Signs of easing U.S.-China tensions have helped calm recessionary fears that gripped markets in recent weeks. We see little risk of an imminent recession, as ongoing policy support, the absence of obvious financial system vulnerabilities and resilient consumer spending helping extend the U.S. economic expansion. Yet a comprehensive U.S.-China trade deal is unlikely in the near term, and trade tensions could likely weigh on growth and pressure inflation, in our view. This could call for a more defensive investing stance.
Rising global trade tensions are spilling over into the U.S. manufacturing sector. This is reflected in the makeup of U.S. GDP growth. The contribution by capital expenditure and net exports turned negative in the second quarter, as the chart shows. The pace of inventory building is still on the rise, as businesses stock up ahead of expected further rises in tariffs. Consumer spending – making up over two thirds of the U.S. economy – is holding up well. Household leverage is limited, and there are no indications of over-extended spending on big-ticket goods as cars and appliances. This dynamic resembles 2015 and 2016, when strong consumer spending and services sector activity offset a contraction in industrial production. Yet there are key differences: Back then, we saw a deflationary combination of a strong U.S. dollar, overtightened policy in China and a collapse in oil prices. Today the shock is likely to be inflationary as it stems from tariffs and supply chain disruptions.
An uncomfortable mix
A protectionist push has become the key driver of the global economy and markets, as we highlighted in our Midyear 2019 Global investment outlook. Escalating tit-for-tat actions by the two countries in late August helped push the U.S. Treasury yield curve to invert (shorter-term yields rise above longer-term ones) – a phenomenon that has historically often preceded a recession and spooked investors. Yet structural forces such as a glut of global savings are suppressing long-term yields, making the yield curve’s shape a less reliable signal than in the past. And yields rebounded last week on signs of a more conciliatory approach by both the U.S. and China to trade talks. We reiterate our view that tensions between the two countries are structural, reducing the likelihood of a comprehensive deal. If all tariffs announced by the U.S. and China were implemented, U.S. growth could fall materially below trend in coming quarters.
The U.S. economy is unlikely to get much help from the rest of the world. Many economies are digesting the fallout from the rapid-fire protectionist measures and the potential for further escalation in trade tensions. We see China’s economy slowing further and Beijing likely to roll out additional stimulus to blunt bigger downside surprises, but a material boost to growth is unlikely. The eurozone economy could be stabilizing at best, with Germany in a technical recession and a range of Brexit-related risks still looming large. Meanwhile in the U.S., we see inflation set to pick up, thanks to more tariffs and faster wage growth in the face of a tight labor market. A mix of lower growth and higher inflation complicates the Fed’s effort to achieve maximum employment and stable prices. A key question: Can U.S. consumers keep supporting overall growth in the face of manufacturing headwinds, slowing job growth and tariffs on consumer goods?
The health of the U.S. consumer spending will be key for U.S. and global economic growth. Our base case points to a global growth slowdown cushioned by additional policy easing. Our moderate pro-risk stance – including an overweight in U.S. equities and exposures to government bonds as portfolio shock absorbers – has worked well thus far. Yet trade tensions pose the risk of slowing growth and rising inflation – a potential threat to stock and bond markets alike.