Short Items of Interest—U.S. Economy
Inflation Surges Due to Gas Prices
The pace of consumer price hikes accelerated last month. The consumer is now looking at higher gas prices for the first time in a while. Prices have been going up from time to time in the last few years, but this is the first time these prices have been accelerating over a significant period of time. However, the rise in the costs of fuel will not have an impact on the inflation rate the Fed looks at for guidance as the core measurement of inflation excludes the prices of food and fuel. These have been judged as too volatile. That makes it very hard to do year-over-year assessments. The "real" or "headline" rate of inflation does include the price of both food and fuel. There has been some steady upward movement here this year.
Deficit Gets Worse
The government is running a bigger deficit than ever as revenues have not been able to keep pace with spending. The plan at the start of the year was to cut taxes and stimulate enough growth to fuel revenue sufficient to pay for the government's budget. It has not worked out that way. The revenue loss has not been offset by growth and the government has been expanding its spending. Not only has there been more spending on programs such as Medicare, Social Security and Medicaid, but there has also been a bigger budget for defense. The fastest-growing segment of the budget has been debt service. It now accounts for some $300 billion every year. The U.S. is now running a deficit of $100 billon as opposed to $63 billion a year ago. This is an 18% jump over what it had been. Thus far, there seems no desire to reduce the size of either the deficit or the longer-term debt.
Multi-Family Construction Slows
The demand for apartments and other multi-family structures remains high, but there is not the interest in building that existed before. The higher interest rates have started to have an impact and banks are less interested in these projects. The estimate within the housing sector is that many of those who are currently in apartments will be seeking opportunities to buy homes. That will create the possibility of excess capacity. The result is slower construction in that sector and therefore higher rents. There are still many communities that are seeing growth, but the slowdown in construction has even affected the previously hot markets.
Short Items of Interest—Global Economy
Chinese Economy Stutters
It is very likely the Chinese will engage in another round of stimulus soon—even as there is concern that this activity will create more threats of a property bubble down the road. The trade war that has erupted between China and the U.S. has cost both nations, but China has had the worst of it as the U.S. is the primary destination for the bulk of Chinese exports. The banks are seeing more nonperforming loans and domestic demand has not been able to make up the losses from the trade war.
It appears the Italian coalition is willing to play a game of chicken with the EU. The populist coalition (Five Star Movement and Northern Alliance) promised its followers a lot of largesse. The budget now calls for extensive new spending. This has been rejected by the EU as financially disastrous and the Italians are facing censure and fines. The EU seems willing to go ahead with the punishment even as Italians talk of their own exit. It is a game of who is bluffing whom.
In country after country, there has been mounting evidence of a fundamental divide between the urban and rural communities. The cities are generally more liberal and the country is more conservative. This has been the battleground in Poland, Britain, Germany, the U.S. and many other nations. Satisfying both constituencies has become ever more challenging.
How Real Is This Brexit Deal?
The deep and convoluted argument over the "great European divorce" has been raging for months. As recently as two weeks ago, the majority of those who have been engaged with the issue were asserting that no real chance for a deal existed. The U.K. was just going to stumble out of the EU and create chaos for itself, Europe and the world. Now, there is news of a deal of sorts, but there are a number of critical issues that have not been addressed. The success of this arrangement is anything but assured.
Analysis: It is useful at this point to do a quick review given the intense controversy that has emerged. In 2016, the British government under the leadership of David Cameron and the Tory party put the U.K.'s membership in the European Union on the ballot as a referendum. It was essentially a political ploy to satisfy the Euroskeptics in the party. It was assumed the measure would lose and this would shut the anti-EU forces down for a while. To the shock of most analysts, the measure won and Britain was suddenly on the path to withdrawal. The No. 1 motivator for the population that supported the break from Europe was immigration as people in the rural areas deeply opposed the open movement required by EU rules. The issue had centered on the waves of migrants from East Europe and the British concern over loss of jobs and the cultural change that was taking place. The communities that actually saw the majority of the migrants were opposed to breaking away from Europe. Once the decision was made, the challenge was to effect an exit that didn't destroy the British economy. That task was made ever harder by the fact that Europe was furious with the British and adopted a position that could best be described as "don't let the door hit you on the way out."
The two stickiest issues have been the future interaction of the British and European economies and what to do about the border between Ireland and Northern Ireland. The U.K. wanted to essentially "have its cake and eat it too"—at least that was the assertion of the Europeans. The U.K. wanted to halt the free movement of EU citizens to Britain, but wanted to stay in the customs union as that allowed easy trade access for British firms. The EU balked at this and has asserted that Britain should be required to forfeit the advantages of EU membership if they were unwilling to shoulder responsibilities as well. Ireland has proven to be an even more vexing issue. Northern Ireland was pulling out of the EU as they are part of the U.K., but Ireland was remaining in the organization. In the Brexit vote, the population of Northern Ireland was overwhelmingly in favor of staying in the EU. The British do not want any kind of a hard border between the two Irelands, but the EU has pointed out that a lack of border controls will simply allow British companies access to the EU across that porous frontier. The border that exists now runs through people's homes and their land. Britain fears that imposing a real border would trigger another round of violence in the region as many in Northern Ireland will have yet another reason to unite with the rest of Ireland.
The plan that is now on the table addresses these issues, but not in a way that will exactly please everybody and possibly nobody at all as the strategy is chock full of compromise that will leave all sides wanting. Mostly, this is a placeholder agreement that gives the Brits and the Europeans time to work on something more lasting. It keeps the U.K. in a customs union. That avoids a hard border in Northern Ireland. It freezes many of the provisions that would affect the conduct of business between the EU and U.K., but nothing is actually put in place. It just keeps things essentially as they are while talks continue. The real crisis for Prime Minister Theresa May is that she will have a very hard time steering this through the skeptics in her own party as there is a faction that hates the connection with Europe so much they are willing to risk any economic damage. Meanwhile, the bulk of the population that voted in favor of Brexit has changed its mind and, according to polls, would change their vote if they had it to do over again.
Ceasefire in the Offing?
The U.S. and China are talking again, but there have been mixed reviews. There are those who assert a breakthrough remains highly unlikely and that the meeting between Steve Mnuchin and Liu He will be little more than an opportunity to vent. Others point to the changed circumstances in the U.S. and assert China and the U.S. have reason to find an opportunity to compromise.
Analysis: The latter estimate is based on an assumption that President Trump will have to find a different path to governing now that he has a split Congress. His previous position was based on GOP control and an assumption that his base was enough to govern. It is now clear that this base is not enough and he will have to add allies or at least blunt his political adversaries. The virulently anti-trade and anti-China message doesn't play well across all groups. As the tariffs and trade barriers start to really hurt the U.S. consumer, the tactic will not be considered as attractive as it was.
The thinking is now would be a good time to work out a deal that can be termed a success for the U.S. China has not yet imposed all the barriers it has threatened to and the U.S. has also not fully implemented its tariffs. There is room to delay these while leaving some of the high-profile barriers in place. Both sides can claim victory and allow some resumption of normal activity. The reality is all of the efforts to reduce the trade deficit have failed because the dollar has been gaining strength for the last two years. The most important factor as far as trade is concerned is dollar value—a strong dollar means cheap imports and fewer exports, while a weak dollar yields the opposite. Nothing on the horizon suggests there will be a weakening of the dollar any time soon, so the U.S. will continue to run a trade deficit as a result.
German Economy Shrinks
The fate of the European Union (EU) rests with Germany—at least as far as the economy of the region is concerned. It is the undisputed powerhouse for the region. When the economy of Germany falters the rest of Europe struggles as well. For the first time in three years, the German economy has shrunk—dropping by 0.2%. The primary problem for Germany has been a decline in exports, but there have also been issues with the auto sector—one of the largest industrial motivators for the economy. The decline in export activity is attributable to the trade war that has erupted between the U.S. and China—a very clear indication that economies are affected by global developments.
Analysis: China has been buying far less from Germany than had been the case earlier, which originally came as something of a surprise. With the decline in business between China and the U.S., it was assumed Europe would be making up the difference and would see more Chinese demand. The problem is that this trade spat between the U.S. and China has badly affected the Chinese economy and has sent it close to recession (anything less than 6% growth is recessionary for China). This decline has meant Chinese businesses are investing less and buying less—from Germany as well as other nations. The EU has not been in a position to make up the difference and neither has the U.S. seen expanded imports from Germany. The German industrial community does not sell much in the way of cheap consumer goods and there is very little export activity aimed at emerging market nations. The Germans trade with economies that look a lot like their own. Exports account for over 50% of the German GDP.
The second issue as far as German growth is concerned is not considered a lasting one. German carmakers have struggled to meet the new emissions standards set by the government. That has delayed production considerably. The estimate is that carmakers will get this figured out soon enough and they will soon be able to start meeting demand again. The export issue is far more complex. The provisions of the new USMCA (the old NAFTA) will cause problems for the German carmakers as there will be tighter domestic content requirements for vehicles that are made or sold in the U.S. The big five automakers in the U.S. already comply with these rules (Ford, GM, Fiat Chrysler, Toyota, Honda), but few of the German offerings do. They will have to expand the parts acquisition strategies they now employ.
This slowdown in Germany will affect the strategy that has been offered by the European Central Bank (ECB). There had been some talk of hiking interest rates at some point, but this development will slow that process. If Germany is not strong economically, the rest of Europe will not be strong either. The last thing the Germans will want is a euro made stronger by higher interest rates. The assertion by the ECB is that they will not deviate from their plans to reduce stimulus, but if the Germans do not bounce back, it will be a tough position to maintain.
U.S. and Saudi Arabia
The evidence has become overwhelming. The Turkish intelligence community monitors the activity of Saudi Arabia closely as the two nations are often bitter rivals. It is still astonishing that the assassination of Jamal Khashoggi took place in Turkey given this fact. It is now abundantly clear Khashoggi was killed on orders from the Crown Prince Mohammed bin-Salman or somebody quite close to him. The fallout has been intense and Saudi Arabia is losing friends and support at a rapid clip. Thus far, the U.S. has been standing behind the Crown Prince. The question is why.
Analysis: The "realpolitik" answer is the U.S. thinks it will have leverage on the Saudi government as the U.S. will be nearly its only remaining ally. The three concessions the U.S. would want from Saudi Arabia would be an effort to keep oil production up in order to keep overall oil prices down, an end to the messy attacks on Yemen and an end to the pressure that Saudi Arabia exerts on Qatar—a key U.S. ally in the region.
If none of these concessions are made, the relationship between the U.S. and Saudi Arabia gets that much more confusing. The oil talks taking place now have centered on an OPEC desire to cut output so oil prices can continue to climb. If the Saudi position continues to favor that reduction, the U.S. interest in supporting the Crown Prince will be in serious question. There has never been a better time to pressure the kingdom to pursue policies that reinforce U.S. positions. This is especially important as the U.S. support for the Crown Prince has horrified many—support for an outright political murder is hard to justify.
It has been a pretty busy week—stops in New Orleans, Atlanta, Tampa, Bismarck, Nashville and San Antonio. My travel is actually boring beyond belief as I rarely see anything other than airports and hotel meeting rooms. This is really OK with me as I don't generally want to linger. I want to get home as fast as I can. This means most of my travel entertainment is confined to watching my fellow passengers and the others one encounters in these venues. One gets a variety of experiences that will either depress or inspire.
I am always astonished at how we can utterly ignore one another. It is the natural reaction to being crushed together with strangers. We each adopt a cocoon so we do not have to interact. Earbuds and headphones make this easy. It is amazing how far people will take this. I have watched people dump coffee on somebody and just walk away. I have seen people trampled and crushed by the frenzy that ensues when the plane lands. On the other hand, I see people trying to help others with their bags and have seen people go out of their way to be kind. The really fun part is witnessing behavior that is wholly unexpected and which challenges assumptions.
The guy on the plane was downright scary—a perfect cast member for The Mayans. He was large, heavily tattooed, leather clad. A biker if ever there was one. His face was deeply scarred and in a permanent scowl. Nobody dared sit in that middle seat next to him. As we left the plane, most scurried as far from him as possible. Turns out we were both on the next leg of the same journey so I saw him again in the waiting area. There was a mom struggling with her teen son. He appeared to have some kind of disability and was on the edge of a full-blown tantrum with lots of screaming and arm waving. The biker guy walked over and we all froze. He sat down and started talking to the kid in the gentlest tones imaginable. He started asking the kid questions like, "Where's the airplane?," "Who has a baby?," "Who is wearing a red hat?," "Who is reading a book?" The kid was now engrossed with looking at everything and everybody and calmed down. The biker guy looked at the mom and said, "My baby brother is autistic too." You just never know!
U.S. Business Cycle Expansions
The chart below shows the NBER analysis of the last several business cycles for the U.S. The period of growth we are in right now is one of the longest experienced since the 1950s, although it has not equaled the periods from 1982-1990, 1991-2001, 2001-2007 or even the one from 1961-1969. The point NBER makes is that each of these long periods of growth ended with a recession of some kind. The assessment from many analysts is that the current cycle is likely to come to an end sometime in 2019 or early 2020. The fact is periods of growth are generally lasting longer than they used to and other analysts have been less pessimistic about how soon this one will end. The sense is issues such as labor shortage as well as inflation and higher interest rates will start to catch up in the coming year.