by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news that Turkey has agreed to support Sweden’s accession to NATO, creating an even more formidable military bulwark in response to Russia’s invasion of Ukraine.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including today’s voting on a controversial environmental law in Europe and new statements about interest rates by several policymakers at the Federal Reserve.

North Atlantic Treaty Organization:  Just ahead of today’s big NATO summit, the Turkish government yesterday unexpectedly released its veto on Sweden’s accession to the alliance.  According to NATO Secretary-General Stoltenberg, Turkish President Erdoğan agreed to forward Sweden’s accession to the Turkish parliament “as soon as possible” after achieving several concessions from Sweden and NATO.  Those concessions apparently included steps aimed at aiding Turkey’s fight against Kurdish terrorists and the U.S. unlocking the sale of advanced F-16 fighter jets to Turkey.  The Hungarian government has also recently said it would lift its veto of Sweden’s accession.

• The Turkish move helps ensure that the NATO summit will project heightened unity and new strength in response to Russia’s aggression against Ukraine.
• Over the longer term, this year’s accession of both Sweden and Finland to NATO will give the alliance increased overall military strength, better insight into Russian activities in northwestern Europe, and the potential to strangle civilian and military shipping in the Baltic Sea in the event of war with Russia.

China-Taiwan:  In a new sign that Taipei is getting more serious about defending against possible Chinese aggression, the government is holding its biggest civil defense drill in decades today.  This year’s version of the Wan’an air raid drill will take place in districts across the country and include practice evacuations of civilians to bomb shelters.

China:  The China Passenger Car Association yesterday said domestic Chinese brands made up 54% of the country’s wholesale shipments in the first half of 2023, up from 48% in the same period one year earlier.  That marked the second consecutive half in which domestic automakers sold more vehicles than foreign makers did.

• As we have been discussing recently, the surge in domestic brands comes mostly from their sudden improvement in electric vehicles.
• That has sapped the profitability of foreign brands operating in China and serves as a harbinger of the competitive threat that Chinese electric vehicles are likely to pose as they begin to be sold in the rich, highly advanced countries of the world.

European Union:  The European Parliament today and tomorrow will be voting on a divisive nature-restoration law that would require setting aside land to encourage the return of healthy ecosystems.  The law, proposed by the European Commission under the leadership of Ursula von der Leyen, has been criticized for potentially undermining farmers’ livelihoods, preventing wind farms from being built, and putting EU food security at risk.

• Ahead of EU parliamentary elections in June 2024, von der Leyen’s own center-right European People’s Party has come out against the legislation. EPP leaders appear to be concerned that the law would play into the hands of far-right politicians, who are already gaining influence through Europe.
• In an interview with the Financial Times, European Parliament President Metsola, who is also a member of the EPP, has warned that parliament members should refrain from crossing an “invisible line” between ambitious green policies and citizens’ support for the changes imposed on their lives.

United Kingdom:  Average weekly earnings in March through May were up 7.3% from the same period one year earlier, significantly more than anticipated and matching the record gain in the three months to April.  The strong wage growth has prompted even stronger expectations that the Bank of England will keep hiking interest rates, which in turn has given a further boost to the pound (GBP).  So far this morning, sterling is trading up 0.3% to a 15-month high of about $1.2895.

U.S. Monetary Policy:  At events yesterday, San Francisco FRB President Daly and Cleveland FRB President Mester both signaled interest rates should go at least a bit higher, with Mester saying a “somewhat tighter” policy stance would help strike the right balance between tightening too much and tightening too little in the face of price inflation.  The statements are consistent with the rising market expectation that the Fed will raise its benchmark short-term interest rate one or two more times, although perhaps with another pause interspersed.

• Separately, New York FRB President Williams reiterated in a Financial Times interview that he sees a need for a few more rate hikes. In his view, the labor market remains tight enough to drive up wages and inflation, even though he sees signs that labor demand is gradually cooling.
• Williams also noted that he doesn’t currently have a recession in his forecast. Nevertheless, he admitted that he sees “pretty slow growth” in the coming quarters.

U.S. Bank Regulation:  Michael Barr, the Fed’s vice chair for regulation, said in a speech yesterday that larger U.S. banks should further strengthen their capital cushions after the crisis among mid-sized lenders this spring.  According to Barr, a recent Fed review of big banks’ capital requirements suggested they should be required to boost their capital/risk-weighted asset ratio by about 2%.  The speech is being taken as a signal that Fed regulators will formally propose the change later this summer.

U.S. Labor Market:  Amid a general shortage of workers, a number of companies have said in recent earnings reports that a shortage of accountants is hampering their efforts to address weaknesses in financial reporting and control.  The lack of accountants reflects both a recent fall in the number of young people pursuing accounting degrees and a growing share of established accountants who are retiring.

Global Gold Market:  A survey by Invesco (IVZ, $17.37) found that global central banks not only boosted their purchases of gold in 2022 and early 2023, but they also shifted toward buying the physical asset instead of derivatives and opted to hold their gold in their own country.  As we’ve been arguing, the U.S.’s move to freeze Russia’s foreign reserves over its invasion of Ukraine last year has prompted many central banks to purchase more of the yellow metal for their own financial security.  Along with our expectations of higher average price inflation in the future, strong central bank buying is a key reason why we think gold will produce good returns in the medium-to-long term.

Global Green-Tech Minerals Market:  The International Energy Agency has issued a report saying global investment in green-technology mineral resources is starting to catch up with the growing demand for those materials.  According to the IEA, worldwide investment in green-tech mineral facilities rose 30% to more than $40 billion in 2022, building on a 20% increase in 2021.

• Still, the report also cited some negative trends. For example, the rise in investment in 2022 was driven by China, which already dominates the production and refining of key green-tech materials.
• The report also noted that the supply of some of these minerals, such as lithium and cobalt, remains too concentrated.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with multiple China-related reports highlighting the country’s growing frictions with the West and its sharply slowing economy.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the collapse of the Dutch government and a preview of U.S. bank earnings in the second quarter.

China-Japan: We’ve noted many times that geopolitical tensions between China and the U.S. bloc are in a clear escalatory spiral, and that China’s increased military aggressiveness is a big driver of that spiral.  In an important recent example, the People’s Liberation Army naval force sailed its second-largest warship and a destroyer escort through the Osumi Strait, which lies just 40 miles south of Japan’s key island of Kyushu and north of the major U.S. military bases on Okinawa.

• The sailing was unusual because the PLA Navy doesn’t typically use the Osumi Strait to transit to the Western Pacific Ocean. Just as important, the vessel in question was the Guangxi, a Yushen-class, Type 075 amphibious assault ship, which can carry some 800 troops, 60 armored fighting vehicles, and 30 helicopters.  Chinese state media trumpeted the transit as the first time a Yushen-class assault ship had “broken the island chain” south of Japan.
• Now that Japan is strengthening its alliances with the U.S., South Korea, and Taiwan, and now that it is rapidly building up its defenses on its southwestern islands, the sailing of the assault ship so close to Japan’s home islands was likely a subtle reminder that China is prepared to take a fight to Japanese territory if necessary.
• Just as concerning, the sailing came just weeks after President Xi gave a speech in which he described China’s historical relationship to the Ryukyu Islands in Okinawa prefecture in the same way he described China’s relationship with Japan’s Senkaku Islands, which China openly claims.
• In other words, it appears that Xi is issuing the following warning to Japan: If you boost your support for Taiwan, South Korea, and the U.S., we will boost our claims on your southwestern islands. To reiterate, this Chinese military aggression will likely feed the current spiral in tensions and further increase risks for investors, especially those investing in China.  (And if there’s any doubt about that, one should consider how U.S. voters would react if Guangxi had sailed between Maui and the big island of Hawaii.)

China-India-Philippines: Concerns about China’s aggression also continue to drive countries into the evolving geopolitical and economic blocs.  In the latest example, the Indian government for the first time has expressed its opposition to Beijing’s territorial claims against the Philippines.  Our analysis still puts India in the “China-Leaning” bloc, but New Delhi continues to slowly align itself more closely with Washington.  At the same time, Iran this month formally became a member of the China-led Shanghai Security Organization, which cements Tehran as a key member of the China-led bloc.

China: Within China, the June consumer price index was unchanged from the same month one year earlier, weakening further after the tepid gains of 0.2% in the year to May and 0.1% in the year to April.  The almost nonexistent inflation reflects just how weak Chinese domestic demand has become as the economic recovery from President Xi’s “zero COVID” policy continues to falter.  Separately, the June producer price index was down 5.4% year-over-year, reflecting weak demand both at home and abroad.  The reports are weighing modestly on the value of global risk assets so far this morning.

Russia-Turkey-Ukraine: Some key “borderland” leaders continue trying to play the China bloc off the U.S. bloc.  Over the weekend, President Erdogan allowed the release of Ukrainian prisoners of war being housed in Turkey, evidently reneging on an agreement with Russia, a key member of the China-led bloc.  Under Erdogan, the Turkish government has alternatively supported both sides in Russia’s invasion of Ukraine.  The release of the prisoners was likely aimed at mollifying the rest of the NATO alliance ahead of its summit this week.

Russia: The Kremlin spokesman today said that just days after Yevgeniy Prigozhin and his Wagner Group mercenaries staged their short-lived mutiny in late June, President Putin met for three hours with Prigozhin and his top subordinates.  As more details are provided, we’re hopeful that we’ll get a better read on why Putin has gone so easy on Prigozhin and what it all means for Russian political stability.

Netherlands: The parties in Prime Minister Mark Rutte’s government decided to disband the coalition on Friday after failing to reach an agreement on migration policy.  The collapse of the Dutch government means Rutte will now submit his resignation to the king, triggering a new general election in the autumn.

• The collapse also illustrates how migration policy continues to create internal divisions in many European governments. In this case, the key issue was how tight the rules should be for asylum seekers trying to enter the Netherlands.
• These divisions have made some European governments more unstable and have created openings for politicians on the far right of the political spectrum. This increasing instability has the potential to undermine the value of European assets.

Israel: Prime Minister Netanyahu and his far-right government have again launched a judicial reform effort aimed at weakening the power of the supreme court.  The new proposal is somewhat watered down from the one the government put on ice in March after mass protests, but it is nevertheless generating calls for new protests and strikes.

Brazil: The lower house of Congress has approved an important tax reform that could greatly improve the country’s investment environment, cut compliance costs for businesses, and boost economic growth.  If approved by the Senate, the reform would replace today’s large number of different levies with just two value-added taxes, one federal and the other local.  After a transition period from 2026 to 2032, the total VAT rate is expected to be about 25%.  The reform is likely to be positive for Brazilian assets going forward.

U.S. Pension Industry: Stephen Meier, chief of the New York City Retirement System, said the increase in bond yields over the last two years has been healthy and will allow him to shift the allocation of his $250 billion portfolio away from equities and toward fixed income, high-yield bonds, and private assets such as private credit and infrastructure.  The report didn’t indicate the maturity structure of Meier’s planned fixed income allocation, but we continue to believe that longer-maturity obligations may be valued too richly and stand at risk of more price declines.

U.S. Banking Industry: As they kick off earnings season this week, the nation’s largest banks are expected to report their biggest jump in loan losses and reserves against them since the depths of the coronavirus pandemic.  The six biggest banks are expected to show that they benefited to some extent from higher interest rates in the second quarter, but they are also expected to say they had to write off a collective $5 billion in bad loans as borrowers struggled with higher rates and slowing economic growth.  They are expected to announce new loan loss reserves of $7.6 billion.  Both those figures would be about twice as high as in the second quarter of 2022.

U.S. Labor Market: As usual, our Comment on Friday provided a quick overview of the monthly employment report shortly after it came out.  Today, we want to mention one deeper aspect of the report related to our recent argument that the U.S. economy appears to be on the verge of a massive re-industrialization as companies bring production back home from Asia or elsewhere.

• The data show U.S. manufacturing payrolls in June were at their highest level since 2008.
• Nevertheless, factory employment has hit a plateau in recent months.
• We still believe re-industrialization will boost manufacturing jobs in the coming years. Nevertheless, the recent plateau in those jobs is consistent with our view that re-industrialization is just beginning and that the impending recession will hold down factory payrolls in the short term before the full impact of re-industrialization becomes clear in the future.

U.S. Postal Rates:  For the six people or so who still use snail mail, the U.S. Postal Service yesterday hiked the cost of a first-class stamp to $0.66, up 4.8% from the previous cost of $0.63.  It was the second price hike this year and the third in the last 12 months.  With the latest price hike, the cost of a stamp is now up 13.8% since 2021.  Inflation, indeed!

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with the latest development from Treasury Secretary Yellen’s trip to Beijing. Next, we discuss the heightened risk of unrest in Russia. Lastly, we examine why tech companies are looking to take greater control of access to consumer data.

Back to China: While the Biden administration may be willing to make some concessions in order to improve relations with China, it is unlikely to abandon its attempt to pivot away from the world’s second largest economy.

• U.S. Treasury Secretary Janet Yellen called out China for its mistreatment of U.S. firms over the last few months. On her first day in the country, she criticized recent crackdowns on U.S. firms headquartered in China as well as Beijing’s decision to restrict exports of critical minerals needed to make semiconductors. Beijing’s harshness is seen as retaliation for U.S. attempts to limit China’s ability to grow its own semiconductor industry. Although Yellen mentioned that the U.S. is not looking for a winner-take-all approach, it is unlikely that the feud will end in the near future.
• China continues to flex its military muscles in an attempt to show that it is now capable of taking on the U.S. in a direct conflict. Last month, a Beijing think tank released a paper claiming that China’s military is capable of sinking the U.S. Navy’s most advanced aircraft carrier strike group. This claim has largely been dismissed as propaganda, designed to convince Taiwan that China is capable of taking over the region whenever it sees fit. Furthermore, it is still highly doubtful that China is preparing to take over Taiwan anytime soon. Nevertheless, the recent military exercises and propaganda efforts do show that annexing Taiwan remains part of China’s long-term agenda.
• The ongoing meetings between the U.S. and China are unlikely to deter the Biden administration from promoting reshoring efforts. The White House believes that it is in the country’s best interest to “de-risk” from China due to national security concerns. This broader shift will likely lead to a new industrial push in the U.S. On the one hand, reindustrialization can help reduce U.S. reliance on China and other countries for critical goods and services. This shift could improve national security and make the U.S. economy more resilient to disruptions in the global supply chain. On the other hand, reshoring could lead to higher prices for consumers and businesses.

Something Brewing: There are mounting concerns of an imminent armed rebellion in Russia as the Wagner Group does not seem inclined to follow Moscow’s orders to disband.

• Yevgeny Prigozhin, the leader of the Wagner Group, is back in Russia despite agreeing to a peace deal in which he would relocate to Belarus. This report comes from Belarusian President Alexander Lukashenko, who was a key figure in brokering the deal following last month’s failed mutiny. Prigozhin’s presence in Russia is likely to call into question Vladimir Putin’s authority. Although Prigozhin’s whereabouts are unknown, state-run television has shown that his offices and home were raided on Thursday. Despite Putin’s best efforts, the Wagner Group is still a force to be reckoned with and thus the possibility of a civil war cannot be ruled out.
• The controversy may incentivize efforts from the White House to create a potential off-ramp for Russian government officials looking to escape a possible takeover attempt. Last week, CIA officials argued that disarray in Russia has created a massive recruitment opportunity. Additionally, there have been reports that former U.S. officials held informal talks with officials in the Kremlin in April regarding a peace deal, suggesting there is backchannel communication between the two sides. The Russian ruble has declined 12% against the U.S. dollar since Ukraine’s counteroffensive began on June 4, and it is now hovering near a 15-month low. At the same time, Ukrainian dollar bonds have rallied to pre-war levels, further supporting the case that the tide has turned against the Kremlin.

• Putin is running out of time and options. He vastly underestimated the West’s support for Ukraine as well as his own military’s ability to secure a quick victory. More than a year after the conflict began, he is now facing his most serious threat to hold onto power since taking office 23 years ago. The next few weeks will likely be crucial in determining whether he will be able to maintain control of the country. If Putin is removed from office, it is not clear who would replace him. As a result, there is the risk of a power vacuum or even a civil war. This could lead to a sudden spike in commodity prices and a rush to safe haven assets.

Tech Wars: Competition between social media companies is heating up as the major players battle for social media supremacy.

• The rivalry between tech billionaires Elon Musk and Mark Zuckerberg escalated this week as Instagram released its new Threads app in an attempt to provide users with an alternative to Twitter. The app added 30 million new users since Thursday, which still pales in comparison to Twitter’s 300 million subscribers. Musk’s social media company has come under much scrutiny after establishing rules that limit users’ access to the website. Threads, on the other hand, appears to offer similar features with none of the same restrictions. The launch of Threads shows how tech firms that alter their services too quickly may open themselves up to unwelcome competition.
• That said, Musk’s decision to limit access to Twitter’s website may be a way to prepare for a world built around artificial intelligence (AI). Tech companies have been able to use a method known as “scraping” to grab data needed to improve machine-learning algorithms. Scraping can be a valuable tool for AI research as it allows programmers to gather information about Twitter users free of charge. Hence, by protecting the data, Musk is ensuring that he keeps a valuable revenue stream open for future use.
• We are now entering the era of Big Data. This new period will be defined by companies buying and selling information as if it were a commodity. This changing dynamic will be particularly important as companies start to integrate AI into their business processes. Social media companies will likely try to compete in the space to ensure they can offer premium data for these models. Additionally, control over the access of data may be critical for companies looking to profit from the AI craze.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion about friction between policymakers in the U.S. and Europe over the pace and direction of interest rate changes. We will then discuss why households are not as confident in the economy as the data suggests. Finally, we will explain why China may be able to make a comeback later in the year.

Less United: Central bankers in Europe and the United States are still undecided about when to end the ongoing hiking cycle.

• The Federal Open Market Committee was divided on whether to pause rates in June, according to the latest meeting minutes. Despite the lack of any dissents to last month’s pause, some policymakers argued for an increase of 25 basis points in the central bank’s benchmark policy rate. Members who favored a rate hike pointed to recent data showing that the labor market remains tight and inflation remains elevated. Despite the disagreement, Fed officials have left the door open for future hikes, with the market pricing in another quarter-point hike toward the end of the month.
• Despite the economic contraction in the Euro area, members of the European Central Bank are still divided as to whether to increase rates again this year. Earlier this week, Joachim Nagel, a member of the ECB’s Governing Council, advocated for additional rate hikes due to elevated inflation. In contrast, Italian governor Ignazio Visco has cautioned against additional increases in the policy rate as the region continues to assess the damage from previous tightening. The tensions between members of the ECB Governing Council reflect growing anxiety about the state of the Eurozone economies. Most countries in the bloc are showing signs of slowing, which raises the political and economic costs of higher interest rates.

• It will be difficult for central banks to justify their hawkish stance as price pressures continue to ease. Producer prices in the U.S. fell well below 2% in June, a sign that producers are feeling less need to pass on costs to consumers. Similarly, Spain has also seen inflation fall well below 2%, making it the first major Eurozone country to do so. This progress suggests that central bankers are getting closer to achieving price stability. However, it is still unlikely that either the ECB or the Fed will cut rates this year as both central banks fear the return of inflation.

Not Sure: Although the government data shows that the economy remains resilient, households are still worried about a potential downturn.

• Middle-class people are becoming more concerned about an imminent recession. Americans making between $45,000 and $180,000 annually and wealth between $100,000 and $1 million reported higher levels of anxiety regarding the economy, according to polls conducted by Bloomberg. The findings showed that only 39% of survey respondents expect their economic situation to improve within the next year. This report comes amidst a series of positive economic surprises showing that the country is stronger than most analysts believed at the start of the year. The rising anxiety among middle-class Americans is a reminder that the economy is not always as it seems.
• Although consumer spending has reverted to pre-pandemic levels, households are still expressing concerns about their present situation. This reality reflects the growing angst that households are feeling in an economy with rising interest rates and elevated inflation. That said, it does appear the data may be catching up to household perceptions of the state of the business cycle. Average weekly hours have fallen in three out of the last four months, meanwhile initial claims data has been trending higher over that same period. These trends generally serve as a precursor to a weakening labor market. As a result, we still believe that it is too early to say whether or not the economy has averted a downturn as some analysts believe.

• The Fed’s reliance on government data could be its Achilles heel, as it may be limiting its perspective. Initiation rates, which measure the percentage of respondents who agree to participate in a survey, have fallen well below pre-pandemic levels. For example, Fed officials have often cited strong payroll data as a reason to keep monetary policy tight. However, initiation rates for establishment surveys have dropped from 67.0% in February 2020 to 38.5% as of April 2023. This decline in initiation rates raises doubts about the accuracy of the Fed’s data-driven decision-making as it shows that policymakers may not have a complete picture of the economy as it sets interest rate policy. Therefore, the likelihood of a Fed mistake is still somewhat elevated.
  • During the last Fed meeting, policymakers also raised doubts as to whether the payroll data accurately reflects the strength of the labor market.

New Day, New Way: Despite its weak start to the year, China still may be able to finish the year strong.

• Top leaders are expected to hold off from making major economic reforms at the July Politburo meeting. The meeting of the 24 most influential Communist Party leaders is likely to set the stage for economic policy in the second half of the year. Investors will be keen to see how the Chinese government plans to respond to the disappointing economic recovery following the end of pandemic restrictions. Additionally, onlookers will be paying close attention to a potential thaw in tensions with the U.S. as well as the outlook for the Chinese property market.
• Despite the recent misses, there is still optimism that China will be able to turn things around in the second half of the year. The People’s Bank of China (PBoC) has reassured markets that it has ample tools to prevent a severe depreciation of the yuan (CNY) against the U.S. dollar (USD). At the same time, there is hope that U.S. Treasury Secretary Janet Yellen’s visit to Beijing may improve diplomatic ties between the two largest economies in the world. This possible change in trajectory is also reflected in the data. According to the OECD leading economic indicator, the Chinese economy is currently gaining momentum and is outperforming the U.S.

• The changing geopolitical landscape has made it more difficult to predict China’s long-term trajectory. However, there is still a reasonable chance of a market recovery over the next 6-12 months. There are a few factors that suggest this could be the case. First, the government does not appear to be in a rush to sever ties with the West. In fact, it is trying to maintain relations with Europe. Additionally, China may be reluctant to completely isolate itself from the U.S. as it seeks to restore confidence in its economy. Second, it is still possible that the government will implement large-scale stimulus later in the year, as it has in previous major downturns. These factors suggest that China may be better positioned than it was at the start of the year.

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