Friday, February 16, 2018

Strategic Global Intelligence Brief for February 16, 2018

Short Items of Interest—U.S. Economy

Nice Surge in New Home Building
There was a 9.7% increase in the construction of new homes in the last month, which could be a very good sign of future growth. There are not many sectors of the economy that track as closely with overall economic growth. The sector involves a whole host of business interests from construction to all the services that are involved in the sale of a house. The growth in housing has been driving the economy over the last few years, but it had slowed in recent months. This has led to higher home prices. There was concern that those anticipated headwinds were starting to have an impact. With the Fed’s plans to hike interest rates, it will only be a matter of time before mortgage rates respond. For now, the consumer is showing a willingness to buy those new homes.

Consumer Sentiment Expected to be Steady
By the time you read this, the consumer sentiment data will have been released by the University of Michigan and unless there is some unexpected shock, the numbers will be good—somewhere around 95. The consumer is going to be watched closely for a while, and there are two things that could alter their future assessment. If they start to think inflation is really around the corner, their behavior may change and that would likely feed the inflation threat. They would start making those big purchases earlier than planned as they think the prices will go up. There is also interest in how confident the tax cut has made people. Thus far, the reaction has been a little more subdued than expected. It really was not the windfall that some expected, as the average earner only saw modest reductions in the taxes they pay.

Intelligence Threats
Each year, the intelligence community outlines the threats facing the U.S. in the short, medium and long terms. This report is designed to provide some guidance as far as priorities. Most of the threats facing the U.S. are pretty well known—everything from North Korea to terrorism. The interesting part of the report is the prioritization of those threats. The top of the list of threats include Russian interference in the mid-term elections as they will use the same technique of disinformation they used in the 2016 U.S. elections and elsewhere in the world. There is also real concern regarding the impact of high deficit and debt numbers.

Short Items of Interest—Global Economy

Renzi Faces Debacle
It seems like a long time ago that Matteo Renzi was seen as the reformer that could drag Italy out of its torpor. He was the young and dynamic mayor of Florence, which catapulted him to national prominence with promises of breaking the ossified system that always seemed to hamper Italy. His popularity was once well over 40%, but he has since struggled to get over 25%. The challenge from the center-right under Silvio Berlusconi and the populist Five Star Movement has been threatening. The bottom line is that he is fighting fantasy and platitudes with hard facts and too many in the country seem to prefer being pandered to. The claims made by Berlusconi and Beppe Grillo are not possibly going to be fulfilled, but there are many who will still believe. This will make the next election much less predictable than was originally thought.

U.S. and Turkey Step Back from Edge of Disaster
The Turkish engagement against the Kurdish forces in the north of Syria as well as within Turkey had set the country at odds with the U.S. The Kurds are vital allies for the U.S. in Iraq and the Turkish attack on them was putting the U.S. in a very bad position. It now seems that talks between U.S. Secretary of State Rex Tillerson and President of Turkey Recep Tayyip Erdo─čan have gone well enough to diffuse some of that tension. Turkey has agreed to back off in the attacks across the border in Syria and the Kurds seem willing to accept this as well.

Snow in Moscow
Want snow removal in Moscow? Write the name of Vladimir Putin’s challenger on the drift and it will soon be cleared. Otherwise, wait until spring.

Long Road for Colombia
The progress that has been made in Colombia over the last decade has been nothing short of spectacular. The country that was once the epicenter of drug cartel operations and revolutionary civil war has seemingly shaken off that bitter past to become one of the fastest growing economies of Latin America—better known now for its coffee than cocaine as well as its competitiveness as a manufacturing state and an oil producer. Under President Alvaro Uribe, the Revolutionary Armed Forces of Colombia (FARC) was defeated and an end was called to an insurgency that killed over 200,000 people and cost millions of people their homes. The drug cartels were smashed as well and forced to move, becoming Mexico’s loss and Colombia’s gain. The president after Uribe was his defense minister, Juan Manuel Santos, who carried the renovation further and made the country an attractive investment target, building a diverse and respectable economy. Unfortunately, the problems of the past are not so simply dismissed. Colombia now faces a real moment of truth as far as its democracy is concerned.

Analysis: The peace agreement between the leaders of the FARC and the government of Colombia called for the leaders of the FARC to shift from armed opposition to participation in elections. At first, it appeared the leaders of the insurgents would reject the plan as they did not trust the government to be fair, but Santos demanded and received the support he needed to put in protections and safeguards for a fair poll. Several of the FARC commanders are running for office and for the presidency. The problem is that many in Colombia are not so eager to forgive and forget and there have been bloody confrontations during the campaign. Rallies called by the FARC leaders have been pelted with rocks and there have been shooting incidents as well. Death threats have been common, as Colombia was host to many right-wing paramilitaries that fought the FARC over the years and have never been supportive of the peace deal.

In response, the FARC leaders have suspended their campaigns in many places. This muddies the waters considerably. Many critics assert that FARC has chosen this dramatic response to cover up the fact they have been pulling very little support. The most recent polls suggest FARC candidates are far behind their rivals and even losing to tiny parties that have long been on the very fringe of Colombian politics. It was starting to be a real embarrassment for the FARC and there are even some rumors that FARC staged the attacks on itself to avoid having their real lack of popularity exposed.

The right has been just as aggressive and is being led to some degree by former President Uribe. His animosity toward the FARC has not waned and he was deeply opposed to bringing them into the political process in any way. He wants these leaders prosecuted and punished and his attitude is shared in most of the urban areas. The rural poor are not exactly fans of FARC as they were often targets of exploitation, but they do not trust the urban elites to address their issues. The war on the cartels was successful, but the rural communities depended on the money they made from the drug kingpins and there has been nothing to replace that income. The power of FARC may have been broken for now, but the grievances that led to the formation of the group remain.

MS-13 and Immigration
There have been many aspects of the immigration debate that has led to much of the controversy as to what the plan should be. There are those who look at the issue from a purely legal point of view—the issue being that people are entering the U.S. without permission and it doesn’t matter why or who they are. Others are concerned about the economic implications, i.e., people willing to work for very low wages and people who may be taking jobs that would otherwise be taken by U.S. citizens. There are those who focus on the criminals who gain entry illegally and still others object to the cultural impact of arrivals who do not speak English and don’t share the dominant culture.

Analysis: In the past year, the Salvadoran drug gang, referred to as MS-13, has become a flashpoint and a symbol. This is a particularly brutal gang that has been engaged in the drug trade in the U.S. and has been responsible for great violence in the U.S. and El Salvador. The complexity of immigration policy is on full display with this drug gang. It really became the threat it is today because members were deported back to El Salvador a decade or more ago. They had contacts in the U.S. and this was a conduit for future activity. The gang is powerful and feared in immigrant neighborhoods and they know residents will not seek help from U.S. authorities for fear of expulsion. The solution to drug gang influence is providing alternative paths for people, but that is nearly impossible with the current climate.

More Evidence of Inflation Build
The latest data from the Producer Price Index (PPI) has followed the same theme as the latest Consumer Price Index (CPI). There was a 0.4% increase in prices from the last reading a month ago and that translates into a 2.7% increase year-over-year. This reading combines with the consumer data, which showed a 0.5% increase last month—the strongest reaction in a month since 2005. Wages have also risen at a pace not seen since the recession started. Any way one looks at it, there is strong evidence of inflation, although nothing yet points to any sort of runaway situation. Much of this increase is expected given the performance of the economy over the last few quarters. After almost a decade, there has been solid growth of around 3% for three quarters. During the recession, most producers had started to reduce output in response to reduced demand and it is taking them a while to boost that activity back to previous levels. While this is taking place, there are capacity issues and that generally means that prices go up as a means by which to manage the shortage. The big questions on the table at the moment are whether the tax cuts spurred this rise in inflation and whether the inflation issue will worsen to the point the Fed will need to step in and slow the economy down with higher interest rates.

Analysis: Measuring the impact of inflation is no easy task as there are always movements in all directions. Even when prices are falling overall, there will be sectors where prices are going up and vice versa. For example, the education sector saw higher prices for tuition throughout the recession as many people were seeking additional training opportunities so they could better compete. The Fed actually pays relatively less attention to either the PPI or the CPI. Both of these are created by identifying a basket of goods that are then weighted to enable analysts to watch what prices are moving and how fast. The baskets are somewhat arbitrary and they are adjusted on occasion to better represent the actual buying patterns of the sector. The preferred means by which the Fed tracks inflation is the Personal Consumption Expenditure Index (PCE) prepared by the U.S. Department of Commerce. Over the last 68 months, the PCE numbers have been less than the Fed goal of 2% inflation in 66 of them. There is obviously no immediate sign of rampant inflation, but it is worth noting that the two months that have been above that goal were in 2018. One of the key differences between the PCE and the CPI is emphasis on healthcare and services in general. The CPI is still heavily oriented toward goods. This means that low import prices can make inflation appear lower. Services are not as affected by imports and are far more sensitive to wage hikes. As wages go up, the impact on the service sector is almost immediate. Lately, there have been significant hikes in the wages paid.

Comments by Gary Cohn, head of the White House National Economic Council, have been designed to downplay the threat of future inflation, but they have been exceedingly vague and have not convinced many analysts that there is nothing to worry about. That was made abundantly clear last week as the markets returned to volatility. Many investors anticipate a fundamental policy shift in the not distant future and are reacting now. Cohn remarked, “We know how to deal with inflation,” and that is clearly true, but it is also the point that critics have been making. Dealing with inflation means slowing the economy through various central bank mechanisms. There will be interest rate hikes, changes in the reserve ratio and changes in the interest that banks are paid for holding their money at the Fed. In other words, every mechanism that comes to mind as far as drying up the money supply. This slows the economy as it is supposed to. Cohn and others may be correct in asserting that inflation will not be so out of control to necessitate draconian measures, but it is near certain the Fed will have to slow things down to keep that radical action at bay. There is also no doubt that the tax cuts will contribute to the rapid growth of the economy—after all, that was what they are for. If all goes according to plan, the growth will take place without triggering a dramatic response from the Fed, but much will depend on how the business community, investors and consumers reacts.

The Fed and the Equity Markets
It is obvious that investors pay attention to what the Federal Reserve does and doesn’t do. The Fed Funds rate affects what banks charge one another for loans and that cascades through all the other rates. Long-term bond yields are affected as well. The Fed has two pretty clear mandates: the first is to control inflation, which is traditionally what they do best. The other is to promote healthy employment and growth numbers, but that can be harder to do. There is also the assertion that the Fed has a third mandate: protect the equity markets. Over the last few years, there have been dovish Fed Chairs in Ben Bernanke and Janet Yellen, and even Alan Greenspan was said to follow the notion of a “Fed put”—a conscious decision to protect the value of the equity market by loosening the monetary strings when the markets appeared to be struggling.

Analysis: The current Fed is considerably more hawkish than it has been in years. There are many who now assert the Fed will not be so quick to interfere if the markets tumble. Chairman Jerome Powell is not an economist and is already clearly deferring to the economists on the board and on staff. If Loretta Mester does become the vice chair, as rumored, she is a strong hawk who has been opposed to actions that meddle with the markets. This change in attitude will likely mean that volatility will be both more common and more extreme, as nobody will be anticipating a bailout from the Fed this time. Many critics have advocated for just such a policy shift as they have blamed the Fed’s loose policy for the market excess. The comments from Powell suggest he is supportive of this hands-off approach and doesn’t really believe the Fed can micromanage the economy nor that it should be engaged in what is clearly political as opposed to economical.

Global Ties
I have been asked to be on the board of an organization called Global Ties. This is a group that has a history going back to the 1950s. It is connected to the state department through a wide variety of programs that all have the basic aim of promoting greater understanding between people all over the world. Essentially, this is a group that oversees and organizes visits and exchanges of people from around the world who are brought to Kansas City, MO to learn more about the U.S. and my community. There are English teachers from Ecuador, journalists from Africa, agricultural experts from Belarus and many, many more. The task of the Global Ties community in Kansas City is to act as host and show them what they came to see.

It is trite to some, but the fact is that people from other places really do not know much about the world outside of their own experience. The only way to dispel that ignorance is to get to know the world. So many of the problems facing the world grow out of fear based on ignorance. We don’t know them and they don’t know us. The bulk of the media coverage of any given place is focused on sensationalism and tragedy and that is not the real story. Foreign visitors to Kansas City have been asked what their impression was before they came and they described a place that was violent and backward. They knew it had some connection to agriculture and that was about it. A week later, their comments were far different, describing it as friendly, vibrant and highly innovative and entrepreneurial; a place far removed from what they had been told.

There is that old adage about walking a mile in someone’s shoes. This could not be a more important concept. We can’t understand people without knowing them and we certainly can’t work with them. Fear and anger grows from ignorance, which can only be fought with knowledge. In the course of a year, Kansas City will see close to 400 visitors and all will go back home with far different impressions than those they started with.