Daily Comment (July 25, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Markets are quiet this morning, typical for mid-summer. Here is what we are watching:

Juncker to the White House: The president of the EU Commission, Jean-Claude Juncker, visits the White House today.[1] It is expected he will offer the U.S. some sort of narrow trade pact on industrial goods and autos. We suspect this meeting will probably end in failure; the auto trade is too important for Germany to give up much and it isn’t obvious what would appease the president. Juncker has made it clear that the EU will retaliate if the U.S. implements tariffs, most likely against agriculture.

The crux of the trade issue: The biggest issue emerging from the trade issue is that the president’s goal is unclear. He appears to view trade from a mercantilist perspective—surpluses are wins, deficits are losses. Although economic theory discredited this viewpoint about 250 years ago, it still remains a common belief among most people. So, how does a mercantilist win? The goal would seem to either be opening foreign markets to U.S. exports or restricting imports, or some combination of these policies. The president has concluded, it seems, that the only lever he really controls is import restrictions. If we are correct in this assessment, the tariff war will almost certainly escalate. The end result will be increased employment and higher inflation in the trade deficit nations, and lower employment and lower inflation in the trade surplus nations.

How this policy plays out politically is complicated. First, the microeconomic impact is quite difficult to parse. Some sectors of the economy are simultaneously benefiting and being harmed. They are facing less import competition for their finished goods, for example, but higher input costs. Over time, these price effects will lead to production adjustments but it could cause political fallout as we head into mid-terms. Second, we are seeing the GOP establishment tentatively push back against Trump’s trade policy[2]; as we noted in the last two WGRs,[3] the class interests of the establishment benefit from free trade so it isn’t a huge surprise that the center-right is finding their voice against protectionism. Our read is that support for free trade has been waning for some time, although recent polls have shown increasing Democrat Party support for free trade. This change is consistent with the idea that the GOP is steadily taking on a constituency of nationalist, working-class voters while the Democrats are becoming the party of globalist elites.

Another problem starting to emerge from the trade tensions is that Chinese investors are apparently liquidating commercial real estate holdings in the U.S.[4] Some of these sales appear to be tied to pressure from the Xi government to curtail potential capital flight. The loss of Chinese investment could be a negative factor for real estate, especially in the coastal regions.

May takes control of Brexit: PM May has taken direct control of the Brexit negotiating team,[5] transferring about 50 staff members from the Department for Exiting the EU. That department’s role will be downgraded to focusing on preparing the domestic U.K. for Brexit. May has been forced to deal with high levels of dissent within her government on this issue and has apparently concluded that she is better off streamlining the process. Most likely, those “hard” Brexit supporters will see this as an attempt to silence their dissent.[6] We suspect this is the case. However, if May can pull this off, the odds of a “soft” Brexit will increase.

Cyberwar worries: The Department of Homeland Security warns that Russian hackers[7] have penetrated the control rooms of U.S. utilities. Although the utilities were thought to be safe because they were “air gapped” from the internet, the hackers used portals created by trusted vendors and used those vulnerabilities to access the control rooms. This development is a major threat because it could cause extended blackouts which would seriously undermine domestic security.

Israel downs jets: The Israel Defense Force has indicated it shot down a Syrian military jet that entered the airspace over the Golan Heights. Israel and Russia are in negotiations to secure Israel’s borders; Israel wants the Russians to create a large buffer zone that will keep Hezbollah and Iran from being able to attack Israel with missiles. Russia has, so far, been unable to create a plan that Israel accepts. The Syrian incursion could be a signal that Israel is taking a hardline stance on its border. Although we don’t expect a flare-up, this could be a new conflict zone if Russia is unable to stabilize the region.

North Korea: Although North Korea has been accused of not taking steps to denuclearize, we are starting to see some movement on the promised dismantling of a missile launch facility. The group 38 North reports there is evidence that Pyongyang is taking concrete steps to decommission the facility.[8] It is always difficult to determine what exactly is happening in North Korea, but the evidence supports that the regime is making an effort, at least at this facility, to move toward some sort of agreement.[9]

It’s bad in Venezuela: How bad is it? It’s so bad that the IMF is projecting inflation could reach 1,000,000% this year.[10] It’s so bad that the government can’t afford to print banknotes of sufficient denomination and is just putting “money” electronically into bank accounts. Interestingly enough, this hyperinflation event is only the 23^rd worst in modern history. The worst case was Hungary post-WWII, which saw prices double every 15 hours. Still, some of the anecdotal reports are stunning; a kilogram of chicken (2.2 lbs) costs 3.3 mm bolivars last week, a bargain compared to the current price of 4.2 mm bolivars. The collapse of the economy is leading to a significant brain drain.[11] Those with skills are leaving the country for better opportunities elsewhere. Oil production fell below 2.0 mbpd last year; in the late 1990s, the country produced about 3.3 mbpd. To a great extent, recent increases in output by the OPEC cartel are designed to offset the production declines by Venezuela.

NAFTA: Earlier this week, we reported that AMLO, the president-elect of Mexico, wrote a letter to President Trump calling for good relations between the two nations and offering to complete a renegotiation of NAFTA. President Trump has responded in a similar fashion, which may improve the chances of an agreement.[12]

Taiwan:China has been pressing U.S. airlines to stop calling Taiwan “Taiwan” as Beijing sees the island as a breakaway province that will eventually “return to the fold.” The agreement about “one China” that Nixon and Carter approved was really a bit of strategic ambiguity; both China and the U.S. said there was “one China” but the U.S. held that Taiwan could remain independent indefinitely. The Obama administration shied away from selling Taiwan large military systems because it felt such sales only angered China. Instead, the doctrine was that Taiwan should make a defense of the island that would increase the costs of invasion to the point where China would simply not want to bear the cost.[13] However, as relations between the Trump administration and China have deteriorated, the U.S. is now considering arms sales of greater capabilities. This action will obviously anger the Chinese but it is an area where the U.S. does have some leverage.