Daily Commentary

Providing succinct, entertaining and savvy thinking on global capital markets. Our goal is to provide discerning investors the most essential information and commentary to stay in tune with what's happening in the markets, while providing unique perspectives on essential financial issues. And just as important, Fisher Investments MarketMinder aims to help investors discern between useful information and potentially misleading hype.

On the Senate’s Busy Week

Where did gridlock go? That is the question many are asking after a flurry of Senate activity this week. On Tuesday, a bipartisan majority passed the Chips and Science Act, a $280 billion package pitched as a solution for the semiconductor shortage and concerns about China’s potential influence over global chip supply—which the House passed and sent on to President Joe Biden’s desk on Thursday. Separately, on Wednesday, the budget reconciliation bill once known as Build Back Better returned from the dead, slimmed down and renamed the Inflation Reduction Act.[i] It hasn’t yet passed and may not, but we see this as a textbook case of how markets and politics typically intersect in the first half or so of a midterm election year—and we think it points further toward a late-year rally as midterm results zap lingering fears of big legislation.

Exhibit 1 shows a high-level look at what is in each bill at the moment, pending committee and both chambers’ votes and possible reconciliation on the Inflation Reduction Act. The provisions could change, but for now, here is how things stand.

Exhibit 1: New Legislation at a Glance

Source: United States Senate, Reuters and The Washington Post, as of 7/28/2022.

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Are July’s Business Surveys Normal?

Has a summertime swoon arrived? July business activity contracted in major developed economies, including the US and eurozone, per the latest surveys. We aren’t Pollyanna about today’s global headwinds, but it is critical to ask whether any of this information is surprising to markets—and in our view, the answer is no. Despite all the headline handwringing, July’s purchasing managers’ indexes (PMIs) don’t reveal much new on the economic data front—stocks likely reflect this weakness to a large extent already.

As Exhibit 1 shows, S&P Global’s July “flash” PMIs weakened across the board from June and missed expectations.

Exhibit 1: The Latest PMIs<

Source: FactSet, as of 7/22/2022.

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Another Fed 75

The Fed announced another 0.75 percentage point (ppt) interest rate hike Wednesday, as widely expected, lifting the fed-funds target range to 2.25 – 2.50%. Stocks didn’t mind, with the S&P 500 rising after the announcement and finishing the day up 2.6%.[i] Bond markets didn’t do a whole lot, with 10-year yields flattish at 2.79%, as we write, and 3-month yields down a whisker to 2.37%.[ii] That shouldn’t shock, considering—as we showed last week—bond markets appeared to have priced this well-telegraphed move in advance. As ever, what matters is what happens from here, as the Fed is on the verge of inverting the yield curve—a matter worth watching, but not obsessing over.

Inversion isn’t guaranteed to happen, mind you, and it will probably rest on how markets interpret the Fed’s guidance. On that front, Fed head Jerome Powell wasn’t terribly helpful when addressing future moves at the post-meeting press conference. He told reporters a third 0.75 ppt hike in September could be warranted and that he sees the fed-funds range’s upper bound being between 3.0% and 3.5% by year end. But he also said the Fed couldn’t give “clear guidance” anymore and that future moves would be data-dependent. Soooooo. Seemingly clear guidance, alongside a disavowal of clear guidance. Try figuring that one out.

If recent history is a reliable guide, markets will spend the next several weeks trying to suss this out, parsing all Fedspeak and incoming data. Observers will likely hyperventilate over central bankers getting together at the Kansas City Fed’s annual big bash in Jackson Hole, Wyoming—this time centering on “Reassessing Constraints on the Economy and Policy.” So expect that now. If investors broadly expect the Fed to keep hiking, then 3-month yields will probably rise. If inflation expectations continue moderating, 10-year yields could continue their drift lower. We aren’t saying either is highly probable, mind you—we are just pointing out possibilities, specifically, the possibility of that 0.42 ppt gap between 3-month and 10-year yields closing.

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The EU’s Holey Natural Gas Conservation Plan

Here are two things that seem related but—on a closer look—aren’t: Tuesday, the IMF sounded the global recession alert, citing the potential for a severe winter energy shortage in Europe. Also Tuesday, the European Commission agreed on a natural gas conservation plan for EU member states.

The IMF’s latest projection may or may not prove correct about those shortages, but in our view, that is less important than the fact that it echoes the past several weeks’ worth of fearful headlines, which stocks have already moved on. Therefore, what matters from here is how reality evolves compared to baked-in expectations. That is where the EU’s move comes in. Read the finer points, and we think it becomes evident the conservation plan mostly kicks the can and doesn’t automatically tee up tough cuts that would take German industry offline and guarantee a eurozone recession.

The EU’s plan is not energy or electricity rationing. Heck, it isn’t even rationing. It is a loose agreement for most member states to voluntarily reduce natural gas consumption by -15% from the average amount each used over the past five years. It won’t apply to islands (Ireland, Cyprus and Malta), which are disconnected from Continental supply lines. It doesn’t have a clear enforcement mechanism, which is jargon for a clear answer to “or what?” It doesn’t mandate how to curb consumption. It leaves loopholes for countries that have full gas reserves, “are heavily dependent on gas as a feedstock for critical industries,” or have sharply raised consumption over the past year (exposing them to severe hardship if they go -15% below the prior average).[i] It also offers exemptions for countries that don’t draw much gas from Continental pipelines and feed gas into the system for their neighbors. And while it leaves room for the cuts to become mandatory if the European Commission declares a “Union alert,” details on what would trigger that aren’t sketched out yet (beyond a request from five member states to do so).

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Adjusting for Swings With Constant Currencies

Q2 earnings season is in full swing, and there is a new buzzword in town: constant-currency. As in, Widgets “R” Us reports earnings grew 4%, or 7% on a constant-currency basis. What is this, and what should we make of it? Read on.

Simply, constant-currency earnings aim to strip out skew from big currency swings in order to zero in on how the core business is faring. As you have no doubt seen headlines railing about, the dollar is near an all-time high relative to a broad basket of currencies, which has implications globally. When the dollar strengthens, it can hurt US companies’ overseas sales. If they don’t raise prices and transaction volumes stay constant, their revenue in dollars drops—the same amount of sales in euros, pounds or yen converts to fewer dollars. Or, if US companies raise prices in hopes of keeping dollar-denominated revenues firm, they risk losing market share. This dilemma often gets at least a partial offset from overseas costs being cheaper when the dollar is strong, but it isn’t always a wash. This is why you will have seen oodles of American companies blaming the strong dollar for disappointing earnings—and oodles of articles arguing it is a huge problem markets are egregiously ignoring.

Meanwhile, companies based abroad have the opposite problem. When their home currencies are weak relative to the dollar, they have to pay more in their local currency for parts, labor and energy sourced overseas and priced in dollars. They can get an offset from overseas sales, though. If they want to, they can cut prices overseas to gain market share without taking a big hit once they reconvert to totals to their own currency. Or, they can keep prices overseas steady and earn big fat profits from currency conversion.

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Italy Can Still Service Its Debts Easily

Editors’ note: MarketMinder is nonpartisan, preferring no party nor any politician. Our analysis aims solely to assess political developments’ potential market impact.

It was supposedly a double whammy for Italian bond markets Thursday after (now caretaker) Prime Minister Mario Draghi resigned and the ECB hiked rates half a percentage point (ppt). Italy’s 10-year yield rose 0.22 ppt on the day to 3.58%—its highest since summer 2020, when credit spreads spiked during initial pandemic lockdowns, before falling back Friday. (Exhibit 1) Pundits now say a financial crisis is brewing, but we don’t think one looks any more likely than last month.

Exhibit 1: The 10-Year Italian-US Credit Spread Widened Some

Source: FactSet, as of 7/25/2022. 10-year Italian BTP yield minus 10-year US Treasury yield, 1/1/2010 – 7/25/2022.

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Our July Fed Meeting Preview

The next Fed meeting is less than a week away, and most analysts are penciling in another steep rate hike. Almost no one expects this to do anything about inflation, given the Fed can’t refine petroleum into gasoline, increase the grain harvest, staff airlines or unload container ships, all of which have fueled accelerating inflation even as money supply has started rolling over. But there is mounting fear that even one more big rate hike could be overshooting and kneecapping the economy, especially given how much the yield curve has flattened in recent weeks. In our view, there is some risk of the yield curve inverting, but it isn’t a given—and even a mild inversion isn’t an automatic recession trigger.

Now, when we look at the yield curve, we don’t use the 2-to-10 year segment that gets most pundits’ attention of late. We think the yield curve’s importance comes from its relationship with banks’ funding costs (short-term rates) and loan revenues (long-term rates), with the spread between them influencing banks’ potential profit margins on new loans—which drives loan growth. Generally, a wide spread means big profits and aggressive lending, while a deeply negative spread can signal a credit crunch. Banks don’t get much funding through 2-year CDs. They fund primarily through retail deposits and interbank markets, which are much shorter-term. We think the 3-month Treasury yield is a better approximation, so we use the 3-month to 10-year yield spread. That spread, as Exhibit 1 shows, has narrowed sharply since early May, from over two full percentage points (a multiyear high) to roughly half a point as of Tuesday’s close.

Exhibit 1: The Rapidly Shrinking Yield Curve Spread

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No, Copper Doesn’t Diagnose Economic Health

The doctor is in—Doctor Copper, that is. The metaphorical Economics PhD with an allegedly uncanny forecasting ability is back in headlines this month, as many argue copper prices’ recent slide signals a nasty recession looms. Yet as leading indicators go, copper’s record is pretty spotty. We don’t recommend relying on it to determine what the economy is up to.

The case for copper’s prescience might seem intuitive. Conventional wisdom says that a humming economy will have widespread construction of homes, offices, factories, warehouses and stores—driving demand for copper, which is a key construction component. Therefore, if copper prices drop, it signals falling demand, which means construction is down, which means the economy is sagging.

But this logic doesn’t really hold up in developed-world economies, where services are much more important to growth than construction and physical goods. Many decades ago, when heavy industry and infrastructure had larger economic roles, it made sense to view copper as a leading indicator. When pioneering the Leading Economic Index (LEI) in 1938, economists Wesley C. Mitchell (founder of the National Bureau of Economic Research, which dates US business cycles) and Arthur Burns included copper on their initial list of the most telling components. But by the time LEI was reconfigured in 1950, copper was out. The more growth came from services and intellectual property, the less of a role copper played.

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IP Doesn’t Spell Recession

With seemingly everyone on recession watch nowadays, many extrapolate any monthly data dip—like US industrial production’s (IP) last week—as evidence. On the flip side, some see the eurozone’s surprising IP growth as a sign recession worries are overblown. But we think there are a couple considerations to note here. First, manufacturing isn’t a huge slice of developed world economies. Then too, although IP (which also includes mining and utilities output) can offer clues on the state of global growth, it is backward looking. Current IP data neither confirm nor deny a recession is underway.

Exhibit 1 shows US June IP dipped -0.2% m/m. That small dip, it is worth noting, was IP’s first decline this year. We always think you shouldn’t overrate a single data point, but this has sparked worry regardless, especially with manufacturing—IP’s largest component—down -0.5% m/m for a second consecutive month.[i]

Exhibit 1: Industrial Production Doesn’t Dictate Economic Activity

Source: Federal Reserve Bank of St. Louis, as of 7/15/2022. US industrial production, January 2007 – June 2022. Recession shading based on NBER business cycle dates.

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Beyond the Data: China’s Q2 GDP

China released Q2 GDP data Friday, and—please stay with us—the data were arguably the least interesting thing about it. No, we aren’t dismissing the sharp slowdown to 0.4% y/y, which missed expectations and reflected the economic damage from this spring’s COVID restrictions.[i] Nor are we glossing over continued real estate weakness, which remains a challenge. But the press release itself was a tour de force in political messaging that, when you understand the context, augurs well for economic policy—and growth—over the rest of this year. That, in turn, argues for economic fundamentals continuing to support Chinese stocks’ rebound off March’s lows. Let us discuss.

In countries with strong institutions and independent statistical agencies, economic releases are usually pretty dry. Most won’t even reference government officials, never mind sing their praises. But China is different. So the official release for Q2’s economic data begins not with a dry summary of the results, but a rather poetic statement: “Faced with extreme complexities and difficulties, under the strong leadership of the Central Committee of the Communist Party of China (CPC) with Comrade Xi Jinping at its core, all regions and departments deeply implemented the decisions and arrangements made by the CPC Central Committee and the State Council, responded to COVID-19 and pursued economic and social development in a well-coordinated manner, stepped up macro policy adjustments, and fully implemented a package of pro-stability policies and measures. As a result, the resurgence of the pandemic was effectively contained, the national economy registered a stable recovery, production and demands saw improving margins, market prices were generally stable, people’s livelihood was protected sufficiently with robust steps, the momentum of high-quality development was sustained and the overall social stability was maintained.”[ii]

It is entirely unsurprising to us to see such a statement now, as this autumn’s National Party Congress approaches. Xi, reportedly, is seeking an unprecedented third term as party leader, which would effectively cement him as president for life. Simple logic suggests that is easier said than done when the government’s zero-COVID policy and its many everyday-life and commercial disruptions complicate everyday life. That creates two urgent tasks: easing COVID frustration and helping the economy rebound as quickly as possible without storing up debt problems later. We read this press release as a preliminary declaration of success. The official message seems to be that lockdowns, while difficult, were successful and therefore worth it, and the payoff of a swift economic rebound is here—aided by fiscal stimulus, under Xi’s watchful eye and careful guidance.

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