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Strategic Global Intelligence Brief for October 1, 2018

Short Items of Interest—U.S. Economy

PMI Backs Down a Bit
The latest data from the Purchasing Managers' Index (PMI) slowed a little from the previous record-setting month. It was nearly inevitable this would be the case as there had been some factors driving last month's numbers that were clearly ephemeral. The threat of tariffs and trade wars convinced a lot of companies they had to act as quickly as they could to avoid the impact of these taxes. That boosted the activity in manufacturing, but it was a boost that was not going to last. It can be asserted this month's data is more accurately representing the state of the sector. Even with the slip from that 14-year high, the numbers are solid at 59.8. The new orders index also slipped a little, but stayed near record levels. That bodes well for the future.

Consumers in Decent Mood
The timing is good for a better than average holiday spending season. The success or failure of the last quarter of any given year depends on three things. Two of these appear to be in place at this point with time for the third factor to come along. The first step is for consumers to have money to spend—sufficient disposable income to make the kind of non-necessity purchases that drive the holiday. The second factor is willingness on the part of the consumer to spend that disposable income, generally measured by consumer confidence numbers. These have been high—close to setting records. That leaves the third factor. It is not quite in place as yet. The retailers went into this season with the same idea they had the last few years—light inventory and an emphasis on getting maximum consumer activity at the start of the season. If the retailers start to raise expectations, they may start to try to rush more inventory into stock.

Oil Headed to $100?
This would not have seemed possible even a few months ago given the glut of supply and the relatively calm demand. Now, there is considerably more demand from the U.S. and even Europe. Also, the supply has ebbed a little as a result of decisions by Russia and Saudi Arabia to reduce their production. Now, the chances are even that oil prices will hit $100 by the end of the year. Brent crude has been up 24% this year. This was once a bad thing for the U.S. economy, but given the importance of oil in the U.S. economy now, there will be gains to offset any oil losses.

Short Items of Interest—Global Economy

Warnings Against Trade War Escalation
The comments by Cristine LaGarde are not all that unusual by this time, the International Monetary Fund (IMF) has been sounding the alarm for some time. The point she is making is stark enough. The lack of multi-lateral emphasis and the determination by the U.S. and others to pursue semi-isolationism forces many nations into a downward spiral that gets much harder to break over time. On the other hand, there have been complaints for years that China has consistently violated those trade rules. The fear is that trade restrictions will drag global growth down by around 1%

China and Africa
The Chinese are still pouring money into the continent. That continues to worry not only the Chinese, but also African leaders. The Chinese have dumped billions into every kind of infrastructure project imaginable. This has led them to get involved in a lot of government activity, which has been less than popular with many of these governments. It is hard to determine who is more intertwined—China has been distressed by the lack of return.

What Are Issues in Brazil?
Here are the main issues as far as the Brazilian voter is concerned. By far the most important one is corruption. The population is thoroughly fed up. Next is violent crime, lack of social and economic progress, unemployment, deforestation and the environment, deficit spending and the future of the pension system. Over two-thirds of likely voters plan to vote on the basis of how candidates handle these concerns.

The New Trade Agreement
It will henceforth be known as the United States, Mexico, Canada Agreement (USMCA). It doesn't roll off the tongue quite as easily as NAFTA does, but it is only a matter of time before somebody notices the similarity to "YMCA" and puts this new treaty to music (with gestures). The deal was struck late Sunday night .This took quite a few analysts by surprise as it appeared the divisions between the Canadians and the U.S. were too broad. In the end, both sides gave in on some aspect of the deal which had previously been non-negotiable. The sense was that politics at a very high level was playing a big part. Mexico agreed to this deal some weeks ago as there was a desire to get something done prior to the arrival of their new left-leaning President Andrés Manuel López Obrador (AMLO). Canada also had politics on its agenda as it seemed likely it would get a better deal after the mid-term elections in the U.S. as the Democrats have been more favorably inclined towards Canada. This deal is not done as yet; the agreement will now need to be ratified by Congress. The majority of those who will be weighing in have indicated they are encouraged, but not convinced since they have not seen the agreement in its entirety. That said, Republicans will want to give President Trump a win right before the election and Democrats will want to keep the pact intact as that has been their assertion for months.

Analysis: The three main sticking points revolved around the auto industry, the dairy industry and the process by which disputes will be settled. Until last night, it appeared that no ground would be given by anybody on any of these. The U.S. wanted three changes as far as the auto sector was concerned: (1) more production and assembly of cars in the U.S.; (2) higher wages paid in Mexico and Canada to make it less lucrative to move operations from the U.S.; and (3) stricter interpretations of what constitutes domestic content. Progress seems to have been made here as most of the required changes would be affecting Mexico.

The dairy issue was one that would affect Canada more than Mexico and the Trudeau government had been digging in its heels. Today, the Canadian government protects their dairy industry with everything from subsidies to trade restrictions. The U.S. has been demanding these protections be reduced. That is a tricky political move in Canada as the majority of these operations are smaller. They are in the pivotal provinces of Ontario and Quebec. The Canadians have not agreed to stop supporting the dairy industry, but trade restrictions are being removed or at least scaled down. The third issue was one the Canadians demanded from the U.S. There is a dispute settlement procedure in place with NAFTA now that assigns a third party to settle trade disputes. It doesn't allow member states to make arbitrary threats and take independent action without consultation. The threats that Trump has made to ban auto exports from Canada or the threats directed at Mexico over some of its agricultural exports would not be allowed to stand unless and until this arbitration panel approved the move. The U.S. did not want that constraint on its actions and Canada did not want to be exposed to the kind of capricious threats and demands that have emanated from the U.S. of late without some recourse.

In some ways, the hard part now begins. This is an agreement between the leaders of these three nations, but in all three states, there will have to be further approval from the legislatures. These same issues will come up along with others that were not as crucial in these talks, but matter a lot to certain constituencies. As was seen with the talks over the Trans-Pacific Partnership, it doesn't really matter what is agreed to by two presidents and a prime minister—now it has to get through two Congresses and a Parliament. There are anti-trade forces in the U.S. on both sides of the aisle. Thus far, they have not endorsed any of this. The Canadian dairy farmers are not happy and neither are those in the auto sector. Mexico has a new president from the left (AMLO) who has made a lot of promises and will be hard pressed to deliver on them. The U.S. in general is not all that popular in either Canada or Mexico these days. President Trump is extremely unpopular, so there will be opposition to anything that looks like a concession.

On the other hand, there is a strong incentive to get this issue behind all three nations. Mexican President Enrique Peña Nieto is going to have plenty on his plate as it is and AMLO is visibly relieved not to have this to take on the second he takes office in December. The GOP is not eager to go into the crucial final weeks of the election without a win; especially one that will generally please the business community. Canada feels it got the best end of the deal with the retention of the dispute mechanism and Trudeau is not facing those angry farm voters for a while.

A Few Other Provisions to Note
The biggest of the NAFTA issues have been pretty thoroughly explored over the last few months, but there are other points of interest.

Analysis: The trade agreement is set to expire in 16 years, but will be discussed and renewed every six years so that deadline can be pushed off every six years. There is a clause that prohibits these nations from manipulating their currency values to favor exports. This is not something any of the three have ever done, so it is part of the agreement so something similar might be in any future deal with Asian states like South Korea, Japan or China. It is likely that steel and aluminum tariffs will be removed or significantly reduced, but these are not part of this deal and will have to be negotiated separately. Canada has retained the system that would allow it to object to these tariffs. Most analysts assert Canada and Mexico would win the argument on steel and aluminum given the U.S. assertion this was done for national security purposes. The U.S. has not accused either of these nations of dumping the metals and the security argument has always been seen as specious.

China's Economy Buckling?
As the trade war threats became reality, there has been much conjecture whether it would be China or the U.S. that would suffer the most. In truth, the pain of a trade war is never evenly distributed within a given nation. There are sectors that depend heavily on exports and imports and sectors that do not. The U.S. has been shifting inexorably towards a service-dominated economy. That has isolated the economy to some extent. It is possible to shift a lot of manufacturing jobs overseas, but much harder to shift service sector jobs. The real test of this stand-off rests on the resilience of an import-dependent country vs. an export-dependent one. In both cases, the core issue is the availability of alternatives.

Analysis: Should the U.S. cut off its access to Chinese imports, the challenge will be getting these inputs from some other location. There will be three categories of imports where the U.S. will need access. The first is consumer goods. Right now, they are the bulk of what the U.S. imports from China. They will also be the easiest for the U.S. to find alternatives. There are no Chinese brands that have any power in the U.S., so for a consumer, it is nothing more than whether the shirt or shoes they buy from Wal-Mart comes from China, India or Bangladesh. The Chinese also supply a lot of parts and assemblies that are used to make manufactured goods in the U.S. These are replaceable, but it would likely take a little longer. The U.S. also buys commodities and raw materials from China .These will be far harder to replace. The Chinese are the prime source for the U.S. supply of rare earth materials. The U.S. is the major buyer of these substances from China which is the main reason the U.S. has not extended its trade restrictions to include these substances. The Chinese are not adding them to their list either.

China is having a harder time finding substitute markets for the goods it sells. It is the long-term goal of the Chinese government to replace these overseas markets with a more robust domestic one, but that is going to be a long-term proposition. Of the 1.4 billion people in the country about 400 million could be classified as middle class, but they are still buying only a fraction of what the overseas markets purchase. The U.S. is by far the largest market the Chinese sell to. They do not have a ready alternative to the U.S. Europe is the No. 2 market for Chinese goods, but remains one-quarter the size of the U.S. The rest of the world combined accounts for less than 15% of the total.

The Chinese factory sector has been shrinking already. Analysts expect China to experience as much as a .05% decline in GDP growth this year. China has the ability to withstand this kind of decline, but it hurts nonetheless. Presumably it will make finding some form of cooperation more appealing. The U.S. is not really against the kind of buying it does from China—realistically the U.S. is not going to produce these items itself; they will be bought from other nations. The U.S. is mostly interested in getting China to buy more from the U.S. and the Chinese middle class has the same desire.

First Challenge for AMLO
The start of the new Mexican president's term has not formally started, but Andrés Manuel López Obrador is already coming under extreme pressure to deal with the violence that stems from the drug gangs. This was anticipated, but the scale of the violence has been a shock. The gangs are worried that AMLO may have the leverage to do them some damage given his popularity in the poorer parts of Mexico that feed the gangs with members. They are moving quickly to consolidate their power and position.

Analysis: The goals of the larger gangs are fairly clear. The first is the expansion of their territory at the expense of the smaller gangs. Many of the killings have been rival gang members who currently hold lucrative positions. The second goal is to keep current gang members loyal to the gang. This means a combination of incentives and violent threats directed at people throughout the organization in order to discourage them from allying with AMLO and his party. The third goal is a little longer term. It involves forcing AMLO to work with the gangs to accomplish his aims. If the gangs are powerful, they will hold the key to what happens along the northern border, in the tourist areas and in the remote countryside. The cartels want to essentially be partners so that they will see less interference from the government.

AMLO has an advantage that previous president's did not have, but it is not clear this will be enough. He has the hearts and minds of the poor—the very group the drug cartels exploit. Is that enough? How will AMLO protect those that choose to work with him? Will he have to be as dependent on groups like the Mexican Marines and the U.S. military?

Feeling Conspicuous
I arrived in Key West last night at about five in the afternoon and will depart at about five this afternoon so I can get home and prepare for a trip to St. Louis tomorrow. I can guarantee I will not evoke as many stares in either KC or St. Louis as I have here. I am in a grey suit, tie and shirt with cufflinks. I feel like one of those endangered species that somebody wants to pin in a box. I have been informed by many people that I am a rare sight in a region whose statement on wearing a suit is as follows "anyone wearing a suit is probably the groom, deceased or a defendant." I hope I am none of those!

Clothes do define one. I am a speaker at these things and thus expected to be dressed up to a degree. I also travel as light as I possibly can and don't carry much more than an extra shirt. I am comfortable with suits after all these years. I also note that somehow people still treat me as more important than I am because of it. This is especially the case with women of a certain age. One stopped me last night and thanked me. She was on her way to dinner at the hotel and lamented the loss of some decorum and formality. "Dinner here was special and people showed it some respect. They dressed and were on their best behavior. Thank you for reminding me of those days and how handsome my late husband looked when we came here." That was worth tolerating a little steamy weather in a suit!

Strategic Global Intelligence Brief for October 2,...
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