Daily Comment (May 22, 2020)

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 policy news:

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:
    • 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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Daily Comment (May 21, 2020)

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:
  • 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.
  • 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 incentivesEconomic 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:

The economic news:

The foreign news:

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 proposalPositions 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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Weekly Energy Update (May 21, 2020)

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

Here is an updated crude oil price chart.  The oil market continues to show signs of recovery.

(Source: Barchart.com)

One interesting development has been in open interest.  Open interest is the number of open contracts in a futures market.  Most of the time, the highest open interest in the calendar of contracts is the nearby or the second nearby, when the first nearby is near expiration.  However, currently the contract with the highest open interest is for December delivery.  Investors are taking the stance that oil prices are likely to rise in the future due to the combination of improving economic growth and falling output.  However, as the debacle recently witnessed in the oil ETFs showed, the nearest contracts are subject to wild price swings due to the lack of storage.  Thus, it appears speculators and investors are moving to the longer-dated contracts to execute positions to avoid the problems inherent in the nearby contracts.  The drawback with this strategy is that, under conditions of contango, the deferred prices are higher than the nearby.  However, this disadvantage has narrowed recently.  As the chart below shows, the July/December spread fell to nearly -10.00 per barrel in late April; it has narrowed to under -2.00 per barrel recently.  Thus, the carrying cost of holding the deferred contract has become less onerous.

Crude oil inventories surprised the markets for the second straight week by falling 5.0 mb compared to the forecast rise of 2.0 mb.

In the details, U.S. crude oil production fell 0.1 mbpd to 11.5 mbpd.  Exports fell 0.3 mbpd, while imports fell 0.2 mbpd.  Refining activity rose 1.5%, in line with expectations.  As we saw last week, there was another jump in unaccounted-for crude oil.

Unaccounted-for crude oil is a balancing item in the weekly energy balance sheet.  To make the data balance, this line item is a plug figure; but that doesn’t mean it doesn’t matter.  This week’s number of -998 kbpd is the largest negative number on record.  It may mean that in the scramble for finding storage, some oil is being inventoried outside the survey system.  In other words, over the week, some 6.9 mb of crude oil went into storage somewhere, just not where it can be recorded.  Or, production is falling much faster than the DOE estimates are capturing so there aren’t any missing barrels; simply put, production is cratering.  We are leaning toward the first explanation, but if inventories don’t rise in the coming weeks the second theory would become more plausible.  The second factor is that the SPR rose 1.9 mb as some of the oil went into the strategic reserve.

(Sources: DOE, CIM)

The above chart shows the annual seasonal pattern for crude oil inventories.  This week’s data, with the caveats expressed in the discussion about the unaccounted-for crude oil, suggests the worst of the inventory accumulation is behind us.

Based on our oil inventory/price model, fair value is $30.89; using the euro/price model, fair value is $44.26.  The combined model, a broader analysis of the oil price, generates a fair value of $36.88.  As we noted recently, the model output is less relevant as there is a non-linearity tied to the loss of storage capacity that cannot be fully captured with these models.  At the same time, if storage remains available, the models would suggest further upside for oil prices.

Although consumption remains depressed, there are reports that driving is starting to recover as lockdown rules ease.  The gasoline supplied data on the chart below also continues to show improvement.  Some data tracking does suggest an upswing in driving activity.

The market news for the week was mixed.  As we noted above, demand does appear to be improving, but prices remain depressed and production will likely continue to fall.  The Dallas FRB has produced research suggesting the net effect of the oil bear market has been negative for the economy, a major reversal from past years, reflecting the growing importance of oil production to the overall economy.  Meanwhile, it is possible the U.S. will restrict Chinese oil firms from buying U.S. oil companies.  And, in a first, the U.S. is on track to generate more electricity from renewables compared to coal.

On the geopolitical front, we are seeing the U.S. and Iran ease tensions.  Washington appears to be ignoring Iran’s trading with Venezuela, for example.  We suspect Tehran does not want to trigger a conflict before the election, a move that might actually boost support for President Trump.  Saudi Arabia is trying to balance the goals of economic restructuring with the loss of revenue due to falling oil pricesArgentina has set a domestic price of $45 per barrel to protect domestic producers.

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Daily Comment (May 20, 2020)

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

Real Economy

Financial Markets

Political Impact

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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Daily Comment (May 19, 2020)

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

U.S. Policy Response

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

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Weekly Geopolitical Report – The Geopolitics of the 2020 Election: Part I (May 18, 2020)

by Bill O’Grady | PDF

(NB:  Due to the Memorial Day holiday, the next report will be published on June 1.)

In our geopolitical outlook for 2020,[1] our most important issue was the 2020 elections.  In general, U.S. presidential elections are geopolitical issues because of America’s hegemonic status.  In an era where the U.S. is changing its position on hegemony, who resides in the White House may be unusually important.  Therefore, foreign governments have an incentive to affect the outcome in November.

Due to the importance of this issue, we have written a five-part report, broken into nine sections.  The sections are as follows:

  1. The Basics of Public Finance: We look at the economics of public goods, the problem of free-riding and the role of the political process in allocation costs and benefits.
  2. Understanding the Electorate: We examine the intersection of identity and class, which create groups, and introduce the Zeihan Grid to graphically show how they interact.
  3. Party Coalitions: In a two-party system, parties are essentially coalitions of groups that change over time.
  4. The Incidence of Current Policy: We show how the policies designed to dampen inflation have acted to harm the lower income classes.
  5. The Role of Social Media: Media is always important to the political process and social media has changed how the parties act.
  6. Who will win? We handicap the race between President Trump and VP Biden (spoiler alert—we are leaning toward Biden due to the current recession).
  7. Foreign Behavior: This section examines the capabilities and leanings of major foreign nations with regard to swaying the election.
  8. The Base Cases: We consider the outcome based on who wins the election.
  9. Ramifications: We conclude with the likely market effects from the election.

Read the full report


[1] The 2020 Geopolitical Outlook, 12/16/19

Daily Comment (May 18, 2020)

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:

The finance news:

The economic news:

The foreign news:

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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Asset Allocation Weekly (May 15, 2020)

by Asset Allocation Committee

As the Federal Reserve expands its balance sheet and the federal deficit balloons, there is a legitimate concern about the potential for inflation.  In this week’s report, we will examine inflation from a theoretical perspective.

There are two simple tools we use to discuss inflation, the equation of exchange and the intersection of aggregate supply and demand.  To start, this is the equation of exchange:

MV=PQ

M is the money supply and V represents the speed at which it is spent; on the other side of the equation is P, the price level, and Q, output.  In the calculation of the variables, the right side of the equation is nominal GDP and M is one of the various formulations of the money supply.  However, the power of the equation, in our opinion, comes from what the variables represent.  For example, Q is best thought of as the productive capacity of the economy, the ability of an economy to procure goods and services.  It would include not just actual production, but also excess capacity.  And V isn’t just a residual; it can tell us the effectiveness of money policy.

The classical economists assumed that V and Q were fixed; V represented the institutional structure of money demand and thus only changed when spending and income patterns were adjusted.  Since prices were flexible, Q was always at full employment and thus didn’t change.  If these assumptions were true, any increase in M would lead to a proportional rise in P.  However, it turns out neither V nor Q were fixed; in some periods, increasing M led to higher price levels, but in others, it did not.

In the last episode of the Federal Reserve balance sheet expansion, velocity fell, leaving prices and quantity mostly unchanged.

This chart shows calculated velocity and the Fed’s balance sheet.  The gray shaded areas indicate periods of official QE.  Note that there is a strong inverse correlation between velocity and the balance sheet expansion, suggesting that households and businesses are not demanding the funds being provided to the banking system.  Thus, the inflationary impact of expansionary monetary policy has been reduced.  Given current risks in the economy and markets, we would expect the current balance sheet expansion to lead to a similar result in the short run—another decline in velocity.

The second tool is aggregate supply and aggregate demand.  Although neither of these can be calculated with any degree of confidence, we can use the tools for illustration.

The key point to this schematic lies in the supply curves, labeled S, S1 and S2.  The latter is what we believe is our current supply curve; demand has shifted from D to D1.  One of the consequences of COVID-19 is that we expect the trend toward deglobalization to accelerate, which would likely mean a shift in the supply curve from S2 to S1.  As deglobalization is eventually tied to reregulation of the economy, we will shift to S.  Of course, the key to rising prices will be the path of demand.  The longer it takes for demand to recover, the less likely it is that inflation will return with any significance.  However, when demand returns, we will likely see upward price pressures; if rising demand coincides with the eventual shift to the terminal supply curve S, the markets could be in for a notable inflation surprise.  We don’t expect this terminal shift to occur in the next three years, but it is highly likely in the latter half of the decade.

Tying this back to the equation of exchange, the supply curves above are represented by Q.  So, as supply becomes increasingly constrained, velocity will need to fall further in order for prices to remain steady as the money supply rises.  If inflation expectations change, it would be reasonable to expect velocity to increase, which would tend to lead to higher inflation.  The key points from this analysis are that (a) Fed policy actions, in isolation, are not necessarily inflationary, and (b) constraining supply, which is an element of deglobalization, could lead to higher price levels once demand recovers.

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