by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news of more trade frictions between China and the West.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including reports of a new breakthrough in electric vehicle batteries out of Japan and further evidence that the U.S. economy may finally be sliding into recession.

China: The Ministry of Commerce on Monday imposed a license requirement on exports of gallium, germanium, and dozens of other related minerals and metals that are produced and refined mostly in China and are critical for manufacturing semiconductors, modern missile systems, and solar cells.  According to the ministry, the licensing requirement, which will take effect on August 1, aims to protect national security and interests.

• The license requirement is widely seen as an effort to retaliate for the West’s clampdown on sending advanced semiconductor technology to China. It also likely aims to put U.S. Treasury Secretary Yellen on the back foot when she visits Beijing later this week.
• At this point, China will likely issue the required licenses, so exports of the minerals may not be immediately impacted. However, there would be a continuing threat to withhold the licenses and cut the flow of exports.  The licensing regime is therefore a bargaining chip for China as it faces the U.S. technology bans.
• In any case, the move could backfire on China by further highlighting the risk of depending on it for any important good or resource. It will therefore incentivize more “de-risking” by the West.  At the risk of sounding like a broken record, we continue to believe that the unending escalation of tit-for-tat restrictions on trade, technology, and capital flows between the West and China will likely put investors at risk.
  • In one new example of how Western firms are de-risking and building supply chains outside of China, the Indian minister of electronics and information technology said U.S. chip firm Micron Technology (MU, $63.90) will break ground on its first semiconductor assembly plant next month and begin producing the country’s first domestically manufactured microchips by the end of 2024.
  • India is likely to be an important beneficiary of the new, de-risked supply chains, and investors have already begun to bid up Indian assets in response.

China-Russia-Ukraine-European Union: The Financial Times cites unnamed sources as saying that Chinese President Xi in March privately warned Russian President Putin against using nuclear weapons in his faltering invasion of Ukraine.  The sources say Chinese diplomats are now taking credit for holding back Putin from a nuclear war to curry favor with European leaders and split them off from the U.S.’s strong anti-China policies.

• We believe there is still substantially less than a 50% chance that Putin would use a nuclear weapon or start a dangerous escalation toward it.
• Nevertheless, the Chinese diplomatic messaging probably resonates more in Europe than it would in the U.S. That highlights the ongoing challenge the U.S. will face in keeping the Europeans on board with a tougher approach to China’s geopolitical aggressiveness.

Japan: Auto giant Toyota (TM, $160.47) announced it has made a technological breakthrough that will allow it to halve the size, cost, and weight of solid-state batteries for its electric vehicles by 2027 or 2028.  The company said electric vehicles with its new batteries could have a range of over 600 miles and be able to re-charge in 10 minutes or less.

• The announcement serves as a reminder that electric vehicle technology remains in flux.
• As we’ve been writing, China appears to be in the driver’s seat with electric vehicles at the moment. However, its leadership is not necessarily guaranteed for the long term.
• That’s especially true if Western governments restrict Chinese vehicle imports and new, more competitive technologies are developed in the West.

South Korea: The government today announced it will allow new entrants into the country’s banking market for the first time in three decades.  The new policy will allow more online banks, permit commercial bank licenses for existing financial firms, and ease the loan-to-deposit rules for local branches of foreign banks.  The government said the aim is to spur competition after President Yoon Suk Yeol criticized existing banks for enjoying a “feast of bonuses” and “easy” profits as interest rates rise.

South Korea-North Korea: A joint U.S.-South Korean analysis of debris from North Korea’s failed spy satellite launch in May indicated the craft’s surveillance capabilities weren’t military grade in any case.  Although North Korea garners a lot of headlines with its high-profile weapons advances, the findings are a reminder that Pyongyang’s actual capabilities may be less than meets the eye.

Guatemala: After a center-left candidate and an anti-corruption reformer appeared to win the first-round presidential election in June, the country’s top court has ordered a suspension of the official results.  The move has raised suspicions that Guatemala’s political and business elites may be trying to ensure a place for the governing party’s candidate, Manuel Conde, in the two-person run-off election next month.  A victory by Conde would likely preclude any meaningful improvement in the country’s corruption, crime, and political polarization, which have prompted large numbers of Guatemalans to try to emigrate to the U.S.

U.S. Re-Industrialization: In data released on Monday, overall construction spending in May was up a healthy 2.4% from the same month one year earlier.  Private residential spending was down 10.8% on the year, but public works spending was up 13.3%.  Even more impressive, private nonresidential construction spending, a proxy for commercial construction, was up 19.6%, marking the fifth straight month of year-over-year increases at that level or above.

• As we discussed in our most recent Bi-Weekly Asset Allocation Report, the recent jump in commercial construction comes in large part from booming factory construction. To be more precise, much of that increase is being driven by new manufacturing facilities for electrical and information-processing goods like electric vehicles, electric vehicle batteries, and semiconductors.
• We continue to believe the jump in factory construction is early statistical confirmation that the U.S. is in a period of re-industrialization as companies shift much of their production back home from Asia or other foreign locales. We think re-industrialization will create equity opportunities in the broad industrial sector, in construction firms and the service companies that support them, in providers of manufacturing materials and equipment, and potentially even in industrial real estate firms.

U.S. Manufacturing Sector: Despite the burst in factory construction, actual manufacturing activity continues to weaken.  The Institute for Supply Management on Monday said its June ISM manufacturing index fell to a seasonally adjusted 46.0, short of expectations and down from 46.9 in May and 47.1 in April.  As with all major purchasing managers’ indexes, the ISM index is designed so that readings below 50 point to contracting activity.  All the key subindexes are now below that standard, but the real drivers of the overall decline in June came from deepening contractions in production, employment, and inventories.  We believe that confirms a sharp slowdown in factory activity, consistent with the overall economy edging toward recession.

Global Fund Management: The Financial Stability Board and the International Organization of Securities Commissioners have issued guidance saying that funds investing in hard-to-sell assets such as property should charge clients for withdrawing their cash to discourage a rush for the exit in times of stress.  The recommendation is especially pertinent as investors today worry about the value of office buildings amid rising interest rates and work-from-home challenges.  Some major fund managers have already implemented such policies.

LIBOR’s Demise: For one final time, we also want to remind investors that use of the London Interbank Offering Rate, or LIBOR, ended on Friday.  We provided a detailed analysis of LIBOR’s demise and its implications in our Comment on Friday, but to reiterate the main points:

• The Federal Reserve and other regulators moved to end LIBOR and shifted to the Secured Overnight Financing Rate (SOFR) as of Friday.
• One important implication is that the market therefore loses the “TED Spread,” or the spread of Eurodollar yields versus T-bill yields. For years, the TED Spread was one of the key indicators of market stress.  The SOFR/T-bill spread will not likely exhibit the same characteristics as the TED spread.
• Bank loans will also lose a buffer. Bank loans are often tied to LIBOR as a base rate.  A typical floating loan is LIBOR plus a spread.  Since LIBOR rates would rise during periods of financial stress, banks were provided a modicum of protection from such events.  Since SOFR is collateralized, the rate relative to the risk-free rate shouldn’t rise when credit conditions deteriorate, so we would expect loan pricing to eventually change to reflect the shift.
• Credit lines could be utilized more frequently during periods of stress. Banks routinely issue credit lines to corporate borrowers, assuming few will use them.  Tying the credit line to a LIBOR rate tended to discourage credit line use because (as noted above) the LIBOR rate would rise when credit conditions weakened.  Since SOFR is secured, the rate probably won’t rise when stress emerges, which may encourage the use of credit lines just at the moment when banks would rather see them lay dormant.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with energy news, including further oil output cuts by Saudi Arabia and Russia, as well as a spate of negative prices for wholesale electricity in Europe.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including further EU support for “de-risking” its supply chains with China and yet another significant strike in the U.S. labor market.

Global Oil Market: The governments of Saudi Arabia and Russia today announced they will further cut their oil production in August to boost prices as global demand slows.  Russia alone will cut its output by an additional 500,000 barrels per day.  Nevertheless, slowing economic growth and expectations of a recession in the U.S. continue to weigh on prices for oil and some other commodities.  So far this morning, nearby Brent crude futures are trading at $76.03 per barrel, up just 0.8% on the day.

European Union: Another commodity with weak pricing these days is wholesale electricity in the EU.  Prices were negative for much of the weekend and for an entire day in Germany, reflecting ample natural gas supplies and a surge of new solar and other green energy sources amid sunny weather.  The negative prices can complicate finances for utility firms and will likely spur more interest in batteries and other storage mechanisms.

European Union-China: At their summit on Friday, the EU’s 27 national leaders formally supported European Commission President Von der Leyen’s call to “de-risk” supply chains with China.  Although the leaders also stressed that they don’t want to completely “de-couple” from China, the statement illustrates how EU leaders continue to shift toward the U.S. position of taking a stronger stance toward China’s political, economic, and military aggressiveness.  As we have noted many times before, these de-risking policies and China’s reaction to them are growing risks for investors.

• On a related note, the Dutch government has tightened its restrictions on selling advanced semiconductor manufacturing equipment to China, as requested by the U.S. Starting September 1, top equipment maker ASML (ASML, $724.75), which is headquartered in the Netherlands, will be required to get a license before selling its most advanced immersion deep ultraviolet (DUV) lithography systems to customers in China.
• On China’s side, the country’s new anti-espionage law went into effect on Sunday. The law potentially criminalizes the release of even basic economic and corporate financial information.  It also could compel locally employed Chinese nationals of Western companies to assist in Chinese intelligence efforts.

China: The Communist Party has named Pan Gongsheng, head of the State Administration of Foreign Exchange, to be its new party chief at the People’s Bank of China.  Not only does the appointment highlight how President Xi has pushed for stronger party representation in public and private organizations, but it has also raised speculation that the central bank could be preparing to defend the renminbi, which has recently weakened to a seven-month low against the dollar.

Brazil: The country’s top electoral court on Friday convicted right-wing Former President Bolsonaro of abusing his political power and misusing the media ahead of last year’s election.  The decision bans Bolsonaro from running again for any political office until 2030, which would likely end his political career, but the former president is likely to appeal to the Supreme Court.  In sum, the electoral court’s decision and ongoing criminal investigations against Bolsonaro suggest the Brazilian investment environment will remain unstable in the near term.

U.S. Labor Market: Thousands of hotel workers in Los Angeles went on strike for higher pay and better benefits yesterday.  Along with the many other strikes we’ve reported on recently, the hotel workers’ strike reflects the increased cost of living and workers’ realization that they have greater bargaining power amidst today’s labor shortages.

• Over much of the last two years, galloping price inflation was more than enough to offset the jump in wage rates. The resulting drop in inflation-adjusted compensation or “real” purchasing power goes far toward explaining today’s worker activism, low consumer sentiment, and the Biden administration’s low approval ratings.
• We would note, however, that the modest cooling in inflation in recent months has started to boost real income. This chart shows that disposable personal income (i.e., income after taxes) is now up about 3.5% year-over-year even after stripping out taxes.  That could potentially cool worker dissatisfaction and help Biden politically going forward.

U.S. Travel Market: AAA estimates that 43.2 million people will travel by automobile for the Independence Day holiday this year, which is 4% higher than the previous all-time high of 41.5 million in 2019.  The organization’s analysis suggests the jump in travel will come largely from the fact that gasoline prices this year are about 30% lower than their peak early last summer, at a national average of $3.49 per gallon.

U.S. Student Loan Market: Despite the slowdown in inflation and the jump in consumer purchasing power at the present, we’re increasingly focused on the risk that consumption demand could suddenly slow in October, when the pandemic-era pause on student loan repayments ends and 27 million people have to start writing those checks again.  In addition, the Supreme Court on Friday invalidated President Biden’s student loan forgiveness plan, which would have cancelled up to $20,000 of debt for some particularly low-income borrowers.  Even though the administration is reportedly working on rules to ease the transition back to normal, the shock of sudden new debt service payments could well undermine consumption spending and finally bring about the recession that we’ve been expecting for some time.

LIBOR’s Demise: Finally, we think it’s important to remind investors that use of the London Interbank Offering Rate, or LIBOR, ended on Friday.  We provided a detailed analysis of LIBOR’s demise and its implications in our Comment on Friday, but to reiterate the main points:

• During the Great Financial Crisis, it was discovered that banks were manipulating their reported interest rates to help their respective institutions and, in the most egregious cases, encouraging other banks to do the same as “a favor.” Because LIBOR was the rate tied to the Eurodollar futures market, this manipulation ran afoul of U.S. commodity trading regulations.  In the wake of the scandal, the Federal Reserve and other regulators moved to end LIBOR and shifted to the Secured Overnight Financing Rate (SOFR) as of Friday.
• One important implication is that the market therefore loses a key data point. For years, one of the key indicators of market stress was the T-bill over Eurodollar spread, commonly called the “TED spread.”  Since LIBOR represented non-government guaranteed dollar deposits, there was credit risk embedded in the rate.  Market participants began to notice that when credit stress developed in the financial markets, the TED spread would widen, with LIBOR rates rising above T-bill rates.  The SOFR/T-bill spread will not likely exhibit the same characteristics as the TED spread, meaning that traders and investors will lose the TED spread as a market indicator.
• Bank loans will also lose a buffer. Bank loans are often tied to LIBOR as a base rate.  A typical floating loan is LIBOR plus a spread.  Since LIBOR rates would rise during periods of financial stress, banks were provided a modicum of protection from such events.  In other words, the rate on LIBOR-based loans would rise as stress levels rose.  Assuming the borrower remains current, the rise in the loan’s rate would exceed the level of the risk-free rate by a wider margin.  This protection would allow banks to offer more competitive rates to borrowers, knowing that the lender had some protection from financial stress events.  Since SOFR is collateralized, the rate relative to the risk-free rate shouldn’t rise when credit conditions deteriorate.  Eventually, we would expect loan pricing to change to reflect the shift.
• Credit lines could be utilized during periods of stress. Banks routinely issue credit lines to corporate borrowers, assuming few will use them.  Tying the credit line to a LIBOR rate tended to discourage credit line use because (as noted above) the LIBOR rate would rise when credit conditions weakened.  Since SOFR is secured, the rate probably won’t rise when stress emerges, which may encourage the use of credit lines just at the moment when banks would rather see them lay dormant.

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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 farewell to LIBOR and ends with a few comments on the overnight news.

The End of LIBOR: As of today, the use of the London Interbank Offering Rate, or LIBOR, will end.  LIBOR developed in London as an ad hoc arrangement in 1969 to set the rate on an $80 million syndicated loan to the Shah of Iran.  By the mid-1980s, the process of establishing the LIBOR rate was formalized by the British Bankers Association (BBA).  A set of London banks would submit their borrowing rates for 15 different maturities and up to 10 different currencies.  The LIBOR rate originally was tied to the Eurodollar market, which represented unregulated dollar deposits held offshore, but over time (especially with the end of Regulation Q in the U.S., which set deposit rates), LIBOR was designed to reflect bank cost of funds.  The BBA would calculate a trimmed-mean average by removing the top and bottom four rates.

During the Great Financial Crisis, it was discovered that banks were manipulating the submissions to help their respective institutions and, in the most egregious cases, encouraging other banks to do the same as “a favor.”  Because LIBOR was the rate tied to the Eurodollar futures market, this manipulation ran afoul of U.S. commodity trading regulations.  In the wake of the scandal, the Federal Reserve and other regulators moved to end LIBOR and shifted to the Secured Overnight Financing Rate (SOFR). And so, effective today, LIBOR is no longer being calculated and will not be available for loans.

What are the ramifications?

We lose a market indicator: For years, one of the key indicators of market stress was the T-bill over Eurodollar spread, commonly called the “TED spread.”  Since LIBOR represented non-government guaranteed dollar deposits, there was credit risk embedded in the rate.  Market participants began to notice that when credit stress developed in the financial markets, the TED spread would widen, with LIBOR rates rising above T-bill rates.

The Chicago FRB National Financial Conditions index rises when financial stress develops.  As the chart shows, the TED spread tends to widen when stress increases; in fact, the two series are correlated at 92.6%.  Since the SOFR rate is secured lending, meaning it is collateralized by a safe asset, it should not exhibit the same reaction to financial stress.  Essentially, the SOFR/T-bill spread will not likely exhibit the same characteristics as the TED spread, meaning that traders and investors will lose the TED spread as a market indicator.

Banks will lose a buffer: Bank loans are often tied to LIBOR as a base rate.  A typical floating loan is LIBOR plus a spread.  Since LIBOR rates would rise during periods of financial stress, banks were provided a modicum of protection from such events.  In other words, the rate on LIBOR-based loans would rise as stress levels rose.  Assuming the borrower remains current, the rise in the loan’s rate would exceed the level of the risk-free rate by a wider margin.  This protection would allow banks to offer more competitive rates to borrowers, knowing that the lender had some protection from financial stress events.  Since SOFR is collateralized, the rate relative to the risk-free rate shouldn’t rise when credit conditions deteriorate.  Eventually, we would expect loan pricing to change to reflect the shift.

Credit lines could be utilized during periods of stress: Banks routinely issue credit lines to corporate borrowers, assuming few will use them.  Tying the credit line to a LIBOR rate tended to discourage credit line use because (as noted above) the LIBOR rate would rise when credit conditions weakened.  Since SOFR is secured, the rate probably won’t rise when stress emerges, which may encourage the use of credit lines just at the moment when banks would rather see them lay dormant.

At the end of May, some $700 billion of high-yield loans remained priced at LIBOR.  We do expect some loans will slip through the deadline.  The rate behavior of these loans will depend on the loan covenants in place.  It is not inconceivable that the loans become essential fixed rate at today’s closing LIBOR rate.  Although the financial industry has had ample time to adjust and prepare, some issues may still emerge.  But, as we note above, the bigger issue is that this change could lead banks to inadvertently take risk.  From our perspective, the loss of the TED spread is a disappointment; although other credit signals exist, the TED spread was an easily accessible way to view financial stress.  Adieu, TED…

In Other News: Inflation is falling in the Eurozone, and currencies in the two largest Asian economies are plummeting against the dollar.  Meanwhile, France is still trying to get protests under control.

• June CPI for the Eurozone declined from 6.1% to 5.5%. The reading was lower than the consensus estimate of 5.6% but still above the European Central Bank’s 2% target.  Although the decline will be welcomed by the central bank, it is unlikely to dissuade policymakers from further tightening.  The ECB has raised rates in eight consecutive meetings and is expected to do so again in July and September.  Futures contracts show that traders are pricing in an additional rate increase of 50 bps by the end of the year.
• Japanese and Chinese currencies are weakening relative to the dollar for opposite reasons. The yen is weakening as traders doubt that the Bank of Japan (BOJ) will tighten monetary policy to counteract rising inflation.  In contrast, the yuan has dropped as China’s central bank, the People’s Bank of China (PBOC), refuses to provide sufficient stimulus to support its struggling economy.  The currency weakness has led the PBOC to intervene through fixing to support the yuan and is expected to lead to action from the BOJ.

The chart above is inverted to show that an increase in the price of a U.S. dollar in another currency reflects a depreciation.

• In France, President Emmanuel Macron is struggling to contain protests following a police shooting of an unarmed teenager. Over 875 people were arrested in France on Friday in the third consecutive night of protests.  Prime Minister Elisabeth Borne is considering setting up a crisis meeting to deal with the situation.  The unrest in France is likely to further diminish President Macron’s popularity, which was already hurt by his handling of pension reforms and other protests.

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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 the market reaction to Wednesday’s financial stress test report. Next, we review the political risks central bankers face as they look to raise rates. Lastly, we will expand upon yesterday’s comments about potential curbs by the U.S. on AI sales and how they could contribute to tensions between the U.S. and China.

Banks on the Rise: Investors are beginning to dismiss concerns of an impending banking crisis as the financial system demonstrates its resilience since the turmoil in March.

• All 23 banks were able to pass the Federal Reserve’s annual stress test. The review examines these banks’ ability to weather a severe financial crisis while continuing to provide credit throughout the economy. The positive results lifted investor sentiment regarding the sector after the failure of several regional banks sparked concern over the financial system in March. Banks are expected to benefit from a relaxation of capital requirements, which should make it easier for them to issue more loans and may lead to higher shareholder payouts.
• Despite major banks catching a potential tailwind from the passage of the stress test, new regulations are expected in the coming months. Federal Reserve Chair Jerome Powell has stated that he is open to additional bank limits to protect against a repeat of the banking events that took place in March. During a conference in Madrid, Powell insisted that the regional banking turmoil would have been much worse had the largest banks been undercapitalized and illiquid. Hence, we do not think the optimism will likely spread into regional banking stocks anytime soon. 
• Disintermediation remains the greatest risk to banks as the Federal Reserve continues to raise policy rates. As the chart above shows, commercial banks are losing deposits at their fastest rate in at least 60 years. This trend has slowed over the past couple of months but will likely not reverse anytime soon as depositors look to take advantage of higher-yielding alternatives such as U.S. Treasury bills and money market funds. We do not think this is a major problem right now, but we do believe it could get worse as the Fed increases its policy rate.

Future Clash: As central bankers prepare the world for more hikes, lawmakers are starting to push back.

• On Wednesday, several central bank leaders vowed to push through further rate hikes as they aim to restore price stability. Fed Chair Powell insisted that policy rates are not restrictive enough to bring down inflation. At the same time, European Central Bank President Christine Lagarde and Bank of England Governor Andrew Bailey made similar statements. The hawkish tone among monetary policymakers comes as the labor market remains relatively tight in much of the developed world. Futures markets expect the end-of-year policy rate to be 25 basis points higher than current levels in the U.S., 50 basis points higher in the EU, and 100 basis points higher in the U.K.
• The seemingly never-ending monetary tightening cycle is starting to unnerve lawmakers. Italian Prime Minister Giorgia Meloni argued that the rate hikes would hurt other Eurozone economies. This sentiment was echoed by American lawmakers, led by Senator Elizabeth Warren, who wrote a letter to Fed Chair Powell requesting him to pause rate hikes. Meanwhile, members of the British Tory Party are growing worried that the impact of the BOE interest rate hikes on mortgages will hurt them at the polls. The furor over the central banks’ handling of the economy is unlikely to subside, with politicians already starting to point fingers at the institutions as their economies head into recession.
• Tightening monetary policy is a relatively straightforward decision when inflation is rising and economic growth is strong. However, the situation becomes more complex when a recession is looming. The EU is already in an economic contraction, and the U.S. and U.K. economies are expected to decline in the second half of the year. This means that policymakers will likely face more political pressure to ease away from tightening to prevent exacerbating a potential downturn. So far, market participants seem to believe that the next recession will be relatively mild. However, these opinions may change if central banks continue to tighten monetary policy.

Chip Wars: Semiconductor firms get caught in the crosshairs as the U.S. and China tangle for AI supremacy.

• Following reports that China has been able to access banned chips through the black market, the U.S. is considering implementing new export restrictions on semiconductors. The South China Morning Post reported on Tuesday that firms in China have been able to purchase banned chips from the Chinese social media site Douyin. This has drawn the ire of the Biden administration, which is expected to offer updated restrictions by the summer. Regulators are considering requiring companies to apply for a license to send chips to China. Speculation about the updated export controls to China is likely to hurt revenues for chip companies.
  • Despite the tech-heavy NASDAQ closing up 0.3% on Tuesday, the Philadelphia SOX index, which tracks semiconductor companies, fell 0.9%. This suggests that so far investor wariness has not led to an overall sell-off of tech stocks.
• In addition to black market purchases, China is still trying to convince native investors to develop the country’s AI industry. Beijing hopes that billionaires within the country will pour money into AI as it tries to bridge the gap between tech companies in Silicon Valley. Although two major powers are home to the top seven AI companies in the world, Chinese investment into the sector still lags behind the U.S., which totaled $26.6 billion in the year to mid-June versus China’s $4 billion. Additionally, the decision to spur domestic investment is also related to expectations that President Biden will unveil limits on investment in China. 

• The battle over AI is likely to add another layer to the overall tense relationship between the U.S. and China. The U.S. has an advantage in chipmaking and investment, which currently gives it an edge , but this lead may not last long. According to Kai-Fu Lee, a prominent AI specialist and Chinese influencer, Chinese chatbot technology is likely to lag behind its American competitors for now but should catch up relatively quickly. The competition between the two countries is likely to lead to increased state aid for the AI industry in both countries, which should provide a tailwind for tech companies. However, AI-related stocks may experience bouts of volatility due to uncertainties over regulation.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with some interesting new revelations on the weekend’s short-lived rebellion in Russia.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including signs of growing pushback against the European Central Bank’s aggressive interest rate hikes and news of a potential new clampdown on the sale of artificial intelligence-related computer chips to China, which is weighing significantly on technology stocks so far today.

Russia Rebellion: Reports yesterday confirmed that Yevgeniy Prigozhin, the erstwhile ally of President Putin who led his Wagner Group mercenaries in a short-lived mutiny against the Ministry of Defense over the weekend, has landed in Belarus as agreed upon in a deal brokered by Belarusian President Lukashenko to defuse the crisis.  However, the extent to which the Wagner mercenaries will be disarmed or subsumed into the traditional armed forces remains unclear.

• Separately, President Putin claims the deal that convinced Prigozhin to cease his march on Moscow involved paying off him and his fighters with billions of dollars from the Russian government.
• As we have assessed previously, the incident has surely weakened Putin by undermining his popular image as a strong leader who doesn’t brook dissent and doesn’t back down from a fight. Putin’s admission that he paid Prigozhin and the Wagner fighters billions of dollars would likely further undermine Putin’s image.
  • Separately, new reports say Prigozhin initially planned to seize Defense Minister Shoigu and Chief of the General Staff Gerasimov when they visited southern Russia over the weekend. Prigozhin apparently expected that lower-level officers and troops would then swing to his support.  Indeed, he apparently sounded out some top generals about their potential support.  It looks like one of those officials alerted Russian domestic intelligence, forcing Prigozhin to move up his timetable and improvise his mad dash toward Moscow.
  • As if to confirm that scenario, U.S. intelligence has reportedly discovered that one or more senior Russian generals knew about Prigozhin’s plans ahead of time and may even have helped him.
  • If true, the reports suggest the Defense Ministry and the military leadership may be deeply fractured and riddled with dissent. That, too, would weaken Putin politically, although reports today say Putin is carrying out a widescale purge of disloyal officers throughout the military.
• At the same time, it’s entirely possible that Putin is whitewashing the real deal that got Prigozhin to back down. One theory that we find compelling is that the payoff to Prigozhin and his fighters actually came from powerful Russian oligarchs who had much to lose if the country descended into civil war or if Putin were deposed.
• In any case, if Prigozhin remains safely ensconced in Belarus, he will likely remain a political threat to Putin and his government for the foreseeable future.

Eurozone: Italian Prime Minister Meloni, in an impassioned speech to parliament earlier today, lashed out at the European Central Bank for its aggressive interest rate hikes.  According to Meloni, the ECB’s “simplistic” approach to fighting consumer price inflation would hurt Eurozone member countries more than it would help them.  Meloni said today’s high inflation was tied to the last year’s energy price shock, implicitly arguing that the ECB should look past the problem.  In any case, her statement points to growing pushback against the ECB’s plan to keep raising rates in the near term.

France: The suburbs surrounding Paris were wracked by rioting overnight following an incident in which police officers shot and killed a teenager during a traffic stop.  The violence was touched off after citizen video of the killing showed that police killed the driver, who was apparently unarmed, as he attempted to drive away.  Thousands of police have been deployed to control the rioting, which exacerbates the disruptions caused by this summer’s frequent protests against President Macron’s unpopular new retirement system reform.

United Kingdom: Senior physicians working for the National Health Service in England have voted to strike for higher pay next month.  We haven’t written much about the summer of labor action in the U.K. recently, but the latest vote shows that the country (and government) continues to face increased demands from employees in both the public and private sectors.  To the extent that the strikers win higher pay, it will likely bolster the U.K.’s current high price inflation and prompt still more interest rate hikes by the Bank of England.

Japan-China: In another apparent case of Chinese technology theft, a Chinese researcher at Japan’s National Institute of Advanced Industrial Science and Technology (AIST) has been arrested on suspicion of illegally sending research data obtained at the institute to a Chinese company.  The spate of these cases is likely to further worsen relations between China and the major developed countries, which we have frequently argued will likely present risks to investors.

United States-China: As the U.S. clamps down on selling advanced technology with potential military applications to China, sources say Chinese users have developed a large black market in smuggled U.S. computer chips.  The Chinese are reportedly focused on acquiring the graphics processing units (GPUs) needed to train artificial intelligence systems, such as the A100 and H100 from Nvidia (NVDA, 418.76).  The report says the black market has thousands of individual intermediaries sourcing the chips, often at a considerable premium to list prices.

• This news suggests the U.S. technology clampdown will merely slow China’s AI development but probably won’t completely stop it.
• In response, reports say the Biden administration is considering further restrictions on the sale of AI-related chips to China. Any such action would be included in the final rules codifying and expanding the administration’s October export control measures.  Since the new rules would apply even to the less-advanced chips that Nvidia and other makers are currently allowed to sell to China, the news is weighing heavily on semiconductor firms so far this morning.

U.S. Cybersecurity: Cybersecurity experts are becoming increasingly concerned about a recent, little-noticed hack of software firm Progress Software Corp. (PRGS, $54.00).  After Russian hackers broke into the company’s systems and stole sensitive data from hundreds of its corporate customers, investigators expected the criminals to launch extortion scams against them.  However, now it appears the criminals are focused on sensitive personal data that could be used, in conjunction with deepfake software, to launch more lucrative extortion scams against masses of individuals.

U.S. Uranium Market: As we wrote in our Bi-Weekly Geopolitical Report from May 15, 2023, we think global uranium prices will be buoyed in the coming years by heightened U.S.-China tensions and a potential new nuclear arms race between the two countries.  As if to confirm that viewpoint, a number of nuclear-related asset prices have recently been climbing.  The latest data shows spot prices for uranium (triuranium octoxide) are up roughly 18% year-to-date, while the share price for Canadian uranium miner Cameco Corp. (CCJ, $29.58) is up 29%.

U.S. Private Credit Market: Moody’s (MCO, $338.83) has issued a report warning that the young private credit industry faces its first serious challenge as tens of billions of dollars of loans underwritten at the top of the market in 2021 are strained by sharply higher interest costs and a slowing economy.  Nevertheless, the credit rater didn’t downgrade its ratings or outlook for any of the major, publicly traded firms in the sector.

U.S. Supreme Court: As we noted in our Comment yesterday, investors are still bracing for the release of several key decisions over the coming days before the court ends its current term on Friday.  The expected decision with perhaps the most implications for businesses will relate to the legality of affirmative action in college admissions.  Whatever the justices rule, the decision is likely to affect affirmative-action policies in corporate settings as well.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on Russian political stability following the weekend rebellion by Wagner Group mercenaries.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including fresh signs of further interest rate hikes in the Eurozone, the likelihood of currency market intervention in Japan, and some unexpected good news for office valuations in New York City.

Russia: In the aftermath of the short-lived weekend mutiny by Yevgeniy Prigozhin and his Wagner Group mercenaries, President Putin and Prigozhin himself spent yesterday trying to spin the events to their favor.  In a televised statement, Putin pilloried Wagner for threatening bloodshed and extolled the Russian people for rallying around their government, despite clear evidence that many Russians were indifferent to Putin’s fate and supported Prigozhin.  Meanwhile, Prigozhin insisted he had never tried to topple the government itself, despite the fact that his troops marched to within 125 miles of Moscow and killed over a dozen Russian aviators.

• Having survived the rebellion, at least for now, Putin has tried to go on the offensive against Prigozhin, initially announcing through his government that the Wagner leader still might be arrested and offering the Wagner troops just three options: sign up as regular soldiers in the official armed forces, go home, or follow Prigozhin into exile in Belarus. The Putin government today also said that Wagner’s heavy weapons would be transferred to the national guard.
• In any case, Putin’s statement suggests Wagner is finished as an independent, organized force. A key question will be whether Prigozhin accepts that fate as it would render him completely powerless.  As we mentioned in our Comment yesterday, the crisis in Russia’s leadership is almost certainly not yet over.

Russia-Bulgaria: Bulgarian Economy Minister Bogdan Bogdanov suggested Russia may have been behind the explosion and fire that struck another weapons factory over the weekend.  As Bulgaria has helped Ukraine arm its military in recent years, a number of the country’s defense industry facilities have suffered mysterious mishaps that are widely seen as Russian sabotage.

Eurozone: At the European Central Bank’s annual conference in Portugal today, ECB President Lagarde said tight labor markets, rising wages, and sticky price inflation will require “persistent” new interest rate hikes in the coming months.  The statement provides additional evidence that the ECB’s benchmark rate will continue to move higher from its current level of 3.5%.  If the Federal Reserve continues to slow its rate hikes, or if it stops them altogether, the additional rate hikes in the Eurozone could help push the value of the euro beyond its current resistance level of approximately $1.10 per dollar.

• Despite the hawkish stance taken by Lagarde and many other key central bank leaders, IMF Deputy Managing Director Gopinath warned at the conference that they may need to pull their punches and allow inflation to remain above the 2% target for some time if rate hikes threaten to cause a financial crisis.
• According to Gopinath, the central bankers risk being faced with a stark choice between solving a future financial crash among heavily indebted countries and raising borrowing costs enough to tame stubborn inflation.

Japan: With the yen continuing to lose value, top currency official Masato Kanda yesterday said he would not rule out any options regarding intervention in the currency market, and Finance Minister Shunichi Suzuki today said the authorities would “respond appropriately” if the drop becomes excessive.

• So far today, the yen is trading at approximately 143.57 against the dollar, down almost 11% from its most recent high early this year.
• The yen is still a bit stronger than the 150.15 per dollar level that it hit last October before the government stepped in to buy up yen and sell foreign reserves to prop up the currency. Nevertheless, it is looking increasingly likely that the Japanese government could soon intervene in the currency markets again to prop up the yen.

Indonesia: President Widodo has indicated in a speech that he won’t back down on a new law that bans the export of bauxite ore despite concerns that China could file a complaint about it at the World Trade Organization.  The law forces miners to refine their bauxite into aluminum before it can be exported, thereby creating domestic manufacturing jobs.  It is similar to an older rule banning the export of raw nickel ore.  The rules exemplify the growing global trend toward industrial policy that intervenes in the free market to bolster domestic industrial development.

United States-China: U.S. Treasury Secretary Yellen plans to visit Beijing in early July to meet with her new Chinese counterpart, according to press reports.  The meeting would mark another step in the Biden administration’s efforts to ease tensions with China, or at least to been seen as doing so.  However, if the meeting happens, it could come just before the administration announces new measures aimed at further curtailing U.S. investments in China.  Prospects for improved relations from the meeting therefore seem low.

U.S. Dollar: The latest annual survey of central banks by the Official Monetary and Financial Institutions Forum (OMFIF) found that reserve institutions managing almost $5 trillion of assets combined expect the U.S. dollar to decline only gradually as a proportion of global reserves over the coming decade.  The surveyed banks estimate the greenback will still account for 54% of total global reserves in 10 years’ time compared with 58% currently.

U.S. Stock Market: Just in the month through yesterday, investors have now bought more call options on the VIX volatility index than in any other month on record.  The data suggests that investors are becoming more concerned that stock prices could turn volatile after a relatively smooth, technology-driven run up for the year to date.  Since we continue to believe the economy is likely to slip into recession in the second half of the year, we would not be surprised if the U.S. stock indexes stage a significant retreat in the coming months.

U.S. Commercial Real Estate Market: Rising interest rates and work-from-home trends continue to batter office owners and commercial real estate lenders, but real estate investment trust SL Green (SLG, $28.20) has managed to sell its stake in a prime New York City office tower at a price that values the building at $2 billion.  The price was only a modest decline from the building’s previous value, giving a healthy boost to much of the REIT sector in trading yesterday, including a 19.8% jump in SL Green shares.

U.S. Supreme Court: With the court wrapping up this year’s term on Friday, investors are bracing for the release of several key decisions over the coming days.  The expected decision with perhaps the most implications for businesses will relate to the legality of affirmative action in college admissions.  Whatever the justices rule, the decision is likely to affect affirmative-action policies in corporate settings as well.

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