Wednesday, August 16, 2017

Strategic Global Intelligence Brief for August 16, 2017



Short Items of Interest—U.S. Economy

Dispute Resolution in NAFTA
The current system involves the use of expert panels to settle disputes between the three nations when it comes to tariffs. This system has been in place for 23 years and the majority of the rulings have been in the favor of the U.S. There have been some high-profile rejections as well. The real concern on the part of the U.S. is that Trump wants to impose a great many tariffs in the future and it is quite certain the panels will reject most of these. The U.S. wants the disputes to be settled in U.S. courts. For obvious reasons the Mexicans and Canadians reject the idea as biased against them from the start.

Housing Starts Down in July
There is a little bit of good news along with the bad on this front. The bad news is that there was a decline in the number of housing starts in July, but the good news (sort of) is that the majority of this decline was in the multifamily sector. The number of single family homes actually increased. This may signal that some of those millennials who have been driving the building of apartments and lofts may be switching to the single family option as they get older and start to form families. Starts fell by 4.8% and that was more than had been expected. There was also an unexpected decline in permits—a decline of 4.1%. The expectation has been that starts would be up slightly, by around 0.4%, and permits would be essentially flat. The sense is that some of the headwinds that many thought would be an issue earlier in the year are manifesting now.

Defections
There have been some high-profile withdrawals from the advisory boards created by the Trump White House. The first to withdraw was the head of Merck and he was greeted by a nasty set of tweets accusing Merck of gouging on drug prices. Subsequently there have been others such as Richard Trumka from the AFL-CIO and Steve Paul from the Alliance for American Manufacturing (created by the steel industry to fight for its survival). These had been people who supported his campaign early on. Others that have chosen to stay engaged have issued strong statements of condemnation of the white supremacist protestors, but have asserted that they need to stay engaged in the debate over jobs.

Short Items of Interest—Global Economy

Border Tensions between China and India
Much of the world has been focused on various high-profile conflicts in Asia such as North Korea and the Chinese activity in the South China Sea. The dispute between the Chinese and Indian governments has been a back-burner issue for a long time, but now it appears to be heating up somewhat. The border skirmish between troops from both nations was brief, but there were casualties and injuries. The two states claim territory in the Himalayas and have been prepared to fight over these claims despite the utter worthlessness of the land.

Kenyatta Wins Disputed Election
As expected, the current president of Kenya held on to power in an election that has been widely criticized as irregular and fraudulent. Uhuru Kenyatta won over Raila Odinga, but few in the country believe the election was fair and many outside observers assert the same thing. In the days after his victory, Kenyatta has been closing down any NGO that opposed his campaign and that has provoked other groups from western states to threaten withdrawal. The country needs this aid, but Kenyatta seems willing to risk the fallout as he seeks to purge any and all opposition.

Italy Sees Fewer Migrants Arriving from Africa
Since establishing new protocols for dealing with refugees and putting a larger naval presence in the region, there has been a 73% reduction in the number of arrivals. The Italian navy is no longer operating close to Italy. They have moved closer to Libya and other parts of North Africa, and as they intercept the refugee craft they are promptly returning them to African soil. The fear in Europe is that refugees will seek other routes and that these will be far riskier than those used to get to Italy.

What’s Up With the Consumer?
Is there anything quite as mysterious and fickle as the consumer? Perhaps we get distracted by the term. It is not as if there is just one consumer or that the consumer is united in any respect at all. There are 330 million consumers in the U.S. They are of all ages, genders, races, and they live in every geographic area one can imagine. Most importantly from an economist’s point of view they are all in different financial situations. Assessing a group this large and diverse will inevitably mean making gross generalizations. This task would be considered too daunting but for the fact that consumption drives the U.S. economy in almost every respect, accounting for roughly 80% of the national GDP and a similar percentage of jobs.

Analysis: Having said all that, what do we know about the consumer right now? One of the more perplexing issues this year has been the disconnect between levels of consumer confidence and their willingness to spend. From the start of the year the surveys from the Conference Board and the University of Michigan (among others) have been asserting that consumers are as confident as they have been since before the recession. They have been encouraged by the low rate of unemployment, the relative lack of inflation, the recovery in the value of their homes and the fact that various trigger events have been subdued (consumers react strongly to the price of gasoline and it has generally been down). This kind of enthusiasm generally translates into a desire to spend more money. The level of retail sales can be expected to rise. The problem is that these retail numbers didn’t rise as expected—at least not until now.

The rate of retail activity suddenly jumped in the last month—a rise of 0.6%. This is as rapid a rise as has been seen in several years and it begs the question, why now? The spending has been diverse and there is no sign that it has been triggered by something unusual. In past years there may have been a surge in spending because of a sharp hike in the price of gas, causing people to spend more at filling stations. That was not a factor this time. People seemed to spend a lot at home improvement stores and lots of people spent heavily online. Amazon had one of the better months in its history. There was even a little improvement in the sales of cars. This is unmitigated good news—right?

It is not completely welcome news as there are some issues that are lurking behind these better numbers. The consumer may be encouraged by the reduced levels of joblessness but they have not been impressed by the wage hikes that have taken place. The rise in wages has been anemic and that has meant that consumers have to turn to their credit cards if they want to increase spending. That is a longer-term worry. Over the last few years there has been a reduction in the levels of credit, but that has been reversing this year. The crisis in 2009 was due in part to the fact that so many people were too highly leveraged. The situation now is not as serious as it was then, but the trends are concerning—especially as the holiday season arrives.

If the pace of spending continues at this rate the chances improve for a robust third quarter growth number. The pace at the start of the year was miserable at 1.4%, but the trend was up in the second quarter, with a rate of 2.6%. This is the pattern that has been showing up almost every year since the downturn. The year starts off very slowly and begins to pick up speed. The third quarter has often been the most robust of the four over the past few years. In 2016 the growth in the third quarter was 3.5%. This year the prediction is for growth between 3.5% and perhaps 3.7%. If this year is like past years the rate will fall again in the fourth quarter and the whole pattern will be repeated in 2018. The Q3 numbers reflect the consumer orientation towards the coming holidays. Once those purchases are made, the process slows down.

Fed Minutes and Clues to the Next Step
The minutes of the last meeting of the Fed will be released today and they will be parsed carefully. This is the best opportunity for analysts to get inside the heads of the decision makers as they will get some sense of the conversation that took place over what the Fed should do. We already know the Fed elected to keep rates where they were and that came as no shock at all. The estimate all year was that a rate hike might take place in September, but the statements coming from Janet Yellen made it abundantly clear that a September rise was off the table. There has not been enough inflation to justify a radical move and the Fed assumes it can continue to be very patient with this process. The most interesting part of the last meeting was the conversation over how and when the Fed plans to reduce its balance sheet.

Analysis: The Federal Reserve started the recession period with a balance sheet of some $800 billion, but it has since grown to at least $4.5 trillion. This was accomplished as the Fed worked to stimulate the economy with three rounds of quantitative easing. The first round was buying up many of the mortgage-backed securities (MBS) so that banks would have the freedom to lend. The banks that had invested heavily in the MBS market had too much nonperforming debt on their books. The second and third rounds of qualitative easing involved buying lots of treasuries to push more money into the banks and subsequently into the rest of the economy. It is debatable how well this worked, but the end result is the Fed has lots of this debt on their books and would like to see it reduced sooner than later. The plan has yet to be detailed but it would involve just letting some of these bonds expire and it may involve actively selling this debt off to other investors. The Fed wants to do this without crushing the market for private corporate debt or municipal bonds, etc. The bond buyer seeks security above all and nothing is as secure as U.S. treasuries. When they hit the market, they tend to crowd out all the other options.

NAFTA Negotiations—Bombast vs. Pragmatism
After months of statements and posturing the actual process of negotiation has started over the future of the North American Free Trade Agreement (NAFTA). This has been one of the more controversial pacts the U.S. has been involved in from its inception, as it had very ambitious goals. The motivation for NAFTA in the beginning was simple enough. The U.S. was watching the trade pact in Europe get stronger and stronger and noted that the European Union was giving the Germans and the other nations of the north an advantage, as it allowed them to develop manufacturing alternatives in the lower-production-cost states like Italy, Spain and many of the former east European countries. The U.S. wanted to ensure that it had a similar advantage in North America, as it would combine the resource-rich Canadians with the lower-cost production of Mexico. Business would not feel compelled to decamp to Asia with this arrangement in place. It was also seen as a pact that could cement the oil business of Mexico and Canada to the U.S. There had been noises in Mexico that suggested they were considering an invitation to join OPEC.

Much has changed since the pact was developed. Everyone now agrees that it needs updating and reform in certain areas, but very few in the business community have any desire at all to see it scrapped. The opposition to NAFTA has been political as opposed to economic. There are certainly businesses in the U.S. that have been adversely affected by the pact as there have been manufacturers that have moved operations to Mexico from the U.S. The point that is often missed is that these operations would be leaving the U.S. in any case. The competitive reality is that companies have to compete with those that have lower costs of production and if these companies can’t lower costs enough in the U.S. they are forced to look elsewhere. It then becomes a matter of where. Leaving the U.S. to set up in Mexico is much more useful to the U.S. economy than moving to China.

Analysis: The business community exerted a lot of pressure at the start of the year and forced the Trump position on NAFTA to change. The rhetoric regarding withdrawal ended and the talk shifted to finding ways to address the trade deficit with both Mexico and Canada in different ways. Now that the talks are starting in earnest, that Trump rhetoric is back as he has threatened once again to walk away from the agreement if there is not significant progress. In many respects, this can be seen as a negotiating tactic as it allows the White House to determine what “significant progress” is. The sides are presenting their most aggressive positions as one would expect. The likely development from this point is a series of gives and takes while both sides trumpet their toughness on the issue. The most interesting development of late has been the push by U.S. manufacturers to capitalize on the Mexican contacts in the rest of Latin America. The U.S. can affect the trade deficit by selling more to the Mexican business community and that means getting more engaged with the trade that Mexico does outside NAFTA.

Fed Is Not Alone
As discussed in an earlier piece, the Federal Reserve is trying to determine what it is going to do with its balance sheet. This task is the same one facing all of the world’s central banks. The last ten years of stimulus dragged the central banks into some pretty unfamiliar territory. In the absence of significant stimulating by the legislatures of the world, the banks were tasked with doing more than lowering rates and reducing reserve ratios. Today the central banks hold a fifth of the debt issued by their governments and that is an unprecedented situation.

Analysis: What is often overlooked when discussing the role of the central bank in stimulating is that they have to work through the banking system. The actions of the legislature can be direct, providing financing for projects that will employ people, cutting taxes and generally funneling money into one effort or another. The central bank can only encourage the lending community to engage with lower interest rates and lately by buying treasuries and other government debt through these banks. The challenge now is that the ECB, Bank of England, Bank of Japan, Bank of Canada, Reserve Bank of India, Reserve Bank of Australia, Bank of China and the Fed (among many others) are sitting on billions of dollars of that purchased debt and they all want to reduce the size of their portfolios. There is no capacity in the global economy for this much debt and that means these banks are constrained by the actions of the others. Some attempt to coordinate all this may be discussed at the upcoming meeting of the central bankers in Jackson Hole. The meeting is about a week away and at this point all of the leaders of the major banks are indicating they will attend.

Damage Control
There are some cruel realities in business. No matter how hard one works or how hard one tries there will be failures and mistakes. The illusion of control is just that and the only thing that anybody can really control is how one reacts to the crisis. Over the last year or so we have seen companies that deserve praise for their reaction and we have seen companies that have completely missed their opportunity to limit that damage. There are few industries more challenged by the unexpected than the airlines as they are always subject to the vagaries of weather. Add in their dependence on highly complex machines and their need to emphasize safety and you have an industry that will be required to react to something every day.

I have made no secret of my preference of air carriers, and to be honest I don’t really know that much about the other airlines as I rarely fly them. I know what shows up in the press and United seems to have a negative story every day. Lately Southwest has had some issue with their new computer system and it has been frustrating. The system has been down too often and the reservation system has been dumping A-listers into the B and C categories. I have not been happy with this hassle, but the response from Southwest has been typically proactive, with frequent communications about what is going on as well as with gestures like assigning me extra points for my trouble. In the great scheme of things, it would be nice if everything worked as it is supposed to but that is simply never going to happen, so the next best thing is reacting appropriately when there is a breakdown.