The U.S.-China trade dispute escalated further on Monday with the U.S. Treasury Department designating China as a currency manipulator after the Chinese yuan fell to its weakest level in more than a decade against the U.S. dollar. That’s after a new set of tariffs on the remaining US$300 billion of Chinese imports that have so far been untouched will come into effect on September 1—a development that’s likely to dent consumer spending, with important implications for the U.S. economy.
We view these events as a gamechanger that alters our prior views regarding U.S. acceleration and a stabilizing China. The new tariffs have tripped the circuit breaker and, in our view, are likely to single-handedly reverse the course of the U.S. and global economy in Q3. This development is particularly disappointing, given that most of our research had found green shoots of stabilization and potential recovery in U.S. business investment, global trade, and the global manufacturing recession. Unfortunately, heightened trade tensions nip those positive developments squarely in the bud and necessitate two key changes of view from the macro strategy team.
We’ve changed our view from expecting a 25 basis points (bps) rate cut from the U.S. Federal Reserve (Fed) in September, followed by an extended pause, to a 50bps cut with the potential for more. We also believe an intra-meeting cut is possible, although that isn’t our base case. To be clear, we don’t believe that 50bps of cuts from the Fed will single-handedly salvage business or consumer confidence, but it could buffer some of the decline in market sentiment, arrest this new round of yield curve flattening, and soften the upside pressure on the U.S. dollar. All of those outcomes would be welcome by the Fed.
We believe a neutral risk exposure in the short term makes sense, heading into what we expect to be a difficult, volatile, and particularly uncertain August and September. However, this doesn’t change our moderately constructive 12-month view, as we believe risk assets (credit and equity) are still in an overall uptrend and will be supported by a low rate environment and extended—albeit weak—business cycle. Indeed, our internal conversations in the past two market days have questioned when the appropriate time will be to buy this dip. Right now, we suspect it’ll be within the next month, but it’s almost entirely dependent on the progression of trade tensions and, secondarily, concerns about emerging-market currencies. In the meantime, U.S. Treasuries and global debt can rally further, and there's some mild to moderate room left for equities to decline from here.
Why the change of view?
While markets are now accustomed to trade tensions, this newly proposed set of tariffs comes with three characteristics that are causing us much more concern than all past iterations.
- This set of tariffs affects the U.S. consumer in a more substantial manner who, until now, has offset weakness in business investment. In particular, new tariffs are set to hit electronics, apparel, and toys and are therefore likely to hamper consumer confidence, spending, and prices. This effect is unique to this new bucket of goods.
- While we feel U.S. dollar/Chinese yuan crossing 7.0 is more of a psychological level than an economically important development, the move cements two risk-off narratives: a low but rising possibility of a capital outflow crisis from China, and retaliatory measures from China that may further dampen U.S. and global growth activity.
- Aggressive global yield curve flattening reignites recession probability indexes and increases the chance of a curve-driven recession in 2020. We aren’t currently expecting a technical recession in 2020, but the depth of the confidence shock resulting from higher tariffs could bring U.S. growth to 1% in 2020 or slightly below, depending on the magnitude.
Where we go from here
Upside scenarios are more limited now than they were six months ago. They’re generally more associated with the potential for additional easing than the market currently expects from global central banks (already a tall order) and/or possible large-scale stimulus from China. Clearly, a reversal of the tariff threat would also present an important catalyst. While the above is all possible, we suggest stepping to the sidelines until we have more visibility on growth.