Strategic Global Intelligence Brief for May 10, 2018

Short Items of Interest—U.S. Economy
Race Is On for Crude Supply
Leave it to geopolitics to upset the run of low oil pricing and start people thinking seriously about the old threats of inflation. The U.S. has not yet worked out the details as far as renewed sanctions on Iranian oil—this may not be decided until November of this year. It looks like there will be lots of exemptions, but there is already considerable activity as far as refiners are concerned. Oil from fields in the U.S. has been in high demand with deliveries of 2.8 million barrels a month—higher levels than anything seen since 2014. There is a rush to get as much oil on hand as possible prior to any resumption of sanctions and the expected hike in the world price. The upshot for the U.S. is that another oil boom is underway in Texas and North Dakota as well as other areas of oil development.
U.S. Relations with Russia Deteriorate
It remains unclear what Trump was thinking during the campaign when it came to Russia. There was an assertion that somehow a new relationship could be developed between the U.S. and Russia because Trump and Putin seemed to have mutual respect for one another. The opportunity for such a new relationship has clearly evaporated due in part to the machinations of the Russians during the election, but it has since become clear that Russia and the U.S. have far different goals internationally. The two states are on opposite sides on Syria, Yemen, Iraq, Iran, South Asia and so on. The rapprochement has ended and has been replaced by overt hostility. The latest difference has been over oil production and Russian support for the OPEC decision to cut output.
Enjoy It While It Lasts
A majority of economists now agree that the next recession is but a few years away. The most common estimate is for this next downturn to occur in 2020 or perhaps 2021—just a couple of years away. The good news is that this will be coming on top of one of the longest periods of expansion since the 1950s. It is further estimated that this downturn will be mild compared to the recession of 2008-2009. The impetus for the decline will be the reaction of the Fed to mounting inflation fears. They will impose higher rates to get the inflation threat under control. This will usher in that slowdown. With any luck, it will be a classic "V" recession—a nice little purgative that resets the system.
Short Items of Interest—Global Economy
Abandoning Allies
Trump has made one thing clear as far as foreign policy is concerned. He has no interest in maintaining alliances and believes the U.S. can do better by going it alone. Trade is now centered exclusively on what favors the U.S. Political deals are designed to appeal to a domestic base regardless of what this does to international relationships. It is certainly true that the U.S. has done things in the past that were not really in the best interests of the U.S. in order to back U.S. allies, but these allies have made the same sacrifices. It is nearly certain the U.S. will get no help from any other nation should it be in a position to ask. The allies of past years now feel excluded and ignored, and do not trust Trump in any way.
Italy May Avoid a New Election Yet
The breakdown in communication between the two insurgent parties that took the majority of votes in the last Italian election had convinced observers that a new election would have to be held, but that seems to have impressed both the Five Star Movement and the Northern Alliance with the prospect of losing support. They are now talking coalition again. It seems to have been the tacit support of Silvio Berlusconi that put this deal in play again.
Malaysia Stages Massive Upset
The new prime minister of Malaysia is the old prime minister. His victory was over the party he created and ran for decades. Mahathir Mohamad was the head of the nation from 1981 to 2003 when he essentially retired. At 92, he has come out of retirement and scored a massive upset win. His campaign was all about betrayal and corruption as he accused his successors of squandering his legacy and indulging in corruption that was weakening the state. His task now will be finding a set of partners with whom he can actually govern.
Iran Nuclear Deal Questioned
The decision by Trump to withdraw the U.S. from the nuclear deal with Iran has created a tremendous level of uncertainty and outright distress. Europe has vowed to stay with the agreement despite the fact the U.S. can exert pressure on the European states and companies if they violate the sanction policies the U.S. is now permitted to re-impose. The leaders of the EU have reacted with everything from disappointment to outright anger. The U.S. is rapidly losing its status as an ally as far as some in Europe are concerned. Others see the points the U.S. had made, but think there were better ways to address the weaknesses.
Analysis: It is probably useful to review what this agreement was supposed to accomplish and what it was trying to address. The Iranians had been committed to building a nuclear weapons capability. This effort had been a high priority of Mahmoud Ahmadinejad and some of the conservative clerics who dominate the Council of Guardians. With his defeat by Hossan Rouhani, the Iranians began to look closely at the plan and seemed amenable to backing away from it. The fear was that Iran was only a year or two away from having offensive weapons that would threaten all of its neighbors. The most worried have been Israel and Saudi Arabia as there is no love lost between these states and the Iranians. Analysts concluded that neither Israel nor Saudi Arabia would tolerate the full development of these weapons and would carry out preemptive strikes on Iran. This would most certainly start a regional war. It would be the kind of conflict that drags other states into a wider war as has been the case with Syria. Russia, the U.S. and Europe have now all been pulled into that mess.
The nuclear deal was not seen as the best possible outcome; Trump has been pointing out the weaknesses since the campaign last year. Iran can continue building ballistic missiles and it continues to be very active in supporting insurgency groups and terrorist organizations. The U.S. wants these issues addressed right now before it would agree to lift sanctions. The Europeans and others assert that the nuclear deal is a start and could be followed up later. Everyone (including Trump) acknowledges that Iran has complied with all aspects of this current deal, but there has been no reduction in missile development or support for those radical groups. The fact is that Iran continues to be a major threat to the region regardless of the status of those nuclear weapons. The missiles it already has can hit targets all over the Middle East. Also, the insurgent groups that have been receiving Iranian support are actively fighting in Lebanon, Syria, Yemen and Palestinian territory in Israel.
A great deal of the calculation as regards Iran comes down to whether there is faith in the reform elements in Iran. The current leader walks a very narrow tightrope between the conservative clerics that run the country in very fundamental ways and the greater population that seeks economic and social progress. Rouhani has been focused on economic reform. That has meant opening up to the western states—primarily through selling them oil and inviting their investment. His population is now overwhelmingly under the age of 30 and demanding reforms. The recent wave of strikes that have swept through the country has been motivated by people who continue to struggle for the most basic survival and resent the billions of dollars spent on various foreign ventures and weapons programs. As a reformer, Rouhani walks on eggshells; he can summarily be removed from office by the clerics who are not motivated by economic progress and remain entirely engaged in virulently anti-western rhetoric and invective.
If one believes that Rouhani and other reform elements can gain the upper hand and use this nuclear deal to counter the influence of Ayatollah Khamenei and the other clerics, there is impeccable logic in place to continue the deal in hopes the next steps will include deals on those missiles and the insurgent support. If one concludes that Rouhani and others are too weak to counter the clerics and the politicians that support them, the nuclear deal is not going to change much. It will not be followed up by more concessions. In fact, it is very likely that Iran will try to cheat the current deal. This is extremely high-stakes diplomacy and an area where the U.S. and Europe lack leverage. How does the western world assist reform in Iran when the very fact that reformers working with the U.S. or Europe would be exposed to intense attack at home?
Who Will Blink and How?
The stakes are high for both the U.S. and China, and for the world as a whole. Nobody really wants to see a trade war erupt between the two largest global economies. It reminds one of the parable of the two elephants fighting—always far worse for the mice than for the elephants. The tensions that have been building between China and the U.S. (as well as with the rest of the world) have to be addressed at some point. It appears that now is the time to some degree. China has undergone dramatic change in the last 20 to 30 years. That process has hardly slowed down. Once upon a time, China was just another struggling third-world state with little to offer the rest of the world other than cheap labor. Decades of competing at that level allowed a spectacular expansion of the Chinese economy. It became a legitimate global competitor on more than just the basis of cheap workers. Now, it is transitioning once again as it seeks to be more like the developed economies it has been selling to all these years. It is this latest transition that opens up the possibility of accommodating western criticism and avoiding a real trade war.
Analysis: To the U.S. and the other states that are engaged with China, the issue is imbalance. They buy far more from China than they sell. This creates chronic trade deficits. It is not that a deficit is necessarily a bad thing, but the sense is that all this purchasing from China is taking business away from U.S. companies. There are several ways that a deficit situation can be addressed. The tactic that is now at the heart of the Trump plan is to limit what the U.S. buys from China. This can be accomplished with everything from an outright ban on these purchases to tariffs, quotas and various regulatory measures. The challenge of this tactic is that it angers one's own consumers as much as it does the Chinese. The variety of goods available is now limited. Most of it gets more expensive as well. The second major problem is retaliation. China will certainly respond in kind with its own restrictions. It means businesses that once sold to China will lose that market. For some U.S. businesses, that will be the end of their ability to grow.
There is another strategy available. China could be persuaded to buy more from the U.S. than is currently the case. This is where their latest transformation comes in. The stated goal as articulated by Xi Jinping has been described as the "Chinese Dream." It is remarkably similar to the American version. It means accumulation of material wealth—a home, a car, appliances and all the other accoutrement of modern consumer life. This opens the door wide to imports as people who are in pursuit of that illusive middle-class lifestyle want access to the output of the world. What might this mean to the U.S.?
To begin with, it is important to remember that the U.S. is not going to suddenly start producing a slew of consumer goods. The fact is that consumers will not pay the price required to have these products made in the U.S., or Europe for that matter. The U.S. will import these from somewhere—if not China, then from India, Mexico or any of the other nations in the world that seek access to the U.S. consumer. The U.S. makes high-level and sophisticated machinery. It relies on the export of technology. The desire on the part of the U.S. is to sell these high-level machines and technologies to China. That is why the issue of intellectual property protection has been so important. There is a cruel truth to the old joke about Microsoft. The good news is that China elected to deploy Windows 10, but the bad news is that China only bought one copy. For the U.S. to sell more to China, these issues have to be addressed. Those engaged in the current round of negotiations assert they are working toward an expansion of opportunity for the U.S. as well as other nations. That may yet be the way to head off a trade war.
Oil and the Iran Deal Collapse
The most immediate impact of the decision by the U.S. to bow out of the nuclear arms deal with Iran has been felt in the oil world as Iran had been producing oil since the lifting of the sanctions. It was accounting for about 2.7 billion barrels a day, roughly 3% of global production. A bigger issue is that supply routes will be altered as a result of these sanctions. As has become a pattern with many of the Trump policies, there are all sorts of exemptions under discussion. Countries that are purchasing Iranian oil will have until November to stop buying. There may also be exemptions for states that significantly reduce the amount they buy. This is still a negotiation designed to bring the Iranians to a point where they would abandon their missile effort and reduce their support for the insurgent groups.
Analysis: There has apparently been conversation with Saudi Arabia and other OPEC members about stepping up production to offset the loss of the Iranian supply. It is assumed that U.S. producers will also increase their output. The impact on global oil pricing will be significant in the short term, but is unlikely to be that important longer term.
How Long Can Consumers Resist?
It has been a very long time since we have had to really deal with inflation. Having said that, I am well aware that people get frustrated with the way economists handle the inflation question, as we do not include items like food and fuel when computing core rates of inflation. These numbers can be extremely volatile and throw off the models used to assess year-over-year activity. The majority of the population has clearly seen hikes in both food and fuel and would assert there has been plenty of inflation to worry about. The reality is that inflation has been subdued for a very long time, even food and fuel costs most years.
Analysis: Now that real inflation threats are manifesting and producers are seeking to raise their prices to cope with their higher input costs, the consumer is resisting. The question is how long this will last. The fact is that much of what the consumer buys is anything but necessary—it is discretionary spending. As such, they react to prices. If it is deemed to be too expensive, the purchase will not be made. At the moment, consumers are used to price stability and will resist higher prices almost as a matter of principle. This breaks down over time, but could take months to develop. In the meantime, producers are inhibited as far as hikes are concerned.
Some Interesting Insights
I get to hear a lot of other presenters when I am on the road. Some are awful and some are worthy of my deep envy for their talents and skills at holding an audience. The topics vary a lot, but usually focus on some aspect of business management. The guy yesterday has a business that involves crisis management and saving a business from a reputation breakdown. These incidents occur almost every day and can utterly ruin a company that is not prepared. We all know the stories—the exploding engine on the Southwest flight, the food poisoning at Chipotle, data breaches almost every day, inappropriate racial bias at a Starbucks and so on. He made three important points in this talk.
The first is that no matter how deep an existing reservoir of goodwill, the public can turn on a company overnight on the basis of a single incident. Starbucks has a sterling reputation as an innovator and a responsible company. It has ridiculously loyal customers, but lost a major chunk of market share over the incident involving two black patrons escorted from a store. The second and related point is that companies must be prepared for the worst and have contingency plans in place. The bottom can drop out in an instant. There needs to be a coherent and instant response. The third point is a bit hard to swallow but true. Even if you are right, it won't matter if the consumer thinks you are wrong. It is no defense to argue with the accuser—trying to justify the decision made. Southwest did not attempt to blame the engine maker or claim they were simply following existing inspection protocols. The company agreed this should never have happened and immediately launched a massive inspection program while trying to provide as much compensation as possible to the affected. The only response is to accept responsibility, move to correct the problem and move on.