Clouded Vision

Geopolitical uncertainty makes economic planning difficult and rife with contingencies.

Despite a recession looming in Europe and a slowdown in the United States, the world’s economy can be seen as a glass at least half full. Forecasts for 2020 from the International Monetary Fund still see advanced economies expanding—albeit a little slower (by 1.7%, down from 1.9% this year), and the entire world expanding a little faster (by 3.5%, up from 3.2% this year).

However, some politicians and economists—including many central bankers who lately loosened policy with official rate cuts—see a dark fog of risk ahead. The gloom arises from a Pandora’s box of potential events that could negatively impact the world’s economy. Are those who see the glass as half empty (and maybe leaking) overly pessimistic? Or are the threats real?

“My concern is that the next two years will be very difficult because we have so many risks to the global economy,” Marcel Fratzscher, German economist and president of Berlin-based research institute DIW tells Global Finance. “We have the trade conflict between the US and China; I expect that Donald Trump will target the European Union and Germany next. Most likely, we have a hard Brexit ahead of us—which has already created a lot of uncertainty and might create further damage. We have geopolitical conflicts in the Middle East. You have plenty of big risks to the economy, so the next two years could be very tough and we could see further setbacks.”

Unexpected events are much more destabilizing than periodic moderate slowdowns. The possibility of a sudden crisis with international repercussions, similar to the financial meltdown in 2007–2008, is what keeps finance people up at night. What many fear is that something somewhere, goes badly wrong and no one takes action fast enough to forestall disaster. Current sources of uncertainty are making such a “badly wrong” event more likely.

Drone attacks on Saudi Arabia’s oil facilities in mid-September offer an example of unpredictable potential problems. A subsequent spike of 15% in oil prices created worries that global demand could be affected, raising the risk of a recession. In this case, Saudi Arabia brought calm with reassurances that output would soon return to normal, pushing prices back down and quelling recession worries. Still, financial markets are ready to jump on the first sign of a new risk, and ready to bet that a recession can come from any unexpected event.

Old Normal, New Normal

After four interest rate increases in 2018, the US Federal Reserve cut its reference rate in July and again in September, with further cuts expected. In August, a number of central banks in developing economies also slashed their rates. With interest rates so low, some worry that central bankers have few tools to cope with a downturn. Clocking in at more than 10 years, the current expansionary cycle in the US is the longest on record, leaving many holding their breath for the inevitable contraction and anxiously watching for signals of widespread contagion.

Andolfatto, St. Louis Federal Reserve: The trade wars are keeping a lot of people on edge because it is very difficult to foresee what the endgame will be.

“The [economic] outlook is certainly not good. We have seen the world economy slow down significantly over the last 18 months, really,” Andrew Kenningham, chief Europe economist at Capital Economics in London tells Global Finance.

Over the summer, the inversion of the US yield curve—which means short-term borrowing became more expensive than long-term borrowing—was flagged as a typical indicator of a forthcoming recession, sparking some panic. After some soothing words from Fed officials, the panic abated.

“There has been a big contraction in manufacturing production in many countries and a big slowdown in global trade. In contrast, the service sector has held up a bit better. Domestic demand in most countries has been reasonably strong,” Kenningham explains. “You’ve got these two-speed economies. The combination led to the beginning of a new round of policy easing that we are seeing in many countries.”

Many economists expect policy adjustments to work, and remain skeptical that the US will have a recession in 2020. Official figures show the lowest unemployment rate since 1969—but recent years show also the lowest labor force participation rates in the same period.

“We think that some of the very recent gloom and doom in the market is probably a bit overdone,” Kenningham says. “The [financial markets] are actually pricing in four more cuts. We think there will actually end up being only two more, and the chances are that the US will probably avoid a recession.” Still, he acknowledges there is a recession risk.

For Germany and the eurozone, however, a recession may already be in the cards. German GDP contracted by 0.1% in the second quarter of 2019 versus the prior year, and a big drop in its industrial orders in July makes another contraction in the third quarter likely. However, experts expect it to be just a moderate correction.

David Andolfatto, vice president of the St. Louis Federal Reserve, notes a distinction between the clear long-term trend of moderating growth in advanced economies and potential near-term surprises. “In North America and in Europe, we have settled in a type of low-growth regime,” he says. As a decades-long trend, that slower growth is at least predictable.

Economic Warfare

The ongoing trade war between the US and China is probably the major reason for global uncertainty, compounded by the political element of the US presidential election in 2020. Will President Donald Trump inveigh against foreigners in his reelection bid? How will campaigning impact policy? And what could it mean for the specter of protectionism that’s rising around the world?

Fratzscher, DIW: You have plenty of big risks to the economy, so the next two years could be very tough.

Keeping a campaign promise to counter what he deemed unfair trade practices from China, Trump signed two executive orders calling for stricter tariff enforcement in March 2017. The next 30 months saw a back-and-forth in tariff announcements and approvals, talks, suspensions of talks, retaliation, and more and higher tariffs—an escalation between Beijing and Washington that is far from over.

At press-time, $250 billion of Chinese products were subject to a 30% tariff; with another $300 billion of Chinese imports expected to be hit later this year. Virtually all Chinese products are expected to be paying a tariff to enter the US before the end of 2019, or at least before the November 2020 presidential election. In retaliation, China has imposed tariffs of its own on certain US goods.

“The trade wars are keeping a lot of people on edge because it is very difficult to foresee what the endgame will be,” Andolfatto says. “For the United States, I hear anecdotes of businesses delaying certain types of investments. The fear itself can be enough to discourage investments, and it is difficult to see where this is going to end in the future.”

The real impact on the US economy has been relatively modest thus far, mostly because China’s exports to the US still impact a low percentage of US GDP, despite all the political rhetoric. US exports, especially farm products such as soybeans, have been affected the most. The increased cost of importing Chinese goods was offset by a correction in the currency—earlier this year, the Chinese renminbi hit an 11-year low, making Chinese products cheaper—and by companies’ willingness to trim profits in order to avoid putting too much pressure on final demand.

But the US-China spat is exacerbating the worldwide wave of protectionism. Already, companies are reshoring or shifting production, and planning around any future trade disputes.

“There was already a lot of conversation about the need to diversify supply chains. The tariff war that we have been seeing for the past two years has accelerated the need,” says Ted Stank, professor of Supply Chain Operations and Planning at the University of Tennessee. “Starting with 9/11, and due to natural disasters as well as global political issues that have occurred, risk management has become a way larger issue in supply chains,” Stank says. “Whether it is a volcano in Iceland, or an earthquake or tsunami in Japan, or global political issues in Ukraine,” companies are increasingly recognizing the need to prepare for potential disruptions.

What’s more, the prior focus on bottom-line efficiency and just-in-time delivery is yielding to a rising need for adapatibility. “Even if it may not be the most cost-efficient perspective, they need to diversify because of the risk of disruption,” Stank says. “And now in the last two years, because of these trade wars, we are seeing yet another tightened risk to the smooth flow of supply chains.”

Some countries, especially in Asia, are nominally benefiting from the trade war between China and the US. “Many [US] firms with a manufacturing supply that had previously been in China—even if they might not move everything away from China—are looking to places like Vietnam, Malaysia, India, South Korea and Indonesia,” says Stank. “We are seeing a lot of manufacturing development in those countries, at least partly as a result of those sources being moved from China.” Apple, for example, is reportedly moving some iPhone production from China to Vietnam and India.

Long-Term Considerations

However, such choices play out against long time horizons. “These are decisions that have months’ or even years’ worth of implications,” says Stank. “We’re trying to make those decisions based on daily news feeds on what is the relationship between President Trump and President Xi Jinping. We need to take into account what is happening in the geopolitical world that could have an impact on that relationship, whether we will or won’t apply tariffs [and] what products will be subject to tariffs. All of that uncertainty causes supply chain leaders to say, ‘Look, we’re making a decision today that we can’t change instantaneously. We’re going to go to someplace safe, some country that’s not subject—or not likely to be subject—to this kind of uncertainty in tariffs.’ ”

Then again, some believe these pressures could abate once President Trump is out of office. “I happen to think that the Chinese perspective is that they’re just going to try and wait out this administration,” Stank says. “And even if it’s eight years, the Chinese have a very long-term perspective, so they’re not going to make really quick decisions.” He adds, “I think some non-Chinese companies are doing that as well.”

In the meantime, though, manufacturing is suffering worldwide. In the US, the impact on the economy will depend on how the trade war unfolds and whether the government ramps up spending in the run-up to the 2020 presidential election. And it ties back to not just who sits in the White House, but what types of policies emanate from a leading economic powerhouse.

“The single most dangerous risk factor for the world economy is protectionism. Companies’ supply chains have evolved so much in the past that tariffs can have large distortionary effects,” says Gian Luca Clementi, professor of Economics at NYU Stern School of Business. Ultimately, consumers could shoulder the cost. “So far, the impact [of the US trade war] has been very limited,” Clementi continues. “The fear is that this trend may continue and have some real impact [stemming from] a loss in production efficiency.”

Worse, the specter of protectionism reverberates with painful—and troubling—historical echoes. “Up to a decade ago, globalization was considered a positive value. Generation after generation were raised with the idea that there would be no way back to protectionism and obscurantism,” says Clementi. “Now it seems that a dramatic change in the paradigm is happening. There are a lot of parallels between what is happening now and what happened at the end of the first globalization wave, ahead of WWI.”