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Strategic Global Intelligence Brief for September 28, 2018

Short Items of Interest—U.S. Economy

Core Inflation Remains Near Fed Target
For the last few years, the Fed has been trying to coax the inflation rate up to around 2%. This has traditionally been seen as the preferred level for inflation measured as core. It is high enough to avoid the stagnation of deflation and not high enough to justify Fed intervention to bring it down. The core rate does not look at some of the more volatile prices in the economy such as fuel and food with the assumption these prices will be reflected in other sectors such as freight rates, airline fares and restaurant meals. The core rate finally hit that 2% mark a month or so ago and now seems to have stabilized at this point. This takes a little pressure off the Fed, but it doesn't discourage the current plan to hike rates again at the end of this year.

Is NAFTA Dead?
In a word—no! There have been very clear political agendas on display throughout the process and they will continue to play out. The Trump administration made NAFTA a target during the campaign and needed to follow up once in office to keep the base happy. This is despite the fact NAFTA was working better for the U.S. now than ever. Mexico agreed to the rewrite as they have a new and very untried president coming to power. Nobody wanted to wait until Andrés Manuel López Obrador was in charge to do this deal. Now, it is Canada's turn to use political leverage. They are waiting to see what the mid-terms will bring as they assume a stronger Democrat presence and the chances of a better deal when that happens. Talks will just wallow around for another month or two.

Consumers Still Spending but at Slower Pace
The latest data on consumer spending in August indicated there was still a lot of it taking place, but the acceleration noted in the spring was not there. This is not too shocking given there was a tax cut to work with last spring. The consumer was a little slower out of the gate than was the business community, but they caught up by the time of summer vacation season. Now all eyes are on the holidays. It appears that consumers are in a decent mood and willing to spend more than had been the case in the past. The sure sign of an improved season is the interest shown in pure luxury goods and non-essentials. It appears fewer men are buying washing machines and trying to pass them off as Christmas gifts.

Short Items of Interest—Global Economy

Duterte Admits to Extrajudicial Killings
There has been no doubt the Philippine government had been engaged in what amounted to mass murder since Rodrigo Duterte came to power. His campaign focused on ridding the country of its drug problem by going after anyone engaged in the drug trade. It has been estimated that some 10,000 to 15,000 people have been killed by the police and military as well as vigilante groups. The government's official numbers are at 5,000. The assault has led to massive abuses as people who have nothing to do with drugs have been killed when in the wrong place at the wrong time. There have also been revenge killings, elimination of romantic rivals and killing of political opponents of Duterte. He now claims he was kidding about the killings, but his public statements may yet end his reign.

Italy Makes a Choice
After weeks of waffling back and forth over whether to adhere to the rules of the EU or satisfy the constituents, the new Italian government did what most expected of them. The new budget adds major spending programs and blows the debt and deficit into the stratosphere. It is going to take 2.5% of the national GDP. Now it is up to the EU to react. If they push too hard, there is a solid chance Italy would elect to leave the EU.

Indonesia Rocked by More Earthquakes and a Tsunami
The latest incidents have hit the coast of Sulawesi. There have been widespread reports of death and destruction from the quakes and the tidal wave. This part of the country has been hammered hard this year and last.

German Consumers in a Decent Mood
There is no nation as dependent on the consumer as the U.S.—they account for two-thirds of economic activity. But the consumer is far from unimportant in other nations. Their mood can spell the difference between a good year and a mediocre one. Germany is still very sensitive to the export side of their economy. Thus, the most consistent worry is around what the rest of Europe is doing and what kind of demand can be anticipated from the U.S. The latest data shows that German consumers are going to be a much bigger factor this year than in the past. They are reputed to be confident (at least according to polls) and they seem to be ready to spend money (at least according to recent retail numbers).

Analysis: It is not just that German consumers are spending; it is what they are spending on. The growth has been in the bigger ticket items such as home appliances, but also a lot of spending on entertainment ranging from recreational vehicles to electronics. There has also been more travel within Germany as opposed to trips outside the country. Many of the common destinations of the past are not as enthusiastic about German tourists as was once the case. Germans are reacting by staying home.

Shifts and Changes in the Oil Sector
Overall, there continues to be expansion in the U.S. oil sector—rig counts are up from last year (860 vs. 744). There have been sectors of the country where development has been slowed by pipeline shortage and other inhibitors, but there remains an incentive to bring more oil to market in expectation of higher prices for the remainder of this year and into next. The bulk of the development has been in the Permian Basin as has been the case for the last several years, but this has created some issues of congestion and shortage. There will be less oil pulled from here than has been the case before. The number of wells completed but not connected to a pipeline will reach 3,620—a monthly rise of 211, the largest jump in several years.

Oil futures have been climbing steadily over the last few years. They are as high now as they have been since the recession started in 2008. This year, the average has been $66.64 a barrel (and lately over $70). In 2017, it was $50.85 and in 2016 it was $43.67. The predictions for 2019 are somewhat varied according to how much of a threat a given analyst thinks inflation will be—consensus is around $72.

Estimates for future rig counts show a continued expansion, but perhaps at a slightly slower pace. From 876 it would go to 1,031 this year, 1,092 in 2019 and 1,227 in 2020. This year remains on track to see the largest rig count since 2014. Future years will see only a slightly reduced pace.

The crucial factor as far as demand remains the continued growth of the U.S. and global economies. As long as there is growth in the U.S. that sits somewhere north of 2.6%, there will be plenty of demand, and the bulk of that demand will be met by domestic production. There will, however, still be interest in the output from the other oil producing states. As usual, the Middle East will be the center of turmoil—several states will see reduction in their output due to unrest and conflict. This will include Iraq, Iran and Libya. The Saudi Arabian decision to reduce output is still in place, but is no longer supported by Russia or many of the smaller Gulf producers. They are planning to ramp up production to take advantage of the rising prices. The impact of this additional output may be delayed for world prices as China will be a major buyer. They have leverage over Iran and have been working with Russia to lower their energy costs.

Oil from Latin America is becoming a bigger issue for the U.S., but with mixed results. Venezuela has all but ceased to exist as a viable economy and is barely able to produce any oil at all. Colombia has been ramping up now that the FARC revolutionaries have stopped their operations in the region where the oil is located. Mexico is expecting to expand its U.S. market share since it has indicated willingness to sign a deal with the U.S. to replace NAFTA. Canada, so far, has not shown the same willingness and may see its market share slip in the coming months.

African oil producers have been ramping up production, but their prime market is Europe. There has been less economic growth and thus less demand. The Nigerian political unrest is still costing the oil sector about a third of its output. Angola is rebounding a little, but like most of the other African producers, it needs investment that has been hard to come by.

Analysis: The status of the oil sector continues to be a proxy of sorts for the U.S. economy as a whole. Gone are the days when every politician decried our dependence on foreign oil and demanded that something be done to gain some sort of oil security. Many of the agreements and deals reached during those crisis years in the 70s and 80s stemmed from our perilous oil situation. The NAFTA agreement was generous to both Mexico and Canada as we were getting access to their oil in return for opening our markets to their products and business expansion. It has been argued that most of the U.S. motivation to be engaged in the Middle East for the last 50 years was in order to protect access to oil. Now that the U.S. is an exporter of crude as well as refined product, the situation is quite different. The U.S. now essentially sets the price of global oil. This also means that cheap oil is no longer the highest priority for the U.S. as our own oil producers would like to see prices up in the 90s and even 100s. The U.S. now has to balance the desires of the producers and consumers. That is not always easy.

Third Quarter Growth Likely Slipped a Little
The same factors that added to the robust readings in the second quarter may serve to drag down the third quarter. The 4.2% surge in Q2 was due in part to some aggressive buying and selling as companies tried to avoid the impact of tariffs being imposed by and on the U.S. There were record sales of everything from farm goods to consumer goods. Now that these trade barriers are in place, they will cut into growth. The likelihood is that Q3 will be somewhere around 3.5%. This is about a point higher than where the economy has been for the last decade; it is certainly not bad growth.

Analysis: The consumer is starting to play the role they were expected to. Growth of consumer spending will be somewhere around 3.8%, better than it has been over the last few years. The export numbers are tumbling, but most of that damage will likely show up in Q4 numbers. The question that hovers over everything is how quickly other nations will move to replace China. The goods now purchased from China will not be made in the U.S.—they would be too expensive. The alternative is getting those goods from nations like India, Vietnam, Brazil and so on. How fast will they be able to ramp up to meet demand and will they be as efficient as China?

M&A Mania—New Records Set
This year the amount of merger and acquisition (M&A) activity is setting records previously thought impossible. There have been periods of intense M&A activity in the past, but the thinking had been that too many of these had failed to work out as planned. The assumption had been that when two companies combined one got the benefits of one and a half rather than two or more. There were too many clashes of culture, too much debt and not enough revenue to cover it. The banks engaged in financing those big deals often came to regret it as the deals simply did not pay off. At the time, there was a lot of concern expressed as to the motivation for the mergers and acquisitions, however. It was thought that too many of them were purely defensive and many were not all that well thought out. Companies bought competitors to better their market share without considering how tough it might be to merge cultures and win consumers over. There was also a lot of downstream and upstream buying as companies sought to control their supply chains. Today, there appear to be other motivations in play, although these older incentives are still playing a role.

Analysis: Thus far this year, there have been $3.3 trillion dollars worth of deals made, a whopping 39% increase over 2017, which was thought to have been a pretty good year for M&A. There have been a few really big deals that amounted to over $5 billion as Comcast, T-Mobile and Takeda spent heavily to purchase competitors and maintain their share of market. The prime motivation for all this activity has been low rates for borrowed money (and the feeling that this may not last much longer), record stock prices and plenty of evidence that consumers and business are both enjoying an unusual level of confidence.

Three sectors have been at the forefront of this activity—energy, technology and health care. All three have seen truly dramatic change in the last few years. Most companies in these sectors are now scrambling to develop the appropriate strategies for growth and maybe even survival. The revisions to the U.S. tax code opened a lot of possibilities. The energy sector was a major beneficiary of these changes. As the price per barrel of oil climbed back to respectability (from the producer's perspective), there has been intense interest in investing in oil assets such as the shale deposits in the U.S. as well as in nations just starting to join that shale revolution (Mexico, Brazil, Russia). The technology sector is still one that accelerates at blinding speed. It seems that as soon as a new technology makes its appearance, there is a better option waiting right around the corner. This has provoked several types of M&A activity. There are companies buying their competitors to either slow that competition down or speed their own advances, but the prime motivator is to buy the "bolt-on" technology that can assist the acquiring company in expanding its market reach. Health care is reacting to the realities of care these days—more centralization, more need for cost control, an older and needier population and the sense that some version of expanded Medicare/Medicaid will be in the offing.

There are also motivations based on where one pays taxes. Plenty of mergers and acquisitions are made simply to locate the taxable heart of the company in a friendlier atmosphere. There is very little to suggest this pace of activity will be slowing any time soon. The analysts are not quite ready to assert 2019 will be another record year, but there is not much to suggest it will be slower than 2018 either.

Another Ill-Conceived Commentary
I really should not be touching this lightning-rod issue with a 10-foot pole. It is not that I have any special insights as this has very little or anything to do with economics or business. It is however highly emotional and controversial. As I was traveling around various cities this week, I was astonished that issues of sexual harassment and attack seemed to be on everybody's mind. People were standing around TVs in the airport watching the hearing on Brett Kavanaugh as if it were a major sporting event. I do not want to even venture an opinion on the veracity of the commentaries—what struck me was the commentary from others. Some came from the members of the Judiciary committee and other comments just burbled out from mouths all over the country.

One was especially insulting to me. The gist of the comments held that "boys will be boys." It is in their teen years that they should be expected to behave in this way. Excuse me! I was a teen boy as well (a looooong time ago) and at no time would it ever have entered my mind to force myself in any way on any girl. I have two stepsons; it never entered their minds either. Both of these Eagle Scouts treated their girlfriends with the utmost respect. I have never even heard crude language directed at the women in their lives. My grandson is a large animal vet and has also been a man who automatically treated women (and everybody else) with respect. I am not saying that someone should be denied a career because they were bullies in high school—I suppose I want to know more about what kind of person they are now. I do object to the assertion that all males were sexual predators and bullies in their younger years. I know a great many men who have never comported themselves inappropriately. I would venture to say there were and are more men that respect women and boundaries than there are men who choose not to.

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Strategic Global Intelligence Brief for September ...


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