Month: March 2018

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

MARCH 21, 2018

 

Contact Richard Power with comments or questions. IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

 

We were planning to move on from Trade and Tariffs in this issue of  IntelDigest, but the Trump Administration insists on keeping the subject front and center in the news.  We wrote last week about the Trade Wars which would be the likely result of Donald Trump’s actions.  He is about to take another giant step forward in waging economic warfare with China, which was our largest trade partner in goods (not services) last year.

 

The China Problem – Redux

We discussed Trump’s focus on China last week.  Now, media outlets are reporting that Trump is about to announce new Tariffs, amounting to at least $60 Billion, on Chinese products. This will likely precipitate a Trade War between two of the largest economies on Earth.  The package could be applied to more than 100 products, which Trump believes were developed by using trade secrets which China stole from U.S. companies or forced them to hand over in exchange for access to its massive market.

We suggested a Measured Approach in our last issue, which would involve negotiations with the Chinese rather than setting up American consumers and companies for harm incurred in a Trade War.  But, Trump made criticism of China a significant part of his presidential campaign, so he is determined to use blunt force in pursuit of his goals.

As reported in  The Washington Post,

“This looks much more like a president who is excessively eager to apply tariffs than a well-calculated move to defend American interests,” said Phil Levy, who was a trade adviser to President George W. Bush.  “There are real concerns about Chinese behavior on intellectual property, for example, but there are much more effective ways to address them.”

John Frisbie, president of the nonpartisan U.S.-China Business Council, was quoted:

“The U.S.-China Business Council believes that tariffs will do more harm than good in bringing about an improvement in intellectual property protection for American companies in China … Business wants to see solutions to the issues, not just sanctions.”

Economists specializing in China have said that it would be difficult for the Trump Administration to target Chinese companies because many products imported from China are made by multinational companies with supply chains that stretch around the world.  Chinese manufacturers might assemble these products or put on the finishing touches, but the country does not export as many products to the United States that are entirely made in China.

According to Nicholas R. Lardy, a senior fellow at the Peterson Institute for International Economics, “So much of what we import from China is produced by multinational companies … Thirty percent are consumer electronics.  I’m sure the president doesn’t want to raise the prices of those and send Apple’s stock into the toilet.”

Lardy maintains that it will be easier for China to retaliate. China can zero in on U.S. exports such as soybeans, which are entirely made in the United States.  Soybeans are one of the top two goods the United States exports to China, along with aircraft and aircraft parts, according to government data.

Further, American producers would gain little from these actions.

“In the best case, they might reduce imports from China by $30 Billion, but it will have virtually no effect on the U.S. global trade deficit,” Lardy continued.  “We’ll just start buying things from the next lowest-cost supplier, such as Bangladesh or Vietnam.  It’s not that the $30 Billion will magically be produced in the United States the day after they announce these tariffs.”

According to the U.S.-China Business Council, many U.S. states export goods and services to China, including some swing states in the 2016 election.  For example, over the decade ending 2016, Pennsylvania exports of goods to China increased 83%, twice the rate as its exports to the rest of the world.  And, Pennsylvania exports of services jumped more than four-fold, which was more than five times the pace of the exports to the rest of the world.

In a survey conducted this week by CNBC.com, the threat of a Trade War is rapidly becoming the top economic fear on Wall Street.  Nearly two-thirds of the survey respondents see Trump’s trade policies as negative for overall economic growth and likely to cause job losses in the U.S.

Protectionism tops the list of worries on Wall Street, far outpacing concerns over inflation, terrorism and even Federal Reserve actions.

Again, from CNBC.com:

“The market has shifted from a fear of a monetary policy misstep, tightening too aggressively, to a trade policy mistake, escalating into a trade war with China,” Art Hogan, chief market strategist at B. Riley FBR, wrote in his response to the survey.  “The balance of risk for equities has moved from the Fed to the White House.”

Added David Kotok, chairman and chief investment officer of Cumberland Advisors, “One man’s income is another man’s expenses.  No one wins a trade war.”

 

 

Herbert Hoover – Redux

History seems poised to repeat itself.

History remembers Herbert Hoover as one of the worst American presidents.  Like Donald Trump, Hoover was a rich international businessman and a political outsider.  He had not held public office before his 1929 inauguration.  Like Trump, Hoover faced intense pressure from struggling American workers.

He signed into law the Tariff Act of 1930, commonly referred to as the Smoot-Hawley Tariff, which raised Tariffs on thousands of imported goods to record levels.  Smoot-Hawley was followed by retaliatory Tariffs from our many trading partners.  When the dust settled, American exports were cut in half, which exacerbated the Great Depression.

Nearly a century later, Donald Trump seems determined to walk down the same path.

Trump had threatened China repeatedly while on the campaign trail.  He fired the opening salvo in this Trade War last summer, when the Administration opened an investigation against China using Section 301 of the Trade Act of 1974.  This Act predates formation of the World Trade Organization (WTO) Dispute Settlement Body, where WTO member states (including the U.S. and China) can meet to settle trade disputes.  Section 301 provides authority to the U.S. Trade Representative to take unilateral action against a trading partner.

According to the  Financial Times, under the 301 statute, “which has not been widely used since the 1995 creation of the WTO, the U.S. would in effect act as judge, jury and executioner on any grievance that it identifies.”

The investigation was the start of a major pushback against China.  In the last two months, the Trump Administration has announced new Tariffs on solar panels, washing machines, and now steel and aluminum.  Although China was not specifically identified as a culprit, China is obviously Trump’s main target.

Mr. Trump is likely embarrassed that, after all of his tough talk against China over the last two years, the Commerce Department recently announced that the U.S. had realized its largest ever trade deficit with China during Trump’s first year in office.

Trump seems to see the trade deficit as some sort of economic “scorecard” between the U.S. and China.  And, he is using our record-high deficit as a convenient excuse to escalate the Trade War.

 

Trade Wars

The response of China will likely start with tit-for-tat Tariffs against American agriculture.  China is also capable of employing asymmetric forms of financial warfare, including:

* China is one of the biggest producers of consumer goods for the American market, so prices for consumers would be driven higher

* China is the largest holder of U.S. Treasury Debt, currently holding approximately $1.17 Trillion

* Our Federal deficit is expected to soar over the next few years, so the U.S. Treasury will be issuing lots of new bonds … large foreign buyers of our debt, such as China, will be needed to keep interest rates from soaring

* China could retaliate with their own Tariffs on American manufacturing, agriculture, and high-tech goods, and block U.S. companies from the Chinese market

* China could also threaten to diversify its reserves away from U.S. Treasuries;  China has been stockpiling Gold for years, and working toward replacing the U.S. Dollar as the  reserve currency  for the world

* China could devalue the yuan … when it did so in August and December of 2015, U.S. stocks fell more than 10% on both occasions

 

We will return to Investing and The Economy next week in IntelDigest.  There are several favorable conditions which continue to support the “Melt Up” in the Markets.  However, an honest-to-goodness Trade War could be just the thing which would derail our economic engine.

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

MARCH 14, 2018

 

 

Contact Richard Power with comments or questions. IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

 

We continue our discussion of Trade and Tariffs this week in IntelDigest, emphasizing the ramifications of the Trade Wars which would be the likely result of Donald Trump’s actions.

Last week, the Director of the National Economic Council, Gary Cohn, resigned in protest of the Trump Administration Tariffs on the importation of steel and aluminum.  We reported that Cohn is viewed as a “globalist” by many in the Trump Administration, putting him at odds with those, including Trump himself, who see themselves as “economic nationalists.”

His replacement is Larry Kudlow, a conservative pundit and raconteur of long standing.  Kudlow’s decades of experience in finance have included stints at the Office of Management and Budget in the Reagan Administration, chief economist at Bear Stearns, and many years as a contributor at CNBC

Interestingly, you may recall that we reported this last week:

In an op-ed entitled, “Tariffs are Taxes,” three Trump-supporters and well-known free market advocates … Larry Kudlow, Arthur Laffer, and Stephen Moore … wrote:

“… even if tariffs save every one of the 140,000 or so steel jobs in America, it puts at risk 5 million manufacturing jobs and related jobs in industries that use steel. These producers now have to compete in hyper-competitive international markets using steel that is 20 percent above the world price and aluminum that is 7 to 10 percent above the price paid by our foreign rivals.”

So, Mr. Kudlow assumes his new post having already expressed his opposition to the Trump Tariffs and Trump Trade Wars.

 

 

Trade Wars

Trump’s top trade adviser is Robert Lighthizer, a veteran of the Reagan Administration.  Back in the 1980s, Tariffs imposed by Reagan and Lighthizer on vehicles made in Japan forced Japanese auto manufacturers to build plants in the United States.  This created thousands of good manufacturing jobs for Americans

It would seem that Lighthizer plans to run the same playbook today, this time against the Chinese.

Lighthizer is part of a hawkish “Trade Troika,” which includes Wilbur Ross, Jr., the Secretary of Commerce, and White House trade adviser Peter Navarro.  They have urged Trump to impose the Tariffs on steel, aluminum, solar panels, and washing machines, which we discussed last week.

Their ultimate goal is to reduce the trade imbalance on a wide range of products … especially with China.  More importantly, they want to stop the ongoing theft of intellectual property from American companies … especially by the Chinese. However, the “shotgun” approach of all the Tariffs announced this year is concerning to our friends, allies and trade partners around the world.

We discussed last week the retaliatory actions proposed by the European Union (EU).  Trump reacted to those threats by threatening (via Twitter) new Tariffs on European auto imports.

Trump has famously stated that he thinks that Trade Wars would “.. hurt them, no us.”  However, most people view a global Trade War with trepidation … fear of the economic slowdown, stock market slide, and rising inflation which would result.  Additional taxes … in the form of Tariffs … on imported consumer goods would hit consumers’ pocketbooks, and cause prices in general to rise.  That could cause a slowdown in consumer spending, which would hurt corporate profits.

Tariffs intensify uncertainty and volatility in markets.  Add that to Federal Reserve policy, where the Fed has already committed to raising short-term interest rates over the next 24 months and unwinding its balance sheet.  Add that to general concern that stock valuations are very high by historical measures.

A full-scale trade war will hurt growth around the world. Given the Trillions in Dollar-denominated Debt in emerging markets, a full-scale foreign sovereign-debt-crisis could result if those emerging markets countries cannot earn Dollars from exports to pay their debts.

For these and many other reasons, Trump’s Tariffs spinning into global Trade Wars is a daunting prospect.

Perhaps that explains Mr. Trump’s walking-back some of his bluster in recent days.  He has extended the “olive branch” to allies and neighbors, such as Canada, Mexico, and Australia. He has hinted at exemptions from some Tariffs before they go into effect later this month.  Perhaps Mr. Kudlow can help him to identify better ways to address trade imbalances.

 

 

The China Problem

The reality is that the focus of Trump’s ire is China.  His intention was to impose these Tariffs in the first months of his presidency … it had been a major talking point during the Campaign.  But, he held off, hoping for Chinese help with the North Korea situation.  Now, he has seen that China has done little to reign-in Kim Jong Un, and there is evidence that China is helping North Korea to cheat on existing sanctions.

Once China’s lack of cooperation on North Korea became clear, Trump saw no harm in confronting China on trade. However, this course is fraught with peril!  There are a number of ways that China could retaliate against the U.S.

* China is one of the biggest producers of consumer goods for the American market, so prices for consumers would be driven higher

* China is one of the largest holders of U.S. Treasury Debt

* Our Federal deficit is expected to soar over the next few years, so the U.S. Treasury will be issuing lots of new bonds … large foreign buyers of our debt, such as China, will be needed to keep interest rates from soaring

* China could retaliate with their own Tariffs on American manufacturing, agriculture, and high-tech goods, and block U.S. companies from the Chinese market

* China could also threaten to diversify its reserves away from U.S. Treasuries

* China could devalue the yuan … when it did so in August and December of 2015, U.S. stocks fell more than 10% on both occasions

 

 

A Measured Approach

The irony is that Donald Trump has eschewed multi-lateral trade treaties because he preferred bilateral deals … one country at a time.  However, his Tariff scheme is a shotgun approach, imposing Tariffs across the board.

If he truly wants to improve the U.S. trade position, he should begin to engage in bilateral discussions, and he should start with China.

The single most important issue with China is the theft of U.S. and European intellectual property.  Imposing Tariffs does nothing to solve that problem.  A measured negotiation on that topic is a better way to engage the Chinese.

And, the Trump Administration has shown that blocking foreign acquisitions of U.S. companies … as happened this week when Singapore-based Broadcom was blocked from acquiring Qualcomm on national security grounds … can be an effective negotiating tool when dealing with our competitors and adversaries.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

MARCH 7, 2018

 

Contact Richard Power with comments or questions. IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

We will return to a discussion of the Economy in the March 21 issue of  IntelDigest.  However, Donald Trump has diverted the conversation to Trade and Tariffs, so we’ll delve into that subject over the next two weeks.

As background, you can read our November 16, 2016 issue … see the  IntelDigest Archive … on the history of Protectionism and the development of Free Trade.

 

Trump Tariffs

In Trump’s mind, “protecting our workers” requires imposition of substantial U.S. Tariffs on steel and aluminum imports.  This comes six weeks after he announced Tariffs on imported washing machines and solar panels.

Many members of Trump’s own party view Tariffs as just another form of taxation on the American people. Conservatives generally tend to be anti-protectionist with respect to trade policy, but even noted conservative influencers  from organizations such as The Heritage Foundation are complaining that they are frozen out of White House discussions on this matter.

Now, one of the leaders of the White House faction which opposes imposition of Tariffs has announced his resignation as the Director of the National Economic Council.  Gary Cohn … formerly an investment banker and president of Goldman Sachs … has been a known advocate for Free Trade.

His tenure at the White House was marked by the major pro-business overhaul of the tax code and significant reductions of rules and regulations on financial corporations.  However, he is viewed as a “globalist” by many in the Trump Administration, putting him at odds with those, including Trump himself, who see themselves as “economic nationalists.”

 

Steel and Aluminum

Trump’s plan is to impose tariffs on steel and aluminum imports … 25% on steel and 10% on aluminum … to be applied “broadly” and “without quotas” to all U.S. trading partners.  We can only hope that this threat is merely a negotiating tactic designed to elicit more favorable terms from our trading partners

However, if the Administration goes through with the plan, there are a few major problems:

First, imposition of additional taxes which favor one industry at the expense of many others is precisely the kind of special-interest-politics which Candidate Trump had decried when he promised to “drain the swamp” in Washington.

Second, the perceived benefit to a relatively small number of U.S. workers in these industries would result in significant costs to millions of other Americans.

Higher steel and aluminum prices would increase profits in U.S. steel and aluminum producers, but hundreds of other American companies, employing millions of other American workers, would have to bear higher costs for these materials.

The other companies could take the decrease in earnings, then dismiss lots of their workers.  Or, they could pass the higher costs on to consumers.  All of us would face higher costs on a variety of products, from cars and trucks to beer and other canned goods.

The point is that, while the steel and aluminum industries may capture a short-term, government-induced win, users and consumers of these materials will suffer the loss. Republican Senator Orrin Hatch characterized the Tariffs as little more than “a tax hike the American people don’t need and can’t afford.”

Third, this plan is not likely to meet its objectives … it will not result in a significant number of new American jobs in these sectors.

The steel and aluminum industries reached their peak in the U.S. in the mid-1950s, and have been contracting steadily over more than 60 years.  For example, steel industry jobs are down by 80% over that period of time.  Data from the American Iron and Steel Institute and the Aluminum Association indicate that these industries employ 300,000 Americans today, which is less than 0.1% of the U.S. population.

With or without Tariffs, that is unlikely to change any time soon.  Companies which have outsourced jobs would have little incentive to bring those jobs back.  And, it would take decades to try to rebuild the capacity lost over 60 years.

Note that U.S. steel production is down by less than 50% over that 60-year period.  While many jobs were lost through outsourcing and the growth of these industries in other countries, much of the reduction in American jobs is attributable to higher productivity here in the U.S.A.

In an op-ed entitled, “Tariffs are Taxes,” three Trump-supporters and well-known free market advocates … Larry Kudlow, Arthur Laffer, and Stephen Moore … wrote:

“… even if tariffs save every one of the 140,000 or so steel jobs in America, it puts at risk 5 million manufacturing jobs and related jobs in industries that use steel.  These producers now have to compete in hyper-competitive international markets using steel that is 20 percent above the world price and aluminum that is 7 to 10 percent above the price paid by our foreign rivals.”

 

Steel Countermeasures

The greatest danger in imposing Tariffs is the risk that our trading partners would retaliate against American industry.

The European Union (EU) is preparing to impose its own tariffs on several U.S. products if the Trump Administration follows through on its steel Tariffs.  Bloomberg reports that the EU plan would target 2.8 Billion Euros ($3.5 Billion) of American goods, applying a 25% “tit-for-tat” levy on a range of consumer, agricultural, and steel products imported from the U.S.

The list of U.S. products includes:

shirts, jeans, cosmetics, other consumer goods, motorbikes, and pleasure boats worth approximately 1 Billion Euros

orange juice, bourbon whiskey, corn and other agricultural products totaling 951 Million Euros

steel and other industrial products valued at 854 Million Euros

The EU has discussed expanding the list of targeted American goods should Trump also follow through on his pledge to impose a 10% duty on foreign aluminum.

 

We will continue this discussion of  Trade Wars  next week in IntelDigest.

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

FEBRUARY 28, 2018

 

Contact Richard Power with comments or questions.   IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

 

We have written about the “Melt Up” in investment markets on several occasions over the last 18 months, and we continue to believe that high-quality equities (particularly banks and multinational corporations) are still buoyed by:

* improving economic conditions around the world

* strong earnings in many U.S. corporations

Corporate earnings are expected to sail for companies … both big and small … because of a new tailwind from the Tax Cuts and Jobs Act of 2017 (TCJA).

 

 

Interest Rates

However, we try to stay ahead of the trends, and the trend with respect to  Interest Rates  is changing as we go forward. As we have written on several occasions … most recently in our final 2017 post on December 20:

“…. we believe that the single most important factor in the current market climate is Interest Rates.  While ultra-low rates have done immense damage to fixed-income investors over the last several years, investors in equities have done very well.  There have simply been no easy options for investors, so they have invested heavily in stocks and stock funds, driving Price-to-Earnings Ratios to unusually high levels.”

The Federal Reserve (The Fed) has clearly signaled that it intends to alter this landscape, perhaps beginning as soon as next month.  The Fed expects to raise short-term interest rates by 1.5%-2% (incrementally) over the next 24 months.  And, it will seek to reduce its balance sheet by selling into the market Billions of Dollars of bonds which it has accumulated since the Financial Crisis of 2008-2009.

Even though short-term rates would still be well below the historic norm, these combined actions will eventually create drag on economies and deflate equities markets.

 

 

Why Do Interest Rates Matter?

In addition to the actions of The Federal Reserve, the United States Treasury must increase its borrowing dramatically, for this year and for several years into the future.  Cheap credit has underpinned the equities markets over the last eight years, and allowed both corporations and governments to borrow huge amounts of money.   The Debt Service on all that borrowed cash is about to become lots more expensive.

 

 

The Debt Explosion

We wrote about the coming  Debt Explosion  in the December 20 issue:

* Government debt (both federal and state) has been growing exponentially in the last 17 years.  Because the Federal Reserve cut interest rates to almost nothing, government borrowing costs have not exploded (yet!)

PLUS

* Consumer debt has returned to an all-time high (less than 10 years after a Financial Crisis which reverberated across the globe)

As we expect borrowing rates to continue rising over the next two years, much of this Debt will prove to be unsustainable and unserviceable.

 

 

Tax Breaks for All!

The aforementioned tax legislation … the Tax Cuts and Jobs Act of 2017 (TCJA) … is already contributing to the  Debt Explosion.  The new law lowers individual income tax rates, so new tax withholding tables went into effect this month.

The Congressional Budget Office (CBO) has estimated that withheld income taxes remitted to the U.S. Treasury will be $10-15 Billion less each month than in recent years.  This was anticipated by Congress … the tax bill was passed under reconciliation rules which allowed reduction of revenue by $1.5 Trillion over 10 years, which works out to approximately $12.5 Billion per month.

 

 

The End of Low-Interest Treasury Borrowing

Because The Fed has pursued an ultra-low interest rate environment in the wake of the Financial Crisis, the federal government has been allowed to borrow tons of cash with minimal financing costs.  The average interest paid on the U.S. Debt has been reduced to less than 2% in recent years.

Simply put:  as interest rates increase, borrowing costs of the Treasury will rise.  With total Treasury Debt of over $20 Trillion, even a 0.5% interest rate increase will impact the overall budget deficit.

As we wrote last week, Congress and the Trump Administration have committed to rising budget deficits. That’s what happens when you cut taxes and increase spending.  The Federal government is expected to issue a mind-boggling $1.3 Trillion in new debt this year.

Add to that the doubling of Interest Rates over the next two years;  and, the new supply of government paper which will hit the market at the same time as The Federal Reserve works to unwind its massive bond portfolio.

The result is a need for at least Two Trillion Dollars of additional funding for 2018 alone!

 

 

How Did We Get Here?

Most Americans have paid little attention to the massive increase in federal Debt over the last 17 years, primarily because ultra-low interest rates kept borrowing costs down. Even though total federal Debt outstanding has increased by 126% since 2008, borrowing costs have fallen over that period of time.   The American public is paying about the same amount in annual interest as it did back in the early 1990s, when the national Debt was 80% less than it is today.

However, net interest payments started moving higher when The Fed began raising short-term rates two years ago.  Today, federal interest payments exceed $260 Billion per year for the first time in history!

The Treasury Borrowing Advisory Committee (TBAC) is a group of private banks which advises the Treasury Department.  TBAC has estimated that the Treasury would need to borrow approximately $955 Billion in the fiscal year that ends September 30, up substantially from $519 Billion in the previous fiscal year.  The TBAC estimate for fiscal 2019 is $1.083 Trillion;  for fiscal 2020, $1.128 Trillion.

The Treasury has also announced that it will shift from predominantly longer-term bonds (average duration of 70 months) to more short-term Debt.  Ostensibly, this shift will help offset the reduction in demand for longer-term debt by The Federal Reserve, as it unwinds its bond portfolio. However, there could be serious consequences to this policy.

First, the additional supply of short-term debt will push short-term rates even higher, and hasten the yield curve “inversion” that historically triggers a recession.  And, the problem of government borrowing costs could be made exponentially worse.

Instead of being able to lock in long-term interest costs on longer-term bonds (even though the Treasury would be committed to paying higher rates on those bonds), the Treasury will have to constantly reissue short-term Debt at rates which begin low, but grow higher and higher over the years.

 

Next week, we will discuss re-positioning some portfolios in light of these developments.