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What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Last week, the US Federal Reserve announced that it will keep the benchmark interest rate unchanged, a decision that was not unanimous. The Fed also said that it is amenable to cutting interest rates in the months to come.1 Fed Chairman Powell indicated that, at the time of the next Fed policy meeting in late July, there will be plenty of new information that will enable it to make an informed decision. Not only will there be new information about employment and inflation, but the G20 Summit would have taken place and the world would know if the United States and China reached an accord regarding their trade dispute. In defending the decision not to cut rates, Powell said, “We felt it would be better to get a clearer picture of things and that we will learn a lot more about these developments in the near term. Ultimately, the question we will be asking ourselves is: ‘are these risks continuing to weigh on the outlook?’” However, addressing worried that the Fed will not take sufficient action, Powell said, “We will act as needed, including promptly if that is appropriate, and use our tools to sustain the expansion.” One Fed Governor, James Bullard of the St Louis Fed, dissented from the decision not to cut rates. Moreover, about half of the other members of the committee predicted that the Fed will cut rates this year. Meanwhile, the futures market now has an implied 76 percent probability of at least one rate cut this year.
The greatest uncertainty concerning the future path of the Fed has to do with the trade war. For example, the probability of a rate cut will likely increase if the United States and China fail to reach an agreement and high tariffs are implemented—and vice versa. Another area of uncertainty, or at least perplexity, is the fact that, despite an historically low unemployment rate in the United States, wage behavior has remained muted. In the past, such low unemployment would likely have led to an inflationary surge in wages, thus compelling the Fed to continue tightening monetary policy. Clearly, we’re in a new world. Powell said, “What’s a little surprising is that you could reach these levels of unemployment, long into a cycle, and not see even higher wages that are pushing up on inflation. We’re very careful about not assuming that there’s no more slack in the labor market.”2 Indeed, the participation rate remains relatively low, thus enabling a rise in employment that does not drive much higher wages.
Investors were evidently pleased with the expected future trajectory of Fed policy.3 The yield on the 10-year US government bond briefly fell below 2.0 percent as investors interpreted the Fed’s words as auguring very low inflation. The yield on the bond is now the lowest since prior to the election in 2016. The value of the US dollar fell and the Chinese renminbi rose. US equities hit a record high as investors assigned a lower discount rate to the present value of expected future corporate earnings. Chinese equities rose as well, due to both US monetary easing and hopes that the upcoming meeting between US President Trump and Chinese President Xi will be productive and lead to an easing of trade tensions. European equities were up as well. Although many investors were clearly happy with the Fed’s words, it is worth noting that the sharp drop in US bond yields not only reflects expectations of low inflation, but expectations of slow economic growth. Investors are happy that the Fed is expected to take steps to mitigate the slowdown, but they are also cognizant of the fact that a slowdown is likely under way.
Meanwhile, the US Federal Reserve was not the only central bank to make news. At a conference in Portugal, European Central Bank (ECB) President Mario Draghi indicated that the ECB may ease monetary policy in the near future in order to revive the Eurozone’s moribund economy.4 His comments led to a sharp drop in the value of the euro and a rise in European equity prices. US President Trump criticized Draghi’s words, saying that the drop in the value of the euro will make it “unfairly easier for them to compete against the USA.” It can be argued, however, that an easing of Eurozone monetary policy should be welcome by the United States as it might help to mitigate the global slowdown. More importantly, Draghi’s words, combined with the words coming from the US Federal Reserve, suggest that we’re now entering a period of synchronized easing of monetary policy in the world’s major economies. Likewise, monetary policy has been eased in China. This reflects the fact that the world has seen a synchronized downturn in economic growth as well as continued and unusually low inflation. Central banks used to spend most of their time worried about keeping inflation in check. Now they struggle to keep inflation sufficiently elevated while being increasingly focused on avoiding stagnant growth.
At a time when the United States is implementing or threatening to implement restrictions on trade with multiple partners, other countries are seeking to boost trade with one another in order to offset the potential loss of trade with the United States. Thus in the past two years, we have seen a free trade agreement between the European Union (EU) and Japan as well as one between the EU and Canada. Now comes word that the EU and Mercosur are on the verge of a major free trade agreement.5 Mercosur is a customs union comprising five South American countries—Argentina, Brazil, Paraguay, Uruguay, and Venezuela. The EU and Mercosur have engaged in talks for roughly 20 years and are now said to be close to finalizing a deal. The deal will involve sizable reductions in tariffs, including EU reducing tariffs on agricultural goods from Mercosur and Mercosur reducing tariffs on automobiles from the EU. Both issues could be politically explosive. The degree to which tariffs are set to decline will be greater than what happened when the EU signed free trade deals with Japan or Canada. That is because the pre-trade deal tariffs in the case of South America are very high compared to the pre-trade deal tariffs of Japan or Canada. The two sides are eager to resolve remaining issues prior to the upcoming election in Argentina, which could result in the election of a populist and anti-trade government.
Singapore has one of the world’s most successful economies, in large part because of its openness to trade and cross-border investment. Yet Singapore is now falling victim to a combination of weakening global demand and the uncertainty brought on by rising trade tensions. It is reported that, in May, Singapore’s nonoil exports fell 15.9 percent from a year earlier.6 This data excludes the impact of re-exports of goods that pass through Singapore as a trans-shipment hub. Rather, the data indicate that goods produced in Singapore are not being sold to the rest of the world at nearly the same pace as a year ago. The drop was the worst performance since March 2016. Exports to China were down 23.3 percent, exports to Hong Kong were down 24.8 percent, exports to Taiwan were down 34.7 percent, and exports to Japan were down 31.2 percent. At the same time, exports to the United States were up 0.2 percent. The decline in Singapore’s exports was especially pronounced in the critical electronics sector, where exports were down 31.4 percent from a year earlier. These figures demonstrate the degree to which the trade dispute between the United States and China is spilling over into the performance of other East Asian economies. Singapore produces high-value electronic components that are shipped to China and other East Asian countries for processing into final goods, many of which are destined for the United States. The current tariffs and threatened US tariffs are likely having a chilling effect on purchases of such components, either by Chinese companies or by companies in other countries that produce inputs that ultimately wind up being processed in China. Moreover, the sharp drop in Singapore’s exports of electronics suggests that a broad-based decline in activity in the global technology sector is likely already under way. Finally, according to the World Bank, Singapore’s exports of goods and services was about 173 percent of GDP in 2017.7 Thus, threats to Singapore’s export prowess can potentially be quite serious.
In response to the US decision to remove India from its program of trade preferences for emerging economies, India is boosting tariffs on US imports. Specifically, India is boosting tariffs on 20 categories of imports from the United States effective immediately.8 The United States has complained about India’s restrictions on various categories of imports from the United States as well as India’s restrictions on foreign direct investment by US companies. It has said that India’s renewed participation in the Generalized System of Preferences will, going forward, be contingent on India removing barriers to US goods. Meanwhile, the United States is also unhappy about the purchase of Iranian oil by India as well as its plans to purchase military equipment from Russia. These areas of dispute come at a time when the United States has also sought to enhance its relationship with India as a means to offset the rising influence of China in the Asia-Pacific region. Thus, the trade dispute between the United States and India could possibly undermine the geopolitical relationship that has been blossoming for the past decade and a half.
In the 19-member Eurozone, economic activity has decelerated and inflation has remained muted, thus compelling the European Central Bank (ECB) to contemplate an easing of monetary policy. However, one indicator of strength is the job market, where the job vacancy rate has increased and wages have accelerated considerably—the latter suggesting that the job market is tightening. The European Union reports that, in the first quarter of this year, the job vacancy rate (the share of available jobs that remain vacant) rose to 2.3 percent.9 This is the highest rate since the EU started keeping records in 2006. In professional, scientific, and technical activities, the vacancy rate also hit a record high of 3.6 percent. These numbers suggest a tightening of the job market, this despite the fact that in several countries unemployment remains relatively high. Not surprisingly, the vacancy rate was higher in countries with low unemployment rates. For example, the vacancy rate was 3.3 percent in Germany and 3.6 percent in Belgium, but only 0.9 percent in Spain and 0.6 percent in Greece. The highest vacancy rate in Europe was in the Czech Republic at 6.4 percent, which also has the lowest unemployment rate in Europe.
Also, the EU reports that, in the first quarter, total labor costs were up 2.4 percent from a year earlier, including a 2.5 percent increase in wages.10 The latter figure was the highest in 10 years. Wage gains varied by country. Wages were up 2.7 percent in Germany, up 2.4 percent in France, up 1.5 percent in Italy, up 4.7 percent in Spain, and down 0.1 percent in Greece. The sharp rise in Spain was a bit of an anomaly given Spain’s relatively high unemployment rate. Not surprisingly, the Czech Republic saw wage gains of 8.7 percent. It is interesting that, despite accelerating wages, Europe is not experiencing an acceleration in inflation. This suggests that labor productivity is accelerating as well. That is, if worker output per hour rises, then accelerating wages can be absorbed by employers without the need to significantly raise prices.
The United Nations (UN) issued its latest forecasts on global population, and there are some interesting insights.11 Of course, population predictions are fraught with risk, especially when predictions go beyond a 10-year time frame. Still, they do provide a useful roadmap about where the world is heading. The latest report says the following:
Global population continues to grow, but at an unusually low rate. The growth rate last year was lowest since the UN started collecting date in 1950. Moreover, the rate of growth is expected to decline further in the coming years. This reflects very low birth rates in developed economies as well as many emerging economies.
In the next 40 years, global population will rise by about 2 billion from 7.7 billion now. One quarter of that growth will be attributable to just India and Nigeria alone. Half of the growth will be attributable to nine countries, which are (in order) India, Nigeria, Pakistan, Democratic Republic of the Congo, Ethiopia, Tanzania, Indonesia, Egypt, and the United States. The United States is the only developed economy that is expected to make a significant contribution to global population growth, despite a very low birth rate. This expectation largely reflects historic trends in the United States on immigration that are expected to be sustained.
By 2050, Nigeria’s population will double to 400 million and the country will replace the United States as the world’s third most populous country. India will be number one and China number two. Nigeria’s surge is part of a larger surge in Africa’s population. By the middle of this century, it is expected that Africa’s population will still be growing even as Asia’s population starts to decline. Thus, Africa’s relatively role in the global economy is expected to increase significantly. The degree to which this is true will, of course, depend on how fast per capita income grows. In recent years, Africa’s economic growth has accelerated significantly from the patterns seen in most of the post-war era. If this is sustained, Africa will, in a sense, be the next China.
Looking at a shorter time frame, by 2030, the global population will rise by about 800 million from where it is today, of which almost half the increase will be in Africa. It is expected that there will be no increase in the combined population of Europe and North America.
China’s economy showed further signs of weakness in May as the government released several data points.12 The trade war is the critical backdrop for this. Specifically, here is what the government reported.
Industrial production in China grew 5.0 percent in May versus a year earlier, down from the previous month and the slowest rate of growth since February 2002. The manufacturing component of industrial production was also up 5.0 percent, also a deceleration from recent months. With new US tariffs coming into effect and others threatened, the Chinese manufacturing sector is likely to experience further stress in the months ahead.
Fixed asset investment for the first five months of the year was up 5.6 percent from the same period a year earlier. This was the slowest growth since September of last year. Residential investment decelerated as did sales of new homes.13 Moreover, the government reported that, by mid-year, there was a sharp slowdown in inbound US foreign direct investment (FDI) into China, likely due to trade uncertainty. However, overall inbound FDI accelerated modestly in May, with an especially big increase in FDI by the technology services sector.
Retail sales in China revived somewhat in May. After growing at a 16-year low of 7.2 percent in April, retail spending grew 8.6 percent in May versus a year earlier.14 However, many analysts noted that shopping for the Labor Day holiday might have boosted the May numbers. The May growth was still below that of March. Meanwhile, sales of vehicles were down 16.4 percent in May versus a year earlier. This was the eleventh consecutive month of declining sales.
Exports revived in May, growing a modest 1.1 percent. However, this was largely attributed to anticipatory purchases in the United States to avoid upcoming tariffs. Separately, Chinese imports fell sharply, down 8.5 percent from a year earlier. This was seen as an indication of weak domestic demand.
Chinese bank lending grew in May, but only modestly.15 Many analysts cited concerns about the trade war with the United States as having a stifling effect on lending, especially lending to businesses, which was flat. Evidently the easing of monetary policy by the People’s Bank of China (PBOC) has not yet led to a significant rebound in credit creation, although monetary policy tends to work with a lag. There is now debate as to whether further easing might be needed, especially if the US Federal Reserve cuts rates, which is now widely anticipated. Meanwhile, inflation in China accelerated, largely due to a shortage of pork stemming from an outbreak of African swine fever.16 Given that the surge in inflation to the highest rate in 15 months was due to a one-off factor, it is not likely that the PBOC will hold off on easing policy. The PBOC likely sees underlying inflation as being controlled.
Meanwhile, China’s government has implemented a series of measures to stimulate investment by regional governments.17 The idea is to boost growth at a time when the economy faces headwinds from trade wars. Yet there is debate about whether these measures will have a significant impact on growth. Moreover, there is concern that the measures will likely add to the problem of nonperforming debt. Specifically, the government is easing restrictions on how local governments can spend the proceeds from the sale of bonds; it is also allowing local governments to borrow from banks to fund infrastructure projects without having to be concerned about limits on debt. These moves are meant to enable local governments to raise money for ongoing projects at a time when their tax revenue has been reduced because of a cut to the value added tax. These moves are expected to modestly boost overall infrastructure spending which, in turn, should have a modest positive impact on economic growth. The government claims that these measures will not increase financial risk as the new bonds must be used for projects that are expected to have a positive return.18 However, presumably that was true of past projects that lost money.
The head of China’s central bank, Yi Gang, says that China has plenty of tools to offset the potential negative impact of the trade war with the United States. As such, he appears to be unconcerned if the two sides fail to achieve an agreement at the upcoming summit between the two presidents. Yi said, “We have plenty of room in interest rates, we have plenty of room in required reserve ratio rate, and also for the fiscal, monetary policy toolkit, I think the room for adjustment is tremendous.”
Retail sales in the United States grew at a moderately healthy pace in May, but the longer-term trend remains weak.19 In May, retail sales were up a strong 0.5 percent from the previous month and were up a modest 3.2 percent from a year earlier. In the last six months, annual growth of retail sales was in a relatively modest range compared to the last three years. This kind of weak growth has not been sustained since early 2016. Still, May was a good month overall. Yet the strength of growth was due largely to a few components of retailing spending: automotive sales, electronics, restaurants, and sales by nonstore retailers. Sales at automotive dealers were up 0.7 percent for the month, electronics stores up 1.1 percent, restaurants up 0.7 percent, and sales of nonstore retailers were up 1.4 percent. In contrast, sales growth was weak at several other types of retailers, including furniture stores (up 0.1 percent), home improvement stores (up 0.1 percent), grocery stores (unchanged), clothing stores (unchanged), and department stores (down 0.7 percent). Although the overall number was good, it is too early to say that the retail market has turned the corner.
According to the University of Michigan, there was a sharp drop in consumer sentiment in June, although the overall index remains at a relatively elevated level.20 The survey authors indicate that one of the principal reasons for the decline was concern about tariffs. They said that, when interviewed, 40 percent of respondents spontaneously referred to tariffs without being prompted when asked about why their expectations for the future had dropped. On the positive side, purchasing plans on the part of consumers improved, and consumer expectations for inflation remain the lowest in the history of the survey. Thus, the overall picture is not bad, but the consumer concern about potential tariff increases suggests that consumers are paying attention to the news and are cognizant of the potential negative impact of tariffs.
Industrial production in the United States grew a bit more rapidly in May than in recent months, with output up 0.4 percent from the previous month.21 That was the best performance since November. However, output was up only 2.0 percent from a year earlier, which was the second slowest rate of growth since early 2017. The manufacturing component of industrial production grew slowly, up 0.2 percent for the month and up only 0.7 percent from a year earlier. The latter figure was consistent with the experience of the last few months. Thus, the manufacturing sector appears to be weak, in part due to the chilling effect of the trade war. The stronger overall growth of industrial production was mainly due to the mining and utilities sectors. Mining output barely grew from a month earlier, but was up 10 percent from a year earlier. This reflects the boost to oil and gas production. Utility output was up strongly for the month, possibly due to weather. Meanwhile, the ratio of inventories to sales for the broad business sector has lately been rising after having steadily fallen from early 2016 until mid-2018.22 The rise means that businesses are producing more than they can sell. This is often an indication that businesses will soon have to cut back on production. It is an early warning sign of a slowdown. That being said, the ratio remains at a relatively modest level.
Consumer price inflation in the United States appears to be abating. In May, consumer prices were up only 0.1 percent from the previous month and up 1.8 percent from a year earlier.23 When volatile food and energy prices are excluded, core prices were up 0.1 percent for the month and up 2.0 percent from a year earlier. The latter figure matched the lowest figure since early 2018. Thus, it appears that underlying inflation is cooling. This follows news that, in May, producer prices rose at the slowest pace in two years. That bodes well for continued weak consumer price inflation. Clearly, this will be a key factor in the deliberations of the Federal Reserve. Meanwhile, wage growth was modest in May, despite a very tight labor market.24 Average hourly earnings were up 3.1 percent in May versus a year earlier, slower than in the previous month. When adjusted for inflation, real average hourly earnings were up 1.3 percent from a year earlier, roughly in line with the experience of the last few months. Thus, real consumer purchasing power continues to rise at a modest and stable pace.
Unless it turns out that the United States is already in recession (unlikely), the current economic recovery is now the longest in US history.25 Just to be clear: this means that the country has experienced an uninterrupted expansion in real GDP for 10 years, which has never happened since economists started collecting data long ago. Actually, expansions have been much longer, on average, during the last 40 years than before. There are a number of explanations. These include the fact that a larger share of economic activity involves less cyclical services and that we’ve been in an environment of persistently low inflation despite a tight labor market, thereby not requiring dramatic action by the Federal Reserve.
Why has this particular expansion been so long? One explanation is that it has been relatively slow, thereby not generating the kinds of inflationary pressures and bottlenecks that, in the past, led the Fed to tighten quickly. Another explanation is that this recovery has been led by the development of technologies that are disinflationary. Also, the last recession was so bad that it took a long time to get back to full employment. Going forward, however, the US economy faces considerable headwinds, not the least of which is the current unprecedented and unpredictable trade war. Recoveries don’t necessarily die of old age, but this one now faces serious problems.
In the Eurozone, many countries have experienced sizable declines in long-term bond yields at a time of weak inflation and weak economic growth. The one exception is Italy, where bond yields, although having dropped modestly, remain relatively high. This likely reflects the impact of the ongoing dispute between Italy’s government and the European Union (EU) about the size of Italy’s budget deficit. It also reflects the fact that Italy’s economy is barely growing and is not expected to grow much faster. Many investors are worried about the risk that growing Italian sovereign debt entails. Indeed, the cost of insuring against default (using credit default swaps, or CDS) is relatively high in Italy. Moreover, there are two kinds of CDS contracts. The old one did not insure against a change in the currency denomination of the debt. The newer contracts do provide such insurance. The gap between the prices of the two contracts has lately widened significantly, indicating that investors have increased their expectation that Italy will exit the Eurozone and return to the lira. Thus, the high yield on Italian debt, in part, reflects perceived risk that Italy will leave the Eurozone.26 And, if Italy were to actually leave the Eurozone, it is likely that it would be compelled to leave the EU.
Meanwhile, it is reported that Italy’s government is considering paying creditors with IOUs rather than euros. The left-right governing coalition is thinking about this as a solution to its fiscal problems. The head of the right-leaning League, Matteo Salvini, said, “One can debate the instrument…it’s a proposal. But the urgent need to pay the tens of billions of euros of public-administration arrears to companies and families should be clear to all.” Yet the centrist and technocratic Finance Minister Giovanni Tria has resisted this idea. He says that doing this would be tantamount to creating new debts for the government. The government currently has arrears of 53 billion euros, the highest of any country in Europe.
Industrial production in Europe has weakened considerably.27 In the 19-member Eurozone, output was down 0.5 percent from March to April and was down 0.4 percent from a year earlier. For the larger 28-member European Union (EU), output was down 0.7 percent for the month and down 0.1 percent from a year earlier. Notably, in the Eurozone output of capital goods was down 1.4 percent from a month earlier and down 1.2 percent from a year earlier. This likely bodes poorly for business investment in the months to come. Performance varied by country. From a year earlier, overall output was down 3.4 percent in Germany, up 1.0 percent in France, down 1.5 percent in Italy, up 1.4 percent in Spain, up 6.9 percent in Ireland, down 2.7 percent in the Netherlands, up 6.6 percent in Poland, and down 2.4 percent in the United Kingdom. Overall, the picture painted by this data is consistent with other indicators pointing to a very weak European economy. It is no wonder then that the European Central Bank has signaled amenability to an easing of monetary policy this year. While the Eurozone does not appear to be at risk of imminent recession, it is clearly vulnerable should the United States fall into recession.
Indian officials, business leaders, and economists have been happy to note that India is currently the fastest growing large economy in the world. But is it really? Arvind Subramanian, a well-known academic economist and former advisor to the Indian government says that, in the period 2011–17, the government overestimated the rate of growth.28 Rather than growing at a rate of 7 percent, Subramanian says that it is more likely that the Indian economy grew at a rate of about 4.5 percent. He says that a change in the methodology used by the government to estimate GDP growth was flawed. He says the new method led the government to understate inflation, thereby overstating real growth. Subramanian is not the first leading economist to raise questions about the government’s methodology. However, given that he was a senior advisor in the current government, his words carry considerable weight. If India indeed grew more slowly than previously thought, it raises questions about the level of income, the degree to which the government can invest in infrastructure and human capital, and the degree to which India is catching up to China. It also challenges the credibility of the current government in claiming a successful economic policy.
The latest employment report from the US government suggests a slowdown in the job market, but it is too early to tell whether this is a reflection of the weakening economy or simply being caused by tightening of the job market. The government releases two reports: One based on a survey of establishments and the other based on a survey of households. Here are some details from the reports:
The establishment survey indicated that only 75,000 jobs were created in May.29 This is less than the 100,000 mark generally considered as necessary to absorb new entrants into the labor market. It was the smallest gain since February and the second smallest since late 2017. Of course, monthly numbers are often volatile and don’t tell the complete story. However, the government downwardly revised job growth for March and April.30 The result is that, in the past three months, average job growth was 150,000, well below the average level of 223,000 seen in 2018.
One could argue that if the slower growth is due to tightness in the labor market, then this should be reflected in a surge in wages. However, this is not the case. In fact, wage growth has eased, with average hourly earnings up only 3.1 percent in May versus a year earlier. Still, wage behavior has been odd and inexplicable for some time. Wages ought to have accelerated a long time ago given that labor market tightness has been extant for a while. Thus, wage behavior doesn’t tell us much at the moment. What we do know is that other indicators of economic activity have decelerated. So, even if problems in the job market are absent, it is clear that the economy is weakening. Now, add the trade war and there is reason to be concerned—which is why the Federal Reserve is considering easing monetary policy. As for job growth, there were only three categories that saw moderately strong gains. These were professional and business services (such as Deloitte), health care, and leisure and hospitality.
The household survey didn’t offer much new insight.31 It indicated moderate growth in employment and participation, with the participation rate remaining unchanged. In addition, the unemployment rate remained unchanged at 3.6 percent, the lowest in half a century.
Bond yields fell in response to the job market news, with the inversion of the yield curve intensifying as investors clearly feel that the job numbers validate their concerns about growth.32 It is worth recalling that a sustained inversion of the yield curve is a reliable predictor of recession. The yield on the 10-year Treasury bond approached 2.0 percent and hit the lowest level since before the US Congress passed the tax cut in late 2017. The dollar fell in value as well. However, equity prices in the United States and elsewhere rose strongly on expectations that the Federal Reserve will cut interest rates, perhaps as soon as July. Outside the United States, bond yields fell in Germany and Japan, with the 10-year bonds in both countries now well below zero.
For some time now, US President Donald Trump has made it clear through public statements that he wants the Federal Reserve to cut interest rates. It now appears increasingly likely that he will get his way, in part due to his own actions.33 That is, the uncertainty created by his trade policy has substantially increased the futures market’s implied probability of a rate cut this year. In the past, when expected future short-term rates were lower than existing rates (which is the case now), a recession usually followed soon. In other words, the expectation that the Fed will cut rates usually takes place when the economy is truly at risk of recession. Meanwhile, Fed Chair Jerome Powell, while referring to the growing trade disputes between the US and its trading partners, said, “We do not know how or when these issues will be resolved.34 We are closely monitoring the implications of these developments for the US economic outlook.” He said that the Fed would “act as appropriate to sustain the expansion.”
Powell’s comments, which were interpreted as implying a possible rate cut, came after two other Fed officials, James Bullard and Richard Clarida, hinted that interest rates might need to be cut. Bullard, who is the president of the Federal Reserve Bank of Chicago, said that he thinks rate cuts will be warranted this year. He added that the inversion of the yield curve, combined with the administration’s trade policy, suggest that the economy is at risk. He also said “the narrative on global trade has darkened,” adding, “monetary policy looks too restrictive in this environment. That has usually been a bad sign for US economic prospects.” Meanwhile, Fed Vice Chair Clarida said that cutting rates might be necessary, although he added that the economic outlook remains favorable.
After Powell’s comments, bond yields fell, equity prices rose, and the implied probability of a rate cut increased. In fact, the futures market now faces a one-third probability that there will be three rate cuts in 2019. Going forward, an important question is whether easing the monetary policy would be suffice in offsetting the negative impact of trade restrictions with a view to avoid a recession. If all the proposed tariffs on China are implemented by the end of the year, it is likely that the negative impact on the US economy would be substantial. It would effectively be a tax increase, which would more than offset the tax cut enacted in late 2017. The earlier tax cut disproportionately benefitted upper-income households. Yet tariffs will disproportionately hurt lower- to middle-income households through the expected increase in prices for consumer goods. And although the 2017 tax cut involved a lower rate for corporations, the tariffs will mean higher costs for US companies that import components, especially for those in the manufacturing sector.
Even as the US Federal Reserve contemplates an easing of monetary policy, the European Central Bank (ECB) is evidently thinking along the same lines. It is reported that ECB President Mario Draghi is sufficiently concerned about the slowdown in growth in the Eurozone to contemplate cuts in interest rates and a renewal of asset purchases.35 Draghi is set to leave office later this year and it is likely that he will want to set in motion policies that will secure his legacy and make it difficult for a successor to quickly reverse. Like his US counterpart Jerome Powell, Draghi is concerned about the corrosive effect of restrictions on trade. He said that the ECB would “use all instruments that are in the toolbox” should the slowdown in trade have a negative impact on the rest of the economy. The fact that Draghi is considering an easing of monetary policy signals that he believes the risks to the Eurozone economy are substantial.
Amid concern that China’s growing trade war with the United States will undermine the former’s economic growth, the Chinese government said it has devised a two-year plan to boost the growth of consumer spending, thereby enabling China to shift more toward growth driven by domestic demand.36 Specifically, the Chinese government will promote the upgrade of various durable goods products, including automobiles, home appliances, and consumer products. Among consumer products, it will promote the adoption of 5G technology in mobile telecom and has already issued licenses to mobile telephony companies. In cars, China will promote smart vehicles and in appliances, it will promote green technology. The government said in a statement: “We will continue to optimize the consumption environment and improve recycling to release the growth potential of domestic demand. We will further upgrade key consumer goods to promote a strong domestic market.” Interestingly, after a long period in which consumer spending lagged the economy, it is coming back and is contributing strongly to economic growth. In the first quarter, consumer spending accounted for 65 percent of economic growth as compared to 12 percent for business investment and 23 percent for net exports. On the other hand, retail sales have decelerated and sales of automobiles have declined. The government hopes to reverse these trends with its new initiative.
Global financial markets were roiled for a while after the United States threatened to impose rising tariffs on Mexico if the latter failed to stem the tide of Central American migrants crossing the US-Mexico border. There was bipartisan opposition to the tariffs in the US Congress and broad aversion on the part of many US businesses that rely on cross-border supply chains. By the end of last week, Mexico and the United States had reached an accord with the latter agreeing to postpone tariffs indefinitely.37 The agreement had Mexico committing to measures aimed at stymying the flow of migrants. However, critics claim that Mexico’s commitments were not concessions, but were similar to what had already been agreed several months ago. The US administration disagreed and threatened to impose tariffs if Mexico fails to meet its commitments. The immediate effect of the accord will likely be relief for businesses—they were concerned about the potential costs of the move and the likely need to raise prices. However, the use of tariff threats to achieve nontrade goals signifies a new degree of uncertainty in trade relations.
The US dispute with Mexico—and its resolution—will likely be carefully examined by China so it can better understand US motivations and tipping points. If China believes, as some critics have suggested, that the United States got nothing from its threats except the ability to claim victory, it may view this as an opening to strike an accord with the country without having to make significant concessions. In such a scenario, it only needs to allow the United States to claim success. If, on the other hand, China believes that the United States got Mexico to make significant concessions, it may interpret this as a relatively high hurdle to achieving its own goals with the country. It will then consider a choice between making major concessions and giving up on a trade accord with the United States with a view to focus on other sources of growth. Meanwhile, the presidents of the two countries are set to meet soon. US Treasury Secretary Steven Mnuchin, referring to the upcoming meeting, said, “I believe if China is willing to move forward on the terms that we were discussing, we’ll have an agreement. If they’re not, we will proceed with tariffs.”38 The United States claims that China walked away from a deal that was agreed upon. China denies this.
Global information provider IHS Markit released its monthly purchasing managers’ indices (PMIs) for manufacturing in multiple countries.39 The PMI is a forward-looking indicator meant to signal the direction of activity in the critically important manufacturing sector. Although manufacturing is a modest share of output in most economies, it has considerable spillover effects on multiple industries. Thus, its performance is important for the overall economy. The PMI is based on sub-indices such as output, new orders, export orders, employment, pricing, inventories, and sentiment. A reading of above 50 indicates growing activity—the higher the number, the faster the growth, and vice versa. The latest PMIs suggest further trouble for the global economy. The global PMI, which encompasses PMIs from all the reporting countries, declined from 50.4 in April to 49.8 in May. This means that manufacturing activity was declining in May. Moreover, the PMI in May was the lowest since October 2012. The sub-indices for new orders, export orders, and employment were all below 50.
The PMI for the United States fell to the lowest level since September 2009, at the tail-end of the last recession. There was weakness in output and a decline in new orders and export orders. Businesses reported having to hold down prices because of weak demand, despite rising costs due to higher tariffs. The result was a squeezing of profits. There was also a worsening of business sentiment.
In the UK, the PMI fell sharply from 53.1 in April to 49.4 in May, indicating that activity is now declining. Businesses are seeing weak demand, partly due to the fact that customers previously stockpiled products in anticipation of the original Brexit date. Now they needn’t order new goods given the need to sell off their inventories. The result is that output and orders have fallen sharply. The continued uncertainty about Brexit is likely having a negative impact on orders. Markit’s commentary said: “Supply chain managers voiced their deep anxieties over Brexit’s continuing impacts as some supply chains were re-directed away from the UK resulting in a drop in total new orders for the first time since October. Clients from Europe and Asia were particularly reluctant to commit to new business across all sectors, but the intermediate sector suffered the worst fall in seven years as the pipeline of work dried up.”
The PMI for the Eurozone remained at a level reflecting a sharp decline in activity. The PMI for Germany was especially poor at 44.3 and that for Italy remained in negative territory. The PMIs for France and Spain, however, were modestly positive. Across the region, there continued to be a sharp decline in export orders. The capital goods sector saw especially poor performance, boding ill for business investment. Markit also commented, “Companies are tightening their belts, cutting back on spending and hiring.”
In China, the PMI was unchanged from April to May, at a level indicating barely any growth in activity. There was growth in both new orders and export orders, but a severe worsening of sentiment. The latter, according to Markit, was due to concerns about the trade war between the United States and China.
The trade war is expanding and is being mixed with the immigration policy. In a surprise move, the US administration announced that it will impose a 5 percent tariff on all imports from Mexico starting June 1040 to pressurize Mexico to do something about migration. The tariffs will rise each month until they reach 25 percent in October. The White House said after that, they are meant to stay at 25 percent “unless and until Mexico substantially stops the illegal inflow of aliens coming through its territory.”41 The administration justified the tariffs on the basis of having declared a national emergency regarding immigration.42 A law passed in 1977 gives the president authority to impose tariffs due to an emergency, but it has never before been used to impose tariffs. The administration said that the tariffs will be retained until the illegal immigration stops, adding that “The United States of America has been invaded by hundreds of thousands of people coming through Mexico and entering our country illegally. This sustained influx of illegal aliens has profound consequences on every aspect of our national life—overwhelming our schools, overcrowding our hospitals, draining our welfare system, and causing untold amounts of crime.” Actually, the rate of violent crime in the United States is historically low and tends to be lower in communities with large immigrant populations than those with fewer immigrants. Economic growth tends to be higher in communities with large immigrant populations.43 In any event, the US decision led to a very sharp drop in the value of the peso. US equity prices fell sharply as well. Also, the yield on the 10-year US Treasury bond fell below 2.2 percent, further exacerbating the inversion of the yield curve. There was strong criticism of the decision from many US business groups as well as from members of the US Congress from both parties.
This new policy, if fully implemented, will have profound implications for both the US and Mexican economies. Last year, the United States imported US$346 billion in goods from Mexico, including over US$85 billion in automobiles and automotive parts.44 There is a highly integrated supply chain in North America for large manufactured products, especially automobiles. Many components cross the border several times as part of the process of producing finished goods. These tariffs would substantially disrupt such supply chains for large manufacturers based in the United States. Either companies would have to pass their cost increases onto their customers in the form of higher prices or they might try to shift more value added back to the United States—but clearly at a higher cost. Either way, American consumers and businesses could quickly face much higher prices on a wide range of products. The US Chamber of Commerce has estimated that about six million jobs in the United States are related to trade with Mexico.45 Added to the new tariffs on China, the end result of the tariffs on Mexico will be the highest average tariff rates in the United States since the Great Depression. Tariffs are taxes—these taxes will likely overwhelm the impact of the tax cut of 2017. The trade war could, therefore, turn out to make the difference between whether the United States has a slowdown or a recession.
At the time that the administration made this decision, US Vice President Pence was in Canada to discuss ratification of the new US-Canada-Mexico Agreement (USMCA), the planned successor to NAFTA, with Prime Minister Trudeau. Yet this new policy will likely mean that the USMCA will be put on hold. It is not clear what Mexico will do in response, but it is hard to see how it can satisfy US demands with respect to migration. The Deputy Foreign Minister of Mexico said that the US move will be “disastrous” and that Mexico will consider retaliation.46 Moreover, the Mexican administration will not want to be seen as buckling under US pressure. Meanwhile, Mexico has lately been a beneficiary of the US-China trade dispute in that a number of companies have chosen to shift assembly from China to Mexico in order to produce goods for the US market. Now, such decisions are likely to be put on hold. Moreover, the surprising nature of the US decision creates a new level of uncertainty about the global trading system. The United States has, at various times, threatened to impose tariffs on other countries. Now investors are likely to wonder who will be next. Not just that, the United States has threatened to impose tariffs on all automotive imports.
Why is the United States doing this? In 2018, the number of illegal migrants caught crossing the border was the highest in six years.47 In other words, six years ago, there was a similar level of illegal immigration, but the general concern was less at that time. Meanwhile, the tariffs will have a large and potentially onerous impact on the economy, especially on the business community. A policy of trade restrictions combined with being tougher on immigration is precisely what President Trump talked about during the campaign in 2016.
The results of the European Parliamentary elections offered a glimpse at what Europe’s voters are thinking, especially about the degree to which European integration ought to continue. The results indicate an increased aversion to integration, and especially to immigration.48 They also indicate that the trend of declining support for mainstream parties is continuing. Here are some highlights:
Turnout increased for the first time in 40 years, and hit the highest level since 1994.
Populists increased their share of the vote, but not as much as some analysts expected or feared. There was an increase for parties of both the left and right, but especially the right. In contrast, centrist parties of both the left and right lost share. Still, parties supportive of the EU remained in a relatively strong position, despite some setbacks.
In France, Marine Le Pen’s far-right party narrowly defeated President Macron’s governing party. At the least, this will undermine the ability of Macron to obtain support for his reform agenda.
In Germany, the left-of-center Green party outperformed the Social Democrats (SDP), who were the traditional focus of left-minded voters. This could lead the SDP to rethink the grand coalition in which it currently participates with Chancellor Merkel. The strong performance of the Greens was attributed to its focus on climate-related issues.
In the United Kingdom, voters flocked to parties that take unambiguous positions on the issue of Brexit, especially the Brexit Party, while voters appeared to abandon the two main parties that are divided on this issue—the Conservatives and Labour combined obtained less than 23 percent of the vote. Aside from the Brexit Party, the major winners were the Liberal Democrats and the Greens, both of which strongly oppose Brexit. The two main parties will now face a period of internal turmoil.
Eurosceptic parties came out on top in the United Kingdom, Italy, Poland, and Hungary. They gained voter share in many other countries. The fact that their share of the new Parliament will be higher than before will likely influence the outcome of Parliamentary deliberations. The European Parliament handles such issues as environmental policy, trade deals, and the choice of leadership for the European Union.
The bigger impact of the European Parliamentary election, however, will be to signal voter sentiment in each country, thereby influencing national politics in many countries.
The yield on the 10-year US Treasury bond continues to fall, reaching the lowest level since September 2017.49 The 10-year yield, below 2.2 percent, remains less than the yield on the 3-month Treasury bill, which is currently 2.35 percent. This persistent inversion of the yield curve could be a warning sign of trouble to come. With one exception, every such inversion in the post-war era was soon followed by a recession, and every inversion in the last 50 years was followed by a recession. The size of the inversion, at 16 basis points, is the greatest since August 2007, just months before the last recession began.
The decline in bond yields is widely seen as partly due to fears about the potential negative impact of the trade war between the United States and China and the burgeoning trade war between the United States and Mexico. Investors evidently worry that the trade war might push the United States into recession. They also expect that the Federal Reserve will respond. Indeed, many investors are now betting that the Federal Reserve will cut interest rates this year.50 The futures market is pricing in a 48 percent probability that the Fed will cut the benchmark interest rate two or more times by the end of 2019, and an 86 percent probability that the Fed will cut rates at least once. The Fed itself has not shown its hand. Rather, it has repeatedly indicated that it will follow a policy of “patience,” waiting for new data to determine its next steps. Yet it clearly indicated that the 2018 policy of tightening monetary policy is, at the least, on hold. If the Fed does cut short-term rates, it could reverse the inversion of the yield curve. Meanwhile, the degree of investor pessimism is clear from the fact that, despite declining bond yields, equity prices are falling as well. Often, they move inversely. Another sign of trouble is the fact that, in the last few months, corporate bond yields have fallen less than sovereign yields,51 thereby increasing the risk spread for private sector credit. This suggests that investors are becoming more concerned about the ability of the corporate sector to service its debts.
The pessimism of investors is related not only to the fact that both the United States and China are boosting tariffs. Rather, investors are likely concerned that the overall relationship between the United States and China is worsening, and that the possibility of resolution is receding. Among the factors irking investors are the United States attempting to keep a large Chinese technology company out of the US market; China contemplating restricting the export of rare earth materials to the US; and the Chinese media promoting anti-American propaganda, including airing films about the Korean War on television. The only thing suggesting any easing of tensions was the fact that the United States once again chose not to label China a currency manipulator.
Aside from the various trade disputes, investors are likely also concerned about signs of a global economic slowdown. In fact, the US bond yields are not the only ones falling—since the start of the year, there have been sharp declines in the long-term yields on government bonds for Germany, France, United Kingdom, Canada, and Australia.52 Commodity prices have fallen as well. This is consistent with the fact that industrial activity appears to be abating in the world’s major economies, including the United States, Eurozone, and China.
Deloitte Canada’s Chief Economist, Craig Alexander, offers his perspective on the performance of the Canadian economy.
The Canadian economy remained in the slow lane at the start of 2019, growing by 0.4 percent in the first quarter, below market expectations for a 0.7 percent gain and similar to a downwardly revised 0.3 percent in Q4 2018 (all figures are annualized and in real terms unless stated otherwise).53 However, while the headline is weak, the details are far more constructive in Q1 with four key differences highlighted below.
First, the consumer got back into the driver’s seat, figuratively and literally, with real personal expenditures up a whopping 3.5 percent (vs 1.0 percent in Q4). This marks the best performance in six quarters as spending on autos and other durables surged 4.9 percent, a stark change after four quarters of declines.
Second, while residential investment fell for the sixth consecutive quarter, the 6.1 percent decline in Q1 is an improvement over the double-digit pullback in Q4. Moreover, renovation activity picked up which along with recent gains in monthly home sales and a rebound in furniture and building material spending in Q1 suggests that the recent soft patch in Canadian housing may be waning.
Third, business investment, which has become a perennial disappointment, rebounded from three quarterly declines, rising by 10 percent in Q1. This rebound comes despite the oil-related pullback in engineering structures and exploration activity. Equipment and software spending was up a whopping 39.5 percent, the highest quarterly growth rate since the mid-1990s.
Last, while net trade was a drag on GDP once again, the story is more nuanced. Exports were down 4.1 percent due to declines in bitumen, farm, and fish products. The 7.7 percent rise in imports was mostly related to the pickup in business and consumer spending.
The report leaves us cautiously optimistic as far as the outlook is concerned. GDP by industry grew 0.5 percent in Q1, with downward revisions to January and February offset by a consensus-beating 0.5 percent (nonannualized) pace in March with three-quarters of all industries growing. The handoff points to a strong second-quarter performance, while a stabilizing housing market, improving incomes, and rebound in investment suggest that growth should continue over the coming quarters. Having said that, the pace of growth is likely to be modest—around 1.3% this year and 1.5% in 2020—with the outlook fraught with plenty of risks, both domestic and international.
In interactions with our clients, I am often asked my view on the likely impact of new technologies, such as artificial intelligence, on the future of the workforce. There appears to be concern that increased automation will substantially disrupt the labor force and result in the loss of many skill-based jobs. In addition, clients have wondered what mix of skills will be in most demand in this new era. I always answer that technological disruption has been a feature of the modern world for the past two centuries, and that we’ve been down this road before and survived. Each episode led to the loss of jobs, but new jobs and new industries were also created. The challenge will be to assure that the labor force has the right mix of skills for the jobs created. Thus, the question as to what skills are needed. Three leading economists, who have studied this issue, have offered relatively similar views on this question. Here is what they have said.
Deirdre McCloskey, a leading economic historian, speaking about the future of work, said, “The work we do will be more and more about decisions and persuading others to agree, changing minds, and less and less about implementation by hand.”54
Brad DeLong, an economic historian, says that humans will have “just four categories of things to do: thinking critically, overseeing other humans, providing a human connection, and translating human whims into a language the machines can understand.”55 DeLong also said that the third category, involving human connections, is likely to be the most important and the one that generates the most jobs.
David Autor, an economist and expert on labor-market issues, says that “the interplay between machine and human comparative advantage allows computers to substitute for workers in performing routine, codifiable tasks while amplifying the comparative advantage of workers in supplying problem-solving skills, adaptability, and creativity.”56 In addition, he says that “focusing only on what is lost misses a central economic mechanism by which automation affects the demand for labor: raising the value of the tasks that workers uniquely supply.”
The consensus appears to be that the most important skills required in this new age will be those that entail human interaction, rather than skills related to understanding technology itself. Thus, the focus on so-called STEM (science, technology, engineering, and math) skills, while important, might be missing what is of even greater importance. In any event, all three economists appear to take a relatively optimistic view of the future impact of new technologies. That is, they do not seem particularly concerned about massive job losses. The good news is that, ultimately, such technologies will boost productivity and, consequently, living standards. This will enable people to enjoy better lives, especially those at the lower end of the income spectrum.