by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EDT] Here is what we are watching this morning:

May responds: The Russians ignored Britain’s deadline so PM May is expelling 23 Russian diplomats, the biggest expulsion since the Cold War.  Expect a similar response from Russia.  This is an issue that bears watching.  We expect that Chairman Xi is closely observing the West’s response to Russia’s rather blatant attacks on its expats in the U.K.  China also has an interest in controlling the actions of its nationals living abroad.  If troublesome characters can be killed with impunity in the West, it would not be a shock to see China engage in similar behavior.  This reaction is probably the best May can muster; without a broader response, we can expect more of these killings carried out by more nations in the democratic West.

Trade talk: One of the evolving features we continue to watch closely is what we call “Trump 2.0.”  In the president’s first year, especially after the appointment of John Kelly as Chief of Staff, the White House became much more orderly.  Populist voices, such as Stephen Bannon, were banished.  The flow of information and persons to the Oval Office was monitored and restricted.  Gary Cohn and the establishment steadily gained control and the key issue the GOP establishment wanted, the tax act, was passed.  That order is now being unwound.  SOS Tillerson’s firing was announced yesterday and Mike Pompeo was nominated as his replacement (conditional on Senate approval).  Cohn has moved on.  As the president becomes more comfortable with the office, he is taking control of the job and the “controllers” are steadily losing power.

For our purposes, what does this mean for financial and commodity markets?

• We would expect more turnover until the president shapes his staff to his liking. The president is making it clear he wants voices around him that are not contradictory.  In reality, most presidents make this shift, although perhaps not as quickly as this one.  Early in the first term of a new president, especially when the party has been out of power, there are a group of political operatives ready and willing to accept appointments.  These are usually “stars” of the party with strong personalities and their own agendas.  As presidents become more familiar with the job, they tire of all the “advice” and replace the stars with people who will execute the vision of the president.  Mike Pompeo will more likely be willing to execute the vision of the president, whereas Rex Tillerson often clashed with the White House.
• This turnover will raise uncertainty but markets will adapt. A similar pattern emerges with geopolitical issues; the first terrorist attack is a big deal.  Over time, markets become inured and they have less effect.
• Our read on President Trump is that he is an economic and geopolitical nationalist. The U.S. is going to become increasingly stingy with providing global public goods, including acting as importer of last resort.  Although Trump will get criticized for doing so, in fact, this is just the most recent attempt to develop a post-Cold War policy.  None of them, since Clinton, have managed to create a lasting policy response to the fall of the Berlin Wall.  It does appear that Trump’s policy of reducing global exposure is popular; although the establishment is horrified (mostly because it has benefited greatly from globalization), the majority of Americans feel that all they get from the superpower role is cheap foreign goods that reduce their employment opportunities.  This doesn’t necessarily mean the U.S. becomes autarkic, but open trade and providing the reserve currency to the world will now come with strings attached.  The big issue to watch is if the world decides that it will reduce using the dollar as a reserve currency.  For now, we don’t really see an alternative; neither Europe nor China is willing to run persistent trade deficits, the requirement to be the primary reserve currency.  But, if foreigners stop using the dollar for reserve purposes, then fiscal deficits suddenly matter…a lot.
• The key market issue is whether trade impediments become serious enough to change inflation and, even more critically, inflation expectations. So far, the rhetoric on trade has far outpaced the actual impact.  But, we know the president has China in his sights and is threatening more serious measures against China’s trade with the U.S.^[1]  If these come to fruition, we would expect inflation fears to become an increasingly negative factor for financial markets.
• Iran will likely become a more serious issue.  President Obama wanted to pivot to Asia and, to do so, he needed to reduce America’s interests in the Middle East.  He decided he was willing to allow Iran to become the regional hegemon and provide order as the U.S. shifted its focus to Asia.  The nuclear deal was a step toward normalization; we suspect Obama assumed Clinton would win in 2016 and finish the normalization process with Iran.  Needless to say, this was a very controversial decision.  Although some regional experts had suggested this outcome as the most rational policy,^[2] Iran is a long-time adversary for the U.S. and it is politically unpopular to support any sort of normalization with the Mullahs.  This president wants to “rip up the script” of the Iranian nuclear deal by May of this year.  If the Iranians disagree, we expect the latter to move quickly to acquire a nuclear weapon.  Rising regional tensions increase the odds of an oil supply disruption.  Keep in mind that the Iran issue will be occurring at nearly the same time as when the president is expected to meet with Kim Jong-un, so the White House will be busy.

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[1] https://www.politico.com/story/2018/03/13/trump-demands-aides-strengthen-china-tariffs-460416

[2] See Baer, R. (2008). The Devil We Know: Dealing with the New Iranian Superpower. New York, NY: Crown Publishing Group. and Friedman, G. (2011). The Next Decade. New York, NY: Doubleday (especially chapter 7).