Moreover, the positive developments that have helped to keep economic momentum going for now, such as falling oil prices and a stabilising Chinese economy, will not be enough to offset the headwinds as they intensify.
Finally, companies and policymakers around the world will soon accelerate the structural adjustments they need to make to survive the big and damaging developments we have seen this year. As they do so, there will be further headwinds to growth.
Right now, the world economy seems to be in reasonably good shape
The surveys of purchasing managers give a good real time feel for what’s happening in the global economy. The latest survey, for June, paints a picture of continued economic growth. Overall service sector activity expanded at a comfortable pace while other components of the survey such as new orders, business activity and company confidence were healthy.
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Activity in manufacturing was somewhat mixed: in aggregate, global manufacturing eked out a tiny rate of growth, but some export-oriented economies saw contractions in manufacturing activity. Surprisingly, despite other surveys showing businesses labouring under great policy and trade uncertainty, these same firms still expressed confidence that things will turn out alright in the end.
The only hint of a slowdown was in the decline in companies’ willingness to hire new workers which was evident in most countries that were surveyed.
At the same time, there was no evidence that the rise in the rise in tariffs were resulting in higher inflation yet. Input costs and prices charged to customers are rising but only modestly with little change in trend since last year. For now, the global economy has weathered the storm well.
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But the headwinds can only intensify, given the outlook for the trade war
The key question then is — will this upbeat situation last? We think not.
This is because the trade war will soon enter a more damaging phase. The “deals” that the US has so far secured, with the UK and Vietnam, for example, tell us a few things about how the trade dynamics might evolve.
First, the average rate of tariffs charged by the US will certainly go up substantially compared to the beginning of the year. It is clear that a 10% additional tariff rate is the minimum that the US will settle for — and only for a few favoured economies, such as the UK which runs a trade deficit with the US and is a strong security partner. For the others, there will be much higher overall rates on all imports, probably similar to the 20% which Vietnam apparently has to accept.
That average tariff will be compounded by separate sectoral tariffs on a range of goods such as pharmaceuticals, automobiles and auto parts, metals such as steel, aluminium and copper and semiconductors, just to name a few. Put it altogether and the actual tariff levels in the US could end up at close to 18%, which is massively higher than the 2.4% that prevailed at the beginning of the year.
Second, while preliminary deals will be struck with many large economies, these deals will probably be incomplete ones with broad agreements at the headline level but with many key details left for the future. This is because negotiating trade agreements is notoriously complex and the Trump administration has not had the administrative bandwidth and the trade expertise to negotiate important details. What that means is that much uncertainty will remain, as there will be scope for more disagreements and misunderstandings.
Third, many countries fear that high US tariffs on Chinese goods will result in Chinese exporters diverting their products to third markets. Some of this is already happening — trade data in recent months shows Chinese exports to the US falling while exports to places such as Europe and Asean are rising.
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This is why other countries are also imposing trade restrictions to prevent Chinese goods once planned for the US markets from being diverted to their markets. Canada has just imposed additional duties on steel and aluminium for this reason. Many emerging economies have used anti-dumping measures and other restrictions to slow the influx of Chinese goods into their markets.
In short, protectionism is rising everywhere, not just in the US. And that can only be bad for global growth. As the trade deals are done and more protectionism is evident, companies which have been holding off drastic adjustments will begin to act. Surveys of likely company behaviour suggest that many will pass on the tariff costs to the American consumer while also suffering lower margins as they will absorb part of the higher costs. Lower profitability will then push companies in the US to rationalise operations so as to reduce costs — that would mean layoffs and higher unemployment and cutbacks in expansion plans.
It is not just the trade war that is a problem
There are many other things that could go wrong.
First, investors may be unpleasantly surprised by geo-political developments. The wars have not gone away. Ukraine is just about holding off a fierce Russian offensive but it is losing territory and its situation could deteriorate. There is still unfinished business in the Middle East given that the US-Israeli attacks on Iran probably did not eliminate its nuclear capacity. Tensions continue to rise in the East and South China Sea while Chinese and Indian troops still confront themselves on the Himalayan border.
Second, the risks of a disorderly correction in the US dollar are increasing. For one, the budget bill that has been passed by the US Congress is projected to swell the American public debt position by more than US$3 trillion ($3.84 trillion) or more over the next ten years. Government deficits will remain elevated at close to 6% for the coming decade. This has increased investor concerns about the fundamentals of the US economy because it shows that the American political class does not have the will to check the deterioration in public finances.
Other commentators worry that some of the factors that drove American exceptionalism are also being undermined by the current administration’s policies. The inflow of scientific and entrepreneurial talent has been central to why the US economy has been so innovative and its companies capable of generating immense shareholder value. With the highly aggressive moves to deport illegal immigrants, this has turned off even legal migrants from wanting to move to the US. Talking to Asian and foreign university leaders, one learns that there has been a surge in applications by senior research fellows as well as post-graduate students exiting the US.
This is why the US dollar has weakened and why US bond yields have not fallen as much as one would expect given that the economy is poised to slow and the Federal Reserve is likely to cut rates later in the year.
Third, other financial risks are also growing. The return of inflation and rising domestic bond yields represents a sea change in Japan that is leading to important changes in how Japanese savings flow to external markets especially the US. Capital flows from Japan will become more discerning and potentially diminish, just as the large increase in American deficits will require more funding.
Are there factors that can offset the headwinds?
There have been three factors that have helped the global economy of late. The question is whether they will be of sufficient help.
One is that oil prices have fallen — and could fall further. Opec and its allies have shifted from production cutbacks to expanding supply at a time when oil demand is not strong. Major oil exporters such as Saudi Arabia want to claim back market share and are prepared to endure lower oil prices for a while to achieve that. Lower energy costs could thus support the global economy through much of this year.
The other piece of good news has been that China’s economy has perked up a bit. Policymakers remain reluctant to provide bold stimulus but are ready to just enough to keep the economy chugging along at a roughly 4%–5% pace. But while it is likely to stabilise, it is unlikely to add substantially to global demand for the following reasons:
The Chinese economy is still suffering from deflationary pressures. In June, producer prices fell at the fastest pace in 23 months, reflecting persistent supply-demand imbalances in the economy — in both the real estate sector as well as in industry where many sectors are seeing ferocious price wars due to over-capacity.
In addition, China is being targeted by the US in the trade war, so its export outlook can only worsen. The Peterson Institute for International Economics estimates that the average US tariff on Chinese exports now stands at 51.1%, much higher than on other countries. China fears that the US strategy is to pressure other nations to cut China out of supply chains. The trade deals with the UK and Vietnam hint at exactly this strategy which if agreed to by enough countries could harm China’s export engine.
The third support for the world economy has been the excitement over technological advances such as AI which has spurred very large investments. In the US, core capital goods orders, a good lead indicator of future investment has remained robust through May.
But there is uncertainty over whether this can be maintained. Companies are beginning to question whether there has been too much excitement about AI and related areas, and might slow their investment plans. Moreover, as the economy slows, companies will probably defer some of their expansion plans.
Conclusion: recent developments will trigger adjustments that could hurt economic prospects
Overall, even accounting for some possible supporting factors, the world economy is likely to slow and potentially face stresses in financial markets as well.
Beyond that there will be adjustments that will not be helpful to economic growth.
One example is that companies will need to adapt to a world where trade protectionism is much worse than it has been for the last ninety years. They will have to reconfigure supply chains, perhaps having two sets of production networks, one for the US and one for China. This will create great inefficiency, raise costs and reduce profitability.
Another example is that in a world that is buffeted by geo-political tensions, resources will have to be diverted to less productive activities such as defence. The recent Nato summit saw member countries committing to substantially higher targets for defence spending of 5% of GDP by 2035, 2.5 times current levels. Such a large increase can only be funded by reductions in productive spending elsewhere.
In other words, financial markets may be greatly under-estimating the downside risks in geo-politics and the global economy.
Manu Bhaskaran is CEO of Centennial Asia Advisors
