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

[Posted: 9:30 AM EST] | PDF

Good morning.  A lot is going on in the world; equity futures were down most of the night but are crawling back to unchanged.  We lead off with a recap of the first Fed meeting of the year, followed by some comments on recent equity market behavior.  China news is next, with remarks on Xi’s Davos speech.  We have an update on the pandemic.  Policy and economic news come next.  U.K. information follows, and we close with an international news roundup.  Being Thursday, the Weekly Energy Update is available; we look at Biden’s oil policy in the report.  The current Asset Allocation Weekly is also available.

The Fed:  No real surprises emerged from the FOMC statement, although we would view the tone as somewhat more cautious on the economy, acknowledging the risks apparent from the pandemic.  In the press conference, Chair Powell was asked repeatedly about the link between financial market froth and policy accommodation.  He made it abundantly clear that the Fed would not tighten policy to combat overvalued markets (which may more reflect his views but not views universally held within the FOMC).  Despite the dovish tone, equity markets tumbled, which brings us to the next topic.

Pros v. flows:  Tracy Alloway, a reporter for Bloomberg, coined the phrase in bold, and in a nutshell, captures the mood.  For the most part, we have studiously avoided commenting on the massive short squeeze occurring in various equities.  But the impact has moved beyond a curious run in a handful of stocks to something looking systemic.  To capture the gist of the situation, try explaining what is happening to an intelligent but generally uninformed person.  We did, as spouses, friends, and neighbors asked, and the nearly universal response is, “isn’t that illegal?”  In our reading of the case law commentary, what is happening on Reddit falls into a legal gray area.  If a group of investors conspired to do what is happening in secret, it would clearly be illegal.  But, when it is a mass movement on a social media platform in plain sight, the element of conspiracy is missing.  Or, for now, that is how it is being read.  Here are a few of our thoughts:

• There is a clear element of “sticking it to the man” in the social commentary surrounding what is happening.  Hedge fund managers are seen as privileged and rich and the actions over the past week or so are seen as getting even.  It doesn’t seem to have much to do with the companies themselves.  One theater company targeted for buying had a company in an unrelated industry with a similar name that also rose sharply, suggesting that what we are seeing here is a targeting of shorted stocks and buying without much interest in the underlying business.
• As short sellers become increasingly squeezed, they are being forced not only to buy their way out of their shorts but probably to sell their longs to make margin. The selling to gain liquidity is likely a factor in the recent pullback.  That isn’t to say it is the only reason—worries about the pandemic and civil unrest have also played a role.
• Regulators appear to have been caught flat-footed. The response from the SEC was underwhelming.  Former regulators are suggesting the market is being manipulated and that current laws should simply be enforced.  As we noted above, that may not be the case.
• A number of factors have developed to bring about this situation. Very low interest rates have encouraged leverage.  Social media creates mass herding.  Trading costs have fallen to zero.  We note recent reports from platforms of temporary outages in trading.  If you stop being paid for an activity, how does one justify upgrades and investment in such activity?
• What is the potential fallout? If short selling becomes impossible, then ”zombie” companies will proliferate.  Despite Chair Powell’s position on not using rate policy to reduce financial froth, it may become untenable to maintain that position.  It would stand to reason that the companies who have enjoyed the ramping up of their prices should simply issue more stock.  There are fears that they will be sued for putting shares on the market that have clearly been manipulated, but this would be a surefire way to reduce the practice.  The SEC could grant a safe harbor for such issuance.  At some point, the “flows” will likely end in tears, much like what happened in 2000.  Will this create a radicalized group?  In the end, our take is that we are seeing a result, in part, of persistent and overly accommodative monetary policy.  We don’t criticize the Fed because the counterexample is the Great Depression. We are now seeing what follows as a side effect of flooding the economy with liquidity.

China:  Davos leads the reporting.

• General Secretary Xi gave a speech at the virtual Davos forum that hit most of the elite topics such as inclusive growth, green investment, consensus, and pushed against unilateral actions. It isn’t hard to criticize the speech as divorced from China’s actual behavior.  However, we did note an interesting take in the speech, which touched on the “north/south” divide that was mostly missed by the Western media.  Xi made a point to express a shared disappointment at Western behavior that denigrates South Asia.  Although several nations see concerns about China’s bullying in the South China Sea, Beijing is clearly trying to build goodwill with South Asia, which seemed to elude Western commentary.  We recommend this recent podcast for background on China’s relations with South Asia.
  • We note that Chancellor Merkel agreed with Xi about avoiding “Cold War blocs” in her speech. Germany has massive investments in China and has been reluctant to criticize Beijing.
• One area of concern within the Chinese financial system has been residential real estate. There is increasing evidence that policymakers are trying to curtail price increases.  What isn’t apparent is if authorities are comfortable with price declines.
• Although the general position of the CPC has been that the U.S. will remain hostile to China, it appears that Beijing is interested in calming relations. There are claims that China has asked for a high-level meeting, although this claim has been disputed.  We doubt that the new administration will dramatically change the path of U.S. policy, but we would expect the tone to be less belligerent, and a focus on an allied response, instead of a singular U.S. response, is more likely.
  • Business leaders remain uncomfortable with rising tensions with China. Chipmakers especially would like to see export controls eased.
  • At the same time, the CPC is pressing the Chinese tech industry to unwind ties to the U.S. and become independent. Interestingly enough, U.S. tech leaders are also supporting a withdrawal from China.
  • The Biden administration is delaying action on the Chinese military ban for investors. We also note that Gina Raimondo, in her confirmation hearing for Commerce Secretary, did not commit to keeping Huawei (002502, CNY, 2.66) on the Entity list, leading Representative McCall (R-TX) to call for a hold on her nomination.
• There are reports of renewed tensions on the India/China frontier.
• In the face of rising tensions between the PRC and Taiwan, the U.S. not only sent a carrier group into the area, but it also declassified a 1982 cable that shows the “Six Assurances” the U.S. has given Taiwan. Although observers of Taiwan/U.S. relations could generally have outlined these assurances from American behaviors, the release now suggests that the new administration wants to make its position clear.  China has responded by making it clear that Taiwan’s independence is an act of war.
• China is expanding its crackdown on fintech. Ant Financial is restructuring as a financial firm.
• Hong Kong authorities are “grilling” finance executives who leave the former colony.

COVID-19:  The number of reported cases is 100,977,927 with 2,177,418 fatalities.  In the U.S., there are 25,599,961 confirmed cases with 429,178 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 47,230,950 doses of the vaccine have been distributed with 24,652,634 doses injected.  The number of first doses is 20,687,970, while the number of second doses, which would grant the highest level of immunity, is 3,801,053.  The Axios map shows that case growth is falling across the country.  The R_t data confirms the Axios map, with only six states showing a reading greater than one.  Vermont has the worst reading, and Nebraska has the best.  Hospitalizations in the U.S. for COVID-19 are declining as well.

Virology

• China has been raising the argument for some time that COVID-19 exists on imported food packaging. The goal is to undermine the position that the virus emerged from China.  Although there is a general consensus that it did, in fact, emerge in Wuhan, Beijing has an interest in making the food-import claim to build the narrative that it isn’t responsible for failing to containing the disease.  The WHO finds itself facing pressure from China to accept this narrative.  And, there is no real evidence to suggest that anyone has gotten sick from COVID-19 by foreign food.
  • As a result, Chinese consumers are shunning food, leading to disrupted supply chains. Foreign sellers are trying to prove the food is safe and are protesting against China’s testing of food imports.
  • China is continuing to use aggressive disinfecting of food import facilities.
  • Taiwan’s health minister has indicated that China should have contained the virus.
  • And, if you are traveling to China anytime soon, take this as a warning.
• In the vaccine area, China has been trying to promote its vaccines to enhance its image. So far, the plan isn’t working out very well.  India is accusing Beijing of undermining New Delhi’s vaccine industry.
• The EU is getting increasingly agitated over the lack of vaccine supplies. Germany is calling for a suspension of vaccine exports.  Germany has numerous vaccine manufacturing sites, so the threat could be a clear example of vaccine hoarding.  There is also a brewing conflict with the U.K.; the EU is considering cutting vaccine exports from Belgium.  The EU is also demanding the U.K. send vaccines that it holds, claiming it has contracts for the drugs.  There are clear shortages in Europe.  Madrid has halted vaccinations due to the lack of supply.  Some of this anger may be tied to widespread unrest against lockdowns in the Netherlands.
• Meanwhile, there are increasing concerns about the mutations of COVID-19. So far, the current vaccines do appear to work against the most recent variants (BTW, here is a good recap of the current vaccines and how they work).
  • Germany has blocked the AstraZeneca (AZN, USD, 52.10) vaccine for anyone older than 65 due to the lack of testing.
  • Minnesota has confirmed the first U.S. case of the Brazilian variant, which is another highly transmissible mutation.
• There is an underlying belief that vaccines will allow a return to normal. The experience of Israel would suggest tempering that sentiment.  Fears of new variants and the uncertainty about whether vaccines offer sterilizing immunity means that social distancing and other measures must continue even after vaccines are distributed.
• The CDC is indicating that the spread of COVID-19 seems controllable in schools and is considering a recommendation that schools reopen.
• Although there is a focus on vaccines, we continue to monitor developments in other treatments.
  • One symptom of COVID-19, especially in severe cases or the “long-haul” patients, is inflammation. A recent trial of Chochicine, a drug usually prescribed for gout and rheumatic diseases, has shown some degree of effectiveness.
  • Regeneron, the antibody treatment, has been shown to reduce COVID-19 infections in high-risk patients.
• Finally, lockdowns have apparently encouraged some Americans to take up cigarettes.

Policy and Economics:  Here are some of the highlights.

• One trend we have been following for some time is how consumer confidence is affected by party affiliation. Recent data from Morning Consult offers another example of this phenomenon.
• The Democratic Party leadership in Congress is considering using budget reconciliation to pass the Biden stimulus. Under budget reconciliation rules, a simple majority will pass the budget bill.  It’s not clear how all parts of the bill could be contained in this rule (e.g., the $15 minimum wage), but some parts could fit.  That could speed the stimulus, assuming all the Senate Democrats would be on board.  That might not be the case.
• The Biden administration’s “buy American” plan is being watched with great trepidation abroad.
• A survey of younger Americans shows a decided openness to regulating the tech industry.
• Telework is raising a serious problem for state taxing authorities. Often workers in high-tax states commute from low-tax states.  As they work at home, do they still owe taxes in the state where the business is domiciled?  If the courts decide they can’t, the temptation to work remotely from a low-tax state will be large.
• Although we know many businesses have failed during the pandemic, it is important to remember that many of these businesses are in industries with low barriers to entry. We are already seeing a rise in new business formation.
• In New York, landlord and tenant groups are cooperating to manage the current rent shortfall. Usually, when this sort of cooperation develops, a third party is encouraged to pay; in this case, the government will likely be tapped.
• Although the U.S. and EU are at loggerheads over the digital tax, in reality, it’s less about taxing and more about control.

In the U.K., the Brexit aftermath continues.  Small businesses are considering shifting operations to the EU to avoid the loss of access.  Truckers are avoiding U.K. ports instead of sitting in line for hours.  And, PM Johnson is facing an increasing risk of Scottish devolution.

International roundup:

• After a year of living quietly, it has been revealed by a South Korean politician that the former North Korean ambassador to Kuwait has defected and is living in South Korea. Kuwait has allowed a contingent of North Koreans to work in Kuwait, likely to earn hard currency for the regime.  But, since 2017, Kuwait has been removing the North Koreans from the country to comply with sanctions.
• President Biden and President Putin had a call yesterday. It doesn’t sound like they are going to be close friends.

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