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Trade, Fed Policy And Recession: It’s Complicated

“We’ll let you know in about three or four weeks”.

Hours after threatening to slap tariffs on everything from toys to cell phones to “live foxes”, Donald Trump expressed guarded optimism that trade talks with China will ultimately “be very successful.”

“We’ll let you know in about three or four weeks”, he said, speaking at the White House Iftar event on Monday evening.

Amusingly, S&P futures moved higher and the offshore yuan erased losses following Trump’s comments – as though he wasn’t just riffing. Or as if the USTR hadn’t just published a list in conjunction with prospective duties on another $300 billion in Chinese goods. Or as though US stocks didn’t just have their second-worst day of the year thanks almost entirely to the president’s decision to escalate tensions with Beijing last week, forcing the Chinese to retaliate.

Somehow, a nonchalant attitude that manifests itself in a “we’ll let you know” approach just doesn’t seem appropriate under the circumstances.

In fact, the latest tariff drama is amplifying recession calls, which never really went away even after December’s drawdown was relegated to the rearview. It didn’t help that the 3-month-10-year curve inverted again last week. “The left-tail risk is that we start to see recession-like levels on some of the big indicators that are affected by tariffs”, JPMorgan’s John Normand told on Bloomberg TV on Monday.

Over the weekend, Credit Suisse’s James Sweeney described how the economic dominoes would fall were talks between Washington and Beijing to stall indefinitely. “The first serious non-market bad news would likely come in survey data [and] we think the ISM would plunge into the 40s in June if tariffs remain in place”, Sweeney wrote.

Read more: ‘This Trade War Has Been Personalized’: One Bank Frets Over ‘Totally Unexpected’ Escalations

And, of course, Morgan Stanley’s Mike Wilson is cautious. “The risk of an economic downturn has increased substantially”, he said in a Monday note.

For their part, Barclays isn’t wholly pessimistic, but in their latest trade update, the bank adopts a new baseline scenario under which the assumption is that the US “places tariffs on most, if not all, imports from China over time and China responds with measures of its own.” Ultimately, the bank estimates the direct hit to the US economy at 0.2-0.3% of GDP, but warns that “indirect effects from a loss in business or consumer confidence, or from an escalation in financial market volatility, could easily lead to larger declines in output and employment.”

You might recall that over the weekend, Goldman pegged the peak hit to US GDP from a worst-case protectionist scenario (i.e., 25% tariffs on the remaining $300 billion in Chinese goods and the imposition of auto tariffs) and a concurrent 10% selloff in US equities at roughly 0.8%.

Barclays goes on to explicitly refute what the bank calls “administration claims to the contrary”:

Despite administration claims to the contrary, tariffs act as a tax on consumption, with losses born primarily by US consumers. These losses are then offset – in theory – by increases in producer and government surpluses. In our revised baseline US-China outlook, we estimate plausible losses to US consumers at about 0.6% of GDP, only some of which is transferred to the government and corporate sector in the form of tariff revenues and profitability. In other words, the hit to the consumer is likely to be several times larger than any net economic loss to the economy.

On the bright side, Deutsche Bank doesn’t see much in the way of “endogenous catalysts” for a downturn in the US – in other words, if things go off the rails stateside, it’ll be because Trump’s tariffs or some other unfortunate series of events tipped the rest of the world into recession.

“Economy-wide leverage has declined since the financial crisis, driven by significant deleveraging in the financial and household sectors [and] concentration of leverage within the public sector [which] is on balance a stabilizing development”, the bank’s Stuart Sparks wrote Sunday, recapping Deutsche’s recent analysis of how leverage has been redistributed post-crisis, on the way to expounding further on the economy as follows:

Payroll income is robust and should support consumption. Corporate margins are benefitting from the recovery in productivity that has led to declining unit labor costs. Moreover, the chart below illustrates that pricing power has improved in the last several years. The chart depicts changes in profit per unit output as a function of changes in price per unit output. When the best fit is upward sloping, the implication is that price increases lead to higher profits.

As far as US monetary policy goes, virtually nobody seems to believe that tariff-related price pressures would be enough to overwhelm the downside risk to growth from an all-out trade war when it comes to influencing the Fed’s decision calculus. That goes double when you consider how potential dollar strength factors into the equation.

“We estimate the direct effect of the latest tariff increase could boost year-on-year inflation rates by 0.1-0.2pp under the assumption of full pass-through and a high import penetration rate that accounts for goods directly sold to consumers and intermediate goods [but] these estimates do not account for potential offsets from currency appreciation, margin compression and weaker growth, which suggest that the overall spill over to consumer may be more limited”, Barclays writes, in the same note cited above, adding that they “remain skeptical that the overall effect of tariffs will create inflation on a sustained basis and at a level sufficient to dissipate concerns from the Fed and investors about the recent tepid inflationary environment.”

We would again point readers to Goldman’s analysis out over the weekend which suggested that the peak impact on core PCE from a worst-case protectionist scenario would be quite substantial. Whether or not that impact would be large enough to offset the structural and “transitory” factors weighing inflation down is another story.

Deutsche’s Sparks summed up the give and take nicely on Sunday. To wit:

The more likely catalyst for the Fed to ultimately cut rates is further deterioration in the external growth environment. Further increases in trade frictions could certainly contribute to that outcome. A strong dollar imports disinflation when global growth is weak. Given significant short rate differentials and return-seeking inflows into dollar assets, further deterioration in global growth relative to the US could drive additional dollar appreciation, putting downward pressure on domestic inflation that could lead the Fed to ease on a precautionary basis, or as part of an official move to average inflation targeting.

Much of the above speaks to the difficulty in saying, definitively, whether protectionism is inflationary or not. A simple read is that it is, especially when policy is being run by a simpleton, but from the start of the trade war, there have been questions about whether the knock-on effects (e.g., demand destruction and dollar strength) could mitigate the assumed inflationary impact.

For now, we’ll leave you with a quick note on the vol. side of things from Deutsche’s Aleksandar Kocic:

Although [the] trade-war-triggered turbulence is reverberating across all markets, the effects are largely concentrated in the currency space, with short dated CNH and JPY vol as the best performers (for reasons that are entirely orthogonal to each other). CNH vol captures the uncertainty about the mode of response to tariffs, while the spike in JPY vol is a consequence of a possible risk-off trade.

Compared to CNH, other markets’ reaction remains subdued. This is largely a function of the nature of the problem. No views in either rates or risk assets are likely to be articulated before the underlying tensions in the FX channel are resolved. The mode of propagation of the tariffs can be materially different depending of how currency, in particular CNH, adjust to it.



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