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India Strategy - Fears of US recession rooted to trade wars potentially derailing a solid economy

The recent easing of economic optimism has prompted bond markets to revive the recession bogie. The risk of recession emanates not from Fed’s past normalization, but more as a policy-induced outcome from Trump pressing hard on punitive China trade actions and retaliations thereof, in our view. On the positive side, things could improve if fears of economic disruption force him to back off. Hence, the case for Fed changing its stance and easing rates is linked more to spillover from ongoing trade conflict.

US markets pricing a recessionary outlook again?

The US markets are back into pricing in a recessionary outlook, given the sudden rise in jobless claims (222,000 in first week of Jun 2019) and dip in non-farm payroll data (75,000 in May 2019). Continued decline in ISM manufacturing to 25.1 in May provides additional fodder with lead indicators for June too sustaining the deceleration.

Aligning to these high frequency data, the decline in core PCE inflation (1.6% in Q1) along with yield curve inversion (10 year treasury at 2.06% is lower than effective fed rate at 2.4%) reinforce expectation of change in Fed’s policy stance soon and eventually its capitulation through rate easing.

We believe the weakening economic sentiment largely emanates from re-emerging of trade conflicts between China and the US, with the US taking an aggressive stance to China’s gradualism to accommodate US demands to its satisfaction. This factor was also the cause of the slump seen during Dec 2018 to Feb 2019. During the time, hopes of thawing of conflict revived, as the two sides sat for negotiations. The same eventually fizzled out in May-Jun 2019.

The uncertainty on the trade front has got companies guessing on their investments and hiring plans, even though it threatens to impact global trade outlook. The same has already been marred by restricted trade practices over last 10 years, led by the US as reflected in data from Global Trade Alerts.

While the base-case expectation is of a slowdown in growth from the high levels seen in 2018 and Q12019, we believe the risk for US recession will arise more from prolonged aggressive US trade policy position and NOT from Fed’s policy stance.

Indeed, the confidence in Federal Economic Policies, a proprietary IBD/TIPP measure of views on how government economic policies are working, declined by 4.9 points to 50.7. This has contributed to the fall in Economic Optimism Index to 53.2 in June 2019 from a 15-year high of 58.6 in May 2019.

Economic indicators still healthy, Infliction from trade conflicts a concern for Fed

The current real Fed rate at 0.9% (fed rate of 2.5% less core inflation of 1.6-1.7%) is not very restrictive, even with respect to a liberal estimate of real neutral Fed rate of 0.5-0.6%. In any case, interest cost that the entire US economy pays out is just about 3% of GDP, nearly half the level ten years back. Corporate profit to GDP ratio is still at a 70-year high of 11% (2018).

Thus, only if the trade conflicts start to inflict major damage to the US momentum, it would be imperative for the Fed to respond with easing. Conversely, on the positive side, the risk of Trump-recession could turn positive, if fears of a slowdown force the US to ease off the trade pedal.

As of today, US leading indicators reflect a gradual slowdown picture versus fairly strong performance in 2017-18 and Q12019. Consumer sentiment remains strong and labour markets exhibit robust conditions. Despite some easing of economic sentiment indicators, small business sentiment indicators have revived. The manufacturing ISM index has moderated meaningfully after the bump-up in 2018.

From Fed’s stand point, while core inflation and import price inflation have moved down in the recent months, the trimmed mean PCE inflation remained above Fed’s inflation target of 2%.