Daily Comment (August 5, 2022)
by Patrick Fearon-Hernandez, CFA, and Thomas Wash
[Posted: 9:30 AM EDT] | PDF
Today’s Comment starts with a focus on the potential spillover effects of Russia’s invasion of Ukraine. Next, we examine policymakers’ dilemma of whether to promote growth or contain inflation. We conclude by discussing a possible rightward shift in U.S. policy.
Russia: The Ukraine war could potentially lead to new conflicts in other parts of Europe and the Middle East.
- NATO Secretary-General Jens Stoltenberg stated that the Ukraine war was the most dangerous moment in Europe since WWII and that Russia must not win it. He also suggested that NATO might act if Russia seeks to extend its military campaign into an allied country. His comments appear to be a veiled threat to Moscow not to provoke a NATO ally. Although the Kremlin has not directly mentioned another country, there are concerns that Russia could incite a war over Kosovo, a non-aligned country with NATO forces.
- Tensions in Eurasia pose a threat to the continent’s delicate commodity supply. Azerbaijan has reignited tensions with Armenia over the heavily contested Nagorno-Karabakh. On Thursday, Azerbaijan forces took over a strategic region in the disputed territory. While Moscow has forces stationed in the area to prevent clashes, the war in Ukraine has made Russia’s presence less effective. Thus, Azerbaijan’s advancement in Nagorno-Karabakh exemplifies how tensions between rival countries within Eurasia could heighten as war continues in Ukraine. Although many countries in Eurasia are typically ignored, disruptions in the region could make it harder for firms to secure natural resources. As a result, these conflicts could exacerbate the energy crisis in Europe.
- It is estimated that the region contains over 31% of the world’s proven natural gas reserves, 17% of oil reserves, 23% of iron ore, 14% of gold, and 7% of copper.
- Vladimir Putin is expected to meet with Turkish President Recep Tayyip Erdoğan in Sochi on Friday. The two leaders will discuss the ongoing situation in Syria. Turkey would like to mount a military offensive against Kurdish fighters within Syria without worrying about a possible conflict with Russian troops stationed in the area. Because Turkey is a NATO ally, a conflict with the Russian military could lead to a broader conflict that includes other members of the security pact.
A broader war in Europe would rattle financial markets and could make commodity supply concerns deeply entrenched. As a result, we expect European firms may look to set up operations in areas that are resource-rich and relatively safe, like the U.S. and Canada.
Inflation worries: Around the world, governments struggle to determine whether they should prioritize inflation or GDP growth when creating new economic policy.
- Chinese Premier Li Keqiang implied that the government would tolerate GDP growth rates below its target as long as inflation and unemployment stay under 3.5% and 5.5%, respectively. Like the rest of the world, China is seeing an increase in consumer prices. In June, headline CPI rose 2.43% from the prior year, its highest jump in over a decade. Keqiang’s remarks suggest that Beijing is reluctant to inject fiscal stimulus into the economy due to concerns that it might worsen inflation. The lack of government support in China will weigh on global growth.
- In the U.K., Liz Truss, the frontrunner candidate for prime minister, directed her ire at the Bank of England and the Treasury for the country’s inflation problem. Although the BOE was the first major central bank to raise interest rates after the pandemic, Truss insists that it should have acted even sooner. Her criticism of the BOE suggests that she may favor eliminating the central bank’s independence. In a speech at a husting of Conservative party members, Truss hinted at changing the BOE’s mandate to align more closely with the other central banks. Her rebuke suggests that she will likely place the blame for inflation on the central bank in order to gain support for her tax cut proposal.
- In Europe, countries are looking to implement measures designed to combat rising inflation. For example, the French Parliament passed legislation on Thursday that would cap rent increases and extend fuel subsidies. Meanwhile, Ireland is considering imposing a windfall tax on energy profits. Government actions to rein in inflation will likely not be too effective because subsidies on fuel and windfall taxes on energy profits prevent consumers and suppliers from adjusting to the market. Fuel subsidies prevent demand destruction, while taxes on excess profits limit energy companies’ ability to expand investment in production capacity.
The decision to address inflation over GDP suggests that governments fear the public may be more sensitive to prices than the economy. This preference could mean countries will be reluctant to stimulate their economies as inflation remains elevated. The lack of financial support from the government during times of economic weakness suggests that any recovery from recession will likely be slow. Thus, we could be headed toward a sustained period of slow economic growth.
U.S. policy: The Democrats may be on the verge of passing another bill, but conservatives still strongly influence domestic and foreign policy.
- Senator Kyrsten Sinema (D-AZ) has agreed to support the climate and tax bill. Her support came after Democrats revised the legislation to eliminate a provision that would narrow a tax break for carried interest. Additionally, there were provisions to alter the 15% minimum corporate tax and add a 1% excise tax on stock buybacks. The tax changes in the bill may not have a significant impact on investors. Instead, they reflect a broader trend away from government spending as the country copes with rising inflation.
- The fallout continues following House Speaker Nancy Pelosi’s provocative trip to Taiwan. On Friday, China announced that it would impose sanctions on Pelosi and has halted cooperation with the U.S. in several areas, including talks on climate change and defense. Her visit to Taiwan has not only accelerated the decoupling between the U.S. and China but is also forcing firms to reconsider plans to invest in Taiwan.
- Equities are already starting to see movement following the trip. Since Pelosi’s visit, stocks related to chipmakers have surged due to predictions that the U.S. and China will invest more in domestically made semiconductors.
There does seem to be relatively more support for conservative policies going into the midterm elections. Democrats who initially pushed for a bill that would have added to the deficit over 10 years are now backing a bill that reduces the deficit, suggesting the country is becoming fiscally cautious. Additionally, Pelosi’s trip reinforces our view that the country is becoming more skeptical of China. It is too soon to say whether this represents a broader trend, but it is something we are monitoring closely.