Strategic Global Intelligence Brief for October 15, 2018

Short Items of Interest—U.S. Economy

Fed Reiterates Intent
It is not at all clear what the motivation is behind the latest tweet storm aimed at the Federal Reserve, but if it was expected to evoke a change in the policy of the Fed, it has not had the desired effect. The Fed has essentially circled the wagons and reiterated what it has been saying all along—rates are going up slowly and methodically as there is abundant evidence the economy is strong enough to handle a rise in rates. It is also strong enough to start providing some real worry about the potential for inflation. The Fed has other reasons to advance rates and these have been remarked upon. Even those who have not been approved by the Senate for posts on the Board of Governors have defended the policy of hiking rates now before the real threat of inflation mandates more extreme measures.

Housing Market on Downward Path
It is pretty obvious the housing market is losing its overall momentum—not something that much surprises anyone. If anything, it comes as a shock it took this long given all the headwinds that have been worrying people for months. It was expected housing would be affected earlier by higher prices and more expensive mortgages, but there were still factors that kept driving the market. Granted, the main motivation for all these gains were the very hot markets in the top-10 cities, but overall, there were enough well-heeled buyers to keep things lively. The good news is the decline of the market has been far more gradual than it was during the great debacle of 2008-2009. That means it will have less of an impact on the overall economy. The sector struggling the most is the starter home. This buyer is the most sensitive to the price and the mortgage rate.

Import Prices Up by 0.5%
Few are surprised at this number except for those who thought it might be worse. The fact is tariffs and other factors are having the predicted outcome. The costs of things from China have risen, and this is only the start. Given enough time, there will be replacement goods available as other countries will rush to fill the void. There may even be some U.S. companies that will try to compete, but this will still leave the consumer facing generally higher prices for the next several months. It is not clear these price hikes will affect the holiday spending season just yet since many retailers stocked up when they first started to hear about the tariffs. There has also been a slight increase in the price of imported oil. The U.S. still buys enough from overseas for that to matter.

Short Items of Interest—Global Economy

Bavarian Debacle
If there were hints Chancellor Angela Merkel was facing trouble, the elections in Bavaria just confirmed all of the worst suspicions. This is the bastion of conservatism in Germany—often referred to as the Texas of German politics. The dominant political force has been the Christian Social Union which has been a longtime partner to Merkel's Christian Democrats. It just suffered the worst electoral defeat in years. The voters defected to two very ideologically diverse options. A huge number went to the far right AfD (Alternative fur Deutschland) and a significant number opted for the Green Party—which has become more pragmatic under its new leader. It now appears that the Christian Union will form a coalition with the Greens. That is not something anybody would have expected even a few weeks ago. This puts Merkel in a very weak position.

Corporations Not Abandoning Globalization
One of the reasons for the global market drop has been the fear of rampant nationalism and protectionism. Most of the world's largest companies have developed a very integrated system of supply chains and are not prepared to give these up. They market globally as well and have no intention of losing the billions they have invested in these systems due to the political whims of various leaders. The markets are reflecting that worry and the fact many companies are in the midst of developing contingency plans that would change a lot of the dynamics.

What Does A New Cold War Look Like?
The U.S. has adopted a much different position towards China under President Trump than has been the case since the days prior to Nixon and Kissinger and their overtures to a post-Mao China. For the better part of five decades, the U.S. (and the world in general) has favored a policy loosely defined as "constructive engagement." This set of policy moves essentially rests on the assumption that nations like China can be persuaded to act like a responsible global player through cajoling them to play by the dominant rules. The threats of action or ostracism would be played down and essentially rejected. It has been pointed out China has never reacted well to overt threats and it has been assumed that as the Chinese adopted a more western version of economic growth, they would also adopt western political and cultural norms. After nearly half a century, it seems China has developed its own system of capitalism. It is not a version that challenges the tight control of that political autocracy. Now that President Trump has decided to reject the way China has been dealt with in past years, there are many questions—starting with what is now expected of China by the U.S. and the rest of the world.

Analysis: There are many theories under discussion. Most of them are only half-baked at this stage. It is still not clear whether President Trump wants a relationship with China—these threats may be just a means by which to get some concessions. On the other hand, the policy statements have gone far beyond trade and business and now involve politics, diplomacy and military strategy. That really could mean igniting a new Cold War. It might be useful to revisit what a Cold War actually means.

The Cold War that was waged between the U.S. and the USSR was a clash of ideologies, of regional power and simply the contest between two nations that both saw themselves as preeminent world powers. There are many elements of the U.S.-China rivalry that look similar. Ideologically, the two states are vastly different even as China has adopted some elements of capitalism. It may no longer be a communist country in the way that Mao Zedong conceived of it, but it remains a tightly controlled autocracy that doesn't tolerate dissent and which regularly persecutes its own citizens. There are no rival political parties, no free press, no free speech and there is a powerful police state. The U.S. and China both want to dominate the Pacific Ocean and both are rivals as far as affecting the future of Africa, Latin America and parts of South and Southeast Asia. The Cold War developed since there was too much to risk in a traditional "hot" war. That doesn't mean aggression is ruled out. There are many situations which result in some exchange of attacks, but these stop short of actual warfare as nobody is willing to pay that price. It tends to rest on the concept of MAD—mutually assured destruction. The thought is smaller conflicts stay small as both sides have the ability to devastate the other.

The U.S. and USSR were never economic rivals as the Soviet economy was always a shamble. They could rarely produce anything beyond basic commodities that anyone in the world wanted. This is a critical difference between the Cold Wars. China is a valued market for U.S. production and an even more valued supplier. This was never a consideration with the USSR and even the Russia of today. The critical element here is which nation has the ultimate leverage. At the moment, the advantage lies with China as it produces so many things Americans never even knew came from China. Those who did know could not possibly have cared less—they just liked the low price. Consumer will be hit first by this trade war. They will either have to pay a far higher price than before or they will not be able to get the items at all. Over time, that situation will change and the Chinese will be facing the disadvantage. China will struggle to find consumers like those in the U.S. Eventually, other business interests will move into the territory the Chinese once occupied. India is rushing to fill that void now, but no matter who leaps in and how fast, there will a period where the consumer faces a rough time.

It is going to be a matter of who can wait longer. Will U.S. consumers rebel and demand a return of those cheap goods and will U.S. manufacturers demand those cheaper parts? Will they be willing to wait until the other nations of the world are ready to fill the void? It all depends on how long it takes to gear up and whether China will be able to exert pressure on these nations. It is unlikely that India will be bullied, but some of the smaller ones might knuckle under to Chinese pressure.

U.K. Edges Closer to 'No Deal' Brexit
The optimism that once surrounded the issue of Britain's exit from the European Union has utterly evaporated. It now looks likely the split will be complete and unorganized. The early days assumed cooler heads would prevail and all concerned would recognize that an animosity-filled process would be bad for everyone. It has not turned out that way. The EU has been angry from the start and determined to make Britain pay a price. This has been as much about keeping other nations from jumping ship as it has been about the U.K. The British, for their part, want a system that gives them most of the advantages of being in the EU, but without the willingness to abide by EU rules or allow EU citizens to move to the U.K.

Analysis: The stickiest issue is Ireland; specifically Northern Ireland. Britain wants the current open border retained while Europe objects and asserts Britain will simply thwart EU rules by bringing goods and materials across that border from Ireland. If the hard border is imposed, it will be impossible to cross between the two Irelands without going through checkpoints and carrying documents. Today, the border cuts right though villages and even people's farms and homes.

Crisis Du Jour
This promises to be one of those weeks that get very complicated quickly. There are three issues setting up that may prove to be hard to handle. It is now getting close enough to the elections in the U.S. that these issues will linger in the minds of the voters—at least some of them. By this point in the election, there are four main goals for each political party and pursuing all four simultaneously can be challenging. The majority of those who are regular voters have long ago made up their minds—both parties have their "base" and there is no fear of losing them to the other side. What is worrying is they have to be engaged and show up to vote. That means making sure there are those "raw meat" issues in play. The second goal is to lure the undecided voter. While there are fewer of them, they make the difference in close races. They are undecided because they are waiting to hear one side or the other address the issue that matters most to them. There is a lot of variety in that category. The third group is the eligible voter who has been sitting this out. Some are registered and many are not, so time is running out to get them on the rolls. Finally, there is trying to limit the voting of the opposition. Most of the efforts to outright block them from the polls have been dealt with, but there are pockets. Now the effort is to find a way to shake their confidence in their chosen candidate to the point they decide not to vote at all.

Analysis: There are three issues emerging this week that could affect any or all of these groups. The first one is the presumed assassination of Jamal Khashoggi by elements of the Saudi Arabian government. He is a dissident in Saudi Arabia and has been writing critically of Saudi Crown Prince Muhammad bin-Salman for several years and has had a high-profile outlet in the Washington Post. The Saudi royal family has never tolerated criticism, but has usually been content to exile people or possibly imprison them. It is hard to fathom the motivation for this future king given his attempts to cast himself as a reformer. If this does turn out to be an act sanctioned by the government, there will be dire consequences. Even President Trump has threatened unspecified but "serious" actions. It is also possible this was carried out by rogue elements. Then the question will be how the Saudis go about catching and punishing them.

The second issue may be the brewing fight between President Trump and the Federal Reserve. He has spoken harshly against the stated policy of hiking interest rates and has done so in very inflammatory language—calling them "out of control." Every objective analyst has come to the directly opposite conclusion—this has been an extremely cautious Fed which has taken great care not to throttle the economy with high rates. Given the Fed is made up almost entirely of people whom President Trump appointed, it is likely these comments are aimed at galvanizing some of his base as opposed to any real policy development.

The third issue is the stock market and its latest round of instability. Thus far, the markets have been very kind to President Trump and have contributed to the overall perception by consumers that economic conditions are great. Despite the complexity of the market and the many factors that play a role in its ups and downs, President Trump has been taking credit for the positive performance. That now means he will have to take ownership of its decline should these corrections start to accumulate. Past presidents have steered clear of the markets and assert no influence as the markets are creatures of their own and are inferior measures of whether the economy is good or not. If the markets stumble and the president is assigned responsibility, it could hurt him among those voters who had been crediting him with the economic situation.

Trump Suggests He Can Fire Fed Chairman
President Trump's tactics are well known by now and always seem to include a vague threat to fire somebody. The latest is Fed Chair Jerome Powell. The president is unhappy with the Fed and its assertion interest rates need to keep going up. That is not an unusual stance for a president or any politician as they are never eager to see the party come to an end and would cheerfully allow inflation to run rampant as long as there is growth. That is not the position of the Fed or the banking community or the business community or consumers or anyone else that remembers what inflation can do to an economy.

Analysis: Is it even possible for President Trump to fire Powell? The technical answer is yes, but under only unusual circumstances such as malfeasance in office, dereliction of duty or "inefficiency." It is not supposedly sufficient to just have policy differences. It has been made clear by Treasury Secretary Mnuchin that no serious effort to fire anyone at the Fed is being made. It has been pretty obvious the nominations to the Fed have been made by Mnuchin. The last appointee is Nellie Liang. Apparently President Trump was unaware she is a lifelong Democrat and was a Fed economist for most of her career. She was not selected by Trump, but Mnuchin is very much aware of her background and what motivates her policy decisions.

Worrying
There are far too many moments in a person's life when there is little or nothing that can be done about something very important. Over the years, there have been many analysts seeking ways to separate us from animals in terms of our behaviors. It doesn't take much observation to note that our feline and canine companions (as well as all those other creatures in the wild) show what can only be described as love, compassion and joy, among others. What I don't see is worry—that seems to be a human trait based on the fact that we have learned to control a lot about our daily life. When we lose that control, the worry sets in and can be almost paralyzing. We worry about our finances and how our kids are doing. We worry about our health and the health of loved ones. We worry when people set off on trips when conditions are less than ideal.

My worrying moment of late involved one of my feline buddies—my Daddy's girl. This has already been a sad year with the loss of Snip, but we contented ourselves with the knowledge that she was almost 17 and time had just run out. Scoot was a different story—she is just eight and in good health. But suddenly she wasn't and had to be treated for a bad abscess that was affecting her whole system. For several days she was in pain and frightened of everything, unable to eat. My heart was breaking as she has always been my constant companion. We were doing all we could, but then we just had to wait and worry. My focus has been on her and little else. I quite frankly lost track of what I did for the better part of a week. She has bounced back and is her old self again, but I was reminded once again that control of what happens around you is essentially an illusion.