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

[Posted: 9:30 AM EST] | PDF

Good morning.  Equity markets are weaker this morning. Numerous reasons are causing this weakness.  Political unrest, rising COVID-19 infections, and the simple fact that markets don’t rally in a straight line are all part of today’s decline.  The underlying factors remain—accommodative monetary policy is a potent factor in supporting asset prices.  Our coverage starts with the political situation in President Trump’s last week of office.  Rising criticism of the Fed is next.  The China news update follows.  Pandemic information is next.  We update the post-Brexit world, India’s farm crisis, Kyrgyzstan, and an economic roundup.  The Asset Allocation Weekly is available.

Politics:  Although the House leadership continues to press toward issuing articles of impeachment, this action probably won’t go anywhere.  First, time is short.  Impeaching someone when out of office may be symbolic, but it is not much more than that.  Second, Congress only has so much bandwidth, and President-Elect Biden, due to the high likelihood he will be a one-term president, will probably see a faster erosion of this political capital.  Thus, if he wants to move on policy, he can’t have Congress debating impeachment that is unlikely to pass anyway.  Instead, there are two developments from the events last week that we are watching closely.

• The unrest was a public relations coup for China, and Beijing isn’t missing the opportunity. This Global Times editorial is a good example of China’s framing of the unrest as not just a one-off incident but a failure of democracy as a system.
• Social media firms have blocked President Trump’s accounts and have taken other actions that affect right-wing platforms. Although these actions have been criticized in the U.S., it has also raised concerns in the EU.  The near-monopoly power of tech firms gives them the ability to set the terms of the debate.  It seems unlikely that they can continue to operate as unregulated monopolies in this arena.

The Fed:  As asset markets continue to rally, the Fed is starting to come under increasing criticism from establishment figures.

• Mohamed El-Erian warns that if the Fed engages in yield curve control, the Treasury market’s ability to signal inflation worries will be lost. He also points out that liquidity injections have become the key reason for investor optimism.  El-Erian also notes that unconventional policy, initially used as an emergency measure, has become conventional.
• Sheila Bair, former head of the FDIC, suggests that the backstop policies the Fed implemented in March didn’t do anything to boost investment and simply lead to more debt issuance.
• Members of the FOMC are also expressing concern about market activity. We note in particular a quote from Neel Kashkari, President of the Minneapolis FRB, who said, “I don’t know what the best policy solution is, but I know we can’t just keep doing what we’ve been doing.”  We must admit, his admitting the lack of a policy solution is both refreshing and unsettling, the former because policymakers rarely acknowledge the uncertainty, the latter because he doesn’t know.

In our opinion, these criticisms highlight the downside of the moral hazard problem.  When a policy protects a person from risk, it should not be a surprise that risky behavior follows.  However, none of these criticisms discuss the alternative.  If the Fed doesn’t engage in yield curve control, the strength in housing will fizzle.  If the Fed had not put the backstops in place in March, the financial markets would have seized up, and another 2008 (or worse) would have likely developed.  Officials often discuss implementing “macroprudential” policies.  Putting such policies in place does work—Glass/Steagall did a great job making the financial system safe at the cost of deep inefficiency.  But, even there, financiers eventually figured out how to evade these sanctions.  There is no simple solution.  If you allow financial discipline to work, you have to live with occasional financial panics, and such events have become politically unpalatable.  If you protect the system from panic, excessive risk-taking tends to follow.  We do closely follow these criticisms because if Congress decides to limit the ability of the Fed to act, the potential for a financial accident will increase.

China:  In the waning days of the Trump administration, Taiwan, tariffs, and investment policy each remain in focus.

• USTR Lighthizer is urging the Biden administration to keep tariffs on China in place. Overall, our take is that the Trump administration’s trade policy on China had mixed results.  The positive element was that the tariffs clearly got the attention of Beijing.  The policy showed that America’s position regarding China had obviously changed.  The negative was that trade probably wasn’t the best tool for changing China’s behavior.  In our opinion, denying them access to U.S. Treasuries would have probably been more effective.
• If there is one hot spot we are watching in 2021, it’s Taiwan. Since normalizing relations with China in the 1970s, the U.S. and China have engaged in decades of strategic ambiguity; both sides say the same words but mean different things when they say them.  That stance has become threadbare.  President Xi appears he intends to bring Taiwan under his control.  The U.S. seems to be encouraging Taiwan’s sovereignty.  Over the weekend, the U.S. announced it is making it easier for officials from the U.S. and Taiwan to meet.
• Investors have been scrambling to comply with new U.S. regulations on Chinese investments. The policy has led to uncertainty and caused some investors to dump Chinese stocks at a loss.  It also has effects beyond the stocks themselves; structured products that contained some of the stocks have been suspended.  China is retaliating, threatening firms that comply with U.S. regulations will face lawsuits in Chinese courts.  There has been much discussion about a new “Cold War” with China, but an important difference between China and the U.S.S.R. is that there were few economic ties between the U.S. and the Soviet Union.  That is not the case with China.
• China has been building dams in South Asia as part of gaining influence in the region. Vietnam is bearing the brunt of this dam-building as it is finding flows on the Mekong are affected by decisions upstream.
• Ant Financial will likely adopt financial market regulations, which will have an adverse impact on valuations.
• The EU has recently inked an investment deal with China. Australia’s recent experience should be a cautionary tale.

COVID-19:  The number of reported cases is 90,367,346 with 1,936,436 fatalities.  In the U.S., there are 22,410,249 confirmed cases with 374,341 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 22,137,350 of the vaccine has been distributed with 6,688,231 of first doses injected.

Virology

• One factor we have been tracking is the reluctance of health care workers to be inoculated. There are numerous reasons for the decision, but a consistent one is a concern about the rapid speed of development of the vaccines.  Also, slow adoption by healthcare workers will likely make non-healthcare workers less open to being inoculated.
• Sweden, facing rapidly rising cases, is implementing restrictions. The country refused to deploy such measures earlier.
• It appears the latest variant is spreading rapidly. On the good news front, it does appear the current vaccines will be effective against it.

 Post-Brexit:  The U.K. is now dealing with the fallout from Brexit.  Although most goods traded between the EU and the U.K. are free from tariffs, items that are reexported can be subject to tariffs, which was not the case before.  U.K. businesses are struggling to figure out the new regime.  In addition, being free of the EU looks like it means a lot more paperwork and regulations for British industry.

India:  The standoff between India’s farmers and the government continues.  The Modi administration is trying to deregulate the sector; small farmers are concerned this will mean reduced support from the government and the loss of their farms.  Modi rarely loses, but this battle may be difficult to win.

Kyrgyzstan:  Last year, we discussed the situation in the country.  Over the weekend, elections were held and Sadyr Japarov took nearly 80% of the vote.

Economic roundup:  Here is a list of items we are watching:

• Homebuilding has been increasing in the U.S., but a growing portion of that new construction is designed for rental and not single-family homeownership. As home prices rise with stagnant wages, an increasing number of families can’t afford a home.  They want the space of a house, so the industry is responding.  However, a major concern is that the inability to own a home can be a detriment to wealth accumulation.
• A recent study suggests that most households intend to use stimulus checks to increase savings or pay expenses. Very little is expected to support consumption.

Automakers are being forced to reduce production due to a shortage of computer chips.

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