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

[Posted: 9:30 AM EDT]

Good morning!  U.S. equity futures are weaker this morning, but off the worst levels of the overnight session.  Our usual commentary on COVID-19 is available.  We cover a myriad of policy issues this morning, including global taxes and the increased scrutiny facing U.S. tech firms.  In policy, a number of central banks took action overnight.  Australia looks like it is in recession and we examine the difference between expectations and reality in the economic reports.  The Weekly Energy Update is available.  Here are the details:

COVID-19:  The number of reported cases is 8,367,894 with 449,397 deaths and 4,091,978 recoveries.  In the U.S., there are 2,163,894 confirmed cases with 117,717 deaths and 592,191 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.  Additionally, we have the weekly Axios U.S. state map.

Virology:

• India is becoming a global hot spot for the virus. Given its population density, the chances the virus will spread in India are elevated.
• The rise in infections around Beijing has coincided with news reports of finding the virus in fish. Although this discovery was mostly accidental (most likely the fish was processed or handled by an infected worker) it has led to a sharp decline in demand for imported salmon.
• As the world awaits a vaccine, there are growing worries about a potential bottleneck; the glass vials used to distribute doses. Currently, there is a shortage of the vials and the demand for them once a vaccine is developed could overwhelm the industry’s capacity.
• COVID-19 is especially fatal for older people. Nursing homes have seen a high level of fatalities due to the virus.
• South Korea’s experience in managing the virus suggests that maintaining an acceptable level of infections means that returning to a pre-COVID-19 lifestyle isn’t really possible.
• Researchers have found direct evidence that COVID-19 can infect the brain and replicate in that vital organ. Although it isn’t clear if the virus regularly makes its way past the blood/brain barrier, if it does, it will complicate treating the disease.
• Remember mood rings? Now we have a “smart ring” that will reportedly signal when a user is pre-symptomatic with COVID-19.  Casinos are planning to distribute them to staff to inform workers and protect patrons.
• Honduran President Juan Orlando Hernandez has tested positive for COVID-19.

Policy news:

• One of the issues that has developed in public finance is taxing multinational corporations. In the U.S., we often see tax breaks offered to companies to move facilities into a state.  It can become a race to the bottom as states are continually faced with the need to offer deals to keep companies within the state.  Because public goods must usually be provided to the company and workers (workers need police and fire protection, schools and company facilities need the same, plus infrastructure) the incidence of funding these services tends to fall on those who lack the resources to “shop around.”  Something similar occurs at the international level.  Nations can attract businesses by becoming tax havens.  Ireland is perhaps the most developed nation example.  Multinational firms have the resources to establish outlets in tax favorable environments and extract subsidies and other support.  In an effort to stop this process, the OECD had sponsored talks to harmonize global tax policy.  However, in any tax regime, there are those who benefit from the current situation and see little reason to change, and those who want to shift the incidence of a tax to others.  Europe has been keen on taxing technology, which, in reality, becomes a tax on U.S. firms.  The EU would gain the revenue and the U.S. would mostly bear the incidence of the tax payment.  Needless to say, the U.S. isn’t all that supportive of this effort.  As a result, yesterday, talks broke down.  We would expect the EU to go ahead with digital taxes and the U.S. to treat this move as targeting the U.S. and respond with tariffs and other penalties.
• The tech industry is coming under increased scrutiny as part of the Communications Decency Act. Initially, in the 1990s, the government was concerned if young tech firms were sued for user content, they would be unable to survive and so the industry was given broad protections against lawsuits from user content.  So, the Communications Decency Act protected the firms from lawsuits.  However, as the firms have grown in size and power, policymakers are taking another look at this issue.  For example, Hawley (R-MO) is introducing legislation that would reduce the protections tied to censorship.  The DOJ is looking at similar measures to reduce immunity.
• Apple (APPL, 353.94) is facing antitrust investigations from the EU over its app store.
• Chair Powell finished this second day of Congressional testimony yesterday. What we noted was that the Chair does not want Congress to begin withdrawing fiscal support quite yet.  He wants some form of jobless benefits to continue, and the extension of other measures as well.
• One of the factors we have been monitoring since 2008 has been the rise of populism which includes opposition to globalization. Within the political parties, this pits the establishment against the populists.  This issue has come up again recently, as the Chamber of Commerce warns against restricting visas for foreign workers, indicating that if businesses can’t get these workers from abroad, they will be forced to bid up wages for local workers…which is exactly the point the populists have been making.
• USTR Lighthizer weighed in on the WTO yesterday. The body is searching for a new leader and the U.S. clearly wants to shape global trade policy in a more favorable manner.  What we find interesting is that Lighthizer doesn’t want to see the WTO scuttled (as some in Congress do), but does want it to fit trade policy to favor the U.S.
• Several central banks eased credit yesterday, with the notable exception of Taiwan, who kept policy steady. This morning, the BOE expanded QE but didn’t move rates below zero.  The PBOC, who so far has been reluctant to expand policy stimulus, appears to be moving to boost growth.

China:

• We continue to monitor the conflict between India and China. The good news is that although there were fatalities on both sides during a recent skirmish, so far, there hasn’t been evidence of military escalation.  The bad news is that aggressive rhetoric is rising on both sides that may create conditions that foster future escalation.
• Yesterday, SoS Pompeo and China’s foreign policy chief Yang Jiechi met in Hawaii. It wasn’t clear why the meeting was held and both sides were reticent to discuss the outcome of the engagement.  In fact, both sides suggested the other asked for the meeting.  We suspect this was about keeping communications open during a period of tensions.  It doesn’t appear that there was anything specific to discuss, although if there was, we should see “something” emerge in the coming weeks.
• Although U.S. foreign policy has had a look of “going it alone” in reality, there does appear to be an anti-China coalition evolving. The tensions on the India/China border may reflect Beijing’s growing concern about this development.
• There are increasing reports of human and capital flight from Hong Kong.
• China’s espionage isn’t only centered on the West. A Russian scientist has been accused of passing along classified information to Beijing.   Reportedly, the information is tied to submarine detection.
• China is collecting blood samples from a large swath of its population in an attempt to create a massive DNA database. China has been steadily moving to create a high-tech surveillance state; the DNA database is part of widespread cameras, facial recognition and monitoring of financial transactions to monitor the activities of its citizens.

Markets:  Insurance companies are reviewing their exposure in collateralized loan obligations (CLOs).  CLOs are usually pooled corporate debt, originated by banks.  CLOs can be separated into different tranches by credit risk and payment priority.  In recent years, insurance companies have been avid buyers of these instruments to take advantage of their higher yield.  However, recently, there has been growing concerns about the credit quality of these instruments.

There is a rising level of delayed loan payments.  Student loans are showing the highest delinquencies.

Economy news:

• Australia’s May unemployment rate rose much faster than expected, hitting 7.1%, up from 6.4% in April.

The country, which hasn’t had a recession since the early 1990s, is clearly in one now.

• One of the concepts a new analyst always has to learn is that the actual data matters less than the data relative to expectations. Recent data has been far better than forecast.

This chart shows the economic surprise index from Bloomberg. It measures the difference between the actual data and expectations; the data included are weighted based on their effects on foreign exchange behavior.  What the index is telling us now is the economic data is coming in much better than forecast.  That doesn’t mean the data is good; it means that expectations are so depressed that even soft numbers are still better that deeply depressed forecasts.  What we have observed over the years is that the expectations tend to catch up in a few months and so better future data may not look as good, even with the improvement, because expectations will tend to rise even faster.  This could lead to “disappointing” economic data by autumn.

• One of the consequences of the lockdowns has been that firms and workers are realizing that they probably don’t need to go to the office to be effective. And, if that’s the case, why would someone stay in a crowded expensive city if they can just as easily live elsewhere.  If this becomes a trend, smaller metropolitan areas may benefit from workers moving to new, smaller cities.
• The massive expansion of central bank balance sheets has raised fears of inflation. Japan, which has seen ballooning government deficits, remains susceptible to deflation.

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

[Posted: 9:30 AM EDT]

Risk assets have wind in their sails today, in large part due to easing coronavirus lockdowns, signs of rapid economic recovery and continued policy support around the globe.  However, those positives are being offset to some extent by serious new geopolitical tensions between China and India, as well as a worrisome new outbreak in Beijing.  We review all the key news below.

China-India:  It now appears that yesterday’s China-India military clash along the countries’ border in the Himalayan mountains was substantially more lethal than first known.  The Indian government now says 20 of its soldiers died, including not just the three direct fatalities that we reported yesterday, but also 17 more who perished after falling into a deep ravine, or succumbing to the freezing temperatures.  To minimize the risk of a shooting war along the disputed border like the major 1962 confrontation, Chinese and Indian troops patrolling the area don’t carry firearms.  The current tensions have evolved from fistfights last month to attacks with rocks and clubs wrapped in barbed wire this week, resulting in the border troops’ first fatalities in decades.

• Ultimately, the confrontation can be traced back to the heightened nationalist disposition of Chinese President Xi Jinping and Indian Prime Minister Narendra Modi.  Both leaders want to assert their country’s sovereignty to the fullest extent possible, including in disputed areas like the Himalayan border.
  • Xi’s efforts to assert control in Hong Kong, Taiwan and the South China Sea are well known.
  • Modi has also been working to assert India’s control over the Kashmir region.  India’s warming ties with the U.S. and an ill-timed decision to postpone a major military exercise in the area probably also tempted Xi to take a tougher stance.
• According to Indian sources, several Chinese troops also died in the melee, so a key risk now is that if the Chinese losses were substantial, Xi may find it hard to back down.  On the Indian side, Prime Minister Modi warned today that his country would provide a “befitting reply” if China tried to worsen the situation.
• As a result of the initial fistfights last month, high-level Chinese and Indian military officers have been meeting to diffuse the situation, and they reportedly met again as recently as yesterday.  Calming tensions and averting a downward spiral in the conflict may require Xi and Modi to swallow some pride and pull back from the precipice.  If they don’t, any shooting conflict in the area would be a major risk to local and global financial markets.

COVID-19:  Official data show confirmed cases have risen to 8,199,838 worldwide, with 444,368 deaths and 3,978,358 recoveries.  In the United States, confirmed cases rose to 2,137,731, with 116,963 deaths and 583,503 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• Arizona, Texas and North Carolina all reported record daily virus-related hospitalizations on Tuesday, suggesting those states may have lifted their pandemic restrictions too early and underlining the risk of a disruptive second wave of infections.  In fact, top infectious disease officer Dr. Anthony Fauci again warned that the nation risks a resurgence of infections should states fail to remain vigilant as they reopen their economies.  We suspect officials in many states and localities would be reluctant to reimpose the full range of restrictions they had in place earlier, but even bringing back just some of the measures or slowing their economic reopening could weigh on stocks.
  • In China, authorities working to contain a new outbreak in Beijing have imposed school closures and flight restrictions, but the number of new cases continues to rise.  An uncontrolled outbreak in the Chinese capital would be particularly embarrassing for the ruling Communist Party, so further tough measures may be forthcoming.
  • New infections, hospitalizations and deaths continue to surge in many large developing countries, including Brazil, Mexico and India.
• Six months into the coronavirus crisis, scientists are coalescing around a consensus that the main way people get infected is through close-up, person-to-person interactions for extended periods.
  • The maximum risk is in crowded events, poorly ventilated areas and places where people are talking, shouting or singing loudly.  In contrast, it’s uncommon to contract COVID-19 from a contaminated surface or fleeting encounters with people outdoors.
  • Firmer knowledge of how the disease is transmitted should help public health officials devise better ways to reduce infections without the costly, wide-scale lockdowns employed to date.
• Researchers at the University of Oxford said dexamethasone, a generic steroid, is the first drug to show in a clinical trial it could improve the survival of severely ill coronavirus patients. The 6,425 subject study found the drug reduced deaths by a third, compared with standard treatment in patients on ventilators.  In patients receiving supplemental oxygen, but not on ventilators, the steroid cut deaths by one fifth, according to the researchers.
  • Less sick patients not receiving oxygen support didn’t receive any survival benefit from the drug.
  • Oxford issued the study results in a press release, not yet in a peer-reviewed journal that provides the full data set that researchers, who weren’t involved in the trial, can review.
• Privately held CureVac has become the second German biotechnology company to be given permission to proceed with clinical trials of a COVID-19 vaccine, days after Berlin invested €300 million in the firm to keep it from falling into foreign hands.  The German regulator said the CureVac trial would be one of just 11 worldwide to be testing its vaccine on humans.

Economic Impact

• In Europe, plunging auto sales during the worst of the pandemic lockdowns have left huge inventories of unsold vehicles, which threaten to discourage more production and slow the economic recovery.

United States:  Congress will scrutinize the Trump administration’s aggressive international trade initiatives today, as U.S. Trade Representative Lighthizer, appears before House and Senate committees.  Lighthizer’s testimony will give lawmakers an opportunity to question how the administration’s recent trade deals are playing out.  We also expect them to probe how the administration sees the U.S. economic relationship with other trading partners, including the European Union and the United Kingdom.

United States-United Kingdom:  Even as the U.K. and the EU struggle to develop a post-Brexit trade agreement, with EU demands for a “level playing field” with lower-regulated Britain, it turns out that many British farmers are worried that the U.K.-U.S. trade deal now being negotiated will leave them unable to compete with even lower-regulated U.S. producers.  The result?  They’re also hoping for a “level playing field” with the U.S.

Hungary:  Parliament voted to end a controversial state of emergency that gave Prime Minister Viktor Orban the right to rule by decree, after leaders in the U.S. Congress and the European Union accused him of using the coronavirus pandemic to amass authoritarian-like powers.  However, the legislators left in place some of the measures the government took during the height of its outbreak to concentrate fiscal control over the country’s largely liberal cities.

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

[Posted: 9:30 AM EDT]

Risk assets are on a tear so far today in response to a blockbuster report on U.S. retail sales suggesting that the economy may be rebounding from the coronavirus crisis more rapidly than expected.  At the same time, officials across the globe continue to signal more monetary and fiscal stimulus, though geopolitical risks are also rising on the China-India border.  As always, we review all the key news below.

United States:  Federal Reserve Chairman Powell will testify before Congress this morning.  While the Fed’s recent forecasts calling for a long post-coronavirus recovery have buttressed expectations that monetary policy will remain extremely accommodative, we’ll be watching closely for any sign that today’s better-than-expected retail sales data may have shifted his views or policy preferences.

COVID-19:  Official data show confirmed cases have risen to 8,058,427 worldwide, with 437,473 deaths and 3,893,780 recoveries.  In the United States, confirmed cases rose to 2,114,026, with 116,127 deaths and 576,334 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• An analysis by the Wall Street Journal found that COVID-19 infections are now accelerating again in more than a dozen states.  Some of the increase reflects broader testing.  However, some of it also appears to reflect increased infection rates, since the share of tests rendering a positive result is increasing in many localities.
  • In spite of the rebound in infections, some localities are no longer aggressively enforcing their social distancing policies.
  • In New York, Governor Cuomo threatened to reverse reopenings in parts of his state that aren’t following or enforcing safety rules. According to Cuomo, the state had received 25,000 reports of reopening violations, predominantly in Manhattan and the Hamptons on Long Island.
•  The Department of Transportation said it would allow Chinese airlines to make a total of four round-trip flights per week, doubling the level it had set earlier this month after China backed off its plan to limit U.S. carriers to just two weekly flights each.  The news is positive for the financial markets because it suggests the two countries may be trying to cool tensions.
• The FDA said it has revoked its emergency-use authorization for the anti-malaria drugs chloroquine and hydroxychloroquine for the treatment of COVID-19.
  • The decision was apparently based on recent clinical studies that have failed to show the drugs are effective in treating or preventing the disease.
  • Those studies are separate from another recent report showing both a lack of effectiveness and a risk of heart problems and death, which was subsequently retracted because of inconsistencies in the data.

Real Economy

• In its monthly oil-market report, the International Energy Agency said that while the world’s demand for crude oil will drop by 8.1 million barrels a day this year (slightly less than forecast in last month’s report), demand in 2021 will rebound by a record 5.7 million barrels a day.  Coupled with the current massive production cuts by major producing countries, the IEA said the rebound in demand could help rebalance the global oil market by late next year.

U.S. Policy Response

• The Fed announced moves to significantly broaden its Secondary Market Corporate Credit Facility beyond its current focus on corporate bond ETFs.  Starting Tuesday, the Fed will also buy individual corporate bonds based on a broad, diversified index of U.S. corporate obligations.  The target index would consist of substantially all corporate bonds in the secondary market that:  a) were issued by U.S. firms rated as investment-grade in late March, and b) have a maturity of five years or less.
  • The Fed said it would recalculate its “broad market index” every four or five weeks to add bonds that newly meet the eligibility requirements and to remove those that no longer meet them.  Going forward, purchases of ETF shares would be limited to 20% of any given fund.
  • The moves would give the Fed greater flexibility to ramp up purchases if the markets seize up again.  The announcement underlines the Fed’s commitment to aggressively support the economy amidst the virus crisis, which we think is a significant positive for equities.
• The Fed also outlined a proposal to include nonprofit organizations in its previously introduced Main Street Lending Program for small and midsize businesses disrupted by the pandemic.  The central bank indicated it wants the nonprofit loan terms to be broadly similar to the MSLP’s five-year maturities at a rate of 3% above short-term rates.
• Finally, in the realm of fiscal policy, the Trump administration is reportedly considering a one trillion dollar infrastructure program to help jumpstart the economic recovery.

Foreign Policy Response

• In a move that would align the ECB’s monetary policies more closely with the Fed’s policies, ECB Executive Director Fabio Panetta offered assurances that his central bank would consider buying “fallen angel” bonds that have recently lost their investment grade rating if necessary to combat the financial fallout from the coronavirus crisis.  Even though the ECB increased the size of its bond-buying program to €1.35 trillion earlier this month, Panetta said it still hasn’t unleashed the “full monty” of its available stimulus.

European Union-United Kingdom:  In their video summit yesterday, top leaders from the U.K. and the EU agreed to redouble their efforts to strike a post-Brexit trade deal in the coming weeks.  The surprisingly cordial post-summit statements from the likes of British Prime Minister Johnson and European Council President Michel are reassuring, but we note that there is still some risk that the two sides won’t come to an agreement and Britain could be facing a sudden stop in its trade with the EU at the end of the year.  Naturally, such a hard break would be negative for European, and particularly British, stocks.

United States-European Union:  Following a preliminary investigation, the European Commission said it has opened two formal antitrust investigations into Apple (AAPL, 342.99).  The investigations will look into the company’s practice of charging media firms’ large commissions to sell their products through its App Store and Apple Pay payment system, even as it uses the information gleaned to promote its own music and book services.  The launch of yet another regulatory move against a major U.S. technology firm is likely to further sour U.S.-EU relations.  The move is also likely to sit badly with Washington because, at the same time, the EU is loosening its state-aid rules to make it easier for member governments to help their own tech start-ups.

United States-China:  As more evidence of cooling U.S.-China tensions, the Department of Commerce yesterday slightly loosened its sanctions against Chinese telecom equipment giant Huawei (002502.SZ, 2.87).  The move will allow U.S. firms to collaborate with Huawei on setting technical standards for 5G and other emerging technologies.  Separately, U.S. Secretary of State Pompeo and Chinese Foreign Minister Yang Jiechi will meet tomorrow in Hawaii.

China-India:  In a dangerous escalation of tensions, the Indian military said three of its soldiers have been killed in clashes with Chinese troops along the countries’ disputed border high in the Himalayan mountains.  The deaths, which were the first since the 1970s in the two countries’ long-running border dispute, came despite multiple rounds of talks by Indian and Chinese military commanders intended to de-escalate tensions.  Those talks had pointed to some easing in the latest round of tensions, but the surprising deaths are a sign that things aren’t going as well as previously thought.  Therefore, the news has weighed on Indian stocks so far today.

North Korea:  In a dramatic display of its frustration with the stalled denuclearization talks and continued sanctions, North Korea has blown up the inter-Korean liaison office near the country’s border with South Korea.  The explosion came just hours after North Korea said via state media that its military would potentially enter border areas that had been disarmed after a 2018 summit between Kim Jong Un and South Korean President Moon Jae-in.

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

[Posted: 9:30 AM EDT]

Good morning and happy Monday!  It’s another risk-off day as financial markets recoil from reports of rising COVID-19 infections.  Our usual commentary on COVID-19 is available.  We update on China and trade issues with the U.K./EU/U.S.  We are watching U.S./Russian relations as Paul Whelan was found guilty of espionage.  We look at the economy and policy news.  Here is what we are watching:

COVID-19:   The number of reported cases is 7,934,277 with 433,919 deaths and 3,789,462 recoveries.   In the U.S., there are 2,094,069 confirmed cases with 115,732 deaths and 561,816 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:

• Reports of rising infections around the world are raising fears of economic disruption, leading to equity market weakness.
  • A surge in cases in Beijing has led to some renewed lockdown measures. The new cases appear to be centered around the city’s largest food market.
  • South America has become a global hotspot for COVID-19. Even Peru, who has been lauded for its response, is struggling to cope.
  • Rising U.S. cases are causing concern about the path of the virus. Although we don’t expect a national lockdown anytime soon, new local restrictions are possible.
• Today is the official reopening day for Europe. Internal border controls are to be relaxed today and “travel bubbles” with some Caribbean nations will allow for freer movement.
• The NY Times magazine had a good recap of the challenges tied to vaccine development. Germany announced it is investing in a private biotech company, which is working on a vaccine development.  The drive to develop a vaccine is raising worries about releasing one before it is fully developed and tested; a failed vaccine could set back distribution significantly.
• Regeneron (REGN, 588.39) said it will begin testing an antibody drug; if it works, it may be available as soon as autumn for emergency uses.

China:  Although the virus surge in Beijing is catching most of the attention this morning, overall economic conditions do show improvement.  Consumers continue to show caution, but are spending on big-ticket items.  Also, as usual, China is using investment spending to lift growth.

This chart shows a steady rebound in the Chinese economy.

SoS Pompeo is meeting with EU foreign ministers to craft a common policy on China.  He is getting some pushback from the EU, which wants to tie cooperation on China with an easing of the trade conflict with Washington.  Of course, Pompeo will try and insist that the issues are separate, but we doubt he will be able to make his case.

Trade:  PM Johnson and EC President von der Leyen will hold video talks today to discuss Brexit.  Johnson is hoping his personal touch will push talks forward while von der Leyen intends to reiterate the EU position on either integration, or a hard border.  At the same time, trade talks between the U.K. and the U.S. will resume today.  There is speculation that Westminster is using talks with the U.S. to extract concessions from the EU; however, Washington could just as easily insist on difficult concessions from the U.K., given its precarious position with the EU.

Russia:  Paul Whelan was found guilty of espionage and sentenced to 16 years in prison.   Although Russia accuses Whelan of spying, his background suggests he probably isn’t one.  He is a corporate security official for a car parts manufacturing firm and was in Russia for a wedding.  He is a Marine, but was discharged under less than stellar circumstances.  We suspect Russia seized Whelan and intends to use him for swap purposes in the future.  We will monitor this case to see if his cause is taken up by the government.

Economy news:  There is growing evidence that the U.S. economy is improving; given how deep the initial decline was, it is almost impossible for things to not look better.  However, it is still good to see signs of life.  Nevertheless, coping with COVID-19 remains a challenge.  We note that manufacturing firms are slow to recover, due to the costs of protective measures and continued infections.

Policy news:  This week, Chair Powell will travel to Capitol Hill to give his semi-annual testimony to Congress.  Given the forecasts from the Fed, we expect him to give testimony that the economy needs additional help.  National Economic Council head Kudlow opposes extending the $600 per week boost to unemployment insurance, but does support a smaller bonus for workers returning to their jobs.  There is worry that the unemployment insurance benefit may be an impediment to returning to work.  At the same time, Peter Navarro says the president wants another stimulus program of at least $2.0 trillion.

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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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