16 minutes reading time (3192 words)

Strategic Global Intelligence Brief for July 16, 2018

Short Items of Interest—U.S. Economy

Low Jobless Rate

The jobless rate is still very low—full employment low—but it has risen slightly and for all the right reasons. The best way to illustrate this is to look at both the U-3 and U-6 designations from the U.S. Bureau of Labor Statistics. The U-6 numbers include those who have been characterized as "discouraged workers"—those who stopped formally looking for work as they didn't think there was much out there. That number is shrinking further as the U-3 level rises. That indicates that more of the once discouraged are finding ways to cycle back into the workforce and the overall search. The labor market remains very tight, but there has yet to be a lot of wage inflation. This month, however, showed more activity than had been expected.

Consumer Prices 'Inching Up'

Consumer prices (measure of inflation) were up just .1% month-over-month in June. Stripping out food and energy to get to core inflation, we saw an annualized rate of 2.3%. Remember that the Fed's target is 2%. The most important part of this June reading is that inflation "held its own." The Fed will read this as another indicator that it can likely take another quarter point hike perhaps as soon as September. Several parts of the consumer price index (CPI) were surprisingly lower. Housing dipped as did energy prices. That was a bit surprising. An important point made in the report is that there was some evidence of higher import and producer prices (raw material price hikes as a result of increases in tariffs). However, it wasn't yet being passed on to street-level consumers. There can easily be some delays in those consumer-level price hikes. But, if it doesn't eventually show up in the macro data, what we see across the CPI is evidence that corporate profits will be impacted—if consumer prices don't start to rise (because we can see the hike in input prices).

Trade Gap Narrowed but It Will Not Last Long

The trade gap narrowed by 6.6% in the last month, which is substantial. Too bad the reason for the gap is almost totally due to temporary factors. The U.S. saw a major surge in exports—especially that of agricultural output. The farmers know full well what will happen when the battle with China gets underway—they have seen it already as the Chinese are refusing to let ships with U.S. farm goods dock. The Chinese market is about to slam shut. There has been a frantic effort to get as many exports out as possible—even at a financial loss. Now, the situation will reverse and the trade gap will grow again as exports all but cease and imports continue as there are not many domestically made substitutes for the goods that Trump is trying to block. They will just become that much more expensive.

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 and 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.

Positive News from Ethiopia/Eritrea

The news from this part of the world has been unrelenting in its reports. There has been little but war and famine and strife. Suddenly, there is a ray of hope from a most unlikely source. The new leader of Ethiopia was not an opposition leader nor did he overthrow the old regime. He was selected by the ruling party and has their support. He has moved very fast to change the patterns that rip this region to shreds. Now he has basically ended the war with Eritrea single handedly by giving up the contested territory and signing a peace deal. Abiy Ahmed has also inserted himself into the Sudan issue as he tries to get these leaders to the negotiating table. He is a reformer and a very busy one.

Economy Balanced in Anticipation or Fear?

Faithful readers of the newsletter will know that we prepare an index of indices for a couple of manufacturing groups—the Chemical Coaters Association International and the Industrial Heating Equipment Association. These are readings that give them some insights into the economy and what is happening at the moment, as well as what they might expect in the mid to long term. The watchword for this month would probably be "slight change" or maybe "status quo." There were four of the readings from the index that trended in a positive direction as compared to seven that trended negatively, but that isn't really the whole story. The majority of the readings this month were very similar to the ones last month—the differences were in fractions of a point. It could be successfully argued that there was almost no change from the month before. That is consistent with the data that has been coming from other measures of the economy. It is an interesting place to be right now—and a predictable one. The real economic watchword might better be "indecisive" or "confused." The numbers this month are showing as many areas of weakness as strength.

There has been extensive turmoil as far as the economy is concerned. Some of that turmoil has fueled growth. Take the issue of a trade war between the U.S. and China as well as the trade disagreements with Europe. This will, at some point, affect business in a negative way as there will be reduced access to key markets, but right now it is driving growth as exporters hurry to get their product shipped before the restrictions set in. Importers are doing the same thing. All of this has been very stimulative—the question is for how long.

Analysis: The positive trends were observed in these four categories: new home starts, steel consumption, durable goods shipments, appliances and transportation. What makes these interesting is that some of them are viewed as harbingers of things to come. That would lead one to believe that positive numbers here make the future brighter. Unfortunately, many of the factors trending negatively are also seen as harbingers. The new home starts data is being propelled by continued demand for the multi-family unit. Thus far, the headwinds have not done enough to stall growth entirely. Steel consumption is up as there are still many companies that are trying to beat price hikes later. Durable goods look good and that is without any special boost from the aerospace sector. It's not that airplanes aren't being sold—it's that sales have been more consistent and are not skewing the numbers from one month to the next. The transportation sector is another one that has been feeling a boost from the desperate exporters and importers trying to beat higher prices later in the year.

The seven that have been tracking in a negative direction would be better described as stable. The differences between this month and last have been slight and for all intents and purposes the data has been stable. Automotive has generally been stronger than expected as demand has held. The small decline is more seasonal than anything else. The level of industrial capacity utilization remains within shouting distance of "normal," but there are many small and mid-size companies that bought machinery when the tax cut came through. It will take a while before this new equipment is productive. Metal pricing declined a little. That was not entirely expected given the fact these metals had been affected to some degree by the tariffs (in the case of aluminum the impact was direct). The Purchasing Managers' Index (PMI) new orders number fell a little, but remains in the rarified air of the 60s—a major motivator as far as the overall PMI has been concerned. The dip was very slight and near meaningless.

Capital investment has been slightly down and there are signs that there is trepidation within the ranks of the business community due to all the trade histrionics. Is this a good time to invest in expansion or is the pattern likely to change again? There is no consensus within government and even infighting at the White House. The factory orders data showed a tiny decline due to the lack of strong consumer demand even as the summer travel months have been underway. The Credit Managers' Index dipped again, but that has been an ongoing theme all year and there doesn't appear to be a bigger issue looming. The big concern is that the unfavorable index has been so weak.

New Automobile and Light Truck Sales

The vehicle sector has been on edge for months now. There seems no end to their trepidation. Every decision taken by the government seems to affect them these days. Most of the time that impact has been negative. This is not unusual as it has always appeared there is a love-hate relationship between automotive and the government regulators. The issue right now is steel. The 25% tariff on steel imports has started to have an impact on the sector despite the efforts of the carmakers to shove the burden on to their parts suppliers. The tariffs may be 25%, but the average increase in steel pricing has been 40% and rising. The consumer is beginning to worry about inflation now. It is not clear they will tolerate much of a price hike. Conversations about tariffs and bans on imported cars have not been helpful either as the auto sector is not so easily divided into these categories anymore. The tariffs would hit GM and Ford as hard as Toyota and others.

This kind of government engagement is hardly new. There have been radical changes mandated in the name of fuel efficiency and safety in the past. There have also been previous periods of quotas and trade restrictions that have altered the industry and its connection to the consumer. This time, the effort to protect steel is going to have a profound and negative impact on the automotive sector and consumers.

Metal Pricing

For the last few months, there have been declines in the price of some industrial metals—even aluminum. It had been expected that that aluminum would go the way of steel. At first it did, but that price surge was somewhat short lived as there was already a surplus of the metal and demand fell off as the price rose. Copper has plunged as usage has altered in the telecoms sector. Gold has also been falling, but for different reasons. This metal is primarily an investment. Its price alters according to what the markets expect. The price hike earlier in the year was a reaction to the threats of inflation that seemed imminent at that point. It has been several months and still the inflation ogre has not appeared. That has reduced the demand for gold as a hedging strategy.

New Home Starts

The housing sector continues to defy the odds as well as the analysts. The "headwinds" are well known by this time, but as far as the sector seems to be concerned, they are better defined as breezes. It was assumed that higher home prices and more expensive mortgages would have taken the sector backwards by this time. In some months, it appeared that this was indeed the case, but then there follows another month where starts are back up. Granted, the new home market is far less important than is the existing home sector, but it is still important to note whether it is the single-family market that is growing or the multi-family. The most recent data shows that much of the growth this month was the multi-family and in communities that are still battling a shortage of available housing. Looking longer term, there has been a bit of a decline in permits issued. That would seem to signal a slowdown in building activity down the road.

Steel Consumption

The steel sector remains in some turmoil as few have any sense of where the policy initiated by Trump will go. For those who have been trying to follow this roller coaster, it started with a blanket imposition of a steel and aluminum tariff on all imported steel. That tactic was quickly abandoned as most of the countries that sold these metals to the U.S. received exemptions. They were supposed to give the U.S. something in return or at least to be grateful for the gesture, but mostly they reacted in anger over having been subject to the penalty at all. The Trump response was to impose the tariffs on everyone again, but again with the hint they could be lifted if these nations did what the U.S. required. This leaves everybody in limbo. The steelmakers have been down this road before in 2002 when Bush imposed tariffs and then lifted them two years later. The steel companies invested in expanded capacity only to see imports come back and reduce their share of market. They are not making the same mistake this time and are letting prices rise as far as they can—much to the detriment of steel consumers. Needless to say, the allies that have been hit by these tariffs are also fighting back with their own restrictions on trade with the U.S. Steel consumption is still being driven to some degree by the users that are trying to hedge against higher prices down the road.

Industrial Capacity Utilization

In general, the rate of capacity utilization has been tantalizing analysts as it creeps closer and closer to the level that would be considered normal (80% to 85%). It got as close as it has in years last month, but has fallen back just a little this month. One of the factors at work here may be the impact of the corporate tax cuts. This money has been spent in a variety of ways, but the small and mid-size companies have mostly been investing in new capacity—both human and machine. There is a period after a new machine is purchased when the output falls short of the investment—it takes time to get the maximum output (and that goes for new hires as well). There is a period in which capacity is not used efficiently. Then machines are integrated, people are trained and new customers are brought on, so the capacity is used efficiently again. That has been part of the reason for the slow advance towards normalcy.

PMI New Orders

The PMI New Orders Index has long served as something of a harbinger for the larger PMI. It is the part of the index that focuses most on future and expected demand. A few months ago, it hit a peak. That was followed by several strong months for the total PMI. It has since weakened just a little, but still remains in exalted territory above 60. This has translated into readings for the total PMI consistently in the mid- to high-50s. The slowdown—which really is minor—has been attributed to some of the uncertainty surrounding global trade and commodities prices. There has been evidence that inflation has been a bigger issue as well. It is not that inflation has reared its ugly head as much as it threatens to. When looking at some of the other index numbers that come from the ISM, there is similar news as there has been good but slowing progress when it comes to both exports and hiring. In general, the service sector has been performing slightly better than the manufacturing sector.

Capital Expenditure

There are all manner of reasons for a bump in capital expenditures. Usually, there is some outside motivation that makes the timing appropriate. This can be the addition (or expiration) of an incentive that propels companies to act right away. It can be the moves of a competitor that force everybody else to catch up. It can be a tax cut or at least a change in how a machine depreciates. This year, there has been a reaction to all of these to one degree or another. The big surge at the start of the year was promoted by the fact that tax breaks were going to expire. The latest bump appears to have been a reaction to the threats of tariffs and trade wars. Companies wanted to get their orders in before there was a price hike. The good news is that expenditures have been pretty consistent over the last year. When there has been a deviation from the norm, it was an upward trend.

Factory Orders

The level of factory orders has also flattened out a bit but remain generally high. The progress this year has not been rapid by any stretch, but it has been fairly consistent. The challenge has been that consumers have not been as engaged as expected after the tax reductions. As predicted, when the tax cuts came through—they were not really large enough to change consumer behavior significantly. For the most part, these reductions made it possible to handle bills and obligations a little simpler, but it did not change the way people had been buying. The summer was supposed to make a big difference, but the impact has been less dramatic than hoped. The higher price for gas kept many people off the road. In many cases, it gobbled up the savings that people saw with the tax cut.

Why Does Russia Matter?

I am quite sure I should stay away from this topic in this newsletter, but I have never been known for following good advice, even if it comes from me. By now, alert readers may have noticed that I take exception with many of the policies that have been developed under Trump. But it should be apparent that I agree with many of them as well. Those who remember a few years ago will know that I was critical of Obama as well. I have long asserted that a good analyst provides his best assessment regardless of political leaning. Even more alert readers will remember that I started my analytical career as a student of the Soviet Union. My Masters is in Soviet and East European Studies and my Ph.D. dealt with transition economics. By dint of my age, I was a Cold War baby and I retain much of that attitude.

With this as background, I am left stunned by the words and actions of the man who currently leads this nation. To stand beside Russia's President and assert there was no Russian meddling is leaning towards the absurd and dangerous. The Soviets meddled and the Russians meddle, they always have; and we meddle right back. Trump's statement is ridiculous in the extreme. I am left pondering what this means. Is he too foolish to actually believe the Putin denial? Does he think he can maneuver Putin? Is he just that trusting and foolish? Or is it all of the above? I am deeply worried and fear that we just gave Russia its next green light to do what it will.

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