Cold War 2.0, a broken Germany and a US Federal Reserve at the crossroads

Eric Schmidt, who has been the CEO of Google and executive chairman of its parent company, Alphabet, predicts that within the next decade there will be two distinct internets: one led by the U.S. and the other by China.

CNBC, 20 September 2018

China: It’s not just about trade

That was three months ago now. I think Schmidt is onto something here. His point was that “you’re going to see fantastic leadership in products and services from China. There’s a real danger that along with those products and services comes a different leadership regime from government, with censorship, controls, etc.”

This sets up an untenable problem for a new globalized world. Either foreign governments and companies cave in to this different leadership regime, with its controls and censorship, or they forego access to one of the biggest markets in the world. At Google, the company has been working in secret on a censored version of its search engine for the Chinese market. But, its own employees are protesting the decision to do so, saying it makes them “complicit” in government abuses.

Up until now, the West has taken a largely laissez-faire approach to the issue, letting companies domiciled in their countries fend for themselves. But increasingly, the West, led by the US, is looking at China as a nefarious competitor. And this sets the stage for the bifurcated world of which Eric Schmidt spoke in September. If his prediction were to come true, it would be a veritable Cold War 2.0.

And the global scepticism of Huawei’s business surrounding Huawei’s CFO’s arrest makes that clear. How will the Chinese react? What will Trump do next regarding the arrest of Meng Wanzhou? They could try and have her extradited from Canada. But that would take weeks, while US-China trade talks are ongoing.

Imagine, for example, if the Chinese were seeking the extradition of Abigail Johnson, President and CEO of Fidelity. Say she was arrested in Macau because China believed Fidelity was abetting money laundering out of Macau. Wouldn’t there be outrage? This is a completely fictitious example. But, I hope it gives you a sense of the magnitude of the situation.

The China-US trade spat is not just about trade. It’s a deeper rivalry. And the acrimony is coming to a head in a way that may well end up being the death knell for globalization, global supply chains, free trade and everything that goes with that.

Germany is broken

Today, Angela Merkel’s party is voting to decide who will replace her as party Chair. The leading candidates are corporate lawyer Friedrich Merz and Merkel protege Annegret Kramp-Karrenbauer. I see this vote separating the Chancellorship from the party chair as a signpost for political tumult in Germany. And an opinion piece in the New York Times really gets to the heart of the matter in ways I have been discussing here at Credit Writedowns.

Here are some key bits:

The stability (and even monotony) associated with German politics under Ms. Merkel appears to be coming to an end. Her looming retirement marks a deepening crisis of the German political system that threatens not just the future of the country, but of the European Union…

But Ms. Merkel, for all her power and influence, is just one politician. Germany’s new political crisis runs much deeper. It stems from an economic system that has resulted in stagnant wages and insecure jobs. The erosion of Germany’s postwar settlement — a strong welfare state, full-time employment, the opportunity to move up in the world — has created a populace open to messages and movements previously banished to the fringes…

…Average real incomes declined for nearly 20 years beginning in 1993. Germany not only grew more unequal, but the standard of living for the lower strata stagnated or even fell. The lowest 40 percent of households have faced annual net income losses for around 25 years now, while the kinds of jobs that promised long-term stability dwindled.

The number of precarious jobs like temp positions has exploded. At the height of postwar prosperity, almost 90 percent of jobs offered permanent employment with protections. By 2014, the figure had fallen to 68.3 percent. In other words, nearly one-third of all workers have insecure or short-term jobs.

So what do people do? They turn away from the established parties and turn toward ‘fringe’ parties. That’s always going to be the case. And what was once a three-party country of CDU/CSU, SPD and FDP now has three more parties – the Left, the Greens, and the AfD – getting significant vote counts. It makes the grand coalition a sort of default governing coalition as the wage stagnation deepens. And that drives people away from the center.

Germany’s political system is in turmoil.

The Fed has no clue what to do

And speaking of turmoil, the US Federal Reserve is at a crossroads. The data look good. And the outlook for the near-term looks good too. But the global growth slowdown, the turmoil in financial markets and the incipient credit stress all point to problems in 2019.

This morning, we saw 155,000 get added to US payrolls, while the unemployment rate held steady at 3.7%. Though the payroll number was below the 198,000 consensus estimate, the 3.1% increase in average hourly earnings over the past year reinforces that the US economy is doing well.

Moreover, just yesterday, ISM Services data came out with a robust 60.7% number, up from 60.3 and beating expectations for a fall to 59.2. This lends credence to my view that the holiday selling season will be robust, especially in an economy boosted not just by rising wages but falling gasoline prices.

What does the Fed do with that information then? Here’s Pedro da Costa’s perspective:

here’s a good chance Federal Reserve Chairman Jerome Powell is secretly hoping one of his colleagues will vote against another interest rate increase later this month.

Why would the chairman of a consensus-seeking Federal Open Market Committee want one his colleagues to break ranks? One word: signaling. The Fed appears to be coming awfully close to the point when it at least wavers about tightening monetary policy further.

Basically, Pedro is suggesting Powell might want cover to change guidance, to hedge toward a more dovish stance. See, Powell’s problem is that the data continue to stack up as well as the Fed’s forecasts say. So, there’s no obvious reason to change guidance. But, everyone knows we are in a different world now, regardless of what the headline numbers say. And so, the Fed faces a dilemma of maintaining guidance and raising rates, even as the yield curve has partially inverted. If recession takes hold, they will be blamed. Trump already is blaming them.

In less than two weeks time, just in time for the Holidays, the Fed will make its views known. If we still have market turmoil and the Fed sticks to its upbeat macro view, expect the curve to flatten even more.

That’s all for today. Have a good weekend.

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