Strategic Global Intelligence Brief for July 24, 2018

Short Items of Interest—U.S. Economy

Severe Housing Crisis
There are many things that affect the housing sector—all those headwinds that analysts talk so much about. One area that didn't used to be so influential is a shortage of homes to buy at any price. This shortage has become acute in many popular cities and is expected to last for quite a while. The problem is that builders are reluctant to overbuild as they did in previous decades. They wait to build until the home is actually sold. There are fewer existing homes coming on the market as well. That is due to the ability of many Boomers to retire at home rather than move to some facility. Finally, there is a major shortage of skilled workers to build these homes. That is unlikely to be reversed any time soon.

Banks Worry About Trade Tensions
There are many parts of the U.S. that are highly dependent on exports, something that many seem to have forgotten. The U.S. depends on export trade for as much as 15% of its GDP (the largest GDP in the world at $20 trillion). Much of that export volume is accounted for by farm output, which is the sector that is taking the brunt of the trade war thus far. The farms are impacted, but so are the regional banks that lend to this community. Loan demand has been falling in areas that are trade dependent. That will only worsen as the trade wars accelerate.

Currency Manipulation
Among the accusations that Trump has made against the Chinese and Europeans is that they are currency manipulators. This assertion gets tossed around a lot whenever the value of a certain currency seems to give a boost to the export sector. Simply put, a lower-valued currency means that it is easier to export. The problem with the Trump assertion is that it is not true. There are three criteria required before the U.S. labels a nation a currency manipulator and is then permitted to impose sanctions. The criteria include: (1) have a trade surplus with the U.S.; (2) have an overall account of at least 3% of GDP; and (3) have engaged in a persistent and one-sided intervention in the market. The third criterion is the tough one.

Short Items of Interest—Global Economy

Everybody Playing to the Base?
The latest confrontation between the U.S. and Iran has analysts somewhat confused. Not that there has been any doubt about the enmity between the two, but why now does there seem to be an escalation? It may be nothing more complex than some posturing. The statements by the Iranian leader may have been designed to mollify the hardliners in Iran who are still furious at the U.S. attitude. President Trump's comments may likewise be designed to appeal to that base that severely dislikes Iran and Islam in general. Then, there is the desire on the part of the U.S. to keep Israeli leader Netanyahu in his place. If the U.S. seems ready to attack Iran perhaps Israel can be convinced not to.

North Korean Compliance?
It appears that North Korea is living up to at least some of its promises, but verification is going to be very hard. Satellite photos seem to show a missile facility for the long-range missiles, but nothing can be confirmed on the ground. Are the missiles still there, is the sanction regime being held hostage for this effort or is this really more theater than reality.

Significant Opposition to U.S.-U.K. Trade Deal
This was never going to be easy and the events of the last several months have only intensified. The hope for the May government was some kind of deal that could be developed for the U.K. business community to offset the impact of Brexit. The consumer gets hit directly by Brexit, so a deal with the U.S. might reduce that impact. The U.S. is not really the ideal trade partner for the U.K., however. The U.S. would rather maintain good relations with the EU (at least most in the U.S. would prefer this—Trump notwithstanding). The May government needs something to soften the blow of Brexit, but it gets harder to see what that would be.

Bombast and Outright Fabrication Competes With Pragmatism
President Trump has demonized trade, but it is still not clear why. The facts are simply not on his side when the issue is trade with Europe. It begs the question as to why he has chosen to be so aggressive with a part of the world that has been so close to the U.S. for decades. The fact is that much of what the U.S. says about China and its trade practices are true. The U.S. is not alone in fighting the Chinese on a variety of fronts—everything from the routine stealing of intellectual property to the massive subsidies that have been given to the Chinese export community. China violates rules set down by the World Trade Organization every day. There is no reason the U.S. should not be trying to address the trade imbalance alongside the Europeans, Japanese and many others. The president's attitude towards Europe is far less understandable.

Analysis: Facts are facts and numbers do not lie. President Trump has numbers that are not true. Few can even figure out where he gets them. The U.S. and Europe have been the leading advocates for free trade for decades and have very similar systems. Both the U.S. and Europe have high tariffs on a small selection of high-value goods and sectors. Both also rely to some degree on subsidies within their domestic economies. The average weighted tariff on U.S. goods coming into Europe in 2016 was 3%, while the average weighted tariff on European goods coming into the U.S. in that same period was 3.3%. The U.S. imposes more tariffs on Europe than Europe imposes on the U.S. That has been the case for over 25 years.

President Trump reiterates the same fallacy on trade deficits and surplus over and over again. His focus is always on trade in goods. He is correct in that Europe sells more "things" to the U.S. than the U.S. sells to Europe. But there is more to a modern economy than selling goods. That is especially true for a country like the U.S. For the better part of the last 40 years, the U.S. has been transitioning from an economy that depends on industrial activity to one that relies on its service sector. It is not quite the post-industrial society that was once envisioned by some, but the service sector accounts for some 80% of the total U.S. GDP. Just as with China trade, we run a deficit when it comes to goods with Europe, but also run a substantial surplus when it comes to services. It's everything from law to accounting to finance and marketing as well as IT, health care and all manner of consulting services. This was a deliberate decision on the part of the U.S. over the last 20 to 30 years as we were assuming the U.S. would no longer be a manufacturing state. Now that technology and robotics has restored U.S. competitiveness, we want some of that industrial activity back.

The demands made by President Trump have been for "fair and reciprocal" trade relations. A fair case can be made that this is lacking when it comes to China. It is equally clear that such a system already exists between the U.S. and Europe. As President Trump prepares to meet with President of the European Commission Jean-Claude Juncker this week, he has been bombarding the world with angry and accusatory tweets insinuating that Europe has been attacking the U.S. for years, but the facts do not bear this out—not even a little bit. It is beyond perplexing why Europe has been a target for Trump especially given the fact that Europe is on the same page when it comes to China and could well be playing a support role with the U.S. as Chinese trade policies are attacked. There seems to be a visceral dislike for Europe in general that may stem from U.S. antipathy towards the more socialistic aspects of European politics, but nobody really knows.

What Impact Would Trade War With Europe Have?
This is a predictably hard question to answer as the actual reaction to a trade war will be within the ranks of the business community and the consumer. Tariffs are not bans. They are taxes and people react to them as they react to any tax. Let's assume the U.S. goes through with the tariff on vehicles from Europe—20% that has been suggested. The crucial question for European manufacturers will be how they react. Will they tack on 20% to the price of the vehicle sent to the U.S. and hope for the best? Will they swallow the 20% tax and sell the car for the same price as always—pushing suppliers to sell them less costly goods and dragging costs out of their own operations? What will the consumer do? The Mercedes and the BMW are already expensive cars and are not being purchased by those who need basic transportation. Will the rich decide they want that Mercedes or BMW anyway?

Analysis: The real damage is from uncertainty. This is a well-worn assessment of course. One has to question the reason so many companies are worried about the lack of certainty. Do they not live in a competitive world with other companies doing unforeseen things all the time? It is true that consumers are fickle and competition is changing, but tariffs are examples of direct government interference. They come and go very unpredictably—seriously compromising any hint of preparation or strategic planning.

What Is There to Really Worry About?
The opening presentation by the group's leader was more than interesting and did more to set the tone of a session than anything I have seen in a while. The group was the National Electrical Contractors Association. The focus of the introduction was why we are so down on the world we currently inhabit. We are ever nostalgic for some version of the "good old days" when the economy was brighter and all was right with the world. The point he made was that by almost any statistical measure, the decade we are in has offered more progress than any other—even with the recession. This is certainly not to say all has been perfect, but it simply means there are always positives and negatives in any period. Right this minute, the economy of the U.S., and the world for that matter, is as well off as it has been in decades—everything from record low unemployment to more rapid growth than had been expected to progress on a host of social problems that have their roots in economic issues. There is less poverty than in the past, more employment opportunities, more upward mobility and so on. To reiterate, this doesn't mean all is well for everyone and we can all just stand pat—there are pervasive and vexing issues galore. The big question is whether there are situations on the horizon that would signal a reversal of the progress that has been made since the recession formally ended in 2009. That's right—as an economist, I am searching for the dark cloud that accompanies the silver lining.

Analysis: The latest numbers on housing suggest there is a problem brewing here. It's one that will have an impact on the greater economy sooner than later. Many factors go into driving an economy, but few are as important as housing, and for a variety of reasons important to the U.S There are the obvious connections that stem from the whole process of building, buying, selling and inhabiting a home as this supports dozens of industries from lumbering to cement production to textile manufacturing to appliance production. Beyond this and of even greater importance is the fact that most Americans make their home their greatest store of financial value. The fortunes of most families rise and fall with the value of their home. For the last few years, the housing sector has managed to shrug off most of the so-called headwinds that many thought would slow the sector (higher-priced homes, higher mortgage rates, shortages of starter homes, labor constraints and so on). After three consecutive months of decline, it appears that these headwinds are starting to have the impact anticipated. That robs the U.S. of that powerful engine.

The second factor to consider is the rate of inflation. Thus far, there have been only modest levels of price increases despite the impact from commodities. Oil has gone up and of course the tariffs on steel and aluminum have caused these metal prices to rise, but real inflation pressure has been kept at bay to a significant degree by the lack of wage inflation. Despite the very low rate of unemployment and the chronic labor shortage situation facing many industries, there has not been a rush to overpay less qualified workers. The rate of wage hike activity has started to pick up as companies deal with competitors that seek to poach their employees. Not only are those who are getting poached getting higher wages, but companies are paying existing staff more in order to hang on to them. This is the missing ingredient as far as boosting inflation to the status of "problem."

This leads to the third potential fly in the ointment. If there is significant inflation appearing within the next few months, the Federal Reserve will act, and likely decisively. The comments by President Trump notwithstanding, the central bank is designed to address inflation. That has long been its core purpose. It is also clear that inflation is best dealt with early as opposed to waiting for it to grab hold of the economy. This would mean that rates would rise at least two more times this year and perhaps as many as four times in 2019. As irritated as Trump appears to be on this subject, he did not take steps to place people on the Fed's Board who would oppose these rate changes. As President Trump entered office, he was looking at as many as five vacancies for the seven-person Board. The only holdovers were Lael Brainard and Jerome Powell. Despite circulating a few radical names as Fed Chair to replace Janet Yellen, the choice was Powell, a traditionalist who had been an ally to Yellen. His first appointment, was Randy Quarles—a mild critic, but essentially a hawk who favored higher rates. The three most recent nominees have not started the Senate confirmation process, but there is not a great deal of opposition to any of the three. None would be considered dovish or even sympathetic to Trump's critique of late. Richard Clarida is a colleague of Ben Bernanke's at Columbia University and a committed monetarist. Marvin Goodfriend is slightly more provocative as far as his feelings on regulation, but he is hawkish on rates. The third candidate is Michelle Bowman, a small-town banker with experience in the regulatory world. Her role will be to back the needs of the small banks like the one her family started in Council Grove, Kansas.

The last of the factors that could turn this year into a sour one is the trade and tariff battle. To be honest, nobody really knows what the policies will eventually be—it all seems to be perpetual negotiation. If these tariffs are all assessed and by all the nations considering them there will be consequences, but as is always the case, there will be winners and losers. The farm sector in the U.S. is already a major casualty and manufacturing is hurting from the high price of industrial metals. Meanwhile, there is potential growth in the steel and aluminum-producing sectors in the U.S. Those U.S. companies that are watching their competitors get hit with this tax will benefit to some degree. It all depends on how angry the other nations become, but it will also depend on leverage. China needs the farm output from the U.S. as badly as the U.S. farmer needs to sell that output. Who buckles first? Will Europe sacrifice a major market to protect its vehicle makers? Will the U.S. ruin a relationship with Europe and lose an export market that accounts for over 25% of U.S. activity over the importation of cars? Is there some bigger issue that Trump is angling to deal with by using both bullying tactics and cajoling offers? If this all goes sour, the U.S. economy is at risk as exports account for over 15% of the national GDP—more than even Japan.

Jumping to Conclusions
Somewhere along the way, we have lost our ability to focus on anything more than a tenth of a second. As we have lost that ability, we have become a nation of the most naïve and gullible people in decades—perhaps centuries. After we observe two seconds of some incident, we have all the information we need to condemn someone or turn them into heroes, or we become the latest mark for somebody manipulating us. Here are just two recent examples.

A guy at a Cubs game was caught on video grabbing a baseball in front of a kid. The world exploded with calls for the man to be tortured and put to death. There were actually threats as it was instantly assumed he was some kind of monster taking that foul ball from a child. Those who decided not to join the mob with torches and pitchforks learned the kid already had two balls. One of those had been given to him by the guy who was being maligned. It also turned out the guy had caught other balls and gave them to other kids. He commented that he had seen too many kids get hurt scrambling for the foul balls, so he tries to catch as many as he can so he can hand them off to some of the smaller kids that can't compete. The "monster" is instead a very nice guy concerned with the safety of those around him. Did the attacks stop? No, he gets threats every day. Some asserted they would find him at the next game and beat him. He has returned his season tickets as he no longer feels his family is safe.

Meanwhile, there is the guy in New York who was hailed as a hero because video caught him pulling a woman to safety at the subway station. Everyone wanted to find him and give him an award. The only problem is that another camera told a different story (as did the woman). He had grabbed her purse and was trying to yank it away and, in the process, nearly pushed her on to the tracks. She didn't fall because she wouldn't let go of the purse. They are still trying to find him, but for different reasons.