by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

In today’s Comment, we begin with an update on the war in Ukraine, with a special look at the bridge attack.  China news comes next, where we discuss the U.S.’s further tightening of semiconductor export controls.  The international news roundup follows where we note that the BOE is preparing markets for what follows after its Gilt intervention activities end.  We close with economics and finance news.

Ukraine War:  We cover the attack on the Kerch Strait Bridge and other news items from the conflict.

• Over the weekend, social media showed dramatic footage[1] of an explosion and fire from what is being described as a truck bombing of the Kerch Strait Bridge. According to reports, a truck bomb exploded and caused seven fuel cars on the adjacent railroad tracks to catch fire as well.  The bridge is a key link between Crimea and Russia and is an important symbol of Russia’s annexation of the peninsula.  It is also a key logistical link to supporting Russia’s war effort.  So far, Ukraine has not taken official responsibility for the attack, which Putin has dubbed a “terrorist act,” but it is highly likely that Kyiv is behind that action.

(Source:  Russia Briefing)

Although the bridge was heavily damaged, it is still partially operable.  The footage of the railroad bridge in flames was notable, but according to reports, some rail traffic has resumed.  However, reports suggest that trains are moving slowly, perhaps worried about the structural integrity of the line.  In addition, as one would expect, security checks have intensified, which has slowed traffic.  Finally, some lanes remain open for auto traffic, but trucks have been banned.  To make up for the break in the bridge, a ferry service has restarted.

In response to the attack, Russia launched missile strikes (during rush hour no less) against Kyiv and several other cities in what looks to be a direct attack on civilian targets.  Moscow is threatening additional strikes in retaliation.

Overall, this attack is a massive blow to the Kremlin.  For those living in Crimea, the severing of the bridge will raise questions about their security.  For the Russian military, the logistical disruptions are coming at a bad time in the war.  There are rumors of yet another shakeup in the command structure.  There are also reports of growing dissention within the Putin regime.  The fact that this attack occurred around Putin’s birthday has to be problematic for the Russian president.

• Meanwhile, in other war news, Ukrainian forces continue to press into Russian occupied areas.

• Ukrainian forces have been using the Starlink system, a satellite internet system built by Elon Musk. There are reports of outages, which has undermined Ukrainian military communications.  It is unclear why these are occurring, but the company suggests that the system has been brought down occasionally to prevent Russian interference.
• Russian shelling has forced the Zaporizhzhia nuclear power plant to go offline, although there are reports that power has been restored. The plant does have backup diesel generators to cool the core, but there is only about a week’s worth of fuel.  There are worries that the reactor may melt down if the disruptions continue.
• In our most recent BWGR, we noted that Russia has been so consumed by the war in Ukraine that it is losing its ability to project its influence in the southern periphery. The New York Times confirms this observation.  Kyrgyzstan has abruptly cancelled joint military exercises with Russia, and no official explanation has been offered, although we believe that Moscow’s inability to intervene in recent tensions between Kyrgyzstan and Tajikistan is likely to blame.  We also note that China has been deepening ties to Georgia, another nation that Russia believes is in its sphere of influence.
• As we noted in recent reports surrounding the Nord Stream 1 and 2 pipeline attacks, there is growing concern that Russia may be attacking European infrastructure. There has been a recent sabotage of Germany’s rail system.  German security officials are investigating.

China News:  As General Secretary Xi prepares for a third term (unprecedented in the post-Mao era), the Biden administration is continuing to restrict semiconductor chip sales to Beijing.

• Although there is little doubt that President Xi will get his third term, the picture he paints of the near future is one of “great struggles.” We would agree.  The economy is rapidly decelerating, and consumer confidence is in near collapse due to a combination of slower growth and China’s Zero COVID policy.  Much of this weakness is tied to Xi’s economic and security policies.

• The U.S.’s policy on restricting tech exports to China continues to undermine Beijing’s efforts to achieve self-sufficiency in semiconductors. If enforced effectively, it would prevent China from accessing the most advanced semiconductors.  China’s foreign ministry spokesperson Mao Ning reacted angrily to the news and pointed out that this policy will not just hurt China but also U.S. tech firms.  She is correct.  Beijing has been consistently trying to use American businesses to lobby against restrictions.  Chinese semiconductor shares plunged on the news.
• The U.S. is warning of secondary sanctions on Chinese companies that aid Russia’s war effort. If this restriction was to expand to energy (which we don’t expect) the impact on Russia would be devastating.

International Roundup:  The BOE prepares the Gilt market for the Friday deadline of its emergency measures, and the U.S. details data protection measures for the EU.

• Late last month, the Truss government unveiled numerous measures to boost and reshape the U.K. economy. As we noted, the financial markets whirled into a panic, with Gilt yields soaring after pension funds were forced to sell the paper to meet margin calls on derivative schemes.  To quell the panic, the BOE began aggressively buying Gilts to bring down yields.  At the time, the bank said the measures were temporary and will end on Friday, but fearing a resumption of selling, the Bank indicated it was willing to continue to buy Gilts if necessary.  We note that although the Bank had plans to buy £40 billion Gilts, it has actually only purchased £5 billion.  This outcome is similar to the Fed’s experience with backstops during the pandemic.  The mere implementation of the backstop was enough to address the panic and allow for normal market functions to return.  The BOE will continue to offer a Gilt repo facility to ensure pensions will have an orderly market to generate liquidity and avoid panic selling.
  • In related news, the Truss government will bring the date forward for its economic and fiscal forecast to October 31 from the original early November target.
• President Biden has signed an executive order which will place limits on what personal information U.S. security agencies can gather on Europeans. EU data restrictions are stronger than U.S. regulations, and the EO is the first step in aligning the regulatory environment.  Interestingly enough, the direction of travel seems to be that the U.S. will get an effective veto on EU regulations.  We expect talks to continue.
• In response to recent North Korean missile launches, the U.S. has added further economic sanctions designed to make it harder for Pyongyang to acquire petroleum. North Korea responded by launching more missiles.
• Germany’s SPD won local elections in Lower Saxony, a key swing state.
• Relations between Greek universities and the government have been tense for years. Campuses have often fostered opposition to various Greek governments.  Recently, the government has attempted to put a permanent security presence on Greek campuses, which has led to unrest.
• An interesting and unexpected feature of left-wing governments in the Americas has been fiscal austerity. In general, leftist governments have historically run large fiscal deficits.  Mexico’s government, however,  has been running modest deficits, and Chile, with a new left-wing government, announced a budget surplus.
• In Japan, Prime Minister Kishida’s popularity has fallen to new lows.
• The Malaysian government has dissolved parliament in preparations for early elections.
• As we have noted in various Geopolitical Reports, Brexit was likely to foster Irish unification. We are starting to see evidence of political movement on this issue.

Markets, economics and Policy:  We touch on the dollar, labor markets, and note the Economics Nobel prize winners.

• This year, the dollar’s rise has been relentless. An aggressive turn in monetary policy has been behind the bullish turn.  Although by parity measures the dollar is overvalued, rarely does valuation alone turn a market.  Historically, strong trends in currencies become self-filling and require political action to turn.  Often, bull markets in the dollar face political pressure from the manufacturing sector.  We are starting to see signs of this pressure building.  We would note that since 1970, manufacturing production (as measured by the subindex of industrial production) rises by 2.2% per year; however, when the JPM dollar index rises by more than 7.5% per year, manufacturing declines by 0.4% per year.
• As bank earnings are released this week, we note that banks are raising loan-loss provisions.
• How tight are labor markets? So tight that criminal records are no longer a barrier to employment.
• Ben Bernanke, along with Doug Diamond and Phillip Dybvig (of Washington University here in River City) have been awarded the Nobel Prize for Economics.[2]

---

[1] Along with some rather funny twitter memes.

[2] Yes, we know that’s not the official name.

View PDF

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with a discussion about the U.S. dollar’s impact on equities. Next, we give an overview of the upcoming Italian election over the weekend. Finally, we conclude with an update on the Ukraine war.

Fed Hangover: All focus seems to be on the dollar after the Fed lifted its policy rate by 75 bps. Here are our thoughts regarding the greenback’s impact on equities.

• The U.S. dollar index rose to its highest level in over 20 years due to the Fed’s tightening cycle and the Russian war in Ukraine. The greenback’s strength hurt firms with substantial overseas sales as these companies receive a weaker currency for payment for their goods and services. An index that tracks the S&P 500 performance of firms based on revenue exposure shows how the lack of dollar exposure may have led to worse performance this year.

• Although eye-catching, the chart above does not explain the complete picture of how dollar exposure impacts equities. Most of the decline in the foreign revenue exposure index was driven by tech. Weakening overseas sales hurt the sector’s performance, but the rise in borrowing costs is also an important factor. Additionally, the Real Estate sector, whose U.S. revenue exposure is only surpassed by Utilities and Telecommunication Services, has underperformed the aggregate S&P 500 Index. Thus, dollar impact on equity performance may be ambiguous at best.
• More hawkish policy from non-U.S. central banks is a possible cure to the dollar’s rise. However, it does come with risks as political backlash could pressure governments to support dovish fiscal and monetary policy as economies barrel into recession. We are seeing this situation play out in the U.K. The Truss administration plans to implement the largest tax cut in the country’s history since 1972. The pound sank to a 37-year low against the dollar following the report as investors fear that the Bank of England will not be able to contain inflation. The political ramifications of a recession will likely mean the BOE may not be the only central bank hesitant to raise rates. Thus, the dollar’s surge should continue if other central banks abandon or slow their monetary policy tightening prematurely to the Fed. In short, we would like to remind our readers not to put too much emphasis on one parameter when making allocation decisions. Although the U.S. dollar’s impact on revenue provides insight into firm profitability, it is essential to consider the broader macroeconomic environment when making investment decisions.

Italian Elections: The right-wing bloc is expected to take over the Italian parliament; however, there are concerns that the coalition may not hold together.

• Italian voters are set to pave the way for right-wing populists to take over parliament. Led by the historically Eurosceptic Brothers of Italy party, the new government will potentially include the League, Forza Italia, and Noi Moderati. Unlike in 2018, the differences between these parties are not significant enough to prevent the formation of a government. The leader of the Brothers of Italy, Giorgia Meloni, will take over as prime minister. Although she is known for being a nationalist on the campaign trail, she has openly supported keeping Italy in the EU and NATO.
• Meloni might not struggle to form a government, but that does not mean there isn’t friction within the coalition. Right-wing bloc leaders Meloni and Matteo Salvini both share a dislike for immigration, support law and order, and promote conservative family values. However, the two have differing views on Russia and government spending. Although the pair get along on the surface, there are rumors that their relationship is far from amicable. The Italian parliament could fall if the rivalry gets out of hand.
• The rise of a right-wing populist coalition in parliament does not seem to be startling Italian bond investors as much as we once feared. Despite desires from members within the coalition for household subsidies to curtail inflation, Meloni has assured Brussels that Italy will be fiscally responsible under her control. At 150.8% of GDP, Italy has the second highest debt burden in the EU. Meloni’s commitment to sound fiscal policy has likely calmed concerns over a potential EU-Italy clash. As a result, the yield gap between Italian and German 10-years bonds has narrowed from 2.40% in June to 2.27% as of September 22.

Ukraine Update: Everyone is looking for an off-ramp from the Ukraine war; however, political pressure is forcing the West and Russia to make uncomfortable decisions.

• Russia is threatening to use nuclear weapons as it grows desperate to consolidate its territorial gains in Ukraine. Despite not fully controlling any of the four regions it is attempting to annex, Moscow wants to give the illusion that it has made progress in its mission to protect separatists in the Donbas and Luhansk regions. However, recent setbacks from the Ukraine counteroffensive and political backlash due to partial mobilization has forced the Kremlin to double down on its claim that the war was necessary. Although the fight is far from over, recent moves from Russia suggest that hardline nationalists may pressure the ruling party to secure a victory at all costs.
• The European Union faces resistance as it gears up to impose another round of sanctions and place price caps on Russian oil. Hungarian President, and Putin ally, Viktor Orban called on the EU to scrap sanctions altogether over concerns that they are worsening the energy crisis in Europe. His remarks come as officials look to dissuade Russia from using nuclear weapons in Ukraine. That said, Viktor Orban is not alone; disputes over sanctions have led to party infighting in Italy and Germany. The disunity has added to speculation that the energy crisis could lead to a break-up of the EU.
  • The European energy crisis has contributed to the decline in the euro against the U.S. dollar as it will likely tip the continent into recession. However, if the winter is mild and energy supplies prove sufficient, the euro could rebound.
• Neutral countries India and Turkey are not pleased with Russia’s referendums to annex parts of Ukraine and mass mobilization efforts. Turkish President Recep Tayyip Erdoğan called the elections illegal, and Indian Prime Minister Narendra Modi demanded the war come to a stop. These leaders’ comments signal that countries may be concerned that non-alignment will hurt them in the long run as Russia ramps up its war efforts. Although we do not believe India or Turkey will jump ship, it is becoming clear that the countries are hedging their bets. In a speech at Columbia University, India’s external affairs minister admitted that his government is starting to rethink its suspicions of the U.S.
  • The gestures from Turkey and India suggest that Russia faces further isolation as it intensifies its operations in Ukraine. Although this does not necessarily pave the way for an end to the conflict, this could prevent Moscow from taking its most extreme action in the war.

View PDF