Daily Comment (December 18, 2020)

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

[Posted: 9:30 AM EDT] | PDF

Good morning and happy Friday!  Although Congress remains in session and Brexit could interfere with the MP’s Christmas, the rest of the world is winding down for the holidays.  U.S. equity futures are mostly steady this morning.  One thing to watch—Tesla (TSLA, USD, 655.90) joins the S&P 500 Index today.  It is the largest firm by market value to be added to the index, so we could see some distortions.  Adding to the “excitement” is that it’s a quadruple witching day, meaning stock index futures, options on those futures, regular stock options, and single stock futures all expire today.

We begin our coverage with the Russian hack; we don’t know much yet, but it looks widespread. We take a quick look at the Bank of Japan’s monetary policy.  Policy and economics follow.  China news is next; a battle between populists and the establishment regarding China policy is brewing.  Pandemic news follows, and then an update on the EU and Brexit.  Being Friday, the Asset Allocation Weekly, the last of 2020, is available, along with the associated podcast and chart book.  As a reminder, starting in January, in a bid to shorten this report, we will no longer publish the AAW at the bottom of the Daily.  It will be available only as a stand-alone report but linked within the Daily CommentAnd, the Daily Comment will go on holiday hiatus starting Dec. 23 and return on Jan. 4.  Here are the details:

 The Hack:  We are still in the early stages of this event, but it is shaping up to be significant.  First, as we learn more, it is becoming clear this was a very sophisticated attack.  Currently, it looks like at least 18 thousand companies and government agencies have been compromised, including Homeland Security and the Pentagon.  Although SolarWinds (SWI, USD, 17.60) was a key path to inserting malicious software, it wasn’t the only tactic deployed.  Second, researchers are expressing surprise at the degree of effort involved.  The attackers focused on U.S. technology, which avoids the red flag of foreign origin.  They didn’t reuse code, which is also a way that cyber analysts detect breaches.  Third, there is a potentially great risk to infrastructure.  At this point, we don’t know if the goal was merely to gather information or to disrupt operations.  It may take years to discover the full depth of this intrusion.

The term “act of war” is starting to show up in the media.  Although we don’t use this term loosely, this event has the characteristics of state conflict.  We have been thinking about the entire notion of war for some time.  Clausewitz postulated that the point of war was to convince an opponent’s civilian population that resistance is futile; cooperating with the aims of the victorious foreign power is the only alternative.  Although militaries still matter, propaganda and cyberwar can directly affect the civilian population and may be an alternative to direct military conflict.  For example, if a foreign power can control news flow or critical infrastructure, e.g., electricity, water, etc., the need to wage a military conflict may lessen.  Given the U.S. dominance in military affairs, focusing on direct non-military intervention on civilians seems reasonable.  The trick for a country being attacked is the response.  The U.S. has ample cyber capabilities.  We will be watching for retaliation.  Where this situation leads remains unknown.

The BOJ:  Meetings of Japan’s central bank tend to be interesting because the country has been something of a harbinger of where the rest of the world has moved.  Despite massive expansions of the balance sheet, Japan has been completely stymied in its attempts to raise price levels.  Today, the bank announced a policy review to look at its current policies to reflate the economy.  Given our expectations of JPY appreciation, we will be watching to see just how radical the bank will go (What is most radical?  Buying U.S. Treasuries to expand the balance sheet.)

Policy and economics:  Congress continues to negotiate on a stimulus package; the latest wrinkle is an attempt by GOP lawmakers to restrict the Fed from restarting its emergency credit facilities that expire at year’s end.  The worry among lawmakers is that a future Congress could use the Fed’s balance sheet for fiscal stimulus, removing lawmakers from such decisions.[1]  As we have noted before, lawmakers have to exercise great care in how they approach this issue.  On the one hand, there is a risk that the Fed could take a bond-buying program and use it to facilitate spending.  It isn’t hard to imagine a muni bond backstop evolving into a program that supports the borrowing efforts of state and local governments.  At the same time, there is a difference between directly lending to support spending and providing a market backstop.  For a financial system that is dominated by shadow banking, there is a need for the Fed to act as a dealer of last resort.  Shadow banking is essentially a carry trade—to use the colloquial, it’s “grabbing nickels in front of steamrollers.”  2008 proved it is impossible to know beforehand where the risks lie.  Therefore, if a certain instrument has become repo’d to the point where the inability to make a market leads to a financial crisis, only the Fed can provide a two-sided market to maintain liquidity.  These programs need to be readily available; although it may be ok to let them lapse in the short run, policymakers must understand that they may be needed at a moment’s notice.  The risk is that Congress won’t act quickly enough.  It would probably be preferable to leave the programs in place with Congressional oversight to ensure the central bank is only providing a backstop.

China:  There is a classic establishment versus populist dual setting up within the administration.  Representing the establishment is the Treasury, seeking to limit the scope of President Trump’s executive order banning U.S. investors from purchasing equities of Chinese companies with links to the PLA.  On the other side is the State Department and the Pentagon, who want to include affiliates and subsidiaries, thus widening the breadth of the order.  Although there are obvious elements of the business v. the security organs, we also would frame this as establishment v. populists.  The establishment supports globalization, and thus, wants to reduce the impact of investment limitations on China.  The populists oppose globalization and want to expand restrictions.  This current battle will end with a new president, but we will be watching to see how the Biden administration handles this issue.  LWP will be just as opposed to a narrow reading as RWP.  Early indications hint that the Biden administration leans more towards the establishment.

COVID-19:  The number of reported cases is 75,096,337 with 1,665,211 fatalities.  In the U.S., there are 17,215,045 confirmed cases with 310,801 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 Rt data continues to show improvement, suggesting that the current surge in infections is peaking.  Currently, 17 states have a reading of less than 1, compared to last week’s eight, suggesting a falling infection rate.  Wyoming has the lowest reading, and Maine has the highest.  Over the past seven days, the infection rate in the U.S. is 0.45% or one in 200.


The EU and BrexitChina and the EU are working on an investment deal.  If it does get done, it will be interesting to see the U.S. reaction.  The Brexit talks have it a new snag; PM Johnson is arguing that the recently passed EU stimulus should not be exempt from the level playing field discussions.  The GBP has eased on the reports.

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[1] MMT proponents have argued for similar ideas, such as the creation of a Fed-like body that would make fiscal spending decisions without the need for Congressional approval.