Strategic Global Intelligence Brief for June 14, 2018

Short Items of Interest—U.S. Economy
Will Higher Borrowing Costs Impact Consumer? At some point, they will have to. The rate on a mortgage loan is now as high as it has been since 2013—standing at 4.54 for a 30-year fixed. Credit card rates will move up by a point or two, and so will car loans and most everything else. It would be assumed this would be enough to damage consumer enthusiasm, but the impact has been minimal. The last time inflation started to make an appearance, the consumer was hit hard and fast, but this time, the average consumer has been less leveraged. That eases the pain somewhat. That said, these interest rates will only be headed up this year. At some point, they will bite.
Advantage China The summit between the U.S. and North Korea had China a bit worried at first. If a specific deal had been struck regarding just how the denuclearization would be carried out and verified, it would likely have been without much Chinese engagement. Now, it seems that China will play a big role as far as monitoring the process and will be significant as far as guaranteeing Kim's security. The best part for China was the surprise offer from the U.S. to end war games that involved the U.S. and South Korea as these always included monitoring and assessing the Chinese along the way. There is also the removal of the sanctions on North Korea. That benefits the Chinese most of all.
Celebrity Leadership There are a number of polls and surveys provided this time of year as the attention of the press turns to elections. The polls usually tell one more about the positions and beliefs of the polltakers than about the people who respond, but some have been more than interesting. There has been an almost total abandoning of party affiliation as far as voter preference is concerned. There has been a significant loss of faith in the Republican and Democratic party and a pronounced shift towards personality-driven politics. Support for President Trump has been called "cult like." The majority of those being suggested as challengers for the Democrats in 2020 are celebrity figures like Oprah Winfrey, Howard Schulz (Starbucks) and Mark Cuban (owner Dallas Mavericks).
Short Items of Interest—Global Economy
What Is the Link? North Korea was quick to assert that Chairman Kim was told by President Trump that sanctions would be lifted right away. Now, Secretary of State Pompeo is trying to walk this back by asserting that any such move would come only after the denuclearization process is well under way. The problem is that no statement has been forthcoming from the administration as regards what this looks like. President Trump has simply said that he takes Kim at his word. That might mean that sanctions get lifted without any real evidence of North Korean compliance. Given the track record of North Korean deceit and dishonesty, it seems unwise to trust this blindly.
Brexit Still Divides U.K. All of the major and minor parties in the U.K. continue to split over how to deal with the Brexit issue. There are pro-European factions in the Tory and Labor parties and they are locked in bitter battle with one another. These differences are enough to create issues for the leadership of both. Prime Minister Theresa May is losing her authority as neither faction supports her middle of the road position. Meanwhile, Parliament member Jeremy Corbyn was handed a significant defeat by the pro-European part of the Labor Party. Even the smaller parties such as the Scottish Nationalists are facing internal fights.
NAFTA in Big Trouble It was not that many months ago that many claimed a deal would be struck soon on the subject of NAFTA. Few assume this now. Trump has taken to launching insults at the Canadian prime minister while imposing tariffs right and left. Meanwhile, Mexico is likely to get Andrés Manuel López Obrador (AMLO) as the new president this summer. Trump has already indicated he thinks the talks need to stop until AMLO is in office next year.
Strange Bedfellows For many years, there was an alliance of sorts between some in the GOP and some in the Democratic Party around the issue of free trade. The Republicans were essentially a party oriented towards the preferences of the business community and the majority of the Congressional free traders were in the GOP. But they were not alone as there were many Democrats that hailed from states that benefited greatly from exports and imports, or states where the consumer was king and demanded the price and variety offered by the ability to trade with the world. Many of the staunchest supporters of trade came from farm states as the farmer knew full well how important foreign demand was for their output. Today, that coalition is in tatters and has been replaced by another one that crosses party lines. The Democrats that hail from manufacturing states and who have major support from trade unions have long been critics of the U.S. trade policy. Now, they have new allies in the pro-Trump, populist and protectionist wing of the GOP. It is a strange world where one sees common cause between Sherrod Brown (Ohio Senator) and President Trump's trade team (Peter Navarro and Robert Lighthizer).
Analysis: Trade relations between the U.S. and the rest of the world have rarely been this bad. The threats that have been issued as far as tariffs and other barriers now amount to close to $2 trillion. Not all of these threats will be followed up on, but at this stage, the assumption is that many will be.
The truth is there has never been free trade or even a very level playing field. Every nation seeks whatever advantage it can gain in these negotiations and for much the same reason. The countries the U.S. does most of its business with are also democracies and subject to the same pressures as face the U.S. There are powerful domestic lobbies with significant political clout. They use that influence to protect themselves. Japan guards its rice production as a national security issue even as it pays five times what that rice would cost if it was imported. Europe protects its rural communities with the Common Agriculture Program. The U.S. farm sector is loaded with subsidies and efforts to underwrite the export of food. Europe protects Airbus and the U.S. protects Boeing.
The fact is that other nations have erected tariff barriers and non-tariff barriers against U.S. exports for years. Generally, they have been more onerous than the restrictions the U.S. has placed on imports from these nations as the U.S. has wanted to continue to please the U.S. consumer. There is no doubt that tariffs need to be examined, but it is not clear that tit-for-tat imposition of taxes will accomplish the stated goal.
It has been assumed that blocking imports would stimulate domestic production of that good, but there is not a lot of evidence that this is the case. The fact is U.S. manufacturers can't produce clothing, shoes, electronics, toys and other consumer-oriented goods at the price that nations like China or India or Mexico can. The other fact is consumers will not buy packages of underwear if they cost $30 rather than $8. Demand for these goods will fall. That means even less incentive for a U.S. maker to emerge. High tariffs and restrictions simply mean that U.S. consumers will do without. That affects retail, transportation, distribution and many other sectors. As tempting as protection seems, it has been tried many times by many different nations. It always fails to deliver on its basic promise.
Why the Difference Between Iran and North Korea? It is assumed the U.S. can be taken at its word when it comes to the spread of nuclear weaponry. The position is that these weapons are inherently destabilizing and should be sharply curtailed. The U.S. is focused on two nations at this point—Iran and North Korea. The approach could not be more different, which makes it more than a little confusing.
Analysis: The Iran deal has been called "the worst deal ever" by President Trump, so the decision was made to withdraw from it. This deal was hammered out last year and demanded that Iran open itself completely to inspection by outside parties. Every aspect of their effort has been under scrutiny. All the inspections have come to the same conclusion—Iran has been in complete compliance. North Korea has agreed to nothing as far as inspection is concerned. All that has been offered is Kim's promise. Iran has been criticized for supporting terror groups like Hezbollah and Hamas and for continuing its missile development. North Korea has sold weapons and technology to those same terror groups and others and continues to develop its ballistic missile program. President Trump calls Kim "talented" and someone he can trust while ignoring the leader of Iran—Hassan Rouhani. The Iranian leader is a bona fide reform element trying to overcome the influence of the conservative clerics, while Kim has continued to order the execution of anyone who dares to question him. What makes Trump despise the Iranians and trust the Kim regime?
Fed Raises Rates and Sets Expectations The meeting of the Fed's Open Market Committee offered no surprises and none were expected. The statements that had been coming from the members over the last few weeks left little doubt as to their motivation and their position on the issue of rates. They acted as expected and raised rates by a quarter point, bringing the Federal Funds Rate to between 1.75% and 2%. Not that there was no suspense at this meeting. The real issue was how the Fed would size up the state of the economy going forward. Here there was a bit of surprise as the statements pretty clearly set up the possibility of two more hikes by the end of the year—the one that has been talked about all along (September) and now another one in December. There were also some vague references to what might take place next year assuming the economy continues to grow at a reasonable pace. The most immediate impact of the rate hike will be hikes in all those rates that are generally tied to the funds rate—everything from credit cards to those adjustable rate mortgages that have been so popular.
Analysis: It is now clear the Federal Reserve has completely changed its focus and will be spending the majority of its energy on the issue it was designed to address. The role of the central bank as a stimulator has always been intended as a supplement to the fiscal side of the equation. For a variety of reasons, the Fed was forced to take the lead as far as pushing the economy out of the doldrums despite the fact the tools at its disposal are limited. The best that a central bank can do is try to make money easier to access by lowering the interest rate, reducing the interest that banks are paid to keep money in the Fed, lowering the reserve ratio and buying treasury bonds. This time around, there were some new approaches tried as well, but all have the same limitation. The Fed depends on others to react to the incentives—basically counting on banks to increase lending. That didn't always happen during the depths of the recession as banks had become very cautious and many borrowers were equally apprehensive about getting too leveraged. The stimulation is supposed to come from Congress in the form of tax cuts and additional spending. There was a belated response from Congress at the start of the year, but even that tardy effort was constrained by not including significant spending.
Now that the Fed can leave that stimulating job behind, it can focus on inflation. It has the tools needed to do so. By raising rates, the interest paid to banks and the reserve ratio, the Fed can suck money out of the system and make borrowing harder and more costly. That slows the economy down and reduces the chances for excessive inflation. The challenge now is to be delicate with this process. Too much of a rate hike and the economy goes into a stall, but too little allows inflation to build up a head of steam and makes control all the more difficult later.
There are several forecasters that have been asserting the economy is headed for a recession in 2019 or 2020. Their logic is based on the inflation threat. The expectation is that inflation will start to rise faster than the Fed now anticipates and will force more aggressive action. If this is the case, there is a good chance we will get a repeat of the 1980s recession which was essentially delivered by Paul Volcker and the Fed. The inflation threat had become a clear and present danger. Volcker elected to tackle it head on with a series of very sharp interest rate hikes. This created the classic "V" recession that economists know and love. The tightening of the money supply shoves the economy into a sharp recession, but the good news is that recovery is just as sharp. Soon there is growth again. The consensus among those who see a recession in the next year is that it will be a "V" or at worst a "U" with some lingering at the bottom. There are few who see another of the "check mark" recessions that we are undergoing now—a sharp downturn followed by a very slow rebound.
The Fed statements yesterday indicated that inflation is once more on its mind, but there is no sense of panic as yet. There have been factors limiting the impact of inflation. The Fed sees these continuing to occur. The most notable is that wage inflation has not developed despite the very low rates of unemployment. There has been plenty of movement in the commodities markets, but thus far that has been the major motivator.
Where Will Business Inflation Come From? The inflation threat has not really manifested all that clearly at the consumer level as yet. There has been some reaction to higher fuel prices, but the other inflation issues are still down the road. On the business side, the impact has been clearer. The two factors that have created the most concern include the tightening labor market and the tariff/trade war.
Analysis: An unemployment rate of 3.8% would suggest that there are not all that many people seeking jobs these days. Indeed, there are more available jobs than there are people to take them. The only way to effectively recruit these days is to poach workers from other companies. This means paying those workers more to leave. It also means paying the existing workforce more so that they will not be poached by somebody else. The tariff threat means the potential for huge jumps in the price of everything from commodities to intermediate parts and assemblies. This will not hit all industries the same way as the tariffs are likely being targeted for maximum political effect. The two issues will combine to push prices up at the producer level. Sooner than later, that will also start to manifest in the consumer sector as well. The business community has been preparing for the inflation expected from the hike in wages, but there has not been time to react to the trade issues.
Equal Time I write a lot about the feline and for good reason. My collection of cat faces demand the attention. But I am not immune to the appeal of other creatures. I get to hear some of these stories in my travels as well. The other day, I learned that even the lowly hooded rat has a heck of a personality. It all started with a psych class and the use of the rat in a series of maze experiments. The bond was too great to abandon once the semester was over and so the rat (D'Artagnan) became a pet. The new owner elected to see what the limits of this new relationship were and made him a little bag he could ride in while his person went on motorcycle trips. I saw the face of one happy little rat on such a trip. When he is out of his cage at home, he makes a direct run to that bag and starts chirping. He has been taught to fetch and allegedly comes when called.
Now, here's a dog story. Another friend heard about the guy who fastened his Fitbit to his dog and racked up lots of steps. So, he thought he would give it a try with his own canine companion. His buddy had over 10,000 steps in one day so he was excited to see what he might get. At the end of the day, he checked and there had been just 1700 steps. The moral of this story is that putting a Fitbit on a Jack Russell terrier will get you more than putting it on a Black and Tan Coonhound!