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.

• Separately, the Israel Defense Force admitted over the weekend that its soldiers mistakenly shot and killed three Israeli hostages during a chaotic combat operation, even though the hostages were waving a white flag and shouting in Hebrew.
• True to character, Prime Minister Netanyahu was slow to acknowledge the mistake or take responsibility for it, drawing further anger from Israelis who see him as having allowed the Hamas attacks on Israel on October 7 and then risking the hostages and Israel’s reputation with the IDF’s attack on Gaza.

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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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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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.

• Western support for Ukraine faces mounting hurdles as domestic concerns and internal fissures within the bloc complicate additional aid. In the U.S., Senate wrangling centers on attaching border security measures to Ukraine funding, while within the EU, Hungary’s Viktor Orban threatens to block further assistance due to concerns about alleged discrimination against Hungarians in Kyiv and his own desire for unfrozen EU funds. The persistent bickering among the countries adds pressure on Ukraine to either win decisively or be forced to compromise with Russia.
• Tensions with the West have prompted both Russia and China to flex their muscles. A recent breakdown of China’s outlook for the country showed that Chinese leaders have placed more emphasis on “security” and less on “reforms” over the last three years. Meanwhile, Putin’s renewed calls for “denazifying and demilitarizing” Ukraine underscore his desire to neutralize a Western ally on his doorstep. These developments suggest that neither Moscow nor Beijing is inclined to simply accept the pre-existing order dictated by the West. Consequently, their cooperation, driven by a shared desire to level the playing field with the U.S., is likely to endure for the foreseeable future.

• 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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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Our Comment today opens with some notes on a major Communist Party economic conference in China.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including some new details on Argentina’s economic reforms under newly inaugurated libertarian President Milei and a preview of the Federal Reserve’s likely action as it wraps up its latest policy meeting today.

China: Wrapping up their annual economic work conference yesterday, Communist Party officials said they would launch additional growth-enhancing initiatives and work to ensure economic stability.  Echoing a statement from the Politburo on Friday, the officials vowed to focus on “establishing the new before abolishing the old,” which is widely interpreted as easing up on the recent rules limiting property developers’ debt.

• The summary statement is pretty opaque, but most observers seem to be reading it as a sign that Chinese economic policy will become only modestly more stimulative in 2024 as General Secretary Xi continues to resist the Party’s traditional policy of debt-fueled investment.
• The problem is that China’s various structural economic headwinds are probably too strong for modest stimulus to make much of a difference. If policy remains too weak to spur growth, global economic growth and financial markets could struggle in 2024.

European Union-China: Trade chief Valdis Dombrovskis yesterday announced that the European Commission in January will propose a set of rules designed to de-risk the EU’s trade and investment ties with potential adversaries, such as China.  The rules will include restrictions on outbound investment to ensure that key technologies and know-how aren’t available to an adversary’s defense and intelligence suppliers.  They will also call for screening inbound direct investment to prevent critical assets from being bought by hostile or monopolistic forces.

• While the EU remains behind the U.S. in limiting trade and investment ties with the China/Russia bloc, the rules coming in January will help get it on the same page with Washington.
• The EU’s coming rules are another example of how China’s rising power and aggressive geopolitical moves are fracturing the world into relatively separate blocs and imposing significant limits on cross-bloc trade, investment, technology, and travel flows.
• As we have argued many times before, the resulting de-globalized supply chains will be relatively less efficient, leading to higher average inflation and interest rates.

Japan: Prime Minister Kishida, who had already been dealing with abysmally low polling support, now appears likely to be implicated in a fundraising scandal engulfing the long-ruling Liberal Democratic Party.  The scandal involves unreported political fundraising by several government and party officials, including some in Kishida’s parliamentary faction.  A key risk is that increased political turmoil could undermine the Japanese stock market’s recent big uptrend.

Australia: To combat sky-high home prices, the government has unveiled new measures aimed at cutting immigration by 14% from what otherwise would be expected over the coming four years.  The move comes after the country of 26 million people absorbed about 510,000 net new immigrants in the latest fiscal year.  Despite global concerns about slowing birth rates, declining populations, and rising average ages, anti-immigration voters in countries ranging from Australia and the U.K. to the U.S. continue to drive policy toward less immigration rather than more.

Israel-Hamas Conflict: Illustrating another way the Israeli-Hamas fighting could broaden, Iranian-backed Houthi rebels in Yemen, who support Hamas and Palestinians in the Gaza strip, have continued to launch retaliatory missile and drone strikes at ships in the Red Sea.  At least one missile struck a Norwegian-flagged tanker carrying palm oil to Italy, setting it ablaze.  When a French frigate positioned herself between the Yemeni coastline and the stricken tanker to protect it, the frigate was forced to shoot down two incoming drones.

• Meanwhile, the Israel Defense Forces have reportedly begun pumping water from the Mediterranean Sea to flood Hamas’s extensive underground tunnel network under Gaza, hoping to flush out the group’s fighters and destroy any military equipment there.
• One key risk for Prime Minister Netanyahu is that the flooding could kill Israeli hostages if they are being held in the tunnels.

Argentina: Just days after radical libertarian Javier Milei was inaugurated as president, his economy minister, Luis Caputo, yesterday outlined key economic initiatives aimed at bringing down inflation, cutting the budget deficit, and averting a debt crisis.  According to Caputo, the government will devalue the peso by about half, slash government spending, and reduce energy and transportation subsidies.

• Now that the Milei government seems to be putting some of his policies into place, investors have been driving Argentine stocks higher.
• The Global X MSCI Argentina ETF (ARGT, 51.31) has appreciated approximately 23.5% since Milei was elected in mid-November. It is currently posting a total return of 52.0% year to date.

COP28 Climate Change Conference: As the annual United Nations climate change conference came to an end in Dubai today, the delegates issued a compromise statement that calls for “transitioning away from fossil fuels in energy systems, in a just, orderly, and equitable manner.”  That’s tougher than the draft statement we discussed in our Comment yesterday, which, under pressure from major oil producers, omitted any reference to phasing out fossil fuels such as oil, natural gas, and coal.  Nevertheless, the politicking on the issue at the conference and in national capitols recently still seems to reflect growing pushback to climate change rules.

U.S. Monetary Policy: The Fed today wraps up its latest policy meeting, with its decision due at 2:00 pm ET.  The policymakers are widely expected to keep their benchmark fed funds interest rate at the current range of 5.25% to 5.50%.  The question is what they’ll say about future policy moves.  Many investors are hoping for a signal of near-term rate cuts, but as we’ve stated before, we think officials remain focused on rebuilding their inflation-fighting credentials and are more likely to repeat their “higher for longer” mantra.

U.S. Financial Regulation: Yesterday, the House Committee on the Chinese Communist Party released a report suggesting the Fed should stress test U.S. banks’ ability to “withstand a potential sudden loss of market access to China.”  The report said the Fed should also assess how U.S. financial markets might be affected by potential sanctions against Chinese firms in the event of a conflict between the U.S. and China.  As we have written before, the growing U.S.-China geopolitical rivalry will likely lead to stronger state intervention in each country’s economy.

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