Strategic Global Intelligence Brief for July 10, 2018

Short Items of Interest—U.S. Economy

Is the Tax Cut Fizzling Already?
According to research from the San Francisco Fed, that is what seems to be happening to the tax cut as far as its impact on economic growth is concerned. This was the fear from the very start of that process. There is nothing unusual about a tax cut and certainly not when the economy is struggling. The problem with this one is that Congress dragged its feet far too long. The ideal time for such a cut would have been in 2013 or 2014 when the economy was just starting to come out of the doldrums, not after the economy had already sported two quarters of 3% growth (Q2 and Q3 in 2017). However, the tax cuts did provoke business activity and eventually some consumer activity as well. The problem is that it was pushing an already expanding situation and may have seen the maximum impact in Q2 of this year. Meanwhile, this plan ushered in sharper inflation threats and added to the debt and deficit.

Trade Spat Likely to Hit Exporters Harder than Importers
Here is the cold reality of global trade. Companies that are buying have far more options than those that are selling. The U.S. companies that are facing tariffs and barriers to trade with China or Europe are likely to find ways to source from elsewhere—India, Indonesia, Nigeria, South Africa and so on. It will not be as easy as sourcing from China, but it will still be cheaper than looking for domestic production. Exporters on the other hand are losing markets as these nations retaliate against the U.S. They will be hard pressed to find alternative markets.

Conference Board Data Points to Tight Labor Market
This certainly comes as no shock to the analysts as nearly everything has been pointing to a tighter and tighter labor market. This is just further data to support this conclusion. Last month the index fell a little, but this month the data has the index on the rise again. That coincides with the data that was released by the Labor Department last week. The bulk of those who have been migrating out of the "discouraged worker" category have been low skilled and generally less educated. Business has admitted it is hiring attitude now rather than aptitude with the hope it can train.

Short Items of Interest—Global Economy

China Cracks Down on Uighurs
This minority group in Xinjiang province has been attacked by the Chinese government for decades. They are in the most remote of regions and are the country's largest Islamic population. They have resisted the usual Chinese process of assimilation. Now, the government has essentially declared the entire population to be terrorists and have been engaged in mass arrests. This has led to thousands of children being placed in state-run orphanages as their parents are unlikely to be released. These kids are being shipped all over China and are being forced to assimilate through abandoning their language and culture in favor of the dominant Han culture of China.

Macron Fights to Salvage Popularity
There was a suspicion that most people voting for Emmanuel Macron were really just voting against Marine Le Pen and didn't really know much about the candidate. Now he faces a declining popularity and accusations that he is unconcerned with the poor. He has responded with a pledge to tackle the welfare system to ensure that it meets the needs of the country as well as the poor, but thus far he is getting sharp criticism from both left and right. It seems an odd place to try to bolster his reputation.

Ethiopia and Eritrea Try to End Hostilities
The war between these two nations 20 years ago cost 70,000 lives and set both nations back by decades. The peace deal was never completed until now when the new leaders of the two states agreed to formally declare peace and embark on a period of cooperation on a wide variety of business development schemes. This could radically change the situation in that part of Africa, and soon.

European Chaos
The mood in Europe is a mix of confusion and anger these days. The many issues that have suddenly jumped to the forefront for the EU were barely considered blips on the radar a few years ago and some have only been months in the making. Last year seemed promising as the EU economy looked to be on the mend. Many of the leaders really thought the biggest threats had been handled. After all, the French voter had rejected the populism of Marine Le Pen and the National Front and the Germans had seemed to be supportive when it came to Merkel. That was about the time that most of these assumptions started to alter. Today, the German coalition is hanging by a thread as the immigration crisis demands center stage, the French president has seen his popularity plummet as he has been labeled the "president of the rich." The Brexit issue has gone from very bad to even worse as the British are savaging each other over how to proceed. It now looks unlikely an agreement will be signed by the October deadline. To top it all off, there is the overt hostility manifested by President Trump—who seems to put Europe in the category of public enemy No. 1.

Analysis: Almost every issue facing Europe right now seems to be an illustration of the old adage "the road to hell is paved with good intentions." The migration crisis was a miscalculation of epic proportion. The crisis in Syria was seen to some degree as a failure of European diplomacy as many thought that there might have been a peaceful resolution of the conflict between Bashar al-Assad and his early critics. That opportunity came and went. In its place was a brutal civil war that pushed millions of essentially middle-class Syrians from their homes. Angela Merkel reacted with an invitation to seek asylum in Germany with the expectation that a few hundred thousand might heed the call. That number soon turned to millions from all over the Middle East and North Africa. Nations that had not been part of the German conversation became the front-line states as the refugees made it to Greece and Italy as well as to the states of East Europe. We know what the situation looks like now. The populist reaction has galvanized this political movement.

Brexit was yet another populist reaction to immigration alongside the long-standing frustration that Great Britain has had with Europe and the overreach that has pervaded the EU. The British voter was not expected to act so decisively, but once that vote was taken, the very challenging process of disengagement began. The British business and financial community was opposed to Brexit from the start. Nothing that has happened since has changed their mind. Many expected the Europeans to be more cooperative than they have been, but the Germans and the French had long been irritated by all the British sniping and complaining and wanted the U.K. to pay to some degree. The future of this relationship is very hard to predict at this point.

Then, there is the unbridled antagonism towards Europe by President Trump. It has taken European leaders a long time to grasp just how intense the hostility has become. Now that many have decided they can't work with the U.S. president effectively, there is both anger and concern. The NATO talks are next on the agenda and Trump is already spoiling for a fight. Not that he is the first U.S. President that has called into question who pays for what, but this time the U.S. is threatening a more unilateral response. Stepping up defense spending is intensely controversial in Europe especially since much of NATO's activity has been outside Europe and in wars that were the priority for the U.S.

Erdogan Expands His Power
The Turkish president has power that far exceeds what existed before—even going back to the days when Turkey was under military rule. The referendum gave him sweeping powers, eliminated the position of prime minister and essentially removed most of the limitations to his rule. He has acted fast and in a highly controversial manner which has caused the markets to fall dramatically. He has appointed his son-in-law to the new post which oversees the Finance and Treasury ministries. In so doing, he has sidelined a pair of leaders who had been held in high esteem by the global financial community. He now has the power to appoint a new head of the central bank with no approval process. That turns the bank into just another political tool for Erdogan.

Analysis: It would be a little too much to assert that Turkey is just another dictatorship as there is still a legislature with powers, but the fact is that nothing much can be done to counter the plans that Erdogan has set in motion. He is powerful in a way that few previous leaders have been (at least since Ataturk). His priorities are not those of the business or financial communities, which seems to invite very significant inflation threats. The other priority will be attacking the Kurds. This could prove very expensive as well as risky politically.

Yes, There Is an Inflation Threat
The economists have been sounding the alarm for several years now—almost like Chicken Little. Virtually every assessment of the future economy has included a pretty straightforward assertion that inflation will start to pick up speed and become the threat to the growth patterns that it always is. But through the last few years, that assessment has missed and inflation has not been manifesting as expected. This has led some to assert that somehow the rules have changed and the triggers for inflation are no longer really in play. While it is true that some of the rules that used to govern the economy are not playing out as they have in the past, it would be a mistake to assume that inflation has been permanently quelled and destined to never rear its ugly head. Granted, the analysts have predicted 23 of the last three inflation surges, but there really are signs that suggest that the almost decade-long run of very low inflation may be coming to an end sooner than later.

Analysis: First up is the indicator that has been so vexing for economists thus far—wage inflation. There has been a rule in place since the 1950s that has had the advantage of being both accurate and intuitive. The Philips Curve simply states that when the unemployment rate gets very low, the average of wages paid will rise and therefore low levels of joblessness will trigger inflation. Makes sense to even the non-economist and it has been playing out as expected for decades—until this year anyway. In fact, the Philips Curve has not been performing as expected for a couple of years now. The rate of unemployment has been hitting record lows and has been staying at these low levels for several years. Despite this, the wage gains have been anemic and certainly not enough to trigger the kind of inflation that would have been expected.

We have discussed why this has been the case in the past—everything from the fact that business has been unable to find the workers needed and hasn't felt like overpaying for people who lack the background and education. It has also been hard for workers to go to where the jobs are. That limits their ability to get the pay they would otherwise be getting. There are other factors as well. They have combined to reduce the impact of the Philips Curve on inflation. One of the factors that led people to assume a real inflation threat soon is there has finally been a response from the business community as far as higher wages. The major reason for these higher wages is protection against poaching. There are many companies that have seen better expansion opportunities and they want to take advantage of them. They can't do this without the people they need. The only way they can find these people is to go after the employees of other companies. They are offering these workers more money to get them to jump ship, but they are also offering their own workers more money to stay.

The second indicator playing a role as far as inflation is concerned is the rise in the price of commodities and key services. This had been taking place without additional outside encouragement, but there has been significant government intervention that has made this threat both more imminent and serious. The price per barrel of oil started to rise at the end of last year as there had been an agreement struck between the Saudi Arabians and the Russians as far as production levels were concerned. This brought the price at the pump almost a dollar higher nationwide. Then, the tariffs on steel and aluminum triggered the metal producers to boost prices by around 40%. The threats of a trade war have further added to the problem as this will make imports costlier. The full impact of this move has not yet been felt, but those days are coming and soon.

Finally, there is the role that expectations play. Right now, the surveys show that consumers expect inflation to rise by about 3% this year and by that same amount in the next few years. This is much faster than inflation has risen in the last few years and it begs the question "why." The consumer is partially responding to all the predictions of inflation, but to be honest, the majority of the population pays no attention at all to the predictions of the economist. The main motivation for these expectations is the natural pessimism of consumers when asked about prices, but the other factor is that they have seen much higher prices in areas that economists do not include in their formal assessments of core inflation—food and fuel. The connection between expectation and real movement is that consumers will resist higher prices unless they are already partially resigned to seeing them.

Supreme Court Battle Begins
The intensity of this contest will likely dominate the rest of the year and will polarize the elections in a way that has not been seen to this point. There will be many issues that Brett Kavanaugh will be quizzed on. Most of them will be social in nature as this appointment could mean the end of many current positions held by the court as it will be a court with five conservative justices and four liberals. The business implications will not be front and center—at least not at first.

Analysis: One area that Kavanaugh has a clear record on is regulation and administrative activity. He has written extensively on the subject. His position has been that government overreaches through the use of bureaucracy and regulation. These moves usurp the role of Congress and the states. It has become routine for the courts to be used when the legislatures are either seen as moving too slowly or they are not taking the route that people prefer. He has held that the courts need to stay out of the legislating business and stick to interpreting the law as held by the Constitution. He is not a fan of an activist Supreme Court and has urged previous courts to leave these issues to the elected officials. This position on regulation and bureaucracy will generally be popular with a business community struggling to figure out strategy in a world of constant regulatory intervention.

An Allergy to Facts?
I am going to harp on this again. It seems to me that this may be the biggest difference between the dialogues of yesteryear and today. I was brought up in a very fact-based household. Dad was an engineer. His hobby was working out complicated math problems and assembling Heathkit electronics. He was a total bibliophile as well (a trait I now share). Each and every discussion held in our home was an excuse to plow into the library at home to find the fact that justified one's position. That often led to a trip to the other libraries in town as all of this was pre-internet. No Google option for us.

We were allowed differences of opinion on many things as long as we had the facts right. Interpretations were fair game. We often clashed over whether something was a good idea or not, but everything was grounded in facts. He died long before the era of "don't confuse me with facts, my mind is made up." He fought that mindset hard even back then. Today, people ignore facts, make them up and assert that facts are all bogus. I maintain that facts are discoverable and can provide some level of certainty. It doesn't mean that people are required to agree with one another. It just means that distorting reality is not acceptable. Beyond accepting fact is having the ability to put things in proper context.

My favorite example of ignoring context is the assertion that one's home is the most dangerous place one can be. This is due to the fact that the majority of serious accidents and injuries happen at home. It doesn't necessarily mean your home is unsafe—it means that vast majority of one's time is spent in the home. That ups the odds that something will happen there.