by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA
[Posted: 9:30 AM EDT] | PDF
Good morning on the first Monday of October. Risk markets are generally lower this morning as uncertainty in Washington and worries about valuations weigh on sentiment. USTR Tai will discuss the trade relationship with China today. We discuss what we expect below, but the short answer is that tariffs will remain in place. Our coverage begins with the state of the budget and infrastructure legislation. Next, we look at the situation at Facebook (FB, USD, 343.01) and the Pandora report, followed by the Fed. Continued tensions in the South Caucasus are discussed as well. Our regular coverage begins with China news. Economics and policy follow, with the international roundup next, and we close with pandemic coverage.
Legislative drama continues: President Biden went to Capitol Hill and apparently sided with the progressives. Moderates were promised a vote on the bipartisan infrastructure package and then didn’t get one. Progressives now say they are willing to scale back the $3.5 trillion budget. The new “deadline” is now Halloween. It appears the progressives won on this round, but the battle isn’t over yet. Is anything going to get done? Probably, but it isn’t going to be easy to watch. There will likely be an abundance of budget adjustments; programs will be shortened in duration to reduce their spending impact, for example. Our take is that the markets don’t like the uncertainty. Although a major increase in tax rates would be a negative, clarity in either direction—the measures fail or something passes—will likely improve market sentiment.
We note a couple of observations. First, the president appeared to side with progressives. Since Biden was a moderate for most of his career, we view his position as a political calculus. Moderates fear that an expansive fiscal package will be a problem for their reelection in 2022. It looks like Biden has concluded that Congress is likely to flip to the GOP anyway, so he has decided to support the progressives to ensure that as much gets passed as possible. Second, the interparty negotiations have deeply undermined party unity. That development isn’t a surprise. Unity comes in acquiring power. Maintaining it while in power is always hard. But the trust deficit that has developed will reduce the party’s ability to pass much next year.
Facebook: Anytime your company is the focus of a 60 Minutes interview, the leadership of the firm has to be nervous. Frances Haugen, a former product manager for the firm, gave a lengthy interview that aired last night, where she put the firm in a harsh light. Haugen was apparently the source for a recent group of articles that were published in the Wall Street Journal. For anyone following the company, or for that matter, social media in general, nothing revealed here should be a surprise. So far, the revelations haven’t affected equity performance significantly. However, if the information results in new regulations, we could see the tech sector affected.
Pandora: No, it is not the streaming service or those charm bracelets but something more akin to the box of Greek mythology. The International Consortium of Investigative Journalists published their third, and arguably their most, comprehensive data regarding how the wealthy and politically connected use a web of offshore accounts and trusts to avoid taxes and shelter assets from scrutiny. Vladimir Putin, King Abdullah of Jordan, and former U.K. PM Tony Blair figure prominently, although there are many others caught in the database. Some observations—political leaders are prominent in the disclosures. Five continents are represented. Surprisingly, South Dakota trusts are also quite popular. Mostly, offshore accounts are used to hide assets and, for some leaders, provide an “exit strategy” if they need to leave the country. Another interesting sidelight is how aggressively Chinese firms used offshore tax havens to create variable interest entities (VIE) to allow for listing on U.S. exchanges and facilitate capital flight. Even state-owned firms had VIE’s for various purposes. The papers also show that U.S. sanctions have forced Russian oligarchs to take aggressive actions to protect their assets.
What is the impact of these disclosures? We seriously doubt if they will lead to significant prosecution. Those involved are too powerful for that outcome. The biggest issue may be that this revelation will deepen the mistrust of political elites. Trust among the ruled is already low, as evidenced by populist movements across the West. The evidence shows that the powerful create legal means to avoid scrutiny. It’s hard to argue for shared sacrifice when the data suggests the sacrifice isn’t shared or likely to be shared at any time.
The Fed: In a similar vein, the Fed has been rocked by trading scandals among the regional bank presidents. It came out over the weekend that Vice-Chair Clarida made large trades just before Chair Powell announced pandemic measures. Although the trades were pre-arranged and cleared by the Fed’s ethics official, the optics are terrible. Clairda’s term ends on Jan. 31, 2022. This news likely precludes any chance of him being renominated.
War in the South Caucasus? Last week, we noted rising tensions between Kosovo and Serbia. It looks like tensions between Armenia and Azerbaijan are escalating again. This conflict is over the troubled Nagorno-Karabakh region, which is claimed by both sides. Last year, Azerbaijan won territory from Armenia; it appears that the conflict didn’t settle the matter. There are two complications from this escalating conflict. First, it will involve outside powers. Russia supports Armenia while Turkey aids Azerbaijan. Second, oil from the Caspian Sea region flows through this territory, meaning that if a hot war develops, it might reduce oil supplies when prices are already elevated. And, if that’s not enough (no wait, there’s more!), Azerbaijan has arrested Iranian truck drivers delivering exports to Armenia. There are unconfirmed reports that Iran is massing military assets on the Azerbaijan frontier.
China news: Trade and real estate dominate the news.
- There was a surge of Chinese military air incursions over Taiwan’s airspace over the weekend. Reports indicate that over 93 sorties were conducted by Chinse military aircraft, prompting a warning from Washington.
- As noted above, USTR Tai will give a speech today on China’s trade policy. All indications suggest the Biden administration will maintain the Trump era trade deal, meaning tariffs will remain in place. Essentially, it looks like Tai is going to argue that China isn’t complying with the Phase One part of the Trump trade agreement.
- The Evergrande (EGRNF, USD, 0.355) saga continues. The company has missed several scheduled interest payments, and it is unlikely many of them will be made. It appears failure of the company is a foregone conclusion; this issue now is how will the fallout be managed. Parts of the company are being prepared for sale. It looks like the goal is to ring-fence the firm, not to save it. Residential real estate is a very large part of the Chinese economy. Bringing the sector under control (along with its associated debt) is probably only possible with a notable decline in China’s economic growth.
- We are seeing a global energy crisis. It’s a combination of several factors. Oil and gas investments have declined due to the pandemic and environmental restrictions, and ESG concerns have played a role in limiting investment funds. Meanwhile, the recovery from the pandemic has led to a surge in demand, which is hitting constrained supply. We have been discussing these issues for weeks in our Weekly Energy Update. China isn’t immune to these issues, but the rolling energy crisis in China has some unique characteristics as well. Pollution in China has been a problem for years, one that General Secretary Xi has promised to address. Reducing coal consumption is part of this goal. At the same time, frayed relations with Australia have led to a sharp curtailment in coal imports. To bring emissions down and deal with constrained coal stocks, China is cutting factory output and electricity, which is affecting production. These cuts are beginning to affect global goods supplies. One interesting sidelight is that the drop in Chinese factory output is leading to a sharp fall in shipping rates.
- The three-year countdown for the delisting of Chinese stocks failing to meet U.S. accounting standards has started.
- A report in The Lancet suggests that China’s population could fall by 50% by 2100. We noted last week that the CPC has moved 180o on population policy, going from using harsh measures to limit births to a new policy that may be just as draconian in the opposite direction. Perhaps it was this study that prompted the more aggressive change.
Economics and policy: Inflation and trade remain key worries.
- A report from the Washington Post details the ongoing global logistical problems. The Economist notes that job postings for truck drivers are up across Europe; it’s not just a U.K. problem.
- The Fed is launching a review of a central bank digital currency. We would not expect a digital dollar to emerge soon but do expect one to be released by the end of the decade. Meanwhile, there is a growing push to regulate stablecoin issuers as banks.
- Global trade fell 0.9% last month.
- Like pasta? It looks like prices will be rising because of poor crop yields for durum wheat, the primary ingredient in pasta.
- As firms across the West struggle to source labor, companies are turning to automation.
- State and local governments have been slow to distribute funds to help renters avoid eviction. A recent podcast is worth a listen on this topic. One interesting development is that landlords tend to prefer eviction rather than the payment of back rent because rents are rising.
International roundup: Rising energy and food prices remain a problem.
- It isn’t just China facing an energy crisis, so is India, as coal supplies dwindle. India has been discouraging imports but may be forced to buy from abroad to avoid outages.
- Georgia (nation, not state) held elections over the weekend. The governing party did well, although there were allegations of election irregularities. We also note that former president Saakashvili returned home and was arrested.
- There were large demonstrations against Brazilian President Bolsonaro over the weekend. Overall discontent is high, in part due to the pandemic but also due to rising inflation.
- Venezuela unveiled yet another new currency, dubbed the “digital bolivar,” although it is still paper money. The new currency lopped off six zeros. Such maneuvers are common in South American history.
- As noted above, the USTR will be discussing China’s trade policy today. In related remarks, President Biden and Commerce Secretary Raimondo spoke in favor of steel tariffs in discussions with the EU.
- German political parties continue to negotiate to form a government.
- Comments from French President Macron led Algeria to ban French military aircraft from its airspace.
- Britain is careening toward a winter of discontent. Shortages of all kinds, coupled with rising prices, are increasing impatience with the Johnson government.
COVID-19: The number of reported cases is 234,356,026, with 4,803,322 fatalities. In the U.S., there are 43,683,392 confirmed cases with 701,178 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 478,410,525 doses of the vaccine have been distributed with 395,934,825 doses injected. The number receiving at least one dose is 215,233,625, while the number receiving second doses, which would grant the highest level of immunity, is 185,492,579. For the population older than 18, 67.2% have been vaccinated. The FT has a page on global vaccine distribution.
- Last week, Merck (MRK, USD, 81.40) announced it developed what appears to be a remarkably potent antiviral in pill form. If this works as initial studies suggest, this could lead to a long way to end the pandemic. Opposition to vaccination is probably going to prevent reaching a level enough to end the spread of the disease. Most estimates suggest that to stop the Delta variant, a level of 80% to 85% is necessary. That level is probably impossible. However, if an easy-to-take antiviral therapy is available to keeps patients out of the hospital, the disease becomes a seasonal nuisance.
- Meanwhile, the demand for antibodies for COVID-19 has been increasing.
- In Alaska, where cases are rising, physicians are forced to allocate scarce care.
- Israel, which has been actively using vaccine passports, is considering pulling them from those who don’t receive booster shots.