Strategic Global Intelligence Brief for June 3, 2019
Short Items of Interest—U.S. Economy
High Inflation Is Bad—So Is Low Inflation
There is no doubt high inflation is a major economic problem. One of the core missions of the central bank is keeping a lid on these price hikes. In many ways, the high prices are more dangerous to an economy than is recession. Inflation that is too low is an issue as well as it condemns an economy to stagnation. Japan has been hampered by a low inflation environment for nearly two decades, while Europe has been locked in one for the last several years. The Fed has been trying to get inflation (at the core rate) up to 2%, but not with much success. This has become a hot topic for the Fed and will be for the next few years.
Manufacturing Starts to Stall
The U.S. has regained a good deal of its manufacturing momentum over the last few years, but it remains a very sensitive area; one that is subject to many influences. Right now, the issue is the strength of the global economy. It has been pointed out that 15% of the U.S. GDP is dependent on exports, but when the subject is manufactured goods, that percentage jumps to more than 40%. The U.S. sells a lot of its manufactured output to nations that have been struggling economically. This issue has been made more vexing by all the trade disputes and the fact that the dollar has been gaining strength almost every week. This rise in dollar value has been due in part to the higher interest rates set by the Fed, but is more a factor of weakness in the other global currencies.
The New Dominant Household
It hasn't happened quite yet, but the trend is clearly present and poses a challenge to marketers and sellers. The old pattern assumed that the consumer with the most money to spend was in a traditional family of some kind. It may not have been the mom and dad and two kids of old, but it was a family. Today, there are far more people living as singles and many of them intend to stay that way. It is not just young people as there are many past 60 who live alone, and by choice. They have different needs and interests as far as consumption is concerned. Marketers are just starting to figure that out.
Short Items of Interest—Global Economy
Traditional Parties Lose Big in France
The old patterns are in tatters. The European Parliamentary elections have thrown the center right and the center left into total disarray in France. The result has been the resignation of many in the leadership. The voter has turned away from both the Republicans (Gaullists) and the Socialists in favor of Emmanuel Macron's version of centrism and the National Rally (formerly National Front) of Marine Le Pen. The voter is not sure what they want, but they seem to know what they don't want.
Mexico and China Still Trying Negotiation
Frankly, it is still hard to decide what the Trump strategy is when it comes to tariffs. To the nations hit by these tariffs, it seems they are negotiating tactics—a way for the U.S. to get their attention. This has led them to keep trying to engage with Trump to figure out what he really wants. On the other hand, there is the fact that long lasting or permanent tariffs can have a long-term impact on a given economy. The U.S. has never been good at setting up these long-lasting tariffs, but it still remains a possibility. That reduces the effectiveness of negotiation.
Modi Pressed to Speed Reforms
Now that Narendra Modi has won his second term, the business community in India has stepped up pressure on him to focus attention on those promised economic reforms. The issues revolve around land reform, labor reform and access to capital. The Indian bureaucracy has been seen as the main impediment to growth, but attacking it has been immensely complex. It is not clear that Modi has the needed support.
Major Immigration Shift in European Heads
If there is one single issue that has driven the rise of the populist right in Europe (and the U.S. for that matter), it has been immigration. The opposition to newcomers has been motivated by a wide variety of concerns. Some of those fighting this migration are overt racists, but many others have far more complicated rationales. They are worried about the impact on their culture, their jobs, and the impact on crime and terrorism. Few want to see an absolute end to immigration, but many are feeling overwhelmed by the pace of the last few years. The Danish elections may be showing a new wrinkle as far as this debate is concerned.
Analysis: The Social Democrats are a center-left party. They are one of the largest traditional parties in a country with a long history of liberal and socially tolerant policies, but that has not stopped the Social Democrat's immigration spokesman from outlining a strict new policy on the issue. Mattias Tesfaye is the son of an immigrant and a former bricklayer, but the position of the Social Democrats has hardened dramatically as immigration is now being blamed for a deterioration of social cohesion and economic stress. This would suggest an anti-immigrant stance is starting to become more mainstream in Europe.
Two Reasons That Tariffs Work and Two Reasons They Don't
Before we get into what makes a given tariff effective or ineffective, we need to point out that there have always been two purposes as far as tariffs are concerned. They have been imposed by almost every nation on earth and have been used for hundreds of years. The most common use is based on economic consideration, but there have long been tariffs used for political aims. A classic example of the latter is the one threatened by Trump against Mexico. There was no economic demand made of Mexico—rather the tariff was a threat to punish the Mexican government if it did not adhere to U.S. demands regarding immigration. Over the years, the politically motivated tariff has a very poor record of success. The economic motivation for a tariff has a mixed record, but under the right conditions, there is the opportunity for the desired outcome.
Analysis: Generally speaking, tariffs (and other trade restrictions) are imposed for four reasons. The most common is the "infant industry" motivation. Countries just developing the capacity to produce something will seek to limit the importation of a competitive product so the domestic producers have time to develop and get ready to compete on a global scale. This kind of tariff has been used extensively by developing nations seeking to compete against established companies in the U.S., Europe or Japan. China erected many such barriers as it sought to develop its native industries. Theoretically, a nation lowers or removes that tariff once their domestic sector matures. In reality very few do unless under some pressure to do so.
A second rationale is essentially an attempt to "level the playing field." Developed nations frequently impose restrictions and tariffs on nations that compete on the basis of their very low production costs. Developing nations generally have very low-paid labor, very loose environmental and labor rules and other advantages that give them a competitive edge. The developed nations seek to blunt that edge with trade restrictions and tariffs, but this comes at a cost to the consumer in the developed nation as they will be denied access to lower-priced goods.
A third rationale is basic protection. There are industries considered important for many reasons. The government will seek to protect them in a variety of ways. There will be trade restrictions and tariffs, but there will also be a whole host of additional protections that range from outright subsidies to government buyouts and special tax considerations. Japan could save billions each year if it bought rice from other nations. China and India are number one and two—Japan is a distant number eight. Japan considers rice a national security issue and refuses to be dependent on any other nation. The U.S. has sought to protect its high-tech sector and anything that relates to the military. This designation gets stretched pretty far at times. In addition to national security, there is a desire to protect industries that provide a large part of the GDP and employment. The U.S. has long been protective of the auto sector and has tried to insulate the farm community with a variety of subsidies and tariffs on imported food.
Protection of innovation is another rationale—somewhat similar to the infant industry argument, but one that is more commonly leveled by the developed nations. The U.S. (as well as Europe and Japan) leads the world in terms of research and development. This is what drives the bulk of innovation in the U.S. economy. The fear is other nations will simply steal or otherwise acquire that technological know-how without spending billions of dollars over a period of years. The U.S. wants to protect its research investment from exploitation, but given the speed at which knowledge travels, that is a very hard thing to accomplish.
Over time, tariffs have been pretty effective at accomplishing the first two goals, but much less so when the latter two goals are examined. The key to any successful tariff is certainty. The tax needs to be in place on a near permanent basis so that domestic producers have the confidence to invest. The U.S. has been notorious when it comes to manipulating tariffs. Most fail to last—affected by changes in political priorities. Remember that the U.S. economy is first and foremost geared to the consumer. The pressure is great to ensure that consumers are able to live their chosen lifestyle and at a very low cost. Given that consumers pay these tariffs, it is always tempting to remove them.
Expensive Year at the Grocery
The threat to impose tariffs on goods from Mexico will hit people right in the stomach. The U.S. imports $12 billion worth of food every year and about 54% of that comes from Mexico. That includes 80% of tomatoes, 80% of avocadoes, 99% of raspberries and strawberries. The initial threat is a 5% tariff, but could jump to 25%. The initial blow would be felt, but that second hit would price these products out of reach. Grocers assert that they will not even attempt to carry them as they do not want to be stuck with very expensive produce they can't sell.
Analysis: Many other sectors will be affected by the tariffs as the U.S. imports more than food. Cement will be affected and so will car parts and other manufactured goods. The average consumer is currently looking at a $4,000 to $8,000 increase in their average cost per year (depending on what they buy). This is due to the tariffs that have been imposed on China, Europe, Canada, Mexico and others. Given that Trump has threatened Mexico with similar trade restrictions in the past and then backed down, there are many who do not believe the tariffs will be imposed—especially as he has been very vague about exactly what Mexico is expected to do concerning the immigration issue. On the other hand, it looked like there was going to be a deal with China and days before that agreement was to be made, the whole thing fell apart.
Recession in the Offing?
This appears to be a pretty absurd assertion given the state of the economy right now. The growth rate for first quarter was revised downward, but only by the slightest of margins from 3.2% to 3.1%. The unemployment rate is still at record lows and that goes for the U3 as well as U6 readings. Consumer confidence has rebounded as expected given the beginning of the summer travel season and there is no real inflation to vex people at the gas pump or even on the trip itself. How can anybody be looking ahead and see a recession? It turns out that quite a lot of investors, analysts, economists and business people are doing just that. There has been a sense that the economy has reached its peak and it is now time to start sliding.
Analysis: At this point, the pessimists are listing three major concerns. Many assert the damage has already been done. This convinces them that by the end of the year the economy will have slowed considerably—perhaps to the point of a recession. The major worry is still rooted in the trade war and the impact of tariffs. For months now, there have been businesses taking significant hits from the tariffs they have to pay. Remember that Trump's intimation that somehow China is paying these tariffs is utterly false. The tariff is imposed on the good that comes from China. If the U.S. company or consumer has no other option, they will pay that additional cost. In theory, this tariff will make the Chinese product too expensive and alternatives will be sought. In time, there may even be U.S. companies that decide to produce that product. This will not happen quickly and it may not happen at all. It has been estimated that 65% of the goods currently purchased from China are not made anywhere else. That means that U.S. companies and consumers are paying the full tariff cost.
The second recession worry stems from investor attitude. The markets are clearly spooked and there has been a very obvious flight from equities to bonds. Yields are as low as they have been in years as everybody seems to be heading for safety. The specter of the inverted yield curve is on everybody's mind. It has always coincided with a recession (at some point). The expectation is that the slow global economy and worry about the U.S. will drive the Fed to cut rates—not a good sign from the investor's point of view.
The third set of worries is more theoretical, but has history on its side. The current business cycle is one of the longest since the end of the Second World War (but not yet the most persistent). The sense is something has to give and soon. Those who pay attention to these cycles are preparing for what they see as the inevitable slide. That could be a self-fulfilling prophecy. It is already apparent that manufacturing is not going to see the same level of growth as was seen in 2018. There has been a slowdown in capital investment and hiring. Some of that has been attributed to the lack of skilled workers and the fact that there is still some slack capacity, but worries about the future persist. Remember that much of what drove growth at the start of this year was businesses trying to stay ahead of the tariffs by buying more inventory than they needed. Now they have to worry about getting rid of it and they get nervous if it looks like consumers are starting to spend less.
Is a recession a certain thing? Not at all, but big policy decisions will play an outsize role. Pursuit of an even more aggressive trade policy will not help and sudden moves by the Fed will be an issue as well.
There certainly seems to be a lot that one would want to escape from these days. The headlines are full of bitter conflict as our politicians spend every waking hour finding ways to attack one another. The violence of the streets is constant and the world appears to be utterly devoted to warfare and tragedy. We don't need a litany of these challenges—what we need is relief. Yesterday offered three such opportunities to escape—at least for me.
The first came as my wife and I sat on the deck—newly planted and brought back to life. The view is of our own little forest as we planted a large number of trees over the last few decades. We can't even see the houses across our little lake anymore. All we see are trees, birds and other wildlife. Add in the sound of the fountain and we have bliss. Later that day, she was singing with the Liberty Community Chorus and I had the opportunity to sit back and bask in the beauty of that choral music in one of the most beautiful and acoustically marvelous buildings in the city. The music was utterly transporting. We finished the day spending time with her son and his wife as we went out for a post-concert dinner. Having a pleasant conversation with people we love was a perfect complement to the day. To top it all off there was the usual array of cats blissed out on our laps before we headed for bed. There is nothing quite like a contented cat to remind one to slow down and enjoy the beauty, peace and calm that still exists alongside the turmoil.
U.S. Immigration Numbers
No matter what one's position is on the subject of immigration it is hard to ignore the profound impact that it is having on the U.S. The number of immigrants to the U.S. has risen dramatically (and these are the legal migrants). This has meant that the population of the U.S. is made up of more immigrants than since the turn of the century. Whether this is a good thing for the economy and the country as a whole depends on many factors, but the most important has been the process of assimilation. The faster newcomers integrate into the mainstream, the more beneficial that new population becomes.