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Strategic Global Intelligence Brief for August 3, 2018

Short Items of Interest—U.S. Economy

Jobless Rate Alters Slightly but No Surprises
There was not a lot of shock value to the jobless total this time around. The rate of unemployment fell a little from 4% to 3.8%. There were not quite as many new employees as had been the norm. The expectation had been that another 200,000 would be added, but this month the total was 156,000. To be honest, there are not that many available workers anymore—not with the skills needed. The bulk of hiring now has been some form of poaching where companies are recruiting from other companies. There are also more people electing to just quit their current job in search of something new. The overall sense of the situation is stability. No real gains as far as jobs are concerned, but no significant losses either. There are no signs of large layoffs and no sense that waves of currently unemployed are just waiting to get back on the employment rolls.

Manufacturing Loses Some Momentum
The numbers slipped a little as far as the Purchasing Managers' Index is concerned, but overall data remains plenty strong. The numbers had been touching the lower end of the 60s and have now fallen back to 58.1. Given that anything over 50 is considered expansion and under 50 is contraction, these are still solid numbers. The part that has caused a little more alarm is the fact that inflation worries are playing a bigger and bigger role. The expectations are that inflation will be above 2% at the core and perhaps as high as 5% in real inflation. That means the Fed will hike rates even further and faster than had been expected. This has many companies rushing to do what they had planned for the year; starting to pursue a more cautious approach for the end of the year.

Trillion Dollar Deficits
The U.S. is now on target to have trillion-dollar deficits for the next several years. Each year will be worse than the last. The government has been pursuing an extremely profligate set of policies that will place the country in real trouble when there is another recession. During 10 or so years of growth, it would have been expected the U.S. would have taken steps to get this debt under control by either raising taxes and addressing it from the revenue perspective or cutting the size of the budget. At one point, that was the stated aim of the Tea Partiers. But they are either all gone or have changed their tune as there has been an increase in spending across the board for years—military, civilian, entitlements and everything else one can conceive of. It is a very dangerous place to be from an economic point of view.

Short Items of Interest—Global Economy

Italian Debt Crisis
Yields on Italian government debt have reached levels not seen since the post-election crisis when there was doubt the country was even going to get a stable functioning government. The current budget talks are in total disarray as the two parties that form the ruling coalition are on very different sides of the fence. It doesn't appear that the PM has the ability to bring any kind of consensus. The sell-off has been accelerating rapidly.

Great Deal with Europe Looks Unlikely
The president has been trumpeting his great success in reaching a deal with the Europeans over trade, and specifically farm sector trade. It has been part of his stump speech of late. Actually, France has flatly refused to see the discussion of farm trade reform and will veto anything that messes with the current policy. The U.S. farm lobby has refused to give an inch unless the French back down from this position. This is an impasse that will not end easily.

Record Heat and Fire Danger in Southern Europe
As if the financial and migration issue were not enough, the states that are on Europe's southern tier are facing the hottest temperatures seen in years. Portugal and Spain are seeing weeks of over 100-degree temps, and these have been affecting southern Italy and Greece as well. This has triggered massive fires that have destroyed millions of acres of farmland and thousands of homes. It has also killed over 200 people thus far.

Be Careful What You Wish For
It turns out that this is good advice in China as well as in the United States. Over the last several years, the aim of Xi Jinping has been to consolidate power to a degree not seen since the days of Mao Zedong.

He now holds all the levers of significant power and can stay in office as long as he chooses. The problem with this kind of accumulation is that he no longer has anywhere to shift blame if things don't go well. He is now facing a few major issues that will serve to undermine his agenda, if not his ultimate power. The two that seem to be haunting him now include the trade war with the U.S. and a developing scandal around vaccines for children that have not been properly made. The blame for these problems has been falling squarely on his shoulders.

Analysis: The trade war may be the most vexing because China is not really losing this battle with the U.S., but neither is it winning. The fact is that no nation really wins or loses these battles. The U.S. will be hurt by the trade war; several parts of the economy have already been negatively affected. Regardless of the handouts that have been promised to the farmers affected by Chinese tariffs, they stand to lose a great deal of money and market access. Many will go out of business and most will just barely limp through the year. There will be export sectors that will miss out on what was once their bread-and-butter market. At the same time, there will be U.S. companies that will benefit from the lack of competitive pressure. It is also certain that U.S. consumers will be negatively affected as they will see higher prices almost across the board given the ubiquitous nature of Chinese exports to the U.S.

China is feeling some of that heat as well; it has become a game of chicken to some degree. The Chinese have an almost insatiable need for soybeans and other agricultural commodities as the nation gets wealthier and the population demands more meat. The bulk of the soybeans purchased by China go to cattle feed as this country has some of the largest cattle operations in the world. It has been a major buyer of U.S. soybeans, and the tariff that China is imposing on this commodity will force it to look elsewhere for that supply in the near future. Unfortunately for the Chinese, this is a bad year to have to seek out a new supplier as many of the nations that grow this commodity have had bad years and production is way down. China will either not be able to find the soybean crops it needs or it will have to pay dearly for them.

Farm commodities are not the only thing that China buys from the U.S., and imposing tariffs on these imports almost hurts the Chinese economy more than the U.S. The tariffs that the U.S. is imposing on China will fall into two categories. There will be some goods the U.S. now gets from China that can be obtained elsewhere. This will do major damage to the Chinese economy. There are also many goods that are not so easily replaced, and the U.S. will continue to buy from China even with the imposition of the tariff. China will not be affected at all, but the U.S. consumer will end up paying that tax.

The other issue that has landed in Xi's lap is the vaccine scandal. These are childhood vaccines that are required by the government and have been administered to millions of children. It turns out that many have been improperly made and are ineffective, leaving these kids vulnerable to all manner of diseases. The parents of these at-risk kids are furious. They have been far more vocal than is usually the case in China because they lay the blame squarely on the Beijing leadership.

Another Hurdle for Zimbabwe
The majority of the ballots have been counted. It is now clear that Emmerson Mnangagwa has won an election that was a bit cleaner than expected, but still very controversial in terms of the military's role. The bigger issue is the attacks that were visited on opposition supporters by the army. It is not clear whether the order to engage came from Mnangagwa, which could be a major issue either way. If he ordered this violence, he has exposed himself as just another African tyrant in the mold of the man he replaced in a coup (Robert Mugabe). If he did not give the order, it means that he has limited control over his own army and police. That doesn't bode well either.

Analysis: To dig out of the hole that Mugabe left Zimbabwe in will require significant levels of investment from the western world. None of that is going to happen if there is not some semblance of order restored in the country. There is a lot of potential in Zimbabwe—it was the breadbasket of southern Africa before Mugabe destroyed the farm sector. It has minerals and the diaspora is educated and spread all over Africa. The attacks have to stop, but now it is nearly certain that some in the opposition will try to hit back. That threatens to create a civil war.

The Inflation Threat Is Getting Real
There has been a cloud on the horizon for quite a while, but of late it has started to look a lot more menacing and imminent. We are heading towards an inflationary period of significance. This is not something that many of us have experienced over the better part of the last couple of decades—we have been busy contending with a recession and then a very slow recovery from that recession.

It would be a good idea to review what inflation actually is, how it is assessed and why it worries economists far more than a recession does. Simply stated, an inflationary period is one where prices of most everything rise, and generally sharply. These prices hikes, however, vary and rarely proceed in lock step. There may be inflation in one sector and even deflation in another, but as the problem worsens, the inflation broadens.

Analysis: The rate of inflation is measured by noting the change in pricing from one period to another—it can be an annual rate, or monthly or quarterly. The annual measure is generally the most reliable as it limits the impact of volatility in pricing. There are generally two types of inflation measures—core inflation and real or headline inflation. The measurement of core inflation often drives people nuts as the economic analysts who do these numbers do not consider the price of fuel and food. These are arguably two of the biggest factors in a given family's budget, so it doesn't seem to make any sense at all to not consider the price change. The measure of real (headline) inflation does indeed count both food and fuel. The reason they are not considered part of the core rate is that these prices are extremely volatile and can change radically within a few weeks. That makes it very hard to make comparisons over a few months or a year. It is also assumed that these price hikes will show up in other ways through the course of the year—higher transportation costs, higher air fares, more expensive restaurant meals and so on.

When it comes to driving prices up, the two most important factors are commodity prices and labor. When there is a rise in the price of oil or natural gas, there is a sharp response in the way of utility costs and the price at the pump. Drivers feel it, transportation providers feel it, consumers feel it when they pay more to heat and cool their homes. Industrial metal prices, plastic resins, chemical compounds, lumber and cement are also among the many other commodities that form the basic building blocks of the economy. Then there are wages. For the last year or so, the expectation has been that wages would go up at any minute as all the conditions were right for such a hike. There is a theory that has been in place since the 1950s called the Phillips Curve that made the connection between low levels of unemployment and higher wages. Naturally enough, it was assumed that when there were fewer people available to hire, the business community would have to pay people more to get them to take the jobs on offer. It was also assumed that companies would poach to get people they needed. That meant higher wages to lure people to change jobs and higher wages to get people to stay.

There was some movement in commodity prices, but not all of them rose as quickly as expected. Wages did not go up as predicted since those looking for work lacked the skills and training needed. If they did get hired, it was with the understanding they would need to be trained and would not be making much more than minimum wage until they were trained. There has been a significant shift in both of these areas in the last several months as commodity prices have been increasing for both natural and artificial reasons. The natural reason is that producers reduced their output when demand faltered and they have been slow to return to prior levels. The artificial motivation has been the tariff and trade war launched by Trump. This has driven the price of steel and aluminum up and various threats directed towards the Iranians and others have pushed the oil markets to hike prices. Business has started to give up on finding qualified people and are hiring attitude, and assuming the need to do their own training.

One very important factor we have not talked about yet is the role of the Federal Reserve. Their job is to manage monetary policy. That means intervening when there are recessions and inflationary periods. In truth, the central bankers are far better equipped to deal with inflation than they are with recession. The only weapon they have to jump start the economy is to make money cheaper through lowering interest rates and finding other ways to get banks active. This has been referred to as "pushing a string" because banks can't be compelled to loan—they have to want to—during a recession they often don't want to. Controlling inflation on the other hand is far easier. All the Fed has to do is make money harder to get by hiking interest rates and reducing the availability of bank assets by setting the reserve ratio or changing the interest rates the banks get for depositing money at the Fed.

In the most general of terms, the Fed is made up of "hawks" and "doves," but the designations are highly flexible depending on how the data is trending from one month to the next. The hawks want interest rates higher and worry far more about inflation than do the doves who think the recession threat is the more damaging. Right now, the hawks seem to hold the majority position within the Fed's Open Market Committee (FOMC)—the body that is charged with setting these rates. The members this year include Fed Chair Jerome Powell and Vice Chair John Williams—the head of the New York Fed. They are joined by the other seven permanent members of the Board of Governors and four of the regional bank heads that rotate for annual terms. Right now, there are only three members of the Board as there have been some resignations and retirements and the replacements have not worked through the Congress. Of the three Powell, Randall Quarles and Lael Brainard are swing votes—hawkish on inflation now, but have been more dovish in the past. The four regional heads on the FOMC this year include the very hawkish Loretta Mester from the Cleveland Fed, John Williams from New York, Raphael Bostic from Atlanta and Thomas Barkin from Richmond. All three have been both hawk and dove at times, but are hawkish now.

All this means the Fed will be quick to raise rates to contend with any sort of inflationary threat. Obviously, it has already started with the rate hikes this year. The stated desire is to raise them again in September and likely in December as well. The assertion is that rates would go up four more times in 2019. The Fed Funds Rate now is 2% and will likely be at 2.5% by the end of the year. If current thinking prevails, the rate at the end of 2019 will be between 3% and 3.5%, but that assumes that inflation stays below 2% at the core level. Many are suggesting this will be a hard line to hold. Our fearless forecast holds that core inflation will climb to at least 3% in the next 12 months. This will provoke the Fed to hike their rates faster than anticipated. We are looking at interest rates between 3.5% and 4.5% by the end of 2019.

The Varied Life of an Entrepreneur
There are a great many ways to make a living. It doesn't take too long to figure that out if one keeps one's eyes open. I am almost amazed at the creativity of the entrepreneur. I once had the delightful task of teaching a series of classes on the subject and soon learned there were two kinds in general. There were those who just wanted to make a living doing what they liked to do. They really didn't have big ambitions as far as making lots of money. The other variety could not care less what the business was as long as it made money. These were the serial entrepreneurs who started and sold businesses as the market determined. I was always more interested in the former as they had the craziest ideas, but most of them worked.

There were plenty of people starting coffee shops and restaurants as well as people marketing their mom's cookies. There were retailers and loads of people willing to share their expertise as consultants. Yet there was one category that stood out even more. These were the ones who made things—manufacturers, fabricators, craftsmen and so on. There was the guy who decided to build working replicas of World War I aircraft or the guy who invented a suburban yard-sized drone that would be used to do everything from dropping seed to fertilizer. I remember a guy whose project was creating massive cat runs for inside one's house—he showed one that snaked through every room hugging the ceiling all the way. It is proof that for everything one can dream up, there is a consumer willing to buy it.

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Saturday, 07 December 2019