Daily Comment (May 15, 2020)

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

[Posted: 9:30 AM EDT]

Good morning and happy Friday!  Equity markets are weaker after a rather robust recovery yesterday.  Trade worries appear to be a problem.  We update the COVID-19 news.  Retail sales are out this morning—details below.  Here is what we are watching:

COVID-19: The number of reported cases is 4,444,670 with 302,493 deaths and 1,588,858 recoveries.  In the U.S., there are 1,417,889 confirmed cases with 85,906 deaths and 246,414 recoveries.  For those who like to keep score at home, the FT has created a nifty interactive chart that allows one to compare cases and fatalities between nations, scaled by population.

The virus news:

  • The good news:
    • Japan has lifted its state of emergency in 39 of the nation’s 47 prefectures. The major cities, Osaka and Tokyo, remain under emergency orders, but the government is planning on ending those orders by May 21.
    • A large-scale study on the use of plasma from infected patients to others was found to be safe, passing Phase 1 of the process. The next step is to see if the process reduces symptoms in those infected.
    • The CDC has released guidelines for reopening.
  • The bad news:
    • Health care workers in Russia are dying at an alarming rate from COVID-19. PPE is generally lacking in Russia and the health care system suffers from underinvestment.
    • We have been worried that the race for a vaccine would become so politicized that it would hamper research and production. The head of Sanofi (SNY, $47.67), a French company, caused a stir when he indicated he would give preference to the U.S. for vaccine supplies because America has provided more money for research and development.  Needless to say, the Europeans were not pleased.  However, this comment raises the problem of free riding; why shouldn’t the U.S. get preferential treatment?  At the same time, there is a moral argument that suggests there should be equal access.  However, in reality, what would that mean?  Equal by what standard?  This row suggests that even when a vaccine is ready, factors for distribution will be difficult to create without triggering a political backlash.

The policy news:

  • The House will vote today on a $3.0 trillion fiscal package. Although the Democrat-sponsored bill should pass, it is meeting some resistance within the party.  The bill appears to have lots of unrelated spending and the GOP-controlled Senate has already declared it won’t pass in its current form.
    • The package includes aid for states. This is a problem for the GOP as there are some states that have created a problem for themselves by creating pension programs they can’t fund.  Thus, the GOP does not want to reward such behavior.  At the same time, in the last recovery, falling state fiscal spending more than offset federal stimulus.  States usually do their budgeting now for a June deadline.  It is almost certain that without some form of aid, state-level spending will decline precipitously due to the lack of revenue.  Because states don’t print the money they borrow in, they must balance their budgets.  If lawmakers are not careful, we could have a situation where fiscal spending is much less than advertised because states are cutting back as the federal government spends.
  • The Fed published a report on consumer finances; no surprise, lower income households have been severely hurt by the pandemic. Nearly 40% of workers earning <$40k per year have lost their jobs.
  • Seventy-five percent of small businesses have applied for government aid. So far, just under 40% have received help.  It is likely the number of those receiving aid will rise in the coming weeks, but the fear is that some may not survive long enough to get support.
  • Chair Powell and other members of the FOMC have made it abundantly clear they will not take policy rates below zero. And yet, futures markets continue to signal that such an outcome is possible.  Why is that?  One factor driving this outcome is a peculiarity of interest rate swaps.  Let’s say I have a fixed rate loan and I think rates are going to fall.  I could go to my bank and repaper the loan to a floating rate.  Or, we could do a swap.  Instead of paying my fixed rate, the bank and I make a deal where I pay the difference on some short-term interest rate compared to the current rate.  So, if rates, fall, I pay less.  However, once rates fall below zero, as the borrower, I would be required to pay the bank.  Borrowers don’t want that risk, so banks offer a downside cap that keeps the rate at zero.  To make that cap, banks go to the futures market and short the instrument so it would pay them if the rate goes negative. Thus, the rate signaling may be less about expectations and more about the mechanics of swaps.

The economic news:

The foreign news:

  • As usual, there was lots of China news:
    • Relations between the U.S. and China remain tense. In an interview yesterday, President Trump suggested that “we could cut off the whole relationship.”  The president proposed that Chinese firms may be required to meet U.S. accounting standards to acquire a U.S. exchange listing, although he did acknowledge this could simply mean Chinese firms may list elsewhere.  The president did seem to suggest that Phase 1 could be in trouble; China is stepping up farm purchases, indicating it doesn’t want to see this agreement fail.
    • Taiwan Semiconductor (TSM, 52.10) announced it will build a chip factory in Arizona. This is a significant act by the firm, which has always straddled the East and West.  By moving production to the U.S., it is signaling a greater reliance on the U.S.  This move will clearly get the attention of Beijing and may prompt greater chip self-sufficiency by China.
    • The Global Times, a tabloid in China, published an article suggesting that China should consider retaliatory measures in response to various COVID-19 lawsuits emanating from the U.S. One idea floated was to freeze U.S. assets in China.  Although this source is not considered an official mouthpiece for the Chinese leadership, it is a fount of nationalist trial balloons and may reflect a warning to Washington that Beijing is not without measures it can take.
    • The National People’s Congress (NPC) meeting starts today after a two-month delay due to the pandemic. We are watching to see:
      • What growth forecast, if any, China establishes. Even a 3% target for the year would require a robust recovery.  On the other hand, a number below that would look bad.  One of two outcomes is likely: either (a) they don’t offer a forecast, or (b) they make a 6% forecast for a two-year period.  In any case, China’s stimulus thus far has been modest and more will be needed if these sorts of numbers are going to be reached.  On the other hand, if there is no forecast, stimulus will likely remain modest.
      • We will be watching for any clues about an official response to cooling U.S. relations.
    • The U.S.S. McCampbell transited the Taiwan strait yesterday. This is a “freedom of navigation” maneuver that will clearly get the attention of Beijing.  It is also notable this occurred a week before the inauguration of Tsai Ing-wen to her second term.  China views the Taiwan leader as a separatist and thus the McCampbell sailing will be seen as a show of support for the incoming president.
    • As we noted yesterday, the head of the WTO has resigned a year before his term ended. It is apparently setting off a leadership struggle as both the U.S. and China vie to put “one of their own” in that role.
  • One of the measures of statehood is that a state holds a monopoly on violence. A country that can’t control security is one that doesn’t fully fulfill the role of a nation.  The active drug cartels in Mexico have raised this problem.  We note the cartels are using the pandemic to burnish their reputations by providing aid to the localities.

Brexit: Brexit talks are not going well.  The latest round of talks ends today.  The EU accuses the U.K. of refusing to compromise on key areas, including fisheries and the legal framework that will exist between the two sides.  The U.K. is accusing the EU of being “ideological.”  It seems unlikely the two sides will have a full deal by year’s end.  This means one of three outcomes: (a) we see an extension, although PM Johnson opposes this outcome, (b) a “mini-deal” that allows the two sides to claim that a deal was struck and then details on a broader deal will be worked out in the coming years, or (c) a hard break.  The most likely outcome is (b), although the odds of (c) are probably increasing.

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