shows signs of approaching the target rate of 2%, price pressures remain high compared to other countries. This is compounded by a 1.2% GDP contraction in the first quarter of this year. Additionally, public debt as a share of GDP has grown since he took office, and long wait times for medical care continue to be a significant concern. However, he did address immigration problems with the passage of legislation allowing asylum-seeker transfers to Rwanda.

• One concern is the potential for the UK to resemble the recent political instability of Italy. If local indicators accurately reflect public opinion, the UK is on track to have its sixth prime minister in eight years since Brexit. This would be a significant change as the country only saw the same number in the previous 40 years. The lack of consistency in leadership is a concern for investors as it makes it hard to push the country in a single direction. As a result, we believe the country may be relatively risky as a long-term investment.

In Other News: Germany’s rebuke of Russia for cyberattacks targeting a political party provides evidence of a worsening relationship between Europe and Russia. In a twist of irony, Boris Johnson faced difficulty voting in local elections after reportedly failing to provide the proper identification mandated by legislation that he championed and helped pass.

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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 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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