Thursday, July 11, 2019

Escalation of Trade War could result in a Global Recession

The nascent Sino-American cold war is the key source of uncertainty in today’s global economy. How the conflict plays out will affect consumer and asset markets of all kinds, as well as the trajectory of inflation, monetary policy, and fiscal conditions around the world. Escalation of the tensions between the world’s two largest economies could well produce a global recession and subsequent financial crisis by 2020, even if the US Federal Reserve and other major central banks pursue aggressive monetary easing.

Much, therefore, depends on whether the dispute does indeed evolve into a persistent state of economic and political conflict. In the short term, a planned meeting between US President Donald Trump and his Chinese counterpart, Xi Jinping, at the G20 Summit in Osaka on June 28-29 is a key event to watch. A truce could leave tariffs frozen at the current level, while sparing the Chinese technology giant Huawei from the crippling sanctions that Trump has put forward; failure to reach an agreement could set off a progressive escalation, ultimately leading to the balkanisation of the entire global economy.


Jaw-jaw or war-war?

Viewed broadly, there are three scenarios for how the situation might develop between now and the end of 2020, when the United States will hold its next presidential election. One possibility is that Trump and Xi will find a truce or modus vivendi in Osaka, paving the way for a negotiated settlement toward the end of this year. On the trade front, the US wants China to buy more American goods, reduce tariff and non-tariff barriers, open more financial and service sectors to foreign direct investment, and commit to maintaining currency stability and transparency with respect to foreign-exchange data.

On technology, the US is demanding that China strengthen intellectual-property protections, cease making the transfer of technology to Chinese firms a condition of market entry for US (and other) companies, and crack down on corporate cyber espionage and theft. A temporary deal could include any of the above, with the US offering medium-term (through the end of 2020, and possibly longer) exemptions to Chinese tech firms that use US components, semiconductors, and software. This would leave Huawei severely constrained, but not dead in the water.

The second possibility is a full-scale trade, tech, and cold war within the next 6-12 months. In this scenario, the US and China would adopt rapidly diverging positions after failing to successfully restart negotiations (with or without a truce). The US would follow through with import tariffs – starting at 10% but increasing to 25% – on the remaining $US300 billion worth of Chinese goods that have so far been spared. And the Trump administration would pull the trigger on Huawei and other Chinese tech firms, barring them from purchasing components and software from US companies.

China, meanwhile, would take steps to protect its economy through macro-level stimulus, while retaliating against the US through measures that go beyond tariffs (such as expelling American firms). Huawei might survive within the Chinese market, but its growing global business would effectively be crippled, at least for the time being.

It is possible that Xi actually wants a full-scale economic war as a means of damaging Trump’s re-election chances.

Beyond trade and technology, this scenario also implies increased geopolitical and military tensions. The possibility of some type of conflict over the East and South China Seas, Taiwan, North Korea, Xinjiang, Iran, or Hong Kong could not be ruled out.

Finally, in the third scenario, China and the US would fail to reach a deal on trade and technology, but they would forego rapid escalation. Instead of plunging into a total trade and technology war, the two powers might ratchet up their conflict more gradually. The US would impose new tariffs, but keep them at 10%, while renewing only temporarily exemptions that allow Huawei and other Chinese firms to continue purchasing key US-made inputs, while retaining the option of pulling the plug on Huawei at its discretion. Negotiations could continue, but the US would essentially hold a veto over Huawei’s bid to develop 5G and other key technologies of the global economy. Given that Trump could suddenly pull the plug on the company whenever it suits him, China’s leaders would probably abstain from blatant full-scale retaliation, but would still intervene to minimise the economic damage.

The third scenario is the most likely for now, because China is playing a waiting game until November 2020, to see if the US elects a more even-keeled president. Even with a truce, therefore, any negotiations that are relaunched after the G20 summit will probably drag on indefinitely, with no real signs of progress. In the meantime, the Trump administration will want to apply additional pressure on China, while keeping its options open. Better, then, to start with a 10% tariff on that remaining $US300 billion worth of exports. The US could always hike the rate to 25%, but at the risk of raising the costs of goods that many of Trump’s own lower-income voters rely on.

In the absence of a trade deal, the same modulated escalation is likely on the tech front. With Chinese firms already on a tight leash, the US could convince European countries and other allies not to grant Huawei tenders or licenses relating to 5G and consumer products such as smartphones, thereby undercutting Huawei’s current advantage in this market. That would buy the US a couple of years to cultivate its own national champions in 5G and related technologies, and to get a head start on 6G.

Moreover, a managed escalation has potential political advantages for Trump, and even for Xi. Trump will not be exposed to charges from Democrats that he got suckered or went soft on China. At the same time, the lingering uncertainty from an unresolved conflict will probably prompt the Fed to start cutting its policy rate in July – or September at the latest. Those cuts could reach 150 basis points if the slow rise in tensions starts to take a toll on business confidence. In fact, if the conflict is managed well, the US could avoid a recession altogether, albeit with a deceleration of annual growth from 2% toward the 1-1.5% range.


Whether the stock market would suffer a correction (a decline of 10% or more) or merely a sideways shift in the third scenario would depend on a variety of factors, such as investor confidence, growth trends, and monetary-policy measures. One also cannot rule out some type of fiscal stimulus in the US and other advanced economies. For example, Trump could try to broker a partial infrastructure-spending deal with congressional Democrats or seek to rebate tariff revenues to politically sensitive constituencies such as farmers and low- and middle-income households in the Rust Belt. Though Democrats would balk at granting Trump such favours, they would block rebates for the “losers” of the trade war at their peril.


The “managed-warfare” scenario also has advantages for Xi. The Chinese economy, after all, can be backstopped with monetary, fiscal, and credit stimulus, not to mention a weakening of the renminbi (above CN¥7 to the dollar). The government could also make a modest show of retaliation, such as by threatening to restrict (but not ban) exports of rare-earth metals, which are used in a wide range of high-tech products. At the same time, the authorities could make life harder for the hundreds of US firms with business and investments in China, not with a full boycott, but through a thousand small cuts and abuses.

… Isn’t really an option

Because China and the US both know that they are in for a decades-long rivalry, they may well conclude that it is better not to risk a full-scale conflict and global recession in the short run. Only through proper preparation over the medium term can the two powers manage a long-term cold war and the de-globalisation that will be necessary to protect their respective supply chains.

But this scenario is not particularly stable, and could easily morph into the first or the second after a few months. If China and the US are both motivated by concerns about growth and financial-market stability, they could overcome their immediate differences, which would allow for a temporary agreement that postpones the question of how to manage a larger cold-war rivalry.

In principle, both countries would be better off with a deal, which is why markets had priced in the first scenario up until this past May, when negotiations collapsed. For the US, an agreement on good terms would boost consumer and business confidence, and thus growth, while reducing inflationary risks from the tariffs.

The sequencing of a potential deal also matters. As matters stand, persistent uncertainty will lead the Fed to loosen its monetary policy one way or another. Suppose that Trump and Xi restart negotiations that then drag on until late fall or early winter of this year. The Fed would have to cut its policy rate by at least 50 basis points, after which point the Trump administration may agree to a deal. Because the impact of monetary easing takes time, the Fed would have to remain on hold until November 2020. (Even if the economy and inflation were to rebound, monetary policymakers would be hesitant to reverse course before the election, lest they appear to be acting politically.)

In this sequence, Trump’s re-election prospects would be doubly improved. The Fed would have locked in rate cuts as insurance, and a new agreement would have bolstered investor confidence and the stock market. But, of course, this could happen only by chance. Trump’s “art of the deal” does not involve such multistep, multidimensional thinking, after all.

As for China, an agreement would, at a minimum, prevent further damage to its economy, and particularly its tech sector. The government would secure a few more years with which to prepare for a longer-term conflict over trade, investment, artificial intelligence, 5G, and geopolitical dominance in Asia and beyond.

The Chinese tend to think long term, and they are well aware of the “Thucydides trap” – a self-fulfilling prophecy in which a hegemon and an emerging power end up at war. Still, they clearly need more time to prepare. A major short-term shock today would be hard for China to absorb, especially if it knocks the country’s national champions offline for the medium to long term.

And indeed, Trump now appears to be opening the door to a truce at the G20, tweeting that critical preparatory work for an extensive meeting with Xi will now begin. But that meeting may still fail, even if both sides pretend that a truce was reached. If there is no substance to the terms of an agreement at the G20 – only painted smiles and stiff handshakes – the subsequent negotiations may quickly fail and lead to a gradual escalation of the trade and tech war.

Thucydides returns

Unfortunately, an even more likely course of events is that the third scenario – a managed trade and tech war, which is my baseline of how the rivalry will evolve over the next few months – would then devolve into the second (a full-scale confrontation). A Sino-American trade and tech deal in the coming months is far from assured. The negotiations broke down in May as a result of substantial differences between the two sides. And now, the complex preparations needed to stage a successful Trump-Xi summit in Osaka are being rushed at the last moment, after six weeks were wasted with no contact.

Even if the Americans and Chinese can overcome differences in their negotiating style, the US will still want legislative commitments from China, and China will still view such demands as a violation of its national sovereignty. The Chinese are highly sensitive to anything resembling the imperial interference that weakened China in the nineteenth century. Like Trump, Xi cannot afford to lose face.

Moreover, as the war of words has escalated over the last month, the spillover of trade frictions into the technology domain has intensified. Once kept formally separate, the two issues are now inextricably intertwined, which will make a resolution even harder to achieve. The Chinese cannot agree to any deal that does not rescue Huawei, but now that Huawei has become a bargaining chip, national-security hawks in the Trump administration and Congress will force Trump to take a hard line on the company.

Each side seems to think that the other will blink first. For example, the US assumes it can inflict more economic pain on China than China is capable of returning, because US exports to China ($US130 billion) are a fraction of China’s exports to the US ($US560 billion). Hence, when it comes to tariffs, China seems to have more to lose.

Yet, as we have seen, the conflict is about much more than tariffs, and China can retaliate in a number of ways. In addition to imposing new non-tariff barriers, it can strike a blow against major US firms that rely on Chinese supply chains and consumer markets, while allowing the renminbi to weaken. And if tensions escalate too far, China could even resort to the nuclear option of dumping its massive holdings of US Treasuries; it has already started to reduce its holdings of such US assets.

Moreover, US leaders may be underestimating the costs of the conflict. According to the prevailing narrative, the tariffs now in place have had only a modest impact on US growth and inflation. But the latest economic data suggest otherwise, as the US and global economy are slowing. In fact, one reason why the Fed has started considering preemptive insurance rate cuts – likely to start in July – may be that it is worried that tariffs are hurting the US economy more than was initially anticipated.

Making matters worse, the US has nowhere near as many tools to respond to macroeconomic shocks as China does. In addition to massive stimulus and currency depreciation, China’s government can bail out private and public enterprises at will. The US, by contrast, must rely on traditional monetary and fiscal tools, all of which are already severely constrained. And while Trump must worry about re-election, Xi has abolished presidential term limits, faces few constraints on his power, and presides over a sprawling apparatus of social control, including the Great Firewall of online censorship.

The art of “no deal”

Politically, then, it is much easier for China to take the long view, which is what Xi has done by announcing a “new Long March” – a reference to the People’s Liberation Army’s long, painful retreat in the 1930s to a new stronghold in Shaanxi province, from which it broke out and took over all of China, under Mao Zedong, in 1949. By wrapping himself in the Chinese flag and fomenting nationalism at home, Xi is preparing Chinese society for a protracted struggle. If a full-scale cold war ensues, he will be able to remind the Chinese of the need to suffer today to achieve glory tomorrow.

In fact, it is possible that Xi actually wants a full-scale economic war as a means of damaging Trump’s re-election chances. A new Democratic president – even one who accepts the reality of a more contentious Sino-American rivalry – would almost certainly be a more constructive and honest broker for China to deal with. In the parlance of the foreign-policy establishment, Xi may see de facto escalation as the quickest route to regime change in the US.

Moreover, Xi is not an absolute ruler. While he controls most of the levers of power, there are still factions within the Communist Party of China (CPC) that could turn on him if he does not mount a sufficiently aggressive response to the US. He is not in a position to accept a deal in which he – or China – loses face or power. If America’s medium- to long-term goal is to contain China, as the Trump administration’s National Security Strategy clearly suggests, Xi cannot agree to anything in the short term that advances that agenda. In the grand scheme of things, it might be better to start a full-scale conflict now than to grant the US a tactical advantage for the next two years.

The danger is that Trump, too, would prefer a partial or full-scale trade and technology war to a weak deal. If Trump makes any notable concessions, he will be accused by both Democrats and right-wing pundits of appeasing China and betraying American blue-collar workers. Even if he can’t secure a favorable deal, at least he can say he remained tough. Among those who have Trump’s ear are national-security hawks – some of them modern-day Dr. Strangeloves – who believe that China is so fragile that an economic shock could precipitate a political collapse, and even regime change. This is a dangerous game to play, because it could lead to actions that turn a cold war into a hot war. The mere presence of such extreme voices in Trump’s orbit suggests that the administration’s intent is to contain China at any cost.

Worse, these hawks have the upper hand now that the “adults in the room” have long since departed. Secretary of State Mike Pompeo, National Security Adviser John Bolton, acting Secretary of Defense Patrick Shanahan, and Vice President Mike Pence all appear to be China hawks. And the situation is no better with respect to trade and economic advisers, where Secretary of Commerce Wilbur Ross, White House Trade Representative Robert Lighthizer, and Peter Navarro, Director of Trade and Manufacturing Policy, have sidelined moderates such as Secretary of the Treasury Steve Mnuchin (who is unwilling to stand up to the president anyway).

Summit signals

Where does that leave us? If both Xi and Trump find the third scenario attractive, neither will be willing to meet halfway on a deal. That makes the second scenario – a full-scale trade and technology war – the most likely outcome, given that a controlled escalation is inherently unstable.

As matters stand, the probability of a deal eventually being reached is low (my colleagues and I put it at just 25%). Still, we will know more after the G20 summit later. If Trump and Xi fail to broker a truce or a temporary agreement regarding Huawei, the US will probably follow through with 10% tariffs on the remaining $US300 billion worth of Chinese exports. We will then be in the initial stages of the third scenario.

On the other hand, if Trump and Xi hold a friendly meeting and agree to a truce, the US will probably withhold new tariffs, and we will be in the early stages of the first scenario. This would make the probability of the two sides reaching a deal slightly higher. But a lurch to the third scenario – a precipitous escalation of the current confrontation – would still be more likely, followed eventually by a descent into a full-scale conflict. Where it will end is anyone’s guess, but an escalating trade and tech war is, in my view, more likely than an eventual deal.


via afr, zerohedge

Tuesday, May 28, 2019

A war between China and USA could swallow the entire world


What started as a trade war between the United States and China is quickly escalating into a death match for global economic, technological, and military dominance. If the two countries' leaders cannot manage the defining relationship of the twenty-first century responsibly, the entire world will bear the costs of their failure.

A few years ago, as part of a Western delegation to China, I met President Xi Jinping in Beijing’s Great Hall of the People. When addressing us, Xi argued that China’s rise would be peaceful, and that other countries – namely, the United States – need not worry about the “Thucydides Trap,” so named for the Greek historian who chronicled how Sparta’s fear of a rising Athens made war between the two inevitable. In his 2017 book Destined for War: Can America and China Escape Thucydides’s Trap?, Harvard University’s Graham Allison examines 16 earlier rivalries between an emerging and an established power, and finds that 12 of them led to war. No doubt, Xi wanted us to focus on the remaining four.

Despite the mutual awareness of the Thucydides Trap – and the recognition that history is not deterministic – China and the US seem to be falling into it anyway. Though a hot war between the world’s two major powers still seems far-fetched, a cold war is becoming more likely.

The US blames China for the current tensions. Since joining the World Trade Organization in 2001, China has reaped the benefits of the global trading and investment system, while failing to meet its obligations and free riding on its rules. According to the US, China has gained an unfair advantage through intellectual-property theft, forced technology transfers, subsidies for domestic firms, and other instruments of state capitalism. At the same time, its government is becoming increasingly authoritarian, transforming China into an Orwellian surveillance state.

For their part, the Chinese suspect that the US’s real goal is to prevent them from rising any further or projecting legitimate power and influence abroad. In their view, it is only reasonable that the world’s second-largest economy (by GDP) would seek to expand its presence on the world stage. And leaders would argue that their regime has improved the material welfare of 1.4 billion Chinese far more than the West’s gridlocked political systems ever could.

Regardless of which side has the stronger argument, the escalation of economic, trade, technological, and geopolitical tensions may have been inevitable. What started as a trade war now threatens to escalate into a permanent state of mutual animosity. This is reflected in the Trump administration’s National Security Strategy, which deems China a strategic “competitor” that should be contained on all fronts.

Accordingly, the US is sharply restricting Chinese foreign direct investment in sensitive sectors, and pursuing other actions to ensure Western dominance in strategic industries such as artificial intelligence and 5G. It is pressuring partners and allies not to participate in the Belt and Road Initiative, China’s massive program to build infrastructure projects across the Eurasian landmass. And it is increasing US Navy patrols in the East and South China Seas, where China has grown more aggressive in asserting its dubious territorial claims.

The global consequences of a Sino-American cold war would be even more severe than those of the Cold War between the US and the Soviet Union. Whereas the Soviet Union was a declining power with a failing economic model, China will soon become the world’s largest economy, and will continue to grow from there. Moreover, the US and the Soviet Union traded very little with each other, whereas China is fully integrated in the global trading and investment system, and deeply intertwined with the US, in particular.

A full-scale cold war thus could trigger a new stage of de-globalization, or at least a division of the global economy into two incompatible economic blocs. In either scenario, trade in goods, services, capital, labor, technology, and data would be severely restricted, and the digital realm would become a “splinternet,” wherein Western and Chinese nodes would not connect to one another. Now that the US has imposed sanctions on ZTE and Huawei, China will be scrambling to ensure that its tech giants can source essential inputs domestically, or at least from friendly trade partners that are not dependent on the US.

In this balkanized world, China and the US will both expect all other countries to pick a side, while most governments will try to thread the needle of maintaining good economic ties with both. After all, many US allies now do more business (in terms of trade and investment) with China than they do with America. Yet in a future economy where China and the US separately control access to crucial technologies such as AI and 5G, the middle ground will most likely become uninhabitable. Everyone will have to choose, and the world may well enter a long process of de-globalization.

Whatever happens, the Sino-American relationship will be the key geopolitical issue of this century. Some degree of rivalry is inevitable. But, ideally, both sides would manage it constructively, allowing for cooperation on some issues and healthy competition on others. In effect, China and the US would create a new international order, based on the recognition that the (inevitably) rising new power should be granted a role in shaping global rules and institutions.

If the relationship is mismanaged – with the US trying to derail China’s development and contain its rise, and China aggressively projecting its power in Asia and around the world – a full-scale cold war will ensue, and a hot one (or a series of proxy wars) cannot be ruled out. In the twenty-first century, the Thucydides Trap would swallow not just the US and China, but the entire world.



via projectsyndicate

Monday, March 18, 2019

The US Fed's change in policy

The US Federal Reserve surprised markets recently with a large and unexpected policy change. When the Federal Open Market Committee (FOMC) met in December 2018, it hiked the Fed’s policy rate to 2.25-2.5%, and signaled that it would raise the benchmark rate another three times, to 3%-3.25%, before stopping. It also signaled that it would continue to unwind its balance sheet of Treasury bonds and mortgage-backed securities indefinitely, by up to $50 billion per month.

But just six weeks later, at the FOMC meeting in late January, the Fed indicated that it would pause its rate hikes for the foreseeable future and suspend its balance-sheet unwinding sometime this year.

Several factors drove the Fed’s volte-face. First and foremost, policymakers were rattled by the sharp tightening in financial conditions after the FOMC’s December meeting, which hastened a rout in global equity markets that had begun in October 2018. And these fears were exacerbated by an appreciating US dollar and the possibility of an effective shutdown of certain credit markets, particularly those for high-yield and leveraged loans.

Second, in the latter half of 2018, US core inflation unexpectedly stopped rising toward the Fed’s 2% target, and even started falling toward 1.8%. With inflation expectations weakening, the Fed was forced to reconsider its rate-hike plan, which was based on the belief that structurally low unemployment would drive inflation above 2%.

Third, US President Donald Trump’s trade wars and slowing growth in Europe, China, Japan, and emerging markets have raised concerns about the United States’ own growth prospects, particularly after the protracted federal government shutdown with which the US met the New Year.

Fourth, the Fed has had to demonstrate its independence in the face of political pressures. In December, when it signaled further rate hikes, Trump had been calling for a pause. But since then, the Fed has had to worry about being blamed in the event of an economic stall.

Fifth, Richard Clarida, a well-respected economist and market expert, joined the Fed Board as vice chair in the fall of 2018, tipping the balance of the FOMC in a more dovish direction. Before then, Fed Chair Jerome Powell’s own dovish tendencies had been kept in check by a slightly less dovish staff and the third member of the Fed’s leadership troika, New York Fed President John Williams, who expected inflation to rise gradually above target as the labor market tightened.

The addition of Clarida amid stalling inflation and tightening financial conditions no doubt proved decisive in the Fed’s decision to hit the pause button. But Clarida also seems to have pushed the Fed toward renewed dovishness in more subtle ways. For starters, his presence lends support to Powell’s view that the flattening of the Phillips curve (which asserts an inverse relationship between inflation and unemployment) may be more structural than temporary. Some Fed researchers disagree, and have published a paper arguing that uncertainty with respect to the Phillips curve should not stop the Fed from normalizing US monetary policy. But with Clarida’s input, the Fed will be more inclined to focus on actual inflation trends, rather than on the official unemployment rate and its implications under traditional models.

Moreover, while Fed staff members tend to believe that the US economy’s rate of potential growth is very low (around 1.75-2%), Clarida, like Powell, seems open to the idea that Trump’s tax cuts and deregulatory policies, combined with the next wave of technological innovation, will allow for somewhat stronger non-inflationary growth.

Finally, Clarida is spearheading an internal strategy review to determine whether the Fed should start making up for below-target inflation during recessions and slow recoveries by allowing for above-target inflation during expansionary periods. And though the review is still in its early stages, the Fed already seems to have embraced the idea that inflation should be allowed to exceed 2% without immediately triggering a tightening.

Taken together, these factors suggest that the Fed could remain in pause mode for the rest of 2019. After all, even a recent modest acceleration of wage growth does not seem to have produced higher inflation, implying that the Phillips curve may stay flatter for longer. And, given the Fed’s new de facto policy of targeting average inflation over the course of the business cycle, a modest, temporary increase in core inflation above 2% would not necessarily be met with policy action.

But while the Fed is most likely to remain in a holding pattern for the bulk of 2019, another rate hike toward the end of the year or in 2020 cannot be ruled out. China’s growth slowdown seems to be bottoming out, and recovery there could start to strengthen in the coming months, especially if the current Sino-American negotiations lead to a de-escalation of trade tensions. Likewise, a deal to avert an economically disastrous “hard Brexit” could still be in the offing, and it is possible that the eurozone’s slowdown – especially Germany’s – will prove temporary.

Moreover, global financial conditions are easing as a result of the Fed and other central banks’ renewed dovishness, and this could translate into stronger US domestic growth. Much will depend on whether Trump abstains from launching a separate trade war against the European auto industry, which would rattle equity markets again. Yet, barring more fights over the US federal budget and the debt ceiling – not to mention possible impeachment proceedings against Trump – the US could be spared serious domestic political and policy shocks in the months ahead.

If US GDP growth does remain resilient this year, some acceleration of wage growth and price inflation could follow, and core inflation may even rise above target in the second half of the year or 2020. And while the Fed seems willing to tolerate a period of temporary above-target inflation, it cannot allow that to become the new status quo. Should this scenario arise later in the year, or next year, the Fed could hike its baseline rate by another 25 basis points before settling into a protracted pause. Either way, the new normal will be a US policy rate close to or just below 3%.

Tuesday, February 26, 2019

Economic conditions may slow down in the coming months

Slowdown but no recession

After the synchronized global economic expansion of 2017 came the asynchronous growth of 2018, when most countries other than the United States started to experience slowdowns. Worries about US inflation, the US Federal Reserve’s policy trajectory, ongoing trade wars, Italian budget and debt woes, China’s slowdown, and emerging-market fragilities led to a sharp fall in global equity markets toward the end of the year.

The good news at the start of 2019 is that the risk of an outright global recession is low. The bad news is that we are heading into a year of synchronized global deceleration; growth will fall toward – and, in some cases, below – potential in most regions.  

To be sure, the year started with a rally in risky assets (US and global equities) after the bloodbath of the last quarter of 2018, when worries about Fed interest-rate hikes and about Chinese and US growth tanked many markets. Since then, the Fed has pivoted toward renewed dovishness, the US has maintained solid growth, and China’s macroeconomic easing has shown some promise of containing the slowdown there.

Whether these relatively positive conditions last will depend on many factors.

1. The first thing to consider is the Fed. Markets are now pricing in the Fed’s monetary-policy pause for the entire year, but the US labor market remains robust. Were wages to accelerate and produce even moderate inflation above 2%, fears of at least two more rate hikes this year would return, possibly shocking markets and leading to a tightening of financial conditions. That, in turn, will revive concerns about US growth.

2. Second, as the slowdown in China continues, the government’s current mix of modest monetary, credit, and fiscal stimulus could prove inadequate, given the lack of private-sector confidence and high levels of overcapacity and leverage. If worries about a Chinese slowdown resurface, markets could be severely affected. On the other hand, a stabilization of growth would duly renew market confidence.

3. A related factor is trade. While an escalation of the Sino-American conflict would hamper global growth, a continuation of the current truce via a deal on trade would reassure markets, even as the two countries’ geopolitical and technology rivalry continues to build over time. 

4. Fourth, the eurozone is slowing down, and it remains to be seen whether it is heading toward lower potential growth or something worse. The outcome will be determined both by national-level variables – such as political developments in France, Italy, and Germany – and broader regional and global factors. Obviously, a “hard” Brexit would negatively affect business and investor confidence in the United Kingdom and the European Union alike.

US President Donald Trump extending his trade war to the European automotive sector would severely undercut growth across the EU, not just in Germany.

Finally, much will depend on how Eurosceptic parties fare in the European Parliament elections this May. And that, in turn, will add to the uncertainties surrounding European Central Bank President Mario Draghi’s successor and the future of eurozone monetary policy.

5. America’s dysfunctional domestic politics could add to uncertainties globally. The recent government shutdown suggests that every upcoming negotiation over the budget and the debt ceiling will turn into a partisan war of attrition. An expected report from the special counsel, Robert Mueller, may or may not lead to impeachment proceedings against Trump. And by the end of the year, the fiscal stimulus from the Republican tax cuts will become a fiscal drag, possibly weakening growth.

6. Sixth, equity markets in the US and elsewhere are still overvalued, even after the recent correction. As wage costs rise, weaker US earnings and profit margins in the coming months could be an unwelcome surprise. With highly indebted firms facing the possibility of rising short- and long-term borrowing costs, and with many tech stocks in need of further corrections, the danger of another risk-off episode and market correction can’t be ruled out.

7. Seventh, oil prices may be driven down by a coming supply glut, owing to shale production in the US, a potential regime change in Venezuela (leading to expectations of greater production over time), and failures by OPEC countries to cooperate with one another to constrain output. While low oil prices are good for consumers, they tend to weaken US stocks and markets in oil-exporting economies, raising concerns about corporate defaults in the energy and related sectors (as happened in early 2016).

8. Finally, the outlook for many emerging-market economies will depend on the aforementioned global uncertainties. The chief risks include slowdowns in the US or China, higher US inflation and a subsequent tightening by the Fed, trade wars, a stronger dollar, and falling oil and commodity prices.


Silver lining

Though there is a cloud over the global economy, the silver lining is that it has made the major central banks more dovish, starting with the Fed and the People’s Bank of China, and quickly followed by the European Central Bank, the Bank of England, the Bank of Japan, and others. Still, the fact that most central banks are in a highly accommodative position means that there is little room for additional monetary easing. And even if fiscal policy wasn’t constrained in most regions of the world, stimulus tends to come only after a growth stall is already underway, and usually with a significant lag.

There may be enough positive factors to make this a relatively decent, if mediocre, year for the global economy. But if some of the negative scenarios outlined above materialize, the synchronized slowdown of 2019 could lead to a global growth stall and sharp market downturn in 2020.

Friday, January 4, 2019

Roubini thinks Trump policies may have increased likelihood of a crisis and global recession

Financial markets have finally awoken to the fact that Donald Trump is US president. Given that the world has endured two years of reckless tweets and public statements by the world’s most powerful man, the obvious question is, What took so long?

For one thing, until now, investors had bought into the argument that Trump is all bark and no bite. They were willing to give him the benefit of the doubt as long as he pursued tax cuts, deregulation, and other policies beneficial to the corporate sector and shareholders. And many trusted that, at the end of the day, the “adults in the room” would restrain Trump and ensure that the administration’s policies didn’t jump the guardrails of orthodoxy.

These assumptions were more or less vindicated during Trump’s first year in office, when economic growth and an expected increase in corporate profits – owing to forthcoming tax cuts and deregulation – resulted in strong stock-market performance. In 2017, US stock indices rose more than 20%.

But things changed radically in 2018, and especially in the last few months. Despite corporate earnings growing by over 20% (thanks to the tax cuts), US equity markets moved sideways for most of the year, and have now taken a sharp turn south. At this point, broad indices are in correction territory (meaning a 10% drop from the recent peak), and indices of tech stocks, such as the Nasdaq, are in bear-market territory (a drop of 20% or more).

Though financial markets’ higher volatility reflects concerns about China, Italy and other eurozone economies, and key emerging economies, most of the recent turmoil is due to Trump. The year started with the enactment of a reckless tax cut that pushed up long-term interest rates and created a sugar high in an economy already close to full employment. As early as February, growing concerns about inflation rising above the US Federal Reserve’s 2% target led to the year’s first risk-off.

Then came Trump’s trade wars with China and other key US trade partners. Market worries about the administration’s protectionist policies have waxed and waned throughout the year, but they are now reaching a new peak. The latest US actions against China seem to augur a broader trade, economic, and geopolitical cold war.

An additional worry is that Trump’s other policies will have stagflationary effects (reduced growth alongside higher inflation). After all, Trump is planning to limit inward foreign direct investment, and has already implemented broad restrictions on immigration, which will reduce labor-supply growth at a time when workforce aging and skills mismatches are already a growing problem.

Moreover, the administration has yet to propose an infrastructure plan to spur private-sector productivity or hasten the transition to a green economy. And on Twitter and elsewhere, Trump has continued to bash corporations for their hiring, production, investment, and pricing practices, singling out tech firms just when they are already facing a wider backlash and increased competition from their Chinese counterparts.

Emerging markets have also been shaken by US policies. Fiscal stimulus and monetary-policy tightening have pushed up short- and long-term interest rates and strengthened the US dollar. As a result, emerging economies have experienced capital flight and rising dollar-denominated debt. Those that rely heavily on exports have suffered the effects of lower commodity prices, and all that trade even indirectly with China have felt the effects of the trade war.

Even Trump’s oil policies have created volatility. After the resumption of US sanctions against Iran pushed up oil prices, the administration’s efforts to carve out exemptions and bully Saudi Arabia into increasing its own production led to a sharp price drop. Though US consumers benefit from lower oil prices, US energy firms’ stock prices do not. Besides, excessive oil-price volatility is bad for producers and consumers alike, because it hinders sensible investment and consumption decisions.1

Making matters worse, it is now clear that the benefits of last year’s tax cuts have accrued almost entirely to the corporate sector, rather than to households in the form of higher real (inflation-adjusted) wages. That means household consumption could soon slow down, further undercutting the economy.

More than anything else, though, the sharp fall in US and global equities during the last quarter is a response to Trump’s own utterances and actions. Even worse than the heightened risk of a full-scale trade war with China (despite the recent “truce” agreed with Chinese President Xi Jinping) are Trump’s public attacks on the Fed, which began as early as the spring of 2018, when the US economy was growing at more than 4%.

Given these earlier attacks, markets were spooked this month when the Fed correctly decided to hike interest rates while also signaling a more gradual pace of rate increases in 2019. Most likely, the Fed’s relative hawkishness is a reaction to Trump’s threats against it. In the face of hostile presidential tweets, Fed Chair Jerome Powell needed to signal that the central bank remains politically independent.

But then came Trump’s decision to shut down large segments of the federal government over Congress’s refusal to fund his useless Mexican border wall. That sent markets into a near-panic, and the government shutdown was soon followed by reports that Trump wants to fire Powell – a move that could turn a correction into a crash. Just before the Christmas holiday, US Treasury secretary Steven Mnuchin was forced to issue a public statement to placate the markets. He announced that Trump was not planning to fire Powell after all, and that US banks’ finances are sound, effectively highlighting the question of whether they really are.

Recent changes within the administration that do not necessarily affect economic policymaking are also rattling the markets. The impending departure of White House Chief of Staff John Kelly and Secretary of Defense James Mattis will leave the room devoid of adults. The coterie of economic nationalists and foreign-policy hawks who remain will cater to Trump’s every whim.

As matters stand, the risk of a full-scale geopolitical conflagration with China cannot be ruled out. A new cold war would effectively lead to de-globalization, disrupting supply chains everywhere, but particularly in the tech sector, as the recent ZTE and Huawei cases signal. At the same time, Trump seems to be hell-bent on undermining the cohesion of the European Union and NATO at a time when Europe is economically and politically fragile. And Special Counsel Robert Mueller’s investigation into Trump’s 2016 election campaign’s ties to Russia hangs like a Sword of Damocles over his presidency.

Trump is now the Dr. Strangelove of financial markets. Like the paranoid madman in Stanley Kubrick’s classic film, he is flirting with mutually assured economic destruction. Now that markets see the danger, the risk of a financial crisis and global recession has grown.