Daily Comment (August 4, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment begins with a discussion on the central banks’ decision to raise rates despite slowing economic growth. Next, we examine how rising geopolitical risks make it more difficult for firms to rebuild their supply chains. We end the report with an update on the climate and drug bill.

 Monetary Policy: Central banks in the U.S., U.K. and the Eurozone appear to be plowing ahead with tighter monetary policy even as their economies slow.

  • Fed officials downplayed expectations that the central bank was close to ending its tightening cycle. Despite the disappointing economic data, regional Fed Presidents Neel Kashkari and Thomas Barkin dismissed speculation that the Fed was finished raising rates and warned of a possible recession. Meanwhile, St. Louis Fed President James Bullard, a voting member, insisted that the central bank must front load big rate hikes to cool inflation. Additionally, he revealed his desire for the Fed’s policy rate to be between 3.75% and 4.00% by the end of the year.
  • To keep pace with the Federal Reserve, the Bank of England raised its benchmark rate by 50 bps on Thursday. Although the increase is less than the Fed’s 75 bps hike in July, the rate rise was the country’s largest in 27 years. By increasing its policy rate, the BOE aims to prevents the pound from depreciating against the dollar and exacerbating the country’s inflation problem. The BOE warned that the country is expected to fall into a recession and that inflation could rise as high as 13%.
  • The European Central Bank appears to have used funds from maturing bonds in the portfolio of its pandemic program to purchase the debt of southern European economies. The data showed that the bank’s net holdings of German, French, and Dutch bonds dropped by 18.9 billion euros in July. In the same month, statistics showed that the bank made 17.3 billion euros of net debt purchases from Italy, Spain, Portugal, and Greece. The central bank’s intervention suggests it will also aggressively raise rates in its next meeting.

Strong U.S. economic growth and tight monetary policy have pushed the euro and British pound to near multi-decade lows against the dollar. The depreciation of the euro and pound have contributed to the inflation problem in their respective regions as it makes dollar-priced commodity imports more expensive. Unfortunately, neither the EU nor U.K. economies have expanded at the same rate as the U.S. since the pandemic started in 2020. As a result, they likely have less flexibility in raising rates. Although all three regions have elevated recession risks, the EU and U.K. are in a worse position than the U.S.

Geopolitical Risks: As the calls for a ceasefire in the Ukraine-Russia war become increasingly louder, conflicts in other parts of the world are becoming more noticeable, making it difficult for firms to return to pre-pandemic normalcy.

  • European leaders are now pushing Ukraine to engage in ceasefire talks with Russia. On Wednesday, former German Chancellor Gerhard Schröder urged Kyiv to negotiate with Russia to end the conflict and modify its demands. Meanwhile, the Irish president and his wife stirred controversy after the first lady posted a letter on the presidential website pleading for world leaders to encourage ceasefire talks. The push by Putin’s allies within Europe is evidence that the conflict may be headed toward a pause. Ukrainian President Volodymyr Zelensky has also sought a meeting with Chinese President Xi Jinping to help negotiate an end to the contest. However, Xi has not replied to any of his requests to talk.
    • Although the possible end of the conflict is good news, it is foolhardy to assume that the relationship between Europe and Russia will return to normal. Russia’s weaponization of its natural resources will mean Europe will still need to reduce its dependence on Russia significantly. Meanwhile, Russia’s limited ability to deliver its natural gas to countries outside of Europe suggests it also needs to invest in building its pipeline capacity to new regions. Figuring out how to remove sanctions is another can of worms no one in the West wants to open. Although it is too early to determine whether the conflict will end soon, the path toward de-escalation is forming.
    • The U.S. and Italy has passed legislation that will allow Sweden and Finland to enter NATO.
  • As the U.S. gears up for another round of nuclear talks, there is speculation that Iran might direct its proxies to attack American and partner targets in the region. Such an attack could lead to a crisis in the Middle East and push up the price of commodities like oil. Iran blames NATO for the recent unrest in Iraq. Over the weekend, protesters stormed the Iraqi parliament to demand new parliamentary elections. The rising tension between the West and Iran suggest that the Middle East remains politically unstable.
  • China engaged in more military drills around the Taiwanese peninsula the day after U.S. Speaker of the House Nancy Pelosi visited the self-ruled island. In China’s most immense provocation in 16 years, its military launched several missiles into Taiwanese waters. The drills are expected to continue until Sunday. However, possible escalation cannot be ruled out. China is in a difficult bind. Pelosi’s visit undermines Beijing’s argument that the U.S. views it as a threat. Meanwhile, U.S. politicians on both sides of the aisle are pushing for Washington to take a tougher stance against China. As a result, we believe that the risk of possible miscalculation leading to direct conflict is elevated.
    • The White House is attempting to rein in Congress after Pelosi’s trip to Taiwan has encouraged politicians to flex their toughness on China’s credentials going into the mid-terms. The Senate is currently working on legislation that would designate the sovereign island as a major non-NATO ally.

One of the trends that we are noticing is that the world is becoming increasingly hostile. Rising global tensions will make it difficult to repair supply chains and could accelerate U.S. firms’ withdrawals from the rest of the world. This shift from relying on global supply chains in emerging markets will be expensive in the short term as firms look to adjust to this new normal.

Biden’s Agenda: The U.S. Senate is expected to pass the Inflation Reduction Act. The bill aims to raise corporate taxes and may negatively impact corporate earnings.

  • Arizona Senator Kyrsten Sinema (D-AZ) is pushing for changes in the bill before backing it. She is a pivotal vote in getting the legislation through the Senate. She has concerns about the changes to the corporate minimum tax and has hinted at possible opposition to a carried interest tax. Additionally, she favors beefing up the amount of funding for the climate and energy portions of the bills.
  • The Congressional Budget Office forecasts that the bill will reduce the deficit by a net $101.5 billion over the next decade. However, the CBO’s estimate did not include the $204 billion tax revenue gain from the increased Internal Revenue Service enforcement. The analysis is key to getting the bill passed as Democrats are trying to make themselves look more fiscally responsible after the initial stimulus package contributed to a surge in inflation.

The new bill from the Democrats is austerity disguised as fiscal stimulus. The trend of reducing the government deficit will likely be a central theme going into mid-terms and could continue afterward. The lack of government spending will lead to slower economic growth.

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