Daily Comment (March 2, 2018)

by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] There is a lot going on this morning.  Let’s dive in:

Trade wars: President Trump campaigned as a trade warrior, promising tariffs and government intervention to boost manufacturing employment and give hope to his electoral base.  However, in his first year of office, if one ignores social media, Trump would be indistinguishable from an establishment Republican.  Tax cuts were the focus and were successfully passed.  Even the budget, which increased the deficit, isn’t inconsistent with previous GOP administrations.  But, lurking under the surface is a president who wanted trade retaliation.  As establishment figures within the administration fade in influence, the president is swinging toward his instincts to impede trade with the idea that this achievement would return the U.S. to a period of mass industrial employment.

In calls yesterday, advisors wondered if he might walk back this policy in light of the drop in equities.  It doesn’t appear this expectation will occur; we note the president tweeted this morning that “trade wars are good and easy to win.”  Needless to say, the establishment GOP is apoplectic.  Editorials in the national papers are calling the announced tariffs a disaster.  No one should be surprised by his actions; he won the presidency as a populist and, unless that stance was a complete sham, at some point this part of the president’s persona was going to emerge.

The problem, of course, is that trade is complicated.  First, when a nation implements trade sanctions, other countries can retaliate.  The U.S. has generally not taken aggressive steps over the past 40 years but that isn’t to say they never occurred.  Nearly all administrations since Carter have taken limited steps in various markets to send signals that nations that engage in unfair practices will face penalties.  But, economic theory rightly shows that trade barriers are a poor way to protect jobs.  For every job protected, other jobs are lost.  In this case, protecting steel jobs will likely raise prices on the end users of steel, e.g., autos.  Second, the U.S. has a particular issue in that it is the provider of the reserve currency.  The world economy is dependent upon the U.S. to run trade deficits in order to provide dollars for global trade.  We can argue for days as to whether or not a single nation should have that role, but the reality is that if the U.S. puts up trade barriers it raises the risks of a global recession.  The U.S. provided the reserve currency to win the Cold War, but policymakers haven’t come up with a more compelling reason to continue the policy since the Berlin Wall fell.  To be fair, there have been losers to trade, which is, by design, unfair.  After all, if the system creates incentive for foreign nations to accumulate dollars for trade and the safest way to get dollars is by running a trade surplus with the U.S. then the system invites unfair actions.  If the U.S. wants to maintain that policy to support world growth, the losers in trade have to be adequately compensated.  That arrangement really hasn’t occurred so some parts of the economy are harmed by trade (manufacturing), while other sectors involved with supporting trade (transportation, finance) benefit more than they would have otherwise.

In this week’s Asset Allocation Weekly Comment (see below) we discuss the difference between cyclical and structural inflation.  Much of the current worries about inflation are cyclical; economic slack is being steadily absorbed and there are legitimate reasons for concern.  However, this cyclical inflation pressure is in the context of disinflationary structural forces.  As long as the U.S. allows the free implementation of technology and is open to trade, inflation tends to remain depressed even during periods of cyclical tightness.  The president’s actions raise the risk that the structural forces that have been steadily depressing price inflation may be reversed.  One measure on steel doesn’t make a complete reversal.  However, even the idea that these trade measures are proper raises the potential that this recent tariff is the opening move in a much broader policy to restrict trade.  If this is the case, the somewhat benign environment for financial assets over the past four decades will evolve into something much more difficult.  We are not there yet, but it is a condition we are closely watching.  Market action so far is worrisome.  Today we are seeing the dollar tumble and interest rates rise.  If the world is concluding that the U.S. is no longer a reliable steward of the reserve currency, we could be heading into a world of great financial tumult (stagflation, higher volatility).  It’s too early to make this call, but market action so far is a concern.

It wasn’t just Trump: At the end of Chair Powell’s testimony yesterday, NY FRB President Dudley suggested in another speech that four rate hikes this year would be considered “gradual.”  That statement also contributed to the equity decline yesterday.

Brexit: PM May is giving a speech at the time of this writing, discussing her government’s position on separating from the EU.  Thus far, it’s mostly platitudes with no substance.  We think May is stuck; the majority of her party wants a hard Brexit but the majority of Parliament wants a soft Brexit, with the U.K. staying in the customs union.  At some point, there will be a vote of no confidence, new elections and the real possibility of PM Corbyn.

Italian elections: The Italians go to the polls this weekend.  We don’t have any new polling data (polling is not allowed before elections so the last poll was Feb. 16th).  Markets are expecting an inconclusive result but, as we discussed in recent WGRs,[1] all parties want fiscal expansion.

SDP decides: The rank and file of the SDP decides this weekend whether the center-left party should join in another grand coalition with the CDU/CSU.  The SDP faces a real problem.  If it votes not to join the coalition, new elections are likely and current polling suggests the party might be less popular than the AfD.  On the other hand, joining the conservatives further blurs the difference between the center-left and center-right and could simply lead to the extinction of the SDP.  We think the 460k members of the SDP will decide to join the coalition but the vote will be very close.

BOJ at the end?  BOJ Governor Kuroda indicated today that the Japanese central bank is planning to begin the process of withdrawing from excessive accommodation in 2019.  The JPY jumped on the news.

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[1] See WGRs, The Italian Elections: Part I (2/12/18) and Part II (2/26/18)