Daily Comment (March 6, 2018)
by Bill O’Grady and Thomas Wash
[Posted: 9:30 AM EST] Risk markets are higher this morning, building on yesterday’s afternoon recovery. Here is what we are watching this morning:
Trade wars—the establishment strikes back: They don’t call it the establishment for nothing. The GOP establishment playbook—tax cuts, open trade, deregulation—has always been a less than perfect fit for a president with populist leanings. This was a worry in the president’s first year but it has generally been accepted that the president mostly tweets like a populist but governs like the establishment. That conclusion is facing a strong challenge from Trump’s anti-trade policies. While some were working on tax cuts, parts of the administration were working on trade impediments and retaliation. Commerce Secretary Ross was working on trade actions on metals and against China, and tough NAFTA negotiations were ongoing. But, the president’s announcement of across-the-board tariffs on steel and aluminum were mostly unexpected, at least in terms of timing.
However, after the initial shock, the GOP establishment is pushing back. First, Gary Cohn, Director of the National Economic Council, is assembling a summit meeting where companies adversely affected by the proposed tariffs can inform the president and the administration of the negative effects of the action. Second, House Speaker Ryan has also openly warned against the tariffs and hinted that the House may create legislation to reduce the president’s ability to implement trade actions. We suspect that some sort of “deal” will be cut; the president can’t lose face by not getting anything on this issue, but the across-the-board nature of the proposed tariffs can be scaled back to the point where they don’t significantly affect trade. In other words, the goal will be to give the president enough to let him claim a win but not so much as to actually affect trade. Hopes that this will be the outcome are probably why equities rallied yesterday and are higher this morning.
Unfortunately, this trade debacle doesn’t address the real issue, which is the management of the reserve currency. The U.S. benefits greatly from running a trade deficit; we get a plethora of goods and services from the world that contain inflation and improve our efficiency. In return for goods and services, we give foreigners Treasuries, which are cheap to produce! This only works for us because there is a natural demand for dollars as foreigners use dollars to conduct trade with other nations who trust dollars over local currencies. However, the process of providing the reserve currency, a key element in our program to win the Cold War, creates distortions in our economy that are unhealthy. Our financial system is very large and our sales and logistics systems are overly large as well (to handle foreign investment when foreigners with dollars don’t spend them right away and need to invest in dollar assets). And, we struggle to create enough buying power for all the imports the world wants to sell us; our answer from 1980 to 2008 was to allow a massive expansion of household debt. Much of this was due to the fact that sectors of our economy have been severely harmed by trade and as a result these workers no longer have the wages to buy the imports the world wants to sell to us. The Great Financial Crisis showed that our ability to lift debt has reached its natural limit. The nation definitely needs a new course on trade and the dollar. Widespread protectionism probably isn’t the answer but what we have now isn’t working. One thought would be to penalize nations with high current account surpluses with automatic trade penalties.
North Korean thaw: North and South Korea have agreed to hold direct talks next month and Pyongyang indicated it would be willing to abandon its nuclear program in return for security guarantees. At first glance, this is difficult to believe but it actually does make sense. Since the “axis of evil” speech, North Korea has had to assume that America’s policy goal is regime change. Thus, having weapons to prevent such an outcome is a reasonable step on its part. However, none of this is new. What has changed is the realization by the two Koreas that none of their allies are really looking out for the interests of either one. The talk of war to prevent North Korea from acquiring nukes essentially showed that Washington is willing to sacrifice South Korea to protect the U.S. In other words, a conventional war with North Korea would devastate South Korea but leave the U.S. untouched. At the same time, cool relations between Pyongyang and Beijing suggest that China would probably not oppose regime change in North Korea if the resulting new government is generally friendly to China’s interests. Therefore, the incentive for North and South Korea to negotiate their own peace makes sense. If North Korea can (a) get a working deal with South Korea to improve and modernize its economy, and (b) get the U.S. to stop threatening regime change by negotiating a security deal for nukes, it’s probably worth it. This recent progress also shows that Kim Jong-un is apparently unconcerned about shifting the nuclear policy, which probably means that any opposition to his rule has been eliminated.
Update on National People’s Congress: China’s National People’s Congress (NPC), the state legislature of China, is holding its meetings. Although it is the most powerful body in China on paper, in practice, it’s a “rubber stamp” for the Communist Party of China (CPC). Yesterday, the NPC agreed to a 6.5% GDP growth target. What’s important about this decision is that it was made at all. China can achieve any GDP number it wants; the key driver is debt. If China is serious about deleveraging, the first step we would expect to see is a reduction or elimination of the growth target. This number is too high to lower debt. Although we still believe that Xi’s actions to extend his rule will eventually lead to a period of deleveraging, this decision suggests it won’t occur in 2018. This target also suggests that the CPC is still uncomfortable with allowing growth to slow. Marxism has been thoroughly discredited and, in its place, the CPC promises high growth. The CPC needs a new goal other than growth for legitimacy and thus this 6.5% growth goal for 2018 suggests it hasn’t found a new one yet.