Ben: It’s time for another one of our periodic discussions centering on the question: “Is the economy about to be screwed?” At the moment, we’ve got a volatile stock market (down 391 points today), a trade war that shows no sign of ending, pessimistic investors, and increasingly disruptive protests in Hong Kong that may presage violence, among other bearish global economic indicators. Is it time to freak out yet?
Josh: It is time to be more concerned, certainly. I think Bank of America has the right terminology, saying there are a lot of indicators that are “flashing yellow.” A recession is not yet certain or even the most likely outcome (BoA puts the odds of a U.S. recession next year at about one-in-three). But it’s gotten quite a bit more likely.
Ben: Which of the current factors is most worrying from a macro perspective? Or is it more that they’re all coming together at once?
Josh: The biggest change is the increase in risks related to China. There is a trade war: A lot of market participants had expected the U.S. and China to get to a deal this year or next (I think the president himself expected this, too), and the breakdown in negotiations and mutual escalations over the last two weeks have convinced people we won’t get a deal. The actions being taken on both sides, like raising tariffs, shutting down agricultural imports, and letting the yuan weaken, are all negative for global growth. There is also the situation in Hong Kong. Protests are disrupting economic activity, including Monday’s airport shutdown. And there’s a lot of worry about what China could do — including sending in the army — and what that would mean for business that’s conducted in one of Asia’s main financial hubs.
And then there are unknown unknowns — what sort of international reaction will there be if China stages a violent crackdown in Hong Kong or abrogates its commitment to maintaining Hong Kong’s separate, more free, and more business-friendly legal and economic system? And what might other countries in the region do in response to devaluation or other trade actions China takes?
We talked a few months back about estimates from Ernie Tedeschi, an economist at Evercore, about how the China tariffs might get bigger — both higher rates and applying to more goods — and how that would mean a change from very mild negative effects on the U.S. economy to more moderately negative effects. The effects still weren’t supposed to be big enough to tip the U.S. into recession on their own. But if the trade-war escalation is a domino that sets off other disruptions in the global economy, watch out.
I should note some non-China issues.
Treasury yields keep falling — this is a generic sign that expectations for future interest rates and future economic growth are falling. It doesn’t tell us why, though. And there are some domestic economic indicators that might be of concern. One reason to remain optimistic is the job-market indicators continue to look quite good.
Ben: A piece in the Times today posits that one central difference between this cycle and a superficially similar one back in August 2007 is that lawmakers are actually within their power to end the trade war, unlike the subprime-mortgage crisis. Should that provide us much comfort, given that neither the U.S. nor China wants to be seen as backing down?
Josh: Yes. One of the main reasons to think this may not lead to a global recession is an escalating trade war imposes costs on both the U.S. and China and both countries have incentives to avoid the worst consequences. That may not save us, but it is possible that politicians (and I count Xi as a politician, not just Trump) will follow incentives to pull back from the brink.
However, as you note, they face certain constraints that could make that difficult (and Trump also sometimes fails to act in his own best interest).
Ben: Is there anything the U.S. or any other government should be doing to further lessen the risk? Other than, you know, ending the trade war.
Josh: Well, though the president’s getting mocked for this, his practice of paying farmers to compensate for the reduction in Chinese agricultural imports is doing something to protect a sector and some regions that are especially exposed to the trade war. And the Federal Reserve making clear that it will cut rates to offset economic costs from trade uncertainty also does something to mitigate the damage.
Ben: I may have been one of the people doing the mocking.
Josh: I think both sides ought to be clear about what their goals are in the negotiations.
It seems clear the Trump administration — even sophisticated people within it, like trade representative Robert Lighthizer — were caught off guard by what they saw as Chinese efforts to recut terms they’d already agreed to. It seems like Xi may not have realized how constrained he is by domestic politics, and that made his negotiating position unclear. Trump’s tendency to change his mind makes it hard for us to maintain a clear position.
And I think Trump certainly shouldn’t be making comments like “That’s between Hong Kong and China” that might tend to embolden the Chinese to be aggressive there.
Western governments are not being too publicly noisy about it now, but you could have a Khashoggi-type situation where an international outrage draws much more attention and significantly escalates a conflict between China and various Western governments.
Ben: Yes, that seems likely, if we’re looking at a Tiananmen-like crackdown. Business as usual after that would be difficult to maintain for a whole host of reasons.
Josh: Yeah. I’m not going to make more specific predictions on that — it’s not my area of expertise — but I broadly think it’s a big reason to be nervous, both about human rights in Hong Kong and about the global economy.
Ben: Does the presidential race play any role in the economic outlook, as far as you can tell?
Josh: I don’t see any evidence of that. A Democrat who wins the election is going to be pretty constrained by Congress in terms of policy-making, as John Delaney likes to annoy everyone by pointing out.
So I think that limits what markets might perceive as “policy risk” from a Democratic win. and I also don’t think election-outcome odds have moved greatly in the last year, so it shouldn’t be a source of change in the outlook.
Ben: Is there a particular sign you’re watching out for that would give us more information about where we are and where we’re going, economically speaking? (I feel I always ask this question.)
Josh: Well, so recessions are usually caused by one of two things. Either you have an investment bubble where people buy a lot of things and later figure out they aren’t worth what they paid, like with tech stocks in 2000 or homes in 2007. Or they are caused by a negative external shock, like the oil crisis of the 1970s.
The China stuff is in the “external shock” box of risks, so basically you look for the external shock.
Indicators like stock prices, bond yields, and oil prices can tell you something about how the market is thinking about growth expectations and risk, so it makes sense to watch those, too.