Daily Comment (July 29, 2021)

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

[Posted: 9:30 AM EDT] | PDF

Good morning.  It’s GDP day!  We cover the data for Q2 below in detail, but the quick view is that the annualized growth rose 6.5%, well below expectations.  Equity markets are ticking higher, but we note that gold is up strongly this morning as the dollar fell, most likely on a dovish take to yesterday’s FOMC meeting.  There are a couple of items of note.  First, the Ever Given, the vessel that was stuck in the Suez Canal, has finally arrived at its destination in Rotterdam.  And second, we would be remiss if not to recognize the passing of Ron Popeil, the inventor of the Veg-o-Matic and other gadgets usually hawked on late-night television.  He spawned a famous parody from Saturday Night Live.  Our special coverage begins with a recap of the FOMC meeting.  Next on the agenda, the Senate has opened a debate on the bipartisan infrastructure legislation (BIL).  Starting off our ordinary coverage is China news, followed by economics and policy.  The International news roundup is next, and we close with our pandemic update.

The FOMC:  As expected, the Fed didn’t change monetary policy; QE continues at the same pace, and policy rates remained unchanged.  In the press conference, Chair Powell admitted that the economy was making progress, but it hadn’t reached the level of “substantial.”  However, he also noted the committee discussed at length the conditions required for tapering to commence.  For obvious reasons, the Chair didn’t detail what is necessary for tapering to begin, but most likely, continued improvement in the labor markets is necessary.  It doesn’t look like there will be a cut in mortgage securities separate from Treasuries, although the Chair left some level of flexibility.  Inflation is still deemed to be transitory, meaning that policy won’t be tightened yet to address it.

In what might be the most important action taken by the Fed yesterday, the central bank established a domestic and foreign repo facility.  The program will allow both domestic and foreign banks to acquire liquidity for collateral at a rate 25 bps higher than the prevailing repo rate.  These new facilities will act as a permanent backstop to the non-bank banking system.  During the March 2020 financial crisis, the inability of financial institutions to borrow short-term led to a spike in rates and caused several markets to “freeze up,” meaning liquidity was nearly impossible to secure at any price.  These facilities should alleviate most of these types of problems.

Infrastructure:  The Senate easily passed a measure to begin debate on the BIL.  This action means that although the bill isn’t completely written, there is enough in place to begin debate.  There is still much that could derail the measure; as the bill gets debated, all the Democrats and at least 10 GOP Senators need to remain on board with the bill.  It is notable that the CBO hasn’t scored the bill.  If it turns out to be a budget-buster, it could undermine support among centrists.  And, just getting it through the Senate doesn’t mean it will pass easily through the House.  Left-wing populists (LWP) are worried that centrist Democratic senators will only support this bill and scuttle a much larger measure that is expected to be passed through reconciliation.  The LWP in the House are threatening to kill the BIL if they don’t see support for the larger second measure.  Other establishment elements in the House are not happy they have had little say in the Senate bill.  So, this is far from a done deal.  However, getting this far is impressive and increases the odds that the $1.2 trillion measure becomes law.

China:  Policymakers try to calm markets, and flooding continues.

  • After convulsing the financial markets in China over the past week, it appears that authorities are concerned about financial stress. State media have started “jawboning” the market to improve sentiment, and regulators are trying to reassure investors.  Banks are also being told to “restore calm.”  Given China’s past behavior in intervening in equity markets, we could see some “bottom-fishing” activity start to occur.  Still, it doesn’t appear the government is finished with its intervention.
    • The property market appears to be the next target of enhanced scrutiny. Evergrande (EGRNF, USD, 0.75) continues to be a threat to financial stability.
    • The context of this crackdown is important. As we are seeing in the U.S., China appears to be also implementing an equality cycle and ending an efficiency cycle.  This quote nails it:
      • “Chinese entrepreneurs and investors must understand that the age of reckless capital expansion is over,” said Alan Song, founder of private equity firm Harvest Capital. “A new era that prioritizes fairness over efficiency has begun.”
      • Due to the authoritarian nature of China’s government, it can move much faster on policy once a decision is in place.
      • This means the regime is likely to be more focused on equality and accept slower growth. The crackdown on wealth, the restrictions on tutoring, and the reining in of major business leaders are all part of this shift.
    • Although the firm denies it, Didi (DIDI, USD, 8.87) reportedly considered going private to pacify regulators and compensate shareholders after the government reacted against the company listing in the U.S.
    • Ultimately, these actions are all about protecting the CPC. Gaining control of data, making the tech firms less predatory toward consumers, and keeping listings in China, is all about control.
  • One way China is retaliating against Chinese overseas activists is to arrest family members. Increasing numbers of Chinese citizens are seeking asylum during Xi’s reign.
  • We have noted recent flooding in China; according to reports, foreign journalists covering the tragedy have become targets of harassment, with apparent government encouragement. The typhoon that affected the Olympics has now reached the Chinese mainland and is exacerbating recent flooding.
  • Satellite reconnaissance shows that China is constructing additional missile silos most likely for nuclear weapons. China has generally had a smaller nuclear missile inventory than Russia and the U.S., and this recent addition won’t bring parity.  But, it will give China a more formidable deterrent.  It is worth noting that these facilities are deeper in the Chinese interior and are out of range of U.S. cruise missiles.
  • China foreign minister Wang Yi has met with the Taliban in Afghanistan.
  • The government is revising the population law to try to increase the birth rate.
  • Chinese cellphone manufacturers have developed their own semiconductor chips.

Economics and policy:  Semiconductor shortages continue, institutional money in single-family homes is a worry, and the poverty rate likely fell.

  • Apple (APPL, USD, 144.98) and Tesla (TSLA, USD, 646.98) are the latest companies warning that the semiconductor chip shortage is affecting the production of its products. Both companies warned the shortages would slow growth.
  • One item we have become concerned about is the incursion of real estate investment into the single-family residential market. This buying is reducing the supply of homes available for ordinary homeowners and lifting prices.  Although current homeowners clearly benefit through higher prices, housing represents the largest portion of wealth to the bottom 90% of households.  Making it difficult to acquire homes at reasonable prices could become a political flashpoint in the near future.
  • GOP members of the Federal Trade Commission expressed criticism of the majority Democratic Party members, arguing that changing from the Bork Standard was ill-advised. Although we understand the concern, the political winds appear to be shifting away from Bork to the neo-Brandeis position that size alone is enough to trigger antitrust concerns.
  • One effect of the massive income support tied to the pandemic is a notable drop in the poverty rate.
  • Coffee prices have jumped to a six-year high, as frost in Brazil threatens the crop.
  • This year’s back-to-school season is expected to be very strong.
  • As investors search for yield, banks are creating securities that directly share the risk of mortgages. In the past, Fannie Mae (FNMA, USD, 1.305) and Freddie Mac (FMCC, USD, 1.14) acted as guarantors for investor losses.  In the 2008 Financial Crisis, mortgage loan losses overwhelmed these two entities, causing the government to effectively nationalize them.  These bonds, a common feature of financial engineering, are structured to allow investors to accept various levels of risk.  The point here is that, as a consequence of low yields, the industry is creating instruments with more yield but have higher levels of risk.
  • The Economist magazine’s Big Mac index confirms the dollar is overvalued.

International roundup:  The Eurozone economy continues to recover, and Crimean water may be the next problem in Ukraine.

COVID-19:  The number of reported cases is 196,095,694 with 4,189,011 fatalities.  In the U.S., there are 34,677,412 confirmed cases with 611,809 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 395,974,515 doses of the vaccine have been distributed, with 343,361,524 doses injected.  The number receiving at least one dose is 189,494,180, while the number of second doses, which would grant the highest level of immunity, is 163,588,042.  The FT has a page on global vaccine distribution.

 View PDF