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

[Posted: 9:30 AM EDT] | PDF

It’s the 75^th anniversary of the bombing of Hiroshima.  U.S. equity markets are a bit weaker after a strong showing yesterday.  We lead off with an update on policy progress (or lack thereof), followed by foreign news, with an update on Lebanon.  We also check in on the pandemic, followed by China.  Being Thursday, the Weekly Energy Update is available.  Here are the details:

Policy news: 

• Congressional leaders remain far apart on the next round of stimulus/support. The White House is threatening to take executive actions in lieu of legislation, although there will be limits to how much this can accomplish.  Although the process looks unsettling, this messiness is very common in democracies.  As Otto von Bismarck is attributed to have said, “There are two things no one should ever watch, the making of sausage and laws.”
  • The lack of agreement has probably already affected the economy. Even if the funds are returned, households will note the fragility of the moment and likely save additional amounts of any new stimulus.
  • Here’s a twist—dead people may get a stimulus check after all.
• As Congress continues to work on a support package, worries about a rise in evictions are starting to develop. The previous support package had put a moratorium in place, but that measure has expired.  At present, the decision to evict is a local issue, unless another moratorium is established.
• The National Guard has provided support for COVID-19 testing and other measures. The funding for these soldiers to participate in this mission will expire on August 21 without new authorization from the White House.  However, the demobilization is set to start tomorrow to allow the soldiers to quarantine for 14 days.  Some states have vowed to pay for the National Guard personnel to remain, but others lack the available funding.
• The WSJ has a detailed report on the Fed’s foreign swap lines. The decision by the FOMC to expand these lines was critical in maintaining global financial stability.
• In a recent AAW, we discussed monetary policy and social goals, specifically, what the Fed could do to improve the lot of disadvantaged groups. For African Americans, the evidence suggests the best way to narrow the unemployment gap (the gap between racial groups) is by extending the business cycle.  Congressional Democrats have introduced new legislation that would give the Fed a mandate to reduce racial inequality.  Here are a couple of thoughts:
  • The original Humphrey/Hawkins bill was designed to give the Fed the mandate to bring about full employment. Much of this thrust came from the civil rights movement, as leaders of that movement noted that having rights mattered little if one didn’t have work.  So, this legislation isn’t anything new; in fact, it is already part of the Fed’s mandate.
  • What is being lost here is that the inherent tradeoff is efficiency versus equality. When a society favors efficiency, it gets low inflation at the cost of higher inequality.  When it favors equality, it pays for that goal with higher inflation.  As we have been saying for nearly a decade, the U.S. is embarking on a cycle shift toward equality and away from efficiency.  That will eventually lead to higher inflation, but, given the level of slack in the economy, it will take a long time before that inflation becomes an issue.  Part of the reason the Humphrey/Hawkins bill never really did much is that it passed in 1978 when inflation was becoming a crisis.  The focus on inflation meant that most of the Humphrey/Hawkins law was ignored.  In fact, the most visible vestige of that bill is the fact that the Fed chair has to go to Congress biannually to testify about monetary policy.  This used to be known as the “Humphrey/Hawkins testimony.”
• One of the consequences of the TikTok issue is that it is further evidence that the World Wide Web is rapidly going regional, or becoming a “splinter-net.” Europe, China, Russia, and the U.S. are all taking measures designed to limit the global scope of internet traffic.  The potential impact on globalization is significant; if data can’t be moved easily anymore, The Great Convergence discussed by Richard Baldwin will reverse itself.

COVID-19:  The number of reported cases is 18,835,986 with 708,278 deaths and 11,381,042 recoveries.  In the U.S., there are 4,824,175 confirmed cases with 158,268 deaths and 1,577,851 recoveries.  For those who like to keep score at home, the FT has created a nifty 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.  Axios has updated its state map; there is clear evidence of improvement.

• There is growing consensus that once a vaccine is developed, supplies will be limited. This means some form of triage will be necessary and the protocol for who gets vaccinated and who must wait will be controversial.  Meanwhile, vaccine developers are starting to float pricing schemes.
• One of the common themes we continue to monitor is that societies are struggling with the balance between reopening and virus control. What we are seeing globally is that lockdown rules are eased.  In response, people congregate, relieved from the pressures of following guidelines.  Shortly thereafter, cases rise, and governments attempt to implement restrictions again.  We haven’t yet mastered the balance between the level of interaction and disease proliferation.

Foreign news:

• Here is what we are watching on Lebanon:
  • Although the initial reports from Lebanon were so horrific that it seemed logical that it must have been a bombing, the general consensus is that the cause was catastrophic negligence.
  • After such events, there is a drive to blame someone. Currently, port officials are under house arrest.
  • The Lebanese public is rightfully furious. For this dangerous material to be stored, essentially unsecured, for several years is unfathomable.
  • Ultimately, this is a problem of governance. Lebanon has the characteristics of a Middle East post-colonial state.  The colonial powers tended to create “states” that were not naturally composed.  Instead, they were borders that ignored conditions on the ground.  Peoples, religions, and ethnic groups that would not have naturally congregated were put together.  When the Europeans left, these essentially ungovernable entities remained.  Iraq, Syria, and Lebanon are all classic examples of this phenomenon.  The current government structure, which emerged from the 1990 agreement that ended a 15-year civil war, is no longer functioning.
  • Even before this catastrophe, Lebanon was in deep trouble. It was in the midst of a currency and debt crisis with no clear path to resolution.  The state is trying to avoid direct involvement in the Syrian debacle and has persistent tensions on its southern border with Israel.  What this blast lays bare is that the government probably can’t cope with all the pressures it faces.
  • We would not be surprised to see fighting break out between rival groups and another refugee crisis emerge.
• Azerbaijan and Armenia have been at loggerheads since the breakup of the Soviet Union.  Outside powers, including Iran, Russia, and Turkey, have routinely intervened to support one side or the other.  Recently, Turkey has been sending signals that it is willing to support Azerbaijan as tensions rise.
• Liam Fox, the former U.K. trade secretary, admitted that classified documents related to U.K./U.S. trade talks had been leaked after Russian hackers broke into his account. The episode highlights the risk of Russian technology infiltration.
• It is likely that Belarus is Russia’s closest ally. President Lukashenko is an autocrat much like President Putin.  In addition, Belarus’s close proximity to Russia means that the former needs to get along with the latter, although Lukashenko has tended to follow the small nation handbook of playing Russia against the West for aid. Recently, relations have been strained as Lukashenko faces a real election threat and he has accused Russia of interfering in the election.  The latest is that Belarus claims Russian agents have penetrated the country; it is not clear what the goal was, although intimidation is likely.  The Russians have been detained, which won’t sit well with President Putin.

Markets and Economic news:

• Gold prices have broken above the $2,000 per ounce line with little resistance. Negative real interest rates, currency debasement fears, and societal stability fears are all combining to lift the yellow metal.
• Housing has always been a difficult asset to value. Total return is calculated by the price change of the asset plus any benefits derived from ownership.  Calculating total return from a financial asset is usually straightforward.  How much did the price change over the period of ownership and was other income, interest or dividends, captured?  Housing is different because the benefits can be difficult to calculate.  It is possible to estimate the price gains of a property, although given the characteristics of the market (homes are not universal in quality and thus prices are best estimates), one doesn’t know for sure until the house is sold.  At the same time, there are benefits of living in a home.  And, if we are stuck at home, getting more benefit from the house becomes important.  We are seeing ample anecdotal evidence that homeowners are undertaking remodeling projects.  In the hard data, if we look at retail sales of building supplies and restaurants, it is evident that we are seeing a massive divergence.  The WSJ has a nice reflection piece on the benefits of homeownership; although they can be difficult to value, they are nonetheless real and enhanced under current conditions.

Although inflation has generally been modest, one area that has seen rapidly rising prices is food.  Such divergences are not unprecedented, but rising food prices do have distributional effects, harming lower income households.  Historically, rising food price inflation is not generally persistent and we would expect this episode to end fairly soon.  However, it highlights that any disruption in income support could have an increasingly adverse effect on lower income households.

• Commercial banks are notoriously procyclical. They tend to be too easy during expansions and too tight during recessions.  The most recent Senior Loan Officer Survey suggests a dramatic tightening of lending standards, which will tend to hamper the recovery.

China news:

• SoS Pompeo indicated the U.S. is prepared to expand its crackdown on Chinese tech firms by expanding into cloud-computing companies.
• Globalization and the drive for efficiency rested on an assumption of geopolitical stability.  Specifically, it needed the U.S. to act as global hegemon, reliably providing security and a reserve currency and the rest of the world accepting that condition.  As China has threatened this assumption, it is starting to expose previously unforeseen risks.  Simply put, under conditions of efficiency, there is little worry about where one produces a good.  The only thing that matters is whether production is cost-effective.  However, as the assumptions that underpinned globalization come under question, the U.S. finds itself in a position where it has supply chain risks it hadn’t acknowledged before.  The pandemic has revealed that the U.S. is dangerously exposed to China when it comes to pharmaceuticals.  That vulnerability isn’t a problem when the U.S. is the hegemon and China agrees, but it’s a big problem when the U.S. doesn’t know whether it wants to be the hegemon and China would like to remove our influence from that part of the world.

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

[Posted: 9:30 AM EDT] | PDF

Moderating coronavirus infections in the U.S. and continued progress in vaccine and treatment studies are helping buoy risk assets so far today, despite a major explosion in Beirut that initially raised fears of terrorism.  Another important positive today is that White House and congressional negotiators say they’re hoping to reach a deal on the next coronavirus relief bill by the end of the week.  We review all the key news below.

COVID-19:  Official data show confirmed cases have risen to 18,570,858 worldwide, with 701,316 deaths and 11,163,388 recoveries.  In the United States, confirmed cases rose to 4,771,846, with 156,839 deaths and 1,528,979 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• New coronavirus cases in the U.S. climbed above 50,000 for the first time in three days, but the tally remained lower than during recent peaks.  In addition, there are now only 18 states where the seven-day average of new confirmed cases is above the 14-day average, compared with 48 states a month earlier.  The data appear to confirm a continued moderation in new U.S. infections, even if some states and some foreign countries continue to face accelerating cases.  The figures should therefore be supportive for risk assets today.
• In contrast with the good news in the U.S. and many other major developed countries, the pandemic is still buffeting many large developing countries.  The Bolivian government has canceled its entire school year, worrying there isn’t enough internet reach across the country to make virtual classrooms feasible.  Longer term, there is also increasing concern that the pandemic will make it even harder for less developed countries to reach advanced country status.
• Novavax, Inc. (NVAX, 157.17) said its experimental coronavirus vaccine induced promising levels of both neutralizing antibodies and T-cells in an early-stage human trial of the shot.  The company also said the vaccine was generally well-tolerated.  That means the Novavax vaccine is in the current horserace of almost half a dozen vaccine candidates that have either moved into a final Phase III trial or are preparing to do so.  The news should help keep alive the current market optimism that a shot can be approved around the end of the year.  There would still be many challenges to be met before the global population can be broadly immunized, but the vaccine progress to date is encouraging, which should be positive for risk assets.
• In the search for treatments, researchers running a large national study found that hospitalized COVID-19 patients who received transfusions of blood plasma rich with antibodies from recovered patients reduced their mortality rate by about 50%.

Economic Impact

• June retail sales in the Eurozone rose by a seasonally adjusted 5.7%, following a revised 20.3% gain in May.  That left sales slightly higher than in February, before the pandemic took hold in Europe, and it left sales 1.3% higher than in June 2019 (see tables below).
  • Clothing and footwear sales rose especially strongly in June, while fuel sales also continued to rise.
  • However, in a sign of what may happen in other advanced economies as they recover from the pandemic, online purchases and mail orders dipped after four months of growth, suggesting consumers were beginning to return to stores rather than relying on home deliveries.
• In an interview with the Financial Times, Tokyo Olympic Games Chief Toshiro Muto insisted Japan will hold the event next summer as currently planned, even if the coronavirus isn’t yet under control.

U.S. Policy Response

• Treasury Secretary Mnuchin said the White House and congressional Democrats are aiming for a deal on the next coronavirus relief bill by the end of this week.  However, he also warned that the two sides are not yet “at the point of being close to a deal.”  Given the way massive monetary and fiscal stimulus have been so instrumental in buoying the U.S. economy and financial markets through the crisis to date, continued negotiations and optimistic statements like Mnuchin’s are a positive for risk assets.  All the same, if brinksmanship rears its ugly head again or the resulting package is deemed disappointing, the markets could become volatile late in the week.

Lebanon:  After a massive explosion at a warehouse in central Beirut killed dozens of people yesterday, Lebanese officials offered assurances that the blast occurred because of a fire and was not on purpose.  Press reports say the explosive was 2,700 tons of ammonium nitrate seized from a Russian ship in 2014 and stored in a waterfront warehouse pending legal proceedings.  However, President Trump called the explosion a “terrible attack” and said U.S. military leaders believe the tragedy was caused by “a bomb of some kind.”  Even though Israel exchanged fire with Hezbollah militants on its border with Lebanon last week, an Israeli government official said Israel had no involvement in the explosion.

United States-China:  U.S. and Chinese officials have agreed to meet via videoconference on August 15 to assess Beijing’s compliance with the Phase I trade deal signed in January.  The meeting will reportedly include both U.S. Trade Representative Robert Lighthizer and Chinese Vice Premier Liu He, President Xi Jinping’s point man on economic policies.

United States-China:  In a move China will likely see as provocative ahead of the trade deal meeting, U.S. Health and Human Services Secretary Azar will lead a delegation to Taiwan to discuss the coronavirus pandemic.  Azar’s trip would be the first visit by a U.S. cabinet official to Taiwan in six years.  In a statement, Mr. Azar said his trip is intended to show President Trump’s support for Taiwan, its democratic government and the leadership it displayed in handling the coronavirus outbreak.

Saudi Arabia-China:  Based on information from Western officials, the Wall Street Journal yesterday said Saudi Arabia has secretly built a facility to extract yellowcake from uranium ore, advancing its drive to master nuclear technology and keeping open an option to develop nuclear weapons.  The Saudi government categorically denied the report, but the news is still bound to generate concern in the U.S. Congress, where a bipartisan group of lawmakers has expressed worries about Crown Prince Mohammed bin Salman’s vow to develop a nuclear bomb if Iran does so.  Given Saudi-Iranian enmity, possession of nuclear capability by both sides would seriously increase potential devastation in the event of war.  Besides that, the report said the facility was built with Chinese help, which will raise concerns that China might try to woo U.S. allies into its orbit with promises of nuclear technology.  Finally, the news will likely be concerning to Israel due to its past military confrontations with Saudi Arabia.

India:  Prime Minister Modi has presided over a ceremony to kickstart the construction of a Hindu temple on the site of a 16^th century mosque, whose destruction in 1992 sparked deadly riots across India.  The ceremony underlines Modi’s commitment to Hindu nationalism one year after he revoked the semiautonomous status of India’s only Muslim-dominated region, Jammu and Kashmir (see our WGR from September 9, 2019).

North Korea:  After a period of relatively good behavior, satellite imagery shows North Korea has ramped up its sanctions-busting coal exports again.  The new activity is being taken mostly as a sign of increased economic pressure on North Korea.

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

[Posted: 9:30 AM EDT] | PDF

Despite the mixed performance for equities so far today, reports are showing a moderation in new U.S. coronavirus infections, as well as hints of progress in the negotiations for a new virus relief bill in Congress.  As always, we review all the key news items below.

COVID-19:  Official data show confirmed cases have risen to 18,317,520 worldwide, with 694,715 deaths and 10,935,280 recoveries.  In the United States, confirmed cases rose to 4,718,249, with 155,478 deaths and 1,513,446 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• Several large states in the South and West that had recently seen a surge of new infections continued to report moderating caseloads, though part of the decline in recent days may reflect the shutdown of some testing sites in Florida ahead of Tropical Storm Isaias.  Unfortunately, public health officials also continue to report signs of rebounding caseloads in the Midwest and some areas of the Northeast.
• Despite the improving overall trend in the U.S., researchers in the U.K. and France warned that without adequate procedures to test and trace positive cases, there will likely be a large, new outbreak of the disease this autumn.
• Scientists are noticing that as many as 10% of those who become sick with COVID-19, including young adults, suffer from a long, drawn-out form of the disease that some refer to as “long-haul COVID,” “LONGCOVID,” or “post-COVID syndrome.”  The condition is evidently similar to chronic fatigue syndrome, or myalgic encephalomyelitis.  The news is a reminder that even if the statistics show large numbers of people recovering from the disease, some of them may actually be saddled with lingering symptoms that could weigh on their ability to work.
• As the horserace among several leading vaccine candidates continues into Phase III tests, investors remain optimistic that a shot will be ready by the end of the year.  However, investors are also starting to pay more attention to the already high valuations for some of the vaccine companies’ stocks.

U.S. Policy Response

• After an hours-long negotiating session yesterday, Democratic leaders and White House officials sounded cautiously optimistic that they were making progress on the next coronavirus relief bill.
  • Nevertheless, the two sides remain at odds over whether to cut the supplemental federal unemployment benefit of $600 per week, whether to provide more assistance to financially strapped state and local governments, and other issues.
  • One complicating factor is that the competing Democratic and Republican proposals are riddled with pork barrel spending unrelated to the virus crisis.
  • To raise pressure on the Democrats, reports say the White House may attempt to implement some relief measures by executive order (a kind of decree), including a cut in the payroll tax and a further moratorium on evictions.
  • According to officials, the negotiations will resume on Tuesday.
• Of course, the Federal Reserve also continues to provide extremely loose monetary policy in support of the U.S. and global economies.  For a useful review of its actions as global lender of last resort, see this WSJ article.
  • The article highlights how the Fed’s agile and powerful action to support the dollar financial system around the world has helped burnish the greenback’s status as the world’s key reserve currency.
  • However, the article also highlights how the resulting status of the dollar as the predominant safe currency has raised concerns that it is too dominant.  That sentiment is a key reason why we place so much importance on the EU’s new coronavirus relief program, which will include the issuance of common EU debt on a scale that should make the euro a more viable reserve currency and a more viable competitor for the dollar.

Financial Market Response

• Double-digit stock gains boosted public pension systems’ median return to 11.1% for the second quarter, marking their best quarterly performance since 1998.  However, even with their rebound from the first quarter, median annual returns for the public pensions, whose fiscal years ended June 30, were just 3.2%, far short of the funds’ long-term target of around 7%.
• As investors begin to note the current upward momentum for precious metals and the positive impetus they’re getting from factors like safe-haven buying, the falling dollar, and the rising federal budget deficit (all of which we’ve described repeatedly), gold and silver continue to rise.  Here is a handy WSJ article on the mechanics of the gold market.

World Trade Organization:  In interviews with the Financial Times, the two main candidates to become the next leader of the WTO said the U.S. has valid concerns over judicial overreach by the organization’s dispute settlement system.  Kenya’s Amina Mohamed and Nigeria’s Ngozi Okonjo-Iweala both said they would support reining in the system, though it’s not clear when or if that would convince the Trump administration to lift its freeze on naming new judges to the WTO’s appellate body, which has prevented it from operating.

United States-China:  President Trump said he is ready to approve the purchase of the U.S. operations of the Chinese video-sharing app TikTok by Microsoft (MSFT, 216.54), but only if the government receives “a lot of money” in exchange.  The move has drawn bipartisan pushback, especially as it would appear to constitute a kind of arbitrary, one-off tax on a private corporate transaction.  Just as important, the demand also exacerbated tensions with Chinese officials, who are chafing at Trump’s earlier threat to ban TikTok from the U.S. over concerns that the company could share sensitive user data with the Chinese government.

United States-Poland:  A week after announcing the pullout of 12,000 troops from Germany and only partially redeploying them elsewhere in Europe, the Trump administration said it will send 1,000 additional soldiers to Poland.  The increased U.S. presence there will include intelligence, surveillance and reconnaissance capabilities, as well as infrastructure to support an armored brigade combat team and combat aviation brigade.  However, the small move in Poland is seen as insufficient to offset the loss of forward defense capabilities associated with the large troop drawdown in Germany.

Argentina:  The Argentine government reached a deal with its biggest creditors on restructuring $65 billion of its foreign bonds after it agreed to make some debt payments earlier than it wanted.  If the country’s bondholders approve the deal, the country will avoid years of exclusion from the global credit markets and a potentially acrimonious, drawn-out legal battle like the one that followed its 2001 default.

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

[Posted: 9:30 AM EDT] | PDF

Happy Monday!  U.S. equity futures are ticking higher this morning and the dollar is stronger.   There was lots of policy news, which will be our lead.  The virus news is next; mask controversy isn’t just a U.S. issue.  An update on China follows, and we close with foreign news.  Here are the details:

Policy news: 

• The U.S. is poised to close TikTok, the video app, but Microsoft (MSFT, 205.01) is interested in buying the U.S. operations of the company. This subsidiary of the Chinese tech company ByteDance claims the U.S. TikTok operations are isolated from China.  The U.S. fears the company gathers data on American users that is accessed by Chinese intelligence.  And, it’s not just the U.S.  Australia shares similar concerns.  Although TikTok is catching most of the attention, the U.S. is moving beyond this particular company to Chinese tech firms, in general.
• The Fed has been considering changes to how it manages inflation targeting. Since Volcker, the Fed moved rates in anticipation of rising inflation.  This policy was enacted to manage inflation expectations.  One of the oft-forgotten elements of inflation is the role of expectations.  When economic actors anticipate higher prices, they make balance sheet decisions accordingly.  Businesses will hold more inventory to preclude higher prices and households will tend to spend faster and make bulk purchases.  In the 1970s, inflation expectations became elevated; Volcker’s shock treatment made it clear to economic actors that the Fed was serious about containing inflation.  In the ensuing decades, that trust meant increases in inflation didn’t gain momentum.  That was due, in part, to the policy of preemptive rate hikes.  It could be argued that the policy has worked so well that despite aggressive attempts to lift inflation by expanding bank reserves, the Fed has been unable to reach its 2% core PCE target.
  • This looks to us to be a classic case of “intergenerational forgetfulness.” Policymakers introduce a policy under conditions, often extreme, that is an appropriate response to the problem at hand.  The Fed adopted preemptive policy rate hikes because the pain of 19% fed funds rates in the early 1980s was emblazoned on the minds of the FOMC.  However, that pain is now 40 years old and we have a different problem now—inflation that is persistently so low that the Fed can lower real interest rates.
  • For those of us old enough to remember, abandoning preemption looks like a really bad idea. However, the succeeding generations of Americans who have benefited from low inflation disregard its value, in part, because they don’t know how corrosive inflation can be.

• • The experience of high inflation is steadily becoming a generational artifact. We are seeing the groundwork of the next great reflation.  The end of preemption, MMT, high deficits, etc. will all eventually end in higher inflation.  That is certain.  What is not certain is the timing.  It could take more than a decade before inflation expectations reverse.  After all, the Depression children, who came of age in the 1950s, did not engage in behaviors consistent with inflation fears even though financial repression was rife.  It wasn’t until the mid-1960s that the policies designed to lift prices gained momentum.  Once inflation expectations turned, it got ugly.
• The Fed’s Main Street lending program has been a disappointment thus far. The question is an age old one for lenders—is the borrower facing a liquidity problem or a solvency problem?  If it’s the former, lending will support the company until conditions improve.  If it’s the latter, lending will only delay the inevitable.  The borderline cases are the problem; it can be exceedingly difficult to determine whether a troubled company really isn’t going to make it or, with help, if it can survive.  For generations, banks trained loan officers for this task.  However, banks noted this was a labor-intensive exercise and decided that lending to larger companies carrying credit ratings was a more efficient way to lend.  We doubt the Fed has the wherewithal to make these judgements and is likely erring toward caution, meaning not a lot of money is being lent.
• Meanwhile, congressional and White House leaders met over the weekend. Nothing was accomplished and the support measures passed in March are expiring.  There are a number of sticking points, but perhaps the most troublesome is the $600 per week employment insurance supplement.  We do expect an agreement to be reached, but the fact that we are seeing a disruption will likely lead households to try to save as much as they can for fear of future disruptions.
• British trade officials are coming to Washington for face-to-face meetings. Westminster was hoping for a quick trade agreement with the U.S. to give the U.K. leverage with the EU over their trade talks.  However, the British found that, after Brexit, the U.K. has little bargaining power.  The U.S. is demanding concessions (agriculture is a big sticking point) and if the U.K. doesn’t concede, Washington has little need to make a deal.

COVID-19:  The number of reported cases is 18,093,891 with 689,625 deaths and 10,700,077 recoveries.  In the U.S., there are 4,667,957 confirmed cases with 154,860 deaths and 1,468,869 recoveries.  For those who like to keep score at home, the FT has created a nifty 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.

Virology: 

• In mid-March, Tomas Pueyo, a tech entrepreneur, published an article in Medium titled “The Hammer and the Dance.” In the article, he outlined the challenges of managing the virus without a vaccine.  We reread the article every few weeks.  In March, most of the developed world was in lockdown.  He correctly predicted that lockdowns would work but were unsustainable.  The “dance” part was how much reopening could occur before infection rates returned and triggered partial restrictions.  His report showed that the “dance” would be difficult because it would be impossible to predict in advance what openings were possible and what were not.  Since lockdowns eased in May, we have seen a resurgence in cases in the developed world.  In a sense, we are learning what actions can be safely managed, and what can’t.
  • For example, we are learning that “bubble” sports, such as the NHL and NBA, seem to work rather well. MLB is stumbling because it is traveling.
  • There is a notion that the controversy over mask-wearing is an American issue. Not so; Germany had a massive protest over the weekend on this issue.
  • Lockdowns are especially difficult for younger people. The natural desire to socialize creates “lockdown fatigue” and eventually breaks down.  Europe is seeing a rise in cases as younger Europeans return to beaches and bars.
  • Australia is implementing regional lockdowns after a surge of cases.
• One of the persistent mysteries of COVID-19 has been the variability of symptoms. Generally speaking, a “mild” case of the flu is a real pain.  A bad one is never forgotten.  But, with COVID-19, there is ample evidence of completely asymptomatic cases.  At the same time, other cases have led to death or permanent damage to cardiovascular systems.  In other cases, patients can’t seem to shake the disease and bear severe symptoms for weeks.
  • A recent Nature article offers an interesting perspective. COVID-19 is a coronavirus, a broad family of viruses that include SARS, MERS and the common cold.  Studies were conducted to determine the immune response from those who had contracted the disease.  For comparison purposes, researches looked at blood samples from others who had not tested positive for COVID-19.   To their surprise, a large number of the unexposed showed similar immune responses to those who had been diagnosed.
    • Researchers speculate that earlier coronavirus infections may have created a degree of immunity, which would either lead to a mild or asymptomatic case of COVID-19.
    • However, they also noted that the wide dispersion of symptoms may be tied to existing immunity triggering a massive immune response once exposed to COVID-19, and it is this cytokine storm that leads to a severe case of the disease.
    • The existence of pre-immunity will complicate vaccine testing. For those with a high level of pre-immunity, the vaccine may very well lead to a robust immune response and suggest smaller doses of the vaccine will be effective.  At the same time, if the vaccine triggers an excessive immune response, it could lead researchers to conclude the vaccine has failed.
  • Additional research is necessary. If confirmed, a pre-test may be required to measure native antibodies in a patient and tailor the vaccine to the existing level of immunity.  That may make the vaccine much safer and effective, but it would likely slow the rollout.
• Eli Lilly (LLY, 150.29) is testing an experimental drug that could potentially protect the elderly and staff at nursing homes.
• Russia is planning a mass vaccination program in October with its vaccine. There are fears that the vaccine hasn’t been fully tested and there is a possibility that extensive vaccinations could lead to adverse outcomes.  This is a situation that will be closely watched.

China news:

• The U.S. has sanctioned a paramilitary group in Xinjiang. The Xinjiang Production and Construction Corps (XPCC) is a group that controls much of the economy of the province.  The U.S., deploying the Global Magnitsky Act, has sanctioned two CPC members tied to the XPCC.  This move will infuriate Beijing as it suggests the U.S. will take actions against individual members of the CPC for executing Chairman Xi’s policies.
• Although we maintain skepticism that the CNY will replace the USD as a global reserve currency (primarily because Beijing has a closed capital account), we do watch for evidence that our position may be wrong. We are seeing broadening use of CNY in Indonesia, suggesting in that country the CNY is being seen as an alternative store of value.  So far, we haven’t seen other nations take similar steps, but the actions China has taken to increase the use of CNY in Indonesia are notable.
  • On a related note, the PBOC is experimenting with a digital CNY in a few provinces. Digital central bank currency is a topic of interest and will likely be the focus of a WGR before year’s end.
• Germany has finally suspended its extradition treaty with Hong Kong. Berlin has been slow to sanction China over its behavior in Hong Kong due to Germany’s extensive direct investment in China.
• In a twist, a recent study found that somewhere between $192 million to $419 million of PPP loans went to small firms controlled by China.
• How have relations between the U.S. and China deteriorated? Here are a couple of charts:

Foreign news:

• In a move that will concern its neighbors, Japan is moving toward a “first use” policy. Since the end of WWII, Japan’s military has struck a defensive posture.  It would not initiate an attack against anyone.  It could maintain that policy because it had faith in the U.S. security guarantee.  It would appear that guarantee is less ironclad, so Tokyo is likely preparing for a world where it may need to defend itself.
• The UAE has a nuclear reactor, the first Arab nation to do so.
• Protests continue in Russia’s far east.

Markets and Economic news:

• Last week, we noted that savings rates remain very high. That would appear to be one of the consequences of the $600 per week unemployment insurance supplement.  Consumers have been curtailing their use of credit card debt in response.
• Just a reminder: it’s employment Friday this week.

Odds and ends:  There have been rising fears surrounding the November elections.  Here’s a new worry to add to the collection—ransomware could be used to take voter data hostage.

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

[Posted: 9:30 AM EDT] | PDF

Happy St. Ignatius[1] Day!  It’s Friday and the “dog days” of August await.  Equity markets are mostly higher this morning after the major tech firms revealed impressive earnings.  This may be one of the rare times where such earnings are a problem given the firms’ recent testimony to Congress.  Policy news, or the lack thereof, leads today’s coverage.  China and COVID-19 are next.  The new Asset Allocation Weekly is posted below (and published as a separate report on our website) and the related podcast and chart book are also available.  Here are the details:

Policy news: 

• As a number of recovery measures are set to expire, congressional leaders remain far apart on a deal for another stimulus package. The GOP has offered a series of individual bills that would address unemployment insurance and evictions.  Democrats were not impressed, fearing that once these measures pass, other goals would languish.  We do expect a bill to be passed, because the lack of additional support would be a serious problem.  As yesterday’s GDP data revealed, the economy is in a difficult spot.
• On the topic of yesterday’s GDP data, the headline numbers were so historically bad that much of the detail was lost in the coverage. This is the fourth recession since 1982, meaning that the U.S. economy has suffered a recession roughly every 9.5 years since then.  From 1946 through the 1982 recession, the economy had a recession, on average, every four years.  One reason that recessions became less frequent was due to a structural change in the economy.  As services became more important, downturns were less frequent.  This is because services are less prone to inventory cycles.  Goods production is hard to get exactly right; if overproduction occurs, and stockpiles rise, activity declines and recessions occur.  But, in services, the “inventory” is actually made up of workers.  Firms will adjust tasks when business slows and only reluctantly reduce headcount.[2]  In general, there is less volatility in services relative to goods.  From 1947 until Q1 2020, the average contribution to GDP from services consumption was 1.1% per quarter with a standard deviation of 0.6%.  For goods over the same time frame, the average was +0.9% with a standard deviation of 1.7%.  However, last quarter, goods consumption subtracted 2.2% from GDP, while services consumption pulled a whopping -22.9%.

This chart highlights the problem of boosting growth.  Consumption dominates GDP and services dominate consumption.  Goods represent 33% of consumption and services 67%.  Services are dependent on contact; 16% of service consumption is restaurant and recreation.  Add health care, another service that usually requires contact, and the percentage rises to 40%.  Without a reliable way to control the spread of the virus, getting services back will be very difficult.  A vaccine with widespread adoption is the best path to this goal, so, as Chair Powell indicated, the economic recovery is dependent on the virus.

• Environmental groups are pressing the Fed to stop buying bonds of energy companies. The recent decision by the Fed to venture beyond buying Treasuries and mortgages exposes the institution to political pressures for which it isn’t accustomed.

China news:

• The CPC announced it will hold its central committee meeting in October. Meanwhile, Chairman Xi is holding Politburo meetings about the economy where he is recommending a focus on fostering domestic demand for future growth.  This “pivot” to domestic consumption and away from the dependence on exports and investment has been recommended by economists for years.  The economics of the move are well understood, but the politics are another matter.  There are two problems with this shift politically; first, those who have benefited from the export/investment policy tend to be powerful members of the CPC.  Xi has deliberately purged most opposition but the blowback from harming this powerful group’s economic fortunes is risky.  Second, the transition won’t be easy; households would need to have assets and income moved in their direction and one would expect a lag between receiving that income and assets and increasing consumption.[3]  That would mean slower growth, at least for a while.  And, the CPC has made its mark on delivering growth, so the party’s political image would be harmed by a drop in GDP.
  • With regard to growth, China has returned to its old playbook of investment to lift output. It is pressing state and local governments to borrow.  This may be a short-term fix, but it does highlight how hard it is to break old habits.  It also explains this quarter’s lift in industrial metals prices.
  • Although this reform is likely necessary for China’s development, the proximate cause appears to be due to the deterioration of U.S./China relations.
  • It is also important to remember that China has a long history of cycling between openness and inwardness. The former tends to occur when the government wants faster growth and the latter when it wants political stability.  We may be heading into an “inward” phase.
• China’s economy does seem to be doing ok. PMI data indicates the expansion continues.
• Hong Kong legislative elections have been delayed, with leaders blaming COVID-19. A number of pro-democracy candidates have been banned from running.
• As we have been saying for a while, China continues to lag in its Phase One commitments. At the same time, we are seeing a surge in corn orders, a welcome sign for American farmers.
• At a hearing before the Senate Foreign Relations Committee, SoS Pompeo indicated that additional measures against China are planned.
• Lee Teng-hui, Taiwan’s first elected president, died yesterday at age 97.

COVID-19:  The number of reported cases is 17,322,041 with 673,833 deaths and 10,156,580 recoveries.  In the U.S., there are 4,495,224 confirmed cases with 152,075 deaths and 1,414,155 recoveries.  For those who like to keep score at home, the Financial Times has created a nifty 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 is showing some improvement.  Forty percent of the states have a reading under 1, which would indicate the virus spread should diminish.  On a local note, Missouri has the highest reading in the union, at 1.2.

Virology:

• Chinese hackers have reportedly targeted Moderna (MRNA, 77.63), one of the leading firms in vaccine research.
• Sanofi (SNY, 52.50) and GlaxoSmithKline (GSK, 40.25) have made an agreement with the U.S. to provide the vaccine to the U.S.
• Survivors of COVID-19 are being warned that their infection may not have provided lasting immunity and thus they should exercise care.
• Former presidential candidate Herman Cain has died from COVID-19.
• We are seeing the first lawsuits against companies over COVID-19 infections. The GOP has been pressing for protection against such suits, correctly fearing that if companies face legal liability they will simply not reopen.  At the same time, if companies are given blanket protection, they will have no incentive to protect workers.  Finding a midpoint between applying complete immunity and full legal responsibility is an obvious necessity.  One way to thread this needle would be to rely on insurance standards—companies have to engage in various precautionary standards and, if those are met, they are protected from lawsuits.
• Testing remains a serious problem. As the country has ramped up testing, it has overwhelmed the test processing industry, leading to delays so long as to render the tests nearly useless.  But, to improve the turnaround, we would need to reduce the number of tests.  Without adequate and widespread testing with quick responses, we are mostly “flying blind” regarding the virus.
• We often hear commentators and political figures speak reverently about science. However, any reading about the history of science will show that science is a method of inquiry.  And it’s a good one.  Following the rules of science will tend to overcome human bias and reach favorable conclusions.  Nevertheless, the process of science isn’t always straightforward and it’s not sacred.  The history of science is littered with positions that were considered “facts” until disputed with new information.[4]  Often, it takes generational change to adjust theoretical understanding.[5]
  • One of the problems with COVID-19 is that we aren’t really sure how it spreads. Initially, it was thought to be spread on surfaces.  Thus, hand washing and mass sanitizing was implemented; this was probably best described as “hygiene theater.”  We all saw the shortages on hand sanitizers and bleach.  But further research indicated that it also probably spreads by droplets.
    • However, even this discovery complicated things. If the dispersion comes from large droplets, they fall to earth by gravity.  This led to the recommendation of being “six feet apart,” or social distancing.
    • At the same time, there is evidence to suggest that much smaller droplets, or “aerosols,” may be the primary spreading vector, meaning that being six feet apart is completely inadequate. These aerosols can be suspended in air for some degree of time and thus being further apart would be necessary.  Instead, the guidance would call for avoiding closed areas and close contact and crowds, especially indoor crowds.  Instead of bleach, we should be considering HEPA filters.
    • It isn’t all bad news. Aerosols don’t last very long outside.  Sunlight can weaken them, and they dissipate in moving air.  There is probably less risk in outdoor activities.  Being indoors, on the other hand, is quite risky.  Mass events and optional mask wearing indoors would present a problem, while walking the dog without a mask is much less risky.
  • The point is, there is much we really don’t know. And that is to be expected.  This is a new virus.  It will take time and research to develop certainty surrounding COVID-19.  Unfortunately, the media does a poor job of reporting on science news, projecting an air of certainty when it isn’t warranted or indicating skepticism when it shouldn’t.
  • So, what should be done? It is important to realize the situation is fluid and that recommendations will change over time.  In finance, we make decisions under conditions of uncertainty all the time.  In the end, all of us have to make probability judgements for which a certain degree of humility is required.

Foreign news:

• European regulators are looking to apply new regulations on tech firms that would undermine their ability to provide “house brands” that undercut prices on competitors.
• For the first time, the EU is applying sanctions on Russia, North Korea and China over hacking.

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[1] The founder of the Society of Jesus (Jesuits).

[2] This is why the advent of gig work is so interesting.  It allows firms more flexibility in their “inventory.”

[3] The economic theory is called the permanent income hypothesis.  It postulates that households spend based on their income and wealth history.  Thus, if incomes fall but the decline is seen as temporary, spending continues.  If the opposite occurs, wherein a windfall happens, spending doesn’t immediately adjust.

[4] Until 1956, it was generally believed that humans had 48 chromosomes; turns out, we have 46.

[5] “Science progresses one funeral at a time.” — Max Plank