Look Out

With the release of the US and EU GDP figures, Q1 is behind us. Amidst the great uncertainty, there is at least one thing that is clear. The current quarter is going to be worse, even if not for China. The good news is that with lockdowns gradually easing, the US and European Union, and parts of Asia are probably near the peak of the economic contraction.

The March data suggested China was likely past its low point, and the April PMI, if one accepts it as face value, shows the domestic economy is gaining traction. The non-manufacturing PMI rose to 53.2 in April, which is above the six-month, 12-month, and 24-month averages (49.5, 51.6, and 53.0, respectively). Fears that China will take advantage of the situation to buy depressed assets are prompting many countries to look to tighten up rules about foreign direct investment, especially by state-owned companies. There also appears to be greater sensitivity to sectors, such as medicine and medical equipment, in which officials want to discourage foreign investment.

In the week ahead, the April PMIs may pose some headline risk, but the preliminary reports steal most of the thunder. The May reports will be more interesting as the economies may begin showing signs of stabilizing, before turning up in June or July. The week will start slowly as China and Japan are on holiday through Tuesday and Wednesday, respectively.

The most interesting, if not important, data point next week the US national employment data at the end of the week. In the four-week period up to the week the establishment survey was conducted, weekly initial jobless claims rose by an astounding 22 mln. Given high levels of uncertainty and unknowns, this gives a rough sense of the magnitude of the impact and, by chance, is also the median forecast for the loss of jobs last month. This in on top of the 701k jobs lost in March.

From the household survey, the unemployment rate is derived. The rise in weekly jobless claims suggests something on the magnitude of 16.0%-16.5%. Here too, the impact has been so profound that the normal confidence intervals around forecasts are not helpful.  Under usual circumstances, the difference of a couple tenths of a percent in the unemployment rate (or 100k in the non-farm payrolls) is significant. Still, now the more considerable variability has been granted. It is also understood that the data lags the developments on the ground, and that thing will get worse in the months ahead.

The US economy contracted by 4.8% (annualized pace) in the first quarter. It held up better than China (-9.8% quarter-over-quarter) and the eurozone (-3.8% quarter-over-quarter). The second quarter will likely tell a different story. China may return to growth. Local government infrastructure spending will provide the necessary fillip. The downturn in Europe and the US will accelerate sharply. A 10%-15% contraction in Q2 in the eurozone looks reasonable. In the US, the annualized decline in output of between 20% and 30% would not be surprising.

The idea that the US economy will be “rocking” by July, as some officials have suggested, seems like one of those aspirational truths rather than a thoughtful economic projection.  First, without a cure or vaccine, it appears that new flare-ups of the virus are nearly inevitable as social distancing is relaxed. Second, in aggregate terms, almost an eighth of the US workforce depends on mass transportation. Of course, it is not evenly distributed, with several large urban centers accounting for the bulk, and only about half of workers have access to public transportation.  Until people feel safe, the re-opening can only go so far.

Canada also reports April jobs data at the end of the week. Remember the proportions: As a rough and ready estimate, Canada’s GDP is a little less than 1/10 of the US, and its population is a little more than 1/10 of America’s. It lost more than a million jobs in March (divided almost 50/50 between full and part-time positions. As of May 1, there were three contributors to the Bloomberg survey for Canada’s April jobs data. Two of them were looking for jobs losses of 5 mln or more. The third was the outlier at a still staggering 1.2 mln. The unemployment rate could rise toward 20%. 

Canada entered the crisis with fiscal capacity. Consider that the federal government’s deficit was a little more than 0.5% of GDP in 2019. The ratio is a function of how large the contraction in the denominator (GDP) and how much the numerator (deficit) will rise. Canada’s fiscal response is estimated to be almost C$100 bln or a little more than 4% of (2019) GDP. The IMF’s new World Economic Outlook projects the Canadian economy to contract by 6.2% this year. Canada could wind up with a budget deficit of something around 5%. In contrast, the US budget deficit in 2019 was about 4.7% of GDP. The Congressional Budget Office projects this year’s shortfall to be near $3.7 trillion or 18% of GDP. 

A common refrain is that US yields are low because the Federal Reserve is buying Treasuries.  It is obscuring the price discovery process. Perhaps, but not in the way that one might suspect. If the Fed stood back completely and pulled back from the alphabet soup of facilities, the capital markets would seize up like a cardiac arrest. The demand for Treasuries would surge. Interest rates would plummet. This is not a projection or forecast. It is what happened for a few days in March when the markets were unhinged, and the 10-year Treasury yield fell to almost 30 bp. The stabilization of the capital markets saw the 10-year yield rise. Last month, it traded between about 54 bp and 78 bp. 

As the markets stabilized, foreign central banks also stopped selling Treasuries. For six consecutive weeks beginning in early March, foreign central banks sold nearly $110 bln of US bonds from their custody accounts the Federal Reserve holds for them. In percentage terms of their holdings, it is rather minor. When their holdings bottomed in early April, they were worth about $2.85 trillion. 

Still, it helped spark the Fed to offer repo facilities so foreign central banks would not have to sell their Treasuries. We were skeptical of its merits as 1) banks were already providing this kind of facility, and 2) that foreign central banks were not the disruptive element. Subsequent research at the Bank for International Settlements suggests it was large pools of leveraged capital playing for small incremental movements played a significant role, for example. 

The repo facility does not appear to have been utilized. However, as the capital markets stabilized, foreign central banks have begun buying back their Treasuries. In the last three reporting weeks, foreign central banks have bought about $24 bln of US Treasuries for their accounts at the Fed. 

One thing that could scare foreign investors and especially central banks is anyone who gave the recent press report that the possibility of that the US would default on debt owned by China a shred of credibility. Even if the US wanted to get China to “pay for Covid-19” by not servicing its debt, it is more complicated then merely not sending Beijing a check on the interest of the nearly $1.1 trillion of US Treasuries it held at the end of February (according to US estimates). 

It was quickly denied by Trump’s chief economic spokesperson Kudlow. One cannot help but wonder why it was leaked in the first place.  It is clear that such a topic is sacrosanct. Even broaching it is dangerous. The amount of money saved by not servicing debt that is owed to China would be lost many times over as a consequence. 

Was it planted intentionally to allow for the denial, and making the other retaliatory measures more palatable?  Other actions, like removal of its sovereign immunity, which would make China subject to lawsuits in the US, is a dangerous road to embark upon as the US also benefits from it.  The US could deny government pension funds from investing in Chinese stocks, but it would likely impact the returns more than China. 

While some US officials appear to have already reached a conclusion, many other countries in Europe and Asia have called for a thorough investigation. It is disheartening and troublesome that China is attacking those seeking an inquiry and not cooperating with the World Health Organization that is looking into the origins of the virus. 

China’s markets are closed for the extended May Day holiday, which will carry into the first couple of days in the week ahead. The offshore yuan sold off on May 1, and the roughly 0.75% decline was the most since mid-March. The dollar was at its best level in nearly a month, reaching almost CNH7.14. Some suspect it could be China firing a warning shot. It might be, but it does not seem like the most likely explanation. The offshore yuan’s decline began during US trading on April 30 and took another leg up in the NorthAmerican session on May 1. There was no need for Chinese officials to do anything because the market was doing it for them if a softer yuan was desired. Asset managers with onshore yuan or offshore yuan exposure (e.g., Dim Sum bonds) might want to hedge the currency risk using the offshore market. Speculators can express their views easier in CNH than CNY. We note that ahead of the weekend, US yields were slightly softer, as the equity losses, disappointing earnings, and weak data sapped risk appetites. 


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