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.

COVID-19:  Official data show confirmed cases have risen to 6,411,023 worldwide, with 380,880 deaths and 2,750,891 recoveries.  In the United States, confirmed cases rose to 1,831,821, with 106,181 deaths and 463,868 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 administration’s top infectious disease official, Dr. Anthony Fauci, said the ability of the human body to naturally overcome COVID-19, in most cases, is strong evidence that a protective vaccine can be developed for the disease.  In fact, he expressed cautious optimism that several successful vaccine candidates would prove effective “within a reasonable period of time.”  In his view, the key question is how long those vaccines will be effective.
• Still, despite the progress on vaccines and treatments, and falling infections in most major developed countries, cases continue to surge in many large developing countries.  India reported a fourth straight day in which new, confirmed cases of COVID-19 exceeded 8,000, bringing the country’s cumulative total to more than 200,000.
• In Iran, daily infections have now rebounded almost back to their highs from late March.  Despite the rebound in infections, however, Tehran continues to ease the lockdown measures that helped push the caseload lower over the last two months.
• 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.

Real Economy

• Even though the OPEC+ group of oil-producing countries is expected this week to extend its massive output cut of 9.7 million barrels per day to early autumn, Saudi Arabia is reportedly so confident that the cut has helped restore order to the market that it will soon reverse its supplemental cut of 1 million barrels per day.  Nevertheless, the expected extension of the baseline cuts continues to buoy crude prices.
• In New Zealand, Prime Minister Ardern released details of a possible loosening of restrictions that would mean the country’s businesses could return to normal with no gathering limits, or social-distancing requirements as early as June 10.
• 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.

U.S. Policy Response

• President Trump will meet this week with his top economic advisors to discuss policy options for the next economic support bill.  Although the scope of the plan is still in flux, reports suggest a wide variety of measures are under consideration:
  • 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.

United States-Venezuela:  The Trump administration further increased its economic pressure on the Venezuelan government by imposing sanctions on four shipping firms allegedly involved in supplying the country with fuel products.

United States-China: Adding to the general trend of U.S.-China decoupling, Senator Rob Portman (R-Ohio) and Senator Tom Carper (D-Del.) today plan to introduce legislation to stop China and other “malign state actors” from stealing U.S. taxpayer-funded research at universities by enhancing the authority of federal agencies to monitor and punish the schools and scientists.

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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.

United States:  With civil rights protests continuing to devolve into violence across the country, President Trump yesterday said he would deploy military forces to take control of the situation in Washington, D.C. and other cities if state and local governments don’t “take the actions that are necessary to defend the life and property of their residents.”  The federal troops would be in addition to the 67,000 National Guard troops already called up by the states.

• 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.
• The rioting also has implications for international politics.  Chinese officials and state media outlets have already savaged the Trump administration’s response to the protests, describing the president as a hypocrite after he supported Hong Kong’s demonstrations.  China’s foreign ministry sent a taunting tweet to the U.S. State Department simply saying, “I can’t breathe.”  Other reports say Russia and China are both flooding social media with content criticizing the U.S. for its handling of race issues.

COVID-19:  Official data show confirmed cases have risen to 6,294,222 worldwide, with 376,177 deaths and 2,714,922 recoveries.  In the United States, confirmed cases rose to 1,811,277, with 105,147 deaths and 458,231 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• There are concerns that mass civil rights protests across the U.S. could spark renewed coronavirus outbreaks that may require the re-imposition of lockdowns.
• Japan and South Korea both reported more than 30 new COVID-19 infections, with many cases found in people who had visited newly reopened restaurants, bars, and other entertainment venues.
• 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.

Real Economy

• The Congressional Budget Office said the sharp contraction triggered by the coronavirus caused it to mark down its 2020-30 forecast for U.S. economic output by a cumulative $7.9 trillion, or 3% of GDP, relative to its January projections. GDP isn’t expected to catch up to the previously forecast level until the fourth quarter of 2029.
• 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.
• In less positive news, reports show the coronavirus crisis is disrupting Italy’s longstanding program to clean up the banking system’s pile of nonperforming loans by packaging them into securities and selling them to investors.
• According to the Institute of International Finance, foreign investors withdrew a record $11.8 billion from Brazil’s stock market in the four months from February to May, and $18.7 billion from its bond market between February and April (the most recent period for which data is available).  The capital outflows, which the IIF ascribed mostly to Brazil’s coronavirus crisis and political chaos surrounding President Bolsonaro, were in contrast with a modest recovery in inflows in many other developing countries.
• According to data provider Trepp, 7.4% of U.S. commercial property loans were delinquent in May, up from 2.3% in April.  Another 8.6% were in their 30-day grace period after initially missing a payment.  The figures underscore the growing threat to commercial mortgage-backed securities the longer the coronavirus disruptions last.

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 11^th since the first cases were detected in 1976.

Russia: President Putin announced the vote on constitutional revisions that would allow him to remain in power for up to 16 more years will be held on July 1, after being postponed by the coronavirus crisis.  Actual voting will begin a week before the official ballot date.

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.

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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…

Civil unrest:  In the wake of the death of George Floyd, protests and violence occurred in numerous U.S. cities.  For the most part, financial markets are generally unaffected by these sorts of events, mostly because they don’t last long.  That isn’t to say they are not having an effect on the economy.  Retailers are being forced to close stores.  We also note the protests are undermining America’s credibility in reference to human rights; China is pointing this out with reference to Hong Kong.  However, overall, equity markets are not showing much effect.

China:  On Friday, as expected, President Trump unveiled U.S. policy with regard to Hong Kong.  Equities rallied, which suggests financial markets were expecting much harsher policy actions.  Still, it is unmistakable that relations are deteriorating and are expanding beyond trade.  At the same time, the EU is making it abundantly clear that it won’t take any steps to jeopardize trade relations.  For the first time in three decades, security officials in Hong Kong have banned the usual Tiananmen Square Massacre vigil, normally held on June 4.  They have cited pandemic issues, but few believe that is the primary concern.  Additionally, Beijing has told its state-run commodity firms to “pause” the purchases of U.S. agriculture products.  If this persists, it will put doubt into the Phase 1 trade deal.

Foreign news:  After German Chancellor Merkel indicated she would not travel to Camp David for the G-7 summit, President Trump decided to postpone the entire affair until autumn.  He has indicated he would like to invite Russia, South Korea and Australia to the meeting to discuss how the world should deal with China in the future.

• 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.

• The good news:
  • There is increasing evidence that children may not be vectors of the virus. In nations where schools have reopened, there has not been a notable increase in cases.
  • Another mystery of COVID-19 is that high altitude areas appear mostly spared from the disease.
  • The U.K. is planning to ease restrictions
• The bad news:
  • Protestors are congregating and showing few signs of social distancing. This behavior may lead to higher cases of the virus.
  • 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.
  • In India, monkeys are accused of stealing blood samples from a suspected COVID-19 victim.

Policy news: The next big worry for the financial markets is state and local governments.  As revenues crater and virus-related spending soars, cities and states are facing the problem of either increasing borrowing or cutting services.  In 2010, local governments cut back spending to the point where it more than offset federal spending.  If that is repeated, it increases the threat of an economic relapse.  The alternative may be either direct fiscal support from the federal government, or expanding Fed buying of municipal debt.

• The EU’s trade commissioner, Phil Hogan, is considering applying for the WTO leader post.
• As the world deglobalizes and consolidates supply chains, companies are asking for government help to source production in the U.S.
• The Fed is very close to starting its lending program to midsized companies.

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.

Economy news:  As we have noted in the WEU, gasoline consumption does appear to be recovering.  GPS requests are rising as well.  An increase in driving activity bodes well for economic recovery.

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

[Posted: 9:30 AM EDT]

Good morning and happy Friday!  Global equities are softer this morning as tensions between the U.S. and China continue to rise.  We discuss the latest with China.  As usual, we update what we know about COVID-19.  The Weekly Energy Update is available.  Chair Powell is holding a virtual discussion with former Vice Chair Blinder at 11:00 EDT.  Let’s get to it…

China:  The National People’s Congress has come to a close and it was a momentous meeting.  The decision to extend the national security law into Hong Kong, overriding the former colony’s legislature, strongly signaled that Chairman Xi is done with the “one country, two systems” approach that was adopted at the handover in 1997.  Here are the key points we are watching:

• The backlash: The U.S., Australia, Canada and the U.K. issued a joint statement opposing China’s national security law decision. The absence of New Zealand is notable; the four nations in the joint statement plus New Zealand represent the “five eyes” alliance.  The decision by Wellington not to join the statement suggests it probably does not want to disrupt trade relations.  We also note that Japan issued a statement of concern.  Beijing is aware it will face a backlash; however, it is likely banking on countries deciding that maintaining economic relations is more important than defending Hong Kong.  It is clear the EU won’t act against its economic relations with China.
• The U.S. reaction: The nation that really matters is the response from the U.S.
  • President Trump will hold a press conference today to unveil at least some of the action the administration is considering; we haven’t seen a time yet. We note equity markets fell on the announcement.
  • The most potent threat Washington has is sanctions against China’s banking system. Although the world rails against the weaponization of the dollar, the fact remains that being cut off from the dollar system is deadly for an economy; just ask Iran.  There are other actions the U.S. could take as well, including delisting Chinese stocks on U.S. exchanges.  There has been fear that doing such action would simply lead to Chinese companies listing on London.  However, given the level of British anger over Xi’s breaking of the 1997 treaty, that may not happen.  Listing in the EU or Japan just doesn’t have the same cache.
  • Another threat is denying China access to the U.S. system of higher education. The U.S. is moving to expel Chinese graduate students in the U.S. who have ties to Chinese military schools.  A bill is winding through Congress that would restrict Chinese student access to STEM programs in the U.S.
  • It appears the White House will sign a bill sanctioning Chinese officials for the suppression of Uighurs.
  • Although not directly related, the U.S. is stepping up freedom of navigation operations and boosting sales of weapons to Taiwan. Both remind China that the U.S. does have the military power to operate in its area of the world.
  • While China realizes relations are deteriorating, it doesn’t appear it is ready to completely end the relationship, suggesting it needs us more than we need it.
• The pain: Since the late 1970s, China has moved from being insular to becoming a major global economy. It has been a key part of globalization as Western firms have built production facilities to take advantage of China’s low-cost labor.  The last time globalization peaked, in 1913, it was considered unthinkable that it could reverse.  Of course, it did, and the reversal damaged global economic growth.  China is betting that nations will overlook its actions on Hong Kong to continue to benefit from trade.  As noted above, the EU appears to be taking that stance.  Major Wall Street firms could suffer greatly from a break in relations.  At the same time, Hong Kong remains China’s financial and investment window to the world.  If the world decides it doesn’t want to invest directly in a country that has rule by law instead of rule of law, China will suffer as well.  China is well aware that the move in Hong Kong could have negative repercussions for its economy and announced steps to support it with fiscal and monetary easing.
• Capital flight: When China was set to acquire Hong Kong from the British in 1997, there was a flurry of capital flight. Any visitor to Vancouver can see the impact.  We expect another round of outflows of people and cash, not just from Hong Kong citizens but from wealthy mainlanders as well.  The latter tended to use Hong Kong as a safe zone to evade Beijing; with that door closing, these Chinese may seek to create their escape pods outside of China.  We will be watching West Coast real estate markets for activity in the coming weeks.
  • The U.K. is extending visa rights to 300k Hong Kong citizens who hold a British National Overseas passport. These were issued to citizens who resided in the colony before 1997.  The extension would make it easier to flee.
  • As we have been noting, Taiwan is also making it easier for Hong Kongers to seek asylum on the island.
  • One factor that increases capital flight is a weaker CNY. Although Beijing could use currency depreciation to offset new sanctions and tariffs, the tool is limited if fears of currency weakness trigger outflows.  We note China has moved to stem recent weakness today, signaling it doesn’t want a freefall in its currency.

Equity markets have staged a remarkable recovery since the March lows.  As we detail in this week’s Asset Allocation Weekly (see below), much of this rally has been driven by supportive Fed policy.  However, a flare-up in tensions with China is a risk to the rally that we will continue to monitor.

COVID-19:  The number of reported cases is 5,837,541 with 360,919 deaths and 2,437,965 recoveries.  In the U.S., there are 1,721,926 confirmed cases with 101,621 deaths and 399,991 recoveries.  For those who like to keep score at home, the FT has created an interactive chart that allows one to compare cases and fatalities between nations, scaled by population.

The virus news:

• The good news:
  • The U.S. may use the military to assist in vaccine distribution if/when one is created.
• The bad news:
  • Herd immunity is the best long-term solution to managing the virus. Unfortunately, the world appears a long way from achieving that level of immunity.

The policy news:

• The House has passed a bill easing rules on PPP loans. Policy restrictions were discouraging companies from taking the loans so Congress is moving to address that issue.  However, there may be some sticking points about the House bill that will need to be changed to get passage through the Senate.
• As extraordinary measures approach their end dates, Americans are growing worried that they may not be able to find new jobs or go back to their old ones. If this is the case, the economy could stall later this year.  We do expect other forms of relief to come (rules that reduce the cost of hiring and employment bonuses, for example), but if they fail the economy will bear some risk.
• The Fed’s balance sheet is now over $7.0 trillion. We noted earlier this week that officials are considering yield curve control.  Policymakers at the Fed are continuing to look for ways to support the economy and, as noted in the opening, Chair Powell may address some of those today.

The finance news:

• One of the reasons we don’t expect the Fed to engage in negative nominal policy rates is because of the heavy reliance of the non-bank system on money market funding. Negative policy rates would almost certainly cause money market funds to “break the buck” and trigger disintermediation.  We note that money market fund managers are already under stress, waiving fees to offer investors at least some paltry yield.
• One of the common media questions is, “Why is the stock market ignoring the economy?” As we detail in this week’s AAW, it has to do with the expectations of a short recession and massive policy support.  However, the U.S. equity market isn’t the only one doing well.  The Tehran Stock Exchange has been on a tear.  There are a couple of reasons for this rally.  First, Iranian investors have the TINA[1]  Second, equities do offer some protection from high inflation.  Interestingly enough, we saw something similar in Zimbabwe during its hyperinflation period.  Although rising inflation harms P/Es, stocks do offer some element of inflation protection as firms can boost earnings and become something of a safe haven relative to bonds during periods of high inflation.

The foreign news:

• The DOJ has indicted some North Koreans and Chinese nationals of operating a massive money laundering scheme. Twenty-eight North Koreans and five Chinese citizens are accused of laundering $2.5 billion in assets.
• In a rare public statement, the NSA is accusing Russian government hackers of targeting U.S. email servers.
• Turkey’s central bank is borrowing dollars from its commercial banks to boost reserves. This action will stabilize the TRL but starve the banking system for dollars, making importing more difficult.
• The administration may override congressional concerns to sell more weapons to Saudi Arabia.
• As talks between the EU and the U.K. stall, Ireland is starting to prepare for a disruptive Brexit.

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[1] There Is No Alternative.