Strategic Global Intelligence Brief for August 21, 2018

How Will Fed Wind Down Portfolio? We know just a few things about the Fed's intent. We know they have decided to start exiting their $4.5 trillion position of mortgage-backed securities (MBSs) and Treasury bills. We know they want to get rid of most of the MBSs and remain in the T-bill market. How this is to accomplished is not all that clear at this stage because it is unknown who will want to buy the MBS portfolio given some of them are still considered "high risk." The fear is that selling off the T-bills will be too destructive to the overall bond market. Most assume the Fed will hang onto many of these until they mature as opposed to rolling them over. Hopefully, this results in more natural levels of decline.

Challenges of the Gig Economy As one would expect, there are major differences between people who are engaged in working as part of the "gig economy." At one extreme are those who used to just be called "consultants"—people with unique skillsets who can sell that expertise to a wide variety of clients at a very handsome price. On the other side of the coin are those in the service sector who are performing a simple and routine job and have no competitive edge. The Uber and Lyft drivers fall into the latter category more often than not. As with other industries, those at the bottom end up needing the majority of the protection. It also puts additional responsibility on the users of the services, as many do not yet understand the tipping protocol for these new offerings.

Tariff Exemptions As we all learned some time ago, it is not really what you know but who you know. Now that it appears that at least some of the threatened tariffs will be imposed on goods from China and perhaps Europe, there has been a massive outpouring of demand for exemptions for specific goods that are unavailable in the U.S. The one thing that almost guarantees an exemption is knowing some person with political clout. Even the arch supporter of tariffs, Mick Mulvaney, argued furiously and successfully for an exemption for a TV maker in his home state.

Short Items of Interest—Global Economy

China—U.S. Rapprochement? Don't hold your breath for a breakthrough, but at least the two are talking, which is something. The two are of the opinion they have more leverage than the other and, to some degree, they are both right. On the other hand, they are both vulnerable and at some point, they will have to either capitulate or undergo some radical adjustments that could drag their economies down a point or two. China needs the U.S. consumer to buy their manufactured goods and the U.S. farm sector needs to sell its output to that market. The talks right now are between trade negotiators that are seeking some ways to get progress in some small areas in hopes this sets the stage for bigger gains later.

Greece Completes Bailout If you missed it, you would not be alone. It is not as if the Greeks were dancing in the streets after the announcement that they had finally emerged from their eight-year trial. The bailout has been declared a success and Greece is ready to stand on its own again. This muted reaction in Greece stems from the fact that this has been accomplished with massive austerity efforts that will remain in place for many years. Greece is still impoverished and weak and unable to provide the jobs that young people are demanding. The brain drain in Greece is crippling their recovery as well. Prime Minister Alexis Tsipras has suggested that riots and demonstrations will likely ensue.

Venezuela Devalues Currency by 95% It just gets worse and worse for the Venezuelans as the currency has now officially been rendered useless. This is a country that is now demonetized and exists solely on barter and informal exchange. It is estimated that 80% of the population lives under the poverty line and 80% of the population exists only to be committing crimes.

Politicizing the Federal Reserve President Donald Trump has once again decided to voice his opinion of the Federal Reserve's actions, this time in front of a collection of GOP donors and supporters. His basic argument is that rate hikes would likely cool off the economy and he is quite correct. That is the basic idea of a rate hike and cooling is exactly what the Fed governors have in mind, nearly unanimously. Trump is certainly not the first president to express frustration with the Federal Reserve and its mandate and he will certainly not be the last. Both Lyndon B. Johnson and Richard Nixon pressured the Fed and convinced them to wait on hiking rates so that there would be no downturn at the time they were up for election. In both cases, there was a sharp rise in inflation that should have been controlled by Fed action. There has been a strong sense that something like that should never happen again. Alan Greenspan was taken to task by George Bush Sr., but did not react or respond. Ben Bernanke shook off the suggestions made by Barack Obama's economic advisors.
In truth, a president has very little power over the Federal Reserve as does the Congress—this is by design. It falls to the Fed to make tough calls that elected officials struggle to make. No politician wants to be the "party pooper" and would cheerfully do all they could to extend high rates of growth. It is obvious that this is all the current crop of leaders have in mind, as they have been spending money like it's going out of style, while also cutting taxes. This has indeed sparked a solid quarter of growth, but in the process, there has been a dramatic expansion of the deficit as well as the national debt. Both are now at levels not seen since World War II. Nobody wants the good times to stop rolling, but this kind of high growth brings inflation. The Fed is just as concerned with that threat as it is with recession and knows that it has to act far enough in advance to nip the rise in the bud.

Analysis: The time for Trump to have altered the patterns of the Fed was when he first came to office when he was looking at a rare opportunity to reshape the Fed completely. The GOP-dominated Senate had refused to appoint the last two Obama suggestions to be on the Fed so Trump inherited those vacancies. Janet Yellen's term was coming to an end and there were three more expirations or resignations. There was some expectation that a fairly radical outsider would be picked as the new chair, with names like Paul Taylor in play. In the end, the president's pick was a very traditional and safe one. Jerome Powell was already on the Fed board and had been an ally of Yellen's. The next pick was Randal Quarles. He has been a mild critic of the Fed policies in the past but not because they raised rates too soon. He is a hawk when it comes to rates and wanted them higher by now.
There are two more appointees working their way through a preoccupied Congress and may not come up for a vote for months. Richard Clarida is a monetary authority and colleague of Ben Bernanke's at Columbia. Since Powell is not an academic, this would be Clarida's role as vice chair. It has been three decades since the Fed chair has not had a Ph.D. and Powell is expected to defer to Clarida on more strictly economic matters. The other appointment is Michelle Bowman. She is a Kansas bank commissioner and former president of her family's bank in Council Grove, Kansas. She has also been a Washington bureaucrat in DHS and fills the spot for a small banker. The bottom line is that Trump had an opportunity to pack the Fed with people who would see things his way, but that has not been the case. Most in Washington assert that these appointments were suggested and pushed by Steve Mnuchin.

Does all this fulminating over rates mean anything at all? Not really. The Fed has not lost its desire to be fundamentally independent. There has been no suggestion that Powell will back down or that there is support from any of the decision makers on the Open Market Committee. The plans are to hike rates in September and perhaps again in December. The 2019 plans are murky, but the consensus view is that three more quarter-point hikes are likely. Several of those sitting as regional presidents have indicated that rates around 5% seem about right for the current situation. The comments by Trump are purely political at this point, although it is conceivable that he would withdraw the two names he has selected and replace them with people more supportive of his current views. One can be assured that he would be strongly counseled not to do this in an election year.

The Revenge of the Central Bank The renewed attacks on Fed policy are not the only challenge that central banks are facing in the world today. The pressure that has been brought against the central bank of Turkey by Recep Erdogan has been intense and the recent constitutional changes rammed through have given him the ability to hire and fire the head of the bank. This seems like some awesome power over that institution, but Erdogan is being reminded why these central banks are kept independent in the first place. Investors are deeply worried nobody will be able to control the Turkish economy and are defecting in droves.

Analysis: Investors are watching the U.S. closely as well. They will either decide that the Fed is knuckling under to the president if they decide not to hike rates or they will assert the Fed is making a point at Trump's expense by being too stubborn to adjust the rate policy. The warning is simple enough. If there is a sense that the central bank is being messed with and that it is reacting to that pressure, the investors react and the market drops. The real and perceived independence of the bank is critical to normal financial markets and it is never a good idea to interfere. The U.S. is a long way from the central bank crisis that has gripped Turke,y but any political interference makes the investment community nervous. Now, there is further worry about what Trump really intends to do about the way that corporations report on a quarterly basis.

Australian Turmoil Malcolm Turnbull has managed a victory of sorts, but he is still being described in Australia as "a dead man walking." His party win was very narrow and the conservative wing of the Liberal/National coalition is still gunning for him and will certainly launch another attack on his leadership soon. Turnbull was once seen as the man who would unite the fractious party and drag it back to the moderate center after the removal of Tony Abbott as the prime minister. Abbott had been a strong advocate of hard right politics and these alienated many of the voters in Australia since they were not as interested in "family values" as he was. Instead, they opposed his willingness to bend over backwards for the mining industry. Turnbull was supposed to be a moderate who could at least talk to the conservatives. That has not turned out to be the case. In this election, Turnbull was pitted against John Dutton, a former police officer who was in charge of a very harsh immigration policy a few years ago. He has picked up Abbott's issues and added crime and immigration to the mix.

Analysis: At this point, nobody has a clue what will happen with the Liberal/Nationals after this miserable fight. The party is as divided as it has ever been and there is no support for Turnbull. But outside the arch conservatives, there is not much support for Dutton either. The Labor opposition is prepared to make political hay in the 2019 election, but that is over a year away. When Turnbull came to power, there was a notion that there were many conservatives like him—socially liberal but fiscally conservative. He was more or less pro-abortion, pro-gay marriage and pro-immigration. It might be more accurate to describe him as ambivalent, but he certainly was not opposed. That changed as he needed to bring his conservative colleagues around to his other policy priorities. As he gave in to their demands, it alienated the other moderates. For many of them, the final straw was his decision to back down from his confrontation with the mining companies over climate change.

With Turnbull in a very weak position, the system in Australia has become as polarized as it has been in the U.S. and Europe. The conservatives will likely regain control over the Liberal/National coalition and that sets the country on a collision course between the very hard line conservatives and the very hard line left in the Labor Party. Once again, a nation that consistently polls as a moderate and down the middle population will have the choice of very far right and very far left.

This all matters to the rest of the world because Australia had been an example of a well-run government that sported growth every year for over 25 years. The immigration policy has been seen as enlightened and the country has also learned how to navigate relations with China. If they struggle to hold things together, it worries other nations with even deeper splits and confrontations.

Climate Change and Freight "It's an ill wind that blows nobody good." That is reputed to be an old adage from Scotland and suggests that what is bad for one is not necessarily bad for another. There has been a considerable debate over the deterioration of the Arctic ice pack and the damage this has done to the environment of the area. However, there have been some reactions from the business community that suggest there are bonuses as well. Maersk will be the first major container fleet operation to explore the possibility of using the long-awaited northwest passage for freight from Asia to Europe and the eastern ports of the U.S. The melting sea ice has opened up this route as a year-round alternative to the southern route that takes ships through the Suez Canal and the dangerous waters that surround the region. Not that those who are concerned about climate change will take this as a good trade, but the shipping industries are very excited.

Analysis: This is just one example of the shifts that will be taking place across the world. There will be limitations in some areas and new opportunities in others. The growing season is climbing further and further north and that may benefit both Canada and Russia, while the U.S. may see less opportunity as drought spreads into once fertile growing regions. The impact on the current farm sector in the world will be wrenching, but new developments will also take place.

There has been intense debate over almost every aspect of the global warming/climate change issue. Outside of a few holdouts, there is little doubt that there has been climate change. There is a lot more discussion over what has caused that change—it is obviously not all natural and it is equally obvious that it is not all man made. The percentage is what is questioned. The more important debate will be over what to do about it—trying to reverse will be next to impossible and that leaves trying to accommodate. That will not be easy either, but it may be all that can reasonably be expected.

Tales of the Road Summer has come to an end and so has the slow travel season. This has been a good year to see things slow down as it gave me a chance to rest up a bit. The next few months will not offer such a break and I think I am ready. I am not sure I am ready for my fellow passengers, at least, based on the most recent trip, I am not. It started with the rookies who had never flown Southwest before and couldn't stop complaining about the lining up process. Having flown the other guys and been assigned to the fabled zone three or zone 16, I wondered what they were so peeved at. Do they really miss the rugby scrum that accompanies every boarding as people fight to be one of the last with a place for their bag? Southwest makes it simple: "C" means "center seat, check your bag."

Once on the plane, there was the guy who elected to impress his friends by refusing all the instructions from the flight attendants. He was chastised by every one of them and the pilot, but he still smirked, smarted off and dared people to make him. We were delayed by about 10 minutes because the local police were summoned and he was escorted off in handcuffs. The smirk had been replaced by a look of sheer panic.