The business cycle has a major impact on financial markets; recessions usually accompany bear markets in equities. The intention of this report is to keep our readers apprised of the potential for recession, updated on a monthly basis. Although it isn’t the final word on our views about recession, it is part of our process in signaling the potential for a downturn.
In April, the diffusion index fell into recession territory for the first time since the financial crisis. Last month, the nationwide shutdown led to the sharpest decline in employment payrolls in the country’s history, while initial claims remain elevated at all-time highs. The financial markets showed some signs of revival as equities rallied the most in history in a month and bond prices rose due to heightened demand for U.S. Treasuries as investors flocked to safety while lockdown orders remained in place globally. Additionally, manufacturing production in certain industries has continued, in spite of the shutdown, to address supply shortages. However, the pandemic continued to weigh heavily on both investor and consumer confidence as there are growing concerns that the impact could continue even after the economy reopens. As a result, seven out of the 11 indicators are in contraction territory. The reading for April fell to +0.030 from +0.393 the previous month, below the recession signal of +0.250.
The chart above shows the Confluence Diffusion Index. It uses a three-month moving average of 11 leading indicators to track the state of the business cycle. The red line signals when the business cycle is headed toward a contraction, while the blue line signals when the business cycle is headed toward a recovery. On average, the diffusion index is currently providing about six months of lead time for a contraction and five months of lead time for a recovery. Continue reading for a more in-depth understanding of how the indicators are performing and refer to our Glossary of Charts at the back of this report for a description of each chart and what it measures. A chart title listed in red indicates that indicator is signaling recession.
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.
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.
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.
China is drafting a new five-year plan, the 14th 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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Beginning in the late 1990s and becoming an even bigger issue after Dodd-Frank regulations were imposed following the Great Recession, many market participants worried that bond market liquidity would be absent in the face of a crisis. Strict regulations discouraged banks and brokerage firms from holding large inventories of corporate bonds, thereby precluding them from their former role as willing buyers in the face of a wave of selling by investors. Compounding the concerns were the sheer size of flows into traditional open-end and ETF bond portfolios. Over the 10-year period from 2009 through 2019, a total of $2.7 trillion flowed into these instruments, almost a third of which were in ETFs. Entering the fray was the popularity of risk parity funds that levered their bond holdings. Though each risk parity scheme has a nuanced approach, they all act in a similar fashion. The concerns were that when risk parity funds and individual investors rushed to exit their bond holdings, market liquidity would be absent, particularly for corporate bonds. Numerous studies and articles appeared over this time frame warning of dire consequences for bond investors, notably violent price movements due to the fact that banks and brokerage firms were no longer participating to a significant degree to assist in maintaining order to the bond market.
In March, the veracity of these concerns was tested as the bond market worked its way through the financial stress triggered by the pandemic. During this episode, ETFs proved their endurance by moving into the void and providing the necessary stabilization of the market. The use of creation/redemption units on the part of Authorized Purchasers [APs] mitigated the severity of the downturn, especially among investment-grade corporate bonds. As the accompanying chart illustrates, spreads for BBB/Baa-rated corporates relative to the 10-Year Treasury gapped to their widest level since the Great Financial Crisis, yet quickly repaired.
An examination by Blackrock of the trading during this critical period in its largest corporate bond ETF, the iShares iBoxx Investment Grade Bond ETF [LQD], provides evidence that not only did the activities of the APs aid in maintaining market liquidity, but the market price of LQD actually led the price discovery process. In other words, rather than the market price exacerbating the premium/discount to net asset value [NAV], the market price was the precursor of the daily NAV print. Moreover, the direction of the market price of LQD often preceded the direction of LQD’s indicative value [IV], which is the real-time estimate of its fair value, based on the most recent prices of its underlying bonds. Since LQD’s 2,169 underlying bonds trade over the counter, and therefore many may contain stale pricing, the price discovery proved invaluable to market functioning. After the dust settled, it was evident that LQD and other bond ETFs provided market pricing that was at least as good as, and oftentimes better than, individual bonds.
As of 4/8/2020. (Sources: BlackRock, Bloomberg and Refinitiv)
Although the market function provided by LQD during the period is not necessarily indicative of every bond ETF in each bond sector, it does underscore the notion that ETFs can provide the necessary liquidity during a period of crisis. The creation/redemption mechanism of ETFs allow for arbitrage opportunities and allow the supply/demand of the ETFs to achieve equilibrium with the value of the underlying bonds. In essence, ETFs are now creating most (if not more) of the liquidity previously provided by banks and brokerage firms, often doing so with greater efficiency.
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 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.
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.
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.
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 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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Additionally, our latest podcast episode, “The Lessons of History,” is available, which examines the economic, market and social effects of earlier pandemics.
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.
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.
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.
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.
We use cookies to ensure that we give you the best experience on our website. If you continue to use this site we will assume that you are happy with it.
