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.

• The Pentagon has started the process of removing all contractors working with the U.S. from Afghanistan. The removal of contractors is seen as the first step taken by the Biden administration to withdraw all U.S. forces from Afghanistan by September 11.
  • The U.S. is considering training Afghan forces in different countries after it fully withdraws from Afghanistan.
• Morocco recalled its ambassador to Berlin in response to Germany’s stance regarding Western Sahara. Following the U.S. decision to recognize Morocco’s claim over the disputed territory in December, Germany called a United Nations Security Council meeting to discuss the issue further. Additionally, Morocco has accused Germany of sharing intelligence with an alleged Jihadist.
• The U.S. and Iran are still engaged in nuclear talks. The two sides remain far apart on securing a deal as Iran would like more sanctions to be lifted before agreeing to comply with restrictions on its nuclear program. The two countries would like to have an agreement before the Iranian elections on June 18 as it is believed it may be harder for the two sides to agree afterward.
• Rising currency pressure has led a member of Taiwan’s central bank to imply that over the next two years the bank could allow the currency to appreciate. Taiwanese firms have seen an influx of investment as rising trade tensions between the U.S. and China have incentivized U.S. companies to diversify their supply chains. The increased investment has put upward pressure on the Taiwan dollar.
• Norway’s central bank governor, Oystein Olsen, has expressed hesitancy in removing the country’s monetary support in the near future as Europe continues to struggle with the vaccine rollout.

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

• The ban on U.S. investments in Chinese companies with links to the Chinese military is expected to remain in place under the Biden administration. The restrictions were initially imposed by the preceding administration and have heightened tensions between Beijing and Washington.
• President Biden announced that he is willing to lower his demand of a 28% corporate tax rate down to 25% on Thursday. Increasing corporate taxes is one of the ways the Biden administration has sought to fund the $2.3 billion infrastructure proposal.
• The intellectual property (IP) waiver for vaccines isn’t expected to resolve shortages in the near future. The process that is needed to lift the patent protections could take months or even years as it will likely involve intense negotiations. Germany’s resistance to the proposal will likely complicate the issue further. The removal of IP is designed to help developing countries produce the vaccine domestically as these countries have lacked the shots needed.
• South Carolina is the second state to announce it will end pandemic unemployment benefits early to address labor shortages; Montana was the first state. Governor Henry McMaster has ordered pandemic-related unemployment programs to end June 30.

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

• The Philippines rejected China’s fishing ban in the South China Sea. The dispute regarding claims over the South China Sea has complicated China’s relationship with countries in Southeast Asia. On Thursday, the National Task Force for the West Philippine Sea had to disperse several Chinese militia vessels in the Sabina Shoal.
• The Chinese census is expected to be delayed as the country has struggled to track migrant workers. The report was supposed to be released sometime in April but has now been postponed indefinitely.
• China’s Long March 5B rocket is expected to re-enter the earth’s atmosphere this weekend. U.S. Defense Secretary Lloyd Austin has stated that the Pentagon has no plan to shoot down the rocket upon its re-entry. The debris from the rocket is not expected to cause any harm.

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.

Virology

• Due to a shortage of critical ingredients, Brazil could possibly run out of the CoronaVac vaccine as soon as next week. The shortage is believed to be related to a growing rift between Brazil and China. Over the last few months, Brazilian President Jair Bolsonaro has angered many in Beijing due to his assertion that the virus may have been an act of biological warfare. More than 410,000 Brazilians have died of complications related to the virus, second only to the U.S.
• The Indian virus variant has been detected in the African countries of Kenya, Uganda, and Morocco.
• New York baseball stadiums will be open to all baseball fans starting May 19. The New York Yankees and Mets will create separate sections for vaccinated and unvaccinated fans. The vaccinated section will be allowed to sit together at full capacity, while the unvaccinated sections will be required to wear masks and sit six feet apart.
• Quality control problems at a Baltimore plant have forced countries to halt the distribution of the Johnson & Johnson vaccine (JNJ, $167.18). The pause will be in place while countries ensure the vaccines are safe following a contamination in March. None of the Johnson & Johnson vaccines administered in the U.S. came from this plant.
• Assuming enough people get vaccinated, the Centers for Disease Control and Prevention has stated it believes the pandemic could be under control by July.
• Japan is expected to extend the virus state of emergency until the end of May. The move comes as Japan tries to slow the virus in preparation for the Olympics. Most major cities are now operating under states of emergency, including Tokyo.

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