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

[Posted: 9:30 AM EDT] | PDF

Good morning; it’s Monday.  U.S. equity futures are moving higher, the World Series is set (congrats to Tampa Bay and Los Angeles), and there is a plethora of news to discuss.  China’s GDP confirms the recovery is gathering steam.  We look at the Fed’s “Tinbergen problem.”  We update the pandemic news; infection rates are rising in Europe.  There were votes held in Bolivia and Chile over the weekend.  Thailand protests continue.  Brexit is still there too.  Next up is policy and the economy, and we close with odds and ends.  Here are the details:

China:  Q3 GDP rose 4.9% which was a bit below expectations.  However, the data does appear to be accurate as it coincides with measures we use as a check on the GDP report.  For example, it matches growth from the Capital Economics growth proxy index.  Although the growth rate was less than forecast, it is one of the few places in the world showing a strong recovery from the pandemic induced downturn.

• The U.S. has been investigating, and in some cases, detaining, Chinese academics working in U.S. universities. There is ample evidence to suggest the Chinese government was coordinating a massive research gathering operation, and the investigations are part of thwarting that effort.  In a chilling warning, Beijing is indicating that U.S. citizens may be detained in response.  China has a history of detaining nationals from countries with which it is quarreling; Canadians have been arrested on flimsy charges after Meng Wanzhou was arrested in Canada.  So far, China hasn’t arrested any Americans, but this is a clear warning that it is considering such actions.
• China has passed a new export control law that increases the odds of reducing rare-earths exports.
• In a surprising move, China is aggressively buying low yielding Japanese JGBs. There are likely one or two explanations.  The first (and the one most likely) is that China is attempting to diversify its foreign reserves.  As tensions rise with the U.S., it would make sense for China to try to reduce its dollar holdings.  However, there is an alternative explanation.  Japanese investors, searching for higher yielding assets, are buying dollar bonds from China, leaving them with JPY to invest.  China is buying JGBs to use and dispose of these accumulated JPY.

The Fed’s Tinbergen Problem:  Jan Tinbergen was a renowned Dutch economist who specialized in econometrics and policy.  For his work, he was awarded the first Nobel Prize in economics.  Tinbergen observed that policymakers need an equal number of policy instruments for an equal number of targets.  Over the weekend, there was a report that a number of Fed officials discovered that expansive monetary policy can lead to asset bubbles.  On the one hand, this is something of a “no duh” realization.  It has been apparent for the last decade that accommodative monetary policy boosts asset prices.  But, until this article, most members of the FOMC downplayed or ignored this observation, suggesting that the economy needed low interest rates due to weak growth, and thus, the asset issues were not really a problem.  The trouble is that it is a problem.  Fed policy has evolved into volatility suppression; as the Fed has dampened volatility, it has encouraged market participants to engage in what can best be described as carry trades.  Carry trades work best when nothing happens.  The usual description of a carry trade is that it is like “gathering nickels in front of freight trains.”  To prevent the activity from getting out of hand, the usual market discipline is to allow the “train” to do its worst on occasion as a warning to others.  However, starting with the 1987 Crash, but becoming most evident in the LTCM failure, the Fed has acted as a brake on the train, preventing participants from getting hurt too badly.  This expectation of protection has, as one would expect, encouraged even more risky and leveraged behavior.  The line “privatizing the gains, socializing the risk” describes how the Fed (and to be fair, the rest of the financial regulatory system) has operated.

We were a bit surprised to see Fed officials openly discuss the asset bubble problem.  However, resolving it is much harder than talking about it.  The Fed’s main policy tool, the interest rate target (along with its sidekick, QE) is blunt.  When used to boost the economy, it works mostly by encouraging asset buying and the subsequent wealth effect.  It will be politically difficult (and likely impossible) to raise rates to overtly reduce asset prices.[1]  So, what should the Fed do?  In other words, to address the Tinbergen problem, the Fed needs additional tools other than interest rate policy.  The usual response is “macroprudential policies,” which means regulation.  We know strict regulation can stop excessive leverage and asset bubbles; the lack of financial stress from 1934 to1970 was due to Glass-Steagall and restrictions on interstate banking.  However, it will be hard to bring back such regulations.  These comments from various members of the FOMC do highlight that at least some of them realize they have created a problem, but it doesn’t look to us that they have any good plan on how to address it.  We suspect there are two directions.  The first is aggressive reregulation.  If a FDIC for MMK is introduced, that’s a sign we are on this path.  The second is actions to force MMK to break the buck on occasion, and to inject enough fear among participants to be less enthusiastic about those “nickels.”  To use an analogy, the Fed has acted like a forest manager that will allow for no fires.  It creates underbrush conditions that lead to uncontrollable blazes.  It would seem rational to allow some “controlled burns” to alleviate this issue.  Unfortunately, someone’s assets will likely be torched in these controlled burns, and they won’t see the wisdom of such actions.

COVID-19:  The number of reported cases is 40,088,893 with 1,114,391 deaths and 27,525,530 recoveries.  In the U.S., there are 8,155,894 confirmed cases with 219,679 deaths and 3,234,138 recoveries.  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.  U.S. hospitalizations are rising.

Virology: 

• WHO has released a study that indicated remdesivir did not improve the outcome for COVID-19 patients. This is a bit of a disappointment on the anti-viral front.
• Several of the vaccine candidates require a sterile “cold chain” of at least refrigeration (although some may require deep freezing) to be effective. This requirement will likely reduce distribution in the emerging world.
• Europe is seeing a mounting rise in infections.
  • Belgium has been especially hard hit and has reintroduced lockdown measures.
  • Italy is also seeing a return of cases and has tightened mobility rules.
  • France has implemented mobility restrictions in some cities.
• Researchers have warned that there was likely to be a return of the virus as winter approached. But one of the problems is that societies are reaching a point of “pandemic fatigue.”  In areas where governments have tried to implement restrictions, compliance is well below that seen earlier.
  • Data suggests the U.S. South has seen stronger economic growth due to easing restrictions; it has also seen higher infection rates and deaths.

Bolivia:  After months of delays, Bolivians returned to the polls to vote on a new president.  Although the results have not been confirmed, interim President Anez has conceded.  The new president will be Luis Arce, a member of Evo Morales’s socialist party.  Although Morales came to power with other socialists in the region—Chavez, Correa and Kirchner—his results proved to be much less radical and better accepted.  We expect a similar governance from the incoming new president.

Chile:  Meanwhile, in Chile, voters went to the polls to decide if the country wants a new constitution.  In the runup to the vote, unrest has been widespread.  Chile has been a standout performer in South America, but rising inequality has led to a backlash.  It is unclear what a positive vote for a new constitution will bring; the vote was to decide to keep or end the current one, but not on what will replace it.  But, we take the vote as a sign of caution on Chilean investments.

Thailand:  Despite threats, widespread protests continue in Thailand.  It appears that protestors are using methods similar those that Hong Kong protestors deployed.  This suggests that if Thai officials want to bring the protests under control, they will likely need to deploy methods similar to those deployed by China.

Brexit:  Although PM Johnson continues to threaten to bring a hard Brexit, the behavior of financial markets suggests he isn’t believed.  Either we are setting up for a shock, or, as the markets seem to expect, Johnson will cave.

Policy and economics:  Speaker Pelosi has set a 48-hour deadline for stimulus talks.  We don’t expect a deal to be reached but would look for a package after the election, regardless of who wins.  As research gathers, it is becoming clear that households saved a significant amount of the income support and are spending it down now that there is no further stimulus.  Although it is difficult to precisely measure when spending will decline, the longer we delay stimulus, the greater the odds are that within the next quarter or two, consumption will stall.

• As we have been documenting for some time, commercial real estate is at great risk due to the pandemic. Malls have been especially hard hit, facing additional pressure from the closure of movie theaters.  In addition, office space is coming under pressure.
• Another industry that has been roiled by the crisis is childcare. Disruptions in childcare will tend to reduce the workforce and slow the recovery.
• One of the revolutions in banking over the past four decades has been the movement to rely on data instead of the discretion of loan officers. Although the human element did a reasonably good job in allocating credit, it wasn’t the most efficient way to make loans, so banks moved to using numerical models to make loans.  However, such models are only as good as the data inputs, and there is a growing worry that FICO scores, as an example, may be overstating creditworthiness.

Odds and ends:  The U.N. arms embargo on Iran has officially ended.  However, given U.S. sanctions on Iran, there will be a limited number of nations willing to make arms deals with Tehran.  The ceasefire between Azerbaijan and Armenia has mostly failed.

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[1] Imagine a Fed Chair testifying to Congress that “we raised the fed funds target because the P/E was too high.”  Greenspan got close to that with his ‘irrational exuberance’ comments and got so much blowback that he never ventured close to it again.