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On EMs & Iran War 2.0 Plus: South Korea’s AI Bet
The resumed US-Iran war will hit Asian nations hard, William reports, destabilizing weak currencies and struggling economies. The rupiah, rupee, yen, and won all have come under renewed pressure, and another oil-supply shock could further depress currencies, increase dollar debt, and raise bond yields. Developing economies are vulnerable as well to second-round effects like food inflation. … Also: Investors looked to the Nasdaq debut of Korea’s SK Hynix for clues to the AI craze’s durability and Korea’s role in it. When the shares sold off on Monday, doubts were kindled. … Toby cautions against reading too much into the activity of a single stock and argues that the Asian AI trade has solid fundamental underpinnings.
Captain America: Guardian Of The Strait!
MOU is DOA. The memorandum of (mis)understanding between the US and Iran is dead on arrival. Act II of the latest Gulf War is underway after a brief interlude. President Donald Trump declared today that the United States will be known as "THE GUARDIAN OF THE HORMUZ STRAIT." He announced that the US is reinstating its naval blockade on Iran and plans to enforce a 20% fee on all cargo passing through the strategic waterway to reimburse the US military for security and safety costs. As a result, the price of oil is rebounding, and so are concerns that inflation will persist as long as the war continues (chart). This pushed the 2-year Treasury note yield up to 4.26% and the 10-year Treasury bond yield to 4.62% (charts). Our out-of-consensus view that the FOMC might raise the federal funds rate at the July meeting received some support from these geopolitical developments and from comments by Fed Governor Christopher Waller today. S&P 500 momentum stocks, particularly semiconductors, are pulling back because they are overextended and vulnerable to developments that might slow economic growth, such as higher oil prices and higher interest rates (chart). The SOXX ETF is down 15.5% since it peaked on June 22. Some of the money from that ETF went into software and Mag-7 ETFs, which had been lagging. Let's have a closer look at recent developments that might keep bond and stock investors on edge over the rest of the summer: (1) Goods inflation up to no good. Goods inflation was easing before the war (chart). Now it is rising again. As a result of the war, PCED inflation in nondurable goods surged to 5.6% y/y in May. Today's oil price increases will keep it elevated after a temporary breather in June. PCED durable goods inflation rose to 3.3%, propelled by tariffs and a spike in computer software and accessories prices linked to the AI buildout. Insatiable global demand for semiconductor chips will continue to pressure consumer electronics prices. Furthermore, New York Fed data indicate that tariff pass-through to consumers is a gradual, drawn-out process, meaning that significant price increases remain in the pipeline. (2) Another squawking hawk at the Fed. Fed Governor Christopher Waller delivered a speech on Monday, and goods inflation was a key reason for his hawkish rhetoric. He warned that the sources of price pressures no longer are limited to tariffs and energy but are broadening throughout the economy. He cited rising producer goods prices, higher manufacturing input costs, and strong AI-related demand as additional sources of inflation. In his view, these developments raise the risk that core inflation remains elevated rather than returning smoothly to the Fed’s 2% y/y target. With inflation still well above target and the labor market near full employment, he said the FOMC must be prepared to tighten policy “in the near term” if upcoming inflation data remain hot. The rise in oil prices and Waller's hawkish remarks caused the market to discount a couple of Fed rate hikes sooner than previously expected (chart). According to the CME FedWatch Tool, the probability of a 25bps rate hike stands at 43.3% for July and 51.1% for September. (3) The federal deficit widens. The 12-month federal budget deficit widened to $1.80 trillion through June, while marketable Treasury securities outstanding increased by $2.43 trillion over the same period (chart). The government's heavy borrowing requirements are increasing the supply of Treasuries that investors must absorb, putting upward pressure on bond yields and keeping the Bond Vigilantes alert. Discretionary outlays have fallen from their pandemic-era peaks, largely reflecting the unwinding of emergency programs and restraint in other annually appropriated spending (chart). They are likely to return to a gradual upward trend as inflation and recurring federal program costs push appropriations higher over time. The larger problem is that nondiscretionary outlays will be difficult to constrain. Retiring Baby Boomers are driving up costs for Social Security, Medicare, and healthcare, while geopolitical tensions support higher defense spending. Interest expense continues to rise. In short, Washington still has a significant spending problem. Higher tariffs boosted customs duties but also raised business expenses, weighing on taxable corporate profits alongside the OBBBA's expanded business deductions (chart). The OBBBA is also pressuring individual income tax receipts through larger deductions, credits, and refunds, while payroll tax receipts have been supported by improving hiring activity and continued wage growth. Customs duties are declining, and the Treasury has had to refund some after the Supreme Court ruled that Trump's tariffs were unconstitutional.
Warsh’s Tasks
The AI boom is fueling the Fed’s hawkishness, as Ed and Elias agree it should, since it’s also fueling inflation currently. Yet Fed Chair Warsh asserted at his confirmation hearing that AI is a disinflationary force. They agree with that as well: It is disinflationary over the long term, which is the crux of our Roaring 2020s economic thesis; but paradoxically, AI is escalating inflation now as rapid demand spurs rapid infrastructure buildout. Once AI adoption is widespread, however, the productivity growth it sparks will propagate disinflationary economic growth. … Also: A look at who will lead Warsh’s five new task forces. … And: Consumers continue to do what they do best.
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