The US – China economic conflict escalated further in August, suggesting further downside risks for global growth and reducing investors’ risk appetite
Economic tensions heightened between the US and China during August. Indeed, following “tit-for tat” actions, the US is set to increase the tariff rate applied to $250 bn worth of Chinese imports, from 25% to 30% as of October 1st. Moreover, the US will impose tariffs of 15% on $300bn Chinese imports in two phases (half as of September 1st and the remainder as of mid-December). China’s retaliation so far includes increasing tariffs by 5% - 10% on $75 bn worth of imports from the US, also in two phases (on September 1st and in mid-December).
With no end to trade tensions in sight, as President Trump also called on US companies to start cutting their economic ties with China and bring their production back to US soil, combined with the high likelihood of tensions expanding to new fronts (e.g. US – European Union), the balance of risks for global GDP growth remains skewed to the downside. The outlook is also clouded by elevated no-deal “Brexit” concerns, political and geopolitical uncertainties (e.g. government crisis in Italy, Hong Kong unrest) and the prolonged weak momentum in the euro area.
In view of the downside risks for the economy, on July 31st the Fed, as expected, reduced the federal funds rate for the first time since 2008, by 25 bps in the range of 2.00% - 2.25%. Furthermore, it terminated in August the normalization of its balance sheet, two months ahead of schedule, at circa $3.75 trillion (18% of US GDP) versus $4.45 tn in October 2017.
Moreover, following the latest escalation in trade tensions, the Fed is expected to proceed with a further cut by 25 bps on September 18th. Attention will also focus on the quarterly Federal Open Market Committee (FOMC) participants’ expectations for the future path of the federal funds rate, with the current substantial gap (of circa 75-100 bps) between the latest FOMC forecasts (June) and the more dovish markets expectations posing a risk for a potential repricing of financial assets (see graph below).
Recall that the Bank of Japan and, more so, the ECB also appear ready for more monetary policy accommodation, while other economies (including New Zealand, India, Mexico, Indonesia) saw their central banks reducing policy rates during August, in most cases by more than expected.
Looser monetary policies, alongside muted expectations for GDP growth and inflation and, more recently, increased “safe haven” demand has sustained the rally in government bonds, with yields at multi-year lows (US: 1.54%, the lowest since August 2016) and an all-time low in Germany (-0.68%). Moreover, the US Treasury 10-2 year yield spread, a metric closely monitored as a signal for increased recession probabilities when it turns negative, has declined sharply by c. 25 bps since mid of July and is hovering around zero (see graph below).
At the same time, the turbulent international trade and policy backdrop fed through to heightened volatility and risk aversion in financial markets. Indeed, risky assets have suffered considerable losses so far in August, with global equities (MSCI ACWI) down by 5%. In the US, the S&P 500 was also down by c. 5% in August, with a strong underperformance by Banks (due to expectations for lower interest rates and weaker economic growth) and Energy (softer demand prospects) both by -11%.