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Strategic Global Intelligence Brief for March 6, 2018

Short Items of Interest—U.S. Economy

Service Sector Continues to Thrive

The shocker for the Purchasing Managers' Index (PMI) this month was the employment gauge. This reading fell hard—over 6.6%. This forced the whole index to trend down a little, but it is still above 59, firmly in the expansion category (anything above 50). Ordinarily, a big drop in the employment sub-index would be a warning that other employment measures would be down as well. However, analysts noted that January's numbers were higher than normal. Most thought the data this month would to return to more normal levels. It is not expected the labor force numbers will be down this week, but should they dip, there will be some question as to why. If there are layoffs taking place, that would be a bad thing, but it may also reflect the fact that more people are voluntarily leaving one job to take a better one.

GOP Members Upset Over Tariff Plan

The Trump team is not the only group that is divided by the steel and aluminum tariffs. There has been competition between the likes of Gary Cohn, Jim Mattis and H.R. McMaster vs. Peter Navarro and the nationalists in the Trump inner circle. The Congressional split has pro-union Democrats siding with the GOP nationalists against those closer to the farm sector and manufacturing, as these will be the sectors that suffer most from the tariffs. The traditional GOP position has been pro-trade, but now that only describes about half the members of the Republican Party in the Senate and House.

Negotiating Tactics Emerge

From the start of the tariff talks, there was the suspicion this was part of a larger game. That has now started to come into focus. The latest set of talks over the future of NAFTA has been considerably less acrimonious than before. It looks like the U.S. is dangling a carrot for both Mexico and Canada. If they step back from some of their positions on NAFTA, the U.S. appears to be offering a set of exemptions that would allow these nations to keep supplying steel to the U.S. Canada is the No. 1 exporter to the U.S. and accounts for about 16% of imported steel, while Mexico is in the top five as far as steel exporters to the U.S.

Short Items of Interest—Global Economy

Potential Movement in Korea?

Right now, talk is cheap. The North Koreans and South Koreans have agreed to some high-level talks that may bring the two leaders into face-to-face interaction. There is a lot that can happen to throw these plans off course, but thus far, this is the agenda. North Korea's leader—Kim Jong-un—has stated that if he can be guaranteed his regime will not be attacked in any way, he could be persuaded to end his nuclear program. The challenge is that neither of these will be easy to prove. It has been exceedingly difficult to verify anything that happens in North Korea. The U.S. and Japan will not abandon the hope that Kim and his ilk leave office.

New South African Leader Gets Economic Gift

For the first time in four years, the South African economy has notched an annual growth rate that is in positive territory. The new leader—Cyril Ramaphosa—now has a functioning economy to work with. That will make it somewhat easier to fulfill some of those campaign promises. Not that all is well and good. Most are acutely aware that success in South Africa is due to overall global growth and not to decisions that have been made internally. The good news is that a new leader and better economic outlook means the lending and investment communities are much more willing to engage now.

State of Emergency Declared in Sri Lanka Again

There seemed to be a semi-permanent truce between the Buddhist and Islamic populations in the country, but that has suddenly broken down as the two sides are fighting over territory as well as political power. The hardliners on both sides had been quieted, but they are back in force. There have been clashes all over the country that have resulted in more police and military engagement.

Here's Why We (and Others) Are Irritated With China

There has been a great deal of consternation over the latest Trump policies as regards trade. The opposition to the steel and aluminum tariffs has included any sector in the U.S. that uses steel. Many within the ranks of both Republicans and Democrats see these moves as needless and provocative. As they say—it takes two to tango, however. The speech by Li Keqiang—China's No. 2 and something of a critic of Xi Jinping—lasted a full two hours. There was plenty in that monologue that would raise hackles in the U.S. as well as many other nations. It is actually a little hard to figure out what China's strategy is at the moment as there have been statements from top party leaders that seem to contradict one another. Li's comments are not exactly out of line or threatening, but they are certainly not going to suggest China is feeling conciliatory or cooperative.

Analysis: Li is a very interesting player in the Politburo. At the time that previous leaders like Hu Jintao and Wen Xiabao were preparing to finish their terms and step down, Li was the odds-on favorite to take the helm in China. This was when Xi Jinping started his own preparations and soon took advantage of the fact Li had his enemies. In the end, Xi was the very clear winner, but Li was not purged or even really demoted. He still has extremely powerful allies in the regions and within the manufacturing community and has not tried to challenge Xi. The most fundamental difference between the two is over the focus for the Chinese economy. Xi has pushed very aggressively for a domestically led economy with an emphasis on the consumer. He is not all that concerned about the rise in imports if they stimulate more consumer activity. He has even been prepared in the past to take some support away from the export sector. This most definitely is not the position of Li Keqiang. He wants more attention to the traditional export economy and is far less supportive of the consumer as a whole, while taking active opposition to imports.

In that two-hour speech, he called for a campaign of "Made in China: 2025." It seems to have a great deal in common with Trump's "America First." He wants broad investment in major industrial sectors such as aircraft manufacturing, big data, clean cars, self-driving vehicles, solar and wind energy and robotics. China is already the world leader in the use of robots and manufacturing technology. The aim of this plan is to advance this lead even further.

There is, of course, nothing at all wrong with goals like these. Every nation espouses something similar at every opportunity. The issue is how these goals are to be accomplished. The U.S., Europe, Japan and most of the rest of the developed world relies far more heavily on the private sector and the market, while China's economy remains state-controlled and directed. To advance in the western states is a series of competitive trials and errors as companies seek to outdo one another to gain market leadership. This is the model outlined by Kellogg School of Management professor Phil Kotler years ago. His construct was that there are nearly always three market leaders that drive a given sector. Right behind them are market challengers seeking to be one of the three. The rest of the given business sector are either market followers that take their lead from the leaders and challengers or those that find a niche opportunity the others are not interested in. It is a messy and complex system with lots of false steps and failures. The Chinese, on the other hand, have a monolithic system run by the government. They create champions through subsidy, tax breaks, paying for their research and development, protection through regulation and tariff and so on. To be honest, every country does a certain amount of this. In truth, the U.S. does far more of this kind of protection than in the past—it wasn't something that Trump came up with for the first time.

At the same time that Li Keqiang was laying out his case, the economy leader in the Politburo was in Washington. Liu He was trying to outline a more conciliatory approach. He pointed out where China had been making it easier for the U.S. to do business there. Thus far, these comments have fallen on deaf ears, but to be honest, the Chinese interest in U.S. investment has been mostly confined to companies that have the ability to transfer technology to the Chinese. The nationalists are every bit as strong in the government of Xi Jinping as they are in the administration of Trump. That seems to ensure confrontation on a regular basis.

Will Any of This Help the Steel and Aluminum Business in the U.S.?

The short answer is not very much. Placing substantial tariffs on imported steel may help some of the companies in the U.S. do a bit better, but the reality is that they do not have the capacity to keep up with demand and steel users will import anyway—it will just be more expensive. The majority of that additional expense will be passed on to the consumer. Is there anything that could be done to really help the steel sector? The short answer is yes, but it may be too late.

Analysis: Decisions made over the last 20 to 30 years have destroyed demand for steel in the U.S. The auto sector was mandated to improve fuel efficiency. The only way to do that was to make vehicles lighter. That meant less steel and more plastic. Also, the reduction in funding for infrastructure over the last two decades ruined public sector activity—the largest market for steel. The inhibitions in the energy sector slowed development of pipelines, which are made of steel. The scrap business drives the modern steel mill, but the No. 1 source of scrap steel in the world is ships. Environmental laws in the U.S. make it very hard to scrap ships here. The bottom line is that steel makers have been on the wrong end of dozens of policies and regulations. Each time this happens, they are that much less competitive. The tariffs will simply not reverse this pattern. They offer a very temporary and insignificant boost, while likely causing that much more of an inflation theat.

European Response to Tariffs

The emerging trade war triggered by the U.S. decision to impose tariffs on imported steel and aluminum has opened up a whole series of debates around the acceptability of both the U.S. tariff decision and potential reactions. The World Trade Organization (WTO) has suggested the European response is less within the rules than the original U.S. decision. According to the WTO system, a nation can take steps to protect its national security if that is under threat. This argument has been used by Japan to protect its agricultural output. Many countries have employed tariffs, regulations and other barriers to protect what they deemed to be critical industries. Steel production in other countries has been deemed a protected industry before, but that has usually been a designation that allowed state subsidy.

Analysis: The European Union asserts that the steel tariffs are not being imposed for national security reasons as the majority of the affected nations are longtime U.S. allies. There is no threat at all of the U.S. being denied the steel and aluminum it requires. The assertion is that these tariffs are "safeguard" tariffs designed to protect local industries from competition. If the WTO rules these are security-based moves, the room for retaliatory action is constrained. If they are ruled to be simply protection of local industry, other nations can engage in the same tactic and stay within WTO guidelines. Given the way the WTO has ruled in the past, it would be likely that the security argument would hold. This would especially be the case if the U.S. granted exemptions and exceptions to nations like Canada and Mexico or some of the other allies.

Europe has a three-pronged strategy to urge the U.S. to either drop the tariffs altogether or at least grant exemptions to the Europeans. The first response would be to restrict U.S. products from European entry or to impose their own punitive tariffs. The list of affected products has not yet been completed—there is still plenty of time to add and subtract, but the products chosen are those that would have the most impact on the U.S. Harley Davidson is said to be a target in no small part because it competes with European motorcycle makers. Many of the products are related to the agricultural sector as Europe knows full well the power of the farm state legislators and knows they will be trying to get re-elected this year. Collapsing the farm sector for the sake of steel will not be a great campaign slogan. The Europeans also plan to target high tech, robotics and other manufacturing-centered activity as they also know that U.S. exports depend on manufacturing and food.

The second plank is the possible imposition of European steel and aluminum tariffs. This would not be aimed at the U.S. as the U.S. doesn't export all that much of these metals. The fear is that exporters that are cut off from the U.S. market will turn to Europe and flood their market with the steel they can't sell in the U.S. The Europeans assume this will convince those nations to put their own pressure in U.S. export markets. Given that these states are already moving in that direction, this is a safe assumption.

The third plank is more purely diplomatic and rests on the fact the U.S. and Europe have many more interests than just trade. The U.S. would be utterly hamstrung in the Middle East without support from the EU. The Europeans are critical members of NATO and that affects U.S. policy in Afghanistan. The Europeans have been stalwart supporters of the U.S. around the world, but this all comes into question now. Will Europe back the U.S. in North Korea, Cuba, Venezuela or in the conflicts that erupt in Africa? Most of the time, U.S. and European interests coincide, but not always. Europe has taken positions not in their best interests to support the U.S. Those days could be coming to an abrupt end.

Big Loss for Traditional Parties in Italy

There had been a faint hope that populism in Europe had peaked and was on the decline after Marine Le Pen and the National Front were crushed last summer in France and when Angela Merkel managed to fight off the rise of the AfD populists in Germany. That position has been reversed by the outcome of the Italian election. The polls looked bleak for both the center left and the center right for weeks, but it was thought that Silvio Berlusconi was on the verge of a comeback (whether that is a good or bad thing is open to intense debate). The actual election made it clear that traditional is out.

Analysis: The two parties that swept to almost half the vote were the overtly populist Five Star Movement and the almost separatist Northern League. In the past, the Northern League was allied to Berlusconi, but that is no longer a certainty. Nobody has wanted to ally with the Five Star Movement. Today, there will be no avoiding a coalition that likely includes both. These parties will drive a very hard bargain when it comes to engaging with Europe. It is expected to be many months before there is a functioning government in Italy.

What Did We Ever Do for Entertainment?

Watch out, I am going into full fuddy-duddy mode. I was conversing with some people of a "certain age" the other day—you know those who have their births in the same decade as I do. We were discussing grandkids and what it now took to keep them amused. The tech world has taken over completely and left these miniature human beings bereft of the ability to amuse themselves for even 10 seconds without some device in their hand. Of course, we all agreed that life was so much richer back in the day. But really, it was. Fantasy was what we made it—not what some game maker decided it was.

I was a kid who resented being inside for very long. I played outside in the fields and woods behind our house. I was very rarely in anything organized as mom hated having to tote me anywhere. She booted me out the door and expected I would be back when the sun went down. My fantasies were my own. One minute, I was my favorite character from "Combat" (Gauge). The next, I was some intrepid explorer discovering the Northwest Territory. I watched birds and bugs. I caught snakes and turtles and whatever else and occasionally attempted to make them pets. Mostly, I just watched them go about their business. Sometimes, there were other kids with me, but most of the time it was just me. I sat in trees and read books. It was an unstructured childhood. I really think this better served me.

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Monday, 25 May 2020