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Strategic Global Intelligence Brief for May 22, 2019

Short Items of Interest—U.S. Economy

Debt Ceiling Blues Again
Given that neither political party seems to have any interest at all in reducing the size of the debt and/or deficit, it should come as no shock to realize that the U.S. is once again running into the issue of the debt ceiling. The government will be unable to pay its bills by mid-summer unless it is allowed to sell more treasuries and rack up more debt. Treasury Secretary Steve Mnuchin is already calling on Congress to raise the limit. It is very likely that they will after an appropriate period of moaning and groaning as if they were not the ones responsible for the government living beyond its means yet again. The debt is now almost 105% of the national GDP (which is now just at $20 trillion). The combination of tax cuts and increased spending necessitates a lot of borrowing.

Potential Fed Nominee Argues for Change
At this point, Judy Shelton is just one of those who has been interviewed by the White House as a potential member of the Fed's Board of Governors. She has been an advisor to Trump and to Ben Carson and holds some unorthodox views from a mainstream point of view. She wants a return to the gold standard for example. She also wants the Fed to deal with interest rate policy differently—taking a more market-based approach as opposed to trying to influence inflation with rate policy. She is a favorite of the Larry Kudlow, the director of the National Economic Council.

Smartphones Make You Dumb
It is not quite that cut and dried, but research has shown some trends that affect how people think and act. The three areas of concern include the ease of getting bad information by simply "Googling" it. The chances are that biased responses will pop up first given that positioning in a search can be paid for. The second issue is that people take little time to just sit and think as they are constantly distracted. Finally, there is the fact that people have fewer actual human-to-human encounters and thus lose social skills and exposure to other people's knowledge.

Short Items of Interest—Global Economy

Who Replaces Draghi?
Mario Draghi is coming to the end of his term as head of the European Central Bank (ECB) and the race for his succession is starting to heat up. When Draghi was made head of the ECB, the choice was somewhat last minute as the expectation was that Germany's Axel Weber would get the post. He dropped out and Draghi was the compromise candidate. Now German monetary hawks want one of their own—Jens Weidman. The lobbying has become intense and Germany is lining up support as fast as it can.

Emerging Markets Feel the Impact
There is an old saying that asserts "when the elephants fight it is the mice that suffer the most." The trade war between the U.S. and China intensifies by the day. This will certainly have an impact on both nations. The greatest impact, however, will be on the emerging markets that have been selling to both the U.S. and China. There will be some nations that benefit as they take production away from China, but many others are going to be adversely affected by the Chinese slowdown. That will mean they have less money to spend on goods and services from the U.S. The ripple effect is already being felt.

Oil Prices Continue to Slide
The U.S. has more crude oil in reserve than has been the case in years. This has contributed to a pretty dramatic decline in the price of oil—low 60s for WTI and Brent crude in the low 70s. This was not what had been expected given the issues in Libya, sanctions against Iran, reduced output from Russia and OPEC and so on. The fact is U.S. producers can ramp up very fast and they did when the per barrel price rose a little. Now there is too much, given current demand. This production will likely scale back sooner than later.

Populists Reeling in Austria
The Freedom Party in Austria is much like all the other populist parties in Europe and elsewhere. It is a loose coalition of various disgruntled voters. There are those who are virulently against immigration, those who had become angry at the scandal and corruption of the old regime, those who have emphasized nationalism in response to notions of European identity and those who have long felt ignored by the traditional elites that have been in power. The Freedom Party has just managed to alienate two of these groups with one video. The deputy leader of the party was caught on tape making a deal with a Russian representative—money in exchange for government contracts. Not only was this blatant graft at the highest level, but it was with Russia. The Freedom Party is now in free fall.

Analysis: Chancellor Sebastian Kurz is from the center-right People's Party, but was essentially forced to make common cause with the Freedom Party in order to form a government. He is now in a position to ditch this group and has wasted no time in replacing Freedom Party members of his Cabinet with a group of technocrats who seem above petty politics. This should satisfy those who still want to root out corruption as well as those who seek to be noticed by the elite. That leaves the Freedom Party with immigration as their only issue.

Has There Been a Pivot?
The fact is presidents frequently change direction and react to different motivations. For the business community, the preference is for policies that stick around for an extended period of time so that companies can adjust and adapt to the situation. The reality is presidents and Congresses react to a whole host of issues—not all of them related to the economy or business community. Trump has been more unpredictable than most and his change of opinion is often very abrupt. There is also abundant evidence that he tends to react to the last person with whom he talks. That sets up a lot of jockeying for influence within his team of advisors. Lately, there seems to have been a shift in attitude at the White House when it comes to how Trump deals with global friends and foes, but most are reluctant to declare this a real and lasting change.

Analysis: From the start of Trump's term, there has been hostility towards friend and foe alike. The U.S. was as eager to contest with traditional allies as it was traditional enemies. Tariffs and trade restrictions were visited on Canada as aggressively as they were on China. Mexico was depicted as a threat along with Iran. Europe was treated as an enemy more often than not and so was Japan. The U.S. seemed determined to go it alone on everything. The approach was based on the assumption the U.S. had been cheated and exploited by everyone and needed to take control back. Lately, there seems to have been a slight change in attitude as Trump seeks to focus his attention on what are perceived to be the biggest threats. China and Iran are now directly in the crosshairs, while the Trump team seeks to get the rest of the world to see this the way the U.S. does.

If there is to be any sort of united front on China and/or Iran, the U.S. will have to alter the way it has dealt with other nations. The only practical weapon the U.S. has to deal with either of these countries is the economic sanction. China has been hit with stiff tariffs and Iran has been hit with sanctions on their oil business. These tactics will most definitely damage the economies of both nations, but without support from other nations, these economic attacks will be far short of crippling and may simply anger these regimes enough to do real damage to the U.S.

China must now find an alternative to the U.S. consumer. That means selling more aggressively in Europe, Japan and the various emerging market nations. This shift in strategy will not go over any better in these nations than it has in the U.S. Chinese companies will put immense pressure on European, Japanese, Brazilian, etc. companies. That will cost domestic jobs—just as has happened in the U.S. There are just as many reasons for Europeans and Japanese and others to want to resist China as there is for the U.S. It would seem a natural alliance and an opportunity to force change on China, but forming that alliance has been challenging as Europe, Japan and the others have little reason to trust and support the U.S. given the hostility and opposition they have faced from Trump. The Iranians are very vulnerable given their near total dependence on oil revenue. The U.S. has imposed sanctions on Iran through financial attacks on those nations that continue to buy oil from Iran. If these nations choose to defy and challenge the U.S., the sanctions will be far less effective. It is unlikely that China will bend to the U.S. pressure, but India and the nations of the EU also buy Iranian oil and they could be persuaded.

In the last week, it looks as if the U.S. has started to ease up on its traditional allies although there has been no formal policy shift. The sanctions on steel and aluminum exported to the U.S. from Canada and Mexico have been lifted (they were the No. 1 and No. 4 suppliers of imported steel to the U.S.). The threats to impose tariffs on European autos and auto parts were delayed until later in the year and there are hints that this idea will be dropped altogether. Does this mean the U.S. is trying a new tactic? Is it one that enlists the support of traditional allies in an attack on nations like China or Iran or perhaps Venezuela? It is likely going to take more than these gestures to get the allies to trust and support the U.S. again. There has been considerable frustration with Trump; the leaders of these nations are not supportive at this point. On the other hand, they have reason to worry about China, Iran and Venezuela. That could push them closer to a more conciliatory U.S.

Retaliation and Blowback
The trade war between China and the U.S. is getting nastier by the day. It has gone far beyond trading tariffs and other restrictions although these remain the moist tangible elements of the confrontation. Over half of the American companies that are doing business in China are reporting severe harassment at the hands of both national and local officials. Not only are they getting hit by some of these Chinese imposed tariffs, they are suddenly subject to inspections and severe fines. They are seeing major delays at customs and their employees are not showing up. There have been numerous reports of sabotage and local officials are denying permits and other permissions. The expatriate community is feeling pressure as well—people have been kicked out of their apartments, shops have refused to sell to Americans and there has been harassment on the streets. This hostility has not become widespread or common as yet, but it has been happening often enough that U.S. companies are rethinking their options.

Analysis: There are several U.S. companies that now expect the trade war to expand and extend indefinitely and are making new plans. They are seeking new locations to produce. Many are looking at other options in the region. They are getting a great deal of support from countries such as Vietnam, India, Taiwan, Malaysia and others. Some of the operations are considering a move back to the U.S. as they move from labor intensive production to robotics and technology. If the U.S. company is not actively seeking to relocate, they are certainly delaying plans to invest further in China.

As with all the other elements of this trade war, there will be damage on both sides. The U.S. companies that set up in China will be losing the value of that investment and will incur costs if they choose to move. It is likely their products will cost consumers more—at least in the short term. China is also losing investment. That was a problem even before the trade battles got underway. The long-term impact is likely to be more serious for the Chinese economy as these U.S. companies have become a major part of their GDP over the years.

If it is assumed these tariffs and restrictions are removed or reduced at some juncture, can it be expected that the situation will return to "normal?" With every passing day, that seems more and more unlikely. Companies are getting very nervous regarding the future of U.S.-China relations. The emerging view is things are only going to get more intense. The assumption that global capitalism would transform China has yielded to the notion that China is changing global capitalism. The incentive to locate and invest in China is eroding fast and companies that leave will be reluctant to return. The most likely winners in this contest between the U.S. and China will be the nations that China supplanted some 20 to 30 years ago.

Once upon a time, the U.S. consumer bought product from all over the world. The average U.S. home likely had goods that came from 30 or 40 nations. China buried these competitors with its low labor costs and its investment in trade infrastructure. The U.S. did not have a major deficit with China until the late 1990s, but always had a major deficit with the rest of the world as a whole due to the fact that U.S. consumers are the most determined to spend their last dime. These diverse nations will be the first beneficiary of this clash of the trade titans.

The Case for Lower Rates
The majority of those at the Federal Reserve have been supportive of the current policy of standing firm. The position has been that the economy is fully robust enough to handle the existing rate of 2.5%. At the same time, there is little or no inflation pressure that would necessitate any sort of rate hike. The head of the St. Louis Fed—James Bullard—has become the first senior Fed official to lay out a case for lowering rates.

Analysis: His argument is that the Fed has been unable to get inflation (at the core) to hit the preferred target of 2% and therefore the Fed may have to consider lowering rates as a means by which to boost that rate up a little. The factors that generally cause inflation have not really kicked in and it looks as if they will not. The unemployment rate is at a 50-year low. Ordinarily, that would cause wages to rise sharply. This is what the Phillips Curve would suggest, but that has not happened for a variety of reasons. Likewise, there has been little pressure from commodity prices as oil has stayed in the $60 to $70 range, while metal prices and food prices have also remained low. A little inflation is a good thing as it allows producers to hike revenues and profits a little—inflation that is too low is inviting a period of deflation, which causes an economy to stagnate. Bullard points out that there are other means by which to boost inflation, but that a rate cut has to be under some consideration.

Travelers Tales
Another night—another reception. The one last night was in Seattle. There were a number of people there who spend as much time on the road as I do and we were commiserating. It is always interesting to note the reactions of people who do not travel much. They hear that you are bound for such exotic locales as Napa or Laguna Beach or Sarasota and become envious of the adventures one must be having. Little do they know that these adventures consist of airports and hotels and little else.

One guy got tired of his teen son and his insistence that Dad was living a life of glamour and excitement. That he was simply lying to his family. So, he took him on his next business trip. This was the one that had him in Scottsdale on Monday, Las Vegas on Tuesday, Salt Lake City on Wednesday, Atlanta on Thursday and Chicago on Friday. On Friday night, he was able to return home to Los Angeles. His son was utterly miserable—bored out of his mind. There was no time to do anything. The kid was at least not in meetings, but that was small consolation. He had no option other than sitting around the room watching TV or maybe hanging at the pool. His opportunities to explore were limited by his tender age of 13. When they finally returned home, he told his mother that his dad had the worst job in the world and that he never wanted to see an airplane again.

This is why I rarely invite my cats to come on any of my trips. I know they would be bored and miss the opportunity to chatter at the neighborhood birds. I just have to assure them that I am not visiting strange animal shelters on the lookout for feline number six. I like being married too much to attempt that.

Chinese GDP Growth and Its Components
The Chinese economy has grown through investment—a far more important factor than domestic consumption or even exports. The U.S. doesn't sell all that much to China, but many other nations do—especially those that supply China with the raw materials and commodities it needs to produce all those manufactured goods. The slide in investment has been behind the slowing of the nation's GDP. Now, that level of investment is expected to shrink even further.

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Sunday, 15 September 2019