Recap
The past few weeks have been a tumultuous ride for the global economy, as the U.S.-China trade war unexpectedly escalated and the new U.K. Prime Minister’s hardline approach to leaving the European Union boosted fears that a no-deal Brexit may very well occur on October 31. There was further evidence of a global slowdown, notably in Germany and China. Geopolitical events have also been in the news, including the rising tensions in Hong Kong and the dissolution of the Italian government. Financial markets have reacted strongly to this complex, turbulent picture. Equity markets have been volatile. Long-term bond rates around the world have moved down sharply to near post-crisis lows.
Meanwhile, the U.S. economy has continued to perform well overall, driven by strong consumer sentiment and spending. Job creation has slowed from last year’s pace but is still above labor force growth. Inflation seemed to be moving up closer to 2%. However, clouds have gathered across other parts of the global economy, including from a pronounced escalation in trade policy uncertainty.
With short-term interest rates already low, the Federal Reserve has little room to cut borrowing costs to spur spending and investing as it usually does in a slowdown. Meantime, the federal debt has exploded, which could hamstring any efforts to boost growth with tax cuts or spending increases. Another interest rate reduction by the Federal Reserve might be needed to guard against the risk that a slowdown in U.S. business investment and global manufacturing activity will not spill over into other parts of the domestic economy.
The U.S. economy does not appear to be headed towards a recession right now. A glance at the incoming data shows solid domestic momentum, pointing to a continued, though slowing, economic expansion. The labor market has remained strong, consumer confidence was high, and consumer spending healthy.
However, the trade war has aggravated a global economic slowdown that has weakened U.S. manufacturing and business investment, clouding an otherwise solid domestic outlook. It is worth noting weakness in global manufacturing activity could seep into the services sector, leading to a slowdown in hiring. A couple of poor monthly payroll figures could in turn damage consumer confidence.
Tariffs
President Trump announced another round of tariffs on $300 billion of Chinese imports that had thus far largely avoided becoming tangled up in the trade dispute. President Trump stiffened tariffs on Chinese imports after Beijing unveiled its new levies on American goods, the latest twists in a trade war rattling investors and confounding central bankers.
The President’s stance has represented a new phase in his longstanding drive to shape U.S. corporate planning to align with his desire to see U.S. companies invest domestically and to force changes in China’s behavior that he has said harms U.S. companies and consumers.
The uncertainty created by that strategy has posed continuous challenges to the Fed’s monetary policy, with Federal Reserve Chairman Jerome Powell saying that the Fed has stood ready to stimulate the economy as needed but that trade uncertainties have compounded the risks to the global economic outlook.
Housing
Given the recent improvement in mortgage applications, it was not surprising to see a bump in existing home sales during July. Overall resales rose 2.5% during the month to a 5.42 million-unit annual pace, while sales for June were revised slightly higher. Total home sales have been up 0.6% over the year. That has marked the first positive year-over-year reading since early 2018. This has been a more favorable comparison given overall weakness last year but nonetheless reflects a steadily rising trend.
Even with the recent improvement, the ongoing lack of affordable product has remained an obstacle in the single-family market. During July, demand remained strongest for homes priced at or below the median. The general shift by buyers away from higher-priced homes has helped moderate increases in home prices. Home builders have responded to this trend with more entry-level construction, a pivot that has helped keep new home sales on an upward trajectory. New home sales dipped 12.8% during July, but June sales were revised up significantly to a 728,000-unit pace, the strongest since 2007.
Inflation
Inflation accelerated in July as the consumer-price index rose a seasonally adjusted 0.3% from June, its strongest two-month gain since early 2006. Core consumer prices also rose 0.3% for a second consecutive month, the strongest two-month gain in more than a decade. Price increases were broad-based in July but particularly driven by energy and services such as health care, shelter, and transportation.
The data marked the latest sign that inflation has found its footing after a sluggish price gain earlier this year. A tight labor market and tariffs imposed by the Trump administration on many imported goods are starting to push inflation higher. There were large increases in import-dependent categories like information-technology commodities and household furnishings and supplies as a sign that recent tariffs had started to feed into the data.
Still, it has been uncertain whether the June-July pickup reflected a long-awaited acceleration in price pressures or merely a bounce back from several months of low inflation earlier this year.
Manufacturing
Manufacturing activity has fallen in most of the world’s advanced economies, another sign that a deepening global slowdown could be weighing on the U.S. expansion. An index of factory activity in August declined in the U.S., Japan, Germany, and the Eurozone.
The recent decline in U.S. factory activity appeared to be tied to three factors – softening demand for motor vehicles; weakening sales at aircraft makers; and growing trade disputes between the U.S. and China. While domestic demand for U.S. manufacturers has remained favorable, weak growth abroad and some renewed strength in the dollar should continue to pose headwinds for the sector.
A global growth slowdown and trade uncertainty appeared to have been responsible for the bulk of the manufacturing slowdown in the developed world. It could be a reflection of growing global pessimism among purchasing managers. Their darkening mood has been associated with the trade dispute between the U.S. and China.
The U.S. and China have restarted talks but no real progress has been made. Beijing appeared to be willing to take a slow approach hoping to extract better terms. This would prolong the uncertainty and further escalation of the trade war risks spilling over in the service and household sectors, which could signal a much larger risk of recession in 2020.
Budget Deficits
The U.S. budget gap widened further in July as federal spending outpaced revenue collection, bringing the deficit to $867 billion so far this fiscal year, a 27% increase from the same period a year earlier.
Federal receipts rose 3% from October through July, totaling $2.9 trillion, while outlays climbed 8%, to $3.7 trillion. Federal revenue collection has picked up significantly since April compared with a year earlier when lower tax rates implemented under the 2017 tax overhaul weighed on receipts. At the same time, rising enrollment in Medicare and higher interest rates have led to higher government costs on benefits and interest payments, pushing the deficit even higher despite robust economic growth that usually shrinks budget shortfalls.
Higher deficits have forced the government to ramp up borrowing since early 2018, due in part to slumping revenue following the tax cut and a 2018 budget deal that lifted domestic and military spending for two years. A recently enacted budget deal would maintain the current government spending trajectory and add further to federal deficits over the next two years. More broadly, deficits are projected to continue rising over the coming decades as a wave of retiring baby boomers pushes up government outlays on Social Security and Medicare.
U.S. Dollar
A prolonged dollar rally has pressured U.S. corporate earnings, hitting commodity prices and threatening to deepen a selloff in emerging markets.
The U.S. dollar has continued to grind higher this year despite an escalating trade fight with China and broadsides from President Trump, who has complained that the dollar’s strength is curbing growth. In July, the dollar rose even after the Federal Reserve cut interest rates for the first time in a decade, defying expectations that lower rates would cut the appeal of U.S. assets to yield-seeking investors.
One key driver of the dollar’s gains have been the relative strength of the U.S. economy, which since 2015 until recently had allowed the Fed to raise rates far above the levels of borrowing costs in other developed countries. The gap in yields is likely to remain in place as central banks ease monetary policy to counter the effects of a global slowdown.
The strong dollar has been negative for U.S. exporters and has also hurt U.S. multinationals by making it more expensive for them to convert foreign revenues into U.S. currency – a worrisome trend for investors betting on an earnings rebound in the second half of 2019.
At the same time, the dollar’s strength has made investors more cautious on emerging markets, as a rising dollar would make it more expensive for these countries to service their dollar-denominated debt, pressuring those who have borrowed heavily in the U.S. currency.
Commodities, e.g., oil, copper and most other raw materials, have not only been buffeted by growth fears and the trade-war escalation, but they have also been hurt by the strengthening dollar. These commodities have been denominated in dollars and become more expensive to foreign buyers when the U.S. currency appreciates.
China
China’s producer prices fell into deflation for the first time in three years, as worries over the trade war with the U.S. sapped demand, adding another complication to Beijing’s efforts to shore up its slowing economy. Factory-gate prices have acted as a bellwether of industrial demand in China. As trade tensions with the U.S. escalate, global demand for Chinese goods will erode, further weighing on the prices of industrial goods.
While producer prices fell 0.3% from a year earlier in July, consumer prices edged up to a 17-month high, squeezing households’ spending power. This has presented a potential dilemma for China’s central bank. It could loosen monetary policy in a bid to stimulate demand and lift producer prices out of deflation, but a massive stimulus program would risk pushing consumer inflation higher and cause the property market to overheat.
The central bank could put more weight on weaker producer prices, giving them a foundation of more policy easing which would be needed to counter the impacts of trade fight and a cooling growth momentum at home.
Eurozone
The Eurozone economy has slowed sharply in the second quarter, with growth at an annualized 0.8% rate in the three months through June, a slowdown from 1.8% in the first three months of 2019. The drop in growth has been led by manufacturing, particularly factories in Germany and Italy, the two Eurozone economies most dependent on the sector.
Continued trade uncertainty delivered a blow to manufacturing confidence, which fell to its lowest level for six years in July. However, trade uncertainty has not been the only drag on European manufacturing. Automakers have wrestled with new rules on carbon emissions and an anticipated shift away from gasoline has seen sales fall. Consumer sentiment levels in Europe have also been low, consistent with levels that have historically preceded a recession.
The U.K.’s departure from the EU has also been a source of volatility. There has been a heightened likelihood that the U.K. will leave the EU without an agreement to smooth its exit, which would hit Eurozone manufacturers.
The Eurozone’s weakness has made it more likely that the European Central Bank would roll out new stimulus measures in September to limit the impact of the manufacturing sector on the rest of the economy, which has been in better shape.
Outlook
Two developments in the last few weeks have had a pronounced impact on financial markets: The Federal Reserve cut rates for the first time in over a decade and the trade war has expanded to include tariffs on an additional $300 billion of goods coming in from China.
The trade war is harming business confidence, leading to a visible pullback in investment that could eventually imperil job growth, which has been healthy. This rising uncertainty over trade policy adds to a growing list of geopolitical tensions, including protests in Hong Kong, Britain’s threat to crash out of the European Union on October 31, a political crisis in Italy that could roil the euro, conflicts between Japan and South Korea, and India’s military lockdown in the Kashmir region bordering Pakistan.
Despite the hand-wringing these events have caused in financial markets, the direct effects on economic growth have not been consequential. That said, turmoil in financial markets, should it continue, could sap consumer and business confidence. These “second-order” effects on the economy could become negative.
The Federal Reserve faces challenges in calibrating U.S. monetary policy to address the potential fallout from a confidence shock generated by the trade war. In July, the Fed lowered its benchmark rate for the first time in more than a decade. One concern is that after decades of monetary stimulus, lower rates may boost asset prices but would not otherwise remove the uncertainty holding back investment. Given the downside risks to growth amid the tumultuous global backdrop, the Fed may cut the fed funds rate again at its September meeting. The negative yield curve raises the probability that they could take further action in the months ahead.
Political leaders are inflicting avoidable pain on the economy with little to show for it. Central banks’ tools are not well-suited to deal with the political sources of economic weakness. Moreover, with borrowing costs already low, the Central Banks in developed countries have less room to cut rates to spur growth.
Sources: Department of Labor, Department of Commerce, Institute for Supply Management The Conference Board, Federal Reserve, Morningstar, European Central Bank, Bloomberg
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