By Enda Curran and Katia Dmitrieva
The escalating trade war between the US and China is nudging the world economy toward its first recession in a decade with investors demanding politicians and central bankers act fast to change course.
In the US alone, the recession risk is “much higher than it needs to be and much higher than it was two months ago,” Lawrence Summers, a former US Treasury secretary and a White House economic adviser during the last downturn, said.
“You can often play with fire and not have anything untoward happen, but if you do it too much you eventually get burned.”
Mr Summers, who teaches at Harvard University, still sees a less than 50/50 chance that the US enters a recession in the next 12 months.
Investors are much more bearish: A closely watched segment of the yield curve, the difference between 10-year and three-month notes, inverted the most since 2007, indicating bets on protracted weakness.
And then the latest figures on German industrial output in June point to the huge damage German exporters are taking on from the US-China trade war.
The June figures from Europe’s biggest economy showed the biggest annual slump in a decade.
One of the market’s most-trusted recession indicators is at pre-crisis lows. New Zealand’s central bank stunned investors by dropping its benchmark rate by 50 basis points, double the expected reduction and sending the kiwi tumbling. Thailand also surprised, cutting by 25 basis points. India’s central bank lowered its rate by an unconventional 35 basis points.
While tight labour markets globally and the recent shift by central banks should provide a cushion, economists are starting to war game for how a recession could happen. Their fears are mainly centred on trade.
Under one scenario, President Donald Trump would carry through with his latest threat to impose 10% tariffs on a further $300bn (€268bn) of Chinese goods, drawing retaliation from President Xi Jinping.
While the direct cost of those tariffs is likely to be small, it is the uncertainty created by a further escalation of the trade war that could weigh on investment, hiring and ultimately consumption.
Morgan Stanley economists predict that if the US puts 25% tariffs on all Chinese imports for four to six months and the country hits back, a global economic contraction is likely within three quarters.
The tensions also extend beyond the US and China to include Japan and South Korea as well as Britain’s future relationship with the EU.
The worry is without a trade truce soon, markets will extend their recent slide and uncertainty-plagued companies would pull back further on investment, extending the pain of manufacturers to the services sector. Then, an otherwise tight job market would start to crack and consumers would retrench.
While central banks would likely cut interest rates and perhaps resume quantitative easing, that may no longer be enough to revive animal spirits this time and governments might not be fast enough to loosen fiscal policy.
“With no end in sight, there are significant downside risks to our forecasts for US and global growth,” Bank of America economists warned clients this week.
Bloomberg’s economists say that any renewed action by the ECB to buy assets will be less effective this time than they were in the past.
“Conventional policy space is limited. Unconventional policy is of limited effectiveness. Best hope it’s not needed,” said chief economist Tom Orlik.
JP Morgan Chase’s global manufacturing purchasing managers index already shows contraction.
The ECB is poised to unleash a renewed round of stimulus as soon as September, potentially including a rate cut further into negative territory, to fight a deepening slowdown.
In the US, manufacturing growth has slowed for four straight months and Citigroup equity strategists have cut their earnings forecast for S&P 500 companies.