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In a fusion of finance (or what’s left of it in a centrally-planned world where asset prices no longer discount the future) and physics, BofA’s Claudio Irigoyen writes that the Schrödinger famous quantum physics experiment resembles the dichotomy that we find today between the state of the economy and some asset prices, in particular US stocks.

In 1935, Austrian physicist Erwin Schrödinger, trying to make the case that some people were misinterpreting quantum theory, designed a hypothetical experiment, famously known as the Schrödinger’s cat experiment. In a nutshell, the experiment goes, if you place a cat and something that could kill the cat (a radioactive atom) in a box and sealed it, you would not know if the cat was dead or alive until you open the box, so until then, the cat was in a sense both dead and alive.

The Schrödinger experiment, BofA argues, “resembles the dichotomy that we find today between the state of the economy and some asset prices, in particular US stocks” where market sentiment remains especially bearish. According to BofA’s most recent Global Fund Manager Survey (discussed here), only 10% of the respondents expect a V-shaped recovery and 75% think the recovery is likely to be either U or W-shaped. Positioning indicators also indicate maximum bearishness. Cash levels are at a record high. In line with that view, we downgraded again our global growth forecast. Now we expect a global contraction of 4.2% in 2020, down from 2.7% just six weeks ago. However, since March 23, US stocks (as measured by the S&P index) recovered 60% of the selloff that started in mid-February and are now trading just 12% below the peak before the crisis.

A natural question is then: how can we reconcile this decoupling between asset prices and expectations? Can the cat be dead and alive at the same time? Abusing the analogy, is this rebound a dead Schrodinger cat bounce? Or is there somebody making the dead cat look like it’s alive and kicking?

A natural question to ask, according to Irigoyen then, is: how can we reconcile this decoupling between asset prices and expectations? The answer, according to the BofA strategist is that “the most powerful element to explain the decoupling is the reaction function of the Fed (and admittedly of many other major central banks, including to some extent the ECB) and the expectation that this reaction function will remain unaltered in the future.” So should we just call it a Schrodinger Cat bounce then?

It’s the Fed, stupid

In order to make sense of this decoupling between expectations and asset prices, BofA notes that there is more than one element to consider.

• In the first place, positioning helps. As liquidity gradually recovered and with sentiment so bearish, people already adjusted their portfolios to the new steady state and are holding the risk they want to hold, so there are no marginal sellers. The pain trade is up, not down. But this can help explain why the market stopped falling, not so much why it rallied so violently. Indeed, extreme bearish positioning explains the recent stabilization in EM. However, the recovery in EM has been much more muted than in the US, so we cannot talk about a decoupling between sentiment and asset prices in EM.
• Another argument that could explain the decoupling is the relative composition of the S&P index, which is likely overrepresented by the relative beneficiaries of the COVID-19 shock, such as tech companies, the most overweight sector in the index. On the other hand, the SMEs, which are impacted the most by the recession, are not listed in the exchanges. Again, this argument can have some validity but is not necessarily verified in other countries also hit by the outbreak.
• A third argument has to do with investors’ expectations. If investors are too optimistic about the shape of the recovery, more inclined towards a V-shaped recovery, we could have a decoupling between the state of the economy and the stock market which is by its own nature forward-looking. Again, we have seen that this argument is prima facie inconsistent with what the GFMS revealed to us this week. In order to rescue the argument, we need to assume some sort of self-selection, in which the most bullish investors are more active than the bearish ones. “Possible, but stretched”, according to Irigoyen .

The analysis above leaves BofA with what the bank thinks is the most powerful element to explain the decoupling: the reaction function of the Fed (and admittedly of many other major central banks, including to some extent the ECB) and the expectation that this reaction function will remain unaltered in the future.

On top of the fiscal programs implemented by the governments of the main economies, central banks around the world have been flooding financial systems with liquidity. The goal has been to reestablish as quickly as possible both market and funding liquidity, with a particular focus on helping SMEs to finance working capital to avoid disruptive bankruptcies. In the case of the Fed, liquidity programs were complemented with credit programs. As part of the several funding and credit facilities implemented, the programs include buying not only Treasuries but also MBS, Commercial Papers and Corporate Debt and Corporate Bond ETFs. Not surprisingly, BofA thinks that “buying risky assets has been key to prop up asset prices and the stock market.“

In a nutshell, what all this means for asset prices is that the Fed put was increased to a record size and the market expectation is that if the economy falls even further, the Fed will step up buying more risky assets and even potentially buying equities, although the bar is very high for that to happen. The Fed is effectively intervening in the market for risky assets in a sort of “whatever it takes” type of reaction function which was strong enough to coordinate towards a stable equilibrium.

Here BofA takes a detour to clarify that “in theory”, the Fed buying program “should not affect the fair value of asset prices, which are the risk-adjusted discounted present value of cash flows, therefore independent of “supply and demand”. Since the Fed is not removing risk from the economy by buying risky assets, but just transferring the risk to taxpayers, in an economy with no market segmentation, people properly discount higher taxes to cover potential Fed losses and therefore the Fed reshuffling does not affect asset prices in equilibrium. However, if markets are segmented, as they are in reality, Modigliani-Miller doesn’t work, even if Ricardian equivalence holds. With sufficient segmentation, the effect on asset prices can be significant.

Even though the fall in interest rates naturally helps stock prices, being an endogenous reaction to a negative shock, it cannot have a first-order effect. The main channel through which the Fed affects asset prices is the risk premium channel. By effectively acting as lender and buyer of last resort, the Fed affects the risk premium and coordinates expectations towards the “good equilibrium”, avoiding endogenous runs against risky assets and setting a floor on the market, the so called Fed put.

* * *

This brings us to the next question: as part of its new “helicopter money mandate” is the Fed also doing fiscal policy?

According to BofA, the program implemented by the Fed, loosely named QE, is in fact way more than QE. Strict Quantitative Easing refers to the policy of creating reserves in order to purchase short-term government bonds. Not even buying long term government bonds represents QE, as this can be thought of the combination of QE and a swap of short-term for long-term government bonds, also known as Operation Twist. At the zero lower bound for short-term interest rates, buying long term government bonds and Operation Twist are equivalent and it can be argued that if those operations belong to the sphere of debt management (issuing short term bonds to rescue long term bonds), they should be conducted by the Treasury rather than the central bank.

If not even buying long term government bonds represents QE, much less in the case of buying risky assets. When the Fed buys risky assets, which can be called targeted purchases, it is not doing monetary policy but credit policy. It is a form of direct lending and it can be argued also that the Fed, by redistributing risks, is actually doing fiscal policy or at the very least monetizing the fiscal deficit, as the Fed could buy short term government debt that the Treasury could issue to fund targeted credit programs.

Even though the difference is subtle, it is in the realm of Congress to implement such policies rather than the Fed. Pushing the Fed to implement them and indirectly picking winners and losers can increase the implementation risks and undermine the perceived independence of the central bank, in addition to the obvious moral hazard implications, which can arguably be considered second-order given the nature and magnitude of the crisis.

This brings us to the conclusion: what are the unexpected consequences of positive surprises

According to Irigoyen, and tying the analysis back to an economy – which like Schrodinger’s cat is both alive and dead – “if the stock market is being supported by the reaction function, current and expected, of the Fed, it means that the shadow level at which the stock market would be trading absent the Fed’s support would be much lower.” That raises an interesting question: how much can the stock market rally if in the coming weeks, as lockdown policies are being relaxed, economic activity surprises positively relative to already very depressed expectations?

The answer is that certainly much less than proportionally, as the positive surprises on the one hand should lift the shadow fair value for the stock market, but on the other hand reduce the market value of the Fed put (as it would be less in the money). It could even happen in extreme that the stock market remains unaltered, only the factors explaining the observed level change. Needless to say that the short term reaction will likely be consistent with a mild rally, “but a rally that would leave the market even more vulnerable than it is now”, or as another BofA strategist, Benjamin Bowler put it, the higher stocks rise, the more fragile the market becomes.

On the contrary, if economic activity surprises to the downside, it would put significant pressure on the Fed to validate the put, which, given the arguments outlined above, might not necessarily be followed by a strong reaction, leaving the market wondering if the size of the Fed put has a limit.

Based on all of the above, BofA concludes that “the risk-reward of being long US stocks does not appear as particularly attractive.”

It looks like hell isn’t coming after all.

Just over two months after billionaire investor Bill Ackman scared CNBC’s viewers with his prediction that “hell is coming” and “America will end as we know it” unless America is shut down for 30 days – while at the same time admitting he was buying stocks hand over fist – Ackman’s “investing strategy” appears to be bearing fruit. According to Reuters, Pershing Square is up between 21% and 27% this year. On the fund’s call this morning, Ackman disclosed that his fund had exited Berkshire Hathaway (Ackman and Buffett sycophant Whitney Tilson must feel quite conflicted about this) and the position in Blackstone he had put on just months prior. Ackman also said that he exited Park Hotels & Resorts. 

As discussed previously, Ackman’s returns for the year were boosted along by a short credit hedge that Ackman, in all fairness, disclosed he was putting on well before the market reacted to the pandemic. The hedge paid off 100x, netting the firm about $2.6 billion for the fund. 

Ackman also said he added Lowe’s about 6 weeks ago and got the “bargain” of a lifetime, and said that he added Starbucks in the $60/share region.

Ackman had said earlier this month that tech companies could become even more dominant as a result of the pandemic:

“The impact of the crisis on companies like Amazon is actually a little bit of short-term negative because they’re spending a lot of money managing through this, but it’s long-term hugely beneficial to the company.”

Recall that it has barely been 2 months since Bill Ackman took to CNBC’s airwaves to proclaim that “hell is coming”, he a few days before the unofficial bottom for the Dow at 18,213 when Powell announced unlimited QE and expanded into buying corporate bonds, helping rebound the Dow above 20,000, where it has been since.  Three days later the hedge fund manager admitted  he went “all in” long on the market. 

Wednesday has been a wild day for US-China relations.

It has been a few months since we’ve checked in with Huawei CFO Meng Wanzhou, who has spent the last 16 months free on bail in Vancouver while the Canadian legal system has processed her case, as it moves to determine whether it will grant the US DoJ’s request to extradite Wanzhou in accordance with the US-Canada mutual-extradition agreement.

On Wednesday, with tensions between the US and China flaring and Huawei back in the headlines, a Canadian judge has ruled that the allegations brought against Meng by the DoJ would constitute crimes in Canada. That hurdle was a critical legal threshold: If the judge had ruled otherwise, Meng likely would have been freed, and extradition would likely be off the table.

BREAKING Judge in #MengWanzhou case rules in favour of Crown – her alleged actions would be considered a crime in Canada. Extradition process continues. #Huawei @CTVNewsVancouver pic.twitter.com/JeMweAhfTF

— David Molko (@molkoreports) May 27, 2020

Just minutes after the decision, Beijing – via the Global Times – has already responded.

Canadian court’s ruling on #Huawei exec #MengWanzhou unjustified, shows Canada’s judicial system has been hijacked by politics and #US bullying tactics, and may lead to “worst-ever” China-Canada ties: experts https://t.co/mjfnGOmErh https://t.co/gDf1OxlsM3

— Global Times (@globaltimesnews) May 27, 2020

Meng was arrested when she landed in Vancouver on Dec. 1, 2018, while President Trump was sitting down to dinner with President Xi in Buenos Aires during a notable episode that re-started trade talks between the world’s two largest economies. Shortly afterward, Trump suggested that she could become a political bargaining chip in the trade talks.

Of course, that was long before the coronavirus. We suspect that whatever happens now, if Meng lands in the US, prosecutors probably won’t be very amenable to a generous deal.

Authored by Patrick Buchanan via Buchanan.org,

Is the U.S. up for a second Cold War — this time with China?

What makes the question newly relevant is that Xi Jinping’s China suddenly appears eager for a showdown with the United States for long-term supremacy in the Asia-Pacific and the world.

With the U.S. consumed by the coronavirus pandemic that has killed 100,000 Americans and crashed our economy to depths not seen since the Great Depression, China’s dictator seems to be making his move.

At the Communist Party conclave this May, China announced that it was seizing control of Hong Kong’s security. From now on, subversion, sedition, secession and foreign meddling within the city will be crushed.

Whatever sanctions the U.S. and its allies impose, there will be no free and independent Hong Kong.

“For an Ascendant China, Reining in Hong Kong Is Just the Start,” is the headline over The New York Times story on China’s new assertiveness.

“China’s move to strip away another layer of Hong Kong’s autonomy was not a rash impulse. It was a deliberate act, months in the making,” writes reporter Steven Lee Myers. “It took into account the risks of international umbrage and reached the reasonable assumption that there would not be a significant geopolitical price to pay. …

“With the world distracted by the pandemic’s devastating toll, China has taken a series of aggressive steps in recent weeks to flex its economic, diplomatic and military muscle across the region.

“China’s Coast Guard rammed and sank a fishing boat in disputed waters off Vietnam, and its ships swarmed an offshore oil rig operated by Malaysia. Beijing denounced the second inauguration of Taiwan’s President Tsai Ing-wen, and pointedly dropped the word peaceful from its annual call for unification with the island democracy.

“Chinese troops squared off again last week with India’s along their contentious border in the Himalayas.”

To warnings that China is risking Cold War II, Beijing seems to be responding: If a Cold War with the United States is the price of securing our strategic interests and position in Asia and the world, bring it on.

Beijing has put the ball in America’s court. What do we do now?

Consider the list of nations with which China has territorial quarrels that have lately produced military clashes.

Beijing claims Indian lands China has occupied since their 1962 war.

China claims virtually all the islets and reefs in the South China Sea and now uses naval vessels to deal with the rival claimants of Vietnam, Malaysia, Indonesia and the Philippines.

Beijing asserts that Taiwan and all of its offshore islands in the East China Sea belong to China. While the Senkaku Islands have long been controlled by Japan, China claims these islands as well.

As for protests of the suppression of Tibetans and incarceration in concentration camps of Muslim Uighurs and Kazakhs, Beijing brushes them off.

Should the U.S. seek sanctions on China if it crushes the resistance in Hong Kong, how many U.S. allies would support those sanctions, when, for Australia, South Korea, Japan and Taiwan, China, not America, is their largest market and trading partner?

How did we allow ourselves to get into this position where a lately backward China is suddenly a greater rival for global hegemony than was the Soviet Union of Josef Stalin and Nikita Khrushchev?

Said Secretary of State Mike Pompeo ruefully this month:

“China’s been ruled by a brutal, authoritarian regime, a communist regime since 1949. For several decades, we thought the regime would become more like us through trade, scientific exchanges, diplomatic outreach … (but) that didn’t happen.

“We greatly underestimated the degree to which Beijing is ideologically and politically hostile to free nations. The whole world is waking up to that fact.”

Yet, the rising totalitarian power of China, even with its imperial ambitions undisguised, does not threaten the vital interests of the United States.

So, again, the question: If China is prepared for a Cold War II with the United States to establish its predominance, what are we prepared to do should China absorb Hong Kong and convert it into a second Shanghai?

What are we prepared to do if China puts new pressure on Taiwan and seizes offshore islands in the East China Sea, as she did in the South China Sea? Sanctions against Vladimir Putin’s Russia to compel it to return Crimea and vacate eastern Ukraine have conspicuously failed.

Are we prepared to fight for any of the islands, none of which we claim and many of which we agree ultimately belong to Beijing?

The Chinese have stolen our intellectual property, coerced technology transfers from our businesses and sent spies posing as students into our universities to thieve our secrets.

Meanwhile, we allowed ourselves to become dependent on China for medicines and drugs vital to the health and the survival of millions of Americans.

Who did this to us? We did it to ourselves.

While one didn’t need the Fed’s Beige Book to know that the US economy is currently in a horrific state as a result of the coronavirus lockdowns, the just published summary of anecdotes from across various Fed regions confirmed the obvious.

After years of “modest” and “moderate” growth across the US, in the latest Fed Beige Book released this afternoon, the assessment of the economy downgraded sharply with the Fed reporting that “economic activity declined in all Districts – falling sharply in most – reflecting disruptions associated with the COVID-19 pandemic.” with the hardest-hit industries—because of social distancing measures and mandated closures— were retail, travel, and hospitality.

The report which had a May 2018 cutoff date, found that:

• Consumer spending fell further as mandated closures of retail establishments remained largely in place during most of the survey period. Declines were especially severe in the leisure and hospitality sector, with very little activity at travel and tourism businesses.
• Auto sales were substantially lower than a year ago, although several Districts noted recent improvement.
• A majority of Districts reported sharp drops in manufacturing activity, and production was notably weak in auto, aerospace, and energy-related plants.
• Residential home sales plunged due in part to fewer new listings and to restrictions on home showings in many areas.
• Construction activity also fell as new projects failed to materialize in many Districts. Commercial real estate contacts mentioned that a large number of retail tenants had deferred or missed rent payments.
• Bankers reported strong demand for PPP loans.
• Agricultural conditions worsened, with several Districts reporting reduced production capacity at meat-processing plants due to closures and social distancing measures.
• Energy activity plummeted as firms announced oil well closures, which led to historically low levels of active drilling rigs.
• A contact in the Pacific Northwest also warned of reduced local government revenue collection and its implication for potential cuts in fiscal spending and public services. In the entertainment sector, demand for broadcasting and voice-over services increased.

And although many contacts expressed hope that overall activity would pick-up as businesses reopened, the outlook remained highly uncertain and most contacts were pessimistic about the potential pace of recovery.

With nearly 40 million unemployed, the Beige Book also noted that “employment continued to decrease in all Districts, including steep losses in most Districts, as social distancing and business closures affected employment at many firms. Securing PPP loans helped many businesses to limit or avoid layoffs, although employment continued to fall sharply in retail and in leisure and hospitality sectors.”

• Contacts cited challenges in bringing employees back to work, including workers’ health concerns, limited access to childcare, and generous unemployment insurance benefits.
• Overall wage pressures were mixed as some firms cut wages while others  implemented temporary wage increases for essential staff or to compete with unemployment insurance.
• Most Districts noted wage increases in high-demand and essential sectors, while wages were flat or declining in other sectors.
• A payment processing firm reported that job applications for current openings soared, though many candidates did not have the stated requirements.

While there was no outright deflation, the report cited pricing pressures which “were steady to down modestly on balance.”

• Weak demand weighed on selling prices, with some contacts noting discounting for apparel, hotel rooms, and airfare.
• Several Districts also reported low commodity prices, including oil, steel, and several agricultural commodities.
• Supply chain disruptions and strong demand led to higher prices for some grocery items including meat and fresh fruit.
• One District reported that firms faced additional costs related to safety protocols and social distancing compliance, while another District noted that the costs of personal protective equipment had risen due to strong demand.

Firms also reported finding ways to cope with the challenges brought on by COVID-19, with new business strategies or new sales people in some cases. All contacts who were eligible for the Payroll Protection Program received funding, which they regarded as vital support; businesses were also lining up other credit lines and resources in the face of uncertainty. The majority of contacts reported no major structural or compensation changes within their organizations due to COVID-19. Overall, there was some hope with contacts expressing optimism, “excited” (as one put it) to facilitate hiring during the upcoming recovery.

Amusingly, the biggest bogeyman of the Beige Book for much of 2019 – tariffs – was gone and forgotten, without a single mention of the term in the entire report for the second month in a row. That however, was been replaced by mentions of “coronavirus” and/or “Covid” which however saw a notable decline from 87 instance in April to just 52 instances in May when the terms made their first ever appearance. Finally, slowness prevailed, literally, with no less than 44 mentions of the “slow” in the Beige Book.

Senator Josh Hawley (R-MO) has demanded that Google answer questions over allegations that it censored YouTube comments critical of the Chinese Communist Party – which the Silicon Valley giant told The Verge was simply a ‘technical error’ they are working to fix.

Hawley rejected the explanation in a Wednesday letter to Google CEO Sundar Pichai, calling it part of a “long disturbing pattern” of Google pandering to the CCP in order to curry favor with the Xi regime, and adding that “This kowtowing is unacceptable,” according to the Washington Times.

NEW: @HawleyMO is demanding that @Google‘s Sundar Pichai provide information about censorship of YouTube comments critical of China’s Communist Party.

“Selling out American principles to curry favor with communist officials is no way to run an American business.”

FULL: pic.twitter.com/N5pfwRGTs3

— j.d. durkin (@jiveDurkey) May 27, 2020

On Tuesday, Google was busted auto-deleting comments critical of the CCP, including “communist bandit” and “50-cent party” – “the latter term referring to a division of the Chinese Communist Party whose purpose is deflecting criticism fromm the Party by using sockpuppet accounts to spread online propaganda,” reads Hawley’s letter.

#YouTube “automatically” deletes a comment in Chinese, “Gongfei”, which means “communist bandit”, in 15 seconds.
This person tested 3 times, same result. #油管 15秒內自動刪除「共匪」留言，網友連試三次皆如此。
他們找了個比李飛飛更厲害的AI專家？ pic.twitter.com/MLCeko0SIY

— Jennifer Zeng 曾錚 (@jenniferatntd) May 13, 2020

And as the Times notes, Hawley’s letter follows a similar correspondence from Rep. Jim Banks to Pichai demanding answers to similar questions over the platform’s decision to allegedly censor content critical of the CCP.