Daily Comment (July 20, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with an update on the Russia-Ukraine war.  Both sides in the war appear to be ramping up their attacks again, but the key developments today revolve around Europe’s intensifying efforts to prepare for a complete cut-off of Russian natural gas supplies.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an important decision by Italian Prime Minister Draghi to rescind his resignation offer from last week if the parties in his unity government accept his economic reforms.

Russia-Ukraine:  In Ukraine’s eastern Donbas region, Russian forces are once again staging modest, localized ground attacks under the cover of artillery fire and making slow, creeping territorial gains, but Ukrainian forces are putting up stiff resistance with the aid of new weapons from the West.  The Ukrainians continue to show signs of preparing for a significant counteroffensive to retake the southern city of Kherson by using advance Western missile systems to strike a bridge linking that occupied city to other Russian forces on the south side of the Dnieper River.  Meanwhile, nationalist military bloggers in Russia are increasingly pressuring the Kremlin to fully mobilize the country and to focus on much more extensive war aims.  Although Russian President Putin could choose to ignore those calls, there is some chance that he could use them to provide political cover for a more extensive mobilization and a shift back to maximalist war aims.  Separately, the White House warned that Russia is preparing to annex the Ukrainian territory it occupies by autumn.  A likely date for a sham referendum in the occupied territory is September 11, which is a unified election date for provincial and local elections in Russia.

  • Amid fears that Russia won’t restart its deliveries of natural gas to Western Europe after the Nord Stream 1 pipeline ends its maintenance outage tomorrow, President Putin last night hinted that the country’s exports will begin again on Friday.  However, he noted that gas deliveries could soon be cut to just 20% of capacity if sanctioned pipeline equipment from the West isn’t delivered – a likely pretext for further energy blackmail in the future.
  • As the European Commission becomes more convinced that Russia could completely cut off its natural gas exports to retaliate for the West’s support of Ukraine, it today proposed new emergency powers allowing it to force EU countries to reduce their gas consumption in the event of devastating supply shortages.
    • The plan calls for EU countries to voluntarily curb their gas consumption by 15% over the next eight months to help build inventories for the winter heating season.  It also calls for countries to set priorities to determine which industrial sectors will be most affected.  Energy-reduction targets could become binding if voluntary actions aren’t enough to prevent a shortage.
    • The plan also promotes switching from natural gas to alternative energy sources including nuclear and coal, setting up auctions that could compensate companies for using less gas, and setting mandatory limits on heating and air conditioning in public buildings.
  • In other fallout from Europe’s impending war-related energy crisis, the German government has asked the country’s electricity providers to run stress tests to see if they could guarantee adequate power supplies if Russia cuts off its gas exports this winter.  The government’s deputy spokesperson confirmed that the results of the stress test could justify extending the life of the country’s three remaining nuclear power plants beyond their scheduled shutdown at the end of the year.
    • Germany’s apparent policy shift toward keeping its nuclear plants open highlights one massively important implication of the war:  with the world’s new focus on energy security, many countries may now adopt an “all of the above” energy policy emphasizing a diversified portfolio of energy-producing assets, rather than shifting wholesale to renewable energy sources like wind and solar.
    • The new-found appreciation for traditional energy sources like oil, natural gas, and uranium is a key reason why we remain bullish on commodities in the coming years.
    • In the near term, the evolving energy crisis is driving home the risk that Europe’s economy and financial markets are likely to face enormous headwinds in the coming months, with negative implications for European stocks and currencies.
  • In still more economic fallout from the war, the Ukrainian government today plans to ask foreign private creditors to allow a two-year repayment moratorium on $3 billion of its outstanding Eurobonds.  Qualifying as a debt default, the move would amount to the first step in restructuring Ukraine’s foreign-owned sovereign debt.

Western Europe:  Britain and the rest of Western Europe continue to suffer through a massive heat wave and wildfire outbreak, with the U.K. recording a record high temperature of 104.5° F and the death toll in Portugal reaching 659.  Since a lot of European infrastructure was never designed or maintained for such heat, it has been a particular source of disruption.  For example, the British government has had to shut down warping roads and airport runways.

Italy:  In a more positive note for Europe today, Prime Minister Draghi announced in parliament that he would be willing to rescind the resignation request he made to President Mattarella last week, but only if the parties in his broad unity government stop creating hurdles to his reform agenda.  Votes in parliament later today and tomorrow will now serve as de facto votes of confidence in his leadership.

  • In the days since Draghi made his resignation request last week, thousands of ordinary Italians, including more than 1,800 mayors, business associations, medical professionals, and Rome’s European allies, have publicly appealed for Draghi to stay and help lead the country through the challenges unleashed by the war in Ukraine.  As Draghi probably intended, the outpouring of support may have chastened the squabbling party leaders in his coalition, forcing them to support the government for at least a bit longer.
  • If Draghi had resigned, or if he loses the confidence votes this week and his government falls, Italy will face new elections sometime in the autumn.  Current polling suggests that right-wing, populist, and eurosceptic parties would win that election and form a new government, threatening Europe’s economic stability and its support for Ukraine.
  • If Draghi remains in power as now seems likely, at least until the regularly scheduled elections in June 2023, there will be less selling pressure on Italian bonds, and Italian yield spreads could be relatively contained.  That, in turn, would give the ECB more leeway to hike interest rates at its policy meeting tomorrow, which is critical in its fight against inflation.

United Kingdom:  In the race to replace Boris Johnson as Conservative Party leader and prime minister, a vote of parliamentary party members yesterday eliminated Former Equities Minister Kemi Badenoch.  The remaining candidates now are Former Chancellor Rishi Sunak (118 votes yesterday), Trade Minister Penny Mordaunt (92 votes), and Foreign Minister Liz Truss (86 votes).

  • Further votes are scheduled for today to whittle the field down to just two candidates.  At that point, the remaining candidates will have several weeks to campaign before a poll of the broad party membership at the end of the summer.
  • A poll of Tory activists last week found that both Mordaunt and Truss would beat Sunak in a head-to-head race, since many conservatives dislike Sunak’s record as a tax-raising chancellor and his perceived disloyalty to Johnson.  However, Sunak could yet pull out a victory on the belief that he would be more competitive in a future general election.

Chinese Real Estate Sector:  Hundreds of landscapers, construction companies, sculpture-makers, and other suppliers to the real estate sector have complained that they can no longer afford to pay their bills because some financially strapped developers still owe them money.  The outcry comes just days after the government ordered increased lending to troubled developers so they can deliver long-delayed housing units to their buyers and preempt a threatened payment strike.  If the government now orders still more bank lending to allow developers to pay their suppliers, it will confirm that the government is prioritizing economic stability over reining in the sector’s debt levels in the runup to the Communist Party’s 20th National Congress in October.

Australia:  In an ominous sign for central bank independence around the world, the Australian government has launched a probe into the Reserve Bank of Australia’s delay in raising interest rates as inflation surged out of control.  The review will consider the performance of the central bank, its board composition, and its inflation targeting strategy, potentially inspiring similar probes (and political meddling) in other countries that have suffered high inflation.

Sri Lanka:  Parliament today elected unpopular six-time Prime Minister Ranil Wickremesinghe as the country’s new president, risking further protests that could complicate urgent bailout talks with the IMF.

Panama:  Despite its long history of stability, in part because its currency is pegged to the dollar, Panama is facing a wave of mass protests over soaring price inflation and government corruption.  As in much of the developing world, rising food and fuel costs are a key reason for the unrest.

United States-Mexico: According to the Wall Street Journal, “the [Biden administration] today launched a trade fight against Mexico, accusing President Andrés Manuel López Obrador’s government of favoring its state-owned utility and oil company at the expense of American businesses.  The U.S. is seeking dispute settlement consultations under the U.S.-Mexico-Canada Agreement—the first step in what could lead to tariffs on a range of Mexican products.”

U.S. Technology Sector:  Last night, the Senate passed the U.S. International Competitiveness Act (USICA), which aims to bolster the country’s competitiveness in key technology industries and reduce dependence on foreign suppliers.  A key provision would provide roughly $52 billion in subsidies to encourage chip companies to boost production in the U.S.

  • The vote paves the way for a larger package that would include additional funding for scientific research.
  • Even if USICA is now paired with the broader science package and passed in the Senate, the bill would still have to be passed by the House and signed into law.

U.S. COVID Vaccines:  The CDC yesterday recommended the use of a COVID-19 vaccine from Novavax (NVAX, $58.00) in adults 18 years and older who haven’t been vaccinated previously.  The recommendation is the final hurdle before the shot can be made widely available in the U.S.

  • Relying on a relatively older, more tested technology based on proteins, the Novavax vaccine will be a new option for people who have avoided the gene-based messenger RNA shots from Moderna (MRNA, $167.14) and Pfizer (PFE, $51.37).
  • Like the U.S. vaccines already available, the Novavax shot will be offered at no charge at pharmacies and through state and local government vaccine programs.
  • The Novavax vaccine requires two doses given three weeks apart.

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