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June 25, 2019

Trade Wars Could End 10 Years Of Economic Growth

In July, the U.S. economic expansion will hit its ten-year mark, making it the longest on record. Yet surveys from the Conference Board and the Business Roundtable show business confidence is dipping, and U.S. CEO’s intend to dial back hiring and spending as they expect sales to trend lower.

Trade Disruption Is The Chief Culprit

While economic indicators may be signaling a slowdown, the most immediate threat to economic stability is the U.S.’ ongoing cold trade war with China.

President Trump’s threat to hit all Chinese imports with tariffs is amplifying uncertainty. CEO’s are nervous: in mid-June, over 600 companies and industry groups, ranging from Walmart to Rawlings, sent a letter urging the President to reengage with China. The companies estimate that continued tariffs and retaliation could result in 2 million job losses and cost the average family $2,300.

Those fears are showing up in the data: second quarter U.S. GDP is starting to slow and economists are revising growth forecasts downward for the year. Left unguarded, the U.S. economy could start to sputter as trade tensions undermine global growth.   

Economic Signals Are Slowing

Investors are also spooked by the inversion of the yield curve, or the negative spread between the 10-year and the 3-month Treasury rates. Historically, this has served as a reliable indicator of a downturn. All seven recessions of the last 50 years have been preceded by an inversion, with only one false alarm in 1998. But the timing between inversion and recession isn’t precise and can range from six to eighteen months.

Treasury Yield Curve Slope: 10 Year-3 Month

Source: Federal Reserve Bank of St. Louis

Shaded regions indicate recessions

Treasury Yield Curve Slope: 10 Year - 3 Month

However, when coupled with two other indicators, changes in the Conference Board’s Leading Economic Index (LEI) and a measure of Fed accommodation, the signal’s readability improves. When all three indicators are simultaneously flashing stress, they predict recessions with a six-month lead time.

Leading Economic Index

Source: The Conference Board
Shaded regions indicate recessions
Leading Economic Index

Fed Funds Rate - Neutral Rate

Source: Federal Reserve Bank of St. Louis
Neutral rate from Laubach and Williams estimates
Fed Funds - Neutral Rate

While the yield curve is currently inverted, the LEI remains positive and the Fed Funds Rate is close to neutral. However, the LEI has started to dip indicating that the economy is cooling. Absent help from improvements in trade or support from the Fed, it could start to flash red in the next few quarters.

While the LEI is a comprehensive cross-section of economic drivers, 60% is dependent on manufacturing activity and investor sentiment. Both have been dampened by trade tension. The most recent ISM measure of U.S. manufacturing activity unexpectedly dipped to its lowest level since Trump took office, having hit a high last August before trade disputes ramped up.

The U.S. doesn’t operate in a vacuum and other economies are also slowing. The IHS Purchasing Managers’ Index, which aggregates data from 30 major countries, showed global manufacturing contracting to a seven year low. Key manufacturing hubs such as Japan, China, Germany, South Korea and the UK are all in a slump. Similarly, the OECD’s composite leading economic indicator, an aggregation of 36 large economies, recently fell to its lowest level since September 2009.

Business Confidence Needs A Boost

With corporate confidence weak, any ramp up in tariffs and tit-for-tat retaliation between the U.S. and China could materially undermine growth. Corporate capital expenditures started to slow in the second half of 2018 as trade tension escalated, and that caution is unlikely to abate until there is some resolution. Add the knock on risk that companies scale back hiring as they wait for trade to improve and the case for concern is clear. History has shown that any uptick in the unemployment rate can quickly accelerate.

In fact, a jump in the unemployment rate of more than a third of a percent, as measured by its three-month rolling average, has been a reliable indicator that a recession is underway.

Unemployment Rate - 3 Month Rolling Average

Source: Federal Bank of St. Louis

Shaded regions indicate recessions

Unemployment Rate - 3 Month Rolling Average

Near Term Stabilization Of Trade Is Critical

Tariffs are essentially a political tool and can be cancelled quickly if leaders conclude they have made their point and decide to cooperate. That leaves markets in a tough spot as they look to crunch their estimates on the severity and duration of trade friction.

Right now, risky assets have priced in a benign scenario. That confidence will be challenged if President Trump and China’s President Xi Jinping leave the upcoming G-20 meeting without progress or a commitment to reengage.

If diplomacy fails in the U.S.-China standoff, markets will cry out for Fed help. Chairman Powell has signaled that he is closely monitoring and will act to “sustain the expansion.”

However, in the face of an extended cold war with China, the Fed is limited in how accommodative it can be from today’s relatively low rates. Recession risk will ramp up quickly if both sides become entrenched feeling the other side’s demands will handicap growth or compromise security. While the Fed will take action, it will be unable to offset a severe hit.

This material contains opinions of the author, but not necessarily those of Sun Life or its subsidiaries and/or affiliates.