Weekly global economic update

What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.

Week of Feb 10, 2020

The US job market chugs along and the Fed stays still

The latest employment numbers from the US government indicate continued strength of the job market. Job growth continues to exceed what is needed to absorb new entrants into the labor force. Moreover, this is being facilitated by an increase in participation in the labor market as formerly inactive workers are encouraged to return to the job market due to an evident abundance of jobs.

The US government produces two reports: one based on a survey of establishments; the other based on a survey of households. The establishment survey says that 225,000 new jobs were created in January, up from 147,000 in December. For the second consecutive month, there was a decline in employment in the manufacturing sector. Evidently, manufacturing continued to reel from the effects of the ongoing trade war. Whether or not this will change in light of the truce between the United States and China remains to be seen. There was also a decline in employment in the retailing sector. Keep in mind that the data is already adjusted for seasonal variation, so the decline in retail employment goes beyond the seasonal decline normally expected after the holiday season. It suggests that store-based retailers continue to be disrupted by the rise of online services. Indeed, employment in transportation and warehousing rose strongly as companies hired in order to meet demand for online retail services. There was modest employment growth in professional and business services, long a significant contributor to job growth. The greatest sources of job growth were health care and the leisure and hospitality sectors. Finally, average hourly earnings accelerated modestly in January, rising 3.1 percent from a year earlier.

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The separate survey of households showed that the share of the adult population participating in the labor market rose in January to the highest level since 2013. However, the number of people employed did not rise as fast as the number of people participating in the labor force. The result was a small increase in the unemployment rate from 3.5 percent in December to 3.6 percent in January.
The Federal Reserve indicated that it will leave its benchmark interest rate unchanged for the rest of this year unless there is a change in data suggesting otherwise. Interestingly, based on the interest rate futures market, it is clear that many investors expect the Fed to cut the rate at least once in 2020. Many investors are less optimistic about the growth of the economy than the Fed leadership, and more optimistic that inflation will be kept under control. Indeed, the Fed signaled its relative optimism, saying that “recent indicators provide tentative signs of stabilization. The global slowdown in manufacturing and trade appears to be nearing an end, and consumer spending and services activity around the world continue to hold up.”

Meanwhile, the Fed acknowledged the potential dangers to the global economy stemming from the coronavirus. It said that the virus “could lead to disruptions in China that spill over to the rest of the global economy.” By the end of this past week, investors were once again becoming concerned about the potential impact of the virus. Equity prices and bond yields fell sharply on Friday despite a positive jobs report in the United States.

Mixed signals about US manufacturing

New orders for US manufactured goods were up 1.8 percent from December to January, the biggest gain since August 2018. The size of the increase was largely due to strong orders for aircraft and military equipment. Excluding transport equipment, orders were up a more modest 0.6 percent. Excluding defense equipment, orders actually fell 0.6 percent. Meanwhile, the two major purchasing manager’s indices for manufacturing both indicated rising activity in January, possibly suggesting that the industry has turned the corner. Notably, the PMI published by the Institute for Supply Management (ISM) rose from 47.8 in December to 50.9 in January. This was the first reading above 50 in six months, indicating that activity in the industry is no longer contracting. The separate PMI from IHS Markit, however, declined from 52.4 in December to 51.9 in January. Still, this number indicates a modest increase in activity. The decline in the Markit PMI was mainly due to a weakening of export orders. Yet the improvement in the ISM PMI was due, in part, to a revival of export orders. How can these contrary indications be reconciled? The answer is that they cannot. It simply means that we don’t yet have sufficient information to draw a robust conclusion about export activity and that we’ll need more information in the months ahead. What we can infer is that, in February, there could be a worsening of US manufacturing activity because of disruption of supply chains due to the coronavirus.

US trade deficit narrows as economy slows

The US trade deficit declined from 2018 to 2019, the first decline in six years. Is this reason to rejoice? Not necessarily. A trade deficit is not necessarily a bad thing. It merely reflects the imbalance between what a country saves and what it invests. In the case of the United States, it invests more than it saves, so it must run a trade deficit which is the counterpart of net capital inflows. Ordinarily, a trade deficit declines when an economy slows down, which is precisely what happened in 2019. A slower growing economy generates less demand for imports. In addition, tariffs reduce imports. Both these things happened in 2019. The US trade deficit with China fell sharply due to trade restrictions imposed as part of the two countries’ trade dispute. As US trade with China declined, trade with other countries increased, especially with Vietnam. If, as many observers now expect, the US economy accelerates in 2020, then it is likely that the trade deficit will rise again. Indeed, the trade deficit rose sharply in December, fueled by an acceleration in imports.

Coronavirus impact

IMF Managing Director Kristalina Georgieva says that the coronavirus is likely to have a dampening effect on global economic growth this year, more so than in the case of SARS in 2002-03. The principal reason she gave is that China’s footprint in the global economy is today so much bigger than it was at the time of SARS. She noted that, at the time of SARS, China accounted for about 4 percent of global GDP. Today the figure is close to 18 percent. In addition, she said that the full impact cannot yet be known because we don’t know how fast or far the virus will spread. However, as of now, there is already some negative impact on the global economy. She said that “we see some indirect impacts building up around manufacturing, value chains being impacted by the disruption caused by the virus. We see impact on travel and on tourism.” Although the latest purchasing managers’ indices for January suggest a modest rebound in US manufacturing activity, many analysts fear a downturn in activity in February because of the disruptive impact of the coronavirus on supply chains.
China’s role in the global supply chains of the automotive and technology sectors could significantly impair manufacturing capability in many countries, if factories in China remain closed for much longer. Although many factories were set to reopen this week, it is possible that many may remain closed. Consider Wuhan, ground zero for the crisis ⁠—it is likely that many factories will remain closed. Wuhan is a major manufacturing center for the automotive sector. Also, factories outside of China rely on Chinese parts for a significant share of imported components. For example, the Chinese share of all imported manufactured components is 30 percent in the United States, 37 percent in Japan, 31 percent in Taiwan, 28 percent in India, and 24 percent in Mexico. Thus, a prolonged crisis could significantly cut manufacturing output in multiple countries, possibly leading to a surge in prices if products are in short supply.
Even after factories reopen, it is possible that transportation restrictions will inhibit a return to full-time production. Plus, it will take time to obtain parts and raw materials that have not been distributed during the crisis. Indeed, one major producer of electronics products said that it could take up to two weeks to return to full production once its major factory reopens. Meanwhile, the shutdown of numerous factories has already had a disruptive effect on global supply chains in several key industries including automobiles and mobile phones. A major Korean automotive company shut its Korean factory due to a shortage of parts. However, the disruption goes beyond Asia, with a major European producer saying that European production might be cut back because of a shortage of parts from China.
Apart from the disruption of manufacturing, the effect of the virus on the movement of people will likely have a negative impact on retail and tourist spending. Retail and restaurant companies have shuttered thousands of locations. Many global companies have shut stores and restaurants, potentially hurting their earnings. The main impact on consumers has a lot to do with fear. That is, consumer fear of the virus might not be consistent with actual risk. Yet fear can have a large impact on economic activity if consumers stay home and don’t spend.
Russia’s shutdown of its border with China is taking a toll on the Russian economy. Russia has benefitted significantly in recent years from expanding trade with China, which has helped to partly offset the negative impact of sanctions from the West. Russian exports of oil and gas to China have expanded. In exchange, Russia has imported a large volume of consumer goods. Plus, Russia has benefitted from a large number of Chinese tourists. Now, two-way trade has declined, oil prices have fallen, and the tourist trade has shriveled. This could have a negative impact on Russian growth.
A leading research institute estimates that the spread of the illness could peak by early March. If so, this would mean that the worst economic impact will be in the first quarter with a lesser but still negative impact in the second quarter. The negative economic impact could be over by the end of the year, setting the stage for a robust resurgence of activity in 2021 or earlier. Again, this is predicated on the assumption that the virus will be contained relatively soon. We still don’t know for sure.

Week of Feb 03, 2020

The potential economic impact from the coronavirus

What economic impact can we expect from the coronavirus that is currently frightening China? It is helpful to examine what happened in 2002-03 during the SARS outbreak. At that time, there was a sharp drop in GDP growth in the second quarter of 2003. Yet this was offset by a sharp acceleration in growth during the following two quarters. That is because, once the virus was contained, there was a need to satisfy the excess demand that built up during the period in which the economy was effectively on hold. The end result is that, if you examine annual economic growth data for China during the first decade of this century, it is nearly impossible to spot a SARS effect. Only when you examine quarterly data do you seen an impact, one that was quickly reversed.

Could the same be true again? The answer is yes, it is likely we will see a similar pattern—provided the coronavirus does not spread far more than SARS. However, there are three important caveats. First, the coronavirus is spreading during the first quarter of the year, not the second. The first quarter in China is when the critically important Lunar New Year celebration takes place. It is a time in which there is a surge in gift giving. It is unlikely, therefore, that the decline in consumer spending will easily be replaced in the following quarters. Second, the coronavirus is centered in Wuhan, a large city that is an important industrial and transport hub. It is now nearly completely shut down. Even once the virus is under control, it will take time to bring the city back to normal. It is comparable to shutting down Chicago in the United States. Third, SARS took place when the economy was strong. Full-year growth in 2003 was 10 percent, even higher than in 2002. This year, even without the virus, it was likely to be no more than 6 percent. Thus, the virus could likely bring Chinese growth to a level not seen in modern times.

That said, some of the decline in consumer expenditures at stores will likely be offset by more online shopping. Some of the cancelled holidays will take place later as consumers have likely set aside money for that purpose. And some of the lost production at factories will be made up in order to meet pent up demand. Thus, a case can be made for minimizing the potential longer-term impact. Still, all of this is contingent on the virus not spreading faster than what happened with SARS. A larger and more prolonged pandemic could be more onerous for the economy.

Even if the virus does not spread rapidly in other countries, it could still have a significant global economic impact. First, China’s economy has lately accounted for about one-third of global growth. Any slowdown has a spillover effect elsewhere. Second, disruption of Chinese factory production and distribution has an impact on the supply chains of neighboring countries. This could mean trouble for factories in Southeast Asia, Korea, and Japan as well as for mines and farms in Australia, Indonesia, and elsewhere. Indeed, commodity prices have fallen sharply in recent days. This will make it more difficult for China to meet the import targets set by the US-China trade deal. Third, Chinese tourists play an important role in the economies of several Asian economies, especially Thailand. Their absence could cause a slowdown in growth. In addition, there are many global companies that depend strongly on sales in China. Already we’re seeing problems for many of these companies, with share prices having fallen sharply. Finally, financial markets have taken a beating, with equity prices falling in response to the crisis. The flight from equities has led to the suppression of bond yields, with the US yield curve inverted once again as of this writing. Nonetheless, the SARS experience tells us that, once the virus is contained, equity prices could surge.

Lastly, making predictions is difficult. There is much we cannot know, such as how fast the virus will spread, how successful China’s government will be in fighting the outbreak, how government economic policymakers will respond, and how ordinary citizens will adjust their behavior. For business, it is probably best to plan for the worst and be pleasantly surprised if the worst does not transpire.

Brexit has happened. Now what?

Debapratim De, Senior Economist at Deloitte UK, provides a look at the road ahead for the United Kingdom and the European Union (EU).

The United Kingdom formally left the European Union on Friday. Brexit day marks the beginning of a transition period until the end of this year, during which the United Kingdom will continue to apply and be bound by all EU laws but cede its seat at the EU’s decision-making tables. For businesses and workers, this means minimal change, especially with continued free movement of goods and people.

Perhaps the most important aspect of the transition period is its duration. Within these eleven months, the United Kingdom is also to negotiate its future relationship with the EU. While the stated objective of the British government is to thrash out a comprehensive and wide-ranging free trade agreement, policymakers and trade experts point out that 11 months is too short a timeframe for such a deal.

This leaves three alternatives. The first is an extension to the transition period. The British government has ruled this out, even legislating against it. The legislation could, in theory, be amended to allow for an extension but it is a clear statement of the government’s intent. The second option would be a “cliff-edge” Brexit at the end of this year, where the United Kingdom and the EU part ways without an agreement, resorting to trade under the rules of the World Trade Organization (WTO). This would be disruptive for both British and European businesses and is likely to be avoided.

The final option—that of a “basic” trade deal—seems the most likely outcome at the moment. Such a deal could cover tariff-free goods trade, an agreement on direct investment and provisions ensuring a “level playing field”, that seek to prevent either side giving their businesses undue competitive advantage. But substantive agreements on services trade or cross-border data flows are likely to take more time.

Striking even a basic trade deal will not be easy though. The European Commission’s president, Ursula von der Leyen, has clearly stated that the degree of British access to the European single market will depend on regulatory convergence—the extent to which the United Kingdom remains aligned to European regulations after Brexit. This is a thorny issue as many in the British government see the ability to diverge from the European rulebook as the very essence of Brexit.

If the negotiations until last autumn are anything to go by, this subsequent phase will likely include its fair share of political drama, going down to the wire. Any outcome will depend heavily on how the British government balances gains from regulatory divergence in specific sectors against benefits to British businesses from EU alignment.

US economy grows modestly

The US economy grew at a modest pace in the fourth quarter, at a rate nearly identical to growth in the second and third quarters. The only areas of strength were residential investment and government spending. Consumer spending grew at a modest pace and, for the third consecutive quarter, business investment declined. In addition, exports fell. However, imports fell even faster. The government’s GDP report suggests that the headwinds that suppressed growth in much of 2019 remained present at the end of the year. Here are the details.

Real (inflation-adjusted) GDP was up at an annualized rate of 2.1 percent from the third to the fourth quarter. This was the same rate of growth as in the previous quarter. For all of 2019, real GDP grew 2.3 percent, down from 2.9 percent in 2018. The difference was largely, but not entirely, due to a sharp slowdown in business investment. However, consumer spending slowed as well due to a slowdown in the growth of real disposable income. Disposable income had accelerated in 2018 due to the tax cut enacted in December 2017. By 2019, the effect of this had abated. Plus, as the labor market tightened, job growth decelerated as well.
Consumer spending decelerated in the fourth quarter, growing at an annualized rate of only 1.8 percent compared to 3.2 percent in the previous quarter. This included a sharp slowdown in the growth of spending on durable goods. Consumer spending on services, however, continued to grow at a steady pace.
For the third consecutive quarter, overall business fixed investment declined, with an especially sharp decline in investment in structures. Investment in equipment was down as well, for the third time in the last four quarters. Equipment largely involves information technology. Despite this, investment in intellectual property continues to grow at a healthy pace. Going forward, there is hope that the new US-China trade deal, by creating a greater degree of certainty about trading relations, will allow a rebound in business investment. Still, the United States appears to be embarking on a trade war with the EU. Thus, uncertainty remains. Moreover, global supply chains have already been significantly disrupted and now face new disruption from the coronavirus. So far, there is no indication of a rebound in global manufacturing activity, which would be needed to fuel a rebound in US investment activity.
Residential investment grew strongly for the second consecutive quarter. This follows 10 quarters in which such investment fell nine times. The rebound in housing is notable and likely due to the decline in mortgage interest rates.
On trade, exports of goods declined in the fourth quarter while exports of services rose at a strong pace. Imports of goods fell sharply, which boosted GDP growth. The big question now is whether exports are likely to significantly accelerate as a consequence of the new US-China trade deal. That agreement has China committing to dramatically boost imports from the United States.

Are US budget deficits unsustainable?

In Europe, an increasing number of people and institutions are urging governments, especially that of Germany, to borrow more and spend more in order to stimulate economic growth. Germany, after all, runs a budget surplus and has negative borrowing costs. In the United States, however, concern is in the opposite direction. After a tax cut and significant spending increases, which took place at a time of full employment, economic growth has failed to accelerate, but the budget deficit has ballooned. Specifically, the non-partisan Congressional Budget Office (CBO) says that, in the current fiscal year, the budget deficit will exceed US$1 trillion, hitting 4.6 percent of GDP. Historically, deficits this large have been reached either during recessions or wars, but not during periods of full employment and peacetime. Moreover, the CBO says that, in the coming decade, deficits will total over US$13 trillion. The Director of the CBO said, “Not since World War II has the country seen deficits during times of low unemployment that are as large as those we project, nor, in the past century, has it experienced large deficits for as long as we project.” Last year, government debt held by the public (as opposed to that part of the debt held by government entities such as the Federal Reserve) amounted to 79 percent of GDP (the highest in 70 years). The CBO says this will reach 98 percent by 2030 and 174 percent by 2050, in the absence of a significant change in fiscal policy. The latter number would be, by far, the highest level in the US history.

Is this a problem? Conventional wisdom says it is. That is because, when the government borrows in competition with the private sector, theory suggests it leads to higher borrowing costs that stifle private investment and suppresses economic growth. Yet recent experience in Japan suggests otherwise. Japan’s debt/GDP ratio is about twice that of the United States and yet the debt has not had any discernable negative impact on investment or growth. Moreover, borrowing costs have remained historically low despite massive borrowing. For the United States, borrowing costs also remain unusually low. Moreover, the deficits will not necessarily be onerous provided that borrowing costs remain low. If they rise significantly, however, the debt/GDP ratio could spiral out of control, exacerbating the problem of higher borrowing costs and potentially stifling private sector investment. If the Federal Reserve were to monetize massive deficits, it could cause ruinous inflation. This is what has happened in such emerging countries as Argentina, Venezuela, and Zimbabwe. The United States is currently far from that kind of situation and will not likely get there during the life of anyone reading this. Still, the projections by the CBO suggest that, in the long-term, US fiscal policy is not sustainable. Moreover, if the dominant global role of the US dollar were to recede in the coming decade, this would likely lead to higher borrowing costs in the United States, thereby exacerbating the size of future deficits.

Finally, what about those tax cuts? Proponents of the 2017 tax cut indicated that cutting taxes would significantly and permanently boost economic growth. Although growth accelerated in 2018, it has since retreated. Currently, the CBO forecasts average growth in the coming decade of 1.8 percent per year, lower than in the recent past. Thus, from this perspective, the tax cut may not pay for itself and could contribute to a fiscal problem. If the fiscal problem worsens what would be potential solutions to the problem? Some would articulate the solutions should include raising taxes, cutting spending, raising the retirement age (so that retirees obtain their government benefits later in life), and boosting immigration in order to increase the ratio of workers to retirees. Others would argue that the tax cuts need to be made permanent in order to realize the full effect, that mandatory spending needs to be reined in, and immigration restrictions, via a merit-based system, would reduce state, local and federal spending as well as provide the associated jobs needed to fulfil the demands of the economy.

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Economics , Weekly global economic update , Americas Economics , Asia Pacific (APAC) Economics , Europe Middle East Africa (EMEA) Economics , Asia Pacific (APAC) , Europe Middle East Africa (EMEA)

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Dr. Ira Kalish
Chief global economist
Deloitte Touche Tohmatsu Limited
ikalish@deloitte.com
+1 213 688 4765