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

[Posted: 9:30 AM EDT] | PDF

Good morning.  After hitting another new high yesterday, S&P futures are consolidating this morning. There is a lot to get through today; the first revision to GDP is out and is covered below.  We lead off with Chair Powell speaking this morning at a “virtual” Jackson Hole symposium (which will stream to the public).  His speech will commence just about the time we finish our comments so we will offer a recap tomorrow, but it is widely expected the Fed will announce changes to its reaction function regarding inflation.  Next, an update on Hurricane Laura.  China news follows with general economic and market updates.  Foreign news is next, and we close today with a pandemic update.  It’s Thursday, so a new Weekly Energy Update is available.  Let’s get to it:

The Fed:  Since Volcker, one of the key features of monetary policy has been to suppress inflation expectations.  To do this, the Fed has signaled it would react to preemptively contain any rise in inflation.  Over the years, the Fed has become increasingly transparent in its policy, setting an explicit inflation target (2% yearly growth in the core PCE deflator), for example.  However, it is arguable the Fed has been too successful.  In the last business cycle, the core PCE deflator was above or equal to 2% only 10.6% of the time.  Inflation is a complicated variable;[1] the Fed may have much less impact on it than the conventional wisdom suggests.  Regardless, we expect Chair Powell to make a somewhat explicit announcement today that preemption is likely over, and the Fed will be content to allow inflation to run over the target.  The market wants an explicit statement of the reaction function. For example, the Fed will target the three-year average of inflation.  We doubt it will be this clear; after all, the Fed wants policy flexibility,  but it also wants to signal that rates will stay low for a long time. Therefore, we expect Powell to disappoint on clarity but reassure nonetheless.

• Although we don’t expect Powell to address this issue, there are growing concerns about how much the Fed is doing in the financial markets. Sebastian Mallaby, one of our favorite commentators,[2] recently wrote about the tensions from the Fed’s ever-widening mandate.  Greg Ip has written a piece this morning.  Much of the Fed’s recent policy moves come close to fiscal policy; as it does so, the bank is brushing ever closer to politization.  Although the Fed has been joined at the hip to the Treasury in the past (it fixed the yield curve rate during WWII), its recent forays into areas of the corporate and municipal bond markets along with direct lending mean it is making choices about who gets credit.  We are starting to research the central bank digital currency area (look for this in an upcoming WGR), which could put the central bank squarely in the political arena.  As long as inflation is low, such broadening will be acceptable. However, once the Fed is required to tighten policy, tensions will become difficult to contain.

Laura:  The hurricane reached category 4 status before making landfall overnight.  It has weakened to a category 2 storm, and its current path looks like most of the Houston area, home to much of the U.S. refining industry, won’t take a direct strike.  However, Louisiana, also with significant refining assets, is in the direct path.  It is not uncommon for gasoline prices to jump in the aftermath of major refinery disruptions, so drivers should expect a temporary rise in prices.  The other concern is the storm surge and Laura was expected to deliver a massive one; we will be watching in the coming hours for the extent of the damage.

China news:

• Both the U.S. and its allies, and China, are holding simultaneous military exercises. China accuses the U.S. of violating its airspace, saying a U-2 reconnaissance plane watched military drills in a no-fly zone.  Beijing accused the U.S. of “naked…provocation” by the overflights.  The U.S. position is that the overflights did not violate China’s airspace but were in international airspace. China launched two missiles designed to attack aircraft carriers, the DF-26B and the DF-21D, as part of its exercises.  What is notable in China’s drills is that the PLA operated simultaneously in four different sea regions, testing its ability to operate on multiple fronts.
  • There are growing fears that the constant tensions may lead to an accidental escalation in military activity. Taiwan is especially concerned because it would likely be in the “firing line” of any kinetic war.
• The U.S. has unveiled a new set of sanctions on Chinese firms directly involved in the construction projects in the South China Sea. China has for years been building military installations on small outcroppings in this area; the U.S. treats these geographical features as mere rocks in the ocean and thus cannot be claimed as islands.  China considers them as part of its territory.  The difference matters. If China is right, the U.S. freedom of navigation operations are violations of its territory. If the U.S. is right, China can’t claim those rocks.  The move to sanction firms involved is yet another escalation of tensions.   If you are interested, here is a file of all foreign firms on which the U.S. has applied sanctions, the entity list.
• China’s foreign minister, Wang Yi, is on a mission to Europe to try to improve relations that have become frayed with Beijing’s treatment of Hong Kong and other issues. He is visiting Italy, the Netherlands, Norway, France and Germany.  One important goal is to try to support Huawei (002502, CNY 3.01) in Europe’s 5G buildout.  Wang’s trip has studiously avoided SoS Pompeo’s overseas visits.  Although the EU would prefer to have the flexibility to use Chinese technology, U.S. pressure will be considerable and difficult to overcome.  Meanwhile, the U.S. is considering accusing Beijing of genocide over its treatment of the Uighurs.
• In public statements, the U.S. and China remain committed to the Phase One trade deal. This agreement is about the only thread remaining where there is some degree of cooperation.  In nearly every other area, relations have turned sour.
• The U.S. has moved to force Chinese firms that list in the U.S. to follow American accounting rules. Chinese companies have tended to resist such measures and U.S. exchanges, wanting to get the listing, have not forced the issue.  That has changed; China wants to talk about it and indicates it is willing to make concessions.
• The CEO of TikTok has resigned.
• Chinese firms have been dual listing in Hong Kong and on the mainland. In an indication of the immaturity of China’s financial markets, prices for the same company on the STAR board have been much stronger than in Hong Kong.
• Xi Jinping carries two titles. He is the president of the state of China and the general secretary of the CPC.  He is rumored to be angling for the name “chairman” to be added.  If he does take that title, it will be the first time since Mao that a Chinese leader will be known as chairman.  Although symbolic, he would probably seek the title to set the stage for remaining in power beyond his informal two-term limit.

Economics and Markets:

• The OECD has detailed the depth of the pandemic downturn, confirming the decline is the worst in six decades for this club of nations.
• One of the bright spots for the U.S. economy has been the robust rebound in housing. Perhaps the most important development to this lift is that it is being driven by millennials.  This generation currently represents over 50% of new mortgages.  We have been waiting for some time for this generation to follow the path of earlier ones, leaving urban areas for the suburbs to start families and buy homes.  It looks like it is underway.
  • One of the interesting facets of this boom is that there appears to be a bias to larger homes. That might be driven by the pandemic.  At the same time, the price of smaller homes is increasing faster than larger ones.
• We are not sure how this will play out (we fear badly); the SEC has relaxed standards for investors to access private equity and hedge funds. The SEC has decided to give businesses more flexibility in disclosing risks as part of this change.
• The NYSE has approved alternatives to traditional IPOs.
• One of the more interesting developments is that households appear to be taking some of the stimulus to pay down debt. If this continues, it suggests that policymakers could resolve the private sector debt overhang with fiscal spending.

Foreign news:

• U.S. soldiers were injured after their vehicle collided with a Russian vehicle. Although both sides do appear to be trying to deescalate, the event bears watching.
• North Korean hackers are apparently trying to rob banks. Be careful with emails.  North Korea, who has already been hit by flooding, is bracing for Typhoon Bavi.
• Germany has been a model of fiscal restraint; however, during the pandemic, it has moved aggressively to lift spending, which could help the EU economy recover.
• Phil Hogan resigned from the European Commission. He was trade minister but got mired in a golf event that violated Ireland’s COVID-19 protocols.  There is a scramble for his replacement.
• Sweden has boosted its defenses as Russia conducts extensive military exercises in the Baltic Sea. Stockholm claims Russia’s war games are the largest since the end of the Cold War.

COVID-19:  The number of reported cases is 24,203,260 with 826,418 deaths and 15,825,921 recoveries.  In the U.S., there are 5,823,923 confirmed cases with 179,743 deaths and 2,523,771 recoveries.  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 weekly Axios map by state shows a definite improvement as the pace of infections decline.

Virology: 

• Abbott (ABT, 103.19) has unveiled a $5 rapid test that will generate results in about 15 minutes. The test has been given emergency approval by the FDA and, if it works reasonably well, would allow for schools and other entities to rapidly test groups on a regular basis.
• South Korea has been given high marks for its management of the virus. However, it is seeing a surge in new cases and is debating how to best manage the new outbreak.  The incumbent government is resisting extensive lockdowns, concerned about the impact on the economy; the opposition wants stricter measures.  Schools are reporting closures.
• Moderna (MRNA, 70.50) is reporting that its vaccine triggered an immune response in older adults comparable to those seen in younger test subjects.

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[1] After years of studying it, we have concluded that the most unappreciated part of inflation is expectations, followed by income distribution.  Under conditions of low inflation expectations and high levels of income inequality, inflation tends to remain low.

[2] His biography of Allan Greenspan is a must read.