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

[Posted: 9:30 AM EDT]

Today’s U.S. market strength stems in part from earnings reports showing many companies have been able to adjust relatively well to the coronavirus challenges, albeit with higher costs.  Adding to the positive vibe is news that all 50 states have now relaxed their coronavirus lockdowns, although remaining restrictions vary widely.  Overseas, officials also continue to loosen their lockdowns, or contemplate doing so, including several large developing countries where infections are still rising.  As always, we review all the key pandemic and related news below.

Additionally, our latest podcast episode, “The Lessons of History,” is available, which examines the economic, market and social effects of earlier pandemics.

COVID-19:  Official data show confirmed cases have risen to 4,922,137 worldwide, with 323,855 deaths and 1,706,539 recoveries.  In the United States, confirmed cases rose to 1,528,661, with 91,938 deaths and 289,322 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• Despite Monday’s good news of a small study pointing to the possible effectiveness of a coronavirus vaccine being developed by Moderna (MRNA, 71.67), a report late Tuesday on the closely followed medical news website Stat called into question the rigor of the study and prompted fresh doubt over the speed at which a vaccine can be developed.  The news sparked a late-day selloff in the stock market, but it’s important to remember that it’s still early days in the crisis, when the news and confidence can be volatile.  Looking farther out into the future and keeping in mind the amount of brainpower and money being thrown at the problem, there is probably still reasonable hope that a vaccine and/or treatment will be developed and deployed in the coming months, quarters or years.
• As Sweden’s coronavirus death rate per capita ticked higher and surpassed that of the U.K., Italy, and Belgium in recent days, officials in Denmark, Finland and Norway are debating whether to maintain travel restrictions on Sweden even as they ease them for other countries.
• In Brazil, the number of new COVID-19 deaths on Tuesday rose to a record 1,179, compared with the previous high of 881 set last week. Brazil now trails only the U.S. in daily deaths as well as the U.S. and Russia in confirmed cases.
• In Mexico, a report by an anti-corruption think tank accused the Mexico City municipal government of vastly underreporting COVID-19 deaths.  The report claimed actual deaths from the disease in recent weeks were about four times higher than in the city’s official data, prompting a rebuttal from Mayor Claudia Sheinbaum.
• Some scientists looking for ways to prevent a return to exponential growth in infections after lockdowns are lifted are focusing on a new approach: avoiding “superspreading” events such as concerts and other groupings where people gather in close proximity to each other for extended periods.

Real Economy

• The nonpartisan Congressional Budget Office yesterday released updated economic forecasts reflecting only a “gradual and incomplete pattern of recovery” from the virus crisis over the next year and a half.
  • The forecasts call for the economy to grow faster in 2021 than projected last month, but GDP at the end of next year would still be 1.6% smaller than in 2019.
  • The forecasts call for the unemployment rate to remain above 9% through the end of 2021.  The CBO’s reasons for a slow recovery in labor demand are also a handy summary of the key risks for investors:
    • The eventual expiration of the Payroll Protection Program, which could prompt renewed layoffs by smaller businesses.
    • Plummeting tax revenues, which could force state and local governments to lay off large numbers of workers.
    • The possibility that generous unemployment benefits and fear of getting sick could encourage many jobless people to put off looking for work.
• Some big U.S. retailers are ending the extra “hazard pay” they gave to front-line workers as coronavirus-related costs pile up and the ranks of jobless Americans surge, tipping the labor market in employers’ favor.
• In Britain, aircraft engine maker Rolls-Royce (RYCEY, 3.24) said it will cut nearly a fifth of its workforce in a bid to survive the collapse in global aircraft demand caused by the pandemic, which is expected to last for several years.
• In Canada, the state-owned mortgage insurer said the average house price in Canada will fall 9% to 18% in the coming year and won’t fully rebound to pre-crisis levels until 2022.  According to Evan Siddall, chief of the Canada Mortgage and Housing Corp., “The resulting combination of higher mortgage debt, declining house prices and increased unemployment is cause for concern for Canada’s longer-term financial stability.”

Financial Markets

• The U.K. has sold bonds with a negative yield for the first time, reflecting growing investor expectations that the Bank of England may need to cut its benchmark short-term interest rate below zero to support the economy, and push inflation back to its 2.0% target. The development came as Britain reported that its April consumer price index was up just 0.8% year-over-year, half the 1.5% increase in the year to March.
• The Turkish central bank said Qatar has agreed to triple its swap agreement with Turkey, under which Turkey can exchange its lira for Qatari riyal, which are pegged to the U.S. dollar.  The effect of the move is to bolster Turkey’s depleted foreign currency reserves by as much as $10 billion, so it should be a positive for the lira and Turkish assets.

Political Impact

• Now that Spain’s coronavirus infection rates and daily death toll are falling, the country’s polarized political tribes are fighting over the lockdown, its loosening and the aftermath, including nightly protests in Madrid’s wealthiest districts, where protesters have been accompanied by members of the hard-right Vox party.
• An airliner from the United Arab Emirates made the first publicly acknowledged direct flight from Abu Dhabi to Israel yesterday to deliver pandemic supplies for Palestinians.  The flight was a milestone in relations between the two nations, which have no formal diplomatic ties.

China-Taiwan:  In her second inaugural address today, Taiwanese President Tsai Ing-wen reiterated her rejection of China’s efforts to assimilate the island, but she also offered to work with Chinese leader Xi Jinping to stabilize relations in ways that respect Taiwan’s democracy and sovereignty—conditions that China has previously rejected.  To bolster Taiwan’s ability to resist Chinese coercion, she also pledged to further revamp the economy, strengthen the military and deepen ties with friendly countries.  After U.S. Secretary of State Pompeo offered his congratulations to Tsai, the Chinese ministries of foreign affairs, defense, and Taiwan relations lashed out at him for interfering in China’s internal affairs, highlighting today’s increased friction in U.S.-China relations.

United States-China:  More broadly, the increased U.S.-China bickering over trade, the coronavirus and Taiwan are signs that the two countries continue to struggle with the “Thucydides Trap,” or the tension caused when an incumbent power seeking to preserve its position is challenged by a rising power seeking to gain what it perceives to be its rightful place in the world.  As we’ve discussed in the past, this type of situation can eventually lead to military conflict if not managed well.  Reflecting the current defense-oriented stance of the U.S., Senator Josh Hawley (R-Mo.) will lambaste China on the Senate floor today, arguing that the international order must be ripped up to avoid America taking “second place to the imperialists in Beijing.”  Separately, the U.S. Air Force has ramped up flyovers of B-1B Lancer bombers over waters near China, complementing increased military operations by both the U.S. Navy and Air Force in the South China Sea, East China Sea, the Taiwan Strait and the Yellow Sea.

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

[Posted: 9:30 AM EDT]

The generally positive trend in risk markets today comes as coronavirus restrictions continue to be lifted around the world and scientists continue to make progress in understanding the virus, coming up with treatments and developing vaccines.  We review all the key news below.

Additionally, our next podcast episode, “The Lessons of History,” is now available. This episode examines the economic, market and social effects of earlier pandemics.  Although the Black Death is mentioned, we focus on relatively recent events, including the Spanish influenza.  One of our themes has been an impending reversal in the equality/efficiency cycle; in this podcast we discuss the potential that the pandemic could accelerate the shift to an equality phase.

COVID-19: Official data show confirmed cases have risen to 4,829,232 worldwide, with 319,031 deaths and 1,801,461 recoveries.  In the United States, confirmed cases rose to 1,508,957, with 90,369 deaths and 283,178 recoveries.  Here is the interactive chart from the Financial Times that allows you to compare cases and deaths among countries, scaled by population.

Virology

• As the aircraft carrier USS Theodore Roosevelt prepares to depart Guam following a two-week layover because of a COVID-19 outbreak, reports indicate some crew members have come down with the disease for a second time.  Defense officials didn’t know whether some of the tests had produced false negative readings, or whether the sailors had contracted the virus after spending two weeks in quarantine in Guam.  Either way, the news serves as a reminder that scientists still don’t know for sure whether being infected by the virus leads to future immunity.
• On the other hand, South Korean health officials found that a group of patients who tested positive a second time for the coronavirus hadn’t passed the disease on to others, lending credence to the possibility that the suspected relapses were a fluke of testing rather than the re-emergence of an active infection.

Real Economy

• In an important sign that people are becoming less fearful of social interaction, a new Axios/Ipsos poll showed only 64% of Americans now see a risk to their health, or wellbeing from in-person gatherings of friends and family outside their immediate household.  That’s down from more than 80% in early April.  Since the poll suggests consumers may be more willing to go out and spend than they were previously, the news should be positive for stocks going forward.
• In another positive note for the economy, the University of Notre Dame said it will not only bring its students back to campus for the fall semester, but it will also try to limit their travel exposure by starting the semester early on August 10^th, ending it before Thanksgiving, and not starting the spring semester until January.  Sadly, the university offered no indication that the move would help the football team finally win a national championship again, as alumni like me (Patrick) have been waiting for.  GO IRISH!
• Federal health regulators released revised guidelines for reopening U.S. nursing homes, offering additional details and more stringent testing requirements than in an earlier draft.
• On a less positive note, New York said it is delaying payment of some $1.5 billion in grants and aid to the state’s counties, cities, colleges and schools because of the massive revenue decline caused by the coronavirus crisis.  According to Governor Cuomo and State Budget Director Mujica, the state would ultimately have to cut spending by $10 billion unless federal financial aid is provided to help make up for the shortfall soon.
• Many commercial property owners are complaining that many national restaurant and cafe operators are asking to renegotiate their leases or extend their rent deferrals on grounds that social-distancing guidelines restricting them to 25% to 50% capacity have forced them to cut expenses to stay in business.
• In a survey of the chief executives and chairmen making up the European Round Table for Industry, more than 80% of respondents said the global economic recovery from the crisis will take between one and three years.  The respondents said the top cost-cutting measures they’re taking to get through the crisis include postponing planned investments, cutting travel and freezing recruitment.

U.S. Policy Response

• Federal Reserve Chairman Jerome Powell and Treasury Secretary Steven Mnuchin will appear by videoconference before the Senate Banking Committee on Tuesday to testify on how they are handling $500 billion in emergency lending programs.  The testimony could potentially include the announcement of new initiatives, or tweaks to the fiscal responses already put into place.

Foreign Policy Response

• German Chancellor Merkel and French President Macron proposed a new, €500-billion coronavirus recovery fund for the EU, boosting hopes for a coordinated European fiscal response to the pandemic.  The funds would be raised by the European Commission borrowing on capital markets — which to date has only been done on a relatively modest scale — and would be used to provide grants funneled through the EU budget rather than loans to national governments.  To be implemented, the plan would need to be approved by all 27 member states at an upcoming EU summit.
  • The plan would move the EU farther toward common debt obligations than it has ever gone before, but it still falls short of the massive grant program funded by joint “coronabonds” that some hard-hit countries in the south have demanded.
  • At the same time, the plan has already met resistance by some creditor nations north of the EU – including the Netherlands, Denmark and Sweden – who oppose any mutualization of debt and any reliance on grants instead of loans.
  • Despite the plan’s uncertain future, it should be a positive for European stocks and bonds.  Indeed, bonds issued by hard-hit, highly indebted countries such as Italy and Spain are rallying on the news so far today.

Political Impact

• U.S.-China tensions continue to worsen against the backdrop of the coronavirus crisis, highlighting the risk of renewed trade disruptions, political tensions, and further deglobalization like we’ve described many times in the past.
  • At the WHO’s online annual meeting yesterday, more than 100 countries, including China, agreed to support an independent inquiry into the source of the pandemic and the early response to it.  However, the resolution was far short of the intense scrutiny on China demanded by the Trump administration, as it omitted any reference to China and allowed for the inquiry to come only after the pandemic has been brought under control.
  • Responding to the U.S. demand for a China-focused inquiry and its threat to leave the WHO unless the organization shows it is independent of China, the Chinese foreign ministry accused the Trump administration of a “smear” campaign designed to shift blame for its own handling of the crisis.  In an effort to bolster its image, China also announced it would contribute an additional $1 billion to the WHO to support its work.
  • All the same, many U.S. firms continue to ramp up their exposure to the Chinese market in spite of the risk of further U.S.-China “decoupling.”
• In Hungary, Prime Minister Orban is coming under fire for his response to the virus crisis.  A key issue is his government’s April requirement that hospitals free up 36,000 of their publicly funded beds for potential COVID-19 cases, forcing the early discharge of many gravely ill people.  Some of those people died, even as the total infections in Hungary has only reached about 3,500.

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

[Posted: 9:30 AM EDT]

Good morning and happy Monday!  Equity markets are on a tear this morning, and oil is also higher.  Reports that vaccine trials are going well are boosting stocks.  There wasn’t much news on China overnight, which probably accounts for some of the lift.  We update the COVID-19 news.  Here is what we are watching:

COVID-19: The number of reported cases is 4,730,968 with 315,488 deaths and 1,739,890 recoveries.  In the U.S., there are 1,417,889 confirmed cases with 89,564 deaths and 246,414 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.  It also has a chart showing global lockdowns.

The virus news:

• The good news:
  • We are seeing a global reopening of economies, although, as one would expect, some new clusters of infections are being reported. In the media, the reopening debate is often pitted as health vs. the economy.  However, this binary position lacks necessary nuance.  A recent paper on the Nordic response concludes that mandated shutdowns had less of an impact on the economy compared to the virus itself.  In other words, just because lockdowns are lifted doesn’t mean that recovery follows rapidly.  People remain selective on what activities they will engage in based on perceptions of risk.
  • Vaccine research continues at a rapid pace. A reliable vaccine is the fastest way the world will return to any semblance of normal.
  • Italy has reopened its borders and suspended quarantines for visitors.
• The bad news:
  • As we have been documenting for some time, the range of effects from COVID-19 infection varies widely. Large numbers appear to have either very mild cases or are completely asymptomatic.  Others are struck with a variety of maladies, including blood clotting, organ failure, etc.  Even months after recovery, some victims continue to report effects from the disease.
  • In the U.S., COVID-19 cases are now rising in rural areas as the crisis starts to dissipate in the urban centers. Unfortunately, the medical systems often lack resource depth and thus may have higher risk of fatalities.  A larger elderly population increases that risk.

The policy news:

• Chair Powell was on 60 Minutes last night and warned that the downturn could be quite lengthy. At the same time, he noted the central bank has unlimited financial firepower and could continue to respond to potential problems.
  • Although we don’t disagree that the Fed has virtually unlimited ability to create money, allocation is another matter. The Fed’s Main Street Lending Program continues to struggle to fill a gap in policy.
  • Late last week, the Fed warned that financial stress could return for banks. We have noted that the stress indices we monitor have been falling recently in response to Fed action.  However, financial stability suggests the Fed’s aggressive “dike plugging” exercise still may not be enough.
• Political haggling has the next round of stimulus on hold. Although more help is critical, it is also important that spending be targeted to supporting the recovery.
• Firms are returning Paycheck Protection Program funds, deeming the threat of audit is greater than the need for the funds. Although there have been some high-profile cases of misuse, there is a risk that the desire for accountability may end up reducing the effectiveness of the program.  The government is attempting to adjust the balance of stimulus and accountability by easing some of the restrictions.
• The creaky state unemployment claims bureaucracy has been overwhelmed by the sheer number of claimants. This conduit has become a serious problem in delivering aid to unemployed workers.
• Under current conditions, we expect a surge of bankruptcies. Unfortunately, the American bankruptcy court system, considered a model for the world, is too becoming stalled as the number of companies surge.  Firms are in limbo as courts fail to handle the rising caseloads.

The finance news:

• The credit union is a fixture of U.S. consumer finance. Created as an alternative to banks and finance companies, these entities are designed to serve a narrow audience, often employees working for a single firm or industry.  The COVID-19 recession has increased the risk of this business model for industries that have faced serious downturns.  By design, the customer scope of these financial firms is limited, so when an industry is especially hard hit the credit union that serves the employees is suddenly at risk.
• The dollar continues to rally but, for now, the White House appears OK with that. Part of this acquiescence to dollar strength could be that reversing it might be close to impossible.  Despite Fed efforts to ease pressure through swaps and other measures, many nations are still scrambling for greenback and thus demand remains elevated.  On the other hand, as the recovery gains strength, we could see the dollar ease later this year.

The economic news:

• As part of his aforementioned interview, Chair Powell warned that the economy may not recover until 2021. A bit of explanation is in order.  In business cycle parlance, the recovery phase begins when the economy stops falling; recovery lasts until the economy exceeds its previous peak, whereby the expansion phase begins.  Powell also warned that the unemployment rate could reach Depression-era levels of 25%.
• Automakers are reopening, but the restart will likely be halting as workers learn how to build cars while wearing protective gear. One major worry is that Mexican parts manufacturers remain on lockdown, which may delay parts shipments and slow the U.S. restart.
• Industries are trying to figure out what the post-COVID-19 world will look like. As we work from home and use video conferencing, it is quite possible that firms will shrink or eliminate home offices.  One of the issues facing the U.S. is that workers have been flocking to cities in recent years, reducing the population in suburban and rural areas.  However, if we can work from anywhere, maybe it might make sense for workers to return to the lower cost parts of the country, which would reverse the recent decades of social and economic problems plaguing rural areas.
• It’s no secret that airlines are struggling. But, as is often the case, some parts of the economy benefit.  Repossession firms for airplanes are seeing a surge in demand for their services.
• NASCAR is back.

The foreign news:

• Although the news about China was overall rather light compared to previous weekends, new restrictions on Huawei (002502, CNY 3.06) have raised fears on the viability of the company. At the same time, there is evidence the company is figuring out how to use fewer U.S. parts in its phones.
  • The EU wants to ensure that China won’t use the crisis to acquire European firms hurt by the recession.
• Brazil’s health minister resigned; this is the second resignation in a month.
• Nicaragua has generally shunned lockdown measures, most likely because its economy would be unable to cope with the economic ramifications. There is evidence the country is taking steps to undercount the COVID-19 death toll.

Brexit: Last week, we reported that trade talks between the EU and Britain were not going well.  It would appear the most logical outcome is an extension to give negotiators more time to develop a trade agreement.  However, PM Johnson has expressly ruled out asking for one.  This situation raises worries that a hard Brexit may be coming.  One possibility to avoid such an outcome would be a conditional extension, allowing both sides to continue talking without asking for a formal extension.  This is exactly the kind of “fudge” or “can-kicking” action that the EU does best.  The financial markets, especially the GBP, have been worried about a hard break, and the potential for a conditional extension reduces that likelihood.

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