The Black Owl Report Intelligence Brief · the current PM and the news that Finance Minister Nhlanhla Nene had been meeting with the Gupta family led to his sacking and the Rand has

The Black Owl Report: An Executive Intelligence Brief

Confidential – Armada Executive Intelligence Brief – Confidential - 1 -

Briefing: Wednesday 10, October 2018

Executive Summary Update on the Financial Stress Index. I haven’t run an update on the Financial Stress Index in a while. But, one would think with bond prices and currency fluctuating, overnight bank loan rates rising, and a host of other relatively important financial metrics in play, the stress index would be climbing. Continue to Keep an Eye on the 2/10. The yield spread between the 2- and 10-year treasury has actually started to reverse course – slightly. Remember that the 2/10 spread has been the center of controversy in the world of economics.

Avoiding Tariffs 101. It turns out that setting tariffs on imported goods can be a very tricky proposition. The way that this is done is to impose these taxes on select goods as defined in the HTS code. This system has 18,927 different entries that attempt to catalog and define everything that comes into the US. More Fed Support for Gradual Rate Hike. As one would expect, politicians continue to express their general opposition to the notion of higher interest rates. They generally do not care about such arcane subjects as inflation or the value of the currency, they just don’t want that growth party to ever end. Separation in Housing Market. Much of the economic data looks really good right now, but it must be pointed out that most of what has been noted of late is concurrent data – the kind of information that tells you right where you are at this point. The leading indicators that describe the future are far murkier. Housing looks solid at first glance, but a closer look shows that there are some deep divisions splitting the market in two. Bolsonaro and the Run Off. Jair Bolsonaro came within a few seats of winning the election in the first round of voting in Brazil, but will now need to head to the second round against his Worker’s Party opponent. All that Bolsonaro needs to do is attract a few additional supporters from among the other eleven parties that ran in the first round while his opponent would need to drag his 26% support past 50%. Where is Jamal Khashoggi? The mystery of his whereabouts has embroiled

the governments of Turkey and Saudi Arabia and even into Europe. Khashoggi has

been a sharp critic of the Saudi government and specifically of the Crown Prince.

This led to his exile in the US where he writes for the Washington Post as well as

other publications. More Scandal Rocks South Africa. The latest issue in South Africa is the fate

of the Finance Minister who failed to disclose that he had been meeting with some

of Jacob Zuma’s cronies. The deposed leader has continued to desperately attack

the current PM and the news that Finance Minister Nhlanhla Nene had been meeting with the Gupta family led to his sacking and the Rand has tumbled to the lowest level seen in a month.

The Black Owl Report is “About Business for Business Executives” and is $7 a month. Please go to

www.armada-intel.com to learn more about an individual subscription or to get a free trial.

Key Metrics

GDP

2015 2.4%

2016 1.6%

2017 2.2%

2018 (Est) 3.3%

2019 (Est) 3.0%

Private Investment

2015 6.0%

2016 -1.3%

2017 6.2%

2018 (Est) 7.0%

2019 (Est) 6.0%

Business Investment

2015 -5.5%

2016 -4.5%

2017 6.7%

2018 (Est) 3.6%

2019 (Est) 4.5%

Retail Sales

2015 1.9%

2016 2.7%

2017 4.2%

2018 (Est) 3.5%

2019 (Est) 4.0%

New Housing Starts

2015 1.1M

2016 1.2M

2017 1.2M

2018 (Est) 1.2M

2019 (Est) 1.5M

Auto Sales (Annual)

2015 17M

2016 18M

2017 17.1M

2018 (Est) 17.2M

2019 (Est) 16.9M



Diesel for the Fall – It’s Now a Story. Rising crude oil prices has definitely had an impact on one commodity – diesel prices. Although you may not put diesel in your car, it’s the second biggest cost item for the trucking sector. So, when fuel surcharges are passed on to you as a consumer through hikes in product prices or when your company pays for those fuel surcharges, you feel it. Michael a Serious Disruptor. Let’s put aside the fact up front that a Category 3 hurricane bearing down on the Florida panhandle is serious enough. But, there’s a much bigger economic story than meets the eye.

• Update on the Financial Stress Index. I haven’t run an update on the Financial Stress Index in a

while. But, one would think with bond prices and currency fluctuating, overnight bank loan rates rising, and a host of other relatively important financial metrics in play, the stress index would be climbing. That’s not the case at all. As you can see from the Fed chart at right, the Financial Stress Index is actually dropping. The index is built from 18 different weekly metrics spanning everything from interest rates, yield spreads, etc. Just like you, I keep watching stories about the “Wall of Worry” and the growing risks in the financial sector. When we peel back the onion and look, it’s just not showing up in the macro data yet. I’ll keep my “eyes focused” on the data.

• Continue to Keep an Eye on the 2/10. The yield spread between the 2- and 10-year treasury has actually started to reverse course – slightly. Remember that the 2/10 spread has been the center of controversy in the world of economics.

Historically, when the yield curve has inverted, it has led to recession. We have watched the 2/10 dive toward the inversion point below zero, but it’s recently started to jog sideways and has even slightly improved – slightly. Everyone from the Federal Reserve to prominent national talking heads have said that they were going to ignore the 2/10 in this

Domestic Economic Issues



cycle because of unprecedented dynamics happening in bond markets and Central Bank liquidity actions. I don’t even know what that means. I’ve listened to the rationale that they’ve been using and it sounds to me like they are trying to find a rationale for why we shouldn’t be worried. Historically, when the 2/10 spread inverts, you can set the calendar and recession has followed within 6-18 months. That’s a big spread. A lot of great business and opportunity can be achieved in 6-18 months, so the day that it inverts doesn’t mean any of us should start bunkering in place. But, many of you run credit operations and we share some common worries. It’s going to be increasingly difficult for certain entities to make money when there’s very little to no spread between credit instruments. Borrowing cheap on the short end and lending expensively on the long end is the way many institutions make a significant chunk of their profits. For the banking sector, it’s a big deal when the spread nears zero. And many will likely have to change their lending policies. Market conditions get tighter. If you have customers “into you” for a chunk of change and you’ve given them favorable terms, don’t be shocked if receivables start dragging out a bit. Throw some elevating interest rates on top of that, higher labor costs, much higher supply chain costs, and some elevated raw material and input costs and you’ve got a formula that will create some trouble in spots of the economy. So, everyone else can write off the 2/10 and ignore me. That’s fine. But, I’ll continue to write about it from time to time because as I travel the country and give talks, I’m hearing concern at the street level about the risks of tightening yields. - Keith

• Avoiding Tariffs 101. It turns out that setting tariffs on imported goods can be a very tricky proposition. The way that this is done is to impose these taxes on select goods as defined in the HTS code. This system has 18,927 different entries that attempt to catalog and define everything that comes into the US. This has become a convoluted mess over the years as there have been numerous requests to alter or establish codes that were too cumbersome. Today Chinese exporters are using these codes to bring product into the US legally – simply because the code for that product is not the same as the ones used in the past. There has already been a lot sent under these circumstances and there will be more to come. It turns out that it is far harder to limit imports than one would assume. This is just one of the many ways that have been developed over the course of time. The most common way to avoid these additional tax burdens is to have the product in question shipped from some other nation that has not been subject to the tariffs and restrictions. For instance, a Chinese company would set up an operation in Malaysia or Botswana or Panama for that matter. The product is shipped to that country in nearly completed status and is finished there and subsequently sent to the US. It is no longer technically “made in China” and thus escapes the tariff. There are a whole series of rules and regulations that apply to assembly and many companies get around the restrictions by doing that final assembly in the US or any other nation they do business with.



The bottom line is that highly determined importers and exporters can find ways to get their products into nations regardless of the rules and restrictions that apply. If there is a willingness to bend or break some of those rules there is even more that can be done but the point is that tariffs can be subverted in a completely legal way. Tariffs are taxes and just as with any tax there are legions of people who are experts in facilitating these transactions. The consumer is the actor that gets hurt as the extra complexity introduced by the tariff causes these more convoluted supply chains that add costs to the finished product. It will depend a great deal on what product one is talking about, but it has been suggested that everyone in the US will be paying more – an average of around $3,000 to $5,000 for the same basket of goods that was purchased. - Chris

• More Fed Support for Gradual Rate Hike. As one would expect, politicians continue to express their general opposition to the notion of higher interest rates. They generally do not care about such arcane subjects as inflation or the value of the currency, they just don’t want that growth party to ever end. The statements from President Trump are not much different from the statements made by previous Presidents, although his were considerably more strident. The reaction of the Fed has been typical. Not one member of the Board of Governors has taken a position opposing the hikes and have instead supported it. These voices have been added to those of the regional Fed heads who have all come out in support of the proposed plan. Not that there is a real “plan” per se. The Fed statements have been clear enough in terms of their motivations as far as the economy is concerned. This has been a very cautious Fed and will continue to be. The growth that has been experienced by the US economy is real enough, but so are the threats to that growth and the Fed is not willing to do a lot of gambling. The three reasons the Fed wants to continue slowly pushing rates up remain as they have been – interrupt the start of an inflationary period, slow down the high-risk practice of borrowing cheap money in order to invest it, and they want to build some higher rates into the system in order to have some ammunition when the economy starts to turn south again. Right now, there is very little the Fed could do to boost the economy with lower rates as they are already at historical lows; and dropping them a quarter point or two would not result in significant additional activity. The things that worry the Fed are as they have been stating all along. They are not sure the economy is able to stand on its own yet as they think the recent growth was goosed by the tax cuts and that impact is about spent. They are also of the opinion that damage from the trade wars and tariffs will be felt by the start of next year at the latest. They also have expressed concern about factors like the mid-term elections and the status of various global economies as these could affect the mood of the country and hence growth. This is why the Fed doesn’t guarantee higher rates next year – it is just that it remains likely the rates will go up unless there is something that causes them to pause.



As it stands, the President may make veiled threats and Congress may fulminate, but the Federal Reserve is mostly set now and will continue to function independently. All of the vacant positions have been filled with nominees although three of them have yet to clear the Senate. Of the three only one has been seen as controversial – Marvin Goodfriend from Carnegie Mellon is a very hawkish economist and has been advocating much higher rates for some time. The latest nominee is a former Fed economist named Nellie Liang – a registered Democrat and very much a Fed insider. The other nominee that waits confirmation is Michelle Bowman from Kansas. She was with the Kansas Banking Commission and is part of a small family owned operation called the Farmers and Drovers Bank of Council Grove. The other Trump nominees have been equally traditional – Jerome Powell was elevated from the Board to the chair position, Richard Clarida from Columbia was made vice-chair, Randy Quarles was named to the post that handles most regulatory matters. These are said to be Trump’s nominees as of course they are officially, but the reality is that these are the choices of Treasury Secretary Steve Mnuchin – the man who has had the most influence over the development of Trump’s economic policy.- Chris

• Separation in Housing Market. Much of the economic data looks really good right now, but it must be pointed out that most of what has been noted of late is concurrent data – the kind of information that tells you right where you are at this point. The leading indicators that describe the future are far murkier. Housing looks solid at first glance, but a closer look shows that there are some deep divisions splitting the market in two.

The top ten housing markets are seeing growth of between 25% and 50%, but the bottom ten of the 25 largest markets are all shrinking - and fast. Not surprisingly the growth has been fastest where the jobs are, but even with that employment growth the wages are not keeping pace with higher home prices. This separation is not seen in just the housing sector and is one of the reasons that economists have been cautious about jumping on the good growth bandwagon. There has been an increasingly obvious separation between those parts of the country that have been benefiting from the economic progress and those that have not. This is always the way it develops as this is a large nation and at any one time there are winners and losers, but the divide is getting wider with every passing month. Generally speaking the high growth cities with the most active housing markets have been those that sport strong high-tech sectors and strong medical sectors. Those that have done less well are generally those that depend heavily on the agricultural community or are dependent on commodities that have not been enjoying steady price increases. There has been mixed news for communities that rely on manufacturing as there has been some reaction already to the imposition of steel and aluminum tariffs. These communities are feeling the pinch. There are other factors at work – including demographics. Those communities that sport a generally older population are not faring as well given the fact that this sector of the population doesn’t spend as much on entertainment and stuff in general. The younger cities are doing far



better than the older ones. There is also a connection between crime and growth. Those cities that have developed a reputation for crime and violence are seeing much slower growth than those with a safer reputation. Housing remains in something of a limbo situation as far as the millennial is concerned as they continue to favor multi-family housing over the traditional single-family abode. The older members of that cohort are finally starting families and preferring the single-family home but the percentage that has drifted to that traditional position is far less than with the Baby Boomers or Generation X. - Chris

• Bolsonaro and the Run Off. Jair Bolsonaro came within a few seats of winning the election in the first round of voting in Brazil, but will now need to head to the second round against his Worker’s Party opponent. All that Bolsonaro needs to do is attract a few additional supporters from among the other eleven parties that ran in the first round while his opponent would need to drag his 26% support past 50%. The markets have been generally kind to Bolsonaro as he has advocated adherence to the traditional economic policies in place. To note that Brazilians are in shock would be an understatement – especially those who have been connected to the major political parties. The tiny fringe party that Bolsonaro comes from had only one seat in the legislature only a couple of years ago and now has nearly as many as it takes to form a majority. Granted, the members are anything but united on anything other than disappointment with the traditional parties but they all back their candidate at this point. Most analysts assert that this unity will dissolve very quickly as the demands they are making will be next to impossible to address. The top three issues for the voters who backed Bolsonaro were crime, corruption and economics. The country has been beset with violent street crime for years – much of it related to the drug gangs but there is also the crime of desperation. The fact is that people will kill one another for the price of a meal and there is a sense that the police can do nothing about it. His “solution” has been to emulate the extreme violence of Rodrigo Duterte in the Philippines where some 60,000 people have been executed on suspicion of being connected to drug gangs by the police and neighborhood vigilantes. Needless to say, the assertion is that thousands of innocent people have been killed in this Philippine crackdown. This is what Bolsonaro asserts needs to happen in Brazil. When it comes to corruption he wants similarly draconian steps taken with long prison sentences and even executions. He has suggested the size of the Supreme Court be doubled so that he would be able to pack it. The fear is that corruption charges would be brought against his political enemies but not against his friends and supporters. When it comes to the economy he has surprisingly traditional views and favors a liberal free trade position that resonates with the business community. He is against over regulation and favors more investment friendly positions. He would welcome foreign investment into what had been

Geopolitics – Business Threats and Opportunities



very sensitive areas of the economy such as the oil sector. He wants to develop and expand business opportunity in the Amazon and takes a very dim view of environmentalists. His position on raising the wages of public sector workers is negative and that runs counter to what has been happening for the last decade. His positions here are very popular with the general business community and they have been reaching out cautiously. - Chris

• Where is Jamal Khashoggi? The mystery of his whereabouts has embroiled the governments of

Turkey and Saudi Arabia and even into Europe. Khashoggi has been a sharp critic of the Saudi

government and specifically of the Crown Prince. This led to his exile in the US where he writes for the

Washington Post as well as other publications.

Last week he entered the Saudi embassy in Istanbul to get papers he needed to marry a Turkish citizen

and vanished. The Turks insist the Saudi government arranged to have him killed and the Saudi

position is that he left the embassy and they have no knowledge of him. This is getting nasty.

The mystery is dragging the Turks and Saudis into an

increasingly testy confrontation. Not that the two

governments have ever been that close, but they had

remained somewhat neutral towards one another.

The Erdogan regime opposes the position held by Saudi Arabia

as regards the Kurds and has spoken out against the war in Yemen. There have been economic conflicts as well.

The issue of Khashoggi is more than a little ironic given

that no nation in Europe has arrested more journalists than

Turkey and there have been accusations that some of

Erdogan’s critics have vanished in a similar manner.

The latest wrinkle is that Turkey will be allowed to search the Saudi facility for evidence of a crime and Turkey has been

demanding that footage of Khashoggi’s departure be provided.

They have evidence of his arriving but not leaving and the Turks

assert that a group of Saudi “hit men” arrived in Istanbul just before Khashoggi arrived.

The British Foreign Office has demanded an explanation and has indicated that Saudi Arabia

would face consequences if it is proved that this journalist was murdered or that there was a

cover up. France and Germany have issued similar rebukes and have demanded a full

accounting of the visit. A manhunt is under way to find Khashoggi but it is very unlikely that he would

be in hiding given his position as a leading critic of the Saudi regime. Even though he has been living in

exile in the US there has been no hint of support from President Trump – other than a brief statement indicating “we know nothing”.

If the assertions made by Turkey are true the reformist reputation of Crown Prince Mohammed bin

Salman will take a very big hit. - Chris



• More Scandal Rocks South Africa. The latest issue in South Africa is the fate of the Finance

Minister who failed to disclose that he had been meeting with some of Jacob Zuma’s cronies. The

deposed leader has continued to desperately attack the current PM and the news that Finance Minister

Nhlanhla Nene had been meeting with the Gupta family led to his sacking and the Rand has tumbled to the lowest level seen in a month.

It has been hard for Cyril Ramaphosa

to get his government on track as he

continues to fight a rear-guard action

against the very bitter loser – Zuma.

The problem is made worse by the

fact that many in the ruling ANC are

still part of that Zuma-led past. The

Gupta family remains one of the richest

in South Africa and their influence has

not been dimmed as much as one would

think by everything from jail time to fines and seizures. They still pull a great many

strings inside and outside the country.

The fact that Nene met with them is not

as much the issue as that he did so in secret. The implications were that he was planning something behind Ramaphosa’s back.

The Zuma attacks on his successor have been aggressive and destructive and have been aided

by gullible western politicians like President Trump. An accusation was made that Ramaphosa was ordering the seizure of white farmer’s land and killing those who refused to turn it over. The story was

picked up by far-right social media in the US and President Trump tweeted a condemnation. There was

not one shred of proof this was taking place. The land that was being seized was due to failure on the

part of the owners to pay taxes on it – a case that had been in court for years. The seizure was peaceful and carried out by the local police. There have been no killings and no land seizures although the country continues try to get abandoned farms into the hands of those that would start it up again.

Zuma would rather burn his country to the ground than see his rival in power and the business community is just sick of the political infighting. It seems a very long fall from the days of Nelson Mandela and even Thabo Mbeki. - Chris

• Diesel for the Fall – It’s Now a Story. Rising crude oil prices has definitely had an impact on one commodity – diesel prices. Although you may not put diesel in your car, it’s the second biggest cost item for the trucking sector. So, when fuel surcharges are passed on to you as a consumer through hikes in product prices or when your company pays for those fuel surcharges, you feel it.

The national price for diesel is now 60 cents a gallon higher than it was at this time last year. In the last DAT Trendlines report, we saw that fuel surcharges were up 17% over September of 2017.

Raw Materials – Business Threats and Opportunities



But, there’s a bigger story happening on the West Coast where a significant amount of the products will flow through headed for distribution centers and warehouses across the country. Diesel is 77 cents a gallon higher on the West Coast than what it was a year ago at this time. And, when you isolate California alone, prices are 95 cents a gallon higher at $4.11 a gallon. I’m not sure that Hurricane Michael will have any impact on the diesel refineries in the southeast, but much of the countries heavy diesel production is spread out in the south. Watch Q3 and Q4 earnings reports and listen to how many companies mention skyrocketing supply chain fulfillment costs as the reason that their profits underperformed in the quarter. There just isn’t enough price elasticity on the consumer end to take on and absorb higher costs. - Keith

• Michael a Serious Disruptor. Let’s put aside the fact up front that a Category 3 hurricane bearing

down on the Florida panhandle is serious enough. But, there’s a much bigger economic story than meets the eye.

There’s a couple of bits of good news about this strong hurricane. First, it’s moving fast. That speed of forward motion will increase the intensity of the winds on the right sweeping edge of the storm, but it won’t linger over land for very long. This should help minimize the flooding potential unlike what we saw in the Carolinas just a month ago. Secondly, land interaction will help cut the severity of the storm almost immediately as it comes ashore. It’s a big storm, so the hurricane impacts will be felt broadly. But, there’s something else I’d like you to watch. Last month, we had a number of economic data metrics that got impacted by Florence ranging from transportation activity to manufacturing. Even the labor report had footnotes that they believe it was undermined a bit by storm impacts. Trucking capacity is a big deal right now as retailers are building

Environment – Business Threats and Opportunities



inventories getting ready for the peak holiday shopping season. Florida is big market and an important consumer market. And although Michael will miss the most heavily populated areas of Florida, he’ll cut off much of the shipping activity moving into the state for at least 5 days (shipments have already stopped flowing and they’ll continue to be shut down till Friday likely…and be delayed through the weekend). Remember that a lot of manufacturers are counting on shipments from their suppliers to keep their assembly lines flowing. It’s especially poignant right now with supply chain bottlenecks all over the country. Expect backlogs to get a little worse as this Category 3 storm impacts the southeast. Lastly, we’ll keep an eye out on crude oil. There’s a lot of geopolitical premium on top of the price per barrel. You can see that in the chart from NASDAQ at right. But, in the last day, there hasn’t really been much of an impact from the threat of Michael despite off-shore rigs in the Gulf being evacuated. The thought that the storm is fast moving is helping keep fears of long production delays at bay. But, as early reports of impacts to rigs come in…don’t be surprised if we don’t see WTI make a run up. Gasoline and diesel would follow. - Keith

Documents

The Black Owl Report Intelligence Brief · the current PM and the news that Finance Minister Nhlanhla Nene had been meeting with the Gupta family led to his sacking and the Rand has