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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 trade conflict between the United States and China has been under way for about a year and a half. It is worth considering what has happened so far and what is likely to happen soon. First, until early 2018, the average US tariff on imports from China was 3.1 percent. When tariffs were introduced in 2018, the average tariff rose to 12.4 percent.1 Then in May 2019, tariffs were increased again, resulting in an average tariff rate of 18.3 percent. President Trump has indicated that tariffs on US$112 billion in imports from China will be increased further by 10.0 percent on September 1, 2019. The result will be an average tariff rate of 20.0 percent. Finally, all remaining imports from China will be subject to a 10.0 percent tariff from December 15 later this year. At that time, the average tariff on Chinese imports will rise to 21.4 percent. All these increases mean higher prices and/or lower profit margins for US companies that purchase imported goods from China. The same is true for Chinese exporters. (Read our latest update on the China economy.)
What is notable about the 10.0 percent tariff increase expected to take effect from September 1 is that, for the first time, a large volume of consumer goods will be targeted. Until now, the lion’s share of US tariffs on China has involved intermediate goods. The impending rise in tariffs will have an effect on apparel, textiles, footwear, and toys. Keep in mind that about 40.0 percent of the apparel and 70.0 percent of the footwear sold in the United States is made in China. Therefore, this development will leave retailers with two options—either boost prices or let their margins take a hit. Either way, the result is likely to be a drop in sales and a decline in the number of retail stores selling apparel and footwear. Moreover, the United States has previously threatened to increase the tariff on these goods to 25.0 percent. One analyst estimates that this would lead to the closure of more than 12,000 stores in the United States.2 Even the 10 percent tariff increase could cause the closure of hundreds of stores. Some US sellers of apparel and footwear will likely attempt to shift sourcing to other countries, which is a difficult and expensive option. Moreover, it is also possible that the tariffs will be called off, rendering such transitions unnecessary. The uncertainty about how this trade war will unfold is creating massive headaches for businesses that would prefer to plan on the basis of a stable future. Indeed, uncertainty has had a negative impact on business investment on both sides of the Pacific. Meanwhile, the tariffs set to go into effect in December will target most consumer electronics products, including mobile telephones, computers, and electronic games. This will likely mean an increase in the prices of such products and/or lower profit margins for their sellers.
The tariffs implemented by the United States have led to retaliatory measures by China. Until 2018, China imposed an average tariff of 8.0 percent on imports from the United States and most other countries.3 After the United States started raising tariffs, China boosted tariffs on imports from the United States and cut tariffs on imports from other countries. Specifically, the average Chinese tariff on US imports is now 20.7 percent while the average Chinese tariff on imports from the rest of the world is now 6.7 percent. This means that US goods are not as competitive in the Chinese market as they were earlier.
Moreover, it was announced last week that the Chinese government will boost tariffs on US$75 billion in imports from the United States in retaliation to the US tariffs. Part of this will take effect from September 1 and part from December 15. The tariffs will range from 5.0 to 10.0 percent and target products in industries such as agriculture, chemicals, and textiles. In addition, China said that in December, it will increase the tariff on imported vehicles from the United States from 5.0 percent to 25.0 percent. In 2017, the United States exported US$10.3 billion in automobiles to China.4 This amounted to about 19.0 percent of all US automotive exports. That share doubled since 2011. Thus, the higher tariffs are likely to have an onerous impact on the US automotive industry. The automotive tariffs, however, are not likely to be especially onerous for Chinese consumers if China simply boosts imports from other countries or boosts domestic production.
Investors interpreted China’s action as indicating that a truce between the two sides is highly unlikely and that the trade war is likely to worsen rather than recede. As such, equity prices and oil prices fell after China’s announcement on expectations that a more intense trade war will hurt economic growth, corporate profitability, and globally oriented businesses.
Following China’s announcement of new tariffs, President Trump tweeted: “Our great American companies are hereby ordered to immediately start looking for an alternative to China, including bringing our companies HOME and making your products in the USA.”5 In addition, he said that the US Postal Service, FedEx, Amazon, and UPS will be ordered to search packages arriving from China for opioids. The president said, “We don’t need China and, frankly, would be far better off without them.” It is not clear that the president has the authority to order US companies to find alternatives to China. Still, the comments indicate that the temperature is rising, a fact that clearly unnerved investors. Moreover, the president later announced that, in response to Chinese tariffs, the United States will further boost its tariffs on Chinese imports—from 25.0 percent on US$250 billion in imports to 30.0 percent. In addition, the planned 10.0 percent tariff on all remaining imports from China will rise to 15.0 percent.
Immediately following Trump’s tweet, US equity prices fell sharply—the second sharp decline in one day. Shares in companies with significant exposure to China fell especially sharply. European shares also tumbled. Interestingly, however, Chinese shares were up. Bond yields fell, and the gap between the yields on the US 10- and two-year bonds once again inverted after having briefly returned to normal. The gap between the yields on the 10-year and three-month securities remained strongly inverted. The inversion of the yield spread is widely seen as a strong predictor of recession. It can be argued that investors are reacting to the uncertainty of the situation, which is likely already having a chilling effect on business investment.
Meanwhile, the value of the Chinese renminbi fell to an 11-year low against the US dollar,6 especially after the People’s Bank of China cut its benchmark interest rate earlier this week—a move seen as potentially the start of a process of easing monetary policy. The lower value of the renminbi has been severely criticized by the US government. However, the fact that the Chinese government is easing monetary policy and enabling the renminbi to fall suggests that it has given up on any hope of an accommodation with the United States on trade. An easier monetary policy will boost domestic demand, and a cheaper renminbi will help export competitiveness.
What will it take to end this conflict? The United States has presented multiple demands before China. It wants China to buy more US goods, reduce its trade surplus with the United States, end subsidies to state-owned enterprises, and protect intellectual property. It has indicated that Chinese promises are not sufficient and that there must be a mechanism to ensure compliance. The US wants to retain the right to impose punitive tariffs if China fails to meet certain benchmarks but wants to restrict China’s right to retaliate. It also wants to retain tariffs until China is in compliance with an agreement. China has rejected these demands. Unless the United States backs down on some of these demands, it is hard to see an agreement being reached. If the US administration decides that tariffs are damaging the US economy, it might be willing to accept a cosmetic agreement and declare victory. However, it has argued that the tariffs are not harming its economy. As for the politics of the trade war, it remains unclear what damage it could do to the economy.
While US trade policy has created uncertainty that affects business investment decisions, it is also true that uncertainty about the future direction of the Federal Reserve’s monetary policy is having an impact on business decisions. Last week the Federal Reserve released the minutes from its policy committee deliberations that took place in July.7 It was at that meeting that the decision was made to cut the benchmark interest rate by 25 basis points. However, the committee also approved a statement suggesting that the rate cut was a mid-cycle recalibration, rather than the start of a sustained easing of monetary policy. It now turns out that the members of the committee were unusually divided in their views. The division within the Fed means that investors do not have a clear indication of where interest rates are headed. Two Fed governors expressed strong scepticism about the need for further rate cuts, while others indicated that sharp cuts are needed.
The minutes reveal that committee members had a relatively positive view of the economy, noting that employment continues to grow strongly while inflation remains below the Fed’s target. The committee also noted that financial conditions have improved, likely due to investor expectations of an easing of monetary policy.
At the same time, the committee expressed concern about the external environment, with the minutes stating that it “saw uncertainty surrounding trade policy and concerns about global growth as continuing to weigh on business confidence and firms’ capital expenditure plans. Participants generally judged that the risks associated with trade uncertainty would remain a persistent headwind for the outlook, with a number of participants reporting that their business contacts were making decisions based on their view that uncertainties around trade were not likely to dissipate anytime soon.”
Still, the committee expressed confidence in the strength of US consumer spending, stating that “household spending would likely continue to be supported by strong labor market conditions, rising incomes, and upbeat consumer sentiment.” The committee’s overall assessment was that “continued weakness in global economic growth and ongoing trade tensions had the potential to slow US economic activity and thus further delay a sustained return of inflation to the 2.0 percent objective.” This explains the view that a modest easing of monetary policy was warranted. However, some committee members indicated that the weakening of inflation was likely transitory and, consequently, the Fed should be wary of too much easing.
As for the decision to cut the benchmark interest rate, the committee offered three major reasons:8 the deceleration of economic growth, driven largely by external factors that have hurt investment and the manufacturing sector, suggests the need for a lower policy rate; an easing of policy would be “prudent risk management;” and inflation is running below the Fed’s target, suggesting that an easing of policy will help boost inflation. Given the evident division within the committee about the optimal path of interest rates, it seems likely that the Fed will be cautious about any further rate cuts, unless the economic circumstances change. The Fed, of course, is data-driven. Thus, if the economy takes a turn for the worse or if the trade war worsens significantly, the chances of further rate cuts will rise.
Still, it is worth noting that monetary policy alone does not drive the economy. Indeed, last week, at the annual shindig of central bankers in Jackson Hole, Wyoming, Fed Chairman Jerome Powell sought to explain the factors that limit the ability of the Fed to influence the economy.9 He noted the uncertainty created by trade conflict, especially in light of the unprecedented nature of the current trade policy. Specifically, he said, “While monetary policy is a powerful tool that works to support consumer spending, business investment, and public confidence, it cannot provide a settled rule book for international trade. Our challenge now is to do what monetary policy can do to sustain the expansion.” He also said that “trade policy uncertainty seems to be playing a role in the global slowdown and in weak manufacturing and capital spending in the United States” and that there are “no recent precedents to guide any policy response to the current situation.”
Powell did, however, suggest that further rate cuts are likely. He specifically cited two episodes from the 1990s when, after tightening monetary policy, the Fed briefly loosened policy by cutting rates by 75 basis points. In each case, the loosening was sufficient to lessen the downturn that ensued. Powell noted, “The Fed was cutting, not raising, rates in the months prior to the end of the first two expansions in this era, and the ensuing recessions were mild by historical standards.” It appears he is preparing investors for a modest bout of loosening followed by a mild recession. The futures market is implicitly predicting a 100 percent chance that the Fed will cut rates by at least 25 basis points in September.
The world increasingly appears to be on recession watch. This is evident from the behavior of investors. Last week, global equities fell sharply after the yield spread between the 10-year and 2-year US bonds inverted for the first time in a decade.10 The spread between the yields on the 10-year bond and the 3-month bill had already inverted in May. Yet the latest inversion shook investors, increasing many investors’ expectations of recession. In the past 50 years, every time this spread inverted, a recession followed. This, however, doesn’t mean that the inversion causes recessions, although it is possible that the inversion contributes to a weakening of credit market activity. Rather, the inversion is a reflection of investor sentiment. It signals that investors expect inflation to fall, which itself reflects expectations of greater economic weakness. Moreover, sentiment can have real consequences. After all, if investors and businesses expect a recession, they might behave in ways that help to bring on recession.
Why are investors so vexed? An important reason is that the economies of the United States, Europe, and China have decelerated, with a variety of indicators pointing to trouble. In recent weeks, we have seen a contraction in the economies of Germany, United Kingdom, and Italy; a sharp deceleration in China’s industrial production; a drop in Japan’s industrial production; and a severe weakening of the US manufacturing sector.11 Thus, the worrisome numbers from the bond market likely reflect investor concern about what the real numbers are saying.
Moreover, it is likely that investors are worried that the trade war between the United States and China will not get better or might even get worse. At the least, the unpredictability of this conflict has already had a chilling effect on business investment, something that is likely to persist. Moreover, there is fear that tariffs will rise further, thereby hurting consumer and business spending and further decelerating trade. Plus, the trade war between the United States and China is just one part of a larger uncertainty regarding global trade. After all, there is uncertainty about Brexit, the future of the new trade agreement in North America, and the future of automotive trade between the United States and Europe. This lack of certainty is likely contributing to investment weakness.
At the same time, the central banks of the major economies have either begun loosening monetary policy or indicated a slant in that direction. Whether this will be sufficient to offset the impact of trade problems is not clear. Monetary policy tends to work with long and unpredictable lags. Plus, monetary policy is stymied by the fact that borrowing costs are already historically low. Meanwhile, there is growing debate about what role fiscal policy should play in addressing the global slowdown. In the United States, the Congress passed a budget that loosens fiscal policy. In Europe and China, there is debate about how far fiscal policy should go in dealing with economic slowdown.
After announcing that it will soon boost tariffs on China, the United States postponed about half of the new tariffs on China until December. Markets initially rejoiced at this news, with equity prices and oil prices jumping sharply.12 However, uncertainty remains, and this is likely to have a continued chilling effect on investment. Companies simply do not know what the rules of the game will be and, consequently, cannot easily make investment decisions. In addition, the US decision to postpone tariffs on mainly consumer goods, such as mobile telephones, was likely intended to avoid price increases during the holiday shopping season. There is nothing reported to suggest that the two sides are any closer to an agreement on trade. Meanwhile, half of the tariff increases will take place in September.
If the Unites States expected that its postponement of tariffs on China would be seen by China as conciliatory and would lead China to make new concessions, it was mistaken. In fact, China has announced it will take “necessary countermeasures,” should the tariffs set for September go into effect.13 However, it did not specify what those measures will be. It noted that the planned increase in tariffs “seriously violates the consensus reached between the two heads of state in Argentina and Osaka, and deviates from the right track of resolving differences through consultation.” Global equity prices fell on China’s statement, as investors evidently saw little chance of a breakthrough on trade.
It is evident that China’s economy is facing considerable headwinds, especially due to the trade war with the United States. Industrial production increased only 4.8 percent in July14 versus a year earlier, the slowest rate of increase since 2002. Manufacturing output was up only 4.5 percent. Meanwhile, fixed asset investment rose 5.8 percent during the first seven months of the year versus the previous year.15 This was consistent with the low rate of growth seen in the past year. Investment has not grown at a similarly low rate in nearly two decades. Government efforts to stimulate the economy by boosting investment in state-owned enterprises led to a stronger 7.1 percent increase in investment in the public sector. Private sector investment, however, increased only 5.4 percent. In addition, investment by the manufacturing sector grew a measly 3.3 percent, evidently hurt by the trade war. Retail sales in China were up 7.6 percent in July versus a year earlier, the second-lowest rate of growth since 2003.16 This included a 1.0 percent increase in sales of telecom equipment, a 2.6 percent decline in sales of automobiles, and a 3.0 percent increase in sales of home appliances. Sales of personal care products were up 13.0 percent while sales of cosmetics were up 9.4 percent. Overall, the industrial production, investment, and retail sales numbers painted a picture of an economy that is growing unusually slowly.
In response, the government has taken a variety of steps to stimulate the economy. They include measures aimed at boosting bank lending. Yet the latest data suggests that Chinese bank lending weakened in July.17 The overall volume of lending declined in July versus June, with an especially large two-thirds drop in the volume of corporate lending. Household lending declined too. The overall volume of bank lending in July was the lowest since April. Given an easing of monetary policy and credit restrictions, the decline appears to be due to weak demand for credit. That, in turn, was probably due, in part, to the uncertainty of the trade war.
In the second quarter of 2019, three of the four largest economies in Europe did not grow from the previous quarter.18 In addition, each of the five largest economies in Europe experienced a decline in industrial production from May to June. It is increasingly clear that Europe is now headed in a direction that involves a risk of general recession. Of greatest concern is the fact that Germany’s economy has contracted for the second time in the last three quarters and appears to be at risk of recession. Germany has the largest economy in Europe and is often seen as an important engine of growth for the rest of Europe.
Here are the details: real GDP in the 19-member eurozone increased 0.2 percent from the first to the second quarter and was up 1.1 percent from a year earlier. In the larger 28-member European Union (EU), real GDP was also up 0.2 percent for the quarter and up 1.0 percent from a year earlier. These modest growth numbers involve significant variation among countries. For the quarter, real GDP fell 0.1 percent in Germany and 0.2 percent in the United Kingdom. In addition, real GDP was unchanged in Italy, a country that has only seen one quarter of growth in the last four. At the same time, the second-largest economy in the eurozone, France, saw 0.2 percent growth in GDP in the second quarter. In addition, Spain’s real GDP was up a strong 0.5 percent for the quarter. The most impressive growth in Europe came in the less developed economies of Central Europe. For the quarter, real GDP was up 1.1 percent in Hungary, 1.0 percent in Romania, 0.9 percent in Lithuania, and 0.8 percent in Poland. Also, growth was strong in Denmark (up 0.8 percent) and Finland (up 0.9 percent) while real GDP fell 0.1 percent in Sweden.
Regarding industrial production, overall output in the eurozone fell 1.6 percent from May to June and was down 2.6 percent from a year earlier.19 The numbers were similar for the larger EU. Notably, output of capital goods in the eurozone fell 4.0 percent from May to June and was down 4.4 percent from a year earlier. This bodes poorly for business investment. From a year earlier, industrial production was down 6.2 percent in Germany, 0.4 percent in France, 1.2 percent in Italy, 1.2 percent in the United Kingdom, but up 1.5 percent in Spain. In all five countries, output fell from May to June.
The weakness in industrial production is likely related to trade problems, of which there are many.20 First, intra-eurozone trade fell 6.6 percent in June versus a year earlier, the largest decline in six years. This accounts for roughly half of exports from eurozone countries. In addition, eurozone exports to noneurozone countries fell 4.7 percent in June versus a year earlier, the sharpest decline in three years. This included a 3.4 percent drop in exports to China. Exports to the United States were up only 1.2 percent. Overall, there was a big decline in exports of machinery and transport equipment.
As for Germany, it is the focal point of concern about Europe’s economy. Real GDP has fallen in two of the last four quarters. In the second quarter, the decline was principally due to a contraction in trade, which was partly offset by a rise in household spending. The weakness of exports was related to the slowdown in China, trade tensions with the United States, and concerns about Brexit. In addition, German automotive production has fallen sharply, hitting a level last reached during the 2009 recession. This reflects the global weakness of the sector as well as troubles in adjusting to new rules regarding diesel fuel. What happens next in Germany? There is an increasing debate about whether the government should use fiscal stimulus to offset negative external influences. Some German business leaders are calling for the government to abandon its commitment to a balanced budget and take advantage of negative bond yields to borrow in order to boost spending. Yet the two major parties that comprise the coalition government remain firm in their commitment to fiscal probity.
Meanwhile the European Central Bank (ECB) has already signaled an intention to ease monetary policy further, including reviving bond purchases (also known as quantitative easing). In fact, Olli Rehn, a Finnish member of the ECB’s policy committee, suggested that, at its meeting in September, the ECB is likely to implement a policy that is more aggressive than investors expect. He said, “When you’re working with financial markets, it’s often better to overshoot than undershoot, and better to have a very strong package of policy measures than to tinker.”21 Rehn’s comments were followed by a further drop in European bond yields. Whether aggressive action by the ECB will prevent a further slowdown in Europe’s economy is hard to say.
Economic indicators for the United States are painting a mixed picture. On the one hand, the industrial side of the economy is weak as evidenced by a decline in industrial production, including a decline in manufacturing output. On the other hand, retail sales performed quite well in July. Meanwhile, inflation is close to the Fed’s target, with consumer prices up 1.8 percent in July versus a year earlier, and core prices (excluding volatile food and energy) up 2.2 percent, higher than the Fed’s 2.0 percent target.22 Thus, the fact that the Fed has at least started to loosen monetary policy indicates that Fed leaders are more focused on the weakness of the economy than on anchoring expectations of inflation.
As for the industrial side of the economy, industrial production fell 0.2 percent from June to July.23 This was the third time in six months that production had declined. Output of manufacturers was down 0.4 percent while output in the mining sector was down 1.8 percent as low commodity prices hurt production. Notably, output of business equipment fell 0.4 percent, boding poorly for business investment. In addition, construction output fell 1.0 percent, reflecting weakness in the housing sector. From a year earlier, industrial production was up a modest 0.5 percent, but manufacturing output was down 0.5 percent.
As for domestic demand, retail sales were up a strong 0.7 percent from June to July.24 Notably, excluding the weak automotive sector, retail sales were up 1.0 percent for the month, an extremely strong increase. Among the sectors with strong growth were electronics stores (up 0.9 percent), grocery stores (up 0.7 percent), clothing stores (up 0.8 percent), department stores (up 1.2 percent), restaurants (up 1.1 percent), and nonstore retailers (up 2.8 percent). Sales at gasoline stations also increased strongly (up 1.8 percent) as gasoline prices rose 2.5 percent for the month. However, sales fell at automotive dealers (down 0.6 percent) and drug stores (down 0.2 percent). Overall, the data on retail sales suggests that American consumers are eager to spend and confident about their finances. They have seen a strong job market with modest gains in wages. Indeed, average hourly earnings were up 0.3 percent from June to July and up 3.2 percent from a year earlier.25 However, after accounting for inflation, average hourly earnings fell 0.1 percent for the month and were up a more modest 1.3 percent from a year earlier. Consumers have also exhibited a greater willingness to take on debt, having paid off debts considerably over the past decade.
In response to President Trump’s announcement that he will impose a 10 percent tariff on all remaining imports from China, the Chinese government allowed the renminbi to fall sharply in value, hitting the lowest level in a decade.26 The People’s Bank of China issued a statement stating, “Under the influence of factors including unilateralism, protectionist trade measures, and expectations of tariffs against China, the yuan has depreciated against the dollar today, breaking through 7 yuan per dollar.”27 The obvious reason for doing this is to offset the negative impact of tariffs on the competitiveness of Chinese exports. But the Chinese decision, which clearly irked the US government, suggests that China’s leaders may have given up any hope of obtaining a trade deal with the United States—at least any time soon. Consequently, they are likely willing to risk the wrath of Washington in order to sustain their exports. By allowing the renminbi to depreciate, China not only offsets the impact of US tariffs on Chinese exports to the United States. Rather, they improve the competitiveness of Chinese exports to other countries as well. A depreciating currency can be inflationary as it leads to higher priced imports. But in the case of China, this is likely not a concern given the very low level of underlying Chinese inflation.
The principal risk to China of a declining currency is that it boosts the cost of servicing foreign currency denominated debts. Yet China has substantial financial resources that can be used to assist troubled debtors. However, the volume of US dollar-denominated debt held by Chinese companies has increased considerably in recent years, hitting about US$1.5 trillion in 2018, a 20 percent rise over three years earlier.28 About half of that debt is held by Chinese banks, thereby creating some additional risk to the financial system. Moreover, if the renminbi is permitted to fall further in the months ahead, then this will imply further stress for China’s financial institutions. At the same time, China’s foreign currency-denominated debt as a share of GDP remains far lower than that of other major emerging markets, such as Turkey, Brazil, and South Korea. Meanwhile, it is important to keep in mind that China’s economy is now driven far more by domestic demand than by exports. Thus, even if the tariffs damage the export-related economy, it is something that China can likely absorb without taking a big hit to growth—especially if the government continues its policy of stimulating domestic demand through fiscal policy.
In addition to allowing the currency to depreciate, it is reported that China’s government has instructed state-owned enterprises to halt purchases of US agricultural products.29 This follows a US accusation that China failed to purchase the volume of farm products that had been promised—an accusation that China denied. Yet the new decision to halt purchases is likely meant to hurt the US administration politically. American farmers have been especially critical of administration trade policy and have complained that they are disproportionately absorbing the negative impact of trade restrictions.
In response to the depreciation of the renminbi, the US administration labeled China a currency manipulator for the first time since the early 1990s.30 US law provides that the Treasury Secretary label a country a currency manipulator if that country intentionally intervenes in currency markets in order to artificially suppress the value of the currency in order to boost export competitiveness. This was not the case with China. It is true that China had previously engaged in manipulation, prior to 2014, in which it sold renminbi in order to prevent it from rising in value.31 However, since 2014, the innate movement of the currency has been downward. As such, the government has been purchasing renminbi (by selling US government bonds) in order to boost the value of the currency—or at least to prevent it from depreciating. However, in response to US tariffs, China chose to not purchase renminbi, thereby allowing it to depreciate on its own. It appears that the US decision to label China a currency manipulator was simply meant to punish China for letting the currency decline in value. Moreover, this punishment appears to have been successful in influencing Chinese behavior. That is, China quickly intervened in currency markets to boost the value of the renminbi—or at least prevent it from falling further. China is evidently worried about allowing the renminbi to fall too far lest the United States engage in further retaliatory action. Meanwhile, the United States has referred its complaint about China to the International Monetary Fund (IMF). Yet it is not likely that the IMF will accept the US argument. In any event, labeling China a currency manipulator is mainly symbolic as the United States has already implemented far more sanctions on China than could be done on the basis of currency manipulation.
The tit-for-tat actions by the United States and China have shaken the confidence of many global investors. The latest actions could exacerbate the trade war. The Chinese actions on currency and purchases of farm products could possibly lead to further retaliatory actions by the United States. In response to all of this, equity prices around the world have fallen sharply, with technology-related stocks falling especially sharply. Bond yields in developed economies have fallen as well.32 The latter indicates that investors are shifting their portfolios toward safer assets, even if it means negative returns—as is the case in Germany, France, and Japan. Indeed, the yield on Germany’s 10-year bond has fallen to the lowest level on record. Yields on US government bonds have fallen to a level last seen before the 2016 election. The inversion of the US yield curve has gotten bigger, as bond yields fall while short-term rates remain steady. Oil prices and the prices of other traded commodities such as soybeans and copper have fallen as well as investors have downwardly revised their expectations for global demand and their expectations for restrictions on trade. A worsening trade war is seen by investors are likely to lead to slower global economic growth. This view is likely to influence future decisions by the US Federal Reserve. The Fed was already expected to cut interest rates further, despite ambiguous recent statements from Fed Chairman Powell. Now, investors evidently expect more aggressive action on the part of the Fed. After all, the Fed had previously signaled that the negative impact of a trade war was one of the reasons for easing monetary policy. Still, although a cut in interest rates will be beneficial to businesses, it will not do anything to offset the uncertainty about trade that is having a chilling effect on investment on the part of globally exposed US companies.
As for the US administration, conflicting words have been coming from different advisors to the president. Economic advisor Lawrence Kudlow held out the possibility that, if China boosts purchases of farm products, the proposed tariffs could be avoided. He said, “A lot of things can happen in a month. A lot of good things can happen in a month.” Then again, trade advisor Peter Navarro said that, in order to avoid tariffs, China must stop its “seven deadly sins.” This means that China must “stop stealing our intellectual property. Stop forcing technology transfers. Stop hacking our computers to steal our trade secrets. Stop dumping into our markets and putting our companies out of business. Stop their state-owned enterprises from [receiving] heavy subsidies. Stop the fentanyl. Stop the currency manipulation.”33 That is a tall order. Keep in mind that Navarro is reported to have been the only Trump advisor who urged the president to impose the new tariffs. All other advisors are said to have strongly disagreed with the decision.34
As the trade war intensifies, China’s exports surprisingly increased 3.3 percent in July versus a year earlier,35 even as exports to the United States continued to decline. The increase was largely due to strong exports to other Asian countries, including South Korea, Taiwan, and Singapore. Exports to the United States, in contrast, were down 6.5 percent. In addition, Chinese imports from the United States fell a staggering 19.1 percent in July versus a year earlier, the 11th month in the last year in which imports fell. With the United States now planning to impose new tariffs on all Chinese exports to the United States, it is likely that such exports will decline further in the months to come. Finally, Chinese imports from the rest of the world fell 5.6 percent in July versus a year earlier, reflecting weakened consumer demand as well as a weakened Chinese manufacturing sector. The latter means that Chinese producers are demanding fewer imported components.
One way that Chinese producers can offset the impact of tariffs is by cutting their export prices. There is evidence that this is happening. China’s producer price index fell 0.3 percent in July versus a year earlier.36 This is the first decline in the producer price index since 2016. Meanwhile, consumer prices in China continue to rise rapidly, largely driven by rising pork prices—itself the result of African Swine Fever. This is cutting into consumer purchasing power, and is a problem at a time when the government is hoping that strong domestic demand will offset the negative impact of the trade war.
There are reports that some Chinese manufacturers, in order to avoid US tariffs, are shipping goods to Vietnam, relabeling the goods as made in Vietnam, and then shipping them to the United States.37 Indeed, Chinese exports to Vietnam have surged in recent months, and Vietnamese exports to United States US have surged as well. The US administration is evidently aware of this pattern and has threatened to impose tariffs on goods coming from Vietnam.
The yield spread, which is the yield on the 10-year US Treasury bond minus the yield on the 3-month Treasury bill, has been inverted since May.38 A few weeks ago, the spread diminished to the point that many investors expected the inversion to quickly end, especially as the US Federal Reserve was widely expected to cut interest rates. Then, the Fed engaged in one interest rate reduction, but offered commentary suggesting that another rate cut was not necessarily in the cards. This led to a further inversion of the yield spread. Then came the unexpected intensification of the trade war, which led the yield spread to widen even further, hitting the highest gap since before the last recession in 2007.
Thus, the investor community appears to be signaling a high degree of confidence that a US recession is coming in the next year—even though many private sector economists continue to downplay the risk of recession. Moreover, a US recession would surely imply either recession or significant slowdown elsewhere in the world. Certainly, Europe is at risk given that growth there has already diminished considerably. And China, which has slowed down in the past year, faces negative consequences not only from a US recession but from the continuing trade war with the United States. During the last global slowdown, China engaged in a massive fiscal stimulus in order to offset the contraction of global trade. This time, it is less clear how China will respond. Among the world’s leading economies, there now appears to be risk of recession in the United States, United Kingdom, Germany, and Japan.
Germany’s economy appears to be headed toward a decline in activity in the second quarter. Industrial production fell sharply in June,39 down 1.5 percent from the previous month and down 5.2 percent from a year earlier. The latter figure was the steepest decline since the recession in 2009. The considerable weakness of industrial production has led many analysts to predict a drop in real GDP in the second quarter.40 Whether Germany is headed for a recession is hard to say. It is the largest economy in the European Union and a recession there would have significant consequences for the region. For now, Germany is among the weakest economies in Europe. The decline in industrial production is likely related to troubles in the automotive industry that are due to a transition away from diesel vehicles, the negative consequences of the US-China trade war (which has seriously hurt Chinese demand for imported capital goods and components), and uncertainty about Brexit.
Investors are demonstrating their pessimism about German growth by pushing the yield on the 10-year government bond far into negative territory, hitting a historic low. In addition, the well-known Ifo survey of business confidence hit the lowest level in seven years. Meanwhile, it was reported that German exports fell 0.1 percent from May to June and were down 8.0 percent from a year earlier.41 Imports were up 0.5 percent for the month, but down 4.4 percent from a year earlier. What happens next? The European Central Bank will likely engage in an easier monetary policy. Yet given Germany’s already low borrowing costs, it is not clear how impactful this might be.
Meanwhile, the use fiscal policy by the government to boost the economy is not widely expected. However, now might be the best time to do so. After all, Germany’s government bonds have a negative yield, which means that there is less than zero cost of borrowing money to pay for fiscal stimulus. Moreover, Germany currently has a relatively low level of debt, meaning that fiscal stimulus would not lead to an unsustainable level of debt. According to the IMF, Germany has a substantial investment gap,42 partly due to restrictive rules on the ability of municipalities to borrow. Yet it is not likely that, under current circumstances, a political consensus can be established to change government borrowing rules.
Britain’s real GDP fell in the second quarter, the first decline in seven years. It reflected a sharp weakening of the manufacturing sector and a slowdown in activity in the services sector. Specifically, real GDP fell 0.2 percent since the first. According to a spokesman for the British government, “Manufacturing output fell back after a strong start to the year, with production brought forward ahead of the UK’s original departure date from the EU.”43 In June, manufacturing output was down 1.4 percent from a year earlier and down 0.2 percent from the previous month.44 As for the services sector, activity grew in the second quarter, but at the slowest pace in three years.
In response to this news, the pound fell further. It has fallen sharply since the seating of the current government led to increased fears of a no-deal Brexit. It remains unclear whether the second quarter data indicates that a recession is under way. What is clear, however, is that the manufacturing sector has weakened considerably, likely due to the uncertainty engendered by the Brexit saga.
Lately, it appeared that the conventional wisdom was that the US-China trade war would remain a stalemate, neither side would budge, no deal would take place soon, and the status quo would continue. The conventional wisdom was that the US administration would do nothing to weaken the US economy or financial markets, with an eye on next year’s election campaign. This conventional wisdom could explain the relatively robust and stable equity market in the United States, for example. Now it turns out that the conventional wisdom might have been wrong. The ongoing trade war has roiled the markets after the announcement that the United States will impose a 10 percent tariff on all US$300 billion in untaxed imports from China starting in September.45 Already, the United States has a 25 percent tariff on US$250 billion in imports from China. Immediately following this announcement, US equity prices plummeted and the yield on the 10-year US government bond fell sharply, hitting the lowest level since before the 2016 election. The yield on German government bonds fell to a record low as investors appeared to seek the safest possible investments at a time of uncertainty. A 10 percent tariff on all Chinese imports not already subject to tariffs will likely mean a significant increase in the prices of mobile telephones, other electronics, apparel, textiles, toys, and footwear. This means that US consumers will effectively become poorer. It could hurt the growth of consumer spending that, lately, has been one of the principal sources of growth for the US economy.
President Trump justified his action by saying that “China agreed to…buy agricultural products from the US in large quantities but did not do so.”46 Additionally, he stated, “My friend President Xi said that he would stop the sale of fentanyl to the United States—this never happened, and many Americans continue to die.” Trump’s action comes roughly a month after the G20 Summit in Osaka at which Trump and Chinese President Xi agreed to a trade war ceasefire. Trump agreed not to impose new tariffs while both sides engaged in talks. Yet the latest talks, which took place in Shanghai, were evidently not successful in resolving complicated differences. As such, Trump’s latest action could be seen as an effort to coerce China into making concessions. However, past such tactics did not succeed, and the chances that the new tariffs will actually take effect are quite strong. The danger for the US administration is that higher tariffs, or even the threat of higher tariffs, could hamper business investment and hiring, especially on the part of globally exposed companies, which include companies that sell globally and that depend on global supply chains. Thus, a furtherance of the trade war could have a negative impact on US economic growth in the months ahead. This, in turn, could influence future decisions by the US Federal Reserve. Meanwhile, China responded by allowing the value of the renminbi to fall to the lowest level in a decade.47 This is intended to offset the impact of tariffs on the competitiveness of Chinese exports.
The US Federal Reserve cut the benchmark rate by 25 basis points. It is the first cut in 10 years, but investors were expecting it. The Fed’s policy committee mentioned, “In light of the implications of global developments for the economic outlook as well as muted inflation pressures, the committee decided to lower rates.”48 The Fed also announced that it will stop reducing the size of its balance sheet.
Keep in mind that the Fed’s action took place before the US administration signaled an intention to boost tariffs on China. Interestingly, equity prices fell as investors interpreted the decision not to cut by 50 basis points as suggesting that the Fed expects a stronger economy and higher inflation than previously expected. This might be related to some of the latest data on the economy, including strong domestic demand and accelerating inflation. Moreover, Fed Chairman Powell characterized his action as a “mid-cycle adjustment” to policy, suggesting that the Fed might not cut rates again this year. Indeed, Powell said that this is not the start of a “lengthy cutting cycle” and “that is not what we’re seeing [that] is not our perspective now, or our outlook.”49 Not only did Powell express evident skepticism about further rate cuts, two members of the Fed’s policy committee, Esther George of the Kansas City Fed and Eric Rosengren of the Boston Fed, voted not to cut rates at all.
Not only did equity prices fall after the Fed announcement, but the gap between the yields on the 10-year and 3-month Treasury securities rose, further exacerbating the inversion of the yield curve (inversion increased further after President Trump said he will boost tariffs on China). It was widely expected that the Fed’s cut rates would end the inversion of the yield curve, but the opposite happened. This means that many investors remained somewhat pessimistic about the economy. Keep in mind that the yield on the 10-year bond is, theoretically, a prediction of investor expectations for future short-term rates. Given that the yield on the 10-year bond remains lower than the yield on the 3-month Treasury bill, investors evidently expect short-term rates to get lower in the future—likely due to future easing of monetary policy in response to a recession. Also keep in mind that the yield curve has been inverted since May and that sustained inversions have almost always been followed by a recession in about a year.
Globally, the Fed’s indication that further rate cuts might not be imminent is likely to have a dampening effect on the willingness of other central banks, especially in emerging markets, to cut rates. However, Brazil’s central bank did cut its benchmark rate by 50 basis points.
Employment growth in the United States has slowed, but remains relatively strong. In July, according to the US government’s survey of establishments, 164,000 new jobs were created, less than in June but far more than in May.50 Once again, professional and business services as well as health care accounted for the lion’s share of job growth. There was also reasonably good growth in manufacturing. However, employment declined in mining, retailing, and the information sector. The survey findings also revealed that wages accelerated slightly, with average hourly earnings up 3.2 percent from a year earlier, slightly faster than in June. The separate survey of households revealed that the unemployment rate remained steady at 3.7 percent.51 In addition, there was a slight increase in the rate of participation in the labor force. Overall, the jobs report revealed that the job market remains relatively robust and that, with wages accelerating, the market appears to be tightening.
What will this mean for the Federal Reserve? Investors appear to believe that this report changes nothing. The futures market’s implied probability of an interest rate cut in September remains high at 70 percent. Yet Fed leaders have already signaled some hesitancy about further cuts. Plus, the latest report suggests that, although job growth is decelerating, it remains relatively strong. In addition, the acceleration in wages indicates the possibility of an acceleration in inflation.
The Eurozone economy continues to decelerate.52 In the second quarter of 2019, real GDP was up 0.2 percent from the previous quarter and 1.1 percent from a year earlier. The year-on-year increase of 1.1 percent is the slowest since late 2013 when the economy was in recession. As recently as late 2017, the economy was growing at a rate of 2.8 percent. The slowdown largely reflects negative external factors such as the slowdown in China, uncertainty over Brexit, and trade tensions with the United States. This, in turn, has had a dampening effect on business investment. Meanwhile, it appears that the consumer sector is doing relatively well. Despite the overall slowdown of economic activity in the Eurozone, retail sales continue to grow at a good pace.53 In June, real (inflation-adjusted) retail sales were up 1.1 percent from the previous month and up 2.6 percent from a year earlier. Both figures were relatively strong compared to recent months. Spending on apparel and textiles increased strongly from the previous month, while spending on computers increased strongly from a year earlier. Also, from a year earlier, spending was up 3.9 percent in Germany, 2.9 percent in Italy, 2.4 percent in Spain, and 1.3 percent in France.
With Europe’s economy slowing, it is not surprising that inflation remains relatively dormant. Overall consumer prices were up 1.1 percent in July versus a year earlier, the slowest pace since early 2018.54 Excluding volatile food and energy prices, core prices were up 0.9 percent from a year earlier, a relatively slow rate of underlying inflation compared to recent months. With the Eurozone economy exhibiting weakness and inflation low, the European Central Bank has an intention to ease monetary policy. Yet it could be argued that, with interest rates already historically low, monetary policy is inadequate to the task of boosting growth. Rather, it may require fiscal stimulus to turn Europe’s economy around. Also, although Germany, France, and Italy all intend to engage in modest fiscal expansion, it might not be sufficient to generate significantly faster growth.
Last week, there was a sharp drop in the value of the British pound due to the uncertainty around Brexit. On Tuesday, the pound fell below US$1.21 and was only slightly higher than the low reached just after the referendum. That was the lowest since 1985. This follows the selection of Boris Johnson as prime minister. While he claims the chances of a no-deal Brexit are only one in a million, his “no-deal” Minister Michael Gove says that this is what they are planning for.55 So, investors are confused about the government’s messaging. In addition, it is likely that investors believed that, once in office, Johnson would shift gears and become less amenable to a no-deal Brexit. That has not happened. Although he maintains that the issue will be resolved, he has not attempted to dampen talk about a no-deal event. As such, investors have upwardly revised the expected probability of a no-deal Brexit.
While people worry about the UK economy falling off a cliff in the event of a no-deal Brexit, it appears that the British automotive industry is already doing so.56 In the first half of 2019, the industry invested 90 million pounds compared to investment of 347 million pounds a year earlier and 647 million pounds in the prior year. Moreover, investment has been shrinking rapidly since the Brexit referendum. As recently as 2015, annual investment was in excess of 2.5 billion pounds. It appears that investment has plummeted because companies are uncertain about the future of trading relations with other countries, especially with the European Union (EU). Industry representatives have told the government that Britain’s automotive industry is highly integrated with those of other European countries, and that a no-deal Brexit would be hugely disruptive if not an existential threat. Meanwhile, contingency planning for a no-deal Brexit has increased dramatically. Production of automobiles in the United Kingdom fell about 20 percent in the first half of this year versus a year earlier. About 80 percent of cars produced in the United Kingdom are exported, with a little more than half of that going to other EU countries, and overall exports are down considerably. Meanwhile, the latest purchasing managers’ index for UK manufacturing indicates that activity in the manufacturing sector continues to decline.
According to data released by the State Administration for Foreign Exchange (SAFE), the US dollar share of China’s foreign currency reserves fell from 79 percent in 2005 to 58 percent in 2014.57 However, SAFE did not provide data on foreign currency holdings for more recent years. Why? Probably because the share has likely fallen sharply in recent years, a fact that the central bank might not want to publicize. One analyst estimated that holdings of US dollars have fallen about 40 percent since 2014, which suggests that the share of foreign currency reserves held in the US dollar is down much further.58 Why has China cut its dollar reserves? It is likely because the government does not want to be too dependent on the fortunes of the US government. Plus, it is eager to internationalize the renminbi, which could entail helping to reduce the dominant role of the US dollar. However, many critics argue that China is hurting itself by holding fewer dollars. They contend that, the dollar provides a degree of liquidity and safety that cannot be replicated. Moreover, the government’s secrecy surrounding holdings of dollars is not consistent with efforts to internationalize the renminbi. A currency that plays a major role in global finance is always issued by a central bank that is highly transparent.
US companies operating in China are facing greater difficulty in doing business reveals a new survey jointly conducted by the American Chamber of Business in China and the American Chamber in Shanghai.59 Three quarters of respondents said that the trade war between the United States and China is hurting their business. In addition, more than half said that tariffs were hurting demand for their products, and 42 percent said they are experiencing higher costs as a result of tariffs. Also, about one third of respondents said that they are delaying or cancelling investment projects. Some 41 percent said that they are considering or have already relocated manufacturing facilities outside of China. Of these, only 6 percent intend to move facilities back to the United States. The most popular destinations for relocation are Southeast Asia and Mexico. About 62 percent of the 239 companies surveyed are involved in manufacturing. The survey offers a quantitative assessment of the impact of the trade war on China-invested US companies. Meanwhile, the trade war continues and, if a deal is not reached soon between the United States and China, could worsen. A further increase in tariffs, combined with continued uncertainty about the future, is likely to undermine investment by US firms in China and compel many manufacturers to look for alternative locations.