Last week, we discussed how equity markets, because of their anticipatory nature, tend to bottom in advance of the end of recessions. Assuming that condition continues, if our expectations for a short recession (but probably a long recovery) are correct, it would make sense that the equity market would have already bottomed. That historical pattern, coupled with extraordinarily supportive monetary policy, is supporting equity values.
The view of the economy for most Americans is the job market. In general, the common belief is that a good economy is one with a good job market. Economists tend to take a broader view and assume that the economy is more than just jobs. And so, when overall economic activity recovers, recessions are declared over. However, there are numerous cases where the economy and equity markets are doing fine, while the labor markets are still sluggish.
This chart shows the S&P 500 with the unemployment rate. We have placed black vertical lines at the trough of the equity index (using S&P 500 monthly averages) and a red line at the peak of unemployment. Here is a table of the results.
This table shows that equities trough about seven months before the peak of the unemployment rate. Thus, if the unemployment rate has peaked the turn in equity markets seen in recent weeks would be consistent with that pattern. The full recovery in the labor markets will take much longer, but we do expect labor market conditions will steadily improve.
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 employment Friday! We go into the details below, but the quick snapshot is that the numbers are much better than forecast and mostly confirm the ADP data from earlier in the week that was stronger than expected. Global equities are mostly higher this morning as optimism over economic reopening and policy support continues. China remains in the news. As usual, we update what we know about COVID-19. There was an Iranian prisoner swap. This week’s Asset Allocation Weekly (AAW) is posted; this week’s report shows how the equity markets recover before the peak in unemployment. Onward!
China:
Although details are lacking, China is apparently considering a $28 billion backstop to the banking system.
The Xi regime is apparently concluding that the costs of seeing the West isolate Hong Kong is worth bringing it under control. This decision suggests Beijing may have been worried that its major cities might push for similar democratic measures if Hong Kong retained its degree of independence. Given how much this move will likely cost China, either the government is underestimating how much it will cost or the government was very worried about Hong Kong’s defiance. We suspect the latter is the case.
Recent data from the Peterson Institute makes it abundantly clear that China is nowhere close to meeting its Phase 1 commitments. We believe that it is just a matter of time before the administration concludes that China is failing on the deal; it remains to be seen what reaction will occur. However, as we have always said, watch USTR Lighthizer; if he leaves, it would suggest he believes the administration won’t follow through on changing the trade relationship with China.
Foreign news:
The U.S. and Iran engineered a prisoner swap. Iran released Michael White, a Navy veteran who had been detained while visiting Iran. The U.S. deported Sirous Asgari, a scientist who was detained on charges of violating U.S. sanctions. Although relations between Iran and the U.S. remain tense, the fact that this swap occurred does suggest backchannel contacts are operable.
One of our concerns with any administration is the problem of bandwidth. A government can find itself under great strain due to multiple simultaneous problems. That is what the Trump administration is facing currently. The deteriorating relations with China, trade issues with the EU, civil unrest at home, the pandemic—it’s a lot happening in real time. It is under conditions of stress that foreign nations try to take advantage of the distraction in Washington. We note that recently Iran and Venezuela jointly violated U.S. sanctions; so far, neither has seen any retaliation. Expect more problems to develop in the coming weeks. We are watching North Korea and Russia to see if they try to take advantage of the situation.
When political systems fracture, fringe groups emerge. The latest in Italy is dubbed the “orange jackets,” a movement with overtures to France’s “yellow jackets.” This new movement is so extremely populist that the League party won’t affiliate with it. Although sympathizers with such political extremes always exist, it is during periods of turmoil that they can coalesce into political movements.
COVID-19:The number of reported cases is 6,658,334 with 391,588 deaths and 2,886,183 recoveries. In the U.S., there are 1,872,334 confirmed cases with 108,211 deaths and 485,002 recoveries. For those who like to keep score at home, the FT has created a nifty interactive chart that allows one to compare cases between countries, scaled by various variables.
Policy news:
The expanded unemployment benefits of $600 per week expire at the end of July. There is a debate on whether they should be extended. The Congressional Budget Office has weighed in on the debate. Its research suggests that over 80% of recipients would get more in benefits than they would earn working and that extending the benefits would likely lead to lower growth this year. However, not extending the benefits will lead to lower growth and employment in 2021, most likely because the growth and employment occurred in 2020. Our read on the report likely means the expanded benefits probably won’t be extended.
Chile is asking the Fed to extend swap lines to the country and is asking the PBOC to increase the swap line with China.
Economy news:
As we have been noting, the next area where we expect support to be provided is commercial real estate. Businesses are not paying their rent and some landlords are taking legal action. The uptick in business bankruptcies suggests that property owners are likely to see continued declines in rent payments and there is a chance this could cascade into lower property values and commercial mortgage defaults.
OPEC has agreed to meet and will likely extend production cuts at least another month. Oil prices rose on the news.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT]
Good morning. It’s ECB day! The ECB continues to support the EU economy. It’s June 4, the 31st anniversary of the Tiananmen Square Massacre; we note China is playing up the current U.S. civil unrest as a counterpoint to Beijing’s actions in Hong Kong. Global equities are mostly lower this morning, as risk markets take a breather from recent strength; however, we have seen some recovery on the ECB news. We cover the ECB meeting and look at the latest with China. As usual, we update what we know about COVID-19. We have a new Weekly Energy Update, with a special look at natural gas. Let’s get to it…
ECB: In its prepared statement, the European Central Bank announced it will expand its emergency QE by €600 billion. Interest rates remained unchanged. It also said purchases will continue into June 2021. Market reaction was swift; as the global risk-on rally has been supported by central bank action, news of the ECB’s move lifted global equities. In something of a surprise, the EUR rallied as well. Usually, QE is bearish for a currency. In the press conference, ECB President Lagarde didn’t offer any major surprises
So far, China has not reacted strongly to the U.S. actions taken with regard to the national security law. It may be that Beijing wants to see what the U.S. will actually do; if the response remains mild, it may signal that China feels the actions taken by the U.S. are not significant.
The U.S. has threatened to block Chinese airlines from coming to the U.S. as China has denied American airlines from flying to China. This morning, China relented and will allow limited flights by international carriers.
It is evident that the Chinese economy has been hit hard by the trade war with the U.S. and the pandemic. Thus far, the policy reaction has been rather subdued. We note that the central government announced it will send money directly to local governments, a sign Beijing is growing worried about slowing growth (and rising unemployment).
Huawei (002502.SZ, CNY 2.900) has been having a tough run of news recently. As we reported last week, the CFO lost her bid to avoid the extradition process as a Canadian court ruled she must stand for the proceedings. There is confirmation that the company did, in fact, evade U.S. sanctions on Iran (which is why the CFO is under house arrest). The U.K., which was open to restricted use of the company’s products in its 5G network, is reversing course in the aftermath of Hong Kong and strong U.S. pressure. All this is bad news for the company.
PM Johnson and European Commission President von der Leyen are likely to engage in direct talks to break the current deadlock on a new trade deal.
COVID-19: The number of reported cases is 6,530,067 with 386,392 deaths and 2,820,488 recoveries. In the U.S., there are 1,851,520 confirmed cases with 107,175 deaths and 479,258 recoveries. For those who like to keep score at home, the FT has created a nifty interactive chart that allows one to compare cases and fatalities between nations, scaled by population. Axios has updated its U.S. infection map.
The good news:
When thinking about a problem, it is helpful to know more about the issue one is trying to resolve. For the most part, medical researchers have been treating COVID-19 as primarily a respiratory disease. This led to the crash production of ventilators and the search for antiviral medicines. However, there is growing evidence that although the virus spreads through the lungs, the biggest impact may be vascular. The virus’s primary impact may be to infect the endothelial cells in blood vessels. When these cells become inflamed, it could lead to microclotting and would explain the wide variety of symptoms. Unlike seasonal flu or SARS, which tend to remain in the lungs, COVID-19 spreads throughout the body, causing damage to kidneys, conditions close to frostbite in toes, and strokes.
If this is how the virus works, the best protection may come from ACE inhibitors, statins and blood thinners. There are trials now underway to see if losartan, a common high blood pressure drug, may prevent the worst symptoms of the disease. In other words, if taking cardiovascular medicine prevents fatalities and hospitalizations, we could treat COVID-19 with common drugs and extreme measures to avoid the disease may not be necessary.
Scientists are studying patterns to see if there is a genetic basis that might explain the wide variation seen in the reaction to infection. There is evidence to suggest that there are sizeable numbers of asymptomatic cases and, at the same time, fatalities. If a common genetic threat could be found, it may allow for less stringent lockdowns and could help in determining who should get vaccinated before others. A recent European study suggests that having Type A blood increases the likelihood of a more serious reaction to infection.
When I was in the Jesuits (Bill talking here), one of “ours,” a missionary in Belize, had suffered an auto accident. He recovered from his injuries with one problem: he had no sense of taste. Although he would get hungry, he was completely indifferent to what he ate. It led to some rather odd dinner situations. The loss of taste and smell is noted as an effect of COVID-19 and some cases indicate the change may be long-lasting.
The Fed’s direct lending program to business has had few takers, in part on borrower concerns of the stigma of taking federal money. Overcoming this issue has been a persistent problem with direct government lending. During the 2008 financial crisis, the Fed and Treasury forced the major banks to take funding to avoid this problem.
As noted before, we continue to closely watch for “gaps” in the supply/payment chain that could disrupt the financial markets. One area of concern is rent payments. Small businesses that have been closed are unable to make their rent. This loss of payment is a risk to landlords, who face their own creditors. We expect that either the Fed or Congress will need to inject funding to support this part of the economy at some point; if support doesn’t occur, it may raise the risk of economic disruption.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
Here is an updated crude oil price chart. The oil market continues to recover after April’s historic collapse.
(Source: Barchart.com)
Crude oil inventories surprised the markets for the fourth straight week with stockpiles falling 2.1 mb compared to forecasts of a 3.0 mb build.
In the details, U.S. crude oil production fell 0.2 mbpd to 11.2 mbpd. Exports fell 0.4 mbpd, while imports declined 1.0 mbpd. Refining activity rose 0.5%, a bit below expectations. As we saw last week, there was another jump in unaccounted-for crude oil.
Unaccounted-for crude oil is a balancing item in the weekly energy balance sheet. To make the data balance, this line item is a plug figure, but that doesn’t mean it doesn’t matter. This week’s number of -1.01 mbpd is the largest negative number on record. For the fourth week in a row, this number is running nearly 1.0 mbpd. The 12-week average is on the verge of going negative for the first time since October 2017. It may mean that in the scramble for finding storage, some oil is being inventoried outside the survey system. This week, the SPR took 4.0 mb, but that doesn’t resolve the unaccounted-for crude issue. This week, some 7.0 mb of crude oil went into storage somewhere, just not where it can be recorded. Or, production is falling much faster than the DOE estimates are capturing so there aren’t any missing barrels; simply put, production is cratering. We still don’t know which thesis is correct. However, given the persistence in the unaccounted number, it is looking increasingly likely the DOE is overestimating production.
(Sources: DOE, CIM)
The above chart shows the annual seasonal pattern for crude oil inventories. This week’s data showed a modest decline in crude oil stockpiles. We are getting close to the beginning of the seasonal draw for crude oil. If inventories don’t decline in the coming weeks, oil prices would be vulnerable to a correction.
Based on our oil inventory/price model, fair value is $29.12; using the euro/price model, fair value is $45.01. The combined model, a broader analysis of the oil price, generates a fair value of $36.57. It does appear that the worries over storage capacity have been resolved, so the model is more reliable. We have been seeing a steady drop in the dollar recently. The Eurozone is considering a mutualized debt instrument to pay for COVID-19 costs. It is possible the Eurozone may use this event to create a permanent mutualized Eurobond which would make the EUR an attractive alternative to the dollar for reserve purposes. A weaker dollar would be bullish for oil prices.
In energy news, the Kingdom of Saudi Arabia (KSA) moved liquidity from its foreign reserves to its sovereign wealth fund. The fund has been aggressively buying assets overseas, viewing the current weakness caused by the virus as a buying opportunity. Foreign reserves act as a buffer to low oil prices and so a decline in reserves may force additional austerity measures on the populous.
This chart shows the KSA’s foreign reserves and Brent oil prices. Lower oil prices tend to reduce reserve levels with a lag. Thus, the decision to shift funds to the soverign wealth fund may reflect the idea that oil prices will rebound quickly.
This week, we want to discuss the natural gas market. May is the “shoulder month” for demand. As summer unfolds, demand for electricity tends to rise and, if temperatures are high enough, helps boost natural gas prices. First, here is the supply/demand balance.
Currently, there is a rather wide supply imbalance, with supply outpacing consumption. Under these conditions, inventories tend to accumulate. The chart below shows seasonally adjusted working natural gas storage. Inventory levels are well above normal as we head into summer.
One bright spot is that the supply/consumption balance is showing some improvement. If we see hot weather in the coming weeks, it should allow the inventory overhang to dissipate and support prices. Another bullish factor is that falling oil production will reduce associated natural gas production, which should help narrow the inventory overhang. However, any bullish scenario rests on an unusually hot summer. The current summer forecast is leaning hot, so there is the potential for a price recovery in the coming weeks.
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. We continue to build on themes discussed in the previous episode, “The Lessons of History,” in which we examined the effects of earlier pandemics. In this episode, we discuss how the COVID-19 pandemic will likely accelerate the reversal of the equality/efficiency cycle toward equality. Deglobalization is a key element of that shift. Although we believe the world has been steadily moving toward equality, this pandemic is moving the process forward. The eventual outcome is higher inflation, although it may take several years for higher price levels to become evident.
Turning to the latest news, it appears the U.S. civil rights protests eased notably last night, but risk assets are rallying today mostly on optimism regarding an eventual coronavirus vaccine, a potential recovery in the economy and labor market, and additional monetary and fiscal stimulus. We discuss all the key developments below.
United States: The latest reports suggest the intense civil rights protests of the last week eased somewhat on Tuesday night, possibly because many cities toughened their curfews and state and local officials began taking action to address protestors’ anger over law enforcement practices and a perceived impunity for police brutality. In Minnesota, where the protests first erupted, Governor Tim Walz said the state is launching a civil rights investigation into “systemic discriminatory practices” by the Minneapolis Police Department. State officials also said the economic cost of the violence in Minnesota alone was at least $1 billion, not including the impact of lost jobs and looting. As we’ve mentioned previously, investors have generally overlooked the violence on the assumption that it will be short-lived. The more salient issue is that the violence could have political implications for the November elections. If the protests continue to ease, the political impact will become less likely.
Just weeks after a staggered reopening of schools in Israel, a surge of infections has forced the government to quarantine around 10,000 students and teachers. The outbreak has also pushed the country’s new infections to almost 100 cases a day for the first time since early May, close to the threshold at which health officials have indicated some lockdown restrictions would be re-imposed. This development is important because it undermines a growing sentiment around the world that young people’s relative lack of susceptibility to COVID-19 means schools and universities can safely reopen.
Sweden’s top epidemiology official, Anders Tegnell, said in an interview that even though the country’s relatively light coronavirus lockdown helped minimize the damage to the Swedish economy, the government should have imposed tighter restrictions to avoid having such a high death toll. The government said on Monday that it would appoint a commission to investigate the country’s approach to the pandemic, bowing to pressure from opposition politicians.
Financial Markets
While the U.S. yield curve as measured by the 10-year Treasury versus the 2-year note or the 3-month bill has recently held steady, with both spreads in the range of 50-60 basis points, the less popular 30-year/5-year spread has widened to almost 120 basis points for the first time since 2017. Traders ascribe the widening to a greater supply of longer-term debt and moderating Fed purchases due to the relative stabilization in the economy.
Ten weeks after the Fed calmed the corporate bond market by promising to buy up to $750 billion of individual businesses’ debt obligations, not a single company has signed up for the program. The Fed’s sole purchases in the market have been $3 billion in corporate bond ETFs. Echoing the traditional reluctance of banks to access Fed backstops, it turns out that companies are reluctant to sign up for Fed purchases because such a move could be seen as a sign of weakness during the market’s rebound.
One top focus will be on ways to encourage people to go back to work, including a proposal to cut the federally funded enhanced unemployment benefit from $600 per week now to as little as $250 per week through the second half of the year.
The administration is also discussing a tourism tax deduction, or credit for people who take a vacation somewhere in the U.S. in the next three to six months.
The president and his aides also continue to push proposals for which they have long been advocating, including a payroll-tax holiday and a capital-gains tax cut.
A longer-term priority will be measures to encourage companies to do business in the U.S., including making certain rules permanent that allow firms to deduct the cost of relocating manufacturing operations from China and other countries.
Foreign Policy Response
As Europe continues to play catchup with the aggressive monetary and fiscal programs put into place by the U.S. to support the economy during the coronavirus crisis, the ECB is expected to unveil some €500 billion in additional bond purchases at its policy meeting tomorrow. That would boost its total firepower to almost €1.5 trillion, or $1.68 trillion, putting it on a par with the U.S.’s spending plan and setting the stage for the central bank to buy most of the new debt that Eurozone governments will issue this year to fight the crisis.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT]
The general uptrend in risk assets continues to stem mostly from the gradual easing of coronavirus lockdowns and progress on vaccines and treatments. Today’s market action also reflects signs that the major oil-producing countries will extend their production cuts, which has boosted crude oil prices. Those developments continue to outweigh the violent civil rights protests in the U.S., though we note that the demonstrations do carry political risks.
It wasn’t immediately clear whether Mr. Trump had invoked the Insurrection Act, a law that allows a president to deploy the military in response to civil unrest. If he did invoke the law, it would be the first use of active duty military troops to quell civil disorder in nearly 30 years.
Although the financial markets typically look past such protests in the U.S., as they’re generally short-lived, the current riots bear watching because they have implications for the November elections. It’s easy to imagine the violence is a spontaneous outpouring of anger related to law enforcement practices, a perception of impunity for police brutality and the frustrations of the long coronavirus lockdown. However, reports also suggest the violence is being further fueled by extremist groups on both the far right and the far left, which politicians are sure to try to exploit for their own gain. Just as important, the deployment of National Guard and federal troops raises the risk that someone with a happy trigger finger could spark bloodshed. In Kentucky, police and National Guard troops killed one man on Sunday night, and here in St. Louis, four police officers were hit by gunfire last night. Any situation in which federal troops killed multiple protestors would likely morph into an even greater political controversy.
India has now reported 8,000 or more new infections for three straight days, underlining how it has become a major pandemic hotspot along with countries like Brazil and Russia. Because of surging cases in large, less-developed countries such as these, along with increased testing in many developed countries, total global infections are now showing a distinct uptrend beginning in mid-May.
Although yesterday’s May ISM Manufacturing Index for the U.S. showed a modest rebound to 43.1, from 41.5 in April, the figure continues to be distorted by the sub-index on supplier deliveries. The ISM indexes and sub-indexes are designed so that readings over 50 point to expanding activity. The sub-index on supplier deliveries is higher when deliveries are slower, on the assumption that delivery delays reflect high activity and bottlenecks. However, in the coronavirus crisis, deliveries are slow and the supplier delivery index is elevated in large part because of lockdowns. Therefore, we think we can get a better feel for the true level of activity by looking at our own, proprietary estimate of the overall ISM index excluding supplier deliveries. As shown in the charts below, that measure rebounded only to 36.9 in May from 33.0 in April, suggesting factory activity continues to contract sharply.
Financial Markets
The OPEC+ alliance of oil-producing countries led by Saudi Arabia and Russia is nearing a deal to extend their coronavirus production cuts to September 1. The current deal, which aims to cut the group’s total output by 9.7 million barrels per day, begins phasing out on July 1. Delegates will meet to discuss the move on Thursday, sparking a notable rally in crude prices so far today.
Democratic Republic of Congo: The government has declared a new Ebola epidemic after it identified six cases in the west of the country, far from the previous outbreak in the east. The outbreak is the country’s fourth in the last three years and the 11th since the first cases were detected in 1976.
Russia: After three medical doctors mysteriously “fell” out of windows in recent months, raising suspicion that they were assassinated for resisting or exposing government missteps related to the coronavirus crisis, now a female police forensic officer has fallen out of a window at a hospital where she was being treated for the virus.
In this five-part series on the geopolitics of the 2020 election, we have broken the reports into nine sections. In Part I, we covered the basics of public finance. This week, we will cover the second and third sections, understanding the electorate and party coalitions.
Understanding the Electorate
Understanding the electorate is about divining the psychological and economic interests of voters. In this section, we describe how we examine the voting public.
There is a distinction between class and identity. Identity is complicated. All of us belong to various groups based upon our gender, race, religion, age, geographic location, education, etc. The interlacing of these various memberships is known as intersectionality. Although the term is often applied to those who face discrimination, in general, this term captures the various “tribal” groups to which we find ourselves belonging. Thus, a white, gay, Catholic with a graduate degree may have something in common with a Hispanic, straight, Catholic with a high school diploma through their religious affiliation. However, it is unlikely the commonality would be very strong. In general, the greater the identity overlap a person has with others the higher the probability they will vote for or favor candidates of a similar persuasion. At the same time, each person tends to “rank order” their identities; some put a much higher rank on race relative to religion, for example. Or, their geographic location is the most important identity classification.
Class is rather straightforward, determined by the decile in which one’s income and wealth falls. This breakdown isn’t perfect, however, as the class interests between two people with equal income can differ. For example, if two middle managers at different firms make the same income, but one manager’s firm benefits from free trade and the other does not, they may favor different economic policies. But, in general, policies favored by class tend to be uniform. For example, the wealthy tend to have similar positions on taxes, while the less affluent tend to think very highly of Social Security.
We define a group as the cross-section of identity and class. A group is a set of like-minded people who tend to support similar political, economic and social positions.
To describe the interplay between identity and class, we have borrowed this grid from Peter Zeihan.
by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT]
Good morning. It’s Monday and the beginning of another month. Global equities are mixed this morning, although we do note the Hang Seng rallied. Over the weekend, civil disorder occurred around the U.S. We discuss the latest with China. The G-7 was cancelled. As usual, we update everything we know about COVID-19. Let’s get to it…
Kim Jong Un is issuing bonds to cover part of the budget, the first time the Hermit Kingdom has issued debt since 2003. The bond is said to be denominated in foreign currency. It is highly unlikely foreigners will be interested in the bonds; North Korea defaulted on bank loans in the 1980s, and these loans have been consolidated into bonds which are apparently available. The current bond issuance appears designed to absorb foreign currency holdings of the North Korea’s elite, although we would not be completely surprised if China or Russia bought nominal amounts of the new bonds.
COVID-19: The number of reported cases is 6,193,548 with 372,479 deaths and 2,656,267 recoveries. In the U.S., there are 1,790,191 confirmed cases with 104,383 deaths and 444,758 recoveries. For those who like to keep score at home, the FT has created a nifty interactive chart that allows one to compare cases and fatalities between nations, scaled by population.
June 1 is the official start of hurricane season, although activity has already begun and usually peaks in early September. States are drawing up plans on how to address storms and evacuations under conditions of the pandemic.
Finance news: We are paying close attention to the dollar’s recent slide. There are likely two factors behind the weakness. First, as the world economy recovers, flight-to-safety demand for the greenback is likely easing. Second, the EU’s decision to create a Eurobond for virus spending relief could bring more potent competition for the dollar’s reserve role. We have serious doubts that the northern European nations will allow this decision to evolve into a general spending Eurobond, but the hope has lifted sentiment toward the EUR.
As noted below, global PMI data is showing signs of improvement from a deep trough. However, China’s PMI data, although in expansion mode, is showing few signs of acceleration.
It does appear that meat processing has recovered; however, in a pattern often seen, meat prices will likely remain elevated for a few weeks as grocers take advantage of improving margins.
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