Daily Comment (August 23, 2019)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EDT] Happy Friday!  It’s quiet this morning in front of Chair Powell’s presentation.  Here is what we are watching:

BREAKING: China to levy tariffs on another $75 bn of U.S. exports.  Bonds and gold rally, while equities, oil and copper decline.  Oil, soybeans and auto exports were specifically targeted.

Powell:  Between the minutes and a series of interviews suggesting a wide disparity of views, there is growing sentiment, which we tend to share, that Chair Powell will struggle to bring the committee to make aggressive rate cuts.  We suspect his speech today will try to create a narrative that will support future action.  A set of variables could be established as guideposts; three possibilities might include persistently low inflation, global economic weakness or the dampening of investment from the trade war.  Another key idea to remember is that Powell doesn’t necessarily have to make the members of the committee happy, he merely needs their votes.  The members know that if Powell can’t sway the committee and he resigns, then the White House may press for a new chair who is an ideologue.  Thus, the committee members may grudgingly accept rate cuts to avoid turmoil.

Recession worries: Although the media coverage of any White House often sensationalizes divisions and concerns within the executive branch, recent reports of concerns about the economy probably have an element of truth.  Worries about the economy, especially in the year before the election, have been evident in most administrations.  We have seen earlier governments attempt to tag the Fed with blame if the economy slumps; again, nothing unusual here.  Presidents Johnson, Nixon, Reagan and Bush (H.W.) all engaged in attempts to sway monetary policy.  We lived through an unusual détente since Clinton where the White House and the Fed left each other alone.  That informal peace accord has clearly ended and we have returned to the earlier tensions.

Therefore, in light of these worries, we have seen a number of trial balloons floated, including indexing capital gains taxes to inflation, a payroll tax holiday and other unspecified tax cuts.  To some extent, the problem is that the trade conflict with China was bound to have adverse economic repercussions.  It’s possible the president didn’t believe that, but his advisors should have been aware.  At the same time, presidents sometimes have a policy goal so important to them that they engage in that policy even though it adversely affects other goals.  It looks to us that President Trump deeply believes the trade regime established after WWII isn’t working for the majority of Americans and a strong case can be made that this is true.  Both sides of the populist wings have turned against trade and only the elites still believe in it (mostly because they benefit greatly from overall globalization, of which free trade is an element).  The problem for the president is timing.  He spent his “golden period”[1] deregulating and cutting taxes.  If these were the president’s most deeply held goals, then he did the right thing.  However, it appears to us that changing the postwar trade regime may be his most deeply felt goal; if so, he should have done that first.  If he had moved on trade immediately after winning the election, then we would likely be past the worst effects by now and the disruption of supply chains would not be threatening the business cycle.

Given today’s news out of China on tariffs, it seems unlikely that tensions can ease without one side caving.  China seems to be banking on the idea that the U.S. needs a deal more than it does because of looming elections.  The U.S. doesn’t appear open to backing down and the recent move to tie conditions in Hong Kong to a trade deal likely reduces the odds of a deal.  It is quite possible that the most effective policy to lift the economy in the short run would be a reduction in trade tensions.  The problem is that neither side appears open to a way out of this conflict.

G-7: The G-7 meets this weekend, with the members deeply divided.  As we noted yesterday, the host nation, France, has already indicated that it won’t deliver a communiqué.  Macron wants to talk about the fires in Brazil, while President Trump wants to talk about France’s recent tech company tax.  The EU would like to ease trade tensions with the U.S.  Although we don’t expect this meeting to have a major market impact, the divisions among the leading democracies are problematic and an indication of the deglobalization that is underway.

Italy: Parties were given until next Tuesday to form a government.  The center-left and populist-left parties are continuing to negotiate.  Although these parties have been at odds for a long time, the prospect of a government dominated by the populist-right is concentrating their efforts.  If the negotiations fail, it doesn’t necessarily mean immediate elections.  Instead, we could see the president of Italy install a caretaker government until the budget process is completed.

Brexit: PM Johnson continues to hear the same message from EU leaders: the backstop is necessary and negotiations are futile.  It is becoming difficult to see how a hard Brexit is avoided unless Parliament stops it from happening.

Champions: The EU is floating a plan to create a €100 bn sovereign wealth fund to create “European champions” in the technology space to compete with the U.S. and Chinese tech giants.  Although the sentiment makes sense, we have doubts that money is the problem.  After all, rates in Europe are below zero in many markets.  The key is allowing companies to “move fast and break things,” something Europe doesn’t seem too comfortable with allowing.

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[1] We consider the first 18 months of a president’s first term as the most important.  This is the period when a president can get the most accomplished and therefore one should try to move their highest priority goals through before the summer of the year before the election year.