The US economy could enter a recession within nine months in the event the Trump administration moves ahead with 25% tariffs on the entirety of Chinese imports.
That’s the message from Morgan Stanley on Sunday. Chetan Ahya, the bank’s co-Head of Global Economics and Chief Asia Economist, says market participants are still behind the curve when it comes to appreciating the effect an all-out trade war would have on the global economy.
This is generally consistent with a theme we’ve been pressing for weeks – namely that although the damage at the index level looked relatively mild in the first three weeks of May, a quick look under the hood at, for instance, semis and energy stocks, betrayed a more worrisome picture. As the tariffs bite, consumer prices will rise to the detriment of demand and corporate management teams, unable to plan for the future, will cut capex. Morgan’s Ahya reiterates all of those points.
Clearly, the Mexico tariffs make the situation worse. “[The Mexico] escalation in the trade war will hinder US economic growth [as] the tariffs will increase the cost for manufacturers and create frictions for production”, BofA warned on Friday, adding the following more granular assessment:
It also creates pain in financial markets. The S&P 500 is already down 6.2% from May 5 when Trump first announced the additional Chinese tariffs. The 3month-10year yield curve has since inverted, sending a worrisome sign. By our calculations, the tariffs with Mexico – if they persist until mid/late summer – will slice another a few tenths off GDP growth this year and next. If they last through October and reach 25%, it will be more damaging to the economy, pushing growth uncomfortably below trend. The tariffs will also boost core inflation – by our simulations, the 5% tariffs could add nearly 0.1pp to yoy core PCE and the 25% could boost the yoy rate by 0.4pp.
The projected impact from the Mexico tariffs on US corporate bottom lines is manageable at the aggregate level, but for companies exposed to tariffs, the hit could be substantial. And that’s to say nothing of the myriad second-order effects.
Meanwhile, it’s important to note that if Trump goes all the way with 25% tariffs on Mexico and 25% duties on all imports from China, around 80% “of some US imported products [would be] subjected to tariffs, including toys, cell phones, and other consumer electronics”, according to some simple math from Goldman.
As discussed at length on Saturday, the Fed faces a rather vexing quandary in all of this. Cutting rates risks emboldening Trump and perpetuating the trade war. The president has repeatedly implored the Fed to cut rates in order to give the US an edge in the fight, and if Jerome Powell acquiesces, it opens the door for the White House to get even more aggressive.
Of course, the more tariffs and non-tariff barriers that get erected, the worse for global growth and the darker the outlook for the US economy. The Fed would thus be indirectly contributing to a trade-related downturn and when that downturn materializes, the perception that the central bank was beholden to Trump may undermine its credibility and thus its capacity to combat a recession.
That said, we argued on Saturday that it may be too late. Powell may have no choice but to cut rates and, indeed, both Barclays and JPMorgan were out Friday calling for rate cuts in September, if not sooner.
Well, if you ask Credit Suisse’s James Sweeney, Powell will cut next month.
“We now expect the FOMC to cut rates by 25bps in July, following a significant increase in business uncertainty amid escalating trade disputes and deteriorating economic data”, Sweeney wrote Friday, adding that while a deal between Washington and Beijing which “reduces or eliminates tariffs would reduce the odds of a cut”, it may not obviate the need for rate cuts in the Fed’s mind.
Even in the case of a deal, “weak survey and hard data may compel the Fed to implement an ‘insurance cut,’ as they have discussed [and] without a deal, weak global and US growth will likely be persistent, forcing the Fed into a series of cuts”, Sweeney goes on to say.
To be clear, Credit Suisse doesn’t see a recession, and Sweeney says, explicitly, that “this is no time for panic.” Rather, it’s time for “insurance”, and as such, he focuses his analysis on 1995 and 1998.
FOMC meeting transcripts from those years “introduce the idea of insurance cuts – taking out a ‘modest and relatively inexpensive – in terms of risk – insurance policy’ against recession, without imminent signs of a growth contraction”, Credit Suisse says, rehashing. The bank also reminds you that recent data and downward revisions showed “domestic business investment and industrial production had already weakened before the recent escalation, making the economy more vulnerable to a negative shock.”
ISM is the key factor. The bank’s previous research shows that “the ISM is the economic indicator most associated with Fed policy changes since 1994.” Credit Suisse recalls the conditions that prevailed in ’95 and ’98. Here are a couple of short excerpts and a visual:
So what was the situation when rates were cut in July 1995? The Mexican peso crisis was underway. ISM manufacturing had fallen from 61.2 in November 1994 to 45.7. Global industrial production momentum (3m/3m annualized growth) had fallen sharply from 10% to below zero in just a few months – but the Kobe earthquake was partly to blame. US industrial production fell for three consecutive months through May and incoming data hinted at further weakness.
The external shock was more severe before the September 1998 rate cut. The 1997 Asian financial crisis and the LTCM episode in August 1998 generated weak foreign demand and tight domestic financial conditions. Global industrial production momentum fell from 8% in the summer of 1997 to -2% in 1998. ISM manufacturing index fell to 49.6 in June.
The bank’s analysis goes well beyond that, but the upshot is that in both of the historical analogs (or what we’re calling analogs for our purposes here), the Fed believed that an exogenous shock could ultimately dent domestic demand. An insurance cut was thus necessary in order to insulate the economy.
Additionally, it’s worth noting that although Powell’s “transitory” rhetoric at the May press conference was clearly designed to push back on market expectations for rate cuts, those expectations have remained sticky. That’s due in no small part to ongoing trade escalations.
While the Fed doesn’t want to be seen as “giving in” (especially after all the criticism Powell took earlier this year for relenting to the market “gods” and also to the man in the Oval Office), getting too disconnected from market expectations itself carries risks.
“Another common element leading up to the inaugural rate cut was a wide-spread expectation of a cut by the markets”, Sweeney remarks in his Friday note, recalling that “there was a 60% probability of a cut priced in for the 1995 one, and it was almost fully priced in for the 1998 one.”
Next, he quotes Janet Yellen, speaking during the July 1995 meeting. We’ll leave you with that quote, and, for good measure, a screengrab from the transcript.
So, I would like to see a cut to prevent a further backup in long-term interest rates, namely, to ratify the expectations implicit in the current structure of longer-term yields. I certainly am not arguing that we should be setting monetary policy by following the fed funds futures, but I think we should recognize situations when the market has gotten things right and act accordingly.