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Strategic Global Intelligence Brief for March 26, 2018

Short Items of Interest—U.S. Economy

John Williams Likely to Replace Bill Dudley

The head of the New York Fed is one of the most important of the 12 regional Fed leaders as it is the branch that interacts with Wall Street most consistently. It is the only regional Fed that has a permanent seat at the table for the Open Market Committee. Dudley announced his desire to retire last year. The consensus view is that Williams would be the most appropriate replacement as he has been head of the San Francisco Fed for many years. He has been considered more dovish when it comes to interest rates and supported both Bernanke and Yellen in their policies. Once again, the Fed has remained in a traditional mode despite the pressure from some in Congress to install radical new thinkers. The last remaining position in the troika that has the most influence is the vice chair. The supposed favorite is Richard Clarida from Columbia University—a former Treasury official under Bush and an advisor to many large financial institutions such as Pimco.

Fourth Quarter GDP Is Up Slightly

The third version of fourth quarter GDP is due to be released tomorrow. By most accounts, it will be up slightly from the previous estimate of 2.5% growth. The consensus view is that GDP grew by 2.7%. That puts it much closer to the rapid rates sported in the second and third quarter. The estimate doesn't really change assumptions for the first quarter of this year, but it may mean that the retail activity that tends to drive Q4 numbers were better than expected. So far, the growth rate for Q1 is expected to be in the neighborhood of 2.6%, but that might be estimated higher based on these new Q4 numbers.

Consumer Confidence Estimates Expected to Remain High

The latest version of the University of Michigan's confidence survey is due out this week and is expected to reinforce the original findings. The index went to 102 from 99.7, the highest level reached in 14 years. The importance of the consumer data can vary—especially when one tries to identify the prime motivator. It seems that consumers are still reacting to the unemployment situation as well as the general lack of inflation, but there was slightly more apprehension about the future due to the recent market volatility and the potential fallout from the emerging trade disputes with China and other nations.

Short Items of Interest—Global Economy

Dutch Leader Emerges as Crucial to Future of Brexit

Mark Rutte has been the leader of the Netherlands for nearly 10 years and is still only 51. He has now been shoved into the role of chief representative for Europe, and by, extension the U.K. The Dutch have long been the middlemen that arbitrate between the great powers. This is where they are again today. The British have a close relationship with the Dutch—neither country wants to lose that connection. He will be trying to get everybody on the same page for a new plan that falls somewhere between the all or nothing positions that have been discussed thus far.

French Deficit Below 10%

For the first time in over 10 years, the French deficit has fallen beneath the limit set by the EU. Thus far, the credit has been given largely to Macron and his policies encouraging the business community. The challenge now is to keep that momentum going as these policies are implemented. Right now, it seems to be a mixture of optimism and the ability of the French to ride the waves of growth in Europe.

Italian Outsiders May Cooperate

It seemed unlikely that parties as different as the Northern Alliance and the Five Star Movement in Italy would find common ground, but it seems the alternative is more unappealing as it would mean forming a government with either the center right or center left. That is anathema to the two of them. It would still be a fractious coalition at best—few think it would last long.

Exemptions Galore

The "universal" tariff on steel and aluminum announced by Trump just a few weeks ago has limped into action, but there is not much of it left. After all the thundering and pontificating, the only nations that did not get an exemption are China, Russia and Japan (for the moment). The tariffs will fall almost entirely on China and Russia—the only two nations that would qualify as national security risks and the two the original study suggested in the first place. Japan is likely to work out a deal of its own in the next week or so.

Analysis: Obviously, this does nothing to "save" the U.S. steel industry and was essentially an excuse to drag concessions out of allies and to allow the Trump team to declare a campaign promise had been kept. In most respects, there has been little change to the steel situation in the U.S. That is a good thing for the U.S. manufacturer, but the fear is that there have already been reactions from allies that will complicate trade. There is still nervousness as far as policy is concerned. Can the U.S. go back on its agreements if these nations fail to comply with U.S. demands and desires? Of course it can, and this will make setting future strategy challenging in the extreme.

China Believes Trump Is Bluffing

This is not an opinion from us or any other observer—this is the statement coming from a senior advisor to China's Xi Jinping—one that has been essentially approved by the leadership. The Chinese have assessed the potential trade war with the U.S. They have reached a number of conclusions based on their understanding of their positions of leverage, the way they perceive the U.S. system to run and the strength of their allies in the world and the U.S. Basically, this is seen as a temporary situation. One they can manage.

Analysis: The first conclusion they have come to is Trump's positioning is that of a businessman engaged in negotiations; not that of a politician. The politician is generally required to consider a very wide variety of issues and inputs ranging from how any decision will affect one's allies, political supporters, political enemies, the public, the press and so on. It is a very complex world and requires a great deal of diplomatic caution. This is not how a businessman negotiates for the most part. The businessman's focus is on one deal at a time. Very little attention is paid to all the implications that might occur. The business decision-maker is most of all determined not to be subject to the "paralysis of analysis" and would rather make a quick decision, fail and try another tactic than to spend great amounts of time trying to decide what to do next. The Chinese do not see a diplomat or politician in charge of the U.S.

Therefore, they believe they have a plan that satisfies everybody in the end. The Chinese announced a master strategy some months ago that included a much more aggressive campaign geared towards increased imports from the U.S. and decreased exports from China to the U.S. This policy is consistent with the transition that Xi Jinping has been championing for years now. The U.S., along with other nations, has long objected to the Chinese dumping cheap products into their markets. The selling of these low-cost goods has not met the formal definition of dumping, but China has taken advantage of its command of the economy to underwrite these exports. The Chinese wanted most of all to keep people employed and thus heavily subsidized this output with the assumption they could get rid of that output in foreign markets. It is no longer in China's interests to subsidize these manufacturers. The concern now is that China has too little skilled labor and not enough in the way of resources, such as oil. It does not want to waste labor and resources on goods that have to be sold at bargain prices. There is now a desire to shut these operations down. As it does this, there will be less product coming to the U.S. or other global markets. The U.S. will see a drop in its deficit with China. As the advisor to Xi stated, "Trump will be able to save face by claiming he accomplished this."

The same plan calls for expanded imports from the U.S. and elsewhere—especially in the area of services. The U.S. already has a surplus with China when it comes to services, and for the most obvious of reasons. Services are over 80% of the U.S. GDP and provide over 80% of jobs. That means it is the sector where the U.S. has clear comparative advantage. Services in the U.S. are aimed at the consumer for the most part. It is the sign of a developed, consumer-driven market when services start to overtake goods in the average consumer's spend. This is where China wants to go. This desire has made them responsive to the import of these services in everything from finance to marketing to health care. Again, the balance will look better and the U.S. can claim victory.

Beyond all this, Xi Jinping plays the long game. He knows he has the decided advantage now that he has an unlimited term. Trump seems unlikely to be as strong politically after the mid-terms. China is assuming he is unlikely to win a second term. China can be far more patient than can the U.S.

China Keeps Soybeans Off the Table—For Now

There are several reasons the Chinese have elected not to hit back at the U.S. with tariffs on soybeans. The glib response from some in the U.S. is that China needs these imports to feed its population. This gives the U.S. leverage. In fact, China now produces all the food it needs to feed its population and would be able to obtain all the imported soybeans it could ever want from other trade partners such as Brazil, Argentina, and several Asian states. China is well aware that its greatest allies in the U.S. are in the farm community. If China cuts off imports, they will be devastated.

Analysis: China is essentially giving its allies time to mount a real opposition to Trump's barriers. They know full well the U.S. Senate is dominated by agricultural interests. That is especially true in an election year. These states are diligently pointing out the damage this does to the U.S. farm sector. That is a voting group the GOP needs to keep its position in Congress. If China does cut off soybean imports, they will do it right before the election.

Market Response

There is not all that much predictability in the markets as a rule. If there were, it would not be so challenging to navigate the ins and outs of investing. It has often been described as the most sophisticated form of gambling known. There is more than a little truth to this assertion. The stock and bond markets all over the world are motivated by the decisions made by millions of men and machines. They are not even all trying to accomplish the same thing. Some are in the markets to make fast money with lots of trades and deals according to what that investor sees as the opportunity of the moment. Others are the market for security and gravitate to the secure and predictable options. Nobody agrees on the significance of any given event, so everything that happens in the world provokes both buyers and sellers. It is also true that the markets are not even the most reliable indicator of the overall health of a given economy as there have been many times when the market was hot, while the economy of a given nation was sliding into recession. The performance of the markets plays a very significant role in the conduct of business, however. It certainly affects the overall performance of the global economy.

Analysis: Last week was not a good one from the perspective of either stock or bond markets anywhere in the world. They all tanked. The major ones in the U.S., Europe and Asia hit lows that have not been seen since prior to the recession. This should have been a week that comments from the Federal Reserve calmed things down as the Open Market Committee repeated its latest mantra for the umpteenth time—three (and possibly four) rate hikes this year. Similar moves in 2019 would take the Fed Funds Rate to 3.4% by 2020. The problem is that it seems the market doesn't believe the Fed right now. The 10-year bond has not budged and seems stuck at 2.8%, while the three-year bond is also stuck at a lower level than expected (2.4%). If the markets really believed that growth and expansion were in the immediate future, these yields would be far higher. The markets are expecting a slowdown and growth reversal and think that higher interest rates are no longer all that likely. The big question is why? Shouldn't there be more confidence in growth right now—after all, there has been a big tax cut and there have been respectable growth numbers even before the tax reform package was finally unleashed. The problem is that the investors are now very skeptical regarding the ability of the Fed to stay the course. There are many who anticipate a time when the economy starts to truly falter again. There is deep concern that nobody will react as they would be expected to.

It all comes down to distrust of Trump and his priorities. It was just a few weeks ago when many started to see what might be described as Trumpenomics. For the most part, it was seen as both understandable and something that investors would be able to get behind. It had strong elements of supply-side policy as practiced to one degree or another under Reagan. It was the brainchild of the three key economic advisors at the time—Kevin Hassett, Steve Mnuchin and Gary Cohn. Today Cohn is gone and has been replaced by Larry Kudlow. It appears the other two carry a little less weight than before. One of the key points in the original supply-side theory, and important to the plan this time as well, was debt and deficit control. This was a concern ignored when the big tax cuts were made, but at least the cuts were consistent with the idea of boosting the ability of the economy to grow through consumption and investment. Trump may have made a last-minute fuss over this latest budget, but it was all political theater. This latest budget is chock full of additional funds for the military and a variety of programs supported by one or another faction in Congress. Trump's major objection was that it didn't spend enough on his pet projects. The debt and deficit just keeps getting bigger and bigger. There is no will to cut anything. This is not consistent with the supply-side mantra.

The future looks even bleaker from an investor perspective when looking at the people who will be running the national security side of things. With people like Pompeo as Secretary of State and now Bolton as National Security Advisor, the Trump team is decidedly hawkish and interventionist. That promises to be very expensive in both lives and money. The markets seem to think there will soon be a reason to be more stimulative again, but everyone involved will be hesitant and will allow the economy to tank before doing anything.

Convenience Is the Enemy

Once more, I have been listening to the laments of friends and acquaintances—things are not what they used to be. They mutter about the loss of their favorite stores and the loss of those friendly people they used to interact with at the coffee shop or the grocery stores and the gas station. They complain about food that is full of preservatives and doesn't taste like it once did. They miss Toys R Us and Sears and gripe about the impersonal nature of modern communication. They seek someone to blame. It is Wal-Mart or Amazon, or the internet in general, but I am only reminded of an old comic strip called "Pogo" and the statement by that wise possum—"We have met the enemy and the enemy is us."

We made these decisions every day. They eventually killed all the things we supposedly held dear. We traded convenience for everything—quality, interaction, loyalty. The only thing that mattered was convenience—even more than price on many occasions. Take shopping for food. My friends and relatives in Europe shop for food every day and purchase just what they need for that day. We lament the quality of our bread, but we want the convenience of buying several loaves and having them around for days. Good bread goes stale in hours. We buy fruit that is not even close to ripe so that we can have it later in the week or even month. Fresh fruit has to be sold ripe, but that means it is only edible for a short time. Shopping every day for the food one eats every day is not convenient. Buying what we need as we need it takes time and effort. We would rather order from Amazon.

If we don't want to lose all of those things we supposedly value, we have to choose to buy differently, but I suspect that even those who complain are not going to make that change.

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