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

[Posted: 9:30 AM EDT] | PDF

Good morning.  U.S. equity futures are mostly steady this morning.  Financial markets are broadly steady, consistent with late summer trading.  Our coverage kicks off with news from China followed by the international roundup.  Economics and policy follow, and we close with our usual pandemic update.

China: U.S./China relations are taking on Cold War characteristics and Lithuania has Beijing upset.

• One of the features of the Cold War was how the U.S. and U.S.S.R. used various tactics to steer nations into their respective camps. The Soviets used force (Eastern Europe) and supplied critical exports (Cuba) or military equipment (Egypt, India).  The U.S. provided security at low cost (Japan, Europe, Canada), market access (South and Central America), shared intelligence (U.K., Australia, New Zealand, Canada), and military aid (Southeast Asia).  After the Cold War ended, much of the U.S. assistance remained, although the domestic political support has waned over the years.  As relations between the U.S. and China devolve into a cold war, both nations are offering carrots and sticks to build alliances.  Although the U.S. has officially indicated that it won’t force nations to choose, recent actions suggest otherwise.  In Brazil, the U.S. is pushing the country to abandon Huawei (002502, CNY, 5.17) telecommunications equipment.  Brazil is a longtime user of China’s technology and getting it to give up on Huawei will be difficult.  According to reports, Jake Sullivan offered NATO membership if Huawei is forced out of Brazil.  Brazil is deeply reliant on China so prying the country away from Beijing will be difficult.
• Lithuania has become a problem for Beijing. The Baltic nation has allowed Taiwan to open an office in the country under its own name, which smacks of statehood, something China opposes.  China has recalled its ambassador to Lithuania in protest.  As expected, state media is making all sorts of threats against Lithuania, including severing diplomatic relations, but there are limits to Beijing’s actions.  Lithuania is a small country, but it is a member of the EU and if China pushes aggressively, it could trigger a broader European reaction.
• Evergrande (EGRNF, USD, 0.80), the troubled Chinese property developer, confirmed it is in talks to sell assets in a bid to improve its financial situation. China’s growth since the Great Financial Crisis has been debt-fueled and trying to bring debt growth under control will almost certainly lead to lower growth.
• Michael Spavor, a Canadian citizen, has been sentenced to 11 years in prison on spying charges. It is improbable that Spavor is a spy (although that doesn’t mean Canadian intelligence doesn’t talk to him); instead, he is being used as leverage in the extradition case of Ming Wanzhou, the CFO of Huawei whom the U.S. accuses of violating Iranian sanctions.  The U.S. has protested the sentencing, but we doubt this will have much of an effect.
• General Secretary Xi has been steadily reversing the policies of Deng. The latter opened the economy and, to some extent, opened the country socially as well.  As Xi has consolidated power, behavior control has become part of his policy.  The latest area seeing a crackdown is post-work bar tours and “harmful karaoke.”
• There are reports that China is using subsidiaries controlled by the Xinjiang Production and Construction Corps to export goods produced in the region that may involve detained labor.
• Another element of Xi’s policies is the favoring of state-owned enterprises. This bias is undercutting small enterprises, which were important to the Chinese economy during the Deng years.  According to reports, small businesses are closing, putting pressure on the economy.
• Although data for female participation isn’t calculated in China, anecdotal reports suggest women are increasingly working in construction as male workers become less available.
• China has built two aircraft carriers and is working on a third. Interestingly enough, analysts are not all that concerned as there is a growing consensus that these vessels are becoming vulnerable to countermeasures.  Thus, it begs the question as to why China is building these, especially when it has developed missiles dubbed as “carrier killers.”
• The Belt and Road project is facing rising criticism over human rights abuses. On a related note, Beijing is increasing its investments in Myanmar.

 International roundup: North Korea won’t be ignored and details on the activities of Russian mercenaries comes to light.

• In our “2021 Geopolitical Outlook,” we warned that Pyongyang would likely test the new administration at some point. It looks like we may be coming to that point.  The U.S. and South Korean military exercises are scheduled for next week.  These regular actions tend to upset the Kim regime and the pattern apparently persists.  Kim Jong Un’s sister, Kim Yo Jong, is warning that the Hermit Kingdom will be increasing its military activity in light of these games, including boosting its nuclear arsenal.  North Korea is apparently also refusing to answer the hotline with South Korea in response to the exercises.  We doubt much else occurs from this incident, but it bears watching.
• The Wagner group is a Russian organization that provides mercenaries who have been active in Eastern Ukraine and Africa. The group allows Russia to have influence with a degree of plausible deniability.  It appears the group has been active in the Libyan conflict.  The BBC acquired a table from a Wagner operative which details its operations in Libya.  Some of the actions, which apparently include the deliberate killing of prisoners, would fall into the category of war crimes.
• Russia is positioning its new military aircraft, the “Checkmate,” as an alternative to the F-35.
• The Taliban continues to roll up gains in Afghanistan. Nine provincial capitals are either under Taliban control or are being contested.  Yesterday, Afghan government forces surrendered a base near Kunduz in northern Afghanistan.  Although the Taliban appears poised to take control of the country, maintaining that control will be problematic.  The most likely outcome is that a civil conflict will develop following the U.S. withdrawal.
• With German elections about six weeks away, the SDP member, Finance Minister Scholz, is seeing his party’s polling improve. The SDP has been part of a couple “grand coalitions” with the CDU/CSU and the SDP has faded from relevance.  Scholz is personally the most popular candidate for chancellor but is polling much better than his party.  Unfortunately, Germany has a parliamentary system so the only way Scholz can take power is if his party can dominate a coalition, which isn’t likely.  Meanwhile, the CDU/CSU candidate, Armin Laschet, is languishing in the polls; his personal support numbers are in single digits.  It is becoming evident that forming a government after the election will be difficult and it currently looks impossible to build a government without Green Party participation.
• Lithuania is also on the frontlines of the Belarus situation. As we noted in earlier reports, Belarus has taken a page from Turkey’s playbook, allowing Middle Eastern refugees to come to the country to traverse into the EU via Lithuania.  The Baltic state is getting border aid from the EU in response.
• Wildfires have been devastating parts of Greece over the past couple of weeks. Algeria is reporting wildfires as well.

Economics and policy:  Policy tightening beckons and tax revenues rise.

• The evidence that the FOMC is going to start withdrawing stimulus soon is becoming overwhelming. San Francisco FRB President Daly, whom we rank as a dove, has now indicated that some stimulus could be withdrawn this year.  While we don’t think Chair Powell is in favor of removing any stimulus in the near term, of this year’s voting members on the FOMC, three of the four rotating members (Barkin, Bostic, Daly) are on record calling for tightening, joining Governor Waller.  Although four dissents would not be enough to force a policy change, this level of dissent isn’t all that common.  The last time we had four dissents was in October 1992.  Since the Fed gained independence, there have been 21 dissents of four or more, or about 2.8% of the time.  We suspect Powell will try hard to avoid removing stimulus until he is reconfirmed as Fed chair, which means that he will try to hold off tightening until early next year.
• Yesterday, the Senate held its amendment session for the upcoming budget. For the most part, this session is all about making the other party look bad.  But the key takeaway is that the Democrats are going to try to push through their budget on a party-line vote.  Getting $3.5 billion in new spending along with a debt ceiling increase looks unlikely.
• As the economy recovers, tax revenue is increasing and that has led the fiscal deficit to narrow by $2.5 trillion. Tax revenue rose 18% to $3.3 trillion over the first 10 months of the fiscal year.
• One observation from the infrastructure bill is that the crypto industry was unprepared to be targeted as a revenue source. However, they did move quickly to respond.  Although their efforts failed, we doubt they will fail the next time.  At the same time, the move by regulators to bring crypto into the “fold” of financial products will tend to increase its usage.
  • On a related note, non-fungible tokens have become another tool for money laundering.
  • BitMEX paid fines and agreed to not allow American citizens to use its platform for trading cryptocurrencies.
  • Hackers took more than $600 million from a Poly Network, a distributed finance facility. The network asked for the “money” back and hackers returned about a third of it.
• Home demand remains robust and builders are slowing down accepting contracts to try to boost housing inventory. This activity is lifting home prices further.

COVID-19: The number of reported cases is 204,917,702 with 4,327,872 fatalities.  In the U.S., there are 36,193,574 confirmed cases with 618,496 deaths.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high frequency data on various factors.  The CDC reports that 409,566,315 doses of the vaccine have been distributed with 353,205,544 doses injected.  The number receiving at least one dose is 196,077,952, while the number receiving second doses, which would grant the highest level of immunity, is 167,105,507.  The FT has a page on global vaccine distribution.

• Texas hospitals are nearing capacity and are delaying elective surgeries to ensure enough beds for COVID-19 patients. Doing so will reduce hospital earnings.
• One overlooked element of the pandemic is that there is some degree of immunity that comes from surviving the virus. This means we may be closer to herd immunity than the vaccination data would suggest.  Unfortunately, neither vaccines nor infection give sterilizing immunity, meaning that new variants and weakening immunity over time can lead to reinfection.  This condition isn’t unique to coronaviruses.  Influenza is similar.   That means periodic booster shots will likely be necessary.
  • The FDA is expected to authorize a third dose to immunosuppressed individuals.
• China has partially closed the Ningbo-Zhoushan port due to COVID-19 infections.
• The IEA confirmed that the delta variant has adversely affected crude oil demand. Oil prices are off their highs due to the upswing in infections.
  • Southwest Airlines (LUV, USD, 51.84) reports that bookings have slowed and cancellations increased due to the rise in infections.
• An increasing number of firms are mandating vaccinations. Mandates have been problematic as long as the FDA’s approval of the vaccines is for emergency use.  But once vaccines get regular approval, mandates will likely expand.  The rise in the delta variant is also disrupting office reopenings.
• U.S. intelligence agencies have drafted their report on the origins of COVID-19.  Although the report is confidential, sources suggest it won’t definitively determine the origin as being either from a lab or from natural causes.

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