Yesterday, the overarching message of my post was this bit:
“as we think of potential outcomes, policy error has to be a real concern here, especially in 2020 once the cumulative impact of all this takes its full measure.”
I don’t think the data show a recession baked into the cake. There’s no reason to think best-case outcomes are any less likely to occur than worst-case outcomes. But, we are in a period of extreme policy uncertainty. And errors are bound to happen.
Yesterday
The market meltdown yesterday is a case in point. The data were mixed. I was certainly alarmed at how soft the services ISM data turned out to be. But, in a world without Trump stoking geopolitical tension, that’s manageable.
In the world we live in though, Donald Trump is a big wild card. The sense I get is that he is on a unilateralist rampage right now, prepared to throw down the gauntlet against any and all adversaries at the same time, consequences be damned.
So, what was a trade war with China when the day started has now morphed into a currency war between the US and China.
The currency war
The Chinese have been measured in their approach here. Look at the sequence of events.
- First, the Fed cuts rates on Wednesday highlighting that trade policy uncertainty was a key motive.
- Almost immediately, as if to force another rate cut, Trump threatens to impose tariffs on $300 billion of consumer-sensitive US imports from China in a month’s time. The subtext is that Trump is sick of the Chinese stalling and believes he can bludgeon them into a deal. This is a clear escalation.
- The Chinese respond by telling state-owned companies not to buy agricultural products from the US and by allowing the Yuan to fall below 7 per dollar for the first time in 11 years. It’s important to note, though, that the market sent the Renminbi down. China simply chose not to intervene to support their currency as they have been doing. This is a clear escalation.
- Trump responds the same day by getting the US Treasury Department to label the Chinese “Currency manipulators” for the first time since 1994. While this move is only symbolic, it does allow the US to impose sanctions down the line. So, it is a clear escalation as well.
- The Chinese then respond by setting the Yuan reference rate above the critical 7 level at 6.9683 to the US dollar. They do this despite the offshore Yuan trading down to as low as 7.12 to 7.14 and a host of banks cutting their forecasts for currency to well below 7. This is a clear de-escalation.
So, to recap, within less than a week, we went from a garden variety global growth slowdown where the Fed was seen as a key actor to a trade and then currency war where no policymaker has the ability to prevent worst case outcomes if we get a series of policy errors.
And, in that scenario, there was a rapid-fire escalation of tension between the US and China before the Chinese rolled back some of the pressure. But, as the Chinese de-escalated, they warned the US through Global Times, a media outlet known to represent official views.
The sharp fall in the foreign exchange market reflected supply and demand and was a normal market reaction to Trump’s latest trade threat.
China has no intention of deliberately depreciating the yuan to spur exports, but Trump’s trade war with China has triggered a de facto weakening of the currency and indirectly supported its imports from China.
If Trump further escalates the trade war by imposing more tariffs, the yuan will probably continue to depreciate to ensure a supply-demand balance in the market. The weakness of the yuan can be positive for market discipline and help the currency market develop in a sounder way.
Outcomes
In trading today, markets have retraced some of the moves we saw during the escalation phase yesterday. But clearly, investors are on edge, worried that a trade and currency war between the world’s two biggest economies could end in a recession or worse.
I think these concerns are justified, particularly because the US president is prone to unpredictable and reckless moves. As a result, we should look at multiple policy errors on either as not just likely, but near certain. And then the question becomes whether these errors can be walked back. Or will the escalation be so damaging as to cause a geopolitical or economic crisis?
This is where we are right now.
Over the near-term, the Chinese currency peg is the biggest concern. Pressure for it to move below 7 may not subside for some time. And as the September 1 deadline for tariffs hit, we risk coming closer to another escalation.
Over the medium-term, the deterioration in the services sectors of advanced economies is the biggest concern. If consumers can remain buoyant through the holiday season, it may give the manufacturing sector the opportunity to rebound and prevent worst-case outcomes.
I still see a 2019 recession as unlikely. Nevertheless, it is not impossible. 2020 is when any accumulated policy errors – lack of fiscal spending in Germany, trade escalation in the US, tight monetary policy – are most likely to precipitate recession. By that time, if the manufacturing sector has not rebounded, we may well see the services sector dip into recession too.
The biggest unknown is whether Donald Trump becomes more or less volatile over time. I believe he will become more volatile. And that means policy errors will be greater.