Daily Comment (May 7, 2021)

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

[Posted: 9:30 AM EDT] | PDF

Good morning, all! U.S. equities are expected to open higher this morning as the jobs report continues to support market optimism; we will go into further detail in the economic releases section of this report. Our report starts off with a summary of the Financial Stability Report. International news follows, with details about the Pentagon’s plan to leave Afghanistan, Morocco’s decision to recall its ambassador to Berlin, the U.S.-Iran nuclear talks, and more. Economics and policy are up next, including the Biden administration’s decision to limit U.S. investment in China and Biden lowering his tax rate demands. China news follows, and we close with our pandemic coverage.

The Fed: The Federal Reserve released its Financial Stability Report on Thursday. Here are the highlights:

Asset Valuations: Although the rise in asset prices is generally backed by an improvement in the economic outlook, the Fed fears that much of the rise may be due to an increase in risk appetites. The report cites declining corporate spreads, particularly for firms that were negatively impacted by the pandemic, as evidence of elevated risk appetites. As a result, the Federal Reserve believes that asset prices could fall following a setback in the recovery such as a relapse in virus containment, a market scare, or possibly a slowdown in the recovery.

Borrowing by Businesses and Households: Debt for businesses and households continues to fall, but still remains elevated, particularly for small businesses. Funding for smaller firms appears to have tightened, thus making it harder for these firms to maintain day-to-day operations. Generally, smaller firms are given less priority than larger firms for credit access. As a result, these firms are vulnerable to shocks and are financially strained even after receiving government support.

Leverage in the Financial Sector: Leverage for banks and broker-dealers remains low, while leverage is elevated for hedge funds and life insurance companies. Although the Fed did mention that life insurance leverage is high, its primary concern was with the leverage of hedge funds. Particularly, it argues that the lack of transparency has made it difficult to determine the level of risk hedge funds pose to the financial system. To support this claim, the Fed highlighted the losses hedge funds took due to the “meme stock episode” in January 2021 and the market turmoil caused by Archegos Capital Management. Their concern is that hedge funds could potentially be a source of financial distress.

Funding Risk: Large banks have relatively low risk of liquidity and maturity mismatches, while money market funds as well as bond and bank loan mutual funds remain a source of concern. Specifically, investors are finding it difficult to meet their liquidity needs when they have trouble selling their underlying assets (such as commercial paper and short-term government notes). Additionally, bond and bank loan mutual funds may have a hard time meeting their liquidity needs due to increased holdings of U.S. corporate bonds. The Fed is currently working with other international organizations to address these concerns.

International news: The Pentagon terminating contracts, Morocco recalls ambassador, and U.S.-Iran nuclear talks.

Economics and policy: The U.S. continues the investment ban, corporate tax rate demand drops, and vaccine/pandemic policy updates.

China:  Conflict in the South China Sea and Chinese census delay.

COVID-19:  The number of reported cases is 155,425,409 with 3,246,844 fatalities.  In the U.S., there are 32,573,436 confirmed cases with 579,572 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 321,549,335 doses of the vaccine have been distributed with 249,566,820 doses injected.  The number receiving at least one dose is 148,562,891, while the number of second doses, which would grant the highest level of immunity, is 107,346,533.  The FT has a page on global vaccine distribution.  The weekly Axios map shows rising cases in about half the country.


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