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Strategic Global Intelligence Brief for May 15, 2018

Short Items of Interest—U.S. Economy
Broad Gains in Retail The expectation was that retail numbers would be up by 0.3% and, for once, the prognostication was correct. The gains varied from one sector to another—the biggest gains were at gas stations with a 0.8% hike. That is due to the rapid increase of gas pricing, as the hike is expected to continue into subsequent months. The good news is that retail didn't just see gains here, but in everything from clothing to food to electronics. The only sectors to register a drop were restaurants and bars. It seems that entertainment is ending up behind some goods accumulation, but there are stark contrasts between communities in a drinking region and the teetotalers.
NAFTA Scenarios The assertion is that some kind of deal is close in regards to NAFTA. It has been the stated goal of the Trump administration that a new deal be in place by the end of the year and there needs to be time for Congress to get in the game. Four scenarios seem to be making the rounds. The first is a quick but partial deal that is focused on the automotive sector. The second option is extending the deadline from May 17 to later in the summer. The third option is continued hyperbole and drama. This is the tactic that has consistently kept business on the edge. The fourth option is holding out for a total rewrite, which has no support at all from either Canada or Mexico. The odds right now seem to favor option two, with the assertion that deals on automotive and agriculture be promulgated.
More and More Fed Support for Rate Hikes The latest reports from the Cleveland and New York Fed banks show that inflation is building and at the rate expected, if not a little faster. The Fed really has no reason to hold off on interest rate hikes with this data in front of them. It is all but certain that rates will rise twice more this year, most likely in June and September. That may not be all that is contemplated by the FOMC and it is not out of the realm of possibility that another hike is executed at the end of the year.
Short Items of Interest—Global Economy
Global Warming and the Humble A/C Unit Every so often, there is a discussion over what technology has most changed the world. A strong case can be made for the car or electricity or antibiotics, but one that has transformed where people work is air conditioning. Previously uninhabitable communities thrive under the cool air. The challenge is that nothing drives demand for energy the way that A/C does, and there are millions and millions of people getting access every year. Is there enough power for this expansion? Not now at least and even if steps were taken right away, it would be years before these new facilities were ready and producing.
Brazil Prepares for Election It has been an election of extremes, with the former president holding a lead in many polls, despite his conviction on fraud charges and hit with a longish sentence. He now seems bent on revenge against those who attacked him. This is a country that has been beset with corruption at very high and very low levels. It is blamed by those in poverty as the one factor that keeps them down and the elite power structure intact. The men and women competing for the top post have very little in common as far as policies and that leaves the voter with some pretty sharp choices.
Riots and Protests over U.S. Decision in Israel Jerusalem is the very epitome of symbolism. The three major religions that grew up here all claim Jerusalem as their ancestral capital and for years, it was in limbo with all claims duly noted. Now, the U.S. has thrown that fragile peace away and violence has ensued. The U.S. has its embassy in Jerusalem and from the Palestinians' perspective, that is a provocation that has triggered another round of bitter and violent protests, killing nearly 50 people. The truce that had been in place was tentative at best, but the whole process has been ditched and Palestinians are feeling betrayed and desperate.
Deal-Making with China The latest wrinkle in the Trump policy toward China seems to be trading access. It has been hard to separate the rhetoric from reality when it comes to Trump trade policy. By all outward appearances, the U.S. has been assailing China as its most potent economic opponent. The U.S. was prepared to pull out all the stops to force Chinese adherence to global trade rules and to blunt the impact of those large trade deficits. Now, the tactics in place seem far less draconian.
Analysis: The massive telecom company in China, ZTE, has been singled out for highly punitive sanctions, as they have been supplying technology to Iran. They have also transgressed when doing business in the U.S.—the vast majority of cheaper cell phones sold here are from ZTE. The sanctions would have crippled the company, but Trump has expressed deep concern over the loss of Chinese jobs and has offered to reduce or remove the sanctions in return for China agreeing to lift restrictions on farm exports from the U.S. to China. For all the bombast and harsh words, it seems that Trump is engaged with China in the same way that his predecessors have been. To get something from China, it is necessary to find something that China wants. This may be better access to some aspect of the U.S. market or removing a threat that has China concerned. China needs the farm exports the U.S. traditionally sends to them and, at the same time, they want to protect some of their newer and more technologically-advanced companies, such as ZTE. This kind of deal seems good for both nations, history aside.
Europe Struggles with How to React to U.S. Threats It has become hard to determine who the U.S. deems a friend these days. The actions of the Trump administration seem very accommodating toward North Korea and until recently, toward Russia. There is a lot of tension between the U.S. and China, but there have been deals in the making throughout. Europe, on the other hand, seems to have become more enemy than friend when it comes to economics, diplomacy and politics. The united stance of the European allies on the pact with Iran was utterly ignored by Trump, even as it came from those Trump claims to have good relations. Now that the U.S. is determined to reimpose sanctions on Iran, the European states are trying to figure out what their response should be. The room for maneuver is slight if the U.S. wants to be ugly about this.
Analysis: As far as Europe is concerned, there are several issues at stake. The first is perhaps not the most important, but it will play a bigger role in the months and years to come. Iran is furious with this step and they are reacting as one would predict. The reform elements in Iran have been dealt a major blow as the hardliners can now accurately state the U.S. can't be trusted to keep its end of a bargain. That cements an image of the U.S. as an implacable enemy. Iran is asserting its nuclear ambitions will be aggressively resumed. That may be nothing but bombast given the position Iran holds that can't be assumed.
The second issue for the Europeans is economic. There was a great deal of investment taking place in Iran and that all stands to be lost since the U.S. will sanction any company that continues to do business with Iran. This investment has been targeted toward the oil business and infrastructure in general. Right now, this amounts to around 20 billion euros annually—not a huge amount compared to the other trading relations the EU has but not insignificant either. The real fear is that Iran will lose its desire to control its weapons development if there is no real monetary incentive to do so.
The third issue is likely the most important. Europe is looking weak. This snubbing by the U.S. has been politically emasculating and calls into question the ability of the EU to function on the world stage. For decades, the assumption has been that Europe and the U.S. were basically on the same page on most global issues, creating a united front. It appears the U.S. has lost all interest in the EU and Trump is seen as outwardly hostile. This leaves Europe vulnerable in many respects, economically, politically and diplomatically.
The response by Europe has been a mixture of shock and disappointment and there are calls for some kind of retaliation. The question is what that would look like. It is not really possible to use the WTO against the U.S. and counter sanctions would damage the EU as much as the U.S. European companies face big fines, threats of asset seizure and even potential criminal charges. These are not risks that most companies will want to take, throwing the issue back into the EU's court. The most likely response will be symbolic, but the EU will remember this slight the next time the U.S. asks for any assistance on some global issue. It is safe to say the U.S. no longer has an ally in Europe.
Turkey Worries About Erdoğan's Plans The Turkish lira has fallen to new lows against the dollar and other leading world currencies. It is at a point never seen before against the dollar. Since the start of the year, the currency has lost 17% of its value and the plunge is far from over. Turkish President Recep Tayyip Erdoğan is now asserting that he will take control of monetary policy should he be re-elected as president of the new system that concentrates the majority of power in the presidency. One of the areas he wants to gain control over is monetary policy by essentially stripping the central bank of its authority. Erdoğan is like all politicians when faced with economic challenges: He wants lower interest rates so the economy can be stimulated back to health. Unfortunately, that tactic usually brings intense inflation and over the years, the Turkish economy has seen its fair share of these inflation surges.
Analysis: If Erdoğan does succeed in getting control of monetary policy, the interest rates will go down and inflation will be right behind. He is betting that growth will be robust enough to offset the impact of that inflation, but that has rarely been the case for Turkey. The more likely outcome is rampant inflation that the central bank will have to combat. The world as a whole is obviously not encouraged by all this, which explains the plunge of the lira as well as other reactions to the extremely short-sighted strategies that an increasingly autocratic Erdoğan has been promulgating.
Surge in Capital Spending One of the most common laments during the recession in the U.S. and the slow growth period that followed was that business was not expanding as is usually the case in the aftermath of a downturn. The pattern has played out many times in the past, recessions serving as a kind of economic purgative. Companies that have not been well-run or have been rendered uncompetitive in some way start to fall by the wayside. This allows other companies to expand their market share by picking up the consumers that once belonged to those failing competitors. It is a somewhat brutal reallocation of resources from the least productive to the more productive. For a variety of reasons, that did not happen with this recession, at least not at the usual level. It was a very deep recession that was triggered by a crisis in the financial sector and limited the ability of even more successful companies to expand. Two measures of an economy's relative success have been generally down and struggling to return to normal levels until just recently.
Analysis: The level of capacity utilization is a good shorthand method of tracking how efficient the overall economy has been. The ideal range is between 80% and 85%—it is assumed that anything under 80% is indicating there is still considerable slack in the economy. This translates into cautious expansion planning. When the percentage reaches 85% and beyond, there will likely be shortages and bottlenecks because capacity will be overstretched. The numbers have just started to get close to the bottom end of normal, readings around 78%. In another month or two, it is likely that capacity will be somewhere in that normal range.
The other shorthand means by which to look at the economy is through the lens of capital investment. This has been down since the recession started for a variety of reasons. Part of it has had to do with the quiet consumer and lack of demand. There has also been a general sense of caution on the part of businesses that do not want to be as leveraged as they were at the start of this recession. There was no sense of urgency since there were few competitors that were all that active. So, there was no reason to ramp up spending. Add in the reluctance on the part of the banks to lend and there is no real movement to expand.
Suddenly, this situation seems to be changing. So far this year, there has been a record level of capital investment, a 24% increase in the first quarter alone. The pace is on target to break records if it continues through the rest of the year. The levels are better than they have been since 2011 when there was a brief return to post-recession activity. The big spenders have been well distributed across many major sectors, such as automotive, energy, aerospace, electronics and health care. Most of this spending was on machines and technology, but there has been some spending on real estate and physical expansion as well. There has been some evidence that hiring has increased, but this has been inhibited because it's been hard to find the qualified people needed in these industries.
For the most part, this expansion has been welcomed by observers, investors and economists since this kind of spending can lead to more market share expansion and growth. However, there are no guarantees that all this investment and spending will pay off. A lot depends on the motivation for the activity. Those companies that stand to gain the most benefit have been planning these acquisitions for a long time and were waiting for the right conditions. The others are more reactive. They see their competition investing in new capacity and feel compelled to match that activity or else they will start to lose ground to those that are expanding. They may not be as ready and their decisions may not pan out as well.
In many of these industries, one can see the Kotler model in play. This theory states there are generally three market leaders that are watching over their shoulders to see what the market challengers are doing. Those are the companies seeking to unseat one or more of those market leaders. If they are successful, the investment will be deemed worthwhile, but if they fall short, the investors will be distressed. It is a gamble on the continued growth of the economy and the efficacy of their plan.
Jim Conn Knew This Was Coming After all, we talked about it. He noted that he enjoyed reading these little personal commentaries and I confided that the act of writing them every working day had changed many of my old patterns. I stay alert to anything that would make for good commentary and have become something of a voyeur in the process. My friends have learned that I can't be trusted to keep their stories private and I have been admonished a few times because of my willingness to share. My commentary today is entirely Jim's fault because he very graciously offered to fly me from Minneapolis to my speaking gig in Alexandria. This would normally have been a long haul in a rental car. This time, it was a one-hour flight in his little Cessna. What a pure delight.
He flew very low the whole way so that we might sightsee and I have to say that Minnesota and its lakes are truly gorgeous from the air. It was utterly fascinating and every mile brought new revelations. I don't get a chance to fly like this very often and every time I do, I am reminded how much I like it. I harbor fantasies of learning to fly and maybe someday, I will horrify my wife and engage. The day gets better when I have dinner with Jim and a friend of his and we all three manage to solve all the problems in the world. Today, I do the talk I came here to do and get another ride back to the Minneapolis airport for the much less-interesting flight home with 140 of my closest friends.

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