Daily Comment (September 21, 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, in which Russia has announced a mobilization of its reserves and has made new threats to use nuclear weapons.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including an overview of today’s interest-rate decision by the Federal Reserve.

Russia-Ukraine:  As Ukrainian forces continue to press their counteroffensives in their northeastern region around Kharkiv and in their southern region around Kherson, ethnic-Russian separatists in occupied areas yesterday announced they will hold referendums on annexing themselves to Russia.  The sham referendums are likely aimed at strengthening President Putin’s narrative that the war is all about “liberating” Ukraine and bringing the ethnic Russians there under Moscow’s protection.  After such a sop to Russian nationalism, Putin may hope to encourage more Russian men to volunteer for the war.  Indeed, in a speech defining the war as an existential struggle for Russia’s survival against what he described as a hostile West, Putin today announced a “partial mobilization” of Russia’s reserve forces.  Defense Minister Shoigu later said that the mobilization would eventually provide about 300,000 fresh troops for the armed forces, although he emphasized that the measure would not involve mass conscription.  Finally, in a further reflection of Russia’s continued manpower shortcomings, the Duma yesterday rushed into place a new law that dramatically increases penalties for desertion, refusing conscription orders, and insubordination. It also criminalizes voluntary surrender and makes surrender a crime punishable by ten years in prison.

  • Russia’s mobilization of reserves is unlikely to have much impact on the war in the near term, since the country’s wartime losses to date have depleted many of the officers, weapons, and supplies needed to train and equip any new troops. The mobilization, coupled with a new Russian threat to use nuclear weapons, is probably mostly geared toward intimidating the West and showing Chinese President Xi, Putin’s key patron, that Russia can turn the war around.  Another reassuring sign is Shoigu’s assurance that there would be no mass conscription, which suggests the government still fears the political consequences of a true mass mobilization.
  • As a reminder, government readouts from their summit last week suggest that Xi raised tough questions for Putin regarding the war. However, it’s unclear whether the message was that the Russians need to stop fighting with one hand tied behind their backs, or that they need to start winding down the war.
    • Putin’s mobilization and the new nuclear threat today could signal that the message was the former. In that case, Russia could now throw its full weight into the war and create much more risk for global geopolitics and the global economy.
    • However, since the Chinese readout didn’t mention Ukraine, and since Indian Prime Minister Modi explicitly questioned the wisdom of the war, it may be that Putin’s most important patrons and enablers are telling him to look for a way out. In that case, Putin’s latest move could merely be a last gasp before starting to search for an eventual wind-down of the war, perhaps by simply settling for a Russian annexation of Ukraine’s Luhansk, Donetsk, and other occupied regions.

European Union-China:  The European Union Chamber of Commerce in China issued a report saying EU companies are being forced to “reduce, localize, and silo” operations in China because of President Xi’s regulatory crackdowns on previously booming industries and his draconian Zero-COVID policies.

  • The bleak report also warns that because of those and other problems, China is losing its attractiveness as an investment destination.
  • The report is consistent with our view that the world is fracturing and regionalizing, with countries breaking up into relatively separate geopolitical and economic blocs. The result is likely to be less efficient production, higher costs, higher inflation, and lower profits.

European Union-United States:  In another example of how many key countries allied to the U.S. are coalescing into a U.S.-led bloc, companies in Europe that make steel, fertilizer, and other feedstocks of economic activity are shifting operations to the U.S., attracted by more stable energy prices and muscular government support.  The trend is likely positive for U.S. investment and employment going forward.

Germany:  The federal government announced it will nationalize the country’s largest electric utility Uniper (UNPRF, 4.27), after it was pushed to the brink of insolvency by Russia’s cutoff of energy supplies and soaring prices for natural gas.  The move is a fine example of how war and crises can lead to long-lasting increases in government power over the economy.

  • The German government, which had already planned to take a 30% stake, will now completely buy out Uniper’s previous owner for €480 million.
  • Berlin will also take on a €7.5 billion credit line from the previous owner.
  • Finally, the government will recapitalize the struggling utility with €8 billion. That move comes on top of a €13 billion government credit line that the government already provided to Uniper earlier this year.

United Kingdom:  To help its businesses weather surging energy prices touched off by the war in Ukraine, yesterday the government said it will cut the wholesale price of energy for businesses and public organizations by more than half this winter.

South Korea:  Even though the country’s currency is depreciating rapidly and is now at its lowest level against the dollar since 2009, the Bank of Korea has denied government suggestions that it will announce a currency swap arrangement with the Fed this week.  At 1,394.90 per dollar, the won is currently down 15.1% against the dollar so far this year, worse than any other major Asian currency except the Japanese yen.

Haiti:  In yet another sign of how high global prices for food, energy, and other commodities are feeding political unrest in developing countries, a government plan to cut fuel subsidies has sparked large protests throughout Haiti.  Demonstrators across the country are calling on Prime Minister Ariel Henry to resign, saying he failed to address a spiraling economic and security crisis that has destabilized the Western Hemisphere’s poorest country.

U.S. Monetary Policy:  Today, Fed officials will wrap up their latest two-day policy meeting, with their interest-rate decision and updated economic projections due out at 2:00 pm ET.  Investors are broadly expecting that the officials will again hike their benchmark fed funds interest rate by an aggressive 75 bps.  We’ll also be watching with keen interest to see what their new economic and interest-rate forecasts say about the path of monetary policy going forward.

  • As we mentioned yesterday, there has been some whispering among observers that the rate hike could be a full percentage point as the officials try to re-establish their inflation-fighting credibility amid continuing fast price hikes.
  • Investors in late summer seemed too complacent about the Fed’s rate-hiking program. While many investors thought the policymakers would quickly pivot to steady or falling rates, we think there is a high chance they will keep hiking and spark a recession.  Indeed, market indicators suggest investors are currently coming around to that view, not just for the Fed, but also for other major central banks.  The prospect for unexpectedly high interest rates will likely continue to challenge stocks, bonds, commodities, and foreign currencies in the near term.

Hurricane Fiona:  After battering Puerto Rico earlier this week, Hurricane Fiona has now strengthened to a Category 4 storm and is moving north-northwest through the Caribbean Sea.  The hurricane is expected to slam into Bermuda later this week.

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