Daily Comment (May 27, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! U.S. equities continue to rally as investors no longer fear that the Fed will become more hawkish. Additionally, a drop in mortgage rates and a strong performance from retailers have boosted investor sentiment. Today’s report begins with the rising popularity of windfall taxes. Next, we discuss the latest updates on the Russia-Ukraine war and other related stories. We comment on the latest U.S. economic and policy news, focusing on the rivalry between Washington and Beijing and waning inflation expectations. We conclude with our COVID-19 coverage.

Tax on Energy: On Thursday, the U.K. government announced that it would introduce a 25% tax on the profits of energy producers. The government will use the tax to provide subsidies of £650 in two installments to low incomes households and £300 to some pensioners. The U.K. is not the first country to push corporations to use their profits to help the country. On Wednesday, the Hungarian government made a similar request for companies to use their “excess profits” to help the government fund utility subsidies. Italy also taxed profits on energy companies to fund aid packages earlier this month.

We suspect that taxing excess profits of firms, particularly those in the energy sector, could be detrimental to resolving the oil shortage. By taxing firms for being extremely profitable, the government gives them less incentive to expand production capacity. Moreover, by using the funds for consumer subsidies, the government is disrupting the communication mechanism for the consumer to purchase less. As a result, the tax on excess profits may hinder attempts to lower prices because it does not reduce demand or encourage firms to expand capacity.

Russia-Ukraine: Russian soldiers are having more success in eastern Ukraine as the troops learn from their previous mistakes. Russian forces are advancing in Severodonetsk and are close to encircling the region. These forces also appear to be closing in on the west and south of Popasna. Despite these gains, Ukrainian officials have maintained a solid defense.

Other Russia-Ukraine news

  • The White House stated it expects a Russian default to have a minimal effect global economy. The remarks came after the Treasury decided not to extend the waiver to allow Russia to repay bondholders in dollars. Last month, World Bank economist Carmen Reinhart warned that a Russian default could stress a financial system already burdened with rising inflation and slowing growth. Russia is expected to pay about $100 million of interest on its foreign debt on Friday.
  • In a phone call with Italian Prime Minister Mario Draghi, Russian President Vladimir Putin stated his country would be willing to help ease the food crisis in exchange for lifting sanctions. U.K. and U.S. officials have described the offer as blackmail. The Kremlin’s decision to block the export of grains is another sign that Russia is trying to raise the cost of the West’s loyalty to Ukraine. The blockade has benefited Russia as it has raised the price it can charge for its grains; meanwhile, it hurts the West by contributing to rising inflation. As food prices increase, we suspect that the Western coalition will start to fray. If we are correct, it would mean that Ukraine is running out of time to retake regions lost to Russia. The rising inflation due to conflict may lead the West to pressure Ukraine to agree to a cease-fire with Russia.

U.S. economic and policy news

  • The U.S. pivot: Despite the ongoing conflict in Russia, Washington still views China as its primary geopolitical rival. In a speech, SoS Antony Blinken stated that the U.S. would attempt to influence China’s behavior by shaping the “strategic environment around Beijing.” The remark came on the eve of economic talks between the U.S. and Taiwan. The Biden administration is developing the Indo-Pacific Economic Framework, designed to create greater economic integration with the U.S. and countries within the region. Meanwhile, China has been trying to expand its military influence throughout the region by acquiring security pacts. Despite the U.S. and China’s supposed advantages, it isn’t clear who has the upper hand. The U.S. is unwilling to provide the market access that China is willing to offer. Meanwhile, China does not have the defensive capabilities to provide the same level of protection as the U.S. military. As the two countries compete for influence, countries within the Indo-Pacific will likely benefit, and thus, these areas could be attractive places for investment.
  • Fiji announced it would join the Indo-Pacific Economic Framework on Friday.
  • Inflation expectations: Although inflation remains elevated, there are growing signs that it may have peaked. Research from the New York fed suggests that consumers’ inflation expectations are starting to wane. The finding shows that consumers expect inflation to fall to 3% in about five years. Consequently, the study suggests inflation expectations are more anchored than most people realize. In another sign that inflationary pressures are fading, staffing companies report firms are becoming more reluctant to raise wages due to concerns that consumers are starting to push back. Although inflation will likely remain above the Fed’s two percent target for the foreseeable future, we suspect the Fed will be less inclined to be more assertive in raising rates.

International news

  • Chinese lockdowns have led to a worker revolt in a factory in Shanghai. To minimize the impact of lockdowns on the global economy, China has forced laborers to work in a bubble. The unrest adds pressure on Beijing to abandon its controversial Zero-COVID Strategy. The lockdown is affecting the economy. In April, industrial profits fell 8.5% from the prior year.
  • The E.U. is preparing for Russia to halt natural gas shipments to the bloc. Europe is already building its inventory stock and is willing to ration gas supplies to industries.

 Interesting fact

  • Following the decline of several of its competitors, Bitcoin has reclaimed its dominance as the most widely held cryptocurrency.

COVID-19: The number of reported cases is 527,941,243, with 6,284,762 fatalities. In the U.S., there are 83,837,175 confirmed cases with 1,004,122 deaths. For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics. The CDC reports that 744,812,955 doses of the vaccine have been distributed, with 586,008,740 doses injected. The number receiving at least one dose is 258,394,333, and the number of second doses is 221,128,528. The number receiving the first booster is 103,110,612, and the number receiving the second booster is 13,235,706. The FT has a page on global vaccine distribution.

  • The White House has stepped up its efforts to make it easier for patients to access the COVID-19 oral pill treatment, The Federal government plans to reimburse a clinic in Rhode Island that immediately prescribes the pill to patients who test positive for the virus. The new approach suggests that the Biden administration is looking for alternative methods outside of vaccinations to contain the spread of the virus.

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