The escalating trade war between the U.S. and China is nudging the world economy toward its first recession in a decade with investors demanding politicians and central bankers act fast to change course.
In the U.S. alone, the recession risk is “much higher than it needs to be and much higher than it was two months ago,” Lawrence Summers, a former U.S. Treasury secretary and a White House economic adviser during the last downturn, told Bloomberg Television. “You can often play with fire and not have anything untoward happen, but if you do it too much you eventually get burned.”
Summers, who teaches at Harvard University, still sees a less than 50/50 chance that the U.S. enters a recession in the next 12 months. Investors are much more bearish: A closely watched segment of the yield curve, the difference between 10-year and three-month notes, inverted the most since 2007, indicating bets on protracted weakness.
New Zealand’s central bank on Wednesday stunned investors by dropping its benchmark rate by 50 basis points, double the expected reduction and sending the kiwi tumbling. Thailand also surprised, cutting by 25 basis points. India’s central bank lowered its rate by an unconventional 35 basis points.
U.S. stocks fell in early trading in New York, bonds rallied globally, and havens including gold and the yen gained ground. The yield curve for both the U.S. and German economies have flashed warning signs of downturns.
While tight labor markets globally and the recent shift by central banks should provide a cushion, economists are starting to war game for how a recession could happen. Their fears are mainly centered on trade.
Under one scenario, U.S. President Donald Trump would carry through with his latest threat to impose 10% tariffs on a further $300 billion of Chinese goods, drawing a retaliation from President Xi Jinping. While the direct cost of those tariffs is likely to be small, it is the uncertainty created by a further escalation of the trade war that could weigh on investment, hiring and ultimately consumption.
Morgan Stanley economists predict that if the U.S. puts 25% tariffs on all Chinese imports for four to six months and the country hits back, a global economic contraction is likely within three quarters. The tensions also extend beyond the U.S and China to include Japan and South Korea as well as Britain’s future relationship with the European Union.
Global Fallout
The worry is without a trade truce soon, markets will extend their recent slide and uncertainty-plagued companies would pull back further on investment, extending the pain of manufacturers to the services sector. Then, an otherwise tight job market would start to crack and consumers would retrench.
While central banks would likely cut interest rates and perhaps resume quantitative easing, that may no longer be enough to revive animal spirits this time and governments might not be fast enough to loosen fiscal policy.