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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Asset Allocation Quarterly (First Quarter 2024)

by the Asset Allocation Committee | PDF

  • The likelihood of a recession occurring during our forecast period has declined.
  • Domestic economic growth should be robust over the forecast period, although momentum has slowed.
  • Elevated geopolitical tensions and ambiguity related to the U.S. elections are likely to create volatility in the markets.
  • Inflation volatility is likely to remain elevated as we anticipate inflation should moderate in the near-term but will reaccelerate to higher than pre-pandemic levels due to various structural influences.
  • Monetary policy is expected to ease, but we believe market expectations may be too optimistic in terms of the timing and magnitude.
  • We have shortened our duration modestly as we expect normalization of the yield curve.
  • In domestic equities, we maintain our Value bias as well as quality factors.
  • We maintained the exposure to gold and, where risk-appropriate, added silver as a hedge in volatile times.


Markets are currently expecting that the FOMC will shift to easing and the economy will avoid a recession. We agree that the likelihood of a recession has declined and expect economic expansion for the majority of our three-year forecast time period. The Fed dots plot indicates 75 bps of easing in 2024 and futures-based market expectations call for even more aggressive easing. Although we concur that the next step is likely to be easing, market expectations may be too optimistic regarding the timing and magnitude, and this mismatch has the potential to create market volatility. We expect the Fed to hold policy steady later this year as we head into elections to avoid the impression of political favoritism.

Economic growth should remain healthy over the forecast period; however, we believe that volatility, in general, will remain high for both economic indicators and markets. For example, we anticipate that inflation should continue to moderate in the short term due to tighter monetary policy but will reaccelerate to higher than pre-pandemic levels in the medium term. Factors contributing to tighter supply chains include supply chain rearrangement with reshoring and friend-shoring of industrial capacity, elevated geopolitical tensions, and developed world demographics. For investors, the volatility of inflation is equally as important as the level. As this first chart indicates, the volatility of inflation during the post-Cold War era has been much lower than it was pre-1990. We also expect many other economic and market metrics to return to the more volatile paradigm similar to what existed during the Cold War.

The effects of fiscal spending are a supporting factor for continued economic growth. According to the Congressional Budget Office, fiscal outlays are expected to further increase over the next three years from the current 23.7% of GDP. The Inflation Reduction Act, the CHIPS and Science Act, and the Infrastructure & Jobs Act form an accommodative fiscal backdrop, supporting corporations as well as consumers.

In the coming quarters, domestic industrial production should slowly increase as geopolitical tensions remain elevated and reshoring moves along its intended path. As this chart shows, industrial capacity construction has increased remarkably. Tight labor markets have hindered progress but growing technology/AI use should advance it. Given that capacity buildouts are extended over multiple years, there will be escalating demands on construction, labor, and materials in the short term, while increased revenue realization is likely to occur outside of our forecast period.

In addition to the U.S. elections, pivotal elections abound globally. This is especially significant amidst high geopolitical uncertainty. As the world continues to polarize into blocs, elections provide signposts along the way about the direction and speed of change. This introduces further volatility to the system, and for investors, it necessitates keeping a close eye on their portfolios. Markets tend to focus more on the uncertainty that elections introduce rather than a specific outcome. Moreover, markets discount election results rather quickly, so a quick resolution to the U.S. primaries would be beneficial.


We expect a good economic backdrop over the forecast period. While earnings growth has slowed somewhat, market consensus is calling for improving margins. The consumer is showing signs of a slowdown, with household debt service ratios rebounding to pre-pandemic highs. While saving levels have fallen, consumer confidence has remained solid and holiday shopping was strong (although we’ll quote Confluence CIO Mark Keller here: “Don’t extrapolate holiday shopping; no matter what, Santa always comes.”). On the other hand, domestic equity valuations might find support from the high levels of cash currently held on the sidelines.

We remain overweight Value across all market capitalizations. In our view, equities categorized as Value have more sustainable earnings growth, their fundamental valuation multiples are historically attractive, and they have a lower exposure to sectors that we view as overpriced. Although Growth has recently outperformed, we anticipate we are in the early stages of a value outperformance cycle. Within large caps, we maintain an overweight position in Energy and exited the Metals & Mining and Industrials sectors. In addition to military hardware exposure via the Aerospace & Defense factor, we also added a position in Cybersecurity as we believe global conflicts will be increasingly cyber-related. The military has a long history of working with private enterprises to innovate in the tech-heavy segments of national security. Our perspective holds that the valuations of small and mid-cap stocks continue to present an attractive proposition, coupled with robust fundamental earnings power. Historically, mid-cap stocks maintain considerable valuation discounts compared to their large cap counterparts. To mitigate potential risks amid economic volatility, we uphold our commitment to the quality factor within our mid-cap and small cap exposures, which involves screening for indicators such as profitability, leverage, and cash flows.

The Uranium Miners ETF that we introduced last quarter was constructive for our portfolios as our thesis of increased nuclear energy use started to materialize. Although the underlying uranium spot price increased significantly, we believe the uranium miners will benefit further. The evolving landscape of baseload energy production, influenced by dynamic policies, has opened a window of opportunity for nuclear energy. Ambitious green energy policies are driving substantial goals for reducing fossil fuel usage, yet the current green energy technologies face challenges in generating energy at the required scale and consistency. Given the constrained supply of uranium over the past decade, we perceive the supply/demand imbalance as a robust opportunity for exposure in this sector.

Low valuations in international developed equities are attractive for the more risk-accepting portfolios. The combination of deglobalization and increased geopolitical risks has widened the volatility range of the asset class. We maintain a country-specific exposure to Japan as shareholder-friendly reforms continue to take effect and as capital flows continue moving into Japan, which could potentially lead to a multiple expansion.


Although the steeply inverted yield curve has attracted outsized interest on the short end, as indicated by the $8.8 trillion in money market funds and CDs as of year-end, it will likely prove fleeting as the Fed begins its pattern of easing. Similarly, our expectations of heightened inflation volatility for the foreseeable future combined with the rally in long-dated Treasuries over the past quarter dampen our return expectations for the long end of the curve. Contrasted with our positive view of long Treasuries last quarter, the rally occurred in a much tighter time frame than we anticipated which encouraged us to unwind this position. The belly of the curve, particularly around five years of maturity, holds the greatest allure in terms of rate stability and limitation of both market risk and opportunity cost. Within this segment, we find mortgage-backed securities (MBS) to hold merit within our thesis of an intermediate-term bond focus. With the bulk of conventional mortgages carrying rates well below refi rates, extension risk is currently dampened. Spreads on MBS remain attractive despite their narrowing since October. Conversely, corporate spreads have narrowed to historically tight levels of roughly +100 bps, encouraging a relative underweight to corporates versus the market benchmark.

Speculative grade bonds are also trading at low spreads to Treasuries; however, the concerns we have are confined to the lower-rated segments below BB. The acceptance by investors to rate adjustments on leveraged loans underscores our concern that the risk appetite has become tilted toward lower rated bonds. While this has positive implications for the refinancing wave that is poised to affect companies rated B and below over the next two years, the increased risk tolerance on the part of investors gives us pause. Consequently, the speculative grade bond exposures remain exclusively in the BB-rated segment.


Among commodities, elevated risks in the Middle East have implications for the price of oil, but the potential economic slowdown is dampening demand; thus, we have exited oil and its derivatives near-term. In contrast, we retain the position in gold as a hedge against elevated geopolitical risks and as international central banks are buying reserves of the metal. Gold is augmented by exposure to silver in the more risk-tolerant strategies given its low price relative to gold by historical measures. Real estate remains absent in all strategies as demand remains in flux and REITs still face a difficult financing environment.

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Asset Allocation Fact Sheet

The 2024 Outlook: Slow-Bicycle Economy (December 18, 2023)

by Patrick Fearon-Hernandez, CFA, Thomas Wash, Bill O’Grady, and Mark Keller, CFA

Summary of Expectations | PDF

The Economy

Economic Growth

We expect the U.S. economy to continue growing into 2024, but its momentum has been slowing, and slowing momentum will put the economy at increased risk of recession. As the growth rate continues to moderate or slow, the economy will become increasingly susceptible to shocks such as a domestic financial crisis or a major geopolitical event that saps confidence.

Just as riding a bike too slowly makes it difficult to stay in balance, slowing economic growth will increase the risk of a downturn in the economy.

Recession Risk

Reflecting the risks inherent in a slower-growing economy, we believe the economy is slightly more likely to slip into a recession in 2024 than it is to avoid one. Nevertheless, if a recession does transpire, we believe it will be relatively mild and short-lived.

Inflation & Monetary Policy

In any case, slowing demand growth and the Federal Reserve’s aggressive interest rate hikes since early 2022 will probably lead to further moderation in consumer price inflation. That should allow the Fed to avoid or at least minimize any further rate hikes, but we expect policymakers to try to keep rates high for an extended period to make sure inflation pressures are eliminated.


The U.S. presidential election in November 2024 could have a big impact on key asset classes. At this point, it appears to be a close race between President Biden and former President Trump, but there is an elevated chance that some third-party candidate or candidates could join the race.

The elevated political uncertainty could keep investors cautious. In contrast, if one candidate appears to break from the pack, or if the election is thrown into the House of Representatives, risk assets could be pushed sharply higher or lower than in our base case.

Market Outlook

Fixed Income

As investors come to accept the Fed’s “higher for longer” stance toward interest rates, we think intermediate- and longer-term U.S. Treasury obligations will be susceptible to selling pressure in 2024, pushing the yield on the benchmark 10-year Treasury note to 4.90% or more.

* The spreads between investment-grade corporate obligations and Treasuries have recently been unusually low, in part reflecting the way many firms refinanced and termed out their debt when interest rates were ultra-low during the coronavirus pandemic. Spreads could remain tight, but if a recession does materialize, we would still expect them to widen to take account of the increased credit risk.

* Similarly, the spread between below-investment-grade corporates and Treasuries is also low, but it would likely widen even more dramatically if economic growth falters.

U.S. Equities

For U.S. large capitalization equities, we forecast that the S&P 500 price index will be between 4,060 and 5,090 at the end of 2024, with a single point forecast of 4,580.

* The rise in the U.S. stock market in 2023 was heavily concentrated among just a few large cap growth stocks. Stocks with smaller capitalizations lagged, making them better values now. We therefore think small cap stocks will outperform in 2024.

* Similarly, value stocks lagged in 2023, likely setting them up to outperform in 2024.

Foreign Equities

We continue to believe that the performance of foreign equities will largely depend on the value of the dollar. Continued strength in the greenback in 2024 is likely to be a headwind for foreign equities, although prudent investors will still want some exposure to the asset class for diversification and as a hedge against any unexpected dollar weakening.


Finally, we expect gold and precious metals to be supported in 2024 by a range of factors, including the end of the Fed’s interest rate hikes, safe-haven buying amid today’s increased geopolitical tensions, and strong buying by central banks.

Broader commodities would face headwinds if a recession materializes, but they could snap back by year’s end if any such downturn ends up being short and mild, as we expect.

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Daily Comment (December 18, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with several items related to the U.S.-China geopolitical rivalry and what it means for investors.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including more bad economic data out of Europe, a growing risk that Japan’s prime minister may be forced to resign, and new warnings from Federal Reserve officials that U.S. investors are being too optimistic about early cuts in interest rates.

U.S.-China Technology Flows:  A new report from the Chinese Academy of Sciences warns that China is at risk of falling into a “middle technology trap” because of the recent U.S.-led curbs on sending advanced technologies with potential military applications to the country.  The report defines such a trap as a situation where a developing country partially industrializes via technology importation, imitation, absorption, and tracking, but fails to join the top tier of rich, advanced countries because it can’t produce its own innovative technologies.

  • The report confirms that one of the major challenges for the Chinese economy these days is the U.S. geopolitical bloc’s clampdown on trade, investment, technology, and even human capital and tourism flows with China, as countries in the bloc belatedly work to reduce their vulnerability to China’s military and economic power.
  • In 2024, we believe China will continue to face economic headwinds from what we call the “Five Ds”: weak consumer demand, high corporate and local government debt, poor demographics, economic disincentives from the Communist Party’s increasing intrusion into the economy, and decoupling by foreign countries.
  • These challenges have prompted General Secretary Xi to seek an easing of tensions with the West, and we think he’ll remain focused on détente in 2024, at least in diplomatic and economic relations. That could spark a temporary rebound in Chinese asset prices, but we think the Five Ds will still limit the returns available in China in the near term.

U.S.-China-Mexico Trade Relations:  To get around the broader U.S. tariffs and other trade barriers against Chinese imports, the Financial Times says at least three of China’s electric vehicle makers and one of its EV battery producers are looking to set up factories in Mexico.  Because of the U.S.-Mexico-Canada trade agreement, producing in Mexico would potentially give the companies tariff-free access to the U.S. market, while also spurring new investment and economic growth in Mexico.

U.S.-China Military Relations:  While we write a lot on the growing U.S.-China geopolitical rivalry and what it will mean for investors, sometimes it’s the small operational changes in the military that best illustrate the situation.  On that score, the New York Times on Friday had an article on how the U.S. Army is again ramping up its jungle training school in Hawaii.  After two decades focused on fighting in dry, desert locations like Iraq and Afghanistan, the Army is trying to prepare its troops for a potential war with China in the jungles of the Indo-Pacific region.

  • The effort to re-introduce U.S. troops to jungle warfare comes as the U.S. Marine Corps has embarked on a controversial re-design that will transform its Pacific expeditionary forces into light, highly mobile ship killers who, in time of conflict, could deploy to islands throughout the region with powerful anti-ship missiles to wreak havoc on the Chinese navy.
  • For those of us who travel often and see lots of soldiers in desert camouflage in the airport terminals, the shift in geopolitical tensions toward the Indo-Pacific and Europe may really hit home when we notice more and more of those soldiers in dark-green jungle or woodland camouflage.
  • On the Chinese side, provincial civilian officials have begun appearing at public events in military uniforms, in an effort to show their support for the military and military-civilian coordination.

Israel-Hamas Conflict:  As Israeli troops continue their attacks on Hamas fighters in Gaza, Iran-backed Houthi rebels in Yemen continue to launch retaliatory missile and drone strikes on ships in the Red Sea.  In response, oil giant BP (BP, $34.81) said today that it is temporarily pausing all its tanker transits through the area.  Shipping majors A.P. Moller-Maersk (AMKBY, $8.58) and Hapag-Lloyd (HPGLY, $68.88) on Friday also curbed operations in the Red Sea after attacks on their vessels.  The moves reflect the conflict’s risk to world oil supplies and commerce.

Japan:  After the ruling Liberal Democratic Party’s spiraling illegal fundraising scandal forced Prime Minister Kishida to sack four of his ministers last week, government and party officials are now openly discussing the possibility that Kishida may soon be forced to resign as party chief.  Since elections aren’t required until 2025, another LDP official would likely take Kishida’s place as prime minister.  The risk for investors is that increased political chaos could undermine confidence and short-circuit the Japanese stock market’s recent strong run.

Germany:  The IFO Institute’s December business climate index fell to a seasonally adjusted 86.4, well short of expectations that it would rise slightly from the November reading of 87.2.  Along with a decline in the December purchasing managers’ indexes published last week, the findings suggest the German economy is limping to the end of the year with declining activity.  Because of the German economy’s large size, its weakness is likely to weigh on other European economies and asset prices.

Serbia:  In parliamentary elections yesterday, right-wing populist President Aleksandar Vučić’s ruling Serbian Progressive Party won 47% of the vote, which will allow it to govern without relying on any coalition partners.  Vučić had already been accused of building an authoritarian state modelled largely on Viktor Orbán’s Hungary, and opposition leaders immediately complained that his win yesterday reflected electoral fraud.

Chile:  In a ballot yesterday, Chileans voted 56% to 44% against a new constitution that would have shifted policy decidedly to the right.  The rejection came about a year after voters strongly rejected a radical leftist constitution and four years after the widespread rioting and protests that kicked off the effort.  For now, the result will leave in place the pro-business constitution passed under the Pinochet dictatorship in 1980.

U.S. Monetary Policy:  In a speech today, Cleveland FRB President Mester warned that investors have gotten ahead of themselves by pushing up asset prices in anticipation of early interest-rate cuts by the central bank.  Her comments align with similar warnings on Friday from New York FRB President Williams and Atlanta FRB President Bostic.  They also align with our view that Fed policymakers are so intent on rebuilding their reputation as inflation fighters that investors should take them at their word when they say rates will stay “higher for longer.”

  • In her comments, Mester said, “The next phase is not when to reduce rates, even though that’s where the markets are at. It’s about how long do we need monetary policy to remain restrictive in order to be assured that inflation is on that sustainable and timely path back to 2%.”
  • More to the point, she also added that, “The markets are a little bit ahead. They jumped to the end part, which is ‘We’re going to normalize quickly,’ and I don’t see that.”

U.S. Fiscal Policy:  Data from the Organization for Economic Cooperation and Development shows government revenue as a share of gross domestic product has risen noticeably in the U.S. and other major developed countries in recent years.  According to the analysis, the rise generally hasn’t come from newly legislated tax hikes.  Rather, the increase has come from price and wage inflation, which can push taxpayers into higher tax brackets.

  • In the U.S., tax receipts at all levels of government rose to almost 28% of GDP last year, up from 25% in 2019 and one of the highest levels in decades.
  • While the higher tax take can impede consumer spending and entrepreneurship, the new resources will also be available to help fund new initiatives, such as infrastructure rebuilding and increased defense spending.

U.S. Corporate Finances:  An updated review of bankruptcy filings shows business failures in the U.S. in the year ended in September were up 30% from the previous year.  The data shows that bankruptcies in several other key countries have also climbed by a similar amount.  The research suggests that the rise in bankruptcies can be attributed to higher costs, rising interest rates, and the continued withdrawal of pandemic relief funds by governments.

U.S. Energy Industry:  New forecasts from the Energy Information Agency project that solar and wind-generated electricity will surpass coal-generated electricity in the U.S. energy mix for the first time in 2024.  The report shows natural gas will remain the top source of electricity, accounting for 42% of the nation’s total, while all renewables will account for 24% and nuclear will stand at 19%.  Coal is projected to provide only 15% of U.S. electricity in the coming year.

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Daily Comment (December 15, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Risk assets surge as bullish winds sweep the market, while the Las Vegas Raiders dismantled their AFC West rivals in a dominant win. In today’s Comment, we unpack the dollar’s accelerating decline, dissect the shift away from mega-cap stocks, and delve into the unexpected delays in Ukraine funding. As always, our comprehensive report encompasses the latest domestic and international data releases.

The Greenback’s Nosedive: The U.S. dollar dropped against major currencies today, likely triggered by divergent policy rate signals from the Federal Reserve and its G-7 counterparts.

  • Amidst a chorus of restraint from other major central banks, the Federal Reserve stood as a lone dove, hinting at a potential policy easing in the near future. This contrasted with commitments from the European Central Bank and Bank of England to hold policy rates steady until price stability is restored. Even the Bank of Japan, long known for its ultra-accommodative stance, suggested a possible shift from quantitative easing and negative interest rates earlier this month. Following the divergent signals from U.S. policymakers and its developed counterparts, the Bloomberg Dollar Index has plunged 3% since Wednesday, reflecting investor expectations of a narrowing interest rate spread between countries. This shift has also triggered a rebound in oil prices, previously weighed down by oversupply concerns.
  • Investors were shocked as the ECB and Bank of England unexpectedly split from the Federal Reserve. However, historical data reveals that this is not unprecedented. In past tightening cycles, the Fed has often led the charge, taking a more hawkish stance than its counterparts, followed by a more dovish pivot during periods of monetary easing. These swings likely stem from concerns about the impact that U.S. monetary policy has on other countries. High U.S. rates can lead to inflation abroad by pushing up import costs for dollar-denominated goods, while low U.S. rates can hurt the competitiveness of foreign exports, which could weaken growth. As a result, rate-setters abroad typically seek a happy medium.

  • Monetary policy as mapped out by the central banks is based on a rosy outlook for next year. European policymakers’ confidence in avoiding rate cuts hinges on the region sidestepping a recession, while the Fed’s conditional optimism rests on inflationary pressures holding steady. A misstep by either could send investors scrambling to adjust their risk appetite and portfolio allocations. While the latest decisions from the central banks offer temporary clarity, investors should remain cautious and prepare for potential adjustments. Should central banks hold firm, the dollar’s downward trajectory is likely to continue, potentially providing a boost to foreign stocks.

The Great Rebalancing: While the index approaches record territory, the current surge is a broad-based rally, fueled by a wider range of actors beyond the usual market darlings.

  • Tech’s year-long dominance is ceding ground to broader market focus, with non-tech sectors like Real Estate and Financials surging past Tech and more than doubling Communications’ growth since November. This rotation suggests a potential turning point in the market as investors prepare for the Federal Reserve to start its easing cycle in 2024. The latest CME FedWatch Tool shows that investors are becoming increasingly confident that the Fed will start to cut rates in the first quarter. Meanwhile, fragility within the repo market has led investors to question how long the central bank will be able to maintain its quantitative tightening program. 
  • The recent rotation in investor preferences is evident in the performance gap between the S&P 500 and its equal-weight counterpart. After dominating 2023, it has lagged its equal-weight counterpart by 2% over the last two months. This shift, fueled by the equal-weight index’s ability to level the playing field, exposes the true pulse of investor sentiment toward large caps. The potential for lower rates next year could fuel further rotation out of AI stocks as investors seek to capitalize on the upside potential of overlooked sectors with robust growth prospects and attractive valuations.

  • After AI exuberance drove risk-taking in 2023, loosening financial conditions are poised to take center stage in the market narrative next year. During easing cycles, investors typically like to go bargain hunting as they look to cash in on companies that have been ignored. As investors rotate away from seemingly overstretched tech giants, smaller and mid-size companies with their more attractive valuations are poised to finally bask in the spotlight, particularly if economic conditions remain favorable, such as downward pressure on long-term interest rates and the abatement of producer price pressures.

Bait and Switch: As Ukraine scrambles to secure vital weapons and equipment, Kyiv battles a storm of mixed messages from the West, stoking fears of its long-term ability to sustain its war effort against Russia.

  • The European Union failed to come to an agreement on €50 billion in financial aid to help Ukraine fend off Russia. Talks collapsed following the decision from Hungarian Prime Minister (and Putin ally) Victor Orban to veto the proposal. Orban’s vote dealt a blow to Ukraine’s immediate financial lifeline and forced the EU to scramble for alternative solutions, raising questions about the bloc’s unity in supporting its embattled ally. While offering membership talks is a positive step forward, the EU must find a way to bridge the immediate financial gap and ensure Ukraine has the resources to defend itself from a potential Russian offensive.
  • The EU’s failure to agree on a €50 billion military aid package for Ukraine coincides with the U.S. Congress’s struggle to pass a similar funding bill. The Senate has failed several times to pass military aid to help Ukraine and Israel as holdouts push for more border security funding. As of Friday, reports suggest the latest funding bill may have enough support to make it through the Senate; however, this is far from a done deal. Although the White House has warned that it was running out of money, President Biden released another round of funding for Ukraine on Tuesday.

  • The emotional pull of the Ukraine-Russia conflict is undeniable, but investors must remember that the market remains indifferent to human tragedy. While a swift end to the conflict would ease supply chain pressures and stabilize commodity markets, a prolonged war significantly raises the risk of escalation, which would send shockwaves throughout the global economy and jeopardize investor confidence. Therefore, in market terms, the debate over funding would be better focused on its potential to incentivize a negotiated settlement, not based solely on achieving a decisive military victory. While Ukraine’s resilience is admirable, further military aid alone seems unlikely to force a Russian withdrawal. As a result, the West may be forced to rethink its support, particularly as domestic backing for the conflict wanes and the costs escalate over the next few months.

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Daily Comment (December 14, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Risk assets surge as investors shake off recent jitters, while Giannis Antetokounmpo lit up the court with a 60-point performance. Today’s Comment navigates the key questions on the minds of many: Will central banks pivot soon? Are investors finally ready for risk? And how is the world’s shift away from globalization shaping government priorities? As always, our comprehensive report encompasses the latest domestic and international data releases.

Higher for How Long? While the market exuberantly celebrated the end of the hiking cycle and a potential pivot, we are increasingly worried that some investors may have gotten ahead of their skis.

  • Despite maintaining its hold on the target federal funds rate at 5.25%-5.50%, the Federal Open Market Committee (FOMC) issued dovish whispers, suggesting a potential pivot by the end of 2024, with the range possibly falling to 4.50%-4.75%. Fed Chair Jerome Powell’s acknowledgment of committee discussions on the timing of rate cuts intensified chatter about a shift, further fueling market speculation. Ten-year yields plunged nearly 20 basis points, while the S&P 500 soared 1.4% on the day as investors strategically repositioned their portfolios for a potential shift toward lower rates.
  • The European Central Bank hinted that its aggressive rate hikes might be nearing an end, but President Christine Lagarde underscored the bank’s unwavering commitment to bringing inflation back to target. Despite keeping rates steady, she warned of future tightening if fiscal measures remain uncontrolled, highlighting concerns about domestic price pressures. Lagarde’s veiled threat underscores the precarious balance the ECB faces—while its hawkish stance aims to tame inflation, it risks exacerbating the Eurozone’s fiscal tensions, particularly as member states grapple with returning to pre-pandemic deficit rules.

  • Although policy easing may be inching closer, the pace and magnitude are unlikely to meet the aggressive expectations of many investors. The CME Fedwatch Tool predicts a potential cut of 150 bps or more in March 2024, while swap rates hint at even deeper cuts from the ECB. However, such optimism may be misplaced, ignoring lingering inflation concerns and underestimating policymakers’ commitment to price stability. A significant economic downturn in the U.S., necessitated by persistent regional inflation, would be the only scenario justifying such aggressive easing. Should our assessment hold, the current market euphoria could be short-lived as policymakers may decide to rein in expectations with hawkish rhetoric.

Where Will It Go? While money market funds were all the rage during the historic rate hikes of the last two years, a potential reversal could see investors fleeing for greener pastures.

  • Higher rates gave life to money market funds and savings accounts, offering investors a viable alternative to riskier assets with their suddenly competitive returns. The Crane 100 Index shows that the seven-day annualized yield currently sits at 5.19%, which surpasses the returns for a third of the S&P 500 sectors. Additionally, the funds have been a magnet for capital as they drew in more than $651 billion worth of assets in the second quarter compared to the year prior. Assuming that rates fall next year, this trend is likely to see a shift in favor of riskier assets.
  • Large cap tech stocks took investors on a wild ride in 2023, driven by FOMO surrounding AI and communication giants. But with their sky-high valuations, the “Magnificent 7” may have already priced in much of their future growth potential. This presents a golden opportunity for investors seeking diversification and hidden gems. Small and mid-cap stocks, boasting lower P/E ratios, have already attracted early birds. Since money market funds reached their peak in November, the S&P 400 and 600 indexes have skyrocketed 13.6% and 16.1%, respectively, compared to the S&P 500’s 11.1% gain.

  • Although the shift away from large caps might be tempting, it hinges on the U.S. maintaining its resilience, especially with inflation potentially lurking. However, worrying signs are emerging. Atlanta GDP Nowcast points to a significant slowdown in economic output compared to the previous quarter. Simultaneously, ADP data suggests small businesses, the engine of job creation, have cut back on hiring for three months straight. Adding to concerns is the looming “debt maturity wall” next year, where a massive chunk of loans come due under much tighter financial conditions than when they were issued. As a result, investors should still exercise caution and due diligence before preemptively looking to price in rate cuts.

 A Smaller Peace Dividend? As the tide of globalization recedes, governments are increasingly turning their attention inward, prioritizing domestic security concerns over international cooperation.

  • The potential unraveling of globalization is unlikely to be smooth or swift as countries aim to mitigate sudden shocks that could erode investor and consumer confidence. China’s recent re-engagement with the U.S., despite ongoing tensions, exemplifies this cautious approach to managing risk. Further reinforcing this view was Thursday’s report that the top defense leaders from both countries met for the first time following an ongoing row over spying.

In Other News: The Senate passed a defense policy bill without much pushback. Passage of the bill highlights the ways in which the government is on the same page regarding maintaining defense spending.

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Weekly Energy Update (December 14, 2023)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA | PDF

(N.B. The Weekly Energy Update is going on indefinite hiatus.  Next year, look for a new report format.)

Crude oil prices are continuing to break down despite OPEC+ efforts to restrain supply.

(Source: Barchart.com)

Commercial crude oil inventories fell 4.3 mb compared to forecasts of a 2.0 mb draw.  The SPR was unchanged, which puts the net draw at 4.3 mb.

In the details, U.S. crude oil production was steady at 13.1 mbpd.  Exports fell 0.4 mbpd, while imports declined 0.6 mbpd.  Refining activity fell 0.3% to 90.2% of capacity.

(Sources: DOE, CIM)

The above chart shows the seasonal pattern for crude oil inventories.  Inventories are below seasonal norms but are following a similar pattern.

Fair value, using commercial inventories and the EUR for independent variables, yields a price of $66.88.  The recent drop in oil prices indicates that the geopolitical risk premium has mostly been priced out of the market.

Since the SPR is being used, to some extent, as a buffer stock, we have constructed oil inventory charts incorporating both the SPR and commercial inventories.

Total stockpiles peaked in 2017 and are now at levels last seen in late 1984.  Using total stocks since 2015, fair value is $90.16.

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