Op-Ed: Don't ignore the 'simmering fires' of trade wars, proxy wars and hybrid wars

    • U.S. asset prices are responding to monetary policies — and nothing else
    • American interest rates are not too low, and benchmark bond yields are about right
    • U.S. investors are ignoring domestic and global political instability at their own peril

      I am seldom moved to "defend" financial market operators from pyromaniacs and naysayers. But, to be fair, let me begin this story by acknowledging markets' ability to determine reasonable asset values under conditions of totally and hopelessly unbalanced U.S. economic policies.

      Start with interest rates. That variable is not only at the core of all financial analysis, it is also the transmission mechanism between the monetary policy and the real economy.

      President Donald Trump speaks during a lunch meeting with Senate Republicans to discuss healthcare at the White House in Washington, July 19, 2017.
      Kevin Lamarque | Reuters
      President Donald Trump speaks during a lunch meeting with Senate Republicans to discuss healthcare at the White House in Washington, July 19, 2017.

      What do markets see there? Do the markets see a reckless fiscal expansion with clashing private and public loan demands driving up interest rates?

      The answer is no. The markets see very little chance — or none at all — of passing the proposed tax changes as the Republican-controlled legislature keeps turning on its own executive authorities.

      The evidence of actual policy actions shows that the Fed fully shares that view.

      Markets responding correctly

      Now, do the markets see signs of trade policy adjustments that would (a) even the global playing field for American companies, (b) boost American exports (12.5 percent of the economy, plus the multiplier effect on jobs, incomes, private consumption and business investments) through better access to foreign markets, (c) stop the unfair import penetration that is killing American jobs and incomes, (d) repatriate the promised manufacturing jobs (that generate 40 percent of Chinese exports to America) and (e) reduce the drag on U.S. economy that costs about 1 percentage point of GDP growth?

      Again, the answer is a resounding no.

      And, finally, do the markets see an activist and coherent structural policy that would increase the efficiency of product and labor markets and raise the dismal productivity growth of 0.2 percent? Such policies were supposed to lead to the economy's higher noninflationary growth potential through investments in health care, education and technological progress to build up the stock and quality of human and (physical) capital.

      The reader needs no hints to correctly guess the answer to this one.

      What, then, do the U.S. markets see, and what are they responding to?

      They see that the monetary policy is left to mind the store all alone among this ruin of America's fiscal, trade and structural policies. Those of you politically inclined can also draw other conclusions.

      And here is a question for pyromaniacs and naysayers: Do they really believe it would be good for America if the Fed followed their advice to withdraw the only life support the economy has?

      Here is also a somewhat technical corollary to that question.

      Last week's peremptory statements that American interest rates are too low are false. Since the beginning of this year, the average yield on the benchmark ten-year Treasury note has been 2.34 percent. That rate has two components: Real interest rate and an inflation premium (based on inflation expectations).

      The real interest rate is a theoretically complex variable; it's not just the nominal interest rate minus inflation. But to make the story simple, let's say that the real interest rate is related to the economy's long-term growth potential. The other part of the bond rate is an estimate based on extrapolations of the most recent inflation data.

      Get back on a campaign trail, Mr. Trump

      So, here are the numbers. The currently estimated U.S. (noninflationary) growth potential is 1.5 percent, while the annualized sum of the monthly increases of the core Private Consumption Expenditure Index — the guiding light of American monetary policy — in the first six months of this year came in at 1.4 percent. Add those two numbers and you get 2.9 percent as an estimate of the ten-year bond yield.

      It, therefore, seems that the current 2.34 percent yield of the ten-year benchmark bond is about right.

      Now for the bad part.

      U.S. markets are ignoring the huge domestic political risks. And since Uncle Sam has a proverbially long hand, Washington is also involved in major trouble spots threatening geopolitical stability.

      Domestically, by paralyzing their own executive authority, the Republicans seem ready for their electoral bloodbath in Congressional mid-term contests a little more than a year from now.

      In view of that, President Donald Trump should do what Ronald Reagan did when he was fighting a hostile, Democrat-controlled Congress: Go directly to the American people with policy speeches and rallies instead of tweeting incendiary one-liners. The president should not allow to be pushed into foreign policy adventures where the Congress can sap his actions to seal his political faith.

      Further afield, China and India are on the brink of war with unpredictable consequences. Losing patience with what they see as Delhi's dilatory tactics, China's military told India last Thursday to immediately withdraw its troops from territory in the Himalayas.

      Even if that military standoff is resolved peacefully, China and India have a lot to talk about — not just about their bitterly contested border claims.

      China is accusing the West (read: the U.S.) of having cooked up the border clash to break up the BRICS (Brazil, Russia, India, China and South Africa) and a security arrangement called the Shanghai Cooperation Organization that just admitted India after long years of hesitation by Beijing. China also sees an American attempt to use India to sabotage Beijing's epochal project for a new Silk Road, connecting Asia, Africa and Europe.

      And China is a country Washington apparently wants to work with to rid the Korean Peninsula of nukes and Intercontinental ballistic missiles that, allegedly, can reach any point in the continental U.S.

      Meanwhile, China is chasing the U.S. planes and naval assets around its maritime borders. Beijing is also furious about $1.4 billion of sophisticated military technology Washington is supplying to Taiwan. That, in China's view, is a direct assault on its sacrosanct "One China Policy."

      Europe, of course, is an even greater mess. Poland and Baltic states are egging Washington into a military confrontation with Russia, because the proxy war in Ukraine is not enough. Those countries are also turning on Germany and France for being "too soft on Russia." Poland is facing European Union sanctions, but is also going to shock Europe with a huge WWII reparation bill it is drawing up for Germany. West Balkan enmities are back to the boiling point, and the U.S.-controlled NATO alliance is seen fanning the fires to stop the Russians.

      Investment thoughts

      U.S. asset markets are rationally responding to the Fed as the only living and acting segment of economic policies. They correctly see fiscal, trade and structural policies as dying hostages to Republicans' paralysis of their own executive authority.

      This unique situation in American history is pregnant with huge risks to domestic political stability. There is also a distinct possibility of an intentional or accidental global armageddon in direct military challenges to nukes- and ICBM-brimming China and Russia.

      The self-serving talk of "a peaceful, transactional cooperation," will fool nobody. China and Russia don't seem to believe a word of that. They are feverishly building their defense capabilities in an ominous arms race, because they see themselves on a permanent collision course with the U.S.

      It is, of course, difficult to factor all those dangers in asset prices and risk profiles of individual portfolios. But that's worth the effort. Don't ignore the simmering fires of trade wars, proxy wars and hybrid wars — all of them featuring the U.S., China and Russia as irreconcilable adversaries.

      Commentary by Michael Ivanovitch.

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