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What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
The Chinese government reports that, in 2018, real GDP was up 6.6 percent from the previous year, the slowest rate of economic growth since 1990.1 Moreover, in the fourth quarter of 2018, real GDP was up 6.4 percent from a year earlier, the slowest quarterly growth since the global financial crisis a decade ago. Although the government has lately initiated monetary and fiscal policy stimulus aimed at boosting growth, the lagged effects of tight monetary policy are likely to persist for a while. Moreover, even though retail sales and industrial production rebounded slightly in December, this was more than offset by very weak export growth and declining sales of automobiles. As for specific indicators, the government reported that, in December, retail sales were up 8.2 percent from a year earlier, slightly better than the 8.1 percent in November. Industrial production was up 5.7 percent in December versus a year earlier, better than the 5.4 percent recorded for November. In addition, fixed asset investment for 2018 was up 5.9 percent from a year earlier.2 Meanwhile exports fell 4.4 percent in December versus a year earlier, the sharpest decline in two years.3 This was partly due to US tariffs, but also due to weaker demand in other parts of the world. Imports were down 7.6 percent, a reflection of weaker domestic demand in China and disruption to global supply chains. The result was that China’s trade surplus increased, which is often a sign of a weakening economy. However, the US administration has complained about the size of China’s surplus and has made reduction of the surplus a goal of trade discussions. Thus, the increase in the Chinese surplus might alarm the US administration and boost the likelihood of further tariffs. If the United States does impose higher tariffs on China, the Chinese economy could face even more severe weakening—and potentially a bigger trade surplus.
Meanwhile, Wang Qishan, the Vice President of China, said at Davos that the economic outlook for China is not as bad as many observers think.4 Although he acknowledged that China faces serious headwinds, especially protectionism in the United States, he said that China’s growth of 6.6 percent in 2018 was “a pretty significant number, not low at all.” Recall, however, that the 6.6 percent figure was the lowest since 1990. Moreover, many independent observers believe that the actual rate of growth was much lower than 6.6 percent.5 Wang said, “There will be a lot of uncertainties in 2019, but one certainty is that China’s growth will continue and be sustainable.” Wang’s comments were likely meant to reassure those who are especially worried about China’s deteriorating situation. The deceleration of China’s economy has already reverberated around Asia, leading to a slowdown in exports from other countries to China. Indeed Japan’s exports were down in December at the steepest pace in two years, largely due to weak exports to China.6 Many investors are particularly worried about the trade war between the United States and China, and are concerned that, with only a short time remaining before the end of the so-called cooling off period, there is little time left to avert the higher tariffs promised by the United States.
China’s authorities traditionally take a gradualist approach to the implementation of new policies. Thus, a recent action taken by the central bank (People’s Bank of China, or PBOC) may be the first step toward a significantly different policy. Specifically, the PBOC has created a bond swap facility that enables holders of commercial bank debt to exchange their bonds for central bank bills.7 Some analysts see this as the first step toward a Chinese version of quantitative easing (QE). Recall that, in the past decade, the central banks of the United States, United Kingdom, European Union (EU), and Japan engaged in QE in order to pump liquidity into their economies at a time when cutting interest rates had become ineffective. Essentially, they were circumventing troubled banking sectors in order to boost liquidity. Now, in China, the PBOC may be attempting to boost liquidity through means other than interest rate reduction. Moreover, the purchase of commercial bank bonds may be a precursor to purchases of government debt, or true QE. China’s authorities have lately been frustrated by the economic slowdown which, in part, is related to the trade dispute with the United States. China has eased both monetary and fiscal policy, but has so far not seen a rebound in economic activity. Thus, the latest move could be a sign that the PBOC wants to engage in a more aggressive form of stimulus.
After her plan for leaving the EU was overwhelmingly rejected by the Parliament recently, British Prime Minister Theresa May was required to offer a plan B. Last week she did that, and the new plan very much resembles the old one.8 She said that her intention is to go back to the EU to seek tweaks to the original plan. She said that the Parliament will have greater input in future trade negotiations with the EU, and that the backstop with Ireland would not be permanent. However, she offered almost no details as to how [any of] this would be achieved. Rather, it appears she is betting that members will fall in line with her when confronted with a no-deal Brexit as the default alternative. Moreover, she is betting that the EU will compromise on key issues if, for them, the alternative is an economic crisis in Britain that would surely spill over onto the continent. Referring to the brilliant film about a day that keeps repeating, Labour leader Jeremy Corbyn said that “this does really feel a bit like Groundhog Day.” Meanwhile, there are members of Parliament who want to force a vote on requesting an extension to the Brexit deadline, fearful that Britain will crash out of the EU as scheduled in March. Such an extension would require the unanimous consent of the other EU Member States, although the terms and duration of any extension they might accept are unclear.
In the midst of huge uncertainty about Brexit, the British economy shows signs of strength. It is reported that the unemployment rate in the three months leading up to December fell to 4.0 percent, the lowest since the early 1970s.9 The number of people employed rose to a record high. The tightness of the job market led to an acceleration in wages. Specifically, wages plus bonuses were up 3.4 percent in December versus a year earlier, the strongest rate of growth since 2008. Moreover, with inflation having decelerated, real wages were up 1.1 percent from a year earlier, the best performance since 2016, the year of the Brexit referendum.10 The strength of the job market would normally suggest that a tightening of monetary policy is warranted. Yet given the uncertainty over Brexit, it is not likely that the Bank of England will take any significant action until there is greater clarity about the future. In the case of a recession an easing of monetary policy might be warranted, although it is notable that Standard & Poor is currently the only forecaster predicting a recession even if there is no deal. At the same time, a no-deal Brexit could lead to a sharp fall in the pound, which would be inflationary. That might tie the hands of the central bank. In any event, the uncertainty about Brexit has led the International Monetary Fund to delay offering any prognostication about the British economy.
Democrats in the US House of Representatives want changes to the revised North American Free Trade Agreement (NAFTA) accord—known as the US Mexico Canada Agreement, or USMCA—before they are willing to approve the new trade deal.11 Recall that, late in 2018, the US administration completed negotiations with Canada and Mexico to revise NAFTA. The new deal involves stricter labor and environmental standards than the previous NAFTA agreement. These new standards were based on the template provided by the Trans-Pacific Partnership, from which the United States withdrew. In addition, the new deal increases domestic content requirements for trade in automobiles, and also requires that a minimum share of cars be assembled by workers earning a relatively high wage. The latter measures are likely to boost car prices, reduce automotive industry employment, and boost the competitiveness of European and Asian cars in the North American market—unless the United States imposes import tariffs on European and Asian cars. The new deal will not take effect until approved by both houses of the US Congress. The Republican-controlled Senate is likely to approve the deal, but the Democratic-controlled House is where there is likely to be a fight. Democrats, many of whom support the protectionist impulses of the administration, are reluctant to hand President Trump the appearance of success. Moreover, many have expressed reservations about the enforcement mechanism for the tighter labor and environmental standards. In addition, many Democrats and Republicans are unhappy that the administration has not yet eliminated tariffs on steel and aluminum imported from Mexico and Canada.
For his part, President Trump has threatened to pull the United States out of the existing NAFTA accord if the Congress fails to approve the new deal. The idea is to pressure Congress to act or face an even worse situation. It is not clear if this tactic will be effective. The governments of Mexico and Canada, which never wanted to revise NAFTA but were happy to reach an acceptable deal, are now worried about what might happen next. For them, and for the United States, ending NAFTA without a new deal would be hugely onerous. It would likely lead to higher prices of traded goods, disruption of supply chains, and slower economic growth in all three countries. For Mexico and Canada, both of which depend on trade with the United States for a large share of their economic output, an end to NAFTA would be especially disruptive.
When the Eurozone economy began to decelerate in the second half of 2018, European Central Bank (ECB) President Mario Draghi said that he wasn’t worried, that temporary factors were at play, and that Europe’s economy was likely to settle into a slower but more normal rate of growth. Now, Draghi says that he is a bit more concerned. He pointed to factors that might deepen and lengthen the deceleration.12 These include the possibility of a no-deal Brexit, continued trade tensions between the EU and the United States, and recent financial market volatility. Draghi’s concern comes amidst a flurry of data that point to trouble. This includes slower GDP growth, lower purchasing managers’ indices (the lowest in more than five years), and indications that Germany and Italy may be headed for back-to-back quarters of declining GDP. Although Draghi said that the ECB does not now intend to alter monetary policy (which remains relatively easy), he did say that the ECB will react if conditions warrant.
Given that policy interest rates remain historically low, there is little room for the ECB to react by cutting rates. Rather, the only major thing it could do would be to reactivate the program of asset purchases, known as quantitative easy. Doing so would be politically controversial. Meanwhile, although the ECB has halted asset purchases, it continues to roll over bonds when they mature, thus leaving the ECB’s portfolio unchanged. This is different than the US Federal Reserve, which is currently winding down its portfolio.
As the world’s leading business and political leaders prepared to gather in Davos this week, the World Economic Forum (WEF, which hosts the Davos event) issued a report on risks to the global economy.13 It conducted a survey of 1,000 business, political, and academic leaders to determine the general zeitgeist about the global situation. It found that the issue of greatest concern to global leaders is trade. Specifically, the 1,000 respondents were given a wide choice of issues that represent a potential risk to the world economy. The issue of most concern was “economic confrontation/frictions between major powers,” which was cited by 91 percent of respondents. The second most important issue was “erosion of multilateral trading rules and agreements,” cited by 88 percent of respondents. The report noted that the political impetus for protectionist policies represents an effort to “take back control” of national direction by individual countries. Yet it said that “the energy now being expended on consolidating or recovering national control risks weakening collective responses to emerging global challenges. We are drifting deeper into global problems from which we will struggle to extricate ourselves.” The WEF worried that “further erosion” of the rules-based global trading system will hurt economic growth and that, following a period of globalization, the world is now moving in the direction of “divergence.” No doubt these will be issues for conversation at Davos.
Many investors have lately demonstrated considerable angst about the German economy. The widely respected Ifo Business Climate Index—an index of business confidence—has plummeted to the lowest level since December 2016.14 One possible reason for this is the high degree to which Germany’s manufacturing sector, especially producers of capital goods, are exposed to the Chinese economy. Given the current trade war between the United States and China, and the related slowdown in trans-Pacific trade, many German companies are finding it increasingly difficult to sell capital equipment to Chinese manufacturers. Indeed, German exports, which make up nearly half of German GDP, have lately performed more poorly than at any time since 2010.15 Not only is Germany exposed to China, but it also faces potential headwinds from other countries. Among the potential sources of trouble would be a Brexit-induced recession in the United Kingdom, politically driven slowdowns in France and/or Italy, a further trade problem between the United States and Europe or between the United States and China, and a slowdown in the US economy driven by monetary policy tightening.
Domestically, Germany’s large automotive sector is facing difficulty in adjusting to new emissions rules.16 This is causing disruption that will likely have a negative economic impact. A slowdown in German growth would be important given Germany’s position as Europe’s largest economy and the world’s fourth-largest economy. Meanwhile, the European Central Bank (ECB) continues to retain an easy monetary policy. Moreover, German fiscal policy has turned a bit stimulatory. Thus, it seems unlikely that there will be a general recession in Europe anytime soon, although a brief recession in Germany cannot be ruled out. After all, real GDP fell in the third quarter and some indicators suggest that it could fall in the fourth quarter.
It appears that Italy may also at risk of back to back quarters of declining real GDP. Specifically, Italy’s economy shrank in the third quarter of 2018, declining by 0.1 percent from the previous quarter.17 Now, the Bank of Italy says that “the available cyclical indicators point to a possible decline in economic activity in the last three months of the year after the interruption in growth in the third quarter.”18 Italy is the third-largest economy in the Eurozone after Germany and France. The Bank of Italy pointed to a cutback in business investment plans and a slowdown in global trade as reasons to expect a deceleration in Italian growth. It also indicated that it expects very slow growth of 0.6 percent for all of 2019. And, of course, Germany’s economy also shrank in the third quarter and indicators suggest this might have also happened in the fourth quarter. In the case of Germany, stress in the automotive sector is creating much of the problem. This stress is related to the transition away from diesel vehicles, as well as concerns about automotive trade with the United States. Interestingly, both Germany and Italy now have governments committed to increased fiscal spending, a factor that should provide a boost to growth. Moreover, the ECB is committed to continuing its low interest rate policy. Therefore, even if both countries experience a brief recession, the outlook for growth in the entire Eurozone remains modestly positive.
One negative sign for the Eurozone was a sharp decline in industrial production in November.19 In the 19-member Eurozone, industrial production was down 1.7 percent from October to November, and was down 3.3 percent in November versus a year earlier. Notably, production of capital goods was down 2.3 percent for the month and 4.5 percent from a year earlier. This is likely related to weak overseas demand for Europe’s capital goods exports. Output of durable consumer goods, such as automobiles, was down sharply as well. This likely reflects trouble in the German automotive sector. From a year earlier, industrial production was down 5.1 percent in Germany, 1.9 percent in France, 2.6 percent in Italy, 2.8 percent in Spain, 9.1 percent in Ireland, and up 0.3 percent in the Netherlands. Within Europe but outside of the Eurozone, industrial production was up 5.3 percent in Poland, up 2.8 percent in Denmark, up 2.6 percent in Sweden, and down 1.8 percent in the United Kingdom.
The efforts of China’s authorities to stimulate the economy in order to boost growth have resulted in a sharp increase in bank lending, but not yet a rebound in economic growth. The People’s Bank of China (PBOC) reports that the volume of new bank loans was up 19.5 percent in 2018 versus 2017, and that the total outstanding volume of bank loans was up 13.5 percent.20 In addition, lending to the private sector was up 70 percent in 2018 versus 2017, reflecting the PBOC’s effort to stimulate loans to small-and medium-sized businesses. The overall surge in lending was due to an easing of monetary policy by the PBOC, especially in response to the negative effects of the current trade war. The Deputy Governor of the PBOC said that, in part, the central bank wants to stimulate borrowing by the private sector. Specifically, he said, “We must continue to use policy support to guide [bank lending] to solve the problem that some banks dare not lend, do not want to lend, and will not lend [to private enterprises].” Yet despite this stated intention of shifting resources to the private sector, many critics complain that the government has starved the private sector while providing strong support to less-efficient state-owned enterprises (SOEs). In an article in the Financial Times,21 leading China expert Nicholas Lardy said of SOEs that, “while these unwieldy state behemoths soak up a larger and larger share of bank credit, they are doing so mostly at the expense of more productive private companies. The share of bank lending to the private sector has shrunk by 80 percent since 2013. Despite the rapid growth in credit overall, the absolute amount of bank lending to private companies has also fallen sharply. This has reversed a long-term trend—the share of investment undertaken by private companies first plateaued and then fell in recent years. Similarly, whereas private industrial companies had previously expanded their output at twice the pace of their counterparts in the state-owned sector for more than a decade, since 2017 the situation has reversed.” Lardy warned that continuation of these trends will result in slower economic growth. He said that, this alone will cut annual growth by 2.0 percentage points, and that this will have significant consequences for the global economy.
As the shutdown of much of the US government continues (as of this writing), there is growing concern about the potential negative economic consequences. About 800,000 Federal workers are not getting paid, a fact that will have an increasingly disruptive impact on consumer spending and mortgage delinquencies. However, this is only part of the problem. The Federal government employs many outside contractors. Many contractors are small businesses that are becoming financially stressed as a result of the shutdown. The chief economist for the White House, Kevin Hassett, said that the impact of this will turn out to be greater than previously thought. He said that the shutdown will reduce economic growth by a tenth of a percentage point each week that it continues. He said, “We’ve been watching the actual effects and noticing that the impact that we see on government contractors is bigger than the sort of staff rule of thumb anticipated.”22 A Financial Times article quotes Jamie Dimon, CEO of the largest of the big four American banks, as saying that if the shutdown is sustained until March, there will be no economic growth in the first quarter.23
Meanwhile, the president of the New York Federal Reserve Bank, John Williams, concurred that the shutdown of the Federal government will have a negative impact on US economic growth.24 He said that depending on how long the shutdown lasts, it could cut annualized growth in the first quarter by between 0.5 and 1.0 percentage point. Past shutdowns were not especially consequential, but this one might be different because of how long it is lasting and how much uncertainty and pessimism there is about the duration of the shutdown. Many government agencies that are involved in the processing of private sector paperwork are unable to fulfil their duties in a timely manner. In addition, the Internal Revenue Service may be delayed in sending out tax rebates. And, of course, the government produces considerable data on economic activity. Without this data, the investment and business communities will lack the information that they often use to make key decisions. At the least, this will create the kind of uncertainty that is likely to boost market volatility. All of these factors could hurt consumer spending, increase consumer delinquencies, and create uncertainty for businesses that rely on government contracts.
Meanwhile, the longest shutdown in US history shows no signs of coming to an end. The president says that he will not agree to reopen the government until Congress funds a wall on the southern border. He is under intense pressure from like-minded pundits not to compromise with the Democrats in the House who firmly oppose a border wall. It is possible that this stalemate will not end until a sufficient number of Republican members of Congress break with the president due to pressure from their own constituents.
US President Trump is said to be seriously considering imposing tariffs on automobiles imported from Europe, according to a Senator close to Trump. Iowa Senator Chuck Grassley, who leads the committee that handles trade issues, said that tariffs on cars could be used as leverage in order to compel the European Union (EU) to reduce barriers to US agricultural products, an important issue in Grassley’s farm state of Iowa. Grassley said that he doesn’t favor tariffs but recognizes their value. Specifically, he said, “I think it would not necessarily be the best thing to do but I think the president is inclined to do it. I’m not in favor of tariffs, but they are a fact of life when Trump is in the White House. They may be an effective tool.”25
Recall that, in 2018, President Trump ordered an investigation into whether automotive imports represent a threat to national security. The Commerce Department must issue a report by February 17. If the report indicates that car imports threaten US security, then Trump would effectively have a green light to impose new tariffs. In a meeting in the summer of 2018 with EU Commission President Juncker, Trump agreed to put tariffs on hold while trade negotiations take place. The United States has pressured the EU to allow the inclusion of agriculture in the talks, but the original agreement between Trump and Juncker foresaw talks mainly about industrial products. Meanwhile, the EU has said that, if the United States imposes tariffs on cars without an exclusion for the EU, then there will be no more talks.
There appears to be a growing likelihood that the US Federal Reserve will shift gears and take a more cautious approach to monetary policy. This view is based on comments made by several Fed officials. First, a word on how the Fed is organized: The US Federal Reserve system is made up of a national Board of seven members as well as the presidents of twelve regional Federal Reserve banks. At any given time, five of those 12, along with the seven Board members, serve on the Federal Open Market Committee (FOMC) that decides monetary policy. Thus, the views expressed by the regional bank presidents is of interest to investors as they attempt to glean the likely path taken by the Fed. In recent days, several regional bank presidents have offered their thoughts, and a consensus appears to be building that the Fed ought to hold off on further action until there is greater clarity about the economic situation.26 This comes after three years of rate hikes that have lately contributed to financial-market volatility.
The president of the Chicago Fed, Charles Evans, says that the Fed ought to take its time before acting. He said, “Because inflation is not showing any meaningful sign of heading above 2% in a way that would be inconsistent with our symmetric inflation objective, I feel we have good capacity to wait and carefully take stock of the incoming data and other developments.”27 He added that “recent financial market developments and uncertainties regarding growth abroad, trade policy, and possible fiscal headwinds have cumulated to increase the downside risks.” Meanwhile, Eric Rosengren, president of the Boston Fed, said that he sees “reduced certainty” but remains optimistic about the outlook. Still, he said that “the appropriate stance for monetary policy is, for now, to not have a bias on moving policy in either direction until there is greater clarity around economic trends here and abroad.”28 He noted uncertainty about China, trade, and asset values as creating the conditions that warrant a policy pause. In addition, Raphael Bostic, president of the Atlanta Fed, said that “a patient approach to monetary policy adjustments in the coming year is fully warranted in light of the uncertainties about the state of the economy and about what level of policy rates is consistent with a neutral stance.”29 Finally, St. Louis Fed president James Bullard said that further rate hikes could cause a recession. He said that the recent decline in bond yields is “signaling that there might be some recession risk ahead” if the Fed raises rates.30 He added that the Fed is “bordering on going too far and possibly tipping the economy into recession.” He said that he believes the other members of the FOMC are moving in the direction of his thinking.
Meanwhile, the Fed itself released the minutes of the FOMC’s last meeting, which was held in December. The minutes state that “Many participants expressed the view that, especially in an environment of muted inflation pressures, the Committee could afford to be patient about further policy firming.”31 In addition, it said that “a relatively limited amount of additional tightening” is likely to be needed. However, the latest comments from Fed officials, noted above, suggest that FOMC members have since moved toward the view that no tightening is needed at the present time. The minutes indicate that Fed leaders are concerned about trade, especially in agriculture, and are also concerned about stress in financial markets. Although leaders expressed the view that the US economy remains strong, they also see downside risk emanating from these factors and, consequently, contributing to a possible pause in monetary tightening.
There are reports that the United States and China are making progress in trade talks aimed at averting new tariffs when a 90-day cooling off period ends on March 1.32 In fact, after two days of scheduled talks, the two sides agreed to extend the meeting to a third day. The Chinese seem eager to avoid new US tariffs, especially given evidence that the Chinese economy is already experiencing significant negative effects of the existing trade war. The US side also seems keen to avoid tariffs given that the drop in equity prices in recent months is seen as being related to investor worries about the trade war. Moreover, the weak performance of some US companies in China has attracted the attention of US officials. Kevin Hassett, the US administration’s chief economist, said recently that many US companies are going to see weakened performance because of the slowdown in China.33 He said that “there are a heck of a lot of US companies that have a lot of sales in China that are basically going to be watching their earnings be downgraded until we get a deal with China.” For its part, China has already boosted imports of soybeans from the United States and has pledged to take several other actions meant to assuage US concerns. These include boosting imports from the United States and not forcing US companies to transfer technology to Chinese companies. The United States wants China to reduce subsidies to state-run companies and to do more to protect intellectual property.34 Of course, the devil is in the details, and the United States is seeking greater specificity from the Chinese. Meanwhile, the US side has designated trade negotiator Robert Lighthizer as the point man for these talks. In the past, other administration officials have taken the mantle, including Commerce Secretary Ross and Treasury Secretary Mnuchin. But internal disputes within the administration and uncertainty about the president’s views hindered progress.35 The hope is that, given Lighthizer’s good relationship with the president, these talks will more likely be successful. At the same time, Lighthizer is said to be averse to an agreement that lacks teeth and is worried that others in the administration will be too eager to accept vague proposals from the Chinese.36 Meanwhile, others in the administration are said to be concerned that failure to strike a deal will likely mean a further decline in US equity prices.
As the US and China continue to seek agreement on trading arrangements, it is worth considering the impact of trade liberalization in this century. The US administration complains that cheap imports from China have led to job losses among US manufacturing workers. This is true. Yet there is another side to the story. About 40 percent of imports from China to the United States are components used to assemble final products. The surge of these relatively cheap imports following China’s accession to the World Trade Organization (WTO) two decades ago enabled US companies to reduce costs, thereby improving their global competitiveness. An analysis by a leading economist found that the US jobs created through this channel exceeded the number lost due to direct competition from Chinese imports.37 This helps to explain why many US manufacturing companies are complaining about tariffs on Chinese imports. Meanwhile, China’s accession to the WTO led to a unilateral dismantling of many trade barriers. Today, about half of China’s imports are tariff-free in those cases where the imports are components used to produce exportable products. This fact has helped to boost exports from the United States to China, which increased over 500 percent in the last two decades.
An analysis by a leading China expert found that the share of inbound investment into China that is subject to joint venture requirements has declined considerably in recent years.38 This means that a declining share of technology brought into China by foreign companies is subject to transfer to Chinese companies. The analysis finds that there remain a number of industries where forced technology transfer still takes place, but that the problem is far less onerous than in the past. Foreign ownership restrictions have been reduced substantially, especially in manufacturing. As the United States and China negotiate, one of the sticking points is the US insistence that China stop forcing US companies to transfer intellectual property to their Chinese partners. The latest analysis suggests that the problem is less acute than previously thought.
An analysis by the Federal Reserve Bank of New York found that the tariffs that have been imposed in the past year by the US government have increased the average effective tariff rate from 1.6 percent to 3.3 percent.39 The effect of this was to raise the average price of all consumer goods and services by 0.3 percent. That is the short-term effect. The longer-term effect could be greater, especially if tariffs are increased further if and when US/China negotiations fail. At the same time, the longer-term effect could involve companies shifting the location of production in order to avert tariffs. The analysis found that 12 percent of total US imports were affected by the new tariffs and that 10 percent of imports are now subject to tariffs in excess of 10 percent. Previously, only 4 percent of imports were taxed at more than 10 percent. The larger impact of tariffs, however, has likely been the chilling effect they have had on business investment, especially due to uncertainty about future trading arrangements.
They say that demographics is destiny. If so, the latest fertility data for the US could suggest a troubled destiny. The US birth rate has fallen to the lowest level since 1950 and, since 2008, has been below replacement level.40 That means that, in the absence of immigration, the population will ultimately decline as it gets older. Moreover, the US birth rate is now below those of France and Russia. What is especially interesting is the ethnic mix of birth rates. Since the early 1980s, the birth rates of most racial categories have been lower than the replacement rate. The one glaring exception was the birth rate for Hispanic women, which was relatively high. That has changed, dramatically. In recent years, the birth rate for Hispanic women fell sharply, to below the replacement level. Thus, birth rates for white, black, Asian, and Hispanic women are all now below replacement level. What does a low birth rate imply? First, the birth rate is now below the most pessimistic scenario of the Social Security Trust Fund. In other words, in the absence of a surge in immigration, America’s system of providing pensions for the elderly will face severe stress in the not-too-distant future. Second, without a surge in immigration or productivity, the economy will likely grow more slowly in the future than previously expected. As of this writing, the US government is shut down because of a dispute about immigration. Thus, it is worth considering the larger consequences of the immigration policy.
The year 2018 was rough for investors, especially during the month of December. In fact, US equities fell more in December 2018 than in any December since 1931 during the Great Depression. For all of 2018, investors made little money, with markets performing worse than at any time in the last decade.41 Yet equities and commodities had actually started the year on a positive note. Rising asset prices reflected optimism about the global economy, especially after the US tax cut. Investors expected that the US fiscal stimulus would cause a boost to US economic growth, add to US corporate profits, and stimulate US demand for the world’s exports. Moreover, they expected that easy monetary policy in major markets would keep economies humming. Yet as the year progressed, something went wrong, leading to a decline in equities and commodities. At the same time, a decline in expectations of inflation in the United States led to a drop in bond yields and a commensurate rise in bond prices. What led to the sharp change in the direction of asset prices?
First, the US administration launched a trade war in March, starting with tariffs on imports of steel and aluminum. In addition, the United States imposed significant tariffs on imports from China, threatened tariffs on imported automobiles, and engaged in a lengthy and uncertain negotiation to revise the North American Free Trade Agreement. The trade war, and the consequent uncertainty, had a chilling effect on investment and, ultimately, on trade flows. This led to investor pessimism about the outlook for globally oriented companies and for the demand for traded goods as a consequence of tariffs.
Second, the global economy appeared to decelerate in 2018. Growth in Europe, China, and several key emerging markets slowed.42 In Europe, political fragmentation created fears about the future of the Eurozone. In Britain, investors worried about the consequences of a no-deal Brexit. Meanwhile, the Japanese economy appeared to stall. Currency crises in Argentina and Turkey are causing recession in these countries, and policy responses to currency depreciation in other countries caused investors to expect a slowdown in growth.
Third, although the massive US economy did accelerate initially after the tax cut, it was likely short lived. By the third quarter, growth remained strong, but largely due to consumer spending and inventory accumulation. Meanwhile, business investment and exports stagnated.43 In addition, a rise in bond yields weakened the housing market and rising short-term interest rates alarmed investors, leading to weaker credit market conditions.
So, what happens next? I always say that, if I could accurately and consistently predict asset markets, then I’d probably own a private island in the Bahamas. Therefore, rather than offer a firm prediction I’ll provide the points of view of optimists and pessimists.
The pessimistic view is that the global economy has peaked and is now heading south. The slowdown in Europe and China will not soon be reversed, despite easy monetary policy, especially as trade concerns continue to stifle investment. Moreover, the United States has peaked and, with a likely further tightening of monetary policy and an imminent reversal of fiscal stimulus, is likely to see much slower economic growth. The recent sharp decline in inflation expectations suggests investors expect slower growth. The pessimistic view is also that the trade war will worsen, with the United States and China failing to find common ground. This view is that, with the US trade deficit actually rising due to strong domestic demand, the US administration will be frustrated at a lack of progress and will, likely impose new tariffs on China, thereby reducing consumer purchasing power and stymying growth of trade. Finally, the drop in energy prices, combined with higher interest rates, will likely create credit market problems in rich countries and more currency crises in poorer countries. The pessimistic view suggests the possibility of a further drop in asset prices.
The optimistic view, on the other hand, is that policymakers will respond to changed circumstances and avoid a downturn. The fact that inflation expectations in the United States have fallen sharply means that the Federal Reserve might choose to delay further interest rate increases, thereby giving the economy some breathing room. Indeed, the futures markets now say that investors see a 90 percent chance of no interest rate increases in 2019.44 Moreover, the US Congress could choose to avert an impending tightening of fiscal policy. The trade war might not worsen, especially if the US administration chooses to accept a modest deal with China and declare victory. Indeed, it has been reported that the US trade negotiator, Robert Lighthizer, is actually worried that this will happen.45 Finally, the optimistic view is that Europe’s economy will be stable amidst continued easy monetary policy and easing fiscal policy. The view is also that China’s authorities, through the use of monetary and fiscal policy, will be successful at stabilizing the Chinese economy and avoiding a further slowdown. The optimistic view suggests that assets might currently be undervalued.
Shares in major global consumer-oriented companies took a beating last week when some companies announced weak performance in the massive Chinese market. Global companies in such industries as telecoms, automobiles, and luxury fashion all announced weak results.46 Moreover, the weakness of these companies is consistent with other information suggesting a weakening Chinese economy. Official retail sales statistics have been especially poor, with November sales increasing at the slowest pace since 2003.47 However, many observers, including some of China’s leaders, are often suspicious of official data.48 So they look to private sector data in order to glean trends in the economy. For example, the automotive industry reports weak demand in China, with sales down roughly 15 percent in November versus a year earlier.49 It appears that Chinese consumers are increasingly averse to big ticket purchases.
Meanwhile, shares in Asian companies that supply US-based companies also took a beating. In addition, the latest purchasing manager’s index (PMI) for Chinese manufacturing indicated declining activity. Similarly, PMIs for South Korea, Taiwan, and Singapore also signaled declining activity.50 Many observers said that the trade war between the United States and China was, in part, responsible. The argument has been made that the uncertainty engendered by the trade war has affected consumer willingness to spend. It has certainly had an impact on business investment on both sides of the Pacific Ocean.
Other factors have also had a negative impact on consumer spending in China. These included the lagged effect of Chinese official efforts to stem a housing market bubble by tightening credit conditions, as well as efforts to stem the rise of private sector debt.51 Lately, however, China’s authorities have eased credit market conditions and boosted infrastructure spending, in part due to concerns about the negative impact of the trade war. Despite these efforts, the economy has not yet rebounded.
As China’s consumer economy decelerates, it could have global implications. China is the largest market in the world for many important products including automobiles, mobile phones, and luxury fashion goods, among others. Weak sales will affect the fortunes of many global companies and will likely have significant spillover effects on suppliers of components and commodities in multiple countries. Weak demand in China could have a negative impact on the exports of other countries. A further intensification of the trade war might worsen the situation. Meanwhile, concern about the state of China’s economy likely played a role in the global decline in equity prices last week. In addition, bond yields in major markets fell, signaling investor belief that inflation is likely to wane and growth is likely to decelerate.
Amidst global concern about the uncertain state of the Chinese economy, China’s central bank, the People’s Bank of China (PBOC), announced last week new measures aimed at reviving the massive Chinese economy.52 Specifically, the PBOC said that it will cut the required reserve ratio for commercial banks by 0.5 percent in mid-January and another 0.5 percent in late January. These actions are expected to pump 1.5 trillion renminbi (about US$210 billion) into the banking system, enabling banks to significantly increase their lending. The PBOC also took steps meant to target increased lending to smaller businesses. This comes following an earlier easing of monetary policy as well as a recent decision by the government to increase the amount of debt that local governments are allowed to issue for the purpose of infrastructure investment. The latter is part of a more aggressive fiscal policy meant to stimulate the economy.
These measures are reminiscent of past actions by the government meant to offset external headwinds. In this case, the headwinds are coming, in part, from the trade dispute with the United States. In response to the latest action, Chinese equities increased strongly. In addition, investors likely reacted positively to news that the United States and China will resume direct trade talks next week. Also, investors were likely pleased by news that the PMI for the Chinese services sector increased in December, indicating faster growth of the services sector.53 This was welcome news at a time when many other indicators suggest a worsening economy.
Markets are now pricing in a 30 percent probability that the US Federal Reserve will actually cut interest rates in 2019.54 This is a dramatic change from just a few months ago when the perceived probability was zero. The probability of no rate change is now 60 percent. This means that investors believe that the Fed will change from its stated intentions due to slowing growth and declining inflation. Indeed, the head of the Federal Reserve Bank of Dallas, Robert Kaplan, referring to uncertainty about the state of the global economy, said, “We should not take any further action on interest rates until these issues are resolved, for better, for worse. So I would be an advocate of taking no action and—for example—in the first couple of quarters this year, if you asked me my base case, my base case would be take no action at all.”55 Although Kaplan is not currently sitting on the policy committee, he is said to be close to Chairman Powell. Meanwhile, the yield on the US government 10-year bond fell to 2.57 percent today, the lowest rate in almost a year. This decline has largely resulted from a sharp drop in measured expectations of inflation. Such expectations have fallen because of declining energy prices and a rising dollar, but also because of concerns about slowing economic growth.
Although investors are concerned about the outlook for the US economy, it is clear that the job market remained exceptionally strong in December. The US government reports that there was very strong job growth, a large increase in the number of people participating in the labor force, and a significant acceleration in wages.56 The government provides two reports; one based on a survey of establishments, the other based on a survey of households. Here is what these surveys revealed.
The establishment survey found that 312,000 new jobs were created in December, the biggest increase since February of 2018. This was far in excess of the number required to absorb new entrants into the labor force. As such, it indicates a further tightening of the labor market, auguring for more job shortages. There was strong job growth in construction, manufacturing, retailing, professional and business services (such as Deloitte), health care, and leisure and hospitality. The tightening of the labor market, not surprisingly, led to a further acceleration in wages. Average hourly earnings were up 3.2 percent from a year earlier, the fastest wage gain since 2009. Wages were up 0.4 percent from the previous month. Still, wage gains are not much higher than the rate of inflation.
The separate survey of households indicated very strong growth in labor force participation, with the participation rate increasing by 0.2 percentage points. Although job growth was strong, it was not as strong as the growth of the labor force. Consequently, the unemployment rate increased from 3.7 percent in November to 3.9 percent in December.
Investors greeted the positive news about job growth by pushing up equity prices substantially, both in the United States and globally. Commodity prices and bond yields also increased. Investors were also pleased by news that China’s government will take new steps to stimulate the Chinese economy. Finally, investors likely approved of a comment made by Federal Reserve Chairman Powell in which he said that the Fed would “watch to see how the economy evolves” as it deliberates on policy.57 This suggests the possibility that the Fed will veer away from its previous plans to gradually raise interest rates.