Daily Comment (September 16, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with an update on the conflict in Ukraine, which includes a discussion about China and Russia’s relationship. Next, we review the dollar’s impact on the global economy. We conclude the report with an overview of U.S. efforts to adapt to a changing geopolitical landscape.

Ukraine Updates: The war shows no signs of ending soon, but Ukraine’s odds of retaking lost territory have drastically increased.

  • The UN’s nuclear watchdog urged Moscow to remove its forces from the Zaporizhzhia Power Plant to avoid a potential catastrophe. Russian troops took over the area early in the war and used the region to launch attacks against Ukrainian forces. The call from the regulators for Russia to depart the site reflects the clear and present danger the conflict is having on the region. The plant’s strategic importance suggests that it is unlikely that the Russians will leave the area. Thus, the possibility of a nuclear disaster is elevated.
  • Russian President Vladimir Putin admitted that China has concerns about the ongoing war in Ukraine. The rare acknowledgment of the two countries’ differences likely signals that Russia does not feel as if it has Beijing’s full support. If correct, this could potentially force Putin to take more decisive action in Ukraine to prevent further losses in the conflict. History shows that Russian leadership does not survive after the country loses a war. Therefore, we expect Putin to take more extreme action to change the tide of the conflict.
  • Ukraine’s recent success in its war efforts has encouraged the West to provide the country with more military support. President Biden announced that the U.S. would provide Ukraine with $600 million in additional weaponry, while Germany said it would send two more rocket launchers and 50 armored vehicles. The increase in Western military aid shows that the war is far from over. As a result, Europe will likely not be able to avoid an energy-supply crunch in the winter.
    • In a related story, Germany seized refineries owned by Russian oil giant Rosneft as Berlin looks to take over its energy sector. The move is designed to prevent disruptions in German energy supply as the country weans itself from Russian gas. In addition to taking over Rosneft, the country plans to take over Uniper (UNPRF, $4.03) and two other gas importers.

Dollar takes off: The greenback’s rise against global currencies will prevent central banks from providing policy stimulus even as economies slow.

  • The yuan surpassed 7 per dollar for the first time since 2020. This sharp decline in the yuan was driven by the deceleration in GDP growth and the rise of the U.S. dollar against global currencies. Although the depreciation of the yuan has typically led to a surge in capital flight to safer currencies, new regulation prevents this from happening. The decline in the yuan could prevent the People’s Bank of China from easing monetary policy while also pushing up the cost of imports. As a result, the depreciation of the yuan will likely add to a long list of economic woes in China, which already include COVID lockdowns, consumer pessimism, and slowing exports.
  • Today, concerns over the U.K. economy have pushed the pound to its lowest level since 1985. The British currency fell to $1.137 after weak retail sales signaled a slowdown in consumer spending. In addition to the sales numbers, investor expectations of a jumbo rate hike from the Fed also weighed on the sterling. The currency’s depreciation will force the Bank of England to continue tightening, possibly even if the economy contracts. Hence, the currency’s weakness could trigger a long and deep recession.
  • The U.S. Dollar Index, which tracks the greenback’s strength relative to global currencies, is up 14.5% year-to-date. For comparison, Energy is the only stock market sector with better performance. As a result, the dollar’s rise has pushed up import prices, making global inflation worse. This trend will likely continue as long as the Federal Reserve continues its currency policy path.

Geopolitical Shifts: The U.S. is adjusting to changes in the geopolitical landscape.

  • S. policymakers cannot agree on whether they want to send military aid to Taiwan. The new legislation, the Taiwan Policy Act, is criticized for being too provocative toward China. The bill would grant the sovereign island $4.5 billion in aid over four years and includes extensive language on sanctions toward Beijing if it were to become more hostile toward the region. As we have mentioned in previous reports, there are many political benefits to getting tough with Beijing. A recent poll showed that 82% of Americans hold an unfavorable opinion toward China. This bravado could backfire at some point if China retaliates, but it is unlikely that Beijing will take aggressive actions before its National Party Congress on October 16. However, this will likely not be the case once the summit is over. Further provocation from the U.S. might lead to a direct conflict with China.
    • China has imposed sanctions on U.S. defense companies for selling arms to Taiwan. The measure is another example of Beijing’s sensitivity to the One China Policy in Taiwan.
  • S. Secretary Tony Blinken has assumed a crucial role in ending military clashes between Armenia and Azerbaijan. The two sides began fighting on Tuesday over disputed territory. A previous cease-fire brokered by Moscow earlier this year failed as Russia was distracted by its invasion of Ukraine. The U.S. involvement in ending the conflict is a possible sign that Washington would like to fill the void left by Russia.

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