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

[Posted: 9:30 AM EDT] | PDF

Good morning and happy Monday!  Equity markets are mixed; the U.S. is modestly lower, while Chinese markets jumped on reports that insurance companies will be able to hold more stocks.  Foreign news leads today’s report as the EU was unable to make an agreement this weekend, but marathon talks continue; the EUR is modestly higher.  Congress is back and negotiations on a fourth stimulus bill are front and center.  We update the pandemic news and close with the economy and markets.  And, as promised, the Asset Allocation Weekly podcast and chart book are updated.  Here are the details:

Foreign news:

• EU leaders continue to talk. France and Germany are pressing for the package, with the Netherlands and Austria acting as spoilers.  This budget summit is critical.  In a situation where the U.S. is no longer guaranteeing the security of Europe, if the EU fails it is hard to see how Europe will be able to have much of a global impact.  A couple of reflections on the EU and Britain: if the U.K. were still in the EU, the idea of a Eurobond would have been a non-starter. And, if the EU can’t act in unity over the pandemic, the U.K. will look prescient, being the first in line to leave a failing project.  If the EU fails, it is hard to see why Italy would remain in the Eurozone.  You can follow the latest on talks here.  The fact that the EUR has held up and Italian borrowing costs have declined despite no deal over the weekend suggests financial markets do expect an agreement.
• Although the EU recently lost its tax disagreement with Ireland, the push to regulate global tech remains in place. A budding trade war over digital taxes is looking increasingly likely.
• Saudi King Salman has been admitted to the hospital in Riyadh over gallbladder inflammation. If he were in serious trouble, we would expect him to be moved to a European or U.S. hospital, although the pandemic may have affected where his treatment would be conducted.  Although his son, CP Salman, appears to have solidified his rule, we would not be shocked to see a power struggle once King Salman dies.  The crown prince would be the first king of his generation, the grandchildren of Ibn Saud.  Given the large number of claimants to the throne and the heavy-handed way King Salman promoted his son, a challenge is possible.
• Bulgaria is facing widespread unrest as protests rise against the center-right government over accusations of corruption.
• Russia is seeing continued protests in the Russian Far East due to Putin’s decision to remove a controversial governor.
• Lebanon, facing a serious debt crisis, is nearing economic collapse. Electricity has become so sporadic that nighttime aircraft landings have become challenging.  International aid is available but only if the country accepts austerity.  Given the political divisions in Lebanon, austerity is problematic because every group wants to shift the burden of adjustment to the other.
• Argentina is negotiating with its creditors but is essentially saying that it can offer no further concessions. It is difficult to have much sympathy for the creditors.  Argentina is a serial defaulter and anyone lending money to it should have expected a fairly high chance of default.

Policy news: 

• Congress is back in session and the leadership is scrambling to negotiate a fourth pandemic stimulus package. There are two areas we are closely watching.  The first is unemployment insurance.  The $600 per week additional support is, in many cases, more than many workers made on their job, giving them a disincentive to return to work.  At the same time, many of these workers have no job to return to.  If you just end the program, the risk is that those without job prospects will dramatically curtail their spending, weakening an already weak economy.  We would expect (hope?) for a bit of creativity from lawmakers, perhaps a bounty for returning to work along with a reduction in the support package.  A second and perhaps even more intractable problem is daycare.  Getting people back to work if their kids can’t go to school or daycare will be a challenge.  But, as anyone who had kids in daycare knows, they are places where infections spread easily.  If the bill doesn’t address funding for PPE in schools, there is a risk that the rebound in employment could be at risk.
• The Senate banking committee is expected to approve Judy Shelton to an open Fed governor position. Shelton may be the most politically oriented governor appointed in my lifetime; we would expect her to support easy policy under a GOP White House but be hawkish if a Democrat is in the Oval Office.  If she does get approved by the banking committee, we do expect her to be approved by the broader Senate.  (An aside…it will be fun to see her interactions with the rest of the FOMC when the full transcripts of the FOMC meetings are released in 2025.)

China news:

• The U.K. has pulled its extradition treaty with Hong Kong.
• Hawley (R-MO) is planning on introducing legislation that will require firms importing goods from foreign sources to certify that the supply chains are free of forced labor. The proposed legislative target is China.

COVID-19:  The number of reported cases is 14,508,892 with 606,206 deaths and 8,134,747 recoveries.   In the U.S., there are 3,773,260 confirmed cases with 135,205 deaths and 1,131,121 recoveries.  For those who like to keep score at home, the FT has a nifty interactive chart that allows one to compare cases across nations using similar scaling metrics.

Virology: 

• The first clinical trial results from the Oxford vaccine will be released later today. This is a Phase One trial.  The NY Times ran a feature article in the Sunday edition raising concerns that acceptance of a vaccine could be slow.  There is an established anti-vaccine movement in the U.S., but beyond this group there are concerns that the rush to deliver a vaccine may increase the odds of unexpected side effects.  It is quite possible that many Americans may take a “wait and see” approach to the vaccine before taking the shots.  If so, even the production of a vaccine may not lead to economic recovery.
• Epidemiologists are noticing that rapid increases in COVID-19 infections appear to be tied to “super-spreader” events, where a few asymptomatic carriers can trigger an exponential increase in cases. This information suggests that (a) widespread regular testing might catch these carriers, and (b) mass gatherings should be greeted with great caution.
• Venezuela is facing a rapid rise in new cases. President Maduro is blaming returning refugees. The collapse of the Venezuelan economy led to a mass migration out of Venezuela in recent years.  However, as surrounding countries shut down due to the pandemic, these refugees are returning to Venezuela.  Although the government is attempting to secure the border, reports of harsh treatment of returnees has led many to illegally return.  If these returnees are infected, they could be boosting infections.
• Hong Kong is seeing a rise in new cases.
• Mask wearing remains controversial. It was controversial in the Spanish Influenza pandemic too.

Market and economy news:

• Back-to-school shopping is the second most important season for retailers, exceeded only by Christmas. Given the degree of uncertainty surrounding the autumn school session, retailers are struggling to determine their response.
• Reflecting on bank earnings, it is clear that the banking industry is expecting a rapid rise in bad loans. Although some of this may be an excess of prudence, it does suggest banks don’t expect a rapid recovery in the economy.  We would concur.
• There is growing evidence that corporate America is adopting the same stance as banks.  If so, we could see a stall in rehiring.

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

[Posted: 9:30 AM EDT] | PDF

Good morning!  Equity markets are modestly higher after a choppy week.  The EU budget summit is underway.  Relations between the U.S. and China continue to deteriorate.  The new Asset Allocation Weekly is published below; the accompanying podcast and chartbook will be available on Monday.  Here are the details:

Foreign news:

• The EU budget summit is underway; here’s a way to follow along. The biggest issue at the meeting is the pandemic rescue plan that includes a mutualized Eurobond.  This meeting is historic; if the leaders agree to a mutualized debt scheme, it would make the EUR an attractive alternative reserve currency.  If the leaders fail completely, it may signal the end of the Eurozone.  We may not get a deal this weekend, but if the leaders agree to continue talks, all won’t be lost.  Given that Chancellor Merkel is endorsing the rescue plan, there is a good chance we see passage at some point.  As we discussed in a recent WGR, a mutualized bond issued by the EU would likely be bearish for the dollar.

China news:

• High ranking U.S. officials have been making speeches denouncing China. AG Barr is the most recent member to give a talk on this issue.  He accused Hollywood and Tech of collaborating with China in his remarks.  He also expressed concerns that businesses could be used by Beijing to undermine the U.S. policy crackdown.  This is a legitimate concern.  Chairman Xi will likely try to offer preferential treatment to U.S. firms in return for informal lobbying efforts to foster a more friendly policy regime.
• The U.S. is increasing pressure on China across a number of fronts. There have been notable trade actions and an increase in freedom of navigation operations in the South China Sea.  The administration is considering travel bans on CPC members.  This would be a significant action; there are over 90 MM members of the CPC.  The U.S. is considering banning TikTok (the owner, ByteDance, is not publicly traded) due to security concerns.
• Although China’s GDP showed a strong recovery, worries that the growth was driven by investment remain. Evidence that policy easing may be fostering yet another property boom could lead to a deterioration of credit quality.  China’s financial authorities have used financial repression for years, keeping deposit rates at low levels to create pools of cheap financing for investment.  Households are seeking higher returns on investment and there is an underlying belief that policymakers won’t allow residential property prices to fall (sound familiar?).  The key question that follows is “who will pay for the bailout, if it comes”?  The recent rise in foreign buying of Chinese sovereigns provides one potential clue.
• After a sharp rally, Chinese equities are taking a sudden hit.

COVID-19:   The number of reported cases is 13,830,933 with 590,608 deaths and 7,735,623 recoveries.   In the U.S., there are 3,576,430 confirmed cases with 135,205 deaths and 1,090,645 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.  Only seven states have a reproduction ratio under one, which means that the virus is expanding at an increasing rate.  However, there was some good news in the data; Arizona, which has been hard hit recently, saw its R₀ fall under 1.

Virology: 

• The S., U.K., and Canada report that Russians are attempting to hack vaccine and anti-viral researchers in an attempt to steal their research.  As expected, the Kremlin has denied the claims.
• “…some animals are more equal than others…”; this famous quote from Animal Farm seems to describe the current testing regime.
• It is looking less likely that school districts will be able to fully open this fall. Instead, a mix of online and in school regimes is more likely.  The long-term impact on education is uncertain, but the likely outcome is a slower pace of learning.
• A bit of good news, as doctors deal with more COVID-19 patients, they are learning more about the disease and are developing treatment protocols that are improving hospitalization outcomes. These include less use of ventilators and a greater deployment of high concentration oxygen, various treatments to reduce the symptoms of the disease and simple changes, like laying patients on their stomachs.

Market and Economy news:

• The 30-year mortgage rate has dipped under 3.00%, a record low.  Housing data has been strong recently and there is evidence of a move to the suburbs.  That could put urban housing at risk.
• Food banks have seen high demand during the pandemic. Now they are dealing with logistics challenges as food supplies are increasing after facing disruptions.

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

[Posted: 9:30 AM EDT] | PDF

Good morning!  Global equity markets are lower this morning.  Chinese stocks fell hard overnight but have been very strong recently.  China’s GDP data came in stronger than forecast; we may be seeing a bit of “buy rumor, sell fact” behavior in Chinese equities.  Retail sales in the U.S. came in better than forecast; we cover the data below.  The ECB met this morning, and there was no change in policy.  The EU suffered a blow yesterday in its attempt to tame the U.S. tech sector.  There is much to discuss on the policy front.  We update the pandemic news.  The Weekly Energy Update is available.  Here are the details:

China news:

• China’s Q2 GDP roared back, rising 59.7% on a quarterly annualized basis, up 3.2% from last year. What is most remarkable about the bounce is that the level of GDP exceeds Q4 2019 by CNY 80MM.  Of course, this stunning recovery was engineered through the usual policy path—a massive rise in debt and forced investment.  Michael Pettis, one of our favorite China analysts, has always argued that China can have any GDP level it wants; it’s just a matter of how much debt and uneconomic investment it is willing to make.  At the same time, cross-country comparisons will look like China has fully recovered from the COVID-19 event and will be used for the full benefit by Chairman Xi to promote China’s economic model as superior to Western democracy.
• China continues to face sporadic bank runs. Although China established a system of deposit insurance in 2015, it only covers deposits up to CNY 500K ($70,400).  In addition, there is deep suspicion that Chinese banks are suffering from loan losses and depositors fear they could be at risk if a bank fails.  Finally, social media has been the platform for spreading rumors about bank instability, causing runs even against sound banks.

Foreign news:

• The EU suffered a stunning defeat yesterday when its second highest court overturned its order for Apple (APPL 390.90) to pay €14.3B in back taxes. The EU has been trying to push for harmonization of tax rates across member nations, undermining low tax regimes such as Ireland’s.  The court indicated that Ireland didn’t violate any laws because its taxing doesn’t specifically give Apple a tax break.  The decision was seen as a rebuke to Margrethe Vestager, who has campaigned against U.S. tech firms on anti-trust grounds.
• The U.S. will remove a sanctions exemption related to the Nord 2 gas pipeline. This controversial pipeline will deliver Russian natural gas directly to Germany, bypassing Ukraine and Poland in the process.  The U.S. worries the pipeline will make Germany overly dependent on Russian natural gas and deprive transit nations the usual fees they gather for hosting pipelines.  The decision to build the pipeline has always been contentious, especially after Russia’s annexation of Crimea and its interference in eastern Ukraine.
• EU leaders are meeting on Friday through the weekend to determine if a support package and the decision to fund the Eurobond will be approved. The “frugal four,” Sweden, Austria, Netherlands and Denmark, are all expressing opposition; at a minimum, they want conditions on the grants and loans.  Chancellor Merkel has thrown her support behind the measure and will meet with Greek officials before the meetings.
• There are longstanding tensions between Azerbaijan and Armenia, mainly over the disputed region of Nagorno-Karabakh (for background, see our WGR). Azerbaijan forces destroyed an Armenian military facility on the border between the two nations yesterday.  Armenia is said to have killed an Azerbaijani general.  Usually, Russia eventually brokers some sort of arrangement to bring an end to overt hostilities, but if it refuses to act, conditions could deteriorate further and may support oil prices.

Policy news:

• As several fiscal programs are set to expire, congressional leaders are laying their markers for what follows. Congress took aggressive steps earlier this year to offset the impact of the pandemic and the actions did prevent a deeper decline in growth.  Now, leaders are trying to figure out what they should do going forward, with an eye on using the crisis to promote their longer-term policy goals.  We do expect additional support, but also would not expect an agreement until the 11^th hour.
• A couple of points on Fed policy:
  • There has been some consternation among the financial media over a decline in the Fed’s balance sheet.

Worries surrounding this decline are misplaced.  The reason the balance sheet is contracting isn’t because the Fed is tightening support.  It’s declining because market participants aren’t using available facilities because they aren’t needed.  In other words, knowing the Fed is backstopping markets is keeping financial markets well behaved.  It is worth noting that a number of facilities do have expiration dates for the end of Q3.  We expect these deadlines to be extended, but even if they are not, if market participants expect the Fed to maintain low levels of financial stress then the need for actual facilities is unnecessary.  Simply put, the fact that the Fed has signaled it will provide support will tend to preclude the actual need to do so because the markets will act as if the support is in place.

• As Fed officials work through a post-mortem of the crisis, the non-bank financial system is, again, seen as the fount of the overall system’s weakness. In other words, the “shadow” banking system remains vulnerable to runs and remains a source of financial instability.  The Fed said its aggressive expansion of policy support was due to funding problems in the shadow system.  At the same time, the non-bank system can’t really be closed because the banks won’t make loans to many areas of the economy due to the inability to scale the lending.

• U.S. sanctions on Hong Kong are putting global financial banks in a difficult position; essentially, it will be impossible to satisfy both Chinese and U.S. regulations. Of course, these large institutions will try to figure out what they can do to maintain operations in both jurisdictions, but it will be an additional complication.
• The USMCA included labor regulations designed to reduce Mexico’s edge in lower labor costs. Japanese auto firms are examining the laws and are trying to determine if remaining in Mexico or moving production to the U.S. makes sense in light of the changes.

COVID-19:  The number of reported cases is 13,538,763 with 584,922 deaths and 7,600,418 recoveries.  In the U.S., there are 3,499,394 confirmed cases with 135,205 deaths and 1,075,882 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.  Axios has updated its state map.

Virology: 

• • We continue to closely watch the path of vaccine development; Bloomberg has a profile of Sarah Gilbert, who is spearheading Oxford’s program. Although we are heartened by the rapid developments on the vaccine front, there remain worries that the level of immunity may be limited.
  • Meanwhile, Chinese firms are using their employees as testing subjects for their vaccine candidates.

Market and Economy news:

• Yesterday’s Beige Book suggested the economy is improving, but at a very gradual pace.
• As of July 13, 87.6% of apartment households paid some amount of rent.

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

[Posted: 9:30 AM EDT] | PDF

Financial markets are responding to important progress in developing a coronavirus vaccine today.  You can almost hear “Happy Days Are Here Again” being played in the back of our minds, though it’s important to remember that plenty of economic and financial damage can still arise before widespread vaccinations are possible.  We review all the key news below:

COVID-19:  Official data show confirmed cases have risen to 13,349,649 worldwide, with 579,335 deaths and 7,430,243 recoveries.  In the United States, confirmed cases rose to 3,431,744, with 136,468 deaths and 1,049,098 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• Moderna, Inc. (MRNA, 75.04) reported that its coronavirus vaccine performed well in its Phase II trial, producing the targeted antibody response in all 45 people studied and proving to be well tolerated.  Importantly, the immune response also appeared to last at least two months.  The vaccine will now enter a Phase III trial consisting of about 30,000 people starting in late July, with final results expected around the end of the year.
  • Dr. Anthony Fauci, director of the National Institute of Allergy and Infectious Diseases, hailed the results as “really quite good news.”
  • Coupled with the other vaccines currently moving through trials, the initial success of the Moderna injection could help rekindle optimism regarding control of the disease, despite the discouraging resurgence of infections in the South and West.  As reflected in the market action so far today, the improving prospect of a vaccine should be bullish for global equities and other risk assets, but negative for bonds and precious metals.
• Despite the improving prospects for a future vaccine, the current surge of infections continues in multiple states around the country, and in several large developing countries abroad.  Here in the U.S., the rise in infections is boosting absenteeism at large employers, leading to production shutdowns and signaling a potential new supply shock for some industries.  On the demand side of the economy, emerging data shows the U.S. recovery to date has been driven mostly by higher-income consumers with stable jobs who have been taking advantage of the rising financial markets to buy homes, cars, and other big-ticket items.  All the same, at least one low-cost item has seen a sustained surge in demand: canned tuna fish.
• Following Britain’s decision yesterday to require face masks in retail stores, the French government said it will require mask-wearing in enclosed public spaces within the next few weeks because of a recent slight uptick in infection rates.
• Central Asian countries that had boasted of their early success fighting the pandemic, including Kazakhstan and Uzbekistan, have reintroduced lockdowns in response to a new surge in coronavirus cases that threatens their economies.

U.S. Policy Response

• Despite the good news on vaccine research, Fed Governor Lael Brainard said difficulty suppressing the new coronavirus will pose substantial risks for the U.S. economy, including a possible double dip in economic activity.  She also warned that the nation faces a long, slow recovery even if those hazards are avoided.  On a brighter note, that’s likely to be a positive for the markets; however, she also underlined Fed Chair Powell’s call for continued monetary and fiscal accommodation.

Foreign Policy Response

• In Japan, a government effort to support the tourism industry will kick off next week by providing $10 billion in subsidies for urbanites to visit the countryside, despite concerns that doing so will help spread the virus.

United States:  Presumptive Democratic presidential candidate Joe Biden released his proposed plan to combat climate change.  Under the plan, the government would spend some $2 trillion over the course of a decade to eliminate carbon emissions from the power grid, put Americans into electric vehicles and zero-emissions mass transit, and rebuild roads, bridges, and other infrastructure.  The plan would devote spending to minority communities and bolster rules to support unions, which the Biden campaign frames as a way to ensure benefits go first to poor and working-class people and to communities hurt the most by pollution.

European Union-United States:  In another blow to the European Commission’s effort to exact more tax revenue from big, U.S. multinationals, an EU appeals court quashed a commission order for Apple (AAPL, 388.23) to pay back €14.3 billion in taxes to Ireland.  According to the court, the commission failed to prove that Ireland had provided Apple with an illegal discretionary tax deal that gave it a competitive advantage.  That echoed the reasoning behind a similar decision last year that spared Starbucks (SBUX, 72.73) from having to pay back taxes.  Taken together, the decisions suggest EU competition czar Margrethe Vestager may be facing a prohibitively high hurdle in her effort to crack down on low-tax regimes in the EU.

European Union:  As national leaders continue to negotiate over the European Commission’s proposed €750 billion coronavirus recovery plan, including the proposal to finance it with mutualized EU debt, the horse trading has kicked into high gear.  For example, in a meeting yesterday between Portuguese Prime Minister Costa and Hungarian Prime Minister Orbán, Costa said matters concerning “liberty and the rule of law” shouldn’t be a part of the EU’s negotiations.  In other words, to make sure Hungary doesn’t veto the program and to ensure Portugal gets its share, Costa doesn’t want to press Orbán on his controversial social and judicial policies.

Japan:  In its latest policy decision, the Bank of Japan kept its monetary policy unchanged.  The central bank held its benchmark overnight interest rate at -0.1%, kept 10-year bond yields capped at “around” 0.0%, and held its purchases of equity ETFs steady at a pace of ¥12 trillion per year.  The decision came even as the institution revised down its economic growth forecasts and warned of further downside risks.  GDP in the year to March 2021 is now expected to decline 4.7%.  Consumer prices are expected to fall 0.5%.

Saudi Arabia:  Despite the challenges caused by the coronavirus, low oil prices and the government’s effort to gradually wean the economy off oil, Riyadh has gone ahead with a tripling of its value-added tax this month.  The move hiked the VAT to 15% from 5% previously.

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