Trade War Risk Extends to 2020

“In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the Committee decided to lower the target range for the federal funds rate to 2 to 2-1/4 percent.”

Federal Open Market Committee 7/31/2019

Macintosh HD:Users:Michelle:Desktop:Screen Shot 2019-08-07 at 11.34.02 AM.png

At the end of July, the US Federal Open Market Committee met and cut their benchmark interest rate 25 basis points and established a new lower range of 2.0%-2.25% for federal funds.  US President Donald Trump immediately critiqued Fed Chairman Jay Powell for not stating this was the beginning of a long rate-cutting cycle. Then, on August 1, President Trump tweeted that the US would place an additional 10% tariff on $300 billion of Chinese goods.  China responded by allowing their currency, the Yuan, to depreciate past the critical 7.00 level against the US dollar. The US officially declared China a currency manipulator. New Zealand, India, and Thailand all cut their official interest rates. Global stock markets tumbled, the global bond yields tumbled, and confidence in ending the US-China trade war tumbled.  Dog Days of Summer indeed.

Let’s unpack this for business to show its impact on the economy, the markets and politics. 

Three main US business takeaways:

  1. US-China trade war will continue and not likely be resolved until October 2020.
  2. Due to this, volatility will remain a key component for every business in the United States –with impacts ranging from supply chain disruption to a slowing global economy.
  3. Democratic 2020 presidential candidates will benefit from a slowing US economy and deprive President Trump a major area of accomplishment, which will impact his approval ratings and ability to win a second term.

Context for Fed decision:  US and global economy in graphs.
Click URL to see the chart

US GDP has slowed, but remains above 2.0%. Source:  St. Louis Fed

2019 Q3 US GDP estimated to be slightly lower. Source:  Atlanta Federal Reserve

The US expansion is the longest on record. Source:  Economist Magazine

This last graph is where most economists and analysts see potential heightened recession risks:  the US economy has expanded for a long time without a pullback.  

Length is not causation and shouldn’t be viewed as such.  

Just as low unemployment isn’t a leading indicator of continued expansion. Source:  St. Louis Fed

US CPI remains below the 2.0% level, where most central banks target. Source:  St. Louis Fed

From the standpoint of these graphs, it would have been reasonable for the Fed not to do anything to interest rates.  However, the central bank was clearly reacting to the slowing global economy and the ratcheting up of the US-China trade war.  A few examples of this are found below.  

China’s GDP slowed to multi-year lows at 6.2%. Source:  Trading Economics

For the first time ever, the entire German yield curve is negative. Source:  Zero Hedge

The latter indicates slowing German growth as well as slowing European growth.  Remember, Germany just missed a recession in Q4 2018/Q1 2019. Given that 47% of the German economy is exports and the US & China are the leading German export destinations, the US-China trade war is clearly harming the German economy.

Finally, US manufacturing PMI index has recently dropped to multi-year lows. Source:  Trading Economics

All of this can be attributed to the Federal Reserve cutting interest rates and stopping quantitative tightening to ease monetary conditions.

For the markets, here are a few charts to get a flavor of what is happening.

10-year Treasury minus the 2-year Treasury:  with the shaded areas representing recessions. Source:  St. Louis Fed

The trade-weighted US dollar at multi-year highs, which puts pressure on US exports. Source:  St. Louis Fed

The S&P 500 sank after the trade sanctions announced. Source:  Bloomberg

Here’s the core problem for the US central bank:  President Trump. The President is engaging in a trade war with China.  The trade war increases the costs of products manufactured in China. This increases costs to US businesses importing Chinese goods.  This disrupts US-China supply chains that have been developed over the last 15-20 years and forces US businesses to reduce their purchases and attempt to find new, cheaper suppliers.  For the consumer, the tariffs act as taxes on their spending if the goods are imported and if higher prices are attached to those goods.  

I stated earlier that I believe the US-China trade war will not be resolved until 2020 because there is no incentive for either the US or Chinese to come to an agreement until then.  For China, they will not likely agree to the current proposals on intellectual property or agree to the enforcement mechanisms the US is requesting. Pressure for an agreement will rise if the Chinese economy slides further and if this economic slide results in domestic unrest similar to (or because of) what is occurring in Hong Kong.

For the US, President Trump has no incentive to an agreement for two important reasons.  First, he is using China as an outside enemy to rally his supporters and demonstrate resolve.  He can control the news flow in the media every time his team meets with the Chinese and every time he believes he’s not getting what he wants from the negotiations.  Second, he can place and retract tariffs any time he wants. Now, Trump is in a phase of unhappiness over the talks and he has placed new tariffs to go into effect on September 1st.  However, he can just as easily reduce the tariffs or put them off any time he wants if he believes either the negotiations are going well or he has a political advantage.  

To this end, any agreement that is created will be subject to intense scrutiny by the media, the voters and the 2020 Democratic presidential candidates.  There is no upside for President Trump to allow any length of time to occur between when an agreement is made and when voters go to the polls on November 3, 2020.  If there is, the opposition will tear into the agreement and likely state it didn’t accomplish what was necessary or was strong enough for the US. If President Trump waits until mid-October, he can then go to the voters to say what a great dealmaker he is and how strongly he stood up to the Chinese.  Remember in the 2016 presidential election, voters overwhelmingly thought trade did not benefit the US economy or US job creation.  

If my timeline is correct, the risk for US businesses remains China supply chain disruption and a slower economy.  A cautionary tale on the trade agreement process is the USMCA. In addition to the US-China trade disruption, there remains a strong risk that Congress will not approve the USMCA trade agreement.  The USMCA is the replacement for the NAFTA trade agreement and is being held up in the Democrat-controlled House of Representatives. Speaker Pelosi is not likely to allow a vote on the USMCA, which could provide President Trump a victory on trade.  If no vote occurs, this would expand supply chain risk from China to Canada and Mexico. The slower global economy will be a product of slowing global growth exacerbated by the US-China trade war with uncertainty heightened by no USMCA vote.    

The risk is that global central banks may not be able to avoid a recession as global interest rates are already at low or negative levels.  The restarting of quantitative easing (QE) programs will initially signal a growing desperation by the central banks to ease monetary conditions and the risk markets (equities and currencies) will reflect this concern.  As well, QE previously had a positive impact due to its novelty and surprise. On top of this, the size of the QE will need to be significantly larger to impact a significantly larger US economy. Already, lower interest rates are not translating into increased home sales or consumer confidence.

Finally, the 2020 election may be impacted if the economy hits a recession.  Under President Trump, there have been several positive business-friendly policies put in place:  corporate taxes were cut significantly; fiscal spending was increased; and a new budget deal removes the risk of a government shutdown for 2 years.  Regulatory reform has aided businesses from rollbacks of the EPA’s WOTUS (Waters of the US rule) to the Department of Labor’s Fiduciary Rule. All of these will be likely back on the docket if a Democrat wins the 2020 race.  As well, there are numerous tax rollbacks and additions that many of the candidates want to use to fund their proposed new social spending, like Medicare For All and the Green New Deal.

Wrapping this up for businesses, there is heightened risk for negative outcomes in the economy, in the markets and in politics.  US-China trade war will continue and not likely be resolved until October 2020. Due to this, volatility will remain a key component for every business in the United States with impacts ranging from supply chain disruption to a slowing global economy.  Democratic 2020 presidential candidates will benefit from a slowing US economy and deprive President Trump a major area of accomplishment, which will impact his approval ratings and ability to win a second term.