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.

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

[Posted: 9:30 AM EDT]

Good morning!  Global equities are steady to higher this morning after a continued strong march higher.  We update the COVID-19 situation; the U.S. death toll now exceeds 100k.  We discuss the Hong Kong/China situation.  The Beige Book was released yesterday.  We are monitoring hostilities on the China/India border.  The EU creeps closer to a Eurobond.  The weekly energy update report will be out tomorrow as the DOE data was delayed due to Monday’s holiday.  Here are the details:

COVID-19:  The number of reported cases is 5,716,271, with 356,131 deaths and 2,367,292 recoveries.  In the U.S., there are 1,699,933 confirmed cases, with 100,442 deaths and 391,508 recoveries.  For those who like to keep score at home, the FT has an interactive chart that allows one to compare cases and fatalities between nations, scaled by population.  Here is an Axios map showing state infection rates.

Although we are seeing the media roll out headlines as the U.S. crosses the 100k fatality level, it should be noted that the U.S. uses a reporting method similar to Belgium, where doctors can assign the cause of death on either a test or symptoms.  If nations are reporting fatalities on tests alone, it is highly likely they are underreporting virus deaths.  Comparing overall death rates to normal death rates is probably a better way to estimate actual fatalities, but no method is perfect.  The bottom line is that focusing on a particular number isn’t necessarily a true picture for comparison purposes.

The virus news:

• The good news:
  • Two city-states that were able to handle the virus well were Singapore and Hong Kong. Both managed to keep the virus away from the elderly and both were aggressive in testing.  Denmark is another nation that has performed well; it was aggressive early in implementing lockdowns and has been the first to reopen.  So far, the reopening has gone well.
  • Given the importance of testing, the slow response of testing and the lack of accuracy has been a problem. Companies are aggressively working to create more rapid, accurate tests.  This development will be critically important during autumn to distinguish between seasonal influenza and COVID-19.
  • Merck (MRK, 77.55) is working on an anti-viral designed to force the virus to mutate rapidly and kill itself.
  • Sometimes showing action is just as, or more important, than actually doing something. Thus, expect companies to make a great show of disinfecting that may or may not provide much safety.
  • Another clinical trial for a vaccine has begun in Australia.
• The bad news:
  • One issue we have been watching for a while is that COVID-19 may become endemic, meaning it really never goes away. Many infectious diseases have this characteristic, even when a vaccine is available.  We still see outbreaks of measles, mumps, pertussis, etc.  Thus, learning to live with it may simply be part of life going forward.  That doesn’t mean constant lockdowns, but it does mean the precautions for preventing the spread of the virus could become part of life.
  • International hackers are pinging U.S. research facilities to steal medical research on treatments and vaccines. This development shows (a) the potential nations see in being the first to provide treatment, and (b) worries that “vaccine nationalism” may prevent them from getting a new treatment in a timely fashion.  Vaccine nationalism is also on the minds of pharmaceutical companies.
  • Brazil continues to suffer from rising COVID-19 fatalities.

The policy news:

• Although the GOP has been cool on additional stimulus, Majority Leader McConnell is apparently talking about another round of spending in the next month or two.
• We do know that the Fed’s balance sheet has been expanding at a historic pace. However, it should be noted that the actual drawing of available facilities has been rather light.  This shows the power of announcement effects.  Once participants realize the Fed will prevent a liquidity squeeze, they are more willing to engage in normal business.

 

• NY FRB President Williams, in an interview yesterday, said the Fed is “thinking very hard” about yield curve control. This would mean the Fed would set rates for the entire Treasury curve.  If the Fed moves toward funding fiscal activity, such control will likely be necessary.
• The EU is moving toward a limited Eurobond to fund virus recovery. The EU has proposed a €750 billion fund to support recovery, part of a larger effort, that will be funded by a special EU bond serviced by a series of special taxes.  The “frugal four” remain cautious, but Germany’s support for the measure could cajole them from a veto.  The selling points are that the bonds (a) are special purpose and not for general fiscal activities, and (b) have their own services flows.  But it is a mutual debt instrument and may move the EU toward a true Eurobond, a bond that funds fiscal operations backed by the full faith and credit of the EU.

The finance news:

• Although LIBOR continues to be used, policymakers are moving to end the life of the benchmark. The alternative, the Secured Overnight Financing Rate (SOFR), will be its replacement.  We will be watching to see when the CME moves the Eurodollar futures to the SOFR futures as the “finishing touches” of the process.  This shift will require millions of loan documents to be repapered to the new rate.  Here is the timeline.
• Bullion banks took a hit on their hedging when futures prices rose above the cash price of gold. Bullion banks usually hedge their positions by shorting futures, which usually trade at a discount to the cash prices to cover the interest cost.  During the March turmoil, investors piled into futures contracts, driving the futures price above the cash gold price.  In response, banks have backed away from hedging in the futures markets.

The economic news:

• The Fed’s Beige Book confirmed what we all have seen—economic activity is down significantly. However, there is evidence in some districts that conditions are starting to stabilize.  The districts of Cleveland, New York and Dallas reported that although conditions remain dire, they are not getting worse.  The problems in hospitality were mentioned often.  One other concern that was raised was that generous unemployment insurance, fear of infection and the lack of child care is preventing workers from returning to their jobs.
• Slow-to-arrive stimulus checks and job losses are putting millions of renters at risk of eviction. Although most state and local governments are not enforcing evictions at present, landlords will likely be forced to move quickly to evict once regulations ease unless the Fed offers landlords and mortgage companies similar relief.

The foreign news:

• SoS Pompeo warned Beijing that if it implemented its national security law, bypassing the former colony’s legislature, the S. would consider Hong Kong simply a part of China; in other words, the former colony is no longer autonomous. This would mean that any special treatment for Hong Kong would cease.  Tensions over Hong Kong are escalating.  The U.S. is reportedly considering sanctions on Chinese officials and companies over Hong Kong.  The U.S. also has an extradition treaty with Hong Kong but not with China; if the U.S. continues to move forward with calling Hong Kong merely part of China, that treaty will almost certainly end.  As expected, the National People’s Congress did approve the security law for Hong Kong.
  • We continue to watch how this situation unfolds. If the U.S. moves to sanction Hong Kong’s financial system, it would isolate China and make it difficult to conduct trade and investment using dollars.
  • Taiwan has indicated it will help Hong Kongers who want to move from the former colony.
• China is drafting a new five-year plan, the 14^th in its history. Reports indicate the CPC is preparing the economy for decoupling from the U.S.  The strategy appears to be designed to rely less on exports, which will require greater domestic consumption.  To some extent, this is a major victory for the U.S.  American policymakers have lectured China for years about the need to restructure its economy away from the reliance on exports.  Although a series of Chinese administrations agreed in theory, restructuring the economy in practice was politically difficult.  The Trump administration’s trade war with China is starting to look like it will become a longstanding policy and the severe global economic decline has made it evident that relying on exports is no longer feasible.  This shift will be necessary if our expectations of deglobalization continue.
  • For Xi, this decision is quite risky because the transition will almost certainly slow China’s economy, at least for a while. The tradeoff Beijing has offered its citizens is that the CPC granted strong economic growth for giving up political influence.  Rising unemployment among China’s young is raising fears that this social contract will become frayed and may undermine the communist party.
  • According to reports, President Trump is becoming jaded about the Phase 1 trade deal, which may lead to the return of tariffs. China is struggling with the dissonant objectives of agricultural self-reliance and meeting the import obligations of Phase 1.
  • The House has sent a China sanctions bill to the White House tied to China’s suppression of the Uighurs. It is not clear if he will sign it.  Although we suspect the executive would prefer to use sanctions against China for other issues, anti-China rhetoric is elevated and looking “soft” on China is not a winning strategy in the current environment.
  • A congressional report warns investors that the Chinese financial system is fragile and questions American financial firms’ moves to build business relationships in China. Although the report’s claims are nothing new, the fact that the report is out now could become the basis for further actions to restrain American investment into China.
• A Canadian judge ruled that the U.S. met its legal test for extraditing Meng Wanzhou, the CFO of Huawei (002502.SZ, CNY 2.96). This means it is more likely Meng will face fraud charges in the U.S. tied to her company’s sales to Iran.
• Decoupling from China and deglobalizing will have profound effects on businesses, especially multinational firms. At a minimum, it will mean creating parallel supply chains, one for China and the other for the U.S.  At worst, both countries will force companies to choose.
• As tensions rise with China, Beijing is allowing the CNY to depreciate. It is unclear how hard the PBOC is working to prevent the weakness (we will get a look when China publishes its reserves data), but it doesn’t appear that authorities are opposed to weakness.  Using depreciation was expressly forbidden in the Phase 1 deal, so if China continues to use this tactic, tensions will certainly increase.
• As the ECB awaits the resolution of the court spat between the European Court of Justice and the German Constitutional Court, the central bank is preparing contingency plans for how it would operate without the Bundesbank.

India/China:  There has been a long history of tensions on the Indian/Chinese border.  However, because the frontier is high in the Himalayas, the ability of the two countries to conduct military operations is severely limited.  Flare-ups are fairly common on the border.  Recently, both sides have been increasing their military readiness around eastern Ladakah.  The region is very remote and, on the ground, borders are somewhat indeterminant.  New Delhi claims that China has moved fighter jets to air bases in the region.  China claims that India has built new roads in the area and worries that the infrastructure would allow India to mobilize troops.  History would suggest that neither side really wants a full-blown military conflict in the region due to the difficulty of conducting military operations in such harsh terrain.  However, both countries have modernized their militaries and may want a skirmish to test their forces.  The U.S. has offered to mediate talks to ease tensions.  We will continue to monitor this situation.

Russia:  Two Russian Su-35s intercepted a USN P-8A reconnaissance aircraft in the Eastern Mediterranean.  The U.S. accused Russia of “unsafe, unprofessional” conduct.

Nord Stream:  The Nord Stream pipeline, which would transfer natural gas from Russia directly to Germany, is back in the news.  The project had been stalled due to U.S. sanctions but the arrival of a special drillship, the Akademik Tscherski, has restarted the project.  The U.S. is considering additional sanctions against Germany and Russia over the project.

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

[Posted: 9:30 AM EDT]

Risk assets appear set to follow through on their rise yesterday, reflecting not only more signs of a nascent economic recovery from the coronavirus crisis, but also a slew of new stimulus measures in the U.S., Europe and Japan.  We highlight all the key coronavirus and other news below.

COVID-19:  Official data show confirmed cases have risen to 5,615,689 worldwide, with 351,077 deaths and 2,307,901 recoveries.  In the United States, confirmed cases rose to 1,681,418, with 98,929 deaths and 384,902 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• In New York, the epicenter of the pandemic in the U.S., new COVID-19 deaths yesterday totaled just 73, marking their lowest level since the surge of infections began in early March.  New York City Mayor Bill de Blasio said he expected the city to enter its first phase of reopening in the first, or second week of June.
• In contrast, Brazil continues to report accelerating infections and deaths.  In fact, for the first time, yesterday it reported more deaths from COVID-19 than the U.S.

Real Economy

• According to data tracker STR, the U.S. hotel occupancy rate rose to 32.4% in the week ended May 16, marking the fifth straight week of increased occupancy after the low of 20.0% in the week ended April 11.
  • The latest reading was the highest occupancy in nine weeks, but still far below the 61.8% rate reported at the beginning of March before coronavirus cases surged.
  • Revenue per available room, a key hotel-performance metric, was just $25.12, up slightly from the prior week, but down nearly 74% from the same period last year.
• U.S. retailers sitting on mountains of, now out-of-date, inventory after the long lockdown are expected to launch massive sales as the economy reopens, potentially helping to boost demand but likely also putting further downward pressure on consumer inflation.
• As economic activity and oil demand show continued signs of recovering, Russian officials signaled they may hold off on committing to any extended production cuts ahead of a June meeting among major oil exporters.  The news is weighing modestly on global oil prices so far today.

U.S. Policy Responses

• Senate Majority Leader Mitch McConnell (R-Ky.) said on Tuesday that there would “likely” be a fifth coronavirus relief bill “in the next month or so.”  Although he insisted the bill would not be the $3-trillion proposal that passed the House last week, he expressed confidence that further economic support is needed.
• Larry Kudlow, the director of the White House National Economic Council, said the Trump administration is examining proposals to provide cash incentives to encourage unemployed Americans to return to work.  He made the comments after being asked about a proposal by Sen. Rob Portman (R., Ohio) to provide a temporary $450-a-week bonus for unemployed workers returning to work, on top of their wages.

Foreign Policy Responses

• Even going beyond last week’s groundbreaking proposal from Germany and France, European Commission President Ursula von der Leyen proposed today that the EU issue €750 billion in debt to establish a coronavirus recovery fund totaling €500 billion, all of which will be handed out as grants to economically hard-hit parts of the EU, and to provide €250 billion in loans to member states.  To pay off the debt in the coming decades, she also proposed a suite of new EU taxes and levies hitting everything from tech giants to carbon emissions.
  • The surprisingly aggressive proposal from von der Leyen has been enough to help give a boost to global markets today, but just as important is the way that the common debt issuance has so far gotten relatively limited pushback, even from the frugal Germans.
  • However, it’s important to remember that this is still just a proposal.  To be implemented, it still needs to be approved by all 27 countries in the EU, including the frugal creditor nations primarily in the north.
• Downplaying the threat from a German court’s recent ruling against the European Central Bank’s bond-buying program, board member Isabel Schnabel said the ECB is “not adjusting our monetary policy in any way in response to this ruling,” on grounds that it is strictly an issue for the court and the Bundesbank.  The statement is probably an accurate characterization of what the ECB and most European policymakers hope will happen with the court ruling, and the statement is supportive of European equities.  Over time, however, we still believe the court ruling will play into the fractures between the EU’s creditor nations in the north, versus its debtor nations in the south.
• In Japan, Prime Minister Abe’s government approved a second supplementary budget providing an additional ¥31.9 trillion to buffer the economy from the crisis.  Combined with planned spending by local governments and the private sector, as well as loans offered by financial institutions, total new support will be ¥117.1 trillion. This is on top of the ¥100 trillion in support approved just last month.  At today’s exchange rates, the total support to date of more than ¥200 trillion is equivalent to about $2.01 trillion.
• In France, President Emmanuel Macron said his government plans to spend billions of euros to help shield France’s auto industry from the crisis, including a state-backed credit facility of €5 billion for automaker Renault (RNLSY, 4.13), and various consumer rebates and subsidies to stoke demand for more fuel-efficient cars.  The plan would also create a €1-billion fund focused on modernizing the auto industry, spurring consolidation among smaller companies and investing in research and development.
• In Japan, Economy Minister Yasutoshi Nishimura said a program to provide up to ¥20,000 ($186) a day in subsidies to travelers who take overnight trips is likely to take effect in late July for nearby trips, expanding to all domestic trips in August. The subsidies can be used to pay for lodging, meals and other expenses.

China-Hong Kong:  In another clear sign that pro-democracy protestors are picking up where they left off during the coronavirus crisis, hundreds of demonstrators gathered to oppose the reading of a contentious law on China’s national anthem in the city’s de facto parliament, sparking renewed clashes with police.  As we’ve noted before, the spiral of tightening controls imposed by Beijing and intensifying protests is a distinct negative for Hong Kong equities.  Importantly, the U.S. is considering a range of sanctions to punish China for its crackdown on Hong Kong, including possibly imposing new restrictions on financial transactions, and freezing the assets of Chinese officials.

Russia-Libya:  The U.S. military has accused Russia of deploying fighter jets to Libya, from a base in Syria, in order to support renegade General Khalifa Haftar in his effort to take control of the country.  Russia has long supported General Haftar, but this dramatic escalation could mark a significant expansion of Russian ambitions in the region.

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

[Posted: 9:30 AM EDT]

The rally in risk assets around the globe today comes as coronavirus restrictions continue to be lifted around the world, economic activity starts to increase again, and more potential vaccines make their way into trials.  So far today, those bright spots are offsetting the continued risk of second waves of the pandemic and renewed U.S.-China tensions.

COVID-19:  Official data show confirmed cases have risen to 5,519,878 worldwide, with 346,836 deaths and 2,253,651 recoveries.  In the United States, confirmed cases rose to 1,662,678, with 98,223 deaths and 379,157 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• Novavax, Inc. (NVAX, 46.11) began a small Phase I study of its coronavirus vaccine candidate NVX-CoV2373, joining the frontrunners in the race to develop a vaccine.  The company expects to have results as early as July.
  • To speed production if the vaccine proves to be safe and effective, the firm is already preparing its production facilities.
  • Because of the manufacturing buildup, Novavax said it could produce up to 100 million doses this year, and potentially more than one billion in 2021.
• Tests on coronavirus-infected health workers in two French hospitals show that 98% of them maintained strong immunity a month later, a finding that will help ease concerns that COVID-19 immunity is not durable.
• In a more negative report, Brazil has now become the only country besides the U.S. in which more than 1,000 people are dying each day from the coronavirus, with Mexico close behind.  The figures underline this risk that infections will surge further in poorer countries that haven’t been able to maintain a prolonged lockdown for economic or political reasons.  That’s bad news because burgeoning infections in poorer countries will make it harder for developed countries to avoid a second wave of infections in the future.

Real Economy

• High-frequency economic data from truck loading to air and hotel bookings show the U.S. economy is reactivating, albeit slowly and fitfully.  The growing sense that an economic recovery is in the works here at home and abroad appears to be a key reason for the risk-on attitude in today’s markets, along with the continued news on coronavirus vaccine development.
• Major U.S. sports leagues are preparing to restart their seasons over the summer, potentially helping a wide range of ancillary employees – from hot dog hawkers to cheerleaders – get back to work.  Importantly, the return of sports would also provide fresh content for major media firms.
• Analysts at Barclays estimate economic activity in the U.K. for the week starting May 11 returned to almost 80% of normal, driven by higher retail sales both online and offline.
• All the same, new infection hotspots are already popping up in some European countries that have eased their lockdowns, raising the risk that restrictions might have to be tightened again.  Italian officials threatened to reinstate restrictions on people’s movements and announced plans to recruit 60,000 unemployed volunteers to help oversee social distancing, after hordes of Italians celebrated the end of the country’s lockdown by going out in public.
• The Organization for Economic Cooperation and Development said the combined gross domestic product of its 37 members was 1.8% lower in the first quarter than in the final three months of 2019, the largest fall since the 2.3% decline recorded in the first three months of 2009 during the height of the financial crash.
• A Dutch body considered an authority in world trade, CPB Netherlands Bureau for Economic Policy Analysis, said flows of goods across borders were 1.4% lower in March than a month earlier, bringing the decline in the first quarter to 2.5% – the largest drop since the Global Financial Crisis.
  • WTO economists estimate flows will fall by 13% to 32% in all of 2020, compared with 33% over three years during the Great Depression.
  • The declines reflect the vast interdependencies between world economies, which is forcing many firms to consider diversifying and shortening their supply chains.
• In the U.S., it’s also becoming increasingly clear that the mortgage forbearance rights in the CARES Act come with a slew of unintended negative consequences that have the effect of tightening lending standards for new mortgages.  Tighter mortgage lending would likely retard the rebound in the economy as lockdowns ease.

Financial Markets

• Investors are gearing up for more emergency share sales from British companies trying to shore up their balance sheets or build acquisition war chests as the pandemic leaves businesses fighting for survival.  According to PrimaryBid, a group that links retail shareholders with companies, more than 50 companies in the UK have raised approximately £7 billion through equity placings in the past two months alone.

Foreign Policy Responses

• The German government and Deutsche Lufthansa (DLAKY, 8.82) agreed on a €9-billion bailout deal—one of the biggest aid packages by a single country hatched so far in the pandemic-hit air travel sector.
• The People’s Bank of China set a daily midpoint for the renminbi at 7.1293 per dollar, marking the currency’s weakest value since February 2008.  The setting suggests the Chinese government now wants a weaker currency to help offset weaknesses caused by the coronavirus pandemic, trade tensions with the U.S., and the limited scope for additional debt financing.  The lower currency risks further stoking tensions with the U.S.

Political Impact

• Prime Minister Johnson has come under fire after news reports showed his top political advisor, Dominic Cummings, took a 260-mile road trip to his parents’ farm shortly after the rest of the country was placed in lockdown.  Cummings’ refusal to apologize has already sparked the resignation of at least one lower-level minister in the government.

China-Hong Kong:  Pro-democracy demonstrators filled the streets of Hong Kong again over the weekend to protest Beijing’s plan to impose a new national security law on the city, sparking clashes with police.  To reassure investors, President Xi insisted the legislation was benign, and China’s foreign ministry commissioner in the city said it would ensure “a more law-based, reliable and stable business environment for foreign investors.”  However, the proposal is still stoking investor concern that the legislation could undermine the rule of law in Hong Kong and produce a more politicized economic and financial system under Beijing’s thumb.   The crackdown on Hong Kong could also signal that President Xi will eventually take an even tougher stand on reunifying Taiwan with China, even as he pushes to gain Chinese control over the East China and South China Seas.  All of these aggressive initiatives, along with efforts to coopt countries ranging from the Philippines to Italy, carry the risk of U.S. sanctions, financial market decoupling, or, eventually, military clashes.  They also exacerbate other U.S.-China tensions ranging from trade relations to disputes over whether China is to blame for the coronavirus pandemic.  Hong Kong stocks have already been hurt by the proposed security law, but the worsening relationship between the U.S. and China also presents a risk to global stocks in the longer term.

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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!  As a reminder, financial markets will be closed on Monday, so the next Daily Comment will come to you on Tuesday.  Hong Kong tensions are depressing global equity markets.  We cover the crackdown on Hong Kong.  As usual, we also update the latest on COVID-19.  Here is what we are watching:

COVID-19: The number of reported cases is 5,125,612 with 333,382 deaths and 1,964,097 recoveries.  In the U.S., there are 1,577,758 confirmed cases with 94,729 deaths and 298,418 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 virus news:

• The good news:
  • The CDC has confirmed that COVID-19 primarily spreads from person-to-person and not from contaminated surfaces, and our pets are not a vector either. Instead, the virus is transmitted by droplets from people, and dense congregations of people are risky.
  • The U.S. is investing $1.2 bn into a potential vaccine that is being researched jointly by Oxford and AstraZeneca (ANZ, 55.28). Their vaccine candidate is being tested in humans.
• The bad news:
  • New research from Imperial College, London indicates that most of the U.S. has a R₀ that exceeds 1, meaning that the rate of transmission is still prone to rise.
  • Brazil is becoming the world’s hot spot for the virus.
  • The head of the government’s Substance Abuse and Mental Health Services Administration warns that another round of lockdowns would pose risks to American’s mental health.

The policy news:

• The Fed continues to warn that there are significant risks for the economy. Chair Powell described the current downturn as “without modern precedent.”  We would concur.  Vice-Chair Clarida agreed and warned that the U.S. faced a problem of deflation, not inflation.  He also said that rate guidance might not return until fall—in March, the Fed refrained from publishing a dots chart.
• As noted yesterday, Congress is working to address flaws in the small business support measures. What is unknown is if they will be able to stem a likely jump in business failures.  Sadly, the Senate adjourned without approving any adjustments, meaning nothing will occur until next month.

The finance news:

• Chinese entities have been borrowing in dollars over the past few years. A court case in Beijing is considering whether “keepwell bonds” offer protection to foreign dollar lenders.  A state borrower tied to Peking University is defaulting on debt and the school is refusing to back the debt.  If the court finds in favor of the university, it will raise doubts about the safety of about $100 bn of these keepwell bonds currently outstanding.
• Earlier this week, the BOE admitted it was considering negative policy rates. British banks warned against such measures, which tend to narrow net interest margins.
• On banking, the head of the IMF, Kristalina Georgieva, suggested that all banks suspend dividends and buybacks to rebuild capital bases.
• Meanwhile, in Europe, one of the problems of the monetary policy has been revealed. A central bank can lower the cost of funds for banks, but doing so doesn’t necessarily mean banks will lend.  This is what is known as ‘pushing on a string.’  Borrowers in Europe are complaining that banks are not lending despite strong incentives from the ECB.
• In a sign of how desperate corporate borrowers are becoming, firms are aggressively borrowing against assets. Over the years, such borrowing has become rare as credit standards have become lax.  Now that fear has returned, banks are demanding collateral, although taking the collateral is fraught with risk.
• Collateralized debt obligations (CLO) are coming under scrutiny again as risky borrowers are struggling to service their debts due to the downturn. CLO’s are created through financial engineering and create various classes of debt based on the primacy of the payment stream.  Usually the first lender in line gets a high rated debt instrument with a low rate; at the back end, a much higher rate is offered.  However, as we saw in 2008, a portfolio of risky borrowers is still risky regardless of how the payment line is structured.  As we have been saying all along, we are watching for ‘holes in the dike’ of the financial system that the Fed fails to plug.  This could be another one.

The economic news:

• There is growing evidence that the economy is bottoming. We are seeing data in both Europe and the U.S. that support the idea that conditions are bad, but not getting worse.  That usually means the recession will end once the trough is met.  If so, this will be, perhaps, the deepest but shortest recession on record.
• As businesses reopen, the new conditions for conducting operations is becoming apparent. Costs will undoubtedly rise as firms need to support social distancing and enhanced sanitation.  Who bears the costs of these measures will be key.
• One of the effects of the stay-at-home orders is the discovery by firms that some employees are effective away from the office. A number of firms are indicating that work from home rules will be relaxed, allowing some workers to continue to work from home on a regular basis.  In general, the ability to work from home appears to be a function of education.

The foreign news:

• China…lots of news:
  • As we noted earlier this week, the National Party Congress meetings begin today. However, policy changes have been announced already, highlighting the ‘rubber stamp’ nature of these meetings.  It’s not that the meetings aren’t important, it’s just that the approval of policy is not dependent on the votes of the congress.
  • The most market moving event was the new security law for Hong Kong.   Beijing has been steadily undermining the “one country, two systems” that was put in place when the U.K. relinquished the colony back to China in 1997.  However, under Xi, the undermining has accelerated.  Here are the details and ramifications:
    • China may base security agencies directly in Hong Kong. This would essentially end the independence of Hong Kong’s police.  Even if Beijing doesn’t put offices in place, the mere threat will probably lead the local forces to do China’s bidding.
    • The new proposal outlaws sedition, treason and succession. Since China follows the “rule by law,” these factors will be defined so broadly that they will be used to prevent anything the CPC wants banned.
    • It is hard to see how Hong Kong’s relative independence will be maintained. We all knew that the two systems fiction would end in 2047 when the 50-year deal China signed with Britain expired.  However, this is happening much faster than expected.
    • Widespread protests are expected, and we will be watching to see how the local police respond.
    • Perhaps the bigger issue is how does the world (read: U.S.) respond. In a rare bipartisan moment, the Senate is calling for sanctions in response.  President Trump offered an unspecific response as well.  The White House is in a delicate spot; if calls for a crackdown escalate, the Phase 1 trade deal could be at risk.  It is also clear that Chairman Xi is making the control of Hong Kong a major priority.  If the U.S. pushed back hard, personal relations between President Xi and President Trump could fray.  Given how tensions are rising, the end of their personal chemistry may be inevitable.
    • The end of Hong Kong as a semi-independent entity will have significant financial market ramifications as well. The financial world has tended to treat Hong Kong as a developed world enclave for financial matters.  If this ends, look for talent and capital to flee the former colony.
  • As we noted yesterday, increased scrutiny of Chinese listed companies is rising. The Chinese search engine Baidu (BIDU.O, $110.03) indicated it was considering delisting from NASDAQ (NDAQ, 113.99).  The Committee on Foreign Investment in the U.S. (CIFUS) told Esko Bionics (EKSO, 3.04) to break up a joint venture with Chinese investors.  The firm was making exoskeleton products that ostensibly allow people with disabilities to use their limbs, but it could also create ‘super-soldiers’ who could wear the exoskeletons to increase their strength and stamina.  We continue to closely watch the delinking between the two countries for its impact on individual companies.
  • In light of the pandemic, China has dropped its GDP target. In some respects this wasn’t a surprise.  Given the severe decline in growth, no target this year made sense, although there was speculation they might opt for a multi-year target.  Dropping the target is important, however.  As we have noted before, China can achieve any GDP number it wants; it merely has to increase debt growth and invest the proceeds to hit the target.  By dropping the target this year, it may be signaling that Beijing finally intends to deal with the debt overhang.  This is bad news for commodity producers; high Chinese growth has been key to supporting prices.  Although we do expect some degree of stimulus, not having a target does relax the need for stronger growth.
  • The U.S. has sold $180 mm of advanced torpedoes to Taiwan.

Odds and ends: The U.S. has indicated it will withdraw from the Open Skies Treaty.  This treaty allowed commercial airliners to film the ground to see if nations are adhering to treaties.  Russia has been violating conditions for some time, so the U.S. decided to end its participation.  The U.S. does plan to have new arms talks that would include China.  Tensions between Greece and Turkey are rising again.  Turkey is constructing a nuclear power plant in southern Turkey which is worrying Greece.  Turkey is also increasing overflights over the eastern Aegean Sea.

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

[Posted: 9:30 AM EDT]

Good morning!  Equity markets are taking a breather this morning.  China is preparing for its CPC spring meetings.  Germany bends (a little) on a Eurobond.  We touch on the Fed minutes and update the COVID-19 news.  The Weekly Energy Update is available, as is our most recent podcast.  Here is what we are watching:

COVID-19:  The number of reported cases is 5,016,171 with 328,471 deaths and 1,913,103 recoveries.  In the U.S., there are 1,551,853 confirmed cases with 93,439 deaths and 294,312 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.  One chart worth noting: the virus is rapidly becoming an emerging world problem.  This is partly because these nations can’t absorb the costs of lockdowns.

The virus news:

• The good news:
  • Although details are sketchy, there are reports that Chinese scientists have created an antiviral using human antibodies from plasma. Drug companies have been using two tracks on the virus—vaccines and antivirals.  The latter would be useful for those who have contracted the disease.  At present, the drug works on animals.  If it progresses, it remains to be seen if it can be made in scale.  However, if true, this would be a major breakthrough.
  • Two antibody stories suggest that being infected with COVID-19 grants some degree of immunity. These were animal studies but were peer reviewed.
  • Vaccine research continues, with standard and novel approaches being deployed.  A prototype has generated immunity in monkeys, setting the stage for human testing.
  • Broad lockdowns do prevent the spread of the virus but at high (and unsustainable) costs to the economy. As we learn more about the virus, scientists are analyzing what behaviors are risky and which are safer.  One behavior that stands out as being risky is mass gatherings, events that put lots of people in close contact, e.g., sporting events (except for Marlins games), concerts, large church gatherings, mass transit, etc.  Studies from Germany suggest that curtailing these events significantly reduces the spread.
• The bad news:
  • Chinese doctors dealing with a new outbreak in the northern provinces of Jilin and Heilongjiang report that COVID-19 appears to be mutating. Compared to what was observed in Wuhan, patients appear to be asymptomatic longer, which facilitates the spread of the disease.  At the same time, they are reporting fewer cases of widespread organ problems; instead, they are seeing the more serious cases concentrated on lung issues.
  • Although children have mostly been spared from the worst of COVID-19, there are rare cases where a few children suffer from severe inflammation. Here is what to look for.
  • A Chicago area auto plant was forced to close soon after reopening after a supplier closed. Another plant in Michigan closed as a worker tested positive for COVID-19.  We continue to closely watch Mexico’s return to work, which will be critical for the auto industry.
  • The head of the CDC warns of another uptick in infections later this year.
  • The experience of the polio vaccine offers a cautionary tale for the eventual COVID-19 vaccine. After Jonas Salk developed the vaccine, a number of drug companies licensed the process to distribute it to the public.  Sadly, one of the drug companies made a serious error.  The Salk process involved a vaccine that used dead polio viruses.  The drug company in question inadvertently failed to kill the virus; instead of sending out a vaccine, it sent out live polio viruses.  The company sent out 165k vials of the tainted vaccine which not only infected some of those who received it, but the newly infected, in some cases, passed it on to other family members.  As one would expect, there was a great rush to distribute the vaccine which likely contributed to the error.
    • Although this story has been mostly lost to history, we doubt the drug companies have forgotten. If they don’t get some protection from lawsuits, they will be very careful in testing the vaccine before distributing, which will inevitably slow its dispersal.
    • At the same time, the news of a vaccine will raise the clamor for distribution, which will increase the odds of a mistake. Given the rising skepticism about vaccination, in general, an error would have serious ramifications.
    • On this topic, the EU has been slow to spend on vaccine research, increasing the chances it will be in the back of the line when the eventual vaccine is distributed.
    • Vaccine nationalism is another risk. The moral quandary of vaccine distribution will become a problem at some point.  Discussing how we should distribute the vaccine once it emerges would make sense.

The policy news:

• Earlier this week, Treasury Secretary Mnuchin and Chair Powell testified before Congress. Although the media has mostly focused on the “compare and contrast” between the two testimonies (Mnuchin was upbeat, while Powell pushed for more fiscal stimulus), the most critical part we found was that the Treasury secretary indicated that his department was ready to “take losses.”  One of the unknowns has been that as the Fed’s balance sheet expands to accommodate its backstops, the central bank is really not able to take losses.  If it does, it will eventually need to be recapitalized by the Treasury.  Mnuchin admitted that this will be the case.
  • The Fed minutes were no surprise; the minutes from the late April meeting showed a Fed that remains deeply concerned about the long-term changes coming from the current downturn. The FOMC is also committed to deploy all its tools to deal with the impact of the slowdown on financial markets.  The signal is clear—no one will likely be refused liquidity aid.  There was also some discussion of returning to guidelines to signal to the markets when extraordinary aid would be curtailed, perhaps a growth level, or unemployment rate.  We suspect this idea is coming from the hawks.
• Speaker Pelosi is working on revamping the small business lending program. The Paycheck Protection Program, put together in haste, has suffered serious flaws.  Companies and non-profits that probably didn’t need the support got it, while small firms that needed it were denied.  Banks were unsure how to make loans, so they concentrated on existing relationships.  Small companies became afraid they would be audited; the short time frame to use the funds has discouraged firms from taking the loans.  The fact that Congress is taking a second swing at this is good news.
• Meanwhile, the Senate continues to slow walk the recently passed House bill. Majority Leader McConnell (R-KY) has indicated that enhanced unemployment benefits won’t be extended.  These benefits have been controversial; although welcomed by households, the benefits, especially outside the coastal urban areas, often exceed what employees earned on their jobs.  Thus, they have an incentive to avoid finding new employment.
• Although we are on the record as forecasting deglobalization, the fact remains that reversing the trend of the past four decades will not be easy. Companies have become adept at managing far-flung supply chains that lower costs.  Getting them to “come home” will be hard and probably require incentives.  Economic advisor Kudlow floated tax breaks for firms that relocate back to the U.S. as one idea to foster reshoring.  Additionally, we are seeing examples of the government supporting reshoring by contract distribution.

The finance news:

• There is an old saying that the inverse of a supply chain is a payments chain. In other words, as goods and services flow one direction, payments flow the other.  This situation is becoming clear in real estate.  Retail firms and restaurants, which often lease space, are dealing with collapses in revenue.  They are, in turn, asking for rent relief from their landlords.  Landlords, understandably, are cool to the idea.  Still, as landlords face these calls and, in some cases, face tenants who go out of business, they are seeking relief from bondholders who often own bonds tied to real estate.  We continue to watch carefully for “holes in the dike” that are not filled by policymakers.  Real estate is an area we are monitoring closely.
  • Delinquencies on credit cards are rising as well.
• The U.K., for the first time ever, sold gilts that priced at a negative yield. Buyers are expecting the BOE to increase QE and thus buy these bonds at a higher price.
• Argentina is preparing for its ninth default.
• The WSJ has a good article about the stresses seen in the financial system in March. It was those stresses that, in our opinion, led to the downturn.  In March, it became apparent that the economy was facing three threats: the virus, the collapse in oil prices and the freezing of the financial system.  This report offers detail on what occurred.
• The Treasury has reintroduced the 20-year T-bond; the first action was well received.

The economic news:

• As the economy tentatively reopens, airlines are reporting a rise in bookings.
• As border restrictions rose, farmers, especially vegetable and fruit growers, found that their immigrant labor force was disrupted. In the U.S., farmers were able to receive selective visa relief.  In Germany, the solution was airlifts.  The food industry is also looking at robotics as a long-term solution.

The foreign news:

• In a surprising move this week, Germany decided to support a common Eurobond to fund a €500 bn recovery fund. This is a significant move, and a reversal of Germany’s historic stance.  It’s not a done deal.  As true of all such measures, passage requires consent from all 27 members of the EU.  It is quite possible that other northern European nations (e.g., Netherlands, Finland and Austria) may scuttle the proposal.  On its face, it would appear this decision would be unpopular with conservative Germans.  However, German conservatives have generally signed off on the arrangement due to its limited scope, suggesting the real problem isn’t a specific mutual Eurobond, but a general one.  So, think of this deal as being similar to a municipal bond for a specific project.  Of course, once a bridge is crossed, doing it again is easier.  Today, the Eurobond may be limited; tomorrow, maybe not.
  • Markets liked the proposal; Italian and Greek yields fell on the news.
  • Despite the historic concession, Italy warns it isn’t enough.
• In the U.K., for the first time in centuries, Wales is putting up barriers to English citizens over London’s virus policies.
• China news:
  • The CPC’s spring meetings, the National People’s Congress, begins tomorrow.  We are watching closely to see the GDP target (if there is one issued).  The Chinese economy is recovering but also clearly hurting as well.  Unemployment is up, which is a threat to any government.  Beijing has been parsimonious with stimulus spending; business is pushing for more help.  Additionally, the military, facing threats from the U.S., wants a bigger budget. The most likely path of new spending will be infrastructure.
    • One reason for China’s reluctance to spend could be fears that debt is becoming unmanageable. China’s gross debt has hit 317% of GDP.
    • Hong Kong policy will also be discussed.  Although it isn’t getting much coverage in the U.S. media, conditions in Hong Kong are deteriorating.  In the legislature, pro-Beijing groups forcibly took control to pass bills.  There are worries about a return to mass protests this summer.
  • Although there was a slow start, China appears to be ramping up purchases of agricultural goods, a key element of the Phase One deal.
  • The U.S. is adjusting policy on Chinese IPOs, making it harder for Chinese firms to list on U.S. markets. This decision is opening the door for London exchanges.  Additionally, the Senate passed a bill increasing scrutiny on Chinese firms, requiring U.S. style audits to remain listed.
  • Technology is becoming a battleground with China. The U.S., as noted above, is stepping up efforts for reshoring; technology is becoming a focal point for these efforts.  In addition, the S. is clearly trying to use China’s lack of chip production against it.  This is leading Beijing to try to fill this gap by building an indigenous semiconductor industry, including its firms building capital for future investment.  Meanwhile, the U.S. is employing Taiwan as a “tip of the spear” against the Chinese tech industry.  Needless to say, China is taking this action as a threat and is increasing its military posture against Taiwan.  Taiwan’s President Tsai Ing-wen started her second term yesterday; the U.S. congratulated her and this made Beijing mad.
  • Meanwhile, U.S. attitudes toward China are deteriorating as well.
  • China is applying tariffs on Australian barley in response to Canberra’s insistence on an international investigation of Beijing’s handling of the coronavirus outbreak. Australia is threatening to take China to the WTO.

Brexit:   Westminster announced its tariff plans for the EU if a Brexit deal is not reached.   Meanwhile, PM Johnson sketched out a trade deal with the EU, similar to the one the group struck with Canada.  Brussels is not happy with that proposal.  Positions between the two sides are hardening.  And, quietly, the Johnson government is admitting there will be customs checks at the shore of the Irish Sea for trade going to the British Isles.

Libya:  The civil conflict in Libya continues to rage, causing widespread hardship.  For the past year, Gen. Khalifa Hifter, who has support of the Gulf States and Russia, has been expanding his area of control, from east to west, heading toward Tripoli.  However, over the past week, Hifter has suffered some significant setbacks as U.N. backed forces centered in the east have seized a key airfield and taken control of two cities.  As turmoil increases, we could see Libyan oil exports fall and there may be a rise in refugees to Europe.

Turkey:  The TRL has been under pressure for months due to falling reserves and rising inflation.  Under normal circumstances, Turkey could petition the U.S. for help; the Fed has been remarkably generous in providing liquidity to nations to ensure ample dollar liquidity.  However, Ankara has fallen out of favor with the U.S. for its treatment of the Kurds and for accepting delivery of a Russian-built S-400 missile system.  So, as its reserves dwindle, it is facing increasing pressure to either (a) raise interest rates to stop the outflows, (b) ask the IMF for help, or (c) find help elsewhere.  The first two options will entail pain, so Turkey went with the third option, getting a boost in its swap line with Qatar.  Qatar is on the outs with other GCC nations and Turkey has been supportive, keeping troops there to discourage the other GCC nations from military adventurism.  It looks like it has been rewarded for its efforts with Qatar.

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