Strategic Global Intelligence Brief for July 6, 2018
Short Items of Interest—U.S. Economy
Labor Market Adjustments
The jobless rate is still very low—full employment low—but it has risen slightly and for all the right reasons. The best way to illustrate this is to look at both the U-3 and U-6 designations from the BLS. The U-6 numbers include those who have been characterized as "discouraged workers"—those who stopped formally looking for work as they didn't think there was much out there. That number is shrinking further as the U-3 level rises, and that indicates that more of the once discouraged are finding ways to cycle back into the workforce and the overall search. The labor market remains very tight, but there has yet to be a lot of wage inflation although this month showed more activity than had been expected.
Trade Gap Narrowed but it Will Not Last Long
The trade gap narrowed by 6.6% in the last month, and that is substantial. Too bad the reason for the gap is almost totally due to temporary factors. The U.S. saw a major surge in exports, especially that of agricultural output. The farmers know full well what will happen when the battle with China gets underway—they have seen it already as the Chinese are refusing to let ships with U.S. farm goods aboard dock. The Chinese market is about to slam shut, and there has been a frantic effort to get as many exports out as possible—even at a financial loss. Now, the situation will reverse and the trade gap will grow again as exports all but cease and imports continue as there are not many domestically made substitutes for the goods that Trump is trying to block. They will just become that much more expensive.
Trump Territory Targeted
It has been noted by many observers that China has a method to its trade war response, and it is the same strategy that every nation employs. If you ever wondered where these strange lists of targeted products come from one need look no further than politics. The Chinese are targeting the regions where Trump support had been strong on the assumption this support would fade once they understood what it was costing them. Canada put various preserves on the tariff list as Smuckers is headquartered in Ohio where Senator Sherrod Brown has been a vocal supporter of the tariffs as a Democrat. Everybody is targeting Kentucky bourbon due to the fact Senate Majority leader Mitch McConnell is the senior senator in that state.
Short Items of Interest—Global Economy
Heavy Industrial Looks to Lose the Most
The trade war is going to provide a variety of experiences for U.S. companies. Among the biggest losers will be the manufacturers of heavy industrial equipment and agricultural machinery. They have major markets in China and will stand to lose them. They also rely on metals and parts from China, and there are few ready alternatives. Even if U.S. companies decided they wanted to make these parts now it would take months and perhaps years to bring production up. The farm sector is going to be hit in several ways and at an inopportune time given the already stressed nature of the sector.
Russia Targets U.S. as Well
In response to the tariffs that have been leveled against Russian steel and aluminum, the Russians have launched their own counterstrike and have been going after imports that are needed by U.S. and foreign operations. The Russians have been even more obvious about their political strategy than Europe as a whole. If indeed Vladimir Putin tried to make certain that Trump was elected he may be rethinking that whole plan at this point.
Brexit Frustration
Absolutely nobody has expressed support for any of the paths that have been set out for Brexit at this stage. The view is that damage has already been done by all the stalling that has taken place already. The business and financial communities are already making their own decisions as they wait to see what is cobbled together and most of them are quitting the U.K. altogether.
What is an Overheated Economy and What is to be Done About It?
After a review of the Fed's last meeting, the term "overheated" has been bandied about a lot. This has become the major concern for the FOMC and will be the issue that shapes policy for the coming year and beyond. What is it about an overheated economy that worries the Fed and does it worry anybody else? What is meant by overheating and what has contributed to the situation facing the economy right now?
Analysis: In the simplest of terms an overheated economy is one that is either experiencing significant inflation or is likely to in the near future. It means that the economy is growing faster than can be sustained by available resources, leading to shortages and bottlenecks. There may be a situation where the total economy has started to overheat or it may be overheating in just some sectors. Unchecked, the overheated economy is gripped by inflation that will affect all sectors of the system. The overheating will generally show up first in shortages of labor and shortages of key commodities. It is hard to argue that the problem has not manifested in employment as there is a record level of low joblessness at 3.8%, and the economy right now has more job openings than there are people looking for work. This should have been driving wage costs up dramatically by this point but there have been other factors that have kept salaries and wages lower than would be expected. The demand for workers is higher than it has been in years, and there have been many who have asserted that these shortages would end if business was not so miserly and paid people more. The fact is those who are currently looking for work lack the skills needed and aren't going to be paid highly when they will be spending the first couple of years just learning their new job. Those who have the skills are often in the wrong place at the wrong time and can't move to where the work is or are limited in some other way. The point is that there is a serious labor shortage that has limited the capacity to respond to the growth in the economy, and at some point, this will show up in wage inflation.
The commodity shortage is showing up already and has added significant costs to the business community. Some of this is due to additional demand for the output and some of these shortages have been exacerbated artificially as the oil producing states have restricted output in order to hike prices. The imposition of tariffs on imported steel and aluminum in the U.S. has triggered a general price hike of over 45% for these commodities, and that has sloshed over into other metals. Food prices have not risen thus far, but they most certainly will next year as farmers will plant far less than they did this year in reaction to this year's low prices.
All of these current and projected shortages will push prices higher and higher as costs tend to chase costs. If the price of labor and commodities goes up, the business paying that extra cost will have to hike prices as well and thus the ever-expanding circle of inflation. The economy is thought to be growing at a pace close to 4.5% for Q2, and if that is the case, the current economy is struggling to catch up. Inflation is the result and the Fed worries far more about the impact of inflation than recession. The control of inflation is their core mission and that is what they have tools for. Dealing with a recession is a secondary concern for the Fed as the lead is supposed to be taken by the fiscal authorities (Congress and the Executive). The Fed can shut down inflation quickly by drying up the supply of credit and money to expand—raising the federal funds rate, raising the reserve ratio, increasing the interest rate banks are paid for their deposits, selling bonds and so on. Too much of this puts a hard brake on the economy and sends it back into recession.
Inflation affects everybody—rich or poor. Recession will not affect almost a half to a third of the economy and is actually helpful to some. Inflation helps nobody and the Fed will do everything in is power to halt it. If that means sending the economy into a crash so be it. If the overheating is too intense, the Fed response will be just as intense and the recession that much worse. The economy of 2018 is close to serious overheating in part due to the ill-timed tax cuts. They did the job they were supposed to do, but that boost came after the economy was in recovery mode already and sped things up beyond the capacity of the economy to handle it. If there is a serious inflation issue at the end of this year or early next, the tax cuts of 2018 will be one of the culprits.
An Anticlimactic Labor Report
The jobs report comes out today (it will have been released by the time you read this). It is not that people are uninterested this month as the rate of unemployment is always the measure that most people react to. It is simply that nobody expects any big changes this month. The overall rate will likely stay at 3.8%, and there will continue to be concerns that wages are not rising as fast as one would expect given that low rate. The economy is effectively at full employment and the issue now is labor shortage.
Analysis: The dialogue on how to address that labor shortage has just started, and thus far, the usual solutions seem out of reach. In the past when the U.S. needed or wanted more people in the workforce it relied on immigration. We tend to forget that for almost a century this was a wide-open nation desperate for people and accepted wave after wave of migrants. Those days are over, but there is still a need to add to the labor force selectively. The size of the average family is now well under replacement level, and the population is aging fast. Some of the demand for workers will temporarily be met by delaying retirement but that is not a long-term solution. Thus far, the immigration debate has been highly emotional and rooted in culture clash and racism, but sooner than later the economic issues will start to dominate. How does the country add the skilled people needed without putting U.S. workers at a disadvantage? How does the U.S. keep companies that are having more success looking for workers in other nations by moving there?
Trade War has Started in Earnest
It is no longer a threat. The U.S. has fired the first shot at the Chinese, and the retaliation was instant. The Trump administration has elected to place restrictive tariffs on $34 billion worth of Chinese exports to the U.S. and threatens to extend that action to all $500 billion of what China sends to the U.S. China swiftly responded with tariffs and restrictions on U.S. goods coming to China although they have not detailed yet which products will be affected. Loads of farm goods that were on ships bound for China have already been denied access and will be forced to return to the U.S. There is now a trade war underway that has been initiated and fueled by the U.S. The questions now are how long will this last, what does the U.S. expect or want and what will the other nations demand from the U.S.
Analysis: Discussion as far as what happens from here starts with the motivation for the trade war in the first place. Is this a calculated move to "level the playing field" as is claimed by members of the administration? Is this an attempt to push a political agenda through economic pressure? Is this a matter of personal animosity between President Trump and the world leaders he seems to delight in disparaging? Is it pandering to a political base in the U.S. that believes the U.S. is routinely bilked by other nations (evidence to the contrary)? In fact, there are probably elements of all these motivations.
At the heart of the issue is whether the U.S. is really at a disadvantage when it comes to trade. If one looks at just one factor it would seem the U.S. really is exploited by the rest of the world as the U.S. buys far more than it sells in the global economy. That is not a particularly good means by which to evaluate trade relationships. The overall aim of trade is to get something not available in your own country or to get a better price for that good in order to benefit the consumer. There is a certain amount of trade for things the U.S. does not have although that is rarer than in most other countries as the U.S. is richer in raw materials than most. The bulk of U.S. trade is done with the consumer in mind, and that is to be expected in a country where over 80% of the economy is dependent on consumption. The calculation is not generally this harsh, but it works out that individual factories and businesses will routinely be sacrificed for the sake of the consumer. This means that the consumer will bear the brunt of the impact of this trade war. Goods that are imported now will cost more, and substitute goods will see prices rise as well. As discussed earlier in this issue, the U.S. economy is already overheating and supply chains are already stretched. This will make that problem even worse.
Does the playing field need flattening? Perhaps, but the U.S. has been responsible for as much of the bumpiness as any other nation. There are all manner of trade restrictions in place here as well—ranging from regulatory hurdles to tariffs to outright bans to webs of subsidy and support for all manner of sectors. This is common practice and countries engage in both their own protection as well as efforts to weaken other national systems. The fact is the U.S. pries open markets every year and often uses access to the U.S. as the leverage needed. Industries that feel abandoned by the U.S. and at risk to foreign competition need to pressure their own leaders to make them a priority.
There is a strong suspicion that little of this trade war activity is really about trade and business. The U.S. wants political concessions from China on issues as varied as North Korea, the status of Taiwan and the activity in the South China Sea. Is this the real reason for the confrontation? Is this simply playing to the base? There are lots of people woefully ignorant as to the role of trade, and rather than try to educate them, the approach is to pander to that ignorance. And, beyond all that there is the distinct possibility that all this is personal and motivated by the simple fact that President Trump doesn't like these other leaders and they don't like him.
Strange Bedfellows Indeed
The relationship between Angela Merkel and Horst Seehofer is legendarily bad. There is far more animosity between these two ostensible partners than there is between Merkel and rivals from the opposition parties (Social Democrats, Free Democrats and even Greens). Seehofer is the head of the Bavarian Christian Union and is far more conservative on many issues than is Merkel. In many ways his party is the right-wing populist brand (not the Alternative for Germany— AfD)
Analysis: He has been lambasting Merkel over the refugee policy for several years and has done so in very public forums. He had designs on taking over the leadership of the center right but those in Merkel's Christian Democratic Party wholly reject him now. Bavaria is generally more conservative on most issues but especially as regards refugees. They remember when the reunification took place at the end of the Cold War, and they seemed to bear the brunt of that adjustment and do not want a repeat.
Suffering Through Bad Baseball
I was not going to pile on when it came to my hometown team. It seems like eons ago that the Royals were the toast of the baseball world and certainly the heroes of Kansas City. That's baseball for you. Today, they are utterly miserable and seem destined to lose every single game left in the season. I think they are 380 games back in the division. What happened?
It seems shocking but that is the way of the world for all the teams save those with massive budgets. To get that World Series pennant, teams have to rent those key players they need and that always means trading the future for the right now. The Royals once had one of the best and deepest farm systems in the league, but that was before trading and selling most of the leading players to get those key pieces such as Johnny Cueto and Ben Zobrist. The Royals were further savaged by the realities of the game as they could not afford to keep players like Lorenzo Cain and Eric Hosmer.
I am not a fair-weather fan and still support my team—in fact the next few years will be bad but fun at the same time. The plan now is to restock that farm system with the next wave of players capable of winning it all. Some will be busts but it is unlikely they all will fall flat, and I look forward to days when we get excited by Khalil Lee, Nick Pratto, Seuly Matias, Hunter Dozier, Adalberto Mondesi, Jorge Bonifacio, Brady Singer, Jackson Kowar and so on. Frankly my attention has shifted to the fortunes of the Omaha Storm Chasers, the Northwest Arkansas Naturals, Wilmington Blue Rocks and Lexington Legends. With any luck this is where the next set of World Series contenders will be playing for the next few years.
I tried to figure out a way to tie all this to some pithy comment on the business community but gave up. I just like baseball and needed something to assuage my frayed emotions over the state of my team this year.
