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

[Posted: 9:30 AM EDT] | PDF

Good morning and happy Monday!  It’s the first trading day of August (a time of the year often unfriendly to equities), and U.S. equity futures are pointing to a higher open.  Our coverage begins with an incident off the coast of Oman.  Economics and policy are up next.  China news and the international roundup follow, and we conclude with pandemic coverage.

Drone attack:  Over the weekend, an oil tanker, the MV Mercer Street, was attacked by drones and killed two people, a Briton and a Romanian.  Zodiac Maritime, an Israeli company, manages the vessel; it is owned by Taihei Kaiun (1968, JPY, 2723).  According to reports, the drones, which apparently carried explosive charges, crashed into the ship’s bridge, killing two crew members.  The U.S., U.K., and Israel have blamed Iran for the attack.  Tehran denies its involvement.  This attack has been part of a series of strikes between Iran and Israel.  We noted in June that Iran’s largest warship, the Kharg, caught fire and sank under suspicious circumstances.  Market reaction has been mostly non-existent.  Oil prices are lower this morning on pandemic concerns.  However, an attack on oil shipping in the region around the Strait of Hormuz does raise the potential for a supply disruption.

Economics and policy:  The infrastructure bill is now printed, real estate is in the news, and there is a potential strike in Chile.

• The bipartisan infrastructure bill is now available, all 2,702 pages. Although we are going to have a period to discuss amendments, we don’t expect major changes to occur.  All signs suggest it will pass the Senate.  However, this deal isn’t done yet; the House leadership wants the Senate to pass a larger infrastructure package via reconciliation before the House takes up this bipartisan measure.  If that requirement remains in place, none of this may get passed.  What is our expectation?  The Senate will pass a smaller additional measure, around $1.5 trillion to $2.0 trillion, and force the House to either get nothing or settle for less.  Our bet is that, after much anguish, the smaller measure along with the bipartisan one will make it through the House.
• Real estate markets have been roiled by the pandemic. We see a global jump in home prices, raising fears of a repeat of 2008.  We believe these fears are overblown; credit standards have held up remarkably well in this cycle.  Calls to raise interest rates to cool the housing market look to us to be misguided.  This isn’t a demand problem but a supply problem.  We need to build more homes and apartments.  While the housing boom is going on, the eviction moratorium appears to have expired, which may soon lead to mass evictions.  It is unclear how this will all work.  Landlords rightly are unhappy with months of unpaid rent and want paying tenants, but if thousands are turned out, it could lead to a situation where rentals are empty because the newly evicted can’t afford to rent out the property.  And, it isn’t just renters; mortgage delinquencies rose during the pandemic, and foreclosures could come next.  There may be enough buyers to purchase foreclosed homes, but you still have the problem of the newly homeless.  The sad part is that Congress has provided massive funding to smooth out the problem; state and local governments have failed to administer the funding.  The area most affected appears to be the South.
• The global supply chain remains under stress. There are a number of crosscurrents.  At the onset of the pandemic, firms prepared themselves for a long and deep recession.  They cut orders and reduced inventory.  Unfortunately, they were half right; it was deep but the shortest on record.  Demand roared back into lean inventories and canceled orders.  Exacerbating the problem was a rise in goods demand relative to services demand, a legacy of the lockdowns.  We are still months from seeing supplies normalize.
  • One item we are watching is whether we end up with inventory instability. Until the 1980s, inventory recessions were rather common.  Technology has completely changed inventory management.  Before the 1980s, firms would overestimate demand and end up with excessive inventory.  It would lead to layoffs as the inventory was sold off.  With modern inventory technology, the supply chain typically knows where everything is.  That has allowed inventory levels to decline overall as sales and stockpiles are closely matched.  Until now.  We are hearing anecdotal reports of double and triple ordering to ensure that products will be available.  It is quite possible that all this “stuff” will show up at once, and firms will find they have an overstock problem.  Such a situation will scramble economic projections.  We doubt anyone’s economic models have inventory reactions from 60 years ago built into them.
  • Complicating matters further is the administration’s regulation policy toward logistics. Ocean shipping and rail have become concentrated over the past 20 years (unlike trucking, which is remarkably competitive), and the administration is looking to open competition in these areas.  Not a bad idea but doing it at this moment may be difficult.
• Chipmaking facilities report gas contamination may affect semiconductor production.
• Workers at Chile’s La Escondida copper mine voted to strike. If a work stoppage occurs, it could constrain already tight supplies for this metal.
• China became dominant in solar panel production, mostly due to lax environmental standards and the willingness to forgo profit for market share. As a result, Chinese solar panels dominated supply.  In response, in 2018, the U.S. implemented an 18% tariff on the product.  That tariff is scheduled to end next year; U.S. firms are lobbying for an extension.  The extension puts the administration in a bind.  The environmental policy supports the expanded use of solar energy, and one factor in adoption is low cost.  Yet, protecting domestic suppliers is a goal as well.
• As entry-level wages rise, established workers are finding their pay relative to new hires has declined. This development is creating problems for employers and may encourage established workers to seek new jobs.
• We continue to monitor news about Chair Powell’s reappointment. He is facing criticism regarding regulatory policy.  Although we expect him to be reappointed, it may mean a populist will get the role of Vice-Chair for regulation.  That position is currently held by Randal Quarles.  His term in this role ends in October.
• An anti-dumping measure in the fertilizer market may lead to higher prices.
• Germany’s pork industry is facing a threat from African Swine Virus. The bug is being found in wild boars, and the fear is that these boars will spread it into farms.
• How do you feel about flying without a pilot? Airlines are considering pilotless aircraft for short flights.

China:  We continue to monitor China’s regulatory policy.

• For the past few weeks, Chinese regulators have taken aim at several industries in China, including for-profit tutoring, e-commerce, and social media. Although this crackdown continues, it is worth noting that it isn’t just Beijing involved in this effort.  The U.S. is pressing Chinese firms looking to list in the U.S. to provide additional risk disclosures.  And Chinese regulators are expanding their oversight of foreign listings as well.
  • We view China’s actions so far as part of industrial policy. We note that hardware firms have not faced any sanction thus far.  The U.S. restrictions on technology goods exports are spurring an expansion in hardware production and investment.  However, China’s behavior does highlight that, for investors, another consideration is a company’s position in terms of China’s industrial policy.  In other words, there may be more firms subject to increased scrutiny.
  • The crackdown on the tutoring industry is being seen as a way to level the playing field in terms of education. After all, a meritocracy that “loads the dice” for the better connected is bound to create social unrest.  However, there are reports that some parents worry that without the tutoring, their children will be at a disadvantage.  It remains to be seen how this plays out, but one way to reduce the pressure for education is to reduce the stakes of not getting it.  So, if the lot of the normal person improves relative to the upper class, the drive to enter the upper ranks is less interesting.
• Japan’s defense minister renewed his linking of Taiwan’s security to Japan’s safety.
• The Biden administration has taken notice of China’s treatment of foreign journalists. Last week, we noted that foreign reporters who were covering recent flooding were harassed.  Apparently, the harassment was encouraged by the Communist Youth League, meaning the CPC essentially endorsed the action.
• Earlier this summer, we reported on problems at the Taishan Nuclear Power Plant in Guangdong province. Chinese authorities claimed there were no problems despite evidence of higher radiation readings.  Last week, the plant was closed for maintenance, raising the possibility of additional problems.
• Amazon (AMZN, USD, 3355.50) has removed a number of Chinese firms from its platform, ostensibly over fake reviews. However, the firms believe the action is coming from orders from Washington.
• We reported earlier this summer that Beijing has been removing LGBT groups from social media. Although an official crackdown against these groups isn’t evident, the restrictions on social media suggest one might be coming.  The German consulate in Guangzhou posted a note about an LGBTQ film festival.  Beijing has banned the consulate from social media for doing so.  We have not seen the U.S. respond to this issue, but the rising number of them will likely spark a reaction at some point.
• Facebook (FB, USD, 356.30) is banned in China. That doesn’t stop the company from earning advertising dollars in China.  Interestingly, Chinese state media outlets have four of the top 25 spots in most liked accounts.
• There are reports that China is encouraging ethnic Tibetans to move to cities; by doing so, the countryside becomes depopulated. This includes the border regions, making them less secure.  In response, Beijing is encouraging the dominant Han ethnic group and other loyalists to move to the frontier regions.
• China has suspended fertilizer exports to ensure ample supplies for China’s farmers. Cutting off these exports will hurt Pakistan and India.

International roundup:  The Philippines renews military relations with the U.S.

• Since coming to power in 2016, President Duterte has had a difficult relationship with the U.S.; he once slurred President Obama after American criticism of Duterte’s drug enforcement activities. Duterte has threatened, over the years, to severe America’s long-standing security relationship with the Philippines.  However, recently, China has been aggressively encroaching on the Philippines.  For China, getting effective control of this island nation would allow it to break out of the first island chain that envelops China.  Last week, Duterte moved to resume security relations with the U.S., likely because he sees the threat from China.
• During the Syrian crisis, Turkey effectively weaponized refugees from the war. After causing a refugee crisis in Europe, Chancellor Merkel worked out an arrangement with President Erdogan.  The EU paid Turkey money, and Turkey kept the refugees out of Europe.  On occasion, when Turkey isn’t happy with Europe, the refugee flow resumes.  It appears that Belarus is taking a page out of Turkey’s playbook.
• Myanmar’s military intends to remain in power into 2023.

COVID-19:  The number of reported cases is 198,425,839 with 4,227,258 fatalities.  In the U.S., there are 35,004,592 confirmed cases with 613,228 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 400,674,525 doses of the vaccine have been distributed, with 346,456,669 doses injected.  The number receiving at least one dose is 191,498,983, while the number of second doses, which would grant the highest level of immunity, is 164,757,423.  The FT has a page on global vaccine distribution.

• Over the weekend, information emerged that the Delta variant spreads much more easily than earlier variants, may be more lethal, and could be spread by the vaccinated. The reports highlight a problem that has been in place during this pandemic.  The media reports on what is incomplete scientific information.  Science is an inductive process; as new information emerges, viewpoints change.  However, the public messaging becomes garbled.  Part of the scientific process is to question and review findings and what was thought to be true once changes over time.  The best we can determine is that the Delta variant does spread more easily.  It’s probably too soon to know if it’s worse than earlier variants.  It does not appear that lockdowns are returning, so we expect medical systems will remain under pressure for a while longer.
• France is seeing massive protests against its new vaccine passport policy. As France opts for sticks, Germany is trying “carrots” or specifically, bratwurst.  That’s right, get a shot, get a brat.
• China is dealing with a large outbreak of the Delta variant. Beijing has mostly used social measures to control the virus and lags on the vaccination front.  The Delta variant, which is more contagious, is leading to renewed lockdowns.

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