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

[Posted: 9:30 AM EDT]

Good morning and happy Friday!  After a big drop yesterday, equities are recovering this morning.  Our take gets top billing in today’s report.  Next up is tech news, followed by foreign developments.  After those sections, we offer a couple of interesting charts. There is an intensification of talks around Brexit.  Our usual commentary on COVID-19 is available, along with some reports on vaccines and immunity; in addition, we are seeing a rise in new infections, with the emerging and frontier world showing the fastest increases.  Policy updates follow and we conclude with China.  Additionally, this week’s Asset Allocation Weekly (AAW) is available; it’s all about silver.  Let’s get to it:

Market news:  Yesterday was a clear risk-off session.  A couple of culprits have been blamed, but the reasons offered in the media always smack of post hoc.  The two most offered explanations for the drop was Chair Powell’s “gloomy” economic outlook and the surge in new COVID-19 cases.  Both conditions were essentially in place before the selloff.  As we noted in the May 29 AAW, this recession will likely be short, but very deep and with a long recovery.  The Fed’s forecast confirmed that expectation.  Why did this confirmation suddenly lead to a sharp selloff?  It probably didn’t.  Our take is that equities rallied very far and very fast from the March lows and some degree of consolidation was likely.  On the pandemic, there is no doubt that easing the lockdown will increase infections.  The bigger issue is the ability of the medical sector to handle the increase.  We expect it will, so national or even state lockdowns are not likely.  That doesn’t mean local ones won’t be necessary.

The key to the rise in equities, we believe, came from two sources; first, equities anticipate and participants realized the recession may be over as soon as next month.  Second, the policy response has been epic and there is no evidence it’s over.  Thus, barring something new (war with China, pandemic takes a much more deadly turn, etc.) we probably are not testing the recent cycle low.  However, it is important to note that the recoveries from recession lows often have long, sideways periods.  We would not be shocked to see a period of consolidation.

Tech news:  Twitter (TWTR, 33.03) has uncovered over 32k accounts linked to the governments of China, Russia and Turkey which the company accuses of spreading disinformation.  In addition, the company says another 174k accounts are fake and tied to China.  Social media has become a low-cost conduit for foreign actors to attempt to sow chaos, or sway U.S. public opinion; how the platforms deal with this issue is complicated and is a potential threat to their business models.  In other tech news, major name brands are getting a boost from the European Commission who is pressing tech companies to police the sale of counterfeit goods using the brand names.

Foreign news:  North Korea’s rhetoric has turned hostile in recent days.  In a statement on the second anniversary of the U.S./North Korean summit, Pyongyang now says that diplomacy has failed and the country will accelerate its nuclear program.  We continue to gather information on Kim’s sister, Kim Yo Jong, who has emerged as a power center in the government, and appears to be unusually hawkish, even by Kim standards.  There are reports that she was instrumental in the recent removal of communication lines between the North and South.  One interesting sideline; North Korea has been illegally selling sand, evading sanctions.  Europe is opening its borders this summer, but with restrictions.

Syrian President Assad has replaced his prime minister; Hussein Arnous is taking over for Imad Khamis.  Syria has seen its economy suffer in recent weeks, likely tied to the pandemic.  The Syrian pound fell to 3k per USD recently.  We suspect Khamis fell from grace due to the slumping economy.  The U.S. and Iraq are opening talks on the future of American troops in the country.  Immediately after the assassination of Soleimani in Iraq, there were calls for ousting U.S. troops.  However, a resurgence of IS and a new PM have led to second thoughts.  We still expect the U.S. to reduce its presence, not just in Iraq but across the Middle East. However the talks suggest that it may not be immediate.

Economic news:  The Fed released the Financial Accounts of the U.S. yesterday for Q1; it was previously known as the “flow of funds” report.  It is a wide set of data about the shape of the economy and the financial system and our first look at the impact of the pandemic.  The net worth of U.S. households fell due to the decline in equities

This chart shows net worth compared to after tax income.  The drop is noticeable.  Net worth is $110.8 trillion, down $6.5 trillion from Q4, which is a record.  However, scaling is important, which is why we offer the above graph.

The U.K. economy fell 20.4% in April, compared to March on a non-annualized basis.  This is a spectacular decline but is exacerbated by the short time frame.  Britain, along with Canada, are among the few nations that offer official monthly GDP reports.  In the U.S., Macroeconomic Advisors calculates monthly GDP for the U.S.

According to their data, the decline in April was -76.3% annualized, or about 11.3% from March, about half as large a decline as reported in the U.K.

One of the datapoints overlooked in the recent employment report was the decline in government employment, which fell 585k.  Virtually all of that decline was in state and local governments, with the latter accounting for 83.3% of the job losses.  Cities and counties are shedding workers are a rapid pace.

Brexit and trade:  The EU and the U.K. have announced a high-level conference with PM Johnson and Ursula von der Leyen on June 15.  Meanwhile, in deference to U.K. businesses, the Johnson government is planning on reducing border checks on the British side of the EU/U.K. trade even though the EU will likely deploy full checks in the absence of a trade deal.  However, this decision only covers the trade with the continent; the plans for the North Sea remain unsettled.

COVID-19:  The number of reported cases is 7,543,070 with 421,948 deaths and 3,561,804 recoveries.  In the U.S., there are 2,023,347 confirmed cases with 113,820 deaths and 540,292 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.

Virology:

• We are seeing a surge of new cases in the emerging world. India’s daily case count has exceeded 10k for the first time, and due to somewhat spotty reporting, the actual number is likely much higher.  The Middle East is seeing a resurgence as well; the KSA is considering cancelling the hajj for the first time in modern history.
• The EU is boosting funding for vaccine research. There are increasing worries about the distribution of a vaccine once one emerges.
• One of the mysteries of COVID-19 is why some are infected severely, while others barely notice the virus. Researchers are looking at potential conditions that may have given some people natural immunity, which may foster the vaccine search.  It’s also possible that some older vaccines for other diseases, such as tuberculosis, may offer limited immunity effects as well.

Policy news:  Although there have been signs the EU was making significant steps in creating a continental response to the pandemic, actual legislation remains a slog.  The White House is considering a second round of stimulus; Congress’s recess schedule is an additional complication.  There are worries that a round of evictions may hit the economy later this summer.  Investors are beginning to calculate the impact of yield curve control.

China:  China is undertaking a $1.0 trillion campaign into technology research.  It is evident the U.S. and China are engaged in a tech race.

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

[Posted: 9:30 AM EDT]

Good morning.  It’s a risk-off day so far, with global equities falling.  Some of this appears to be some well-deserved profit taking in the wake of a strong equity rally.  The FOMC meeting ended yesterday.  We examine what they announced and other policy developments.  There may be a thaw in Brexit talks.  We update the latest on China.  Our usual commentary on COVID-19 is available along with some reports on vaccine development and a global rise in new infections.   Precious metals prices have been strong (they are higher this morning); we look at recent internal issues caused by a disruption of supply flows.  The Weekly Energy Update is available.  Here is the information:

Policy news:  The FOMC meeting ended.  There were no surprises in the statement.  The Fed kept rates unchanged and didn’t signal any adjustments to QE or other programs.  The tone of the statement was very cautious; the committee clearly wanted to convey a sense that the downturn is still a major risk to American citizens and that monetary policy will remain easy for the foreseeable future.   The statement was approved by all the voting members of the committee. Because this was a meeting on the quarter, the FOMC released economic projections.  It’s forecast for this year’s GDP is -6.5%, with a 5.0% reading in 2021 and 3.5% in 2022.

Their forecasts suggest that the recovery won’t end until sometime in 2021; the level of GDP will remain below the 2019 peak for the next two years.  Consequently, the forward guidance from the Fed is no change to the policy rate is expected until 2022, based on the median dot.  In other words, the Fed is now engaging in forward guidance, signaling that rates will stay low for at least the next 30 months.

There were three other items of note.  First, although there was no mention in the statement about yield curve control, Chair Powell noted the committee did talk about it in the meeting in response to a question in the press conference.  Second, there was no discussion about negative interest rates, although two St. Louis FRB economists suggested it might be necessary in order to boost the economy back to its long-term trend.  There is an argument to be made for negative rates.

These charts show the Mankiw rule variations.  Regular readers will recognize this rule as an offshoot of the Taylor Rule, which attempts to estimate the Fed funds target based on inflation and economic slack.  The difference is in the measure of slack. Taylor used the difference between GDP and potential GDP.  The latter number is not directly observable.  Mankiw substituted the unemployment rate.  We added three other measures of labor slack.  The chart on the right highlights the current situation; three of the four variations of the Mankiw rule are in negative territory, with the employment/population ratio model suggesting Fed funds should be 5.65%.  We don’t expect the Fed to deploy negative policy rates.  Negative rates would wreak havoc on the non-bank financial system and probably end money market funds as a financial instrument.  Third, Powell was asked about the problem of creating overvalued asset markets through easy monetary policy; Powell, in line with his predecessors, made it abundantly clear that he does not see how the Fed could raise rates and potentially hurt workers by trying to contain an asset bubble.  The ramifications are obvious; Fed policy will continue to support asset prices.

To put what the Fed has done in context, compare the S&P 500 to the policy response.  This chart looks at the yearly growth rate of M² and the S&P.  We have taken the average growth rate of the money supply and one standard deviation bands over the period 1959—2020.  The black vertical lines show the month end peak of the S&P; the red lines show how long it took the Fed to lift money growth above the standard deviation line after a bear market ensued.  In 2000, it took 13 months; in 2007, 14 months and this time, four months.  Additionally, in the previous two episodes, once the standard deviation line was hit, money growth promptly fell.  Compare that behavior to the current cycle; not only is money growth running in excess of 20%, more than two standard deviations above the average, the time to reach that level has been very short.  Simply put, policy support is extreme and accounts for much of the rally in stocks.  There was nothing heard yesterday that makes us believe that policy stimulus will be removed anytime soon.  If anything, there could be more actions in the pipeline.

In terms of market reaction, equities initially rallied on the statement but retreated during the press conference.  We didn’t see anything particularly bearish, so the decline is probably profit taking.  Precious metals prices jumped.  The dollar initially fell but did recover after the press conference ended.  Interest rates also fell.  Our view is that (a) policy will remain easy but (b) the Fed remains reluctant to take more radical steps (yield curve control, deliberate dollar depreciation, negative interest rates) without additional deterioration in economic conditions.

In other policy news, Treasury Secretary Mnuchin indicated that he believed more fiscal action would be necessary to boost the economy, especially to small businesses.  The U.S. is proposing additional spending to bolster the semiconductor industry; this is partly to offset the costs of separating from China.  The U.S. is expanding its price fixing investigation of the poultry industry.

In overseas policy news, the ECB is apparently considering creating a “bad bank” that would absorb bad loans across the EU caused by COVID-19.  This approach allows for the loan to be worked out, and cleans up the balance sheet of the bank that held the bad debt.  Amazon (AMZN, 2647.45) will face anti-trust charges from the EU over its treatment of third party sellers.

Brexit and trade:  Michel Barnier, the EU chief negotiator for Brexit is asking for flexibility on the issue of a “level playing field.”  The EU has been worried that the U.K. would become a low regulation “Singapore on the Thames” that would undermine EU trade regulations.  Thus, the EU has held a rather hard line on not giving Westminster such arrangements.  The fact that Barnier is asking for some wiggle room suggests that the EU is starting to bend.  Why the change?  Probably because nations, like Ireland, which would be hurt badly by a hard Brexit, want to avoid that outcome.

China:  Here is what we are watching:

• China has been allowing the CNY to weaken in response to increased U.S. pressure. As long as capital flight remains contained, we expect Beijing to continue to weaken its currency.
• Despite the looming new security law, protests continue in Hong Kong.
• For some time, China’s high debt has been a worry. Although there is evidence of increasing stress caused by the global downturn, so far, we are seeing informal methods, such as quiet restructurings and debt service postponement, to avoid outright default and bankruptcy.
• The U.S. is maintaining military pressure on China. The S. Navy has deployed the USS Ronald Reagan and the USS Nimitz, two aircraft carrier groups, to the Asia/Pacific area.  The USS Theodore Roosevelt was in port at Guam, dealing with an outbreak of COVID-19.  However, according to reports, it is back at sea, giving the U.S. three carrier groups in theater.  This is a show of force that will not go unnoticed by Beijing.
• China’s auto sales rose 14% in May, the second straight month of recovery.
• Issues of inequality are not just a concern in the West. China’s high levels of inequality have caught the attention of it’s leaders as well.
• In the aftermath of the end of Hong Kong’s “one country, two systems” model, relations with the U.K. have clearly deteriorated. It has now moved to the point where it is affecting U.K./China trade.
• And finally, one of the deep social problems facing China has come from its one-child policy. The CPC rigorously enforced a policy of only allowing one child per family in a bid to slow population growth.  The program did what it was designed to do; China’s population growth slowed and for a number of years, it benefited from a falling dependency ratio.  However, such benefits, absent of high levels of immigration, could not be sustained.  Now, China’s dependency ratio is rising (and from the wrong end—its elderly population is rising much faster than its child population) and it has gender distribution problems.  Due to many families being restricted to one child, steps were often taken to ensure that the only born was male.  As a result, China now faces a demographic problem; it’s getting older and it has too many males relative to females.  Despite easing one-child restrictions, Chinese couples seem reluctant to have larger families.  So, one academic in China has offered a solution—polyandry, where women take on multiple husbands.

COVID-19:   The number of reported cases is 7,397,349 with 417,109 deaths and 3,478,385 recoveries.   In the U.S., there are 2,000,464 confirmed cases with 112,924 deaths and 533,504 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.  And Axios has its map of the U.S. showing infection trends by state.  There are now 15 states with a R_t>1, which means that infections are rising at a faster rate.

Virology:

• There are several vaccine candidates that are being tested this summer. Here is a listing of all the vaccine candidates, the firms or schools involved in their production and where each is in the process of testing or development.  Russia has embarked on a crash program to develop a vaccine.
• Although we are seeing some areas in the U.S. with rising infections, there does not appear to be any move to return to lockdowns. This development suggests that political leaders have concluded that the negative effect on the economy outweighs the medical risk.  This isn’t unique to the U.S.,  foreign governments are taking similar positions.
• Iran is reporting a new surge in infections.
• It is looking increasingly likely that the recent death of Burundi’s president was caused the COVID-19. If true, Pierre Nkurunziza would be the first head of government felled by the virus.
• European leaders are under fire for their management of the pandemic. PM Johnson has seen increased criticism.  Sweden, who’s leaders took a more relaxed position on social distancing, are also coming under fire.  On a more constructive note, EU leaders are looking at developing a more continental approach to dealing with the pandemic.
• In something as unusual as a pandemic, there are always unexpected outcomes. One that has emerged is that COVID-19 has apparently crushed the price of coca due to a collapse in the narcotics trade.  Some of the drop is due to borders closing; other factors are the loss of chemicals needed for processing.  However, for now, the pandemic has succeeded in doing something years of policy have failed to achieve.
• China is denouncing a Harvard study that suggests the virus was circulating in Wuhan at the end of the summer of 2019. Confirmation would suggest that Chinese officials were either unaware or covered up the evidence and it reflects badly on the government.  At the same time, the EU is accusing China of conducting a disinformation campaign on its handling of the pandemic.  Much of the narrative is being spread through social media.

Commodity news:  Gold prices have been strong in recent months, helped by global uncertainty.  The pandemic has boosted demand as well.  What has been unexpected is the flows of gold to New York.  Although there are lots of ways to buy gold, including physical purchases and ETF’s, perhaps the most sophisticated way to buy the metal is to take delivery on a long futures position.  The delivery can be kept at the Comex vault and can be sold into the futures market at any time.  It is a very low-cost way of transacting a gold purchase.  Banks do something similar with their gold holdings.  Most physical gold is held in London and Zurich, but most of the futures trading occurs in New York.  Most of time, this isn’t a problem; the spread between the futures price and the physical product is small.  However, over the past few months, demand for gold has increased and because shipping has been disrupted due to the pandemic, the spread between futures and cash gold widened.  This forced banks, who were long the physical and short futures, to charter airplanes to deliver gold to the Comex in lieu of making margin calls.  In other gold news, Russia has been increasing its exports of gold; the country is the third largest producer of gold.  In other commodity news, rice prices are rising due to global demand and likely some precautionary inventory purchases.

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

[Posted: 9:30 AM EDT]

The relatively muted tenor in risk assets so far today comes as investors look forward to the Fed’s latest policy decision, forecast update and Chairman Powell’s news conference this afternoon.  We’ve also seen some pessimistic forecasts for the global economy from the OECD, signs the Republicans are pushing back harder against the next fiscal stimulus bill and the possibility of a future military takeover in Brazil.  We review all the key news below.

United States:  Today the Fed will wrap up its latest two day policy meeting.  As we’ve mentioned before, the policymakers have made it clear they don’t want negative interest rates, so the benchmark Fed funds rate will be held unchanged at essentially 0.0%.  The real debate will likely be over yield curve control.  Besides watching that debate closely, we’ll be parsing the policymakers’ latest forecasts for the economy and the future Fed funds rate.

COVID-19:  Official data show confirmed cases have risen to 7,264,866 worldwide, with 411,879 deaths and 3,394,970 recoveries.  In the United States, confirmed cases rose to 1,979,893, with 112,006 deaths and 524,855 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• The WHO now says it isn’t clear how often people contract and then spread Covid-19 without showing symptoms, pulling back from a top official’s earlier assertion that such invisible transmission appears rare.  The clarification highlights the continuing uncertainties about how the disease is actually transmitted.
• In Russia, authorities in Moscow eased many pandemic restrictions even as infections remain high.  Under the new guidelines, most businesses and other parts of ordinary life are expected to be fully up and running again by June 23.
• Top epidemiology official Dr. Anthony Fauci told a pharmaceutical conference that there is no way COVID-19 will simply burn itself out through current public health measures, so it will remain a problem until a vaccine is found.  On a more positive note, however, Fauci also said, “I’ll guarantee there is going to be more than one winner in the vaccine field because we’re going to need vaccines for the entire world . . . Billions and billions of doses.”
• In fact, the director of vaccine research at the National Institute of Allergy and Infectious Diseases said the federal government plans to fund and conduct final, decisive Phase III studies of three experimental coronavirus vaccines beginning this summer.  The trials are expected to involve tens of thousands of subjects at dozens of sites around the U.S.

Real Economy

• The OECD issued a set of downbeat forecasts for global economic growth after the virus crisis, warning that even though developed countries are likely to see a sharp rebound initially, the recovery will probably then stall because of the lasting impact of unemployment, corporate bankruptcies and residual social distances practices.
  • In the new OECD forecasts, the global economy will contract by 6% this year if a second wave of infections and containment measures can be avoided and 7.6% if a second wave isn’t avoided.  Such contractions would be at least twice as large as forecast by the IMF.
  • If there is no second wave of infections and lockdowns, the forecasts call for global GDP to rebound 5.2% in 2021.  With a second wave, the forecasts call for growth of just 2.8% in 2021.  The OECD’s nifty graphics showing the various global and country-by-country forecasts can be found here.
• Managers at major department stores say sales at recently reopened stores have been significantly better than expected.  The news is bullish for stocks because it boosts hope that the post-pandemic economic recovery could be more robust than previously feared.
• Global rice prices are surging in response to pandemic lockdown demand and weather issues.

U.S. Policy Response

• Labor Secretary Scalia said he opposes any extension of the supplemental federal unemployment benefit of $600 per week that workers are receiving as a result of the coronavirus pandemic.  The extra payment is scheduled to end on July 31, but Scalia argued that no extension would be necessary because job opportunities in August should be “far greater” than they are now.

United States-Germany:  Nearly two dozen Republican House members are urging the Trump administration to reconsider its decision to drastically cut the number of American troops assigned to Germany, according to a letter viewed by the Wall Street Journal.  In the letter, the Congressmen argue that, “such steps would significantly damage U.S. national security as well as strengthen the position of Russia to our detriment.”

United States-Russia-China:  Even though the U.S. and Russia have officially invited China to participate in the new arms control talks to open in Vienna later this month, Chinese officials have reportedly rejected the invitation.  Moreover, Russian Deputy Foreign Minister Ryabkov poured cold water on any hope that Russia would pressure China to participate.  The development undermines hope that a new, multilateral nuclear arms treaty can be signed to follow the U.S.-Russia New START agreement that expires next February.

EU-Russia-China:  The European Commission issued a report accusing Russia and China of conducting targeted influence operations and disinformation campaigns about COVID-19 in the EU, its neighborhood and globally.  The report accuses Moscow and Beijing of trying to “undermine democratic debate and exacerbate social polarization and improve their own image in the COVID-19 context.”

EU:  As EU members jostle to shape the bloc’s upcoming budget and coronavirus recovery fund to their liking, countries including Belgium and Ireland are arguing that more funds may be needed because of the risk of a hard Brexit at the end of the year, on top of the economic damage from the COVID-19 shutdowns.  EU and British negotiators continue to talk but are making little progress on a trade deal for the period after December 31.  Separately, Portuguese Finance Minister Centeno resigned his position, forcing him to also give up his role as head of the EU finance ministers’ group.  The proposed EU budget and recovery fund, including the idea of issuing common EU bonds, will be discussed next week by national leaders rather than finance ministers.  All the same, given Centeno’s pivotal role in pushing through the EU’s fiscal support packages to date, his departure increases the odds that the debt mutualization proposal could be rejected or substantially modified.

Brazil:  One of President Bolsonaro’s sons, who has previously praised the country’s past military dictatorship, said a similar break with democracy in Brazil is now inevitable.  The statement adds to signs that Bolsonaro is leaning toward a military takeover of the country as he deals with the coronavirus crisis, political scandals and fleeing foreign investors.  The political instability associated with any military takeover would likely be at least a near-term negative for Brazilian assets.

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

[Posted: 9:30 AM EDT]

Our newest podcast episode, “The Long-Term Effects of COVID-19,” is available.  In this episode, we discuss how the COVID-19 pandemic will likely accelerate the reversal of the equality/efficiency cycle toward equality.

Many countries continue to report falling coronavirus infection rates and economic reopening, helping to push the NASDAQ to a record close yesterday.  All the same, it appears that the official declaration of a recession in the U.S. and sobering trade data from Germany have helped spark some profit-taking in the financial markets today.  As always, we recap all the key news below.

United States:  Yesterday, the arbiter of the U.S. business cycles, the National Bureau of Economic Research, officially declared that the economic expansion that began in March 2009 came to an end in February 2020.  The surprise wasn’t that the NBER’s Business Cycle Dating Committee believes the U.S. economy has been in recession ever since then.  Just about all economists and financial market analysts around the world, ourselves included, have thought that for some time.  The surprise was that the group moved so quickly to declare the recession, rather than waiting until deep in the downturn or even later like it usually does.  The quick designation likely reflects the extreme depth of the pullback, which has made it obvious to just about everyone.  The big question is whether a recovery is at hand, and if so, how long and robust it will be.  We think things have stopped getting worse and the recovery is now starting.  The NBER therefore, could declare an end to the recession sooner than it has in the past.  Given the depth of the decline, however, we suspect the recovery back to the previous level of activity will be long and fitful.  A key risk is that officials could withdraw the supportive monetary and fiscal policies they’ve deployed to date and take the wind out of the recovery’s sails.  Indeed, yesterday Senate Majority Leader McConnell and White House advisor Hassett both suggested that improving employment numbers would mean any further fiscal packages to support the economy could be scaled back.

COVID-19:  Official data show confirmed cases have risen to 7,142,462 worldwide, with 407,067 deaths and 3,316,747 recoveries.  In the United States, confirmed cases rose to 1,961,187, with 111,007 deaths and 518,522 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• Preliminary data from a study of more than 750,000 participants showed that people with Type O blood were 9% to 18% less likely to have tested positive for Covid-19.  According to the report, which has not yet been peer reviewed or published in a medical journal, Type O people who had been exposed to the virus were 13% to 26% less likely to test positive for the disease.
• While many U.S. states continue to report a falling count of new infections each day, allowing continued easing of pandemic restrictions, daily infection counts are accelerating in at least a dozen states, keeping alive the risk of a broad new outbreak in the coming months.
• India reported another record single-day rise in infections, with 9,987 new cases, bringing the total to 266,598.
• New Zealand marked its first day without coronavirus restrictions, while the country’s border remained closed with limited exceptions.
• Raising concern about a brewing coverup, the Brazilian government has stopped publishing the daily count of new infections and deaths, delayed reporting on total infections, and will now revise its death toll to date.

Real Economy

• German exports dropped by a record 24.0% in April, coming in worse than expected and leaving foreign shipments for the month down 31.0% from April 2019.  Imports also contracted sharply in April, with a drop of 23.6% from the previous month.  As shown in the tables below, this produced a sharp drop in the country’s trade balance for April.
• Although weakened demand from the crisis has driven down overall inflation so far, many food prices are rising at their fastest pace in decades.  This has the potential to further weigh on overall demand, as consumers are especially sensitive to rising costs for essentials like food.

U.S. Policy Response

• As we mentioned yesterday, today is the first day of the Fed’s latest two-day policy meeting.  Given that the policymakers have made it clear they don’t want negative interest rates, the benchmark fed funds rate will be held unchanged at essentially 0.0%.  The real debate will likely be over yield curve control.  Besides watching that debate closely, we’ll be parsing the policymakers’ latest forecasts for the economy and the future fed funds rate.
• The Fed announced another set of changes to its Main Street Lending Program for small and medium businesses. This is as it strives to make the $500 billion program more attractive to borrowers and banks, without taking undue credit risk when it ramps up in the coming weeks.  The loans still will be run through the nation’s banks, which can sell 95% of the loans to the Fed, but under the latest set of changes:
  • The minimum loan amount will be reduced to $250,000 from $500,000, which will make the program more attractive to smaller firms.
  • The maximum loan amount will be raised to $35 million for new loans, or up to $300 million to refinance an existing loan if a firm’s total debt, relative to its 2019 earnings, is below certain thresholds. Those maximum loan amounts had been set at $25 million and $200 million, respectively, in late April.
  • The maximum loan term will be extended to five years from four years previously.
  • Businesses will be allowed to defer principal payments for the first two years instead of just the first year.

Foreign Policy Response

• In France, the government announced two significant extensions of its economic support program.
  • Finance Minister Bruno Le Maire unveiled a €15-billion ($16.9 billion) aid package for the aerospace industry.  The package, which includes the €7 billion of aid previously announced for Air France-KLM (AFLYY, 6.87), consists mostly of government investments, loans and export credit guarantees.
  • Labor Minister Muriel Pénicaud announced that “temporary unemployment” wage subsidies would be extended for up to two years.

NATO-China:  NATO General Secretary Stoltenberg called for nations around the world to join with the alliance to resist China’s “bullying and coercion.”  In his speech, Stoltenberg warned that, “The rise of China is fundamentally shifting the global balance of power, heating up the race for economic and technological supremacy, multiplying the threats to open societies and individual freedoms and increasing the competition over our values and our way of life.”  While there is now broad consensus around the world regarding China’s aggressive moves to build, expand and exercise its power, Stoltenberg’s statement reflects what may be another growing consensus:  That because of China’s size and aggressiveness, resisting it will probably require the combined power of many like-minded democracies operating in alliance, i.e., not just individual countries pushing back against China, but a clash of Western Civilizations against a Chinese Civilization seeking its renaissance.

China-Hong Kong:  Hong Kong-based hedge funds are exploring ways to move their operations elsewhere as China prepares to impose sweeping national security legislation on the city.  According to one advisor who works with hedge funds in the city and elsewhere in the region, “Hong Kong as we know it is dead.  It will become just another city in China. The hedge fund community will move on to Singapore and elsewhere.”  Separately, thousands of protesters rallied Tuesday evening in downtown Hong Kong, defying a police ban on demonstrations to mark the one-year anniversary of a million-person rally that thrust the city into its biggest turmoil in decades.

North Korea-South Korea:  The North Korean state news agency KCNA said the inter-Korean communication line by which the two governments speak daily, as well as a separate hotline to the South Korean president, will be severed from midday on Tuesday.  The move is in retaliation for South Korean non-governmental groups that have been sending balloons and drones to drop anti-North Korean leaflets over the country, though it probably also reflects Kim Jong Un’s frustration at the collapse of the denuclearization talks with the U.S.

United States-Russia-China:  U.S. Special Envoy for Arms Control Billingslea said the U.S. and Russia have agreed to open a new round of arms control talks in Vienna later this month, and that China has been invited to participate as well.  The talks may include discussions to extend the New START nuclear arms treaty that is due to expire in February 2021.

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

[Posted: 9:30 AM EDT]

Our newest podcast episode, “The Long-Term Effects of COVID-19,” is available.  In this episode, we discuss how the COVID-19 pandemic will likely accelerate the reversal of the equality/efficiency cycle toward equality.

Good morning and happy Monday!  Global stocks are mixed; Europe is lower on disappointing German data, while U.S. equity futures are ticking higher.  Tropical Depression Cristobal hit Louisiana over the weekend and remnants are expected in St. Louis on Tuesday.  The Fed meets this week; we will get forecasts and maybe a dots plot.  Brexit fears are rising; we look at the looming trade deadline and other European trade issues.  We update on China and touch on its trade data.  The U.S. is pulling troops from Germany.  OPEC+ has a deal and oil prices are higher.  We update COVID-19, focusing on U.S. and global reopening from lockdown.  Additionally, we have some Monday charts!  Here is the update:

Policy news:  The Fed meets this week.  There is absolutely no mystery on the policy rate; since the FOMC has made it clear it doesn’t want negative fed funds, there really isn’t more to be done on that front.  Instead, we expect the debate to be over yield curve control.  This isn’t exactly new for the Fed; during WWII, the central bank fixed rates across the entire yield curve to control Treasury borrowing costs.  However, the impact of such control would be significant.  For example, the Treasury curve would no longer be a forecasting tool; we might be able to use the corporate curve, but even there, one would expect some relationship to the risk-free rate.  The other issue we will be watching for are forecasts for the economy and the policy rate.  The bigger issue here is that if the Fed goes this far, it has essentially ceded its independence.  It can get it back at some point, but it will be a war because no president wants to be in office when the Fed stops the stimulus.  Harry Truman would concur, we suspect.

Brexit and trade:  Although the actual exit date isn’t until year’s end, if the U.K. is going to ask the EU for an extension of Brexit negotiations, it must do so by June 30.  By all accounts, PM Johnson has made it clear that he will not ask for an extension, so the odds of a hard break are rising.  Trade officials and businesses are beginning to count the costs of a hard border with Europe.  A concern has been that British negotiators don’t seem clear on what they want from an agreement with the EU.  One of the benefits of a hard break is that the U.K. can make trade deals with other nations; Westminster is looking to make a deal with the U.S. in short order.  The U.S. has made it clear that such a deal would include U.S. agriculture, including the infamous “chlorine chickens.”  The issue of the U.S. and EU food regulation and trade is nothing new, but could become an issue when the U.S. and U.K. begin trade talks.

China:  A sharp decline in imports offset a drop in exports, expanding China’s global trade surplus.

Meanwhile, analysts are questioning China’s employment data, suggesting it is painting too rosy a picture of China’s recovery.  Recent policy statements seem to confirm this notion.  Lastly, China’s drive to semiconductor self-sufficiency has been lagging badly.

Foreign news:  The U.S. announced over the weekend that nine thousand U.S. troops will be leaving Germany.  Relations between Berlin and Washington have been strained for some time; while some commentators are suggesting this decision is supportive for Russia, that may not be the case.  Poland is hoping that the U.S. will move these forces to its soil.  The U.S. is threatening both the EU and China over lobster tariffs.  EU support has, for now, reduced financial stress in Italy.

OPEC:  As expected, OPEC and Russia have reached a deal to extend supply cuts.  Russia and Saudi Arabia were able to corral some of the smaller producers in OPEC, which have been overproducing; of course agreeing is one thing, cutting is another.

COVID-19:  The number of reported cases is 7,036,623 with 403,131 deaths and 3,153,223 recoveries.  In the U.S., there are 1,942,363 confirmed cases with 108,211 deaths and 506,367 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 news surrounding the virus, across the world, is the next phase of the crisis—the reopening.  Europe is easing restrictions; British pubs are scheduled to reopen June 22.  As we are seeing in the U.S., there are regional differences, with some European nations opening to all travelers, others creating travel bubbles, allowing free entry of some nations, restrictions from others.  Meanwhile, in the U.S., New York is starting to reopen.  In the U.S., there is evidence that as social distancing restrictions ease, infections are rising.  This should be no surprise.  The point of the lockdowns were to control the rise of infections so the health system could cope.  However, the economic costs of the lockdowns were high and, barring a mutation in the virus that turns it into something with a fatality ratio similar to smallpox, we doubt we will see broad lockdowns repeated.  Thus, the fear of the “rise in autumn” that is often discussed is probably not that great of a risk to the economy.  Instead, we expect to see targeted measures, which would protect the most vulnerable from infection while leaving the rest of the economy to normalize.  In Brazil, the government is limiting the release of virus data.

Monday charts:  Here are three charts we have been working on.  First, Friday’s employment data raised great hopes that a recovery is underway.  We tend to agree with that idea; as we stated in a recent Asset Allocation Weekly, recoveries start when conditions stop getting worse.  Given the catastrophic drop in growth, it should be no surprise that conditions are improving.  However, it is important not to confuse the trough with the path of the recovery.  The economy is in a deep hole that will take a long time to dig out of.

In this chart, we index the level of employment to the peak before the onset of recession.  Each recession is measured to see how long it takes before the previous cycle high is met.  There is nothing in the postwar experience that matches what we are seeing here.  So, if policymakers take Friday’s data as a reason to hold off on additional stimulus, it could be an epic mistake.

Meanwhile, the recovery in equities has been surprising.  This chart shows the weekly Friday closes from the onset of recession; we rebased the S&P to the market peak prior to the beginning of each recession.

Two things are notable about the current cycle. First, the decline was the fastest in the postwar experience.  The cascading decline in February and March was extremely fast.  Second, the recovery has been remarkable as well.  Only two earlier recessions, the 2001 and 1956, have the index higher than we are currently.  The 2001 recession was very mild; the 1956 recession occurred during the Asian flu pandemic, although the drop was mostly attributed to monetary policy.  The 1956 recession was very deep but short, which is similar to what we are expecting.  Here is a note of caution; the average line shows that sideways performance tends to follow once the initial bounce occurs.  We would not be surprised to see markets consolidate at some point.  On the other hand, we have never seen this degree of policy support in the postwar world.

 

Finally, this is the weekly S&P chart compared to retail MMK fund levels[1]; the orange bars show periods where MMK fell below $920 billion, which tended to coincide with market consolidations.  We have been noting rising caution among retail investors since 2018 when the trade conflict with China escalated.  Even with the strong rally in equities from Q3 2018 into Q3 2019, retail MMK continued to rise.  Cash levels have continued to rise through the recent decline and recovery in the S&P.  Note that the bull market that began in March 2009 was fueled by a decline in retail MMK; if a similar pattern develops in this cycle, we could see further gains in equities.

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