by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

We are seeing some reversals of recent trends in the wake of the Fed minutes.  Currently, equity markets are lower this morning.  Some of the weakness is being attributed to the lack of new fiscal stimulus, but we think a better case can be made that the Fed disappointed, which we discuss below.  We update news on China, the pandemic and Belarus. And, being Thursday, the Weekly Energy Update is available.  Here are the details.

Fed policy: The Fed released the minutes of its July 28-29 meeting.  Let’s get to the point—the sentence that has roiled the market is this one: “Many participants judged that yield caps and targets were not warranted in the current environment but should remain an option.”  Financial markets have been building in the idea that the Fed was going to engage in financial repression.  Specifically, the expected policy mix was fixing interest rates across the yield curve, a slow reaction to rising inflation and continued policy accommodation.  This has led to low Treasury yields, higher gold and equity prices and narrowing credit spreads.  As the above quote indicates, there was a surprising degree of reluctance to embrace the idea.  Some of this hesitancy was due to the lack of upward pressure on interest rates (of course, part of the low rate situation is due to market expectations of yield curve control).  It was a decided minority (“a couple of participants”) who seemed to express support for the idea.  It won’t really be tested until rates rise.  But, in the end, it appears the FOMC is in a “wait and see mode,” keeping current policy in place but seems unlikely to add additional stimulus unless there is a decided decline in economic activity.  This is not what financial markets wanted to hear.  Our take is that Chair Powell is supportive of the concept of yield curve control, but the lack of support suggests the rest of the FOMC isn’t on board yet.  At the same time, we think the market’s assessment of the Fed’s future policy is correct; financial repression is likely.  The continued process to avoid preemptive rate hikes to quell inflation, the move to average inflation targeting and extensive forward guidance are all part of this policy.  It’s just that markets like clarity, and the Fed has little reason to provide it when the financial markets are already enforcing that policy.  The real test will be when there is a whiff of inflation; if long-end yields begin to rise, will the Fed tolerate it?  We doubt it will.  But we don’t know for sure and, apparently, neither do FOMC members.

In the rest of the minutes, the assessment of financial markets and the economy suggested that there was some improvement in economic and financial market conditions, although both were said to be sensitive to pandemic developments.  The staff economic outlook was generally upbeat, expecting stronger GDP and higher inflation in 2021 and 2022.  However, they did express concerns about a slowdown in H2 2020.  Participants were more guarded, noting the unequal dispersion of economic weakness caused by COVID-19.  They also expressed that the economy’s path was still highly uncertain; it is not clear if this uncertainty was due to their own analysis or from comments the regional presidents are hearing from their local business contacts.  They also expressed concern about the potential lack of fiscal support.  The committee members also noted continued risks to financial stability.  Overall, this meeting’s tone was “wait and see.”  Markets rarely like such indecision.

China news:

• China’s flooding woes continue. Heavy rains have persistently pummeled southern and central China, putting strain on dams, including the massive Three Gorges Dam.  Complicating matters is that Typhoon Higos is hitting the coastal areas.  If the Three Gorges Dam breaks, it would be a catastrophe and put severe pressure on the Xi government.
• Apparently, Phase One trade talks are not off. When the president said he didn’t want to talk to China, it wasn’t meant to signal that these specific talks were scuttled.  Thus, they are delayed for now, but they will occur.
• The U.S. has formally suspended its extradition treaty with Hong Kong in light of the new National Security law.
• The U.S. is increasing the pressure on Chinese tech as the U.S. has essentially denied Huawei (002502, CNY 2.99) access to U.S. semiconductors. Some are calling this a “death sentence.”  The sanctions will also adversely affect U.S. and other foreign chipmakers as Huawei is (was) a major customer.
• It is apparent that China is trying to cool tensions. This may be due, in part, to hopes that it will be dealing with a different president after January.  In addition, Beijing may fear that tensions could be used as an election issue, and thus is trying to avoid escalation.  At the same time, the U.S. is avoiding provocative actions in other areas.  For example, Taiwan was not invited to participate in recent large-scale military exercises.  Taipei has expressed interest in joining such events.
  • At the same time, the drills were quite extensive. Nuclear capable B-2 bombers participated, and the U.S. Navy sent a destroyer through the Taiwan Strait.
• Chinese students studying at major universities are being told when class material may include items that are politically sensitive in China. This may be done to protect the students from harassment from Chinese authorities, but the decision to engage in such warnings has the appearance of “kowtowing” by U.S. higher education.
• U.S. regulators have warned college endowments to divest of Chinese equities that are at risk of delisting.
• The WSJ reports on China’s global efforts to recruit scientists through a network of 600 recruitment stations.

COVID-19: The number of reported cases is 22,427,939 with 788,030 deaths and 14,349,696 recoveries.  In the U.S., there are 5,530,247 confirmed cases with 173,193 deaths and 1,925,049 recoveries.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high frequency data on various factors.

• U.S. intelligence agencies have concluded that local officials in China purposely circumvented reporting channels created after the SARS epidemic to prevent the central government from receiving information about COVID-19.
• One of the key goals to reducing the impact of COVID-19 and returning the global economy to some semblance of normal is the development of herd immunity. Immunologists generally argue that if 70% of a population is immune, the risk to those who are not immune is insignificant.  Essentially, at the point of herd immunity, the virus can’t find enough people to infect and it dies out.  For older Americans, we saw this firsthand with diseases like measles, mumps and chicken pox; our classmates tended to lose class time in the early grades, but by fifth grade, enough people had suffered these maladies that losing time to them was uncommon.  New modeling work suggests that herd immunity might be met with only 50% of the population immune.  That may mean we are close to herd immunity in some communities.   For example, reports indicate that about a third of people tested in the Bronx are carrying the antibody.
• Infection data from California shows that new cases are hitting the Central Valley, a key agricultural area. Farm workers are adversely affected.
• We are seeing a surge in cases in a number of countries that had earlier reduced their case count. The chart below shows new cases per million.  Spain has seen a resurgence; South Korea’s increase appears to be driven, in part, by religious services.  Night clubs were cited as well.

• The mask debate isn’t just a U.S. issue. The Scandinavian countries have provided very loose guidelines for using masks, citing that the benefits from using them do not offset the social issues of face coverings.

Economics and Markets

• As interest rates decline, it is becoming increasingly difficult for financial firms that usually generate revenue from interest rate spreads to survive. They are increasingly turning to extra fees and slow responses to rate declines.  Although these actions support their profitability, they undermine the power of monetary policy.
• For years, Warren Buffett and Charlie Munger have derided gold as an asset. In their latest disclosure report, it turns out they have decided to purchase a position in gold miners.  This suggests that even long-time critics are seeing value in an asset designed, in part, to offset currency debasement.
• The real estate industry is warning that it is facing a wave of rent delinquencies.
• Twenty-two percent of college students have decided to delay the start of their college careers until campuses reopen. The declines in enrollment will put additional pressure on cash-strapped colleges.
• Copper prices lifted to +$3.00 per pound on stronger Chinese demand, rising U.S. housing activity and supply disruptions in South America tied to COVID-19.

Belarus: Although Lukashenko has lost the workers and urban dwellers, the security forces remain loyal.  There have been anecdotal reports of former security forces rejecting the leader, but these rejections do not appear to be systemic at present.  Lukashenko remains adamant that he will remain in power.  The EU is trying to walk a narrow diplomatic line; it wants to reject Lukashenko’s actions but doesn’t want Putin to fear he will “lose” Belarus and militarize the situation.  Therefore, EU leaders have condemned Lukashenko’s actions, calling the elections a sham, but have not called for a new vote.  We could see targeted EU sanctions against individuals in the Lukashenko government.  President Putin has warned the EU against “meddling” in Belarus, but Lukashenko should not take comfort that the Russian president wants to keep him in power.

One interesting twist to the Belarus saga is that the country was a participant in China’s belt and road project.  Although investment levels were not all that large, China did arrange a line of credit to Minsk.  Lukashenko tried to diversify Belarus’s economy away from its deep dependence on Russia and thus cultivated China’s interest.  It isn’t clear if this investment will be secure if Lukashenko is ousted.

Navalny poisoned: Russian opposition leader Alexei Navalny is in a coma after an apparent poisoning.  His condition appears grave.  Poisoning is an oft-deployed tactic of Russian security agencies against political enemies.  There is always a risk that such a blatant attack will backfire and lead to unrest; however, we believe that risk is low.

Coup in Mali: Mali has had its share of troubles in recent years.  There has been a constant fight against Islamist groups that has drained resources and displaced millions.  And, the government was seen as corrupt.  Although President Ibrahim Boubacar Keita was elected to office twice, he initially took control after a coup in 2012.  Yesterday, elements of the armed forces staged a coup, and the president has left office.  The coup leaders are promising to hold new elections soon.  Mali is Africa’s fourth largest gold producer; several gold mining companies with operations in Mali suffered a selloff in light of the news.

Brexit: Although talks continue, negotiators are stuck on the degree to which British truck drivers can traverse the EU and conduct business.  The U.K. wants drivers to have the ability to move across Europe and make multiple stops and deliveries.  The EU sees that as too close to being a member and wants to grant less freedom.  Although this issue probably won’t completely derail talks, it does suggest that a number of contentious issues remain; if talks fail, the GBP could decline.

Going postal: No, this isn’t about the recent mail controversy.  One of the proposals we have seen circulate would be for the Fed to offer limited banking services to the general public.  The banking system appears incapable of providing basic banking services to low-income households, leaving them to the tender mercies of payday check cashers and money orders.  The idea is that the Fed could provide basic services, but they would need a venue for such services.  In other countries, the venue has been post offices (Japan’s Postal Savings system is perhaps the most famous).  Of course, this would be a major expense for the Fed and perhaps for the USPS.  However, we note that JP Morgan (JPM, 98.55) has offered to install branch offices in postal stations.  This may be a way to head off the threat of competing directly with the Fed or it may offer the Fed a path to providing basic services but use the infrastructure that JP Morgan would provide.  We will continue to monitor this idea.

Policy odds and ends: Treasury Secretary Mnuchin has indicated that talks remain stalled but suggested the parties might resume negotiations because the House has returned to deal with the USPS.  Speaker Pelosi has suggested she would consider reducing the $3.0 trillion package passed by the House.  Republicans haven’t directly responded.  Both parties remain divided on the path forward on stimulus.  Business leaders are indicating that they probably won’t implement the payroll tax cut executive order because it only delays the tax, setting up a situation where companies will have to send the tax to the Treasury early next year.  The order is being dubbed as “unworkable.”

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

On this, the 29^th anniversary of the August 1991 coup in the Soviet Union, it looks like the U.S. equity market will follow through on its rise yesterday to a new record-high close.  Today’s apparent follow-through comes despite very little coronavirus news…or perhaps because of it?  Most of today’s key news is political, as we outline below.

China: President Xi has reportedly launched a major purge of the country’s security personnel.  Since the purge commenced last month, dozens of high-level police and judicial officials have been arrested, fired, or sent for “ideological training,” including the Shanghai chief of police.  Xi has often purged officials in order to stamp out corruption or remove opponents and overly ambitious rivals, especially early in his tenure.  However, reports indicate this purge is much more sweeping.

• Some commentators suggest the new firings merely represent another anti-corruption effort, but it’s likely that such a broad move also reflects growing political opposition against Xi within the Communist Party establishment.
• That opposition is hard to see from the outside, but various reports by knowledgeable China observers, including former Australian Prime Minister Kevin Rudd, indicate Xi has generated considerable discontent within the Communist Party for several of his policy initiatives.  For example:
  • Many party officials dislike Xi’s abandonment of collective rule and his attempt to build a cult of personality in which he alone holds all power as an autocrat.
  • Xi’s reputation has also been heavily damaged by his failure to keep a lid on the novel coronavirus when it first surfaced last year.
  • Xi has generated pushback against his aggressive geopolitical moves in places like the South China Sea and the Himalayas.  Those moves represent an abandonment of Deng Xiaoping’s dictum to “hide your strength, bide your time.”  Many Communist Party officials are probably also uncomfortable with Xi’s failure to avoid an economic, political, and technological conflict with the U.S.  In simplistic terms, these concerns center on the possibility that Xi has misjudged China’s strength and has embarked on moves that are generating strong pushback from the U.S. and other Western democracies before China really has the power to follow through on them.
• If the purge really does turn mostly on Xi’s need to stamp down burgeoning internal political opposition, his past success with purges suggests he will probably be successful.  All the same, if the breadth of the purge reflects how broad the political opposition has become, it also raises the risk of political instability at some point in the future.  That possibility, in turn, suggests that one thing missing from current U.S. policy toward China is an effort to play to Xi’s opponents, perhaps by offering a softer policy again if Chinese geopolitical or economic policy becomes less aggressive.
• In any case, if Xi’s opponents were to gain power and the country became politically unstable, it would naturally be disruptive for global markets.  On the other hand, increased opposition to Xi overseas and a burgeoning political opposition at home could chasten Xi and lead him to cool his geopolitical and economic ambitions, at least temporarily.  That reaction might help cool global tensions and create a more favorable investment environment.

United States-China: As if to illustrate the U.S. pushback that Xi’s policies have generated, President Trump said he ordered the cancellation of last weekend’s planned U.S.-China meeting on the implementation of the “Phase I” trade deal, which the countries signed in January.  His administration has also urged university endowments to divest their holdings of Chinese stocks ahead of the companies potentially being delisted from American exchanges.  Those developments help explain today’s drop in the Chinese and Hong Kong stock markets.

Japan: Just months after his last regular checkup, Prime Minister Abe unexpectedly spent an entire day in a Tokyo hospital this week for unspecified medical tests.  Abe only has one year left in his final term as leader of the ruling Liberal Democratic Party, but the visit has led to growing speculation about his political future.  It also intensified maneuvering by his rivals for the chance to succeed him.  His main potential successors are Fumio Kishida and Shigeru Ishiba, both former ministers and leaders of party factions.  Separately, the Democratic Party for the People is expected to approve a merger today with the Constitutional Democratic Party of Japan, forming a more organized, numerically viable opposition to Abe and raising the prospect of snap elections.

Canada: A day after his previous finance minister quit, Prime Minister Trudeau named his deputy, Chrystia Freeland, as the country’s new finance minister and said he would suspend parliament until September 23 in order to develop a new plan for addressing the coronavirus pandemic and economic recovery.  That plan, which Mr. Trudeau hinted would include aggressive spending measures, would be subject to an immediate vote, giving the opposition parties—which hold a majority of seats in the legislature—a chance to defeat the Liberal government and trigger an election.

United States: The Democrats formally nominated Joe Biden as their candidate for president last night.  Biden is expected to formally accept the nomination in a speech on Thursday.

United States-India: Although Biden’s choice of Kamala Harris as his vice presidential running mate has excited many Indians, given her Indian heritage, reports say the Indian foreign policy establishment is becoming apprehensive about how a Biden-Harris administration might respond to Prime Minister Modi’s aggressive Hindu nationalist agenda, which has deeply alienated the country’s Muslim minority.

United States-Russia-China: After two days of U.S.-Russia meetings on extending the New START nuclear arms treaty, which is due to expire in February, administration officials signaled they are no longer insisting on China’s participation in a follow-on deal.  The change of approach should help ensure that the key arms limitation agreement will be extended.

European Union-Belarus-Russia: Ahead of today’s emergency EU summit to discuss the political crisis in Belarus, Russian President Vladimir Putin warned German Chancellor Merkel and French President Macron that he would not tolerate any outside pressure on the Belarusian leadership.  At the meeting, EU leaders are expected to discuss imposing sanctions on Belarusian leaders and officials who oversaw the recent election and the brutal response to the initial protests, which led to thousands of people being detained.

Mali: Renegade soldiers in Mali detained President Ibrahim Boubacar Keita, Prime Minister Boubou Cisse, and dozens of other senior officials in what appeared to be a coup attempt after months of civilian demonstrations calling for the government’s resignation.  Keita soon acquiesced in the takeover and announced his resignation.  According to the military, a transitional government will now be set up to rule until new elections.

COVID-19: Official data show confirmed cases have risen to 22,169,145 worldwide, with 781,575 deaths and 14,138,936 recoveries.  In the United States, confirmed cases rose to 5,482,823, with 171,833 deaths and 1,898,159 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• Newly confirmed U.S. infections continue to show signs of moderation, but more universities and colleges are having to backtrack on their plans for the school year as they deal with a surge of cases on their campuses.
  • At Notre Dame, where students were already back on campus and attending classes in person, a surge of infections spurred by off-campus parties prompted the school to move to online classes only for at least two weeks.  The administration also warned that if the outbreak isn’t contained quickly, the school will send students home to learn remotely, similar to the campus closure that happened last spring.
  • At Michigan State, an outbreak of cases prompted the administration to ask students not to return to campus just yet.
• Responding to the resurgence of infections around Europe, German Chancellor Merkel said her country would stop easing virus restrictions for the time being.  The comments serve as a reminder that Europe’s encouraging recovery to date remains fragile, since failure to keep easing restrictions could short-circuit the recent improvement in activity and in European stocks.
• Speculation continues to rise that the virus could be transmittable via frozen or refrigerated food, with at least one major Chinese city banning the importation of frozen meat from coronavirus hotspots.

U.S. Policy Response

• With the White House and Congressional Democrats still at a stalemate over a new pandemic relief bill, some Republicans in Congress reportedly are considering a pared down “skinny bill” that would cost only about $500 billion compared with the latest White House proposal of approximately $1 trillion and the Democrats’ proposal for a bill worth $3.5 trillion.
• Meanwhile, several states said they sought and received approval for federal disaster funding to pay an extra $300 per week over their normal unemployment benefits as provided for in President Trump’s recent executive orders.  However, it appears it will take several weeks for those funds to start being distributed to the jobless.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

The modest uptick in risk assets so far today comes despite new U.S. moves to punish Chinese companies on national security and economic policy grounds, as well as the continued stalemate over a new U.S. coronavirus relief bill.  We review all the key news below.

United States: The Democratic Party opened its virtual convention last night with a theme of “We the People,” seeking to emphasize national unity while at the same time celebrating U.S. diversity.  The program included surprise appearances by several high-level Republicans, including former Governor John Kasich of Ohio and former Governor Christine Whitman of New Jersey, who argued for Republicans to support the presumptive Democratic candidate for president, Joe Biden.

United States-China: The Commerce Department issued new rules prohibiting non-U.S. firms from selling microprocessor chips made using U.S. technology to Chinese telecom equipment giant Huawei (002502.SZ, 3.00) without a special license. The rule even covers widely available, off-the-shelf chips made by overseas firms.  In addition, the department added 38 Huawei affiliates in 21 countries to its “Entity List,” which prevents companies from exporting U.S. technology to those entities without a license.

• Given the dominance of U.S. technology in certain segments of chipmaking, the new rule reportedly amounts to a blanket ban on any chip sales to Huawei, hitting its 5G equipment and handset businesses.
• By further crimping Huawei’s ability to operate, the moves will escalate the administration’s tough-on-China policy, highlighting the risk of even more bilateral tension and economic disruption down the road.  In fact, President Trump also signaled that his administration is considering similar moves against other Chinese firms on national security and economic policy concerns.

China:  According to a new study by law firm Baker McKenzie and economic consultancy Silk Road Associates, Chinese exports had already started losing global market share last year, before the coronavirus pandemic hit.  The study showed that Chinese exports of 1,200 products accounted for 22% of the world’s exports, 3 percentage points lower than in the previous year. For consumer goods, the country’s global market share fell by 4 percentage points to 42%.  The study found that the decline in China’s market share stemmed mostly from the U.S.-China trade dispute, the rise of new technologies, and corporate governance demands.

European Union: As EU member countries continue working to implement the bloc’s big, new coronavirus relief and mutualized debt program, the so-called “frugal four” countries that agreed to the program in return for higher rebates from the EU budget are now demanding that those rebates be increased by 2% per year to offset price inflation—despite expectations that inflation is likely to remain minimal in the EU for the foreseeable future.

Belarus: In a sign that President Lukashenko continues to lose support after the apparently fraudulent elections earlier this month, the autocrat was booed by workers at a major defense factory he was visiting.  The booing was notable because workers at the plant, which produces key components for Russia’s military, are probably among the best paid and highest privileged workers in the country.  It was also noteworthy because Lukashenko was using the occasion to announce he is preparing a referendum on a new constitution that could eventually lead to him handing over power.  Obviously, the workers weren’t buying it.

Canada: Finance Minister Morneau said he will step down, the biggest casualty to date from a scandal tying the Liberal government to a charity with close links to the family of Prime Minister Justin Trudeau.

COVID-19:  Official data show confirmed cases have risen to 21,916,639 worldwide, with 774,720 deaths and 13,908,270 recoveries.  In the United States, confirmed cases rose to 5,444,205, with 170,559 deaths and 1,865,580 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• Newly confirmed infections in the U.S. rose by only about 35,000 on both Sunday and Monday, marking the lowest two-day tally since late June and bringing the seven-day rolling average down to its lowest level since early July.  Of course, some locations continue to see resurging cases and deaths, such as Texas, Louisiana, Tennessee, and Florida.  The region with the lowest infection rates continues to be New England.
• Overseas, Australia and New Zealand have also shown progress on capping their infection resurgence.  However, in a worrying development, both countries have reported that the staff at designated quarantine hotels have tested positive for the virus and, in at least one instance, have infected a quarantined person.
• The University of North Carolina at Chapel Hill said it will shift all undergraduate courses for the fall to remote instruction starting Wednesday, following a series of COVID-19 outbreaks on and around campus since classes started last week.
  • The move illustrates how hard it will likely be for organizations to resume anything like normal operations before a viable vaccine is available for the disease.
  • Separately, a monthly survey for the Financial Times and the Peterson Foundation found that 64% of likely voters in the U.S. were not confident it will be safe for elementary, middle, and high schools in their state to reopen in the autumn owing to outbreaks of coronavirus.
• With China closing in on a coronavirus vaccine, Beijing’s top officials and some of its pharmaceutical firms have started to promise early access to countries of strategic interest, including Brazil and Pakistan.  In contrast with the U.S. approach of prioritizing shots for U.S. citizens before any domestic vaccine is made available internationally, China’s promise of doses is designed to draw the targeted countries into Beijing’s orbit and split them off from the West.

Economic Impact

• While the pandemic has hurt real estate properties of all types, it’s having an especially heavy impact on New York’s iconic Empire State Building as more companies embrace remote work or cheaper satellite offices outside city centers.  Some in the industry say the building is worse off than many peers because it relies on smaller office tenants, which tend to be more at risk during a downturn.
• In the longer term, one little-discussed implication of the pandemic is that the disease and the associated economic disruption will likely push down birthrates and further slow population growth.  That’s starting to be an especially important concern for Japan, which already had one of the most rapidly aging societies even before the pandemic.
• Even though China was able to minimize infections when the pandemic first broke out late last year, and has been staging an impressive economic recovery since then, it turns out that the recovery has widened income inequality, just as it has in many Western democracies.

Financial Market Impact

• While the pandemic has helped touch off a sustained depreciation of the dollar versus other major currencies, key emerging market currencies continue to suffer even more.  The Brazilian real, the South African rand, and the Turkish lira have lost about 20% of their value against the dollar this year, putting the former two on course for their biggest annual declines since 2015. The Russian ruble and the Mexican peso have dropped roughly 15%.

U.S. Policy Response

• Senate Majority Leader Mitch McConnell has warned that the ongoing discussions on a new coronavirus relief bill may not lead to a deal.  Media reports also say Republicans are considering further reducing their proposed stimulus amount.  Both developments are raising concerns that the fiscal rug could be pulled out from under the economy before a solid and sustainable recovery is in place.  Those concerns appear to be a key reason for the muted tenor of the risk markets so far today.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

Happy Monday.  Equity markets are higher this morning as the S&P 500 slowly trends toward a new high.  Foreign news leads off our comments this morning, with a special focus on Belarus.  China news is next, followed by market and economic news.  We close with the pandemic update.  Here are the details.

Foreign news:

• The turmoil in Belarus continued over the weekend. Here is what we are following:
  • There were massive protests over the weekend. After last week’s elections, protesters were dealt with harshly, prompting the weekend’s gatherings.  In a worrisome development for Lukashenko, it appears he is losing the state-owned company workers.  They have joined the protesters and are threatening a general strike.  He may be losing support within his government as well; Igor Leshchenya, Belarus’s ambassador to Slovakia, announced he was supporting the protesters.  And, there are rumors that security forces are seeing defections to the protesters as well.  Historically, when the security services turn, a leader is in serious trouble.
  • Lukashenko has requested support from Putin. The two nations have a mutual defense pact, which means they will defend each other against a foreign invader.  Russia has indicated it was prepared to protect Belarus from outside influence, but Russia is not obligated to protect Lukashenko from his own people.  There are reports of military exercises on the Russian/Belarus frontier, but we doubt that Putin wants to directly intervene.  Unlike Ukraine, which was showing clear signs of leaning to the West, Lukashenko was constantly trying to extract resources from both sides.  In addition, there is little evidence in the protests that there is anger at Russia.  From Putin’s perspective, it is unlikely that Belarus will leave Russia’s orbit with or without Lukashenko.  If a reasonable replacement is found, we suspect Putin will be fine with Lukashenko heading to retirement.
  • Meanwhile, NATO, the EU and the U.S. have been mostly quiet. The EU is threatening sanctions, but we doubt the West will directly intervene.
• Although U.S./Russian relations remain fraught, one thing remains the same. Wealthy Russians still like being in assets other than rubles; so far this year, capital flight is up 53%.
• In the Middle East, the U.S. is preparing a new round of sanctions on Syria to prevent a return to normal relations between Syria and neighboring states.
• Although the UN Security Council rejected a U.S. proposal to extend the five-year ban on the sale of conventional weapons to Iran, Washington is preparing to take unilateral action against Tehran. The current weapons sale ban ends in October.
• Thailand is seeing widespread protests against both the government and the king. Protests against the royal family are rare.  The former sovereign, King Bhumibol Adulyadej, was generally revered and was careful about his intervention into politics.  He died in 2016.  His son, Maha Vajiralongkorn, is not well liked.  Thailand has unusually strict lèse-majesté laws, which make it illegal to publicly criticize the king.  The protesters could be imprisoned under these laws.  There has been political tension between the city dwellers and rural voters for the past two decades.  The latter have supported the Shinawatra family, who were prime ministers in 2001-06 and 2011-14 and have been ousted by the royal family and the military.  The Shinawatra governments supported redistribution to the countryside.  They have been opposed by the established political power, which resides in the cities, the military and the royal family.

China news:

• The U.S. and its allies are conducting massive military exercises in the South China Sea this week. Unfortunately, the Philippines won’t be participating; President Duterte is attempting to straddle the U.S. and China and wants to avoid a confrontation with Beijing.  Losing the Philippines makes containing China within the first island chain difficult.
• Scheduled meetings to monitor the Phase One trade deal were postponed. Although an official reason wasn’t proffered, it is “Beidaihe season” in China.  Beidaihe is a seaside resort in China where CPC leaders meet quietly every August to discuss policy matters.  The resort was a favorite of Mao’s, and the tradition continues.  It does appear that Chinese leaders were preoccupied with these meetings, which is probably why there were delayed.  No new dates have been set.
• President Trump indicated that additional Chinese companies could be subject to U.S. sanctions. The focus continues to be on tech companies; the break between U.S. and China on technology continues to widen.
• China’s bank regulator is warning that easy U.S. monetary policy could undermine global financial stability. It isn’t clear what he would have Chair Powell do exactly (raising rates would certainly have a negative effect on the global economy), but he is correct that given the dollar’s widespread usage, low interest rates will tend to trigger a rise in world borrowing.

Market and Economic news:

• We have noted our concerns about state and local government spending. Another area that could hurt the recovery is the continued problems of child care.  Providers are struggling to make day care safe.  Elementary and secondary schools are trying to decide if they can open to in-class participation or remain online.  In the middle are families trying to juggle taking care of children and the responsibilities of work.  If this problem can’t be resolved, it will reduce the number of available workers and undermine the recovery.
• The economy continues to show signs of uneven growth. On the one hand, for those who have remained employed and have benefited from stimulus spending, there has been a bump in savings that has started to translate into consumer durables spending.  Thus, car sales have been good, and home improvement is doing very well too.  Some of this spending is occurring because other areas, such as tourism, have been reduced.  At the same time, there is growing evidence that lower income households are struggling as food banks report strong demand, and there has been a rise in government food assistance.
• China and Russia are increasingly using currencies other than the dollar to settle trade. The use of the dollar is now under 50%.  The EUR is now up to 30%, while national currencies represent 24%.  Both nations are facing U.S. sanctions.  Although this diversion could weaken dollar demand, it could also increase Moscow’s dependence on Beijing, something that history would suggest is a problem for Russia.
• German anti-trust authorities are investigating the activities of Amazon (AMZN, 3148.02).
• It has been noted that gold prices have been rising. Gold miners are doing well, but report that the costs of new mines are rising.  This increase in cost is leading companies to be cautious about projects, worried that future prices won’t support a high cost mine.  Of course, this reluctance is bullish as it means less new gold will be on the markets even at historically high prices.
• Worries about a disruptive election will likely lead to a higher VIX as we head into November.

COVID-19:  The number of reported cases is 21,707,773 with 775,926 deaths and 13,690,055 recoveries.  In the U.S., there are 5,404,115 confirmed cases with 170,052 deaths and 1,833,067 recoveries.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high frequency data on various factors.

• Novavax (NVAX 146.51) announced that its vaccine is beginning Phase 2 trials and could begin Phase 3 trials by late September. The company will be conducting its trials in South Africa due to the surge of cases in that country.  In fact, for trials, a high rate of infection makes a country attractive.  Brazil, with high infection rates and a strong public health system, is increasingly looking like a good country for experimental treatments.
• There is growing evidence that containing the virus once doesn’t mean the problem is resolved. Both South Korea and New Zealand are reporting new outbreaks.
• The FDA is reporting that surgical gowns, testing supplies and masks are in short supply.

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by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] | PDF

Happy Friday!  It looks like a risk-off morning.  Foreign news is the opening focus—the U.S. has engineered the UAE’s recognition of Israel, only the third nation in the region (Jordan and Egypt are the others) to grant formal recognition.  China news comes next, in which Chinese concerns about financial sanctions and threats to Taiwan dominate.  We update the virus news and close with economics and markets.  Being Friday, the new Asset Allocation Weekly is available, along with the podcast and chart book; the topic this week is precious metals.  Here are the details.

Foreign news:

• In a momentous breakthrough, the UAE has agreed to formally recognize Israel. The UAE offered Israel a deal—if Israel didn’t annex areas of the West Bank, the UAE would grant formal recognition.  The U.S. was cool to the idea of annexation anyway, so, from the American perspective, this development is a win.
  • In fact, it’s historic, not quite on the same level as Egypt’s normalization,[1] but it’s close. Editorial writers are lauding the agreement.
  • The next step is to see if other Persian Gulf states follow the UAE’s lead. Pressure on Riyadh will be elevated.  If normalization becomes a trend, the agreement with the UAE would be the most significant in history.
  • The Palestinian leadership is devastated.
• So, what’s the bigger picture here? The driving force behind this outcome, in our opinion, is the U.S. reducing its geopolitical footprint in the region.  A key “known/unknown” is how the world acts as the U.S. pulls back.  S. hegemonic management after WWII assumed that three “hot spots” would require constant U.S. engagement to prevent an outbreak of hostilities.  These areas were Europe, where the German problem had to be managed, the Far East, where the endemic conflict between Japan and China had to be quelled, and the Middle East, where a colonial legacy left states designed to be unstable.  Optimists believe that if the U.S. pulls back from these hot spots, Japan and China will work out their differences, German regional hegemony in Europe will be beneficial, and the Middle East will adjust without going to war.  Pessimists expect that optimists are falling into the trap of mistaking hope for a plan.
  • As the U.S. withdraws from the Middle East, the nations there need to figure out how to counteract Iran’s malign influence, control Turkish ambitions, and manage outside actors, such as Russia. Israel and the Gulf States have mutual interests—they all want to contain Iran, are uncomfortable with Russia, and have enough memories of the Ottomans to want to keep the Turks at bay.
  • As long as the U.S. was guaranteeing security, these nations could avoid uncomfortable compromises. But if that guarantee is fading, the Arab States and Israel have an urgency to make common cause.
  • And so, this agreement is a “win” for the optimists. And, it allows the U.S. to focus its efforts on China.
• A theme we have held for a while is that if U.S./Chinese economic relations are set to fray, Mexico should be a major beneficiary. Although there is clear evidence of pressure, most U.S businesses, so far, are trying to keep their ties to China.  In addition, AMLO’s government in Mexico has not been considered “business friendly” and his management of the economy and the pandemic have been a disappointment.  Mexican equities have tended to underperform; over the past five years, the iShares Mexico ETF (EWW, 34.14) is down 37.1% compared to the S&P over the same time frame, which is up 61.6%.   However, at long last, perhaps Mexican leaders are starting to see their geographic advantage―reports suggest Mexico is working actively to lure U.S. firms that are considering leaving China.
• For the first time, the Trump administration has seized Iranian fuel shipments that violate American sanctions. This action will further raise tensions between the two states.
• The EU is formally protesting U.S. sanctions on the Nord Stream 2 project. This project would bring Russian natural gas to Europe under the Baltic Sea, bypassing Ukraine.  The U.S. has consistently opposed this project.

China news:

• U.S. and Chinese officials will meet tomorrow to update the Phase One trade deal. It looks like there is little chance China will meet its obligations, but it doesn’t appear that either side wants to scuttle the arrangement.  Thus, we expect a smooth meeting with lots of promises.  An actual break in the deal would be a shock.
• We are seeing increasing reports that Chinese officials are worried the U.S. will move to exclude China from the global dollar infrastructure. Although we haven’t seen anything directly suggesting the Trump administration is considering something so radical, it would have significant effects on the global economy.
• The tech battle between the U.S. and China continues. SoS Pompeo intimated that recent executive orders are “broader” than just TikTok and WeChat (TCEHY, 65.32).  American corporations are warning U.S. officials that the tech ban would harm their businesses.  Despite all the tensions, U.S. firms are generally maintaining their ties to China, although there is rising reluctance to operate in Hong Kong.
• China’s retail sales were disappointing. Essentially, we are seeing a plateau after a sharp recovery.
• China’s financial regulators are warning of a surge in bad loans in the near future.
• We are seeing moves and countermoves on the military front between the U.S. and China. The U.S. has moved B-2 bombers to Diego Garcia; usually, this is done when tensions rise in the Middle East, but this action appears to be designed to counter Chinese naval exercises, especially recent ones around Taiwan.
• There is no sign of easing tensions between China and India.

COVID-19:  The number of reported cases is 20,950,402 with 760,235 deaths and 13,015,379 recoveries.  In the U.S., there are 5,254,878 confirmed cases with 167,253 deaths and 1,774,648 recoveries.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high frequency data on various factors.  The R_t data shows 28 states with a reading less than one, a positive development.  The lowest state is Maine, while the highest is Hawaii.

• Russia has introduced a vaccine for limited use with very limited testing. It appears that some of this was a headline grab.  We will be watching to see how it does and hopefully it will work.
• One of the frustrating elements of this virus is that we are all learning on the fly. There is a tendency to try to project facts off limited data.  One of the items that has been noted is that children, for the most part, seem to be less affected by COVID-19.  That isn’t to say all are safe from it, and it says nothing to the issue of carrying the virus to others.  The effects on children are critical to the reopening of schools.  A new datapoint seems to suggest that minority children may be at greater risk to the virus, which complicates the reopening issue.
• A vaccine is the most likely path to normalization. This report highlights the difficulties in producing and distributing a vaccine once one is developed.

Market and Economic news:

• The recent executive order about suspending the payroll tax is increasing uncertainty for businesses. Since the tax is only deferred, businesses are not sure if they should continue to collect it or give it to their workers only to take it back in a lump sum early next year.  This was clearly not the intent of the order, but it does show the difficulty of governing without legislation.
• Yesterday, we noted that mortgage insurers were preparing to assess a new fee on refinancing.  The White House is criticizing the move.

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[1] Egypt was the most significant military threat to Israel; the normalization between Israel and Egypt meant that the former didn’t need to worry about its southern border and the latter could operate in the Sinai without risk.