U.S-China trade war escalates, but U.S. recession remains unlikely

The financial markets’ negative reaction to the breakdown in U.S.-China trade talks in a week where progress toward a deal was expected shouldn’t surprise anyone. 

If there were an official playbook for how investors might react to heightened trade policy uncertainty, it wouldn’t have veered far from what we witnessed last week: safe haven assets rallied while risk assets faltered. Investors have once again found themselves back in “risk-off” territory, feverishly monitoring media outlets and, increasingly, social media for any indication of what direction policy might take and how that could affect the market and the outlook for the U.S. economy.

Admittedly, the overall picture doesn’t look as upbeat as it did a month ago. In our view, most of the positive news has already been priced in—from the expected improvement in U.S data to the Trump administration’s decision to delay imposing tariffs on cars and auto imports for up to six months—meaning we’ll need another positive catalyst, such as strong corporate earnings or positive economic data from Europe, to propel the markets higher. These positive catalysts have yet to, and may not, materialize. We also know from experience that business investments both in the United States and elsewhere typically stall during periods of uncertainty as corporate confidence wanes. This will inadvertently weigh on growth. 

"In our view, the bigger concern is that a protracted trade war could hurt areas that have contributed significantly to margin expansion in recent years."

Research suggests that the tariffs that have been imposed since the start of the U.S.-China trade talks (excluding the latest round) have had a limited effect on the U.S. economy so far and, more importantly, U.S. consumer spending. Although their impact on corporate earnings has been slightly more pronounced, it hasn’t been significant.¹ In our view, the bigger concern is that a protracted trade war could hurt areas that have contributed significantly to margin expansion in recent years.  This could have a knock-on effect on earnings growth if an agreement can’t be reached soon.

Coming into 2019, our main concern was how potentially higher interest rates might derail growth in 2020 and into 2021. From that perspective, the recent decline in rates—driven by a dovish tilt from the U.S. Federal Reserve and other developed market central banks—suggests that a recession in the next 24 months is less likely now than it was at the beginning of the year. Our base case is for U.S. growth to slip below trend next year (i.e., less than 1.5%), but we don’t expect the economy to slip into a traditional recession. That said, given that we’ve essentially traded one set of risks for another (geopolitics), recession risks, however muted, remains.

There isn’t necessarily a prescribed playbook on how the financial markets will behave in these conditions, considering that the potential for surprises (both positive and negative) remain high. In times of heightened geopolitical risk, focusing on economic fundamentals can help to cut through the noise. And at this stage, from a macroeconomic perspective, the alarm bells haven’t gone off yet.

1 Empirical Partners Analysis, 5/10/19.