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

[Posted: 9:30 AM EDT]

Good morning.  Global equities are higher as Chinese markets continue on a tear.  News on China leads our commentary this morning.  Our usual update of the pandemic follows, along with foreign news, an update on policy, market action and the economy.  The updated Weekly Energy Update is available.  Off to work:

China news:

• China’s foreign minister, Wang Yi, gave a speech this morning suggesting that current relations are at their lowest point since normalization in 1979.
• Since taking power in 2012, Chairman Xi has aggressively consolidated control through a number of measures, including jettisoning informal term limits and purges of enemies. We noted a recent event where leaders close to Xi appeared to be instituting an aggressive crackdown on the legal system through a program of re-education (a long standing favorite tool of communists everywhere).  We are a bit surprised by the ferocity of this response; after all, there has been scant evidence of an independent judiciary for some time in China.  The fact that Xi seems to think these measures are necessary suggests a leader that is still unsure of his position, despite overwhelming evidence he has quelled opposition.  Either (a) Xi is becoming increasingly insecure, or (b) like Mao, he sees these sorts of measures as the way China is to be governed, a situation of constant “revolutionary” turmoil.
• There are reports that the U.S. is considering steps to undermine the Hong Kong dollar’s peg to the U.S. dollar. Hong Kong uses a currency board and issues its own currency based on U.S. dollars held in reserve.  If the U.S. were to deny the Hong Kong currency board access to U.S. dollars, the board could only issue new Hong Kong dollars by allowing the currency to depreciate.  It doesn’t appear that this action is imminent, although the very fact that it is under consideration suggests a deep deterioration of relations between China and the U.S.  Interestingly enough, Hong Kong has been experiencing inflows from abroad, which has required the currency board to intervene to prevent the Hong Kong currency from appreciating.
• The U.S. has put visa restrictions on Chinese officials involved in setting Beijing’s Tibet policy. China has retaliated.
• China is criticizing U.S. fiscal stimulus, fearing a drop in the dollar and calling for a new reserve arrangement. We note the CNY rallied this morning and this market action might be raising concerns in Beijing. This call for another reserve currency isn’t new, but there is a lack of attractive alternatives to the dollar.  We do note, in a recent WGR, we discussed that the potential for a Eurobond might be an attractive vehicle for reserve purposes.
• FBI Director Wray gave a speech at the Hudson Institute where he indicated the Chinese government and the CPC are a threat to U.S. economic and national security.
• It appears that if the U.S. wants to prevent the use of Huawei (002502, CNY 2.86) equipment, it is going to require the building of alternatives. In other words, the U.S. government may need to fund the creation of 5G equipment from firms other than Huawei. Meanwhile, the company is asking the K. to slow its decision on using Huawei’s 5G equipment, fearing it will be ejected from the British market.
• Despite the end of the “one-child policy” and steps to encourage additional births, Chinese couples apparently didn’t get the memo, as births hit a new low in 2019.
• Over the past couple of weeks, we have been reporting on massive flooding in south-central China along the Yangtze River. The sluice gates have been opened at the Three Gorges Dam which will exacerbate flooding downstream.  The current death/missing toll is 119.
• The Institute of International Finance (IFF) estimates that China’s total debt is 317% of GDP at the end of Q1 2020. That is up from 300% in Q4 2019 and the largest quarterly rise in history.  Consumer debt is the fastest growing segment.  Foreign investment in China’s bonds is only 2% of the total; the vast majority of China’s bonds and debt are held internally.  The rise in debt is likely tied to stimulus efforts tied to the economic recovery from the pandemic.  In related news, we note that a Chinese developer has not paid its bondholders.
• Chancellor Merkel has come under criticism for her government’s tepid opposition to China’s actions in Hong Kong. Germany is trying to maintain economic relations with China in a period where Beijing’s actions are making it difficult to keep such ties.
• The new national security law for Hong Kong makes it illegal for anyone to promote democratic reforms or criticize the government. This includes people living outside of China or Hong Kong.  The extensive reach of this law is remarkable; it begs for a global response.
  • Meanwhile, China’s secret police have officially taken up residence in Hong Kong.
  • S. tech firms are trying to decide if they can safely continue to operate in Hong Kong.
• There have been worries that the new security law will undermine Hong Kong’s financial firms. At the same time, Beijing needs Hong Kong’s expertise in this area and we suspect that Chairman Xi will take steps to support the financial firms in Hong Kong while he cracks down on security.  Although we are early in the process, recent listings by Chinese tech firms in Hong Kong suggest that the former colony’s financial prowess will likely be preserved, at least for now.

COVID-19:  The number of reported cases is 12,062,863 with 549,900 deaths and 6,609,462 recoveries.  In the U.S., there are 3,055,144 confirmed cases with 132,309 deaths and 953,420 recoveries.  For those who like to keep score at home, the FT has created a nifty interactive chart that allows one to compare cases across nations using similar scaling metrics.  Axios has updated its state cases chart.

Virology:

• In the race for a vaccine, the U.S. has committed $2.0 billion to two companies, Novavax (NVAX, 101.44) and Regeneron Pharmaceuticals (REGN, 654.42) who are working on vaccine candidates as part of Operation Warp Speed.
• Testing is being conducted on a drug derived from the blood plasma of former COVID-19 patients. The drug may work for both treatment and as a prophylactic for the disease.
• As testing increases, wait times for test results have increased as well. This development is a problem because a tested person doesn’t know if they should continue their normal activities, assuming a negative test result, or self-quarantine, fearing a positive one.
• Although mask wearing remains controversial, we note a natural experiment that occurred in Germany suggests mask use does reduce the spread of infections.  In March and April, some German states required masks, others did not.  Researchers were able to measure infection differences and conclude that mask wearing reduced inflection spread by 40% compared to areas that didn’t have similar rules.
• Another area of controversy is the debate over airborne transmission. The fact that infections appear tied to events held indoors in close quarters suggests that the virus is probably airborne and can stay in that state for long periods of time.  However, WHO continues to say that the evidence is inconclusive.   If it is established that a prime transmission factor is indoor crowded events, mitigation measures could be adopted, e.g., more outdoor events, crowd spacing, masks, improved ventilation, etc.  But as long as the messaging is inconclusive, mitigation measures will likely not be adopted.
• As hospitalizations rise, the health care system is reporting growing shortages of personal protection equipment.

Policy news:

• Nearly 60% of Americans have nothing saved for retirement. States are now moving to address this problem by creating programs to strongly encourage companies and individuals to start IRA contributions.
• Recently, Washington issued rules that required foreign college students to take classes in person. This action will either mean that colleges will need to take on campus students to retain and attract foreign students, or continue online classes and lose this source of tuition revenue.  This trend comes along with an anticipated decline in Chinese students due to deteriorating relations.
• Last September (seems so long ago, doesn’t it?) the financial markets were roiled by problems in the repo markets. Although Fed officials still seem to struggle to explain what exactly happened, the response was to flood the non-bank financial system with liquidity.  The balance sheet contraction ended and has expanded with abandon with the onset of the pandemic.  One sign of good news is that the Fed has withdrawn specific repo support due to the lack of demand.  Of course, when one sends the balance sheet to historic highs, one shouldn’t see problems in the short-term funding markets.
• One of the areas of risk to the economy are state and local governments. Unlike the Federal government, the state and local governments don’t issue debt in a currency they control and so their spending is pro-cyclical; it rises and falls with the business cycle.  Due to the downturn in the economy, state and local government spending is showing signs of falling, and if the Federal government fails to intervene, it could undermine Federal stimulus efforts.
• The entire housing payments chain is at risk as well. Renters and homeowners pay rent or mortgages respectively.  These payments flow to landlords or mortgage servicers and these flows eventually end up in mortgage backed securities.  There are government programs that offer protection to bondholders, but little support is available downstream.  Congress continues to discuss another stimulus package; some of the last one did support the housing payments chain.  If additional support isn’t forthcoming, the housing payments chain is at risk.  Interestingly enough, this problem is also a threat to state and local governments, because if this payment chain is broken, property tax payments will likely fall as well.

Foreign news:

• Yesterday, Mexican President Andrés Manuel López Obrador, commonly known as AMLO, made a rare foreign trip to Washington to mark the implementation of USMCA.  Although the relationship between Presidents Trump and AMLO was rocky at first, they have gotten along rather well over time.  Relations between Mexico and the U.S. have improved over the past two years.
• The U.K. Johnson government unveiled a massive fiscal support package to help the economy’s recovery. Much of it is based on funding to subsidize returning workers.
  • Scotland is rejecting Westminster’s food and environmental standards, showing continued divergences within the United Kingdom. Separatism in Scotland has been rising, in part due to disagreements over Brexit.
• Saudi Arabia is planning a summit meeting with Chinese officials. As the U.S. loses interest in the Middle East, the high revenue/low population nations in the Middle East will look for new patrons.
• It appears some European banks inadvertently purchased bonds issued by front companies for organized crime.
• Argentina has improved its offer for restructuring its defaulted bonds, taking the offer to 53.5 cents on the dollar, from 40 cents. The response from creditors was positive.

Market and Economy news:

• Although equity indices continue their impressive run, the equity market internals show that the industry’s most sensitive to reopening—travel, leisure and entertainment—are lagging. The so-called “reopening” trade has been stalling.   High frequency data in states hit by surging cases tends to confirm what is happening in the equity market.
• S. companies are cutting dividends aggressively, the fastest pace since 2009.
• While equities have rallied, precious metals have as well. We also note that industrial metals prices have improved too.  In the China section, we note that debt levels are surging, evidence that monetary stimulus is in place.  Aggressive monetary stimulus globally is a support for precious metals while Chinese stimulus is a boost for industrial metals prices.  Inflows into gold ETFs have been rising lately as investors add the yellow metal to portfolios in light of these factors.
• The Atlanta FRB’s CFO survey suggests that employment will remain below pre-pandemic levels through all of next year. Fed presidents from Atlanta, Boston and Richmond all suggest that the economy may be stalling, which would suggest that policy support from the Fed will likely remain in place.

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